Capital and Its Structure

Lachmann, Ludwig M.
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First Pub. Date
Kansas City: Sheed Andrews and McMeel, Inc.
Pub. Date
2nd edition.

Chapter III


The theory of capital has to start from the fact that the capital goods with which entrepreneurs operate are heterogeneous. These heterogeneous capital goods have to be used together. Heterogeneity here implies complementarity in use. The mode of this complementarity, the proportions in which the various heterogeneous factors of production are being used for a given purpose, must find its expression in the Production Plan. Each such plan is characterized by the coefficients of production of its input and the output result it envisages. But while the output result is at first merely planned, the decision about coefficients of production has to be made at once; otherwise there can be no plan.


If the plan fails it has to be revised. The coefficients of production will thus be affected.*30. Some labour will be dismissed, other lab our may be taken on. The same happens to capital goods. Some are discarded, others acquired. A revision of a plan will as a rule involve capital regrouping, a variation in the mode of complementarity of the capital goods used.


The theory of capital has to explain why capital goods are being used in the way they are. Their mode of use depends on the complementarity pattern of resource use reflected in the various production plans, a pattern which varies with the successes and failures of these plans. The theory of capital must therefore concern itself with the way in which entrepreneurs form combinations of heterogeneous capital resources in their plans, and the way in which they regroup them when they revise these plans. A theory which ignores such regrouping ignores a highly significant aspect of reality: the changing pattern of resource use which the divergence of results actually experienced from what they had been expected to be, imposes on entrepreneurs.


That to the planning entrepreneur his capital resources are primarily given in their heterogeneity, as buildings, machines, tools, etc., may seem obvious to the reader. Unfortunately this fact is at variance with the main trend of the traditional theory of capital which treats capital as a homogeneous value magnitude expressed in money terms. No doubt this notion of capital corresponds in many ways to the concept of capital actually used in business life, in particular in its accounting and financial aspects. It may therefore seem worthwhile to point out that for our purposes in this chapter, the description of the formation and revision of capital combinations in production plans, these business uses of the word 'capital' are irrelevant.


It is true of course that every enterprise has to start with a sum of homogeneous money capital, 'free capital'. But the collection of the money capital from owners and creditors belongs to a phase which logically (if not actually: the technical blueprints may already be in existence) precedes the making of the production plan. As we shall learn in Chapter VI, it is true that what happens during the 'financing stage' of an enterprise is not entirely irrelevant to what happens later on: the 'control structure' may well influence later decisions, for instance about expansion or reconstruction. But as long as we are concerned with the making of the production plan and the building-up of the capital combination on which it rests, all this is irrelevant. After all, one cannot earn a profit on capital without 'investing' it, and that means to de-homogenize money capital.


It is also true that all the time there will exist a capital account in which the various capital resources appear as a homogeneous value aggregate. But the capital account within the precincts of which we reduce our capital resources to a common denominator, is merely an institutional device for testing success or failure. We use it to test the result of the plan, not to operate the plan. Changes in the total value of assets, to be sure, are our measure of success, but they cannot tell us what happened or why, any more than a thermometer can tell us whether the patient suffers from malaria or influenza.


The path of economic progress is strewn with the wreckage of failures. Every business man knows this, but few economists seem to have taken note of it. In most of the theories currently in fashion economic progress is apparently regarded as the more or less automatic outcome of capital investment, 'autonomous' or otherwise. Perhaps we should not be surprised at this fact: mechanistic theories are bound to produce results which look automatic.


The view which, by establishing a functional relationship between them, practically identifies progress with capital accumulation, rests on at least three fallacies. In the first place, capital accumulation is not the only force engendering progress; the division of labour and changes in technical knowledge are others. Sometimes these three forces support each other, but often they offset each other as, for instance, when changing technical knowledge makes specific skills or specific equipment redundant. Secondly, as we shall learn in Chapter V, even where capital accumulation appears to engender an increase in output, this is in many cases not the direct result of merely quantitative change, but its indirect result, and the direct result of a concomitant change in the composition of capital.


But the most egregious fallacy of the view which identifies capital accumulation with progress is surely its complete disregard of the facts of malinvestment. The fact that in modern industrial countries progress is accompanied by annual net investment must not make us forget that a good deal of the new capital value will be lost before its planned depreciation period is over. A realistic theory of capital has to ask why this is so, and what processes in the sphere of production and planning the change in capital value reflects.


