Financing is not funding. Finance is a means of keeping track of who has
agreed to fund what, through contractual arrangements known as bonds, notes
and equity shares. While promises can be multiplied without limit, the
ability to keep them is finite. A financial promise can be cancelled with
other financial promises, but at the end of the line, if real goods are to be
produced, then a real means of funding must be provided. The creation of more
finance (promises) can never replace the creation of more real means of
funding.
Self-evident as the above propositions are, economic history is littered
with a long list of attempts to disprove them. The lodestar of inflationism
is the search for a way to create more real funding out of paper. Antal
Fekete’s attempt
to resurrect the Real Bills Doctrine is one such proposal. Fekete’s
rehabilitation of this long-discredited doctrine is motivated by an argument
that savings are insufficient to fund production and that this limitation
can be overcome through the issuance of financial instruments.
The root of the error in Fekete’s doctrine is the confusion between
finance and funding. Real Bills do not fund anything. The result of
monetizing more bills is merely an increased quantity of paper claims to the
same pool of funding. The alleged insufficiency of savings to fund investment
is based on a serious misunderstanding of what savings are, compounded by
accounting errors in Fekete’s examples.
I have dealt with these problems in a series of articles (1 2 3 4). The current
essay illustrates the necessary causal connection between savings and
production through the subsistence fund, a concept that appears in the
writings of Austrian economist Richard von Strigl.
Wealth is ultimately the ability to consume more goods and services. In
order to consume, there must first be goods suitable for consumption. (These
are called consumption goods or final goods.) Prior to consumption, then,
final goods must have been produced. Goods are costly to produce, so prior to
production, there must be some means of funding the production.
It is here that Strigl introduced the subsistence fund to explain the
relationship between consumption and production. The subsistence fund is the
supply of consumption goods available at any point in time. In this model, an
act of consumption is a withdrawal from the subsistence fund. The production
of a final good is a deposit in the subsistence fund.
Because people must consume some goods in order to survive while they are
producing other goods, productive activity can only be sustained by
withdrawals from the subsistence fund.
Consider the classic example of Robinson Crusoe, who has been shipwrecked
on an island. He sets out to catch fish in order to supply himself with food.
In order to sustain himself, he requires a daily intake of five fish. The
fish are final goods. Working from dawn to dusk, he can catch ten using his
bare hands. He soon realizes that he could catch twenty fish in the same
amount of time with the aide of a net. However, the net would take ten days
of his time to weave. During ten days of full-time net making, Crusoe would
require a total of 50 fish. Crusoe decides to dry and set aside five fish
each day, until he has accumulated 50 fish to feed himself during the period
of net weaving.
In the example, the 50 dried fish form Crusoe’s subsistence fund. When
Crusoe adds to the accumulation of dried fish he is saving. When he consumes
the fish during the net fabrication, he is investing. What is the nature of
the net? The net is not consumed directly, so it is not a final good. The net
is a capital good, a good that was created as a tool for use in production of
more final goods. The capital stock is simply the total supply of capital
goods that exists at any point.
