Altes Elliott-Wellen-Forum - The Cone of Production / Artikel von mises.org, engl.

The Cone of Production / Artikel von mises.org, engl.

verfasst von - ELLI -, 16.12.2002, 15:53

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The Cone of Production

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By Sean Corrigan 

[December 16, 2002]

Finally, the mainstream has come to

recognise--albeit dimly--that the phenomenology of this cycle is not like the

ones to which it has been introduced by its teachers. It is not about

insufficient demand or money, nor it is a result of a technology shock.

It is a story of malinvestment--resources misapplied due to bad interest-rate

signaling from the Federal Reserve itself. 

The mainstream still stutters about 'overinvestment'

rather than the much more accurate 'malinvestment', and still largely fails to

recognise the critical role of unbridled credit creation which was at the

heart of the recent Boom and its subsequent Bust. 

However, there is another issue at stake in the

prevailing circumstances which is again missed by the Hierophants of Orthodoxy,

but an understanding of which is absolutely vital to acquiring a grasp as to

what is going on in today and what the investment implications are of this.

The issue, put simply, is this: does

stimulating consumption lead to the generation of a structure of production

which will profitably and sustainably provide the desired goods to the

consumers, alongside the means with which to buy them? 

More pointedly, we need to recast this question

to consider the negative side: can stimulating consumption disrupt, or even

preclude, the generation of such a structure?

Having set out our thinking on this issue, we

will then look at the vexed issue of an official policy which is geared to

making savers despair of the value of their money holdings and of encouraging

spenders to continue to squander their patrimony.

We need to step back a little to lay out a

model of the economy somewhat different to the one most people have been given

to consider: something we'll call the Cone of Production.

[img][/img] 

In its simplest form, it shows how the division

of labour is made so that men can work to provide that rich basket of ultimate

consumer goods and services to the broad masses which is the defining triumph

of free market capitalism.

At the left hand end of our diagram, we have

raw material production, such as mining and refining. Next, we go through the

area of capital goods, where we make not so much the things we wish to enjoy,

but the tools with which we will fashion them. Successively, we then proceed

through intermediate goods in general, and onto the distributive industries of

wholesale, transport and retail, as well as those which center upon the

provision of less tangible services to their customers.

The horizontal axis in this diagram is, in fact,

a time axis (though we would be loath to include any determinate time

intervals on this highly schematic layout). 

The vertical, by contrast, we can intuitively

grasp, should be widening, as jobs become less specialized, more labour, and

less capital, intensive, and as the mass of products gradually swells as we

move from barn, to grain elevator, to baker, to bagel stand.

This is only to say that there are more people

driving taxis than designing them, or that more money is spent on potato chips

than on chip fabrication plants.

What we can also think of the cross sectional

area of the cone as measuring, therefore, is the flux of money flowing through

the system--or of corporate (and, strictly, non-corporate business) revenue at

each particular stage of production.

The slope of the curve must thus represent the

amount of value added in a unit of time. More fundamentally, by imputation,

the value of any higher order product (i.e. one located more towards the left

hand apex) must represent a suitably discounted present value of its expected

future worth as a consumer good.

In less technical terms, what this is saying is

that no-one buys a tool-die, or a metal-cutting lathe, for its own sake, but

instead with an eye to the value of the range of consumer goods to which it

ultimately gives rise. 

Thus, starting from the right hand end, we can

take the money clattering into the nation's shop tills and work backwards to

those factors of production--both human and physical--which participated at

any preceding stage in the given consumer item's manufacture, including all

legal, marketing, packaging and delivery costs. 

To make this rigorous, we should use a

continuously compounding discount factor to accomplish this calculation,

something which will give us a smooth, exponential curve. 

This discount factor, since it depends upon how

willing we, at the right, are willing to wait for a product to make its way

along from the left, is a measure of our time preference, something which the

Austrians categorize as the 'natural interest rate'.

When we take into consideration that a man,

working today to produce goods in the shops for next Christmas, will need to

be fed for a year ahead of the point where his labour comes to its final

consummation, we should also see that he needs the assurance that he himself

can draw upon a stock of consumer goods throughout this period, or he will not

willingly undertake the task. 

That, in turn requires an act of

forbearance--of saving--and the satisfyingly consistent inference is that a

lower time preference (less material impatience, if you will) implies higher

savings and thus the ability to support more workers further off to the left.

