Re: [OPE-L] J Winternitz's "The Marxist Theory of Crisis" online

From: michael perelman (michael@ECST.CSUCHICO.EDU)
Date: Wed Dec 22 2004 - 20:37:40 EST

Jerry, here is a section of the book that discusses the problem.

Gerald_A_Levy@MSN.COM wrote:

>Michael P,
>In what countries?
>Over what period of time?  For what recessions?
>What exactly is being measured?
>Sorry I don't have your book, but I'd like to look at the data.
>In solidarity, Jerry
_Empirical Limits to the Study of the Replacement Investment_

The exact nature of the replacement decision should be a matter of 
interest for those who frame economic policy, especially considering the 
lip service paid to economic modernization. Yet, despite the elegant 
mathematical tools and the extensive data bases available to economists, 
we know astonishingly little about actual replacement practices.

Common sense suggests that equipment should be replaced once it becomes 
obsolete, but this idea is tautological. On a superficial level, the 
term 'obsolete' conveys the idea that the article in question should be 
replaced. Upon closer scrutiny, the idea of obsolescence becomes 
considerably vaguer. For example, Strassman has catalogued a number of 
supposedly obsolete techniques which firms continued to adopt long after 
more advanced technologies had become available because they were 
serving particular markets or using special inputs which made these 
technologies a profitable proposition (Strassman, 1959a). For example, 
charcoal blast furnaces continued to be built long after anthracite and 
coke furnaces were becoming widespread, because they produced the purer 
output which blacksmiths needed (Strassman, 1959b; also see Ono, 1981).

Despite the difficulty in clearly defining obsolescence, this concept 
must be part of any theory of investment. In Griliches' words:

[A] theory of investment without obsolescence is like Hamlet without the 
prince ...

[Yet] we have very little information about the expected life of 
different machines, or about the factors that determine the relative 
prices of different ages of machines in the used machinery markets. 
Without this knowledge, we don't know how to measure any kind of 
capital. (Griliches, 1963, pp. 123 and 135‑6)

Replacement investment follows a different course from net investment 
(Klaasen _et al*.*_, 1961, p. 227), but Feldstein and Foot rightly 
complained that all the attention had been given to net investment 
(Feldstein and Foot, 1971, p. 49). Their call for more empirical 
analysis of replacement investment went largely unheeded. In fact it 
came after a brief flurry of interest in the subject had already come to 
an end. This debate began when Joan Robinson initiated the Cambridge 
Controversy by asking how the capital stock could be measured (Robinson, 
1953‑4; see also F.M. Fisher, 1969). Although she did not directly 
broach the question of replacement investment, the relationship between 
the difficulty of measuring capital and replacement investment is 
self‑evident. This connection is most obvious in the theory of vintage 
capital models (Whitaker, 1966).

Economists then began wrestling with the notion of vintage capital 
models until Tobin and his co‑workers cleverly applied some unrealistic 
assumptions, including the ubiquitous notion of perfect knowledge, to 
develop a vintage model consistent with neo‑classical theory (Solow _et 
al_., 1966). Robinson might have conceded that with perfect knowledge of 
future prices and discount rates, appropriate shadow prices for capital 
goods could be theoretically calculated. Her quarrel was with the 
realism of that approach. Once Tobin and his associates showed how 
vintage models could be stuffed back into the neo‑classical bag, 
interest in the subject died off rapidly.

Only a handful of articles have attempted to analyse the phenomenon of 
replacement investment. Feldstein, along with Foot, attempted to analyse 
scrapping behaviour empirically (Feldstein and Foot, 1971). He returned 
to the subject again in another joint article, where he gave a rigorous 
mathematical argument for dropping the assumption of proportionate 
scrapping (Feldstein and Rothschild, 1974). No data accompanied this 
theoretical exercise. It stressed the importance of changes in the 
assumed constant rate of decay of equipment rather than the actual 
scrapping decision.

