Subsistence fund

The subsistence fund (or the "pool of funding" or "advances fund") is the pool of final goods ready for human consumption.

Creating the subsistence fund
To maintain life and well being, man must have an adequate amount of consumer goods. But these goods are not readily available; they have to be extracted from nature. Without any tools at his disposal, man can only secure from nature very few goods for his survival. For instance, take an individual, John, stranded in a jungle. To stay alive, he can only pick up some apples. Let's say that by working 10 hours a day, he picks 20 apples, which keep him alive. The 20 apples that John has secured from nature is his subsistence fund.

What if John had a special stick, which would allow him to become more productive? His daily production of apples could be, say, 40 apples. To make the special stick requires two days of work. By spending his time on making the stick he can't pick up the apples that keep him alive. He puts aside an apple a day for the next forty days. By saving an apple and enduring hunger, after forty days he will have enough apples to keep him fed while he is making the stick. After forty days, John’s pool of funding will be comprised of 40 apples, which enable the making of the stick, that will raise the production of apples and lift John’s living standard.

But there can be an individual, Rob, who specializes in making sticks and is willing to make one. Because he is an expert in stick making, it takes him only one day. Rob also needs 20 apples a day to keep him going. But now, John only needs to save 20 apples, which will enable him to hire the services of Rob.

While the stick is being made - while capital is formed - it absorbs real funding and in this sense it is a burden — John had to make a sacrifice and save 20 apples, risking his health and well being. But after 21 days he will be able to use the stick, which will allow him to double his production of apples. On day one his pool of funding will be 40 apples, of which 20 are used for consumption and 20 are saved. On day two will his pool of funding comprise of 20 saved apples + 40 apples from current production, i.e., 60 apples of which 20 is consumed and 40 are saved. On the third day his pool of funding will be 80 apples, out of this John consumes 20 and saves 60 apples.

As the pool of funding expands, this allows John to work on other projects and hire the services of other individuals. The size of the pool of funding determines the quality and the quantity of various tools that can be made. If the pool can only sufficient to support one day of work, then the making of a tool that requires two days of work cannot be undertaken. In short, the size of the pool of funding sets the limit on the projects that can be implemented. Tools and equipment - capital - allow the production of more goods and save time, and create new goods that were not available at all. The making of useless tools on the other hand simply consumes resources from the pool.

Money
The introduction of money doesn’t alter the essence of the pool of funding. Money can be seen as a permit to access the pool of funding, or a claim on the goods in it. Various producers who have exchanged their produce for money can now access the pool whenever they deem it necessary. If a baker has exchanged 10 loaves of bread for 10 units of money, it means that he has a claim on final goods that is worth 10 units of money.

Payment is always done by means of various goods and services. For instance, a baker pays for shoes with the bread he produced, while the shoemaker pays for the bread with the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced before the exchange. As long as the flow of production is maintained, the baker can always exchange his money for the final consumer goods he wants (i.e., he can always exercise his claim on final goods and services). Obviously, if for some reason the flow of production is disrupted, the baker will not be able to fully exercise his claim.

However, it is quite different when an individual exchanges money for a promise to repay money in one-year’s time. In this case, the buyer of the promise is temporarily transferring his claim on consumer goods to the issuer of a promise. The buyer of the promise provides a credit to the seller of the promise. This is a credit transaction.

Determining the interest rate
Through saving can man achieve his ultimate goal, which is bettering his situation. It implies giving up some benefits at present - this is the price paid for the attainment of the end sought. The value of the price paid is called cost, and costs are equal to the value of the satisfaction which one must forego to attain the end aimed at. The return on savings must be in excess of the cost of savings. If the costs are too high - if savings can’t better an individual’s life and well being - then saving will not be undertaken.

Consequently, the return on savings must be above the premium for man to agree to save. A positive time preference (i.e., the existence of a premium) precludes the natural emergence of a zero interest rate. Should a zero interest rate be imposed, this will abort all savings and lead to the destruction of the production structure. The premium of having goods now versus having them in the future is getting smaller with the increase in their stock. This, in turn, means that the required return on savings will be lower. An increase in the pool of funding sets the platform for lower interest rates.

Apart from time preferences, the purchasing power of money and business risk are important elements in the formation of interest. However, their importance is assessed in reference to the fundamental factor, which is time preference. For instance, if one dollar buys one apple and the agreed interest rate is 10%, then in one-year’s time the lender of the apple would expect to get back 1.1 apples. The lender of the apple will also be happy to accept $1.1 since this sum will permit him to purchase 1.1 apples.