On Crusoe’s island we can see the connection between savings, investment,
the capital stock, and the subsistence fund. If Crusoe ate all his fish on
the day that he caught them, then he would never increase the size of his
subsistence fund. If he saves and invests in capital, then he can create a
larger subsistence fund by using the capital. Strigl explains this here:
Production can only be maintained if each attained subsistence fund is
used to support another round-about method of production. It is not, then,
the fact that a subsistence fund exists which makes the continuation of
production possible, but the way in which this subsistence fund is used: It
must not be used in a "purely consumptive" way, but rather in the
sense of "reproductive consumption," in the sense of consumption
which simultaneously assures further production…. these consumption goods
must be used in such a way that, simultaneous to their expenditure, a later
attainment of a new return of consumption goods is assured. (p. 12)
[all citations to Strigl from Capital
and Production]
One difference between the example and a modern economy is that in the
example, savings and investment proceed sequentially, while in a modern
economy they are done in parallel. In the example, the subsistence fund is
produced in its entirety before the investment in the net is started, and the
fund is completely consumed by the time the net is done. More realistically,
in a modern economy with a large population, an advanced division of labor,
and a large accumulated capital stock, the creation and the depletion of the
subsistence fund proceed in parallel. Every day, some final goods are
produced, while other final goods are consumed. Over the course of one year,
one year’s subsistence fund is produced and consumed in continuous
increments, even though one year’s subsistence fund never exists as a
stockpile at any single point in time. As Strigl explains,
In addition to the subsistence fund, we always find unfinished products in
the various stages of maturity. The supply of unfinished products is built up
in such a way that in each following week a subsistence fund large enough for
one week’s needs will be finished. Each time, the finished available
subsistence fund of the economy is reduced to a minimum. (p. 13)
Another difference between the example and a modern economy is division of
labor. In the example, Crusoe saved, invested, produced capital gods, and
final goods. In an advanced economy, with continuous production and
consumption proceeding alongside each other, some producers create final goods,
while others consume those final goods and produce different final goods or
capital goods, all at more or less the same time.
In the example, savings are stockpiled, while in a modern economy, the
stockpiling of finished goods is of less importance. In modern times, large
inventories are not necessary as long as goods are supplied at about the same
time and in the same quantity that they are demanded for consumption. Under
these conditions, as Strigl explains, the size of current inventories will be
small compared to the total subsistence fund:
The always available subsistence fund [i.e. inventory of finished goods]
will be reduced in importance even more as compared to the overall supply of
goods in various stages of maturity. (p. 13)
Even in a monetary economy, in-kind savings is not entirely replaced by
monetary saving-and-investing — some stockpiling does exist. For example,
when a consumer purchases a refrigerator with a ten-year life, then he has
saved a stockpile of ten years of refrigeration. Even if no new refrigerators
were produced over the next ten years he could continue to have refrigeration
by using up the saved stockpile of refrigeration. The same could be said of
cars, homes, and other long-lasting consumer goods.
In the Crusoe example, the same person created the final goods (fish) and
the capital good (net). In an advanced economy, different people generally do
these functions. When these functions are separated, the question arises, how
are people who are not producing final goods able to consume final goods?
Where does their supply of final goods come from? Their supply of consumption
goods can only come from the subsistence fund. Strigl here elaborates:
the production of consumer goods must also "support"…the
creation of durable factors of production and the appropriation of raw
materials, i.e., it must supply these production processes, which themselves
produce nothing that can be directly considered consumer gods, with those
consumer goods necessary for the subsistence of those employed in these
production processes. (p. 19)
Over time, as capital goods are used, they tend to wear out or are used
up. The capital stock requires continuous new investment in order to maintain
its capacity to produce the subsistence fund. Remember Crusoe. With daily
use, his net will wear out. The creation of a new net would require either
another new period of savings-and-investment, or ongoing minor repairs.
The entire existing capital stock is necessary to produce the current
subsistence fund. If the subsistence fund is not to gradually shrink, then
the entire existing stock of capital must also be repaired, maintained, or
replaced. This capital investment can only be funded out of the subsistence
fund. As an economy grows and becomes more complex, the funding of capital
repair and replacement consumes a large, and generally increasing, proportion
of the subsistence fund itself. As Strigl explains, “the continuation of
production is only possible if this subsistence fund is again used so that
the various integrated production processes can be carried on continuously.”
(p. 13).
How can the entire capital structure be maintained out of the subsistence
fund? Strigl responds:
- The subsistence fund must support everyone who is
involved in producing the finished product.
- The subsistence fund must support everyone who is
involved in producing raw materials for the production of means of
subsistence.
- The subsistence fund must support everyone who is
involved in the production of machines (relatively durable factors of
production); that is, of those machines used directly in the production
of consumer goods as well as those which are used in the production
processes that precede the production of consumer goods.
