Capital & Interestfor Introduction to Austrian Economics

By Paul F. Cwik, Ph. D.Mount Olive College & The Foundation for Economic Education

In 1884, Böhm-Bawerk published his evaluations of Capital and Interest Theories

Capital and Interest: A Critical History of Economical Theory (translated into English in 1890)

The problem to be solved is this: Suppose a machine can produce

$10,000/year for 10 years. Why is it not worth $100,000

right now? In other words, why is there a net

return for the investor?

Colorless theories refer to thinkers like Smith and Turgot who merely assert that there must be surplus value.

Productivity theories assert that the application of productive power to capital produces output of greater value. (Jean-Baptiste Say)

Abstinence theories simply state that interest is derived from the postponement of present consumption.

Remuneration theorists believe that the wage for labor contains some amount of surplus value.

Exploitation theories hold that interest is the abridgement of the proper wages of workers.

Böhm-Bawerk’s Categories of Interest Theories:

Böhm-Bawerk’s The Positive Theory of Capital (1889) (in English 1891) Böhm-Bawerk advances a positive time preference

theory. “Present goods have in general greater subjective

value than future (and intermediate) goods of equal quantity and quality. And since results derived from the ascribing of subjective value determine objective exchange value, present goods have in general greater exchange value and a higher price than future (and intermediate) goods of the same kind and quality.”

(Yes, for Böhm-Bawerk that is a clear statement. )

“Time Preference” is the social rate at which people prefer present goods to future goods. Each individual prefers sooner to later, ceteris paribus.

Böhm-Bawerk’s Three Elements for Interest Rates

1. Present wants are more intense than future wants.

2. Many people underestimate future wants relative to present wants because they lack imagination or willpower or are uncertain about their life span.

3. Present goods have a technical superiority over future goods; roundaboutness is productive.

• (There is a dispute centered on the last category. )

Böhm-Bawerk’s Lapse? In volume 1 (1884), Böhm-Bawerk savages the productivity

theory of interest, and then in volume 2 (1889), he presents productivity as a big component in the formation of interest rates.

In 1895, he clarified his position and shifted more toward the time preference theory, but the productivity aspect was never fully exorcised.

Lord Robbins puts it this way: “[S]ome people have thought, and in my judgment not entirely

without justification, that Böhm-Bawerk was really letting productivity in by the back door, having so to speak, with oaths and with curses turned away productivity theory out by the front door. He denounced it in the terrific passage of the first volume of Capital and Interest—page after page after page denouncing all productivity theories.”

Böhm-Bawerk’s Lapse? continued

So is it that after discarding a productivity theory of interest in the first volume, he allows it to resurface in his own positive theory?

Hayek, in The Pure Theory of Capital (1941), argues, yes, Böhm-Bawerk characterized time preference as the subordinate determinant of the formation of interest rates in the short run.

This issue is still open to debate. Thus to understand Böhm-Bawerk’s interest theory

we need to look at his capital theory.

Austrian Capital Theory

Unlike modern Neo-Classical theory, Austrians view capital as heterogeneous.

Böhm-Bawerk built upon Menger. Menger made the distinction between higher order goods (earlier stages of production) and lower order goods (later stages of production).

Böhm-Bawerk argued that there is a definite time element and a structure to the production process.

He entered into a debate with John Bates Clark twice over capital theory. (It was essentially the same argument.)

Then in the 1930s, Hayek argued with Frank Knight, again, over the exact same points.

So how does Austrian Capital Theory work?

Imagine you are on an island…

Original Factors of Production:

1. Natural Resources

2. Labor

3. Time

Categories of Capital:

1. Capital Equipment

2. Intermediate Capital (Goods-in-Process)

3. Financial Capital

Böhm-Bawerk’s conceptualization of a Structure of Production

Goods that will become consumer goods within the next year.

Goods that will become consumer goods in two years.

Goods that will become consumer goods in threeyears.

A More Roundabout Economy

A more capitalistic economy will have more circles.

This is Economic Growth.

Clear?

Hayek redraws the Structure of Production (SOP) Here is the traditional

Structure of Production that Hayek drew in Prices and Production (1931).

