Human Capital Investment, Another Boom/Bust?

Austrian business cycle theory (ABCT) received a lot of press due to the recent economic realignment (I'm not sure what to call it since any title presupposes an explanation).

Austrians are different in their explanation of the business cycle. Clearly, Austrians emphasize words like malinvestment, boom, bust, or artificially lower interest rates. Unfortunately, most of these ideas are foreign to your average economist, at least in the way that Austrians use them.

This is because the underlying explanation of ABCT is Austrian capital theory. The Austrian emphasize the structure of production. Growth in capital investment cannot be easily reversed when these investments turn out to not be profitable. There is not blob of capital, K, and there is no instantaneous corrects.

The difficult correction explains the fluctuations in output. Always, capital is the underlying mechanism. This is the unique contribution of Austrian theory to macro, as I tried to show in an undergraduate project of mine on Austrian Business Cycle Theory and the Panic of 1907.

Unfortunately, most economists after Frank Knight assume away capital theory. Either capital does not matter or the changes come from outside of "the system."

A quick explanation for non-Austrians: When Austrians talk about investment, they discuss the lengthening of production. Originally, an actor can only satisfy his most urgent wants. I want food, so I find food. There is a close link between the goods and the wants.

As capital accumulates through savings, the actor can then lengthen his production process. Instead of simply consuming berries, the actor can spend his energy building a stick which will indirectly lead to berries. The process required to eat berries is now longer, because it includes making a stick. Investment allows longer structures of production. The Hayekian Triangle below provides a visual representation.

Hayek Capital Structure

One of the factors that facilitates lengthening production is a low-interest rate. If people can borrow at low rates, longer production appears profitable. When Austrians talk about capital theory, the image is always of a manufacturer that can invest in better equipment and provide for further stages.

My goal of this post is not to rehash all the arguments for or against Austrian business cycle theory or to decide what parts have been incorporated by others and which have not. Instead, I want to discuss another area of Austrian capital theory that I have not found addressed anywhere, human capital1.

Is Human Capital Different?

Discussing human capital in class, I realized that the Austrian theory has a unique viewpoint to offer on this topic too. Investment in any capital requires time and since capital is heterogeneous, it is costly or impossible to reverse. After spending 4 years studying physics, it is costly to readjust and start building my human capital in economics, trust me.

If the underlying mechanism, heterogeneous capital with costly readjustments, is the same as other forms of capital. There is a generic human capital, but specific skills that sometimes can only be applied in specific situations. This is exactly like other capital.  Should we expect human capital to follow the same boom/bust cycle?

Of course. Lowering the interest rate on investment in human capital causes people to lengthen their personal structure of production, possibly through more years of schooling. The mechanism is simple. The cost of school is lower, so people buy (invest) more of it. This could leave to a boom in education investment.

Unfortunately, this boom will ultimately lead to a bust when the investments turn out unprofitable once interest rates rise. Some people thought an English literature degree was worthwhile at 2%  but not at 5% after student loan rates rise. This is a costly readjustment period, possibly involving new investment in other trades. Since this is only a market specific boom, it would not have the impact that an economy wide boom had in the 2000's.

This is not a specific prediction of a collapse in the education market. Such predictions are difficult, if not impossible. Instead, it explains the types of forces that are operating. The fact that all human capital is not interchangeable can lead to costly readjustments. Other changes could offset this lengthening of production thus mitigating some of the problem, but if it goes on too long, it is bound to bust.


1.Peter Lewin does have a related paper on human capital but has a different emphasis.

 

2 thoughts on “Human Capital Investment, Another Boom/Bust?

  1. "Lowering the interest rate on investment in human capital causes people to lengthen their personal structure of production, possibly through more years of schooling. The mechanism is simple. The cost of school is lower, so people buy (invest) more of it. This could leave to a boom in education investment."

    The issue here is that while the cost of borrowing to go to school is lower, the opportunity cost of going to/staying in school is higher because wages also increase during the boom.

    • Not really. If the boom, i.e., the easy money, goes to education, the boom is in education, not in all economy. Then can happen that it is cheaper to stay at school, but the wage in industries other than education stay in the same level than before.

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