The loss in value of course reflects the fact that capital instruments, particularly those that are durable, have to be used in ways other than those for which they were designed. In these new uses the instruments may be either more or less profitable than in their designed uses. In the former case there will be a gain, in the latter a loss of value, i.e. their market value will differ from their cost of production. The cause of the phenomenon is unexpected change. Hence, durable capital goods are more likely to be affected than those more short-lived. In the case of buildings our phenomenon often occurs for the simple reason that they last for longer periods than could possibly enter any plan-maker's 'horizon'. Often, as we stroll in the streets of an ancient town, the merchants' palaces turned into hotels, the former stables now garages, and the old warehouses which have become modern workshops, remind us of the impossibility of planning for the remote future. In this case our phenomenon, viz. the fact that capital goods are not used in accordance with the plans originally made for them, is the mere result of the passage of time. Here only the most durable goods will be affected.


In modern industrial economics, however, rapid technical progress and the growing predominance of durable capital equipment have brought a very large proportion of capital resources within the scope of our phenomenon. In such a world there can be few fixed capital goods which year after year are used in the same manner. Dr. Terborgh has illustrated this fact by

the life history of a freight locomotive of the vintage, say, of 1890. It began in heavy main-line service. After a few years, the improvement in the new locomotives available and the development of the art of rail-roading made the unit obsolete for that service, which was taken over by more modern power. It was thereupon relegated to branch-line duty where the trains were shorter, the speeds lower, and the annual mileage greatly reduced. For some years it served in that capacity, but better power was continually being displaced from main-line duty and 'kicked downstairs' onto the branch lines, and eventually our locomotive was forced out at the bottom, to become a switcher in one of the tanktown yards along the line. But the march of progress was relentless, and, in the end, thanks to the combination of obsolescence and physical deterioration, it wound up on the inactive list. For some years more it lay around, idle most of the time, but pressed into service during seasonal traffic peaks and special emergencies. Finally, at long last, the bell tolled and it passed off the scene to the scrap heap.*31.


If, then, at each moment we must expect to find capital goods used in ways other than those for which they were originally planned, a realistic theory of capital cannot altogether ignore these facts. We must make an attempt to trace the process by which these changes in capital take place, and by 'tracing' we mean showing how cause becomes effect and effect new cause. It is readily seen that for this purpose the method of equilibrium analysis is of but little use. Equilibrium analysis can tell us whether courses of action are, or are not, consistent with each other. It cannot, except in rather special circumstances, explain how inconsistencies are removed. These special circumstances would require that all possible forms of action can be described in the form of continuous functions which do not vary as the inconsistencies are discovered and spell failure. They require, in other words, downward-sloping demand curves, upward-sloping supply curves and a point of intersection between them. As we shall see, there is no reason to believe that such continuous functions can exist in the market for capital goods. To trace the process of changing capital use we shall have to apply the method of Process Analysis to the use of capital resources.


Most economists are now familiar with the method of Process Analysis as expounded in the writings of Hicks,*32 Lindahl*33 and Lundberg.*34. It is a causal-genetic method of studying economic change, tracing the effects of decisions made independently of each other by a number of individuals through time, and showing how the incompatibility of these decisions after a time necessitates their revision. In order to appreciate its merits we have to contrast it with the method of study it is designed to supersede, or at least to supplement, i.e. equilibrium analysis.


In equilibrium analysis our interest is confined to plans which are consistent with each other. We assume that consumers, producers, investors, etc., have a large number of alternative plans, so large a number indeed that these plans can be analytically described in terms of continuous functions, or graphically depicted as curves or surfaces. From these plans we select those which are consistent with each other, disregarding all others. In fact, the whole system of human action is here described not in terms of the network of operative plans of which it is in reality the final outcome, but in terms of a small cross-section of plans which happens to lend itself to mathematical treatment. Justification for this procedure is sought in the fact that inconsistent plans of individuals who stand in exchange relationships with each other cannot succeed, and that the resultant failures will necessitate continual revision of plans, until a consistent set of plans has been discovered. In this view, then, economic activity consists largely in the testing of plans for mutual consistency. While this takes time, we have to assume that during the 'period of adjustment' nothing happens that may disturb our original data expressed as alternative plans. While the failure of each successive plan conveys significant additional knowledge to the individuals concerned, it does not affect the shape of the demand and supply curves. It merely induces individual actors to choose other points on them for testing. It is usually assumed that as a result of the accumulating experience gained from a series of unsuccessful tests, a consistent solution is sure to be found in the end, in other words, that in the 'real world' there does exist a 'tendency towards equilibrium'.


