WEBVTT NOTE 8.02. The Effect of Net Investment 1 00:00:00.000 --> 00:00:04.960 2. The Effect of Net Investment 2 00:00:04.960 --> 00:00:12.320 Having considered the ERE and its relation to specific entrepreneurial profit and loss, 3 00:00:12.320 --> 00:00:20.240 let us now turn to the problem, when will there be aggregate profits or losses in the economy? 4 00:00:20.240 --> 00:00:26.240 This is connected with the question, what is the effect of a change in the level of aggregate 5 00:00:26.240 --> 00:00:34.000 Saving or Investment in the Economy Let us begin with an economy in the equilibrium 6 00:00:34.000 --> 00:00:41.760 depicted in chapters 5 and 6. Production 6 years in total length. Total gross income 7 00:00:41.760 --> 00:00:52.800 is 418 gold ounces. Gross savings investment is 318 ounces. Total consumption 100 ounces. 8 00:00:52.800 --> 00:00:56.480 The net savings investment is zero. 9 00:00:56.480 --> 00:01:04.440 Of the 100 ounces of income, 83 ounces of net income are earned by land and labor owners, 10 00:01:04.440 --> 00:01:07.840 17 ounces by capital owners. 11 00:01:07.840 --> 00:01:14.240 The production structure remains constant because the natural rates of interest coincide 12 00:01:14.240 --> 00:01:20.080 and the resulting price spreads conform to the aggregate of individual time preference 13 00:01:20.080 --> 00:01:22.880 Schedules in the Economy. 14 00:01:22.880 --> 00:01:29.520 As Hayek states, whether the structure of production remains the same depends entirely 15 00:01:29.520 --> 00:01:37.120 upon whether entrepreneurs find it profitable to reinvest the usual proportion of the return 16 00:01:37.120 --> 00:01:43.440 from the sale of the product in turning out intermediate goods of the same sort. 17 00:01:43.440 --> 00:01:49.520 Whether this is profitable, again, depends upon the prices obtained for the product of 18 00:01:49.520 --> 00:02:05.520 of this particular stage of production on the one hand and on the prices paid for the original means of production and for the intermediate products taken from the preceding stage of production on the other. 19 00:02:05.520 --> 00:02:18.520 The continuance of the existing degree of capitalistic organization depends accordingly on the prices paid and obtained for the product of each stage of production, 20 00:02:18.520 --> 00:02:27.520 and these prices are, therefore, a very real and important factor in determining the direction of production. 21 00:02:27.520 --> 00:02:36.520 What happens if in a certain period there are now net savings as a result of a lowering of time preference schedules? 22 00:02:36.520 --> 00:02:46.520 Suppose, for example, that consumption decreases from 100 to 80 and that the saved 20 ounces enter the time market. 23 00:02:46.520 --> 00:02:47.520 Market. 24 00:02:47.520 --> 00:02:51.640 Gross savings have increased by 20 ounces. 25 00:02:51.640 --> 00:02:57.880 During the transition period, net savings has changed from 0 to 20. 26 00:02:57.880 --> 00:03:04.240 After the new level of savings has been reached, however, there will be a new equilibrium with 27 00:03:04.240 --> 00:03:11.000 gross savings equaling 338 and net savings equaling 0. 28 00:03:11.000 --> 00:03:14.640 To the superficial, it might seem that all is lost. 29 00:03:14.640 --> 00:03:22.200 Is Not Consumption Decreased from 100 to 80 oz? What then will happen to the whole complex 30 00:03:22.200 --> 00:03:28.760 of productive activities that rest on final consumption sales? Will this not lead to a 31 00:03:28.760 --> 00:03:36.520 disastrous depression for all firms? And how can a reduced consumption profitably support 32 00:03:36.520 --> 00:03:43.960 an increased volume of expenditures on producers' goods? The latter has aptly been termed by 33 00:03:43.960 --> 00:03:50.920 by Hayek, The Paradox of Saving, that is, that saving is the necessary and sufficient 34 00:03:50.920 --> 00:03:57.640 condition for increased production, and yet, that such investment seems to contain within 35 00:03:57.640 --> 00:04:03.680 itself the seeds of financial disaster for the investors. 36 00:04:03.680 --> 00:04:11.600 It is clear that the volume of money incomes to capitalists won will be drastically reduced. 