Video Transcript: Austrian Capital Theory - Roger W. Garrison

This is on Austrian capital theory. And as you can see in the subtitle, it's a  prelude, prelude to capital based macroeconomics, more specifically, a prelude  to discussion on Austrian theory the business cycle, although in my own writings in time and money. I make it clear that capital based macroeconomics has a lot  more to say about other parts of the economy than just business cycles, but  business cycles are the most fully developed of the Austrian school, so I want to  focus on that this afternoon. Let's go here. I'm going to start with two views the  Hayekian stages of production model, and you've already seen a lot about that  from Professor Salerno. I might give a little different spin on it, but not much. And then the Knightian and in parentheses, I say freedmanian stock flow model,  that's that's the alternative. As far as looking at Hayek and Friedman is  concerned. So we'll try to give that a pretty good workout. I say two views. Well,  yeah, there they are. There are two of them. I could have put a third view in. Let  me do it right here the Keynesian view. It's animal spirits model that doesn't  quite pass muster as a model, actually, but if you've read the general theory and let me show a show of hands, how many have read The General Theory? Great. That's great, both of you. So it turns out that over a span of a page and a half,  he used the term animal spirits to give you an idea of movements of investment. Is investment picking up or is it slowing down? And it's all run by what he calls  animal spirits. Well, that doesn't fit well very analytically into a macro model, but  we'll have something to say about that too. Okay. Now start by just indicating  that there's many meanings of capital, and I'm just going to give you a few, if you want. If you've read Bohm-Bawerk, I want to ask how many people have read all of Bohm-Bawerk, but he goes through quite a list of different things that capital  mean, or have meant, and so on in the literature, but I'm just going to go through a few and then and then, focused on two particular meanings, bank capital.  That's just assets minus liabilities. Here we have financial capital, cash and  funds raised by, say, stock and bond sales, fixed capital, plant and equipment,  the fixed just implies durable a big machine that'll last 30 years or whatever.  Working Capital has goods in process, an automobile that's halfway put together and is on its way down the assembly line. That's working capital, capitalized  value. That's just the present value of future receipts and human capital. That's  more recent in the literature, the present value of skilled workers future  earnings. They've got skills, and have those skills right now, and that constitutes  human capital, that they can apply it in years and months ahead. Okay, now I'm  getting serious, because I'm underlining things. That's my guess. The clue,  capital stock, okay, the stock of productive factors that yield a flow. There's the  other underline, of consumption goods. And this is the Frank Knight view, and  it's just defined dimensionally. In other words, a stock is something that exists  right now. There it is. That's the stock. The flow is on its way out. You know, it's  making the goods go out the door and so on. That's the. Flow and what gets to  something even more severe than that. All right, so what we're going to focus on

in today's lecture is that distinction between the structure on the one hand, that's the Austrians, and the stock and flow on the other hand. So that's, that's  Friedman and Knight or, well, yeah, that's the best contrast that I want to, want  to be making. Now there's a problem in measuring capital, and I want to spend a little time on this to convince you that it is a problem and it's unique to capital.  And so you start out easy, capital is heterogeneous. Well, who would disagree  with that? Okay, of course it is. But you might come back with the claim that,  well, so is labor and so is land, right? So why is capital being heterogeneous  such a big deal? So aren't labor, labor and land homogeneous too well? Yes,  they are. So we go to the next step. Capital is radical, radically heterogeneous.  That sounds like something Ludwick Lockman would write, okay? And I'll go a  step forward and say, well, we get asked just how radical is capital  heterogeneous? Okay? And the answer is, it's dimensionally heterogeneous.  We just don't have the dimensions that we would like to have to give a  meaningful measure of capital. And let me elaborate by giving you a fill in the  blank assignment. Here it is, and you see the sentences are all alike, except  what goes in that blank? So not all what? Well, units. We need some units in  there. Okay, what are the units start at the top, worker, hours. Okay, that's  standard. Now I'm allowing for labor to be heterogeneous, and it goes, it says,  not all are alike. Okay, that means they're heterogeneous, but at least we have a unit where we can indicate what just what the units are, and realize that some  worker hours are more productive than others and so on, but they're worker  hours. And how about land? What do we do here acres? Or we could say acre  years, you see that in some textbook, and that would be more in line with worker hours and labor and acre years. But land is heterogeneous too, which means  not all acres of land are alike. Now we get into the real problem, not all what of  capital are alike. What would you what would you say? Well, look, look at what's there very closely, and you can see one way the textbook authors treat this.  They just remove the parenthesis. Okay, not all units of capital are like, Well, I  mean, you know, if you're reading through that at 11:30 or midnight in your  dorm, you read right? Passes, oh, yeah, units, yeah. You don't know. Okay, not  old units are alike. So if you're taking notes, write down unit is not a unit. Now  I've become sensitized in the in the literature to see what else people have. We  can look at some, say, doses, some doses of capital. Well, how big is a dose?  What else we got? Chunks and hunks, okay? And you can look at some other  units and see if any gallons or whatever. You can't see anything that would work. And if you, if you look at these units that are used, you're kind of leery that they  would work. Let me show you. There's a dose. Could you major capital that  way? How about a hunk? I mean, some hunks are bigger than other hunks, all  right, or some chunks are bigger than other chunks. And what about a hunk?  That's human capital, I guess. Okay, now let's get to two combatants here,  which is Frank Knight and Friedrich Hayek on the issue of capital. And soon 