In other words, higher savings allow for more

specialized, more capital - and skills -intensive work to be conducted,

something which gives us a greater chance of heightening value productivity

and of encapsulating innovation and inventiveness into the everyday round of

production.

Savings, we might begin to glimpse, are what

help us enrich ourselves.

Once we assume these conditions, all will be

well in this ideal world where there are no more than local--and cumulatively

offsetting--fluctuations between supra- and sub-optimal businesses to violate

the smoothness of the curve.

Then, as we can see from the diagram, our

capital goods producer pays for resources (materials, equipment and labour) to

the tune of the area in the red disc and, a little while later, sells his

product on to realize the slightly larger area shown in the nearby blue disc.

The difference between the two--a small ring

around the circumference of the blue disk, typically, perhaps, some 5-10% of

its total area--will represent the net income of the capital goods makers. 

As this passes on down the chain, each

successive intermediary, in turn, earns his own surplus and the sum of all

those surpluses is simply the integral of those annuli--which neatly amounts

to the total blue area of consumption at the extreme right end of this

productive funnel.

In other words, everyone eats his own cooking

and cooks his own eating. The system is closed and consistent.

There are a number of other features to notice

in the diagram.

The first is that the standard GDP figures, to

which so much misplaced emphasis are accorded, only count the light blue areas

of our figure: namely, final consumption and a rather arbitrarily defined

category of investment in fixed capital and inventory. 

That this is arbitrary can be seen with the

WorldCom like recategorization of software as a capital expenditure, not an

expense, a few years back, or by comparing the inclusion of houses (consumer

durable goods) with the exclusion of boats, fridges and cars (also consumer

durable goods).

But, quibbles aside, what the GDP method of

accounting completely ignores is what goes on in the yellow portion at the

core of the funnel, a volume which we can see, in reality, makes up a sizeable

proportion of the cone - in fact, no less than $9 trillion dollars

in today's economy.

This oversight lies, in fact, at the heart of a

great deal of the error committed by the mainstream and is this responsible

for the damaging policy prescriptions they regularly seek to carry out.

In essence, a great many livelihoods rest here,

in the business-to-business area, and, at every stage and continuously

throughout time, the workers, owners, and managers of these enterprises are

asked to make voluntary choices to contract, to maintain, or to expand their

current activities.

Each one of them, too, must constantly be

assessing whether he will be acting in what he sees as his own best interest

by taking another set of inputs from those further to the left in our diagram

and transforming them into a new set of lower order, more nearly finished,

products, hopefully to be used again by his customers off to the right.

It is an absolutely critical observation that

there is no automaticity in any of this, as the mainstream blithely assumes in

its erroneous doctrine of 'effective demand'. 

Rather, each actor must repeatedly rethink the

decision whether or not to save the greater part of his income (for

gross savings are what a firm makes when it simply re-stocks its

production lines, or offsets wear and tear on its equipment, while net

savings are moves to add to either its fixed or circulating stock of capital).

That this is a genuine choice must always be

borne in mind, for there is nothing which precludes the businessman, or his

shareholders, from seeking instead to consume an increased proportion of their

income at any point, in the pursuit of more direct, if, perhaps, less lasting,

satisfaction. 

Carrying this forward, it shouldn't take a

degree in mathematical topology to realize that we can build a solid with a

much wider base (we can engage in more consumption) and yet shrink the rest of

the cone, and so produce a higher GDP number on a smaller overall volume.

This new shape will be less revenue rich and

less specialized. It will contain fewer niches for workers and entrepreneurs,

and fewer outlets for capital. It will be one which is likely (though we

haven't demonstrated that rigorously here) to grow more slowly, while being

more prone to the more obvious effects of monetary inflation.

Astute students of corporate performance will

have realized that we have pretty much summed up what recent rounds of

quarterly results, capital expenditure trends, and labour market developments

have shown to be in train today, when we enumerate these deductions. 

For now, let us leave any effects arising from

credit conditions out of the equation and just look at what happens if there

is a spontaneous raising of time preference on the part of the populace. 

People will have less appetite for saving (the

act of providing for goods tomorrow) and a greater desire for consumption (the

appetite for goods today). The natural rate of interest will rise and the cone

will become steeper and wider: less of a wizard's hat and more of a coolie's -

which is rather fitting, if you think about it.

