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Source link: http://archive.mises.org/14490/richard-and-frank-or-uncles-sam-and-ben/

Richard and Frank? Or Ben and his uncle Sam?

November 3, 2010 by

Whenever I consider discussions of Keynesian financial stimulus plans, I think of Richard von Strigl and his concept of the subsistence fund and Frank Shostak and his formulation of real savings. To explain further, let me provide an analogy.

Like his father before him, Richard farmed his piece of Equilibrium Valley – an isolated paradise. A wise and prudent man, Richard built three silos on his farm. The first one held the newly reaped grain bound for his kitchen and the weekly market. The second held the grain he stored to feed his family and pay employees during the winter and planting months. The third held the grain he used to pay workers to mend and improve his barn, fencing, and house.

In the valley were two other farms, each having a similar set up, with one of the farms producing corn and the other soybeans. In addition to the farms, three ranches raised beef cattle, pigs, and chickens respectively. Just like the farms, the ranches had three freezers that served the same purpose as the silos.

In the village situated by the stream that divides the valley lived twelve workers and their families. The men worked on the farms and ranches. This constituted the entire population of Equilibrium Valley.

On Saturdays, the farmers and ranchers would travel to the village to hold market. The folks settled their transactions by using slips of paper that entitled the holder to a portion of the foodstuff printed on the front. One slip might be worth a bushel of corn while another pound of chicken. The happy folks in the valley exchanged these slips of paper, redeeming some and holding onto others. Foodstuff not redeemed during the market was returned and stored for the following week.

On rare occasions, someone would ask for credit from one of the farmers or ranchers. A farmer might agree to issue a slip or two against his storage, which the debtor exchanged on market day. In a week or so, the debtor exchanged for circulating slips and returned them to the creditor, thus extinguishing the line of credit. No one ever failed to pay on time.

There being nothing fractional about Equilibrium, the slips in circulation never exceeded the amount of foodstuff held in silos and freezers. And everyone in the valley had a lockbox containing their slips which they would redeem when needed.

According to Shostak, the contents of the silos and freezers constituted the real savings of the community – the slips being nothing but paper. According to Strigl, silos two and three held the subsistence fund, with silo three specifically holding the capital replacement fund. Without sufficient storage in the subsistence fund, the community could have never survived the winter. And without sufficient storage in the capital replacement fund, capital could not have been maintained and the infrastructure would have collapsed as barns, fencing and houses slowly sank to the ground.

The economy of Equilibrium had been stable for years. The slips of paper – issued by each farmer and rancher – were trusted in all exchanges. Life was cozy and comfortable, until two strangers arrived one day: Ben and his uncle Sam.

Sam and Ben rented small rooms in the house of one the workers, paying him with slips of paper identical to those exchanged on market day. The worker and his family were happy since the collection of slips in their lockbox increased with the weekly rent.

Sam and Ben were not lazy roustabouts; they were planners with big ideas – real big ideas. One morning they sat with their landlord Dave and expounded on their latest project. Sam was going to build a monument in the village. Not just any monument, he was going to build a right grand one. Sam explained to Dave that in order to complete his project, he would need Dave’s labor. And Sam was willing to bid Dave away from Richard, his current employer. Dave was exhilarated.

Work soon began. Sam paid Dave a weekly salary of 10 slips, redeemable in one bushel of grain each, twice his normal wage. Dave started spreading these new slips of paper at the Saturday market. Valley residents sensed a boom.

A few days later, Frank, the cattleman, returned home to find Sam and Ben quietly waiting on his porch.

Ben started, “Frank, you know things are beginning to heat up in the valley. We thought you might want to get in on the action, so we are proposing to loan you enough slips to complete your new fence line. That way you can raise more beef, just like you have always wanted. We are so convinced of your project that we will loan you slips interest free.”

Frank was taken aback, with these new slips he could bid workers away from the other farms and ranches. And he could build his dream ranch. Interest free, nonetheless. How could he beat that? Frank shook Ben’s hand in agreement.

Soon the valley’s economy boomed as other dream projects broke ground. All the while, the workers would go to the market and exchange slips for produce. And since times were good, the workers exchanged slips for more produce than normal. Their stomachs and lockboxes were full.

One afternoon, Richard took stock of his silos. He opened silo three to find if empty. Panicked, he opened silo two to find it half empty. His heart raced. It was only late fall and his savings had dwindled.

Richard ran across the road to Frank’s ranch and told Frank of his find. Frank opened his freezers to the same condition. There was trouble in the valley.

