Against the Tide

X

The Formation and Use of Capital*

TRANSFORMATIONS IN THE ECONOMIC SYSTEM

On looking back over the course of the Western world’s economy since the war, we find growing evidence of a change of outstanding importance. Nearly everywhere, not altogether excluding even Switzerland and the United States, profound transformations have taken place in the ways of capital formation and in the manner of its use, and this has led to one of the most serious upheavals in the economic system. We can hardly refuse to admit, at this stage, that what has come to pass in the sphere of capital formation and investment is one of the principal causes of today’s grave economic disturbances. In these circumstances, it seems opportune to try to discuss the essentials of these processes and their consequences.

The crucial point is that in nearly all economies capital has increasingly come to be formed and used by methods very different from those that until ten years ago were regarded as normal for an essentially free economy. These new methods have imparted a more and more collectivist aspect to this part of the economic process, which we call the capital sector. To put it briefly: Everywhere, a diminishing proportion of investable funds, and in certain leading countries only a small fraction of them, has been drawn from the traditional source of voluntary savings out of current income, and the decision regarding the total volume and the direction of investment has largely become a matter of government planning. The formation and use of capital have thus been increasingly withdrawn from the systematic context of the market economy even where the latter has in other respects been allowed to survive or, as in Germany, has been re-established by a radical reform. The consequences are plainly visible today in the capital sector’s being out of tune with the economy and the economic order as a whole, to a degree that in some countries has led to the gravest disturbances. On close inspection, mismanagement in the capital sector will be seen to be the chief trouble with postwar economic developments. The problem it poses for economic policy in all countries must be counted among the most important and difficult of all. Its solution cannot be long delayed if governments are in earnest about re-establishing an efficient economic order and putting a stop to the present crisis, the most visible expressions of which are permanent inflation and balance-of-payments deficits, instead of muddling through with the help of one expedient after another. These may seem rather bold statements not comprehensible at first sight; they need to be justified and explained.

In speaking of mismanagement in the capital sector as a mark of postwar economy in many countries, I have in mind two things: an excess of investment in the national budget and an economically faulty choice of individual investment projects. Characteristically, both types of mismanagement tend to coincide, since excess investment presupposes the same collectivist and inflationary economic setting, that is, the same disturbance of the free forces of the market economy, which is responsible also for the faulty distribution of the excessive volume of capital.

Now, the statement that excess investment is one form of mismanagement in a nation’s capital account may need some explanation. Not everyone may understand at first sight how anything done in this respect could possibly have been too much after the terrible destruction of the last war. What about the proud and impressive testimony of postwar reconstruction and the figures of investment statistics? Is this not an achievement hard to fault? These are natural enough questions. Clearly, we shall have to settle exactly what is to be understood by an “excess” of investment. The clearest way of putting it, perhaps, is to say that all this investment would indeed be an achievement deserving of unqualified praise if, apart from Marshall aid, it had been financed by genuine savings.

There are two reasons, on that assumption, that this investment would be above suspicion as a serious source of disturbance. First, it would have been compensated by a corresponding reduction of consumption, and second, this offsetting reduction of consumption would have been voluntary and hence not associated with any compulsion disturbing the economic process. The first circumstance would have ensured that investment, compensated by a corresponding reduction of consumption, would not have overstrained the economy and thus led to the well-known consequences of inflationary pressure and balance-of-payments difficulties. And the second advantage of this kind of coverage of investment expenditure would have been that a voluntary, as against a government-imposed, reduction of consumption would have found its own place in the system of the market economy’s regulatory and functional forces, instead of leading to today’s equally well-known fiscal burden of compulsory public saving, with all its implications.

That this is a completely unrealistic assumption is something I need not be lectured about. Of course, there was not the remotest chance, even in the best possible conditions, of covering the extraordinary amount of postwar investment in Europe by genuine savings. I am ready to concede even more. There are good arguments for supporting the view that part of this investment was so urgent that, given the insufficiency both of the nations’ genuine capital formation and of American aid for covering it, it was probably inevitable that they would fall back on methods exempting investment from the usual requirement of genuine saving, in spite of the perils involved. Be that as it may, the point at issue here is that such exemption cannot be granted with impunity, that it has serious consequences not to be overlooked, that these consequences can be described as “excess” investment, and that they are such that, whatever may in the past have recommended these methods, they should now be abandoned. It is time now to remember the limit imposed upon investment in our continent in its present state by the extent of its own genuine saving, except insofar as foreign capital aid can be counted upon. My purpose is to affix a warning at this boundary that has been transgressed so recklessly and with so much disregard of the danger involved.

