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In Part One I discussed the clear and present danger to pension
rights: deflation as manifested by the interest rates structure that has been
falling for almost thirty years, while most observers still think that the
real danger is inflation. In this concluding part I carry out a deeper
analysis of the pension problem, looking at the marginal productivity of
labor and capital.
Higher
marginal productivity: boon or bane?
The main point of Mises in discussing the pension problem is
that the only means to increase permanently the wages and benefits payable
to workers is to increase the per capita quota of capital invested in the
methods of production, thereby raising the marginal productivity of labor.
(See References, Planning for Freedom, p 6.) This is certainly true so
far as it goes. It is also true that, if we project this observation to the
world at large, then we can conclude that in order to have a progressive
world economy and receding poverty, global capital accumulation must
accelerate relative to increase in population. The greater the quantity and
the better the quality of tools, the greater will be the output of the
marginal worker, that is, the greater will be the marginal productivity of
labor.
One
may get the impression from reading Mises that an increase in marginal
productivity is always beneficial to society ― as indeed it
would have been under the conditions he envisaged. However, in the case of a
monetary system that admits both large swings and a prolonged slide in
interest rates, this is not true. If the matter were simply increasing
marginal productivity, monetary policy would be a valid means of
“turning the stone into bread”. All it would take is central bank
action to keep raising the rate of interest indefinitely. Under this scheme
the marginal producer whose capital produces at the marginal rate of
productivity is forced to close down his operations. His marginal equipment
and plants are idled. His workers producing, as they are, at the marginal
rate of productivity of labor are laid off.
We
conclude that the marginal productivity of both capital and labor
automatically rises as a consequence of a rise in the interest rate
structure. However, in this case the rise in productivity, far from being
a boon, is a bane to society, as it makes output and employment shrink. The
trick is precisely to make marginal productivity rise along with
rising output and employment.
Gold
standard: a safeguard against deflation
No one has asked how it is possible that an increase in marginal
productivity could be beneficial to society in one instance, and harmful to
it in another. The point is that the gold standard is an absolute
prerequisite for a rise in marginal productivity to be beneficial. Only the
gold standard can prevent wholesale capital consumption. Only the gold
standard can provide the necessary background of stable interest rates or,
more precisely, a gentle fall in the rate of interest due to an acceleration
in the accumulation of capital as compared to population growth, so that a
steady rise in marginal productivity along with production and employment be
assured. This brings the role of pension funds into a sharp focus. An
increase in population growth rates, whenever they may occur, will soon
enough cause an acceleration of capital accumulation due to an increase in
the demand for pension rights. The new capital thus created must be put to
work in an optimal way.
Without
the proviso on stable interest rates that can only be guaranteed by a gold
standard it is possible that increasing marginal productivity may lead to
diminishing of output and employment, that is to say, to deflation. The
gold standard, contrary to the propaganda of its detractors, is the chief
guarantor that deflation will not occur while marginal productivity keeps
increasing ― assuming that private pension funds provide fully
funded plans for the benefit of the prospective pensioners. Only investments
in improvements of production methods can make sure that future pensions can
be paid when they are due.
Thesis,
anti-thesis, synthesis
Mises built his theory of interest exclusively on his thesis of
time preference. He categorically rejected the anti-thesis suggesting
that the productivity of capital may also have something to do with the rate
of interest. The fact is that a synthesis between the two competing
and seemingly antagonistic theories is possible, as I have shown in my
lectures developing my own theory of interest that extends Carl
Menger’s idea of distinguishing between the asked and bid price from
the commodity to the bond market.
I
start by defining the rate of interest as that rate at which the coupons
(along with redemption at face value upon maturity) will amortize the market
price of the gold bond. As the latter could well be higher or lower than face
value, the actual rate of interest could be lower or higher than the coupon
rate. It is important to note that the relation between the two is inverse.
Only in the statistically rare event when the market price of the bond
coincides with its face value will the rate of interest be equal to the
coupon rate.
