8.03. Capital Values and Aggregate Profits in a Changing Economy

0:003. Capital Values and Aggregate Profits in a Changing Economy Net saving, as we have seen, increases gross investment in the economy. This increase in gross investment at first accrues as profits to the firms doing the increased business. These profits will accrue particularly in the higher stages, toward which old capital Capital is shifting and in which new capital is invested. An accrual of profits to a firm increases, by that amount, the capital value of its assets, just as the losses decrease the capital value. The first impact of the new investment, then, is to cause aggregate profits to appear in the economy, concentrated in the new production processes in the higher stages.

0:56As the transition to the new ERE begins to take place, however, these profits more and more become imputed to the factors for which these entrepreneurs must pay in production. Eventually, if no other interfering changes occur, the result will be a disappearance of profits in the economy, a settling into the new ERE, an increase in real wages and and Other Real Rents and an Increase in the Real Capital Value of Ground Land. This latter result, of course, is in perfect conformity with the previous conclusion that a progressing economy will lead to an increase in the real rents of ground land and a fall in the rate of interest.

1:46These two factors, in conjunction, both impel a rise in the real capital value of ground and Land. Future rises in the real values of rents can be either anticipated or not anticipated. To the extent they are anticipated, the rise in future rents is already accounted for and discounted in the capital value of the whole land. A rise in the far future may be anticipated but will have no appreciable effect on the in the present price of land, simply because time preference places a very distant date beyond the effective time horizon of the present. To the extent that rises in the real rate are not foreseen, then of course entrepreneurial errors have been made, and the market has undercapitalized in the present price.

2:42Throughout the whole history of landholding, therefore, income from basic land can be earned in only three ways. We are omitting, improving the land. 1. Through entrepreneurial profit in correcting the forecasting errors of others. 2. As interest return, or 3. By a rise in the capital value to the first finder and user of the land. The first type of income is obvious and not unique. It is pervasive in any field of enterprise. The second type of income is the general income earned by ground land. Because of the market phenomenon of capitalization, income from ground land is largely interest return on investment, just as in any other business.

3:35The only unique component of income that ground land confers, therefore, is three, accruing to the first user, whose land value began at zero and became positive. After that, the buyer of the land must pay its capitalized value. To earn rent on ground land, in other words, a man must either buy it or find it, and in In the former case he earns only interest and not pure rent. The capitalized value can increase from time to time and not be discounted in advance only if some new and unexpected development occurs, or if better knowledge of the future comes to light, in which case the previous owner has suffered an entrepreneurial loss in profit for Gone, for not having anticipated the new situation, and the current owner earns an entrepreneurial profit.

4:37The only unique aspect to ground land, then, is that it is found and first put on the market at some particular time, so that the first user earns pure rent as a result of his initial Capital Discovery and Use of the Land. All later increases in the capital value of the land are accounted for in the value either as entrepreneurial profits resulting from better forecasting or as interest return. The first user earns his gain only at first and not at whatever later date he actually The Theory of Money and Credit

5:45This is not the same as assuming an E.R.E., for in the E.R.E. there are no changes to to be foreseen. The first finder will reap the net gain immediately, and from then on, all that will be earned by him and by successive heirs or purchasers is the usual interest return. When future rises are too remote to enter into the capitalized price, this is simply a phenomenon of time preference, not a sign of some mysterious breakdown in the market's process of adjustment.

6:43The fact that complete discounting never takes place is due to the presence of uncertainty, and the result is a continual accretion of entrepreneurial gains through rising capital values of land. Thus we see, this time from the landowner's point of view, that aggregate gains in capital value are synonymous with aggregate profits. Profits begin with the higher order firms, then filter down until they increase real wages and the aggregate profits of landowners, particularly owners of land specific to the higher order stages of production. Land specific to the lower stages will, of course, bear the brunt of decreases in capital value, that is, losses in the progressing economy.

7:39As the only income to ground land that is not profit or interest, we are left with the original gains to the first finder of land. But here again there is capitalization and not a pure gain. Pioneering, finding new land, that is, new natural resources, is a business like any other. Investing in it takes capital, labor and entrepreneurial ability. The expected rents of finding and using are taken into account when the investments and expenses of exploration and shaping into use are made, therefore these gains are also capitalized backward in the original investment, and the tendency will be for them, too, to be the usual interest return on the investment.

