Capital and Its Structure
In Chapter III we saw how entrepreneurs form and dissolve capital combinations in response to the varying needs of changing situations, and how these capital combinations, embodied in plans, have to be regarded at each moment as the 'atoms' of the capital structure. In Chapter IV we endeavoured to show how the forces inherent in a market economy tend to operate towards consistent capital change and a coherent pattern of service streams flowing into and out of capital combinations; and that in this sense we may say that a capital structure, though it could hardly ever exist for any length of time, is always in the process of being formed, a process continually interrupted by unexpected change. In this chapter we shall be chiefly concerned with the changes which the capital structure undergoes as capital is accumulated or, as we might say, with the specific forms the capital structure assumes in an 'expanding economy'.
In Chapter III we thus saw how the ultimate constituents are determined, in Chapter IV how these constituents tend to form a system. In the present chapter we shall study the properties of this system under conditions of 'uniform' change.
We shall, however, have to change our method of attack. Thus far we have built up our argument, by and large, by the analysis and interpretation of certain well-known facts of business life, paying scant attention to what economic theories have to say about them; taking our justification for such disregard from the fact that theorists have, on the whole, had little to say about the matters in which we are interested, and that what little they have to say is, like Keynes' theory of speculation, as often as not misleading rather than to the point.
In other words, it is of the nature of our approach that we are looking at capital as the entrepreneur does, who has to build up capital combinations from a diversity of material resources. So we had little to learn from economists who adopt the point of view of the accountant, private or social, to whom the common denominator of the capital account is the heart of the matter, and most economists have at least implicitly adopted the accountant's point of view. But we shall now have to deal with one of the exceptions. In studying changes in the capital structure we cannot ignore previous discussions.
We shall in this chapter be mainly concerned with a question to which the intuitive genius of Boehm-Bawerk gave an answer of a kind, an answer, to be sure, we cannot fully accept and which, moreover, is marred by an excessive degree of simplification, yet an answer we cannot afford to disregard.
We ask what typical changes the capital structure undergoes as capital is accumulated. Boehm-Bawerk's answer was, briefly, that the 'period of production' increases and causes an increase in output per man-hour. We cannot accept this answer as it stands, but we believe it possible to re-interpret it in such a way as to make it exempt from most of the more damaging attacks it has suffered in recent years. Our procedure in this chapter will therefore take the form of a reinterpretation of Boehm-Bawerk's thesis about the higher productivity of 'Roundabout Production'.
There is a certain inconsistency in Boehm-Bawerk's theory which is relevant to our purpose in this chapter, and to which we must turn first. On the one hand, no other economist saw more clearly than he the essential heterogeneity of all capital. He speaks of capital as a 'mass of intermediate products' or a 'complex of products destined for further production'. On the other hand, his theory is essentially an attempt to reduce this 'complex' to a common denominator and to measure all changes in it in the single dimension of time. It seems to us that the root of his failure lies in this inconsistency. Starting from a view of the capital problem which is fundamentally sound, he failed when he tried to introduce the incongruous element of single-dimension measurement into a theory conceived in terms of heterogeneous products.
In re-interpreting Boehm-Bawerk it will be our task to separate what is relevant to our purpose from much that is not. For Boehm-Bawerk of course the 'higher productivity of roundabout production' was important merely as the 'third ground' for the explanation of the existence of the rate of interest. As we pointed out in Chapter I, we are not interested in interest as such. Why a (positive) rate of interest exists, is a question which does not concern us directly in our quest for the forces which shape the capital structure. But indirectly it does concern us.
After all, men invest capital in order to have an income. They reshuffle capital goods in order to obtain a higher income than they otherwise would. All capital change is governed by the magnitude of the income thus obtained—and this income is interest!