It is sometimes called the Hayekian Triangle.

However, it was reformulated again by Roger Garrison in his book Time and Money (2001).

Time

Value

Output / Consumer Goods

Raw

M

ater

ials

Man

ufac

turi

ng

Who

lesa

le

Ret

ail

Tim

e

ValueOutput / Consumer Goods

Raw Materials

Manufacturing

Wholesale

Retail

Modern Austrian conception of the Structure of Production (SOP)

Time

Value

Resources and Labor

Output / Consumer Goods

Markets

Raw

Mat

eria

ls

Man

ufac

turi

ng

Who

lesa

le

Ret

ail

Embedded in each stage of production is Capital Equipment.

Financial Capital moves in the opposite direction, facilitating markets.

Intermediate capital goods move through the SOP. They are combined with original factors of production and preexisting Capital Equipment.

Structure of Production

Time

Value

Output / Consumer Goods

Markets

There are more that four stages in the SOP. There are unaccountably many. So we can illustrate the concept through the triangle.

However, there is no telling where a particular firm might be in the SOP. Furthermore, there are recursive loops and dual purpose items, further complicating the problem.

Roundaboutness—Lengthening the Structure of Production Roundaboutness is an essential concept in

Austrian Capital Theory. Böhm-Bawerk argued that in order to increase

production the capital structure would have to become more roundabout, or complex.

Why would entrepreneurs make their production process more complex?

Adding Length

The purpose of lengthening the production process is, obviously, to increase profits.

This could manifest in a faster assembly line, higher quality products, more diverse products, etc.

We need to recognize that adding length for its own sake is counterproductive.

Furthermore, what matters is the lengthening of the overall SOP.

Adding Length continued

Auto manufacturers used to draw cars and tools on drafting tables by hand.

Today they use computers making the process much faster.

Is this lengthening the SOP? Yes. Who made the computers? Who made the

software? What are all of the steps in between? We have added complexity to the production

process and we call that being more roundabout.

The “Magic” Formula for Economic Growth: We start with…

Savings Investment Capital Accumulation

Higher Productivity More Stuff

Higher Living Standards

C1

Time

C0

Consumer Goods

We begin with our Structure of Production

Supply

Demand

Price

Quantity

Supply

Demand

Price

Quantity

Early Stage Goods Late Stage Goods

Po Po

Qo Qo

D’

P1

Q1

D’

P1

Q1

Now, we make the SOP more Roundabout

The factor markets supply each of these stages, and they are each affected differently.

What do the other schools of economics do about this? They tend to ignore it.

So does roundaboutness change the interest rate? First, we have to distinguish between rents and

interest return. Every factor of production earns a return—a rent. This return (rent) is the price that must be paid to a

factor of production, which equals its marginal product.

Thus, every factor earns a rent that is equal to its marginal product.

In the machine example, at the beginning of the lecture, the rent is $10,000/year.

So does roundaboutness change the interest rate? Marginal productivity explains the height of

the factor’s rental price. However, it does not explain why these rents

should be discounted across time. The explanation lies with the idea of “Time

Preference.” The idea that people prefer sooner to later.

Rothbard answers the problem: No, productivity is not an influence . “Roundaboutness is an important aspect of the

productivity of capital goods. “However, while this productivity may increase the

rents to be derived from capital goods, it cannot account for an increase in the rate of interest return, that is, the ratio between the annual rents derived from these capital goods and their present price.

“That ratio is strictly determined by time preference.”

Contrasting with Neo-Classicals

John Bates Clark wrote his first response to Böhm-Bawerk in 1893 with his essay, “The Genesis of Capital.”

Clark envisioned that capital is like a pool of water in which there is a waterfall and an outlet stream.

The pool is a perpetual stock of resources, while the stream and waterfall are flows.

The level of the pool has to be maintained by the market, but the distinction is that no time is needed for the production of goods.

Thus Clark argued, capital could be viewed as a homogeneous pool of K.

Depreciation or depletion

Flow of new investment

Stock of Capital

Contrasting Continues

Clark claimed that time was needed to get a factory up and running, but once it was running, no waiting was required.

