Venezuela has become the latest developing country to fall for the illusion that socialism delivers genuine and sustainable economic growth. It has had to learn the hard way that while socialism may boost GDP growth in the short run, in the long run it never fails to leave economic destruction in its wake.

Yet, it wasn’t too long ago that eminent mainstream economist Joseph Stiglitz spoke approvingly of the “very impressive growth” enjoyed by the country. This is somewhat reminiscent of another Nobel laureate, Paul Samuelson, who heaped praise on the impressive GDP growth in the Soviet economy in his popular textbook, predicting it would eventually overtake the United States.1

Austrian Insights into the Transformation of Capital

Unfortunately, this view is all too common amongst mainstream economists who fail to take into account the heterogeneity of capital, or the capital structure. Economic growth, as Austrian economists understand it, is a complex transformation of this disaggregated array of capital goods, not a mere increase in a homogenous magnitude.

Growth in the World of Robinson Crusoe

To illustrate the importance of the capital structure to economic growth, it helps to think in terms of a simple Robinson Crusoe economy. A poor Crusoe’s capital structure will look very different from that of a rich Crusoe. Moreover, growth or extension of this structure will not take place all at once but will consist, instead, of a series of steps, with each step reshuffling the bundle of capital goods in the economy.

Thus, from a state where he possesses no capital goods Crusoe might wish to produce a raft and a net in order to become a more productive fisherman. Or if he wants meat he will have to build a bow and some arrows, while he will need to produce a whole host of capital goods in order to successfully build a house.

Every step in the process requires a fresh decision regarding the allocation of resources. He must, for instance, decide whether to allocate an hour of labor time from fishing with his bare hands to the production of a raft and a net. And then he must make further decisions about reducing the time spent fishing with them in order to be able to produce a bow and some arrows.

Each decision requires Crusoe to engage in economic calculation: the weighing of the associated marginal benefit and cost. Since his economy, even in a state of relative prosperity, is characterized by production processes that are short and that involve few capital goods, Crusoe does not need money prices in order to engage in such calculation.

He is able, at every step, to isolate the additional satisfaction obtained and the additional satisfaction forgone as a result of an allocation of labor time. The decision of shifting an hour from fishing with his bare hands to building a raft, for instance, can be made by directly comparing the satisfaction lost in the nearer future to that obtained in the more distant future from the additional fish generated by the hour devoted to the production of the raft.

Growth in a Market Economy

The process of economic growth within the division of labor involves a radical transformation of the capital structure. The tractor must replace the horse-drawn plough and modern machinery must take the place of the rudimentary capital goods utilized in small-scale cottage industries. This transformation also is not a one-shot affair but consists of innumerable steps undertaken over a significant period of time.

The problem of resource allocation in such an economy is complex. At any moment, even in a relatively poor market economy, there exists a substantial array of capital goods as well as land and labor resources of various qualities. Each step in the growth process and the accompanying transformation of the capital structure requires making decisions, not just about one resource, as in the case of Crusoe, but about this whole array of existing resources.

Moreover, the production processes of consumer goods are now of substantial length and consist of many stages. Thus, in most cases a long period of time and a number of succeeding steps now lie between the devotion of resources to the production of a particular capital good and the consumer goods that will ultimately result from it.

This complexity implies that decisions regarding the transformation of the capital structure can no longer be made by directly comparing the satisfaction obtained with that foregone. Consider, for instance, the choice of allocating a unit of coal to the production of steel or the production of electricity. The number of steps that lie between the production of either good and the consumer goods that each could ultimately contribute makes it humanly impossible to reduce the marginal benefits and costs involved to satisfaction gained and satisfaction forgone.

It follows that economic calculation in this more complex setting requires reducing the costs and benefits involved to a common denominator. The only units that can serve this purpose are money prices. The generation of these prices, however, requires the existence of private property in the means of production and the presence of markets for the factors of production.

Given these institutional conditions, the growth process will be punctuated by private entrepreneurs making decisions of resource allocation guided by their estimates of revenues and costs. This, allied with the profit-loss system that rewards those entrepreneurs who have good judgment and penalizes those that do not ensures the coordination of production and consumption activities throughout the length and the breadth of the capital structure as it is transformed.

The Inevitable Failure of Socialism

Mainstream theorists, by treating capital goods as a homogenous magnitude, ignore the problem of successful resource allocation that is integral to achieving genuine and sustainable growth. As a result, they are blind to the necessary institutional underpinnings for such a process to take place, especially the crucial role that private property plays in facilitating it. This explains their often favorable view of growth figures generated in a socialist economy.

Using the concept of the capital structure, the Austrian economist realizes that the suppression of factor markets and prices that characterizes a socialist economy makes economic calculation impossible. As a result, the allocation of existing resources and the ensuing transformations of the existing capital structure are guided, not by consumer preferences, but by the whims and fancies of those in power.

Such a system can generate growth in GDP, but only due to a rampant malinvestment of existing capital goods. It inherits a capital structure shaped by the decisions of private entrepreneurs, characterized by capital goods of various orders that “fit” with each other, thereby ensuring the smooth flow of consumer goods and transforms this structure into one where the capital goods no longer “fit” together in any meaningful fashion.

The new structure does not accomplish its chief objective: the production of the goods desired by consumers. Hence the economic destruction that socialism always brings in its wake. The higher GDP growth is the result of capital consumption. What remains is a disjointed and decimated capital structure accompanied by a dearth of consumer goods.

It is tragic that this vital lesson that Austrian capital theory has for economic development is often ignored. The failure to do so devastates the lives of millions, as it recently has in Venezuela.

• 1. Examples of the inability of socialism to generate prosperity are provided by the literature that analyzes its past failures from an Austrian viewpoint in the Soviet Union (Boettke 1990), India (B.R. Shenoy 1966, Sudha Shenoy 1971, Manish 2011, 2013, 2014) and during World War II in America (Higgs 1992).