Capital theory

Alasdair Macleod – 1 July 2010

Over the last few years it has become increasingly obvious that the development of modern economic theories may have intensified boom-and-bust cycles, rather than achieved the stated objectives of price and economic stability. Furthermore, there is much that Keynesianism and monetarism seem unable to explain.

These dogmas are purely macroeconomic and are based on assumptions that an understanding of microeconomics can easily disprove. The former is in the heads of academics, the rest of us exist in the real world of the latter. It has to be remembered that Keynes was a mathematician and academic; when he developed his economic theories, microeconomic theories were being refined in German, so this information was not easily available to him, even if he had wished to understand them. Monetarists share many of their theories with Keynes, and have even admitted macroeconomics does not offer adequate explanations. Britain’s economic success in the nineteenth century was a mystery to Milton Freidman. The Spanish monetarist, Pedro Schwartz, wrote in 1993 “There is no proven theory of cycles: it is a phenomenon we simply do not understand. However with money becoming elastic, and recessions leaving us speechless, it is easy to understand how we macroeconomists became unpopular.”[i]

Indeed. But there is a microeconomic theory that clearly explains where modern macro dogmas go wrong: capital theory as developed by the Austrian school.

Put simply, this capital theory states there is a fundamental difference between capital investment financed by an increase in savings, and capital investment financed by bank credit. To understand why, it is helpful to consider a theoretical example of each.

First case: Capital investment financed entirely from savings

The amount of money allocated to consumption will obviously fall to fund an increase in savings. This lower consumption puts downward pressure on consumer product prices, intensifying price competition. The message from the high street to the manufacturing chain is to lower unit costs and innovate, all of which requires investment in capital equipment. At the same time, the increase in the level of savings drives down interest rates, and funds from increased savings are available for this capital investment. Manufacturers are therefore able to invest in more efficient plant and equipment at attractive rates. Furthermore, new manufacturing processes and specialisations become viable, so new links in the capital goods chain are established.

It is worth noting that the increase in savings reduces the value of business at the retail end of the consumer goods chain, relative to the value of capital goods used in the manufacturing process. This arises from lower relative returns from retailing activities, and a rising value of the income stream generated by investment in capital goods as a result of lower interest rates. There is therefore a fundamental shift in economic emphasis away from consumer goods towards capital goods. The result is that a continual process is set in motion that leads to cheaper, better end-products, manufactured by a bigger, deeper pool of manufacturing industry.

It is important to note there is no “crowding out” effect, since labour and other economic resources are gradually released from activities closer to the finished product, to be redeployed upstream in the growing number of manufacturing specialisations and by manufacturers of capital goods.

This process continues into the longer term and labour costs tend to increase as prices decline. Rather than reduce wages, employers throughout the manufacturing chain will continue to invest in capital equipment to reduce manufacturing costs. The result is that employees, who are also consumers, become wealthier from a tendency for prices to fall relative to their income. Furthermore, the growing accumulation of their savings is enhanced by the rise in its purchasing value and is more than sufficient to comfortably finance their retirement, health and leisure.

Second case: Capital investment financed entirely by credit

When banks increase the availability of credit, interest rates are lowered for the same reason as when savings are increased. The difference is that the expansion of credit lowers interest rates below their natural rate, and there is no reduction of consumption to accommodate new investment. The two situations are therefore fundamentally different.

The initial effect of lower interest rates is to stimulate loan demand from businesses, and also from consumers for the purchase of durable goods. Lower interest rates also boost the present value of capital goods making investment in them more attractive, since the discounted value of their output is increased. Businesses are therefore encouraged to invest in greater production. Furthermore, lower borrowing costs make marginal investment propositions more attractive, persuading entrepreneurs to invest in new processes.

