 This is on Austrian capital theory, and as you see in the subtitle, it's a prelude to capital-based macroeconomics. More specifically, a prelude to discussion on Austrian theory of the business cycle. Although in my own writings, in time and money, I make it clear that capital-based macroeconomics has a lot more to say about other parts of the economy than just business cycles. But business cycles are the most fully developed of the Austrian school, so I want to focus on that this afternoon. Let's go here. I'm going to start with two views. The Hayakian stages of production model, and you've already seen a lot about that from Professor Salerno. I might give a little different spin on it, but not much. And then the Knightian, and in parenthesis I say Freedmanian, stock-flow model. That's the alternative as far as looking at Hayak and Freedman is concerned. So we'll try to give that a pretty good workout. I say two views. Well, yeah, there they are. There are two of them. I could have put a third view in. Let me do it right here. The Keynesian view is animal spirits model. That doesn't quite pass muster as a model, actually. But if you've read the general theory, and let me show a show of hands. How many of you have read the general theory? Great. That's great. Both of you. So it turns out that over a span of a page and a half, he used the term animal spirits to give you an idea of movements of investment. His investment picking up or is it slowing down, and it's all run by what he calls animal spirits. Well, that doesn't fit well very analytically into a macro model. But we'll have something to say about that, too. Okay. Now, I'm going to start by just indicating that there's many meanings of capital. And I'm just going to give you a few. If you've read Bombaviric, I'm going to ask how many people have read all of Bombaviric. But he goes through quite a list of different things that capital mean or have meant, and so on in the literature. But I'm just going to go through a few and then focus on two particular meetings. Bank capital, that's just assets minus liabilities. Here we have financial capital, cash and funds raised by, say, stock and bond sales. Fixed capital, plant and equipment. Fixed just implies durable, a big machine that will last 30 years or whatever. Working capital, that's goods in process. An automobile that's halfway put together and is on its way down the assembly line. That's working capital, capitalized value. That's just the present value of future receipts. And human capital, that's more recent in the literature, the present value of skilled workers' future earnings. They've got skills and they have those skills right now and that constitutes human capital that they can apply it in the years and months ahead. Okay. Now I'm getting serious because I'm underlining things. See, that's the clue. Capital stock, okay? The stock of productive factors that yield a flow. There's another underline of consumption goods. And this is the Frank Knight view. And it's just defined dimensionally. In other words, a stock is something that exists right now. There it is. That's the stock. The flow is on its way out. You know, it's making the goods go out the door and so on. That's the flow. And it gets to something even more severe than that, all right? So what we're going to focus on in today's lecture is that distinction between the structure on the one hand that's the Austrians and the stock and flow on the other hand. That's Friedman and Knight. Or, well, yeah, that's the best contrast that I want to be making. Now there's a problem in measuring capital. And I want to spend a little time on this to convince you that it is a problem and it's unique to capital. And so you start out easy. Capital is heterogeneous. Well, who would disagree with that, okay? Of course it is. But you might come back with the claim that, well, so is labor and so is land, right? So why is capital being heterogeneous such a big deal? So aren't labor and land homogenous too? Well, yes they are. So we go to the next step. Capital is radically heterogeneous. That sounds like something Ludwig Lachman would write, okay? And I'll go a step forward and say, well, we could ask just how radical is capital heterogeneous, okay? And the answer is it's dimensionally heterogeneous. We just don't have the dimensions that we would like to have to give a meaningful measure of capital. And let me elaborate by giving you a fill-in-the-blank assignment. Here it is. And you can see that the sentences are all alike except what goes in that blank. So not all what? Well, units. We need some units in there, okay? What are the units? Start at the top. That's standard. Now I'm allowing for labor to be heterogeneous because it says not all are alike, okay? That means they're heterogeneous. But at least we have a unit where we can indicate just what the units are and realize that some worker hours are more productive than others and so on, but they're worker hours. And how about land? What do we do here? Acres, or we could say acre years. You see that in some textbook and that would be more in line with worker hours and labor and acre years. But land is heterogeneous too, which means not all acres of land are alike. Now we get into the real problem. Not