 This is a PowerPoint show on Austrian capital theory, which is an important part of what I call capital-based macroeconomics. Not that I want to shy away from the Austrian economics, but here at Auburn some of my students are confused. I think it only pertains to Austria and some of them think it pertains to Australia. It works that way, but if I say this capital theory, we'll get along just fine. I'm going to look at two views. One is the Hayek stages of production model, and I'm going to contrast it with the Knightian, Frank Knight, stock flow model. And I put in Friedmanian because Friedmanian bought in pretty heavily to the Knightian capital theory, as we'll see in this show. And for several reasons, I'm going to neglect Keynes' animal spirits model. I think we can do without that. Okay. Now, it turns out that one of the problems with getting a handle on capital theory is that there's so many different meanings of the word capital even in the Austrian system and certainly in economics generally. So let me show you some of them. Don't write them down. There are too many. And I'll show you where to stop and actually pay attention. So it goes like this. Bank capital, yeah, we know what this is. That's assets minus liabilities or net worth. What do we got now? Liquid capital. There's liquid capital. That's the cash held by producers for future investments. Now, that does come into play with the Austrians but less dramatically than some of the others. In fixed capital, that means plant and equipment. Fixed implies durable. There's working capital and that's goods in process, raw materials. And some of my finished goods. Human capital, present value of a skilled worker's future earnings. We get that. Okay. And now I'm getting serious. I've got two things up here that are underlined and that's what you want to take notes on. Okay. One is capital stock and the stock of productive factors that yield a flow of consumption goods. So the flow part of it is all consumption goods. The stock part of it is just that, a stock. We'll get into that. Capital structure, well, you know, that's the Austrian term which is a temporal pattern of heterogeneous producers goods. So that's what we want to pay attention to and we'll get rid of the rest of them for the time being. Now, we start with the problem of measuring capital which is a pretty severe problem and is one of the reasons that a lot of economists stay away from capital theory. All right. Let's see what we've got here. Capital is heterogeneous. Well, yes, it is. But you could say, well, it's always workers and land and so on. A lot of things are heterogeneous. And so we can ask, aren't labor and land homogeneous too? Well, yeah, but capital is radically heterogeneous. Now, that sounds like something Ludwig Lachman would say, I'm sure. And it's true. And we asked just how radical is capital heterogeneity. Capital is dimensionally heterogeneous. Now we're getting to it. We'll see how this works. And we have fill-in-the-blank exercise here. You don't need to bark it out, but have it in your mind what should go in. Not all blank of labor are alive. All right. Well, that's true. But what's the blank? How are we measuring? Well, we've got away and you probably have it in your mind right now. And that would be units of some kind. So let's get going. Worker hours. Yeah, worker hours. Not all worker hours are alive, but they all are worker hours. So you've got something of a unit there. And how about the next one? Not all blank of land are alive. Well, seems like that's acres or could be acre years, depending on just what you're going to do. But now I challenge you. I challenge you. Not all units here of capital are alive. What goes in there? So watch those units real close there for capital and you'll see what shows up in some of the textbooks. Not all. Yeah, units. What does that mean? And I went to the University of Virginia and I heard lectures about capital and I heard about units. And then I heard a few others too. It goes like this. One, doses. And what else? Chunks and hunks of capital. So could we make do with any of these? One thing I did is just I just googled those words to try to see what those things actually look like. And would they really be units per capital? So there's a bunch of units. Well, there is a tablespoon there, but no real no real dose. So and nothing else is going to work. So let's see. Yeah, there's a dose. Okay, could you measure capitals with a dose? You think so? A chunk? There's a chunk. Okay, now we don't know. Is that a standard chunk? I don't know. And how about a hunk? That's labor, isn't it? That's not capital. Okay, so now what we see is that there's lots of economics who try to get away from this notion of having to find units for capital. And this is particularly so with economists who are empirically they do empirical jobs most of the time and talking about econometrics and so on, right? Freedom will qualify for that as we'll see because it's hard to get a handle on how much capital there is. So let's go on. What I've got before is Frank Knight and Hayek. And they did battle in the