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Tuesday, July 27, 2010

Interest-Free Money, Part V: The Formation of Capital

Conventional economic wisdom declares that you cannot finance the formation of new capital unless you cut consumption, save, and then invest. Logically, this means that ownership of the means of production must be concentrated, and that the great mass of people must rely exclusively on wages and redistribution for their income.

Keynes and von Hayek

Nowhere is this reliance on existing accumulations to finance capital formation and its effect on our understanding of money and the rate of interest more highly developed than in the economic theories of Friedrich von Hayek. Ironically, although von Hayek and Keynes considered themselves opposed, they agreed on this most fundamental and yet false economic assumption. They differed only on how or to what degree the quantity of money should be manipulated, and whether or to what degree the State should set the rate of interest.

Von Hayek's ideas on money, credit, and banking came from Ludwig von Mises who, as we might expect, was an adherent of the British Currency School — the belief that "money" consists solely of coin, currency and (on occasion) demand deposits and selected time deposits. This "Austrian School" generally includes currency backed by government debt under the definition of money, but claims that it is not legitimate. Specie — gold — is the only legitimate currency and the only basis of a sound monetary policy.

According to von Hayek, ups and downs in the economy can adequately be explained by State interference in the free market. The central bank of a country causes booms and the consequent depressions/recessions by inflating the currency and misallocating credit by means of its monopoly power used to artificially raise and lower interest rates.

As von Hayek explained, "The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process." A monopoly, especially a State monopoly like a central bank, does not have the necessary knowledge, contained only in the general consensus of the free market, to determine the quantity or the price of money, or how to use it.

Naturally, the Keynesians counter that State-issued fiat money à la Knapp's chartalism (Knapp, The State Theory of Money, op. cit.) backed by the government's power to collect future taxes is just as legitimate as specie — and certainly more amenable than gold and silver to management in order to achieve political goals. The economy can't be expected to run itself — not when capital formation can only be financed out of existing accumulations of savings, and capital is responsible for a greater and greater share of production.

Income generated by capital goes by right of private property to the owner of capital. The increasing productivity of capital (even though measurements of productivity are, paradoxically, always in terms of "labor hours") ensures that a relatively smaller share of production, and thus income (effective demand), goes to labor.

Therefore, in order to ensure that most people have sufficient income (effective demand), the State necessarily re-edits the dictionary with respect to the definition of private property by changing the definition of money — to be sound, remember, money must be connected through the institution of private property to the present value of existing or future marketable goods and services. The State then engineers redistribution of effective demand through inflation, minimum wage legislation, and transfer payments. This requires constant "fine tuning" of the economy to ensure that just enough effective demand is transferred to consumers, and just enough in savings is transferred to producers.

Inflation and "Forced Savings"

Friedrich von Hayek, while he made his own monetary mistakes, was quite correct in singling out Keynes's collectivism — "aggregates" — (in addition to an endless argument over the effect of interest rates on the rate of profit for business) for condemnation when he critiqued Keynes's 1930 Treatise on Money. As one commentator analyzed the situation,

In an extended critique of this early rendition of Keynesianism, F. A. Hayek found many inconsistencies and ambiguities, but his most fundamental dissatisfaction derived from Keynes's mode of theorizing — from his "language and apparatus": "Mr. Keynes's aggregates conceal the most fundamental mechanisms of change" (Hayek, 1931a: p. 227). Keynes had argued that changes in the rate of interest have no significant effect on the rate of profit for the investment sector as a whole. Hayek's point was that profit reckoned on a sector-wide basis is not a significant part of the market mechanism that governs production activity. A change in the rate of interest means that profit prospects for some industries rise, while profit prospects for others fall. The systematic differences in profits rates among industries, and not the average or aggregate of those rates, are what constitute the relevant "mechanisms of change." There were fundamental shifts in Keynes's thinking during the six years between his Treatise and his General Theory, but none that could be considered responsive to Hayek's critique. In the General Theory, impenetrable uncertainty about the future clouded the decision processes of investors and wealth holders; the interest rate became a product of convention and psychology, largely if not wholly detached from economic reality; changes in market conditions were accommodated by income adjustments rather than price or interest-rate adjustments; and unemployment equilibrium became the normal state of affairs. (Roger W. Garrison, "Is Milton Friedman a Keynesian?" Mark Skousen, ed. Dissent on Keynes: A Critical Appraisal of Keynesian Economics. New York: Praeger Publishers, 1992, 131-147.)
The logical conclusion of Keynes's thought is that the State owns everything, and everyone becomes an economic as well as political slave of the State. To paraphrase Henry George, the State becomes the universal proprietor without calling itself so. (Henry George, Progress and Poverty. New York: Robert Schalkenbach Foundation, 1979, 406.) Further, Keynes assumed as a given that "everything" consists exclusively of existing inventories of wealth. (John Maynard Keynes, General Theory of Employment, Interest, and Money, 1936, II.7.v.) This is a logical conclusion from the assumption that existing accumulations of savings are absolutely necessary to finance new capital formation. Von Hayek and the other members of the Austrian School, along with the Monetarists and virtually every economic school today, accept this assumption almost as a religious dogma.

