 Capital-based macroeconomics, I've used that term for a number of years and it's began to soak in and other people are using it too, that it doesn't come from a particular country. Well of course it did, with Minger and all that, but it certainly applies to many more economies than the Austrian economy and that's why I put it that way. Now what we're going to do today is look at the difference between sustainable and unsustainable growth. This is adapted from my book Time and Money. Start with the elements of this story and start with a production possibilities frontier which most Austrians don't like to use that and in fact it's not very usable by itself but with some of the other graphics it works very well. Loanable funds market and that's a market that we have what we think of in the widest possible sense. I know Murray Rothbard in Manneconomy and State doesn't much like the loanable funds market, the graph of the loanable funds market, but he looks at it in a very narrow sense so I think I can get away very easily with using it but in a very broad sense. The structure of production, that's what you saw in the first lecture that I gave which is one of the more unique parts of the Austrian theory and therefore I did it as a separate thing just to show you that that's what's going on in this theory and labor markets well but this time stayed specific labor markets which is differentiated from the normal neoclassical view and I won't save my message to the end but I'll just show you right here that what we're looking at is sustainable growth which has to be founded by savings and on the other hand unsustainable growth which is triggered by credit creation so that's the that's the distinction that we're going to look at all through this show. A methodological point and this is paraphrase from Hayek he says before we can even ask how things might go wrong we must first explain how they could ever go right right now in business cycle theory that little maxim is usually flouted especially in Keynes who seems to think it never goes right so there's no way of showing how it might and what you'll see in this PowerPoint is that even though it's about business cycles that's a whole stick here but it turns out that we probably will use about two-thirds of the lecture showing how markets work right and once you show how they work right then you're in a good position to show how they can go wrong with federal reserve policy for instance okay so capital based macro features consumption and investment as alternative uses of the economy's resources and here what should strike you is that this is this is very different from the Keynesians because Keynesians add them together C plus I plus G and here we're putting C and I on opposite at opposite levels there consumption and investment so under favorable conditions a fully employed market economy allocates resources to both uses making the most out of the trade-off and what I say favorable conditions I mean the market is allowed to work okay so we're on the production possibilities frontier shown like so okay so the PPF is often used for emphasizing the concept of scarcity as illustrating the implied trade-off and the expositing theories of capital and interest economic growth and international trade but the PPF is rarely appears in macroeconomic constructions this show though is gives heavy weight to the possibilities frontier so investment here represents gross investment which includes replacement capital and we show you here there's gross investment and replacement capital is a pretty good part of gross investment but not all of it which leaves room for net investment okay and that investment is what allows the economy to grow so with positive net investment the economy grows the PPF shifts outward from year to year permitting increased levels of both consumption and investment now here what you see with the graphs is that if you're looking at one PPF then yes consumption and investment are alternative ways of using resources but over time from period to period if the PPF shifts outward then you have consumption and investment moving together okay so this investment based outward shifting of the PPF represents sustainable economic growth based on savings okay what's the economy grow okay so poor four periods of growth are shown with consumption as well as savings and investment increasing each period the actual rate of expansion of the PPF depends upon many factors and first and foremost a change in the savings preferences which provokes a movement along the initial PPF affects the rate at which the PPF expands outward okay so we should be able to see this suppose people become more thrifty more future oriented they reduce the current consumption and save instead so if that happens and we're moving along the PPF get something going on there okay with the increased saving and investment the economy grows at a faster rate we'll see if that works what's the economy grow okay it's doing its it's doing its job okay it's the increased saving that makes the difference so you see when you have growth then sure enough investment and consumption are moving together it's just when you have when you're on a given PPF that see and I move opposite directions of one another okay so let's compare the high growth economy with the original low economic growth we can do that with no initial increase in saving the economy grows at a modest range you can watch the arrow there on the left and with the initial increase in saving investment increases at the expense of consumption after which both consumption and investment increase dramatically from period to period what's the right side okay and if you look across there you can think you see now that okay the economy is out performing what it used to be before you had the increase in saving now let's look at the loanable funds market the loanable funds market was a staple in pre-Keynesian macroeconomics and here we're just plotting the interest rate against saving and investment and it goes like this saving constitutes the supply of loanable funds there this supply curve is and demand reflects the business community's willingness to borrow and undertake investment projects like so okay so with the interest rate serving is a price loanable funds theory is a straightforward application of the marshalian supply and demand analysis so if the market is working then we get an equilibrium point which equates savings with demand for investment so loanable funds theory was closely identified by Dennis Robertson a contemporary of Keynes and a critic of Keynes's alternative theory which was the liquidity preference theory of interest so this is just my little plug to Dennis Robertson I liked him okay on the