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The subject of immigration is keenly debated both within libertarian circles and in the mainstream, having been an important issue in the British referendum to leave or remain in the European Union on June 23rd and also in the forthcoming US Presidential election in November. This essay will outline the core libertarian theory concerning immigration before examining the key area for contention among libertarians – whether, in a world populated by states, any particular state should restrict or otherwise control movements across the border by persons who are not considered to be citizens of that particular state and whether this is in accordance with libertarian theory. We will also explore the additional question, assuming the same, worldwide condition of individual states, of which ways immigration can be said to be a “good” thing and in which ways it can said to be a “bad” thing.

In strict libertarian theory there is no treatment of immigration separate from the general libertarian approach to private property. In a libertarian world all pieces of homesteaded land would be owned by private individuals. Although the owners of neighbouring or otherwise closely situated pieces of land may share a common language, ethnicity and culture, there would be no legally defined national borders; all we would have are the borders, or rather, the boundaries of each parcel of private property marking the point where one person’s ownership ends and another person’s begins. Who, how and when other individuals cross these borders is a private matter for the property owner. It is his property and he can welcome and exclude whomever he likes and on whichever terms he likes. If the property in question is his home then his closest, most immediate family, who may also live there, are likely to have unrestricted access; more distant family and friends may be granted access at mutually agreeable times when they wish to see each other; a lodger will have access governed by a tenancy or licence agreement; and “handymen” or contractors may be granted temporary access to carry out certain work that the owner pays them to undertake. Everybody else in the world, on the other hand, is likely to be excluded. At no point, prior to any agreement or contract with the owner, does any person have a legal right to cross the border of another person’s property. An uninvited crossing is, in libertarian theory, defined as unlawful, aggressive behaviour and may be met legitimately with physical resistance. The only places where people could wander wherever they please, except for their own property, would be onto un-homesteaded or ownerless land as only in this condition would they be undertaking an action which does not interfere with the prior rights of another individual.

In a world populated by states, however, there are not just borders or boundaries between privately owned pieces of land; rather, there are borders between whole swathes of territory which form the landmass of the states. A particular stretch of land immediately on one of these borders need not be privately owned – it may be publicly owned if it is a road or a park or even ownerless if it is, say, an unkempt meadow (although the government will, of course, claim ownership over all un-homesteaded land). In such a world the question concerning immigration would not be whether immigrants would have the right to enter your home or, say, your privately owned business premises; not even the staunchest supporter of immigration contends that this should be the case and if we assume, as minarchists do, that the state has a legitimate responsibility to protect individual parcels of privately owned property from uninvited access by either foreign or domestic individuals then this stance is perfectly in accordance with libertarian theory. Rather, the issue concerns whether the state should grant, without question, prospective immigrants a right to enter the territory of the state at certain, designated  points on the border into publicly owned or ownerless territory that the state nevertheless claims is within its jurisdiction. This, necessarily, raises the further question of whether successful immigrants would be at liberty to access all publicly owned territory, such as roads, to use publicly funded facilities and to claim publicly funded welfare.

In this imperfect world of state borders the question we as libertarians have to answer boils down to how, in libertarian theory, we should treat the ownership of publicly owned land. If the government permits any foreigner to cross the border into publicly owned land can such an arrangement be equivocated with, or approximated to, an uninvited, physical invasion of owned property, in which case it would not be permitted? Or is it an action that is more equivalent to crossing into ownerless or un-homesteaded land and thus does not violate the rights of an existing owner? If we lean towards the first possibility then the resulting situation would be one of “open borders” – the de facto right of any foreigner to cross into publicly owned or ownerless territory of another state. However, if the answer is no then it does not follow that closed borders would result – it is only a quasi-invasion if foreigners cross uninvited. To listen to the mainstream arguments one would be forgiven for thinking that the immigration question needs to be met by an all or nothing answer – it is apparently a contest between liberals, or self-styled “progressives”, clamouring for fully porous borders on the one hand versus conservative, racist bigots who supposedly want to keep everyone out. We reject this false dichotomy and recognise that it is quite possible to be in favour of permitted, regulated immigration – allowing some people to cross the border as immigrants to come and live and work in the territory of the state while denying that privilege to others.

The most convincing reconciliation of this situation with libertarian theory is arrived at by asking a simple question. If the state was to dissolve itself today who, if anyone, would have the strongest ownership claim over the publicly owned land to which immigrants would gain access if they were permitted to cross the border? It is doubtful that such land can be construed convincingly as unowned given that it contains significant infrastructure – roads, railways, utility networks and so on – that have been deliberately engineered, bringing the land into a developed condition that is far from its natural, ownerless state. This infrastructure was paid for by the domestic, tax paying citizens for the benefit of domestic, tax paying citizens, and was not paid for by foreigners who have not been tax payers. It follows, therefore, that the strongest ownership claims to publicly owned land reside with the domestic, tax paying citizens of the state. As long as, therefore, the state owns and operates this land on behalf of the tax paying citizens it should be construed as the owned property of those citizens, to which non-owners can be excluded from entry in just the same way as a house owner may exclude strangers from his house. Thus it is reasonable to suggest that foreigners do not have a legitimate right to cross a state border. Moreover, if the opposite was true and libertarian theory was construed publicly owned land as ownerless then it would seemingly allow foreigners, or indeed, anyone, to homestead this land and take it out of public ownership. The suggestion that one could homestead a major road to the exclusion of the rights of those who were forced, by the state, to pay for that road’s construction, is clearly absurd.

An objection to this suggestion is that non-taxpaying domestic citizens, such as low earners and children, will be permitted access to the publicly funded infrastructure. If we are ascribing ownership of public assets to those who fund them through tax contributions then shouldn’t these domestic, non-taxpayers be excluded too? In the first place we could suggest that the taxpaying citizens – i.e. the taxpaying parents of children and taxpaying businesses who need customers to access them via public roads – have extended a quasi-invitation to non-taxpayers to use the publicly funded infrastructure. However, before we begin to contort our analogy in a tortuous fashion we have to remember that no answer we can give in this regard is going to be perfect. A world populated by states is not a perfect situation with which libertarian theory has to deal. Libertarian theory properly excludes the state entirely; however, if we have to suffer the state in some form then there is an impetus upon us to make it function in the most liberty-oriented way, an endeavour we can only accomplish by approximating ownership as it would be in a stateless society rather than by replicating it entirely. Moreover, it is probably not possible to distinguish taxpaying citizens from non-taxpayers on a public highway, whereas it is eminently possible to exclude foreigners at a frontier.

If we maintain this theme of attempting to approximate ownership in a stateless society we can also determine the situations where foreigners would be permitted to cross a border. As we noted earlier, in libertarian theory owners may invite non-owners onto their property as and when they see fit and upon whichever terms are agreed. Such an entry would not then be an invasion. The most likely way that such invitations could be extended to cross state borders would be if a foreigner is offered employment within the territory of the state, or married into a domestic family. Alternatively, perhaps, a foreigner may purchase property that is within the territory of the state. Critically, however, these invitations should initiate from private sources and private exchanges, not from quota systems or other arbitrary rules and restrictions emanating from the state. Not only does this serve more convincingly our approximation of public ownership with private ownership, but there are also sound economic reasons for stating that this should be the case. If, for example, an invitation to cross the border is dependent upon an offer of employment from a private company or individual it demonstrates that the skills possessed by the immigrant are genuinely in short supply within the domestic population as perceived by the real wealth creators. The immigrant will arrive and will be integrated into the employer’s workforce immediately, co-operating with the existing, domestic co-workers in the production of goods and services. This is less likely to exist with either unlimited immigration, or immigration defined according to government direction, where the influx of immigrants may simply be creating a greater supply of labour which pushes down the wages of existing, domestic workers, and is likely to increase racial tension and xenophobia.

Indeed, the economic cases for and against immigration are rarely stated correctly in the mainstream debate and so it is worth our while to concentrate on these for a moment. Those who advocate open borders will be keen to point out that immigrants bring productivity and skills which serve to increase the standard of living of the indigenous population. Those who argue for restriction, on the other hand, will stress that, in fact, an influx of foreign workers simply competes with domestic workers for employment opportunities, sowing the impression that foreigners are “stealing our jobs”. Both points of view contain kernels of truth yet neither is valid in all situations. Whether or not immigration is a benefit or a burden concerns whether labour and capital goods are balanced in a particular location. The applicable economic theorem in this regard is the law of returns, which states that if the quantity of a factor of production is increased while the quantities of the complementary factors are held constant, there will come a point when the increases will produce diminishing returns and, eventually, no returns at all. For example, a farmer who wishes to grow crops may take land, seeds, water and fertiliser as his factors of production. If he holds the quantity of land, seeds and water constant while increasing the quantity of fertiliser then at first he will experience increasing crop yields per additional unit of fertiliser he deploys. Eventually, however, further increases of fertiliser will produce fewer and fewer crops per additional unit deployed without further increases in land, water and seeds, until eventually there will be no additional returns at all. Finally, of course, production will cease altogether when the land becomes buried under a mountain of fertiliser. If, on the other hand, there are increases in the quantities of complementary factors of production in addition to increases in the quantity of fertiliser, it is possible for the farmer to experience an increase in crop yields per additional unit of fertiliser deployed. Exactly the same is true when the increased factor is not fertiliser on a farm, but is, rather, human labour. If labour is increased, through population increases, but it is not possible to increase the complementary factors of production then the increase in population will simply result in diminishing returns and an overall reduction of per capita real incomes. This will be particularly acute if there is a sudden influx of a particular type of labourer that requires specific types of complementary goods in order to be productive. If there is an increase in low-skilled, manual labourers then a given territory also needs to have the additional factories, machines, tools and equipment for them to use. If it does not then the existing stock of such items simply has to be used more intensively by a greater number of labourers, which, if the increase in labour is left unchecked, is the recipe for diminishing returns. There is no point in shipping in a boatload of carpenters if there isn’t enough timber for them to work on, or if there are not enough workshops to house them; it is futile to welcome more workers onto a car assembly line if the assembly line itself has not been built, or if there is a shortage of steel or aluminium. In principle, at least, this extends to highly skilled labour as well. If a state brings in from overseas a load of doctors then the additional hospitals, surgeries and medical equipment have to be available too. Obviously the situation can become dire if the incoming population cannot work at all – for example, if there are a lot of children suddenly entering a territory, or those otherwise demanding educational services, then there needs to be the additional schools and colleges, otherwise existing class sizes simply swell and the quality of education (i.e. the “returns” on inputs into education services) diminishes. All of these additional capital goods – the machines, the factories, the equipment, the raw materials and so on – are demanded right from the moment that the immigrants arrive and seek work. However, their availability is not immediate as the production of capital goods requires both time and, more importantly, savings. Therefore, if the labour is specific, i.e. specialised to only one kind of occupation, then immigration will serve simply to increase the supply of labour applied to the relevant capital goods, thus pushing down wage rates for the domestic population. If, on the other hand, the skillset of the immigrant labour is unspecific then it may be possible to put them to work in creating these capital goods – i.e. building the very factories and tools they need to increase their productivity. However, capital goods do not yield an increase in productivity until they are completed and if the immigrant population is to go to the effort of creating them then they need consumer goods to sustain them during this phase of construction, a phase which may take a number of years before the additional capital goods are able to increase the supply of consumer goods. The only source of the latter is the prior production of the indigenous population. In other words, the domestic citizens have to reduce their level of consumption today in order to save and fund the additional production of capital goods, thus lowering their standard of living. The only way to induce this voluntarily is to raise interest rates so that more people save out of their current income. However, higher interest rates are precisely what are discouraged by spendthrift governments and economists hypnotised by Keynesianism, who do everything that they can to lower interest rates and decrease the incentive to save. The domestic population therefore continues to maintain its preference for consumption over saving and so all that they see is higher prices for the very consumer goods they wish to buy and lots more people from far flung lands wanting to buy them. It was the understanding of this whole phenomenon which formed the basis of Malthusianism – that if population increases outstrip gains in productivity then society becomes, overall, poorer. For the indigenous population of a given state, the incoming population simply becomes competing consumers of existing, or a barely increasing stock, of goods and services. Indeed, some libertarians have pointed out that this may be the aim of the state in the first place – to bring in more welfare parasites and weaken the wealth and power of the indigenous population, thus expanding the size and scope of government.