In some instances, capital goods are surprisingly long‑lived. The steel 
mills of Youngstown represented a prime example, at least until their 
recent demise. Many of these plants had remained in operation for 
three‑quarters of a century or more. In other cases, capital goods 
become obsolete in a short period of time. Micro‑computers offer a 
popular example.

The difficulty of pin‑pointing the act of scrapping adds a further 
complication to the analysis of replacement investment. Even with as 
familiar an asset as a bus, dating a piece of equipment is all but 
impossible because of the complex history of partial improvements and 
repairs involved (D.C. Holland, 1962, p. 417); in Paul David's words: 
'[A]lthough textile machinery survived 'in place' to legendary ages, in 
many instances the equipment had been rebuilt in piecemeal fashion ‑‑ 
sometimes more than once ‑‑ so that by the end of its formal service 
life it contained scarcely a bit of metal dating from its debut on the 
mill floor' (David, 1975, pp. 177‑8). For the aggregate economy, 
replacement of capital goods is not equivalent to retirement. Many 
capital goods find their way to second‑hand markets. Plant and 
equipment, no longer used for their original purpose, are frequently put 
to other uses or worked less intensively (Foss, 1981a, 1981b and 1985).

The inclusion of the multitude of options for redeploying replaced 
capital goods blurs the boundaries between replacement and expansion. 
For example, British firms report difficulty in distinguishing the 
replacement from improvements in technique (Barna, 1962, p. 31).

Even when old capital is no longer actively used, it may continue to 
serve as an inventory of capacity to meet possible future peak load 
needs (Oi, 1981). Terborgh illustrated the changing uses to which 
capital can be put with a delightful history of a fictional 1890 vintage 

It began in heavy main‑line service. After a few years, the improvement 
in the art of new locomotives available and the development of the art 
of railroading made the unit obsolete for service, which was taken over 
by more modern power. It was thereupon relegated to branch‑line duty 
where the trains were shorter, the speeds lower, and the annual mileage 
greatly reduced. For some years it served in that capacity, but better 
power was continually being displaced from main‑line duty and 'kicked 
downstairs' onto the branch lines, and eventually the locomotive was 
forced out at the bottom, to become a switcher in one of the tanktown 
yards along the line, but the march of progress was relentless, and in 
the end, thanks to the combination of obsolescence and physical 
deterioration, it wound up on the inactive list. For some years more it 
lay around, idle most of the time, but pressed into service during 
traffic peaks and special emergencies. Finally, at long last, the bell 
tolled and it passed off the scene to the scrap heap. (Terborgh, 1949, 
p. 17; see also 1945, pp. 102‑3)

Indeed, Terborgh reported that in 1927‑29 new locomotives averaged about 
50,000 miles per year. Thirty-five year-old units only ran about 14,000 
miles (Terborgh, 1945, p. 105).

Even from the scrap heap the locomotive might have made a modest 
contribution to the economy. Parts might be used on other locomotives. 
Imaginative second‑hand dealers profit from selling components for 
purposes totally unrelated to their original use. A firm might pay 
$80,000 for the right to demolish an obsolete chemical plant in the 
expectation of selling the plant and materials for $2,000,000 (Deigh, 1987).

Firms may hold what appears to be excess capacity one moment only to 
face backlogs the next (De Vany and Frey, 1982; see also Steindl, 1976, 
p. 8). The incentive to use capital rather than labour to meet sudden 
increases in demand depends, in part, upon the ratio of capital costs to 
labour costs. For example, in the textile industry where labour is a 
relatively small fraction of total costs, surges in demand tend to be 
met by increasing labour inputs rather than capital. By contrast, in 
coal mining where labour costs are relatively high, industry meets 
demand shocks by moving pits on‑ and off‑line (Rowe, 1928, pp. 10‑2).

In addition to the complications associated with the various 
possibilities for replacing obsolete capital goods, the common empirical 
measures of the existing capital stock are seriously flawed. Until 
recently, imported capital goods were not included in the measures of 
current investment in the US. When this omission was discovered, the 
investment account had to be revised upwards for more than $20 billion 
in 1978 alone. Additionally, purchases of home computers are included in 
business investment (Anon., 1983).

