“Austrian” Business Cycle Theory and the Rate of Interest

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In an earlier essay, the present author explained “Austrian” Business Cycle Theory (ABCT) as an analogy to basic price theory, namely the specific law that a price ceiling for a specific good will lead to a shortage of that good. Here we will build on this analogy with an elaboration of what is meant by “the interest rate” with an additional emphasis that stresses the mismatch between the rate of saving and the rate of investing.

The reason for this new elaboration is that ABCT typically concentrates on “the rate of interest”, explaining the business cycle as an effect of “the market rate” of interest falling below “the natural rate”. This has opened “Austrians” up for criticism because any adherence to the pure time preference theory of interest runs into the problem of there being many “natural” rates for different capital goods and so we never know precisely which rate it is that is being undercut by credit expansion1. Moreover we might as well also point out that different borrowers pay a multiplicity of interest rates and that is dependent upon their specific contract so there is no, single “uniform” rate paid by every borrower.

What will be demonstrated here is that, while ABCT’s emphasis on interest rates is valid and is necessary to explain why particularly lengthier, roundabout projects will be engaged in, the most important aspect is that credit expansion simply permits borrowers to access funds for durations that lenders are not willing to lend for and it is this lack of harmony – made clear by our analogy to the results of price fixing – that is the key to unlocking the business cycle.

Robinson Crusoe Economics

In the situation where we have a lone human being (who, for argument’s sake, we shall call John), the fact of scarcity results in the necessity for John to choose which ends he will pursue and which he will discard. There are costs and benefits related to everything he does – such are the logical implications of the action axiom – but exchange of these costs and benefits is unilateral. If John decides to pick apples instead of picking oranges, the benefit he derives from picking apples comes at the cost of picking oranges. He cannot pursue both ends – he therefore exchanges picking oranges for picking apples, albeit unilaterally and in his own mind. This is the nature of basic, simple choices between presently available goods and services.

If John wishes to increase his consumption by investing in capital goods he must also make an exchange, but an exchange of a different nature. At any one moment John will have an array of resources available to him. His basic choice over these resources is whether to consume them now or to invest them to yield consumer goods in the future. It is plainly clear that John cannot do both at the same time – he cannot consume resources and invest them. If he wishes to invest the resources in a capital project that will yield consumer goods in one year’s time then he must be prepared to abstain from the consumption of the resources that he will invest in that project for one year’s time. If the period of investment will be two years then he must be prepared to abstain from consumption for two years, and so on. The precise length of time for which he will abstain from consumption and engage in investment is determined by his relative weighting of the value of time against the value of the quantity of consumer goods yielded – if the quantity of future consumer goods is more valuable to him than the waiting time then he will invest, wait and then enjoy the larger quantity of consumer goods when the investment project reaches its completion; if time is more valuable to him than the additional quantity of future goods then he will not invest but consume the lower available quantity of goods now. The result of such a valuation is summarised simply by the term “time preference”.

Is it possible for John, in his lonely world, to experience the unilateral equivalent of boom and bust? Will he experience a sudden spurt of investment followed by a downturn in his investment activity? The answer is yes, he could, because his capacity to keep on investing is connected solely to his willingness to carry on with the abstinence from consumption of the resources that are required for the investment project to come to fruition. If, half way through his investment project, he changes his mind and his desire for consumption increases so that he must divert resources away from the investment project then he will experience something of a bust – the project must now be liquidated as it has been starved of resources for completion. The viability of the investment project is wholly dependent upon his willingness to abstain from consumption and invest those resources that he could have consumed. The investment therefore turns out to be a malinvestment, unconnected to his consumption/waiting preferences as they are now revealed to be.

Bilateral Exchange

In an economy of more than one person, exchange of a simple good is now bilateral rather than unilateral but it is still based upon the same principles. We make a choice of what to receive in exchange and what to give in exchange. Normally, of course, we give money in exchange rather than a concrete good but we can think of the real cost as being other goods that the money could have bought. If, for example, I only have enough money to buy an apple or an orange and I choose to buy the apple, the cost of me buying the apple is the orange which I could have bought had I not purchased the apple. We can say that I exchanged the orange for the apple, even though the actual physical exchange involved not the orange but, rather, the money that could have been used to purchase it. It is clear, moreover, that I cannot have both the apple and the orange at the same time – or both the apple and the money used to buy it at the same time. I must choose between them because of the eternal condition of scarcity. Only an increase in wealth can alleviate this so that a person is in a position to be able to afford both an apple and an orange.

The market price of a good is the price at which the quantity of the good demanded is equal to the quantity supplied – in other words, it is the price where the number of willing buyers is equal to the number of willing sellers, the level where those who wish to give up in exchange equals the number of those who wish to receive. There is, therefore, not only a harmony of interests at the market price but also the market price regulates the amount of consumption of a certain good that is sustainable by the current level of wealth. Attempts at price controls interfere drastically with this harmony. Artificially lowering the price of, say apples, may, on paper, make it appear as though one now has enough money to buy both an apple and an orange rather than just an apple. The problem, however, is that at the new, sub-market price for apples, the number of willing buyers exceeds the number of willing sellers; the shrunk supply will be bought rapidly by the swollen demand and, therefore, shortages will ensue and there will be no apples left anywhere. This much is standard economic theory. What we can note, however, is that price controls are solely an attempt to allow people to have their cake and eat it – that, whereas at the market price, they could only afford an apple or an orange, the fixed, low price attempts to give them the ability to afford both the apple and the orange at the same time but without any corresponding increase in wealth. On our Robinson Crusoe island we noted that John could not enjoy apples and oranges at the same time because his wealth was insufficient to do this. Any attempt to do so would be at variance with reality and he would end up having to choose between them anyway. Exactly the same law operates in bilateral exchange. Simply trying to forcibly change the prices that emerge in bilateral exchange cannot defy reality and the whole scheme collapses precisely because the objective of providing more and cheaper goods cannot be sustained – you cannot have more of something without increasing wealth. People will find that all of the apples are gone and all that will be left is oranges so they are in the same position as before with only one fruit being available to them, except now without a choice of one or the other. Sustainable trade cannot exist under terms where the suppliers are not willing to offer goods for sale to the demanders.

A further feature of general buying and selling that we might note for our comparison with lending and borrowing that we shall explore in a moment is that every buyer pays the same price as every other buyer and every seller sells for the same price as every other seller. One buyer’s dollars are as good as any other’s and one seller’s good is interchangeable with another’s. In other words, except in cases where there is favouritism or prejudice for the individual personalities, there is insufficient qualitative difference between the different buyers and sellers to make an impact upon price.

Bilateral Investment

On our Robinson Crusoe island we noted that if John wished to increase his consumption in the future he had to abstain from the consumption of resources today in order to use them in investment projects that will yield consumer goods in the future. John’s level of investment was precisely correlated with the amount that he refused to consume and channelled into his project.

In the complex economy, where the abstinence (or saving) on the one hand and the investment on the other is carried out by different people the transaction is effected through the market for lending and borrowing. The market for money loans is actually little different from the sale and purchase of ordinary goods, except that what is being traded and at which prices is a little more difficult to understand. Specifically, what is being traded is not a hard good such as an apple or an orange; rather, it is the purchasing power over resources. A lender, in making a loan to a borrower, transfers his purchasing power over resources today in exchange for the borrower transferring an (at least nominally) higher purchasing power over resources at a point in the future. The market price for these loans – that is, the rate of interest that the borrower pays – is the price at which all willing lenders would be able to lend to all willing borrowers.

There are several key aspects of this market that must be highlighted. First, all loans contracts are for a specific duration which, for argument’s sake, we will say is three years. The lender here must be prepared to sacrifice his purchasing power over resources for three years. During this time, the borrower will use the resources purchased for his investment and will arrange himself to be in a position to transfer back purchasing power in three years’ time. More specifically, what this means is that the lender gives up his power to consume the resources that his purchasing power would afford him and transfers them to a person who wishes to invest them for a three year period that will yield consumer goods at the end of that period, thus earning him an income and the wherewithal to transfer back the purchasing power to the lender. This is the fuel of sustainable growth because the lender relinquishes consumption for exactly the same period as the borrower engages in investment. The basic theory is therefore nothing different from John on the Robinson Crusoe island. Just as John had to abstain from consumption for the duration of his investment project, so too must the lender be prepared to do the same so that the borrower’s project can be completed.

One notable difference of this market when compared to the market for simple, present goods, is that the rate of interest paid by different borrowers will be different rather than uniform for all borrowers. This is because the business of lending money contains an entrepreneurial element. The borrower is making a business decision that his investment will accrue enough income to enable him to pay back the capital and the interest. The lender, wishing to maximise the chance that he will receive his money back, shares this entrepreneurial burden and hence adjusts the rate of interest he charges to different borrowers. The riskiest borrowers – those whose entrepreneurial efforts appear the least likely to succeed – will pay higher rates of interest than the less risky borrowers. There are two possible ways of analysing this. Either we can say that there exists a single market for money loans which, all else being equal, every borrower would pay the same “core” interest rate determined by supply and demand for loanable funds with the difference between the actual rates constituting an entrepreneurial profit and loss element for the lender. Or, we could suggest that the qualitative difference between borrowers creates distinct markets for different categories of lending that attract different rates. In the markets for lending that contain the least risky borrowers the supply of loanable funds will be relatively high so interest charges will be low; in the markets with the most risky borrowers, however, supply will be relatively lower to demand resulting in higher interest charges to these borrowers. We shall use both analyses below although we will conclude with a preference for the latter – that of distinct markets that attract different rates. However, the most important fact that we need to concentrate on is that, whichever analysis we use, all lenders are prepared to fund all borrowers’ enterprises for the duration of their projects under whatever interest rate is agreed and hence these projects can be fully funded to completion.

The fact that the exchange between borrowers and lenders is facilitated by an intermediary – usually a bank – makes little difference to this situation. The bank simply borrows from the lender (or “saver”) at a certain rate and lends to the borrower at a slightly higher rate, the difference between the rates compensating the bank for its efforts in channelling the savings of ordinary people into the profitable projects of borrowers. The key aspect, again, is that there are real funds that can fuel all projects through to their completion under the terms agreed.

Credit Expansion

In order to understand the effects of credit expansion, let us first of all posit the case where a direct lender creates a mismatch with a borrower. Let’s say that a lender is prepared to lend for three years whereas the borrower thinks (erroneously) that he is borrowing for five years. The borrower’s project takes five years to complete and he needs purchasing power over resources for five years as his project will not earn an income to transfer back that purchasing power before five years is up. If, after three years, the lender, wishing to take back his purchasing power for present consumption, calls in the loan the borrower will have a shock. His project is only 3/5ths complete. Only two options are possible. Either the lender must change his priorities and save for the full duration of the investment project; or the borrower must liquidate the investment in order to pay back the lender2. If the latter option is necessary then we have a mini boom-bust between these two individuals; the investment is revealed to be a malinvestment as the borrower was not willing to lend purchasing power over resources for a time sufficient to complete the investment project. In order to create a sustainable investment project the lender must be prepared to advance purchasing power to the borrower for the full duration of the project. If he is not then the project cannot continue.

Now let us examine what happens when an intermediary bank engages in credit expansion and brings about effectively the same thing. The borrower is now a depositor of the bank and the borrower borrows from the bank rather than directly from the lender. Above we cited two possible analyses of the loan market – either there is a “core” rate of interest governed by supply and demand for loanable funds with individual variations in loan contracts representing the entrepreneurial risk that the lender takes; or, there are distinct markets for different types of loan, each of which attracts a different rate. We will use both analyses here.

On the eve of the credit expansion all willing lenders will have lent, through the bank, to all willing borrowers at whatever terms in the individual contracts. The willing lenders will be prepared to lend the funds for exactly the duration of the loans of the willing borrowers. Let us call these fulfilled borrowers Group A. When the bank expands credit, however, it gives the impression to unfulfilled borrowers – let’s call them Group B – that the supply of loanable funds has expanded. Under the first analysis, if the supply of funds expands then the “core” interest rate will reduce as the fresh funds have to find new, willing borrowers as those who were prepared to pay the highest charges have already been loaned to. This brings down the total amount of interest (“core” interest +/- the entrepreneurial charge) that Group B borrowers pay. Before credit expansion a core interest charge of (for example) 10% plus an entrepreneurial element of 5% would have given a Group B borrower a total interest charge of 15%, which may have been too high for him to take out a loan. Now, however, if the effects of credit expansion reduce the “core” interest charge to 5% leaving the entrepreneurial element unchanged then the total rate payable will be 10%, at which rate he may become a willing borrower. Hence the number of willing borrowers begins to expand. Under the second analysis, where there are distinct markets for different loans to different categories of borrower, expanding the volume of credit will expand the number of markets to which funds can be lent. As all of the Group A markets are fully lent to the new funds must seek out new, unfulfilled markets in Group B. This has the effect of bringing down the individual interest rates in these markets. Before credit expansion, the interest rate in these markets was infinitely high as supply in these markets was zero. Now, credit expansion has created supply that moves into these markets and depresses the interest rate to a level at it may reach demand. Hence loans will start to be made in these new markets.

To the present author, the second analysis seems preferential for visualising clearly the reconciliation between ABCT with the multiplicity of interest rates that are paid by borrowers. Indeed, while separating out the “core” rate from the entrepreneurial rate may be easy to conceptualise to a degree3, the idea of lowering rates is less straightforward to perceive when we think of the market as a unified whole. Conceiving them as separate rates in distinct markets which are individually depressed by credit expansion removes this conceptual difficulty4.

