 Okay, you're quiet down at three o'clock, it works fine. This lecture is on Austrian Capital Theory and that's essential to learning about the business cycle of the Austrian school and I'll do a lecture on that in another day or so but I'm going to lead up to it so that you can so see just how crucial it is to get the capital theory straight and to recognize that other schools of economics just don't see it. They don't see it at all and especially Milton Friedman and so I'll show you two views here. One is a Hayekian stages of production model you know what that is and the other one is the Freedmanian and actually it's Knightian. It comes from Frank Knight when both Knight and Friedman were at the University of Chicago and I would claim that Friedman got just a little too much Knight to understand how the business cycle works. We're going to neglect King's animal spirits. Okay, we'll just leave that aside. Now start out that one of the reasons that people get confused about capital in Austrian theory or any other theory is that the word capital is used in so many contexts and so I'll show you a few and then we'll zoom in on a couple that are at issue this afternoon. We could talk about bank capital as assets minus liabilities or net worth. You know we know about that. Liquid capital how liquid is it? Well that's cash held by producers for future investment so it's that's the dollar capital. Here's fixed capital you know what that is plant and equipment. Fixed implies durable. Working capital that's goods in process raw materials and semi-finished goods. Capitalized value that's present value of net future receipts. So the word is used to mean a lot of different things and human capital present value of a skilled workers future earnings. Rothbard didn't like the use of the word human capital and I'm not sure just why I think I know and that's because business firms have to hire people and the capital that those people have are their capital not not the producer's capital but nonetheless that's still another use of the word capital. Now we're going to get serious because I'm underlining things okay and one of them is Frank Knight. His concept of capital was as a capital stock so it's a stock of productive factors that yield a flow of consumption goods so you'll hear a lot this time about stock and flows and then you could guess the other one is capital structure that's the Austrian school the temporal pattern of heterogeneous producers capital okay and it's a pattern that can change and can change by changes in the interest rate and the changes based on the interest rate do one thing if the rates come down because people start saving more and it does another thing if it's a central bank that pulls them down one gets you increasing growth the other one gives you boom and bust so that's what you want to look for in this lecture throw all the rest of them out and those are the ideas of capital that we're going to work with now there's a problem of majoring capital and sometimes it's hard to get a handle on this what's what's the problem okay and one way of saying it is capital is heterogeneous doesn't get very far a lot of things are heterogeneous okay so that can't be it exclusively another one let's see but aren't labor and land heterogeneous too well yeah yeah so what's so strange about capital let's go on capital is radically heterogeneous now that sounds like something Ludwig Lachman would say okay and that's fine but we need to see what it means okay so just how radical is capital heterogeneity so capital is dimensionally capable there are heterogeneous it's dimensionally heterogeneous all right now let's look at our labor land and capital and I've put in some units here for you to figure out what they are not all units of labor are alike well of course not all units of land are alike not all units of capital are well so what's so good or what's so strange about capital and I'll show you what and you'll be able to see just what let's start with the with labor worker hours that's that's the working unit now okay we could talk about unskilled labor or semi-skilled labor or skilled labor okay but there's still heterogeneous but at least we have an idea of what the units are and then you could guess what it is in land we call it acres if you're talking farmland and of course it can be different grades of fertility it can be terrain it could be location and so on but we can talk about acres if it's residential then of course went the other way if it's residential then you know that's another way of looking at it now I'll ask you what what are the units of capital what are those units and you kind of hard pressed to say something and I've scoured through a number of well say intermediate level macro books to see what they say about it right so and so here are a few of them they just put units I mean just take out the parenthesis there are units of capital yeah what are the units well let's look at even some worse intermediate macro what you get dosage of capital that's not gonna work okay chunks and hunts I'm a different you know I went to the my computer and just looked up and see what these things are and and if that can work okay so you know there you got gallons and you got pounds and so no that's not gonna work there's a dose of capital okay there's a chunk is it a standard chunk I don't know it could be in a home that's human capital so who knows what that means big Rothbard's against that too okay now what our focus is on is the Austrians and Frank Knight and later Freedman right so you can see what the divisions are temporal pattern that's that's the Austrians it is not just hi it's minger me says Schumpeter moma there it's all about the temporal pattern you have to have a time element in there and it can change with the interest rate and it's important to what about what it is that changed the interest rate as I've already indicated and then stock and flow has a pretty antiseptic look to it doesn't it doesn't have any pattern at all just a stock of it and the flow from it right now it turns out that that same clash came much earlier with of course now