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The Subsistence Fund

Mises Daily: Wednesday, August 25, 2004 by


What typifies the modern economy, writes Mises, is complex production that is a "continuous, never-ending pursuit split up into an immense variety of partial processes." This complex structure of production generates a seemingly endless amount and variety of goods which not only maintains our life, but also makes life more pleasant.

It would appear that there is a mysterious navigator who continuously modifies the complex network of the production structure in order to cater for individuals’ changing requirements. It seems that the production structure has, as it were, a self-regenerating mechanism, a kind of life of its own.

Careful examination, however, shows that without a key ingredient, the entire infrastructure could not have emerged. The ingredient that makes it all possible is what Mises calls the subsistence fund, or what I (following Richard Strigl) have called the pool of funding. The following simplified example will allow us to understand the essence of the idea of the pool of funding.

The basics of the pool of funding concept

To maintain life and well being, man must have at his disposal an adequate amount of final goods, also called consumer goods. These goods, however, are not readily available; they have to be extracted from nature. Without any tools at his disposal and so by means of his bare hands, man can only secure from nature very few goods for his survival.

For instance, take an individual, John, stranded in a jungle. In order to stay alive, he can only pick up some apples from an apple tree. Apples are the only good available to him that can sustain him. Let us say that by working 20 hours a day, he manages to secure 20 apples, which keep him alive. The 20 apples that John has secured from nature is his ‘pool of funding’ which sustains him.

Being a sophisticated individual, John realizes that if he had a special stick this would allow him to become more productive. His daily production of apples could be 40 apples (i.e., double his current production). The problem, however, is that the stick is not available—it must be made. To make the special stick requires two days of work. If John was to decide to make the stick he would have a problem. By spending his time on making the stick he would not be able to pick up the apples that are required to keep him alive.

The only way out of this predicament is for John to put aside an apple a day for the next forty days. In other words, by saving an apple out of his daily production and enduring hunger, after forty days he will have an adequate stock of apples that will sustain him while he is busy making the stick. (We make the unrealistic assumption here that apples can be preserved in edible form for forty days). Thus, after forty days, John’s pool of funding will be comprised of 40 apples, which will see him through while he is making the special stick. We can see here that the saved or unconsumed 40 apples enable the making of the stick, which raises the production of apples and lifts John’s living standard.

Let us slightly alter the previous example and introduce an individual Rob who specializes in making sticks. Because he is an expert in stick making it takes him only one day to make the special stick that John requires. Also, Rob has to have 20 apples a day to keep him going. Note that rather than saving 40 apples John needs to save only 20 apples now, which will enable him to hire the services of Rob.

Observe that Rob the stick maker is sustained by John’s saved 20 apples, while John is maintained by the current daily production of apples, which is also 20 apples. In short, John’s pool of funding of 40 apples is allocated toward the production of final consumer goods (i.e. apples) and toward the making of the special stick. The 20 apples that John consumes sustain him and thereby enable him on the following day to engage in the picking of apples (i.e. producing apples), whereas the 20 apples which John saved are now sustaining Rob—the stick maker.

While the stick is being made, it absorbs real funding and in this sense it is a burden—John had to make a sacrifice and save 20 apples thereby endangering his health and well being. However, after 21 days he will be able to use the stick, which will allow him to double his production of apples. If he continues to consume 20 apples a day, then it means that he can save 20 apples in one day. What does this imply for John’s pool of funding?

On day one his pool of funding will be 40 apples, of which 20 are allocated for consumption and 20 are saved. On the second day his pool of funding will comprise of 20 saved apples + 40 apples from current production, i.e., his pool of funding is 60 apples of which 20 is consumed and 40 are saved. On the third day his pool of funding will be 80 apples (i.e., 40 apples from the daily production and 40 from savings). Out of this John consumes 20 apples and saves 60 apples.

As the pool of funding expands, this allows John to hire the services of some other individuals that can maintain and enhance his production structure, and thereby raise further the production of apples.

Observe that the size of the pool of funding determines the quality and the quantity of various tools that can be made. If the pool is only sufficient to support one day of work, then the making of a tool that requires two days of work cannot be undertaken. In short, the size of the pool of funding sets the limit on the projects that can be implemented.