Under both analyses however, we can see that increased credit expansion leads to loans at rates that are lower than those that would be paid on the unhampered market. It is important to realise, though, that the contracted interest rates paid by borrowers in Group B – the new borrowers – may actually be higher than the rates paid by Group A. What we may observe is new borrowers in Group B paying what appear to be increasingly higher rates rather than increasingly lower rates. But the crucial point for ABCT is that the rates paid by Group B are lower than those that they would pay on the unhampered market. Such rates do not have to be lower than Groups A’s and thus it is still true to say that, overall, credit expansion has lowered interest rates.

How is it, though, that Group B borrowers, if they may pay higher rates than Group A borrowers, channel these funds into longer, more roundabout investment projects? Wouldn’t the interest rates have to be lower than Group A’s in order to accomplish this? The comparison to Group A’s rate is not relevant, however. It is still the case that extending loans to Group B will cause an overall lengthening of the structure of production as funds that previously were earmarked for consumption will now be channelled into investment5.

However, whatever the duration of a loan and whatever terms on which is it advanced the cardinal fact remains as follows: lenders are not prepared to devote real resources towards the investment projects of the borrowers for the entirety of their duration. Just as in the same way as price controls in our example above tried to give people the ability to have their cake and eat it – afford both one apple and one orange at the same time even though the level of wealth could not sustain these purchases – and just as in the same way that John on the Robinson Crusoe island not consume his resources and invest them at the same time, so too is credit expansion a societal wide attempt to indulge in both consumption and investment simultaneously. The borrower thinks his new money allows him to purchase resources for investment whereas the lender, not having relinquished his purchasing power, thinks that he can still use his original money for consumption. What happens in practice, of course, is that the credit expansion forcibly transfers purchasing power from the lender to the borrower. The increased money supply causes an increase in the prices of capital goods and a relatively weaker increase in the prices of consumer goods. The lender still loses out, therefore, as he must now pay higher prices for the things that he wished to consume – in just the same way as he would lose out from price controls when he sees that the shelves are empty. As the cycle gets underway, higher doses of credit expansion are necessary to maintain purchasing power in the hands of the borrowers as prices rise sharply and inflation premiums begin to be written into loan contracts. Once the inflation gets out of control and the credit expansion is halted or reduced funds are cut off to the borrowers in Group B as they must now rely upon the genuine saving of lenders. But lenders are not prepared to lend real purchasing power under the terms that these borrowers are willing to pay. Thus, starved of resources to complete their projects, Group B borrowers must liquidate their half-finished investments which are now revealed, after the true consumption/saving preference of lenders becomes apparent, to be malinvestments. The bust phase of the cycle therefore sets in.

Conclusion

What we have seen from this analysis, therefore, is that while the “Austrian” claim that “credit” expansion lowers “the interest rate” leading to the business cycle can be elaborated and defended to account for multiple rates paid by multiple borrowers, the primary fact is that lenders are not prepared to lend purchasing power over resources to the borrowers for the duration of their investments. It is this lack of harmony in the use of resources which is the key to understanding the start of the boom and the eventual collapse and this should be the focus of anyone wishing to understand and expound “Austrian” Business Cycle Theory.

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1See, for example, the relatively well known Hayek-Sraffa debate. “Austrian” economist Robert P Murphy has stated that “Austrians”, or at least those who ascribe to the pure time preference theory of interest, are yet to provide a sufficient answer to Sraffa’s objections. Robert P Murphy, Multiple Interest Rates and Austrian Business Cycle Theory, unpublished.

2We are, of course, ignoring the real-world possibility of refinancing.

3Although the length of time may itself be an element that is accounted for in risk.

4It is also the case that, even if all else was equal, there would not be one “core” interest rate in the loan market anyway as different lending periods would also attract different rates. Again, the second analysis overcomes this problem as different time periods would constitute individual markets.

5From a simple cost account point of view, the longer a particular business enterprise takes to come to fruition the harder it becomes to fund interest charges on the borrowing that has funded it. An uncompounded interest charge of 10% on a loan of $1m for a project that will last one year will result in a total repayment of $1.1m, something that might be manageable. If the same loan at the same rate was made for ten years, however, the borrower will to pay twice the capital – $2m – back at the maturity date; a cripplingly high cost for even the most profitable of projects. If the interest rate is reduced to 2%, however, the ten-year borrower would only pay back a total of $1.2m, which would be more manageable.

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Economic Myths #4 – Profits are Evil

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One of the elements of any economic system founded upon free exchange that induces a purple-faced rage amongst statists and progressives is the concept of profit. This residual – the amount left over once an entity has deducted its costs from its revenue – is said to line the pockets of greedy shareholders while exploiting labourers and consumers.

First of all it is important to understand what we mean and what we do not mean by profit. Here we will be discussing profits that an entity may earn purely as a result of voluntary trade and free exchange; we do not mean those “accounting” profits that entities may earn as a result of favourable government regulations, direct government subsidy or any kind of residual of a trade relationship based upon force. These profits – including bank bailouts and stimulus funding – are rightly to be condemned as unjust and immoral, sustaining the power base of the incompetent, wealthy elite at the expense of everyone else. But such a condemnation must not be allowed to throw out a very precious baby with repulsively filthy bathwater – for profit is one of the most vital elements that gives life to an economic system that relies upon the division of labour.

For the praxeologist profit is, of course, endemic in any human action and not just those based upon monetary calculation. All actions seek to produce better circumstances than those that would prevail, but for the action. All humans in everything they do therefore seek for a psychic profit – making more money than before is only one of these possible actions. Strictly speaking, therefore, any condemnation of profit would be a performative contradiction as, in the mind of the critic, the satisfaction of achieving condemnation would be a better circumstance than not having done so. Although such a technical and theoretical argument is unlikely to appeal to the mass of lay persons who view profits as evil and unjust, it is important to understand the roots of the concept for here we can see the importance of the profit motive – the stimulus for engaging enterprise in the first place. Without the possibility of earning profit – i.e. a better circumstance than that which prevailed before – no entrepreneur or inventor would ever bother developing and bringing to market all of the wonderful products that make our standard of living so high.

Abandoning for a moment our commitment to wertfrei economics and embracing the belief that anything that benefits the consumer or labourer is “good” and anything that harms him is “bad”, let us examine two or three specific, recurring myths concerning the concept of profit.

First of all, let us deal with the allegation that profits line the pockets of the capitalists at the expense of workers and consumers. Profits are not achieved at the “expense” of anybody. The amount of profit is only ever determinable in retrospect after all of the consumers have purchased their wares and all of the workers have been paid their wages. At the time that the consumers bought the products and the workers negotiated their terms of employment nobody knew what the profit was going to be – or even if there would be a profit at all! If you felt that you were being “fleeced” at the time you purchased a product or sold your labour then why did you enter the transaction? If a firm should be required to divest its profits back to those whom it has cheated and stolen from then what happens when the firm makes a loss? Does it work the other way round too? Did not the customers and the workers cheat the firm in this instance? Should the firm be able to go back to a customer who may have purchased an item six months ago and take more from him to wipe out the deficit? Profits, instead, benefit the consumer by ensuring that scarce productive resources are devoted to their most highly valued ends – industries and production lines where profits are abnormally low will have resources reduced and redirected to areas where they are abnormally high, thus decreasing supply in the former and increasing it in the latter. Ironically, the combined action of entrepreneurs has the ultimate effect of eliminating all profit by balancing resources throughout the economy. It is only because consumers’ tastes and preferences are constantly changing that profit opportunities continue to exist and deployment of resources must be repetitively assessed and altered accordingly. Ultimately, therefore, it is the consumer who is responsible for the existence of profit and not the capitalist-entrepreneur. Furthermore, it is profit that provides entrepreneurs with the resources to further invest in capital equipment and expand the business. This will increase supply and lower prices.

Second, even if the concept of profit for inducing enterprise was accepted, what of the allegation that profits are really used to “extract” money from the industry to pay shareholders – money that would otherwise be invested back in the business to the benefit of consumers? What this overlooks is the fact that if a distribution is made to owners or shareholders it is because the entity has already invested in the business to the extent that is economically viable and any further expansion would be wasteful. While the firm may retain some additional earnings as a buffer in anticipation of a poor performing year or for some other kind of insurance, masses of retained earnings are otherwise wasted by lying in corporate bank accounts. It is better to distribute those funds to the shareholders so that they can be reinvested in other productive enterprises that are still in need of investment. Thus the consumer is benefitted by this fresh investment in other products and services that ensures that the supply of these can also be increased and their price lowered.

Finally, it is worth emphasising that which we indicated above – that profits are never certain and the possibility of their corollary – loss – is always present. Capitalist-entrepreneurs do not first of all calculate how much profit they want and then work out how much they will pay for inputs and charge for outputs. Such a calculation may form the motivation to engage in enterprise and it might determine the boundaries of their productive action but they cannot force the outcome to agree to their projections. Rather, they must be prepared to be the highest bidder for inputs and the lowest seller for outputs in order to ensure that they can purchase resources on the one hand and then sell the resulting products on the other. This process is fraught with uncertainty and only at the end is it possible to ascertain if it has been profitable – and, indeed, a certain line of production which may hitherto have been profitable may suddenly find it is loss-making. All it may take is a marginal increase in costs as a result of competing entrepreneurs bidding away resources to other uses, coupled with no corresponding increase in sales in order to completely wipe out any profit. Or may be consumer tastes change and competing products and services become more attractive? Although profit is the motivator of entrepreneurial activity it is never certain and everyone else must be paid in full before it can materialise, if it does at all.

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Statism and Non-Aggression

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In the ideological battle between statists and libertarians, the latter are happy to apply the scriptures of non-aggression and non-violence to any human being. We do not distinguish between certain categories or castes of human in explaining this application; rather, it is a universal ethic. It is often supposed that statists embrace the opposite or the precise contrary of this principle – that, in favouring the violent invasion of other people in order to impose their will, they lie on the other extreme of the spectrum of the permissibility of violence.

It would be a mistake to view the statist contention in this way. For the precise opposite of the non-aggression principle – that no human may initiate violence against another – is that any human may or should initiate violence against another. But statists do not hold this view; indeed they do not, in any way, come close to rejecting the edicts of non-aggression. They simply believe that it does not apply to a certain set of individuals who form part of the state. Indeed one popular argument in favour of government and against anything approaching anarchy (in its literal meaning of “no ruler”) is that only government can preserve “order” and prevent “chaos”, chaos which almost certainly would prevail if everyone were allowed to run rampant by stealing from and murdering each other. Universal aggression is, therefore, firmly rejected by statists.

In understanding this we come to the, perhaps, surprising realisation that statists have more in common with libertarians that we might at first suppose. States, which may use violence permissibly according to the statist, are, after all, always a minority and the ordinary citizenry, who must refrain from violence, make up the majority. Statists do, therefore, very much embrace the non-aggression principle more than they reject it – they believe it applies to most of the population! In presenting a challenge to them, therefore, simply repeating the mantra of non-aggression is to overlook this fact. We are therefore faced with the challenge – or perhaps, the opportunity – of having to apply a more subtle and nuanced argument against statists. Instead of blathering on about how violence is unethical and how holy the non-aggression principle is (although one most not deny the truth of either of those propositions), let us meet the statist on his own terms: “fine, let us accept that violence is permissible – the why restrict it to only these humans beings that make up the state? Why are they so special? Why is only a monopoly of violence held by certain individuals justified?”

The present author argued recently that our primary preoccupation is with the state and how persuading people of its evil nature – or at least, its lack of necessity – is often a different task from understanding and refining core libertarian doctrine. Taking on the state is therefore our first and highest priority and accomplishing this through the shortest and most persuasive route possible should be prioritised ahead of trying to fill everyone’s heads with the details of libertarian thought (although it would hardly be a bad thing if everyone wished to embrace those details). The line of argument suggested here is a case in point, focussing on the core issue of the monopoly of violence enjoyed by the state, rather than concentrating on violence per se that may lead one to awkward and otherwise unpersuasive debates concerning, for example, lifeboat situations. This may be a more penetrating and revealing line of attack for one’s audience. But even if we were to proceed down the route of non-aggression and end up debating hard cases such as whether a person can be forced to save a drowning toddler, we can still deploy the rejoinder: “OK fine, let us say that a person can be forced to save this drowning baby. Why may only the state do the forcing? Why does this situation call for these people and only these people to force this person to act?”

How then, might such a challenge to a statist unfold? The first counterargument is likely to be that which was mentioned earlier – the necessity for order. That without the state, society as we know it will simply collapse into a frenzy of individualistic war of all against all. There are numerous retorts to this line of thinking. First of all, far from being the resolver of conflict, government is, rather, its creator and sustainer. Conflicts only exist because people hold different opinions as to the ends to which scarce resources should be directed. Government forcing one set of ends to triumph over the others does not resolve these conflicts – in fact it is a manifest admission that resolution is not possible or is not worth trying. Resolution of a conflict would be to peacefully and voluntarily agree an outcome and hence all parties would be satisfied, even if grudgingly. The imposition of violence, however, simply forces an end upon an unwilling victim, totally overriding any concerns the latter has whatsoever, harbouring not harmony and understanding but bitterness and resentfulness. Indeed we might even say that government force is a direct incitement to revolution and overthrow. Statists rarely admit that what they mean by collectivism is their own version of it – that government is brilliant and harmonious so long as it is producing ends that they themselves desire. But they never consider the situation of the barrel of the gun pointing at them and ordering them to do something with which they disagree, or even detest. In any case we should point out that if the lack of a government will unbridle an inherent disposition on the part of humans towards chaos and violence then we are entitled to ask why giving some of these very same evil, animalistic ogres special powers of violence will improve the situation. Won’t they just respond to using these special powers with the very same base and savage motivations that propel them towards disorder in an anarchical society? Indeed isn’t it giving them a unique advantage in doing so? Why are they suddenly so wise, trustworthy and angelic simply because they operate under the aegis of the state? To this we could anticipate the rejoinder “Ah but we have democracy! The stewards will be accountable to the people so will never abuse their powers!” Even if we were to accept the notion that a majority vote once every few years is sufficient to control the demagoguery we are still left with the same problem – the majority is still made up of humans choosing humans to supervise humans. Rather than simply place their trust in these holy guardians to keep the peace, won’t they just try and use them as a legitimised route to the same plunder and pillage that they would have otherwise tried to accomplish through a war of all against all?

