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NOTE Capital, Interest and the Structure of Production

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Okay, good morning everyone. Today we have the exciting topic,

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a little broach exciting topic of capital interest and the structure of production.

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Just a thing to wake everyone up.

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Let me start by noting that we've already mentioned that all production takes time.

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In fact, all action takes time.

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Time is what really differentiates human beings from beasts.

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Human beings use time as a means to improve their welfare,

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As we'll see, because time is essential to production.

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Beasts, on the other hand, experience time as duration.

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Humans do things, beasts endure things.

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We use time as a tool.

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And we talked a little bit about the law of time preference.

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And let me just recap very quickly.

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According to the universal law of time preference, in fact, individuals prefer to achieve their

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Their goal sooner rather than later. All other things equal. Their value scales, their future

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incomes and so on. That's not to say, and we'll get to this a little bit later, that

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someone will not save for no return in the future. In fact, that will happen. If someone

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believes, in fact I had a little exchange with Brian Kaplan on the Mises list, if there's

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There's a human being on an island, isolated alone on an island, and he has a stock of durable goods.

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And let's say he's very, very long-lived, that is, that the span of his life is not a question here.

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The key point to be made is that, yes indeed, he will not consume all the durable good today or even this year.

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He will spread that consumption over time, but in fact he will satisfy more of his wants today than he would, let's say, 50 years from now.

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In other words, he will allocate, because of time preference, units of the good maybe to his first 100 wants on his value scale.

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But the 100th want today, assuming his wants don't change over time, will be more important to him than, let's say, the 10th want 50 years from now.

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So he might only save 10 units of goods for 50 years from now, consume 100 units today.

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And what will happen over time to these durable goods is that eventually they'll run out, and he'll pass from the scene.

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That is, he will not continually postpone action so that those goods last for infinity.

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The wants today, or the satisfaction of those wants today, are more important to him, all other things equal, than wants in the future.

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Another way of saying that, of course, is that people prefer their satisfaction today to the same satisfaction at some time in the remote future.

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Or they prefer a given sum of money today to the same sum of money in the future, all other things equal.

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And this really explains the loan market, how interest rates and why interest rates exist on a market for loans.

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Let's perform a mental experiment. Let's say that despite my lineage and the fact that I'm from New Jersey, you trust me implicitly.

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And that is to say, if you made a loan to me, you fully believe that I will pay that loan back one year from now.

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So let's say I solicit people to loan me $10,000 and I will pay you back one year from now $10,000.

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$10,000. Would you make that loan? Assuming no default risk. You don't anticipate any default risk on my part or me just running off with the money and never returning.

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Of course you wouldn't. You would have to be bribed in some sense to overcome your time preference. The fact that during that year you would have to abstain from consumption, from spending that $10,000 on consumption.

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There is an opportunity cost then to making that loan to me.

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And that opportunity cost is the disutility of waiting for consumption, for this money which you will then spend on consumption.

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So now, if I offer $11,000 future dollars, that is to pay you back $10,000 in principal plus $1,000 in interest a year from now,

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then you may very well make me the loan.

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And I could continue to raise that interest premium to the point where almost everybody in this room would be willing to make me a loan.

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Even the most high time preference person like Peter, maybe if I promised him $20,000 for that $10,000 loan, he would make the loan.

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So, in effect, what we have here is just simply a voluntary exchange.

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The method of separating a principal from the interest payment more or less beclouds the issue, okay?

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Really what's being exchanged is the sum of future money, total sum of future money for total sum of present money.

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And because present dollars are worth more as a result of time preference than future dollars, I must promise or I must pay you,

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to give you an IOU for more of those less valuable future dollars

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in order to get you to part with the more valuable present dollars.

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So in the case of a loan transaction, we have the borrower, we have the lender,

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and the borrower prefers the $10,000 in the present,

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I'll put P here and that's, let's say, today,

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to $11,000 in the future, meaning he is willing, fully willing to give up $11,000 in the future

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To obtain $10,000 today, he ranks the $10,000 present above the $11,000 future dollars.

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The lender ranks them in opposite order. That is, the lender, if he does make the loan, prefers the $11,000 IOU, or future dollars, in the form of an IOU, a promise to pay, to the $10,000 of present money.

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So, each person benefits from the exchange.

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They both improve their welfare in the sense that they move from a lower-ranked good to a higher-ranked good.

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This is a very powerful analysis.

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This allows us to shed light on a number of vexing issues, which I'll get to in a moment.

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But the key here is to recognize that the $10,000 today is worth more to the borrower than the $11,000 he's willing to pay for that at some point in the future.

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The interest is just a formality. That is, we call it the additional premium on the additional $1,000, which is the premium on present money.

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We call that the interest, and then we can do an arithmetical operation and we say that the interest is 10%, because I'm paying you back $10,000 or $1,000, $1,000 more future dollars.

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And some people have denied that time preference exists.

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They've come up with a supposed counterexamples, very early on when Boehm-Bawerk introduced this notion of time preference.

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The first economist to really make it an essential part of his system.

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He entertained objections such as, well, what about the case in which someone picks 20 pints of fresh blueberries

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One month from now, and ten rotten pints of blueberries, one month from now.

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So by giving up those ten pints of blueberries, they're not the same good.

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If he kept them in his possession, stored them, they'd be rotten one month from now.

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So he's really comparing rotten blueberries to fresh blueberries.

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And he prefers the five pints of fresh blueberries to the ten pints of rotten blueberries.

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And then there's the old example of ice in winter and ice in summer. If someone were given a choice, and let's say it's the middle of January, and this is before the era of refrigeration, and they were given a choice to get a delivery today of ice in the middle of January, or to take delivery in July of the same quantity of ice, they would take it in July.

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So doesn't that, in a sense, counter time preference, that action, doesn't contradict the universal law of time preference?

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Of course not. Again, they're different goods. Ice in the winter is much less desirable than ice in the summer, if you don't have a refrigerator.

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So, almost all counter examples can be shown to confuse two different goods, ice in winter, ice in summer, or rotten blueberries and fresh blueberries.

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Now, time preference differs between different people and over time for the same person.

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Let me give you some examples.

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Children have notoriously high time preferences.

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We say high time preferences.

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What we're referring to is someone who puts a big premium on present satisfaction.

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Someone with a low time preference is someone who is more willing or relatively more willing to wait for their satisfactions.

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So what would the children want? Children want things right away.

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When my son was three or four years old, we used to go to a local diner and in the entryway to the diner there was a video game machine.

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commitment to voluntary exchange, overrode his time preference, dragged him to the table and only gave him one quarter when he came back when we were ready to play.

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So children tend to have high time preferences. But part of the maturation process for a human being is that their time preferences become lower.

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They take more thought for the future. They're more willing to save. And so their time preferences fall.

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They never fall to zero, obviously. People, because they act, are always pulling their goals closer to them.

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Anytime you embark on action, as I mentioned, you pull your goals closer.

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You still want things sooner rather than later, which is that you put a lower premium on having things sooner.

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Now, as people tend to age, as they become older, we have a phenomenon sometimes called a second childhood,

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to all the people who begin going on cruises and spending money on sports cars that they never would have purchased and enjoying their lives.

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So people who are outside observers will say, oh, they're in a second childhood.

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Well, no, the fact is as they get older and have fewer, less time left to enjoy goods and services, they're going to begin to have higher time preferences.

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So, over time, there's a sort of a cycle of time, a normal cycle of time preferences.

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Also, outside events can affect people's time preferences.

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Let's say that we have that scenario from the movie Deep Impact, was it?

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I think it was called, where there was a meteor that was going to smash into the Earth,

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and the Earth would effectively, or all human life on the Earth would be effectively wiped out.

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And let's say that there was good scientific evidence that this would occur in a year.

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And let's say this was revealed in the paper, let's say tomorrow morning.

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What would happen the next morning? What would you see on the front page of the business section?

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Interest rates skyrocket. Okay?

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No one will make anything more than a one-year loan, and even making very short-term loans, people will demand high interest rates.

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because they want to, they're moving all their satisfactions into the present, okay, because there is no future or there's not much of a future, okay, and there is none after one year and so time preference will skyrocket, interest rates will skyrocket, as we'll see is a positive relationship between interest rates and time preference, okay, time preference being a causal factor, interest rates being the result of changes in time preferences. Now on the other hand, let's say that there's

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an elixir that's discovered by medical researchers that will prolong the average human life, double it, to 150 years.