It is impossible to strip an argument of irrelevancies without considering what they are, or at least might be, relevant to. Our contention in what follows will be that Boehm-Bawerk's 'third ground' is an important element of the theory of economic progress which somehow, by mistake, its author put into the wrong pigeonhole and inserted into his theory of interest. The nature of this mistake will have to be elucidated. And the first step in this elucidation will have to consist in showing that the rate of interest can be 'explained' without the help of his 'third ground'. To this task we now have to turn, and in doing so we must for a little while digress from our main path. No originality is claimed for what we shall have to say in this digression. In showing that a positive rate of interest would exist even in a stationary economy we simply follow the implications of the argument so lucidly set forth by Professor Lindahl.*60 We shall then attempt to show that the validity of the argument is not impaired by recent 'monetary' doctrines of the interest rate as long as the difference between equilibrium conditions and the equilibrating mechanism is firmly kept in mind.
Of late a controversy has raged in the field of the theory of interest on whether the rate of interest is a 'real' or a 'purely monetary' phenomenon. The former may be called the 'traditional' view of the matter, while the latter, though by no means entirely new, derives most of its present-day impetus from Keynes. We shall see that once we distinguish clearly between equilibrium and disequilibrium conditions, and take the trouble to define the circumstances in which intertemporal equilibrium is at all conceivable, the substance of the controversy vanishes.*61
The rate of interest is the overall rate of exchange of present for future goods. It is thus an intertemporal exchange rate. There will be as many intertemporal exchange rates as there are future dates at which goods will become available, just as there are as many international exchange rates as there are countries participating in international trade. Just as these 'foreign exchange rates' require a 'foreign exchange market' to become explicit and to reach an equilibrium level, so intertemporal exchange rates must be settled in an intertemporal market. To understand the phenomenon at all we must assume forward markets for tin, copper, houses, etc., in which the 'own-rates' of interest are fixed for three months, six months, a year, etc.
It is readily seen that these 'own-rates' will tend to become equal if we allow for differences in the cost of carrying stocks. Arbitrage will bring this about. Let us first assume a barter economy with forward markets for each commodity and no cost of carrying stock. If a present house sells for 100 tons of 'spot' copper, and a house available a year hence for 100 tons of twelve months' forward copper, and the 'own-rate' for both copper and houses is 10 per cent, then the house available a year hence must sell for 90 tons of 'spot' copper. If the price were either more or less than 90 tons, i.e. if the own-rate for houses were either higher or lower than that for copper, 'switching' would take place. The good with the lower own-rate would be sold, and its spot price would fall until the own-rates become equal. It is in our understanding this over-all rate of exchange of present for future goods, as it would establish itself in a barter economy, with an intertemporal market for most goods, which Wicksell had in mind when he spoke of 'the natural rate of interest'.
Let us now drop our two assumptions. If we allow for differences in the cost of carrying stocks we shall have different 'gross' own-rates, but the equilibrium relationship between own-rates remains; the own-rates net of carrying cost must still tend towards equality. The case is exactly parallel to the over-all equilibrium in the forward exchange market which subsists despite differences in interest rates in different financial centres which will make the 'swap' rates vary, but do not affect the net rate of profit.
Nor does the introduction of money with an intertemporal market to determine the money rate of interest affect our argument. The money rate of interest will have to adjust itself to the over-all commodity rate of intertemporal exchange. If, to start with, it is lower than the commodity rate (the familiar case of inflation) there will be a general 'switching' from money to goods, a 'flight from money' resulting in higher spot prices of goods in terms of present money and lower prices of future goods in terms of future money, until the commodity rate has fallen and the money rate, owing to the depletion of idle money stocks due to the 'flight' from it, has risen. Vice versa for the case in which the money rate exceeds the commodity rate: falling spot prices, rising forward prices, and an accumulating stock of 'idle' money would bring about the equality of the rates. The money rate no more 'rules the roost' than any other rate of intertemporal exchange.
Mr. Sraffa in 1932 was, to our knowledge, the first to point out that in this whole field the crucial distinction is between equilibrium and disequilibrium, and not between a barter economy and a money economy.*62 He developed the notion of own-rates, without actually coining the word, in an appropriate setting of forward markets, though unfortunately he considered these in isolation and thus failed to realize how, to re-establish equilibrium once it has been disturbed. He came to interpret Wicksell's 'natural rate' as an average of 'actual' own-rates as they would exist, side by side, in a barter economy,*63 and not as the result of the operation of market forces. He thus substituted a statistical device for an analysis of market relationships.
