Real Bills, Phony Wealth
Financing Is Not Funding
by
Robert Blumen
by Robert Blumen
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.
May
31, 2006
Robert
Blumen [send him mail]
is an independent software developer based in San Francisco.
Copyright
© 2006 LewRockwell.com
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