Let’s turn next to the question of economic order. Even if he was to concede that government isn’t needed to keep the peace, wouldn’t our budding statist still be armed with the fact that there would simply be market and allocational chaos without government, that there would be shortages, booms, busts, depressions, greed, avarice, and so on? After all, everyone knows that the free market and capitalism caused the Great Depression, right? I trust that the majority of the readers of this essay will understand why this view is completely incorrect but it is worth repeating the truth because it is so ironic: that government, far from being the cure of or even an innocuous attempt at trying to relieve these problems, is in fact the very cause of them. Allocational chaos always stems from government interference whereas the pricing profit and loss system would produce neither surplus nor shortage, and it is government induced credit expansion through a fraudulently propagated fractional reserve banking system, together with the ring fencing of politically connected financial institutions from losses, that causes the business cycle. Government is responsible for these catastrophes, and we certainly do not need their attempts to solve them with the very thing that sets them off in the first place.

What if the statist falls back on saying that we all need to “follow the same plan” and “move in the same direction?” Such an argument could be made from either an economic viewpoint, a moral one, or both – that we either need government to direct production (or at lay down the “rules” for freer production), to provide us with moral guidance and outlaw certain behaviour, or to do both of these things at the same time. This raises the question of precisely which and whose moral or economic programme should be followed, and why. Government is only “needed” because everyone’s plans differ and, as we said above, they do not want to devote the scarce resources available to the same ends. You therefore have to force them into directing them towards the government’s ends. Why does the statist think that a good, productive and morally nourished society is built upon the fear and intimidation of being bullied and harassed into directing production, or into following a certain moral code, according to the will of a handful of faceless bureaucrats? In short, what is so special about these people’s ends – why are they to trump all others? But even if this could be answered the entire alleged necessity of following one “plan” is based upon a misunderstanding of the need to avoid conflict. Certainly, if we execute our individual plans, we need to avoid skirmishes with each other when we do so, but it doesn’t follow from that that we must all be forced to take the same path like a set of mindless lemmings, and that there is not a way for different plans to peacefully coexist.

These are just some of the possible lines of argument that might proceed from an understanding of how statists really view violence and non-violence, and embracing this more nuanced view might permit more incisive and hard-hitting arguments that libertarians can deploy during debates with their ideological opponents.

View the video version of this post.

Land and Natural Resources Part Two – Trade and Exchange

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In part one of this two-part series of essays we explored the utility, value, profits and losses that are associated with a single human’s action in relation to land and natural resources. In this second part we will now turn to a consideration of the same in a world where there are multiple humans and the economy is a complex one of trade and exchange of these resources.

Land Settlement in the Complex Economy

Where we have a world of many humans each of them are, at birth, in the same position as our lone human at his birth. They are gifted their own bodies, their standing room and a set of free goods that they do not need to make the object of their action in order to derive utility from. Every action thereafter will be taken at a cost with the object of receiving a gain that will outweigh that cost. To reiterate again these costs and gains must be estimated in advance and so every action is only speculative; there is no certainty that an action will, in fact, yield a gain. In a world of trade and exchange land and its product will trade for money and so these gains and costs will, likewise, be estimated not in terms of land’s physical product but in terms of the money that they will fetch in exchange. Now, therefore, leaving aside mental appreciations such as aesthetics or personal value attached to specific areas of land such as one’s home, we are not talking about merely psychic profits and losses but the actual revenue and outflow of money from operations with natural resources. In other words, how can one make money from using natural resources and how can we categorise the components of this income?

The first, if seemingly trite, observation concerning an unsettled plot of land is that no one has estimated the land as being valuable. In other words no one yet believes that the revenue to be gained from settling this land will outweigh the cost of doing so. Existing settlements or other prospects are deemed to be more valuable than settling the plot in question. The prices of the scarce resources that will be devoted towards settling the plot are being bid up by other potential uses and people estimate that the yield from the land will not be sufficient to cover these costs. Where, therefore, one human decides to settle land it will be because he, uniquely, decides that this land will, in fact, yield a definite gain and that everyone else is in error in leaving the land fallow. Let us again take the example of Plot A, demonstrating now the gains and costs not in terms of physical product but in terms of money. There are only three possibilities:

  1. Plot A will make a profit;
  2. Plot A will break even;
  3. Plot A will make a loss.

Let us examine each of these possibilities in turn, assuming again that the prevailing rate of interest will apply a 10% discount to the gross yield in each year. In scenario 1, we will take the gross yield to be £200K per year with the costs amounting to £100K per year. We can illustrate the net gain as follows in Figure A:

Figure A

Year      Gross Yield        Costs                Gross Gain        (Discount)          Net

1          £200K               £100K               £100K               (£10K)              £90K

2          £200K               £100K               £100K               (£20K)              £80K

3          £200K               £100K               £100K               (£30K)              £70K

4          £200K               £100K               £100K               (£40K)              £60K

5          £200K               £100K               £100K               (£50K)              £50K

6          £200K               £100K               £100K               (£60K)              £40K

7          £200K               £100K               £100K               (£70K)              £30K

8          £200K               £100K               £100K               (£80K)              £20K

9          £200K               £100K               £100K               (£90K)              £10K

10         £200K               £100K               £100K               (£100K)            £0K

The result of this has been a net profit for the land settlor. The land has actually turned out to yield more monetary income than was estimated by everyone else. In other words, everybody else was incorrect in estimating that the land would not produce an end that is more highly valued than some alternative. Rather, the product of the land is more highly valued than other ends to which the scarce factors of production could have been allocated and this value will be imputed back to the land itself so we can say that the land will have a capitalised value equal to the sum of the final column which, in this instance, is £450K. We will return to this again shortly but before that we shall examine scenarios two and three. In the former, it should be obvious that there will be no net gain at all. Let us illustrate this by assuming that the land will still yield £200K per year but now costs have risen to an equal amount:

Figure B

Year      Gross Yield        Costs                Gross Gain        (Discount)          Net

1          £200K               £200K               £0K                   (£0K)                £0K

2          £200K               £200K               £0K                   (£0K)                £0K

3          £200K               £200K               £0K                   (£0K)                £0K

4          £200K               £200K               £0K                   (£0K)                £0K

5          £200K               £200K               £0K                   (£0K)                £0K

6          £200K               £200K               £0K                   (£0K)                £0K

7          £200K               £200K               £0K                   (£0K)                £0K

8          £200K               £200K               £0K                   (£0K)                £0K

9          £200K               £200K               £0K                   (£0K)                £0K

10         £200K               £200K               £0K                   (£0K)               £0K

In this instance what is produced is exactly what is paid out in costs and there was, therefore, absolutely no point in settling the land. While there has not been a loss and the settlor is not in any worse position than he was before, there has also been no gain and the entire operation has been pointless. What about scenario three? Now let’s assume that costs remain at £200K but that now the land only yields £100K of gross income:

Figure C

Year      Gross Yield        Costs                Gross Gain        (Discount)          Net

1          £100K               £200K               (£100K)             £10K                 (£90K)

2          £100K               £200K               (£100K)             £20K                 (£80K)

3          £100K               £200K               (£100K)             £30K                 (£70K)

4          £100K               £200K               (£100K)             £40K                 (£60K)

5          £100K               £200K               (£100K)             £50K                 (£50K)

6          £100K               £200K               (£100K)             £60K                 (£40K)

7          £100K               £200K               (£100K)             £70K                 (£30K)

8          £100K               £200K               (£100K)             £80K                 (£20K)

9          £100K               £200K               (£100K)             £90K                 (£10K)

10         £100K               £200K               (£100K)             £100K              (£0K)

Here the settlement was entirely erroneous and will result in year after year of net losses for the settlor. He estimated incorrectly that the yield from the land would be sufficient to cover the costs and, in fact, there were more valuable uses to which these costs could have been devoted. The entire operation has been a waste and the land will simply be abandoned1.

Let us now turn back to scenario one where the land yielded a profit. We noted that the settlor realises a gain upon the realisation that the land will produce a yield the value of which exceeds that of its costs. Once again, as in part one, we must emphasise that this gain is earned not by the “productivity of the land” or its “natural powers”. The land was only doing that which it is under the orders of the laws of physics to do. Rather the earnings, the net income, are wholly the reward of the decision of the settlor to turn that land into productive use, a decision that resulted from his judgment that the land would yield more than its costs, an outcome that was, furthermore, clouded with uncertainty. Everyone else was free to make the same decision and to settle the land first but nobody did. To the extent, therefore, that a person earns a net income from productive use on the land it is only because this person, uniquely, has realised that devoting scarce resources to its settlement and use will yield a stream of utility that is more valuable to consumers than that which existed before. It was his decision that created the increase in value with the resulting flow of productive services, and it is to this aspect that the net income flows.

If this is doubted then we should consider the situation of the evenly rotating economy where all revenues equal cost. In other words there is trade and activity but all the utility of what is received from an action equals exactly the utility of that which is foregone. So if the produce of land yields £200K per year then the landowner will have to pay precisely £200K per year in costs2. If this was the way the world worked then it should be clear that there is no room at all for uncertainty and for decision making. If it is certain that there is no realisation of value, that nothing could ever be made better, then there is no premium to be put on the making of judgments that results in decisions. Net income disappears precisely because there is no need for these aspects. It is only because we live in a world where things can be made better and that this betterment is shrouded in uncertainty that a judgment must be exercised in order to realise it. Good judgments that direct the scarce resources available to a stream of utility that is more preferable than that given up are rewarded with net income. Bad judgments which waste those resources on ends that are not preferred are penalised with losses.

What about, for the sake of completion, a world where things could be made better but that the improvement is certain? That if we made a decision we would know for sure that the outcome would exactly be as intended so that, in other words, everyone’s judgment would exactly predict what would happen. If this was so then everyone’s judgment and everyone’s decisions would be exactly the same. A person can only profit from a decision because everyone else has underestimated the value of the yield from a productive activity, this underestimation resulting in an underbidding for the productive resources that are devoted to that activity. If, however, everyone knew the outcome then there would be no underbidding at all and all costs of production would be bid up fully to the height of the revenue of the resulting product. Hence, there would be no net income.

Therefore our conclusion can only be that the realisation of value is a product of superior human judgment.

Going back to our landowner does he now realise a constant, year on year net income from his ownership of the land? Unfortunately for him he does not. For the £450K worth of net income, representing the capitalised value of the land, is was he earns now and correspondingly takes its place in his rank of values now. It must therefore be ranked alongside other actions which could be more or less valuable now and while he hangs onto the land he always bears the opportunity cost of foregoing other actions. In the case of our lone human in part one this was the result of having to decide whether to continue to produce on the current plot of land or whether to stop and move to an alternative piece of land. In the complex economy, however, the decision that must constantly be assessed and remade is whether to hang onto the land or to sell it to a purchaser. Let us examine the ramifications of this necessity.

Trade of Land

In the first place, let us assume that the net present value of the land – £450K – is not only correct but that also all entrepreneurs know that it is correct and that this is certain. In other words the precise yields from and costs of production on the land are as they are in Figure A above and everyone knows that there will be no deviation from this schedule. What this means is that the purchase price will be bid up to exactly this net present value – £450K – with all potential suitors offering not a penny more and not a penny less. The decision for the landowner is a very simple one – to carry on with production of the land and wait for the fruits of its productivity; or to sell and to accept the present value of this future yield now in cash. The result of this is to impose upon our landowner an opportunity cost that completely wipes out any continuing net gains in income. As he can take the present value of the yield in cash the foregoing of this opportunity through holding onto the land will leave him only with interest from the future yields, i.e. the difference in value of the future yields when they mature and the capitalised value of the land now.

In reality, however, the situation is much different. Rather than everyone knowing the future yields of land they constantly have to be estimated. As we said in part one there are at least four factors that affect this:

a)     Direct costs of farming a plot will change from year after year and must be estimated in advance of their occurrence;

b)     Opportunity costs will change from year after year and, likewise, must be estimated;

c)      The gross yield of a plot of land is not certain in advance; rather, factors such as the weather, seed quality and soil deterioration will intervene;

d)     The discount to be applied to future gains is dependent upon the individual’s time preference rate which is subject to change.

To this we may add one more:

e)     The precise end to which the land is devoted also has to be decided. Should it be used for farming, for the building of a factory, or for building houses? Which of these streams of utility is most valuable to the customers who will provide the revenue?