journals on this issue of how to treat capital. And several decades before that there was Bomba Verk and John Bates Clark that went at it about how to deal with capital. Well, of course, I go with Hayek and I go with Bomba Verk. Although I have to have some sympathy with Clark if only because he looks exactly like my grandfather. Like that picture. Okay, well let's get started and see what's going on. I don't know if you can read that or not. What about production time in the Clark Knight vision? And this comes to fruition in a book by Stigler, George Stigler. And of course Knight and Stigler were at the University of Chicago when they were there at the same time Friedman was. And that I think is what got Friedman into the Clark Knight view. Let's see what this view is. We look at a bunch of trees that have been planted and the key here to this exercise is the thing that's underlined. Once a steady state is reached. All right, well the Austrians aren't too interested in the steady state. They want to know what's going on in the economy. And if you just theorize strictly in terms of the steady state, you're not going to come up with very good economics. So once a steady state is reached, production is irrelevant. And you notice quotes on irrelevant. And that's not because he saw some other author that used that word. That's from Knight. Okay, irrelevant. Knight puts quotation marks on a lot of things. And if you get into it, if you get into his reading, you see what the quotation marks mean. It means something like if you'll let me get away with this. That's what it means. All right, so we'll look at it and see how it works. The trees have a linear maturity structure. Well, probably look linear actually, but we won't worry about that. Each period of sampling is set out and a mature tree is harvested. Okay, the next period presents us with the same maturity profile. And there it is. Okay, now it's the setting out that enables look at the quotation marks there. It's the setting out that enables the harvesting. Is that right? Setting out doesn't enable harvesting, but it almost seems like it does just because we've already said we're only looking at the steady state. Okay, so setting out the sampling now produces the harvestable tree now. Okay, well, it doesn't produce anything just by setting it out. Again, that's Knight. So production and consumption are simultaneous. So you don't have any production time, right? You harvest a tree and you plant a tree the same day. Hayek just called that wordplay when he talked about Knight. He said it's just wordplay. Okay, so George Stigler defends Clark and dismisses Bomba Veric on the basis of the simultaneity of production and consumption. And not really that way. Now get this, you can hardly imagine that someone would say this with a straight face. 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 is simply no point in saying it. And of course, the point is there only if you're stuck with this steady state. And that's Stigler production and distribution theories, which was his dissertation under Frank Knight that he finished in 1941. 43 years later, he said something a little different and we can get you that. Now this is Stigler talking. 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 the literature that it was a good many years before I could read economic classic through my own eyes instead of his. And he goes on, I've never brought myself to read through my dissertation, doctoral dissertation, production and distribution theories, the formative theory that was 41, because I knew I would be embarrassed by the knighting excesses and his immaturity. Now let's look at what I call black box capital theory. Does anybody know what color the black box is? Orange. Okay. There's our black box flight recorder. He says, do not open. So any complex piece of equipment, typically plug-and-play unit in the electronic system, the specific contents about which the user has no need to know, that's what that means. And so what we get here is the capital stock and is treated in Chicago economics as the black box. Okay. That the stuff is in there. And well, I need to add, do not open. Okay. Can't be quite sure how that works. Now what we want to do is show how this black box functions. Yeah, there it goes. So you have a flow of consumption. So anything is actually flowing. Anything that has a time dimension to it is just consumption, consumption goods, and it even makes it more severe than that. And the thing that circles back into the black box or orange box is the maintenance of capital. All right. So it spews out both the goods and then the maintenance that keeps the maintenance itself, I guess. You put that maintenance back there because the capital stock includes the maintenance as a technical detail. Now think about that. Would any economist say that maintenance is a technical detail? No, you can maintain it once a month or twice a month or whatever depending on one thing or another. So it's not just a technical detail, but it's treated as a technical detail in Frank Knight's view. Hence, the capital stock is permanent. Would