It's been a strange week for me on questions of substitutability

So Steve Horwitz especially has had several posts this week on capital and labor heterogeneity and specificity. What's been strange about it is that as a budding labor economist whose scant contributions to the field have mainly revolved around (1.) evaluating training programs that provide human capital to workers who aren't qualified to do certain jobs, (2.) understanding unemployment which cannot be remedied simply by lowering a reservation wage, and (3.) highly specialized labor markets, particularly for scientists and engineers, which can't turn on a dime, I was initially very receptive to Steve's posts. Indeed, as he was putting out these posts I've been writing about specialized engineering labor and how that specialization changes the response of the engineering labor market to increases in demand! My big quibble with Steve's post was that unless you assumed no substitutability it seems silly to deny that stimulus will have ripple effects: if 58% of ARRA-funded workers come from other jobs they will be largely replaced. Nobody has to abandon labor and capital heterogeneity to know this.

Anyway - because of all this I was predisposed to agree with Steve on labor and capital, but disagree on the implications for the stimulus (which he still left very vague). But as it happened, on Steve's blog an English PhD told me he knew what I thought and what economists thought about these things better than I do, a former central banker continued a long-standing habit of condescension towards me, and Steve mocked my question rather than answering it... so I don't feel like commenting on his new post on capital heterogeneity and the interwar period (another thing I'm very intereseted in) that is also quite thought-provoking.

But I did want to say something about capital specificity and Keynesianism.

One of the key insight of Keynes is that the act of saving is not just the other side of the coin of the act of investing. Money and debt allows for that connection to be severed. It's very hard to maintain that view and also think that capital is homogenous. Saving is about a demand for a prospective yield. Capital is about the execution of specific plan. If capital were not specific and were just a homogenous blog-like stream of benefits you would have a much easier time arguing that the act of saving and the act of investing are essentially the same act.

It's worth quoting extensively from Chapter 16 of the General Theory:

"An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

If saving consisted not merely in abstaining from present consumption but in placing simultaneously a specific order for future consumption, the effect might indeed be different. For in that case the expectation of some future yield from investment would be improved, and the resources released from preparing for present consumption could be turned over to preparing for the future consumption. Not that they necessarily would be, even in this case, on a scale equal to the amount of resources released; since the desired interval of delay might require a method of production so inconveniently “roundabout” as to have an efficiency well below the current rate of interest, with the result that the favourable effect on employment of the forward order for consumption would eventuate not at once but at some subsequent date, so that the immediate effect of the saving would still be adverse to employment. In any case, however, an individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order. Thus, since the expectation of consumption is the only raison d'être of employment, there should be nothing paradoxical in the conclusion that a diminished propensity to consume has cet. par. a depressing effect on employment.

The trouble arises, therefore, because the act of saving implies, not a substitution for present consumption of some specific additional consumption which requires for its preparation just as much immediate economic activity as would have been required by present consumption equal in value to the sum saved, but a desire for “wealth” as such, that is for a potentiality of consuming an unspecified article at an unspecified time. The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.

It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment. Moreover, in order that an individual saver may attain his desired goal of the ownership of wealth, it is not necessary that a new capital-asset should be produced wherewith to satisfy him. The mere act of saving by one individual, being two-sided as we have shown above, forces some other individual to transfer to him some article of wealth old or new. Every act of saving involves a “forced” inevitable transfer of wealth to him who saves, though he in his turn may suffer from the saving of others. These transfers of wealth do not require the creation of new wealth — indeed, as we have seen, they may be actively inimical to it. The creation of new wealth wholly depends on the prospective yield of the new wealth reaching the standard set by the current rate of interest. The prospective yield of the marginal new investment is not increased by the fact that someone wishes to increase his wealth, since the prospective yield of the marginal new investment depends on the expectation of a demand for a specific article at a specific date.

Nor do we avoid this conclusion by arguing that what the owner of wealth desires is not a given prospective yield but the best available prospective yield, so that an increased desire to own wealth reduces the prospective yield with which the producers of new investment have to be content. For this overlooks the fact that there is always an alternative to the ownership of real capital-assets, namely the ownership of money and debts; so that the prospective yield with which the producers of new investment have to be content cannot fall below the standard set by the current rate of interest. And the current rate of interest depends, as we have seen, not on the strength of the desire to hold wealth, but on the strengths of the desires to hold it in liquid and in illiquid forms respectively, coupled with the amount of the supply of wealth in the one form relatively to the supply of it in the other. If the reader still finds himself perplexed, let him ask himself why, the quantity of money being unchanged, a fresh act of saving should diminish the sum which it is desired to keep in liquid form at the existing rate of interest.

Certain deeper perplexities, which may arise when we try to probe still further into the whys and wherefores, will be considered in the next chapter.

It is much preferable to speak of capital as having a yield over the course of its life in excess of its original cost, than as being productive. For the only reason why an asset offers a prospect of yielding during its life services having an aggregate value greater than its initial supply price is because it is scarce; and it is kept scarce because of the competition of the rate of interest on money. If capital becomes less scarce, the excess yield will diminish, without its having become less productive — at least in the physical sense."

Think about how hard this passage would be to write with an understanding of capital as a homogenous blob. There are blobs in there: the prospective yields that people demand. They just want a yield. It doesn't matter if it comes from owning capital in a mining firm, a manufacturing firm, or a barber shop - it doesn't even have to come from capital. People just want a yield, and that's understandable why that would be a blob. Savers are not entrepreneurs.

But that is precisely the problem. If capital were also just a homogenous good producer and prospective yield producer, this would be much easier. Savers could be satisfied with the guarantee of a homogenous prospective yield. With that guarantee they could more easily signal that they want some future blob of consumption, which would justify bringing forth that homogenous capital in the first place. The fact that saving and investing are separate acts would not pose too much of a problem if capital were homogenous. It poses a problem, according to Keynes, precisely because (1.) capital is heterogenous, and (2.) demand for prospective yields by savers largely isn't.

This is the key line: "The prospective yield of the marginal new investment is not increased by the fact that someone wishes to increase his wealth, since the prospective yield of the marginal new investment depends on the expectation of a demand for a specific article at a specific date."

Savers can save without specificity on their future demand. They can refrain from current consumption without placing an order for any specific future consumption. Investors can't invest without specificity.

So why do the commenters on Steve's blog (and apparently Steve himself) have this idea that Keynesians think capital is homogenous. There are several commenters for whom the reason appears to simply be ignorance. But this isn't true of all of them. For most I think the problem is models with "K" or "I" in it. This is a hang-up that they need to get over. A few points on that:

1. Models aren't reality. This may conflict with your methodology, but that doesn't mean you can pretend that they are real. Models are abstractions from reality that provide insights into specific mechanisms that we think are important in a less abstract reality. Of course the abstraction you make in modeling may be non-trivial, which is why we test models to make sure they still hold up. But models aren't reality - so don't freak out when you see a "K" or an "I" in models.

2. Models are so damn useful that lots of people use precisely the models you criticize us for using. Flip through Hayek. Flip through Garrison. I can't speak for Mises but I'm sure there are others. Tell me how many "K"s, "I"s, and references to "investment" or "capital" you see. You see a lot. Why? Because the abstraction is useful. That's very different from making an argument with a variable "K" that depends on homogeneity.

3. Finally, you need to differentiate between aggregation and homogenization. Saying "I'm talking about the schedule of the marginal efficiency of capital given a particular demand" is the aggregation of all heterogeneous capital on a single metric that all that capital shares. To point out that they share this quality and can therefore be aggregated is very different from saying that they all produce the same thing.