It should be noted that even though the credit is made available, the necessary economic resources have not be released by lower consumption – as in the First Case above. This leads to a number of problems:

  1. Labour and other production costs rise as the borrowers of this new credit compete for production resources that have not been released, since there is no balancing fall in consumer demand. To obtain these resources, they have to be “bid up”.
  2. The redeployment of labour and other resources from final assembly to earlier stages of production tends to be disruptive and create supply shortages, because there is no slack in the system. At the same time an increase in wage rates, due to the general increase in demand for labour, in turn increases demand for consumer goods. The result is that prices of consumer goods can be expected to rise as fast, if not faster than wages.
  3. An illusion of entrepreneurial prosperity is therefore generated by the difference between artificially low financing costs and now rising consumer prices. The growing tendency for consumer prices to rise faster than the costs of production enhances the illusion. The consequence of the illusion is that businesses themselves contribute to the increasing levels of demand, driving up the prices of goods further.
  4. The rising prices of consumer goods benefit businesses in the stages closest to consumption; meanwhile those farthest from consumption have the least benefit, yet face general increases of the cost of production. Many of these businesses become unviable, and economic resources tend to return to the businesses in the stages closer to consumption. The economy becomes more consumption-oriented as a result, and looses the depth of production activities associated with long-term industrial stability.

Put another way, these problems generate a growing inflationary effect, because price rises tend to outstrip the rise in wage costs. Investment in capital goods becomes less profitable than employing labour, whose cost does not rise so fast as that of finished articles. Instead of the economy enjoying the benefits of rising living standards from falling prices relative to wages, it experiences the inflationary opposite. Instead of workers being able to save for a comfortable retirement, their fewer savings are eroded by inflation, and become insufficient for retirement through a fall in purchasing power.

A boom generated in this way through an expansion of credit is clearly unsustainable, and it is followed by a bust triggered by the following processes:

  1. Sooner or later, the pace of credit expansion stops accelerating sufficiently to keep interest rates below what they would have been if the credit creation had not occurred. Interest rates then rise to pre-stimulus levels or even higher. They usually go even higher, because distressed borrowers will be prepared to pay any rate to complete unfinished capital projects, and lenders begin to anticipate further inflation and build this into bank lending terms.
  2. Losses develop in the capital goods businesses most removed from consumers and gradually spread along the production chain. The result is that investment projects are abandoned, factories closed, and workers laid off. Pessimism spreads with the notion that an inexplicable economic crisis has happened after people had become to believe in the boom.

Economies that are driven by the creation of credit experience progressively larger cycles of disequilibrium, because the inevitable response after the bust is to promote yet more credit to alleviate the effects. The logical end of this repetitive process is a build-up of economic distortions that can only be resolved by a final bust.

Historical confirmation

The two cases summarised briefly above represent the difference between an economy based on sound money and one financed through inflation. They confirm that government and central bank policies based on macroeconomics and without any regard to the actual microeconomics have been the origin of boom-and-bust cycles. Furthermore, there are historical examples that confirm Austrian capital theory works in practice.

Britain operated under a gold standard from about 1820, after the Napoleonic Wars until the First World War, a period of some 90 years. During that time, prices fell by about 25%, yet Britain’s economic strength was such that she became the most powerful trading nation in history.

More recently, whether through accident or design, both Germany and Japan developed post-war economies driven by savings. These economies featured strong capital goods industries, full employment, low inflation, strong currencies, and high levels of individual wealth spread throughout society. They have proved that deflationary growth associated with real savings is the ideal economic outcome, and in the process their apparent economic miracle became the envy of nations living on credit. They have disproved the macroeconomic theories of Keynes and the monetarists, who quite simply do not admit that you cannot substitute real savings with fiat credit.

Concluding remarks

Capital theory provides confirming evidence that Keynesianism and monetarism are thoroughly destructive, have been responsible for the economic ills of the Anglo-Saxon countries, and for the persistent inflation that led to the pensions crisis. US and UK governments are now on the hook for trillions of dollars and pounds to replace private savings that were discouraged through high levels of taxation (remember the investment income surcharge?), artificially low real interest rates, and then all but destroyed through inflation. In spite of this, economists advise yet more unsound money, by means of “quantitative easing”, or through the benefits of “exchange rate flexibility” – for which read only downwards.

We now have an microeconomic explanation for the economic crisis that built to a peak in the late 1970s, when the cycles of increasing credit creation were halted at the time of Reagan and Thatcher. But it was not long before the Fed and the Bank of England resumed their old ways, leading us again to a series of increasingly violent credit-driven cycles of boom-and-bust. The build-up of false credit today is greater than ever, and stopping the merry-go-round of ever faster credit creation will probably bankrupt the entire banking system.

So capital theory provides a credible explanation of why the US and UK economies in particular are in such deep trouble today.


[i] As translated and quoted in de Soto’s “Money, Bank Credit and Economic Cycles”.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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