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What will happen to interest rates? They'll drop. People will have more of a future to provide for.

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So what you will see is more saving lower interest rates. People have lower time preferences.

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Because there are more wants now in the future that they want to satisfy.

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Once again, it won't drop to zero.

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Now, time preferences are reflected in what we call the consumption-saving ratio.

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The higher that ratio is, that is, the greater proportion of your income you devote to consumption versus saving, the higher your time preference is.

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So if there's a young couple that gets married and their income is, let's say, a combined income is $1,000 a week or something, or whatever, let's say $2,000 a week.

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They may very well spend $1,800 on consumption, so this is C, and put $200 aside per week.

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That's a 9 to 1 ratio.

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Now, the wife becomes pregnant and their time preferences fall as they begin to think about the four or five hundred thousand dollars of college tuition they're going to have to pay in eighteen years.

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And the other stream of expenditures they're going to have to make now for the child over time as the child grows.

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So this might very well fall to, let's say, fifteen hundred to five hundred.

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So, what's going to happen is savings is going to increase, consumption is going to decrease, and you're going to find that the ratio is going to decline.

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Less is going to be devoted to consumption, more is going to be devoted to saving as time preferences come down.

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So, we're not saying that people are somehow prisoners of their time preference.

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Their time preferences are really embedded in their value scales, and those value scales can change from moment to moment.

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So not only do they rank different goods on their value scale, they rank goods at different periods of time on their value scale.

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There really is, at any given moment when you're allocating resources, there's one value scale that includes all your present wants and all your known or anticipated future wants.

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And the way you allocate your income is going to determine what your consumption-saving ratio is.

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is not a part of your subjective valuation process that's somehow separate it is not okay that's important let me get some issues before we get to production and those issues are have to do with first the attack on on on the payday lending

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These are some issues before we get to production.

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And those issues have to do with first the attack on the payday lending industry.

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Does everyone know what payday lending is?

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What payday lending is, generally it occurs for people with low incomes.

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What happens is that those people will go in and get an advance on their next paycheck.

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It's usually a two-week advance.

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So for example, if they want a $200 advance or loan, typically as I said, a two-week loan,

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it could be a one-week loan, what they'll do is they'll write out a post-dated check

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to the payday lender for a greater sum of future dollars two weeks from now.

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And so they'll write out a $250 check that will be cashed when they get their paycheck

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two weeks from now.

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It will be dated two weeks from now and the lender will hold that check and give them

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$200 in return.

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Now this tends to, the interest rates tend to be by our standards, astronomical.

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It's usually $15 or $20 per $100 borrowed, but that's only a two-week loan.

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And so, for example, they give, in North Carolina, there was a study, the median payday loan fee in North Carolina is $36,

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and the median two-week loan is $244. So here's what happens.

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It's a loan like any other type of loan, so you have the borrower, then you have the payday lender.

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And what you get is the borrower getting $244 in the present.

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In exchange, they have to pay a $36 premium, so that's $280.

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They promise to pay $280 back, and that promise is in the form of a post-dated check two weeks from now.

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The exchange takes place from now. The payday lender gives up the $244, the present money, and receives a $280 post-dated check. That's the IOU.

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And the exchange takes place. Both expect the benefit from this.

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Now, I mentioned before that when we separate out the interest rate, which we do for purposes of analysis,

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this is the essence of what happens. We separate out the interest rate and we figure out what it is, $36 on $244 for two weeks.

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Does anyone want to venture a guess on what it is per annum or per year?

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It's 419% per year, okay. So people look at the interest rate. Activists look at the interest rate and they say, this is exploitative. They're exploiting this poor person's need, okay.

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There's a number of, well the first response to that is the person who takes the payday loan isn't stupid.

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He's going to or she's going to find the lender that will lend to them at the lowest possible rate.

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So you're focusing on the wrong person when you blame this person for making the loan.

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And secondly, the borrower is benefiting. They prefer the $244 today to the $280 two weeks from now. It's simply a voluntary exchange.

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But when you restate it as it's a 419% interest rate, that's usury, that's exploitation, that's gouging, price gouging, interest gouging.

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The second critique, criticism, is that this is also called predatory lending, by the way.

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This is predatory lending because if the customer can't pay, he doesn't have sufficient funds to pay,

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they allow him to roll that loan over, to write another check, post-date another two weeks, for another 419%.

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And so somehow then this is increasing, intensifying the exploitation, but of course, do we have to pay off our credit cards which have relatively high interest rates?

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No, we don't. This argument could be used against credit card lending. It's predatory because you're allowed to roll it over.

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You don't have to pay it off every month.

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So there's a little touch of sort of a condescension on the part of the people that are making this critique.

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Middle class people and upper class people who go into debt on their credit cards in many cases in a way that they regret later on,

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They're not asking government to regulate their credit cards. They're asking them to regulate the loan market for the poor.

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So the poor are poor. They're not stupid. That's the key point. They will shop around for the lowest cost loan.

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Now, let me get to another criticism. What you must keep in mind is that there's been a study that's shown that payday borrowers are more likely to have poor credit histories

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Histories have worked with credit counselors in the past and are more

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likely to have one or more bounce checks in the previous five years so they are

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high credit risks so that's not a pure interest rate part of that is a risk

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premium but secondly there's a very high overhead cost okay for making loans if

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the hundred thousand dollar loan it's relatively small but if it's a very

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small loan those high overhead costs don't they don't change much okay so

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So, part of it is not even an interest rate, part of that extra $36, part of it is the cost of administering that small loan.

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And part of it, of course, is the risk premium for the inevitable defaults that occur.

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The bottom line is those who criticize this lending are making a judgment on people's time preferences.

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They're saying they don't believe that it's immoral or it's wrong for the borrower to have these high time preferences,

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to be willing to pay such a high premium for having present goods.

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Another point to be made is that, or another critique, is that, well, the payday lender does not, well, by the fact that it exists, it turns people into habitual borrowers.

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But once again, that can be expanded to saying, well, the fact that we can get credit cards, that we've had credit cards offered after World War II, they became so widespread,

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that that may turn the middle class or upper-income people into habitual borrowers.

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No, what it does is to give people a choice to either pay today or to only purchase within the income that you're earning today

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or to borrow and be able to purchase things and enjoy them now and not have to wait for them in the future.

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I mean, that's exactly what a mortgage loan is.

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There weren't any mortgage loans before the 1930s in the United States.

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People saved up and they paid for their house.

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They saved up 10, 20 years and they finally got a house 20 years later.

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Now the mortgage market allows us to anticipate our future income

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and to get that house now and to enjoy it for 20 years.

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But for that enjoyment we are paying an interest rate.

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Same thing is true with poor people.

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Finally, one point we made here, the payday lending industry has been totally created by government regulations.

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Most states have usury laws. That is, they cap interest rates at certain levels.

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I saw a figure, it could be as low as 20% or as high as 300% in some states, but there are caps.

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This is a way of getting around that. These, in Walter Block's terms, these are our heroes, because they are getting around that loophole, because they don't state it as an interest rate, they simply state it as a payday loan, and you just write a check to them, so there's no formal interest rates stated.

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more reputable and lower-cost lenders would be able to lend, maybe a bank would lend in a state where it's 100% it's a cap, they might lend this guy at 120% instead of 419%, because their costs will be lower and they can spread the risks more, okay, because they'd have a bigger clientele, but they're not permitted to, so these people, the payday lenders are those who stand between a poor person and the illegal loan shark, okay, they're the last resort before illegal lenders

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Legal Loans. So now am I saying payday lending is good or bad? No, I'm not saying that.

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I'm saying from the point of view of poor people, given the situation, given government

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regulations, they are benefiting just as much as the payday, not in a measurable sense,

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but just like the payday lender is benefiting. And I think payday lending is a great innovation

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of the Market.

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Let me get to one other issue in the loan market, and that is so-called toxic mortgages.

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And there's a Center for Responsible Lending, and there's a Center for Irresponsible Language.

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Toxic mortgages, it's a pejorative term, obviously.

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You can immediately load the dice against people that make sub-prime loans, institutions that make sub-prime loans, sub-prime mortgage loans to, again, people with low incomes or people with bad credit records.

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But now they're complaining that they're making these loans.

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If you recall about, I think in the late 1980s, there was, and even before that in the 70s, there was a phenomenon called redlining in the United States.