Every entrepreneur, therefore, including the present land owner must constantly assess and estimate the effect on the productivity of the land by these aspects and this list is not necessarily exhaustive. Having estimated the future yield, each entrepreneur will discount it to a net present value resulting in a price that he is willing to pay for the land now3. Let us look at the mechanics of this fact in situations that lead to a profitable outcome for our landowner. Let’s say that there are three entrepreneurs, A, B and C, of whom our current landowner is entrepreneur A. Each engages in his estimation and calculates the following net present values of the land:

A        £450K

B        £350K

C        £250K

In this instance every other entrepreneur estimates the net present value of the land as being lower than the estimate of A. As A estimates that there is more to be gained from holding onto the land and selling its produce at a later period in time than from selling the land now then he will refuse to sell the land to the highest bidder which is B. If A is correct and the land yields a produce that is more than the estimate of the next highest bidding entrepreneur (let’s say that A’s estimate is precisely correct) then what is the analysis of A’s income? As his opportunity cost was to sell the land for £350K and earn interest on this sum, his actual outcome has been to hold onto the land and earn interest on a sum of £450K. The difference between these two will therefore form a net income – an income that A received solely because he estimated the produce of the land as being higher than that of rival entrepreneurs. Examining each of our criteria a) through to e) above he could have done this a number of ways and, in practice, a combination of them will always be active:

a)     A more accurately estimated the costs of farming the land as being lower than the estimates of B or C; or the methods that A chose in farming the land were less costly than those that B or C would have employed. A’s economy therefore conserved scarce resources to be released for employment towards the fulfilment of other ends.

b)     A accurately estimated that the other opportunities available to him would yield a lower (if any) net income than holding onto the land;

c)      A more accurately predicted the conditions of farming than B or C; the latter might have erroneously predicted more unfavourable farming conditions which led to their lower estimates;

d)     This is a little more complex and will be examined when we discuss land hoarding and speculation (below). Suffice it to say that A may have more accurately estimated the future societal rate of time preference than B or C and hence the discount to be applied to the future yields;

e)     And finally, A might have devoted the land to an end that is more valuable in the eyes of consumers than B or C would have done and thus the consumers were willing to pay a higher amount for its produce than for the produce that B or C might have churned out from the same land4.

Let us say that having witnessed A’s burst of productivity, B and C revise their estimations of the land’s capabilities. For argument’s sake, A maintains his estimate at the previous level:

A        £450K

B        £550K

C        £350K

Here what should be clear is that A now has the opportunity to sell the land for a net present value that is greater than his estimate of the same. He believes that B has overestimated its productivity and will incur a loss if he purchases for that sum. A therefore cashes in by selling to B and earns interest on the sum of £550K. To his horror, however, B finds that the land only yields a present value of £450K and hence he earns interest on this lower sum. It would have been better for B to have foregone the purchase and held onto the cash, earning interest on £550K instead of £450K. The difference between these two therefore represents B’s loss and A’s profit. The loss of B has accrued to a bad decision, a decision to devote the scarce resources available to an end that was less productive than that estimated. The reader can examine our criteria a) – e) above in order to speculate upon the source of B’s error, but the important point is this: where there is a net income it results from diverting the scarce resources to an end more highly valued than that estimated by other entrepreneurs. A loss is made when resources are devoted to an end that is less highly valued than that estimated by the same. Good decisions and beneficial use of scarce resources therefore yield a reward – a net income, a profit. Bad decisions and the waste of resources are punished with losses. Net income therefore flows to good decision-making ability and it is this ability alone – not any productive power of the land or any virtue of its ownership – that commands a premium in the marketplace5.

Now we shall turn to situations in which A’s decisions make a loss. Let us return to the first set of estimations:

A        £450K

B        £350K

C        £250K

A, obviously, will again choose to hold onto the land. But let’s say that in this scenario the land only yields £300K’s worth of income. It would have been better to have sold to B and made a presently valued profit of £50K rather than hold onto to the land and lose that opportunity. A’s decision was erroneous and this error was met with a loss. What about the second set of valuations?

A        £450K

B        £550K

C        £350K

Again A will sell to B in this scenario. A thinks that B is a fool in this scenario for thinking that he (B) can ever ring out £550K’s worth of productivity from the land and A congratulates himself for having made a handsome profit. But what if the land actually yields a presently valued income of £650K? In this instance, therefore, it would have been better for A to have held onto the land and carried on production. Instead he sold it and the passing up of this opportunity imposes a loss upon him.

What we realise, therefore, is that all present and prospective landowners constantly bear the burden of having to assess the future income from land. Present landowners have to determine whether the future income will outweigh the purchase prices offered by prospective buyers. The latter have to determine whether they can offer a purchase price that is outweighed by the future income. Those that make the most accurate decisions in this challenge are those that devote the scarce resources available to their most highly valued ends. They took the decision to direct their resources in this way in the face of uncertainty while nobody else did. The result is a net profit.

We should also add here that good decisions and good decision-making ability are determined relatively not absolutely – the profitable entrepreneur only has to be more accurate than the next entrepreneur. For example, let’s say that the land would yield a net present income of £650K and the following entrepreneurs estimate it as follows:

A        £450K

B        £350K

C        £250K

In this case it is obvious that A will hold onto the land and earn a net income when the yield of the land turns out to be worth a present value of £650K. But what if the estimations were as follows?

A        £450K (same as before)

B        £550K

C        £250K (same as before)

Here A will make the choice to sell to B. Yet even though his choice was derived from the same estimation as in the previous scenario, he now incurs a loss as it would have been better for him to have held onto the land and earn interest on £650K than to have taken £550K in cash. Looking at that same scenario from the buyer’s perspective, B now earns the profit. But what if there was a third set of valuations as follows?

A        £450K (same as before)

B        £550K (same as before)

C        £600K

Now, the profit maker is C. Therefore, even though the judgments that underpinned the decisions of A and B remained constant, the entry of a more accurate entrepreneur meant that the latter earned the profit and they did not. It is, therefore, the most relatively accurate decision in directing scarce resources to their ends that is rewarded. Clearly the same will also be true from the loss-maker’s point of view – a judgment that once was loss-making will become profitable if other entrepreneurs lose their accurate foresight.

Profit, therefore, can only be made when a person renders a valuable service that no one else is able to do. If entrepreneurial foresight becomes more prevalent and accurate its supply increases and, just like any other good, as supply increases then, all else being equal, the price it can command must diminish. If a piece of land yields £650K per year and the most accurate prospective purchaser bids £450K for it that he will earn a net present income of £200K. If, however, the market is suddenly flooded with entrepreneurial talent then each entrepreneur will bid up the land successively towards its mark of £650K. If an entrepreneur would bid £630K for the land then there is a chance for another, more accurate one, to bid, say, £640K. But the entry of a further, still more accurate entrepreneur could raise the purchase price to £645K with profit diminishing to a mere £5K. The extension of this situation would obviously be where every entrepreneur values the land exactly correctly and everyone would bid precisely £650K for it, with any chance of net income disappearing entirely. The existence of net income is therefore negatively correlated with the prevalence of good decision-making ability and as soon as the latter is abundant it ceases to command a high premium and profit comes close to disappearing.

In part one we questioned whether it was possible for luck to influence a person’s net gain. Could, for example, one buy or sell a piece of land having absolutely no idea whether it will yield a net income ahead of the purchase price? Or, alternatively, could one sell a piece of land without a single clue as to whether he is selling it for more than it is worth? In other words couldn’t someone just yield a profit by gambling rather than through any special entrepreneurial talent? If one makes a net income on these occasions then it states one of two things. First, as we said in part one, to consign one’s fate to luck is itself a decision and to the extent that it is more profitable than a carefully considered decision then it is the best decision. Secondly, if one makes a profit from gambling then it is still the case that resources were directed to an end that was more highly valued by consumers than that estimated by other entrepreneurs. In short, the gambler’s guess was better than anyone else’s decision and in its absence the economy would be worse off. It is the realisation of value that is rewarded, whatever the method through which it is achieved. It is just that in our world luck plays a very minor role in reaching this goal whereas good decision-making ability is most often needed.

Speculation and Hoarding

With all of this in mind let us now turn our attention to the speculation and hoarding of land. Land owners are often accused of sitting on fallow land and earning year on year profits while this land could be used for the fulfilment of vitally needed ends6. Can we square these facts?

The first question we have to address is why does fallow land have any capitalised value at all? If it isn’t being used for anything then how is it generating any value whatsoever? The answer to this can only be that, in the estimations of entrepreneurs, the land will not yield any valuable utility from a stream of production now but will, rather, yield the same from production that is begun in the future. Say, for example, that if entrepreneurs estimate that additional housing capacity is not required now but will be required in, say, ten years then the land’s ability to meet this end at that point in the future will be imputed back to the land itself and it will trade for a capitalised value. Obviously the discount applied to a utility only taking effect at such a far off point will impose a cumulatively heavy toll, but there would still be a capitalised value. Entrepreneurs therefore have to decide not only what to devote land towards but precisely when to do it and it is the differences of these estimations that permit one to earn a net income from the hoarding of land.

Let us say that A purchases a plot of land now with the intention to hold onto it without development and is able to earn a net income on this operation. There are two aspects to the explanation of this outcome. First, if all entrepreneurs are agreed as to when is the most suitable time to develop the land is then A can only make a profit if he more accurately estimates the value of the yields that result once this time is reached and the land is developed. This is essentially no different from what we discussed above – the only difference is that the first act of production will not be now but at some point in the future. But secondly, if entrepreneurs are not in agreement over when the most suitable time to develop the land is then A can make a profit by more accurately estimating this suitable time. Let’s say, for example, that the five entrepreneurs would develop the land after the respective intervals have elapsed following purchase and their estimations of the present value of the yields are as follows. Let us also assume, for simplicity’s sake, that each is correct in the estimation of what the land would yield after these intervals:

A        5 years         £600K

B        4 years         £500K

C        3 years         £450K

D        2 years         £210K

E        1 year           £130K

What this means is that E believes that the most productive use of the land will arrive after only one year and that he won’t, therefore, gain more than a present value of £130K by waiting either longer or shorter. D believes that two years is the correct period to wait and any longer or shorter will never achieve as high an income as £210K, presently valued. And so on for C, B and A. The latter, however, is the most accurate and he is the one who will purchase the land (in this case, offering only slightly more than the discounted value of B’s estimate in order to price B out of the market) and he will earn a profit. The effect of A’s action is to withhold the land from development that would otherwise occur too early and thus its direction to an end that is less valuable to consumers is prevented; rather the land is released for development right at the precise time when it is needed for fulfilling the most pressing end. A of course might be “incorrect” in an absolute sense – perhaps had he waited another year still (so six years in total) the land might have yielded a present value of £700K. But as the relatively most accurate entrepreneur he is the one who yielded the profit. Had another person, F, come along and bid £650K then A would not have earned that profit.

Related to this is the height of the societal time preference rate which determines the interest rate. As we said earlier, all future utility from land is discounted according to the prevailing rate of interest. But this too is subject to fluctuation and must be estimated, a point we noted earlier. If time preference lowers then the discount to be applied to future yields of land will diminish and hence the capitalised value of land will rise. On the other hand if time preference rises then the discount will be increased and the capitalised value of land will fall, its promise of future utility being less valuable to consumers. In practice this phenomenon tends to go hand in hand with the fact that land may yield its most valuable end not now but sometime in the future. For land is the ultimate remote good out of which capital goods must be furnished and increased demand for it is almost synonymous with a lowering of the societal time preference rate and a desire to engage in more roundabout methods of production and the creation of economic growth. The estimation, therefore, by entrepreneurs that land will yield a more valuable use not now but in the future also translates into estimating that the societal rate of time preference will be lower.

The allocation of resources across time is also one of the most difficult activities which must be faced by the present landowner, let alone a prospective purchaser. A failure to estimate how much to produce and when to do so has the potential to cause serious losses. The capitalised value of a copper mine, for example, will, as we know, represent the discounted value of all of the future copper that will be extracted from that mine. The choice of how much copper to mine this year is made not only in the face of current costs such as labour, equipment etc. but also the mine owner must consider the fact that any extraction of copper now will mean that there is less copper to be had in the future. If the mine owner extracts copper now then this will cause a write down in the capitalised value of the land as, the copper having been extracted, a portion of it is no longer there to provide for future utility. Whether or not the mine owner successfully allocates copper to the present or to the future depends on the relationship of the revenue from selling copper now on the one hand to the height of the write down on the other. If, having accounted for all other costs, the revenue he receives from selling a portion of the copper today is higher than the write down then this means that the present value of copper sold has a higher value than the same copper would have done had it been left under the ground. Therefore the quantity of copper that the mine owner brought to market was in line with the preferences of consumers and copper was not wasted by being mined too soon. On the other hand, if the value of the write down is higher than the revenue that is received then this means that the copper that is brought to market would have had a higher present value had it been left under the ground to be preserved for a future use. The copper was brought to market and supplied too early and consumers were not willing to devote it to an end today that is more valuable than an end at some point in the future. In short, the copper has been wasted and the resulting loss will penalise the mine owner for this oversight. It is for this reason why capitalism and free exchange provides the best method of conserving resources as the profit and loss system entices entrepreneurs to deploy them precisely when they can meet their most valuable ends.