Although economists are trained to count in terms of monetary values, 
satisfactory monetary values are often unavailable except for newly 
purchased capital goods. Once capital is installed, indicators of its 
value become increasingly unreliable. Accepted accounting practices are 
almost entirely based on cost rather than the actual values of installed 
plant and equipment (Beidleman, 1973, p. vii). Thus, accounting values 
bear little relationship to the actual economic values (Beidleman, 1976; 
F.M. Fisher and McGowan, 1983) unless depreciation rates track the 
actual economic deterioration of plant and equipment. To construct such 
depreciation formulae is all but impossible. It would require the 
relative values of two vintages of machines to be independent of 
changing price ratios.

Even if such depreciation formulae could be devised, they probably would 
not be used. Allowable depreciation is determined as much by political 
as economic considerations. The book value of much of the old plant and 
equipment will tend to be insignificant, having been either all, or 
mostly depreciated away. Such discrepancies are of major importance in 
the study of scrapping.

Econometricians continue to debate about the appropriate depreciation 
formula (Hulten and Wykoff, 1981a and 1981b). Does capital depreciate 
evenly or does it lose its value more quickly in the early years? Some 
estimates suggest that capital, once installed, may actually appreciate 
over the first few years, since one‑ or two year‑old investment seems to 
have a greater effect on aggregate production than new investment (Pakes 
and Griliches, 1984). Sylos‑Labini went even further, estimating that 
current investment tends to decrease productivity because of what he 
calls the 'disturbance effect' (Sylos‑Labini, 1983‑4, p. 173). I will 
return to this subject later, in discussing the subject of 'learning by 
doing'. In reality, the depreciation rates implicit in actual market 
prices are highly irregular. For example, the annual rate of market 
price decline for two‑year old Ford F600 trucks ranged from 7.8 per cent 
in 1976 to 25.8 per cent in 1971 (Bulow and Summers, 1985, p. 27).

Government estimates of capital stocks are unsatisfactory. They are 
constructed on the basis of the perpetual inventory method, which 
determines the capital stock each year by adding the difference between 
the value of new investment and an estimate of the annual depreciation 
of existing capital goods. Unfortunately the assumed pattern of 
depreciation is based on a predetermined economic life for each category 
of investment goods, usually based on Bulletin F of the Internal Revenue 
Service (first published in 1931) or Winfrey's 1935 study, developed 
from mortality curves compiled by workers at the Engineering Experiment 
Station of Iowa State College during the 1920s and 1930s (Winfrey, 
1935). The capital is then assumed to depreciate according to some fixed 
pattern, such as double‑declining balances or straight line depreciation.

The estimated lifetime of capital introduces further bias in the 
aggregate depreciation figures. An error of one‑third in the assumed 
asset life of capital alters the estimated size of the capital stock by 
about one‑third (Redfern, 1955, pp. 142‑7). The economic lives used for 
tax purposes often are unrelated to the actual economic lifetime of the 
plant and equipment. By the time a machine tool is scrapped, three 
entire generations of tools can be written off (Beidleman, 1976). 
Feldstein and Rothschild note that the basis for the 1942 edition of 
Bulletin F lives was never published, although the estimated lives were 
based on Winfrey's work, as well as conferences with industry and 
statistical studies (Feldstein and Rothschild, 1974). Even so, these 
estimates of capital goods lives are not sufficient. For example, 
Hickman questioned the accuracy of Bulletin F, speculating that the 
standard of obsolescence applied during the 1930s was atypical because 
plant and equipment might be less readily scrapped during a depression 
(Hickman, 1965, p. 241). In fact, a depression may actually shorten the 
life of capital goods, creating more incentive for scrapping and less 
for the renewal of plant and equipment (Boddy and Gort, 1971; and 
Eisner, 1978, p. 182).

