I won’t bother to explain the context: Murphy, Krugman, etc.

by on January 21, 2011 at 7:51 am in Economics | Permalink

If you care, you already know the context with p = 0.87.  Bob Murphy writes:

Cowen is right that a sustainable lengthening of the capital structure initially requires a reduction in consumption; what happens is investors abstain and plow their savings into the new projects. But during a central-bank-induced boom, there hasn't been real savings to fund the new investments. That's why the boom is unsustainable, but it also explains why consumption increases at the same time. It's true that this is impossible in the long run, but in the short run it is possible to increase investment in new projects, and to increase consumption at the same time. What you do is neglect maintenance on critical intermediate goods, just as our islanders were able to pull off the feat for a few months.

Krugman's response, which focuses on slightly different issues, is here.  I will say that in the Austrian theory, once the central bank lowers the real interest rate, the increase in investment ought to come from shorter-term processes, such as real consumption.  (That's if you think the interest rate substitution effect is dominant, as the theory implies.)  Capital maintenance is usually a longer-term process and it ought to be encouraged by the lower rates induced by monetary policy.  The employment and liquidity boosts of the boom also might encourage more capital maintenance.

There is of course a literature on the cyclicality of depreciation, capital maintenance, and so on.  Overall it supports my claims, for instance: "In all cases, investment and maintenance are gross complements."  Or see hereThe most careful study I could find, based on Canadian data, shows that investment and capital maintenance move together in the same direction.  This piece argues for countercyclical maintenance expenditures, but not on the basis of any actual evidence.  In any case, how much is capital maintenance as a percent of gdp anyway?  Here is one earlier Canadian estimate of about six percent.  Will variations in that sum — with conversion time — be enough to support a consumption boom?  With expanding capital investment, a full employment assumption, and a basic closed economy model?  I doubt it.

Maybe Murphy has a revisionist view of the capital maintenance literature or maybe he would consider those unfair tests, because they are not all embedded in Austrian scenarios.  Still, the burden of proof here is on him and I don't see that he has cited evidence at all.  Comovement remains an embarassing empirical fact for Austrian accounts of the boom.

1 Ian Lippert January 21, 2011 at 4:12 am

What causes the boom in mainstream monetary theory? It seems like there has to be a cost somewhere to monetary stimulus. Is the boom somehow funded by the later inflationary effects? Does the boom come from savings which causes savers to realize they have lost their investments in the stock market once the bust has been priced in?

Interesting to see empirical falsification of the Austrian belief that it comes from replacement capital.

2 Josh January 21, 2011 at 4:33 am

I thought that was misdescribed by Murphy. Isn't the issue that the money that's spent on investments when interest rates are set too low comes inordinately from borrowing rather than from savings, and that the consequent feel-good times also increase consumption – in other words, people act as though resources are more available than they really are, and that the further we go in this direction, the thinner our safety margin is stretched, so that we are more and more vulnerable to collapse from lesser and lesser shocks?

3 Andrew January 21, 2011 at 6:19 am

Is accounting depreciation the same as actual maintenance?

"money that's spent on investments when interest rates are set too low comes inordinately from borrowing rather than from savings" Please tell me how I can search for more on this concept?

4 dearieme January 21, 2011 at 6:32 am

"Is accounting depreciation the same as actual maintenance?" Good God no; not in the firms I've worked in. You spend on maintenance along lines that are, you hope, rational: governed, fundamentally, by physics and chemistry. "Accounting deporeciation" is usually a tax-code convention, isn't it?

5 mulp January 21, 2011 at 7:13 am

Investment requires hiring ZMP workers and that is bad for economic growth.

In a time of high unemployment, low demand, and a need for increased personal savings, and deteriorated infrastructure, the solution is to cut all spending that generates no marginal production, and that means especially cutting all research, development, and productive capital construction, because those workers are ZMP workers.

And let's look at it from a capitalists point of view: as the capital base fails and is no longer productive, the remaining capital base is in more demand and thus the price that can be charged for its output increases, and that makes the remaining deteriorating productive capital increase in price. And to have a depreciating capital asset increase in price means that the capitalists are responding to the tax incentives given to capital gains.