With the purpose thus clarified, let us proceed. In many European countries postwar investment, however urgent and desirable it may have been, can be described as “excessive” to the extent that it was made possible by methods of capital formation that transgressed the limits of genuine saving and therefore amounted to a violation of the economy, to a strain on its strength, and to a disturbance of its system of regulatory and functional forces. The statistics of major European countries do, in fact, show that, disregarding American capital aid, the share of individual savings in investment coverage has shrunk to very modest proportions in comparison with what it used to be and has, indeed, become almost insignificant. Today’s three leading sources of capital formation are credit creation, fiscal-forced saving, and self-financing out of corporation profits. There will be more to say presently about the revolution this has meant for present-day capital formation. Leaving aside for the moment the question of self-financing and its special problems, and concentrating on the extraordinary part played by credit creation and taxation as a means of forced capital formation, it ought to be clear now what they mean as methods of boosting investment, and why the volume of investment resulting from them is to be regarded as dangerously “excessive.”

Insofar as investment has been financed by credit creation, this is a process identical with the well-known expansionary “cheap money” and “full employment” policies that are now coming in for increasingly sharp and unanimous criticism. Still fatally obsessed with the ideas stubbornly surviving from the Great Depression, many of the Western countries treated their current troubles as though they were due, as they were then, to a deflationary interruption in the circular flow and thought that in leaving so much of the function of financing investment to the additional liquidity pumped into the banking system by the central bank, they were merely closing the gap in the circular flow, and thus serving full employment without fear of inflation. Nor is this all. Following the dogmatic rut of ideas begotten by the Great Depression and, at best, appropriate to it, large-scale investment without prior saving, that is, without a corresponding reduction of consumption, was not only considered worth risking, or, indeed, required for the sake of economic equilibrium, but, beyond that, governments took it upon themselves even to raise mass consumption to a further considerable extent by means of a suitable social and wages policy.

And thus the policy of overinvesting has become one of the principal causes of the process fittingly described as “permanent inflationary pressure,” the consequences of which need not be discussed again here. The reason that the volume of investment originating in credit expansion is to be qualified as excessive is that the resulting sum of investment and consumption exceeds the economy’s production capacity at current prices and hence finds expression, domestically, in an inflationary rise of prices and, externally, in a balance-of-payments deficit. What this excess signifies is that money is spent twice over, and that the country spends on mass consumption and on investment more than is covered by goods. The simple truth has had to be learned again—a country not only can live beyond its means but also build beyond its means, electrify railways, renew machinery, and modernize factories beyond its means. In more than a few European countries it became possible after the war to point to a newly built power plant, to a new model railway station, or to the new cable standards of a railway line about to be electrified and to say: Here is your balance-of-payments deficit and your dollar shortage.

THE SOCIALIZATION OF CAPITAL FORMATION

Today there must be few people to whom it is still necessary to explain that the policy of permanent inflationary pressure is dangerous and that, by virtue of simultaneous efforts to raise mass consumption, it has become a very serious mistake. It is this inflationary pressure that is the main source of all the postwar economic disturbances on the national and international scale. Even though it may be assumed that this is at long last generally understood and admitted, this knowledge has unfortunately come so late that it has become all the more difficult to go into reverse—witness Great Britain’s agonizingly slow recovery.

The other of the two methods of artificial investment expansion, forced capital formation through taxation, seems to come off a good deal better in this respect. By taxing away purchasing power and using it for investment, the government achieves a simultaneous reduction of consumption. This method of capital formation, which in 1951 contributed only a little less than half the total in Great Britain but is now so important, therefore has the merit of avoiding inflationary pressure with all its consequences.