In process analysis, on the other hand, we need no such assumption. While retaining the postulate of consistent action for each actor, we no longer assume that the acts of large members of people will be consistent with each other. On the contrary, we take interpersonal inconsistency for granted and study its effects. Process analysis, we may say, combines the equilibrium of the decision-making unit, firm or household, with the disequilibrium of the market. There is a good reason for this assumption: The human mind is an instrument for reducing chaos to order. All those acts which are inspired by the same mind are therefore unlikely to display chaotic inconsistency. Whatever number of acts a mind can control it can also bring into consistency, and as consistency of action is a necessary, though not of course sufficient, condition of success in action, the mind will have to do so. But beyond this sphere of manifestations of the individual mind, outside the firm and household, no such agent exists. It is true of course that the market serves to produce interpersonal consistency, but it does so indirectly by modifying the conditions of action of the individuals. The market is no substitute for the decision-making unit. Precisely in order to explain how market phenomena affect decisions we require that interpretation of experience, constituted by acts of the mind, which we discussed in Chapter II.


It will be remembered that the classical economists, who of course were only concerned with firms and not with households, had an additional institutional safeguard to ensure interpersonal consistency: the bankruptcy court. All those unable to equate average cost and price are supposed to disappear sooner or later from the scene of economic action. Only those able to adjust themselves to existing conditions would continue to act. But the extension of the theory of the firm to cases other than those of competition, and in general the extension of economic analysis to the household, and that is to say, to everybody, have deprived this case of its former significance.


The method of process analysis which lends itself to the treatment of micro- as well as macro-economic problems, has thus far been mainly applied to the explanation of pricing, production, and saving-investment-spending decisions. In what follows we shall use it in order to elucidate the dynamic implications of decisions about the use of capital resources.


Every resource has a number of possible uses. The best use will, in each instance, depend on a number of circumstances, for instance, the relative prices of input and output. The owner of a capital resource will thus, in arriving at a decision about its use, have to compare the prices, present and expected, of the various kinds of output it could produce, with the wages, present and expected, of the various types of labour that could produce it. But a capital resource in isolation can produce no output. Every decision about its use will therefore imply decisions about the use of other resources complementary to it.


Often of course it will be possible to produce different kinds of output from the same capital combination(plant, Machinery, working capital, etc.) for instance, by varying labour input. Then that output will be produced which maximizes profits, and any experience calculated to induce the belief that the current production plan does not do this will lead to a revision of the plan. But the range of outputs which might possibly be produced will always increase if possible variations of the existing capital combination are taken into account. In a market economy a firm can always vary its capital combination by buying and selling capital goods. Hence, each firm will intermittently use the market in order to acquire those capital instruments which, when operated by the labour available at current wage rates, will maximize profits. The firm will pay for its purchases by discarding those capital goods which in the new combination are no longer required.


In what follows we shall assume that each firm has one plant which during the period under investigation it neither sells not enlarges.*35 In combination with its plant it uses capital equipment of various types. The proportions in which the various types of equipment are combined with the plant, what we shall call 'the capital coefficients', are embodied in the production plan. A plan cannot be changed during a period, while it can and probably will be revised at the end of it. The capital coefficients are thus rigidly fixed for each plan, but flexible for longer periods. Even so, however, we shall assume that the number possible capital combinations from which the firm has to choose is limited. While the mode of complementarity may change from period to period, the relationship between most capital resources is usually one of complementarity.


There is, however, one important exception from this rule.


Every plan has to make provision for unforeseen contingencies. Certain factors have to be kept in reserve (Spare parts, excess stocks, etc.) to be thrown into action if and when necessary. The extent to which they will be used is not known in advance; hence, these quantities are not amongst the fixed coefficients of production in the plan. Indeed their variability is the very reason for their existence. To what extent they will become complementary to the factors of production actually in operation depends on chance. It might therefore be better to speak of supplementary capital goods to distinguish them from the components of the capital combinations.


These supplementary resources have an interesting property: the record of their quantitative change can be used as a primary test of success or failure. Depletion of the reserves is a sure mark of failure. Even in less extreme cases the need of using reserves swill increase costs and reduce net profit.


