Capital and Its Structure

Lachmann, Ludwig M.
(1906-1990)
BIO
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Editor/Trans.
First Pub. Date
1956
Publisher/Edition
Kansas City: Sheed Andrews and McMeel, Inc.
Pub. Date
1978
Comments
2nd edition.

To M.L.

PREFACE TO THE SECOND EDITION

PS.1

An author who, after twenty years of rather heated controversy in what has come to be known as "capital theory," has a book on capital published unrevised owes his readers a word of explanation.

PS.2

My first reason is that the problems constituting the subject matter of this book have little to do with what has been going on in the arena of recent controversy. This book deals with the stock of social capital and its structure, not with income accruing to the various classes of its owners. Its main concern, in Professor Hayek's formulation of thirty-six years ago, "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 to explain the factors which determined the value of a given stock of productive equipment and of the income that will be derived from it."*1 Professor Solow in 1963 assigned to capital theory an almost exactly opposite task. "In short, we really want a theory of interest rates, not a theory of capital."*2 It may be useful, then, to distinguish between Hayekian theory of capital and Solovian capital theory. This book belongs in the former category and is unaffected by the vicissitudes the latter has suffered.

PS.3

The theory of capital, alas, has made little progress since 1941. This book was written about a dozen years later in an attempt to make economists aware of the existence and urgency of these structural problems. It went out of print fairly soon and was not reprinted.

PS.4

My second reason for having it reprinted unchanged stems from the fact that it was written in an epoch of economic thought which now appears to be past, the era of unchallenged neoclassical ascendancy. But the neoclassical style of thought does not lend itself readily to a discussion of problems of capital structure. The book had to be written in a somewhat unorthodox fashion. To revise it now would be like putting steel windows in a baroque building.

PS.5

In 1956 when the book first appeared, the fortunes of Austrian economics were at a low ebb. Most economists were more interested in econometrics than in subjectivism. Nobody reminded them in those days that the present, in which we stand and judge, is but a thin veneer between an unknowable future and an irrevocable past, from which our knowledge is drawn. Today this is common cause, but some of its methodological implications are as yet not well understood. The 1950s were a bad time for subjectivists. The role of expectations in economic theory, except for Shackle's pioneering efforts, was hardly appreciated. To some extent the book was a gesture of defiance to the spirit of the age. In the preface I wrote, "Our own approach in this book follows another trend of modern economic thought, not towards the 'objective' and quantifiable, but towards the subjective interpretation of phenomena." I had to review the existing theory of capital from such a perspective.

PS.6

For some time one particular feature of Austrian economics had puzzled me. Its theory of capital, an essential and perhaps its best known ingredient, did not appear to fit the canon of methodological individualism. Austrians in general accepted that we must start with the individual and proceed by exploring the, often unintended, consequences of its maximizing endeavors. The Austrian theory of capital, on the other hand, from Böhm-Bawerk onward, proceeded along altogether different lines and offered little scope for the effects of individual action.

PS.7

It was easy to see that this fact had something to do with Böhm-Bawerk's cast of mind. As much a Ricardian as an Austrian, he asked the old Ricardian question, how it is possible in a competitive market economy for the owners of augmentable capital resources to enjoy a permanent income. It was only in the pursuit of this endeavor that, as a means to his end, he came to construct the rudiments of a theory of capital structure. No wonder, then, that his theory looked so "objectivist" and Ricardian. It seemed to me that the most urgent task was to infuse a dose of subjectivism into this theory of capital and to relate capital phenomena to individual choices.

PS.8

It is, of course, true that the "average period of production" reflects the collective time preferences of saver-consumers, but this expression in itself denotes a macroeconomic entity. Moreover, it is measurable only in a classical one-commodity world in which labor is the only factor of production, and we do not live in such a world. In a multicommodity world, on the other hand, the stock of capital is heterogeneous, and we face the task of explaining its composition in terms of individual choice.