Taxation of Land

It follows from the analysis in both parts of this series of essays that any attempt by the government to tax the proceeds from land must fall upon one of the three streams of income:

  1. Costs;
  2. Interest;
  3. Entrepreneurial Profit and Loss.

If costs are the target then clearly this just raises the cost per unit of productivity from the land. Within this category will fall all taxes on labour, direct taxes on the costs such as sales taxes, and the taxes that must be borne by suppliers. If, though, interest is the target then this has the effect of increasing the discount from future yields of land. The relative attractiveness of future goods will therefore decline and so too will any engagement in roundabout methods of production that lead to economic growth. Finally, a tax on entrepreneurial profit and loss will penalise the decision-making ability that directs resources to their most highly valued ends. There will, therefore be relatively less inclination to seek out the most valuable ends coupled with relatively more wasting of land as the lack of scrupulousness means that the land ends up being devoted to less urgent ends7.

All taxation on land will simply magnify the costs and reduce the gains. But it is important to stress its effect on our third category of income above, which relates to the entrepreneurial aspect of land ownership. The purpose of the analysis in these two essays has been to demonstrate that regardless of any natural qualities of the land or resource in question every decision and every action – even just holding onto the land – entails a cost that may outweigh its gain. Net gains from land ownership can only be had by demonstrating a relative entrepreneurial talent. They cannot be gained simply by owning land and sitting on one’s backside – there is no category of “unearned” or free income from land ownership that is ripe for taxation and there is no form of taxation that will be neutral on productivity.

At the beginning of part one, we stated that every action has a cost and a gain, the magnitude of each being uncertain. The only free or unearned “income” that a person ever has is his own body and standing room at the moment that he is born. Not only did we indicate in part one that these cannot be considered as “gains” as such but if one is adamant that unearned income should be taxed away then it follows that the only logical proposal to enact that policy is to tax birth. Is any advocate of the taxation of unearned income expecting to be able to propose such levy and, at the same time, to be taken seriously?

Conclusion

What we have sought to demonstrate in this two part series of essays is how an acting human can realise utility, gains, benefits, profits, losses and value from his actions in relation to land, including its use and its trade. We have concluded that the gross yield is directed to three sources – compensation for costs, interest, and entrepreneurial profit and loss. Finally we concluded that attempt to levy a tax on any one of these must have the effect of raising costs and decreasing gains, leading to a relative wasting of land.

View the video version of this essay.

1Alternatively, if the landowner was locked into the operation and had to suffer the repeated losses, the only way he could escape would be to transfer the land to someone else. But who would want to do this? Who would want to take on the burden of a loss-bearing piece of land? The only way that it could happen is if the current land owner was to compensate the purchaser for the future losses – in other words he would have to pay someone the net present value of each year’s loss, the sum of which is that of the last column in figure C – £450K. The interest earned on this sum will compensate the new landowner for the maturity value of the losses (£100K) as each year comes round. This situation is not unusual if you consider the possibility of an enthusiastic entrepreneur taking on burdensome and lengthy obligations to third parties in relation to the operation on the land.

2In most descriptions of the evenly rotating economy there would still be discounting as the costs are incurred at a period of time before the vending of the final product. Indeed one of the advantages of this imaginary construction is that it is able to explain the phenomenon of interest as being distinct from entrepreneurial profit and loss. If the land yields £200K then, applying a discount rate of 10% per annum, costs that are incurred one year earlier will amount to £180K.

3For the sake of simplicity we will ignore the effects upon price of bartering and assume that each purchaser would pay a purchase price equal to his valuation of the land.

4It might also be the case, of course, that A is simply a more productive labourer than B or C and can farm more produce per acre. But any gain in income from this aspect accrues not to A’s entrepreneurial decision-making ability but rather to the remuneration for his labour and this additional income would be categorised in the “costs” column of an analysis of the gross income from the land rather than in the “net income” column.

5We are not intending the words “good”, “bad”, “reward” and “punishment” to imply any moral evaluation of an entrepreneur’s actions; rather, the terms should be appreciated only to the extent that people prefer making profits to losses.

6The recent accusations of the leader of the UK Labour Party, Ed Miliband, were of precisely that.

7In practice, taxes on interest and profit and loss amount to the same thing as it is not possible to separate them from an accounting point of view.

Land and Natural Resources, Part One – Human Action, Profits and Losses

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NOTE: The tables in this essay will be updated in due course so that they fit onto the page! Apologies for any difficulties in comprehension.

The economics of natural resources can be a complex and often controversial topic. It is not, in the end, a particularly difficult one and this set of two essays will lay out clearly how humans derive utility, value, profits and losses from the Earth around them. Part one will examine this in the “Crusoe” situation of a single, lone human, while part two will explore the implications arising from trade and exchange in a complex economy.

The Gifts of Birth

At birth, a human being is gifted two things by nature1 – his own body; and then a vast array of natural resources that are external to his body. A person does not come into existence without the physical manifestation of his body and this body’s uniqueness is resides in the fact that it is the only gift of nature that is intimately bound to his own will and is directly controllable. The second gift, viz. the remainder of all resources, consists, from the core of the Earth to the top of the atmosphere (and even further if we consider the possibility of space exploration), of densely packed atoms in various configurations as chemical elements and compounds. Here we have the essence of the two ingredients of all economising action – labour, the effort expended in the use of one’s own body, and land, the matter external to the body in the condition upon which a human discovers it. Part of the land will be used by the body after the first moment of birth, for the body cannot exist without three dimensional space; because of the nature of gravity this space will always take effect as a piece of physical land plus the air space above it necessary to accommodate the volume of the body, all of which we will summarise under the term “standing room”. At birth, therefore, the gifts that are immediately utilisable to a person are his body and his standing room.

To the extent that a person prefers being alive to being unborn we can say that the gifts of a person’s body and the land he uses as standing room are “gains” to him, that he has achieved something “better” than what he had before. However, given that a human is not consciously aware of any existence prior to birth means that it is far more convincing to state that his body and standing room are not gains but are, rather, the base line from which he begins. He cannot compare any mode of existence without having his body and standing room as a prior condition. The utility he derives from them, therefore, while being a gift, does not represent any conscious benefit or gain. He is merely at the zero point, the starting line of the remainder of his life.

What about the remainder of the land, that which does not form part of the standing room? In the absence of any human being, all of this “stuff” in the universe is precisely that – just stuff. Regardless of whether it is manifest as iron, oxygen, trees, animals, or as anything else, all matter is basically just a variety of atomic configurations. It yields no utility, no value, no ends, no satisfactions or anything. It is dead and inert, subject only to the physical laws of the universe and any condition in which it finds itself yields no service. When a human being comes along, however, all of the resources of the universe may yield to him utility – that is some kind of service or facility that contributes to his welfare2.

Let us assume that the human being remains in the position of his original standing room. In this situation, another resource will do one of two things; first, it may deliver him utility if it contributes to his general welfare but does not have to be consciously made the subject of his action in order to gain this welfare. The almost clichéd example is air – it is immediately available, served by nature in the form in which its qualities can be utilised by human beings, and this utility is available for all of time. Similarly, we may say the same thing of a beautiful view. The landscape does not have to be worked into a configuration to produce the view and it is, furthermore, everlasting. It is a gift of nature that will yield perpetual utility. Secondly, a resource might deliver him no utility whatsoever. Iron ore buried deep below the ground, for example, or trees on the other side of the world yield no service to our human and his condition or welfare would be the same without their existence3. In both of these two instances a resource is said to be non-scarce. Non-scarcity is determined when the quantity of an available resource exceeds the services (present and future) that it contributes towards human welfare4. With resources that simply produce no welfare whatsoever this is obvious, but this truth is less clear with resources that do provide welfare but nevertheless are so abundant that they still possess a non-scarce quality.

There are three important and directly related aspects to stress when understanding the qualities of the latter type of non-scarce resource. First, the resource must be in a condition in which one’s labour does not have to be directed from one end to another in order to utilise it. This is determined praxeologically and not physically. It is true, for example, that the body has to utilise energy to draw air into the lungs and then to exhale and that this energy could serve another purpose. Or, with the beautiful view, it is true that light waves have to reflect off the landscape into the viewer’s eye and that these waves must, in turn, be processed by the brain. But this physical exertion has no praxeological effect. For in order to qualify as the latter these physical aspects have to be appreciated by a human being. As long as a human inhales and exhales without any conscious thought or appreciation of the physical mechanics involved and as long as the sight of the beautiful view can be enjoyed without conscious knowledge of his body’s physical effort to produce that enjoyment then these purely physical matters are without substance in the realm of economics. Directly related to this is the second aspect which is that while a resource in its entirety may possess the same physical uniformity this does not mean that it is in a condition in which it is immediately utilisable without the intervention of labour. In other words, not all portions of a physically homogenous resource have equal serviceability to a human being. Water that is right next to me, for example, is physically the same resource as water that is twenty miles away, but praxeologically, i.e. in terms of the utility they each provide me, they are not the same resource but different resources as only the former may be enjoyed without my labour. Therefore, in order for a resource to be non-scarce, the portion of the total quantity of it that is physically homogenous and with which labour does not need to be mixed so that the resource’s utility may be received must be in a quantity that exceeds the needs of a human. In order to clarify this we will, hereafter, refer to a “resource” when we mean physical homogeneity (i.e. water), and to a “good” when we mean praxeological homogeneity (water next to me, water twenty miles away, water in the sea, etc.). Different goods, therefore, may have the same physical qualities but what determines their difference is their serviceability to a human being so, praxeologically, this difference makes a good a separate and distinct good from other portions of the same, physically homogenous resource5. Thirdly, the contribution to human welfare of a particular good is made by specific units of that good and not by the whole quantity of the good itself. Humans have no relation to categories of goods in their entirety, such as all of the air in the world or all of the gold, iron, wood, water, and so on, even if this is all available for their immediate use without the need to labour. Rather we only use these things in single, concrete portions to yield a particular service and hence, when we say that a good is non-scarce we mean that any individual unit is not consciously appreciated by a human. A single breath of air, for example, can be easily replaced by another breath, and there are enough units of air to satisfy a human’s need for it immediately and into the future of his life. Similarly, with the beautiful view, we may consider units of this view as being slices of time in which the view can be enjoyed. One unit of this view is just the same as any other and, from the point of view of the individual’s life, further units present themselves perpetually (this would be different, of course, if we knew that the view was going to be destroyed tomorrow). So, summing all this up, as long as the total quantity of units of a good that do not require the intervention of labour outweigh the needs of a human being then any individual unit will be unappreciated by that human and the good can be said to be non-scarce.

What do we mean when we say that being able to utilise a non-scarce unit of a good means that any human appreciation of this particular unit is absent? First of all, it means that the human experiences no gain. For there to be a gain then a previous set of circumstances must be replaced by a better (in his view), following set of circumstances. However, with a unit of a free good the circumstances are continuous – one unit of the good can only replace another unit of the same good. Similarly there is no conscious loss to a human if one unit should disappear as it can be replaced without effort by another. Hence an equally serviceable unit of the good is always available to be utilised – there is no transition from a period of being without to a period of being with. Similarly we can say that there is no benefit from utilising a single unit of a good. For a benefit implies some advantage, something “better”, but there is no benefit from utilising one unit of air – the condition of air’s presence and utility is on-going, so one particular unit provides nothing that was not already available. And finally there is no cost or burden associated with the utility of a unit of air – nothing has to be given up by the human in order to “enjoy” this utility. Crucially, what all of this means is that any single unit of air – and any single unit of all non-scarce goods – has no value. For all of these concepts – gains, costs, benefits, etc. – are all tied to the concept of valuation. For valuation is the comparison of one stream of utility against another – it is to prefer one to the other, i.e. to recognise a gain when one is achieved at the cost of losing another. None of this exists with units of non-scarce goods and so the utilisation of a unit of air, requiring no cost and achieving no gain, has no value. The very circumstances of air’s abundance, i.e. its complete non-scarcity, prevent the necessity of any kind of valuation. Again, without meaning to labour the point, all of these concepts – gains, benefits, costs, etc. – are to be understood praxeologically and not physically. Obviously air gives one a physical benefit and comes at the expense of physical costs but as long as there is no conscious gain and no conscious cost then these physical matters are irrelevant.

A unit of a non-scarce good, therefore, may yield unvalued utility – that the utility from the unit, a stream of service, is present, but it is not valued by the human. For the very essence of valuation is to desire, to prefer, to want or to need a certain stream of utility. But there is nothing about the relation of a human to a unit of a free good that demonstrates this. He reveals nothing about whether he prefers either the utility stream’s continuance or its cessation. Again, we must stress that this is only in relation to any particular unit of the good. We are not facetiously claiming that a person would not care if he was to lose all of his air and would not mind suffocating to death. We are only asserting that he does not care whether the utility rendered by one particular unit of air continues6.

In all cases, therefore, the condition of non-scarcity is dependent upon a quantity of immediately utilisable units of a good being sufficient to outweigh all of a human’s needs that can be serviced by that good. The utility present at a human’s birth, then, derives from his own body, his standing room and from non-scarce goods such as air. As we said above, this condition cannot be said to be “better” than anything else as there is no other condition from which the human has consciously been aware of departing from in order to arrive at it. Let us now, therefore, explore the condition when the human encounters scarcity, viz. when the quantity of an immediately utilisable good is not sufficient to outweigh all of a human’s needs that it can service.