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Redlining meant that banks, I don't have a red pen here, what if I do, that what banks would do in the mortgage market in a city, okay, let's say you have a city here, let's say it's Philadelphia.

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North Philadelphia is notorious for the crime and the arson and murders and so on.

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What they would do is say, you know what, we don't trust the people in this area.

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It's a mainly black area. We don't trust the people in this area to pay back.

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Now, they're making a legitimate business decision. They're not doing business, they're racist.

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They're just saying that, you know, we're grouping these people all together.

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It's very difficult for us to tell the difference between them as far as their credit histories and so on.

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So we're going to draw a red line and we're going to say, no one gets mortgage loans in that area.

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So there was a big outcry, this criticism of banks for doing this.

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The Federal Reserve changed regulations or regulated lending to the extent that they forced lending into these areas.

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Now the exact opposite is happening.

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Now, they're complaining that they're making too many loans or loans that are toxic, that these poor people are victimized by.

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And we'll get to why these loans are occurring.

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Again, it's a problem, part of it is due to the government-inspired or stimulated boom, housing boom that we've had.

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But let me just say a few words about the so-called toxic mortgages.

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There's a number of different types. There's the simple adjustable rate mortgage, which has low teaser rates.

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Sometimes they're called 2 slash 28s, which means the first two years you pay very, very low rates.

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And then the last 28 years, you're subject to having those rates adjusted as interest rates change.

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There's also 100% financing where people don't have to put down any down payment.

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There's also interest only loans where people almost never pay off their equity.

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That is, the minimum payment is the amount of the interest.

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So it's called the no equity loan.

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So if someone sells their house, they don't have any equity in that house.

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The most toxic one is the negative equity loan, where the minimum payment is actually less than the interest rate, so if you buy a $180,000 house and you're only making the minimum payment, the amount you owe is increasing, okay, every year, it's actually going up, you're building up negative equity, that's called a negative equity loan.

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The amount you owe is increasing every year. It's actually going up. You're building up negative equity.

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That's called an option adjustable rate mortgage.

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So it provides you with options of either paying at least the interest or even more than that, or paying actually less, but at least the minimum payment, which is lower than the interest rate.

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So, in fact, I just heard today on NPR, coming here, that the Fed is meeting today to make decisions about regulating the subprime loan market.

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And the Center for Responsible Lending had a speaker on there talking about all the negatives of the subprime lending.

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But, of course, now, what they're not telling you is that many young couples, many poor people, are simply not going to get houses.

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They're not going to be able to afford homes. They're going to have to live in apartments and so on.

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once again it's a question of people's time preference

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okay they're willing to go into this debt because maybe they believe that their

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income is going to go up

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over time sufficiently to meet the higher interest payments

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or sufficiently to make more than the minimum payments

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on

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and they

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make mistakes okay they're not saying that everyone in the subprime market

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is defaulting on their loans but the defaults have increased in the last year or two

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as interest rates have climbed

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The key, of course, though, is that Americans, since 1995, have believed that housing prices were going to continue to increase.

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So that if that happened, then you can sell your house if you can't make the payments, and you will have enough to pay off the mortgage.

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So once again, they're closing off choice by people with higher time preferences to exercise those high time preferences, to pay the higher interest rates.

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And you can go on, it's very interesting to go on to the website, which I just looked at briefly this morning, of the Center for Responsible Lending.

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Predatory Lending

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The most important determinant of the interest rate in the capitalist economy is what we call the production structure.

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As I said before, production takes time and it proceeds in stages.

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So let me just give you a visual example of that.

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For example, the production of shoes.

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If you wanted to produce shoes from scratch, it would take you a substantial amount of time.

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You'd have to actually have the cattle, and then if the cattle were slaughtered, then you'd go into the next stage, which we call the higher stage, or the higher order, as Peter talked about yesterday.

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So highs are higher order good, that is the animal skins, and then you would have to tan them and so on and go through a process of turning them into leather in the next stage, and that would take a certain amount of time.

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And then you could assemble the shoes from that and from other materials.

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In each stage you would of course need land and labor as well as these capital goods.

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So the hides, the leather and so on are intermediate or capital goods that are being created in this production process.

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And then they would be turned into shoes and then you would have to combine the shoes with various distribution services, transportation and so on to get them to the retailers

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and then they would be sold to consumers at the end of the process.

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Or if this is a Robinson Crusoe making his own shoes,

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he would then employ the shoes himself for his own consumption.

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Now, in a capitalist economy, all goods are produced under the Division of Labor and Specialization

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in an extremely time-consuming fashion, in which there are many stages of production.

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Now, what is the, let me step back for a moment.

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The criticism of the capitalists, which began with Marx, actually before Marx, was this.

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The capitalist is someone who simply invests money in a firm.

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We're not talking about a manager.

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Let's assume the capitalist simply invests money in a firm,

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And then at the end of the year, somehow, let's say he's invested $100,000, the product is sold for $120,000, he receives the extra $20,000, and he's seemingly done nothing, okay?

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Why do we need a capitalist? Okay, what is the function of the capitalist?

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Mark said it was nut-nut, there wasn't any, that he was just extracting surplus from the workers.

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He was paying them enough to reproduce themselves in some sense, to reproduce their labor, and seizing the surplus.

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Well, in fact, let's think of trying to produce an automobile from scratch.

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You would need mining tools, so there's a group of people, they have the knowledge, they have the technology,

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and so on, and they're going to produce, let's say, through a cooperative effort, let's say a producer's cooperative.

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So what they'll do then is, somehow they're going to have to save up in advance enough food and enough clothing and so on to see them through the production process.

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Let's say it's going to take seven years from the beginning.

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And they have the mine, so they own the mine and so on.

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So what they do then is they combine the original labor with the mine.

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They have to make some tools and then they mine the iron ore.

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Then they have to, from the iron ore, they have to transform that into steel, so they have to produce, again, themselves, you know, the steel plant, steel machinery, and then process the iron ore, turn it into steel, and then an auto assembly plant and machinery, assemble the automobile, and then seven years later, they sell the stock of automobiles for, let's say, one million dollars, and they split it amongst themselves. The key is,

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In order to do that, without starving in the process, they had to save in advance.

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They had to postpone consumption, to save up the goods necessary to get them through,

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to maintain them during the lengthy production process.

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Well, this is what the capitalist does. This is the capitalist's function.

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The capitalist is the one who abstains from present consumption, pays the workers every two weeks,

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provides the consumption, pays the workers every two weeks, even though the product is not going to emerge onto the market for another three months, a year or five years, whatever the production process is, and then at the end, reaps a premium.

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Now, let's assume a perfect certainty. We're assuming that he's not bearing any burden of loss. All he's doing is postponing consumption to the future.

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He perfectly knows, everyone knows what the price will be for automobiles in the future.

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Now because of the returns to, excuse me, specialization and the division of labor, the greater efficiency of specialization,

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you don't even have one set of capitalists, which we call a firm, producing any good in today's world from beginning to end.

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What they do, rather, is produce one stage, or even a part of a stage.

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The firms will produce, maybe you have mining firms, then you have steel plants and steel firms, and you have auto assembly plants, GM and Ford.

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So they're separate. Each set of capitalists then wait for their income during a period in which production is taking place.

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They pay the workers either in advance or every two weeks. The workers get paid.

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At the end of the process, the workers, in exchange for getting paid every two weeks before the product comes onto the market,

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the workers give up the ownership of the capital good, and let me put another sample up here.

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They give up the ownership of, let's say, the wheat, in this case we're talking about bread, and the flour.

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in exchange for present money.

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So that's the exchange that takes place.

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It's very, very similar to the exchange that takes place on the loan market.

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So what you have is the following, you have the laborers and you have the capitalists.

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Okay, and the laborers, let's say, in total give up, say, the control of or the ownership of, let's say, the wheat.

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In return, they get a certain sum of money, they get wages.

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Okay, that's present money.

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The capitalist gives up the present money, in exchange the capitalist gets the wheat, wheat goes to the capitalist, present money, so present money here, which we call wages when it's paid to labor, goes to the laborers, okay, they both are better off.

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Now why would the capitalist can't eat all that wheat, why would the capitalist want the wheat? Right, the capitalist doesn't want the wheat for his own consumption, okay, or he wants maybe only a very small part of it.

