Posts Tagged ‘capital goods’

Real economy suffers while financial markets stuff around with prices

Thursday, October 9th, 2008

In yesterday’s ABC 7:30 Report, Associate Professor Steve Keen commented that in the context of today’s global financial crisis,

Well I think Kerry I can actually make a reference to what’s happened to the Australian dollar say every price you see is crazy.

There is no way the prices of anything make any sense at the moment.

Prices in the financial markets are extremely volatile right now. Even prices of commodities (e.g. base metals, oil), gold and silver are moving much more rapidly then we expected (remember a few weeks ago when gold rose by almost US$100 in 2 days?). Currency exchange rates are also very extremely volatile, as we witnessed the fall of the Australian dollar from around US$0.97 to US$0.64. It was just a couple of days ago when the Aussie dollar was around $0.73. Now, at this time of writing, it is US$0.70.

Such volatility and irrationality of prices, if sustained over a much longer period of time, can eventually damage the economy structurally. To understand why, consider what we said in The myth of financial asset ?investments? as savings,

… saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

The accumulation of capital goods requires a time lag whereby current consumption is postponed for future benefits. Improved standards of living come to the public from the fruits of capital investment.

For example, producing metals is a very capital-intensive activity. The stages of production includes:

  1. Exploration
  2. Digging large quantities of dirt, which requires expensive, complex and expensive equipment.
  3. Construction of nearby infrastructure (e.g. roads, railways, power stations, development of water supplies and townships) due to the remoteness of mining projects.
  4. Protection of environment, which increase capital and operating cost.
  5. Extraction of ore from dirt.
  6. Processing of ore.
  7. Refining of metal concentrates.
  8. Shipping and transporting to destinations.

Thus, a mining project from start to finish can take several years. Therefore, you can see that the accumulation of capital goods is long term processes in the economy. As such, all these industrious activities require long-term planning.

What if in the interim, prices are extremely volatile, ‘crazy’ and irrational?

As the late Professor Murray Rothbard wrote in What Has Government Done to Our Money?,

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations.

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinders long-term planning.

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades (see Example of a secular trend- commodities and the upcoming rise of a potential superpower and The Problem that can throw us back into the age of horse-drawn carriages). Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

With long-term planning made much more difficult, how is it possible to engage in investments that allows the nation to continue to accumulate capital goods? Without the ongoing accumulation of capital goods and too much monetary capital wasted on either hoarding, bailing out bad investments and patching a dysfunctional financial system, there wouldn’t be a proper and efficient allocation of monetary capital. The economy will be engaging on capital consumption. If a nation starts to consume its capital, how can there be real economic growth. Without real economic growth, how can future generations enjoy a more plentiful and prosperous existence?

As we ponder on the long term implications of today’s volatile, ‘crazy’ and irrational prices, we saw a sampling of such a phenomenon in one of the news article today, Volatile economic conditions unsettle farmers,

UNDER normal circumstances, an interest rate reduction coupled with a devaluing of the Australian dollar would make farmers very happy indeed.

But not this time, according to National Farmers Federation vice-president Charles Burke.

“There are some other factors at play at the moment that none of us really know how to measure,” Mr Burke said.

“Nor do we know how to deal with it because we don’t know how long it will last.”

That’s why the Austrian School of economic thought advocate a painful deflationary liquidation of mal-investments (read: severe recession/depression) in order to clean out the rot in the system, put on a sound monetary system so that the economy can get back on its feet as soon as possible from a clean slate. But central bankers and governments are trying their utmost to drag on this war between deflation and inflation indefinitely, which means more uncertainty ahead for the foreseeable future.

The first step in an economic slowdown?mal-investment in capital

Tuesday, February 13th, 2007

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 which is not found in other school of economics.

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!

The myth of financial asset ?investments? as savings

Friday, February 2nd, 2007

Today, the savings rate of the United States has never been lower since the Great Depression. This is a very serious concern that should never be underestimated. However, there are some who argued that if we include financial asset ?investments? such as home equity, pension and managed investment funds, stocks and so on, the savings rate is actually positive.

Here, we wish to dispel this myth.

First, we would need to understand what the true nature of savings is. In Chapter 15, Section 2 (Capital Goods and Capital) of Ludwig von Mises?s book, Human Action: A Treatise on Economics:

At the outset of every step forward on the road to a more plentiful existence is saving?the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e. tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods. Thus, saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

Goods that directly relieve a need or want are called consumer goods. Capital goods, on the other hand, are goods that help in the production of consumer goods?they increase the future productive capacity of the economy. As we all know, the economy has a finite quantity of resources. It has to choose between producing consumer goods for current consumption or capital goods which will help in producing future consumer goods. Furthermore, capital goods depreciate over time?resources are required to maintain them. The extent in which the people in the economy choose to produce (and maintain) capital goods over consumer goods constitutes the savings rate of the economy.

For example, let?s say we save $100 in the bank. The bank then lends out $90 to an entrepreneur who uses it to set up a business enterprise that will produce goods that consumers want down the track. In this case, the $100 that we save is a sacrifice on our current consumption. Part of that $100 of ours is then put in good use to add value to the economy in the future. In return for my sacrifice, we are paid interest.

In another example, let?s say a company decides to raise money in the stock market to fund its expansion plans. We invested $100 in that company?s IPO. That company then uses our $100 to build a new manufacturing plant that will produce consumer goods in the future. In this case, that $100 that we invest is considered savings since it involves us sacrificing current consumption worth $100. In return for our sacrifice, we are paid dividends from the company?s future earnings.

Now, based on this understanding on savings, can our home equity be considered savings? We have ‘equity’ in our homes if its current value exceeds the amount we owed. But the problem with such ‘equity’ is that it depends on the home’s current value, which is merely a paper value based on the principle of imputed valuation (see Spectre of deflation for the concept of imputed valuation). As we said before in The Bubble Economy, since the phenomena of inflating home values is mainly due to the increase in money supply (colloquially known as ?printing money?), they cannot be considered as savings as they do not have any resulting influence in the increase of capital goods in the economy. In the same way, if we buy and sell existing stocks (as opposed to newly issued ones in an IPO) in the stock market, are we in any way contributing to the accumulation of capital goods in the economy?

As the financial side of the economy (see Analysing recent falls in oil prices?real vs investment demand on the concept of the real and financial side of the economy) becomes increasingly influential in the economy, we wonder how much this side contributes to the amassing of capital goods, which is the foundation of building the future wealth of the nation? Can the printing of money, which spawns the growth of an industry to shuffle it, cause a nation to be richer in the long run?