In effect, the permanent inventory method of calculating capital stock 
suggests that the retirement of capital is a wholly technical decision, 
unaffected by prevailing economic conditions. It presumes that no matter 
what sort of shocks occur, the relative prices of different vintages of 
capital goods will remain unaffected. The weakness of such assumptions 
is obvious. You do not have to be a firm believer in the Kondratieff 
cycle to suspect that technical change does not always evolve regularly, 
but often seems to come in spurts. Sometimes it will be concentrated in 
specific industries. At other times, it will be more evenly distributed 
among industries. In addition, capital decays faster when it is utilized 
more intensively (Keynes, 1936, pp. 69‑70; Marx, 1977, pp. 527‑9). 
Certainly statistical evidence indicates that failure rates do rise with 
capital use (Davis, 1952; Jorgenson, McCall and Radner, 1967).

Are we to believe that capital equipment is kept in operation for a 
fixed period of time, regardless of the prevailing long‑run 
macro‑economic conditions? Otherwise, the permanent inventory procedure 
is unjustified for estimating both the capital stock and models of 
investment. Yet every empirical study of which I am aware suggests that 
the capital stock decays irregularly. Most observers agree current 
economic conditions affect the scrapping decision. For example, a number 
of British firms were asked to give the percentage of assets of 
different vintages surviving in 1957, as well as the percentage of 
assets of different vintages scrapped in the same year. The first 
question elicited survival rates and the second, mortality rates. 
Survival rates constructed from current mortality rates were higher than 
the rates obtained directly, leading to the conclusion: 'This is 
consistent with the hypothesis that the rate of scrapping varies with 
the trade cycle and in boom years scrapping is postponed' (Barna, 1957, 
p. 88).

Parkinson's data on the pattern of scrapping ships supports Barna's 
finding of variable scrapping rates:

The first conclusion that emerges from a general survey of scrapping 
rates is that the service life of a ship is not rigorously determined by 
factors of a technical nature governing structural strength ...

The decision to scrap a vessel will depend very greatly on anticipated 
movements of freight rates and the rising trend of repair costs with 
increasing age ... A sudden increase in the demand for tonnage at a time 
when new building cannot be increased is likely, therefore, to give rise 
to some postponement in the scrapping of those types of tonnage in 
demand, almost irrespective of age. (Parkinson, 1957, p. 79)

Ryan found that in the Lancashire cotton industry between 1860 and 1838, 
38 per cent of the machinery replacements occurred in the boom years 
1906‑1908, 1912‑14, and 1919‑21 (Ryan, 1930, p. 576). Feldstein and Foot 
wrote: 'Expansion investment causes an offsetting fall in replacement 
investment, supporting the view that firms postpone replacement during 
periods of expansion investment and accelerate replacement when there is 
less expansion investment' (Feldstein and Foot, 1971, p. 54). This 
conclusion must be taken with a grain of salt, based on the justifiable 
criticisms of their estimates by both Jorgenson and Eisner (Jorgenson, 
1971, p. 1140; Eisner, 1978, pp. 175‑88), which I will discuss later.

Since replacement does not occur with the regularity assumed by the 
permanent inventory method, the government's published series for the US 
capital stock is inaccurate. Realization of the problems resulting from 
the assumption of the permanent inventory method prompted Feldstein and 
Foot to write:

The rejection of the proportional replacement theory as a description of 
short‑run behavior has important implications. First, all of the current 
methods of estimating parameters of net investment may be misleading 
because they rely on the proportionate replacement assumption either to 
derive a net investment series or in specifying a gross investment 
series. Second, understanding and forecasting short‑run variations in 
gross investment requires a more complex model of replacement 
investment. (Feldstein and Foot, 1971, p. 57)

The implicit widespread acceptance of the perpetual inventory assumption 
is ironic. Despite the recent emphasis on rational expectations, which 
purportedly highlights business' supposed immediate reaction to new 
economic information, the economics profession still assumes away (or at 
least it relies on data that assume away) any effect of expectations on 
the retirement of capital. This practice is especially troubling since 
capital accumulation is generally accepted as central to the functioning 
of the economy.

