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2. The Effect of Net Investment
Having considered the ERE and its relation to specific entrepreneurial profit and loss, let us now turn to the problem: When will there be aggregate profits or losses in the economy? This is connected with the question: What is the effect of a change in the level of aggregate saving or investment in the economy?
Let us begin with an economy in the equilibrium depicted in chapters 5 and 6. Production occurs in processes up to six years in total length; total gross income is 418 gold ounces, gross savings-investment is 318 ounces, total consumption 100 ounces, net savings-investment is zero. Of the 100 ounces of income, 83 ounces of net income are earned by land and labor owners, 17 ounces by capital owners. The production structure remains constant because the natural rates of interest coincide, and the resulting price spreads conform to the aggregate of individual time-preference schedules in the economy. As Hayek states:
Whether the structure of production remains the same depends entirely upon whether entrepreneurs find it profitable to reinvest the usual proportion of the return from the sale of the product in turning out intermediate goods of the same sort. Whether this is profitable, again, depends upon the prices obtained for the product 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. 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, and these prices are, therefore, a very real and important factor in determining the direction of production.5
What happens if, in a certain period, there are now net savings as a result of a lowering of time-preference schedules? Suppose, for example, that consumption decreases from 100 to 80 and that the saved 20 ounces enter the time market. Gross savings have increased by 20 ounces. During the transition period, net saving has changed from zero to 20; after the new level of saving has been reached, however, there will be a new equilibrium with gross savings equalling 338 and net savings equalling zero. To the superficial, it might seem that all is lost. Has not consumption decreased from 100 to 80 ounces? What, then, will happen to the whole complex of productive activities that rest on final consumption sales? Will this not lead to a disastrous depression for all firms? And how can a reduced consumption profitably support an increased volume of expenditures on producers’ goods? The latter has aptly been termed by Hayek the “paradox of saving,” i.e., that saving is the necessary and sufficient condition for increased production, and yet that such investment seems to contain within itself the seeds of financial disaster for the investors.6
If we observe the diagram in Figure 40 above, it is clear that the volume of money incomes to Capitalists1 will be drastically reduced. Capitalists1 will receive a total of 80 instead of 100 ounces. The amount that they have to apportion to original factors and to Capitalists2 is therefore also considerably decreased. Thus, from the side of final consumers’ spending, an impetus toward declining money incomes and prices is sent along the production structure. In the meanwhile, however, another force has concurrently come into play. The 20 ounces have not been lost to the system. They are in the process of being invested in the economy, their owners ranging throughout the economy looking for maximum interest returns on their investment. The new savings have changed the ratio of gross investment to consumption from 318:100 to 338:80. A “narrower” consumption base must support a larger amount of producers’ spending. How can this happen, especially since the lower-rank capitalists must also receive a lower aggregate income? The answer is: in only one way—by shifting investment further up the ladder to the higher-order production stages. Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages, while preserving uniform (lowered) interest differentials (cumulative price spreads) at each stage, is to increase the number of productive stages in the economy, i.e., to lengthen the structure of production. The impact of net saving on the economy, i.e., of increased total savings, is to lengthen and narrow the structure of production, and this procedure is viable and self-supporting, since it preserves essential price spreads from stage to stage. The diagram in Figure 60 illustrates the impact of net saving.
In this diagram we see the narrowing and the lengthening of the structure of production. The heavy line AA outlines the original structure. The bottom rectangle—consumption—is narrowed with the addition of new savings. As we go up in step-wise fashion—the steps in these diagrams accounting for the interest spreads7—the new production structure BB (the shaded area) becomes relatively less and less narrow compared to the original structure, until it becomes wider in the upper registers, and finally adds new and higher stages.
The reader will notice that the steps (differentials between stages) in the new production structure BB are considerably narrower than the ones in AA. This is not an accident. If the steps in BB were of the same width as in AA, there would be no lengthening of the structure, and total investment would diminish instead of increase. But what is the significance of the narrowing steps in the structure? On the assumptions on which we have drawn the diagram, it is equivalent to a lowering of the interest spreads, i.e., a lowering of the natural rate of interest. But we have seen above that the consequence of lower time-preference rates in the society is precisely a lowering of the rate of interest. Thus, lowered time preferences mean an increased proportion of savings-investment to consumption and lead to smaller price spreads and an equivalent lowering of the rate of interest.
The lowering of interest spreads may be portrayed by another diagram, as in Figure 61.
