Credit Expansion Squanders Capital
The chief effect credit expansion exerts on the productive structure is ultimately that it discoordinates the behavior of the different economic agents. Indeed entrepreneurs rush to lengthen and widen the productive stages and make them more capital-intensive, while the remaining economic agents are unwilling to cooperate by sacrificing their consumption and raising their overall voluntary saving. This maladjustment or discoordination, which stems from a systematic attack on the process of social interaction (the privilege governments grant banks, allowing them to use a fractional reserve on demand deposits), invariably triggers a crisis process that eventually corrects the entrepreneurial mistakes committed. Nevertheless the process takes time, and inevitably, by its end, serious errors will have been made that will have become irreversible.
The errors consist of launching and attempting to complete a series of investment projects which entail a lengthening and widening of the capital goods structure, projects which nonetheless cannot come to fruition, due to a lack of real saved resources. Moreover once resources and original factors of production have been transformed into capital goods, these goods become non-convertible to a certain extent. In other words, many capital goods will lose all of their value once it becomes clear there is no demand for them, they were manufactured in error and they should never have been produced. It will be possible to continue using others, but only after spending a large amount of money redesigning them. The production of yet others may reach completion, but given that the capital goods structure requires that the goods be complementary, they may never be operated if the necessary complementary resources are not produced. Finally, it is conceivable that certain capital goods may be remodeled at a relatively low cost, though such goods are undoubtedly in the minority.1 Hence a widespread malinvestment of society’s scarce productive resources takes place, and a loss of many of its scarce capital goods follows. This loss derives from the distorted information which, during a certain period of time, entrepreneurs received in the form of easier credit terms and relatively lower interest rates.2 Many investment processes may also be left half-completed, as their promoters abandon them upon realizing they cannot continue to obtain the new financial resources necessary to complete them, or though they may be able to continue to secure loans, they recognize that the investment processes lack economic viability. In short the widespread malinvestment expresses itself in the following ways: many capital goods remain unused, many investment processes cannot be completed, and capital goods produced are used in a manner not originally foreseen. A large portion of society’s scarce resources has been squandered, and as a result, society becomes poorer in general and the standard of living drops, in relative terms.
Many economists have misunderstood the fact that a significant number of the errors committed manifest themselves as completed capital goods which, nonetheless, cannot be used, due to the absence of the complementary capital goods or working capital necessary. Indeed many see this phenomenon of “idle capacity” as clear proof of a necessity to boost overall consumption with the purpose of putting into operation an idle capacity which has been developed but is not yet used. They do not realize that, as Hayek indicates,3 the existence of “idle capacity” in many production processes (but especially in those furthest from consumption, such as high technology, construction, and capital goods industries in general) in no way constitutes proof of oversaving and insufficient consumption. Quite the opposite is true: it is a symptom of the fact that we cannot completely use fixed capital produced in error, because the immediate demand for consumer goods and services is so urgent that we cannot allow ourselves the luxury of producing the complementary capital goods nor the working capital necessary to take advantage of such idle capacity. In short the crisis is provoked by a relative excess of consumption, i.e., a relative shortage of saving, which does not permit the completion of the processes initiated, nor the production of the complementary capital goods or working capital necessary to maintain the ongoing investment processes and to employ the capital goods which, for whatever reason, entrepreneurs were able to finish during the expansion process.4
- 1. As a general rule, the closer a capital good is to the final consumer good, the more difficult it will be to convert. In fact all human actions are more irreversible the closer they are to their final objective: a house built in error is an almost irreversible loss, while it is somewhat easier to modify the use of the bricks if it becomes obvious during the course of the construction that using them to build a specific house is a mistake (see comments on pp. 280–82 previously).
- 2. Thus the theory of the cycle is simply the application, to the specific case of credit expansion’s impact on the productive structure, of the theory on the discoordinating effects of institutional coercion, a theory we present in Socialismo, cálculo económico y función empresarial (esp. pp. 111–18). Lachmann arrives at the same conclusion when he states that malinvestment is “the waste of capital resources in plans prompted by misleading information,” adding that, though many capital goods reach completion, they will lack complementary factors in the rest of the economy. Such lack of complementary factors may well express itself in lack of demand for its services, for instance where these factors would occupy “the later stages of production.” To the untrained observer it is therefore often indistinguishable from “lack of effective demand.” (Lachmann, Capital and its Structure, pp. 66 and 117–18)
- 3. In the words of F.A. Hayek himself:
The impression that the already existing capital structure would enable us to increase production almost indefinitely is a deception. Whatever engineers may tell us about the supposed immense unused capacity of the existing productive machinery, there is in fact no possibility of increasing production to such an extent. These engineers and also those economists who believe that we have more capital than we need, are deceived by the fact that many of the existing plant and machinery are adapted to a much greater output than is actually produced. What they overlook is that durable means of production do not represent all the capital that is needed for an increase of output and that in order that the existing durable plants could be used to their full capacity it would be necessary to invest a great amount of other means of production in lengthy processes which would bear fruit only in a comparatively distant future. The existence of unused capacity is, therefore, by no means a proof that there exists an excess of capital and that consumption is insufficient: on the contrary, it is a symptom that we are unable to use the fixed plant to the full extent because the current demand for consumers’ goods is too urgent to permit us to invest current productive services in the long processes for which (in consequence of “misdirections of capital”) the necessary durable equipment is available. (Hayek, Prices and Production, pp. 95–96)
- 4. After the boom period is over, what is to be done with the malinvestments? The answer depends on their profitability for further use, i.e., on the degree of error that was committed. Some malinvestments will have to be abandoned, since their earnings from consumer demand will not even cover the current costs of their operation. Others, though monuments of failure, will be able to yield a profit over current costs, although it will not pay to replace them as they wear out. Temporarily working them fulfills the economic principle of always making the best of even a bad bargain. Because of the malinvestments, however, the boom always leads to general impoverishment, i.e., reduces the standard of living below what it would have been in the absence of the boom. For the
credit expansion has caused the squandering of scarce resources and scarce capital. Some resources have been completely wasted, and even those malinvestments that continue in use will satisfy consumers less than would have been the case without the credit expansion. (Rothbard, Man, Economy, and State, p. 863)