37 00:04:11.600 --> 00:04:25.600 The amount that they have to apportion to original factors and to capitalists, too, is therefore also considerably decreased. 38 00:04:25.600 --> 00:04:36.600 Thus, from the side of final consumers' spending, an impetus toward declining money incomes and prices is sent along the production structure. 39 00:04:36.600 --> 00:04:42.600 In the meanwhile, however, another force has concurrently come into play. 40 00:04:42.600 --> 00:04:46.600 The 20 ounces have not been lost to the system. 41 00:04:46.600 --> 00:04:50.600 They are in the process of being invested in the economy, 42 00:04:50.600 --> 00:04:58.600 their owners ranging throughout the economy looking for maximum interest returns on their investment. 43 00:04:58.600 --> 00:05:10.100 The new savings have changed the ratio of gross investment to consumption from 318 to 100 to 338 to 80. 44 00:05:10.100 --> 00:05:16.800 A narrower consumption base must support a larger amount of producers' spending. 45 00:05:16.800 --> 00:05:25.200 How can this happen, especially since the lower-rank capitalists must also receive a lower aggregate income? 46 00:05:25.200 --> 00:05:35.200 The answer is, in only one way, by shifting investment further up the ladder to the higher order production stages. 47 00:05:35.200 --> 00:05:44.200 Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages, 48 00:05:44.200 --> 00:05:52.200 while preserving uniform lowered interest differentials, cumulative price spreads at each stage, 49 00:05:52.200 --> 00:06:02.200 is to increase the number of productive stages in the economy, that is, to lengthen the structure of production. 50 00:06:02.200 --> 00:06:09.200 The impact of net saving on the economy, that is, of increased total savings, 51 00:06:09.200 --> 00:06:17.200 is to lengthen and narrow the structure of production, and this procedure is viable and self-supporting, 52 00:06:17.200 --> 00:06:31.260 Let us consider the price changes in the various stages and the processes by which they occur. 53 00:06:31.260 --> 00:06:37.540 In the lower stages, prices fall because of the lower consumer demand and the resulting 54 00:06:37.540 --> 00:06:42.740 shift of investment capital from the stages' nearest consumption. 55 00:06:42.740 --> 00:06:49.060 In the higher stages, on the other hand, demand for factors increases under the impact of 56 00:06:49.060 --> 00:06:53.820 the new savings and the shift in investment from the lower levels. 57 00:06:53.820 --> 00:06:59.700 The increased investment expenditure in the higher levels raises the prices of the factors 58 00:06:59.700 --> 00:07:01.620 in these stages. 59 00:07:01.620 --> 00:07:09.360 It is as if the impact of lower consumer demand tends to die out in the higher stages and 60 00:07:09.360 --> 00:07:16.940 is more and more counteracted by the increase and shift in investment funds. 61 00:07:16.940 --> 00:07:23.520 The process of readjustment to lower price spreads caused by increased gross saving has 62 00:07:23.520 --> 00:07:26.440 been lucidly described by Hayek. 63 00:07:26.440 --> 00:07:32.920 As he states, the final effect will be that through the fall of prices in the later stages 64 00:07:32.920 --> 00:07:57.920 The Changes in Cumulative Prices in the Various Sectors will lead to changes in the prices of the particular goods that enter into the cumulation of factors. 65 00:07:57.920 --> 00:08:12.420 These factors are, of course, the capital goods, land and labor factors, and are ultimately reducible to the latter two, since capital goods are produced and reproduced factors. 66 00:08:12.420 --> 00:08:21.420 It is clear that lower aggregate demand in the lower stages will cause the prices of the various factors there to decline. 67 00:08:21.420 --> 00:08:28.300 The specific factors will have to bear the brunt of the decline, since they have nowhere else to go. 68 00:08:28.300 --> 00:08:35.900 The non-specific factors, on the other hand, can and do go elsewhere, to the earlier stages, 69 00:08:35.900 --> 00:08:39.660 where the monetary demand for factors has increased. 