Part III Of Time: Austrian Capital Theory
Introduction to Part III One of the least satisfactory pedormances by Walras, as noted in the introduction to Part I, was the theory of savings and investment, which is not to dispute some very important contributions. His use of a perpetual annuity unit to homogenize all capital goods and money was a most important step forward. But the motivation behind saving and investment was not examined in depth, and the genesis of the market functions for investment was unclear. I feel that economic theory has an important obligation to ground economic motivation explicitly in preferences and technology - extra-economic phenomena - in order to provide a complete and symmetrical general equilibrium theory. The reader will note that in this Part and in Part IV I have spent a great deal of effort in the attempt to integrate capital and money in the primitives of economic behavior. Austrian capital theory has always seemed to me to come closest to explaining these foundations of the existence of interest, saving and capital, even though it failed to build a satisfactory general equilibrium model employing them. It is, in a sense, poetry that has never been satisfactorily translated into prose, and it retains the insights of the former without sustaining the transformation to the utilitarian purposes of the latter. In chapter 4 of my Theory of General Economic Equilibrium I present a variety of capital theories and try to indicate the shortcomings of each. And, in 1971, I was invited by the Columbia University Press to write a monograph on Bohm-Bawerk's theories. It is presented as Chapter 14. Bohm-Bawerk attempted to expand upon Menger's vision of distribution theory as an extension of utility theory, and to weave a theory of interest and capital into the body of economic thought. To do so was to integrate that theory into a model of general equilibrium, for utility theory was viewed by Menger and Walras to be the motivating core of such grand constructions. To Bohm-Bawerk, interest was not a payment for a separate factor service that enters capital as a cost, nor was it a return for the psychological pain of 'abstinence', since no such disutility exists. It arose because time distorts subjectively the objective marginal utility of future goods and hence prevents capital goods from being produced to the point that their 'true' marginal utility of product should dictate. Interest and 323
324 Of Time: Austrian Capital Theory capital theory are manifested in markets where present goods are exchanged for future goods at a consequent premium. But demands for current goods by capitalists could not be wholly divorced from technology. Capital goods, as inchoate forms of future consumer goods, were constructed because it was an empirical fact that they allowed man greater leverage over the forces of nature. They permitted more product to be produced from a given number of today's resources than could be obtained from the application of those resources to production directly. But interest is determined at the margin, and only the psychological myopia of consumers prevents the construction of capital goods to the point where the marginal value of such constituent factor services in congealed form equals the marginal value when used directly. Were that to occur the marginal advantage of capital goods would disappear and the interest rate become zero. Even, however, were no capital goods to exist, a positive interest rate would arise in the consumer loan market because of such short-sightedness. Hence, it is ultimately in consumer preferences that the phenomenon of interest is grounded. The longitudinal view of capital through time, as an intertemporal set of consumer goods at different stages of completion, is a distinctive feature of Austrian capital theory. It differs from the crosssectional view of capital as a stock of equipment and inventories existing at a moment of time, yielding independent factor services over a period of time. All such theories implicitly accept time extents as an important part of their explanation of capital and interest, although some (e.g. Knight's) seek to abstract from it in assuming the capital stock, once created, is eternalized through reinvestment, frequently by assuming the stationary state. It is a distinctive feature of Austrian theory that time is a vital element in the creativity of capital and the ultimate explanation of interest. Note that money as a good which is never consumed over time but yields a flow of services eternally does not fit this framework well, and hence is not extensively treated by Bohm-Bawerk. In this sense, Walras's cross-sectional view of capital as a stock of factors yielding saleable factor services period by period accommodates money (and land) and unifies the treatment of factors for greater ease of incorporation in a general equilibrium system. Bohm-Bawerk strove hard to keep productivity out of the theory of capital and interest, but failed in the end to do so. His Third Ground for the existence of interest is simply the marginal productivity of investment that time activates. One of the greatest faults