The shared concept of "forced" or "involuntary" savings illustrates this acceptance of the presumed necessity for existing accumulations of savings to finance capital formation. Binary economists have, in the past, used "forced" and "future" savings as equivalent terms. This may have engendered as much confusion within the limited scope of this and similar discussions as has the term "capitalism" in the wider world outside the narrow confines of political economy.

We will therefore from now on try to describe the saving that results from using the future stream of income to finance capital formation as "future savings," and restrict the terms "forced" or "involuntary" savings to the sense used in so-called "mainstream economics." This should be useful, for the concept of future savings as used by Kelso and Adler is a beneficial process, while the idea of forced or involuntary savings, as described by, e.g., Keynes (Keynes, General Theory, op. cit., II.7.iv; IV.14.i; V.21.i; VI.22.iii.) and von Hayek, (Friedrich von Hayek, Monetary Theory and the Trade Cycle. New York: Augustus Kelly, Publishers, 1966, 218-226.) describes what can only be described as massive theft. As demolished by Moulton, however, the concept loses all credibility:
Many economists have contended that the use of bank credit for purposes of capital expansion does not obviate the necessity for concurrent saving — using the term saving in the sense of restricting consumption. They argue that instead of voluntary saving for the purpose of accumulating funds for capital expansion, the use of bank credit for the purpose forces involuntary saving. It is held that the result of the expansion of bank credit is merely to raise the general level of prices, and that since money wages and most other income remain the same, the real purchasing power of the masses is restricted. The expansion of capital thus appears still to have been at the expense of consumption.

This analysis completely overlooks the dynamics of the process. It fails to note that the rate of capital formation would be less rapid if business enterprisers had to wait until money savings were first accumulated. It thus fails to see the effects of accelerating capital expansion upon productivity and the volume of national income. Thus it is possible to increase the supply of capital goods without an antecedent or concurrent restriction of consumption. The truth is that the accelerated capital expansion and increased productivity result in an increased output of both capital goods and consumer goods. Thus real wages are increased. The history of capital expansion and wage and price trends in the United States affords no support for the theory that bank credit expansion merely means involuntary saving. Nor do the facts support the thesis that savings in the sense of positively reducing consumption is essential to the formation of capital. (Note in quoted text: "See Moulton, The Formation of Capital, pp. 37-43."), (Harold G. Moulton, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940, 26.)
The key sentence in this passage, and the most concise statement of the concept of "forced savings," is, "It is held that the result of the expansion of bank credit is merely to raise the general level of prices, and that since money wages and most other income remain the same, the real purchasing power of the masses is restricted." That is, there are two beliefs as fixed as they are false of the Currency School and its many heirs that Moulton addresses:
1. Investment in new capital can only take place after saving has occurred. (Moulton, The Formation of Capital, op. cit., 47-48.)

2. Saving is narrowly defined as cutting consumption. (Moulton, Capital Expansion, loc. cit.)
Since these two fixed beliefs are considered absolutes, virtual religious dogmas, in fact (dissent from which is considered "heresy"), (Joseph A. Schumpeter, The Theory of Economic Development. New Brunswick, New Jersey: Transaction Publishers, 1993, 96-97.) they cannot, and, indeed, are not questioned. New capital formation can thus be financed (according to Keynes) by inflating the currency. Consistent with the quantity theory of money, inflating the currency drives up the price level. Adherents of the Austrian School claim that this process takes place even if there is no increase in the price level. (Friedrich von Hayek, Monetary Theory and the Trade Cycle, loc. cit.) Because wage incomes tend either to remain at the same level or lag behind the price level, people reduce consumption as their wage purchasing power and the value of their savings evaporate. This meets the definition of "saving" used by economists today.