Among the firm's resources the use of which is plotted in the plan, money capital has a peculiar part to play. That money capital which will be used during the plan period to pay wages, purchase raw materials, etc., must not be regarded as capital for our purpose, as otherwise we should be guilty of double-counting.If we think of the coal used for production during our plan period as a capital good, of its quantity as a capital coefficient, we cannot at the same time call the money paid for it 'capital;. If labour is a factor of production and a component element of the plan, the money laid out to pay for it cannot simultaneously be capital. At most we might say that at the start of the plan money capital 'stands proxy' for those factors of production who are part of the plan but scheduled to appear on the stage later on.


But not all the money at the firm's disposal is allotted to such specific uses. Some of it is not planned to be used at all. It forms the cash reserve which has the same general function as all reserves: to be thrown into action in case of unforeseen contingencies. The cash reserve is therefore capital in the same way, and for the same reason, as spare parts are. While such money is 'idle', its idleness is a condition of successful action.


All these supplementary goods have to be more or less perfect substitutes for those goods actually in operation which, if need be, they are to replace. This fact has given rise to the need for the standardization of equipment, a device for keeping the size of such supplementary stocks within manageable proportions. In this respect money, the universal substitute, is superior to almost all others as, if necessary, it can be exchanged for any other good currently on the market.


Unplanned variations in the stock of money are highly significant primary tests of success or failure of business plans. The ultimate measure of business success sis, of course, the balance sheet as a whole. But as profit will as a rule accrue in the money form, and since the cash reserve is mostly the central reserve which no serious failure can leave unaffected, success and failure are likely to be recorded by changes in the cash reserve before being recorded anywhere else.


While for the period of the plan most coefficients are fixed, each plan must allow for some flexibility. Variations of the variable factors thus convey currently information about how the plan is going. If all factors were rigidly fixed there would be no variable element left to record success or failure.


Let us suppose that during a period t1 a firm has a capital combination of the form

kA + lB + mC...      (1)

where A, B, C... are different types of equipment and k l, m... are constants.


At the end of period t1, in the light of experience gained during the period it is decided to alter the combination. Some of this experience may be 'purely technical knowledge'about the capacity of our combination to achieve, with the help of the labour force assigned to it, in the production plan for t1, the 'output targets' set for it in the plan, In this case the economic significance of the technical knowledge thus gained is quite unambiguous and its meaning for future production plans obvious. But some of the experience of period t1 is marketing experience, which cannot be used for future planning without interpretation of the kind discussed in Chapter II.


Let us now suppose that in the light of all the circumstances regarded as relevant to planning of the future, it is decided in period t2 to change the combination (1) into another combination

l'B + m'C + nD...      (2)

where l is smaller than l' and m larger than m', and D a type of equipment not hitherto used by the firm. The firm will therefore have to sell kA and (mm')C and buy (l'—l)B and nD. Assuming no net investment or disinvestment we may suppose that

kA + (m-m')C=nD + (l'-l)B...      (3)


Let us not assume that at the end of t1 each entrepreneur revises his production plan for t2 and his capital combination. At once we have to ask what determines the prices of the capital goods thus discarded and acquired. At a first glance it might appear that the problem can be solved within the traditional framework of equilibrium analysis. For each entrepreneur, it seems, there will be minimum prices below which he will not sell, for instance because he expects that if he waits until t3 he will get a better price. And there will be maximum prices of capital goods above which he will not buy, as at prices above them (2) will not be an optimum combination. Somewhere between these maxima and minima it might seem that the interplay of the market would establish equilibrium prices for each category of capital equipment. Thus we might be led to believe that on a 'market day' which marks the beginning of t2 a 'temporary equilibrium' of the market for capital goods will establish itself.


At closer inspection, however, it is seen that the position is not determinate and equilibrium analysis not applicable.


In the first place, the assumption that each firm will be able to finance the reshuffle of its capital combinations without having to draw on its cash reserve or outside sources seems far removed from reality. There appears to be no reason to believe that the proceeds of the sale of the instruments discarded will always just suffice to buy the new instruments. If so, (3) is not valid. We might assume that firms count with the fact that the sale of old equipment will not cover the purchase price of the new equipment, and plan to make up for the difference by drawing on their cash reserves. Then we have

kA + (m-m')C + z = nD + (l'-l)B...    (4)

where z is the diminution of the cash reserve. In general, the new capital combination will be chosen in such a way that if a is the expected average profit from it,

is maximized.