But the government is not thereby absolved from the reproach of abuse and over-straining the economy. On the contrary, it may be argued that the immoderate growth of the share of capital formation and investment resting on fiscal compulsion is one of the main causes of a revolutionary transformation no less dangerous and no less far-reaching than that due to permanent inflationary pressure and, for reasons that need no further explanation in this context, closely connected with it. The transformation I have in mind is that everywhere the proportion of national income claimed and administered by the state directly or indirectly (through the social services) has even after the war remained at a level that, quite apart from its revolutionary social effects, is in the long run incompatible with the system of regulatory and functional forces that is the condition of the Western countries’ free economy and society. Fiscal socialism, as this erosion of the market economy by the budget may be called, and inflationary pressure for the sake of “full employment” (maximum investment and simultaneous maximum consumption by the masses) are the two contemporary developments that share the common effect of undermining our economic and social system in a manner as fatal as it is insidious, because it is creeping and not easy to diagnose. But they are seen to share also a common cause, which is an excess of investment dissociated from the solid foundation of normal capital formation.

There is only one fitting conclusion to be drawn from all these considerations. The true source of the trouble is the disproportion between the volumes of investment and saving in the economy. But, fatefully, deficient saving, in its turn, is, to no small extent, the very consequence of this whole system of forced capital formation resting on the devaluation of money, unduly heavy taxation, destruction of wealth, the impairment and blunting of the incentives to produce and save, the curtailment of capital returns, and an overall policy undermining long-run confidence. Once more, we are moving in a circle: the attempt to make good the shortfall of genuine savings by inflationary credit creation not only generates economic consequences so grave that this policy has to be abandoned but at the same time is one of the main causes for the insufficiency of saving. Does anyone still need to be told that this vicious circle has to be broken through at last?

What all this amounts to is that we have finally come to understand how dangerous are the ways taken by capital formation and how threatening to the foundations of our economy and society. Genuine saving in all its forms, not least in that of equity investment that is so stunted today in most countries, must be restored to the preeminent position from which, through misunderstanding its function, we have shortsightedly allowed it to be displaced during the last twenty years. This can only be done by a radical reform of the system as a whole with all its now typical collectivist and inflationary aspects and its overemphasis on fiscal methods. After the rush of socialization in capital formation, the time has come to acknowledge that it has consequences that no reasonable person can gloss over, and that are such as to make it imperative to retransform socialization into individualization, thereby reinserting this decisively important process into the overall system of an efficient economic order. No one with even the slightest understanding will need more than a hint that what is at stake is, in fact, more than the economic order as such; it is the whole foundation of a free society.

In this light, the task is seen to be of such momentous importance that it must be considered as cardinal to the whole of our economic and social policy. We are at one of the great crossroads, where decisions of almost incalculable implications have to be made. It is here that we must make our stand if we are to succeed in stemming the sinister, trampling march of a proletarianized mass society with its mechanized, compulsory social welfare system and its ultimately inevitable goal of a totalitarian mammoth state. This demands, above all else, that the center of gravity in the responsibility for people’s lives should be shifted from the state back to where it belongs by all standards of common sense and historical experience— to the individual surrounded by his family, to free organizations, to the broad masses of the people themselves.

However much corporative capital formation, which is known as self-financing, may have gained in importance, it is no satisfactory substitute for the shortfall in personal capital formation from income. If a horrible neologism may be permitted, I would say that in the overall and long view the “corporatization” of capital formation in its present dimensions is only fractionally better and less dangerous than its socialization. To be sure, it was irreplaceable as a help to rapid postwar reconstruction in many countries, but here again it must be realized that this was only an expedient, whereas considerations of many kinds, which cannot be further discussed here, compel us to regard a lasting shift from personal to corporate capital formation as a degenerative process that can hardly be taken too seriously.

To return to our original theme, mismanagement in the capital sector, we recall that it takes two forms. Having discussed excess investment in the relative sense denned, it remains to add a few remarks on the second form of mismanagement, the economically faulty choice of investment projects. In addition to allowing a disproportion to arise after the war between the total volume of investment and the national budget, Europe committed a second sin; having violated the economy as described above, and thereby having additional investment opportunities alongside those opened up by Marshall aid, many countries used these opportunities in a manner that cannot be described otherwise than economically wrong. The economies were overstrained by excess investment, but, directed to wrong purposes as it was, this overexertion led neither to the hoped-for cure of the economy nor to its balanced progress, but left behind it tensions and distortions of all kinds.