But look what happens to the higher order

industries as this takes place and recall, when you do, that these are more

specialized and tend to be more capital intensive. Also recognise that it is

quite likely, too, that hard-to-adjust fixed costs will be higher in these

firms, relative to the variable and more conformable costs of doing business.

Starting off with much the same level of costs

(the red disc), they now find the market for their product has shrunk

appreciably (the blue disc). They begin to make potentially

solvency-threatening losses and, if this persists for any length of time, they

will either move out of their current business, or be driven out of it.

Moreover, since this process will start much

further down the curve than we have chosen to illustrate, each such firm, as

it encounters a shrunken blue surface into which it can deliver its output,

will attempt to contract its red surface to match its straitened circumstances

- remember, businesses as producers can never really

control the price at which they sell to their customers, but, as consumers

of others' output, like all consumers, everywhere in the chain, they do

help determine the prices realized by their own suppliers.

Further, bear in mind that firms have a much

higher discretionary component to their income than individuals and so changes

here can be much more radical than at the rightmost extremity of the diagram.

Firms don't need feeding and clothing and don't pay school fees. If firms must cut

outlays, they can cut them - all the way to zero, if need be.

This in itself serves to focus the pain up into

the shortening apex of the cone - that is, upon those least able to bear

such sizeable shifts in the constituency of demand - but there is worse. 

The Impact of Credit 

The pernicious role of expansive credit now

needs to be considered for its impact.

It is a central tenet of <st1:place>

<st1:PlaceName>

Austrian</st1:PlaceName>

<st1:PlaceType>

School</st1:PlaceType>

</st1:place>

theory that a period of credit inflation - always accommodated, if not

predicated, by the central bank - is what gives rise to the Boom in the

first place.

This comes about because the extra credit

initially finds its way into bidding up the prices - and down the yields -

of financial assets.

This lowers the cost of capital dramatically

- whether in the form of debt or equity - and allows a rash of previously

unfunded ventures to be launched and the majority of these are always prone to

be found in the higher order categories of goods (technology is sexy, and New

Eras seductive, after all).

Another reason for the concentration here is

slightly more indirect. To the natural rate of interest which we have

introduced, and which consists of people's instinctive pricing of the passage

of time, we must, in the real world, add two other factors: a compensation for

the potential loss of the purchasing power of money and an added return

commensurate with any increased risk specific to an individual business

undertaking.

From all we have argued so far, we can see that

higher order businesses must be deemed to be inherently more risky than lower

order examples. They are more capital intensive, they are more specialized and

thus less adaptable. Their lead times and forecasting horizons stretch further

into a dimly-perceived and uncertain future. The value imputed to their output

also passes through many more hands and hence is filtered through a greater

number of layers of decision makers through the body of the cone, making it

much more susceptible to large fluctuations.

This element of a risk premium in the discount

rate might therefore be thought to be more elevated, the further left in the

diagram we go, under normal circumstances (in fact, we have included exactly

such behaviour in the equation which generated our curves).

But, come the Boom, and the bidding up of asset

prices and down of yields tends to lead investors to extend out the credit

spectrum, as well as to tolerate longer maturities. Risk premia therefore

become squashed, often unrealistically so. Lower risk premia, combined with

artificially lowered rates in general, means lower project finance hurdles

over which to jump and hence more projects being rolled out than are warranted. 

Moreover, there are fewer firms - as well as

more visible ones - at the high end of the cone, so the money chasing into

their securities can have more dramatic effects in the initial stages: an

instability which becomes structural through the detrimentally slavish

devotion to the fetish of 'indexation' practiced by most institutional money

managers, who thus keep reallocating in favour of the winners, like punk

gamblers betting more each time on the last winning number. 

Thus, higher order firms will be

disproportionately present in this dangerously ill-founded and inherently

misdirected expansion - and these will rank highly among the ultimate

victims of the Boom as a result. 

Indeed, the very fact that these schemes were stuck

on the drawing board before the Boom began should be enough to determine that

they represent plans for using resources for less urgent, lower priority needs

than those already in effect. In other words, these businesses were

sub-marginal under the prevailing mix of consumer needs and capital

possibilities and only easy credit allowed them a chance to compete for a

ration of the nation's ever scarce pool of resources.