Let's say the purchasing power of money falls, and the price of an apple increases by 10% to $1.1. The lender will not accept $1.1 in one year time, since $1.1 will only buy him one apple. He will require $1.21 to agree to lend since $1.21 will secure the lender 1.1 apples.

Effects of a monetary expansion
In a real economic growth, if the money used to finance production was secured on account of the previous production of consumer goods, the withdrawal of consumer goods results in productive consumption. In other words, the consumption of the holder of money is fully backed up by his contribution to the pool of funding.

But, when money is created out of "thin air" it weakens the pool of funding. The holder of the newly created money can use it to withdraw final consumer goods from the pool of funding with no prior contribution to the pool. This money diverts funding away from wealth producers who have contributed to the pool of funding toward the holders of the newly created money. Wealth producers will discover that the purchasing power of their money has fallen since there are now less goods left in the pool—they cannot fully exercise their claim over final goods since these goods are not there.

As a result of the artificial lowering of interest rates, businesses undertake new capital projects to expand and lengthen the production structure. These capital projects didn't appear to be profitable before the interest rates were lowered. Now, economic activity zooms ahead and an economic boom emerges.

Monetary growth cannot produce a general expansion in economic activity (economic growth). The economy is being pulled in two directions. Entrepreneurs want more capital goods, at the same time that consumers want more consumer goods. The needed correction comes in the form of a recession, during which many projects are liquidated and unemployment rises.

The decline in interest rates means it pays less to save, so consumption is raised beyond levels that would have otherwise taken place. At the same time, more real funding seems to be available for businesses. More resources are used for the production of consumer goods and less for the maintenance and improvement of the wealth-producing infrastructure. This lowers the economy's capacity to produce final consumer goods and so it weakens the pool of funding - contrary to the popular idea that a central bank can grow the economy by keeping interest rates as low as possible.

At the same time, redirecting resources makes maintenance of other projects much harder. As the production of various final consumer goods is undermined, it is even harder to make provisions for savings.

As long as the pool of funding is expanding, the central bank’s monetary policies seem to work. But that is just an illusion. Loose monetary policies of the central bank can only create nonwealth-generating activities ("artificial forms of life"). But as various unpleasant side effects of this loose monetary policy emerge — such as rising price inflation — the central bank reverses its loose stance. That will undermine various activities that sprang-up on the back of the previous loose monetary stance and will lead to an economic bust. If the pool becomes so depleted that it ceases to grow, or it even declines, the economy falls into a "black hole." Once this happens the central bank can print as much money as it likes but it cannot "revive" the economy - on the contrary, it further weakens the pool and delays the economic recovery.

What if the fiat money stock was expanded due to a rising demand for money? What matters is that new money which is not backed up by any real goods and services was created. This in turn means that regardless of the reasons an increase in money supply always leads to the impoverishment of wealth producers and to the boom-bust cycle is still a threat.

Commodity money
Money emerged from an ordinary commodity, that people demanded, because it contributed tangible benefits to their life and well being - one of them are the services of a medium of exchange.

If commodity money is used, an increase of the production of the commodity means more useful goods - so the pool of funding grows. The introduction of paper money, which is fully redeemable into a commodity (money substitutes), doesn’t alter anything. This paper money is a receipt or a claim on the commodity.

If paper money is unbacked by anything (created out of 'thin air'), there wasn’t any prior production of any useful goods including commodity, and this of course must lead to a weakening of the pool of funding.

Malinvestment
The complicated and somewhat fragile production structure requires that the inputs be available not only in the right magnitudes but also at the right moments in time. If they are not, then projects that appeared profitable are soon revealed to be unprofitable. In other words, what appeared to be capital creation is seen in fact to be capital consumption.

The Austrian Business Cycle Theory focuses on the "medium run", because that is where problems arise. In the short run, the capital structure cannot be changed significantly, and in the long run all errors have been rectified. In the medium run there is time enough for capital projects to be initiated and the direction of production to change, but not enough time for malinvestments to be corrected - at least not without serious repercussions.

The inability to smoothly liquidate or redirect projects stems largely from the heterogeneity of most capital goods. Capital goods cannot immediately be converted into final consumer goods - or other capital goods. Changes in the structure of production cannot easily be reversed. There is a significant degree of "path-dependence" involved with the capital restructuring that occurs in the medium run. The economy cannot simply "erase" the errors and start over.

Malinvestment occurs due to misleading relative price signals, and it necessitates a corrective contraction - a bust following the boom.

Links

 * Is Debt Alone a Threat? by Frank Shostak, November 2006
 * Explaining Malinvestment and Overinvestment (pdf) by Larry J. Sechrest, winter 2006
 * Capital, Credit Expansions, and the Subsistence Fund (pdf) by Larry J. Sechrest, November 2002