- Finally, the subsistence fund must also support everyone
who is involved in producing the raw materials used in the machine
industry. (p. 18—19)
Producers can be arranged in a sequence from those who create final goods,
to their suppliers, to their suppliers’ suppliers, and so on. Each firm in
the supply chain takes as input partially finished goods produced by firms at
the next stage of the chain. Only those firms at the very end of the chain produce
final goods.
Note the special role played by the producers of finished products: they
are the only producers whose output directly contributes to the
subsistence fund. All other producers only make withdrawals from the
subsistence fund. The producers of capital goods indirectly contribute to the
subsistence fund because the capital stock is necessary for the creation of
the subsistence fund.
The employees at the firms further back in the chain must make withdrawals
from the subsistence fund in order to sustain their life while they work. And
so must their suppliers, and their suppliers’ suppliers. Everyone, everywhere
must make withdrawals from the subsistence fund. But how do the owners and
employees of the other firms obtain final goods? The firms further up the
supply chain receive a portion of the subsistence fund as it is passed on
down the line from the end of the chain in payment for partially finished
intermediate goods. As long as all firms continue to create new capital or at
least replace their capital stock, any worker wherever he is in the chain,
will be able to make withdrawals from the subsistence fund. Again we turn to
Strigl for commentary:
The owner of a firm producing finished consumer goods first pays from the
returns of his production everyone who provides him with originary factors of
production for further production, then everyone who supplies him with raw
materials, and lastly, everyone who renews his stock of machines. The
manufacturer of machines in turn will be able to "work" with the
fund he receives from the sale of his produced factors of production. With
this fund he in turn pays those who make originary factors of production
available to him, those who sell him raw materials, and those who deliver
replacements for used up machines. In precisely the same way, the producers
of raw materials will support their production with that fund of consumption
goods which they have attained through the sale of their products. (p. 19)
If firms, or their owners, did allocate part of the subsistence fund
toward the repair and replacement of their capital stock when it wore out, a
larger portion of the subsistence fund would be consumed, the capital stock
would not be replaced, and when machines wore out, the subsistence fund would
shrink.
Strigl above defines the "renewal fund" as that portion of the
subsistence fund that is set aside for the construction or reconstruction of
the capital structure. The renewal fund is another term for gross savings. On
the renewal fund, Strigl wrote:
A consumer-goods industry equipped with durable factors of production can
continue to work for a while even if no renewal takes place, if during
economic fluctuations the splitting off of a renewal fund out of returns is
not possible. Production will then only come to a standstill if the equipment
is completely consumed. The production of factors of production is, however,
entirely dependent on being supported by a renewal fund provided through the
consumer good industry. It will come to a standstill once no renewal fund is
accumulated in production. The renewal fund made available by the consumer
goods industry is the economic successor of the expenditures in the
production of durable factors of production. The renewed availability of this
fund is the precondition for the production of factors of production being
able to work toward the renewal of durable investments in the consumer goods
industry. (p. 25)
Savings is the diversion of some part of the subsistence fund into the
renewal fund. Note that up to this point, nothing has been said about money.
By understanding savings as a diversion of a part of the subsistence fund to
capital goods producers, the real process can be seen separately from its
monetary aspects. Savings does not consist of money, nor does the creation of
more money augment savings.
This is not to deny the importance of money. A monetary economy has a huge
advantage over a barter economy for two reasons: the simplification of
exchange (as compared to barter) and the facilitation of profit-and-loss
accounting.
In particular, consider the second reason: economic calculation.
Profit-and-loss accounting enables all production processes, both past and
those imagined for the future, to be compared in terms of a single measure.
This single measure is the monetary unit. When a firm makes a profit, it is
has added more — in monetary terms — to the subsistence fund than it
withdrew. Through profit-and-loss accounting, each firm can determine whether
its net impact on the economy is an addition to, or a depletion of, the
subsistence fund.