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What he wanted for is to sell it on the market in exchange for money, so what he sees in the wheat is not the wheat itself, it's the expectation of future income.

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That's what he gets from ownership of the capital goods, so each day as the wheat progresses towards being finished and ready for sale on the market, he has an expectation of future money.

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So it's no different than an exchange on the loan market. It's present money basically for future money, wages for the capital good.

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Now to produce any good you must have a structure of production.

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Now, so let's just sum up the capitalist function. The capitalist function is to assume the burden of waiting for income from factors.

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The interest is the difference between the sum of the factor payments, let's just talk about labor, the sum of the wage that he pays to the laborers, and the total revenue that he gets from the sale of the automobile.

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So let me show you how this might work in a multi-stage production process.

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Okay, let me just make this a little bit smaller.

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Okay, for the time being that's, this is our sort of, this is the production of a particular good, but it also could be expanded to the entire economy, we can call it the structure of production for the whole economy, but for the moment let's just look at it for one good, let's say that in the highest stage, so we call it the fourth stage, what happens, the capitalist

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If you let me direct your attention to the capital space, $10, $10 million, $10,000, whatever it is, the capitalist pays $10 in the fourth stage.

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It's not working.

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So the capitalist pays $10 to the laborers.

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The laborers then work for the capitalist in that fourth stage in producing some capital good.

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At the end of that stage, the capitalist then is able to sell the capital good for $11.

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Now he gets a premium of $1 which is about 10%.

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So in the left column here is his interest.

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He earns $1 in the production process, laborers earn $10.

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Why did he earn that $1?

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He didn't do anything.

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Let's assume he hired the managers and they oversaw the assembly line workers and the

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The managers got paid and so on. All he did was pay wages in advance. Well, that's what he did. He paid wages in advance.

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He overcame his own time preference. He abstained from consumption, renounced consumption for a full year.

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In exchange, he gave $10 up and got $11 a year later.

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The capital good is then sold to the third stage capitalist or firm. It's sold for $11, but they need workers to work on that capital good to turn it into a lower order capital good, a capital good that's closer to the consumers.

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So what happens is that they pay $11 in wages, they pay $9 in wages, $11 for the capital good, they lay out $20.

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At the end of that stage, they sell the capital good for $22 and receive an interest return of $2, which again is about 10%.

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As we'll see, there's a tendency in the market economy for the interest rate, the pure interest rate, to be equalized in every process of production and over all stages of production.

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The Capitalists own it at the end and they sell for $55. The capitalist then gets $5 in interest, which again is 10%. $50 was invested, part of which went to the workers, the other part went to the third stage capitalists.

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Okay, there's a few things I want to point out here. Now, finally, obviously, in the first stage, or the consumer goods stage, the capital good is sold for $55.

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Let's say this is the automobile industry, okay? So the steel and so on is sold for $55, and all the parts.

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And the last stage is the assembly of the automobile, and workers are hired in the assembly class for $45 that are invested in wages.

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So for $100 then of investment, the capitalists at the end, when they sell the final good to consumers a year later, they sell for $110 and they get a $10 interest payment or return.

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They get the difference then. So the interest rate in the structure of production is the price spreads, the rate of price spreads.

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The ratio of what you receive over and above what you've paid out, divided by the amount that you've invested, the total amount that you've invested.

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Once again, we can sort of sum this up here. If this is the economy as a whole, what has happened is that consumption was $110, saving an investment, if you look at the investment in every stage,

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The amount that capitalists laid out in every stage, from the first to the fourth, that comes to $180.

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The total spending then in the economy was the consumption plus the investment.

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So $110 was spent by consumers, $180 by capitalists to give us $290.

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And we can see what the ratio was. The consumption saving ratio was C slash S.

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That is $180 was saved in the economy, $110 was consumed.

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What's interesting is that if you want to keep your structural production permanent,

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and we'll talk a little bit about Robson Crusoe to make this a little bit more concrete for you,

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what you have to do is you have to abstain from spending.

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The capitalists cannot spend any of that $180 for their own consumption.

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They can only spend it on capital goods.

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Otherwise, what will happen is that the structural production will become shorter

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and the economy will become less productive.

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So what happens is the workers spend all $92 on goods,

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the goods that are produced in the economy,

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and the capitalists can only spend $18 on goods, only the interest return.

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The other money that they receive in production has to be what?

365
00:48:23.360 --> 00:48:30.360
Reinvested if the economy is to reproduce the same goods in the next period.

366
00:48:30.360 --> 00:48:34.360
Let me say a few other things here.

367
00:48:34.360 --> 00:48:38.360
These are the rents that Peter talked about, the capital goods in the second and fourth stage.

368
00:48:38.360 --> 00:48:42.360
$55 was paid for the capital good in the first stage.

369
00:48:42.360 --> 00:48:49.360
$22 in the second stage, and in the third stage $11 was paid for capital goods.

370
00:48:49.360 --> 00:48:55.360
And that gave us $88. We see some consumer goods of $110.

371
00:48:55.360 --> 00:48:58.360
I don't want to go into too much more detail here, but you see the point.

372
00:48:58.360 --> 00:49:21.360
Good point. What if in the next period, when the capitalist received, let's say, the $55 in that second stage, when he sold the good for $55, what if he spent the whole amount on consumption and didn't reinvest in buying the capital good from the second stage and didn't pay the laborers?

373
00:49:21.360 --> 00:49:27.360
What would happen to the amount of goods in the economy eventually? They would go down.

374
00:49:27.360 --> 00:49:32.360
What if every capitalist stopped investing and everybody spent their money on consumer goods?

375
00:49:32.360 --> 00:49:43.360
Well, what would happen, exactly, in a very short time, the amount of consumer goods would dry up and people would be eating hand to mouth and many of them would starve.

376
00:49:43.360 --> 00:49:51.360
Now, that's all very abstract and again, it's just a diagrammatic representation of what happens in the economy.

377
00:49:51.360 --> 00:49:54.360
There's a lot of complexity here.

378
00:49:54.360 --> 00:50:07.360
As Peter pointed out, you would use trucks in the fourth stage, let's say, to haul the iron ore, but also trucks would be used as a consumer good.

379
00:50:07.360 --> 00:50:19.360
So, different goods of the same physical quality, I mean, similar goods that are exactly the same physically, would be different stage goods, depending on how they were used.

380
00:50:19.360 --> 00:50:39.360
This is all, as I said, is all very abstract. Let me, for a moment, throw you back to the Crusoe economy and let you see, and I want you to just neglect that last column.

381
00:50:39.360 --> 00:50:43.360
We don't need that. Actually, we don't need, we only need the first three.

382
00:50:43.360 --> 00:50:57.360
And let me show you how capital accumulation, the building of capital, and also what we would call saving, occur.

383
00:50:57.360 --> 00:51:05.360
Robin de Cruz is on an island. He has only his own energy. There's nothing there. It's just the natural resources on the island.

384
00:51:05.360 --> 00:51:11.360
He has no capital goods and his own energy. Let's look at what his inputs and outputs are.

385
00:51:11.360 --> 00:51:24.360
In the first period, and we call it T sub zero here, what happens? Crusoe spends 12 hours, and I sort of use a similar example, fishing, and can catch four fish with his hands.

386
00:51:24.360 --> 00:51:31.360
Very low productivity. He has to stand in the stream and literally grab at the fish. So he catches one every three hours.

387
00:51:31.360 --> 00:51:38.360
Leisure is also a consumer good. It's a directly produced consumer good. It's one of my favorites, actually.

388
00:51:38.360 --> 00:51:43.360
Just laying around watching television, watching my high-definition television that Peter helped me set up.

389
00:51:43.360 --> 00:51:49.360
Anyway, so he's got a very low standard of living, just keeping himself alive.

390
00:51:49.360 --> 00:51:55.360
Now, he knows that if he produces a net, he can increase his output.

391
00:51:55.360 --> 00:52:02.360
So what he does then is he cannot just produce the net and have the same standard of living.

392
00:52:02.360 --> 00:52:10.360
of Living, he has to reduce his leisure and or his output of consumer goods like fish

393
00:52:10.360 --> 00:52:16.360
in order to have time or to save hours to invest in the net. And notice what he does.

394
00:52:16.360 --> 00:52:20.360
So now he doesn't just have consumer goods industries, you see 11 hours for leisure,

395
00:52:20.360 --> 00:52:28.360
9 hours for fish, his standard of living falls for a while, and it takes him 500 hours, 400

396
00:52:28.360 --> 00:52:35.360
In the last four hours of the day, he spends on building the net, and after 500 hours, over time, that net is built.