"Somewhat Comprehensive Socialisation"

To make certain that just enough new capital is financed, the State also needs to set the rate of return to capital — the interest rate — and the allocation of resources to production. As Keynes explained,
The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. (General Theory, V.24.iii)
"It is not the ownership of the instruments of production which it is important for the State to assume." In other words (as Henry George pointed out), legal title is irrelevant as long as the State exercises absolute control. Despite the apparent mildness of the words, what Keynes proposed was not "somewhat comprehensive socialization" — "somewhat comprehensive"? — but socialism, period. As lawyer-economist Louis Kelso pointed out, "Property in everyday life, is the right of control." (Louis O. Kelso, "Karl Marx: The Almost Capitalist," American Bar Association Journal, March 1957.)

Both Right and Wrong

Ironically, both the Austrians and the Keynesians are right — and both are wrong.

The Austrians are correct that, in a democracy based on natural rights and sovereignty of the person, the State has no business telling people how much return they can receive on their savings — that is, in setting the interest rate, whether low to encourage investment, or high to inhibit capital formation. Neither does the State have any business manipulating the currency to restrict or inhibit either consumption or saving. All these are outrages against human dignity and a violation of personal sovereignty by interfering with the natural mechanism of the free market. Interfering with nature causes the drastic swings in the business cycle.

The Keynesians are correct that, assuming a system in which capital formation is financed exclusively out of existing accumulations of savings (a false assumption), and capital is rapidly becoming increasingly productive relative to labor as technology advances, effective demand can decline catastrophically unless the State steps in and redistributes purchasing power. Similarly, if people are consuming too much, there will presumably not be sufficient savings in the system to finance the new capital formation essential to job creation. That being the case, the chief economic — and political — goal of the State is to reach full employment. This requires careful manipulation of interest rates, the quantity of money, and tax policy to ensure that the State, working together with the central bank, achieves exactly the right mix to reach full employment: Keynesian "fine tuning."

Thus, from the Keynesian perspective, the only hope for people within a system enslaved to existing accumulations of savings is for the State to seize control of the central bank, and manipulate the interest rate and allocate resources to try and reach full employment. This is intended to put as many people as possible into wage system jobs, or maintain them on welfare by inflating the currency to fund transfer payments. Ultimately, nothing matters except pumping enough liquidity into the economy to redistribute sufficient effective demand to stimulate new capital formation and thereby create jobs. (Vide Keynes, General Theory, op. cit.,

Yes, both the Austrians and the Keynesians are right — given their basic assumption about the necessity of existing accumulations of savings to finance capital formation. To the Austrians, freedom is more important than the laws of economics, although they assert that the laws of economics would, presumably, operate properly if the State would stop interfering. To the Keynesians, the laws of economics are more important than freedom, although they tend to believe that if people would act rationally instead of insisting on natural rights such as liberty (freedom of association) and private property, the most basic right of all, the right to life, would presumably be secured by adequate provision for humanity's material needs supplied via a wage system job.

It does not appear to occur to either the Keynesians or the Austrians that it is possible to reconcile both the laws of economics — based on human nature — with humanity's natural rights, also based on human nature. The only thing necessary for such a reconciliation is for adherents of both schools (to say nothing of virtually all the other modern schools of economics) to surrender their dogmatic belief that capital formation can only be financed by cutting consumption, saving, then investing.

Capital Financing Under Past Savings Assumptions

As far as von Hayek was concerned, the question of how investment in new capital was to be financed answered itself. All that is necessary is for the State to step aside and let the free market function properly. If there are insufficient savings in the system to finance new capital, a rise in interest rates will bring new savings into the market, either by encouraging more saving, bringing in marginal savers, or through capital movement into the country. If there is too much, a naturally lower rate of interest will discourage additional saving, promote dissaving (consuming more than is currently being produced), or force savers to seek better investment opportunities outside the country. The ownership of all new capital is thereby concentrated in the hands of whoever has been able to refrain from consuming to a degree sufficient to generate the savings necessary to finance the new capital.

The Austrian analysis recognizes the importance of the market, and the fact that when the State sets interest rates or manipulates the quantity of money, it violates the very rights it was established to protect. The Austrian analysis does not, however, recognize that there are barriers that exist to entry into the market, so that it cannot truly be called "free" even if the State leaves the market strictly alone.

The chief barrier to free entry into and participation in the market is the restrictive definition of money on which the Austrians as well as the Keynesians insist. Defining money solely in terms of specie or State-issued purchase orders restricts entry into the market to those who either already have existing accumulations of savings, anyone who receives a redistribution of wealth from the State, or who is able to persuade others to let them use existing accumulations belonging to those others. Given the erroneous assumption that it is impossible to monetize the present value of existing and, especially future marketable goods and services, and that "money" consists exclusively of State-issued coin, banknotes, demand deposits, and some time deposits (i.e., M2), State control of money and credit, as well as allocation of resources would, the Keynesians assert, solve the problem.