PS.9

It seemed to me that to this end the macroaggregate "capital stock" had to be broken up into smaller entities responsive to microeconomic forces, entities which can be shown to be the results, however indirect, of individual acts of choice. A theory of capital of the type envisaged had to start with the capital combinations of the individual units of production, or "firms," combinations of buildings, equipment, machines, stocks of working capital, and so forth. In them we find the "natural elements," the microeconomic roots, of the social capital stock. Within the limits set by technology, each such combination reflects the production plan of its owners and managers. It is certainly not a mere replica of the other combinations in the same "industry." The divergence of expectations makes for some variety. With product differentiation, the scope for variety is even further enhanced. One of the tasks of a theory of capital devoted to pursuing the implications of the heterogeneity and complementarity of nonpermanent resources is to explain why, even in the most fiercely competitive market, each firm bears the mark of the individuality of its leading minds.

PS.10

It is to be hoped that the approach to capital followed in this book will find further development in the near future. For this, the climate may be more favorable today than it was twenty-one years ago, since our age of permanent inflation has lent urgency to some problems formerly unduly neglected. In this connection, those of capital replacement and malinvestment call for particular attention.

PS.11

There was a time when most economists took the maintenance, granted. Failure in this respect would soon drive firms out of repair, and replacement of the existing capital stock very much for business. Only the bankrupt or near-bankrupt would thus fail to replace their capital resources. In any economy in which capital was normally accumulated every year, we could be sure that its existing capital stock would be duly replaced. The neoclassical notion of "steady growth" evidently rests on this assumption.

PS.12

Today we have learned to be more skeptical. We now realize that capital replacement, far from being a matter of business routine, is a most problematic activity. It must rest on expectations, subjective and individual, about future income streams and choice among them. There can be no such thing as a "correct" method of depreciation and replacement in a changing world. The possibility of capital erosion in some sectors of the economy at the same time as accumulation is occurring in others is no longer to be dismissed.

PS.13

That malinvestment and its consequences should have been ignored as long as macroeconomic thinking was dominated by an income-expenditure model, which had no place for capital gains and losses, is perhaps understandable, if not pardonable. It is important to realize, however, that the effects of malinvestment are not confined to the losses of wealth suffered by the capital owners directly concerned and their creditors, but that through the network of structural complementarity they may extend throughout the economic system. The appearance of malinvestment in any kind of capital resource will affect the processes of its maintenance and replacement and thus the output of its means of production, and possibly also maintenance and replacement of the latter in turn.

PS.14

In our world of permanent inflation many of these problems have come to the fore. Everybody knows that in an inflation the more heavily in debt a firm is, the more profitable it appears to be, because by ordinary accounting rules the capital gains its owners make at the expense of their creditors must appear as profits. Most economists by now know this to be only an extreme case of the ubiquitous difficulty of ascertaining "true profits." But the implications of this set of problems are often not well understood.

PS.15

Most contemporaries know the plight of industries with prices controlled by public authorities, usually in such a fashion that in any particular round of inflation their prices are the last to rise, but the implications for capital replacement and its repercussions mentioned earlier are less readily appreciated. In a world in which what Hicks has called "fixprices" and "flexprices" exist side by side, all industries whose output prices belong to the former, while the major portion of their input prices are of the latter category, are in approximately the same position as industries with controlled output prices.

PS.16

As it is by no means obvious where current replacement cost information can be obtained, it will not help us to blame the accountants for the apparently irrational character of their rules for the evaluation of profits. These rules, on the other hand, display a tendency to turn into business institutions which decision makers dare not ignore, even where they fully understand the real issues at stake. Moreover, as Solomon Fabricant reminded us,

the situation with regard to plant and other structures is still more difficult. Construction data assembled from a variety of sources and published in the Survey of Current Business, for example, are of mixed quality. Some relate to the cost of the finished structure—the building—but most relate only to the cost of materials and labor used in construction, with little or no allowance for other inputs or for productivity changes.*3

PS.17

The replacement of capital is indeed an economic activity of somewhat problematical character.