397
00:52:35.360 --> 00:52:41.360
So now he has a capital good, now there's a capital structure in the economy.

398
00:52:41.360 --> 00:52:45.360
He uses the net then to increase his productivity.

399
00:52:45.360 --> 00:52:50.360
With the net, he can catch one fish per hour. His productivity in fishing has tripled.

400
00:52:50.360 --> 00:52:57.360
So if you look under T2, what he does is he increases his leisure and he increases his consumption of fish.

401
00:52:57.360 --> 00:53:07.360
consumption of fish, consumption of fish more than doubles, his leisure increases by two hours, he has to spend one hour replacing the net, repairing it every day, cleaning it and so on, otherwise it will fall apart, okay?

402
00:53:07.360 --> 00:53:20.360
If he stopped doing that, and used that other hour to work and catch another fish for leisure, that net would wear out, and he would be thrown back to a very low standard of living, okay?

403
00:53:20.360 --> 00:53:26.360
So what we're trying to say here is that people have to overcome their time preference for present goods,

404
00:53:26.360 --> 00:53:32.360
that is, they have to reduce their amount of leisure and fish for a period of time in order to accumulate capital.

405
00:53:32.360 --> 00:53:36.360
It's a sacrifice to accumulate capital. That's what the capitalist does.

406
00:53:36.360 --> 00:53:42.360
Okay, now, does he want to grow more? Because this is really economic growth.

407
00:53:42.360 --> 00:53:46.360
Does he want to grow more? Well, let's assume he does. But again, it's going to take another sacrifice.

408
00:54:16.360 --> 00:54:25.360
in leisure from 14 to 13 hours, cuts back in fish from 9 to 7, and he saves three hours a day.

409
00:54:25.360 --> 00:54:30.360
Okay? So what happens to standard living? It goes down again from what it was.

410
00:54:30.360 --> 00:54:37.360
Still higher than before he built the net. So he spends three hours a day in 200 days,

411
00:54:37.360 --> 00:54:41.360
because it's 600 hours total investment in building the ladder. He builds the ladder.

412
00:54:41.360 --> 00:54:47.360
And then what happens? We see that the fruits of that sacrifice come only in the future, okay?

413
00:54:47.360 --> 00:55:04.360
Now, under T4, he has 13 hours of leisure, no less than he had before, or one less than he had before, but he has eight fish, okay, instead of seven, and he has six coconuts, okay?

414
00:55:04.360 --> 00:55:11.360
And he has to spend a half hour fixing the ladder every day and repairing it, keeping it in good repair, and one hour placing it in the net.

415
00:55:11.360 --> 00:55:15.360
But now he has a greater variety of goods as the standard living has risen.

416
00:55:15.360 --> 00:55:18.360
So we'll just take it one more step.

417
00:55:18.360 --> 00:55:20.360
He might want to build a house.

418
00:55:20.360 --> 00:55:26.360
And there, to build a house, he's going to have to cut back on the amount of fish, the amount of coconuts,

419
00:55:26.360 --> 00:55:32.360
and he'll spend an hour and a half a day building the house, and eventually the house will come into existence.

420
00:55:32.360 --> 00:55:38.360
Now, this is how the United States, just to take an example, grew economically.

421
00:55:38.360 --> 00:55:44.360
Think about the first pilgrims that landed and how to carve a living pretty much with their hands,

422
00:55:44.360 --> 00:55:55.360
out of the forest and so on, and build some rough sort of shelter to find wild game and so on.

423
00:55:55.360 --> 00:56:00.360
But they built up a capital structure. They made axes. They built buildings.

424
00:56:00.360 --> 00:56:07.360
They built wagons and carts and so on. They domesticated horses, or horses were brought with them.

425
00:56:07.360 --> 00:56:12.360
But they bred the horses so they would have more horses and so on.

426
00:56:16.360 --> 00:56:29.360
And very slowly America, the U.S. became, developed a mighty capital structure so that by World War I we had the greatest industrial power in the world.

427
00:56:29.360 --> 00:56:37.360
Now, my question to you is, what if everybody suddenly had a high time preference during the 19th century, okay?

428
00:56:37.360 --> 00:56:44.360
Let's say people suddenly said, you know what, or even today, it doesn't matter, let's say all of us stopped saving today, okay?

429
00:56:44.360 --> 00:56:55.360
We all went out and splurged and bought luxury cars, ate out every night, everyone sold their stocks and bonds, emptied their bank accounts, okay?

430
00:56:55.360 --> 00:57:01.360
What would happen to the mighty capital structure built up over hundreds of years in the United States?

431
00:57:01.360 --> 00:57:08.360
Factories wouldn't be repaired. For a while we would get a lot of consumer goods. In fact we'd get more consumer goods for a while.

432
00:57:08.360 --> 00:57:11.360
Because there's a lot coming down through the pipeline.

433
00:57:11.360 --> 00:57:15.360
But payments could not be made to workers in the mining industry and so on.

434
00:57:15.360 --> 00:57:19.360
So eventually the mines were closed. No one would be working the oil wells.

435
00:57:19.360 --> 00:57:24.360
We wouldn't be getting any natural resources to turn into raw materials.

436
00:57:24.360 --> 00:57:32.360
The factories would then over time begin falling apart and we would be thrust back to the 1600s.

437
00:57:32.360 --> 00:57:36.360
And probably most of the population would die.

438
00:57:36.360 --> 00:57:41.360
The key thing is, capital does not reproduce itself automatically.

439
00:57:41.360 --> 00:57:45.360
It takes sacrifice on the part of capitalists.

440
00:57:45.360 --> 00:57:48.360
Now, capitalists are not a separate class. It's another point we have to make.

441
00:57:48.360 --> 00:57:53.360
All of us are capitalists to the extent that we save and invest.

442
00:57:53.360 --> 00:57:59.360
Even putting money in a mutual fund, you don't have to directly invest in a company through a stock or a bond.

443
00:57:59.360 --> 00:58:04.360
You can put money in a mutual fund, in a bank, in an insurance, in your pension.

444
00:58:04.360 --> 00:58:09.360
All that money is invested throughout the structure of production that we talked about before.

445
00:58:09.360 --> 00:58:12.360
I'll put it back up again.

446
00:58:12.360 --> 00:58:19.360
Actually, I'll put up a new diagram that shows it being increased.

447
00:58:19.360 --> 00:58:23.360
Before the structural production had four stages, now it has six stages in this example.

448
00:58:23.360 --> 00:58:30.360
The reason being that I assumed that people now change their saving, consumption-saving ratio.

449
00:58:30.360 --> 00:58:33.360
Remember before consumers were spending $110?

450
00:58:33.360 --> 00:58:38.360
Consumers now cut down to spending only $90 and saving an extra $20.

451
00:58:38.360 --> 00:58:43.360
If you want to save the extra $20, you have to add extra stages.

452
00:58:43.360 --> 00:58:48.360
And the extra stages means that we have more and more capital goods being built.

453
00:58:48.360 --> 00:58:52.360
So now the value of the capital goods is much higher than it was before.

454
00:58:52.360 --> 00:58:57.360
It's $20 higher than it was before. We don't have to go into too much detail here.

455
00:58:57.360 --> 00:59:07.360
But now, instead of spending $110 on consumption, that was before, and only $180 on capital goods,

456
00:59:07.360 --> 00:59:12.360
we're now spending only $90 on consumption, but $200 on capital goods.

457
00:59:12.360 --> 00:59:20.080
Key point here though, we have less spending on consumption, why would capitalists invest

458
00:59:20.080 --> 00:59:24.280
if they expect fewer dollars at the end of the process?

459
00:59:24.280 --> 00:59:29.320
This is what Keynes called the paradox of thrift.

460
00:59:29.320 --> 00:59:33.800
Before Keynes wrote, in 1936 however, Hayek had already solved the problem.

461
00:59:33.800 --> 00:59:37.960
In 1929 he wrote a paper called the paradox of saving, in which he showed exactly why

462
00:59:37.960 --> 00:59:38.960
it happened.

463
00:59:38.960 --> 00:59:47.960
Now what happens is this, as laborers are shifted up to the higher stages and more capital goods are produced, it lowers costs.