all what of capital are alike. What would you say? Well, look at what's there very closely and you can see one way the textbook authors treat this. They just remove the parentheses, okay? Not all units of capital are alike. Well, I mean, you know, if you're reading through that at 11.30 or midnight in your dorm, you read right passes and say, oh yeah, units, yeah. What are they? You don't know, okay? Not all units are alike. So if you're taking notes, write down unit is not a unit, okay? Now, I've become sensitized in the literature to see what else people have. We can look at some say doses, some doses of capital. Well, how big is a dose? What else we got? Chunks and hunks, okay? And you can look at some other units and see if any gallons or whatever. You can't see anything that would work. And if you look at these units that are used, you're kind of leery that they would work. Let me show you. There's a dose. Use your capital that way. How about a hunk? I mean, some hunks are bigger than other hunks, all right? Or some chunks are bigger than other chunks. And what about a hunk? That's human capital, I guess. Okay. Now, let's get to two combatants here, which is Frank Knight and Friedrich Hayek on the issue of capital. And soon enough, we'll have Friedman involved because he's picking up the Frank Knight idea of capital. And it's important to note that Friedman and Frank Knight were colleagues at University of Chicago. And Frank Knight was a very dominant figure there. And we'll see that with Stigler's book and so on as we go along. He's very dominant there. He's very emphatic about just how to theorize about capital. And I can tell you at this point that there was a time in the late 40s or 1950, along in there somewhere, where Friedman, I'm sorry, where Hayek was trying to get a position at the University of Chicago in the economics department. And it turns out that they wouldn't have him. They wouldn't have him. And they didn't... They wouldn't have him because of his capital theory. They didn't want someone who was the author of Prices in Production, which is antithetical to Knight's view of capital. Okay. Now, the argument in the journals, there were articles about capital theory, Hayek's capital theory, and several different capital theories, but the emphasis was back on her old Frank Knight. Okay. And it turns out that before that, a number of years, look at the dates, back in the mid-1800s, that same battle was waged with Bon Bavere, the Austrian, and John Bates Clark, that actually was a forerunner of the theory that Knight picked up on. And so this has a long history of these two views of capital, stock flow on the one hand and the structure of production on the other. So my sympathies are my choice, of course, is Bon Bavere, although I have good feelings about Clark if only because he looks just like my grandfather. Okay. Kind of sweet. Okay. Now let me give you an idea. I don't know if you can read that from the back. What about production time in a Clark Knight vision as opposed to Bon Bavere Hayek vision? And it goes like this. The claim is, let me give you the claim to start with so you're not jarred into it later, is that production time doesn't count for anything. And it goes like this. Imagine trees being planted and harvested. And here's the story. Once a steady state is reached, and I underline that because that's key. That's key. Nothing else follows unless you start with that. Once a steady state is reached, production time is irrelevant. Okay. And notice irrelevant is in quotes. I'll have to explain that later, but it's in quotes. Production time is irrelevant. And so the trees have a linear maturity structure. Actually, it's long linear, but we'll let them get away with that. Each period a sampling is set out, and a mature tree is harvested. Let's see how that goes. Here's year one, and watch right under year one sign. We'll get a sapling. We set that out. And then look at the other end, and we harvest that other tree. There it is. Okay. And then the next period presents us with the same maturity profile. So watch the trees. There they go up. Okay. So you've got the same forest for the next year that you had this year. And so Knight writes it's the setting out that enables, with quotation marks, the harvesting. And so setting out the sapling now produces, in quotation marks, the harvestable tree now. All right. So production and consumption are simultaneous. Trust you to notice the quotation marks. Okay. So that's their story. That's Clark's story. That's just the whole story. All right. Now, George Stigler of all people. Stigler, of course, was a colleague at University of Chicago, too. Freedmen and Stigler were very good friends. So Stigler defends Clark and dismisses Bombavere on the basis of the simultaneous production of production and consumption. And here's what he writes. Look at this. Here's a Stigler. 