On the other hand, it is clear that if there has been an increase in the non-human factors of production but not an increase in labour then these factors too will be subject to the same law, the law of returns. In other words, an increasing number of machines, tools and factories will be used by the same number of labourers, with the result that the latter become spread out more thinly over a burgeoning supply of capital goods. In this instance, an increase in population is precisely what is needed to increase productivity and to make use of the additional capital stock. So, for example, if an empty factory with nobody to operate it, and machines and tools lying idle, is filled quickly by immigrant workers then productivity can rise on account of the fact that there has been a commensurate increase in labour and capital goods. Such a situation is not unheard of in areas where there are extremely favourable reasons for creating capital goods – low tax rates, strong private property rights, good transport links, and good supplies of natural resources – except for a sufficient supply of willing labour. For example, a mining business has to open up shop where the ore it wishes to mine is located. The labour must come to the ore in order to ensure any productivity from the mine. Going back to what we said earlier, if there is an under or oversupply of either labour or resources, only private business owners and entrepreneurs should make decisions as to what moves where – whether labour should be moved to where resources are or whether resources should be moved to where labour is – for only they are in a position to judge, through pricing, profit and loss, which is the most cost effective solution in ameliorating the imbalance between labour and capital goods. Any direct action by the state in this regard will simply create surpluses and shortages either of labour or of capital goods in different areas, as government management of anything always does. Indeed, in a previous essay on “Overpopulation”, the present author argued that increasing population is generally not a concern, from an economic point of view, under conditions of an unmolested division of labour; but it does become a very acute problem when government interferes in population levels, especially in specific areas. In particular, if we look at the two most extreme positions the state could take with regards to immigration – a policy of completely open borders (or even an active pursuit of higher immigration numbers) on the one hand, and a policy of completely closed borders on the other – the former will tend to lead to a surplus of labour while the latter will tend to lead to a shortage. In a world without the state where each parcel of land was owned privately, areas with relatively high populations and low concentrations of capital goods would have higher access costs – higher prices to access roads, higher property prices, higher school prices, and so on, deterring immigrants away from an area where there are already too many people. On the other hand, areas with relatively low populations and relatively high concentrations of capital goods would have lower access costs, encouraging immigrants to move to the place where there are not enough people. Thus, through the pricing system, the market sends signals to prospective immigrants telling them which areas need them and which areas do not. In a world managed by states, however, a policy of open borders will mean that the free cost of access to state controlled territory such as roads, schools and hospitals artificially lowers the cost of immigrating, a situation which is, of course, exacerbated when immigrants have either unrestricted or lightly restricted access to welfare benefits. There will therefore be more immigrants and a higher population than the area requires. On the other hand, a policy of totally closed borders artificially raises the cost of immigration to the level of imprisonment or being shot on the frontier. Thus, while for some this cost is justified (as trying to cross the Berlin Wall was, although this border was directed at keeping people in rather than out), the overall result will be fewer immigrants and a lower population than the area requires. States with heavily restrictive immigration policies, such as the United States, can often find that their domestic companies become exasperated by the difficulty in hiring foreign talent while there will be relatively more attempts to cross the border illegally.

This leads us onto another central theme concerning immigration and that is racism and xenophobia. Any treatment of the topic of immigration cannot avoid addressing these issues, particularly given that any opposition, principled or otherwise, to a policy of “open borders” is often shouted down as racist or at least racially motivated. In the first place, libertarian theory has nothing to do with racism. Our conclusion earlier, predicated on the approximation of ownership rights with regards to publicly owned property, that states may, legitimately, restrict foreigners from crossing the border into the territory of the state says only that the state may choose to exercise such a restriction on behalf of its tax-paying citizens. It may equally choose to relax or forego any restriction. Libertarian theory says nothing about the motivations that the state, its politicians and bureaucrats, and the citizens it supposedly represent, may have for making a choice either way. It states only that they may make such a choice. Libertarian theory is emphatically not motivated by anything that could be construed as racist. Moreover, if one does cross over to a value judgment and state that immigration should be restricted in certain circumstances, as the economic concerns that we just outlined suggest is wise, then it is preposterous to assume that the motivation is necessarily racist. These economic concerns would be true in a world populated entirely by whites, entirely by blacks, entirely by Asians or whomever, all speaking the same language and all with a relative cultural homogeneity. Yet the argument – that an increase of labour without an increase in complementary capital goods would lead to diminishing returns – would still be exactly the same.

Rather, what we will attempt to argue here is that racism and bigotry derive from, rather than precede, a state’s policy of fully open borders and that it is such a policy which aggravates racial tension. A libertarian policy of managed borders, with invitations to cross extended to immigrations extended by private individuals and companies would, in fact, result in a relatively peaceful world where different races would co-exist without difficulty.

The key to understanding why this is so is to do with how the economic aspects we outlined above intertwine with cultural homogeneity in a given society. A society is not simply a collection of atomistic persons doing whatever they like whenever they like, even though such a society may exist hypothetically in libertarian theory. Rather, people in a society embrace a certain culture and the particular morals, rules, habits and hierarchies that are created by that culture. The reason for this is not accidental or spurious. Rather, relatively predictable, reliable, homogenous practices across the populace as a whole not only aid but may even be absolutely necessary for effective social co-operation, and it is through social co-operation – the division of labour – that people are able to raise their standard of living for themselves and for their families.  A common language is, of course, an important, if not the most important homogenous, cultural phenomenon required for social co-operation. It is no accident that in very few places in the world there is a complete mixture of different languages and that, for the most part, different languages are separated geographically. Even a country such as Switzerland, which officially speaks French, German, Italian and Romansch has different areas in which each of these languages is dominant, with only a handful of fully bilingual areas. The barriers to social co-operation if the opposite was the case are obvious. Imagine coming to work one day and finding that your boss speaks only Russian, your co-worker Chinese while the team you manage speaks a mixture of Spanish, Welsh and Punjabi. Cultural practices extend also, however, to such apparently menial aspects as the 9am until 5pm working day, or when the main meal of the day is eaten. If people stroll into the office whenever they please or vanish at 10 in the morning to enjoy a three course meal clearly social co-operation is impaired. This is not to imply, of course, that everybody has to do absolutely the same thing all the time in a given society. However, the exceptions prove the rule and different practices – such as working at night and sleeping during the day – are regarded as unusual. Moreover, there is also the fact that humans are a tribal race – we prefer to associate with those who are familiar to us, those who do what we do and those who agree with us, if only for the comfort of predictability, regularity and routine in addition to the contribution of such aspects to social co-operation. Indeed, if the benefits of cultural homogeneity for social co-operation are true then it is possible that our preference for it is an outcome of evolution, which has biased us towards desiring things, through instinct, that ensure are our survival and betterment. However, it would be a mistake to assume that most specific cultural practices emerged randomly or through simple preferences. Rather, they were shaped and formed by the challenges presented by the specific climate, geography, topography and the available resources of the particular locale. For example, the Mediterranean practice of taking a siesta in the middle of the day originated because the temperature was too hot to work at that time. Indian food makes use of a lot of spices because of the difficulties in preserving food in such a hot climate, a difficulty that was not quite so prevalent in regions further from the equator. The practice of circumcision originated out of the challenges posed to male hygiene and comfort in a hot desert environment. The creation of the family unit and sexual fidelity, which we take for granted today, originated at least in part from the need for fathers to bear the costs of raising their children when population levels in hunter gatherer communities began to outstrip resources, something which could not be managed in a culture of “free love”. The family is a cultural practice we see all over the world because the problem it solved was experienced throughout the world, whereas less universal cultural practices sought to solve only specific, local problems.

When immigrants move from one state to another they are usually moving from one culture to another – from one language, one religion, one set of social norms, one type of cuisine, and so on, to something else with varying degrees of difference. If a relatively homogenous culture is both a natural human preference, is a requirement for effective social co-operation, then it follows that cultures of both the immigrants and the indigenous population of a given state are not likely to mix naturally within the same locale and that, rather, one set of cultural practices must yield to the other. This is particularly so when the cultural practices of the immigrants were developed with regards to the challenges posed by their homeland and may be superfluous or completely contradictory to what is required in the state to which they have emigrated. When, as we outlined above, individual immigrants are invited to the state by individual persons and companies to accept an offer of employment it is because there is a pressing, economic need for their presence – there is a surplus of capital goods and equipment and a shortage of labour. The immigrants, in this instance, will begin work immediately and will mould themselves into the cultural practices and habits of the indigenous population. Furthermore, their skills and abilities, being in genuine short supply, will be recognised and appreciated by their co-workers, with whom they will be co-operating to create more wealth and a greater standard of living, rather than competing to consume an existing stock of wealth. It is true, of course, that immigrants may retain cultural practices of their homeland in the domestic situation of their own home; however, the first generation of children, born in the state to where their parents have emigrated, will become heavily surrounded by its culture. To them, this new state is their homeland and not a foreign place and they will know little to nothing of their parents’ place of origin. Thus they become even more integrated into the culture of the new state and will most likely consider themselves as citizens of the new state even if they retain an obeisance to the state from which their parents emigrated. This is not to imply, of course, that the culture of the immigrants will be completely eradicated. Indeed, in some cases, foreign cultural practices find their way into the indigenous culture. The delights of foreign cuisine, for example, are often embraced by a domestic population, as Indian and Chinese food has throughout the West. All we are saying is that at if social co-operation is to be pursued to its fullest extent, one of the cultures must become recessive and to the extent that the immigrant population form a minority it is likely to be the indigenous culture that remains dominant. The outcome, of course, is a prosperous society where immigrants and natives work together peacefully without racial tension or xenophobia.

Contrast this situation, however, with the case of where it is the government of the state which welcomes immigrants to its territory, either through a policy of open borders or according to some artificial quota system which is wholly unrelated to the genuine demand for additional labour within the state. Here, the immigrants will arrive without offers of employment but they will quickly look for them. However, because there is no demand for additional labour at the existing wage rates the effect of the arrival of the immigrants is to push existing wage rates down for the indigenous population. Thus the latter draws the perception that immigrants are simply creating a crowd, a crowd which competes for existing resources but seemingly does little to add productive value. This becomes exacerbated by minimum wage laws and other costly employment regulations that the state heaps upon employers – if wage rates drop below these levels then unemployment must result. Hence the perception that foreigners are coming over to “steal” jobs from the indigenous population, although both will be afflicted. Moreover, if the immigrants cannot find jobs then it is less likely that they will be integrated into the working practices and the cultural environment of their new state. What results, therefore, is that they form their own communities and their own local economies which, with little impetus to do otherwise, retains the cultural distinction of their homeland. Hence, the perception amongst the indigenous population, that entire towns and communities are being “invaded” by an alien culture and that one’s own homeland is being turned into an outpost of some far and distant country. The stage is set, therefore, for an increase in racial tension and xenophobia, an increase which will be exacerbated if the government follows a deliberate policy of multiculturalism – i.e. the explicit intention to create numerous cultures within the same society where one was previously dominant by inviting immigrants. Multiculturalism has rarely existed under purely voluntary conditions. The only exception is where vast swathes of immigrants from different places move to a previously uninhabited or sparsely habited area. The difference here, however, is that everyone, from wherever they have come, has moved to the new land in order to make a better life for themselves and they are attempting to do so in a place where there are few, if any, indigenous persons of a given culture seeking to preserve an existing culture. Everyone, in other words, is embracing change and the challenges that come with improving their lives, rather than attempting to defend one that already exists. Such was the early history of the United States which, of course, was populated by immigrants from all over the world.

What we can see, therefore, is that policies of open borders and forced integration are the cause of racism and xenophobia through economic and cultural clashes. They are not the solutions to these problems. However, even if there were no economic barriers to welcoming immigrants to a given state and even if the only motivation for indigenous people to exclude them was racism and xenophobia that sprung from their own minds entirely as a matter of preference, our priority is to ensure that all of the six billion people of different creeds, colours, races, and religions are able to co-exist peacefully on this small rock hurtling through space. If different peoples and cultures living in separate geographical locations achieves this whereas mixing them all together in a single place causes them to fight then it is reasonable suggest that preference should be given to the former.

Progressives often label their policy of mixing cultures in the same locale as a policy of achieving “diversity”. Yet the world as a whole already is a diverse place. Some places are hot, some places are cold, some are wet, some are dry, some have fertile soil while some are barren. As we said earlier, this diversity of geography, climate and topography, together with the unique challenges posed by each difference with which humans have to deal, is what creates diverse cultures. The forced creating of “diversity” in every single locale simply amounts to a travesty. Not only does mixing every culture everywhere in every location, in fact, create bland uniformity as opposed to diversity, it is the equivalent of trying to put a mountain, a hot desert, and a jungle all in New York City. To that extent we might say that attempting to create “diversity” is a utopian revolt against nature.


To summarise what we have concluded here:

  • In a world where the existence of states is assumed, the ownership of state property should be approximated to the ownership of the state’s tax paying citizens, thus ruling out a right, in libertarian theory, for non-taxpaying foreigners to cross the border;
  • That invitations to cross the border should be made to prospective immigrants by private companies and individuals;
  • Such a policy would prevent the relative surplus or shortage of labour experienced when the state actively manages immigration policy; labour and capital goods would be channelled, through pricing, profit and loss to where they are most needed;
  • That it is relative surpluses of labour through policies of open borders, forced integration and the pursuit of multiculturalism, which are the causes, and not the solutions to, racism and xenophobia. The prevention of surpluses of labour through the method we described would also prevent such racial and cultural clashes and is more likely to create a world of peace and prosperity for all persons, regardless of colour or creed.

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“Austrian” Business Cycle Theory – An Easy Explanation

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Against the simple and straightforward siren song of “underconsumptionist” and “underspending” theories of boom and bust, “Austrian” business cycle theory (ABCT) can seem contrastingly complex and lacking in communicability. The former types of theory, associated with “mainstream” schools of economics, in spite of their falsehood, are at least advantaged by the veneer of plausibility. A huge glut of business confidence and spending will, it seems, naturally lead to an economic boom, a boom that can only come crashing down if these aspects were to disappear. For what could be worse for economic progress if people just don’t have the nerve do anything? Add in all the usual traits of “greed” and “selfishness” with which people take pride in adorning the characters of bankers and businessmen (again, with demonstrable plausibility) and you have a pretty convincing cover story for why we routinely suffer from the business cycle. ABCT, on the other hand, with its long chains of deductive logic, can seem more impenetrable and confusing. Is there a way in which Austro-Libertarians can overcome this problem?