PS.18

The world around us abounds with problems to which a structural theory of capital of the type outlined in this book is germane. It is to be hoped that a number of them will attract the attention of economists.

New York University
January 1977
L. M. Lachmann


Notes for this chapter


1.
F. A. Hayek, Pure Theory of Capital (London, 1941), p. 3.
2.
R. M. Solow, Capital Theory and the Rate of Return (Amsterdam, 1963,) p. 16.
3.
Solomon Fabricant, "Towards Rational Accounting, in an Era of Unstable Money, 1936-1976," National Bureau of Economic Research, Report 16 (December 1976), p. 13.

Chapter 1, THE ORDER OF CAPITAL

End of Notes



PREFACE

P.1

For a long time now the theory of capital has been under a cloud. Twenty years ago, when Professor Knight launched his attack on the capital theories of Boehm-Bawerk and Wicksell, there opened a controversy which continued for years on both sides of the Atlantic. Today very little is heard of all this. The centre of interest has shifted to other fields.

P.2

In practice of course problems concerning capital have by no means lost their interest. There can be few economists who do not use the word 'capital' almost every day of their working lives. But apart from some notable exceptions, economists have ceased to ask fundamental questions about capital. It is pertinent to enquire why this has happened. It would seem that there are three major reasons to account for this curious neglect.

P.3

In the first place, many economists have evidently come to believe that we do not require the conceptual framework of a theory of capital in order to discuss problems germane to capital, or at least those problems in which practical interest has of late been greatest, such as investment. In other words, the view appears to have gained ground that a theory of capital is not really necessary. This, as I shall attempt to show in this book, is an erroneous view. It is hardly possible to discuss the causes and consequences of a change in a stock without some knowledge of the nature and composition of this stock; or, it is only possible to do so if we are prepared to abstract from all those features of the situation which really matter. In the discussion of capital problems, as of any other problems, we cannot dispense with a coherent frame of reference.

P.4

A second reason for the present-day neglect of the theory of capital has probably to be sought in the contemporary preoccupation with quantitative precision of statement and argument. Most contemporary economics is presented in a quantitative garb. This is not the place to enquire into the reasons for this predilection. To some extent of course economists, in spending so much effort on quantifying the terms in which they present their theories, wittingly or unwittingly merely reflect the spirit of our age.

P.5

But why should such quantification be more problematical in the theory of capital than it is in other fields of economic study? In most business transactions capital is treated as a quantity. In every balance sheet we find a capital account.

P.6

The fact remains, however, that in spite of protracted efforts it has proved impossible to find a quantitative expression for capital which would satisfy the rigorous requirements of economic thought. Most economists agree today that, except under equilibrium conditions, a 'quantity of capital' is not a meaningful concept. In this book an attempt is made to follow up some implications of this conclusion. But the fact that the concept of capital has for so long proved refractory to all attempts at quantification is almost certainly one of the reasons for the lack of interest, and hence of progress, in the theory of capital.

P.7

A third reason, closely related to the one just mentioned, appears to lie in the rather peculiar nature of the relationship between capital and knowledge. The various uses made of any durable capital good reflect the accumulated experience and knowledge gained, in workshop and market, by those who operate it. But modern economic theory cannot easily cope with change that is not quantitative change; and knowledge is as refractory to quantification as capital is. The acquisition and diffusion of knowledge certainly take place in time, but neither is, in any meaningful sense of the word, a 'function' of time. Modern economists, uneasily aware of the problem, have tried to avoid it by assuming a 'given state of knowledge'. But such an assumption, if taken literally, would obviously prevent us from considering economic change of any kind. For instance, as Mrs. Robinson has pointed out, 'a "change in methods of production in a given state of knowledge" is, strictly speaking, a contradiction in terms'. With very durable capital goods the assumption becomes quite untenable. Our railways after all are not run by people with the technical knowledge of 125 years ago.