Introduction to Part III 325 in his theory of interest and capital is this attempt to present it as wholly the result of consumer preferences. He ends, as Wicksell and Fisher recognize, with both positive time preference and the productivity of capital as co-ordinate forces in the determination of interest and the explanation of the motivation for investment. I shall return to this criticism of the Third Ground in Chapters 15 and 16 to follow. The theory propounded by Bohm-Bawerk sought to integrate capital and interest into the whole of value and distribution theory in a manner that was Walrasian in spirit. It was in this sense a general equilibrium theory, but faulty because of an inability to conceptualize the role of time in such measures as the period of production except under the simplest of conditions and because of his lack of technique. Examples of the latter which hampered his theory were his failure to understand the notion of simultaneous, interdependent causation and to adopt production functions which permitted continuous substitution among factors. It was left to Wicksell and Fisher to start from his model and to improve it in these regards and in the acceptance of productivity to accomplish the integration satisfactorily. In this chapter I attempt to synthesize Bohm-Bawerk's concepts into the general equilibrium model at which he aimed. This must be done within the context of the stationary state and with the incorporation of other extreme departures from reality (point-input - pointoutput production functions, for example). In the end, the requirements necessary to formalize it and to render unambiguous his concept of the period of production are too unrealistic to accept, and modern capital theory has never been tempted by it. Nonetheless, his concept of positive time preference, and the insights into the role of time in economic decision-making with the distinctive features it bestows upon capital goods, is an enduring legacy. The core vision remains, and after major adjustments and corrections, continues to inform economists' thoughts about capital and interest. Indeed, in the transmuted forms present in the work of Wicksell and Fisher, the imputed insights are invaluable contributions. Selections 15 and 16 develop more fully the challenge to Bohm-Bawerk's 'third ground' for the existence of a positive interest rate: the so-called 'technological superiority of present goods over future'. He believed that if positive time preference did not characterize consumers' choices between present and future goods, the former would still be preferred to the latter because of
326 Of Time: Austrian Capital Theory the productivity of roundabout or indirect processes that employed time. The two papers show the conditions under which this would be true and reveal the unreality of those conditions. Even though the productivity of roundabout processes characterized production functions, provided they reached a maximum in function of time it would not bring about the third ground. That is, the technological superiority of present goods is not identical with the productivity of roundabout processes. For the former to occur, positive time preference would have to rule, which would destroy B6hm-Bawerk's notion of its independence from consumer attitudes toward the future. Chapter 15 was written as a brief note commenting on a valuable article by Professor R. Dorfman on Austrian capital theory. Chapter 16 develops more fully arguments that were foreclosed by space limitations on Chapter 15, and seeks to isolate the assumptions that must be made for B6hm-Bawerk and his critics to be correct. It was an attempt to provide some definitive answers to a debate which frequently proceeded from different sets of implicit assumptions. The paper defines three different definitions of time preference and considers four cases in which the productivity of roundabout processes does or does not approach an upper bound and in which terminal consumption occurs or reinvestment is possible. In terms of realism, the invalidity of the third ground must be accepted. B6hm-Bawerk's rather stubborn insistence on the third ground reflected his continuing desire to adopt a straightforward productivity of capital goods, but in the end merely reinforced his need to recognize it as of dual importance to time preference in his theory of interest. In the end he does so, and indeed with a vengeance: as indicated in Chapter 14, at times he seems to view productivity as the dominant factor and to arrive at a productivity theory of interest. Austrian theory in its purest form, in seeking to measure the productivity of capital by the length of a vague 'period of production' which eliminated the value of goods from its calculation, is not a fruitful manner of incorporating capital and interest into a general equilibrium system, or, indeed, of dealing with partial analyses. Treatment of capital goods as separate factors of production providing flows of productive services is much more useful in these respects. Moreover, the desire to establish interest as the reflection wholly of consumer preferences was a vain and needless one, as B6hm-Bawerk effectively came to realize. But the notions of positive time preference and of the productivity of roundabout or capital-based processes which accrued only at the
Introduction to Part III 327 cost of postponed consumption were valuable contributions to the understanding of the foundations of economic theory. And the practical outcome of that theory's early formulations were the improved theories of Wicksell and Fisher which illuminated the origins of demand and supply functions for savings and the determination of the rate of interest.