“Austrian” economics is unique in that all its laws are deduced from a handful of self-evident truths, the most important being the action axiom, often peppered with a few additional assumptions or empirical truths (such as the desire for leisure time). The entire corpus of economic law – right from the isolated individual choosing between simple ends all the way up to complex structures of production, trade and finance – therefore forms a unified and logically consistent whole. This is not true, however, of “mainstream” schools of thought which tend, nowadays, to be splintered and scattered into separate, specialised areas of study that are based upon their own, individual foundations. The fissure between so-called “microeconomics” and “macroeconomics” is a prime case in point; while “Austrians” will read much that is agreeable in “microeconomics” (although it still contains many faults and general misunderstandings resulting from the lack of coherence and soundness that is furnished by deduction from the action axiom), “macroeconomics”, on the other hand, seems to be a completely different ball game, considering only “the economy as a whole” without reference to its individual components1. It is this fact that “Austrians” can use to give them the upper hand when explaining the business cycle. For in ABCT, the explanations of “macro” phenomena are little more than an extension of what is found in “micro” price theory.

The market price for a good is the price at which the quantity demanded equals the quantity supplied. Prices therefore serve to ration goods as a response to their scarcity, the goods available being traded from the hands of the most eager sellers to the most eager buyers. Those buyers who are not willing to pay the market price will go away empty handed and those sellers who are unwilling to sell at the market price will not be able to get rid of their goods. What happens, then, if this relationship is disturbed by a forced fixing of prices by the government? First, if the price is raised above the market price to create a price floor, the new price will attract more sellers into the market for that good because the price that they will receive for a sale is now the price at which they are willing to sell. However, at this heightened price there are fewer people wishing to buy the good. Some, who were not previously prepared to pay the lower, market price, are certainly not going to pay the higher price now. And those who would have paid the market price before may now decide that the new price is too high so they also do not buy. What results, therefore, is an increase in sellers and a decrease in buyers which can lead to only one thing – a surplus of unsold goods. The sellers may be very eager to sell at the new price but they will have a hard time finding anyone to sell to. Secondly, the opposite case, where the price is lowered below the market price (a price ceiling) creates, as one would expect, the opposite effect. This new price will attract more buyers into the market for that good because the price that they will pay for a purchase is now the lower price at which they are willing to buy. However, at this lowered price there are fewer people wishing to sell the good. Again, some, who were not, before, prepared to sell at the market price, are certainly not going to sell at the lower price now and those who would have sold at the market price may now decide that the new price is too low so they also do not sell2. What results, therefore, is a decrease in sellers and an increase in buyers which, clearly, leads only to a shortage of goods. Buyers will swarm into the marketplace eager to purchase the articles at the new, attractive price but, to their dismay, the shelves will be empty, cleared out by all of the more hasty buyers who got there before them3.

It is this latter scenario – that of artificially lowered prices – that is relevant for ABCT. For the business cycle is, according to “Austrians”, little more than price fixing on the widest scale, the fixing and the manipulation of what is possibly the most important price in the economy – the interest rate on the loan market. Rather than being the price at which a single good is traded, the interest rate is the price at which saved funds are borrowed and lent (i.e. demanded and supplied) in the economy.

When the stock of money is fixed, if one person wants to borrow (demand) money then another must have saved it in order to lend (supply) it. The resulting rate of interest is the point at which the quantity of money saved/lent equals the quantity of money borrowed. Any borrowers who want to borrow at a cheaper rate and any sellers who want to lend at a higher rate will find themselves priced out of the market for loanable funds, the sub-marginal buyers unable to borrow any money and the sub-marginal lenders unable to lend any. This situation produces a stable amount of saving, lending, borrowing and investment because the interest rate – the price of saved funds – is in harmony with the preferences of consumers, in particular, their preferences for allocating their funds towards either capital or consumer goods. The portion of his funds that the saver retains for consumption will be spent on consumer goods (i.e., present consumption) whereas the portion that he allocates towards saving and lending for investment will be spent on capital goods that will not provide any immediate consumption but will provide a greater amount of it in the future. At the market rate of interest goods and resources in the economy will be allocated in harmony with these desires. If, for example, a borrower wishes to borrow money to build a factory (a capital good) and his calculations reveal that the prevailing rate of interest is low enough for him to make a return on this enterprise, it means that savers are willing to lend a sufficient quantity of funds in order to make it viable. If, however, the prevailing interest is too high it means that savers are not willing to lend enough funds to build the factory – the money that could be spent on building the factory they would prefer to spend on their own, immediate consumption4.

What happens, then, if the rate of interest is set below the prevailing market rate? Exactly the same as what happens when prices are forcibly lowered for any single good. At this rate borrowers who before found the rate of interest too high for their ventures suddenly find that they can afford to borrow. The quantity of funds demanded, therefore, will rise at this new, low price. Savers, however, will be less willing to lend at this price. Certainly if they weren’t prepared to lend at the previous rate of interest they will not be induced to do so by an even lower rate and some savers who were prepared to lend at the market rate will not be prepared to do so at the new, artificially fixed rate. The increase in borrowers and decrease in sellers, therefore, causes a shortage of saved funds, or at least it should do so. Why, then, does this shortage not materialise immediately at the point that the interest rate is fixed? Why aren’t the banks empty of cash and why can they keep on lending and lending and lending? Why can this situation perpetuate for years and end in a calamitous crash that causes almost unrelenting havoc?

This is where a degree of complexity enters the explanation. What is really being borrowed and lent is not money but, rather, the real goods and resources that they can buy. We said above that if someone wishes to borrow money another person has to have saved it. But what this really means is that the saver has to have worked to produce real goods and resources in order to earn that money. He then lends that money to the borrower and the borrower uses that money to buy those goods that the lender produced and diverts them towards his enterprise. If, of course, saving, lending and borrowing took place with real goods, or if the supply of money was fixed, then obviously a forced lowering of the rate at which these goods could be borrowed would result in their shortage very quickly. But the fact that the saving and lending takes place through the mechanism of an easily expanded paper money supply creates a clever smokescreen. For our entire financial system rests not on the principal of every pound borrowed requiring a pound to be saved, but rather that pounds can be “created” out of thin air by the central bank and lent out even though someone has not saved. By printing fresh money (or its digital equivalent) the volume of borrowing can expand without a corresponding expansion of the volume of saving. This easy ability to produce more money to meet the higher demand for borrowing means that the artificially low interest rate never causes a shortage of money as we would normally expect when the price of any other good is fixed below its market price. A second problem, though, is that the real goods that this new money can buy have not increased in line with the increase of the supply of money, but, rather, have remained constant and there is, therefore, still only the same quantity of goods that have to be allocated towards either consumption or investment. Surely the artificially low interest rate will mean that there will be a shortage of real goods to devote towards investment?

Unfortunately, at the beginning, this is not so. For the newly printed money transfers purchasing power over goods out of the hands of those holding existing money and into the hands of those who have the new money. The result of this is that the borrowers of the new money – those who want to devote the goods purchased to capital investment – now have an advantage over those who wish to devote them to consumption. Let’s say, for example, that I earn £1000 in a given month. This means that I have worked for and created real goods in the economy on which I can spend this £1000. Let’s say that I allocate £750 towards consumption and £250 towards saving and investment. Therefore, what I want to achieve is to consume 75% of the goods on which I can spend the money and save and invest 25%. This £250, the 25% of the goods I wish to devote to saving and lending constitutes supply in the loan market that will help to set the market rate of interest. We can illustrate this allocation accordingly:

Consumption  £750   75%


Saving          £250   25%


TOTAL           £1000  100%

If, however, a commercial bank depresses the interest rate and simply prints an extra £500 to meet the new demand at this lower rate, what has happened now? There has been no change, remember, in the quantity of goods – the new money must be still be spent on these goods. The purchasing power of the existing money that I wished to spend on consumption therefore reduces and that of the new money that is to be spent on lending and investment correspondingly increases. All that happens therefore is that the proportion of goods that can be devoted to lending and, hence, to investment has now been forcibly increased from £250 to £750 – and increase from 25% to 50% of the new total stock of money, thus:

Consumption  £750   50%


Saving          £250   17%

New Money    £500   33%


TOTAL           £1500  100%

Newly printed money that enters the loan market therefore forces the economy onto a different consumption/investment ratio from that which is desired by consumers. The poor consumer will find that the newly created money has caused the prices of goods to rise; he is forced, therefore, to curtail his consumption in real terms. The goods that he can no longer afford to buy and consume will be purchased by the new borrowers who will devote them towards their capital enterprises. It is for this reason that none of the expected effects of price fixing occur and the economy proceeds along what appears to be a sustainable boom in capital investment. The problem, though, is that capital projects usually take several years to complete and rely on a continuous supply of goods throughout this time. But consumers don’t want to save voluntarily the amount necessary to complete these projects. The interest rate must therefore be constantly kept low and the new money reeling off the printers to meet it if the projects are to continue. It is only down the line when price inflation inevitably begins to accelerate and the central bank forces an increase in the interest rate and a corresponding reduction in growth of the money supply that the problems are revealed. For now the consumption/investment ratio once again begins to reflect the preferences of consumers – they want, if we remember, more consumption and less saving which means that lending and investment has to reduce. Hence half-finished capital projects have to be left incomplete. They have been starved of the resources necessary as they can no longer afford to purchase them at the new rate of interest. This precipitates a collapse in the prices  of capital assets, a collapse that causes widespread bankruptcy and liquidation of firms and enterprises that, hitherto, had seemed sustainable and profitable. Ludwig von Mises describes the perfect analogy:

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal5.

Mises’ last sentence is important. As the prices of capital goods were accelerating upwards during the boom and then suddenly come crashing down, there is a temptation to analyse this as “overinvestment”. While this is true and that “too much” has been devoted to long term investment projects it should be clear from our analysis that the real problem is malinvestment – a diversion of resources from desired consumer goods to capital goods.

Observant readers might say that it is actually the return to the market rate of interest and not the fixed rate that has caused the sudden shortage of capital goods. This would not be a correct interpretation. Artificially lower prices always give the illusion of plenty, of abundance and availability for everyone. It is just that with the fixed price of a particular good the illusion becomes obvious more quickly. But with fixing the rate of interest, because it takes effect through the mechanism of money, the illusion of plenty is obscured and, for a time, looks very sound. For this new money has the very real ability to divert resources away from consumption towards capital investment. Nothing more has been created but it looks like there has. Couple that with price inflation with higher nominal wages and people, at least, think that they are better off than they were before the “miracle” of artificially low interest rates. Real abundance and plenty, however, would not merely divert resources from consumption. Rather, resources for capital investment would exist independently of and in addition to those desired for consumption, as dictated by the desires of consumers.


What we have seen, therefore, is that ABCT sits coherently with the examination of individual price action and is little more than an extension of it. The business cycle is simply a case of price fixing writ large, causing widespread waste, chaos and misery when its effects are finally revealed. There are no separate bases or foundations of this “macro” sphere of economic theory. There are, however, certain special features that make this form of price fixing especially insidious and long-lasting – that of the easy ability to print fresh money to meet the new, low rate of interest, permitting purchasing power to be transferred to new borrowers and, hence, the real diversion of resources. As soon as this situation ceases the smokescreens vanish to reveal the waste and futility of these diversions.

Whenever, therefore, one has difficulty in either understanding or explaining ABCT, think back to what you know about simple price fixing. In fixing the rate of interest, the most important price in the economy, “Austrian” economics, with its strict deductive logic from the action axiom, will tell you that the results will be the same.

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1Murray N Rothbard, Man, Economy, and State with Power and Market, p. 269 (n. 19).

2This isn’t just stinginess on the part of sellers; rather, the cause of their unwillingness to sell will be, in the long run, that they simply cannot – the lower price will usually not be sufficient for them to recoup the costs of production so they have to abandon the particular line altogether.

3These results were seen during the high inflation of the 1970s in the US when price controls led to long queues at gasoline station because the demanded quantity of gasoline could not be supplied at the artificially low price.

4An interesting question is whether the interest rate may strictly be considered a “price”. In the exchange of goods, the price of a good is the quantity of another good that is fetched in exchange. For example, if one apple sells for two oranges, then the “orange” price of an apple is two oranges (and the “apple” price of an orange is 0.5 apples). In the complex economy, of course, every good is exchanged for money so we always reckon prices in terms of the quantity of money received in exchange. However, whatever the other good that is received, it makes no sense to compare the two physically heterogeneous goods in terms of magnitude. For how does one calculate the “difference” between two apples and one orange, or between £2.00 and a bag of oranges? In the exchange of a present good for a future good, which is what happens in the loan market, this is not the case, however. If a borrower agrees with a lender to borrow £100 today and to pay back £110 in one year’s time, strictly the price of one unit of present money is 1.1 units of future money (or the price of 1 unit of future money is approximately 91p of present money). But because the two goods are physically homogenous we can compare the two magnitudes – 1.0 and 1.1 – in order to derive a rate or ratio between them of 10%. We would therefore state that the interest rate per annum in this scenario is 10%. This rate is therefore not strictly a price but an expression of two prices – the price of present money in terms of future money and the price of future money in terms of present money. However, it should be clear that a manipulation of the rate of interest would have the effect of fixing the actual prices of present and future money. If, for example, the interest rate is forcibly lowered to 5% then the price of one unit of present money is now 1.05 units of future money rather than 1.1 units of future money. The resulting effects of price fixing will therefore be felt in this scenario. Hence, it makes sense to speak of the rate of interest as a price just like any other and, indeed, this is how it is treated by acting humans in the loan market.

5Ludwig von Mises, Human Action, p. 557.

Capital – The Lifeblood of the Economy

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It is the gravest deficiency of mainstream economics that it fails to understand the necessity, role and structure of capital in the economy, a failure that permeates through to lay debates concerning production, income, wealth and redistribution. This essay will explain why this deficiency will lead to economic ruin unless its errors are comprehended and corrected.


