The Nature of Capital

We wanted to expand a bit on a theme we have often discussed here, namely the fully predictable recent failure of the central economic planning agencies in the regulatory and nominally 'capitalist' democracies of the West.

As our regular readers know, we have asserted for a long time that the attempt to 'rescue' the economy by means of Keynesian deficit spending and money printing would not only fail, but would in fact make the economic contraction worse.

As we explained, the economy's problem has been misdiagnosed by the prevailing economic orthodoxy, mainly due to the fact that both the various branches of Keynesianism and monetarist theory lack a well-developed theory of capital. Keynesians believe – and Nouriel Roubini has once again confirmed this in the course of his recent bizarre attempt to resurrect and validate Marx – that the economy's central problem is a 'lack of aggregate demand'. As the term already implies, in Keynesian theory economic data are generally aggregated. So it is also with capital, which in the Keynesian world (and the monetarist world for that matter) is simply yet another aggregate – 'K' (for 'Das Kapital' :)).

This is however incorrect. Capital is definitely not a homogenous blob 'K', a kind of self-replicating fund that will swing into action of its own accord if only 'aggregate demand' rises sufficiently. On the contrary, the economy's production or capital structure consists of a myriad of heterogeneous complementary goods that are arranged in a complex latticework of inter – and intra – temporal relationships. Once an economist comes to accept this truth, he can no longer possibly agree with the rest of the Keynesian orthodoxy's tenets. For instance, the idea that 'fiscal stimulus spending' can 'revive the economy' must be immediately discarded once the heterogeneous nature of capital is acknowledged.

We would note here as an aside that it is not true, as some people assert, that due to the fact that there exist competing economic theories it can not be proved with certainty which one them is correct. Likewise,  one can not simply 'pick whatever one likes' from each of the competing theories and in that manner put together one's own preferred version of how the world works. There is in fact only one correct theory of economics, and ever since Ludwig von Mises has refined it and put it to paper, the task of economists is in the main that of working out a few details. Its foundations can not be improved or successfully contradicted anymore.

The economy's problem is not one of 'underconsumption' as mainstream economists in academe and the world of policymakers continually assert. This should be obvious to anyone with even a shred of common sense. How can one possible increase wealth by means of consumption? Once a thing is consumed, it is gone. The only means of increasing wealth is in fact the foregoing of consumption in favor of saving and investment. Note here that only if there is a surplus of production that remains unconsumed (or in other words, is saved), will it be possible to maintain the existing production structure or add to it.

It is not enough to simply print money. Money is a medium of exchange, it does not per se constitute 'wealth'. Wealth is embodied in the capital goods accumulated over many generations. Any policy that has the sole aim of increasing consumption will eventually lead to a consumption of this accumulated capital.  This is where the policies of the Western governments and their central banks have brought us to today. We have been consuming our scarce capital in one credit boom after another, with the result that we may now have finally arrived at the tipping point where more wealth is consumed than is produced.

As Sean Corrigan recently remarked with regards to the misguided idea of mad hatters like Ben Bernanke and his colleagues that it is possibly to print the economy back to prosperity:

“He [John Law, ed.] also held, like all of his ilk that have succeeded him,  that the panacea for a nation groaning under an unsupportable burden of debt and famished for a lack of productive capital was the emission of more and more money. This age old error of confusing the medium of exchange with the object of exchange is one we continue to commit. It's as if a man's thirst can be slaked by giving him a box of drinking straws or his appetite sated by kitting him out with a shopping basket.'


Bank of England Throws 'Inflation Target' Overboard

In the context of the failure of our esteemed central economic planners to achieve any of their stated goals an article at the WSJ recently caught our eye. It looks at the Bank of England and its apparent 'change of plans'.

The BoE is supposed to hold fast to a so-called 'inflation target', i.e., it is supposed to deliver 'price stability' by keeping the rate of change of UK CPI at or below a target of 2% per annum. Whenever the bank fails to meet this target, its governor (currently Mervyn King) must write the so-called 'Dear Chancellor' letter, explaining the failure to the UK's chancellor of the exchequer.

It has failed to achieve this target for a long time now – in fact, the official 'inflation rate' is almost ten times higher than the BoE's administered interest rate. Evidently the goal of 'price stability' has been thrown overboard. As Allan Mattich writes: 

“The Bank of England‘s new mandate is to prevent output volatility. It is no longer targeting inflation.

There’s no other way to interpret Governor Mervyn King’s open letter on why inflation remains above the bank’s 2% target. By his own admission, inflation is likely to breach 5% this year.

OK, so it is well nigh impossible for the bank to control inflation over the very short term, and double digit utility price rises bake in a further jump in consumer prices over the coming months.

Mr. King, instead, argues that over the coming year inflation will come down because it is unlikely commodity prices will continue going up at the pace they’ve been rising so far, because the effects of this year’s value added tax rise will fall out of the equation, because sterling’s 25% devaluation in 2007 and 2008 will at long last stop exerting upward pressure on import prices and because the government’s austerity program will keep the economy fragile.”

As it were, all these excuses Mr. King keeps citing are marred by the fact that he has made similar forecasts of the expected rate of change of UK CPI for the past two years and they have yet to come true. King is in fact attempting to deny that a so-called 'stagflation' is possible – and yet, this is precisely the condition now prevailing in the UK – and it is clearly the BoE's fault.

Mattich continues:

By his own admission, Mr. King has said a country’s inflation rate is entirely down to the central bank’s choice. The Bank of England could have met its inflation remit, but only at the expense of driving down the growth rate.

