But wait — it gets worse. The fixed idea in virtually all of modern economics, finance, and (alas) politics is that the only way to finance new capital formation is to cut consumption, accumulate money savings, and then invest. That is, economic growth and development are tied irrevocably to what Louis Kelso and Mortimer Adler called, "the slavery of [past] savings."
Now, the actual phrase that Kelso and Adler used in the subtitle of their second collaboration in 1961, The New Capitalists (lousy title, great ideas), was "the slavery of savings." The word "past" is our addition, put in brackets to show the exercise of editorial license. This, of course, raises the issue as to why we differentiate "savings" and "past savings." Aren't all savings the same?
No — and that's the problem. In The New Capitalists, Kelso and Adler define "savings" as, "the use of goods or services to produce capital goods rather than for immediate consumption." (The New Capitalists. New York: Random House, 1961, 9-10 . . . and, sorry, the page references are to the print edition, not the .pdf provided by the Kelso Institute, and won't match up.) But . . . wait a minute. Doesn't that mean that you have to cut consumption in order to divert goods and services to produce capital goods?
No. First, of course, to the supplier of goods and services, whether they are consumed or invested by the purchaser, it's all consumption — there are two sides to every equation, and you need to look at both sides, just as you do in the accounting equation to distinguish ownership from what is owned. With respect to production, consumption, and income, as Adam Smith noted, the purpose of production is consumption. Embodied in Say's Law of Markets, all production is supposed to end up as consumption. If it doesn't, it's because something is out of balance, usually the fact that those who would consume cannot consume because they can't produce. Ideally, however, production not only equals income, it equals consumption.
The key word in this respect in Kelso and Adler's definition is immediate. The seller is indifferent whether the purchaser uses the seller's productions for immediate consumption, or to form capital to produce other goods and services for consumption. All the seller knows — or needs to know (as long as the invoice is paid) — is that the seller's produce is sold. The seller then realizes revenue. Out of this revenue the seller repays the financing of the capital used to produce the goods sold (thereby generating revenue for someone else), or uses as income to purchase goods for immediate consumption (again generating revenue for someone else). In this way, production in the aggregate not only equals income, it also equals consumption.
Thus, from the standpoint of the seller and the system as a whole, there has actually been an increase, not a decrease in consumption. Harold Moulton pointed this out in his comments on Friedrich von Hayek's analysis of the saving process. As Moulton explained, "Hayek assumes that the creation of new capital necessarily involves a diversion of labor and capital from the production of consumption goods to the creation of capital goods. Again he cites no evidence either in support of the diversion theory or to show that the prices of capital goods and consumers' goods move in the ways indicated." (The Formation of Capital. Washington, DC: Economic Justice Media, 2010, 166.) As Moulton concluded,
Hayek's analysis breaks down at its very beginning. The assumptions on which he predicates his whole argument are not in accordance with the facts of the business world. Moreover, the central issue in the problem of capital formation, namely, the relationship between consumptive demand and the demand for capital goods, has not been analyzed. (Ibid.)If it is not necessary to cut consumption in order to save, however, then what is the source of the financing for new capital? Anyone following this blog on a regular basis has the answer to that: expansion of commercial bank credit. As Moulton explained,
Funds with which to finance new capital formation may be procured from the expansion of commercial bank loans and investments. In fact, new flotations of securities are not uncommonly financed — for considerable periods of time, pending their absorption by ultimate investors — by means of an expansion of commercial bank credit. (Ibid., 104.)To summarize the process very briefly, someone with a productive project — capital — for which he or she has a sound and properly vetted proposal takes the proposal to a commercial bank. The loan officer of the bank looks over the proposal and, if he or she finds that it is sound, agrees to "loan" the money for the project. The "borrower" draws a bill on the present value of the project (creates money), and "discounts" the bill at the commercial bank in exchange for the commercial bank's promissory note.
The bank may use the promissory note to back smaller fungible promissory notes called "banknotes," or a demand deposit created for the borrower, on which the borrower can draw checks, a check being a form of bill of exchange. The borrower finances the new capital with the banknotes or demand deposit, puts the capital into production, markets the good or service, realizes a profit, and repays the loan — more accurately, redeems the original bill of exchange he or she drew on the present value of the new capital. In this way the money supply expands and contracts with the needs of the economy and, assuming most or all the capital projects on which bills are drawn are sound, the currency is both adequate and stable.