In Keynes' system, by contrast, an over-all commodity rate does exist: the marginal efficiency of capital. It is a peculiar feature of his teaching that when the marginal efficiency of capital exceeds the money rate of interest, equality is brought about by the market through investment, while when it falls short of it, disinvestment is the only equilibrating force. This of course is due to his peculiar assumptions, first, that present prices, kept rigid by rigid wage-rates, cannot fall sufficiently to make investment profitable in the face of a high money rate, and, secondly, that accumulating money stocks have no effect on forward commodity prices.
When we abandon these restrictive assumptions we realize that there is a number of ways in which intertemporal market forces tend to bring the commodity rates and the money rate to equality; that investment is not the only modus operandi of these forces which would operate even in a stationary economy, i.e. one without investment; and that therefore the view of the rate of interest as an over-all intertemporal rate of exchange is not really affected by the Keynesian argument. It remains a curious fact, however, that Keynes, by making the distinction between the marginal efficiency of capital and the rate of interest the corner-stone of his system, actually re-enthroned that distinction between money and commodity rates for the irrelevance of which Wicksell and Professor Hayek had been so severely criticized by Mr. Sraffa, his acknowledged intellectual mentor in this matter.
There is one question which remains to be asked and answered by a theory of interest. Can the rate of interest become negative? Experience suggests that it cannot. A theory of interest should be able to provide plausible general reasons to account for the fact that we only observe positive values of the phenomenon.
We know already why the money rate of interest cannot become negative while commodity rates remain positive: there would be a general 'switching' from money to goods, from loans to shares. Very little money would be lent while the demand for loans would become immense. Who would not become an entrepreneur if his creditors were ready to pay him for it? The resulting excess demand for money loans would soon bring back the rate of interest into the positive range.
So far we have merely demonstrated that the money rate cannot, for any significant period, differ from the over-all commodity rate, but we have not shown that the latter cannot turn negative. Yet it is readily seen that it cannot. The ultimate reason for this lies in the simple fact that stocks of goods can be carried forward in time, but not backwards. If present prices of future goods are higher than those of present goods, it is possible to convert the latter into the former unless the good is perishable or the cost of storing excessive; while future goods cannot be converted into present goods unless there are ample stocks not otherwise needed which their holders are ready to reduce for a consideration. And as there are always a number of goods for which the cost of storage would be small, money being one of them, a negative rate of interest would be eliminated by a high demand for present goods which are easy to store and a large supply of easily storable future goods, at least as long as the stocks carried are covered by forward sales.
We now have to return to our chief task in this chapter, the re-examination of Boehm-Bawerk's third ground. We have just seen that the phenomenon of the rate of interest can be adequately accounted for without it; that a positive rate of interest would exist even under stationary conditions which do not, of course, preclude the intertemporal transfer of goods any more than they preclude the inter-local transfer of goods, but only preclude unexpected change, and that means change in knowledge. Boehm-Bawerk's third ground is thus not a necessary condition of the existence of interest. But what is its true role? In Professor Lindahl's words, 'Although the third ground is therefore not a necessary condition for the existence of a rate of interest on capital, it is actually of the most decisive importance for the concrete level of the interest rate, as a determining factor on the demand side.'*64 How does it have this effect?
First of all, we must try to see Boehm-Bawerk's thesis in its proper setting. Like Adam Smith's Division of Labour to which, as we shall see presently, it is closely related, the principle of roundabout production is, correctly interpreted, a theorem about economic progress. Now, the full significance of a theorem in any science can only be shown under 'artificial' conditions requiring a higher or lower level of abstraction. These make up 'the world' in which the theorem would be true.