boom Bavaric looking at the temporal pattern and John Bates Clark was stock and flow okay I don't I don't see much of stock and flow that he had as opposed to some of the others and Freedman for instance although I have to say I have good feelings with Clark but that's only because he looks just like my grandfather I'll spot him that so what about production time in the Clark night vision and it goes like this you see a bunch of trees that have been set out and some of them are growing because they've been there more time than others and Clark would argue and so would night and so would Freedman okay that once the steady state is reached and I underline that then production time is irrelevant it's irrelevant and right now clue you and that you may not have read enough night but night puts quotation marks around verbs that make you wonder why do you do and to me it seems like it when he puts quotation marks he's just sort of crossing his finger like I hope you'll go for that you know so we'll see more though I'll let you look for the quotation marks point them out if you don't see it okay so trees have a linear maturity structure actually logged linear you can see the curve a little bit okay each period of sampling is set out and a mature tree is harvested now okay look there over on the left we're starting out with year one these already got set out okay and so there we've got another one okay and then look over at the right and you can harvest that tree okay so you've got a new tree and yet you've got left what you had to start with all right because it's a steady state as long as you maintain the steady state there's no time element involved at all according to night and freedmen in that sense so the next period presents us with the same maturity profile right let's see yeah I see that grows it grows again so that's what you had before you don't have to worry about time at all okay so here's a look at look at the quotation marks okay it's the setting out that enables the harvesting really is that what enables the harvesting and what that means of course is that somehow if you're just dead set on having a steady state economy with no increase or no decrease if you just have to have that then this is what you do okay now this this one just got high act he couldn't stand it setting out the sapling now produces looking close the harvestable tree now okay and and of course high access that's just an absurd use of words that's all there is to it can't be true and there you go so production and consumption are simultaneous so don't whack why are you worried about the time element it's the same every every time so this is what what night and then freedmen are thinking about okay now here's George Stigler and Stigler of course as most of you know was at Chicago at the time that the Breedmen was and night was so George Stigler defends Clark and dismisses Bomba there on the basis of the simultaneous simultaneity of production and consumption 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 that a strange thing that's George Stigler and that's prices in production no that's not it that's production production and distribution theories in 1941 and that's Stigler's dissertation under guess who Frank Knight so that's the story and we'll get one more thing about about Stigler look at this I wrote my dissertation in the history of economic thought under Frank Tine 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 classics through my own eyes instead of his I have never brought myself to read through my doctoral dissertation and that's production and distribution theories again because I knew I would be embarrassed by both the 90 and excesses and its immaturity that's Stigler who said it at a talk in the 1984 that that's it all right now we got what I call it black box capital theory what about black box capital theory it's like a flight recorder on an airline that's the black box is it really black you know it's orange okay it's orange the blackness is that you don't get to see inside that's it don't just don't look at it okay don't open it up so as any complex piece of equipment typically plug-and-play unit in an electronic system the specific context about which the user has no need to know all right now this is a complete analog to the capital stock all we need you know though so that's the idea that you don't miss what's in the box that's that's the capital in there see what we can do with it yeah see you have maintenance of capital it sort of maintains itself as you can see and a flow of consumption so oh I ought to leave the maintenance of capital there because that is just a technicality I think that's what that's what you're looking at with the capital stock capital stock includes maintenance as a there it is technical detail well of course it's not a technical detail I mean some people would do more maintenance than others you might do it once a week or once every ten days once every five days whatever you choose to do okay and worries about if if it goes wrong maybe you should do a little more maintenance all right so it it's not a technical detail at all so hence the capital stock is permanent it it maintains itself it's permanent and they say it you know I'm saying he puts quotation marks every time you turn around and that that's actually not always because he has another way of saying it capital's the Gerald O'Driscoll put me on to this years ago and I keep underlining it in my book on on night here it is the capital stock is permanent well in a sense and then a page or two later well capital stock is permanent as it were what else we go capital stock is permanent so to speak what can you do it's not permanent we're sorry okay so the permanent capital stock yields a perpetual flow can you think about what the qualifications are in a sense as the word so to speak so if you go for a night and that's that's what you've got to get into so here we are capital stock we've got maintenance of capital we got flow of consumption okay so we have a system of capital yielding consumable output all right and then he says that really there's only one factor of production