On this, Richard von Strigl wrote:

Let us assume that in some country production must be completely rebuilt. The only factors of production available to the population besides labourers are those factors of production provided by nature. Now, if production is to be carried out by a roundabout method, let us assume of one year’s duration, then it is self-evident that production can only begin if, in addition to these originary factors of production, a subsistence fund is available to the population which will secure their nourishment and any other needs for a period of one year. . . . The greater this fund, the longer is the roundabout factor of production that can be undertaken, and the greater the output will be. It is clear that under these conditions the "correct" length of the roundabout method of production is determined by the size of the subsistence fund or the period of time for which this fund suffices.[1]

The essence of the pool of funding (or subsistence fund) which we have established with respect to our individual, John, can be widened to include many individuals that trade with each other. John, who produces apples, can now secure meat and clothing from other individuals. This means that the pool of funding is now comprised of a greater variety of final goods ready for human consumption.

According to Bohm-Bawerk:

The entire wealth of the economical community serves as a subsistence fund, or advances fund, and, from this, society draws its subsistence during the period of production customary in the community.[2]

The pool of funding and money

The introduction of money doesn’t alter the essence of what the pool of funding is. Money can be seen as a permit to access the pool of funding, or we can also say that money is a claim on the goods in the pool of funding, so to speak.

Various producers who have exchanged their produce for money can now access the pool whenever they deem this to be necessary. If a baker has exchanged 10 loaves of bread for 10 units of money, it means that he has received a claim on final goods that is worth 10 units of money.

Furthermore, when an individual exchanges his money for goods, all that we have here is an act of an exchange and not an act of payment—money is just the medium of exchange.

Payment is always done by means of various goods and services. For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. (Both shoes and bread are part of the pool of funding as they are final goods). When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange.

As long as the flow of production is maintained, the baker can always exchange his money for the final consumer goods he deems necessary (i.e., he can always exercise his claim on final goods and services). Obviously, if for some reason the flow of production is disrupted, the baker will not be able to fully exercise his claim.

Intermediate Goods

What about a producer of an intermediate good, like a producer of a special tool—what is his contribution to the pool of funding? An individual who exchanges his money for the tool will employ the tool in the production of final consumer goods or in the production of intermediate goods that, in turn, will contribute to the production of final consumer goods some time in the future.

In other words, the producer of the special tool, or a producer of any intermediate good, doesn’t directly supply final consumer goods. However, he does offer a means to secure these goods. Additionally, he also offers time. For instance, John without a stick can only pick up 20 apples a day. With a stick his output stands at 40 apples—implying that John can now secure 40 apples in one day instead of two days. According to Rothbard:

Crusoe without the axe is two hundred fifty hours away from his desired house; Crusoe with the axe is only two hundred hours away. If the logs of wood had been poled up ready-made on his arrival, he would be that much closer to his objective; and if the house were there to begin with, he would achieve his desire immediately, he would be further advanced toward his goal without the necessity of further restriction of consumption.

Also, with the introduction of more advanced tools and machinery various new consumer goods can be produced, which prior to the making of these new tools weren’t available at all to individuals. Obviously, if the tools and equipment acquired turn out to be useless, then the savings of purchasers of these tools and equipment will be squandered.

Saved final consumer goods that were transferred to the producers of tools and equipment are therefore simply consumed by them and they make no contribution to the pool of funding. We could also say that the production of useless tools and equipment weakens the pool.

Claim transactions versus credit transactions

When individuals exchange final goods and services for money, they are in fact engaging in a claim transaction. For instance, a baker has agreed to exchange his ten loaves of bread with a shoemaker for ten dollars. They have agreed on the terms of the exchange because they both believe that it will promote their individual well being. For the baker, the value of his means, which is his saved bread, is lower than the value of the ten dollars.

Similarly the shoemaker holds that the ten loaves of bread are much more valuable to him than his ten dollars. The baker who secures the ten dollars now holds a claim on consumer goods up to the value of ten dollars. The baker can exercise his ten dollar claim any time he deems it to be required. In other words, the baker, while transferring his bread to the shoemaker, has never relinquished his claim on final consumer goods.

However, it is quite different when an individual exchanges money for a promise to repay money in one-year’s time. In this case, the buyer of the promise is temporarily transferring his claim on consumer goods to the issuer of a promise. Or we can say that the buyer of the promise provides a credit to the seller of the promise. Hence what we have is a credit transaction.

In a credit transaction the two parties to an exchange also set the terms of the exchange. Now, however, the baker agrees to exchange his ten dollars, which he obtained by selling his ten loaves of bread, for eleven dollars in one-year's time. Why would the baker demand eleven dollars rather than ten dollars? The difference emanates from his so-called time preference. What does this mean?

Interest rate-determination

Consider our simplified example of John who with his bare hands can secure only twenty apples per day. These twenty apples sustain him (i.e., keep him alive). To improve his life and well being, he requires a greater amount of apples. This, we have seen, can be achieved by means of a special stick that must be made. To make this stick requires that John put aside every day an apple so that at the end of forty days he will have enough apples to sustain him during the period of the two days that he is making the special stick.