It so happens that the world of Boehm-Bawerk, as the world of Adam Smith, differs from the conceptual systems familiar to economists of the mid-twentieth century: it is neither a stationary nor a fully dynamic world. In a stationary world of course there can be no capital investment; while of the disconcertingly dynamic world of our daily experience technical progress is an outstanding feature. As Boehm-Bawerk often pointed out, roundaboutness is not a form of technical progress. Technical progress requires new forms of knowledge spreading through the economic system while Boehm-Bawerk assumes a given knowledge equally shared by all. The world of Boehm-Bawerk is, then, a peculiar world of restricted progress, of progress in only one direction: that of capital accumulation the results of which are predictable. In this respect it is quite similar to the recent models of Messrs. Harrod and Hicks who have adopted Cassel's notion of the 'uniformly progressive economy' without unexpected change and have saved their models from the effects of the more disconcerting features of progress by the simple assumption of a 'steady rate of progress'.
For Adam Smith the division of labour was the most important source of progress. The same principle can be applied to capital. As capital accumulates there takes place a 'division of capital', a specialization of individual capital items, which enables us to resist the law of diminishing returns. As capital becomes more plentiful its accumulation does not take the form of multiplication of existing items, but that of a change in the composition of capital combinations. Some items will not be increased at all while entirely new ones will appear on the stage. (At this point the reader is invited to ask himself whether this result could ever have been reached had we treated capital as homogeneous; and to judge the fruitfulness of our method by his answer.)
The capital structure will thus change since the capital coefficients change, almost certainly towards a higher degree of complexity, i.e. more types of capital items will now be included in the combinations. The new items, which either did not exist or were not used before, will mostly be of an indivisible character. Complementarity plus indivisibility are the essence of the matter. It will not pay to install an indivisible capital good unless there are enough complementary capital goods to justify it. Until the quantity of goods in transit has reached a certain size it does not pay to build a railway. A poor society therefore often uses costlier (at the margin) means of transport than a wealthy one. The accumulation of capital does not merely provide us with the means to build power stations, it also provides us with enough factories to make them pay and enough coal to make them work. Economic progress thus requires a continuously changing composition of the social capital. The new indivisibilities account for the increasing returns.
We must note that the introduction of new indivisible resources, feasible only when the volume of complementary capital reaches a certain size, will as a rule also entail a change in the composition of this complementary capital, with the result that some of these capital goods will have to be shifted to other uses while others, which cannot be shifted, may lose their capital character altogether. Thus the accumulation of capital always destroys some capital, a fundamental fact which economists too often have either ignored or misinterpreted. Such misinterpretation usually takes the form of confining attention to the effects of capital accumulation on income from some capital, and is one of the more sinister results of the homogeneity assumption.
In the light of our argument it is quite wrong to say, for instance, that continuous investment will lower the marginal efficiency of capital. What continuous investment will do is to destroy the capital character of some resources for which the new capital is a substitute, while increasing the incomes from labour and capital resources complementary to it. In conditions of capital change the 'marginal efficiency of capital' (though not Professor Lerner's 'marginal efficiency of investment'!) is thus seen to be a meaningless notion implying, contrary to common observation, that the earning capacity of all capital resources will be affected in the same way.*65 For similar reasons it is unlikely that 'capital saving' inventions will save much capital, unless the latter happens to be unusually non-specific.
All this has now to be related to Boehm-Bawerk and his third ground.
As Boehm-Bawerk pointed out again and again, his thesis about the higher productivity of roundabout processes is an empirical generalization; it is not derived from the axioms of economic action. The same applies to our thesis about the typical changes of the capital structure as capital accumulates. There is no a priori reason to expect that a sufficient number of exploitable indivisibilities will always present itself, but the history of industrial countries over the last 200 years goes to show that they usually do. We contend that the circumstances in which Boehm-Bawerk's generalization holds are in general identical with those in which ours holds.