you thought there were three there were only one it is capital okay so human capital everything everything becomes capital land becomes capital and so on in the broad sense of sources so now we've gone to the idea of sources okay because sources much more inclusive than just capital as you thought it was before you realize that really there's only one factor of production in the sources now look at our maintenance of capital well land labor and capital are all capital in the broader sense right so maintain maintenance of sources is what we look at and look at the flow of consumption it's the flow of services because night doesn't want to mess with people who aren't producers that nonetheless have things like houses that yield a return over time okay he wants it he wants it all be services so you have to think that everybody's a renter or something everybody has a service because they own a home all right now don't try to read this don't try to read this it just wasn't wouldn't work let's put the sources up and the maintenance of sources and the services so that's what we got and I'm gonna try to read it for you I may not make it but to help me and maybe you a color coded so you know where the services are and you know where the sources are now before I go through this I say why go through all this all this gibberish this is this one is Freeman it goes over to the next slide and I'll show you where it comes from Freeman so this is Freeman and so he's locked in tonight on on capital theory okay well I have one blue thing up there just to let you know what it's about the key feature that's Freeman and then I write of the process in which interest rates have been lowered and it's put it that way because what they're talking about has been lowered by the central bank okay not that you not that you decided that it to change your saving habits okay it's been lowered okay so and so the key feature is that it tends to raise the prices of sources okay that's the orange thing of both producer and consumer services and those consumer services have to do with houses that are rented okay relative to the prices of services themselves really are services like the maid or something like that it therefore encourages the production of such sources and at the same time I mean everything happens here at the same time so you don't have any any problems during a bust right because it all happens at the same time 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 prices of sources that is to undo the initial effects of the interest rate okay so nothing really has happened because no time has been allowed for anything to happen and it goes on pretty let's see okay the final result maybe a rise in expenditures all directions without any change in interest rates at all interest rates and asset prices may simply be the conduct through which the effect of the monetary change is transmitted to expenditures without being altered at all so everything just happens at once essentially and this is there's no time for a depression or a downturn and and this comes from pre-vins optimum quantity of money and other essays you could look it up that's a strange thing so essentially he could have said he could have said okay so much for that me says you know so much for that high act because nothing actually happens all right now despite the fact that you're talking talking about steady state they do realize that things can go awry and you can actually grow or you can actually drink right and so that they show how this works to see if we can do it okay there's a capital stock doesn't get much output but everything comes back to the capital stock alright now this let's just look at night and high act and module say freedmen and high act all right it goes like this maintenance is a technical detail high I couldn't agree maintenance is a matter of choice capital is permanent no capital depreciates but is augmentable capital is the only factor capital is heterogeneous and multi-specific production time is irrelevant production time is a key variable and boy is that true in Austrian economics it's key variable it's all about sources and services it's all about temporal capital structure it's about stocks and flow according to night and it's about dynamic market processes according to high high you can't think of two economists it would be that far apart on these basic issues but there they are and to me it's I don't get it with freedom I don't get it the freedom would pick up on that and the only thing I can think of is that he was there with Frank Knight and you heard what what was said what Stigler said about how how he just couldn't read it on his own had to read it through night as reported in Mark Scalzen in his Vienna in Chicago Larry Wimmer and an early 1950s PhD candidate at the University of Chicago reports that Austrian capital theory was one of those subjects verboten verboten in Chicago right he says one of those what were some of the others I don't know all right now let's look at Minger and show what's going on here he used the term goods of different orders goods of the seventh order goods of the first order the goods of the first order are consumption goods so we'll change that to consumption good and you have higher order good and that that always struck me as strange higher what makes it higher and all I can think of it's up there at the top of the screen that's higher you call the higher order goods but the higher highest order goods near the top of the screen and and Hayek followed suit as you'll see shortly right so there's a higher order goods now what we see here is production proceeds top to bottom well how could it not you can't start at the bottom and go at the top right but value imputation goes from bottom to top okay some of this parallels what Dr. Salerno talked about this morning now you can see what I've done is just super imposed Hayek structure of production that's page 56 or whatever in the structure of production orders of goods and this this thing sort of strange took me a long time to wonder what is that Minger thing and now the Hayek thing or strange and what