Richard and Frank headed to the village and called a meeting of the valley residents. What were they all going to do? It would be lucky if the community survived until the next harvest. The residents had down-turned heads and ashen faces as they discussed their reality – they had depleted their subsistence fund by substituting their real savings for paper. All projects would have to stop so that the residents could forage food in the woods and meadows.

Sam and Ben would have none of this. They rose and said that they only needed to create additional savings by issuing more credit – more slips of paper – and then the boom would begin once again.

Now who are you going to believe? Richard and Frank? Or uncles Sam and Ben?

{ 35 comments }

Beefcake the Mighty November 3, 2010 at 10:09 pm

So your position here is that money is nothing but a veil, not part of the real economy? Is that correct?

J. Murray November 4, 2010 at 5:50 am

Not really. It’s that money is only a physical representation of an existing good in existence came into being becuase it’s easier to carry and trade a slip of paper than it is to carry a pound of beef. The slips of paper in existence cannot exceed the amount of the commodity that it trades for and adding more paper doesn’t generate more of the commodity in question.

Beefcake the Mighty November 4, 2010 at 10:10 am

“It’s that money is only a physical representation of an existing good in existence came into being becuase it’s easier to carry and trade a slip of paper than it is to carry a pound of beef.”

If this is the case, how could economic calculation ever be a problem for a socialist economy?

J. Murray November 4, 2010 at 12:45 pm

Because those at the top assume what people want ahead of time. If I don’t want a pound of beef, then I won’t accept the note that’s good for trade for a pound of beef. If the socialist economy overestimates the desire to trade for beef, then there will be a lot of beef lying around rotting and worthless paper backing it up. Hence why such economies like demanding trade in a single, fiat currency. It’s impossible to distinguish what that currency is for so the command aspect becomes hidden and slowly deteriorates instead of immediately.

Walt D. November 4, 2010 at 11:05 am

J:
One way of looking at this is that you cannot make yourself wealthier by writing an IOU to yourself.

jeffrey A. November 4, 2010 at 12:01 am

I think his position is that money is a part of a real economy, but it should represent real wealth, which is savings, rather than fake wealth of fiat money that doesn’t represent anything.

Dan November 4, 2010 at 12:31 am

How do you come to that conclusion beefcake? He described a perfectly functioning economy with commodity backed currency with 100% reserves. Only when counterfeit money enters the system do we see problems began. It is an example of a boom bust cycle and the futility of printing more worthless paper to solve the problem.

Colin Phillips November 4, 2010 at 2:31 am

Very good article, I’m going to share this with my doubting friends.

konst November 4, 2010 at 4:13 am

Funny story but something is wrong with this story. The money even in the beginning of the story is not a receipt to a commodity. The village is not a free market economy. It’s more like a rationing or a barter economy. The credit slips issued sound more like a chartalist based monetary system (see Modern Monetary Theory although I don’t think there much modern about it since it’s Keynesianism in disguise with some additions).The village is unsustainable to begin with.

Seattle November 4, 2010 at 6:10 am

I thought about this as well. If the villagers “pay” each other by issuing IOUs good for redeeming from their stock of food, then what was in place to stop a villager from promising more than they had in the first place?

Peter November 4, 2010 at 8:23 am

konst: It is surely primitive, but why wouldn’t it be a free market economy?

Seattle: And yes, there is nothing to stop them from doing that – in fact, Ben and Sam introduced that financial magic to the valley.

iawai November 4, 2010 at 7:51 am

You’re right: the model economy in the story isn’t a perfect reduction of either the real economy or an ideal free market economy. The slips aren’t a perfect reproduction of free market money.

But that doesn’t change the results: the slips are analogous to today’s debt notes, and the production of more slips doesn’t change the real amount of anything in the economy, whether labor, capital, or goods. At best the notes serve as markers of debts to be paid (whether or not the real goods exist to back them), but this story shows the natural result of increasing the number of slips, that they serve to enrich the counterfeiters first and their direct trading partners second but eventually the real producers of goods must pay out more from their real savings to cover these notes.

Like any fable, the lesson can be learned despite the fictional setting.

Adam Berkowicz November 4, 2010 at 7:40 am

Isn’t a free market economy just the natural evolution of a bartering economy? We simply use an intermediary object (money) to trade with.

Jim Fedako November 4, 2010 at 7:50 am

All good points. Like sarcasm, analogies have a tendency to miss with readers as the liberties taken can be more glaring to some (most?) readers than the point of the article.

Unsustainable? Absolutely. It’s not real either.

Not a free market? There is no government mentioned so it is apodictically a free market.

Chartalist? Again, no government so it cannot be chartalist.