Neither the Austrians nor the Keynesians recognize commercial banks and central banks as institutions that can create money out of a borrower's private property interest in the present value of existing and future marketable goods and services. Instead, both schools consider a bank to be an institution that exists solely to lend out existing accumulations of savings. Given this assumption, when either a commercial or central bank prints banknotes or creates demand deposits in excess of deposited savings, purchasing power is transferred through an increase in the price level.

When the increase in the money supply goes to people who previously had nothing to spend, there is an increase in effective demand — income. Consumption increases because people who previously had no money, now have money and are able to consume. When units of the devalued money go to people in payment of their wages, the increase in the price level forces wage earners to consume less. This decrease in consumption "forces" savings that can be used to finance new capital formation. The ownership of all new capital is thereby concentrated in the hands of whoever has been able to refrain from consuming to a degree sufficient to generate the savings necessary to finance the new capital, or who has been granted a State subsidy financed by inflating the currency or confiscatory taxation.

Thus, according to both Keynesians and Austrians, because ordinary people cannot afford to cut consumption and save in appreciable amounts, economic growth absolutely requires a class of extremely rich individuals — the richer, the better — who not only can afford to save, but are actually forced to save because they cannot possibly consume their enormous incomes. Only in this manner will there be sufficient savings in the system to finance new capital formation and the system function properly.

This is because the rich reinvest their unconsumed income in additional new capital, thereby creating wage system jobs for the rest of humanity, with the State taxing away any excess for redistribution. As Keynes declared, "The immense accumulations of fixed capital which, to the great benefit of mankind, were built up during the half century before the war, could never have come about in a Society where wealth was divided equitably." (John Maynard Keynes, The Economic Consequences of the Peace, 1919, 2.iii) In other words, unless most people are deprived of their natural right to own a capital stake (
Leo XIII, Rerum Novarum ("On Capital and Labor"), 1891, § 46) large enough to generate a secure income sufficient to meet common domestic needs adequately (Pius XI, Quadragesimo Anno ("On the Restructuring of the Social Order"), 1931, § 71), the economy will not function properly.

Reality Check

That's the theory, anyway. As even Keynes admitted, however, matters don't work out that well in practice. The problem is that since "power naturally and necessarily follows property" (Daniel Webster in the Massachusetts Constitutional Convention of 1820), what happens is that private interests inevitably take over the State and operate it to their advantage. Walter Bagehot described this process in The English Constitution (1867) and the result of the process in Lombard Street (1873). To Bagehot, "democracy" meant that England was ruled by an economic oligarchy,
i.e., the financial and moneyed classes ran the British Empire by controlling parliament through the "rotten borough" system. The rest of the people were too stupid ("not quick of apprehension") to run their own lives, much less the Empire.  These "real" rulers of England were not to be confused with the "the Upper Ten Thousand," who, with the Queen at their head, ruled society.

Inevitably, the State has to step in and either create or control (i.e., "own") the economy in place of the "despotic economic dictatorship." (Pius XI, Quadragesimo Anno ("On the Restructuring of the Social Order"), 1931, §§ 105-106.) By this means the State is supposed to encourage the rich to save more, thereby reducing effective demand. To offset the decrease in effective demand, the State is forced to regulate the interest rate — the rate of return to capital — and otherwise manipulate the financial system, inflating or deflating the money supply in order to achieve just the right mix to ensure full employment or low inflation, whichever seems more desirable to the politicians at any given point in time.

Both the Austrians and the Keynesians are therefore in fundamental agreement that the system works this way. The only real conflict between the two is whether a "free" market that prevents most people from entering or participating in any meaningful sense, is superior to a market in which the State attempts to ensure that, regardless of their inputs to the production process or degree of participation in the market, everyone has an adequate and secure income through a wage system job.

From the standpoint of the Just Third Way, both the Austrians and the Keynesians are wrong. This is not because the market would not function in the manner described given that existing accumulations of savings are the sole source of financing for new capital formation. On the contrary, it is because the market does not function in the manner described, for the simple reason that existing accumulations of savings are not the sole source of financing for new capital formation. That being the case, the interest rate — specifically the return on existing accumulations of savings as opposed to the return on capital — artificially manipulated or set by the market, might not be as critical a factor in financing the formation of new capital as either Keynesians or the Austrians believe.