Now, we don't just find ourselves in a chicken

farming Boom. We have the possibility of a fully-fledged mania, for one of the

most destructive of all currents is that firestorm which develops in an

asset-credit vortex whereby money chases an asset and forces up its price,

increasing speculative demand for it and, at the same time, improving the

value of the existing holders' collateral. That then provides both motivation

and means for another round of borrowing and buying, ratcheting prices - and

indebtedness - higher at each turn. 

There is nothing to guarantee that the focus of

all this activity is actually adding to real value, rather than merely to the

kind measured with the rapidly-shrinking ruler of money's worth.

What it certainly cannot conjure out of thin

air either is the complex capital array needed to see the start-up's, or new

business division's, product through to a finished and wanted consumer good.

It did not originate in a voluntary shift to more saving - signaling

relative satiety with the basket of goods on offer today and hence the

possibility of a latent, higher desire for new goods in future - nor can it

help assure that any such production as is completed will

be viable.

All that this frenzy of misplaced activity can

wreak is contained in the lesson of the last two and a half years, and it

should serve to tell us what the awful consequences of such a grand folly can

be.

Is Consumption the Answer?

But we are not addressing the pathology of the

Boom-Bust cycle here for its own sake: we have done that often enough and at

length - both during its final soaring ascent and all through the hurtling

decline since.

Rather, since what we have been considering

here are the effects of enhanced consumption on the Cone of Production, let us

briefly consider what consumer credit does to its structure, before marrying

the two parts and trying to assess whether a policy of unrestrained

consumption can ever be the answer to a bust which had its roots in a

misguidedly lengthened cone.

To recap our earlier conclusions, accumulating

more capital per head of the populace is what leads to progress, whereas

destroying capital can only make us poorer, and a shift towards consumption is

- a priori - a shift towards the latter.

In the case which we looked at in detail, we

only considered a spontaneous shift towards higher time preference (a more

intense appetite for immediate goods and services) without worrying about

credit effects. So, now, let us allow consumers to borrow ever more freely as

well.

While businesses are all too fallible - and

can often be run as engines of ill-deserved gratification for their managers

and bankers - the ostensible purpose of business borrowing is for

reproductive purposes, that is, it is aimed at using the extra resources it

can now command in such as way as to give rise to enough extra income to

service, amortize and, one day, discharge the debt so incurred.

Used irresponsibly, or contracted in the midst

of a miasma of monetary expansion, this can be damaging, but it is not the

credit itself, but its misuse, that is the evil. Corporate credit is like fire

- useful when controlled, but the source of an inferno, if unchecked - but

corporate credit, when the funds have previously been saved, is as

legitimate a form of capital as shareholders' or proprietors' equity. 

Consumer credit, on the other hand, has few

redeeming features, since it is aimed squarely at the pleasurable extinction

of those things for which one has not already offered up a compensatory

creation of value through work, or the use of one's assets.

The best consumer credit can do is to promise

proper payment out of future contributions, but this is merely to indulge a

spoilt child, doling out treats today on the pledge of good behaviour tomorrow.

Imagine a business given a special subsidy to

enable it to buy in supplies and to pay for labour ahead of its rivals. Very

soon, this business would begin to crowd all other businesses out of the

chance of making the returns they require. 

It would bid up costs - of materials,

services and labour - and it would, no doubt, have an increasingly insistent

first call on such genuine capital, as well as such extra created credit as

was available, so depressing the chances of investment elsewhere in

the cone.

Consumer borrowing can be thought of as exactly

such a subsidy.

Indeed, we can see this process clearly at work

if we use our new-found perspective to re-interpret what the latest NABE

survey was telling us about costs being the worry, not credit availability.

More corroboration comes from a recent NFIB small business survey where, when

asked to rank their most pressing problems, whereas fully two-thirds cited

issues of costs, taxes and regulation, only 25% cited matters related to

demand and competition, and a risible 2% cited credit issues.

Consumer credit, moreover, has been actively

encouraged by the authorities, whether through exhortation (remember 'Shopping

for America', in the wake of the WTC attack?), through lowering rates with the

aim of making money holdings as unattractive as possible, or through the

disingenuous promotion of the housing bubble as a means of building 'equity'

(in fact, just another asset-credit spiral) - equity, no less, which is then

to be withdrawn and spent via cash-out refis and dedicated lines of credit! 

Thus, if a producer credit boom wastes scarce

real capital by channeling it to over-ambitious, or fundamentally flawed,

business ventures (what we call malinvestment'), consumer credit burns capital

on the altar flames of a fatalistic self-indulgence.