·     The bank’s policy committee has consistently shrugged off inflation rates well above its target but the moment it looked to dip below 2% it started warning of deflation and talking about the need for extraordinary measures. It should be remembered the U.K.’s inflation rate has never even dipped below 1% since the financial crisis.

·     Members of the rate setting Monetary Policy Committee have been clear that they prefer to err on the side of too much inflation than on the side of too little.

·     The bank has consistently misinterpreted the economy. Before the financial crisis it allowed the U.K. to overheat because it underweighted the impact of global factors in keeping inflation down. Since the crisis it has understated the impact of sterling’s decline on inflation and overestimated how much of an impact the downturn would have on unemployment. The bank has consistently also overestimated the degree to which there is an output gap in the U.K. economy and how much productive potential it has. In all, the biases and errors all point in one direction: that is towards allowing inflation to be too high.

·     As academic economists with a Keynesian background, much of the MPC is contemptuous of savers. Savers, or rentiers as Mr. Keynes called them, were a drag on an economy’s potential and deserved to have their money confiscated–his euthanasia of the rentier.


(emphasis added)

Well, there you have it. For one thing, the MPC is incompetent and continually makes wrong forecasts – thereby displaying the very problem that lies at the root of the impossibility of socialist central economic planning. It is simply not possible for a central planning agency to make decisions that are superior to the outcomes a free market would produce, as can not possibly come into possession of the necessary knowledge. In the case of central banks this represents in essence a variation of the socialist economic calculation problem, as Spanish 'Austrian' economist  J.H. de Soto has shown.

Secondly, in typical Keynesian fashion the BoE's policies attack – similar to the Fed's –  the very savers whom the economy urgently needs if the foundation for a sustainable economic expansion is to be laid. By destroying the incentive to save and waging war on savers, it deprives the economy of the means to maintain and repair the damaged capital structure. Again, this policy is based on the erroneous assumption that 'underconsumption' is the economy's chief problem.  In reality the problem is that the preceding boom has distorted the economy's production structure. The BoE's policies are designed to damage it even further.

Mattich concludes by noting:

“The upshot is that 2% now represents the U.K.’s inflation floor. The bank has shown itself comfortable with inflation at 5% and above, which suggests the ceiling before it starts to react could well be in the order of 6% or 7%. Oddly enough, economists like Kenneth Rogoff have long argued that economies with large debt burdens need a few years of 6% or 7% inflation in order to get back onto an even keel”

To paraphrase the above quoted Sean Corrigan, Rogoff maintains that 'in order to save this man that has staggered out of the desert dying of thirst, we must supply him with a million new drinking straws'.  

If consumer prices were to shoot up to 6% or 7% per annum it would not signify that the 'economy is back on an even keel', it would signify a total economic catastrophe. May the Lord preserve us from these modern-day purveyors of John Law's monetary quackery.


Chart Update

Below you find an update of our usual basket of charts. CDS prices and yields in basis points, color-coded where applicable. As can be seen, the situation in sovereign CDS and bond yields has calmed down somewhat, but as we have noted, everyone's attention has lately shifted to the rickety banking system and the weakening economy instead. Besides, CDS spreads on sovereigns have also begun to 'hook up' a bit again.



5 year CDS on Portugal, Italy, Greece and Spain – a bounce is underway – click for higher resolution.



5 year CDS on Ireland, France, Belgium and Japan – let's keep an eye on Japan. French CDS at 150 basis points are still extremely high – click for higher resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – also bouncing higher – click for higher resolution.



5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – click for higher resolution.



5 year CDS on Romania, Poland, Slovakia and Estonia – click for higher resolution.



5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – click for higher resolution.



10 year government bond yields of Ireland, Greece, Portugal and Spain – Greek debt keeps selling off – click for higher resolution.



10 year government bond yields of Italy and Austria, UK gilts and the Greek 2 year note – the 'safe haven' yields continue to collapse – click for higher resolution.



5 year CDS on Germany and the US and the Markit SovX index of CDS on 19 Western European sovereigns. It appears the SovX is soon going to be at a new high – click for higher resolution.


Inflation adjusted yields continue to plunge – click for higher resolution.



5 year CDS on the 'Big Four' Australian banks – bouncing up again – click for higher resolution.





The fact that Finland managed to wrangle collateral from Greece to guarantee its share of the Greek bailout has now led to a comical scramble by other euro area governments that want the same treatment. The bailout of Greece thus  threatens to become even more of a farce than it already is.  As Forbes reports:

“Officials from Austria, Slovenia and Slovakia say that their countries are pushing for Greece to provide collateral to secure their contributions to a 109 billion euro ($157 billion) rescue loan.

The demands risk driving up the cost of the bailout because Greece would need extra money to be able to put up the collateral. Their requests follow a deal sealed Tuesday in which Athens agreed to deposit hundreds of millions of euros in a Finnish state account, a sum that will eventually generate enough interest to fully secure Finland's contribution to the second Greek bailout. Officials from Austria, Slovenia and Slovakia said Thursday that their countries should get a similar deal.

A spokesman for the Austrian finance ministry said that the Netherlands have also indicated interest in collateral.”


(emphasis added)

As we often say, you couldn't make this up.



Charts by: Bloomberg



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2 Responses to “The Central Planners Fail, Plus A Chart Update”

  • swaper:

    Peter, I would like to better understand how the “On the contrary, the economy’s production or capital structure consists of a myriad of heterogeneous complementary goods that are arranged in a complex latticework of inter – and intra – temporal relationships. ” actually looks as an example. Is there a good passage or article that fleshes this out. Thanks

    • Hi Swaper,

      I was about to pen an extensive reply, but then decided that your question should actually be answered in a separate post, as this is surely of interest to many readers. I intend to publish it on Friday.

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