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The Importance of Efficient Capital Allocation

Eugen Bohm-Bawerk's picture





 

Posted by Bawerk.net 

The masses of frustrated people obviously discuss economics and try to discern the various sources responsible for the lackluster “recovery” and by extension their own plight.  Having read newspapers and watched the evening news, maybe some of the “enlightened” laymen have even read Krugman`s column, they tend to form an opinion and often identify one single reason and consequently one single remedy. Something has to be done. Either they come up with a “brilliant” scheme to reduce the monthly mortgage payments through government subsidy. If the politicians would only find it in their heart to lessen the burden on the house owner, surely their propensity to consume is higher than the receiving creditor, spending would lift the whole economy to the benefit of all. Or alternatively, if the government just hired all the unemployed people to do something it would be better than keeping them on the dole.

But what about the deficits and increased debt that follows from such programs? Krugman and his fellow unthinking Keynesians have apparently found the unbreakable argument against such foolishness.  Yes, one can discuss fiscal multipliers and always find a study that suits your own view. However, the Keynesian does not need to, because debt cannot be a problem by definition. You see, one man`s liability is simultaneously another man`s asset. All debt is owed to ourselves! This childish argument must be extremely hard to refute since we haven`t seen one decent attempt yet. And the reason why it can be hard is simply because very few people are truly economists. As Mr. Hazlitt noted

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

Now, in a pure aggregated accounting sense it is of course true that a financial liability is another man`s financial asset and that the two will always balance. In an economic sense on the other hand it may mean something quite different. Think of debt as a promise to pay in the future the same amount plus interest as borrowed. Not in money terms, but in terms of supply of goods and services. If one were to take on debt it should be with the intention of increasing one`s productivity in order to enable oneself to pay back the goods and services extracted from society at present. However, the usage of resources debt enables one to purchase greatly influence the future productivity emanating from said debt. If one were to squander the resources on for example vacations, cars or redecorating a house, there would be no future productivity gains. If the whole society were to go along this route, eating in to scarce savings and ultimately consuming previously saved and invested capital, future productivity will surely suffer. In that sense, poorly invested capital acts as an inter-temporal tax on future production.

Now, we are not saying debt is a bad thing per se. On the contrary, by pooling resources to invest in large capital intensive projects one can greatly enhance economic growth and prosperity. What we are saying is that capital poorly allocated will lead to lower and lower growth and if taken to the extreme to downright retardation.  A growing society is in desperate need of a well-functioning capital market that allocates resources on strict terms. Obviously, the massive manipulation central banksters currently do to capital markets is detrimental to our future prosperity.

One man`s liability may be another man`s asset, but if the liability of many men reduces overall production the asset side is not in balance with the liability side. There is a large tax wedge separating the two, and that particular tax is expressed through inevitable defaults, because the production assumed to radiate back into capital markets as final payment will never materialize. Stated differently, when capital markets becomes politicized, resource misallocation will be systemic, leading to widespread capital consumption, lower productivity, defaults, financial crisis and a reduction in living standards. Please observe, this is a long term phenomena and not necessarily a once in a life-time big-bang event that changes everything from one day to the next!

So how exactly can we differentiate between various types of debt? We suggest the following classification:

1)      Good debt – debt issued with the intent of making a subsequent sale. Within this category we find business loans that are made to increase future production through efficient investment of capital today, in order to facilitate debt payback in the future

2)      Bad debt – is consumptive in nature, but may provide a useful service to the debtor. For example, taking on debt to buy a house near work is useful, but it does not increase future productivity and if too much debt is allocated into house building the bust becomes inevitable. We also include financial sector loans and foreign loans in this category

3)      Destructive debt – is pure consumption such as consumer credit loans that withdraw capital from society without providing anything back. The very fact that capital has been consumed today without ever being able to replace it means future production must inevitable drop. Naturally we also include all debt held by government in this category.