It is an advanced barter society. I used this since I wanted to keep the focus on real savings.

The point being made is that real savings in the substistence fund is the key, not paper money.

Beefcake the Mighty November 4, 2010 at 10:09 am

Analogies are fine, as long as their limits are recognized. So, you are claiming what happens in a barter economy has some bearing on explaining the cycles that occur in capital-using (ie, money-using) economies? Already, this analogy seems to be in big trouble. A serious criticism of conventional ABCT goes unmentioned by critics: it is in serious conflict with Mises’ arguments about the impossibility of socialist calculation. Any account of error cycles that does not take into account money as an essential feature of the economy is bound to fail. Clearly, there’s more to money (paper or otherwise) if the existence of capital markets where factors of production are exchanged for money is a necessary condition for rational economic action. Structure of production and time preference indeed play a role in any theory of error cycles, just not the sole role that conventional ABCT attributes to them.

It’s clear from the Garrisonian account of the cycle (of which your post [as well as Shostak's articles] is a variant) that money is really a veil for real, underlying factors. Again, serious attention must be given to Huelsmann’s criticisms of the conventional theory; a good place to start is:

http://mises.org/journals/qjae/pdf/qjae4_3_4.pdf

Jim Fedako November 4, 2010 at 12:28 pm

You are reading too much into the analogy. “The point being made is that real savings in the subsistence fund is the key, not paper money.”

Maybe I should have used money instead of slips. But then I might have lost the connection between real savings and the subsistence fund.

Reminds me of an experience in a college literature class. My Marxist professor invited an author to talk about the book he had written and we had read. She introduced the author and then began detailing her narrative of the story – focusing on one of the characters. The author sat quietly, staring at the floor. When she finished, she turned to him and said something like, “Did I capture the essence of why you created character X as you did?” He replied, “It’s a story, and stories require characters.” He left it at that.

Beefcake the Mighty November 4, 2010 at 12:42 pm

“But then I might have lost the connection between real savings and the subsistence fund.”

The point is, you are over-emphasizing this connection. The cycle you describe here has little relevance to what is happening in modern, money-using economies.

DayOwl November 4, 2010 at 10:04 am

This is a great illustration of the difference between fiat money and money tied to resources. The misallocation of resources that results from the introduction of counterfeit is also made clearer.

Well done.

King George November 4, 2010 at 2:33 pm

So the moral of the story is that these false booms are really drawdowns of capital? However, why did any of these people accept Ben and Sam’s notes just like that? And why were they so stupid that they could not notice what was happening to their capital?

Beefcake the Mighty November 4, 2010 at 2:53 pm

Good questions.

DayOwl November 4, 2010 at 3:05 pm

In a small village, as in the story, you would think they would know that the slips were fake, but in a huge economy, that wouldn’t be as clear, especially when the slips all come from the same printer.

King George November 4, 2010 at 3:32 pm

That point is acceptable. However, why are people fooled into embarking on “unsustainable” projects? Why do they not notice that they are depleting their own capital? Surely, in spite of what interest rates are telling them, they can realize what kind of a bet they are making? Does anyone really think that the Fed’s current policy is sustainable forever and that this is in any way backed by real savings?

Daniel November 5, 2010 at 12:06 am

Considering that capital goes into investments that cannot be properly assessed for risk and demand and are commonly leveraged many times over, it would be a wonder if they DIDN’T consume their capital.

King George November 5, 2010 at 9:25 am

Why can’t they say “well, the fed is QEing, so it’s much safer to go with a rate of 5% instead of 1%”. Again I don’t understand why people *must* be fooled into making an error by the fed’s artificially low rate, since EVERYONE knows that it’s being kept artificially low. Some people are taking advantage of this by trading these cheap dollars, but I don’t think anyone is fooled into believing that these rates represent real savings and that they should now embark on riskier projects because of this.

Ryan November 5, 2010 at 2:14 pm

It wouldn’t work for the same economic reasons cartels fall apart. If your neighbor is borrowing from his bank at 1%, you’re giving money away by borrowing at 2% from your “responsible” bank instead of just going to your neighbor’s bank and borrowing there.

Beefcake the Mighty November 5, 2010 at 2:42 pm

This is a poor analogy. Cartel members have incentive to cheat because their gains are their competitors’ losses. They are going to try to sell their product anyway, whether they choose short-term gain (increased sales at the expense of their fellow cartelists) over longer-term benefits (presumably higher prices from collusion). In your example, I do not have to borrow, I can sit out the boom and wait to pick up the pieces after the crash. The question you have to answer is, WHY does everyone borrow during the boom, instead of prudently sitting it out? In other words, the question is not, “why does everyone borrow at the lower rate,” but rather, “why does everyone borrow at all.”

