Primarily a critique of the financial assumptions underpinning Keynesian economics, The Formation of Capital presents the case for "pure credit" as the source of financing for new capital formation and the soundest approach for the source of funding for a sustainable economic recovery.
Pure credit refers to the fact that it is possible to enter into a contract — create money — without first having had to cut consumption and accumulate money savings. Again, the assumption that the only way to finance new capital formation is to cut consumption and accumulate money savings is the fundamental principle and common ground on which the three mainstream schools of economics agree, whether they are Keynesian of any stripe, Monetarist/Chicago, or Austrian.
The past savings doctrine, a basic tenet of the British Currency School of finance, may be why Louis Kelso believed binary economics and mainstream economics were permanently irreconcilable. Kelso may not have given sufficient consideration to the fact that classical economics, from which the three mainstream schools of economics claim descent, was divided into Currency School (which mandated past savings) and Banking School (which accepted Say's Law and the real bills doctrine), and was thus divided on the definition of "money."
The presumed primacy of past savings as the sole source of financing for new capital formation is basic to both the Keynesian and Austrian schools. The Formation of Capital is directed at presenting an alternative to the Keynesian New Deal, but in an appendix takes a look at the analysis of the Austrian school, especially as presented by Friedrich von Hayek. As Moulton explained,
"We may first consider the analysis of the Austrian economist, Dr. F. A. von Hayek, now at the London School of Economics. The following statement is based upon his little volume entitled Prices and Production and upon subsequent articles elaborating his point of view. The basic assumptions which underlie Mr. Hayek's analysis are indicated in the following summary statement:
What happens . . . when somebody saves a part of his income hitherto devoted to consumption . . .? Clearly the demand which is directed to means of production [capital goods] increases, and that directed to consumption goods correspondingly decreases." (Economica, May 1931, p. 142.) "At first the new savings will serve the purpose of transferring a portion of the original means of production previously employed in producing consumers' goods to the production of new producers' goods." [Italics Hayek's. This transfer is induced by changes in the relative prices of capital goods and consumers' goods.] (The same, p. 140.) "The immediate effect of the increase in the demand for producers' goods and the decrease in the demand for consumers' goods will be that there will be a relative rise in the prices of the former and a relative fall in the prices of the latter. (Prices and Production, p. 70.)
"It will be observed from these quotations that Hayek assumes that the formation of capital involves a transfer of labor and materials from the creation of consumers goods to the creation of capital goods — this being accomplished by the price mechanism. It is implied, it will be seen, that our productive forces are normally fully employed and that it is impossible in consequence to increase the production of capital goods and consumption goods simultaneously. Hayek submits no evidence to show (a) that the expansion of capital occurs when consumption is declining, or (b) that the prices of capital goods rise while the prices of consumers' goods fall. These are mere assumptions, and they find no support in the data which we have assembled in the course of our investigation.
"Hayek notes that in periods of depression there is some slack in the industrial system, but he bases his primary argument on the assumption that we have full productive capacity. He states that "the assumption of an 'industrial reserve army' is incompatible with the known facts and theoretically inadmissible as a starting point for a theory which attempts to show the causes of crises on the basis of the modern 'equilibrium theory' of price determination." (Economica, May 1931, p. 140.) As our studies conclusively show, there remains a large amount of slack in the industrial system even at the peak of boom periods.
"Hayek next considers the effects of expanding bank credit upon the formation of capital. When bank money is loaned to business men with which to employ labor and materials for the construction of capital, he argues, "entrepreneurs are in this case enabled to attract factors of production . . ., not by a corresponding transfer of funds from consumers' to producers' goods but by additional money handed to them. This means that they will bid up the prices of these factors without there being a corresponding fall in the prices of other factors. Total money income will, therefore, increase, and this increase will in turn lead to an increase in the amount of money expended on consumers' goods." (Econometrica, April 1934, p. 158.) While the prices of consumers' goods will thus rise, they will lag behind the rise in the prices of capital goods. Eventually, after the issue of new bank credit ceases, the prices of consumption goods will rise in relation to the prices of capital goods and depression will ensue. Hayek finds the basic source of maladjustment to be the extension of credit; and he believes a "neutral money" policy would give us permanent stability.
"Again it will be observed that 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.
"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."