strange is is that you have time coming down the horizontal axis well okay but there's nowhere else in this world of economics where time goes downward always goes upward but they've got it goes downward you might think that it crashes at the origin or something and at the bottom you have consumer goods that are fleshed out okay and that's that's sort of odd to clean it up a little bit that's that's just Hayek now okay now I worked on this to sort of fix it because I didn't like this time coming down and I worked on it quite a while Walter Block told me I did a good job okay so let's see how it works so so the time goes left to right as you would think and the consumption comes out of right as you would guess okay now there's a more stylized triangle well it does not style it that's the triangle we talk about the Hayek and triangle it's just really the blue part there or purple whatever whatever that is Hayek and triangle yeah production time is a sequence of stages we get that now you might all be thinking if we're dealing with the capital structure isn't that really a simpleton thing a simpleton way of looking at it geez but at least you have the time element there and if you really think that's just too simple for you to play with then go to pure theory of capital instead of prices in production and here's what you find so you'll be better off with with the purple triangle okay okay here we go structure of production I think I've got time capital based microeconomics disaggregates capital to intertemporally consumable output is produced by a sequence of stages of production the output of one stage feeding in to the input of the next the temporal temporarily defined stages are arrayed graphically from left to right the output of the final stage constituting consumable output so there's the triangle in stages at least we put the stages back in and there's somebody at the early stage it looks like he's on the ball goes what he's doing late stage that guy's kind of loafing and dinner and customers but they'll show up okay late stage investment activities as exemplified by inventory management now I put this in here this is a factory says main gate down here and you see the main gate over there and you'll see a sign that says you are here you've ever gone to look at you are here but what's missing is it one that says we are here and the point the point is that that almost any factory would be producing things that some go one stage and some go another and you're not quite sure because you're having red prices in production you don't know what is where so they wouldn't be able to tell you where it goes it might be ball bearings that are that go to that go to mining mining equipment and also go to skateboard is that early stage your late stage so it's really you can't sort it out at the industry level for pedagogical convenience the initial capital structure is shown as having five stages with growth the number of stages will increase so while all five of these stages are in operation during each period resources can be tracked to the structure of production over time let's see what what's that what's the goods in process there it is oh this is a note here Henry let's see I can introduce the triangle in 1931 when Henry Ford was still producing a model a if only hi had had PowerPoint he could have shown how the abstract triangle aligns with real-world output but we can do that here and that's just to show you that the output doesn't fall out of the bottom okay it comes to the right together the sequence of stages form a hike in triangle of 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 and that is it'll increase in size if people are saving right it'll change in shape if they decide to save more or save less that's what it meant watch to the watch the structure of production expand here you can see it expands people must be saving but it's the same general shape as the triangle when people choose to save more the change in their preferred temporal pattern of consumption is registered by the market the first and foremost by reduction in interest rates and let's see reduced current consumption frees up resources in the late stages which then can be employed in the early stages I should say which some can become employed in the early stages so it looks it looks different let's see so watch the structure of production respond to an increase in saving all right so sure enough see when Kane saw that he didn't have a triangle so when he saw that people saved that means they're not consuming well how they're not consuming why would we be producing and high access and realizes that no if they're saving that changes the interest rate and it makes it makes production better more profitable so in high I can theory increased saving results in a reallocation of resources towards the early stages of production here the differential interest rates that sensitivities are rare the night in theory in night in theory increasing saving beyond capital maintenance requires requirements result in an increase in the capital stock but with no implications about capital's temporal structure that's that's what lame about this you can get a big capital stock but it's not spread out just right an increase in output of consumer goods emerges over time as it as the early and intermediate products move through the more time consuming structure of production so now now that you have saving you can increase faster we can see clearly the critical difference between night and high if you burn through the casing of the night in black box we see the high high achy and temporal structure of capital that allows for differential interest rate sensitivities and hence reveals the market mechanism that tailors production plans to the inter temporal preferences if the interest rates are telling the truth about people's willingness to save it gets genuine sign of sustainable growth if interest rates are being held down by the central bank we get an artificial boom followed by a bust so that's the end of this one in the start of boom bust cycle when i do another view okay there there they are thank you