A Capital Paradox
What, exactly, is economic capital? It is the productive potential of the economy, the ability to make things that people need and want to consume. But unlike paper, capital does not grow on trees. Capital itself must first be produced, in the form of capital goods. Let’s start from the beginning: We all need to consume food. Few of us produce our own. So we need to purchase food with our earnings. When we go to the supermarket and purchase a trolley of food, we are purchasing the output of a mind-bogglingly complex productive process. To highlight just a few aspects of this, consider:
- Arable land requires regular attention to remain productive, including irrigation, soil and fertilizer treatments;
- Irrigation is only partially provided by natural rainfall and drainage. An increasing portion is provided by some mechanical means, e.g. wells, pumps, aqueducts, desalinization, etc;
- Soil and fertilizer treatments are overwhelmingly produced in factories requiring substantial energy input;
- Farm machinery must also be produced in factories and properly maintained thereafter;
- Wells, pumps, aqueducts, desalination plants, fertilizer and farm machinery factories themselves don’t just exist; they too need to be manufactured and, thereafter, regularly maintained with suitable equipment, which must itself be manufactured and maintained with suitable equipment, and so on.
Now why would someone go to the trouble of manufacturing suitable equipment for making suitable equipment for maintaining a factory which is full of suitable equipment for producing fertilizer, which is then packaged and transported using suitable logistical equipment requiring regular maintenance using suitable equipment to a farm when it is loaded on to a tractor (requiring regular maintenance using suitable equipment), which was manufactured in a factory full of suitable equipment which was itself manufactured in another factory full of suitable equipment… ? Well, as with all economic activity, someone must believe that they will make a fair profit by engaging in some aspect of this process above, or else they wouldn’t do so. But do you see the complexity? How on earth can anyone just sit back, survey all these various stages of production and possibly know how each and every step should work, much less what sort of profit should be expected? Well, no one can. (This is one intuitive way of understanding why command economies are horribly inefficient, even assuming that everyone is competent, is trying their best and no one is corrupt, three assumptions that are at odds with historical experience and, as such, highly suspect.)
But if no one understands how this process works, then how does it work at all? Simple: The division of labor. At every stage of every productive process, either within a firm or between firms, there is always someone to perform each specific task. As long as those participating continue to believe that they receive fair compensation for their contribution, they will continue to work accordingly, doing their part to make a highly complex productive process a sustainable reality.
Now that we understand how complicated economic production is in a modern economy, even for something as basic as foodstuffs, let’s consider how the capital stock comes into existence in the first place. Even though no one can conceive of each and every detail in a highly complex production chain as that described above, nevertheless there are people who are willing to step up where they think they see an opportunity and invest their savings in capital goods of some kind, from which they are reasonably confident they will earn a respectable return. So the capital stock originates in savings. No savings, no growth in the capital stock.
Once created, however, the capital stock needs to be maintained. All real capital depreciates, be it buildings, factories, machines, roads, vehicles, refineries, electrical grids and power plants, even, as in our example above, arable land. Without maintenance, the capital stock will eventually depreciate to the point where it is no longer able to perform the functions for which it was originally intended. Beyond that point, it is a write off, either to be abandoned, sold for scrap or otherwise recycled.
Now why is this important? Consider: The larger the capital stock, the higher the productive capacity of the economy. As such, we should all have an interest in growing the capital stock over time. Yet the larger the capital stock, the greater the potential depreciation and therefore the greater the maintenance required to prevent it. Who is going to provide this maintenance? In much the same way as capital comes into existence in the first place, someone is going to come along who believes that they can make a reasonable profit by using their savings to provide maintenance on the existing capital stock. So the maintenance also originates in savings, without which the capital stock will depreciate, eventually to the point of becoming unproductive.
Intuitively, of course, we know this is correct. Building a home costs money. Maintaining the home once built costs money. If we spend all our income on day-to-day consumption of food and clothing, rather than saving up for occasional home maintenance, the home will depreciate to the point of being rendered uninhabitable.
Returning to the economy, both creating and maintaining a capital stock requires savings. Now what happens if there IS no savings? What if, for example, the financial assets which are claims on the present and future productive value of the capital stock–net of depreciation of course– rise in value to the point that the holders thereof feel themselves “richer” and neglect to save? What if, for whatever reason, the central bank holds interest rates artificially low, such that there is little incentive to save? What if, in response to an unusually prolonged slump in economic activity, the central bank starts directly and artificially propping up asset prices by buying securities, thereby making it even less attractive to save?
Well, guess what? Amidst artificial disincentives to save and asset price distortions that make people feel “richer”, what, exactly, is going to happen to the capital stock? IT IS GOING TO DEPRECIATE, LOWERING THE POTENTIAL ECONOMIC GROWTH RATE! What if this state of affairs lasts for years? THE CAPITAL STOCK IS GOING TO DEPRECIATE DRAMATICALLY, TO THE POINT WHERE MUCH OF IT BECOMES A WRITE-OFF, LOWERING THE STANDARD OF LIVING!
Don’t be fooled into thinking that the capital stock is unlimited. It is anything but. It is the most highly leveraged, most sensitive, most easily distorted part of the economy. The slightest changes in interest rates, in taxes, in regulations, in perceptions and confidence can have a huge impact, over time, on the size, structure and health of the capital stock. And as it is strictly limited to functioning, economically viable capital goods, the more these are used by the government, the less they are available for private sector uses. So-called “crowding out” of capital is not just a financial theory; it is a harsh economic reality. For each dollar in savings that the government takes for itself to fund its deficit it is taking one dollar away–at present prices–from private savings. And if the government then uses that dollar to bail out insolvent financial enterprises or to fund consumption–say to provide entitlement benefits of some kind–rather than for investment, then the government is contributing directly, not just indirectly, to the depreciation of the capital stock.
Don’t be surprised when you look around and see the crumbling infrastructure. With asset prices artificially high, discouraging investment, and the return on savings artificially low, discouraging savings, there is naturally little in the way of resources available to maintain the existing capital stock, much less expand it. And don’t be fooled into thinking that somehow higher taxes would help. Is the private sector going to save more, or less, if the tax burden rises? The answer to that is obvious. No, there are only two ways in which the existing capital stock can be properly maintained: With either a higher private savings rate, presumably a result of higher after-tax interest rates; or, alternatively, for the government to redirect existing entitlement spending–consumption–toward infrastructure instead.
Finally, although asset prices can rise indefinitely and infinitely in nominal terms–for example if the purchasing power of the currency is constantly and exponentially declining–they can only rise sustainably in real terms if the underlying economic value of the capital stock continues to grow. In a great paradox, the policies which the Fed has implemented to artificially prop up asset prices and stimulate economic activity are, in fact, contributing directly to a reduction in savings; to an accelerating depreciation of the capital stock; to a decline in the potential growth rate; and, ultimately, to a reduction in the standard of living. That is the unseen “cost” of propping up failed financial institutions and preventing a natural, salutary reorganization and rebuilding of the capital stock.
The Fed has not merely demonstrated that it is incompetent as the chief financial regulator and that it is increasingly pathological in its pursuit of inflation at all costs. It is destroying, by stealth, the nation’s capital stock, its real wealth. When the smoke clears, the pile of rubble which once was arguably the greatest ever accumulation of capital in world history will be reflected in crumbling real financial asset values. Now, do you want to be holding those assets, or something else entirely?
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]