However, the classical understanding of capital and its place in economic theory was muddled. Even though it was refined in light of the new marginal productivity theory of pricing, the increasing formalism of economics in the 20th century led many economists to lose the new insights.
This article outlines these developments and explains why many of today’s economists would benefit from a better understanding of the nature of capital. The issue is important not just for the basic theory of income distribution, but also for understanding complex topics such as business cycles.
These are two of the opening three paragraphs of one of the May Econlib Feature Articles. The article, by Robert P. Murphy, is titled “The Importance of Capital in Economic Theory.”
Another paragraph:
Framed in terms of macroeconomic aggregates, the Keynesians do seem to have a strong case against the RBC [real business cycle] theorists and other free-market economists who think the economy should be “left alone to sort things out” during a recession. If we use a model that represents the capital stock by a single number (call it “K”), then it’s hard to see why a boom period should lead to a “hangover” recessionary period. Yet if we adopt a richer model that includes the complexities of the heterogeneous capital structure, we can see that the “excesses” of a boom period really can have long-term negative effects. In this framework, it makes sense that after an asset bubble bursts, we would see unusually high unemployment and other “idle” resources, while the economy “recalculates,” to use Arnold Kling’s metaphor.
The whole thing is worth reading.
READER COMMENTS
LD Bottorff
May 6 2014 at 5:07pm
I appreciate how Econlog exposes how little I know about economics.
I would have defined capital as ‘deferred consumption.’ In order to build that grain mill or factory, the investors must have deferred their consumption of goods so that they can pay the workers who build the mill or factory and sustain the workers until the investment actually starts to pay a return. However, this definition does not need to refer to money; whether or not there is money, in order to build a capital good, someone has to defer consumption so that the builder and the worker can eat until the capital good begins to pay for itself. Money is a great thing and makes capital investment much easier, but capital investments were made before money was developed.
There is so much to learn.
Lee Waaks
May 8 2014 at 9:24pm
David Steele, author of From Marx to Mises, wrote this comment a few years ago on a libertarian discussion group:
The distinctive thing about Austrian trade cycle theory is its view of “real” factors in the onset of the slump. Of course, much of what Mises and Hayek say overlaps with the “purely monetary” theories of people like Milton Friedman, and long before that, of people like [Ralph] Hawtrey. So it may create a phoney boom, followed by an uncomfortable period of adjustment. What is distinctive about the Austrian theory is that it says the specific physical form of the capital which is malinvested plays a crucial role in the onset of the slump. So, for example, if lengthening the production structure requires a particular type of big, expensive machine that has no use with a shorter production structure, then that machine will have to be written off as a loss, since it is not suitable to the “return to reality” when the boom is over.
What struck me very early about this (I think it crossed my mind when I read Rothbard’s book on the 1930s depression, around 1971) was that it’s an empirical claim, and at a quick glance, such physical incongruities don’t seem to loom all that large. So, if the production structure lengthens, you change the shape of investment into something more appropriate to a lower time-preference. Fair enough. So, if the production structure lengthens, you change the shape of investment into something more appropriate to a lower time-preference. Fair enough. But what does this really mean? Let’s say you have a factory. You start to use different types of machine tools, let’s say. Still, most of your factors will be just the same, or almost the same, as before: electricity, computers (or in the old days, office stationery), unskilled workers, workers with various types of skill such as accountants, engineers, salespeople, and managers, your factory building itself, your use of trucks to get materials into the factory and products out, and so on. In others words, the overwhelming majority of the factors you employ are not specific to higher or lower orders of production. It’s true that their application to specific tasks will shift a bit, but this goes on all the time, and is an inexact science at best.
Since the claim that physical incongruities are crucial is an empirical claim, I was then struck by the experience of the US at the end of World War II. If ever there was a case of an abrupt, almost overnight, mismatch between prior allocations of capital and today’s applications, we could hardly imagine a more spectacular example. Millions of people left the army and found civilian work. Hundreds of thousands of factories which had been producing military goods had to transform their operations into civilian production. Why was the whole system not seized by a violent slump?
To the purely monetary approach, this is simple and obvious. There was no violent contraction of the money supply, so there was no slump. But to the Austrians, what explanation could there possibly be? Their claim is that once the boom has got going it cannot be ended without a slump, and that this is so because of the need to suddenly re-allocate physical assets to completely new uses. But that re-allocation was obviously thousands of times greater in 1945 than it could ever be as the result of a few years of bank credit expansion, and yet there was no slump!
The whole system adapted to the utterly changed conditions with amazing ease and smoothness.
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