If n firms reshuffle their capital combinations, then, as long as they sell their discarded equipment to each other, i.e. as long as no new equipment is bought nor any old equipment sold for scrap, we would have

z1 + z2 + z3 +...+ zn = 0...   (5)

where z1 is the cash reduction of firm 1, z2 of firm 2, etc., In this case clearly some of the z's must be negative. Some firms will find themselves with an actual cash surplus after having completed the operation.


Now, the fundamental difficulty which makes it impossible to apply equilibrium analysis to our case, lies in the fact that the regrouping decisions of the various firms need not be consistent with each other. If they are not, some of them cannot be carried out. This dilemma expresses itself in the fact that, on the one hand, the regrouping decisions are based on the assumption of certain prices for new equipment bought and old equipment sold, while, on the other hand, these prices cannot be known before the process of exchange is completed. In other words, our firms do not know in advance what they will get or have to pay, yet they have to make their plans which involve acts of exchange in advance of the actual carrying-out of these plans. Prices expected maynot be realized, and realized prices not be such as would make a particular regrouping decision profitable.


It is not a way out of our dilemma to postulate that each firm starts with a number of alternative plans depending on buying and selling prices in the market. In the first place, there is still no reason why among this large number of probably inconsistent plans there should be at least one set of plans (one for each regrouping firm) which would be consistent. Moreover, even if this were so, even if we could draw supply and demand curves and get 'points of intersection', there is the fact that we have not one market but a number of markets in fact as many markets as there are types of goods to be exchanged. These supply and demand curves, even if they were continuous, would not be independent of each other since the prices at which goods are offered or demanded are not independent of each other. If the A-goods, for example, fetch higher prices, higher offers can be made for D-goods, and vice versa. We know from general equilibrium theory that such circumstances are sufficient to make prices in each market indeterminate unless we either assume that all prices are fixed simultaneously or permit Edgeworthian re-contract. For the sake of realism we can admit neither. Hence, the results of earlier transactions will influence prices in later transactions. Prices thus come to depend on the chronological order of transactions, and this order is of course quite arbitrary. On the other hand, there must be such an order. As there can be no sales without purchases, we cannot assume for instance that all firms sell their old machines first and then form the new combinations on the basis of prices realized.


There is one escape from our dilemma which would enable firms to carry out their regrouping decisions 'according to plan'. But if we choose it we cannot possibly call the position reached at the end of the operation an 'equilibrium position'. Let us assume that there are 'given' prices for new equipment and 'given' scrap prices for old, prices which would not be affected by dealings in the second-hand market. Let us further assume that each regrouping firm bases its policy on what Professor Neisser has termed 'The Strategy of Expecting the Worst': it expects neither to get more than the scrap price for the equipment itdiscards nor to be able to buy equipment in the second-hand market, but to have to buy new equipment at the current price. In this way the 'ceiling' price for new equipment and the 'floor'price for old form the basis of its plan. And if we assume that the scrap pricewould not be affected by our regrouping (a doubtful assumption) and that the (ex factory) prices of new equipment are sufficiently rigid not to be affected by demand arising from regrouping (a somewhat more realistic assumption in the world of modern industry), these plans might be feasible.


But the 'strategy of expecting the worst', while it may be the safest, is not necessarily the 'best' policy. The position reached as the result of carrying out these plans cannot be called an optimum position for the firm. To be sure, if all firms base their plans on the 'worst possibility', almost all of them will make 'gains'. To the extent to which the market offers them terms more favourable than were envisaged in their plans, their actual z the draft on the cash reserves actually experienced, will be less than the planned z. Indeed for some of themd their actualz may become negative if they find they can sell their old machines at prices much higher than the scrap price and buy machine on the second-hand market much below the 'new' price. But the fact remains that, had they known in advance on what terms they would be able to trade in the second-hand market, they would have made regrouping decisions other than they actually did.


Two conclusions, one negative and one positive, emerge from what has been said. First, equilibrium analysis must not be applied to capital regrouping. Regrouping decisions are unlikely to be consistent with each other, and even where they are, firms may yet find themselves, when the operation is completed, in a position they would not have closen had they known what alternatives were open to them. The reshuffling of capital combinations, whatever its motives and consequences, is not a 'return to equilibrium'. The very acts it implies are likely to have new disequilibrating effects.