P.8

The theory of capital is a dynamic theory, not merely because many capital goods are durable, but because the changes in use which these durable capital goods undergo during their lifetime reflect the acquisition and transmission of knowledge.


P.9

Our own approach in this book follows another trend of modern economic thought, not towards the 'objective' and quantifiable, but towards the subjective interpretation of phenomena. Of late many economists have exercised their ingenuity in fashioning their science in accordance with the rigid canons of Logical Empiricism. Even the theory of value has been made to conform to the strict rules of the behaviourists: nowadays we are not supposed to know anything about human preferences until these have been 'revealed' to us. But few of these efforts have been successful. The fact remains that the two greatest achievements of our science within the last hundred years, subjective value and the introduction of expectations, became possible only when it was realized that the causes of certain phenomena do not lie in the 'facts of the situation' but in the appraisal of such a situation by active minds.

P.10

The generic concept of capital without which economists cannot do their work has no measurable counterpart among material objects; it reflects the entrepreneurial appraisal of such objects. Beer barrels and blast furnaces, harbour installations and hotel-room furniture are capital not by virtue of their physical properties but by virtue of their economic functions. Something is capital because the market, the consensus of entrepreneurial minds, regards it as capable of yielding an income. This does not mean that the phenomena of capital cannot be comprehended by clear and unambiguous concepts. The stock of capital used by society does not present a picture of chaos. Its arrangement is not arbitrary. There is some order in it. This book is devoted to the exploration of the problems of the order of capital.

P.11

The chief object of this book is thus to rekindle interest in the fundamental problems of capital rather than to present a closed system of generalizations about them; to outline a new approach and to show that it can be applied, with some promise of success, to a number of such problems ranging from the productivity of capital to the demise of the 'strong boom'; to point out the implications of certain economic facts which have been long neglected; and, above all, to emphasize the transmission of knowledge, the interaction of minds, as the ultimate agent of all economic processes.

P.12

I am painfully aware of the fact that this book leaves many vital questions unanswered. It could hardly be otherwise. But it is my hope that others will follow and make their contributions to the theory of capital. There can be few fields of economic enquiry today which promise a richer harvest than the systematic study of the modes of use of our material resources.

P.13

It is not impossible that at some time in the future the concept of capital structure, the order in which the various capital resources are arranged in the economic system, will be given a quantitative expression; after all, any order can be expressed in numbers. For many reasons such a development would be most welcome. But this book has been written to meet the present situation in which we badly need a generic concept of capital, but in which all attempts to express it in quantitative terms have thus far been unsuccessful.


P.14

My greatest debt of gratitude is to Professor F. A. Hayek whose ideas on capital have helped to shape my own thought more than those of any other thinker. To Professor F. W. Paish who, during his stay at this University in 1952 as a Visiting Trust Fund Lecturer, undaunted by a heavily loaded time-table, read several chapters in draft form, I am indebted for much sagacious comment and advice. In writing the final version of Chapter VI I have drawn heavily on his unrivalled knowledge of the intricacies of modern business finance. But needless to say, the responsibility for what I say is entirely mine.

P.15

I owe more than I can express in words to my friends in the University of the Witwatersrand for their steady help and encouragement, in particular to Mr. L. H. Samuels and Mr. T. van Waasdijk, who patiently read draft after draft, and from whose helpful comment and suggestions I have derived much unearned profit.

P.16

I also wish to express my gratitude to the Research Committee of this University who by their generous financial assistance have considerably eased my task.

P.17

Lastly, I have to thank the Royal Economic Society, the editor and publishers of the Manchester School of Economic and Social Studies, Messrs. George Allen & Unwin, the McGraw-Hill Book Company, Inc., and Messrs. Routledge & Kegan Paul for permission to quote passages from works published by them. I also wish to acknowledge my gratitude to the authors of these passages.

L. M. LACHMANN
University of the Witwatersrand
Johannesburg
September, 1955

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