Capital & Interest for Introduction to Austrian Economics

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?

Böhm-Bawerk’s Categories of Interest Theories: • 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 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 • Present wants are more intense than future wants. • Many people underestimate future wants relative to present wants because they lack imagination or willpower or are uncertain about their life span. • 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: • Natural Resources • Labor • Time

Categories of Capital: • Capital Equipment • Intermediate Capital (Goods-in-Process) • Financial Capital

Böhm-Bawerk’s conceptualization of a Structure of Production

A More Roundabout Economy • A more capitalistic economy will have more circles. Clear? This is Economic Growth.

Value Raw Materials Manufacturing Time Output / Consumer Goods Manufacturing Wholesale Wholesale Raw Materials Retail Retail Value Time Output / Consumer Goods 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).

Modern Austrian conception of the Structure of Production (SOP) Value Intermediate capital goods move through the SOP. They are combined with original factors of production and preexisting Capital Equipment. Resources and Labor Output / Consumer Goods Manufacturing Wholesale Raw Materials Embedded in each stage of production is Capital Equipment. Retail Markets Financial Capital moves in the opposite direction, facilitating markets. Time

Value Output / Consumer Goods Markets Time Structure of Production 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. There are more that four stages in the SOP. There are unaccountably many. So we can illustrate the concept through the triangle.

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.

Consumer Goods We begin with our Structure of Production C0 C1 Now, we make the SOP more Roundabout Time What do the other schools of economics do about this? They tend to ignore it. The factor markets apply to each of these stages, and they are affected differently. Price Price Supply Supply P1 Po Po P1 D’ Demand Demand D’ Q1 Qo Q1 Qo Quantity Quantity Late Stage Goods Early Stage Goods

The “Magic” Formula for Economic Growth: We start with… Capital Accumulation Savings Investment Higher Productivity More Stuff Higher Living Standards

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, it does not. • “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.”

Flow of new investment Stock of Capital Depreciation or depletion 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.

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 turned to 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.”

Output TP Stage I Stage II Stage III Input (L) Output APL MPL Input (L) 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.

Interest Rate Supply = Savers People who need $ now for an investment. People who love to spend. People who are natural savers. Borrowers with options. Demand = Borrowers Quantity of Loanable Funds i1 Q1 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 the relationship of capital goods. • We need to describe the demand curve.

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?

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 it would be irrelevant to consider the SOP. • In fact, this is 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 trade present consumption for the production of future consumption. • In other words, the SOP rotates and lengthens. • 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

Capital & Interest for Introduction to Austrian Economics