In this diagram, cumulative prices are plotted against stages of production, and the further right we go, the lower the stage of production, until consumption is reached. AA is the original curve with the topmost dot representing the highest cumulative price—the one for the final product consumed. The dots next to the left are the lower cumulative prices of the higher stages, and the differences between the dots represent the interest spread and therefore the rate of interest return from stage to stage. BB is the curve applicable to the new situation, after saving has increased. Consumption has declined; hence the rightmost dot in B is lower than the one in A, and the arrow depicts the change.
The point next to the left on the BB curve is, of course, lower than the rightmost dot, but lower by a smaller amount than the corresponding dot in AA, because the lower interest rate signifies a smaller spread between the cumulative prices of the two stages. The next dot to the left, having the same rate of interest return, will be on approximately the same slope. Therefore, since the BB curve is flatter than the AA curve—because of the lower interest spread—it crosses the AA curve and from that point leftward, i.e., in the higher productive stages, its prices are higher than A's. Arrows depict this change as well.
In Figure 60 we saw the effect of additional saving, i.e., positive net savings, on the structure of production and on the rate of interest. Here we see that the change in the rate of interest lessens the spreads of cumulative prices, so that aggregate consumption is lower, the immediate next higher stages are less and less lower, until the lines cross, and the prices in the higher stages are higher than before. Let us consider the price changes in the various stages and the processes by which they occur. In the lower stages, prices fall because of the lower consumer demand and the resulting shift of investment capital from the stages nearest consumption. In the higher stages, on the other hand, demand for factors increases under the impact of the new savings and the shift in investment from the lower levels. The increased investment expenditure in the higher levels raises the prices of the factors in these stages. It is as if the impact of lower consumer demand tends to die out in the higher stages and is more and more counteracted by the increase and shift in investment funds.
The process of readjustment to lower price spreads caused by increased gross saving has been lucidly described by Hayek. As he states:
The final effect will be that, through the fall of prices in the later stages of production and the rise of prices in the earlier stages of production, price margins between the different stages of production will have decreased all round.8
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. 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. It is clear that lower aggregate demand in the lower stages will cause the prices of the various factors there to decline. The specific factors will have to bear the brunt of the decline, since they have nowhere else to go. The nonspecific factors, on the other hand, can and do go else-where—to the earlier stages, where the monetary demand for factors has increased.
The pricing of capital goods is ultimately unimportant in this connection, because it is reducible to the prices of land, labor, and time, and because the slopes of the curves, the interest spread, indicate the mode of pricing of the capital goods. The ultimately important factors, then, are land, labor, and time. The time element has been extensively considered and accounts for the interest spread. It is the land and labor elements that constitute the fundamental resources being shifted or remaining in production. Some land is specific and some nonspecific; some can be used in several alternative types of productive processes; some can be used in only one type. Labor, on the other hand, is almost always nonspecific; very rare indeed is the person who could conceivably perform only one type of task.9 Of course, there are different degrees of nonspecificity for any factor, and the less specific ones will be more readily shifted from one stage or product to another.
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. What of the nonspecific factors, which include all labor factors? These will tend to shift from the later to the earlier stages. At first, there will be a difference in the price of each nonspecific factor; it will be lower in the lower stages and higher in the higher stages. In equilibrium, however, as we have seen time and again, there must be a uniform price for any factor throughout the economy. The lower demand in the lower stages, and the consequent lower price, coupled with the higher demand and higher price in the higher stages, causes the shift of the factor from later to earlier stages. The shift ceases when the price of the factor is again uniform throughout.
We have seen the impact of new saving, i.e., a shift from consumption to investment, on the prices of goods at various levels. What, however, is the aggregate impact of a change to a higher level of gross savings on the prices of factors? Here we reach a paradoxical situation. Net income is the total amount of money that ultimately goes to factors: land, labor, and time. In any equilibrium situation, net saving is zero by definition (since net saving means a change in the level of gross saving over the previous period of time), and net income equals consumption and consumption alone. If we look again at Figure 41 above, we see that the total income for original factors and interest can come only from net, rather than gross, income. Let us consider the new ERE after the change has taken place to a higher level of saving (ignoring for a moment the relevant conditions during the period of change). Gross savings = gross investment has increased from 318 to 338. But consumption has declined from 100 to 80, and it is consumption that provides the net income in the equilibrium situation. Net income is, as it were, the “fund” out of which money prices and incomes are paid to original factors. And this fund has declined.
The recipients of the net income fund are the original factors (labor and land) and interest on time. We know that the interest rate declines; this is a corollary of the increased saving and investment in the productive system, caused by lowered time preference. However, the absolute amount of interest income is gross investment multiplied by the rate of interest. Gross investment has increased, so that it is impossible for economic analysis to determine whether interest income has fallen, increased, or remained the same. Any of these alternatives is a possibility.