Secondly, and this is out positive conclusion, capital regrouping has to be trated as a dynamic phenomenon similar to the processes which give rise to it. In it, as in everything else, firms might succeed or fail. Their relative strength in their new ventures will be affected by the measure of success they have achieved in regrouping. A negative 'z', for instance, will mean greater financial strength. A priece of machinery may have been bought so cheaply that it can be used profitably for purposes other than those envisaged in the regrouping plan. If so, it may entail further purchases of complementary capital equipment. In any case, what happens in period t2 is not the mere result of what happened in t1, nor the result of what happened in t1 plus the decisions made at its end. It will be the combined result of events during t1, plan revisions at its end, and the success with which these decisions met before t2 even began.


We now have to take account of some of the repercussions our process will have. The existence of maximum prices means of course that at them new capital goods will be brought into our capital combinations, and if minimum prices are set by scrap values, some of our old capital goods will be turned into scrap rather than change hands. But there will now also be goods kept in physical existence, though not in productive use, in the hope of higher prices in the future, just as equilibrium price does not preclude the existence of unsold goods that would be offered at higher prices. While the 'strategy of expecting the worst' requires a 'floor' price, this need not be the scrap price.


When looking at the new combinations we shall thus find among them some new capital goods the sale of which is not the result of past failure, but the result of the fact that prices of similar existing goods have reached the upper limit. Conversely we shall find, but not as part of our new combinations, some disused equipment which is not turned into scrap since the owners expect its future value to exceed present scrap prices, perhaps because they expect scrap prices to rise, perhaps because they can foresee more favourable conditions for future use. This is the 'idle capacity' with in the 1930's gave rise to so much misunderstanding and the importance of which for dynamic theory has now been discovered by Mrs. Robinson,*36. and others. It is usually regarded as the result of 'lack of effective demand'. But this is only half an explanation. What we need to know is not merely why capital is not used in the way it was planned to be used, but why no alternative use has been found for it.


Looking at the matter in the way we have done also opens up a new vista on the problem of the 'incentive to invest'. New capital goods are being used in combination with existing ones. This form of complementarity means that the lower the price of existing capital goods the greater the profitability of the new goods. In the theory of investment currently in fashion, to be sure, complementarity is never mentioned. Economists, making an economic virtue of accounting necessity, have uncritically taken over the accounting convention which treats all capital as homogeneous.


In the real world, however, entrepreneurs have to combine buildings, plant, equipment, etc., and the success of the production plans embodying these combinations determines how long they will be maintained. This whole set of problems must remain concealed from a theory which treats all capital as homogeneous. Investment then becomes merely a question of changing the absolute quantity of this homogeneous capital stock. Its composition does not interest the economist whose theory of investment is bound to be somewhat fragmentary.


Yet it is surely plain that, just as the profitability of all capital goods in a combination depends inter alia on the wages of the co-operant labour, so the rate of profit on each capital good depends on the cost at which complementary capital goods can be secured. The 'marginal efficiency of investment', i.e. the expected profitability of new capital goods, depends inter alia on the prices at which existing capital goods can be obtained in the market. The lower the latter the higher the former.


Keynes, to be sure, did not neglect the effect of the prices of existing capital goods on new investment, but, treating in characteristic fashion all capital as homogeneous, only saw the possibility of substitution. So he held that prices of existing capital goods below reproduction cost would weaken the incentive to invest. But in reality capital is as a rule heterogeneous and complementary. Except in the case, which Keynes alone considered, where existing and new capital goods happen to be substitutes, low prices of the former will have a favourable effect on the incentive to invest. Neglect of the heterogeneity of capital thus vitiates the theory of investment.*37


What has thus far been said in this chapter also throws some light on certain problems in the theory of money. This is not the place to discuss fully the role of money in the Theory of Assets. We have already learned something about the function of the cash reserve in the execution of the production plan; and more will be said about money as an asset in Chapter VI. But meanwhile we may consider the relevance of capital regrouping to the distinction between 'active' and 'idle' money which is so fundamental to the Keynesian theory of money.