suggestion of Roy Herrod who was a sympathetic expository of the Keynesian system Keynes included in his general theory page 180 a graph rendering of the loanable funds market and now it turns out that Keynes did put it in but only to emphasize that he was throwing it out okay he didn't like that loanable funds theory and we'll see why as we go along if people become more future oriented they increase their saving causing the interest rate to fall and thereby encouraging the business community to undertake more investment projects so watch the saving curve shift rightward increase in saving there it is with a given technology the equality of saving and investment is prerequisite to genuine sustainable economic growth it's saving that finance the investment the loanable funds market and the PPF tell mutually enforcing reinforcing stories so we just look at these two graphs together like so now you have to look at both graphs at once okay notable funds market shows how the interest rate brings saving and investment in the line with one another the PPF shows how the trade-off is struck between consumption and investment the market adjustments and output prices and wages and other input prices keep the economy functioning on the PPF so there's a assumption here at this point that the market is working and the prices change if they need to change so wages and so on so these two elements of capital based macro economics show the pattern of movements in consumption saving and investment and the interest rate that are consistent with the change in intertemporal preferences that is with saving so as before we let people become more future oriented they save more which transmits a signal a lower interest rate to the business community so watch the saving induced increase in the interest rate and the corresponding movements along the PPF here we go so we've got it we've got the thing working right right the lower rate of interest establishes a new equilibrium in the loanable funds market and the economy moves along the PPF in the direction of more investment and less current consumption now most other macro economists will just balk at that that somehow you're you're getting less consumption but more investment and we'll show you why because Keynes looked at it the other way but it turns out that at lower interest rates then lots of investment projects become affordable and investors are eager to use those resources which will give output in future years or future months whatever it is even the possibility of a market economy could work in this way is at odds with Keynesian theory you get this get the flavor of Keynesianism here note that more investment is undertaking as consumption falls that's that's the Austrian view okay you can see that on the graphs but according to Keynes any reduction in consumer spending would result in excess inventories which in turn would cause production cutbacks worker layoffs a spiraling down of of income and expenditures the economy would go into recession and the business community would commit itself to less not more investment that's Keynes paradox of thrift so in other words from that PPF Keynes sees that the that the market is just going inside the PPF it's it's going with less consumption and less investment so you get a depression right there for Keynes now the key is about the retail inventories the rep their representative investments according to Keynes if retail investors retail inventories were a representative investment then Keynes would be right here the drive demand effect dominates reducing the consumer spending means reduced inventory replacement in general late stage investments move with consumer spending that's what Keynes would say however the interest rate effect dominates in the long term or interest stage investments a lower interest rate can stimulate industrial construction for instance or product development so you get that trade off okay so to keep track of the changes in the general pattern of investment activity we need to consider the structure of production and the stage specific labor market and that's what we looked at a couple of days ago the structure of production and it's so unique of the Hayekian theory the Austrian theory that I had a separate take on that a couple of days ago okay so capital based macroeconomics disintegrates capital inter-temporally consumable 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 raised graphically from left to right in the output of the final stage constituting consumable output alright so an early stage process would be something like product development looks like that's going on there and the late stage would be inventory management the guy needs some customers actually but there they are okay so late stage investment activity is exemplified by inventory management for pedagogical convenience the initial capital structure is shown as having five stages of course there are lots of stages in a market economy but we're making do with five here with growth of the number of stages can increase although all five of these stages are in operation during each time period resources can be tracked through the structure of production over time and we'll see if we can do that together the sequence of stages form the Hayekian triangle the summary depiction of the economy's inter temporal structure of production in a growing economy the triangle increases in size along with the outward expansion of the production possibilities front here now we'll see let's watch this and now we're going to link up those two graphs so watch the PPF and the structure of production expand together okay so that's just ongoing growth no change in the saving preferences but people are saving all along and that gives you ongoing growth so when people should choose to save more they send two seemingly conflicting signals to the market and they're seemingly conflict conflictive because people are thinking in terms of Keynesian term so decreased consumption dampens the demand for the investment goods that are in close proximity with the consumable output this is the drive demand effect in other words that they're saving more they're not spending as much on consumer goods and so inventories drop people put holding so much inventory because people aren't consuming that much but a reduced interest rates which means that lower borrowing cost stimulates demand for investment goods that are temporarily remote from the consumable output this is the time discount or interest rate effect the drive demand and time discount are in conflict only if investment is conceived as a simple aggregate as it is in Keynesia C plus I plus G so investment no matter whether it's consumption or in or early stage is is considered