It is self-evident that everything desired by humans that is not the free gift of nature at the immediate point of consumption must, in some way, be worked for. By “worked for” we mean that the human consciously strives to devote means to bringing about an end that would not otherwise exist. The benefits of air, for example, must be “worked for” in the sense that the body has to contract the diaphragm to inhale. But to the extent that this is not a conscious process, that the human does not knowingly have to divert resources to meet this end means that air is, to all intents and purposes, a free good. Very few, if any, other goods meet this criteria and the environment of the first human that walked on the Earth was one of unrelenting scarcity, a complete and utter dearth of anything necessary, enjoyable or desirable for that human being’s existence.

An isolated human, therefore, has to work to produce his goods. The extent of his success determines his productivity or, to put it more starkly, his income. If, at the start of the day, he has nothing and he labours to produce three loaves of bread then by sunset we may say that his productivity, or his income, is three loaves of bread per day. Productivity does not rise proportionally with effort. It may be possible to achieve a high level of productivity with relatively little effort or, conversely, to waste ones efforts on boondoggles that turn out to be a complete failure. While it is generally true, therefore, that harder work will begat a greater level of productivity it is not necessarily true – humans must direct their efforts in the most appropriate way to enable the greatest productivity, not necessarily in the hardest way.

Let us take, then, the first human on Earth who has nothing except air to breathe and nature’s gift of his body which empowers him with the ability to labour. Let us say that, at this point, his wealth, his accumulated stock of produced goods, is zero. It will be the task of his existence to increase this level of wealth. How does and how should he go about this?1 Let us say that his first desire is to find firewood to burn and keep warm. So on the morning of day one of his existence he has no logs to burn and his wealth is zero. Off he goes on a brief expedition and, using only the body that nature has given him, he returns in the evening with three logs. His productivity, or his income for the day, is therefore three logs. We may also say that his wealth has increased from zero to three logs. However, he then makes the decision to burn all of the three logs to keep him warm for the night. His act of burning the logs is his consumption. He has used the three logs as consumer goods to directly yield him a satisfaction in his mind. However, with the arrival of morning, he is in exactly the same position that he was in on the previous morning – his stock of wealth is once again zero. So off he goes on another expedition and returns again, with three logs. Once again his income is three logs and his wealth has expanded by three logs. But again he burns them overnight, meaning that yet again his stock of wealth on day three is back to zero.

It is therefore the case that one’s stock of wealth is directly related to the amount of it that is consumed. The more of one’s produced product (income) that is consumed, the less overall wealth one has.

Let us say that, within a week, our human grows weary of collecting three logs every single day only to see them vanish again overnight. He wants to increase his wealth. What can he do? It should be self evident that the only thing he can do is to reduce his consumption; if, he wants to be wealthier at the start of tomorrow than he was at the start of today he needs to reduce his level of consumption by abstaining from burning one or more logs. Let us say that he decides to burn only two logs and sets aside one. The following morning, therefore, his wealth is now one log, whereas the previous morning it was zero logs. He is now wealthier today than he was twenty four hours ago, this increase of wealth being owed to the fact that our human he has engaged in an act of saving2. With his saved wealth he can do one of two things. The first possibility is that he can hoard it. If he hoards it then all this means is that, while his wealth will increase as his act of hoarding continues, the human’s consumption of the wealth that he is accumulating daily is merely delayed. This method of saving does not, in and of itself, permit wealth to grow and from this perspective serves little purpose. If all else is equal, he might as well burn the third log today and enjoy the extra warmth rather than leave it lying around for a future date3. However, the second thing that he can do is to take his saved logs and invest them. To invest means rather than consuming his wealth directly the human takes it and uses it as a tool of production of further goods. This must be the result of a transformation of the goods into such a tool. Let us say that the human saves enough logs to invest in the production of a wheelbarrow and that, for one week, he labours to construct the wheelbarrow. The finished wheelbarrow is now a capital good – a good used in the production of further goods. The aim, in this case, is for the wheelbarrow to be used to transport logs that will then, in turn, be burnt as firewood. Let us say that with the aid of the completed wheelbarrow he is now able to bring home six logs per day rather than the initial three. By aid of the capital good he is therefore able to increase his production of other goods. His wealth therefore increases by more than it would have done so without the aid of the capital good.

What, therefore, are the inherent qualities of this act of saving and investment? What, in particular, will induce the human to engage in it? There are several aspects to note:

  • It requires abstinence from direct consumption of the good that will be transformed into a capital good;
  • The abstinence is for a period of time, that is the time taken to transform the goods into capital goods that yield further goods for consumption;
  • In order to justify the period of abstinence, the yield of goods from the capital goods must be higher than it would have been without the capital good.

This final point is of crucial importance. For what will determine the human’s propensity to save/invest on the one hand and his propensity to consume now on the other? The answer will be his willingness to trade the period of waiting in which the capital good will be constructed against the increased quantity of goods that will result. He will start to save at a point when the increased quantity of goods yielded is more valuable to him than the utility gained from direct consumption now of the capital good. He will stop saving when consuming now will yield him more utility than waiting for an increased quantity of goods in the future. This propensity to wait is called his time preference. If time is relatively more valuable to him than an increased quantity of goods then he has a high time preference. If the increased quantity of goods is relatively more valuable than the waiting time then he has a low time preference.

Increasing Capital – the Structure of Production

The consequences of the increased yield of consumer goods – in this, case, from three logs per day to six logs per day – and the resulting increase in wealth means that our human yet again has to face the same choice as he did with his original stock of wealth – to consume or save (hoard/invest). Only now, however, he has to make this choice with an increased quantity of goods. What will be the possibilities?

  • He could choose to consume and save at the same rate as he did previously, that is one saved log per two consumed. Out of a total of six logs he will, therefore save two logs per day and consume four;
  • He could choose to consume at an increased rate and save at a reduced rate. One day of doing this would be to save the same quantity of logs as he was before (one) and consume the remainder (five); however, he could also increase the quantity he saves while decreasing the rate, for example by saving one and a half logs and consuming four and a half.
  • He could choose to save at an increased rate and consume at a reduced rate, for example by consuming the same quantity of logs as he did before (two) and saving the remainder (four); however, he could also increase the quantity he consumes while decreasing the rate, for example by consuming three logs and saving three.

The precise consequences of each choice are unimportant, merely that each will occur at a different rate depending on what is chosen. It should be self-evident that more saving will begat more capital goods and more consumption but only after the period of waiting; more consumption will mean more goods can be enjoyed today at the expense of relatively fewer in the future. But in practice, we might add, it tends to be the case that the wealthier a person becomes the more he tends to follow the third scenario, specifically by increasing the quantity he consumes while decreasing the rate. The rich, for example, consume a much greater quantity of goods than poorer people do but as a proportion of their wealth they consume less. This will have important consequences as we shall see when we consider the effects of taxation and redistribution below.

However, let us assume that, whatever choice the human makes, there will be a rate of saving that permits investment to continue. What will happen now?

As the level of production is now dependent upon a capital good, the rate of saving must, at the very least be able to maintain this capital good. Capital goods are not consumed directly but they are consumed in the process of production through wearing down. While no new wheelbarrow will need to be produced, of course, a level of saving that permits its parts to be repaired or replaced will be necessary. If the human is not able to maintain his capital goods what happens? It means that he is using it for the purposes of production the results of which are consumed to the detriment of repairing and replacing the capital stock; in short he is engaging in capital consumption. It should be self evident that if the capital is lost, production must decline and so too will the standard of living. The dangers of capital consumption will become clearer when we discuss it below4.

However, let us assume that our lone human is able to maintain the existing capital stock and also has enough further saving that does not need to be used for this purpose. What will happen? He will, of course, invest in further capital goods to increase his production of consumer goods. Let us say that, satisfied with the utility gained from and his ability to maintain his wheelbarrow, he decides instead to invest his logs in the production of tools. Let us say that he fashions from a log directly an axe handle. But the axe head cannot be made out of wood. He must acquire and fashion metal in order to complete the axe. Aren’t the saved logs useless for this purpose? Not at all; for while the saved logs cannot be used directly in the production of the axe head, they can be used indirectly in order to sustain our human during the production of the axe head. In short, let’s say he goes on an expedition far from home in order to acquire the material to fashion the axe head. He takes the saved logs with him and burns them at night to keep him warm. To the extent that the venture is successful and he returns from the expedition with the material to fashion the axe head, then the consumption of the logs has been compensated by the acquisition of the axe head. The axe head can then be used to fell entire branches or even trees which can then be transported in the wheelbarrow for our human to consume. Let us say that, once again, his output doubles as a result of the introduction of the axe, meaning that he now takes home twelve logs each day.

What does this addition of another capital good – the axe – demonstrate? In the first place, it once again demonstrates the requirement of waiting during the production of the additional capital good, waiting that must be sufficiently offset (in the valuations of the human) by the resulting increased level of production. But there are two more crucial aspects:

  • That, in terms of providing for the human’s needs, it is relatively less important to stress the amount of capital he possesses as compared to its precise structure. The new capital structure is intricately woven and the stages are dependent upon each other. For example, if he had two axes and no wheelbarrow, he could fell a lot of trees but would lack the means to transport them. If he had two wheelbarrows and no trees then he could transport a lot of logs but he wouldn’t be able to fell enough trees to fill and use two wheelbarrows. As we can see therefore, capital growth manifests itself as increasing the stages of an intricate production structure through the passage of time. Any interference with the precise structure of capital would be as detrimental as capital consumption; in the complex economy a corollary would be all of the world’s factories, tools and machines, consisting only of tractors. It would not be hard to see that, in spite of the overall level of capital being very high, the specific glut of tractors and corresponding shortage of absolutely anything else would lead to a very severe degree of impoverishment;
  • That the logs used in discovery and fashioning of the axe head, by not being used directly as a capital goods, were used as a fund to produce a capital good. The majority of capital investment is, in fact, the use of a fund of saved products that are consumed in the production of other products and these latter products are the capital goods. In the complex economy we can see how wages, for instance, which are consumed by workers are paid out of saved funds in return for their production of goods which are either sold or used as capital goods (or both if the buyer uses them as capital goods), just in the same way that the logs were consumed in production of the axe head.

This method of saving and investment in capital goods is frequently termed in “Austrian” literature as “roundabout” methods of production; that an increase in capital leads to a longer production structure with multiple stages (in our case hacking of logs off the trees with tools, collection of logs in the wheel barrow, followed by consumption). However a more appropriate description would be that increased saving and investment in capital goods results in a process of production that takes more time for a greater quantity of produced products.

Further Increases in the Structure of Production – The Source of Wealth

This outline of a simple economy consisting of our lone human and two stages of production should illustrate how that human can further increase his wealth. Assuming he continues to save at a rate above that which permits him to maintain the existing capital goods (the wheelbarrow and the axe) he can continue to expand the stages of production of logs or begin to invest in the lower stages of production of other goods. He might, for example, use one log to build a fishing net to catch fish, thus increasing his quantity of fish to add to his wealth. He then might be able to use quantity of saved fish and saved logs to sustain him in building a boat which permit him to catch and even greater quantity of fish. It is this process of capital accumulation, its maintenance and its regulation into a particular structure that is the cause of the increase of wealth. Relatively speaking, the more capital that our human has, the more tools, equipment, machines, etc. that he fashions by abstaining from the consumption of the goods that make them (and by waiting for them to be completed), the wealthier he is.

It should not be difficult to abstract from this simple illustration the workings of a complex economy. The only substantial differences are the existence of the division of labour and the resulting necessity of trade which serve as the most complicating factor in trying to visualise the complex, growing economy. For in such an economy people, on the whole, do not produce goods for their own consumption but rather they concentrate on the production of a specific good (or service) which they then trade in return for other goods. The other goods, of course, are never traded directly but with the aid of a medium of exchange, money, so that you sell the goods that you produce for money and then take money to buy the goods and services that you want to consume5. Each and every single day, then, any person who goes to work engages in production of a produced product. If you are a baker you produce bread, if you are a butcher you produce meat, if you are a fishmonger you produce fish. But no one butcher, baker or fishmonger directly consumes his own product, rather he trades it for money which he then uses to buy the goods he wants. So the baker, for example, may sell bread to the fishmonger who will pay for it with money. The baker may then use the money he receives to buy meat from the butcher. From the point of view of the economy as a whole, the situation is no different from that of the economy with the lone individual. We will remember that, in the latter situation, if our loner produced three logs per day and burnt (consumed) three logs per day then on the morning of the following day he is in exactly in the same position regarding his personal wealth as he was the previous morning. If, in our complex economy, the butcher, baker and fishmonger produce, respectively, on one day three cuts of meat, three loaves of bread and three fish, then if after trade these are all consumed by somebody at the end of the day, then tomorrow the economy as whole will be in exactly the same position as it was at the start of the previous day. If, however, some of these products are saved then tomorrow the economy as a whole will be wealthier than it was at the start of the previous day6.

Saving and investment in the complex economy will not, of course, take place in the form of hoarding the physical products like it did in the simple economy. Rather, let’s say that that the baker sells three loaves of bread to the butcher and receives in exchange for them money. His saving takes place in the form of saving money rather than goods directly. His investment will come in the form of spending this money on goods that are used for investment – i.e. are transformed into capital goods – rather than for consumption. For example, let’s say that he takes his saved money (we shall call it £100) and buys fish from the fishmonger. In exactly the same way as the logs sustained the lone human in constructing the axe head, the fish provide sustenance for the baker while he increases his capital at his bakery – let’s say he invests in a new oven. The fish, therefore, provided a fund which was used to construct a new capital good, the oven which will produce more consumer goods. In his own mind, however, the baker will not reckon in terms of fish, ovens, or the extra amount of bread that is produced as a result of the oven’s construction. Rather, he will say that he has an investment of £100, an investment whose return will be measured not by the physical quantity of extra bread produced but by the increased money he will receive from being able to sell the extra bread. It is this extra money that, in his own mind, compensates him for the waiting time in constructing the capital good. If we say, for example, that he invested his £100 at the start of the year and by the end of the year his sales had increased by £10 then we may that the return is 10% per year. This return is known as interest, the compensation for the waiting time between the point of saving and the point that the increased quantity of consumer goods is available for consumption (and in this case, when the baker has the money from the increased sales).