enough, we'll have Friedman involved, because he's picking up the Frank Knight idea of capital. And it's important to note that Friedman and Frank Knight were  colleagues at University of Chicago, and Frank Knight was a very dominant  figure there, and we'll see that with stiglers book and so on as we go along. He's very dominant there. He's very emphatic about just how to theorize about  capital. And I can tell you at this point that there was a time in late 40s or 1950  along in there somewhere where Friedman, I'm sorry, where Hayek, was trying  to get a position at the University of Chicago in the economics department. And  it turns out that they wouldn't have him. They wouldn't have him, and they didn't  they wouldn't have him because of his capital theory. They didn't want someone  who was the author of prices and production, which is antithetical, antithetical to  Knight's view of capital. Okay, now the argument or the in the journals, There  were articles about capital theory, Hayek's capital theory and several different  capital theories, but the but the emphasis was back on our old Frank Knight,  okay? And it turns out that before that a number of years, look at the dates back  in the mid 1800s that same battle was waged with Bohm-Bawerl, the Austrian,  and John Bates Clark. That actually was the forerunner of the theory that knight  picked up on. And so this has a long history of these two views of capital, stock  flow, on the one hand, and the structure of production on the other. So my  sympathies, or my choice, of course, is Bohm-Bawerk, although I have good  feelings about Clark if only because he looks just like my grandfather. Okay.  Kind of sweet. Okay, now, let me give you an idea, if you can read that from the  back. What about production time in a Clark Knight vision, as opposed to Bomb Bawerk Hayek vision? And it goes like this. The claim is, let me give you the  claim to start with, so you're not jarred into it later, is that production time doesn't count for anything. And it goes like this. Imagine trees being planted and  harvested. And here's the story, once a steady state is reached. And I underline  that because that's that's key, that's key. Nothing else follows unless you start  with that once a steady state is reached, production time is irrelevant. Okay, and notice irrelevant is in quotes. I'll have to explain that later, but it's in quotes.  Production time is irrelevant. And so the trees have a linear maturity structure.  Actually, it's logged linear, but we'll get them. Let them get away with that. Each  period of sapling, a sapling is set out, and a mature tree is harvested. Let's see  how that goes. Here's year one, and watch right under year one sign, we'll get a  sapling, we set that out, and then look at the other end, and we harvest that  other tree. There it is, okay. And then the next period presents us with the same  maturity profile. So. Watch the trees. There they go up. Okay, so if you got the  same forest the next year that you had this year. And so Knight writes, it's the  setting out that enables, with quotation marks, the harvesting. And so setting out the sample the sapling now produces in quotation marks, the harvestable tree  now, all right, so production and consumption are simultaneous. I trust you to  notice the quotation marks, okay, so that's, that's their story. That's Clark's story, 

