The Austrian Theory of
Capital and Interest
Peter Lewin: University of Texas at Dallas
plewin@utdallas.edu
My Web page
This file online
The Capital Idea
The Capital Based View of the Firm
A Story in Two Parts
Part One – The Theory of Capital
Part Two – The Theory of Interest
Part One – Overview: The Theory of Capital
Capital Theory and the Austrian School of Economics
It’s the Austrians’ “claim to fame.”
Menger (1871)
Böhm-Bawerk (1880 – 1921)
Wieser
Mises
Hayek (1930’s, 1941)
Rothbard
Lachmann
Kirzner
Current applications
Garrison
Horwitz
Lewin ….
(macro) (macro-family) (management)
Wider Connections
Without which it is difficult to understand Capital Theory
Adam Smith (1776)
David Ricardo (1817)
Karl Marx
Neo Ricardians –
Post Keynesians
(Nicolas Kaldor
Joan Robinson
Pierro Sraffa –
Keynesian Marxists)
Neo Classicals
Carl Menger
Joseph Schumpeter
John Hicks
Adam Smith
The annual produce of the land and labor of
any nation can be increased in its value by
no other means, but by increasing either the
number of its productive laborers, or the
productive powers of those laborers who
had before been employed. The number of
productive laborers, it is evident, can never
be much increased, but in consequence of
an increase of capital, or of the funds
destined for maintaining them. The
productive powers of the same number of
laborers cannot be increased, but in
consequence either of some addition and
improvement to those machines and
instruments which facilitate and abridge
labor; or of a more proper division and
distribution of employment. In either case
the additional capital is almost always
required. It is by means of an additional
capital only that the undertaker of any work
can either provide his workmen with better
machinery, or make a more proper
distribution of employment among them
(Smith 1982: 343, italics added).
David Ricardo
Carl Menger
Neo Classicals
Karl Marx
Neo Ricardians
Post Keynesians
Joseph
Schumpeter
John Hicks
According to Smith
Saving is necessary for the achievement of economic
growth.
The earning of profit is consequent, not simply upon the
accumulation of capital, but, significantly, also upon the
fruits of the division of labor
– in modern terms capital accumulation, technical progress and
economic organization are tied together. The availability of
capital is necessary (though apparently not sufficient) for the
adoption of new and more productive methods of production.
There is a type of diminishing returns
– this is clearly not in the form of a declining rate of return to
investment in a given mode of production, but rather refers to the
eventual possible exhaustion of investment opportunities for
extending the division of labor, that is, for the discovery and
introduction of new and improved production methods.
David Ricardo
Different world, different concerns
Malthus and the pressures of
population – land is fixed, wages are
fixed, so rent keeps rising and profit
keeps falling until the stationary state
is reached.
David Ricardo
“Laws” of distribution between K,
N and L
“factors” of production – profit,
wages and rent. To calculate the rate
of profit you need to measure capital
 the labor theory of value.
Industrialization and the
heterogeneity of capital
All capital is circulating?
The Ricardian practice of assuming
equilibrium.
Capital flows ensure a uniform rate
of profit.
Carl Menger
Neo Classicals
Karl Marx
NeoRicardians
Post
Keynesians
John Hicks
Joseph
Schumpeter
Ricardo’s Legacy
Quantification
– A shift towards a more mechanical way of
looking at things
Cost of production valuation
– A reflection of the materialist fallacy, partially
banished by the marginalist revolution. Labor
value was replaced by equilibrium value
(general equilibrium).
Carl Menger
Owes much to Adam Smith and nothing to Ricardo.
– There is a time structure to the production process. Goods of
lower and higher order. The earlier one intervenes in nature’s
processes the more productive one can be.
“[B]y making progress in the employment of goods of higher orders
for the satisfaction of their needs, economizing men can most
assuredly increase the consumption goods available to them
accordingly - but only on condition that they lengthen the periods of
time over which their activity is to extend in the same degree that they
progress to goods of higher order.” (Menger 1981: 153 italics added).