What happens to total original-factor income is also indeterminate. Two forces are pulling different ways in a progressing economy (an economy with increasing gross investment). On the one hand, the total net income money fund is falling; on the other hand, if the interest decline is large enough, it is possible that the fall in interest income will outstrip the fall in total net income, so that total factor income actually increases. For this to occur is possible but empirically highly unlikely.
The one certain prospect is that total net income for factors and interest will fall. If the total original-factor income falls, then, since we have implicitly been assuming a given supply of original factors, the prices of these factors, as well as the interest rate, will “in general” also decline.
That the general trend of original-factor incomes and prices may well be downward is a startling conclusion, for it is difficult to conceive of a progressing economy as one in which factor prices, such as wage rates and ground rents, steadily decline. What interests us, however, is not the course of money incomes and prices of factors, but of real incomes and prices, i.e., the “goods-income” accruing to factors. If money wage rates or wage incomes fall, and the supply of consumers’ goods increases such that the prices of these goods fall even more, the result is a rise in “real” wage rates and “real incomes” to factors. That this is precisely what does happen solves the paradox that a progressing economy experiences falling wages and rents. There may be a fall in money terms (although not in all conceivable cases); but there will always be a rise in real terms.
The rise in real rates and incomes is due to the increase in the marginal physical productivity of factors that always results from an increase in saving and investment.10 The increased productivity of the longer production processes leads to a greater physical supply of capital goods, and, most important, of consumers’ goods, with a consequent fall in the prices of consumers’ goods. As a result, even if the money prices of labor and land fall, those of consumers’ goods will always fall farther, so that real factor incomes will rise. That this is always true in a progressing economy can be seen from the following considerations.
At any time, the wage or rent of the service of an original factor of production will equal its DMVP, the discounted marginal value product. This DMVP is equal to the MVP (marginal value product) divided by a discount factor, say d, which is directly dependent on the rate of interest. The MVP, in turn, is approximately equal to the MPP (marginal physical product) of the factor times the selling price, i.e., the final price of the consumers’ good product. Hence,
In this discussion, we are considering the prices of consumers’ goods “in general” or in the aggregate. The “real” prices of the original factors equal the money prices divided by the prices of consumers’ goods. 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.
The P's cancel, and the result:
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, and a fall in the discount or interest rate concomitant with falling time preference and increasing gross investment. Both elements—the increase in MPP and the fall in d—impel an increase in the real prices of factor services in a progressing economy.
The conclusion is that in a progressing economy, i.e., in an economy with increases in gross savings and investment, money wages and ground rents may well fall, but real wages and rents will rise.11
One question that immediately presents itself is: How can the prices of factors decline while the gross income remains the same and gross investment even increases? The answer is that the increase in investment goes into increasing the number of stages, pushing back the stages of production and employing longer production processes. It is this increasing “roundabout-ness” that causes every increase in capital—even if unaccompanied by an advance in technological knowledge—to lead to higher physical productivity per original factor. The increase in gross investment, in particular, raises the prices of capital goods at the highest stages, encouraging new stages and inducing entrepreneurs to shift factors into this new and flowering field. The larger gross investment fund is absorbed, so to speak, by higher prices of high-order capital goods and by the consequent new stages of turnover of these goods.12
- 5. Hayek, Prices and Production, pp. 48–49.
- 6. See Hayek, “The ‘Paradox’ of Saving” in Profits, Interest, and Investment, pp. 199–263.
- 7. This production structure diagram differs from our usual ones; it presents both the capital structure and the payment to owners of original factors as amalgamated in the same bar, to represent total investment at each stage. The steps in the diagram, then, represent the interest spreads to the capitalists (in rough, not exact, fashion).
- 8. Hayek, Prices and Production, pp. 75–76.
- 9. Of course, the productivity of a labor factor will differ from one task to another. No one disputes this; indeed, if this were not so, the factor would be purely nonspecific, and we have seen that this is an impossibility. “Specific” is here used to mean pure specificity for one production process.
- 10. See below for discussion of this point.
- 11. Historically, the advancing capitalist economy has coincided with an expanding money supply, so that we have rarely had an empirical illustration of the above “pure” process described in the text. We must remember that we have throughout been making the implicit assumption that the “money relation”—the demand for, and particularly the supply of, money—remains unchanged. Effects of changes in this relation will be considered in chapter 11. The only relaxation of this assumption here is that the number of stages increases, and this tends to increase the demand for money to that extent.
- 12. The demand for money increases to the extent that each gold unit must “turn over” more times in the increased number of stages, thus tending to lower the “general level” of prices.