70 00:08:40.860 --> 00:08:46.140 The pricing of capital goods is ultimately unimportant in this connection, 71 00:08:46.140 --> 00:08:53.980 because it is reducible to the prices of land, labour and time and because the interest spread 72 00:08:53.980 --> 00:09:01.740 indicates the mode of pricing of the capital goods. The ultimately important factors then are land, 73 00:09:01.740 --> 00:09:08.220 labour and time. The time element has been extensively considered and accounts for the 74 00:09:08.220 --> 00:09:13.900 interest spread. It is the land and labour elements that constitute the fundamental 75 00:09:43.900 --> 00:09:49.900 The possibility of a labor factor will differ from one task to another. No one disputes this. 76 00:09:49.900 --> 00:09:55.900 Indeed, if this were not so, the factor would be purely non-specific. 77 00:09:55.900 --> 00:09:59.900 And we have seen that this is an impossibility. 78 00:09:59.900 --> 00:10:06.900 Specific is here used to mean pure specificity for one production process. 79 00:10:06.900 --> 00:10:12.900 Of course, there are different degrees of non-specificity for any factor. 80 00:10:12.900 --> 00:10:19.900 The less specific ones will be more readily shifted from one stage or product to another. 81 00:10:19.900 --> 00:10:32.900 Those factors which are specific to only one particular stage and process will therefore fall in price in the later stages and rise in the earlier stages. 82 00:10:32.900 --> 00:10:38.900 What of the non-specific factors, which include all labor factors? 83 00:10:38.900 --> 00:10:44.020 These will tend to shift from the later to the earlier stages. 84 00:10:44.020 --> 00:10:49.180 At first there will be a difference in the price of each non-specific factor. 85 00:10:49.180 --> 00:10:54.540 It will be lower in the lower stages and higher in the higher stages. 86 00:10:54.540 --> 00:11:01.980 In equilibrium, however, as we have seen time and again, there must be a uniform price for 87 00:11:01.980 --> 00:11:05.000 any factor throughout the economy. 88 00:11:05.000 --> 00:11:11.300 The lower demand in the lower stages and the consequent lower price coupled with the higher 89 00:11:11.300 --> 00:11:18.140 demand and higher price in the higher stages causes the shift of the factor from later 90 00:11:18.140 --> 00:11:20.080 to earlier stages. 91 00:11:20.080 --> 00:11:26.500 The shift ceases when the price of the factor is again uniform throughout. 92 00:11:26.500 --> 00:11:33.400 We have seen the impact of new saving, that is, a shift from consumption to investment 93 00:11:33.400 --> 00:11:37.300 on the prices of goods at various levels. 94 00:11:37.300 --> 00:11:43.680 What however is the aggregate impact of a change to a higher level of gross savings 95 00:11:43.680 --> 00:11:46.480 on the prices of factors? 96 00:11:46.480 --> 00:11:50.100 Here we reach a paradoxical situation. 97 00:11:50.100 --> 00:11:57.040 Net income is the total amount of money that ultimately goes to factors, land, labor and 98 00:11:57.040 --> 00:11:58.440 time. 99 00:11:58.440 --> 00:12:05.800 In any equilibrium situation, net saving is zero by definition, since net saving means 100 00:12:05.800 --> 00:12:12.960 a change in the level of gross saving over the previous period of time, and net income 101 00:12:12.960 --> 00:12:17.360 equals consumption and consumption alone. 102 00:12:17.360 --> 00:12:26.340 Total income for original factors and interest can come only from net rather than gross income. 103 00:12:26.340 --> 00:12:34.180 Let us consider the new ERE after the change has taken place to a higher level of saving, 104 00:12:34.180 --> 00:12:40.140 ignoring for a moment the relevant conditions during the period of change. 105 00:12:40.140 --> 00:12:48.340 Gross savings equals gross investment has increased from $3.18 to $3.38, but consumption 106 00:12:48.340 --> 00:12:55.460 One has declined from 100 to 80, and it is consumption that provides the net income in 107 00:12:55.460 --> 00:12:58.060 the equilibrium situation. 108 00:12:58.060 --> 00:13:05.140 Net income is, as it were, the fund out of which money prices and incomes are paid to 109 00:13:05.140 --> 00:13:10.880 original factors, and this fund has declined. 110 00:13:10.880 --> 00:13:17.900 The recipients of the net income fund are the original factors, labor and land, and 111 00:13:17.900 --> 00:13:20.060 Interest on Time. 112 00:13:20.060 --> 00:13:23.120 We know that the interest rate declines. 