As long as there are continuous inputs, there will be continuous outputs.

One sticks the raw materials in at one end of the factory and simultaneously outputs are coming out the other side.

Synchronicity Clark called this process “synchronicity.” Capital, the homogeneous blob (or pool) of K, could

be shaped and molded into anything. He presents an example where a whaling ship

(capital) is transformed into a shoe factory. As the whaling ship is used two things occur: first the

whaling ship is earning returns that are then used to fund the building of the shoe factory and secondly the ship is wearing out, depreciating. Thus, the capital is fully transferred and transformed at the end of the process.

How?

Clark’s Origin of Interest Rates

As you can see, Clark denied the need for the time element. “Abstinence, then, originates new capital: it diverts income in

money from the expenditure that would secure goods for consumption to that which secures instruments of production.”

Once the capital was in place, no more waiting would have to occur.

As a result, time could no longer be used as the basis of interest.

Clark adopted a productivity theory of interest. “The power of capital to create product is, then, the basis of

interest.”

Böhm-Bawerk replies to Clark Böhm-Bawerk says that Clark’s analysis of changing capital

goods and a permanent capital fund is based entirely upon analogies.

Böhm-Bawerk recognizes this flaw and calls Clark out on it: “There seems to dwell in the human heart an enervating

proneness for playing the poet in matters of science, and for placing by the side of the common natural things and forces with which we have to do in the world of prose visionary doubles in the form of all sorts of mystical beings and powers, to which a semblance of reality is imparted by means of an ‘elegant’ abstraction. I hold this practice to be fraught with greatest danger to science. If one departs from the bare truths of nature by only a hair’s breadth, scientific accuracy of thought is irretrievably lost; the sway of truth gives place to that of words and sounding phrases.”

The Modern Neo-Classical Concept of Capital Frank Knight, who taught

Milton Friedman, based his capital theory on Clark.

Today, economists freeze K and allow L to move.

Here is how the mainstream tends to view production.

Even when economists allow K to vary (e.g., Solow Growth models or Real Business Cycle Theory), it is only allowed to do so within certain parameters.

Output

Input (L)

Input (L)

Output

MPL

APL

TP

Stage I

Stage II

Stage III

Modern Neo-Classical Concept of Interest Setting the Keynesian conception

aside, the modern approach uses the Loanable Funds market.

The supply side is portrayed as the subjective time-preference component.

The demand side is portrayed as the objective productivity component.

In order for productivity theories to hold, we have to at least be able to recognize how capital goods relate as complements or substitutes.

Q1

i1

Supply = Savers

Demand = Borrowers

InterestRate

Quantity of Loanable Funds

People who need $ now for an investment.

People who are natural savers.

Borrowers with options.

People who love to spend.

Is Capital Substitutable or Complementary? In the Neo-Classical framework, capital is homogeneous and

perfectly substitutable. However, this assumption does not hold in the real world. Suppose that you are a

baker and have a delivery truck.

If you purchase a second truck, is that truck a substitute or a complement to the first?

Is that Capital Substitutable or Complementary? continued In one scenario, the second truck is definitely a

substitute because it is exactly identical to the first.

It can do exactly the same job as the first truck. However, it can also complement the first truck

by following a different delivery route.

Capital Complementarity and Substitutability

If we examine the real world, we see that most capital is arranged in complementary patterns.

While there is some capital that is substitutable, the Structure of Production shows the degree of complementarity.

In other words, if all capital was substitutable, then the SOP would be irrelevant.

In fact, this is exactly what the Neo-Classicals do—ignore the SOP.

Conclusion

Why is the SOP so important? The SOP leads to insights that cannot be uncovered

otherwise. A Keynesian looks at a decrease in consumption and panics. An Austrian says that we can reduce present consumption

for the production of future consumption. In other words, the SOP becomes more roundabout. A capital-based approach to macroeconomics will be

presented in the next lecture: The Austrian Theory of the Business Cycle.

Capital & Interest

By Paul F. Cwik, Ph. D.PCwik@moc.edu