464
00:59:47.960 --> 00:59:52.960
Each laborer becomes more productive, so labor costs are lowered, overall costs are lowered.

465
00:59:52.960 --> 00:59:59.960
And as a result, as the goods come out on the market and think about now the high tech industry, as we got more and more PCs,

466
00:59:59.960 --> 01:00:05.960
as there was more saving and investment in that industry, what happens to the prices of PCs?

467
01:00:05.960 --> 01:00:15.960
They tumble. So you could get a computer for $3 million in 1978, and it would take up a whole room in your house,

468
01:00:15.960 --> 01:00:22.960
and it wouldn't even have the computing power and the speed that just a normal run-of-the-mill PC would have today.

469
01:00:22.960 --> 01:00:30.960
Prices have come down to $2,000 for a desktop of $500 now.

470
01:00:30.960 --> 01:00:48.960
But yet, the computer industry didn't shrink, the first year PCs were shipped there was something like 500,000 shipped, by 2000 there was something like 10 million shipped, but prices were falling, why would these capitalists continue to invest and expand the computer industry?

471
01:00:48.960 --> 01:00:53.960
Because their costs were falling by more, which is exactly what happens here.

472
01:00:53.960 --> 01:00:57.960
Now, if the Fed didn't inflate, we would actually see prices falling.

473
01:00:57.960 --> 01:01:02.960
Because now there's $90, consumers spending $90 on more goods.

474
01:01:02.960 --> 01:01:07.960
So there are more goods being sold, all supplies are shifting out, and less money being spent.

475
01:01:07.960 --> 01:01:09.960
So all prices would fall.

476
01:01:09.960 --> 01:01:14.960
Now, that's how the increase in your standard of living will be reflected.

477
01:01:14.960 --> 01:01:16.960
That's how it used to be reflected in the 19th century.

478
01:01:16.960 --> 01:01:23.960
Every year, except for wars, like the Civil War and the Britain, the war against Napoleon,

479
01:01:23.960 --> 01:01:26.960
every year there would be a fall in prices.

480
01:01:26.960 --> 01:01:30.960
As the capital structure increased, increased labor productivity,

481
01:01:30.960 --> 01:01:32.960
caused more goods to come onto the market,

482
01:01:32.960 --> 01:01:36.960
and with a given amount of gold, or a very slowly increasing amount of gold,

483
01:01:36.960 --> 01:01:40.960
as we were on the gold standard then, prices would fall.

484
01:01:40.960 --> 01:01:43.960
So that's the paradox of saving.

485
01:01:43.960 --> 01:01:49.960
and it was solved eight years before Keynes came up with his brilliant idea of the paradox of thrift.

486
01:01:49.960 --> 01:01:55.960
That is that if we all try to save more, well then we'll be spending less on consumption goods

487
01:01:55.960 --> 01:02:00.960
and capitalists will want to produce less and it will plunge the economy into a depression.

488
01:02:00.960 --> 01:02:08.960
But this shows a complete lack of understanding of the capital structure and how the capital structure is developed.

489
01:02:08.960 --> 01:02:13.960
And that is, what capitalists are interested in isn't the final payment.

490
01:02:13.960 --> 01:02:17.960
It's the difference between the amount they invest and the amount they receive.

491
01:02:17.960 --> 01:02:23.960
And you can see, even at more stages, they're investing less than they're receiving.

492
01:02:23.960 --> 01:02:32.960
It's the rate of price spreads that determines capital investment.

493
01:02:32.960 --> 01:02:37.960
Now, so you have two parts of what we call the time market.

494
01:02:37.960 --> 01:02:41.960
or the inter-temporal market, where people are trading present goods for future goods.

495
01:02:41.960 --> 01:02:46.960
You have the loan market, the biggest part of which is actually loaning money to producers,

496
01:02:46.960 --> 01:02:52.960
but also consumer loan market on the one hand, and then you have the structure of production.

497
01:02:52.960 --> 01:02:59.960
Everybody who invests, or either lends or invests money, is a capitalist.

498
01:02:59.960 --> 01:03:04.960
So we actually perform as individuals more than one role.

499
01:03:04.960 --> 01:03:10.960
We're capitalists, but we also may be workers. Most of us are also workers. We're laborers.

500
01:03:10.960 --> 01:03:17.960
And if we own land or rent out land and so on, then we're also landowners.

501
01:03:17.960 --> 01:03:26.960
Notice one thing here, and I'll get back to it. The rate of return when we had less saving was 10% before.

502
01:03:26.960 --> 01:03:32.960
Remember I mentioned that to you? Now, in each stage, the rate of return is about...

503
01:03:32.960 --> 01:03:39.920
somewhere interest it's about fourth it's about that's wrong the rate of

504
01:03:39.920 --> 01:03:47.520
interest well it's basically um if the final stage see we have sixty it's

505
01:03:47.520 --> 01:03:52.040
whatever four over over six sixty dollars is okay I thought I had the

506
01:03:52.040 --> 01:03:54.880
interest rate here let's see oh that's a rate of interest it's about seven

507
01:03:54.880 --> 01:03:59.600
percent okay so the interest rate will fall as is more saving as the interest

508
01:03:59.600 --> 01:04:11.600
If the interest rate falls, what happens is that that's an incentive to capitalists to borrow more money and to begin to invest more in new stages and to develop a greater capital structure.

509
01:04:12.600 --> 01:04:27.600
So keeping in mind that there's two parts of this inter-temporal market, I can show you then the simple supply and demand diagram.

510
01:04:29.600 --> 01:04:56.600
The Interest Rate is determined by the supply of savings, which is the supply of present goods and the demand for future goods, that is, it's determined both by those who are lending money to borrowers, as well as those capitalists who are investing in the structure of production.

511
01:04:56.600 --> 01:05:00.600
Those are the people who supply present goods or savings, okay?

512
01:05:00.600 --> 01:05:05.600
Those people who demand savings are the consumers that are borrowing, okay?

513
01:05:05.600 --> 01:05:10.600
As well as wage earners that are getting wages.

514
01:05:10.600 --> 01:05:14.600
The intersection will give you the interest rate, okay?

515
01:05:14.600 --> 01:05:20.600
Now, as people's time preferences fall, the supply of savings shifts out.

516
01:05:20.600 --> 01:05:24.600
So the interest rate will drop. In this case, it drops from...

517
01:05:24.600 --> 01:05:32.600
Let's say we have an interest rate initially of 10% at the top here and suddenly people want to save more.

518
01:05:32.600 --> 01:05:34.600
Their time preferences begin to fall.

519
01:05:34.600 --> 01:05:41.600
As we said, there could be a variety of reasons for time preferences falling for people re-evaluating future versus present goods.

520
01:05:41.600 --> 01:05:50.600
One of the most important reasons is as we get richer, as the capital structure evolves and makes all workers more productive,

521
01:05:50.600 --> 01:05:55.600
Given a higher income, you will tend to save a higher proportion of that income.

522
01:05:55.600 --> 01:06:00.600
So it's self-reinforcing, not automatically self-reinforcing,

523
01:06:00.600 --> 01:06:08.600
but the more money we have now, the more we begin to allocate money to the future.

524
01:06:08.600 --> 01:06:12.600
So if you think of a very, very poor person that really has just enough income to keep alive,

525
01:06:12.600 --> 01:06:14.600
they save very, very little.

526
01:06:14.600 --> 01:06:18.600
But as your income increases, you begin to take more thought for the future.

527
01:06:18.600 --> 01:06:28.600
Now, you can't compare between people. There might still be, we know there are rich playboys like Mike Tyson, for example, that earned $400 million in his boxing career, and he's bankrupt. It's all gone.

528
01:06:28.600 --> 01:06:34.600
We call that super high time preference.

529
01:06:34.600 --> 01:06:44.600
Other sports stars have gone on and been very frugal with their money and have started companies afterwards and so on.

530
01:06:44.600 --> 01:06:56.600
So again, it's a question of your values. But anyway, so suddenly you have more savings than can be absorbed at 10%.

531
01:06:56.600 --> 01:07:06.600
And so the interest rate has to fall. As the interest rate falls, and let's assume that there are financial intermediaries like mutual funds and banks and so on,

532
01:07:06.600 --> 01:07:11.840
and so on. Capitalists will borrow more and invest those into the structure of

533
01:07:11.840 --> 01:07:21.400
production. One other point I want to make, consumption loans. If consumption

534
01:07:21.400 --> 01:07:25.280
loans increase, the demand for consumption loans increased, and you didn't have any

535
01:07:25.280 --> 01:07:29.960
increase in investment in the structure of production, you could reduce your

536
01:07:29.960 --> 01:07:33.600
structure of production, right? Because consumption loans are dis-saving, okay?