113 00:13:23.120 --> 00:13:29.300 This is a corollary of the increased saving and investment in the productive system, caused 114 00:13:29.300 --> 00:13:31.420 by lower time preference. 115 00:13:31.420 --> 00:13:38.780 However, the absolute amount of interest income is gross investment multiplied by the rate 116 00:13:38.780 --> 00:13:40.340 of interest. 117 00:13:40.340 --> 00:13:46.860 Gross investment has increased, so that it is impossible for economic analysis to determine 118 00:13:46.860 --> 00:13:54.520 Whether interest income has fallen, increased or remained the same, any of these alternatives 119 00:13:54.520 --> 00:13:57.140 is a possibility. 120 00:13:57.140 --> 00:14:03.400 What happens to total original factor income is also indeterminate. 121 00:14:03.400 --> 00:14:10.580 Two forces are pulling different ways in a progressing economy, an economy with increasing 122 00:14:10.580 --> 00:14:12.660 gross investment. 123 00:14:12.660 --> 00:14:17.640 On the one hand, the total net income money fund is falling. 124 00:14:17.640 --> 00:14:23.160 On the other hand, if the interest decline is large enough, it is possible that the fall 125 00:14:23.160 --> 00:14:30.220 in interest income will outstrip the fall in total net income, so that total factor 126 00:14:30.220 --> 00:14:33.440 income actually increases. 127 00:14:33.440 --> 00:14:39.440 For this to occur is possible, but empirically highly unlikely. 128 00:14:39.440 --> 00:14:47.240 The one certain prospect is that total net income for factors and interest will fall. 129 00:14:47.240 --> 00:14:53.760 If the total original factor income falls then, since we have implicitly been assuming 130 00:14:53.760 --> 00:15:00.960 a given supply of original factors, the prices of these factors as well as the interest rate 131 00:15:00.960 --> 00:15:05.200 will in general also decline. 132 00:15:05.200 --> 00:15:11.840 That the general trend of original factor incomes and prices may well be downward is 133 00:15:11.840 --> 00:15:18.480 a startling conclusion, for it is difficult to conceive of a progressing economy as one 134 00:15:18.480 --> 00:15:26.040 in which factor prices, such as wage rates and ground rents, steadily decline. 135 00:15:26.040 --> 00:15:33.220 What interests us, however, is not the course of money incomes and prices of factors, but 136 00:15:33.220 --> 00:15:41.780 of Real Incomes and Prices, that is, the goods income accruing to factors. 137 00:15:41.780 --> 00:15:49.340 If money wage rates or wage incomes fall, and the supply of consumers goods increases, 138 00:15:49.340 --> 00:15:57.820 such that the prices of these goods fall even more, the result is a rise in real wage rates 139 00:15:57.820 --> 00:16:01.220 and real incomes to factors. 140 00:16:01.220 --> 00:16:09.460 That this is precisely what does happen solves the paradox that a progressing economy experiences 141 00:16:09.460 --> 00:16:12.220 falling wages and rents. 142 00:16:12.220 --> 00:16:18.820 There may be a fall in money terms, although not in all conceivable cases, but there will 143 00:16:18.820 --> 00:16:24.220 always be a rise in real terms. 144 00:16:24.220 --> 00:16:31.180 The rise in real rates and incomes is due to the increase in the marginal physical productivity 145 00:16:31.180 --> 00:16:37.900 Productivity of factors that always results from an increase in saving and investment. 146 00:16:37.900 --> 00:16:45.380 The increased productivity of the longer production processes leads to a greater physical supply 147 00:16:45.380 --> 00:16:52.860 of capital goods and, most important, of consumers' goods, with a consequent fall in the prices 148 00:16:52.860 --> 00:16:55.060 of consumers' goods. 149 00:16:55.060 --> 00:17:02.500 As a result, even if the money prices of labor and land fall, those of consumers' goods 150 00:17:02.500 --> 00:17:09.180 will always fall farther, so that real factor incomes will rise. 151 00:17:09.180 --> 00:17:16.800 That this is always true in a progressing economy can be seen from the following considerations. 