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 it. Now, isn't that amazing? And in fact, it's only true if you make the very dramatic assumption about a steady state. And so that Stigler production, or George Stigler production and distribution theories of 1941. I made the mistake, and maybe I shouldn't call it a mistake, I was at a Mont Pelerin meeting some years ago and sitting at a dinner table with Stigler just across the table from me. And Stigler was carrying on about how it is that we don't really need that much history of thought, although he writes a lot of it. Because the theories in the past, if they're any good, we've still got them. And if they're no good, we've gotten rid of them. So why do we really need to study all that history of economic thought? And so I came up with what I thought was an exception. And I came up with this not having read Stigler's book. And so I mentioned Hayek and stages of production and how that all fell to the wayside. And Stigler had just exploded. And let me know that, no, that's something that needed to fall away. It was not viable. Okay. Here we go. Okay, so once the steady status reached production is irrelevant and so on, they carry on. You can read it. So here's what Stigler said about 43 years after his 41 book. This is interesting. 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 literature that it was a good many years before I could read the economic classic through my own eyes instead of his. I never brought myself to read through my doctoral dissertation. That was at distribution theories production. Yeah, there's the title. Because I knew I would be embarrassed by both the 90s excesses and its immaturity. So he started disclaiming it without actually reading it. But it shows what kind of an effect that Knight had on Stigler and on all the other economists essentially at University of Chicago at the time. Okay. Now, I call it black box capital theory because it's one thing to talk about these trees. It's a very specific example and it only works if you assume a steady state and so on. But that sort of gets dropped out of the wayside and you have just a capital stock and from the stock a flow. So that's the idea. I call it black box capital theory. I'll show you a black box that you've seen on TV occasionally. Flight recorder. How black is it? It's orange, okay. But black box actually has a meaning totally apart from the color of the case. Black box just means it's an electrical engineering term. Black box means that the user, someone that buys the box and sticks it in the airplane, the user has no reason or no ability to get inside the black box and see what's there. So it's black in that sense. It's hidden from the user. You don't know what's in there. But you hope it has the function that it's supposed to have. So that's the black box idea. So the definition of black box then is any complex piece of equipment typically a plug-and-play unit in an electronic system the specific context of which the user has no need to know. So this is the way that Stigler and Friedman and others at Chicago sort of put away all of the issues of capital. It's just in a black box, leave it where it is and not worry about it and go on. Now I have a suspicion, I can give you a couple of reasons. Why Stigler, I'm sorry, why Friedman signed on for the black box and never changed that. He never doubted that that's what he wanted. And one of the reasons is what I've already shown is the useable units. You know, you could say $1 worth of a piece of capital but that just mixes the value of it with the amount of it. But you don't have any units to talk about the amount of capital. You keep it in that black box and don't worry about it. That's the idea. So I've got no doubt given how that the Friedman modeling was that he did not want to have to measure units of capital because he wouldn't know whether it was the same old capital that now is worth more or it could even be worth less but it's actually more in volume. But what is the volume? How do you measure it? You don't know. So just keep it in that black box. That's one reason that he just leaned on to that particular theory. The other reason is one that I hesitate to mention because it amounts to psychologizing. And I don't like to do that. I just don't do psychologizing and I won't do psychologizing except for today. Okay. And it goes like this. This is kind of neat because I'm an Austrian economist but this is an empirical study that I'm going to offer you. And it goes like this. It's about economists that marry one another, husband and wife both of which are economists. And I know a lot of those couples. It's kind of sad actually. My wife is a flutist. I don't tell her how to play the flute, you know. So we get along great. Okay. Now, you might know, most of you probably do or some of you probably do, that Rose Friedman was also an economist. She was working on a PhD at the University of Chicago. That's where they met. Okay. And I read, I can ask who's read this book, a big thick book written by Friedman, both of them, Milton and Rose. It was called Two Lucky People. Okay. And I bought the book and read it. And it turns out that for years, Rose Friedman was working on a dissertation. And usually she'd start working again when they moved. They moved and okay, she had, let me start working on this again. They moved again and so on. So a number of times she kept working on this dissertation. And the dissertation was about capital theory. And who do you think her dissertation director was? Okay. Now here's the empirical part. I think it's empirically almost dead sure that a married couple