any Austrians say that? The capital stock is permanent. Now, he kind of makes a different statement. He says the capital stock is permanent. This is Frank Knight. Capital stock is permanent in a sense. Or sometimes he says it's permanent as it were. We'll go on, so to speak. I have to say it's Jerry O'Driscoll who was at South Royalton in 74 who told me about this and these little tags on his sentence. And I love it. I like that. It's Jerry. So the permanent capital stock and look at the permanent there it is. Permanent capital stock yields a perpetual flow. And you know what the qualifications are? In a sense as it were, so to speak. Okay, now let's see where we go. We have a system of capital yielding a consumable output. And yeah, this wasn't quite right with Knight to call it consumable output. He says, well, we have a system of sources yielding services. Services aren't anything concrete. Services don't last at any time. They're just services. And that's the view of capital. And because of that, he says there's only one factor of production and that factor of production is capital in the broad sense of sources. You're going crazy trying to read Frank Knight's stuff. So land, labor and capital are all capital in the broad sense. That's the idea. Now, don't try to read this. Don't try to read it. Let me read it for you. But to read it for you, I have to color code it to keep from stumbling. And the person who's writing this is not Knight. It's, yes, Milton Friedman. Friedman sort of bought into a lot of the Frank Knight stuff. And see if I get some color coding here. Got a little blue up there. I put the blue in actually because I want you to know what he's talking about. And so I'll read down to the end of the blue. The key feature of the process in which interest rates have been lowered, supposedly by the central bank. And we have to see what this process is. And you've got it color coded and you know what he means by sources. You know what he means by services. We could all read it in unison. But let me read it. I try not to stumble. So the key feature is that it tends to raise the price of sources of both producer and consumer services relative to the price of the services themselves. It therefore encourages the production of such sources. And at the same time, there's no there's no time coming along at all. The direct acquisition of the services rather than of the sources. But these reactions in their turn tend to raise the price of services relative to the price of sources so that to undo the initial effects of interest rates. So in other words, in no time, the interest rate, if it went down, it would be back up in no time because services and that's free. And he goes on about this. I can do it all in white now. The final result may be a rise in expenditures in all directions without any change in interest rates at all interest rates and asset prices may simply be the conduit through which the effect of the monetary change is transmitted to expenditures without being altered at all. Now, what you see here, if you go back and read this, is that he's really showing what Hayekian recession would be, except with Hayek, there's a time element. And things happen. Bad things happen when the Fed is pumping money into the system. And it doesn't make its changes all at once with no lasting effect. So this is all the problem of the treatment of capital. Here, Friedman is an econometrician and he can't get that capital in his equations because he doesn't have any reasonable kind of a unit to do it. In other words, it's always a mix-up of the value of the capital and the amount of the capital. You can't have a word for just the amount because that's not a possibility. And so that's why he gives short shrift to the capital that is going on during the process of the business cycle. Okay. Well now, after talking about the Stigler dissertation, which was done under Frank Knight, I wanted to mention that there's another person writing a dissertation under Frank Knight and about capital theory. And that was Rose Friedman, okay, Milton's wife. And it turns out that it was a long drawn-out process. In fact, she never actually finished the dissertation. But she went back to it time and time again. Have any of you read Two Lucky People written by Milton and Rose Friedman? I read that book. It's a long book. And one thing I picked up is that a number of times, and generally every time they switched residences from one city to another, Rose would, when she settled into the new house and she didn't know any of the neighbors and she didn't have a lot of friends there, that's when she went back working on her dissertation. So time and time again, she's working on a dissertation on Frank Knight's capital theory, all right? Now here, I'm, you know, I think of myself as an Austrian economist, but I'm going to do some statistics. I'm going to look at what's going on here in this story. And that is, I knew about all this trying to get the dissertation finished. And I also know from other books that the Freemans never had any troubles in their household at all. They were just good for