152 00:17:16.800 --> 00:17:23.740 At any time, the wage or rent of the service of an original factor of production will equal 153 00:17:23.740 --> 00:17:34.740 It's DMVP, the Discounted Marginal Value Product. This DMVP is equal to the MVP, Marginal Value 154 00:17:34.740 --> 00:17:42.460 Product, divided by a discount factor, say D, which is directly dependent on the rate 155 00:17:42.460 --> 00:17:51.620 of interest. The MVP in turn is approximately equal to the MPP, Marginal Physical Product 156 00:17:51.620 --> 00:17:58.660 of the Factor times the selling price, that is, the final price of the consumer's good 157 00:17:58.660 --> 00:18:00.220 product. 158 00:18:00.220 --> 00:18:06.420 In this discussion we are considering the prices of consumer's goods in general or 159 00:18:06.420 --> 00:18:08.140 in the aggregate. 160 00:18:08.140 --> 00:18:14.840 The real prices of the original factors equal the money prices divided by the prices of 161 00:18:14.840 --> 00:18:17.020 consumer's goods. 162 00:18:17.020 --> 00:18:38.020 Strictly, there is no precise, praxeological way of measuring these aggregates, or real income, based on changes in the purchasing power of money, but we can make qualitative statements about these elements, even though we cannot make precise, quantitative measurements. 163 00:18:38.020 --> 00:18:52.020 Now the progressing economy consists of two leading features, an increase in the MPP of original factors resulting from more productive and longer production processes, 164 00:18:52.020 --> 00:19:01.020 and a fall in the discount or interest rate concomitant with falling time preference and increasing gross investment. 165 00:19:01.020 --> 00:19:02.020 Development. 166 00:19:02.020 --> 00:19:10.780 Both elements, the increase in MPP and the fall in D, impel an increase in the real prices 167 00:19:10.780 --> 00:19:15.500 of factor services in a progressing economy. 168 00:19:15.500 --> 00:19:22.460 The conclusion is that in a progressing economy, that is, in an economy with increases in gross 169 00:19:22.460 --> 00:19:30.900 savings and investment, money wages and ground rents may well fall, but real wages and rents 170 00:19:30.900 --> 00:19:32.700 will rise. 171 00:19:32.700 --> 00:19:40.500 Historically, the advancing capitalist economy has coincided with an expanding money supply, 172 00:19:40.500 --> 00:19:47.020 so that we have rarely had an empirical illustration of the pure process described. 173 00:19:47.020 --> 00:19:53.060 We must remember that we have throughout been making the implicit assumption that the money 174 00:19:53.060 --> 00:20:00.820 relation, the demand for and particularly the supply of money, remains unchanged. 175 00:20:00.820 --> 00:20:06.060 The effects of changes in this relation will be considered in Chapter 11. 176 00:20:06.060 --> 00:20:12.900 The only relaxation of this assumption here is that the number of stages increases, and 177 00:20:12.900 --> 00:20:19.180 this tends to increase the demand for money to that extent. 178 00:20:19.180 --> 00:20:26.180 One question that immediately presents itself is, how can the prices of factors decline 179 00:20:26.180 --> 00:20:32.540 While the gross income remains the same, and gross investment even increases? 180 00:20:32.540 --> 00:20:39.340 The answer is that the increase in investment goes into increasing the number of stages, 181 00:20:39.340 --> 00:20:46.200 pushing back the stages of production and employing longer production processes. 182 00:20:46.200 --> 00:20:53.780 It is this increasing roundaboutness that causes every increase in capital, even if 183 00:20:53.780 --> 00:21:01.460 with unaccompanied by an advance in technological knowledge to lead to higher physical productivity 184 00:21:01.460 --> 00:21:03.780 per original factor. 185 00:21:03.780 --> 00:21:10.260 The increase in gross investment in particular raises the prices of capital goods at the 186 00:21:10.260 --> 00:21:17.940 highest stages, encouraging new stages and inducing entrepreneurs to shift factors into 187 00:21:17.940 --> 00:21:21.080 this new and flowering field. 188 00:21:21.080 --> 00:21:28.280 The larger gross investment fund is absorbed, so to speak, by higher prices of high-order 189 00:21:28.280 --> 00:21:35.480 capital goods, and by the consequent new stages of turnover of these goods. 190 00:21:35.480 --> 00:21:42.840 The demand for money increases to the extent that each gold unit must turn over more times 191 00:21:42.840 --> 00:21:49.640 in the increased number of stages, thus tending to lower the general level of prices.