The unsatisfactory measures of the capital stock substantially 
complicates the analysis of replacement investment. In contrast to 
econometricians' solicitude about the characteristics of their 
residuals, they display no concern about the shaky empirical 
underpinnings of this measure of capital, although they frequently 
include this measure of capital as a _key variable_ in their 
macro‑economic models. Ideally we need measures of present value, but 
the present values, which are calculated in journals and on blackboards, 
require knowledge about the future which is impossible to obtain (Hayek, 
1941, p. 90). You need only consult Lock's description of the survey of 
the capital stock of the Dutch cigar industry to appreciate the almost 
impossible challenge of calculating an adequate, let alone precise 
measure of the capital stock (Lock, 1985). As Boddy and Gort noted: 
'Capital stocks are midway between an observable phenomenon and a state 
of mind. One can touch and see the tangible assets, but to measure them 
in constant units requires a theory of production and a host of 
assumptions' (Boddy and Gort, 1973, p. 245).

Mistakes in the depreciation rate can significantly affect the estimated 
rate of return on capital. The US Department of Commerce estimated that 
in 1983, profits for non‑financial corporations based on Bulletin F 
lives ranged between $171 and $260 billion, depending on whether 
straight line or double declining balances were used in calculating 
depreciation (Anon., 1984a).

To make matters worse, the unfounded assumption of a determinate 
economic lifetime can also distort measures of productivity (Enke, 1962; 
Miller, 1983 and 1985a). Considering that national economic policy is 
predicated upon this measure of the health of the national economy, 
reliance on this data is especially distressing.

In the future, some of the problems resulting from reliance on data 
calculated on the basis of the perpetual inventory method may be 
gradually overcome. Since 1977, the Annual Survey of Manufactures of the 
US Department of Commerce has surveyed business concerning retirements 
of its capital stock (US Department of Commerce, 1987, p. 4). In 1988, 
the annual time series consisted of only nine observations, 
demonstrating a strong positive trend. In 1977, retirements equalled 
almost 50 per cent of new capital acquistions.

_Table 3.1 _

_Retirements and expenditures on used capital ($ billion)_

_Year_ _Retirements_ _Expenditures on Used Capital_^1

_Billion Dollars_ _Billion Dollars_

1985 41.7 8.2

1984 33.7 5.4

1983 33.2 5.6

1982 29.3 6.3

1981 30.0 5.1

1980 23.6 4.5

1979 18.3 3.4

1977 18.6 3.3

1976 15.0 n.a.

^1 including structures

Source: US Department of Commerce, 1987


The figures shown in Table 3.1 are far from perfect. They depend upon 
voluntary information based on the book values of capital goods 
replaced. As information accumulates about this time series, more 
interest may develop in studying the scrapping decisions.

Although considerable information is collected regarding aggregate gross 
investment, scrapping rarely leaves a satisfactory paper trail. One 
partial exception may be the stock of ships which are listed in Lloyd's 
Register (Parkinson, 1957).

In the absence of any useful public data base, researchers depend on 
access to private records. Even if firms were required to give a public 
accounting of the retirement of all plant and equipment, substantial 
measurement problems would still remain since detailed studies of actual 
business replacement practices, such as Holland's account of the Bristol 
Bus Company are rare indeed (D.C. Holland, 1962).

_Variations on a Theme by Terborgh_

Jorgenson claims, 'There is no greater gap between economic theory and 
economic practice than that which characterizes the literature on 
business investment in fixed capital' (Jorgenson, 1963a, p. 47). This 
admission is especially valuable since Jorgenson has been the most vocal 
advocate of theories designed to gloss over the complexities of 
investment (see below).

On the simplest level, profitable investment in capital equipment 
requires that the present value of the investment exceed the costs. This 
far from trivial comparison occurs within a very complex calculus of 
risk considerations. In Keynes' words, business invests in capital goods 
'in light of _current_ expectations of _prospective_ costs and sale 
proceeds' (Keynes, 1936, p. 47). These expectations include the first, 
second and perhaps higher moments of the expected future returns from an 
investment; that is, not just expected profits, but the expected 
variance and skewness of future profits.