In a monetary economy, most people save-and-invest with money, rather than
through stockpiling inventories of consumer goods. The direct purchase of
capital goods, as, for example, starting a business, and the indirect purchase
of capital goods, through financial assets, are both examples of
saving-and-investing.
Finance can augment production as well by facilitating intermediation
between borrowers and savers. Increased financial intermediation enables
savings to be invested more efficiently. The creation of public impersonal
capital markets provides a greater array of production possibilities to be
evaluated and purchased by savers.
However, neither monetary calculation nor financial intermediation changes
the nature of savings. Savings is always an allocation of some portion of the
subsistence fund to the renewal fund. Monetary savings is a transfer of the
saver’s ability to withdraw from the subsistence fund to the investor who
receives the monetary savings. As Dr. Shostak
says, "Various producers who have exchanged their produce for money
can now access the [subsistence fund] whenever they deem this to be
necessary." Strigl points out that, while most people think in terms of
the monetary process, money is simply a representational tool:
Nothing much will change in [the process of saving and investment] if this
process in a monetary economy is finally hidden behind a "veil of
money"; if the entrepreneur who builds up a renewal fund does not know
that the money he receives in return for his products and deposits in a bank
"represents" a subsistence fund; if he who borrows money from the
bank is not aware that in so doing he draws from a renewal fund of means of
subsistence provided elsewhere in the economy, and that as he pays back the
money, he will in turn provide a renewal fund or some products produced with
its assistance.
We are now in a position to show the errors in Fekete’s doctrines about
savings from the point of view of the subsistence fund.
First, his theory relies on a distinction between fixed capital and
"circulating capital," which he defines here:
Similarly, the flow of myriad goods from producer to market also undergoes
a remarkable metamorphosis when it gets within sight of the consumer. Adam
Smith was the first to notice this interesting phenomenon. He formulated the
concept of social circulating capital. By this he meant the mass of finished
or semi-finished consumer goods which has reached sufficient proximity and is
moving sufficiently fast to the ultimate cash-paying consumer so that its
destiny of being consumed presently can no longer be in doubt.
and:
It is hard to see how thoughtful people can treat the notion, that
circulating capital no less than fixed capital must be financed out of
savings, with respect.
The differentiation of circulating capital from fixed is a distinction
without a difference. There are capital goods and final goods. There is no
third category: so-called "social circulating capital" is just
plain capital. Ninety-days-from-final goods are in principle no different
than 900-days-from-final goods in that they cannot be consumed. If they
cannot be consumed, they are not the real means of funding for any productive
activity, and therefore not part of the subsistence fund.
Production, properly understood, is the entire activity of bringing raw
materials to the point of consumption. This point has been reached when no
more withdrawals from the subsistence fund are necessary to goods to the
point where they can be consumed. Shipping, warehousing, retailing,
marketing, and other parts of the production process of moving these goods are
costly. These costs can only be funded — in real terms — by withdrawals from
the subsistence fund. There is no other real source of funding than the
subsistence fund with which to carry out these activities.
There is nothing other than the subsistence fund with which to fund
capital construction. That part of the subsistence fund allocated to
investment is the renewal fund. The goods in the renewal fund must have been
saved: that is the only way they could get there.
The issuance of Real Bills is a means of financing, not a means of
funding. A financial instrument records an agreement concerning real funding.
Bonds, bills, notes, etc. come into being to record a promise by the funder
to provide a portion of the subsistence fund under their control, at some
point in time, for the real funding of some productive activity. As Shostak clearly explains,
Payment is always done by means of various goods and services. For
instance, a baker pays for shoes by means of the bread he produced, while the
shoemaker pays for the bread by means of the shoes he made. (Both shoes and
bread are part of the pool of funding as they are final goods.)