Note that the act of saving is quite painful for John, since it means that he has been kept alive on just nineteen apples a day. He is, however, ready to save and endure hunger because he believes that with the special stick he will be able to improve his life and well being. Hence, the act of saving by John is a means through which he can achieve his ultimate goal, which is bettering his situation.[3]

In short, he expects that the future benefits to his life and well being that will come as a result of a greater output of apples will surpass the cost that the act of saving imposes on him at present. The cost is on account of the fact that while John saves, he denies himself the consumption of apples and as a result, doesn’t get enough nourishment, which could undermine his health and poses a threat to his life.

On this, Mises wrote:

That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.

According to Rothbard:

The decision that he (Crusoe) makes in embarking on capital formation will be a result of weighing on his value scale the utility of the expected increased productivity as against the disutility of his time preference for present as compared to future satisfactions. It is obvious that the factor which holds every man back from investing more and more of his land and labor in capital goods is his time preference for present goods. If man, other things being equal, did not prefer satisfaction in the present to satisfaction in the future, he would never consume; he would invest all his time and labor in increasing the production of future goods. But "never consuming" is an absurdity, since consuming is the end of all production.

It follows, then, that the return on savings must be in excess of the cost of savings in order for John to agree to save. As far as John is concerned, the savings of forty apples has allowed him to double his daily production of apples. However, the cost of achieving this was that he had foregone the consumption of these forty apples and the consequent near starvation existence for forty days. Hence, if savings can’t better an individual’s life and well being, then saving will never be undertaken.

After all, saving implies giving up some benefits at present. This means that consuming an apple at present will always carry a premium over a saved apple, which will be consumed some time in the future. This premium is what the phenomenon of interest is all about. 

Consequently, the return on savings must be above the premium in order for John to agree to save. We can thus conclude that positive time preference (i.e., the existence of a premium) precludes the natural emergence of a zero interest rate. Should a zero interest rate be imposed, this will abort all savings and lead to the destruction of the production structure.

According to Carl Menger:

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well being in a later period. . . . All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.[4]

As his pool of apples or the pool of funding expands, John can allocate a greater percentage of apples toward savings. The reason why he can now allocate a larger percentage is because with more apples at his disposal, the allocation toward savings will only cause him to give up lesser benefits as far as life and well being are concerned in relation to his previous situation. This stems from the fact that the first apple in John’s possession serves to support his most important requirements as far as life and well being are concerned. The second apple serves to support the second most important requirements, etc. 

The premium of having the apple now versus having it in the future is getting smaller with the increase in the stock of apples. This, in turn, means that the required return on savings will be lower. In other words, an increase in the pool of funding sets the platform for lower interest rates.

The interaction between individuals’ time preferences sets the so-called market interest. Thus, the time preference of the baker, which is established in accordance with his particular set-up, determines that he will exchange his ten dollars for the shoemaker’s promise to repay eleven dollars in a year’s time.

As far as the shoemaker is concerned, he is willing to borrow the ten dollars and repay eleven dollars because he believes that a borrowed ten dollars will allow him to generate more than eleven dollars. This, of course, implies that he will generate enough final goods (shoes) to allow him to repay the ten dollars and the interest of one dollar.

Apart from time preferences, the purchasing power of money and business risk are important elements in the formation of interest. However, their importance is assessed in reference to the fundamental factor, which is time preference. For instance, if one dollar buys one apple and the agreed interest rate is 10%, then in one-year’s time the lender of the apple would expect to get back 1.1 apples. The lender of the apple will also be happy to accept $1.1 since this sum will permit him to purchase 1.1 apples.

As a result of a fall in the purchasing power of money, the price of an apple increases by 10% to $1.1. Now the lender will not accept $1.1 in one year time, since $1.1 will only buy him one apple. He will require $1.21 to agree to lend since $1.21 will secure the lender 1.1 apples. Furthermore, the lender will also require recouping the expense of insuring the credit transaction against the risk of default by the borrower.

Monetary expansion and the pool of funding

When money is created out of "thin air" it leads to a weakening of the pool of funding. What is the reason for this? The newly created money doesn’t have any back-up behind it as far as the production of goods is concerned—it sprang into existence out of "thin air" so to speak. The holder of the newly created money can use it to withdraw final consumer goods from the pool of funding with no prior contribution to the pool. Hence this act of consumption, or nonproductive consumption, puts pressure on the pool of funding. (The consumption is nonproductive because the individual consumes goods without making any contribution to the pool of funding).