Scarce Goods

Let us begin by positing a change in the condition at the “starting line” of a person’s birth. Let’s say the supply of immediately utilisable air was to diminish drastically to the point where further loss would cause a human to suffocate. The quantity of units of this good is now not sufficient to command all of a human’s needs. Air cannot be enjoyed as it once was as now each individual unit is not replaceable by another unit. The loss of one unit now very much entails a loss of service, a loss that wouldn’t have been experienced when air was available in abundant quantities. The result, therefore, is that the human is now confronted with a choice. With restricted air the choice is between whether to enjoy air now and risk suffocation in the future, or to restrict one’s consumption of it now in order to store it and preserve it for the future. To bring about the substance of his choice the human has to act in relation to the good, i.e. he has to make it the object of his action (or “mix his labour” with it). The result of the action is to divert the good from providing one stream of utility to another. So if I work to capture a unit of air in a glass bottle where it can be stored for the future I have ceased its service to my present respiratory needs and reserved it for my future respiratory needs. The result of this choice brought about through action in relation to the good is, therefore, the demonstration of a value. For I have now valued one stream of utility – present air – against another – future air and this valuation is imputed back to the good in question. My act of preference has been to set aside or to incur a loss or a cost of one stream of utility at the gain or profit of another stream of utility. Value, then, springs from the choice, the decision, of a human to set aside one utility for another, the resulting gain in utility being wholly rewarded to this choice or decision. It is these qualities – value, gains, profits, costs and losses – in relation to natural resources that will be the focus of this essay7.

The realisation of value, then, is to achieve something better than what existed before through human action. What, therefore, are the elements of valuation that occur with a human act? A human, in the condition that he finds himself after birth, must recognise that the potential stream of utility from a unit of a good is preferable to that which exists already. There must, therefore, regardless of the body he has, the standing room on which it is place, and the free goods which contribute to his general welfare, be some kind of uneasiness or dissatisfaction. He believes that the external resources available to him will offer him a stream of utility that is better than what he receives already. Let us posit something simple; his current standing room is position A whereas he would prefer to stand in position B because the ground is firmer and the human believes it will feel more comfortable to stand on. What elements are involved in this choice? First of all, there is the fact that while positions A and B both qualify as the resource of standing room in a physical sense they are different, heterogeneous goods in a praxeological sense. Position A is un-firm ground and position B is firm ground as judged by the human. The quantity of firm ground available for immediate utilisation is outweighed by the needs of a human’s welfare and hence firm ground is a scarce good8. Secondly, we can now say that a human has a conscious end – to derive the utility stream that is offered by firm ground. Thirdly, he has means, the tools he uses to achieve the end – his labour and position B. Fourthly, there is now a definite cost for the human cannot experience the utility of position A and position B at the same time. The achievement of standing in position B therefore requires the foregoing of position A and everything it has to offer for his welfare. Further, it requires him to experience the disutility of labour. Fifthly there is the element of uncertainty, which is pervasive through all action. Uncertainty falls into two categories – the uncertainty of the physical qualities of the resources and the uncertainty of future human desire. The former category is manifest in the fact that the human does not know whether position B will, in fact, deliver him the good of firm ground that he desires; rather it is merely an estimate, a prediction. Also when he gets there he might find that there are other conditions that had not entered his consideration that make position B a more or less desirable place in which to stand than position A. In the second category, the human does not know his future evaluations and choices. He might, for example, no longer desire the end of firm ground upon arriving in position B. Or he might become aware of the even better position C; but that position C was closer to position A than it was to position B and hence the move to the latter was unnecessary. There is, therefore, the element of risk that a utility stream gained through action will not, once it is accomplished, be more highly desired than that foregone. Sixthly, there is the element of profit (or gain) and loss. The human will experience a psychic profit to the extent that the utility stream received through action actually does contribute to his welfare more than the utility stream given up, the extent of the profit being his mental appreciation of the difference between these two. He will experience a psychic loss if the utility stream received through action does not contribute to his welfare more than the utility stream given up. Finally, there is the realisation of value, the “reward” of the profit and loss being derived entirely from the decision to prefer one stream of utility over another.

There is an additional complicating factor that is added to the element of cost. In reality, of course, a human faces a multitude of positions on which to stand. But his labour too is also scarce and he can apply it to only one position at a time. If there were also other positions on which he could stand and, for arguments sake, the labour cost of appropriating each of them was equal, then the human would choose the one with the firmest ground. But psychically, his profit and loss would be evaluated against the opportunity cost and not the actual cost foregone even though the former is not demonstrated through action. So if, for example, he is standing in position A and position C he estimates to be better than position A but worse than position B, in choosing to stand in the latter his profit and loss will be the utility gained from B minus C and not from B minus A.

The gross utility from a good that is achieved through a human’s action can, therefore, be categorised into two elements:

  1. Compensation for Cost
  2. Profit and Loss

This may be illustrated as follows in Figure A.

Figure A

Position A          0A—————————1A

Position B          0B—————————1B——–2B

0A–1A represents the utility derived from position A that is lost through the action (and the cost of labour involved in the move from position A to position B). 0B–2B represents the gross utility that is derived from moving to position B. Out of this gross utility 0B-1B represents compensation for the cost of losing 0A–1A while 1B–2B represents the profit and loss. The net gain in utility, that part that has caused an improvement to the human’s welfare, is therefore represented by 1B-2B and it is this part that represents the achievement, that which is better than that which experienced before. This gain in value, this preference for position B over position A is imputed back to the goods themselves so that we can say that, for this human, position B is more valuable than position A.

In no way, of course, should the length of the lines be taken as a “measurement” of the two utilities involved. The fact that we have illustrated 1B-2B as being smaller than 0B-1B should not be taken to mean that these two elements can be compared in magnitude. For the gain is only psychic and irreducible to a common unit with only the individual human knowing precisely how much more satisfied he is by the move from position A to position B. 1B-2B could be represented smaller or it could be so big that it could not be fitted on the page.

This is, of course, a very simple example which the reader may regard as so trivial as to be hardly worthy of any elaboration at all. But imagine if this is the human’s first ever act on his Earth. The result has been to compensate him for his loss of the original gift of standing room which was provided to him by nature and to give him a gain, something additional that was not there before. He has now, then, moved out of his starting position and onto the course of the rest of his life where he will make further actions after this initial one. Every single action that he undertakes from now will involve these very same elements; they will all undertaken because the human expects them to a) compensate him for the costs of utility foregone and b) to provide an excess of utility above this compensation. The net change in a human’s position, the part that has made him better off, has rewarded him and improved him, is only that part that remains after compensation for costs. This fact, we will see, is very important when we consider the income from land ownership and the ownership of durable natural resources such as land, ore deposits and mining facilities.

Another simple example, but one that involves a more obvious act of production, is where the human is faced with a choice of two apple trees. At the moment he picks apples from tree A, which yields him five apples per day. However, he believes that tree B will yield him more than five apples per day. He therefore decides to stop picking apples from tree A and starts picking them from tree B. Let’s assume that the labour cost from each is equal and that this operation is successful. He is therefore now able to pick seven apples a day from tree B. Figure B illustrates the composition of his gain in utility.

Figure B

A1—-A2—-A3—-A4—-A5

B1—-B2—-B3—-B4—-B5—-B6—-B7

A1-A5 represents the utility gained from the five apples from tree A; B1-B7 the gross utility gained from seven apples gained from tree B. A1-A5 is the utility that is given up by (i.e. the cost of) moving from tree A to tree B. Of the utility gained from tree B, therefore, B1-B5 represents the compensation for cost and B5-B7 represents the gain in utility, the profit and loss. Once more, we should not understand the equal spacing of the lines to mean that each additional apple contributes an equal increase in utility in the human’s mind. We do not know by how much each additional apple contributes to his welfare. All we know is that tree B contributes more to his welfare than tree A. The move from tree A to tree B has, therefore, been a realisation of value, of something better, an improvement, and this is imputed back to the goods themselves so that we can say that tree B is more valuable, more preferred as a result of its contribution to welfare, than tree A.

From where has this gain, this realisation of value, come? What is its source and from where does it spring? Is it from tree B? It is true that the utility itself, B1-B7 as illustrated above, is serviced by tree B. But we must remember that both trees A and B are just a collection of chemicals in the absence of any human. It requires a human being to appreciate the stream of utility provided by tree B as being preferable to the alternative stream of utility that was provided by tree A. Crucially, however, this stream of utility would not be realised or discovered if it was not for the human’s decision to apply his labour in the direction of yielding it. It was the human who decided that it would be worthwhile to give up tree A and move to tree B and therefore, the increase in value, the gain, the improvement, is solely an achievement of this decision-making ability. There are two ways in which we can illustrate this. First, what if, in addition to a choice between tree A yielding five apples and tree B yielding seven apples, there was also the option of tree C that yields three apples? Let’s say, though, that the human erroneously estimates that tree C will yield seven apples and so he gives up tree A in favour of tree C but tree C in fact yields only three apples. We can illustrate this as follows in Figure C:

Figure C

A1—-A2—-A3—-A4—-A5

C1—-C2—-C3—-C4—-C5

(C4)—(C5)

C1-C5 represents the compensation for loss of A1-A5, but (C4)-(C5) represents the loss that was experienced by the move. This loss is not generated by tree C itself; it is merely doing what it is under the order of the laws of physics so to do. The loss is, rather, entirely a derivative of the human’s erroneous decision to move from tree A to tree C. The “punishment” for the loss – the reduction in utility and, consequently, of welfare – is accorded to the bad decision-making ability. In exactly the same way the profit from the move from tree A to tree B was the result of a good decision and the increase in value was entirely a product of good decision-making ability. Bad decisions are therefore punished and good decisions are rewarded and all of these decisions are made in the aura of uncertainty that the result will be as intended. The second illustration is to imagine a world in which there is no gain in utility from any action at all. Let’s say that all trees in the world yield only five apples and that whatever the human does, wherever he goes he will never find a tree that yields anything other than five apples. In this case, therefore, the utilities exchanged in the act of, say, moving from tree A to tree B will be as follows in Figure D:

Figure D

A1—-A2—-A3—-A4—-A5

B1—-B2—-B3—-B4—-B5

In this example, therefore, the utility achieved exactly equals the utility that is lost. What is lost is recouped and what is recouped is what was lost. There is nothing better nor worse that can result from any action. Therefore, there is no need for any decision at all nor any decision-making ability, no reason to decide how to act for all acts will produce the same, uniform result. Any decision will yield an outcome that is exactly the same as its cost and hence there is no reward for good decision-making ability and no punishment for bad decision-making ability. In a complex economy this situation is akin to that of the evenly rotating economy, a world in which there is utility but revenue always equals cost. If the stream of utility given up is equal to that received then there can be no preference and if there is no preference then there can be no questions of there being any realisation of value. We will use this fiction to illustrate the profits from ownership of land and of natural resources. The realisation of value, therefore, can only result from a decision, a decision to withdraw labour from one stream of utility and to direct it towards another. The increase in utility received determines the height of the profit and, consequently, how good the decision was.

Could it be said that a person gains value merely from luck? Could it be that, actually, a person could possess no skill whatsoever and still profit from his actions? Yes, it could, but one must remember two things. First, that to consign one’s fate to luck is itself a decision and to the extent that it is more successful than not doing so then it is a good decision. Indeed such a world where we only had to rely on chance to provide us with every gain in value would be a serious improvement on the existing world. Secondly, as we shall see in more detail when considering profits that are gained from the ownership of natural resources in an exchange economy in part two, net gains from luck can only result if one’s luck is more accurate than someone else’s decision.

Time

What we have said above is true of all human action in relation to simple resources that yield an immediate gain in value. Let us now turn our attention to another aspect that is related to the use of natural resources such as land (including resources under the ground such as ore deposits or coal fields) and the more complex decisions and actions that have to be taken in order to yield value from them. This is the aspect of time, that is, that utility is yielded not immediately but, rather, after the elapse of a period of waiting (such as a long process of production) so that, if one was to start acting in relation to a good now, the utility to be derived would not be received until, for example, another year9. We noted above that physically homogenous resources are not necessarily praxeologically homogenous goods – for example, the differing locations of physically homogenous water can mean that they are, to the acting human, different goods with different degrees of serviceability. Exactly the same is true of time and portions of the same physically homogenous resource that are serviceable at different times may be considered as different goods. Water that is immediately serviceable, or serviceable with only a single action, may be one good, whereas water that is serviceable after only one year may be considered entirely differently, and water after two years forming a third category of good. The necessity of having to wait for serviceability burdens the utility of goods to be received with a degree of remoteness. It therefore follows that goods with serviceability nearer in time will be of higher value than the goods with serviceability further into the future, even if they are the same, physically homogenous resource. Where, therefore, one has to consider in one’s action goods that will yield a utility only in the future one has to discount the utility that is to be derived from the future yield, the effect of the discount being to apply a present value to a future good. The height of the discount will be dependent upon the individual’s preference for present utility over future utility. If he is very present oriented and prefers satisfaction sooner rather than later then the discount he will apply to any future utility will be heavy, perhaps bringing the present value of this future utility to below the value of immediately serviceable goods. If, however, he is not so present oriented the discount he applies may be light, perhaps assigning to a future good a present value that exceeds that of an immediately serviceable good10.

For the sake of simplicity, let us illustrate this with apple trees. We still have the following trees yielding the following numbers of apples as we did above but now let’s also add a fourth tree, tree D:

Figure E

Tree A               Five Apples                    Now

Tree B               Seven Apples                 Now

Tree C               Three Apples                 Now

Tree D              Ten Apples                    After One Year

In figure E, whereas with trees A, B and C the utility is immediate and the yield from the trees was, praxeologically, contemporaneous with the action, this is not so with tree D, where the utility the human will receive will only come after one year. If our human is currently picking apples from tree A, what are his options if he wishes to receive an increase in value, a stream of utility that is better than what he is receiving already? They are as follows:

  1. Lose five apples from tree A now and gain seven apples from tree B now;
  2. Lose five apples from tree A now and gain three apples from tree C now;
  3. Lose five apples from tree A now and gain ten apples from tree D in one year’s time.