This elementary proposition has enormous consequences for investment 
theory. Over and above Keynes' suggestion that rational calculation was 
all but impossible because uncertainty was so pervasive that probability 
distributions could not be known, the difficulty of integrating the 
expected variance of future investments into capital theory is so 
daunting that it has been ignored in the economics literature. In 
contrast, finance theorists have analysed the expected variability of 
future returns since they are concerned with the remarkable array of 
financial instruments which business has invented to hedge against an 
increasingly uncertain environment. Just as the mix of financial assets 
changed as business attempted to cope with uncertainty, the mix of real 
capital assets purchased should be similarly affected by uncertainty. 
Let us take a leaf from the financial theorists.

Terborgh suggested that purchasing capital goods is akin to 
participating in a futures market for capital services (Terborgh, 1949, 
p. 29). A hypothetical futures market for capital services differs from 
actual futures markets since spot markets for capital services do not 
generally exist. Futures markets typically develop for widely traded, 
homogeneous commodities. Most capital services, or even capital goods, 
are neither widely traded nor homogeneous. Existing futures markets are 
difficult enough to predict, but the hypothetical futures market for 
capital services would be even more complex.

Broader spot markets for capital services could evolve if capital 
services were produced by capital goods that had a lifetime of only one 
period, making the spot market for capital services identical with the 
capital goods market. Indeed, if all capital goods only lasted one fixed 
period investment theory would be simple since all capital would be 
circulating capital.

To make the concept of a spot market for capital services more general, 
consider a notional spot market for capital services measured by what 
firms would be willing to pay for a flow of capital services during a 
particular period. Under some sets of expectations, firms may want to 
lock themselves into a firm contract at existing prices. In Woodward's 
terminology, they would be willing to pay a solidity rather than a 
liquidity premium (Woodward, 1983).

The existence conditions for a liquidity premium are well known ‑‑ the 
most important one being that present conditions convey significant 
information about the future (Day, 1986). In addition, the expected cost 
of producing capital services would have to grow more rapidly than the 
discount rate.

Brownian motion with drift might reasonably describe the pattern for the 
value of capital services. It imples that the variance of expected 
future prices t‑periods ahead is proportional to the value of t. 
Consequently, the risk of investing in future capital services increases 
the more distant their delivery. In the absence of inflationary 
expectations, 'normal backwardation', would be expected to occur in this 
notional futures market because the owners of capital goods have to bear 
the risk of taking a long position on capital services (Keynes, 1923a).

Some students of futures markets deny that normal backwardation is the 
rule. They argue that in a balanced commodity market, those ‑‑ such as 
millers or feed processors ‑‑ who intend to purchase commodities in the 
future may also want to protect themselves from risk. Their preference 
for a short hedge tends on average to balance out the suppliers' demand 
for a long hedge, thereby eliminating any tendency for normal backwardation.

Hicks discounts the likelihood of balanced futures markets, referring to 
the 'congenital weakness of the demand side' (Hicks, 1946, p. 137n.). 
His case is even stronger for the futures market for capital services. 
According to Hicks:

Now there are quite sufficient technical rigidities in the process of 
production to make it certain that a number of entrepreneurs will want 
to hedge their sales for this reason; supplies in the near future are 
largely governed by decisions taken in the past ... But although the 
same thing sometimes happens with planned purchases as well, it is 
almost inevitably rarer; technical conditions give the entrepreneur a 
much freer hand about the acquisition of inputs than about the 
completion of inputs ... If forward markets consisted entirely of 
hedgers, there would be a tendency for a relative weakness on the demand 
side; a smaller proportion of planned purchases than planned sales would 
be covered by forward contracts. (Hicks, 1946, p. 137)

The absence of speculators who are willing to bear the risk of holding 
long‑lived capital goods contributes to firms' reluctance to invest in 
them. Think of a long‑lived capital good as an inventory of expected 
future capital services. The owner must generally bear the risk of 
holding the inventory. Some exceptions occur. Owners of buildings 
attempt to transfer risk to occupants by means of long‑term lease 
agreements (Keynes, 1936, p. 163). Unfortunately no equivalent exists 
for most capital goods.