Beefcake the Mighty November 4, 2010 at 3:42 pm

It’s probably worth posting a link to this paper again:

http://mises.org/journals/qjae/pdf/qjae1_4_1.pdf

Elwood P. Dowd November 4, 2010 at 4:47 pm

If Hulsmann were correct in his critique of Mises, it would mean that there was
no problem of economic calculation as described by Mises. Socialism and communism would be entirely viable. Hulsmann misunderstands the nature of entrepreneurial forecasting, it is not simply guessing rightly. If it were, the successful entrepreneur could be placed in charge of the entire economy and voila, instant successful socialism. There is nothing in Mises
theories that make it impossible, for people deprived of the correct data necessary for good forecasting, to nevertheless randomly and blindly guess correctly. But to propose that in the real world this blind guessing could continue to be accurate indefinitely is a bit much.
Yours Truly, the heretic and poor lost soul, Sy Akhplart

Beefcake the Mighty November 4, 2010 at 7:30 pm

I have no idea how you draw these conclusions from Huelsmann’s work.

Elwood P Dowd November 4, 2010 at 9:57 pm

On page 4 of the article you posted the link to, Hulsman says “Yet, such
increases can be anticipated. The mere fact that the quantity of money changes
does not prevent the entrepreneurs from judging correctly what influence it will
exercise on market prices.” If entrepreneurs can do it so can Bernanke, or if
not Bernanke, some other bureaucrat. Hulsmann errs when he says that ABCT relies
on simple change as being the source of error. He also errs by not seeing the
difference between change that is a reflection of real world conditions and
arbitrary change unrelated to those conditions such as increases in fiat money.
Mises point and the foundation of ABCT is that though increases in fiat money
can sometimes be anticipated, their specific consequences over time are
unknowable. Mises points out the inherent inability to engage in economic
planning without the existence of market prices, freely determined in an
unhampered marketplace. These prices, and only these prices, reflect real world
conditions, at any given time. That, is in fact, the entire function of prices,
to sum up all of the real world influences regarding a specific good at a
specific time and boil it down to a single number. The question at hand is not
change per se, it is change which specifically distorts market data, in an
inherently unpredictable way. In order to predict the specific consequences of a
change in money supply over time, one would have to be able to seperate the
change in price due to changes in all other factors from changes specific to the
change in money supply. If Hulsmann can provide a reliable method for doing
that, then he is assured of a Nobel prize in economics.
Further, on page 8, Hulsmann says “The necessary time lag between an error
and its discovery implies an error cycle, with all the familiar features of the
business cycle theory.” A false statement, a cycle requires an impetus to keep
it ‘cycling’, there is nothing in the delay between an error and its discovery
that leads to another error, thus constituting a true cycle. In fact, a look at
the long history of human progress would suggest that the progression is error,
discovery of error, try something else, eventually succeed. Definitly not a
cycle, except possibly for politicians who always skip the last step.
Thanks for the opportunity to spout, hope it makes some kind of sense.
Yours Truly, the heretic and poor lost soul, Sy Akhplart

Beefcake the Mighty November 4, 2010 at 10:30 pm

“If entrepreneurs can do it so can Bernanke, or if not Bernanke, some other bureaucrat. ”

I fail to see the relevance of this to the main point: WHY are entrepreneurs unable to distinguish central bank credit expansion from an actual change in time preferences, as the conventional ABCT posits? This is a common objection to ABCT, and I believe it is a valid objection. The responses usually given are not convincing, IMO. Entrepreneurs are able, e.g., to anticipate the distortions from a price control, mass error and cycles do not result. What is so special about central bank actions?

“These prices, and only these prices, reflect real world conditions, at any given time. That, is in fact, the entire function of prices, to sum up all of the real world influences regarding a specific good at aspecific time and boil it down to a single number. ”

Translation: money is a veil, not a real good. This statement of yours actually ties into the whole dehomogenization debate concerning Hayekian vs. Misesian conceptions of the socialist calculation debate. Prices do NOT convey information, this is only a metaphor. Prices are exchange ratios, and the question that has to be answered by adherents of the conventional ABCT is why entrepreneurs permit the formation of exchange ratios that would not prevail absent the credit expansion, indeed, they assist in the distortion.

“The question at hand is not change per se, it is change which specifically distorts market data, in an inherently unpredictable way. In order to predict the specific consequences of a change in money supply over time, one would have to be able to seperate the change in price due to changes in all other factors from changes specific to the change in money supply. ”

This whole passage assumes what must be established, namely that central bank actions are inherently different from any other change-inducing mechanism on the market, which it is generally agreed that entrepreneurs are able to anticipate.

