1. Capital & Interest
for Introduction to Austrian Economics
By Paul F. Cwik, Ph. D.
Mount Olive College &
The Foundation for Economic
Education

2. 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?

3. 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.

4. 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
“Time Preference” is the social of equal
value than future (and intermediate) goods
quantity and quality. people prefer derived from
rate at which And since results
the ascribing of subjective value determine objective
present goods to future goods.
exchange value, present goods have in general greater
Each individual prefers sooner to
exchange value and a higher price than future (and
intermediate) goods of the same kind and quality.”
later, ceteris paribus.
 (Yes, for Böhm-Bawerk that is a clear statement. )

5. 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. )

6. 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.”

7. 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.

8. 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?

9. Imagine you are on an island…

10. Original Factors of Production:
1. Natural Resources
2. Labor
3. Time

11. Categories of Capital:
1. Capital Equipment
2. Intermediate Capital (Goods-in-Process)
3. Financial Capital

12. 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 three
years.
Goods that will
become consumer
goods in two years.

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

14. Hayek redraws the Structure of
Production (SOP)
 Here is the traditional
Structure of Production that
Value
Hayek drew in Prices and
Production (1931).
Time
Raw Materials
 It is sometimes called the Output /
Consumer
Hayekian Triangle. Manufacturing Goods
 However, it was
Wholesale
reformulated again by
Roger Garrison in his book Retail
Time and Money (2001).
el as el oh W
gn r u caf una M
sl ai r et a M w R
li at e R
a Value
Time Output /
Consumer
i t Goods

15. Modern Austrian conception of the
Structure of Production (SOP)
Intermediate capital goods move Value
through the SOP. They are
combined with original factors of
Resources and
production and preexisting Output / Consumer
Labor
Capital Equipment. Goods
Embedded in each
stage of production is Markets
Capital Equipment.
Financial Capital
el as el oh W moves in the opposite
gn r u caf una M
sl ai r et a M w R
li at e R
a
direction, facilitating
Time markets.
i t

16. Structure of Production
However, there is no
There are more that Value
telling where a particular
four stages in the
firm might be in the SOP.
SOP. There are
Furthermore, there are Output /
unaccountably many.
recursive loops and dual
So we can illustrate Consumer
purpose items, further
the concept through Goods
complicating the
the triangle.
problem.
Markets
Time

17. 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?

18. 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.

19. 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.

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

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

22. 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.

23. 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.

24. 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.”

25. Contrasting with Neo-Classicals
 John Bates Clark wrote his first
response to Böhm-Bawerk in 1893
with his essay, “The Genesis of
Capital.” Flow of new
investment
 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 Stock of Capital
resources, while the stream and
waterfall are flows. Depreciation or
depletion
 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.

26. 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.

27. 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
How?
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.

28. 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.”

29. 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.”

30. The Modern Neo-Classical Concept
of Capital Output
TP
 Frank Knight, who taught
Stage I Stage Stage
Milton Friedman, based his II III
capital theory on Clark.
 Today, economists freeze K
and allow L to move.
 Here is how the mainstream Input (L)
tends to view production. Output
 Even when economists
allow K to vary (e.g., Solow
Growth models or Real APL
Business Cycle Theory), it
is only allowed to do so
within certain parameters.
MPL Input (L)

31. Modern Neo-Classical Concept of
Interest
Interest
 Setting the Keynesian conception Rate Supply = Savers
aside, the modern approach uses People who need $
the Loanable Funds market. now for an People who love to
investment.
 The supply side is portrayed as i1
spend.
the subjective time-preference People who are
Borrowers with
natural savers.
component. options.
 The demand side is portrayed as Demand = Borrowers
the objective productivity Q1
Quantity of
component. Loanable
Funds
 In order for productivity theories
to hold, we have to at least be
able to recognize how capital
goods relate as complements or
substitutes.

32. 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?

33. 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.

34. 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.

35. 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.

36. Capital & Interest
By Paul F. Cwik, Ph. D.
PCwik@moc.edu