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Thursday, October 6, 2011

The Expanding Sphere of Opportunities

Keynesian fears are groundless.

In earlier columns and other writing I have tried to emphasize that an excessive focus on economic aggregates can distort our understanding of how markets work and the effects of government policies. One area in which aggregates can be particularly problematic is the capital structure of an economy and the related concept of investment. Treating “investment” and “capital” as undifferentiated aggregates often leads to a distorted view of how economies grow.

An example of the errors excessive aggregation can lead to is found in Keynes. In places he argued that one problem facing the economy of the 1930s was that opportunities for productive investment were becoming fewer and fewer and so savings would permanently exceed investment.  For Keynesians, excess savings represented  a decline in consumption, which in turn reduced aggregate demand and therefore potentially led to depression. This theme was echoed in other writers at the time.  So what many had seen as the key to economic growth — accumulation of capital — was in Keynes’s view a fool’s errand since there was no place for the capital to be invested profitably.

Thus for Keynesians there is no link between savings and investment; the lack of demand associated with excess saving meant that investment opportunities were drying up. This is one reason Keynes favored the socialization of investment: He believed government could direct those savings in ways that would create new investment spending.

Not a Singular Good

Putting aside whether he was correct about the power of government to allocate resources, the deeper problem is that capital is not a singular good.  We don’t just add some lump of “capital” to other lumps of “capital” and get investment. In reality capital is comprised of a whole panoply of heterogeneous goods, each of which has its own demand and supply. More important, the economy as a whole is comprised of a structure of capital, which requires that these individual pieces of capital (including human capital) fit together like pieces of a jigsaw puzzle. Capital goods complement each other in an integrated structure. When entrepreneurs think up a production process, they envision a grouping of capital goods, including human capital, that they see as fitting together to form a coherent plan.  If the firm profits, it continues with the plan.  If it makes losses, pieces that don’t fit are discarded and new pieces that fit are added on (assuming there are no bailouts!).

Rather than viewing investment opportunities as something finite to which we apply successive dollops of capital, seeing capital as an integrated structure enables us to understand why investment and growth beget more investment and growth. As resources are deployed to come up with new products, those new products, if successful, create opportunities for new investments that add value to them. The most obvious example is the personal computer and the Internet, which dramatically multiplied opportunities for new investments in hardware, software, and human capital.

Removable Fingertips

Investment in technology begets new investment in complementary products. Who needed a cell phone shell until there was a cell phone? A friend recently bought gloves with removable fingertips, allowing use of a smartphone without taking the gloves off.  This is the story of economic growth, a story best understood when we get out of the habit of thinking about capital and investment as undifferentiated aggregates.

So rather than seeing an economy as a balloon slowly deflated as new investment opportunities dwindle, the better analogy is a balloon the surface of which is expanded by innovation, putting it more in contact with new opportunities.

There’s no worry that we’ll ever run out of investment opportunities or ways to use capital. Human ingenuity will continue to come up with new products, and that same ingenuity will capitalize on the new complementary investment opportunities those products create. Growth begets growth and expands the sphere of opportunity without practical limit.

  • 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.