The next two charts depict the development in these debt categories for the US relative to gross domestic consumption (GDC).  In the first chart it is staggering to see the constant relative share of the good debt category, while the bad and destructive debt explodes. The massive change witnessed since the 1970s is the tax wedge imposed on productivity today! In the second chart we see what happened when the inevitable default on bad debt occurred: it was bailed out by adding destructive debt! This is our tax imposed on the next 10 – 20 years. You cannot fail to see the Ponzi-nature of this scheme. What happens when there is no more capital to bail out the destructive debt that will come to some sort of default, overt or covert?   

  

Source: Flow of Funds Accounts (Z.1), Bureau of Economic Analysis (BEA), own calculations

  

Source: Flow of Funds Accounts (Z.1), Bureau of Economic Analysis (BEA), own calculations

 

If the debt composition has changed so drastically, from predominantly good debt to bad and destructive shouldn`t this be reflected in asset valuations? One might think so, but remember that in a fractional reserve banking system secured by the central bank, credit is money and the more money the more inflation; this will bid up nominal asset values.

Based on this, and if our theory is correct, that most debt issued today is nothing more than a tax on productivity, then asset valuations relative to GDC should diverge from their long term trend. And this is exactly what we see, especially since the Greenspan / Bernanke doctrine entered the Fed.

If debt is used to allocate capital to production and not to boost asset valuations into unsustainable levels, the relationship between valuation and GDC should remain constant as production followed asset values up. Any divergence is indication that society consumes more capital than it produces.

 

Source: Flow of Funds Accounts (Z.1), Bureau of Economic Analysis (BEA), own calculations

 

 

Source: Flow of Funds Accounts (Z.1), Bureau of Economic Analysis (BEA), own calculations

 

Source: Flow of Funds Accounts (Z.1), Bureau of Economic Analysis (BEA), own calculations

 

Conclusion

Western societies with their politicized capital markets misallocate capital and probably consume more than they produce through perverted price signals. This leads directly to lower living standards and more frequent financial crisis.

Follow us on twitter https://twitter.com/EBawerk 

This blog post were influenced by a Mountain Vision paper we wrote in 2012.

 


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Wed, 07/10/2013 - 07:20 | Link to Comment Skin666
Skin666's picture

Production always comes before consumption. This is how the real world works...

The keynesian 'economists' cannot seem to grasp this fact...

Tue, 07/09/2013 - 09:58 | Link to Comment Jim in MN
Jim in MN's picture

Short version for the ADD-enabled:

If raccoons or global elite kleptocrats eat your seed corn, you are fucked.

If we as a society LET them eat it..........

Tue, 07/09/2013 - 06:28 | Link to Comment new game
new game's picture

yes e.b-b. there is logic based hope - but, will it resonate with the sociopathic manipulators for self control/gain?

of course not, that in itself would be admission of wrong policy, while ignoring(controlling) true markets. 

your sound austrian founded logic says yes, but on a very long and patient timeline...

eventually, all the time buying schemes exhaust themselves with many unintended misallocations...

Tue, 07/09/2013 - 03:10 | Link to Comment Eugen Bohm-Bawerk
Eugen Bohm-Bawerk's picture


We want to express our gratitude to the ZeroHedge staff for letting us publish on their great blog and to you, our dear readers, for the very kind words.  

We will do our utmost to continue posting solid work both here and on our blog.

 Thank you!

Tue, 07/09/2013 - 02:20 | Link to Comment WTFUD
WTFUD's picture

Bad /destructive debt whereby you spend $100's of billions on war/ defence/ spying making a living for a few with a resulting nightmare for the rest.
Surely therefore it would be patriotic to insist the current fascist criminal regimes Stand Down!
After much consideration the last hope we have to avoid global catastrophe is to CONVINCE the German Public to vote out Merkel.

Tue, 07/09/2013 - 01:30 | Link to Comment Bohm Squad
Bohm Squad's picture

"Tax on productivity..."

Bingo.  Not only has the dollar lost value, but the decrease in its worth includes productivity gains.  Often overlooked.

Tue, 07/09/2013 - 01:11 | Link to Comment threeputting
threeputting's picture

The Bawerk.net blog, from where this article was taken, is the shit!

It looks to be only a few days old, but every post is solid.