Where firms have to draw on their cash reserves or borrow from outside sources in order to finance regrouping, it might seem at a first glance that 'idle' money is brought into circulation and 'activated'. Now, in so far as new capital goods are bought or old equipment sold for scrap, this is so. Such money is now 'active'. But in so far as such money is spent on existing capital goods in financing the capital loss arising from the reshuffle, such money is, in the Keynesian terminology, 'idle': its expenditure creates neither output nor employment, it merely facilitates the exchange of existing assets. Such money is therefore in every respect akin to money in the finan cial circulation. But if we follow Keynesian terminology, the demand for idle money is governed by Liquidity Preference. In our case, however, to say this would be absurd. The size of each firm's 'z', as we saw, depends not on its liquidity preference but largely on what happens during the process of exchange. We saw that for some firms 'z' might actually be negative. The root of the trouble is that the Keynesian theory of liquidity preference is a typical equilibrium theory with all its limitations, and thus not very useful in cases of disequilibrium. It tells us that a situation is conceivable in which the relative marginal significance of each type of asset held would be equal. It demonstrates that such a situation would, given our relative preferences for various assets, be preferable to any other. But it entirely fails to tell us how such a situation could ever be reached. For in a dynamic world, while the exchange of assets that might lead to an optimum position is still going on, other changes will supervene which drastically modify the situation. In our case, for example, all attempts to reach an 'optimum distribution' of assets were defeated by the unexpected gains and losses which accompanied the reshuffling of capital combinations, as a result of which some firms found themselves with less, others with more money than they had 'preferred'. Any attempt at a reshuffle of assets in the direction of 'optimum distribution' will set up those very dynamic processes the results of which, had they been foreseen, would have induced the choice of another distribution.


We may now briefly summarize the conclusions we have reached in this chapter.


In the first place, unexpected change, that chief vehicle of all the more important economic processes, makes frequent plan revisions necessary. Such plan revisions involve changes in existing capital combinations, i.e. regrouping decisions.


Secondly, decisions to regroup capital combinations, like other plan revisions, involve the making of new plans. The decision to reshuffle is subject to the same hazards as other plans: the reshuffle may fail.


Third, such failure of the regrouping plan will inter alia result in a shift of the money holdings in various firms. Hence, such shifts must not be regarded as necessarily reflecting 'shifts in liquidity preference'. Some of these shifts are among the undesired consequences of plan revisions, decisions not made of free choice. The view that all shifts in money holdings reflect shifts in liquidity preference presents just another case where the essential characteristics of a dynamic process are assumed away by static assumptions.*38 Liquidity preference is seen to be essentially a static concept, inapplicable to a dynamic world.


Finally, we have seen that New Investment and Idle Capacity have also to be interpreted as the incidental results of dynamic processes. New investment depends primarily on the availability of cheap complementary resources of labour and capital. Their abundance is as often as not the result of dynamic processes of the past. Idle capacity is economically a form of scrap kept in physical existence by optimistic expectations of future value which may or may not be fulfilled. To understand why this capacity is kept in existence we need to understand, not merely why the original plans failed, but why no alternative use for it has been found.


All unexpected change causes capital gains and losses. These, far more than 'output', 'incomes', or even profits, are the real motor of a dynamic market economy. They are mostly the result of failure of production plans; but often the result of the failure of regrouping plans to materialize in accordance with a predetermined pattern.

Notes for this chapter

The criterion of success or failure, as we pointed out in the last chapter, has to be sought within the expectational framework of the plan
By permission from Dynamic Equipment Policy, by George Terborgh. Copy-right 1949. McGraw-Hill Book Company, Inc., p. 17
J. R. Hicks: Value and Capital, 1939.
Erik Lindahl: Studies in the Theory of Money and Capital, 1939, in particular Part One, pp. 21-138
Erik Lundberg: Studies in the Theory of Economic Expansion, Stockholm and London, 1937, especially Chapter IX
This assumption will be abandoned in Chapter VI.
Joan Robinson: The Rate of Interest and Other Essays, 1952, especially pp.77-80
'In order that a complementary investment should be profitable, its cost must be less than the increase in the value of the old plant due to the complementary investment, that is, less than the value of the modernized or extended plant minus the value of the old plant. Thus, the more this latter value sinks, the more likely it is that complementary investment will pay' (Tord palander: 'On the Concepts and Methods of the "Stockholm School"', International Economic Papers, vol. 3, p. 32).
F. A. Hayek: Individualism and Economic Order, p. 94.


End of Notes

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