537
01:07:33.600 --> 01:07:40.600
People who have high time preferences are getting those loans and they're using them to spend on consumer goods.

538
01:07:40.600 --> 01:07:48.600
So another point I want to make is the supply of savings isn't just what you put into a bank.

539
01:07:48.600 --> 01:07:55.600
There's a wide variety of financial instruments that you purchase that will funnel your savings into the production structure.

540
01:07:55.600 --> 01:07:59.600
So we're including money not just put in banks in that supply of savings,

541
01:07:59.600 --> 01:08:19.600
Money spent on new or old stocks, bonds, mutual funds, put in pensions, many, many different ways of saving.

542
01:08:19.600 --> 01:08:31.600
I just want to say a few more words about something that Peter touched on, but I want to just go over it real quickly.

543
01:08:31.600 --> 01:08:45.600
Actually, before I do that, let me just give you a little series of symbols here that really represents the reputation of Keynes's paradox of thrift.

544
01:08:45.600 --> 01:08:56.600
See, where most macroeconomists just look on the economy as producing one lump that they call GDP,

545
01:08:56.600 --> 01:09:03.600
the Austrians, Hayek and Mises, tend to divide the economy up into two different kinds of sets of industries,

546
01:09:03.600 --> 01:09:06.600
actually more than two, but for simplicity I'm only using two.

547
01:09:06.600 --> 01:09:13.600
On the top, you have all these Cs as subscripts, and what they do represent is the consumption goods industry.

548
01:09:13.600 --> 01:09:18.920
On the bottom, you have Ks, and that represents capital goods industries.

549
01:09:18.920 --> 01:09:21.600
As we know, actually, we have a whole structure of capital goods.

550
01:09:21.600 --> 01:09:24.040
Let's say people's time preferences fall.

551
01:09:24.040 --> 01:09:28.560
Suddenly they want to, they begin spending less on consumption and saving more.

552
01:09:28.560 --> 01:09:33.880
Let's say it's a baby boomer generation ages, and they're worried about paying for their

553
01:09:33.880 --> 01:09:34.880
college.

554
01:09:34.880 --> 01:09:35.880
Well, that's all gone now.

555
01:09:35.880 --> 01:09:38.640
We're already paying for, we've already spent hundreds of thousands on our kids' college

556
01:09:38.640 --> 01:09:39.640
education.

557
01:09:39.640 --> 01:09:43.640
and money aside for retirement and so on.

558
01:09:43.640 --> 01:09:47.640
So there's a big change in social time preferences.

559
01:09:47.640 --> 01:09:54.640
So this ratio goes down meaning the numerator falls, consumption spending, and saving increases.

560
01:09:54.640 --> 01:09:59.640
Well, here's what Keynes looked at. He looked at the top line here.

561
01:09:59.640 --> 01:10:04.640
Obviously if consumption spending falls, the demand for consumer goods goes down.

562
01:10:04.640 --> 01:10:07.640
That's why I have the downward arrow.

563
01:10:07.640 --> 01:10:13.640
The price of consumer goods then falls. And so does profits. Pi represents profits.

564
01:10:13.640 --> 01:10:21.640
And the amount of labor and wages fall in consumer goods industries, and therefore labor decreases. They leave.

565
01:10:21.640 --> 01:10:25.640
They shift to higher paying, as we'll see in a moment, capital goods industries.

566
01:10:25.640 --> 01:10:32.640
And finally, the amount of consumption itself, or the amount of consumer goods decreases.

567
01:10:32.640 --> 01:10:37.640
Well, Keynes said, if all that happens, that's going to cause unemployment.

568
01:10:37.640 --> 01:10:41.640
Firms are going to cut back on the amount of consumer goods they produce, which is all true.

569
01:10:41.640 --> 01:10:47.640
Well, Keynes missed, of course, either out of ignorance or deliberately,

570
01:10:47.640 --> 01:10:50.640
because he was writing a tract for the times.

571
01:10:50.640 --> 01:10:59.640
That is, he wanted to write a tract justifying government deficit spending and increases in the money supply,

572
01:10:59.640 --> 01:11:03.640
Because he believed this would get us out of the Great Britain out of the Depression.

573
01:11:03.640 --> 01:11:13.640
Whatever the reason, he didn't take into account the fact that when the denominator increases, you have a fall in interest rates.

574
01:11:13.640 --> 01:11:18.640
And once you have a fall in interest rates, there's an increase in the demand for capital on the part of the capitalists.

575
01:11:18.640 --> 01:11:24.640
And they will then demand more capital goods, which means that the price of capital goods will go up.

576
01:11:24.640 --> 01:11:30.400
and therefore profits in the capital goods industry will go up, which will stimulate them to expand.

577
01:11:30.400 --> 01:11:35.200
And so therefore they'll try to get more workers, they'll raise wages for workers

578
01:11:35.200 --> 01:11:39.560
and they'll get more workers. So the workers that are being set free

579
01:11:39.560 --> 01:11:42.920
in the consumer goods industry, being laid off, will

580
01:11:42.920 --> 01:11:46.840
find their way into the capital goods industry, or in fact will be drawn into the capital goods industry

581
01:11:46.840 --> 01:11:48.320
by the higher wages.

582
01:11:48.320 --> 01:11:50.840
Eventually we'll have more capital goods produced

583
01:11:50.840 --> 01:11:52.840
and then finally in the future

584
01:11:52.840 --> 01:11:55.480
You'll get more consumer goods, so I have CF there.

585
01:11:55.480 --> 01:11:59.120
The point is, when people reduce their spending on consumer goods now,

586
01:11:59.120 --> 01:12:02.680
does it mean that they want less consumer goods for all time?

587
01:12:02.680 --> 01:12:03.800
Of course not.

588
01:12:03.800 --> 01:12:07.080
They don't want to sacrifice consumer goods for no reason.

589
01:12:07.080 --> 01:12:11.960
They do that because they believe they can have more consumer goods in the future.

590
01:12:11.960 --> 01:12:14.720
Now, if you think back to the Robinson Crusoe example I gave you,

591
01:12:14.720 --> 01:12:18.800
when Robinson Crusoe consumed less fish when he was building the net,

592
01:12:18.800 --> 01:12:21.160
does that mean he wanted less fish for all time?

593
01:12:21.160 --> 01:12:30.660
Did he say to himself, you know what, my economy is in depression now, I'm only working for three fish, I have to go home for the last four hours.

594
01:12:30.660 --> 01:12:34.760
No, he used the four hours to do what? To build the net.

595
01:12:34.760 --> 01:12:48.060
So laying off workers in the consumer's goods industry is a sine qua non, sine qua non, the French word, without which not.

596
01:12:48.060 --> 01:12:52.620
It's a prerequisite of increasing capital goods, okay?

597
01:12:52.620 --> 01:12:57.060
And that's what the Austrians understood and that's what Keynes ignored, okay?

598
01:13:00.900 --> 01:13:05.260
Let me just say two more words, or two more, make two more points.

599
01:13:07.820 --> 01:13:10.100
One point is that, as Peter pointed out,

600
01:13:18.060 --> 01:13:23.060
Far right. Got it. Okay. Thank you.

601
01:13:26.060 --> 01:13:32.060
Once you have a change in the interest rate, or rather, once we introduce the interest rate,

602
01:13:32.060 --> 01:13:39.060
if you have the demand for labor as being determined by the marginal revenue product of labor as Peter talked about,

603
01:13:39.060 --> 01:13:45.060
you have to take into account that that labor is being paid in advance, paid for in advance by capitalists.

604
01:13:45.060 --> 01:13:52.560
So, to refute Marx, the laborers are getting less than their full marginal revenue product,

605
01:13:52.560 --> 01:14:02.060
less than they're adding to production, but that's because the product is not coming forth onto the market until some future period of time, okay?

606
01:14:02.060 --> 01:14:06.060
So the demand for labor shifts down to the DMRP, okay?

607
01:14:06.060 --> 01:14:12.060
So at each point, laborers get paid less than the full marginal revenue product.