It is obvious that, all else being equal, the human will not choose option 2 unless he was acting in error as that would represent a clear loss. The choice, therefore, is between options 1 and 3. We note that if he moves to tree D rather than to tree B he will gain ten apples rather seven, a difference of three apples. But to gain these additional three apples he must wait an entire year. What can we deduce from the choice he makes, or rather, what will determine this choice?

In order to make the valuation he has to discount the future utility to be derived from tree D in order to compare it with tree B. If he is very present-oriented then he may, as we noted above, apply a hefty discount. Let’s say he applies a discount of four apples to tree D. Therefore, in this scenario, the present value of tree B would be seven apples and the present value of tree D would be six apples. He will therefore choose option one, foregoing the greater utility that could be received in one year’s time in favour of a smaller utility that can be enjoyed now. In other words, the additional three apples that he would gain from tree D by waiting a year were not preferable to the additional two apples he would gain from tree B now – he would prefer seven apples now to ten apples in one year’s time. If, however, he is not so present-oriented and he applies a lighter discount to tree D (let’s say two apples), what would be the result? Now, the present value of tree B remains at seven apples but the present value of tree D stands at eight apples. He will therefore choose option three, foregoing an immediate, smaller utility in order to gain a larger utility in the future.

The height of the discount that is applied in order to reach the present value of a good that yields utility in the future is known as interest. If, as we just stated, he applies a discount of two apples to tree D then the height of the interest is two apples. We now have, therefore, not two but three elements that make up the gross utility of a decision to act in relation to a good:

  1. Compensation for costs;
  2. Interest
  3. Profit and Loss.

In the case of this choice of tree D, although his actual cost is the loss of five apples from tree A now he incurs the opportunity cost of foregoing the seven apples that he could have picked from tree B now. The composition of the gross utility from his action can therefore be illustrated as follows in Figure F:

Figure F

B1—-B2—-B3—-B4—-B5—-B6—-B7

D1—-D2—-D3—-D4—-D5—-D6—-D7

(D8)—(D9)—-D10

So D1-D7 (seven apples) represents compensation for the loss of utility from foregoing the gain from tree B; D7-D9 (two apples) represents the discount while D9-D10 (one apple) is his resulting profit and loss. Even though, therefore, physically our human has three more apples than he would have if he had chosen tree B, the fact that he has to wait a year for these apples means that his net gain is reduced by the height of the discount he applies. In this case, therefore, this gross gain of three is reduced by the discount of two apples to a net gain of just one apple11.

A person will therefore, all else being equal, act in relation to a good if he a) believes that it will sufficiently compensate him for his costs, b) believes that it will provide an increase in utility compared to the current stream of utility, and c) prefers a larger gain in utility in the future (or later) to a smaller gain now (or sooner).

In the real world the concept of time is very important when considering natural resources such as land and mineral deposits. For example, a field of wheat must be fertilised in the winter, ploughed and sown in the spring, tended in the summer then finally harvested in the autumn. It is not until this latter act, almost a year after the first, that the human can consume his first bushel of wheat. But more importantly the total benefit to be derived from many natural resources will yield itself not in the first year but across many years to come. Only one harvest’s worth of wheat can only be gained from a field this year; one has to wait until the second year before gaining the second harvest, until the third year for the third, and so on. A copper mine might extract only a small percentage of its total deposit in one year, a similar percentage the next year, etc. Time therefore plays a major role in valuing these streams of utility and in analysing the composition of that utility that is gained as a result. Let us explore this in more detail by considering, again, a lone human who now tries to settle himself on and make use of a durable natural resource.

Land Settlement and Capitalisation

Let us once more put our human in the position of picking apples from tree A. As we stated above he derives an immediate utility of five apples from this tree. However, he now wishes to abandon apples altogether and wants to settle a plot of land in order to grow wheat year after year. Let us assume, for simplicity’s sake, that there is only one plot of land to settle. His costs will again be the loss of utility from tree A, but also the cost of settlement, labour, planning, ploughing, seeds, and so on. His gain will be the additional utility above and beyond the amount of wheat necessary to compensate him for these costs. In addition, however, the field will not only yield a harvest this year, but also next year as well, and in the third year, and so on. His gain in utility, the part that does not compensate him for costs, will stretch across many years and therefore must be discounted accordingly.

Let us say, for argument’s sake, that the land will yield 200 bushels of wheat per year. Of this, 100 bushels will compensate our human for costs leaving the remaining 100 representing a gross gain in utility. Let us also say that he applies a discount of the height of 10% to this gross gain. The gross yield, therefore, of the harvest in the first year can be analysed as follows:

Figure G

Year      Gross Yield        Costs                Gross Gain        Discount                  Net Gain

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      90 bushels

As a result of having to apply the 10% discount, therefore, the net gain in utility is from 90 bushels of wheat per year and not from 100. We could, therefore, say that the net value of this action, the increase in utility, what has been gained, is 90 bushels. This value, in turn, is imputed back to the land itself so that we would say that the land, having applied the discount at the start of year 1, is, at that time, “worth” 90 bushels. However, as we noted above, the land will not only yield 200 bushels in year 1, but also in years 2, 3, 4, 5 and potentially forever. How is this gain in future utility valued at present, i.e. what is the value of these yields to our human at the start of year 1?  As more time has to elapse for the bushels that appear in year 2 and even longer for those that appear in years 3, 4, 5 and so on, he will apply a heavier discount to the value of the net gain from these successive years so that the present value of this gain diminishes. If we assume, for simplicity’s sake, that the costs remain fixed at 100 bushels per year and that he will continue to discount the gain in future utility at a rate of 10% of per year we can now analyse the gross yields from each year as follows in Figure H:

Figure H

Year      Gross Yield        Costs                Gross Gain        Discount                  Net Gain

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      90 bushels

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      80 bushels

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      70 bushels

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      60 bushels

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      50 bushels

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      40 bushels

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      30 bushels

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      20 bushels

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      10 bushels

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     0 bushels

What we see is that the more remote in time the gain in utility the heavier the discount that is applied to it. The effect of this is to completely wipe out any gain of utility that appears after ten years or more. In other words, even though the land will go on yielding harvests way after this time they are so far off that they are of no present value. The total present value of the gain in utility from the land is, therefore, the sum of the final column, which is 450 bushels. This will be imputed back to the land itself so that the land will have a capitalised value of 450 bushels of wheat. In other words, the land is “worth” 450 bushels and we could expect the land to fetch that amount if it was sold.

It is very important to realise that this net gain in utility is a one shot affair. The capitalised value of 450 bushels is the value of the land now, having already accounted for the fact that the utility will not be received until a period of time has elapsed and hence, in our human’s mind, is realised now and he does not yield a perpetual net gain in utility year after year. Even though, at the start of year 1, the present value of the first year’s harvest is 90 bushel’s yet after the end of that year the landowner yields a gross gain of 100 bushels and the difference of 10 bushels will obviously form part of his income from which he will derive utility, this income is interest, earned solely because of the elapse of time between these two points and it does not represent any net gain in utility. While, therefore, a landowner can yield a perpetual interest income from the land year after year, he cannot yield a perpetual net income. Once it is known how much the land will yield each year any net gain in utility will be fully discounted to a present value – in this case, 450 bushels – achieving a place in the landowner’s value rankings now and determining his impetus towards future action now. In the real world, however, there are two complicating factors. First, the yields from future harvests are themselves uncertain and must be estimated before they are discounted to a present value. Secondly, our human must weigh the present value of the utility of the land against the utility to be derived from other possible actions. It is these factors that provide the opportunity for further net gain. What, then, are some of these options that he could face and what is their consequence on his gain?

One possibility is that another patch of land may – or may not – be more productive than the one he is settled on currently. Let’s call this new patch of land plot B and the current patch of land plot A. He therefore has to make a choice – to stick with plot A or to move to plot B. There are three possible outcomes regardless of the choice that is made:

  1. Plot B is more productive than plot A;
  2. Plot B is equally as productive as plot A;
  3. Plot A is more productive than plot B.

Which option is true is, of course, unknown before the action is completed. For argument’s sake we will assume that the costs of farming plot A are equal to the costs of farming plot B (although in reality, of course, variable costs will factor into the consideration and will serve to increase or decrease the net gain in utility from land). We will also continue to assume that the yields from each plot are constant year after year and that the same discount rate – 10% per year – will be applied to the net gain in utility. All that is unknown, therefore, at the point a decision has to be made to stick with plot A or move to Plot B is the productivity of Plot B. We will explore each of these outcomes 1-3 under each of the two possible actions that he can take.

First, let us say that our human abandons plot A and moves to plot B. What will be the effect of scenario 1? Let us say that Plot A continues with a gross yield of 200 bushels per year. Plot B, however, yields 300 bushels a year. How now will we analyse the net utility from Plot B? One solution could be as follows in Figure I:

Figure I

Year      Gross Yield        Costs                Gross Gain        Discount                  Net Gain

1          300 bushels       (100 bushels)     200 bushels       (20 bushels)      180 bushels

2          300 bushels       (100 bushels)     200 bushels       (40 bushels)      160 bushels

3          300 bushels       (100 bushels)     200 bushels       (60 bushels)      140 bushels

4          300 bushels       (100 bushels)     200 bushels       (80 bushels)      120 bushels

5          300 bushels       (100 bushels)     200 bushels       (100 bushels)     100 bushels

6          300 bushels       (100 bushels)     200 bushels       (120 bushels)     80 bushels

7          300 bushels       (100 bushels)     200 bushels       (140 bushels)     60 bushels

8          300 bushels       (100 bushels)     200 bushels       (160 bushels)     40 bushels

9          300 bushels       (100 bushels)     200 bushels       (180 bushels)     20 bushels

10         300 bushels       (100 bushels)     200 bushels       (100 bushels)     0 bushels

Figure I points out the fact that plot B is, after direct costs, physically twice as productive as plot A. However, this would not be a true statement of the net gain that is yielded by our human from plot B. This is because he can already, with the same costs, gain a utility from Plot A. By moving to plot B from Plot A he foregoes the utility to be derived from this latter plot and so this becomes an opportunity cost. In other words, the gain in utility from Plot A that could have been made has to be subtracted from the utility gained from plot B. This is illustrated in Figure J:

Figure J

Year      Gross Yield        Costs                Gross Gain        Discount                   Opp. Cost          Net

1          300 bushels       (100 bushels)     200 bushels       (20 bushels)      (90 bushels)      90

2          300 bushels       (100 bushels)     200 bushels       (40 bushels)      (80 bushels)      80

3          300 bushels       (100 bushels)     200 bushels       (60 bushels)      (70 bushels)      70

4          300 bushels       (100 bushels)     200 bushels       (80 bushels)      (60 bushels)      60

5          300 bushels       (100 bushels)     200 bushels       (100 bushels)     (50 bushels)      50

6          300 bushels       (100 bushels)     200 bushels       (120 bushels)     (40 bushels)      40

7          300 bushels       (100 bushels)     200 bushels       (140 bushels)     (30 bushels)      30

8          300 bushels       (100 bushels)     200 bushels       (160 bushels)     (20 bushels)      20

9          300 bushels       (100 bushels)     200 bushels       (180 bushels)     (10 bushels)      10

10         300 bushels       (100 bushels)     200 bushels       (200 bushels)     (0 bushels)        0

As we can see, therefore, our human’s net gain of moving from Plot A to Plot B is equal to his net gain from moving to Plot A in the first place. While, therefore, Plot B produces a gross gain that is double that of plot A, the effect of discounting and of opportunity cost has been to reduce this gross gain to a net gain that is equal to that of the original move to Plot A. There is, however, some net gain and the move from Plot A to Plot B is profitable.

The effect of scenario two should be obvious – if both Plots A and B have a gross yield of 200 bushels a year and we apply the same costs and discounting then there will be no net gain whatsoever. The opportunity cost that is incurred by abandoning plot A will be exactly recouped from plot B. We can illustrate this as follows in Figure K:

Figure K

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      (90 bushels)      0

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      (80 bushels)      0

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      (70 bushels)      0

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      (60 bushels)      0

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      (50 bushels)      0

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      (40 bushels)      0

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      (30 bushels)      0

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      (20 bushels)      0

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      (10 bushels)      0

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     (0 bushels)        0

While, therefore, the move has not incurred a loss it was, otherwise, pointless and purposeless12. What about scenario three? Let us assume here that the gross yield from Plot B is only 150 bushels a year, lower than that of Plot A. What happens then?

Figure L

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          150 bushels       (100 bushels)     50 bushels         (5 bushels)        (90 bushels)      (45)

2          150 bushels       (100 bushels)     50 bushels         (10 bushels)      (80 bushels)      (40)

3          150 bushels       (100 bushels)     50 bushels         (15 bushels)      (70 bushels)      (35)

4          150 bushels       (100 bushels)     50 bushels         (20 bushels)      (60 bushels)      (30)

5          150 bushels       (100 bushels)     50 bushels         (25 bushels)      (50 bushels)      (25)

6          150 bushels       (100 bushels)     50 bushels         (30 bushels)      (40 bushels)      (20)

7          150 bushels       (100 bushels)     50 bushels         (35 bushels)      (30 bushels)      (15)

8          150 bushels       (100 bushels)     50 bushels         (40 bushels)      (20 bushels)      (10)

9          150 bushels       (100 bushels)     50 bushels         (45 bushels)      (10 bushels)      (5)

10         150 bushels       (100 bushels)     50 bushels         (50 bushels)      (0 bushels)        0

As we can see in Figure L the effect of the lower productivity of plot B, after accounting for what he lost from the move from Plot A, has been to impose a loss on our human. Even though he is still producing something it would have been far better for him to have stuck with Plot A where the yield was much higher.