“A false statement, a cycle requires an impetus to keep it ‘cycling’, there is nothing in the delay between an error and its discovery that leads to another error, thus constituting a true cycle. ”

I think if you had read further, you would have found an answer to your question: it is the State, the only institution in society that is able to *repeatedly* engage in violent interference in the market (due to the false sense of legitimacy its subjects hold it in), that gives rise to the cycle.

Del Lindley November 5, 2010 at 8:16 pm

Beefcake,

An interesting discussion. You have incited me to ponder the supposed tension between the classical ABCT and the calculation problem. While I am favorably disposed to Hulsmann’s work, I am thinking that it may not be necessary to resolve the supposed conflict. Here is my composition for this Friday afternoon. Let me know what you think.

The advantage of the free market is its ability to allocate dynamically all available resources so as to order current production to best satisfy future consumer demand. All available resources include land, labor, consumer goods, capital goods, commodity money, and credit. A subset of labor is dedicated to the entrepreneurial function of anticipating future consumer demand using a detailed understanding of a particular market and its consumers. With this knowledge the apparent uncertainty in future consumer demand is reduced. The successful entrepreneur is rewarded with a profit from which his allocation for future production resources can grow. Similarly, the less successful entrepreneur will experience a relative decline in his allocation for future production resources. A set of independently acting entrepreneurs operating under a system with secure property rights interact to determine the allocation of resources and the DMVPs of all the production factors at any given time. Since consumer demands change in time (and the expectations for those demands even more so) the resource allocations and DMVPs are always in flux. A decentralized economy can survive entrepreneurial error because the errors tend to be small and uncorrelated. The dynamic feedback mechanism within such a market promotes error damping, i.e. small errors are unlikely to grow into large errors.

To me, the socialist calculation problem boils down to the fact that resource allocation and factor DMVPs cannot reliably track future consumer demand as the free market’s producer-consumer and producer-producer feedback mechanisms are suppressed as the economy is centralized. This applies to resource allocation across (over different products) and through (over the stages of) the production structure. Of course this does not mean that a socialist economy could not accidentally arrive at the same allocation set that would be produced by a free market, and so it would not be correct to say that it can never work for all time. The general statement might be that as an economy becomes more complex the likelihood that it can reproduce the allocations of a free market (and therefore satisfy consumer preferences) rapidly approaches zero. Note that this statement has the flavor of the Thermodynamics’ Second Law in its statistical mechanical form.

The crux of the classical ABCT relates to the misallocation of resources and the DMVP distortions induced by the chronic (and acute) monetization of debt. Let’s assume we have a free market in all goods except for money. In an artificial credit expansion the entrepreneurs are said to be fooled by a depressed rate of interest into extending their production structures while the consumers are induced to over-consume. This imbalance between consumer and producer time preference leads to a crisis as the available consumables (the real savings) decline with time. Once the crisis is identified the natural response would be for the consumer’s time preference to fall and the producer’s time preference to rise as the level of credit falls. Obviously this re-alignment is not a pleasant experience.

But the question is, “Why do those entrepreneurs who are expected to perform so well in the ideal free market become so inept in the face of an artificial credit expansion?” I believe that a partial answer to this question stems from the misallocation of the human resource induced within the class of entrepreneurs. The artificial credit expansions, both chronic and acute, will tend to inflate the number of less able entrepreneurs and deflate the number of highly-skilled entrepreneurs, i.e. those who would be acting in a strictly free market. Essentially the pseudo-entrepreneurs reduce the gain potential (i.e. the profit and interest return) of the real entrepreneurs by reducing their resources. If the credit-based distortions are severe enough then the influence of the pseudo-entrepreneurs can come to dominate, and once this happens the market becomes susceptible to credit instabilities (asset bubbles or runaway deleveraging) if the central bank becomes too accommodative or un-accommodative.

In conclusion the market impacts of socialism (the suppression of the free market’s decentralized feedback mechanism) and un-backed credit expansion are qualitatively distinct even though they both lead to resource misallocation from the consumer’s perspective. The behavior of the pseudo-entrepreneurs during an artificial boom therefore says nothing about the abilities of the free market entrepreneurs or the ability of socialists to approximate a free market.

Beefcake the Mighty November 5, 2010 at 10:29 pm

Del, let me try to respond on a Friday evening; a bit disadvantaged relative to the afternoon, if you catch my drift, so subsequent clarifications may be in order.