With
Menger’s insight we realize that the market produces not one but in
fact two prices for the gold bond: a higher asked price and a lower bid
price. Transactions take place between these two extremes. This means
that the actual rate of interest varies between the floor and the ceiling,
and vary it does inversely with the bond price. Because of this inverse
relationship the asked price corresponds to the floor, and the bid price to
the ceiling of the range for the rate of interest.
My
theory asserts that the floor for the rate of interest is determined by
marginal time preference, i.e., time preference of the marginal bondholder.
The rate of interest could not fall through the floor because it would be
resisted by the marginal bondholder selling his bond (a future good) to keep
the proceeds in gold (a present good). The ceiling, in turn, is determined by
the marginal productivity of capital, i.e., the productivity of the marginal
producer. The rate of interest could not go through the ceiling either, because
it would be resisted by the marginal producer selling his capital goods to
put the proceeds into the higher-yielding gold bonds.
Clearly,
the floor and the ceiling for the rate of interest are conceptually
different. They are subject to different forces, acting independently of one
another. In more detail, the floor is regulated by the arbitrage of the
marginal bondholder between the bond market and the gold market according to
marginal time preference. By contrast, the ceiling is regulated by the arbitrage
of the marginal producer between the capital goods market and the bond market
according to the marginal productivity of capital.
Mises
passed over these instances of arbitrage. In particular, he missed the
arbitrage of the marginal producer who, in leaving his own capital goods idle
and buying the bonds of his more productive colleagues whenever interest
rates rise and, conversely, selling the bonds at a profit and redeploying his
own idled capital goods when interest rates fall, provides a clear manifestation
of human action. This action plays a fundamental role in regulating the rate
of interest. This is “the other blade of the scissor” (the first
blade is the action of the marginal bondholder) without which there is no
cutting. As this analysis shows, there is an interaction between changes in
the marginal productivity of capital and the rate of interest ―
something Mises overlooked when he dismissed productivity considerations from
his theory of interest. I had to go back to Menger for inspiration to make
repairs for the oversight. My theory of the origin of interest is motivated
by Carl Menger’s theory of the origin of money.
Is
there life after Mises
I am an admirer of Mises who unquestionably made a great
contribution to economic thought. After Menger, he will in all probability
prove to have been the greatest economist of the 20th century. But
Mises was a modest man and never took the view that his own word should be
taken as dogma. He would have been made uncomfortable by those disciples of
his who, effectively, frown upon further economic research by treating
Mises’ work as the last word, and who automatically disagree with
anyone who proposes a different or a more refined view. No branch of human
knowledge can advance under such circumstances.
I
have always considered it my duty to point out errors, whatever the
consequences. This attitude on my part is in fact completely uncontentious
― it is motivated solely by the desire to advance knowledge
“without fear or favor”. It is unfortunate that, when my comments
involve something Mises said, I am the object of name-calling and personal
attacks by those who seem to want to preserve the work of Mises, frozen in
time ― rather than something that serves as a basis for discussion and
further research. I can do no better than quoting Mises himself:
Calling names is quite out of place if the accuser is not in the position to
demonstrate clearly in what the deficiency of the smeared author’s
doctrine consists. The only thing that matters is whether a doctrine is sound
or unsound. This is to be established by facts and deductive reasoning. If no
tenable arguments can be advanced to invalidate a theory, it does not in the
least detract from its correctness if the author is called names… Those
who call authors with whom they disagree names merely confess their inability
to discover any fault in their adversaries’ theories.
Marginal
productivity of labor
In Human Action Mises does not treat marginal
productivity. There is one sentence on the marginal productivity of labor in
the essay Planning for Freedom. I have quoted that sentence above.
More can be found on this subject in his The Anti-Capitalistic Mentality (see
References).
Following
Mises I define the marginal productivity of labor to be the change in net
output upon the elimination of a marginal worker from the labor force. A
worker is marginal if his contribution to net output is smaller (at any rate,
no greater) than that of any other worker. It is that worker whose job has
become obsolete, is no longer justified on grounds of productivity, and will
be terminated by the producer at the first opportunity. (In his original
definition Mises did not qualify the noun “worker” with the
adjective “marginal”. This would appear to leave the concept of
marginal productivity of labor ambiguous.)