that's, that's, that's just the whole story, all right. Now, George Stigler, of all  people now, Stigler, of course, was a colleague at University of Chicago too,  very Friedman and Stigler were very good friends. So Stigler defends Clark and  dismisses Bohm-Bowerk on the basis of the simultaneous product of production  and consumption. And here's what he writes. Look at this. Here's this is a  Stigler. We can say that any one row of trees takes 50 years to mature, but  since there is a constant output of timber forever, there's simply no point in  saying it. Now. Isn't that amazing? And in fact, it's only true if you make the very,  you know, the dramatic assumption about a steady state. So that's Stigler  production, or George Stigler production and distribution theories of 1941, I  made the mistake, and maybe I shouldn't call it a mistake, but I was at a Mont  Pelerin meeting some years ago and sitting at a dinner table With Stigler, just  across the table from me, and Stigler was carrying on about how it is that we  don't really need that much history of thought, although he writes a lot of it,  because the theories in the past, if they're any good, we've still got them, and If  they're no good, we've gotten rid of them. So why do we really need to study all  that history of economic thought? And so I came up with what I thought was an  exception. And I came up with this not having read Stigler's book. And so I  mentioned Hayek and stages of production and how that all fell to the wayside  and Stigler just exploded. And let me know that, no, that's, that's something that  needed to, needed to fall away. It was not viable. Okay, here we go. Okay, so  once the steady state is reached, production is irrelevant and so on. They carry  on. You can read it, production consumption are so here's what Stigler said  about 43 years after his 41 book. This is interesting. He says, I wrote my  dissertation in the history of economic thought under Frank Knight, he was so  strong minded and so critical a student of literature that he was a good many  years. It was a good many years before I could read the economic classic  through my own eyes instead of his. I never brought myself to read through my  doctoral dissertation. That was that distribution theories, production. Yeah,  there's the title because I knew I would be embarrassed by both the knightian  excesses and its immaturity. So he's disclaiming it without actually reading it,  you know, but it shows what kind of an effect that Knight had on Stigler and on  all the other economists, essentially University of Chicago at the time. Okay,  now I call it black box. Capital theory, because, I mean, it's one thing to talk  about these trees. It's very specific example, and it's only works if you assume a steady state and so on. But that sort of gets dropped out of the wayside, and  you have just a capital stock, and from the stock a flow, all right, so that's the  idea. So this is Black I call it black box capital theory, and I'll show you a black  box that you've you've seen on TV, occasionally, flight recorder. How Black is it?  It's orange, okay, but black box actually has a meaning totally apart from the  color of the case. Black Box just being, it's an, it's an electrical engineering term, okay, black box means that the user, someone that buys the box and sticks it in 

the airplane, the user, has no reason or no ability, to get inside the black box and see what's there. So it's black in that sense, it's hidden from the user. You don't  know what's in there, but you hope is what you know, you hope it has the  function that it's supposed to have. So that's that's the black box idea, all right,  so the definition of black box, then, is any complex piece of equipment, typically  a plug in play unit in an electronic system, the specific context of which the user  has no need to know. Okay, so this is the way that Stigler and Friedman and  others at Chicago sort of put away all of the issues of capital. It's just in a black  box. Okay, that's we'll leave it where it is, okay, and not worry about it. And go on now, I have a suspicion I can give you a couple of reasons why Stigler, I'm sorry  while why Friedman signed on for the black box and never changed that. He  never, he never doubted that's what he wanted. And one of the reasons is, what  I've already shown is that there's no usable units. You know, you could say  month dollars worth of a piece of capital, but that just, that just mixes the value  of it with the amount of it. Okay? So you don't have any units to talk about the  amount of capital. You keep it in that black box and don't worry about it. That's  the idea. So I've got no doubt, given how mathematical that the Friedman  modeling was, that he did not want to have to measure units of capital, because  he wouldn't. He wouldn't know whether it was the same old capital that now is  worth more, okay, or it could even be worth less, but it's actually more in volume. But what is the volume? How do you measure it? You don't know, so just keep it  in that black box. That's one reason that he just clinged on to that particular  theory. The other reason is one that I hesitate to mention, because it amounts to psychologizing and I don't like to do that. I just don't do psychologizing, and I  won't do psychologizing, except for today, okay? And it goes like this, and this is  kind of a neat because it's an emperium, an Austrian economist, but this is an  empirical study that I'm going to offer you. And it goes like this, it's about  economists that marry one another, husband and wife, both of which are  economists, and I know a lot of those couples, it's kind of sad. Actually, my wife  is a flutist. I don't tell her how to play the flute, you know. So we get a long great. Okay. Now you might know, you probably some, most of you probably do, or  some of you probably do that. Rose Friedman was also an economist. She was  working on a PhD at the University of Chicago. That's where they met. Okay, so. I read, I can ask it, who's read this book? Big, thick book written by Friedman,  both of them, Milton and Rose. It was called two lucky people, okay? And I  bought the book and read it. And it turns out that for years, for years, Rose  Friedman was working on a dissertation. And usually she'd start working again  when they moved, they moved, and okay, she'd now let me start working on this  again. They move again, and so on. So a number of times she kept working on  this dissertation, and the dissertation was about capital theory. And who do you  think her dissertation director was Frank Knight. Okay, now here's, here's the  empirical part. I think, I think it's empirically. Almost dead sure that a married 