608
01:14:12.060 --> 01:14:16.760
Why? Because the discount is what goes to the capitalist.

609
01:14:16.760 --> 01:14:20.560
That amount of money, the discount on the marginal revenue product,

610
01:14:20.560 --> 01:14:25.060
is what the capitalist earns for time preference.

611
01:14:25.060 --> 01:14:32.360
Last but not least, something else that I believe Peter went over.

612
01:14:32.360 --> 01:14:41.060
The interest rate is necessary to determine the capital value of durable factors of production,

613
01:14:41.060 --> 01:14:43.560
Capital Goods and Land and so on.

614
01:14:43.560 --> 01:14:46.280
So if you have a machine with a life of three years

615
01:14:46.280 --> 01:14:48.560
and you expect that machine to add $1,000

616
01:14:48.560 --> 01:14:51.600
to the revenue of your firm each year

617
01:14:51.600 --> 01:14:53.240
and the interest rate is 10%,

618
01:14:53.240 --> 01:14:55.960
there's a very simple present value formula

619
01:14:55.960 --> 01:14:57.640
that you use to find out

620
01:14:57.640 --> 01:14:59.980
what the total capital value of the machine is.

621
01:14:59.980 --> 01:15:02.400
You can either rent it for $1,000 a year each year

622
01:15:02.400 --> 01:15:05.280
or you can purchase it in advance

623
01:15:05.280 --> 01:15:09.960
for an amount of $2,487.

624
01:15:09.960 --> 01:15:17.960
Now, if you purchase it in advance, then the return on the machine is basically 10% per year.

625
01:15:17.960 --> 01:15:21.960
That's what the interest rate would be.

626
01:15:21.960 --> 01:15:27.960
Last but not least, the basic land, which we know is permanent.

627
01:15:27.960 --> 01:15:31.960
We're not talking about agricultural land, but basically a standing room.

628
01:15:31.960 --> 01:15:37.960
Land where you have to stand to work on, or you put buildings on or farms on.

629
01:15:37.960 --> 01:15:56.960
The basic ground land. If that is going to yield you $50,000 per year in terms of the addition to the total revenue of the firm or the production process, then what's going to happen is that you're going to get, the factor price is going to be equal to the marginal revenue product divided by the interest rate.

630
01:15:56.960 --> 01:16:08.960
So, if land is assumed to give $50,000 a year in additional revenue, then you would divide that by the 10%, .10, and so that land would be worth $500,000.

631
01:16:08.960 --> 01:16:13.960
If you had no time preference and interest rate was zero, then the land would have what kind of value?

632
01:16:13.960 --> 01:16:21.960
An infinite value. Because you wouldn't discount that $50,000 a year at all. So it would be an infinite price.

633
01:16:21.960 --> 01:16:35.960
So that's another argument, or illustration rather, that time preference exists and must be positive, the fact that land has a finite price.

634
01:16:35.960 --> 01:16:41.960
I will stop here and entertain any questions you may have. Yes.

635
01:16:41.960 --> 01:16:50.960
Why do I keep hearing the fear of declining prices? What's the basis of this fear of declining prices?

636
01:17:11.960 --> 01:17:24.960
The point is that there is deflation phobia that has arisen as a result of the experience with the Great Depression,

637
01:17:24.960 --> 01:17:29.960
not the experience itself, but the misinterpretation of what caused the Great Depression.

638
01:17:29.960 --> 01:17:38.960
And much of this misinterpretation has to be laid on the shoulders of Milton Friedman and his very influential interpretation of the Great Depression.

639
01:17:38.960 --> 01:17:43.960
The Great Depression, actually himself and his co-author Anna Schwartz.

640
01:17:43.960 --> 01:17:47.960
Their point was that the Fed caused the Great Depression,

641
01:17:47.960 --> 01:17:52.960
or they caused a garden variety recession to turn into a Great Depression

642
01:17:52.960 --> 01:17:57.960
because they allowed the money supply to shrink.

643
01:17:57.960 --> 01:18:03.960
Now, first of all, that's deflation in a different sense than just falling prices, number one.

644
01:18:03.960 --> 01:18:12.760
But secondly, yes, the money supply did shrink, and it shrunk substantially by about one-third, I believe, from 1930 to 1933,

645
01:18:12.760 --> 01:18:20.360
but it shrunk in an economic environment in which prices were not allowed to fall,

646
01:18:20.360 --> 01:18:26.260
in which Hoover brought in, at the beginning of the Depression, the big businessmen in the U.S.

647
01:18:26.260 --> 01:18:29.960
and exhorted them not to lower wages because if they lowered wages,

648
01:18:29.960 --> 01:18:33.460
that means that workers would have less to spend on consumer goods

649
01:18:33.460 --> 01:18:40.700
And we'd have more unemployment because fewer consumer goods would be produced and it would be a downward spiral.

650
01:18:40.700 --> 01:18:52.420
And then later on, when Roosevelt came in, we had the National Recovery Act, which basically cartelized different industries and made prices rigid.

651
01:18:52.420 --> 01:18:58.900
If prices were permitted to fall, as the money supply fell, things would have been much different.

652
01:18:58.900 --> 01:19:07.900
We wouldn't have had the problem of falling prices or really a rising purchasing power of money confronting fixed rigid wages.

653
01:19:09.900 --> 01:19:18.900
Also, one thing which was interesting, I believe it was Joseph Stiglitz or, I think it was Stiglitz, it may have been Krugman.

654
01:19:18.900 --> 01:19:25.900
They wrote an article this past year in which they pointed out, it was a memorial to Milton Friedman,

655
01:19:25.900 --> 01:19:55.900
Friedman, but in the article they pointed out some of the mistakes he made and what they said was that in fact, they were saying from a Keynesian point of view, in fact it was not the case that the Fed caused the money supply to contract, the Fed did everything it could after 1930 to inflate the money supply by issuing new money, but it was Krugman who said that, Paul Krugman said that, by issuing new money, one of the few true and important things Krugman has ever said.

656
01:19:55.900 --> 01:20:04.400
issuing more bank reserves, but the banks were fearful of lending these out so that, you know, they were holding excess reserves,

657
01:20:04.400 --> 01:20:10.300
and also people were taking money out of the banks, reducing their reserves at the same time.

658
01:20:10.300 --> 01:20:13.500
So the Fed had no experience with this before.

659
01:20:13.500 --> 01:20:19.000
I mean, the Fed was trying to the best of its ability and knowledge to increase the money supply for a number of years,

660
01:20:19.000 --> 01:20:27.600
But society was massively moving away from the banking system.

661
01:20:27.600 --> 01:20:35.500
It was really the chickens of the 1920 monetary inflation coming home to roost.

662
01:20:35.500 --> 01:20:38.200
The banks had overextended themselves, and in a market economy,

663
01:20:38.200 --> 01:20:44.100
there's nothing wrong with even financial institutions failing if they've made mistakes in the past.

664
01:20:44.100 --> 01:20:48.900
And that was what was happening. It was the liquidation process of past errors.

665
01:20:48.900 --> 01:20:57.400
What do you think of the current savings rate in this country? Is it in fact low? And if so, how would you explain it?

666
01:21:18.900 --> 01:21:26.900
Well, there's a couple of things here. One is the fact that people have saved less because of the housing boom.

667
01:21:26.900 --> 01:21:31.900
They see the equity in their houses going up, and they feel that, well, you know what?

668
01:21:31.900 --> 01:21:39.900
That's fungible with the money in the bank, so I'll take some money out of my bank, or I'll even take cash into my equity, and I'll consume more.

669
01:21:39.900 --> 01:21:44.900
They are saving. They're saving in that the value is locked up in their house.

670
01:21:44.900 --> 01:21:51.900
Yes, that's true. But really, if it's a bubble, it's a false value.

671
01:21:51.900 --> 01:21:58.900
It's a value that's going to be reversed, as we see now with the housing bubble collapsing.

672
01:21:58.900 --> 01:22:03.900
Also, I think the saving rate 401k contributions are not counted as savings.

673
01:22:03.900 --> 01:22:06.900
I wasn't aware of that. If that's true, that's seriously undercounting.

674
01:22:06.900 --> 01:22:10.900
The money coming out is ignored.

675
01:22:10.900 --> 01:22:20.900
Okay. I didn't realize that. Yes, Pavel? Okay. Anyone else? Any other questions? Okay, thank you.