Two problems were involved in restoring order to the economy, namely, the proper readjustment both of the total volume of investment and of its use in individual cases. Neither has been solved satisfactorily. There should be no disagreement nowadays with the view that what is responsible in both cases is the attempt to solve the problem of economic adjustment by methods that, being both collectivist and inflationary, invalidate the economy’s own steering mechanism. It is not hard to prove that in all cases of patent misinvestment interference by economic planning and an inflationary distortion of value relations had prevented this steering mechanism from functioning properly.

Every well-informed person knows the concrete cases to which this applies. Strictly speaking, two separate things are involved: misallocation as regards the share of individual branches of industry, and misallocation as regards the amortization period of capital investment, or, so to speak, errors “in breadth” and “in depth.” A well-known example of the first type of misallocation is the deficiency of investment in German heavy industry as a result of its not having been included until recently in the reforms re-establishing the market economy in Germany and, in addition, of its legal structure’s and economic reputation’s having been severely undermined by all sorts of interference. Instead of taking timely steps to remove the main cause of this maladjustment, that is, the controls that distorted iron and coal prices, a device was thought up that is truly worthy of our age, namely, to raise capital for heavy industry by a compulsory loan exacted from those sections of German industry to which the free market had restored economic health, and then to pump in that “investment help” under political pressure—via Parliament, government departments, and the official confederation—instead of through the market. This pumping method took so long to prepare that in the meantime the original conditions had altered considerably.

What is meant by misallocation “in depth” is illustrated by the example of all those countries that committed the error of orienting their investment programs too much toward long-term projects, that, while seductive to the constructive imagination of the planners, sacrificed the hard enough present to a distant future and disregarded the principle that at a time of extraordinary capital shortage, the right investment to choose is one that yields quick returns and has a short amortization period. Neglecting projects close to the consumption stage, investment was directed to those remote from consumption. Now that Marshall aid, the main source of those investment funds, has dried up, the resulting disproportions are coming to light, most strikingly in France with its much praised but, in this sense, badly misplanned Monnet Plan, as well as in Austria.

Notwithstanding these experiences with planning methods in the allocation of investment capital, the view is still widely held that ours is a time when not only the volume but also the type and direction of investment should be determined no longer by the market and its regulators—namely, free prices, a rate of interest truly reflecting the market’s supply, and demand schedules and capital returns conditioned by competition—but, instead, by government planning and the state’s fiat. It is perhaps with reference to this particular problem of the economic order that faith in planning, which otherwise is now so badly shaken, has survived longest in many European countries. Unfortunately, it was not the least of the numerous and serious errors of the whole system of Marshall aid that it gave almost dogmatic force to the belief in the necessity of the planned guidance of capital use. The time is now ripe for an impartial reappraisal of that phase in European reconstruction, and in such a reappraisal this constructional defect of Marshall aid will come in for extensive criticism, all the more so as its aftereffects are still with us and cannot be masked even by uncritical production statistics.

If we look at the principle of the matter and ask what forces are to be entrusted with responsibility for the use of capital and the alignment of investment with the economic order as a whole, we find that, as in other spheres, we have a choice only between the market method and the collectivist one. Since the latter method has come to predominate in so many countries, and not only capital formation, but also the use of capital has been socialized to a large extent, it is time to point out the significance of the resulting transformation: without detriment to such concessions as are unavoidable, it is one that, in the long run, is not compatible either with an orderly economy or a free society. Experience should help us to see through all the assurances to the effect that only government planning and official orders can take care of the selection of national investment priorities and avoid wasting scarce capital on less urgent projects; experience should also help us to recognize that all these assurances can obscure neither the absence of objective standards of priority nor the danger of decisions that, in the last resort, are arbitrary and hence lead to misinvestment. Only a doctrinaire can still refuse to admit that socialization of capital use is one of the things to be viewed with increasingly grave concern and that investment guidance by the market, through free prices, unmanipulated rates of interest, competitive returns, and well-organized captial markets must be restored to its due position, a position that planning methods wrongfully contested with unfulfilled promises.

* Neue Zürcher Zeitung, October 17 and 18, 1952.