It
is important to distinguish between two distinct possibilities of increasing
marginal productivity of labor, and to analyze the difference. Marginal
productivity may increase when workers reaching retirement age are replaced
by newly trained workers aided by newer, better tools. The new marginal
worker produces more than the recently retired marginal worker. The marginal
productivity of labor has increased. Mark that total output and employment
has also increased. We may call this the progressive way of increasing the
marginal productivity of labor.
The
other possibility is very different. Here the marginal worker has been laid
off without replacement. The next most productive worker at the lower end of
the productivity spectrum is now promoted to the position of being the
marginal worker. There is no improvement in tools and production methods,
only a shift of the margin from less to more productive labor. As a result,
both output and employment shrink. We may call this the retrogressive way of
increasing the marginal productivity of labor. As an example to show how this
might happen, consider an increase in the rate of interest. It will turn
marginal workers into submarginal ones, earmarking them for layoff, thereby
increasing marginal productivity but decreasing total output and employment.
The
difference between the progressive and retrogressive increase in the marginal
productivity of labor can also be seen in relation to capital. In the
progressive case there is capital accumulation. Newly perfected tools or
production methods are introduced and freshly trained workers employed. This
is a dynamic change that cannot help but increase total output and
employment. In the retrogressive case, the change has increased marginal
productivity at the expense of employment, and there is capital decumulation.
Material factors, still serviceable, are phased out of production along with
the elimination of marginal workers. No new factors of production are
introduced, only the attrition of workers and their obsolescent tools is
stepped up.
Marginal
productivity of capital
Apparently Mises has never defined the concept of the marginal
productivity of capital formally (although he refers to it in Human Action
and also in The Anti-Capitalistic Mentality). Presumably he shied away
from developing this aspect of the theory because it would reveal that a
position according to which productivity has nothing to do with the rate of
interest is untenable.
I
define the marginal productivity of capital as the change in net output which
occurs when a marginal material factor is withdrawn from production. A
material factor of production is marginal if its contribution to net output
is smaller (at any rate, no greater) than that of any other of the same
value. It is that piece of equipment or plant that the producer will discard
first ― because it is insufficiently productive ― at which time
another piece of equipment or plant with a higher productivity takes its
place.
Again,
it is important to distinguish between two distinct scenarios in which the
marginal productivity of capital can increase, and to analyze the difference.
In the first scenario the producer plays an active role. In making
investments to improve tools and methods of production he aims at producing a
greater amount or better quality of goods than before. There is a dynamic
shift from the less to the more productive through reshuffling workers and
tools. Whether the removal of a marginal piece of equipment or plant simply
means reassigning it to a new task, or whether it means scrapping and
replacing it with brand new material factors, makes no difference. In neither
case is there a contraction of output or employment; there might well be an
increase. We may call this the progressive way of increasing the marginal
productivity of capital.
The
other scenario is very different. Here the producer plays a passive role. He
responds to forces outside of his control. He leaves marginal material
factors of production idle. He lays off workers who have been producing with
the now-idle equipment in the now-idle plants. Marginal productivity
increases solely on the strength of a shift to another marginal material
factor that was already in service. There is no improvement in tools and
production methods per se. As a result of the shift of the margin from
the less to the more productive, marginal tools and plants are rendered
submarginal. Both output and employment shrink. We may call this the
retrogressive way of increasing the marginal productivity of capital.
Typically it occurs whenever the rate of interest rises.
An
important special case is the action of the marginal entrepreneur. When there
is an increase in the rate of interest, he sells his idle equipment or plant
and buys bonds. This allows him to participate in the earnings of other
producers whose material factors produce at a higher productivity than that
of his own. When the rate of interest subsequently declines, the marginal
entrepreneur will sell his bonds at a profit and with the proceeds buys new
plant equipped with new tools. Now he can compete successfully with other
producers.
This is arbitrage between the capital goods market and the bond market. It
reveals that the marginal productivity of capital sets the ceiling to the
range within which the rate of interest can vary. The arbitrage of the
marginal producer between the market for material factors of production and
the bond market is a most important instance of human action, one that
promotes not only the stability of interest rates, but that also helps renew
society’s park of capital goods. Along with the analogous arbitrage of
the marginal bondholder between the bond market and the gold market, these
two instances of human action are indispensable for the understanding of the
market processes responsible for the formation of the rate of interest. It
goes without saying that both have a bearing upon the pension problem.
