American Economic Association

Capital FormationAuthor(s): Alvin JohnsonSource: The American Economic Review, Vol. 26, No. 1, Supplement, Papers and Proceedingsof the Forty-eighth Annual Meeting of the American Economic Association (Mar., 1936), pp.126-128Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/1807772 .

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CAPITAL FORMATION

ALVIN JOHNSON, Chairman

Harold G. Moulton presented the thesis that capital formation cannot, as in classical economics, be attributed simply and directly to saving:

The very process of saving money for investment works directly against the profitable employment of the money thus saved. A decline of consumptive demand and falling prices for consumer goods serve to lessen the immediate possibilities of profit from the use of additional capital goods. It increases the volume of the existing capital equipment that is unutilized and discourages additional construction....

The real demand for capital goods is derived from the demand for its products, and this emanates from consumers. Hence restriction of consumption in order to save money lessens, immediately speaking, the demand for capital goods which is derived from consumption.

Expanding output of consumption goods and expanding construction of new capital goods occur simultaneously and not alternately. . . . Expanding consumption and rapid capital formation, and contracting consumption and decreasing capital construction, occur together. There is no evidence to support the view that new capital construction will take place long in advance of consumption.

A simultaneous increase in the flow of money income through consumption and invest- ment channels is made possible by an expansion in the total volume of money and credit, principally the latter. . . This expansion of credit finds its way into the money income stream through its disbursement in the form of wages, interest, etc. Now this augmenting volume of income makes its possible for individuals both to save more and to spend more than was the case in the preceding time period. Accordingly, the expanding demand through competitive channels does not have to be matched by a contraction in the flow through savings channels, or vice versa. . . . In a period of recovery an expansion of credit for the purpose of financing an increase in the volume of business need not raise prices-the increased volume of credit being matched by the resulting increase in the volume of goods and services. But it is pointed out that the moment the slack in the market for labor and materials has been taken up and capacity production is reached, any further expansions of credit can merely serve to raise the level of prices.

Our studies indicate that in the prosperity period of the twenties, at least, the slack in the market for labor and materials was never absorbed. Indeed, from 1922 to 1929 we had continuously about the same margin of unutilized industrial and labor capacity. . .. The explanation simply is that the construction of new plant equipment was automatically increasing the volume of capital goods, and also automatically increasing the labor supply through the medium of capital displacement. The very term "technological unemployment" implies that the growth of new capital on the upswing of a cycle tends to prevent the development of a shortage either of capital equipment or labor.

We do find, however, that a maladjustment may occur between the rate of increase in saving and the rate of increase in consumptive expenditure. This conclusion applies both to the upswing of the cycle and secular trends. During the prosperity period of the twenties, we find that while both savings and consumptive expenditures were expanding, savings were increasing faster than consumption; in other words, that an increasing percentage of the national income was being diverted into productive channels. This was attributable to the rising standards of living which made it possible for all classes to save more, and also to the fact that the rate of income increase was most rapid in the high income brackets where savings are largest.

In 1929 the money savings of individuals amounted to something like fifteen billion dollars, while the volume of funds that was taken out of the investment markets by business corporations for the purpose of constructing new plant and equipment was something like one-third of this amount. The total volume of corporate issues and farm and urban mortgages floated in 1929 was less than twelve billions. The larger part of the proceeds of corporate issues was not used in constructing new plant and equipment. The amount of actual capital construction that was financed by individual savings in 1929 was in the magnitude of five billion dollars. Business corporations decided how much new capital would be constructed by reference to considerations relating to potential markets rather than by reference to the supply of investment money available.

The truth is that there is seldom any close correspondence between the volume of a nation's money savings and the demand for such savings by business enterprisers. At certain

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Capital Formation 127

periods of a nation's history the demand for funds with which to expand plant and equipment may greatly exceed the available supply, while at other times the supply may greatly exceed the demand.

David S. Friday, while accepting generally Moulton's thesis of the simul- taneous movements of consumption and capital formation, laid stress upon the expediency of a more general conception of capital, to include durable consumers' goods.

Simon Kuznets also took exception to Moulton's limited conception of capital. The chief point of his criticism was directed against Moulton's thesis of a neces- sary dilemma, that increased savings mean abundance of funds for capital formation, but the decrease in consumption involved in savings makes the formation of new capital unprofitable:

Let us assume that the volume of consumption declines and the volume of savings increases. This not only reduces the prices of consumption goods, but presumably also the interest rate; i.e., the effective price of capital. Such a decline in the interest rate will possibly create opportunities for capital investment which under the higher rate of interest prior to that time were not in the profitable zone. Thus, whether upon a contraction in the rate of consumption and an increase in the rate of savings there will follow a con- traction or expansion of capital formation will depend upon the relative weight of the expansive influence of a lower interest rate and the depressive influence of a smaller rate of consumption. Once capital formation either expands or contracts, it will have a repercussive influence on the volume of consumption, and make for a concurrent move- ment of consumption and capital formation.

In criticism of Moulton's view that consumption takes the lead in recovery after depression, Kuznets analyzed the relevant statistical material and pointed out that historically there is no ground in principle for assigning a lead to the factor of consumption.

David Coyle stressed the bearing of technological factors upon the problem of capital formation in its relation to prosperity:

The amount of capital formation which will give the best results ought to be examined in the light of the great increase of technical productivity, as compared with the still greater increase in the rate of growth of capital.

For any particular industry, with a specific rate of technological progress, the optimum rate of replacement of plant can be shown to be proportional to the square root of the rate of technical progress divided by the square root of the cost of machinery. A rate of replace- ment or modernization slower or faster than this optimum will give a smaller net output of useful products per unit of expenditure. This is a physical relationship, independent of strictly commercial aspects. For the national industrial plant as a whole, a similar relation holds.

If capital formation is too slow to provide replacement at the optimum rate, that is a condition which calls for increased savings, voluntary or forced. When the capital forma- tion is so large that replacement occurs faster than the optimum, then the physical standard of living is necessarily reduced.

G. A. Kleene raised the question whether the presence of unused produc- tive capacity might not be ascribed rather to the existence of monopolistic price formation, checking the expansion of consumption, than to the restriction of consumption through saving. He also pointed out that an increase in saving, if attending a relatively greater increase in national income, might be quite com- patible with both increasing consumption and capital formation. Again, "saving is not likely to be abstinence from the consumption of necessities." A movement to save at the expense of luxuries would indeed depress the luxury industries, but it would leave open possibilities of profitable investment in the industries

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128 American Economic Association

producing necessities. In short, an analysis of the relation between saving and industrial depression cannot be based upon a study of all industry but must look to the specific situation of the several industries and groups of industries. While conceding the importance of expansion of bank credit as a means of expanding both consumption and capital formation, Kleene would not impute to it the cardinal role that it plays in Moulton's thesis.

Raymond T. Bye attacked Moulton's thesis at four main points:

He has dismissed the whole question of interest from the picture-an omission for which no adequate justification is offered, and which is vital for the problem. He has slighted and misunderstood the part played by technological progress in stimulating both consumption and capital formation, yet this was a dominant factor during the very periods on which he lays the most stress. He has confused relative amounts of saving and consumption with absolute amounts. Finally, he has assumed that there are finite limits to human wants. These errors have caused him to misstate the established theories which he criticizes, and they destroy the validity of his own conclusions.

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