In our previous article, The real story behind the phenomena of booms and busts, we mentioned that when the central bank finally raise interest rates, the economy will slow down as ?entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut.?
Why would entrepreneurs have to slow down their rate of investments, which result in an economic slowdown? To answer this question, we have to understand that capital can be mal-invested. The reason why capital can be mal-invested is because it has structure, which is one of the key insights of the Austrian School
What is the structure of capital?
Recall that in The myth of financial asset ?investments? as savings, we mentioned that capital goods are ?goods that help in the production of consumer goods?they increase the future productive capacity of the economy.? Capital goods that are directly used in the production of consumer goods are termed ?first-order? capital goods. An example of a first-order capital good is a sewing machine that is used to produce clothing for consumers. Capital goods that are used in the production of first-order capital goods are called ?second-order? capital goods. An example of a second-order capital good is the robot that put together the sewing machines in the assembly line. The third-order capital good are then used in the production of second-order capital goods and so on. Thus, capital goods can be arranged from the first-order up to the higher orders?this is the vertical structure of capital. Capital can also have horizontal structure. Some capital goods are complementary to other capital goods in the production of other goods. For example, computer software and hardware are complementary capital goods. In reality, the capital structure can be more complex?capital goods can play different roles in the horizontal and vertical chains simultaneously and may perhaps function as a consumer good at the same time.
As Ludwig von Mises said in Chapter 20 (Interest, Credit Expansion and the Trade Cycle), Section 6 of Human Action: A Treatise on Economics
It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. The entrepreneurs employ the available supply of r + p1 + p2 as if they were in a position to employ a supply of r + p1 + p2 + p3 + p4. They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later. The unavoidable end of the credit expansion makes the faults committed visible.
Now, we return to our original question: why do entrepreneurs have to slow down their rate of investments? Based on our new understanding capital structure, it is more accurate to say that entrepreneurs not only have to merely slow down their rate of investments, they may even have to liquidate their investments due to their errors in judgements. As the economy booms, entrepreneurs make plans and invest in the belief that the economy’s capital structure will provide the necessary higher-order and complementary capitals in the future. What happens when capital are mal-invested, leading to an unbalanced structure of capital in the economy? The entrepreneurs’ plans will fail, which mean they will have to liquidate their investments. When that happens en masse, it will result in what we see as layoffs, cancelled projects and so on.
How would this work out in real life? Stay tuned!
Tags: ABCT, Austrian Business Cycle Theory, business cycle, capital goods, entrepreneurs, first order, Ludwig von Mises, mal-investments, over-investments