Consider the alternative: If you build new productive capital to obtain a fair rate of return, say 10% over the life of the capital asset of say 50 years, then the price of its output, say electricity, will be constant for the long term, and that will mean that the deteriorating capital assets will not be able to demand higher prices for their output, and in fact might be forced to cut their prices as the new assets operate over 50 years at a lower price point, and that will cause the price of deteriorating capital to fall.

The tax code punishes those who have capital losses, so all capitalists need to ensure that their capital always increases in price, especially as it deteriorates in productive value. Clearly the tax code requires that the capital base is not allowed to increase because that will result in higher taxes paid for any income earned.

A recent report criticizes US electric power policy because the US is spending $4 annually for grid infrastructure per unit of power generation vs $8-12 in places like Europe and Asia, and this contributes to the losses from power supply instability in the US, and drives up the prices of electricity as the grid will not support real competition in electric supply. What the report fails to acknowledge is the virtue of this under investment in electric grid because it allows the electric power industry to charge more for less capital and thus drive up the price of the inadequate capital asset base which creates wealth for the capitalists. The innovation of the US is being able to take deteriorating infrastructure and instead of having the price fall as happens in other socialized and centrally planned economies, the less productive and worth less capital benefits from higher prices and increased profits to the capitalists.

And by the Fed lower and keeping low the interest rates, these deteriorating capital assets can more easily be sold at even high prices to investors who are highly leveraged and who will flip it in a few years to reap the capital gains from the further price increases as the infrastructure deteriorates further and its price increases.

6 Justin January 21, 2011 at 7:37 am

In Accounting, depreciation is simply a way to allocate the cost of an "long-lived" asset over that asset's useful life. Useful life means the amount of time the asset is expected to contribute to the firm's revenue. This is done in order to match revenues and expenses, which is one of the fundamental Accounting concepts. It has very little to do with actual maintennce cost and often it has very little to do with the actual deterioration of the asset.

7 David N January 21, 2011 at 9:19 am

I don't think lax maintenance can even begin to explain how investment and consumption can both rise in an "Austrian" malinvestment boom. However, during the two most recent booms we saw workers who in other times might have low-level retail or service jobs attaining ahistoric higher status and higher incomes. The dot-com CEO in his college dorm. The startup software developer with 3 months of Java classes under his belt. The 26 year-old venture capitalist. The supermarket night manager turned "successful" real estate agent/mortgage broker/appraiser. The newly-minted physics PhD turned quantitative risk "genius."

In both booms paper gains in options values or home equity fueled a sense of wealth and encouraged consumption. In both booms standards were lowered all over the place, not just in the maintenance of assets.

8 JP White January 21, 2011 at 1:53 pm

It seems to me the Austrian explanation requires the appearance of co-movement in order to affect the expectations of market participants, without there actually being co-movement. Capital maintenance statistics, as noted by numerous people above, are totally unreliable. Most are fictions for tax purposes. Those that aren't are pretty much wild guesses. Especially for industries where obsolescence eliminates the value of your capital long before wear and tear does. That being said, it doesn't seem (from the literature cited) that any reasonable figure for capital maintenance is going to be large enough to support the Austrian position. A more reasonable source seems to be the illusion brought about by the expansion of bank credit. If banks (interpreted widely) are lowering reserves (expanding leverage) then the claims against real resources are expanding, without the quantity of real resources necessarily expanding. This creates the illusion of co-movement. More is nominally spent on both consumption and investment. When, however, the expansion of credit inevitably comes to an end, and claims against real resources are exercised, it is discovered that real savings were substantially less than the nominal savings (for instance, assets such are mortgage backed securities are found to be worth much less than their book value) When this is discovered, expectations change radically and the credit contraction process ensues.

9 Laura January 24, 2011 at 7:42 am

Murphy has replied here: http://mises.org/daily/4993 to Krugman's critique and addresses part of your criticism.

10 John V January 26, 2011 at 6:08 pm

I'm no economist…Austrian or otherwise. However, I'm always perplexed at how self-described Non-Austrians recount Austrian Principles. It never has any resemblance to what I read from Austrians on the matter.

Why is that? I don't know.

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