The first thing to note is, in speaking in terms of DMVP (discounted marginal value product), you’re already presuming a common unit of measurement. In Rothbard’s superb discussion in MES, this discussion takes place in terms of *money prices*. That is, he considers the *monetary* value that is gained or lost by the addition or subtraction of a particular factor from some production process. Of course, the existence of money prices means that there is a market for these factors, ie a capitalist economy. The point I take from the Misesian rendition of the socialist calculation debate is, these monetary values do NOT correspond to any kind of
measure of value. This is because the value of a good is the end that can be attained by the addition of that good to an actors property (or the end that must be foregone if that good is subtracted from the actors property). Hence there can be no kind of value calculus, as ends can only be compared to one another ordinally, they are not commensurate in any way. For example, neoclassicsts like Caplan are right that neoclassicism does NOT assume cardinal utility (contrary to many Austrian critiques). However, what they DO assume is the notion of value equivalencies between goods, such that RATIOS of marginal utilities (marginal rates of
substitutions) are meaningful and can be related to price ratios (say, under equilibrium conditions, ie the usual U_x/px = U_y/py ensemble). This is the central role indifference plays in neoclassical value theory. If, however, the notion of value equivalence is rejected (as is certainly the case in Misesian/Rothbardian theory), then there is no sense in which prices (or rather price ratios) serve as a proxy for value equivalents (or relative scarcities, say). Thus, there is no knowledge that
could be conveyed through prices that would be of any interest to a socialist planner. Capitalist planning is inherently different from socialist planning, not because the former has access to condensed knowledge through the price system that the latter is lacking, but because allocation through monetary calculation is the only kind of economic action possible with producer goods. But then, money clearly is more than a veil, it is a part of the real economy, without which economic calculation (and associated factor allocation) is impossible. Further, this characteristic (crudely termed as unit of account) is a corrolary of the fact that money is a medium of exchange.

So, a problem I see with your account here is that you’re viewing prices (or rather price ratios) as proxies for more “fundamental” entities like time preference, etc. Correct me if I’m wrong, but this is how I read it.

Now, my criticism of conventional ABCT is that it relies on the notion of the Wicksellian natural rate, the equilibrium interest rate that would prevail in an economy without capital markets. But, if you subscribe to the viewpoint I’ve laid out above, this is an absurd construct. There can be NO economic allocation of factors of producion without capital markets. The implicit assumption of ABCT, that there is a distinction between the “real” economy and the “monetary” economy (such that
central bank machinations can create upheaval through an “unsustainable” mismatch of the two) is spurious. (I further accept the mainstream criticism that the theory presupposes ignorance on the part of actors in the face of central bank actions, and I’ve found most Austrian responses here wanting.)

I believe the theory can be put on solid ground by recognizing that money is a medium exchange AND part of the real economy. As a medium of exchange, it necessarily has a purchasing power. Traditional aspects of ABCT can be retained by noting that production does indeed take time, during which consumption must still take place. However, the flaw in the theory is in assuming that monetary calculations are in some sense a proxy for consumption quantities (a very stark
example of this is in Shostak’s writings, this whole “subsistence fund” concept). Production can only be carried through to fruition if TWO conditions are satisfied: it must be profitable (the traditional Austrian emphasis on the entrepreneurial function), AND the purchasing power of money must be sufficient to finance consumption during the production process (which could be lengthened or shortened, as Austrians emphasize, with changing conditions, likely driven primarily by time
preference [but see again Huelsmann's critique of traditional Austrian theories of interest]). This is where central bank action sets in motion the boom-bust process: their actions necessarily weaken the purchasing power of money, while simultaneously making it *appear* (through their priveleged role as the state’s
monopolist of money creation) that certain production processes are profitable. This process of course must end in failure (the end result being not just recession, but worse, capital consumption). OT, but I would say the issuance of fiduciary media (as under FRB) could (but perhaps not necessarily) set this process in motion for the same reasons.

I’m not sure I’ve addressed all of your comments here, but hopefully I’ve elaborated my position so you can see where we differ. Let’s continue tomorrow, I’ve got to trash some stuff now.

Del Lindley November 8, 2010 at 7:14 pm

Beefcake,

Thank you for your very detailed response. Over the weekend I had a chance to review these issues and re-read Rothbard’s summary of the calculation debate and its history. I have also re-read Hulsmann’s critique of the ABCT and I have to say that my opinion of his error cycle theory has declined as a result, but for reasons that do not deal directly with the calculation-ABCT consistency question.