each other, okay? Now, it turns out, I mean, I know a lot of couples that are both economists. It's kind of sad, actually. They're both economists. And if they stay out of one another's major part in economics, then they'll be fine. But if they start looking at what the other one is doing and being critical about it, it's all off, okay? So I'm sure that Milton stayed away from it. That's my empirical my empirical way of looking at things, okay? Now, she never finished it. But still, that was how their family operated. Okay, what we got going here. So we can show an expanding economy. I mean, that was, it's not a stagnant economy. So you just have a little bit of maintenance. No, we got a lot of maintenance going on, not so much consumption. So that can work, okay? And what else have we got? A lot of consumption under maintained. So you can get that. Okay, so a summary here, just to show how different night in Hayek are, maintenance is a technical detail. No, maintenance is a matter of choice. Capital is permanent. Capital depreciates, but is augmentable for Hayek. For night, capital is the only factor on how to disco. Production time is a key variable. It's all about sources and services. It's all about temporal capital structure. Night, it's about stocks and flows in Hayek. It's about dynamic processes. Now, one thing I've heard from Mark Scousen, do you know who Mark Scousen is? Has reported by Mark Scousen in his Vienna in Chicago. Larry Wimmer, a 1960s PhD candidate at the University of Chicago, reports that the Austrian theory was one of those subjects verboten in Chicago. Okay, now we're going to switch and talk about this structure of production and how it fits into the Austrian model, at least in the way I model it, and start out with Linger's law. And it goes like this, the value of higher order goods derives from the anticipated value of the respective consumer goods. Well, okay, we'll go with that. So we get goods of different orders. Goods of the first order that's right down there on the bottom is actually consumption goods. And then second, third, fourth, fifth, sixth, seventh order are called higher orders. And they are, they're higher, you see them? Seventh one is the highest one, all right? So higher order of goods, creating the consumption goods. Now, what Minger saw, and this was a big breakthrough really in macroeconomics, is that production proceeds top to bottom. Well, of course, you can't start with the consumer goods and go the other way. It goes top to bottom. And value imputation goes from bottom to top, right? Well, we understand that. And now I just superimpose that one page out of Hayek's production, prices in production, and you can see essentially the Hayekian triangle. But the strange thing about that triangle, the strange thing at least to me, is that the time element is shown as progressing from top to bottom. I don't know if any other graph in all of economics that has time going from top to bottom, it almost makes you wonder what time does when it hits the origin. And let's see. Let me clean it up just a little bit, a little bit more. So that's it. That's the Hayekian triangle. You see the triangular aspect of it. But we have time coming from top to bottom. Now, Walter Block, is he here? Walter Block has claimed that I was the one that changed all this, right? I didn't think of myself as really changing it much. But the business of having the time go from top to bottom is just, it's hard to get your head in. And I have to say that I did work at it. I worked on it to get it to look a little bit more reasonable. And you can watch that. There. I did it. I think all in one day. Now time goes from left to right, and the value dimension is vertical. And I'm sure that some of my stuff in Austrian macro is suspect because they don't realize that the triangle has been changed. But anyhow, that's it. And so we can superimpose the triangle without seeing all of the different stages of production. And there it is. Again, it's pretty simple. And I'm getting this all from the structure of production, right? Structure of production. It's a thin volume. It was initially done orally at LSE and then made into a book. But much later came pure theory of capital. And if you want to work on IAC's capital theory, you might want to go ahead and go from prices and production to the pure theory of capital. And if you do, I'll show you what you're going to be in for. Now, I can't figure out how to twist that one around to make it look any better. Okay, but that's it. Okay, that's it. Okay. Okay, now capital based macro disaggregates capital intertemporally. Consumption output is produced by a sequence of stages of production, the output of one stage feeding in as input to the next. The temporal temporarily defined stages are arrayed graphically from left to right. In the output of the final stage is constituting consumable output. Okay, okay. Let me get my story going here. So there's the early stage investment activity exemplified by product development. Looks like he's doing a pretty good job there. And late stage investment activity is exemplified by