couple will get along fine with one another only if they stay out of each other's  concentration in economics, okay, so Milton didn't say anything about anything  bad about Friedman's capital theory. He stayed out. They were two happy  people. I mean, two lucky people, if he had denied that that was a good capital  theory. They may not have been so lucky. I think that might have had something  to do with it. Okay, well, let's go on. Let's see what we've got here. So this is my  capital stock. It's same color anyhow. And we, oh, we need to add, do not open,  right? And then let me get something going. There it is. You got the flow of  consumption and the maintenance of capital, see, so you get a feedback, and in fact, that maintenance has to be just right, so that the capital stock doesn't  increase or doesn't decrease, it just stays the same. And that's the steady state,  isn't it? And so you can see what's in green. That's the flow of consumption. And then the stock, plus plus the maintenance, are the stock of capital. And the claim is by Knight, is, is, is that the maintenance is just a technical detail. It's a  technical detail. You think it wasn't, but, and by making it a detect technical  detail, then he can get his notion of his stock flow. Okay, let's go on. All right, so  I'll put a box around this, because both of those things, the actual capital stock,  plus the maintenance, is what Knight is taking to be capital. Okay, so the capital  stock includes maintenance as a technical detail. Again, there is technical in  quotes. Hence, the stock of capital is permanent. That's in quotes. Now drove  me nuts reading night to see all these quotes like this, and I learned from Gerald Driscoll. He was one of our early Austrians that wrote a dissertation at UCLA,  and he clued me into some of the of the ways that that that knight expressed  himself. And so knight would say, capital stock is permanent, in a sense, okay,  you can see this all through his writing. Sometimes he would say, the stock is  permanent, as it were, okay, the stock is permanent, so to speak. Wait a minute. You get tired of saying that, and he just puts quotation marks on. Stock. So a  permanent capital stock yields a perpetual flow, that's the idea. And of course,  the qualifications are, in a sense, as it were, so to speak. That's a strange  capital theory, but that's it. Okay. Now we even go a step further here. We've got capital stock and the flow of consumption. But what's what Knight really like to  do is change this to sources. He calls it sources yielding services. And that's that seems like a sort of a roundabout way of putting things. There's sources. So we  don't call it capital, we call it sources and and then he says there's only one  factor of production. This is odd. It's capital, okay, in the broad sense of sources. So land, labor and capital are all capital in the broad sense. So in other words,  labor means the labor is a building, a willingness to work, whether you're  actually working or not. That's, that's the capital aspect of it. And so we change  the maintenance to sources. Maintain sources, and you have a flow of  services. Now you might wonder, what's the difference going from consumption,  let's say, to to services. Well, one thing you could do is take, you know, the  production, let's say, of refrigerators, and then the refrigerator becoming a 

consumption good, all right, but it's a good, it's something and it is a durable  good. Knight doesn't want it to be durable. He wants it just the services of the  refrigerator. That's that's what we're looking at. Not the whole refrigerator. It's  just the current services of it and the sources of it, the sources of that service, of course, are the refrigerator. That's the way it works. And so it's really a definite  or a dimensional difference. One's a stock and one's a flow one and in the  extreme, okay, goes like that. Now this is going to be challenging, but I think we  can do it. I'll call that sources again, and maintenance of sources and services.  And I'm going to read this, but you can't just start reading the thing. You have to  realize that it's it's full of sources and services, enough to make your head swim. And it helps if you identify where those are right now. So there they all are. And  this is a quote by Milton Friedman. In other words, Friedman doing his capital  theory has cabbage on to Knight, and he's doing he's doing it in terms of  services and sources. And then the key thing I've underlined is at the same time. This is stuff that's all happening at once. Okay, there's no time. Let's see if I can  read it. I'm not sure I can, but the key feature, and he's talking about of the  process in which interest rates have been lowered, and that's what sets off a  business cycle. Okay, at least an Austrian thinks it sets off a business cycle, but  Friedman doubts it, because the key feature of the process is that it tends to  raise the price of sources of both producer and consumer services relative to the prices of the services themselves. It therefore encourages the production of  such sources, and at the same time, the direct acquisition of the services, rather than of the sources. Are you with me? But these reactions and their turn tend to  raise the price of the services relative to the price of sources, so that that is to  undo the initial effects on the interest rate, and that's all at once, okay, so as  soon as that interest rate goes down, then then, just in a flash, all of that  happens, and it didn't. It doesn't make any difference in anything from that, from  that point on. And that's Friedman, okay. Now, to be fair about this, that's. It goes on. There's one more part of it where he's not talking about he says the final  result may be a rise in expenditures in all directions, without any change in the  interest rate of all Well, how could it be any change? Because it went down and  up in a split second, wasn't any time for it. Okay, no change at all in the interest  rate. Interest rates and asset prices may simply be the conduit through which  the effect of monetary change is transmitted to expenditures without being  altered at all. And of course, what happens is that the interest rate is altered  over a fairly large point in span of time until it finally does adjust to its old level,  and maybe not even quite its own level, because a lot of misallocation has gone  on in between. And it's true that if all of this change in interest rate happens at  once, both down and up, now, there's no effect right now. In fairness to  Friedman, in this same section, in the article, the 1961 article that I'm citing in  the same section, he talked about how things will be different if you're if you're  thinking in terms of building, building, some kind of an industrial building, or 

