I received a good deal of mail on my recent Mises.org piece on the questionable nature of government schemes to boost industry, "See the Pyramids Along the Nile." Most of it was favorable. However, a few correspondents were puzzled (or even distraught) over my use of an example from Bastiat's "What Is Seen and What Is Not Seen." (To see the full example per Bastiat, click on the link in the table of contents for part one, then scroll down to section nine, "Credit.") I wrote:
However, Bastiat pointed out that in any loan, money is only the intermediary. What is being borrowed is ultimately always a currently existing good (or goods). When the government lends money to a farmer, he spends it on a tractor. What the farmer has really borrowed is the tractor. And since there are only so many tractors in existence at one time, someone else does not have that tractor as a result. [I changed Bastiat's example only to update his plow to be a tractor.]
The complaints about that example were interesting and worth addressing. They illustrate the difficulty in perceiving the real economy through the "fluttering veil" of money, and the difficulty in clearly seeing the difference between the economy at a point in time and the progress of the economy over time. Furthermore, they point to an important distinction between the Austrian and neoclassical approaches to economic analysis.
We'll take up that difference between Austrian and neoclassical analysis first. One correspondent wrote to ask whether it wasn't "simplistic" to use a model with no inventory to describe this phenomenon?
There is a basic misunderstanding of the Austrian approach at work in this remark. Some neoclassical economists (though not the wisest of them) take the job of an economist to be producing models of the economy that will "behave" as much like the real economy as possible, in the sense that they will produce numerical predictions that are close to the prices and quantities that really emerge. In the attempt to create such a model, the more of the complicating factors of the real world that can be brought into play, the more realistic the approach is thought to be.
Austrian analysis is quite different. We employ imaginary constructions that (we hope) allow us to see the essence of economic phenomena operating beneath the bewildering complexities of the real economy, not models that attempt to mirror that complexity. Having grasped these essences, we use them to navigate our way back to an analysis of more complex situations. Carl Menger set out this method in the very first work of the Austrian School proper, his Principles of Economics:
In what follows I have endeavored to reduce the complex phenomena of human economic activity to the simplest elements that can still be subjected to accurate observation, to apply to these elements the measure corresponding to their nature, and constantly adhering to this measure, to investigate the manner in which the more complex phenomena evolve from their elements according to definite principles.
Bastiat, usually consider an Austrian precursor, anticipated Menger's method. Commenting on his example of the plow, Bastiat wrote:
True, I have reduced the operation to its simplest terms, but test by the same touchstone the most complicated governmental credit institutions, and you will be convinced that they can have but one result: to reallocate credit, not to increase it. In one country, and in a given time, there is only a certain sum of available capital, and it is all placed somewhere.
Bastiat's construction is not simplistic, but simple, just as it should be. Yes, he could have included unsold inventories of plows in his story, just as he could have included the price of the plow, what color it was, where the farmer lived, and how many pigs he had. But none of these things, including inventories, are relevant to understanding the essence of the phenomenon in question. (I'll address inventories more a little later.)
But what about the example itself? Does it really capture that essence? I'll take up the various questions I received about that aspect of the example one at a time:
In what sense could Bastiat contend that the essence of the loan was the borrowing of a plow, and not the borrowing of money?
Bastiat was able to peer through the fluttering veil of money to see that people borrow it for the goods they can acquire with it. (The desire to hold cash balances is a complicating factor, but it does not change the essential analysis.) He wrote:
In this question it is absolutely necessary to forget money, coin, bank notes, and the other media by which productions pass from hand to hand; in order to see only the products themselves, which are the real substance of a loan.
For when a farmer borrows fifty francs to buy a plow, it is not actually the fifty francs that is lent to him; it is the plow.
And when a merchant borrows twenty thousand francs to buy a house, it is not the twenty thousand francs he owes; it is the house.
Money makes its appearance only to facilitate the arrangement among several parties.
Peter may not be disposed to lend his plow, but James may be willing to lend his money. What does William do in this case? He borrows money of James, and with this money he buys the plow of Peter.
But actually no one borrows money for the sake of the money itself. We borrow money to get products . . .
Whatever the sum of hard money [gold] and bills that circulates, the borrowers taken together cannot get more plows, houses, tools, provisions, or raw materials than the total number of lenders can furnish.
But can't manufacturers just produce more plows (or tractors) in response to increased demand, rendering Bastiat's analysis a moot point?
Well, certainly, over time, they can. But where did the resources to produce more tractors come from? If the government has been specializing in tractor loans, then all it has done is to shift resources, against the wishes of the consumers, from the manufacture of other goods to the manufacture of tractors. If the government is lending money to all lines of manufacturing, it should be clear that this does not magically call more factors of production into existence. Only real savings and labor can create new capital goods.
The money the government is lending ultimately comes from one of two sources: taxes or the printing press. If the government is using tax revenues to make such loans, then all it has done is shift resources from those who are taxed to those who are receiving the loans.
But it seems as though there may be a way out of this bind. If the government prints up and lends the money, it doesn't appear to have taken the resources from anywhere—they just appear! This is the "magic" of Keynesian economics.
In reality, the government has taken the resources from everyone in the economy who is holding cash. Real demand in the economy is precisely the supply of real goods and services viewed from the other side of every exchange. If I produce corn, this corn is my demand for tractors, seed, TV sets, cars, and so on. (This is truth at the heart of Say's Law: it is not that supply creates demand, but that it is demand.)
What someone hopes to receive in exchange for their production is a certain amount of real goods and service, not a certain amount of pieces of paper with presidents' faces on them. A swift, unexpected increase in the amount of such paper in circulation may briefly fool people into believing they will receive the real goods they are demanding, thereby creating a temporary boom, but the subsequent disappointment creates the bust afterwards.
Well, just why aren't inventories relevant?
Here is the trump card in the Keynesian deck. "Ah," the Keynesians will claim, "the above analysis is fine when the economy is at full employment and comprises no unused production capacity. But if the economy is in a slump, the increase in paper money will prime the pump, prodding those idle resources back into the cycle of production."
Here, we must ask ourselves why certain resources are idle. The answer is that the owners of those idle resources expect to receive more for them than they currently are being offered. They are holding out, waiting for a better price. When such a situation is prevalent in the economy, Austrians would contend that it is the result of the false expectations created by the previous boom. In any case, as the great economist W.H. Hutt pointed out, what is needed to restore full productivity is for individuals in the economy to adjust their expectations to better align with the real demands for their products and services. The Keynesian solution is to try to fool producers (including workers) into thinking that their unrealistic demands are being met.
To whatever extent that the Keynesian solution "works," it prevents the needed adjustments in expectations from taking place. Certain lines of manufacture should be shut down, since they are using resources that consumers demand more urgently in other places. Some workers should lower their wage demands, since they are unemployable at the wage they currently expect. Instead of an overall movement of the price level, what is really needed is for certain prices to be adjusted relative to others.
Rather than allowing those adjustments to take place, the Keynesian solution attempts to prop up artificially high prices (including wages) and failing businesses. The Austrian business cycle theory is sometimes mocked as being a "hangover theory," but in fact, as Murray Rothbard pointed out, this particular metaphor is fairly accurate.
When the economy has been on a bender and wakes up with a crashing headache, the Keynesians recommend having a few drinks, when what is needed is for the poison to be purged from the system. Real demand will only be restored when the structure of prices moves back toward a configuration more closely reflecting consumer's wishes. Printing, and then lending, money only delays that adjustment.