In his replies to critics, notably in his famous Exkurse, Boehm-Bawerk reiterated that, in the first place, he did not hold that all lengthening of production processes would cause higher productivity, but only that those 'wisely chosen' would, and that historical experience had convinced him that 'by and large' ('im grossen und ganzen'), as he put it in the first edition of his Positive Theory of Capital, or 'as a rule' ('in aller Regel'), as he says in later editions, the lengthening of productive processes would have this result 'with the practical effect that he who wishes and is able to lengthen his productive processes need never be at a loss as to how to improve them'.*66 Boehm-Bawerk also made it clear that his thesis did not mean that capital could not be increased in any other way than by 'lengthening', but only that, where this is possible, we would soon encounter diminishing returns.*67
Boehm-Bawerk's thesis thus clearly applies to those cases in which it is possible to invest capital, yet to escape diminishing returns. Which are those cases? Where existing capital is merely duplicated ('widened'), operated by a given labour force, diminishing returns will soon appear. Where new capital resources, but of the type employed before, are being substituted for existing labour ('deepened'), we may have to wait a little longer for diminishing returns to make their appearance, depending on the elasticity of substitution, but appear they will in the end. The only way in which we can hope to resist the pressure of diminishing returns is by changing the composition of capital and enlisting an indivisibility which, with fewer complementary capital resources, could not have been used. 'Higher roundabout productivity' therefore has to be interpreted in terms of this case. The only circumstances which permit it are those circumstances which permit a higher degree of division of capital.
The strong resemblance of our argument to Boehm-Bawerk's can be shown in another way. In Chapter V of Book II of the Positive Theory, Boehm-Bawerk introduces the concept of 'stages of maturity' and shows that capital growth will take the form of an increase in the number of these stages. The richer a society the smaller will be the proportion of capital resources used in the 'later stages of production', the stages nearest to the consumption end, and vice versa. There can be little doubt that the introduction of these stages, illustrated by the 'concentric rings', constitutes a crucial step in Boehm-Bawerk's argument. We shall attempt to show that these stages find a ready place in our argument.
In an industrial society raw materials have to pass a number of processing stages before they reach the consumer. The accumulation of capital will partly show itself in an increase in this raw material flow, but partly take the form of an increase in the number of processing stages. To the extent to which the latter is the case, a higher degree of the division of capital, as it accompanies the accumulation of capital, will thus be reflected in an increasing specialization of the processing function, in 'vertical disintegration' of the capital structure.*68, *69 As we see it, these stages are essentially layers of specialized capital equipment through which the 'original factors', i.e. raw materials, gradually filter on their journey to the consuming end. Progress through capital accumulation therefore means, firstly, an increase in the number of processing stages and, secondly, a change in the composition of the raw material flow as well as of the capital combinations at each stage, reflecting specialization as new stages are being added to the existing structure.
There are, however, two important differences between Boehm-Bawerk's conception of economic progress and ours. In the first place, for him all capital is circulating capital, while for us the layers of specialized capital equipment and their mode of change are the essence of the matter. His main attention was directed to the flow of goods, the 'original factors' assuming a succession of economic functions as they change their physical shape on their journey towards the consumer, while we are more interested in the number and character of the stages than in the flow that passes them. Hence, criticism of the whole conception of 'original factors', as advanced by Professor Knight, does not affect our thesis as it does Boehm-Bawerk's. By substituting 'raw materials' for 'original factors' we may hope to escape Professor Knight's strictures.
Secondly, and much more important, Boehm-Bawerk, in trying to find a measure for his flow of goods, found the measure in time. His 'stages of maturity' are measured by years of distance from the consumption end of the process. In this way he was led to neglect other important changes which accompany the accumulation of capital, and exposed himself to the familiar criticisms. We, on the other hand, having thus far contrived to tell the story of roundaboutness without mentioning time, must now beware of identifying the whole process with the mere multiplication of processing stages, since we have shown that the capital composition of the intermediate stages changes with each increase in their number. It is only if we make very restrictive assumptions that capital change can be regarded as a function of time.
It seems to us that Boehm-Bawerk, in making time the measure of capital, was led to confuse a process with the dimension in which, in very special circumstances, it may take place. Time by itself is not productive, nor is human action necessarily more productive because it takes longer. Boehm-Bawerk was fond of the examples of the growing trees and the ageing wine, but then there are many examples of goods (fruit, flowers) which are spoiled by the lapse of time, a fact he always readily recognized. Yet the third ground is not merely an illegitimate generalization of a segment of experience too narrow to warrant induction. We have seen that the essence of the phenomenon rests in the increasing number of specific processing stages which raw materials, Boehm-Bawerk's 'original factors', have to pass on their way to the consumer. We may imagine these materials spending a certain time at each stage, absorbing the services of the fixed equipment there. Now, if the period spent at each stage were given, then an increase in the number of stages would indeed mean an increase in the length of the whole journey. It is only on this assumption that the whole process can be measured in time. If the periods of sojourn at each stage vary as new stages are added, the process as a whole can no longer be measured in time. Time is the dimension of processing only as long as a definite, invariant, time period can be allotted to each processing stage. As we saw, the capital combinations at each stage are bound to vary with the addition of new stages. Hence, the periods of sojourn at each stage cannot remain unchanged as new stages are being added, quite apart from the changing composition of the raw material flow.