creating machines, or doing things that actually do take time. Well, of course, it  would be very different. In fact, that's the thing that is the focus of the Austrians  in seeing what's going on. Okay? And yet, he drops that, you know, he says that, but it doesn't become part of his theory. He sticks with the knightian view, a  strange thing. Okay? Now, another strange thing. Let me do that again. Felt  good, even though Knight thinks of that that feedback as a technical issue, he  does allow that it can be more than enough to keep the capital intact, okay? Or it could be less than enough to keep the capital intact. Well, those would have to  be decisions, wouldn't they? You could over maintain or under maintain, or  whatever that'd be decisions. Well, how is it that it's it's technical, if it just keeps  it intact. But you have a choice of beefing it up or letting it or let it letting it run  out, okay. And but if you do let it run, if you do beef it up, you get something like  this, okay? And if you let it go the other way, you get something like this, it's  gone okay? So that would have to be a matter of choice, right? Where are we?  Time wise, yeah. So here's a summary. Knight and Hayek, so maintenance is a  technical detail, but we may we're wondering about that last slide or so. Okay,  Hayek maintenance is a matter of choice. You can you could run the thing day  and night if you want to get some products out the door for some specific reason and waste away your machine. Capital is permanent. No capital. Capital  depreciates, but is augmentable, beef it up, replace it and so on. Capital is the  only factor well make any sense. Capital is heterogeneous and multi specific.  Production time is irrelevant with quotation marks and production time is the key variable you'll see in a later lecture how Hayek and Friedman used the word key Friedman is the empiricist, of course, and when he says key variable, he means  it moves around a lot, and so we can, we can do econometrics with it, right? But  Hayek is saying production is production. Time is a key variable. It's all about  sources and services. That's night. It's all about temporal capital structure. It's  about stocks and flows. No, it's about dynamic market processes. You couldn't  get a bigger contrast of two capital theories than that. Okay, I've got a few  minutes and I want to Oh, here's something, as reported by Mark Skousen in his Vienna in Chicago, Larry Wimmer, He's an economist, an early 60s PhD  candidate at the University of Chicago, reports that Austrian capital theory was  one of those subjects verboten at Chicago. I didn't want to hear about it. Okay.  Now, little bit about mengers law, and I'm going to breeze through this because  you've heard a lot from Joe Salerno. There's the goods of different orders, okay,  consumption goods at the bottom and higher order goods along the top.  Production proceeds in this diagram, and it's it's consistent with menger,  production proceeds top to bottom, and value imputation goes bottom to top.  Joe covered some of this stuff, and I'm superimposing the page in Hayek's  prices in production that lines up with what I've already shown you, and you  have orders of goods, clean it up like that. And the one thing that's kind of odd  about this is that when you're using that diagram, it looks like time is coming 

down the vertical axis. Okay, I mean, that's, that's the direction of the actual  production time is coming down the vertical axis, it almost makes you wonder  what time does when it bumps up against the origin. It's not it's not something  it's not a graph that you're used to seeing, okay, and sometimes it can be an  obstacle to people figuring out how this consumption or how this works. Now,  Walter block has claimed several times to an audience like this, that I solved this problem. I solved the problem and getting away with time coming down the  vertical axis, and I did. I did. I worked on it. I worked on it, and I came up with a  solution. I want to see what you think about there it is, okay. Then now time goes from left to right, and your value is the other way. All right. Make a Hayekien  triangle out of it, production time and sequence of changes. And if you want  something more complex, more complex, look at that one that's out of Hayek's,  pure theory of capital. Myself, I like that one. Okay, I need to stop right there.  Thank you, Mike, you.