Production is the result of human planning - there can be
errors - the market tends to correct such errors, but there
is no continual equilibrium - there is continual groping of
the structure of production toward the changing structure
of consumption.
Underlining Menger’s Insights
Adopting Menger’s perspective one cannot lose sight of
the variety of goods and services and individual activities
and choices. There is no suggestion of a uniform rate of
profit at any point in time. Yet there is an inescapable
order within the variety provided by our understanding of
the purposes of individuals.
“The process of transforming goods of higher order into
goods of lower order, ... must always be planned and
conducted, with some economic purpose in view, by an
economizing individual” (Menger 1981: 159-60).
Capital and the conscious organization of production are
inextricably linked.
Eugene von Böhm-Bawerk
The most visible and well known Austrian
economist – the “master” of Austrian Capital
Theory – 3 volumes over many years, engaging
many eminent scholars
B-B’s vision is the same as Menger’s – a series
of concentric circles – wisely chosen
“roundabout” methods of production are more
“productive” – they yield a greater volume of
consumption goods.
Roundabout Production is
Advantageous
“There are two concomitants of the adoption of the capitalist
methods of production, ... One is advantageous, the other
disadvantageous. …. With an equal expenditure of the two originary
productive forces, labor and valuable forces of nature, it is possible
by well chosen roundabout capitalist methods to produce more or
better goods than would have been possible by the direct
noncapitalist method. It is a truism well corroborated by empirical
evidence.” (Böhm-Bawerk 1959: Book II, 82-3).
“...[O]ne thing that can be stated with a reasonable degree of
certainty is the proposition ... that as a general rule a wisely selected
extension of the roundabout way of production does result in an
increase in the magnitude of the product. It can be confidently
maintained that there is no area of production which could not
materially increase its product over the result obtained by its present
method (Böhm-Bawerk.” 1959: 84-85).
But a Sacrifice is Involved
“The disadvantage which attends the capitalist method of
production consists in a sacrifice of time. Capitalist
roundaboutness is productive but time-consuming. It yields
better consumption goods, but not until a later time.” (BöhmBawerk 1959: 82).
“All consumption goods which man produces come into
existence through the cooperation of human powers with the
forces of nature, which are in part of economic character, in
part free natural powers. Man can produce the consumption
goods he desires through those elemental productive powers.
He does so either directly, or indirectly through the agency of
intermediate products which are called capital goods. The
indirect method entails a sacrifice of time but gains the
advantage of an increase in the quantity of the product.
Successive prolongations of the roundabout method of
production yield further quantitative increases though in
diminishing proportions.” (Böhm-Bawerk 1959: 88).
Structure or Quantity?
Menger or Ricardo?
He believes in structure: “A nation’s capital is the sum of heterogeneous
concrete capital goods. To aggregate them one needs a common
denominator. This common denominator cannot be found in the number
of capital goods … nor their length or width or volume or weight or any
other physical unit of measurement …. The only measuring rod that
does not lead to contradictions … is the value [of these capital goods]”
(Hennings 1997: 132, his translation of Böhm-Bawerk 1959 [1921] III 105).
He provides a formal quantitative treatment: “It is more important, as well
as correct, to consider the average time interval occurring between each
expenditure of originary productive forces and the final completion of the
ultimate consumption good. A production method evinces a higher or
lower degree of capitalist character, according to whether, on the
average, there is a longer or shorter period of waiting for the
remuneration of the expenditure of the originary productive forces, labor
and uses of land.”
(Böhm-Bawerk 1959: 86).
Calculated the APP as follows.
Quantity (Stock) or Structure?
Quantitative
Ricardian
Cost of production
Marxist, Neo Ricardian
Joan Robinson
Luigi Pasinetti
(the Italians)
Compositive
Mengerian
Schumpeterian
General Equilibrium
Paul Samuelson,
Robert Solow, Paul
Romer, Robert Barro,
Robert Lucas
Modern Growth Theory.
Modern Austrian
Mises, Hayek, Lachmann,
Rothbard, Kirzner
A Bunch of Capital Controversies
The APP is vulnerable to all kinds of attacks.