Relation
between the marginal productivity of capital and labor
The first interesting question that arises in connection with
the pension problem is the relation between the two marginal productivities:
that of capital and labor. The observation, made by Mises, that improvement
in the marginal productivity of capital must precede and exceed that of
labor, is justified by the necessity to create the funds needed to improve
the quality of life of the working people. This is why the health of the
pension plans has such an utmost importance. The first impetus in the long
chain of improvements from the marginal productivity of capital, through the
marginal productivity of labor, through the improvement in wages to the
improvement of pensions must come from the pension funds themselves. If they
are healthy (meaning fully funded), then they will serve as the source from
which the capitalist borrows the funds lending them to the entrepreneur, who
will invest them either in more tools, or in research leading to new
production methods.
The
second question is how to allocate the potentially available new capital
between simply purchasing more tools, or investing it in research and
development to develop improved production methods. Further analysis will
show how the allocation problem is solved by the market. Clearly, it cannot
be solved at the level of the shop-floor, nor even at the level of the
executive board-room. The decision must take into account demographic
movements such as net change in the number of pensioners relative to net
change in the number of workers contributing to pension plans.
I
have treated this allocation problem in my other writings by graduating from
a simple diagonal model of the capital market involving two participants (the
supplier and the user of capital) to what I call the hexagonal model of
capital market involving six participants (the annuitant, the annuitand,
the entrepreneur, the inventor, the capitalist and, finally, the investment
banker, see References). For example, if the balance between the annuitands
and annuitants is changing in favor of the latter (otherwise expressed, there
is a demographic shift increasing the number of pensioners relative to that
of the workers), then more funds will be allocated to the entrepreneurs to
acquire more or better tools, and less to the inventors working on improved
production methods. The point is that the market will always find the “optimal
mix”, fitting the given data, provided that it can operate freely, and
the central bank is constitutionally barred from “regulating” the
rate of interest.
Mises:
happy warrior combatting inflation
The strength of Mises is in his unflagging criticism of
inflationism. Unfortunately, sometimes this goes at the expense of his
drawing a clear line between inflationism and deflationism. Mises treats
deflation in an off-hand fashion, as if it was merely a side-effect of
previous inflation (credit expansion). This hardly does justice to the
problem. We now know that deflation is a great problem of economics in its
own right. For example, Mises deals with the perennial effort of the
government and the banks to suppress the rate of interest, if need be all the
way to zero, only as a manifestation of inflationary propensities. Still more
serious is his ignoring the possibility that the government and banking
system may succeed in pushing the rate of interest down all the way to zero
without actually triggering hyperinflation, and in doing so unwittingly
causing deflation. Declining interest rates are responsible for the
hard-to-detect erosion, ultimately destruction, of capital that is plaguing
the world economy right now.
Incidentally,
the same successful effect of artificially suppressing the rate of interest
furnishes a major part of the real explanation for the Great Depression of
the 1930’s. By sabotaging the gold standard the governments allowed
bond speculators to bid bond prices sky high, thus driving interest rates
down to unprecedented lows.
In
the same order of ideas I also mention that in the public mind the deliberate
wrecking of the gold standard by the government is firmly associated with
inflation. But as a more detailed analysis will show, the absence of gold
standard could also cause deflation through making interest rates fall,
namely, by rendering bullish bond speculation risk-free. The Austrian school
has so far failed to study this important fact, even though this is the best
argument to show that the pension problem cannot be solved without the
rehabilitation of the gold standard.
I hope that my contribution to the vexing problems of the theory of interest
will help to end the century-old fratricidal war between the time preference
and the productivity schools. I also hope that my thesis about falling
interest rates causing capital destruction will be exhaustively discussed and
the alarm will be sounded, in order to save the pension funds from
extinction. Finally, I hope that the day is getting closer when the Austrian
theory of interest is universally recognized — just as the Austrian
theory of value is recognized already.
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