Another possibility is that rather than expanding his existing business the baker creates a new one; or he could lend the saved funds to somebody else to invest in their business. Let’s say that he lends the money to a new entrepreneur, the candlestick maker. The candlestick maker has himself also saved £100. for his new business and so, together with his own saving and the money lent to him by the baker, he has a total investment in his firm of £2007. The candlestick maker will then take that money and spend it on the fish (or other goods) that will sustain him in producing the capital goods needed for his new candlestick business. Let us say that this business is successful and, at the end of the year, the resulting sales means that the value of the business has increased from the initial £200 to £220 – the original £200 capital and £20 return on that capital as a result of increased sales. This £20 will be divided between the baker and the candlestick maker depending on the terms of their investment, but overall the firm has received interest of 10% per annum.

We have, of course, left out of this simplistic calculation the fact of depreciation – the wearing down of the capital goods during their use in production. Suffice it to say here that at the end of the year the original amount of saving reckoned in money terms will be less than £200 owing to the depreciation of the capital goods in the venture. More on this can be read here].

Another aspect we have deliberately ignored is entrepreneurial profit and loss. The rate of return that any one person needs to receive to induce him to save and invest is the interest return – the compensation for waiting. We have assumed in all of the illustrations above that any saving and investment will for sure result in the return that is expected. But this is never the case in real life – the actual return may be greater than, less than, or equal to what was expected. In all cases, then, the actual return will consist of:

Interest + Profit/Loss8

Going back to our original lone human, he may find that his wheelbarrow actually is only enough to bring him an extra two logs per day whereas he originally wanted three. His return will therefore consist of an interest return of three logs and a profit/loss of negative one log. Or, he may be delightfully surprised to find that his wheelbarrow is enough to bring in four logs per day in which case he will earn interest of three logs and profit/loss of one log. Or, the most disastrous of all outcomes would be that he finds the wheelbarrow is a complete hindrance and, in fact, means that he is able to harvest fewer logs than he was with his bare hands! Let’s say he can only bring home two. In that what is earned is interest of three logs and profit and loss of negative four logs. The real loss that he experiences is much higher than the nominal loss of logs – four and one respectively – as, at the time he decided to save and invest, he needed a return of three logs to justify the waiting time. Although he only appears to lose one log by erroneous construction of the wheelbarrow his actual loss is much greater because of the waiting time he endured. In our complex economy, profit and loss takes the form of having to anticipate that other people will want to purchase the additional produce that is enabled by the capital good. If the actual selling price of the final goods is more than what was needed to induce an entrepreneur to save and invest then this represents an entrepreneurial profit. If it is less than he suffers an entrepreneurial loss9.

It is not necessary for the reader to dwell too much on the intricacies of profit and loss in order to understand the role of capital in increasing wealth. An elaboration is offered here merely for the sake of a degree of completion. Interest, however, is vital in understanding the role of capital. It must be emphasised again that people will begin to save and invest in capital goods when the resulting outlay of consumer goods is higher than what could be produced without the capital goods, and this outlay must be sufficient to compensate for the waiting time in which the capital goods are constructed. In short, people must make a choice between having fewer goods to consume today or more goods to consume at a future date. The number of additional goods that a person wants to appear at the future date to induce saving is his interest return. Whether this return actually appears or not and to what degree determines his profit and loss. But it is this desire to consume more in the future, to abstain from consumption today for a lot more of it tomorrow, that enables the economy to grow and for wealth to expand. There is no other way than by saving and investment in capital goods.

In the complex economy, of course, everyone can be savers and investors and we do so in a multitude of different ways and through different channels. Anyone who earns a wage and then spends a portion of it on his monthly outgoings (i.e. consumption) and uses the remainder to, say, deposit in a savings account, or to buy bonds or shares is investing in capital goods and increasing the capital stock of the economy. If it is saved in a savings account, the bank will lend that money to companies who will use it to invest in the capital goods, the return on which will enable the bank to pay interest to the depositor. If stocks or bonds are bought then money is advanced to a company directly. The crucial aspect is that by saving money, you are not consuming. By investing it you are turning those goods that could have been consumed today into capital goods that will produce more goods to be consumed in the future.

Having therefore examined in some detail the role of capital in wealth accumulation and raising the standard of living, let us proceed to analyse some aspects of Government interference that will affect the rate of saving and investment.


Taxation is the deliberate confiscation by the Government of that which has been produced. It must be emphasised that all taxation, whatever name it is given, however one may attempt to justify it, must be a taxation of produce. There must be something that has been produced that the Government can come along and take. In our example of the lone human, the Government would have come along and taken some of his logs, i.e. confiscated his produce directly. In the complex economy the Government tends not to confiscate produce directly but rather money which it then spends on produce, i.e. the produce that the taxed individual could have bought is diverted, by way of money, to the Government.

From our analysis of saving and investment above we also know that there are only two types of produce that can be taxed – that which is produced today (income) and that which was saved and invested (capital, or wealth). There is nothing else that can be taxed and all taxes are either taxes on income or on wealth. What are the implications and results of each? Let us deal with the material effects first of all. If the Government taxes income, that is, the presently produced product, we know from our analysis above that it can do so up to a point which still permits enough saving to maintain the existing capital stock. If it does this, the present level of production can continue as the capital goods will keep functioning. However, for the remainder of the produce that is confiscated, there will be less saved in the hands of private individuals and entrepreneurs to invest and increase the capital stock. Capital growth, therefore, will be retarded. And even if the private individuals would not have saved this income but would have consumed it, it is still the case that they have suffered a loss from the fact that the produce is directed towards Government ends rather than their own. The important point is, however, that taxation retards the ability of private individuals to grow capital and increase production and, hence, the standard of living must either stagnate or improve less quickly.

It is no answer to this charge to assert that Government might take this money and spend it on allegedly “important” capital projects such as roads, schools, hospitals, and other spending on what they like to call “infrastructure”. As we noted above it is not the capital stock that is so important but rather the capital structure. For the invested capital must take a form in which it meshes cleanly with the rest of the existing capital and its produce supports the production of goods further down the chain of production. It would, for example, be useless to bring a fishing net to a cattle ranch. The only way to determine whether capital contributes to the capital structure is through the pricing, profit and loss system – that capital that is successfully producing generally needed products to create further products will turn a profit for the enterprise. But how does Government, devoid of the need for profit and loss, know that, say, a factory or a road must be built? What if it diverts its taxed resources to building a grand factory but there are no machines to put in this factory? How does it know how large the factory should be, what it should produce, etc.? No Government has any method of gauging these criteria. Our lone human, we noted, needed in his capital structure an axe to fell trees and a wheelbarrow to transport the logs. Having instead two axes or two wheelbarrows would have been of no use to him. Precisely the same is encountered when Government produces roads when there are no cars, hospitals but no operating equipment, tractors but no plough, railway locomotives but no wagons. Such was frequently the case in the former Soviet Union where buildings and machinery frequently were lying incomplete because a crucial part had received underinvestment and hence was simply missing. It is true, of course, that the capital structure that remains in private hands will adapt to the capital that Government has forced upon it. If a Government produces a road, for example, it becomes more economical to increase the production of cars in order to fill it. But all this means is that private investment has been forced to adapt to what the Government has produced whereas these Government projects are frequently sold to the public as being necessary to “boost the economy” etc. Instead the capital structure has been twisted and distorted from the form that it would have taken had it been left alone and the structure that is in fact produced is serving ends that are relatively less valuable than those that would have been served in the absence of the Government interference. As Bastiat would put it, the Government may be able to point to its wonderful roads that are full of cars (that which is seen), but what is not seen is all that was not produced as a result of this diversion of funds10. It is for this reason that, economically, all Government spending must be regarded as waste spending.

However, what if the Government initiates an even higher level of income taxation, a level that does not permit enough saving to main the existing capital stock? Then, disaster will strike. For now the existing capital stock will start to wear down and cannot be replaced. As the capital structure collapses, production will decline and so too will the standard of living. Production processes will become shorter and less roundabout as the produce that could have maintained them is siphoned off into Government consumption. The situation is exactly the same as if the lone human consumed the logs that should have been diverted to maintaining his wheelbarrow. He enjoys, for the moment, the additional consumption of the log but at the expense of a severely reduced level of consumption in the future. But when the Government taxes income at such a level the private citizens do not even get to enjoy this temporary upswing of consumption, merely the bureaucrats and politicians whose lifestyles it is supporting.

Within this category of taxation of income we may place all of the everyday taxes from which people suffer – income taxes, sales taxes, excise taxes, corporation taxes, capital gains taxes, dividend taxes, VAT, etc. Anything that is a tax on productivity or newly produced good is a tax on income.

Finally, we consider the horror of horrors – when Government doesn’t tax the presently produced product but instead directly taxes the existing stock of capital. Within this category fall inheritance taxes, property taxes and wealth taxes. The results of such action should be obvious as it deliberately sets about consuming the capital stock. It dismantles the factories, machines and tools and diverts them towards Government consumption and even if the Government diverts them to “investment” then this will simply be of the same kind of Government “investment” that we just outlined with regard to income taxes. Wealth taxes are the most ruinous and destructive, attacking the very means of production and leading to a rapid decline in output and the standard of living. The situation is precisely analogous to our lone human chopping up his wheelbarrow and using it as firewood – there is a temporary increase in enjoyment today that must be offset by a very rapid decrease tomorrow.

It is at this point that we should consider all “soak the rich” taxation rhetoric and practice. For it is usually the point of view of politicians and the non-rich that the wealthy provide an inexhaustible slush fund that can be plundered and pillaged to serve whatever “needs” might be desired. Earlier we noted that there is a tendency (although not strictly a necessity) that as income increases the proportion of that income that a person devotes to consumption decreases and the proportion that is devoted to saving and investment increases. Therefore, while the rich consume more in terms of quantity than a poorer person, as a percentage of their overall income they consume far less. A person earning an income of £1 000 per month might consume £800 worth and save £200, a consumption rate of 80% and a saving rate of 20%. However a person earning £10 000 per month might consume £3 000 and save £7 000 – a consumption rate of 30% and a saving rate of 70%. So while the rich person is visibly consuming more in terms of quantity he is saving and investing a very great deal more. This saving and investment is obviously channelled into capital goods, goods which are used in the production of consumer goods that other people can buy. By increasing the supply of consumer goods the prices of these items drop and so they become more affordable to everyone else and the general standard of living increases. To the extent that the “rich become richer” through this process it is only because they invest in those capital goods that produce the wares that are most eagerly sought for by the masses. Indeed the only way to really become rich under conditions of free exchange is to abstain from consumption and divert your savings to that which people most want to buy11.

If the Government therefore sets about taxing the rich to what extent can it do so? It should be clear from our analysis that it can tax the proportion of the rich person’s assets that comprise his consumption spending. If this is done then what the rich man would have spent on fine dining, chauffeurs, exotic holidays etc. is simply diverted to Government spending. The capital structure remains untouched. But the amount of consumption spending by the rich is extremely limited; indeed if all of it was to be confiscated and distributed to the world’s poor there would barely be enough to give everyone a handful of pennies. Therefore, if taxes on the rich are to be increased then they must start attacking the saved wealth of the rich, that is the capital structure. In short, factories, machines, and tools – the very things that were churning out affordable products that the masses wanted to buy – are liquidated and diverted to Government uses, either to Government consumption or to a form of investment that, as we noted above, must necessarily be less valuable than that which existed before. The very worst thing that can be done is to tax the capital stock and distribute it in welfare for then the saved wealth of society is quite literally transferred from those who saved and invested it to those who consume and destroy it. With fewer machines and tools there will be less production, with less production there will be fewer goods, with fewer goods there are higher prices and with higher prices there is less that everyone is able to buy.

We might conclude this section, therefore, by saying that from the point of view of the standard of living, all taxation will retard its level or growth. However, that form of taxation which decays the existing capital stock is the most destructive. Wealth taxes, inheritance taxes, property taxes and their ilk should be firmly resisted.

It is not sufficient, however, to merely consider the material effects of a policy of taxation, wherever it may fall. We also need to consider the psychic effects. It is self-evident that all taxation is a confiscation from one set of persons and a distribution to another set of persons. Those who have had their goods confiscated must be producers; those who receive in distribution must be (relative) non-producers. Indeed, usually some kind of non-productive status is what qualifies a person as a recipient of welfare spending – poverty, illness, disability, etc. It is an axiom of human action that all humans devote their energies to that which has the most benefit for the smallest cost. We endure the toil of labour because the loss experienced in doing so we deem to be worthwhile for the value that is gained as a result. The same is true of consumption and investment. Each has its own benefits and costs. The benefit of consumption is the enjoyment that it provides to the mental faculties; its cost is the labour expended in production of the article to be consumed and that, once it is consumed, it is gone forever and cannot be devoted to an alternative or additional use and further needs must be met by increased production. The benefit of investment is an increased yield of consumer goods in the future; its cost is the pain of having to deny oneself the consumption today of the goods that will be added to the capital stock.