Mon, 07/08/2013 - 23:20 | Link to Comment CheapBastard
CheapBastard's picture

Great article. My dad used to talk about "Good debt" and "Bad debt." Crucial for Yutes to understand before they learn it the hard way [like i did...but i learned].

Mon, 07/08/2013 - 22:22 | Link to Comment newengland
newengland's picture

Misallocation of capital is the biggest problem post WII, imo. That was done for political purposes, and now we have a generation of overfed house cats...their fans and apologists.

Mon, 07/08/2013 - 19:32 | Link to Comment perelmanfan
perelmanfan's picture

Love this piece. You can read Krugman for decades - God help you - and never find him making this distinction between forms of debt. Good debt is nearly always the result of grass-roots analysis of what the world really needs (in other words, capitalism) rather than top-down decisions re: what people ought to have (centralized economic control).

Tue, 07/09/2013 - 07:18 | Link to Comment markmotive
markmotive's picture

On a personal level we speak of good debt and bad debt all the time. Consumer debt (e.g. borrowing to pay for clothes, vacations, etc.) is bad.

Mon, 07/08/2013 - 19:39 | Link to Comment Renfield
Renfield's picture

heh, haven't heard the terms "good debt" and "bad debt" in years. In a healthy economy I remember there was a distinction. Back in the day...

I thought this article was an informative look at the relationship between debt and consumption, and gave a clear picture of why increasing GOVERNMENT debt cannot increase economic productivity, therefore cannot help in a depression. While government stimulus maybe could help in a recession - I think our governments have been treating this economic depression, as though it were a recession. Hence their stimulus attempts have caused further harm and not brought the expected benefits. Productivity is the problem and I don't think government even recognises this.

<<If the debt composition has changed so drastically, from predominantly good debt to bad and destructive shouldn`t this be reflected in asset valuations? One might think so, but remember that in a fractional reserve banking system secured by the central bank, credit is money and the more money the more inflation; this will bid up nominal asset values.>>

<<Based on this, and if our theory is correct, that most debt issued today is nothing more than a tax on productivity, then asset valuations relative to GDC should diverge from their long term trend. And this is exactly what we see, especially since the Greenspan / Bernanke doctrine entered the Fed.>>

Unfortunately, government stimulus in this depression environment does indeed equate to a tax on productivity.

<<If debt is used to allocate capital to production and not to boost asset valuations into unsustainable levels, the relationship between valuation and GDC should remain constant as production followed asset values up. Any divergence is indication that society consumes more capital than it produces.>>

I thought this statement especially useful - government has not allocated capital to production, but to higher asset prices. I am not sure that it is possible for gov to allocate to production (at least not reliably), since this same problem came up in the 1930s, didn't it? (Our last economic depression.)

What is the government's role in a depression? If they are allocating capital, is it even possible for government to be able to recognise productive areas?

Tue, 07/09/2013 - 09:50 | Link to Comment Itinerant
Itinerant's picture

Identifying what is good and what is bad debt is not that simple. Ideally, market forces indicate what was good and was bad, but only years post facto in many cases.

You think you can identify the "bad debt" as government debt, but in fact many forms of government debt are good debt, e.g., winning a war is a good investment if the losing it were to be catastrophic. The same applies to infrastructure spending which creates value and facilitates low cost productive activity (all wealthy nations have invested in social and physical infrastructure).

Private investment is no more a guarantee of "good debt". The financial crisis did not start with defaulting sovereigns but with huge piles of hinky derivatives (bad debt), for which the government decided it would fill in as marshal.

This derailed in the Reagan period when people started talking about "wealth creation": using tax breaks on capital gains to the rich who did not plough the savings into productive capacity as the supply side trickle down theorists claimed, but into a self-reinforcing positive feed-back loop bidding up financial instruments (debt).

When governments "recapitalize" banks they are simply squandering scarce capital to make the creditor class whole. Economists preaching stimulus are like witch doctors in a drought whose counsel is to use the scarce water remaining to wet the streets, b/c historical correlation shows wet streets and rain always come together. (Low interest rates -- capital being plentiful -- coincide with a healthy economy).