will get along fine with one another only if they stay out of each other's concentration in economics. Okay. So Milton didn't say anything about anything bad about Friedman's capital theory. He stayed out. They were two happy people. I mean, two lucky people. If he had denied that that was a good capital theory, they may not have been so lucky. So I think that might have had something to do with it. Okay. Well, let's go on. Let's see what we've got here. So this is my capital stock. It's same color anyhow. And we we need to add do not open. And then get something going. There it is. You've got the flow of consumption and the maintenance of capital. So you get a feedback in effect that maintenance has to be just right so that the capital stock doesn't increase or doesn't decrease. It just stays the same. And that's the steady state. Isn't it? And so you can see that what's in green that's the flow of consumption. And then the stock plus the maintenance are the stock of capital. And the claim is by night is that the maintenance is just a technical detail. It's a technical detail. You think it wasn't but by making it a technical detail then he can get his notion of his stock flow. Okay. Let's go on. So I put a box around this because both of those things the actual capital stock plus the maintenance is what night is taking to be capital. Okay. So the capital stock includes maintenance as a technical detail. Again, there is technical in quotes. Hence capital is permanent, and that's in quotes. Now it drove me nuts reading night to see all these quotes like this. And I learned from Jerry O'Driscoll, he was one of our early Austrians that wrote a dissertation at UCLA. And he clued me in to some of the ways that night expressed himself. And so night would say capital stock is permanent in a sense. You can see this all through his writing. Sometimes he would say the stock is permanent as it were. Okay. The stock is permanent so to speak. You get tired of saying that and you just push quotation marks. Okay. So a permanent capital stock yields a perpetual flow. That's the idea. And of course the qualifications are in a sense as it were so to speak. That's a strange capital theory, but that's it. Okay. Now we even go a step further here. We've got capital stock and the flow of consumption. But what night really like to do is change this to sources. He calls it sources yielding services. And that seems like a roundabout way of putting things. There's sources we don't call it capital sources. And and then he says there's only one factor of production. This is odd. It's capital. Okay. In the broad sense of sources. So land, labor and capital are all capital in the broad sense. So in other words labor means the labor is a building, a buildingness to work. Whether you're actually working or not. That's the capital aspect of it. And so we change the maintenance to sources. You've got to maintain sources. And you have a flow of services. Now you might wonder what's the difference going from consumption, let's say, to services. Well one thing you could do is take you know the production, let's say of refrigerators and then the refrigerator becoming a consumption good. All right. But it's a good. It's something and it's a durable good. Knight doesn't want it to be durable. He wants it just the services of the refrigerator. That's what we're looking at. Not the whole refrigerator. It's just the current services of it. And the sources of that service, of course are the refrigerator. That's the way it works. And so it's really a definite or dimensional difference. One's the stock and one's the flow one and in the extreme. Okay. It goes like that. Now this has got to be challenging, but I think we can do it. I'll call that sources again and maintenance of sources and services. And I'm going to read this, but you can't just start reading the thing. You have to realize that it's full of sources and services enough to make your head swim. And it helps if you identify where those are right now. So there they all are. And this is a quote by Milton Friedman. In other words, Friedman doing his capital theory has cabbaged on to Knight and he's doing it in terms of services and sources. And then the key thing I've underlined is at the same time this is stuff that's all happening at once. Okay. There's no time Well, let's see if I can read it. I'm not sure I can, but the key feature and he's talking about of the process in which interest rates have been lowered and that's what sets off a business cycle. Okay. At least the Austrian thinks it sets off a business cycle, but Friedman doubts it because the key feature of the process is that it tends to raise the price of sources of both producer and consumer services relative to the prices of the services themselves. It therefore encourages the production of such sources and at the same time the direct distribution of the services rather than of the sources. Are you with me? But these reactions and their turn tend to raise the price of the services relative to the price of sources so that is to undo the initial effects on the interest rate and that's all it wants. Okay. So as soon as that interest rate goes down then just in a flash all of that happens and it doesn't make any difference in