If there is any change in the relative proportions of these benefits and costs it follows that certain activities will become more attractive (i.e. more valuable) and others will become less attractive. Yet this is precisely what the effects of taxation are, effects that fall heavily upon the impetus to produce, consume, or invest. We noted earlier that a person will start to invest at the point that the increased quantity of goods that results from the investment is sufficient to compensate him for the waiting time necessary to produce the capital good. Yet if the fruits of this productivity are taxed it means that the yield is reduced. To the individual saver and investor, the benefit of saving and investment has declined, but the costs remain the same – he must still expend the same amount of labour and must endure the same amount of waiting time but only now for a smaller yield. The value, therefore, of investing will, to him, decline and consumption will become relatively more attractive. There will therefore be less investment and more consumption, lower output and the standard of living will decline. It gets worse, however, when we look to the recipients of taxed income or wealth. For in a world where there is no tax, the enjoyment of consumption must be outweighed by the costs of production and the incentive to invest. Only if the value of consumption is higher than the toil of production and the yield from investment will consumption be carried on. But if one now receives an income free of the necessity to produce, both of these costs are removed. For now, why should one labour to produce when he can simply receive the benefit – the enjoyment – for free? And why should he invest when he can simply demand another article from the Government once he has consumed the first? And even if he did invest his income from other people’s taxes, this will simply be taxed away anyway. Why bother?

In short, therefore, taxation reduces the relative value of production and investment. It increases the relative value of consumption. There will therefore be less production and investment and more consumption, the stock of capital will decline, output will decline and the standard of living will lower also.


Regulation is, in common social democratic discourse, deemed to be a necessary tempering (or tampering, one might say) of the otherwise capitalist economy, the wise overlords stepping in and ensuring that people do not compromise “safety”, “quality” or whatever in their supposedly lustful pursuit of profits. We will leave to one side any discussion of the fact that regulation is itself a service that consumes scarce resources and that the benefits of a regulation must be offset by its cost – hence it is a market activity just the same as any other. Rather, we shall focus exclusively on the effects of Government (i.e. forced) regulation upon saving and investment in the capital stock.

The effect of a regulation is to ban a certain activity from being carried on by otherwise free individuals; an example would be a restriction on to whom a certain product can be sold, perhaps by age or income. Or, it can take the effect of a requirement to do so something, usually before something else can be done. For example, it may be required to provide a list of ingredients or a nutritional breakdown on an item of food before it can be sold. However sensible they may seem the effect of regulations is to limit the ends to which capital may be devoted.

Let us first of all consider regulations that take the form of bans. As we noted above the incentive to save is dependent upon the fruits of production that are the result of the investment. In a free market a person can invest in whatever he thinks people will want to buy. By advancing goods and services to meet people’s ends he earns a return. The public could, for example, in the saver’s estimation be demanding more of goods X, Y and Z. He will invest in the line of production that he believes will yield the highest return. But what happens if the Government then intercedes with a regulation? It is effectively saying to the investor “you may invest in goods X or Y, but not in good Z”. In other words, an entire avenue of investment opportunity is closed off even though both the public and the investor may wish to trade the good Z. What then happens if Z was the most profitable investment? Then, by having to invest in the relatively less profitable X or Y, the value of saving and investing to the investor will reduce. Therefore, there will be less saving and less investment. Indeed he might even decide that the profit opportunities afforded by X or Y to be insufficient to reward him for the waiting time between the act of saving and the receipt of returns. He may just decide to consume entirely that which he would have invested. The amount of capital investment therefore decreases and so too does the standard of living. But even if he does invest in X or Y this is not what the buying public are demanding – they want Z and no extra amount of X or Y will compensate for this loss.

However, the more common type of regulation is of the second kind – that a product may be invested in but there are regulatory requirements that must be met before one can do so. Let us take the typical type of regulation on which the Government feels itself qualified to pronounce judgment and that is health and safety. If the public demands food, for example, it may be perfectly happy to buy food that comes without any detail of ingredients or nutritional breakdown. The Government then decides that people aren’t giving enough thought to their health (probably as a result of them being able to get free healthcare, which has been dealt with in detail here). So the Government then steps in and says to the investor “OK, you can invest in food but to do so you must provide a list of ingredients, a nutritional breakdown and, with every sale, you must provide a free fact sheet of how to live healthily.” The effects of such an edict should be clear – for every article that is now sold, the investor must spend additional money on analysing every article of food for its ingredients and nutritional content and must spend even more money further on producing the factsheet. Yet the public are not demanding these things so they will not be willing to pay any more for the articles that are purchased. The effect of this regulation, then, is to increase the amount of capital that is needed to produce the same return. Or, to put it another way, the same amount of capital produces a lower return. So once again, then, the value of investing to the investor is lowered and there will be less of it. By heaping on to production artificial, deadweight costs that serve no one capital is simply consumed purposelessly. It is conceivable that regulation may cripple an industry so much that it deters all investment and investors will simply stop producing the regulated products altogether. In practice what tends to happen is that regulation forces out the smaller investors, the upstart companies, while the big players are able to absorb the added costs. The economy is then left with a few key providers in each sector who are able to raise prices and lower quality as a result of this insulation from competition.

Regulation is therefore one of the most powerful ways in which capital investment can be restricted, possibly even more so than taxation.


The final aspect of Government intervention into saving and investment we will consider is that of uncertainty. Whereas before we were analysing the effects of known Government policies on taxation or regulation, here we will look at what happens when someone simply doesn’t know, or cannot be sure of, precisely what the Government will do.

Rothbard describes succinctly the role of uncertainty in human action:

[A] fundamental implication derived from the existence of human action is the uncertainty of the future. This must be true because the contrary would completely negate the possibility of action. If man knew future events completely, he would never act, since no act of his could change the situation. Thus, the fact of action signifies that the future is uncertain to the actors. This uncertainty about future events stems from two basic sources: the unpredictability of human acts of choice, and insufficient knowledge about natural phenomena. Man does not know enough about natural phenomena to predict all their future developments, and he cannot know the content of future human choices. All human choices are continually changing as a result of changing valuations and changing ideas about the most appropriate means of arriving at ends. This does not mean, of course, that people do not try their best to estimate future developments. Indeed, any actor, when employing means, estimates that he will thus arrive at his desired goal. But he never has certain knowledge of the future. All his actions are of necessity speculations based on his judgment of the course of future events. The omnipresence of uncertainty introduces the ever-present possibility of error in human action. The actor may find, after he has completed his action, that the means have been inappropriate to the attainment of his end.12

It follows from this excerpt that an increased degree of uncertainty leads to an increased possibility of error – that there is an increased likelihood that the scarce goods used in attainment of the end will, in fact, not attain the end and will be wasted. And, as Rothbard highlights, part of the composition of this uncertainty stems from future human choice, in our case the choices of the Government actors.

We noted above that the effect of Government taxation and regulation is to render less valuable the act of saving and investment to the individual. If he knows that he will be taxed and regulated to nth degree then he can, at least, factor this in to his calculations and act accordingly. If, however, the Government creates an aura of uncertainty – that an individual investor may find his fruits taxed or regulated not necessarily to the nth degree but may be to the n + 1st degree, or the n – 1st degree, or to a whole other range of possible degrees, then this weighs heavily on his mind in deciding whether to save and invest. Indeed heaping on uncertainty effectively increases the psychic costs of an action. The greater the degree of uncertainty and the more likely it is that his decision to invest will result in error (the error in this case being that he will suffer a more crippling degree of taxation or regulation than he would prefer) the more costly it becomes. Hence, the relative attractiveness of consumption increases. Indeed, consumption renders neutral this uncertainty – if something is consumed then the Government, for sure, can’t come along later and attempt to tax it away. There will, therefore, be more consumption and less saving and investment. The capital stock will not grow as fast and neither also will the standard of living.

Uncertainty, often labelled “regime uncertainty”, has been an important factor following the 2008 financial crisis and the subsequent malaise. Precisely because nobody knows precisely what the Government will try next, whether it be stimulus, taxes, regulations, capital controls, inflation or whatever, nobody is willing to take the risk to save and invest. Indeed, in the US, the huge increase of excess bank reserves – i.e. banks simply holding onto cash – following the expansion of the monetary base is at least partly explained by the phenomenon of increased uncertainty.


What we have realised through our analysis, therefore, is that capital accumulation is the source of increased wealth and an increased standard of living. Where there are strong private property rights to this capital and its fruits then capital accumulation will, all else being equal, be encouraged. Where these rights are compromised by taxation and regulation, they will be discouraged. Further, as our discussion of uncertainty entails, it is not sufficient that these rights are left uncompromised today but there must also be an expectation that they will not be compromised in the future.

We have not said much about Government-induced credit expansion that leads to business cycles. The effect of credit expansion is to divert goods away from consumption and to invest them in more roundabout production processes. This looks, on the face of it, as if the Government is doing a benevolent thing – it is causing us to increase the capital stock! But as we noted above, the return on capital must be sufficient to justify the waiting time. If people are not willing to endure this waiting time then investment cannot occur. Indeed credit expansion is forced saving and investment in an increased capital stock. When the credit expansion halts it is not possible to continue this diversion of goods into building and maintaining this capital structure; rather the latter now becomes fully dependent upon the consumption/saving preferences of consumers. But these preferences are not sufficient to carry out the level of investment required. The capital structure is revealed as malinvestment and must be unwound. Tragically, the Government, in ignorance of what we have learnt here about waiting times and the necessity for a precise capital structure that meets the needs of consumers, responds to this series of events by trying to boost consumption, even though it is not consumption that needs a shot in the arm. If anything, there needs to be more saving and investing so that at least some of the projects that were embarked upon during the credit expansion can be justified.

All in all the effects of Government upon capital accumulation and the creation of wealth are a disaster. All that is needed for these things to occur is private property and free exchange and Government, if we are to endure at all, should concentrate on guaranteeing these institutions.

1Strictly it is a necessity of human action that it seeks improvement to the current condition. Therefore, simply moving an object out of one’s way or to where one would prefer it to be is an act of “production” and an increase in “wealth” from the acting human’s point of view. But for the sake of simplicity we will discuss production, income and wealth as alluding to driving towards an increase in the number of material, tangible goods that the human can enjoy.

2Here we may briefly consider what the purpose of increasing wealth is. Excluding the possibility that someone gains utility simply from owning a lot of stuff, it can only be to consume in the future. The ultimate aim of all production is consumption, if not by yourself then by your heirs. Production that does not eventually result in consumption gains nothing. This is important for understanding what the human does with his saved wealth.

3We must add emphatically that hoarding is not unproductive and typically takes place in times of uncertainty – when one does not know whether he might suddenly need to call upon extra resources – or to cater for a known period of un-productivity, such as storing food for the Winter.

4Technically speaking if the level of “saving” is insufficient to maintain capital then there is a net dis-saving. As Mises puts it: “The immediate end of acquisitive action is to increase or, at least, to preserve the capital. That amount which can be consumed within a definite period without lowering the capital is called income. If consumption exceeds the income available, the difference is called capital consumption. If the income available is greater than the amount consumed, the difference is called saving. Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption.” Ludwig von Mises, Human Action, Scholar’s Edition, p. 261. However for the purposes of this essay we shall define income as the produced product and saving as the portion of the income that is not consumed, regardless of whether the rate of saving is sufficient to maintain the capital stock.

5Money as well as being the medium of exchange is also is the facilitator of economic calculation without which a complex economy could not exist. Money is also a good in its own right but there is not space here to dwell on the fascinating reasons how and why it comes into existence. Interested readers should consult Ludwig von Mises, The Theory of Money and Credit.

6A word of extreme caution in necessary when discussing the economy in the aggregate. Simply because we say that x amount of produce is consumed or y amount of produce is invested does not mean that it does not matter precisely who is consuming and who is investing. For it matters very much to the particular individuals concerned. If, for example, the baker purchases three cuts of steak from the butcher with the intent to consume all of them but the fishmonger steals them and consumes two but saves one, even though the fishmonger has “saved” one steak that would have been consumed by the baker we can in no way say that the economy is “better off”. The loss of utility of steak consumption to the baker cannot be compared or measured against the gain of utility to the fishmonger who consumes two steaks and saves one. Similarly if a slave is forced to labour to produce bread in the bakery and he gets nothing in return we cannot say that the economy is better as a result for there has been a very real loss to the slave in spite of the bread produced. We can only assume that there are gains in utility when there is voluntary exchange and any analysis of the economy as a whole which results in conclusions of one state of affairs being “better” or “wealthier” than the other must be made under the assumption of voluntary production and exchange.

7Whether someone is a stockholder or a lender to a firm or enterprise is a legal difference, not an economic one. They are both advancing saved funds to further the firm’s ventures but on different terms.

8There is also the possibility of additional compositions of return that we will ignore here. See Murray N Rothbard, Man, Economy, and State, Scholar’s Edition, pp 601-5, although it remains doubtful whether some of these can be distinguished conceptually from existing categories of return.

9Calculated profit and loss in the complex economy is measured against the societal rate of interest which is determined by the societal time preference rate. The societal interest rate is the price at which all willing borrowers can borrow money and all willing lenders can lend it and the success of failure of an enterprise will, by and large, be judged against this rate.

10Claude Frédéric Bastiat, That Which Is Seen and That Which Is Not Seen.

11Capitalism, in contrast to socialist and Marxist myths, has always been a system of production for the masses, of increasing the outlay of basic, everyday items that are sold inexpensively to everyone. Very little of capitalist production is devoted to luxury production for the rich.

12Rothbard, p.7, (italics in original).

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Money, Inflation and Business Cycles – The Pricing, Profit and Loss System Explained


Against all of the fallacious forms of “under-consumption” theories of boom and bust Say’s law stands as a charming and simple rebuttal. Wrongly and ignorantly described as “supply creates its own demand”, a better and accurate formulation is “goods are paid for with other goods”. In short, while recognising that money is emphatically not neutral and is itself a good, goods are supplied by an individual (demand) in return for money, the latter of which is then used to buy other goods (supply).