The distinction between good debts (invesment in productive potential) and bad is very iimportant, but it is far from simple to determine. Investing in real-estate gains, for instance, may reap one profits (capital gains), but it does not contribute to productive potential, it simply skims off part of the location's value (with the except of the improvements realized).

Tue, 07/09/2013 - 14:23 | Link to Comment Renfield
Renfield's picture

Thanks for the thoughtful comment. On an article like this, I appreciate it when commenters say things I can learn from, instead of just lazy one-liners.

Mon, 07/08/2013 - 18:04 | Link to Comment Dewey Cheatum Howe
Dewey Cheatum Howe's picture

It this is actually pretty good article but some constructive criticism for the author, use larger font. I have 20/20 vision and this is hard on my eyes to read. I'm not old and putrified either imagine how hard it is for people like them whose eyesight is diminishing with age to read this.

Tue, 07/09/2013 - 01:38 | Link to Comment Tapeworm
Tapeworm's picture

Small font........... Try "control+" to increase size, or ctrl- to decrease.

Mon, 07/08/2013 - 18:03 | Link to Comment Kayman
Kayman's picture

Current Consumption paid by long term Debt?  Don't tell Kruggy that's bad. 

Somehow there is a complete disconnection between layers of conjured up Debt and the increase in  productivity of real assets needed to pay the pound of flesh demanded by the new debt. 

Mon, 07/08/2013 - 17:17 | Link to Comment Stuck on Zero
Stuck on Zero's picture

What about debt incurred by government to stuff the pockets of billionaires?  Is that good, bad, or destructive?

 

Mon, 07/08/2013 - 16:47 | Link to Comment withglee
withglee's picture

Capital is unnecessary in a properly managed Medium of Exchange. Money is "a promise to complete a trade". Finding a capitalist is just one way to guarantee a trade ... and not a particularly good one.

Todd Marshall
Plantersville, TX

Tue, 07/09/2013 - 06:33 | Link to Comment Ghordius
Ghordius's picture

Todd, if a farmer does not consume a cow (i.e. hamburgers) but allocates it to production (calving & milk) he creates CAPITAL

note: money is only involved in the *exchange* of capital

first comes SAVING, i.e. NOT CONSUMPTION, then comes allocation as capital, then comes in increased production, i.e. gains

money as such is only potential capital. then if you lend to the farmer at interest, he still has to buy fodder with it, or a barn, or the cow, or the cheesing equipment, or pay wages of the employees

Mon, 07/08/2013 - 16:13 | Link to Comment lordbyroniv
lordbyroniv's picture

I’ll begin in broad strokes, just like my friend Keynes
His theory conceals the mechanics of change,
That simple equation, too much aggregation
Ignores human action and motivation

And yet it continues as a justification
For bailouts and payoffs by pols with machinations
You provide them with cover to sell us a free lunch
Then all that we’re left with is debt, and a bunch

If you’re living high on that cheap credit hog
Don’t look for cure from the hair of the dog
Real savings come first if you want to invest
The market coordinates time with interest

Your focus on spending is pushing on thread
In the long run, my friend, it’s your theory that’s dead
So sorry there, buddy, if that sounds like invective
Prepared to get schooled in my Austrian perspective


The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key.
Malinvestments wreck the economy

The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones

Who invest in new projects like housing construction
The boom plants the seeds for its future destruction

The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few

So the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack.

Whether it’s the late twenties or two thousand and five
Booming bad investments, seems like they’d thrive
You must save to invest, don’t use the printing press
Or a bust will surely follow, an economy depressed

Your so-called “stimulus” will make things even worse
It’s just more of the same, more incentives perversed
And that credit crunch ain’t a liquidity trap
Just a broke banking system, I’m done, that’s a wrap.

Mon, 07/08/2013 - 16:01 | Link to Comment NotApplicable
NotApplicable's picture

Dead men telling tales?

Tue, 07/09/2013 - 06:32 | Link to Comment new game
new game's picture

alive sociopaths fucking over average peoples?

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