investment okay in capital based macro capital and hence investment is conceived as a structure so changes in the demand for investment then can add differentially to or subtract differentially from the several stages of production that make up the structure Keynes theorizing in terms of aggregates rather than in terms of structure underlies care high-exclaim that Mr. Keynes aggregates conceal the most fundamental mechanisms of change and that that was it that's what Hayek needed to say at that point that was the problem increase saving results in an allocation of resources among the stages of production the two effects derived demand and time discount have their separate and complementary effects on the capital structure let's watch that and here just for emphasis let me say this slightly differently that a decreased demand for consumption goods dampens investment activities in the late stages of production that would be inventory replacement that would be dampened reducing the height of the Hayekian triangle and with time discount the reduced rate of interest stimulates investment activities in the early stages of production increasing the base of the Hayekian triangle okay so watch the structure of production respond to an increase in savings note the emergence of the sixth stage of production increased saving results in a reallocation of resources among the stages of production the two effects derived demand and time discount have their separate and complementary effects on the capital structure okay now we can use these two graphs together and show how it works increased saving then has an effect on both the magnitude and the investment aggregate and the temporal pattern of capital creation so what's the economy respond to an increase in saving okay so it didn't fall into the interior of the PPF like Keynes thought it would it simply changed the activities from the late stage to the early stage in view of the increased saving and of course those increased savings are what the people operating in the early stages are using they're borrowing those savings in order to you know in order to have those early stage activities so the PPF shows that more saving permits more investment see the arrows the Hayekian triangle shows that capital creation in the late stages such as retail inventories is decreased while the capital creation in the early stages such as product development is increased you get that kind of a twist of the structure of production and all this is by way of showing how markets can work okay without being hobbled by a central bank the structure of production is given a more future orientation which is consistent with the saving that made the restructuring possible that is people are saving now in order to increase their future spending power that's why they say okay they don't save for fun it's not fun okay and and so they plan to spend it and take some entrepreneurial judgment to figure out what they're going to spend it on but that's that's what the apartment part that's what the economy is all about okay note the increase in the growth rate this the sound is kind of lags what's going on but we'll we'll make do okay so now let's look at it first I think we look at the PPF as tracked by both the PPF and the Hayekian triangle consumption is seen to fall as the economy is adapting to a higher growth rate after which consumption rises more rapidly than before and eventually surpasses the old projected growth path so look at the PPF you get a little you get a little bit of a fault and then a big bounce you get the same thing let me do that again watch the graph down and then up okay and now down below here I've I've got a graph that shows consumption over time and it would look like this and that's exaggerated showing it goes way down and it typically just still goes up but at a less a lesser rate but I want the people in the back room to be able to see it so I'll make it go down all right and then you can compare the the dashed line with the solid line and see the saving implies giving up of some consumption in the near future and you'll see that there okay saving implies the giving up of some consumption in the near future in order to enjoy more consumption and the intermediate and far future and that that there's where you see the far future is getting more getting getting more consumption okay while most macroeconomic theories deal with the labor market and the wage rate capital based macro allows for state specific labor markets with the change in the interest rate stage specific wage rates change in a pattern rather than change uniformly and we can see that we put some labor markets down here although a labor market for each stage could be depicted the pattern of changes I ask wage rate gradient is revealed by distinguishing between the early stage and the late stage labor market so there's a early stage labor market and there's a late stage labor market so what's the economy respond to an increase in saving just looking at labor labor markets what you'll see well let's do it and we'll see let me do that once more if you didn't see it so what's it what's happening here is that workers are leaving the retail markets and going into the investment markets because that's what the economy responding to increased saving involved so here we go so one demand curve shifts left and the other one shifts right and then we can even show what Hayek called the wage rate gradient that there's a movement in relative wage rates which is the very kind of market signal that causes workers to drop out of the retail business and get into the investment business now we've got it all together here loanable funds market production possibilities frontier structure production stage specific labor markets looks like that okay so now watch the economy respond to an increase in saving and you can see it's poetry in motion I think it would be the right word but here here it goes I'll do it a couple of times okay so you don't get Keynes sliding into depression you just market mechanisms work like market mechanisms are supposed to and that's it I'm going to show this again if only because it took me a long time to make it look so there it goes okay now we're going to shift gears totally we were really talking about business cycles as opposed to how the economy works so now we're talking about policy induced unsustainable growth the macroeconomics of boom and bust and I take this from Steve Hankey because he has a much more stern luck than I can muster but he did I have to say he didn't read time and money before he wrote this so he wrote with interest rates artificially low consumers reduce savings in favor of consumption and entrepreneurs increase the rate of investment spending