All Commentary
Thursday, July 22, 2010

Not More Capital — the Right Capital

Capital goods are parts of an unfinished plan.

Of all the unique contributions of the Austrian school of economics, none is as central as the theory of capital.  Other economists have consistently misunderstood that theory, leading to much confusion, particularly in the two controversies that defined Austrian economics in the twentieth century: the socialist calculation debate and the Hayek-Keynes debate.  Even today, mainstream economists commenting on the Austrian theory of the business cycle misunderstand these issues.

Austrians start by defining capital as, in Israel Kirzner’s words, “unfinished plans.”  Capital is all the elements of an entrepreneurial plan that have to be combined to produce final output, including labor (sometimes called “human capital”), machinery, raw materials, and intangibles such as particular business processes a firm uses or its connections to suppliers.

When we see capital this way, we also recognize that capital goods are heterogeneous things. Capital is not like a bucket of water from which we scoop identical cups.  Instead, capital goods, including human capital, have a limited number of specific uses to which they can be put.  As Peter Boettke puts it, capital is not like Play-Doh, which can be formed into any shape, but like Legos, the versatility of which is limited by the sizes, shapes, and interconnections of the pieces.

Austrians speak of the need for capital to be “complementary” to other capital in order for it to help create an integrated production plan.  A producer must have the “right” capital, that is, capital that “fits together.”  An important implication here is that “more” capital isn’t always better.  What firms need are pieces that fit, not just duplicates of what they already have.

Complements or Substitutes?

Consider the major sports story of the last few weeks:  LeBron James’s move to the Miami Heat of the NBA.  At first blush, this seems like a huge gain for the Heat because they now have two of the best players in the game — James and Dwyane Wade (and perhaps a third, Chris Bosh).  Economically, it might look like the Heat will be much more “productive” because they’ve added very productive human capital in the form of James.  However, from an Austrian perspective there’s a question worth asking, as Tyler Cowen has pointed out:  Are James and Wade complements or do they just substitute for one another?  If they play too much alike, will they “fit together” in the way capital goods need to?  Often the best teams in sports are ones that find good “role players” who complement one or two excellent players.

If James and Wade, for example, can’t play defense well enough or they both like to handle the ball too much, and no one else on the Heat can pick up the defensive slack or move without the ball, there will be a hole in the production plan.  Having more really productive capital isn’t useful if it is just a substitute for what you already have rather than a complement in the mixture of capital goods that are needed to produce the output.  In fact, what makes capital productive is precisely that it is complementary to other factors of production.

All these points are misunderstood by critics of the Austrian explanation of the recession.  What Austrians claim happens during the boom is that inflation drives down interest rates, creating malinvestment as entrepreneurs begin production processes with too many stages between inputs and outputs (which seems to be justified by the artificially low interest rate).  Labor gets allocated to those industries as well.

Notice that it’s not that they have over-invested in capital. Rather they have the wrong mix of capital.  If one doesn’t understand the heterogeneity of capital, that distinction is easy to overlook.

It also explains why the road to economic recovery is not a matter of just more spending and more investment in general.  Capital and labor need to restructure themselves to meet the new reality of the post-crash marketplace.  Just throwing more capital at firms won’t help; neither will trillion-dollar government spending on consumption or job training.  Only the discovery process of the market can reveal which specific capital goods and what sorts of labor are required for entrepreneurial plans to succeed in the current economy.

We don’t need “more” capital and labor. We need the “right” capital and labor. Figuring out what’s right is what markets do better than the alternatives.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.