The cry is going up from our economic commentariat that the Australian economy is running into “production constraints” and that this in turn will drive up interest rates. It is also argued that this situation is likely to be compounded by the inflationary effects of rising wages. This nonsense, readers, is what passes for economic wisdom, not only in the Australian media but also the world-wide media. Listen out for the same arguments appearing more and more frequently in the US as the Bush boom gets close to its economic economic denoument, unless the Fed unexpectly slaps on the monetary brakes .
The problem here lies in what is being taught to economics students. Neo-classical economics not only treats capital as homogeneous it also tends to thinks of it as a permanent fund that mysteriously maintains itself without the need for human action. Just as bad is the belief that production and consumption are basically synchronous. (For this view we need to thank John Bates Clark and Frank Knight, founder of the Chicago school. I should add that some neo-classical economists are not happy with time and heterogenity being exiled from orthodox economic thought). In addition, money is treated as being neutral, meaning that monetary expansion influences only the price level while leaving relative prices to the forces of supply and demand.
It’s important for an understanding of present conditions to grasp the ramifications of the preceding. If capital is homogeneous and money is neutral why should bottlenecks appear? Surely any monetary expansion would mean a proportional increase in demand resulting in a proportional increase in output until all idle resources were fully employed, at which point prices would begin to rise. It follows that sufficient monetary tightening would stop inflation without the emergence of malinvestments. (These are expenditures on projects that would be unprofitable in the absence of inflation).
I am not suggesting that unemployment would not arise in such a situation. Clearly it would as it is highly unlikely that expectations of future prices rises would be entirely absent. But the point is that once these expectations were adjusted to the new ‘price level’ the full employment of labour and capital could be quickly resumed.
By now the reader should see the contradiction between what is taught and what is reported. I cannot think of a single member of the economic commentariat who has cottoned on to the fact that their statements on bottlenecks and inflationary labour costs are in direct conflict with what is taught as ‘capital theory’. The importance of this dismal reality lies in the fact that if they had been sharp enough to connect the dots it would have dawned on them that the policies they urge on politicians are the very policies that bring about the economic phenomena that they publicly lament as threatening inflation.
The economic reality is that money is not neutral. Expanding the money supply has the unavoidable effect of changing spending streams. This will inevitably alter the pattern of production as firms rearrange their factor combinations in an effort to satisfy the new pattern of demands.
The vital fact that capital goods are heterogeneous is not only never mentioned by our economics journalists, the enormous ramifications of this fact are not even remotely understood and neither is specificity. Now capital goods range from the specific to the highly non-specific. These goods are obviously combined with land and labour to ultimately produce consumer goods. It should be clear to those with some economics training that when spending streams change so do the evaluation of capital goods. If a certain process employs specific factors then any fall in demand for their product will bring about a disproportionate fall in the prices of these factors.
The prices of the complementary factors (those factors that have to be combined with the specific factors) cannot fall below the value of their services in any alternative production process. Hence the less specific a factor is the less likely the value of its services will be affected by a fall in the demand for its product in a particular line of production. What all of this amounts to is that monetary expansion will have the eventual effect of not only creating capital gains but of generating capital losses where none would arise in an economic environment governed by monetary stability. In this case society will suffer a genuine loss of welfare. This raises the important point that Hayek made when he stated that what is really
...relevant is not whether full employment exists, but whether the particular kinds of resources needed exist in the proportions corresponding to the state of demand. (Friederich von Hayek The Pure Theory of Capital, The University of Chicago Press, 1975, p. 391).
Emerging bottlenecks tell us that monetary policy has distorted the pattern of production to the point where firms now find that either they do not have sufficient complementary factors to meet the demand for its product, in which case they must continue to bid against each other for the necessary factors, which also include circulating capital. This is always the case where investment has been driven by artificially low interest rates and the boom is allowed to continue until brought to an end by real factors. The point may even be reached where firms are forced to continue to compete for the services of these factors even as interest rates rise. (With respect to Hayek’s theory of the trade cycle, Fritz Machlup correctly stated “that monetary factors cause the cycle but real phenomena constitute it”, Essays on Hayek, Routledge, Kegan Paul 1977, p. 23).
As this process continues we should expect those stages of production furthest from the point of consumption to find themselves suffering a disproportionate increase in cost compare with the lower stages. And this is exactly what we do find. Materials use by Australian manufacturers has risen 56 per cent from June 1997 to June 2007. (Reserve Bank of Australia: Alphabetical Index of Statistics).
The ABS (Australian Bureau of Statistics) uses a three-stage approach: preliminary, intermediate and final, the last one refers to goods destined for direct consumption. Austrian analysis predicts that in an inflationary situation input prices will eventually rise at a faster rate than the prices of consumer goods. The ABS index shows that since September 1998 preliminary prices rose by 38 per cent, intermediate prices by 32 per cent and final prices by 25 per cent. (Ibid.). It is no coincidence that in the last 11 years M1, bank deposits and currency have more than doubled.
The problem of capital theory, monetary policy, inflation, interest rates, demand for labour, bottlenecks, etc., is far more complicated than this very limited article would suggest. Nevertheless, it should alert readers to the unfortunate fact that much of what we are told by the media about economics — in fact, most of it — is dangerously misleading.
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