I want start by saying that, I have recently been introduced to the Austrian school of economic thought through a lucid and easy to understand book – “Economics for real people” by Gene Callahan. I enjoyed the simplicity and elegance with which the ideas were presented.
I want to summarize my understandings – albeit a little crudely.
Capital is defined as a “way station” in somebody’s plan to provide a good or service for profit. For example a farmer who decides to plow and sell his produce – The tractor would be an intermediate way station in his plans. The value of his capital (tractor) is essentially determined by the returns (FCFE) that can be realized from his capital.
The market indicators to channel capital to value adding sectors are – Prices (value of goods defined by personal utility), Interest rates (time preference defined by personal utility).
One of my earlier scribbles defining Capital, Prices and interest rates can be found here Link
A simplified example to address how market intervention affects the economy –
Assume that the economy is a bus that needs to arrive at a specific destination (better lifestyle in the future) and also ensure a comfortable temperature (current lifestyle). The Fuel (savings/capital) in the bus powers both the air-conditioning (consumption) and the speed of the bus (investment). The passenger controls his individual A/C knob (consumption) whereas the driver controls speed (investment).
- If the ticket prices for the bus are artificially fixed too high they incentivize the consumer to take the train or other means of transport. Maybe even illegal ones. This is similar to a minimum wage/support price regime.
- If an external force decides to tell the driver (entrepreneur) that the demand for air-conditioning is not high (interest rates are zero, which assumes that the consumer will postpone current consumption for practically nothing in return) then the driver believes that he has more fuel available to increase the speed (investment). This means that the driver increases speed – however the passenger still demands air-conditioning and this means that fuel dries up really quickly causing the bus to stall.This is similar to a zero interest rate environment where the consumer still demands a return and prefers to consume/speculate when those returns are absent. However the entrepreneur believes that there are savings available to borrow and invest for growth. What happens is that the economy over-heats and after sometime the entrepreneur there are no real savings (like skilled workers/ infrastructure/ other real goods) to exchange in return. For example, If the interest rate is zero – companies start R&D on flying cars with borrowed money (savings) and after a few years when they start selling these flying cars, there is nobody to buy them because people have already consumed their savings.
- If an external force gives the driver (entrepreneur) an exaggerated efficiency figure – ie the speed acquired from every liter of fuel is very high – then he will miscalculate the distance he can cover with the investment of fuel in speed. The bus will stop before its destination .This is similar to the over-valuation caused by buying assets in the QE program. The entrepreneur starts believing that the potential returns from the capital invested are very high. As stated earlier the value of capital is derived from its estimated contribution in the future. So the heady valuations suggest to the entrepreneur that the future demand and subsequent contributions are going to be off the charts – however there is no demand in the economy to subsist it.
Market distortions like price fixing/ interest rate fixing / buying assets with printed money – are bound to create some unpredictable outcomes. However some key takeaways for investors in such environments are
- Don’t over-estimate future demand. Consumer’s time preference is key.
- Always keep a margin of safety in the valuation of invested capital.
- Liquidity is your friend