Contrast this with the case when money is secured on account of the previous production of consumer goods.  In this case, the withdrawal of consumer goods from the pool of funding by means of money results in productive consumption. In other words, the consumption of the holder of money is fully backed up by his contribution to the pool of funding.

We can infer from this that when money is created out of "thin air" it diverts funding away from wealth producers who have contributed to the pool of funding toward the holders of the newly created money. For a previously given pool of funding this will imply that wealth producers will discover that the purchasing power of their money has fallen since there are now less goods left in the pool—they cannot fully exercise their claim over final goods since these goods are not there.

As the pace of money creation out of "thin air" intensifies it puts greater pressure on the pool of funding. This in turn makes it much harder to implement various projects as far as the maintenance and the improvement of the infrastructure is concerned. Consequently the flow of production of various final consumer goods weakens, which in turn makes it much harder to make provisions for savings. All this in turn further weakens the infrastructure and so undermines the flow of production of final consumer goods.

We can thus conclude that contrary to assumed ways of thinking, monetary growth cannot produce a general expansion in economic activity—also labelled economic growth. On the contrary, by diverting real funding from wealth generating activities toward nonwealth generating activities monetary expansion only weakens economic growth.

Monetary expansion also undermines the pool of funding as a result of the consequent decline in interest rates. An increase in monetary injections lowers interest rates below the accepted level where it pays to save. This in turn raises consumption beyond levels that otherwise would have taken place. Subsequently, more funding is allocated toward the final production of consumer goods and less toward the maintenance and the improvement of the wealth-producing infrastructure. As time goes by this lowers the economy’s capacity to produce final consumer goods and it hence weakens the pool of funding. This runs contrary to the popular way of thinking that the central bank can grow the economy by keeping interest rates as low as possible.

As long as the pool of funding is expanding, the central bank’s monetary policies appear to work. For instance, by employing so-called counter-cyclical policies the central bank seems to be able to "navigate" the economy. However, all of this is just an illusion. By means of loose monetary policies the central bank can only create nonwealth-generating activities. But as various unpleasant side effects of this loose monetary policy emerge—such as rising price inflation—the central bank reverses its loose stance. The reversal of the stance undermines various activities that sprang-up on the back of the previous loose monetary stance and this in turn leads to an economic bust.

After a certain "cooling off" period, the central bank reactivates its loose stance. This again revives various "artificial forms of life," and the so-called economic boom emerges again. It must be realized though that the emerging economic growth that accompanies the boom is on account of the fact that the pool of funding is still expanding. In other words, the pool still manages to support not only wealth producers but also various nonwealth-generating activities. If, however, the pool becomes so depleted that it ceases to grow, or it even declines, then the economy falls into a "black hole." Once this happens the central bank can print as much money as it likes but finds that it cannot "revive" the economy. On the contrary, it only weakens the pool further and delays the date for a meaningful economic recovery. A stagnant or shrinking pool of funding therefore shatters the myth that central bank policies can grow and navigate the economy.

Can commodity money lead to boom-bust cycles?

Would it make any difference if the money stock was expanded due to a rising demand for money? The answer is no. What matters here is that new money which is not backed up by any real goods and services was created. This in turn means that regardless of the reasons an increase in money supply always leads to the impoverishment of wealth producers and to the boom-bust menace. Is this conclusion also valid for commodity money?

The introduction of money made it possible for individuals to specialise and engage in trade on a much wider scale than the barter economy would have permitted. Historically, many different goods have been used as the medium of exchange. On this Mises wrote that, over time,

. . . there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in word, money.

With the advent of money an individual could exchange his products for money and then use money to secure the goods and services he requires. In the early stages of the emergence of money it was an ordinary commodity that people demanded because it contributed some tangible benefits to their life and well being.

In other words, people already attached some importance to this commodity. In addition to offering benefits such as any other good does, people also discovered that this commodity, let us call it commodity x, had some features that made it more marketable than other commodities. For instance, commodity x is durable and it is also portable. Various producers of perishable goods found that it is to their benefit to exchange their produce for commodity x and then use commodity x in exchange for other goods.

The acquired x provided the producers of perishable goods with greater flexibility as far as securing various goods and services was concerned. Note that producers of perishable goods can now save their produce so to speak by means of x. All this means that there is now much greater demand for x than before. In short, the producers of perishable goods realized that by means of x they could make their perishable goods more marketable in the sense that more goods and services could be now secured for their products. So as the demand for commodity x rises its purchasing power follows suit, which in turn makes it even more marketable.