8:31Deviations from this return will constitute entrepreneurial profits and losses. Therefore, we conclude that there is practically nothing unique about incomes from ground land, and that all net income in the productive system goes to wages, to interest and to profit. A progressive economy is marked by aggregate net profits. When there is a shift from one savings investment level to a higher one, therefore a progressing economy, aggregate profits are earned in the economy, particularly in the higher stages of production. The increased gross investment first increases the aggregate capital value of firms that earn net profits.

9:20As production and investment increase in the higher stages, and the effects of the new When new savings continue, the profits disappear and become imputed to increases in real wage rates and in real ground rents. The latter effect, added to a fall in the rate of interest, leads to a rise in the real capital values of ground land. What happens when there is a shift in the reverse direction, a changed proportion such that gross saving and investment decline consumption increases. For the most part, we may simply trace the earlier analysis in reverse. That is, consider the shift from a 338 to 80 situation to a 318 to 100 situation.

10:12During the transition to a new equilibrium, there would be a net dis-saving of 20 ounces, since gross saving decreases from 338 to 318. There would also be a net disinvestment of the same amount. The cause of such a shift would be an increase in the time preference schedules of the individuals on the market. This would increase the rate of interest and widen the interest spread between cumulative prices in the production stages. It would broaden the consumption base but leave less money available for saving and investment. will be higher prices for consumers' goods, and therefore a greater demand for factors in this and other lower stages.

11:02On the other hand, there would be general abandonment of the higher stages in the face of the monetary attractions of the later stages, the decline in investment funds, and the shift of these funds from the higher to the lower stages. Specific factors will bear the brunt of lowered incomes and sheer abandonment in the higher stages, and they will gain in the lower stages. There will be a rise in net income and consumption in monetary terms, and therefore a rise in aggregate factor income. The interest rate increases, while the gross investment base declines. In real terms, the important result is a lowering in the physical productivity of labor and of land because of the abandonment of the most productive processes of production, the lengthiest ones.

11:58The lower output at every stage, the lower supply of capital goods, and the consequent lower output of consumers' goods leads to a lowering in the standard of living. Money wage rates and money rents may rise, although this possibly might not occur because of the higher interest rate, but the prices of consumers' goods will rise further because of the reduced physical supply of goods. The rise in general money prices in monetary terms is accounted for by the decreased demand for money as a result of the lower number of stages for the monetary unit to turn over The case of decreasing gross capital investment is defined as a retrogressing economy.

12:50The definitions of the progressing and the retrogressing economy differ from those of Mises in human action. They are defined here as an increase or a decrease in capital in society, while Mises Mises defines them as an increase or a decrease in total capital per person in the society. The present definitions focus on the analysis of saving and investment, population growth or decline being a very different phase of the subject. When we are making an historical welfare assessment of the conditions of the economy, however, the question of production per capita becomes important. The decreased investment is first revealed as aggregate losses in the economy, particularly losses to firms in the highest stages of production, the firms which are now losing customers.

13:49As time proceeds, these losses will tend to disappear as firms leave the industry and abandon the now unprofitable production processes. The losses will thereby be imputed to factors in the form of lower real wage rates and lower real rents, which, combined with a higher interest rate, cause lower real capital values of ground land. Particularly hard hit will be the factors specific to these lines of production. The reason why there are aggregate profits in the progressing economy and aggregate losses in the retrogressing economy may be demonstrated in the following way.

14:34For profits to appear there must be under-capitalization or over-discounting of productive factors on the market. For losses to appear there must be over-capitalization or under-discounting of factors on the market. Market. But if the economy is stationary, that is, if from one period to another the total gross investment remains constant, the total value of capital remains constant. There might be an increase of investment in one line of production, but this is made possible only by a decrease elsewhere. capital values remain constant, and therefore any profits, the result of mistaken undercapitalization, must be offset by equal losses, the result of mistaken overcapitalization.

15:30In the progressing economy, on the other hand, there are additional investment funds made available through new savings, and this provides a source for new revenue not yet capitalized anywhere in the system. These constitute the aggregate net profits during this period of change. In the retrogressing economy, investment funds are lowered, and this leaves net areas of overcapitalization of factors in the economy. Their owners suffer aggregate net losses during this period of change. It is possible that the changes in investment were anticipated in the market, to the extent The fact that an increase or a decrease was anticipated, the aggregate profits or losses will accrue in the form of a gain in capital value before the actual change in investment takes place.