Alternatively a firm could contract to lease a capital good from the 
supplier. Ignoring risk considerations, a firm's profitability would be 
unaffected whether it would enter into an agreement to lease a capital 
good or simply borrow the funds to purchase it outright. In effect, the 
lessor would be lending money to the firm to finance the inventory of 
capital services.

Of course, the motive to lease goes far beyond the extension of credit 
from the lessor. Ignoring the tax consequences, the lessor bears two 
kinds of risk. First, the lessor will suffer if the earning capacity of 
the capital good deteriorates. Second, in a straight lease agreement, 
the lessee has an incentive to overwork a leased capital good. The 
lessor has to shoulder the loss if the operator fails to maintain it in 
good working order (Rust, 1985, p. 590).

When lease agreements are in force, lessors often tend to be especially 
suited to bear the risk associated with holding an inventory of capital 
services (Flath, 1980; see also Bulow, 1986). For example, '[t]he lessor 
may be active or skillful in dealing in the associated second‑hand 
market: his specialized knowledge may give him an edge' (Flath, 1980, 
citing Lewellen, Long and McConnel, 1976, p. 796). The continual threat 
of obsolescence causes firms to prefer to lease computers (Flath, 1980). 
Obviously computer manufacturers are better informed than their 
customers about the future likelihood of obsolescence. Because computers 
do not wear out from overworking as much as mechanical equipment, they 
are less subject to abuse. Thus computers are leased more frequently 
than most capital goods. With the exception of computers and 
transportation equipment, especially the sort that is subject to 
government mandated maintenance schedules, capital goods are not 
generally leased (B. Klein, Crawford and Alchian, 1978).

Does the absence of leasing agreements mean that normal backwardation is 
inapplicable to the notional futures market for capital services? 
Probably not. What Hicks called the 'congenital weakness' in the demand 
side occurs because those who purchase capital goods do not have a 
strong need for a short hedge. Some of those who might require capital 
services in the future normally can squeeze an extra period of capital 
services out of old plant and equipment. Those that hold excessive 
inventories of capital services do not have the same degree of 
flexibility. As a result normal backwardation might be even more normal 
in this hypothetical futures market than in more familiar ones.

Lessees are generally willing to pay a premium to lease a capital good 
in the same way Keynes suggested that long hedgers in futures markets, 
such as farmers, are willing to pay speculators the premium associated 
with normal backwardation to protect themselves from risk. Where lease 
arrangements are not available, the willingness to pay for the security 
of leases manifests itself as a reluctance to invest in long‑term capital.

Imagine a Walrasian world without technical change. Each firm is endowed 
with machines of different durabilities and a cash balance. Firms trade 
until they are satisfied with their portfolio of money and machines. 
Then trading commences. If the producers believe that they are entering 
a stable, golden age with a commonly expected rate of interest, then the 
price of each capital good will equal the expected discounted value of 
the capital services that it will deliver. To eliminate the problem of 
discounting, the price of each capital good will be measured in terms of 
the annual payout of an annuity over the lifetime of the capital good, 
with an interest rate based on the commonly expected rate. If capital 
goods prices are expected to rise, then contango will exist. Firms will 
be willing to pay more for the certainty of a future flow of capital 
services than they would pay for immediate capital services (say, the 
value of an old capital good with only one more period of service).

If firms have a high liquidity preference, they will hoard their money. 
Sellers of capital goods will have to lower their price to entice other 
firms to part with their funds. Future values of capital services, 
reflected in the values of newer capital goods, will be very low 
relative to the value of current capital services.


Michael Perelman
Economics Department
California State University
michael at
Chico, CA 95929
fax 530-898-5901

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