Now let’s examine what happens if he doesn’t move from Plot A to Plot B. What are the results of our three scenarios then? Now, where Plot B is more profitable but he chooses to remain on Plot A, he will continue to derive the same utility from Plot A that he does at the moment however the effect of the foregoing of the more profitable plot B is to impose an opportunity cost upon his gain from Plot A. Applying the same costs and discounting as before his net utility gained will, therefore, be as follows in Figure M:

Figure M

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      (180 bushels)     (90)

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      (160 bushels)     (80)

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      (140 bushels)     (70)

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      (120 bushels)     (60)

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      (100 bushels)     (50)

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      (80 bushels)      (40)

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      (60 bushels)      (30)

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      (40 bushels)      (20)

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      (20 bushels)      (10)

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     (0 bushels)        (0)

While, therefore, our human continues to derive utility from Plot A the existence of the opportunity cost of foregoing the utility of Plot B has had the effect of imposing upon him a net loss. In other words, he made the wrong decision in choosing to stay on the less profitable Plot A and this erroneous decision has been penalised by the loss.

In the second scenario, obviously there is, again, no net gain or loss from remaining on Plot B and the composition of utility derived will be as in Figure K, above. What about scenario 3, however? This is where Plot B is less profitable than plot A and our human chooses to remain on Plot A. What is the composition of utility now?

Figure N

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      (45 bushels)      45

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      (40 bushels)      40

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      (35 bushels)      35

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      (30 bushels)      30

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      (25 bushels)      25

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      (20 bushels)      20

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      (15 bushels)      15

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      (10 bushels)      10

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      (5 bushels)        5

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     (0 bushels)        0

 

What has happened is that Plot B, although less productive than Plot A, still yields a greater productivity than that which our human was experiencing before his first move to Plot A. Therefore, his net gain in utility from the original move to Plot A (Figure H, above) has been reduced accordingly, although there is still a net gain and the decision to remain on Plot A is profitable.

What we must reiterate from all of this is that our landowner’s gross income all falls into three categories:

  1. Compensation for Costs;
  2. Interest;
  3. Profit and Loss

Category 1 includes compensation for all direct costs associated with producing the land’s yield and also opportunity costs. The more productive, therefore, an alternative action on an alternative piece of land the higher these latter costs will be and category 1 will claim a larger portion of the gross yield than categories 2 and 3. Category 2, interest, is equal to the height of the discount that is applied to each yield and is earned only after the appropriate period of time has elapsed. Category 3, the net yield, can only be earned through an entrepreneurial judgment, a decision that takes place under the condition of uncertainty. Once it is known or realised precisely how much the yield will be this income will be fully discounted to a present value and, thereafter, a landowner can earn only interest on this income. In reality, of course, the decision is much more complex because of a multitude of uncertainties that exist:

a)     Direct costs of farming a plot will change from year after year and must be estimated in advance of their occurrence;

b)     Opportunity costs will change from year after year and, likewise, must be estimated;

c)      The gross yield of a plot of land is not certain in advance; rather, factors such as the weather, seed quality and soil deterioration will intervene;

d)     The discount to be applied to future gains is dependent upon the individual’s time preference rate which is subject to change.

A fuller analysis of these factors will become clearer through the situation not of a lone, individual human being, but through one where there is the trade of land and resources between many human beings. To this task we shall turn in part two.

Go to part two.

View the video version of this post.

1Alternatively by a deity if that is one’s inclination. The cause of the creation of matter and life in the universe is not under examination in this essay and one is perfectly entitled to substitute “God” for “nature”.

2The neutrality of description of that which is yielded to a human by utility is extremely important to grasp, as we shall see a just below.

3It is actually more often the case that the matter in existence falls into this second category. In spite of a population of approximately 6 billion people on the planet, humanity has only succeeded in tapping into a very small fraction of the matter available in the Earth. Although much of the Earth’s land surface has been utilised to a wide extent, the seas, the sky and below the Earth’s crust remain unexploited territories simply because it is too costly to make use of them.

4Carl Menger, Principles of Economics, pp. 94-8.

5It is also possible for physically heterogeneous resources to be praxeologically homogenous goods – for example, if there are two steaks on sale, one of which weighs 300g and the other of which weighs 300.1g, this physical difference will be irrelevant if the human believes that each of the two resources has equal serviceability and they will, therefore, be two portions of the same good].

6A clear conception of the law of marginal utility may assist any difficulty in the comprehension of what is being said here. Briefly, as the available units of a good increase, the quantity of a human’s ends which become fulfilled by these units increases also. If, therefore, a human loses one unit of a good then he will forego the least urgent end and continue directing the remaining units to the more valuable ends. His appreciation of any one unit of a good, therefore, is the loss of utility that he would experience by leaving the least urgently needed end unfulfilled. However, as the quantity of air exceeds the number of ends towards which a human can direct it the loss of one unit of air entails no loss of utility whatsoever and hence a single unit of air is unappreciated by a human being. For a particularly lucid explanation see Eugen von Böhm-Bawerk, The Positive Theory of Capital, Book III, Chapter IV.

7The valuation between goods again springs not from the utility to be derived from whole classes of goods such as “present air” and “future air” but only from the marginal units of these classes. If all units of air exist as present air, a human will act to direct units towards future air when the stream of utility to be gained from the first unit (i.e. the unit to be gained) of future air is, to him, preferable to the stream of utility to be derived from the last unit (i.e. the unit to be lost) of present air. He will stop acting in such a way when the utility from the last unit of present air is more preferable to him than the utility from the next unit of future air.

8As the human is standing in position A and not position B it should be obvious that the quantity of firm ground available for his immediate use is zero.

9Again, what matters here is not the physical elapse of time but its praxeological significance. All actions, of course, take place through time and their resulting utility can only be received at a point after which a decision has been made to carry them out. For example, I first have to decide that I want to eat a sandwich before I derive the utility from doing so. But unless the elapse of time involved in this process is consciously appreciated by me then it will have no significance in economics.

10One can analogise goods that yield utility at different times to those that yield utility in different locations as both time and distance are factors of remoteness that cause one to apply a discount to the net utility to be derived. All else being equal, goods that are closer are more serviceable than those that are further away. In order to compare the utility from a distant good with a near good, therefore, one has to apply a discount to the distant good. Here, however, the discount is easily calculable as it consists simply of the costs of transporting the distant good. If, therefore, the utility from a distant good minus transportation costs is higher than the utility to be derived from a near good then the distant good is more valuable than the near good and the human will act in relation to it. If, however, the effect of transportation costs brings the utility of a distant good below that of the near good then the distant good is not more valuable than the near good and the former will remain untouched.

11The height of the discount applied will also, of course, account for the fact that apples D1-D7, compensating him for the loss of B1-B7, will also not be received until after a year.

12In reality, also, there would be the transaction cost of moving plots to be accounted for which would result in an overall loss from the move but for simplicity’s sake we have omitted these here.

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.

Production

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

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

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.

Uncertainty

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.

Conclusion

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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Free Choices or Coerced Choices?

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The Academy of Medical Royal Colleges, which apparently is a “united front” of the medical profession, says its doctors are seeing the consequences of unhealthy diets every day and that it has never come together on such an issue before. Needless to say a whole raft of interventionist measures are recommended to curb this apparent problem:

  • A ban on advertising foods high in saturated fat, sugar and salt before 9pm;
  • Further taxes on sugary drinks to increase prices by at least 20%;
  • A reduction in fast food outlets near schools and leisure centres;
  • A £100m budget for interventions such as weight-loss surgery;
  • No junk food or vending machines in hospitals, where all food must meet the same nutritional standards as in schools;
  • Food labels to include calorie information for children.

We will set aside for the moment the issue of whether it can be said that there are “right” choices for people to make when it comes to what they want to do with their own bodies (why, for example, should people prefer a longer life to the enjoyment provided by a burger and fries washed down with a pint of coca-cola?). Instead, the problem here is rather more grievous which is that, whenever members of the public make choices about how they want to live their lives there is the ever present assumption that, as these choices are made with apparent freedom, that it is the free market that has failed in preventing the emergence of the “undesired” outcome. What is never discussed or even raised is the possibility that people’s choices are already constrained or influenced by existing Government interference to the extent that, not only is it impossible to say that the choices made would be the same as those that would be made on a genuine free market, but that Government intervention is itself causing the undesirable choices to be made. And, lo and behold, blinded by such ignorance, the call is always for more Government intervention to augment that which we already have to put up with.

The present author has examined in detail why socialising healthcare will lead to greater ill health. There is little need to repeat all of this here except to say that people prefer doing that which comes at a lower cost, all else being equal. So that if you lower or remove the cost of becoming ill then, relatively, you will have more people who lead lifestyles that will result in ill health.

But the same fallacy is advanced in all cases where the proximate cause of a problem is people’s apparent free choices. Let’s examine some of the most popular:

“There is not enough food in the world! If the free market has brought such widespread hunger then Governments much intervene!”

The allegation here is usually some variant of the rich world refusing to share its wealth with the poor world. Leaving aside the fallacious belief that one person having means that another must not have, just why is it that we have widespread poverty in the age of the iPad? The plight of poor nations has nothing to do with being unable to understand technological development, nor are they in anyway lacking a rich diversity of raw materials. Rather it stems from the lack of capital investment per head of the population compared to the West. In the West, we have more machines and better tools that can churn out more and better goods per person than they can in poor nations. So yes, investors and capitalists have not invested in poor countries. The free market has not reached these nations, it must have failed! But the precise reason why the West has benefited from the free market is that it has long cherished institutions that have allowed to the free market to flourish, in particular strong legal rights to private property and relative political freedom. These are precisely the conditions that are lacking in poor nations, conditions that cause entrepreneurs to seek other havens for their investments. At the back of their minds, no doubt, is also the mass expropriation of foreign investment in the post-colonial era. Why should anyone bother investing in a poor nation if their wealth will just be pinched by the Government? To make matters worse, poorer nations began to model themselves on their Western role models just at the point when the latter started to turn away from a social order based on private property towards interventionism and social democracy with the result that the wrong lessons are being learnt. A product of this tide has been that Western governments now heavily interfere in world food markets, whether it be through such wicked and wasteful outfits as the Common Agricultural Policy, subsidies for farmers to devote farmland to ethanol production, or the vast regulatory network that impedes food production at the behest of a few powerful lobbyists. The recent scandal of horse meat appearing in processed beef products sold in UK supermarkets should be viewed in this context.

Poverty and hunger are therefore a failure of Government, not of the free market.

“The forests are disappearing! The free market, seeking ever greater profits, is decimating our natural resources! The Government must stop it”

Let’s go even further: add to the list fish stocks, elephants, whales, and any other of the countless number of “endangered” species that you like. Yes, there is a great problem, and yes, looking at the issue at face value, it appears that capitalists are running down these resources.

But this raises the question of why has the free market not produced similar shortages of other things? The dairy industry, for instance, exploits cows for profit but we never hear of a shortage of cows. Nor do we seem to be in short supply of chickens to supply us with eggs on our breakfast plates. So why is it only some resources that seem to be in danger of depletion? What is the difference between the endangered group and all the others?

The reason is that people are not permitted to own the capital value of forests, parts of the sea, elephants, tigers, etc. If one is able to own the capital value of the resource then exploiting it for present revenue has to be balanced against the loss of capital value in doing so (a full explanation of this is available here). But if one does not own the capital value then the only concern is for present revenue – there is no cost to exploiting resources to their fullest now. In fact the only cost is that someone will get there before you. So instead of all the myriad of Government restrictions and regulations concerning these depleted resources in order to “cure” the alleged free market ravaging all that is needed is to extend full private property rights to these resources and they will be conserved. Once again the problem is not too much free choice but the fact that people have been prevented by the strong arm of the Government from having a reason to make the “right” choices.

And let us conclude with the most pertinent of all alleged market failures, the phenomenon of “boom and bust”:

“Free market greed has caused capitalists to invest in wasteful projects! Clearly they need the Government to give them speed limits!”

Once again, looking at only the proximate causes of boom and bust will reveal that entrepreneurs invested too heavily in a particular sector, inflating a bubble that eventually pops, causing widespread misery and unemployment. In the 2007-8 financial crisis, the effects of which are lingering with the current malaise, a summary of the charge is that greedy bankers had lent money to people who could not afford to pay it back. End of story. But what is not told by peddlers of this narrative such as Paul Krugman is the moral hazard created by the so-called “Greenspan put” which had the effect of financial institutions expecting their profits to be retained and their losses to be borne by an influx of monetary liquidity during any risk of collapsing asset prices (i.e. in short paid for by inflation). If one can keep one’s profits and socialise one’s losses is it any wonder that people took wild risks? If there is only ever an upside then wouldn’t you? This is before we consider the fact that credit expansion is the cause of the business cycle in the first place that will always lead, by falsifying the societal time preference rate, to the expansion of unsustainable investment projects that must be rendered wasteful as soon as the inflation stops.

Therefore, next time you read that the “free market” has caused this, that, or the other, stop and think as to precisely what the options of the free market participants were. More often than not you will trace the source of the bad decision to some kind of Government interference.

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