Tuesday, July 9, 2013

The Importance of Efficient Capital Allocation

by Eugen von Böhm-Bawerk

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

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

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

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

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

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

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

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

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

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

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

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

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

If the debt composition has changed so drastically, from predominantly good debt to bad and destructive, should not this be reflected in asset valuations? One might think so, but remember that in a fractional reserve banking system secured by the central bank, credit issued are money and the more money the more inflation, and this will bid up asset values.

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

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

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

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

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


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

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