and then you have an imbalance between saving and investment you have an economy on an unsustainable growth path this in a nutshell is the lesson of the Austrian critique of central banking developed in the 20s and 30s so we'll see how this goes this is from Hayek I think I'll take time to read it because some people have claimed that in his late years he didn't he didn't approve of that business cycle that he had done earlier but here is he's in his late years okay and he says booms have always appeared with a great increase in investment a large part of which proved to be erroneous mistaken that's because people weren't saving the interest rate just went down because of the Fed that of course suggests a supply of capital was made apparent which wasn't actually existing the whole combination of a stimulus to investment on a large scale followed by a period of acute scarcity of capital because people weren't saving is consistent with the idea that there has been a misdirection due to monetary influences and that general scheme I still believe is correct okay now look what we've got credit expansion increasing increases in the money supply enter the economy through credit markets the central bank literally lends money in existence the new money masquerades is saving that is the supply of loanable funds and tails shifts rightward but without there being any increase in saving okay so what's the opposing movements of saving in investment as the central bank adds money Delta M to the supply side of the market for loans no this clues you off this is a different kind different kind of structure there you go so so he increased the money supply but that didn't increase saving it reduce saving because saving the interest rate is lower now and so people save less they're not so eager to save at the at that low rate of interest responding to a lower interest rate people actually save less and consume more right so they're consuming more the result is not a new sustainable equilibrium but rather a disequilibrium that for a time is masked by the infusion of loanable funds okay now pumping new money through credit markets drives a wedge between saving and investment investors move down along their demand curves taking advantage of the lower borrowing costs you see that arrow okay and savers move down along their unshifted saving curves in response to the weakened incentive to save that is that lower interest rate so the discrepancy between saving and investment is papered over literally isn't it papered over with newly created money which is self-represents no investable resources and there's that arrow so that's what's going on in the labor market much of Hayek's writing on money is aimed at shifting focus away from the bedrock relationship between money and general level of prices and toward the intertemporal discoordination that is caused by credit creation now look what happens upstairs here favorable credit conditions spur on investment activity which suggests a clockwise movement along the PPF in the direction of investment like so but income earners are actually saving less and hence consuming more which suggests counterclockwise movements along the PPF in the direction of consumption so what you're looking at here is some very serious disequilibrium the wedge between saving and investment translates into a tug of war between consumers and investors okay noting the investment dimension of the clockwise movement and the consumption dimension of the counterclockwise movement we see that credit expansion pushes the economy toward a point that lies beyond the PPF the PPF is that is the sustainable levels of consumption and investment it can go beyond the PPF but then it's in the unsustainable region that's the whole point all right so we got consumers pushing upward and investors pushing rightward and the result is the economy going out beyond the sustainable PPF into an unsustainable region that's how that's working okay okay now look at production possibility the stages of production the triangle the low interest rates consistent with future orientation stimulates investment activities in the early stages so you can see that to the left there but without sufficient resources being freed up elsewhere many of these investment projects will never be completed that's why you have the dotted line doesn't quite get completed compounding the intertemporal discordination increased consumer demand draws some resources toward the late stages further reducing the prospects of completing the new capital structure in other words people are consuming more rather than saving and you get a distorted triangle in that direction the dynamics of booming busts entail both overinvestment shown in the PPF and malinvestment the unsustainable lengthening of the hierarchy and triangle so you get mal investment overinvestment you get overconsumption as shown in both the PPF and the triangle so Mises repeatedly used the phrase malinvestment and overconsumption to describe the business cycle okay the tug-of-war pits that consumers against investors pushes the economy beyond the PPF unsustainably the low interest rate favors investment in increasingly binding resource constraints keep the economy from reaching that extra PPF so look at that PPF diagram and you can see that you're moving towards but you don't get there all right because resources are scarce much more scarce than than was thought and so the temporally conflicted structure of production dueling triangles John Cochran in Birmingham gave me that phrase dueling triangles I like it and so the economy can fall into depression and so if you look at that orange line probably no use orange and blue because that's all colors you know but look at that orange line and you see that's the only thing that Cain's picked up on you know he just saw the economies falling into the interior and there it is okay now real quickly because we're almost out of time you got a wedge between saving and investment you've got a tug-of-war between consumers and investors here we go padding the supply of loanable funds with new money drives a wedge between saving and investment papering over differences between saving and investment gives play to the tug-of-war between consumers and investors pitting early-stage against late-stage distorts the hike and triangle at both directions the temporal coordination eventually turning boom in the buzzed so watch the economy respond to credit expansion let's see if this works and you're all too young to know who that is you know who it is who that's that's Joe the flummer that gave these people hard time back in an earlier presidential election okay I don't have time for the rest of this so we'll quit right here thank you very much