This essay will use Say’s Law to illustrate that what is meant by “under-consumption” is, in fact, not a dissatisfaction with consumption (or rather purchasing) per se, but rather that the precise structure of production is not in harmony with the valuations of consumers; the distortion of this structure at the height of the boom proceeding to a bust is only the most extreme of this type of instance.

Say’s Law

While emphasising again that money is not neutral and its status as a good in its own right does have an effect on the structure of production, money does not in and of itself constitute demand. Rather, your demand is the goods that you have to offer for sale in the first place as it is these real goods that sustain the supplier in producing what you buy from him in turn. How productive you are determines the effectiveness of your demand as revealed in the precise exchange ratio – if the goods with which you demand are highly valued they will be able to buy more; if they are valued lower they will buy less. In reality this exchange ratio takes place not directly but through the money mechanism. For example:

1 apple          sells for         20p

20p              buys             1 orange

The mere possession of money in this scenario does not constitute demand. For in order to gain money to demand oranges a person must first have supplied apples and the amount of money he receives will be determined by his productivity in producing apples – the more productive he is the more money he gets which in turn allows him to demand more oranges. His demand is linked firmly to his original ability to produce and supply apples. It is not therefore that 20p, the money, is the demand for either one apple or one orange. It is, rather, that one apple will demand a supply of one orange1. In other words, the price of a single apple is one orange and the price of a single orange is one apple.

It follows, then, that if changes in the relative valuation occur between goods then this will be reflected in the exchange ratio between these goods. If, for example, oranges decline in value relative to money yet apples maintain their value relative to money a future exchange rate might be as follows:

1 apples        sells for         20p

20p              buys             2 oranges

In other words, whereas before one apple could buy only one orange, the value of oranges has declined so that now one apple can buy two oranges. Any change in valuation of a commodity therefore necessarily takes effect as a change in the exchange ratio between goods.

Supply, Demand and Prices

In the first place we must be somewhat suspicious of any theory that tells us that there is any under-consumption, i.e. that there is a general glut of everything. For it is suggesting that we suddenly find ourselves in the position of having too much stuff. But this is nonsensical even without any analysis for it implies that humans have suddenly stopped desiring; but human wants are insatiable and we are always striving for more. So engrained in our own experience is this fact that it seems pointless to try and prove it – an abundance of goods, all else being equal, is a cause for celebration rather than for alarm.

If we dig deeper what is really meant when there is a “general glut” is that the costs of producing goods cannot be recouped by their selling revenue, in other words that all goods are experiencing losses. But this is nonsensical because the very existence of a cost means that there is an alternative use for the capital goods that produced the final good – if a loss is experienced then it means that some other good was more highly valued than the good that was in fact produced. It is therefore impossible for there to be a general glut of all goods as the very reason for the glut – the existence of costs – presupposes that there is a demand for some other good. But if capital was misdirected and should have been used to produce another good then it follows that there is not a glut of this latter good at all but a relative shortage.

Let us take a hypothetical economy where all the only goods are fruit. Let’s say that there are twenty apples, twenty oranges, twenty bananas and twenty pears. Let us also say that it takes the use of one unit of a piece of fruit to produce a single unit of another piece of fruit and so that, in equilibrium, the exchange ratio of the different fruits will be as follows:

20 apples:20 oranges:20 bananas:20 pears

I.e., that there is a final exchange ratio of 1:1:1:1. When one fruit trades for a single fruit, there are no profits and no losses. If the apple producer, for example, trades ten of his apples for ten oranges, he can use them in production for ten more apples – in short, the cost of ten apples has yielded a revenue of ten apples. The same is true of the orange producer – he has bought ten apples with oranges which he used to produce ten more oranges, a cost of ten oranges netted against a revenue of ten oranges. Total profit and loss is zero and the economy is in a state of equilibrium.

What happens if the above numbers are multiplied – i.e. if there are forty, sixty, one hundred, one thousand or one million of each fruit? Does it make any difference? Not at all as one fruit will still trade for one other fruit which can be used to produce another piece of fruit. No fruit will be able to sell at a loss (or at a profit) and nothing will remain unsold. More of each fruit in the same ratio simply indicates a more prosperous economy than one where there are fewer pieces of each fruit.

What about, however, where the ratio of fruits is altered? Let’s say that, instead of there being twenty of each fruit there are, in fact, 10 apples, 10 oranges, 30 bananas and 30 pears. It still takes one of each fruit to produce one other fruit (i.e. the demand curve has not shifted). So what has happened to our exchange rate? It will be as follows:

10 apples:10 oranges:30 bananas:30 pears

In other words, 1:1:3:3. So now, one apple will still trade for one orange, but for three bananas or three pears. But as the production of one piece of fruit still requires only one piece of another fruit there will now be relative profits and relative losses. The apple producer, for example, can now use one apple to buy three bananas with which he will make three apples – a cost of one apple versus a revenue of three apples. The same is true of the orange producer. The poor banana producer, however, suffers. He has to spend three bananas to purchase one apple with which he can only produce one banana – a cost of three bananas versus a revenue of one banana. The same is true of the pear producer. We therefore have an instance of there being two fruits – bananas and pears – that are unable to sell for enough in order to cover their costs. But this is not a general glut, for we also have two fruits whose revenue more than covers their costs. Resources will flow out of banana and pear production and into apple and orange production, increasing the number of apples and oranges while decreasing the number of bananas and pears. The result of this is that the purchasing power of apples and oranges will fall again and that of bananas and pears will rise again, reducing the profitability of the first two industries and the losses of the latter two. This will continue until an equilibrium is restored with an exchange ratio of 1:1:1:1 and no industry is either profitable or loss making.

The result then is that there can never be a general glut of all goods, but rather specific gluts of particular goods that were not preferred mirrored by specific shortages of other goods. And as we know from our analysis of Say’s Law above these costs are ultimately expressed in terms of other goods relative to each other, i.e. the exchange ratio will widen as their values diverge.

How does this happen on the real market? Obviously gluts and shortages don’t just appear as they did in our example above; but rather, they result from the ever-shifting demand curves of consumers which have to be foreseen by entrepreneurs. For example, if entrepreneurs invest heavily in apples when in fact the public wants oranges, the capital that would have produced oranges is diverted to apples. The resulting glut of apples and relative shortage of oranges may mean that it takes five, ten or twenty apples in order to demand a single orange. If this low selling price for apples is insufficient to pay the costs of production while the high selling price for oranges results in a bumper profit for the foresighted entrepreneurs who stuck to producing oranges, then it follows that resources will flow out of apple production and into orange production until an equilibrium is restored where both apples and oranges will exchange at a ratio where they are both able to cover their costs of production.

However, as the valuations of consumers are always changing the hypothetical state of equilibrium will never be reached and there will always be relative gluts of some goods that have been overproduced and relative shortages of goods that have been under-produced.

Nothing about any of this is a cause for alarm – it is the task of entrepreneurs to adjust the structure of production to the tastes of consumers and in the normal run of the mill, so to speak, nothing about this will cause any great or dire need for concern. What we shall see, however, is when there is monetary intervention in the forms of inflation and credit expansion, very wide dislocations between the goods that are demanded and those are supplied occur, leading to extreme gluts and shortages. The analysis of these instances is no different from simple dislocations, but what will be revealed is that any attempt to “boost demand” merely ends up perpetuating the production structure that is failing to meet the ends of consumers in the favour of those producers who are selling loss-making goods.

Simple Inflation

At any one snapshot of time there is a fixed stock goods in the economy. Let us return to our hypothetical fruit economy with the same stock of goods and the same exchange ratios so that

20 apples will buy 20 oranges, or 20 bananas, or 20 pears.

In other words there is once again exchange ratio of 1:1:1:1. In the economy where money has to be earned, no one can spend without first producing real goods. So if a melon producer now produces sixteen melons and (once again, assume that one melon exchanges for one piece of any other fruit) and decides to purchase with them sixteen apples, the stock of goods in the economy will now be four apples, sixteen melons, twenty oranges, twenty pears and twenty bananas. The exchange ratios will be thus:

4 apples:16 melons:20 oranges:20 bananas:20 pears

While apples have now become more expensive relative to any other fruit (a whole five oranges, for example, is now needed to purchase one apple whereas before only one was needed), melons have become cheaper relative to any other good. Overall, therefore, what has been lost in apples has been gained in melons.

The additional purchasing power of apples caused by the demand of the melon producer spurs the apple producer into producing more. What can he do? As he has sixteen real melons he can use these in the production of sixteen more apples, thus restoring the total stock of goods to twenty apples, twenty oranges, twenty bananas and twenty pears. There has therefore been a productive exchange on the market. What was demanded by the melon producer in apples was supplied by him in melons, permitting the apple producer to fund his subsequent production of more apples. Crucially, however, as the purchasing power of other fruits was not diminished the profitability of these industries did not decline and they could carry on as before.

The fact that all of the exchanges take place in the real economy through the medium of money is of no consequence to this analysis. For in reality, the melon producer would have sold his melons to a third party, X, for money and then used the money to purchase the apples. X might have used the melons to produce pomegranates and then the apple producer uses his money received from the melon producer to buy pomegranates, the latter being used by him to produce more apples. The important point is that goods are trading for other goods and that the production of new goods must be funded by other goods.

What happens, then, when new money is printed? Is it possible for economic prosperity to be delivered by the printing and spending of new money? Let us return to our original array of goods – twenty apples, twenty oranges, twenty bananas and twenty pears. If the Government prints more money it has to spend it on these existing goods. Let’s say that, with the new money, it decides to buy sixteen apples. Does this new money in the pockets of apple producers entice it to spend more, which in turn causes their suppliers to spend more and so on until we reach ever dizzying heights of prosperity? No. For the problem is that no new real good has been supplied by the Government in return for its purchase and consumption of apples. Whereas the melon producer compensated for his consumption of apples by producing melons, all that has happened when the Government has printed more money to spend on apples is that the total of stock of all goods has declined by sixteen apples. As the stock of apples has declined relative to other goods the purchasing power of apples has risen accordingly. Instead of twenty fruits now trading for twenty others we now have:

4 apples:20 oranges:20 bananas:20 pears

What is the result of this? As the purchasing power of apples has now risen it means that this industry has become extremely profitable – with a single apple can be purchased five of any other fruit which can be used in production of five more apples, i.e. a cost of one fruit producing a revenue of five. All of the other industries, however, have now suffered relatively rising costs and lower revenues as they will each have to spend five fruits to gain one apple which will in turn produce only one of their particular fruit. What happens, once again, therefore is that resources will shift out of the orange, banana and pear industries and into the apple industry, reducing the relative surplus of the first three fruits and relieving the relative scarcity of apples. This process will stop when none of the industries can make either a profit or a loss, i.e. when one fruit again exchanges for one fruit. The shortest way for this to occur is for the apple producer to purchase four oranges, four bananas and four pears and to use them in the production of a total of twelve apples. The resulting array of goods will now be as follows:

16 apples:16 oranges:16 bananas:16 pears

What therefore is the result of the inflation? It is simply a reduction of the total number of goods available in the economy. Whereas before there were twenty pieces of each fruit now there are only sixteen. The Government, in failing to compensate for its consumption of apples with a supply of real goods in return, has simply reduced the total stock of goods by sixteen fruits. The earliest receivers of the new money, therefore, have received a benefit – the Government by being able to buy apples it hasn’t paid for in other goods and the apple producer by being the favoured receiver of the Government’s new money is ensured continuous profitability as its selling prices rise before its buying prices do. For everyone else, however, who receives the new money later, buying prices have risen faster than selling prices. They experience losses and a relative degree of impoverishment. Finally when the effects of inflation have worked themselves through the economy the result is a net loss for the economy as a whole.

This would be the effect of a one-shot inflation – the structure of production being left relatively intact but at a lower level. Things are much worse, however, when the inflation is continuous. For now, the Government keeps on buying apples with its newly printed money and not refunding this consumption with any real goods. What will happen, therefore, is that apples will be in continuous short supply relative to other goods and resources will continuously shift out of the production of other fruits and into apple production. The fruits furthest away in the supply chain from apples will suffer the most and eventually go out of business as their fruits remain permanently in high supply relative to the artificially created shortage of apples. There will be a permanent change in the structure of production in favour of the Government and its preferred suppliers at the expense of everybody else, resulting in an overall loss and reduction of total goods.

The Business Cycle

Whereas in our example of simple inflation the dislocation to the structure of production took place between different consumer goods, when it comes to the business cycle the disharmony caused is that between the demand of two classes of goods – consumer goods and capital (producer) goods. The artificial credit expansion fuelled by monetary inflation deludes entrepreneurs into thinking that more resources should be channelled into producing capital goods and fewer resources should be devoted to producing consumer goods, against the real wishes of consumers. Resources flow out of consumer goods and into capital goods. The end of the monetary inflation reveals the illusion – consumers did not have a rate of time preference and consequent rate of saving that makes the investment in capital goods profitable. The resources devoted to the production of capital goods should have been directed towards the production of consumer goods. There is, therefore, a specific glut of capital goods and a specific shortage of consumer goods. From Say’s law what this means is that consumer goods will command a high selling price in terms of capital goods and capital goods will command a low selling price in terms of consumer goods. Resources need to flow out of capital good production and into consumer good production until an equilibrium is restored where both are meeting their costs.