So I take it that you view a calculation-ABCT inconsistency arising primarily from ABCT’s reliance on Wicksell’s natural interest rate construction, and secondarily upon ABCT’s assumption that the expansion of fiduciary media is a necessary and sufficient condition for entrepreneurial error. If we understand that Mises’ calculation argument (that rational capital goods production is not possible without money-based capital markets) to be apodictically true, then one of the burdens of any BCT is that it must at least be consistent with this truth. The main point that I derive from Hulsmann’s analysis however (contrary to his interpretation), is that no BCT can be apodictically true. Hence there can be no (logically) sufficient condition for a BC, but there may still be a “practically” sufficient condition for it.

I have yet to look into the details of Wicksell’s theory of natural interest rates, so I do not know why the natural rate definition must rely on the absence of a capital market. Might it be possible to define a new “natural” interest rate that would apply to an economy with a capital market? We can certainly define a “natural” time preference for a capital market economy, so if a corresponding natural interest rate cannot be defined, then we should conclude that the interest rate itself is not a very useful concept (at least for theoretical applications–I happen to think that time preference is a much more useful concept for other reasons as well.) In any case it seems to me the ABCT could be reformulated by using time preference mismatches within the true (real) economy alone and not via a supposed conflict between two fictitious economies. By using Rothbard’s definition of social time preference, for example, it is possible to show (using reasonable assumptions and a small inflation rate) that the free market (or natural) time preference is equal to the harmonic mean of an ‘illusory” time preference and the “actual” time preference.

Regarding the money veil question, I do see the concept of money as an a priori productivity enabler which (obvously) has an impact on the economic conditions. Money is one means to obtain desired ends with minimum effort. (Labor division plays a similar role but its ability to enable productivity is empirically based.) In a consumer market with N products the number of possible price ratios is N(N-1)/2. Commodity money prices reduce this to number to N-1 ratios and so the action of exchange is thereby simplified. The productivity enabling influence of money extends into the producer market for capital goods: Productivity enhancing capital goods can barely exist without indirect exchange. Advanced capital goods have essentially no direct consumption value and so a barter trade between them makes little sense. Advanced capital goods are useful only when used in combination with other capital goods and land/labor factors.

Because of the ordinal nature of valuation, Mises argues that the values for capital goods are imputed to production goods indirectly through the capital markets. It is the quality of the entrepreneurial function (gauging future consumer valuations) that gives this indirect imputation meaning. Capitalism is no better than socialism if the entrepreneurial function is completely lost. Therefore a highly performing free market entrepreneurial class is assumed to make advanced capitalism superior (i.e. more rationally allocated) to “advanced” socialism.

Classical ABCT claims that the entrepreneurial function is degraded as a consequence of monetary inflation. In my way of thinking the valuation of capital goods is compromised because of an inequality that inflation produces between an actual and illusory social time preference. The proximate cause for the degradation is that the rational basis for profit and loss calculation is weakened, especially during periods following acute inflations. A secondary cause, which I suggest may result from chronic inflation, is the systematic decline in the average entrepreneurial skill level due to distortions in the entrepreneur selection process.

Monetary profit and loss is the only means by which entrepreneurs can gauge their success. This calculation has its fullest meaning when the monetary unit has a known and predictable purchasing power. Since profits and losses are computed over a time interval in which the effect of inflation can be realized in prices, inflation will distort the monetary yardstick in unpredictable ways. What matters to a particular entrepreneur is not the overall purchasing power of money; it is the particular purchasing power it has for the goods relevant to his industry. Inflation injects an essentially random (and biased) element into the calculation problem. No amount of training or experience can offset this distortion. This is not true of free market influences which tend to be more predictable as they proceed at an evolutionary pace. Other modes of market intervention tend to be either less widespread or less random in their intermediate to long term influence.

As I mentioned before the process for entrepreneurial selection must also be influenced by chronic inflation: the average skill level of a free market entrepreneur must be greater than that in an inflationary market. This follows from the introduction of an arbitrary element into the entrepreneurial “merit function.” It also follows from the admission of sub-marginal entrepreneurs (and the exit of supra-marginal entrepreneurs) due to the time preference imbalance.

So in conclusion, I am suggesting that there should not be any fundamental discord between the classical ABCT model and Mises calculation argument. The “problem” with the ABCT (as I now see it) is that no BCT can be apodictically true. This gets into an analysis of Hulsmann’s error cycle theory which I would be glad to discuss with you, if you would like, later.

Beefcake the Mighty November 9, 2010 at 1:56 pm

Del,

“So I take it that you view a calculation-ABCT inconsistency arising primarily from ABCT’s reliance on Wicksell’s natural interest rate construction, and secondarily upon ABCT’s assumption that the expansion of fiduciary media is a necessary and sufficient condition for entrepreneurial error. ”

Actually I think both points are pretty important. I think the notion that error follows *necessarily* from credit expansion is false.