Real Bills are a means of finance, not a means of funding. Real Bills do
not form a part of the subsistence fund. Creating more "real bills"
will not do the work of savings because the bills themselves cannot be
consumed. On the contrary, the goods that they are issued against are capital
goods, which will require additional debits from the pool of funding in order
to complete their journey. An accounting that added the market value of
capital goods to the subsistence fund would make the subsistence fund appear
larger than it is in reality. But this would be nothing more than an optical
illusion achieved by double counting.
Because the funding of productive activity is not — in real terms — done
with money, creating more money, real bills, fake bills, clearing receipts,
fractional reserve deposits, fiduciary media, or any other form of paper does
adds nothing to the subsistence fund. These instruments are only claims that
enable withdrawals to be made from the subsistence fund. Creating more of
them only creates more claims against the same subsistence fund.
Fekete has been a
critic the of 100% gold reserve requirement advocated by Rothbard and
other Austrian economists.
It follows from my analysis above that a “100 percent gold standard” will
not be able to survive for reasons having to do with the burden it
unnecessarily puts on savings. There isn’t, nor will ever be, savings in
sufficient quantity to finance circulating capital in full, given our highly
refined division of labor and roundabout processes of production. Luckily,
this is no problem, as so much circulating capital to move merchandise in
sufficiently high demand by the final consumer can be financed through
self-liquidating credit. Advocates of the “100 percent gold standard” must
realize that they have grossly underestimated the degree of sophistication of
the structure of production in the modern economy. They must also come to
grips with the fact that financing circulating capital with real bills is not
inflationary. Real bills enter and exit circulation pari passu with the
emergence and ultimate sale of consumer goods.
As for the idea that the 100% reserve requirement puts an excessive burden
on savings, I have already shown that savings alone must bear the entire
burden of funding production, simply because there is no other means of
funding than savings.
According to Fekete’s scheme, banks should monetize his beloved Bills. To
monetize a bill means that a bank purchases the bill with new money
substitutes that it creates out of nothing. (If the bank purchased the bill
using its own capital or funds that had been loaned to the bank for
investment purposes, then no monetization would occur.) The money substitutes
are usually a checking deposit but they could be bank notes. They are money
substitutes because they circulate at parity with real money, and they
constitute a claim, at face value, on the bank’s (inadequate) gold reserves.
Now consider the meaning of the 100% reserve requirement in terms of the
subsistence fund. What this requirement does is to enforce the rule that
everyone who withdraws from the subsistence fund must also make an equal
deposit of equal value in monetary terms. When a bank monetizes an asset,
they have created purchasing power for the bank out of nothing. The problem
with the monetization of debt (bills or otherwise) is that the bank is able
to make withdrawals from the subsistence fund with its new money without
having made any prior deposits to the subsistence fund. The creation of
credit without savings represents unfunded consumption, an "exchange of nothing for something."
The error in Fekete’s dream of prosperity through inflation is that the
monetization of Real Bills does not create any new means of funding. On the
contrary it only serves transfer the ability to access the existing means of
funding from other holders of money to the bank. Through monetization, the
bank is privileged to make more withdrawals from the subsistence fund than
they are entitled to by their prior productive activity.
Have the Austrians "underestimated the degree of sophistication of
the structure of production in the modern economy"? In spite of the many
differences between Crusoe’s island and modern times, the relationship
between the subsistence fund and the capital stock is a logical one and does
not change with size. As Strigl reminds us,
The more elaborate the temporal partitioning of production into a number
of synchronized production processes, the smaller the finished available
subsistence funds will be. The always available subsistence fund will be
reduced in importance even more as compared to the overall supply of goods in
various stages of maturity. But note that nothing changes regarding the
function of the subsistence fund. [emphasis added] (Strigl p. 13)
In my series of articles on this topic (1 2 3 4), I have
examined the issue of savings, investment, and Real Bills from several
angles. The fundamental question under investigation has always been the
same: can the creation of additional paper instruments contribute to the
production of more wealth? The answer must always and for all time be no, at
least not until the day that paper promises can transmute themselves into
real goods.
Robert Blumen [send him mail] is
an independent software developer based in San Francisco.