Indeed, economic crises are always crises of capital and not of consumer goods. This fact is often masked by the nominal price inflation of the boom accompanied and the subsequent deflation of the bust as the supply expands and contracts respectively. During the boom it is true that all prices, those of capital and consumer goods, rise and so there is a tendency to think that there is an all round prosperity. But what is really happening is that the prices of capital goods rise faster than those of consumer goods, so that there is a shift in the real price relationship (expressed in terms of goods) between consumer goods and capital goods. Once the bust happens, there is a corresponding deflation of all prices leading to the apparent view that the entire economy is suffering. But the reality is that the prices of capital goods decline faster than those of consumer goods so that, in real terms, the prices of consumer goods rise and those of capital goods fall as resources move out of the latter and into the former.

Indeed it is ironic that under-consumptionists view the alleged “problem” of the bust as a lack of consumption causing economic stagnation. For the reality is that there is no problem with consumption at all and it is in fact the desire for consumption that has been frustrated during the boom. If anything there needs to be less consumption and more saving so that the relative shift of goods out of the capital goods industry is less severe and at least some of the projects that were embarked upon in the boom may have a chance of achieving profitability (hence Government deficit spending – rampant consumption – only makes the bust even more painful). But unless that is desired by consumers it is futile to go on inflating and pumping in more credit as the structure of production that is so out of kilter with the desires of consumers is simply perpetuated as a lifeless zombie.

The Demand for Money

Up until now we have been considering cases where the relative gluts and shortages in the economy are between real goods with money serving only as an intermediary between goods. However money, or more accurately, the desire to hold money is itself a good that serves an end in its own right. Money is the most marketable of all goods and holding it provides a degree of reassurance that holding other goods does not. The desire to hold a larger cash balance, all else being equal, therefore reveals a degree of uncertainty on the part of its owner, an uncertainty that is hedged by the ability to quickly use cash to exchange for whatever goods and services are needed in the period of uncertainty. Holding money therefore in and of itself providers a satisfaction in much the same way as a real good does. So what happens, then, when the relative gluts and shortages involve not surpluses of goods against shortages of other goods, but surpluses of goods against shortages of money? In other words, when the demand to hold cash rises? Surely now our under-consumptionists can hold validly that everything will remain unsold as everyone scrambles to soak up more cash and the whole economy will collapse into a depressing slump?

The simple, and orthodox, “Austrian” answer to this apparent problem is that if the demand for cash suddenly rises then everyone must sell goods. The sudden influx of goods onto the market increases their supply resulting in a reduced price of each good in terms of money. But in terms of the ratio of goods to goods there needn’t be any change at all. For example, if the following exchange ratios existed before the demand for cash rises:

1 apple          sells for         20p

20p              buys             1 orange

The ratio of the apple to the orange is 1:1. But if the demand for cash suddenly rises such that the money prices of all goods declines then the following exchange ratio may result:

1 apple          sells for         10p

10p              buys             1 orange

Whereas the exchange ratio between goods and money is now lower, the exchange ratio between goods is the same. Exactly the same real trade in terms will therefore take place, just at lower money prices.

Indeed it is for this reason that deflation is not a problem for the running of business. For what matters for businesses is neither rising nor falling prices but the differential between their revenues and their costs. If both their revenues and their costs are falling then it is still possible to make a profit and to expand business. Indeed, the period between the dawn of the Industrial Revolution and the eve of the New Deal era was generally one of a long, secular deflation and this was the most productive period in the whole of human history.

However the story is not so straightforward for it is in fact true that a greater demand to hold cash changes the structure of production but not its level. As we noted earlier, cash is it self a good and the demand to hold cash is itself an act of consumption. An increase in the demand for it is, therefore, an increase in consumption and results in a higher societal time preference and a rise in interest rates. Indeed this makes intuitive sense. If the holding of a cash balance is a hedge against uncertainty, a higher degree of security will be accompanied by a willingness to engage in more roundabout methods of production and to exchange present money for assets that promise to pay a greater amount of money in what is, relatively, a certain future. If that certainty disappears, however, people begin to prefer liquidity today rather than liquidity tomorrow, curtailing their investment in future goods and selling them for cash now. Societal time preference and, therefore, the rate of interest rises. The selling price of the monetary commodity – e.g. gold or silver – will rise while its costs of production will fall, so that resources will shift into the gold or silver mining industry in order meet the new demand for money. There is therefore no reduction in production, merely a shifting of production out of lengthier, roundabout production processes and into the production of a) the monetary commodity, and b) lower order producer goods and consumer goods that can quickly be bought with the hoarded money when adverse conditions arise2.

Societal Profits and Societal Losses

The foregoing analysis gives the impression that a profit that appears somewhere in the economy (i.e. a relative scarcity) must be offset by a loss somewhere else in the economy (i.e. a relative glut). Is it true, therefore, that societal profits are always mirrored by societal losses?

Accounting profits are an excess of revenue over cost – that a firm has paid out less money that what it has received. Losses are the opposite, a firm paying out more money than what it receives in revenue. If all cash income was added to a firm’s profits and all cash expenditure added to its losses then it would be true that societal profits would equal societal losses as no firm could receive more in revenue than it paid out in expenditure without somebody, somewhere, paying out more in expenditure than they received in revenue in order to fund this difference. Indeed, the social function of all entrepreneurs is to arrange the structure of production in a way so that it best meets the needs of consumers. The decisions they make have to be made in advance, resulting in an appraisal of what it is that consumers will value tomorrow. They subsequently set about incurring costs by purchasing factors of production that they arrange into a production structure that they think will best meet the needs of consumers. If all of the entrepreneurs managed to arrange, on day one, the production structure exactly as consumers wanted it on day two, come that latter day revenue would exactly equal cost. The entrepreneurs would have utilised just the correct quantity of factors and have produced just the right quantity of specific goods that consumers were willing to pay for. No one entrepreneur would have bought too many producer goods and deprived an alternative end of their use, nor would any entrepreneur have bought too few producer goods and permitted too much of their use to alternative ends3. In reality, however, this state of apparent perfection is never reached and the resulting structure of production is never completely in tune with the valuations of consumers. Every structure of production is begat by a forecast, a prediction, or empathetic understanding of the businessman for his clients. It therefore never quite hits the mark and some goods will be relatively over-produced while others will be relatively under-produced. If a firm overproduces then the revenue it received was insufficient to pay for the factors of production, in other words that there were competing ends that were bidding up the prices of these factors and that the firm starved these ends of their means of production. A loss cannot materialise therefore without a corresponding underproduction elsewhere, meaning that revenue for these latter goods was more than sufficient to pay for the factors of production, in other words that these entrepreneurs did not bid up the factors enough to starve the loss-making ends of superfluous production.

So is it true, then, that every successful, profitable businessman is riding high on the losses of someone else? That for every entrepreneur arriving to work in a chauffeur-driven limousine another has been relegated to taking the bus?

Not at all, for it is entirely possible for societal-wide profits (and societal-wide losses) to emerge. This is owing to the capitalisation of durable producer goods. As a durable good is expected to produce revenue-generating consumer goods not immediately but also into the future, the capitalisation of a producer good is the market value of that asset’s future revenue, discounted to allow for the fact that these revenues are future revenues and not present revenues. At the point of purchase, therefore, the good is not recognised as an expense of the purchaser but as an asset (and correspondingly the cash that paid for it will show up on the asset side of the balance sheet of the vendor). No cost at all is shown in the accounts of anybody. Rather, the cost of the good is recognised incrementally over its lifetime as it depreciates, i.e. its use in furnishing consumer goods renders lower its ability to produce goods in the future. Entrepreneurs therefore face a choice – to increase present production and increase present sales revenue but at the same time incur the cost of heavier depreciation charges; or to reduce production and preserve the capital value of the asset but reducing sales revenue. Once again, the entrepreneur has to appraise how many goods to produce today and how many to leave for production tomorrow. If the revenue received from expanding production is exactly equal to the depreciation charge of the capital good (plus other costs) it means that he has exactly produced the favoured amount of present goods at the expense of future goods. The market was willing to pay in present goods precisely what it lost in future goods. What, though, if there is a profit? This means that the revenue received is greater than the cost of depreciation, in other words, the entrepreneur withheld from production more present goods than the market was willing to pay for. Future production will therefore be higher but at the expense of present production. And correspondingly, if there is a loss it means that revenue was insufficient to pay for the cost of depreciation – the entrepreneur produced too many goods in the present when they were more valuable in the future.

Societal-wide profits and losses therefore emerge when collectively entrepreneurs under and overproduce, respectively, present goods. Profits represent entrepreneurial saving – the deferment of present production for future production – whereas losses represent entrepreneurial dis-saving – the ravaging of future production for the sake of present production. And as we know it is saving that is the hallmark of capital accumulation, the increase in production and ultimately a higher standard of living. Dis-saving, however, results in capital consumption, a decrease in future production and ultimately a lower standard of living4.

Does this mean, then, that “vicious” entrepreneurs can simply withhold from present production increasing numbers of goods, driving the profit rate higher and higher and spreading widespread misery? No, for in the first place this ignores the non-capitalised factors of production. If an entrepreneur reduces production in order to drive up profits then he also has to reduce his demand for these latter factors – including non-durable producer goods but especially labour. The cost of these factors will therefore decrease, leading to competitors to employ them, restore full production and reduce the market share of the abstaining entrepreneur. The same would also be true of a cartel. If entrepreneurs in concert decided to restrict production, swathes of non-capitalised factors would become available and eventually the cartel would break when one of the entrepreneurs takes advantage of the opportunity this affords. But the main effect of societal profits is that they afford the ability to expand production. For if depreciation charges are lower than revenue then it means that comparatively less has to be spent on maintaining the existing stock of capital. Entrepreneurs can therefore do one of two things – either expand the existing capital stock, in which case production of the same consumer goods will be increased, thus lowering their price and capturing market share from competitors; or they can invest in more roundabout production processes that will afford the ability to provide more newly introduced consumer goods that have never appeared before. A variant on the second option is that, as entrepreneurial saving represents a fall in societal time preference rates, the interest rate will also fall and new entrepreneurs whose projects were too costly before will now offer to borrow the saved funds and invest them in their more roundabout processes of production. Hence you get the famous “Hayekian triangle” – a production structure that becomes longer and thinner as resources are directed out of producing and maintaining the existing capital stock into producing new capital.

Indeed entrepreneurial profit is simply the corollary of private saving. In both cases an excess of revenue over cost means that consumption is denied to the present in favour of the future, these funds being diverted to new, higher stages of production that result in a greater outlay of consumer goods. The greater the profit margin in the lower stages then the greater this effect will be.

Obviously the opposite happens when profits are reduced – more has to be devoted to maintaining the existing capital structure with comparatively less being used on expansion. If losses are experienced then capital is actively being consumed as there are no funds at all left over to replace the existing stock once it is fully depreciated. Production therefore declines along with the standard of living.


It is clear then that under-consumptionist theories are nothing but a tissue of falsehoods. In summary:

  • Goods ultimately trade for other goods and the production of one good requires the use of other, real goods;
  • General gluts cannot arise on the market; only specific gluts and specific shortages which will become apparent through the price system and ultimately through the exchange ratio between goods;
  • It is the task of entrepreneurs to ensure that these gluts and shortages do not arise, the pricing, profit and loss system regimenting them in the fulfilment of this important function;
  • The business cycle is a specific glut of capital goods and a specific shortage of consumer goods on a wide scale; that the pricing, profit and loss system has been distorted by credit expansion leading entrepreneurs to believe that the economy can support a larger capital structure than it really can;
  • Increased demand for money does not have any effect on the level of production and is no cause for alarm; it may affect the specific structure of production but this is wholly in line with the valuations of consumers.
  • Profits and losses do not offset each other – societal profits and societal losses are possible. Societal profits indicate a lowering of the societal rate of time preference, leading to capital accumulation and the expansion of production; losses indicate a raising of the societal time preference rate, leading to capital consumption and a decrease in production.


1We are, of course, ignoring for the purpose of this illustration the issue of constancy. For more on this see Ludwig von Mises, Human Action, pp. 102-4.

2Whether an economy is operating with a fiat money or a commodity money is what makes the difference between whether an increased demand for cash will leave the time-structure of production unchanged (as in our first scenario laid out above where the exchange rate of goods remains equal) or whether the time-structure will be changed. See Jörg Guido Hülsmann, The Demand for Money and the Time-Structure of Production, Ch. 31 in Jörg Guido Hülsmann and Stephan Kinsella (eds.), Property, Freedom and Society, Essays in Honor of Hans-Hermann Hoppe. See p. 322 for an explanation of how the shift in the time-structure of the economy that occurs under commodity money (but does not under fiat money) better serves the needs of consumers than a production structure that is left as it was before. All we need to note here is that with either fiat or a commodity money the level of production does not change and that there is consequently no depression of business brought about by under-spending or under-consumption.

3This is the hypothetical “equilibrium” state that seems to be the shibboleth of mainstream economists.

4It is, therefore, supremely ironic, let alone wildly inaccurate, that opponents of the free-market charge profit-seeking with the depletion and destruction of the Earth and its natural resources. This fallacy stems from always focusing on the fact that entrepreneurs want to maximise revenue while completely ignoring the fact that they also have to minimise costs. Profit indicates a saving of resources, not their depletion – the entrepreneur has advanced fewer goods than the market was willing to pay for. By incurring costs lower than revenue he has saved resources, not decimated them. It is precisely those assets over which full private property rights (and hence, their capitalised value) are available to the capitalist-entrepreneur that are not in short supply or at any risk of being depleted. For the ever present urge to reduce costs means that they cannot be depreciated more quickly than the market is willing to pay for, otherwise losses will be incurred. Those resources over which there are no private property rights, however – in particular forests, fish stocks, “endangered” animals – are precisely the ones where we experience a depletion. With no one able to enjoy the capital value of these assets and to incur the cost of their depletion against their revenue there is no reason to avoid their decimation.

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