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
Its the Austrians claim to fame.
Menger (1871)
Bhm-Bawerk (1880 1921)

Wieser

Mises
Hayek (1930s, 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 Po
st 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

David Ricardo
Carl Menger
Neo Classicals

Karl Marx
Neo Ricardians
Post Keynesians

Joseph Schump
eter
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.

Carl Menger
Neo Classicals

Industrialization and the

heterogeneity of capital

All capital is circulating?

The Ricardian practice of assuming

equilibrium.
Capital flows ensure a uniform rate
of profit.

Karl Marx
NeoRicardians
Post Keynesi
ans
John Hicks

Joseph
Schumpeter

Ricardos 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 natures
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 Mengers Insights

Adopting Mengers 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 Bhm-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-Bs vision is the same as Mengers 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. (Bhm-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 (Bhm-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. (BhmBawerk 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. (Bhm-Bawerk 1959: 88).

Structure or Quantity?
Menger or Ricardo?
He believes in structure: A nations 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 Bhm-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. (Bhm-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-Bs 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 (Lachmanns 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
Lachmanns 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-Bs 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 Samuelsons 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.