According to Rothbard,

Just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability.

Would an increase then in the supply of x, in response to an increase in the demand for x, undermine the pool of funding? The answer is no. Since x is a commodity it implies that individuals attach importance to it on account of the benefits it offers, among them the medium of exchange services. So the fact that producers of this commodity derive a much greater benefit than otherwise is no different from a case when a particular final good for some reason suddenly experiences much stronger demand than before.[5]

Now, being a final consumer good it will be part of the pool of funding. Hence, a producer of the good x will have the right, so to speak, to withdraw from the pool in accordance with the value of the good x he has produced. Consequently, an increase in the production of x doesn’t deplete the pool of funding but on the contrary expands the pool.

Now, if all of a sudden the supply of x were to increase sharply in excess of demand, people would find that its purchasing power would fall and this in turn would diminish its marketability. Should this persist, the demand for x as the medium of exchange would decline and people would seek the services of another commodity as the medium of exchange. Once a commodity loses its appeal as the media of exchange it remains in demand for its other attributes.

Now the introduction of paper money, which is fully redeemable into commodity x, doesn’t alter anything we have said so far. Paper money should be seen as a receipt or a claim on the commodity x. So, whenever this certificate is exchanged for goods and services the seller of these goods acquires a claim on x while the seller of the claim acquires goods and services. Note that in the process of the exchange useful goods have been traded.

This is, however, not so when a bank prints a certificate which is unbacked by x. The bank then lends this unbacked certificate to an individual Arthur. What we have here is a claim on money that was created out of thin air. There wasn’t any prior production of any useful goods including commodity x, and this of course must lead to a weakening of the pool of funding. We can therefore conclude that in contrast to the money out of ‘thin air’ a market chosen money can never be harmful to individuals' well being.

Summary and conclusions

Most individuals in the western world take the ample availability of goods and services for granted. Indeed, the complex structure of production gives the impression that what is required is simply the existence of demand and the rest will follow suit.

It is, however, much less appreciated that the sophisticated structure of production, which generates seemingly unlimited goods and services, does not have life of its own. In order that the production structure can continue to supply the great variety of goods that it does requires a key ingredient, which is the pool of funding. It is the pool of funding which not only maintains, but also enhances the production structure and thereby promotes our lives and well being.

There is, however, a growing threat to this pool and to the high living standards that we have become accustomed to. This threat emanates from the view that there is no need to worry about the supply of goods, and that what matters is only demand. These ideas, which were popularized by John Maynard Keynes, dominate the thinking of today’s western economists.

Given the assumption that goods will always be there, most economists are preoccupied with how the demand for goods and services can be boosted. When asked how demand is going to be funded most modern economists reply: by means of monetary pumping and low interest rate policies of the central bank. For them funding is something that can be created out of "thin air." Cheap monetary and fiscal policies, which masquerade as policies that aim to grow the economy, are in fact achieving the exact opposite.

The only reason why economies are still growing is not because of central bank and government policies but in spite of these policies. So long as the pool of funding is still big enough to support various economic activities, the central bank and government can give the false impression that it is their policies that made economic growth possible. Once, however, the pool of funding becomes stagnant or begins to shrink, economic growth follows suit and the myth that government and central bank policies can grow the economy is shattered.

On this Mises wrote,

An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.

Since early 2001 the US pool of funding has been subjected to the most vicious attack in the form of the aggressive lowering of interest rates. Yet despite all the monetary pumping and the aggressive lowering of interest rates the economy has continued to struggle. The fact that the economy has failed to respond as in the past to aggressive loose monetary and fiscal policies should be seen as an indication that the pool of funding is in serious trouble. This in turn means that all the aggression against this pool must be stopped as soon as possible in order to prevent the unpleasant economic side effects that are the inevitable results.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Comment on this article on the Mises Economics Blog. See also  Capital, Credit Expansions, and the Subsistence Fund by Larry Sechrest.

[1]Richard von Strigl, Capital & Production, Mises Institute, p. 7.

[2]Eugen von Bohm-Bawerk, The Positive Theory of Capital, Book 6, chapter 5, Macmillan and Co, 1891).

[3]  See an interesting discussion on means ends by Jorg Guido Hulsmann, A Theory of Interest. Quarterly Journal of Austrian Economics vol 5, No 4 Winter 2002.

[4]Carl Menger. Principles of Economics, New York University Press. Pp. 153–54.

[5]See William Barnett and Walter Block. On The Optimum Quantity of Money. Quarterly Journal of Austrian Economics vol 7, no 1 (Spring 2004).