Ask yourself this, if the end of the Boom has

already necessitated a painful shortening of the productive structure, how can

fostering individual habits of profligacy and material gluttony - which only

serves to shorten the cone yet further - be of any assistance whatsoever?

It should be apparent that floundering,

post-Bubble entrepreneurs are striving to secure a foothold somewhere in a

structure revealed to be not as rich and supportive of higher-order processes

as had been believed. It should also be an ineluctable conclusion that

mobilizing the masses to force the cone into an even steeper, more truncated

form, is only to be moving the ground from under those companies anxious to

swap the quicksand of the Boom for the bedrock of relative certainty once more.

What is the Answer?

So, what is the prescription?

Well, if credit-led over-consumption drags

everything to the mouth of our cone, and if the secular trend of capital

accumulation is what, at root, ensures progress, surely we should be telling

people to emerge from denial, to recognise the real degree of loss occasioned

in the Boom, and to begin to under-consume - i.e. to save.

Yes, some goods will go begging when first

offered - they will even fall in price (GASP!) to reflect this. To condemn

that is to castigate veracity in expressing their place in individuals' freely

compiled lists of preferences.

Yes, some companies will fail, but if they are

not viable under true free market conditions, they are merely locking up

scarce capital in decidedly less than optimum undertakings. If the advice to

winnow them out is fit for <st1:country-region>

<st1:place>

Japan</st1:place>

</st1:country-region>

, it is surely fit for the Anglo-Saxons, too.

Finally, yes, the banks and the other

multifarious financial intermediaries will, like the State itself, not reap

quite so much of the handsome, if rotten, fruit of credit expansion. Some of

the more egregious of them may also fail, but the more sound survivors will be

the ones best suited to act wisely in future. As for the State, it will just

have to be more honest about how much of our labour it

would conscript to pay for its guns and other peoples' butter.

Far from being a bane, in truth, none of these

consequences is more than an act of preparing the groundwork for future, more

stable, increases in genuine earned prosperity.

Of course, we then want such savings as we do

make to be channeled by sound financial intermediaries, acting on wise and

prudent principles of stewardship, to companies with realistic aspirations,

run by open and honest managers.

The cynics among us may grunt that such a

combination is hardly to be found, but just because it is a labour to ferret

it out, doesn't mean we should despair of its existence and, more to the

point, a continuation of the present flawed, chronically inflationary and

morally hazardous financial system is not likely to be conducive to such rare

blooms seeding themselves among the weeds of monetary and ethical corruption. 

But sermonizing aside, does this represent

anymore of a way out than the current ruse to provoke just enough inflation to

maintain headline billing for our great debt-asset Ponzi scheme for another

period 'in the short run'?

The flip answer is to recall the old Irishman's

response, asked, as he sat smoking his briar at a country crossroads, by a

lost and benighted traveler: 'Could ye tell me the way to Skibereen, please?' Pushing

up his cap to scratch his hoary old head for a moment, the old man looks the

fellow up and down and drawls: 'If Oi was after getting there, Oi wouldn't be

starting from here!' 

There are no easy choices. Huge - perhaps

unprecedented - imbalances, record indebtedness perched atop still-overblown

asset prices, the ire of powerful vested interests, and a blind dedication to

a whole pharmacopoeia of quack remedies and misdiagnoses stand in the path to

recovery and regeneration.

But, after eighty years of increasingly

ubiquitous and unabashed central bank-led inflationism, one which financed two

industrial-scale, and a host of lesser, slaughters, two monumental booms, and

one Great Depression, might it not be time to refer the patient to a more

sympathetic, traditional doctor to see if he can effect a cure, before our

current debt-fuelled consumption leads us to such a state of exhaustion and

enervation that we risk another such Depression and--almost inevitably--a

new and more horrible global conflict? 

The voices of political and intellectual

inertia may cry a resounding, No!, to such an imprecation and <st1:City>

<st1:place>

Rome</st1:place>

</st1:City>

may fall again, as a result.

But, at least you will not now have to wonder

why the consumer not only didn't save the day, but may well

have lost it for us.

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Sean Corrigan is a principal of www.capital-insight.com,

a London-based economic consultancy.

Thread gesperrt

gesamter Thread:

The Cone of Production / Artikel von mises.org, engl. - - ELLI -, 16.12.2002, 15:53