“The main point that I derive from Hulsmann’s analysis however (contrary to his interpretation), is that no BCT can be apodictically true. Hence there can be no (logically) sufficient condition for a BC, but there may still be a “practically”
sufficient condition for it.”

I think the way I would phrase Huelsmann’s point is that there must be some essential feature of the economic system that makes error necessary. It’s not the fact, e.g., that central banks can expand credit, it’s the fact that the actions of the central bank, indeed the entire institution, is regarded as a legitimate part of the economic system. The effects of credit expansions as such can be anticipated, like any other change. It’s only if market participants believe that central banks really are making more resources available can it be the case that endeavors undertaken on
this belief *must* end in error. In short, an illusion.

“I have yet to look into the details of Wicksell’s theory of natural interest rates, so I do not know why the natural rate definition must rely on the absence of a capital market. ”

To be honest I’m no Wicksell scholar, but the concept is pretty straightforward. Here are two useful accounts:

“There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.” Knut Wicksell, Interest & Prices, p. 102.

quoted here by Murphy: http://mises.org/daily/3555

and

“So named by Swedish economist Knut Wicksell, the natural rate of interest is the rate that reflects the underlying real factors. In macroeconomic terms as applied to a wholly private economy, it is the rate that governs the allocation of resources between current consumption and investment for the future.”

by Garrison at http://mises.org/daily/2513

Interestingly, when I asked Ebeling and Horwitz about this (using a different GWAR alter-ego) at the GMU blog, they evasively noted that the natural rate is a construct (albeit one they regard as useful):

http://www.coordinationproblem.org/2010/07/cowen-on-monetary-misperception.html

You write:

“Regarding the money veil question, I do see the concept of money as an a priori productivity enabler which (obvously) has an impact on the economic conditions. Money is one means to obtain desired ends with minimum effort. (Labor division plays a similar role but its ability to enable productivity is empirically based.) In a consumer market with N products the number of possible price ratios is N(N-1)/2. Commodity money prices reduce this to number to N-1 ratios and so the action of exchange is thereby simplified. The productivity enabling influence of money extends into the producer market for capital goods: Productivity enhancing capital goods can barely exist without indirect exchange. ”

OK, but note money does a bit more than this. In your example, the combinatorial number of exchange ratios are only relevant in local markets, so to speak. I.e., a beer-pretzel exchange rate can only take place across the preferences of actors willing to make this exchange. That’s the whole point of the problem of double coincidence of wants. Money applies across the entire market, by it’s very nature, so it’s more than just a economizer of exchange rates. And very true as you note: capital goods cannot be directly compared, they can only be appraised in terms of price calculations, and in particular in terms of money prices. Again, this is why Rothbard’s discussion in MES is in terms of the *monetary* amount that is lost or gained by the absence or presence of some factor of production. There is no notion there of this amount corresponding to some “fundamental” value.

“Because of the ordinal nature of valuation, Mises argues that the values for capital goods are imputed to production goods indirectly through the capital markets. ”

OK, but note that there is some lack of clarity here over “values” being imputed. It is rather prices that are imputed, something very different. BTW, I have come to realize that, like with Mises monetary work, some of this statements here are subject to dispute. Certainly his early work is in conflict with his later writings.

“Classical ABCT claims that the entrepreneurial function is degraded as a consequence of monetary inflation. In my way of thinking the valuation of capital goods is compromised because of an inequality that inflation produces between an actual and illusory social time preference. ”

“Monetary profit and loss is the only means by which entrepreneurs can gauge their success. This calculation has its fullest meaning when the monetary unit has a known and predictable purchasing power. Since profits and losses are computed over a time interval in which the effect of inflation can be realized in prices, inflation will distort the monetary yardstick in unpredictable ways. ”

Not a bad way of putting it, but again, the question at issue is *why* inflation has the effect of inducing *error*. Note that there isn’t an issue over whether inflation induces distortions, like any other violent intervention (eg, a price control). The issue is why it results in mass error (which price controls, stupid as they are, don’t).

It may be the case that many observed cycles do entail an initial lengthening and subsequent restoration of the structure of production like the conventional theory asserts. Plausibly the current cycle can be characterized thusly, but I think it’s a big stretch to view the dot-com bubble this way. Ultimately, any theory has to recognize the inherent monetary features of a capitalist economy, and not rely on supposed monetary proxies for other allegedly more fundamental properties (like time preference).

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