anything from that point on. And that's Friedman. Okay. Now to be fair about this let's see it goes on there's one more part of it where he's not talking about he says the final result may be a rise in expenditures in all directions without any change in the interest rate of all. Well how could it be any change because it went down and up in a split second when any time for it. No change at all in the interest rate. Interest rates and asset prices may simply be the conduit through which the effect of monetary change is transmitted to expenditures without being altered at all. And of course what happens is the interest rate is altered over a fairly large point in span of time until it finally does adjust to its old level and maybe not even quite its own level because a lot of misallocation has gone on in between. And it's true that if all of this change in interest rate happens at once both down and up yeah there's no effect right. Now in fairness to Friedman in the same section in the article 1961 article that I'm citing in the same section he talked about how things will be different if you're thinking in terms of building some kind of an industrial building or creating machines or doing things that actually do take time. Well of course it would be very different in fact that's the thing that is the focus of the Austrians in seeing what's going on. And yet he drops that. He says that but it doesn't become part of his theory. He sticks with the Knightian view, the strange thing. Now another strange thing we can do that again feel good even though Knight thinks of that that feedback as a technical issue he does allow that it can be more than enough to keep the capital intact okay. Or it could be less than enough to keep the capital intact. Well those would have to be decisions, wouldn't they? You could over-maintain or under-maintain or whatever. That would be a decision. Well how is it that it's technical if it just keeps it intact but you have the choice of beefing it up or letting it run out okay. But if you do let it run if you do beef it up you get something like this okay. And if you let it go the other way you get something like this and it's gone. Okay. So that would have to be a matter of choice. Where are we time-wise? So here's the summary Knight and Hayek so maintenance is a technical detail we're wondering about that last slide or so. Hayek maintenance is a matter of choice. You could run the thing day and night if you want to get some products out the door for some specific reason and waste away your machine. Capital is permanent. No, capital depreciates but is augmentable beef it up replace it and so on. Capital is the only factor well it doesn't make any sense. Capital is heterogeneous and multi-specific. Production time is irrelevant with quotation marks and production time is the key variable. You'll see in a later lecture how Hayek and Friedman use the word key. Friedman is the empiricist of course and when he says key variable he means it moves around a lot and so we can do econometrics with it. But Hayek is saying production time is the key variable. It's all about sources and services that's Knight it's all about temporal capital structure it's about stocks and flows no it's about dynamic market processes. You couldn't get a bigger contrast of two capital theories than that. I've got a few minutes and I want to oh here's something as reported by Mark Scousen in his Vienna in Chicago Larry Wimmer he's an economist an early 60s PhD candidate at the University of Chicago reports that Austrian capital theory was one of those subjects at Chicago. They didn't want to hear about it. Now a little bit about Minger's law and I'm going to breeze through this because you've heard a lot from Joe Salerno there's the goods of different orders consumption goods at the bottom and higher order goods along the top production proceeds in this diagram and it's consistent with Minger production proceeds top to bottom and value imputation goes bottom to top Joe covered some of this stuff and I'm superimposing the page in Hayek's prices in production that aligns up with what I've already shown you and you have orders of goods just clean it up like that and the one thing that's kind of odd about this is that when you're using that diagram it looks like time is coming down the vertical axis that's the direction of the actual production time is coming down the vertical axis and almost makes you wonder what time does when it bumps up against the origin it's not something it's not a graph that you're used to seeing and sometimes it can be an obstacle to people figuring out how this consumption or how this works now Walter Block has claimed several times to an audience like this that I solved this problem I solved the problem and getting away with time coming down the vertical axis and I did, I did I worked on it and I came up with a solution and I want to see what you think about it there it is then now time goes from left to right and the value is the other way alright we'll make a Hayekian triangle out of it production time and a sequence of changes and if you want something more complex look at that one that's out of Hayek's pure theory of capital myself I like that one okay I need to stop right there thank you much