16:27Losses arise during retrogression because previously employed processes have to be abandoned. The fact that the highest stages, already begun, have to be abandoned, is an indication that the shift was not fully anticipated by the producers. Thus, another conclusion of our analysis is that aggregate profits will equal aggregate losses in a stationary economy, that is, profits and losses will equal zero. This stationary economy is not the same construct as the evenly rotating economy that has played such a large role in our analysis. In the stationary economy, uncertainty does not disappear and no unending constant round pervades all elements in the system.

17:20There is in fact only one constancy, total capital invested. Clearly, the stationary economy, like all other economies, tends to evolve into the ERE given constant data. After a time, market forces will tend to eliminate all individual profits and losses, as well as aggregate profits and losses. We might pause here to consider briefly the old problem, our capital gains, increases in Capital Value, Income. If we fully realize that profits and capital gains and losses and capital losses are identical, the solution becomes clear.

18:08No one would exclude business profits from money income. The same should be true of capital gains. In the ERE, of course, there are neither capital gains nor capital losses. Let us now return to the case of the retrogressing economy and a decrease in capital investment. The greater the shift from saving to consumption, the more drastic will the effects tend to be, and the greater the lowering of productivity and living standards. The fact that such shifts can and do happen serves to refute easily the fashionable assumption that our capital structure is, by some magical provision or hidden hand, permanently and eternally self-reproducing once it is built.

19:01No positive acts of saving by capitalists are deemed necessary to maintain it. The ruins of Rome are mute illustrations of the error of this assumption. Fail to maintain the value of capital, that is, the process of net dis-saving, is known as consuming capital. Granting the impossibility of measuring the value of capital in society with any precision, this is still a highly important concept. Consuming capital means, of course, not eating machines as some critics have scoffingly referred to it, but failing to maintain existing gross investment and the existing capital goods structure, using some of these funds instead for consumption expenditure.

19:55It is often assumed that only depreciation funds for durable capital goods are available for capital consumption, but this overlooks a very large part of capital, so-called circulation and Capital, the less durable capital goods which pass quickly from one stage to another. As each stage receives funds from its sale of these or other goods, it is not necessary for the producer to continue to repurchase circulation capital. These funds, too, may be immediately spent on consumption. Professor Frank H. Knight has been the leader of the school of thought that assumes capital to be automatically permanent.

20:42Knight has contributed a great deal to economics in his analysis of profit theory and entrepreneurship, but his theories of capital and interest have misled a generation of American economists. Knight succinctly summed up his doctrine in an attack on the Austrian investment theory History of Boehm-Bawerk and Hayek, Knight said that the latter involved two fallacies. One is that Boehm-Bawerk viewed production as the production of concrete goods, whereas in reality what is produced and consumed is services. There is no real problem here, however. It is not to be denied, in fact it has been stressed herein, that goods are valued for for their services, yet it is also undeniable that the concrete capital goods structure must be produced before its services can be obtained.

21:40The second alleged correction, and here we come directly to the problem of capital consumption, is that the production of any service includes the maintenance of things used in the process, And this includes reproduction of any which are used up, really a detail of maintenance. This is obviously incorrect. Services are yielded by things, at least in the cases relevant to our discussion, and they are produced through the using up of things, of capital goods. And this production does not necessarily include maintenance and reproduction. This alleged detail is a completely separate area of choice and involves the building up of more capital at a later date to replace the used up capital.

22:35The case of the retrogressing economy is our first example of what we may call a crisis situation. A crisis situation is one in which firms in the aggregate are suffering losses. The crisis aspect of the case is aggravated by a decline in production through the abandonment of the highest production stages. The troubles arose from under-saving and under-investment, that is, a shift in people's values so that they do not now choose to save and invest enough to enable continuation of production processes begun in the past. We cannot simply be critical of this shift, however, since the people, given existing conditions, have decided voluntarily that their time preferences are higher, and that they wish to consume more proportionately at present, even at the cost of lowering future productivity.

23:38Once an increase to a greater level of gross investment occurs, therefore, it is not maintained automatically. Those have to maintain the gross investment and this will be done only if their time preferences remain at the lower rates and they continue to be willing to save a greater proportion of gross monetary income. We have demonstrated further that this maintenance and further progress can take place without any increase in the money supply or other change in the money relation. This can occur, in fact, with falling prices of all products and factors.