We conclude that the accumulation of capital renders possible a higher degree of the division of capital; that capital specialization as a rule takes the form of an increasing number of processing stages and a change in the composition of the raw material flow as well as of the capital combinations at each stage; that the changing pattern of this composition permits the use of new indivisible resources; that these indivisibilities account for increasing returns to capital; and that these increasing returns to the use of capital are, in essence, the 'higher productivity of roundabout methods of production'.
These results suggest another, less optimistic, conclusion. If the economic system, as it progresses, evolves an ever more complex pattern of capital complementarity, it is bound to become more vulnerable as it becomes more productive. A household with six servants each of whom is a specialist and none of whom can be substituted for another, is more exposed to individual whims and the vagaries of sickness than one that depends on two or more 'general maids'. Thus an 'expanding economy' is likely to encounter problems of increasing complexity, quite undreamt of in the Harrodian philosophy. For progress to be 'stable' the outputs of the various capital goods would have to be increased in proportion to the changing complementarity pattern, an unlikely feat even in a well-co-ordinated market economy. What this means for the trade cycle we shall see in Chapter VII. Meanwhile the reader may take note that disproportionalities and the resulting maladjustment of the capital structure may give rise to serious problems in economic progress.
Notes for this chapter
Studies in the Theory of Money and Capital, pp. 288-91.
The reader will not fail to notice that in the text we make an attempt to reconcile what we may call the 'neo-Wicksellian' theory of interest with the argument of Chapter 17 in Keynes' General Theory on 'The Essential Properties of Interest and Money', pp. 222-44. See also A. P. Lermer: 'The Essential Properties of Interest and Money', Essays in Economic Analysis, pp. 354-85.
'Dr. Hayek on Money and Capital', Economic Journal, March 1932, p. 49. 'If money did not exist and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might be at any moment as many "natural" rates of interest as there are commodities, though they would not be "equilibrium" rates. The "arbitrary" action of the banks is by no means a necessary condition for the divergence.'
Evidently Mr. Sraffa failed to see how in a barter economy intertemporal arbitrage would tend to bring the various 'natural' rates into conformity, thus tending towards establishing the 'equilibrium' rate.
Ibid., p. 51
Lindahl, op. cit., p. 291.
This fact has obvious implications for the distribution of incomes. In a dynamic world it is not possible to say that the accumulation of capital will cause the 'share of capital' to fall relatively to the 'shares' of other factors of production. In such circumstances the 'share of capital' also becomes a meaningless notion. What really happens is that some capital owners lose income while others gain. In a 'capitalistic' economy there are thus always capital owners, but, like the inhabitants of a hotel, they are never for long the same people. In a world of unexpected change economic forces generate a redistribution of wealth far more pervasive and ineluctable than anything welfare economists could conceive!
Exkurs I, 4th ed., p. 3. Our translation.
See the discussion with Taussig, Exkurs I, pp. 13 as.
This, of course, may take place within the same factory. The reader will not fail to notice that we are using the word here in a sense different from that employed in discussions of economic organization. All that matters to us is that the flow of materials successively comes into contact with, and is being processed by, an increasing number of distinct types of equipment.
In the real world, to be sure, we often find vertical integration of stages of production. As a rule this is either a manifestation of oligopoly or of technical progress, or of both. As they lie outside the framework of Boehm-Bawerk's model we need not consider them here.
Chapter 6, CAPITAL STRUCTURE AND ASSET STRUCTURE
End of Notes
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