–
Point input point output or flow input point output but not flow input flow output. How to value the
inputs (neglect of land)? Is interest paid?
J. B. Clark (later repeated, with variations by F. H. Knight against Hayek). Attacked the
APP.
– Time is irrelevant - T is either 0 or ∞
B-B’s formalization allowed for the extension of the Ricardian approach into the
modern “production function”
– Q=F(K, L, N)  K has the form it needs - used at both the firm and economy level.
Diverts attention away from questions concerning real world capital formation
decisions.
Cambridge US v. Cambridge UK (K is bogus – therefore profits are unjustified)
– Both are Neo-Ricardians?
– The UK Ricardians attacked the wrong thing (Lachmann’s critique).
But what is it really about? What is really at stake?
The nature of the economics process – hence desirable economic
policy
The best way to do economics – the scope of economics
From Hayek to Lachmann and Beyond.
Hayek is of the “compositive” school
Hayek at the LSE – contra Keynes – needed a more
complete theory of Capital – The Pure Theory of Capital –
1941
– “Our main concern will be to discuss in general terms what type of
equipment it will be most profitable to create under various
conditions, and how the equipment existing at any moment will be
used, rather than explain the factors which determined the value of a
given stock of production equipment and the income that will be
derived from it.” (1941: 3)
– “The problems that are raised by any attempt to analyze the
dynamics of production are mainly problems connected with the
interrelationships between the different parts of the elaborate
structure of productive equipment which man has built to serve his
needs. But all the essential differences between these parts were
obscured by the general endeavor to subsume them under one
comprehensive definition of the stock of capital. The fact that this
stock of capital is not an amorphous mass but possesses a definite
structure, that it is organized in a definite way, and that its
composition of essentially different items is much more important
than its aggregate ‘quantity,’ was systematically disregarded.” (1941: 6).
Lachmann extends the “compositive” vision
Hayek never managed to produce a
treatment of Capital that satisfied him
Investment that raises the demand for
Capital (1937) is the inspiration for
Lachmann’s work on Capital
1956 – Capital and Its Structure – the final
chapter?
Lachmann - Aspects of the Capital Structure
Capital is Heterogeneous – capital vs. capital goods.
Capital goods are part of the Capital Structure. A “structure” is an
order.
The capital structure is partly designed and partly the result of
adaptation – “spontaneous order.”
– The design part is about firms (and households)
– The spontaneous part is about the market process
The capital structure is characterized by complementarity and
specificity.
– Decision-makers form capital combinations with complementary
resources – some are dynamically more specific than others
– Change cause substitutions to be made - capital gains and capital
losses – coherence vs. flexibility
B-B’s insight is valid - the capital structure becomes increasingly
more complex over time.
Is it relevant? – the scope of economics
Structure v. Stock – quantity v. quality –
composition v. size
the scope of economics. The black box of the
firm vs. the economic organization.
Hayek Richardson, Penrose and recent work
on firm boundaries and strategies (linking up
with Coase and Williamson).
– When does aggregation (quantity) obscure structure?
When incommensurate items are aggregated.
Modularity may be the way to go.
– Organization matters for production.
A wider (and more fruitful?) perspective.
Part Two -The Theory of Interest
B-B explains why the existence of interest is a
matter of time preference
TP is a necessary and sufficient condition for the
earning of interest PTPT theory of interest.
Productivity cannot explain the earning of interest.
But the PTPT is vulnerable
– What does TP mean?
– There are multiple interest rates – Samuelson’s rice
model.
How should we speak? What viewpoint is more
relevant to the real world in which interest is paid
in money?
Implications of PTPT
Interest is not profit!! Profit is the result of
uncertainty (Knight, Mises, Hayek, Rothbard).
Resource owners earn rent (Rothbard, Fetter) wages (human capital), rent (land and physical
capital) - all resources are part of “capital” - also
relevant to the economics of organization.
The level of interest rates has very little to do
with economic growth and productivity. Directs
our attention to the market for loanable funds.