inventory management. He just needs some customers, all right? Sure on that. Now, look at that triangle. It looks awfully simple. And yet it's not. It's not simple. Because there's a lot of eddies and all sorts of things that cause those stages of production to be here and there and other places. Let me show you. Here, for instance, is a, this is a ball bearing outfit here. They produce ball bearings. And you see a main gate down there. You see it on up there is a you are here sign of people just want to stroll through and see what's going on. That's where they start with you are here. You always see you are here. So when you have this, but one thing you never see is we are here. We are here producing ball bearings, but they really don't know just where they are. Because they're producing ball bearings partly for skateboards and partly for mining equipment and partly for a bunch of other things. All right. So it's it's not clear to the management of this of this site to figure out what's going on with interest rates and how to determine whether there's money inflation or not and so on. Right? That's sort of a lockman input. You know, the lockman realizes that kind of stuff. You really don't know. And in theory, it's there but but the individual investor can't possibly know just where all of his stuff is going. Okay. For a pedagogical convenience, the initial capital structure is shown as having five stages with growth. A number of stages will increase. And we can show that. I think we'll see. I've had students in my class say, is there only five, you know? No, lots of them. With growth, a number of stages will increase, although all five of these stages are in operation during the same period, resources can be tracked through the structure of production over time. This would never happen with night. Watch the goods in process move through the stages. There they go. So here's a note. Hayek introduced the triangle in 1931 when Henry Ford was still producing the Model A. Model A was produced in 2831, if you don't know. I think you should know that. If only Hayek had had PowerPoint, he could show how the abstract triangle aligns with the real world output. Let's see. Did they go by? Didn't they see them on mine? Okay. So that's part of showing you the output didn't come out at the bottom of that triangle. It goes out there. Okay. So together, the sequence of stages from for my Hayekian triangle, the summary depiction of the economy's inter-temporal structure of production. In an economy experiencing secular growth, the triangle increases in size, but not or not necessarily in shape. Some people would say that if it increases in size, people tend to tend to save more proportionally. Well, they might, but we'll show it as just an increase in size. So when people choose to save more, the change in their preferred temporal pattern of consumption is registered by the market, first and foremost by reduction in interest rates. Reduced current consumption frees up resources in the late stages, which can be employed in the earlier stages. Lower interest rate favors more time consuming production. So that's what's that. We get lower interest rate. What's the structure of production respond to an increased saving? Like so. In other words, it's cutting down on consumption in order to save. But when they do that, that causes interest rates to fall because savings is more plentiful. And when interest rates fall, then it becomes profitable to engage in some long term projects that were not profitable at higher interest rates. So the Hayekian theory, in Hayekian theory, increased saving results from a reallocation of resources towards the early stages of production. Here the differential interest rate sensitivities are at work. In the Hayekian theory, increasing savings beyond capital maintenance, capital maintenance requirement results in an increase in capital stock, but with no implications about the capital's temporal structure, because there was no time structure in the capital stock in the first place. So in that case, it would be growing, but with no tilt towards bigger savings. Okay. Yeah, those are big jumps, okay. So the increased output of consumer goods emerges over time as the early and intermediate products move to the more time-consuming structure of production. In the Hayekian theory, increasing savings beyond capital maintenance requirements results in an increase in capital stock, but again, no implications about the saving. So we can clearly see the critical difference between night and Hayek. If we burn through the casing of the night in black box, we see the Hayekian temporal structure of capital that allows the differential interest rate sensitivities and hence reveals the market mechanism that Taylor's production plans to intertemporal preferences. Let's see if we can burn through the box. And there it is. If interest rates are telling the truth about people's willingness to save, we get genuine growth, sustainable growth. If interest rates are being held down by the central bank, we get an artificial boom followed by a bust. And that's the story. Thank you.