The Foundations of Modern Austrian Economics
By Edwin G. Dolan
In June 1974 the Institute for Humane Studies sponsored the first of a series of conferences on Austrian economics. This conference was held at Royalton College in South Royalton, Vermont, and attracted some fifty participants from all regions of the United States and three continents abroad. The conferees came to hear Israel M. Kirzner, Ludwig M. Lachmann, and Murray N. Rothbard survey the fundamentals of modern Austrian economics and thereby challenge the Keynesian-neoclassical orthodoxy, which has dominated economic science since World War II.Each lecturer addressed himself to two general questions: What is the distinctive Austrian contribution to economic theory? And what are the important problems and new directions for Austrian economics today? By answering these questions, the papers collected in this volume become more than just a set of conference proceedings—they take on the character of a manifesto and provisional textbook as well…. [From the Preface by Edwin G. Dolan]
First Pub. Date
Kansas City: Sheed and Ward, Inc.
Collected essays, various authors. 1976 conference proceedings. Includes essays by Gerald P. O'Driscoll, Israel M. Kirzner, Murray N. Rothbard, Ludwig M. Lachmann, and more.
The text of this edition is copyright ©1976, The Institute for Humane Studies.
To most economists today the words
Austrian capital theory denote work in the line of succession of Eugen von Böhm-Bawerk. Sir John Hicks noted that the tradition originated before the last quarter of the nineteenth century and can even be traced to the Renaissance, yet described his book
Capital and Time as
A Neo-Austrian Theory inasmuch as it deals with production processes that take time to complete.
*34 How many know that Carl Menger regarded Böhm-Bawerk’s theory as “one of the greatest errors ever committed”?
I wish to argue, however, that Böhm-Bawerk’s model, being essentially macroeconomic, does not provide an adequate basis for a capital theory that could properly be called Austrian. Work in constructing such a theory must start at the foundation, and this means at the level of individual action. Böhm-Bawerk never meant to be a capital theorist. He was essentially a Ricardian who asked a Ricardian question: “Why are the owners of impermanent resources able to enjoy a permanent income and what determines its magnitude?” The notion of a temporal capital structure consisting of a sequence of stages of production was a mere by-product of an inquiry into the causes and the magnitude of the rate of return on capital and not the main subject. In pursuit of this Ricardian inquiry Böhm-Bawerk battled on and failed like a Ricardian. In his model there are one factor of production, labor, and one final consumption good. Ricardo failed when trying to apply conclusions holding in a simple corn economy to a multicommodity world, in which the real wage rate
depends on the workers’ expenditure pattern and relative prices of wage goods (hence on choice!). Böhm-Bawerk’s argument foundered on the same rock.
With a number of consumption goods, we need a price system which must be invariant to changes in the rate of interest that accompany the accumulation of capital. But such a price system cannot exist. Moreover, with the subsistence fund consisting of a number of goods, some of the capital invested will be malinvested if the composition of the fund does not correspond to the workers’ expenditure pattern. In the absence of perfect foresight on the part of the capital owners, some malinvestment is inevitable, and some of the capital accumulated vanishes from the scene.
There are other reasons for abandoning Böhm-Bawerk’s theory. As Samuelson pointed out
*36 and Hicks noted,
*37 the possibility of “reswitching” affects the “average length of the period of production” just as much as the “quantity of capital.” Moreover, to reduce the whole complex of relationships among capital resources—within firms as well as between firms in different industries and stages of processing, often with relations of complementarity in time but just as often not—to the single dimension of time is a bold idea (originating with Ricardo), but not a very good one. From an Austrian point of view, too much violence is done to the diversity of the world.
I suggest that we reverse the Ricardian approach to the problem of capital and make the capital structure the primary object of study by starting at the ground level, that is, at the microlevel where production plans are made and carried out.
On the other hand, can the rate of return on capital, Ricardo’s and Böhm-Bawerk’s primary object, have any place in a market economy if, in an Austrian mood, the variety of goods and services and its corollary, the heterogeneity of capital, are recognized? This rate of return is of central concern to the neoclassical theorists, from Irving Fisher to Robert Solow, and constitutes the main issue of controversy. For the neoclassical economist it is a dependant variable of the general-equilibrium system. To the contrary, the neo-Ricardians hold that it has to be determined
outside this system since there can be no quantity of capital and hence no marginal product of it. In my view this controversy about a fictitious macroeconomic magnitude is a symptom of the arid macroeconomic formalism that afflicts both schools. For in a market economy a uniform rate of return on all capital invested does not exist.
If we follow Menger instead of Böhm-Bawerk, a distinction may be made between the rate of interest on loans and the rate of profit on capital invested. The former does exist, that is, there is a structure of interest rates determined daily in the loan market as its equilibrium price. The latter does not.
*38 There is also in a market economy a uniform rate of (dividend and earnings) yield on capital assets that the market assigns to the same class. But this uniform rate of yield has nothing to do with either Ricardo’s rate of profits or Fisher’s rate of return over cost. It reflects all capital gains and losses made since the inception of the company in question. It is precisely the diversity of such gains and losses recorded on the stock of different companies that permits the market to make the present rate of yield on all assets uniform. This Mengerian criticism of Böhm-Bawerk is confirmed by Hicks, the leading neoclassical thinker, who, having proclaimed the “‘Austrian’ affiliation of my ideas” and paid a tribute to Böhm-Bawerk,
*39 nevertheless concluded on the last page of his book that “only in the steady state can we unambiguously determine the size of profits. Out of the steady state the profit that is allocated to a particular period depends on expectations…there is no such convention that is unambiguously right.”
*40 But the “steady state,” like all equilibria, is a fiction, and the real Austrian view has been Hicks’s final view all the time!
Our main task is to lay the foundation for a theory of the capital structure. Our capital theory, unlike Böhm-Bawerk’s, is not devised to serve as a basis for an interest theory. Its purpose is to make the shape, order, and coherence of the capital structure intelligible in terms of human action.
Starting with the facts of the heterogeneity of capital and following its logic, we find in every firm a capital combination—a combination of land, buildings, equipment, machines, and
stocks of various goods. There are constraints on the possible modes of complementarity of these resources, some of them technological, some the results of the market situation. Relevant here are both the market for the products of the firm and those for labor and materials. Within these boundaries the manager-entrepreneur chooses a mode for the use of the capital under his control to maximize his profits. And since his decision involves the future as well as the present, he bases his plan on his expectations.
Since his capital combination could produce a number of different output streams of various composition, he has to choose among them. But his capital combination is not immutable; he can reshuffle it, discarding some capital goods and buying others. Entrepreneurial action with regard to capital, then, requires continuous “alertness” to change and a willingness to make frequent changes, the switching “on” or “off” of various output streams as well as the reshuffling of capital combinations. The firm and its resources are immersed in the stream of knowledge. Technical progress in the form of “learning by doing” probably takes place within the firm’s walls. But new knowledge usually reaches it by way of the markets for its products, factor services and alternative capital goods that might be added to, or used as substitutes in, the existing capital combinations.
A comparison may be made between the just described heterogeneity of capital and that in other models. Neoclassical writers like Samuelson and Solow apparently admit the heterogeneity of capital as a matter of fact and in principle, but eschew the consequences, whenever a problem germane to it arises, by means of such devices as the surrogate production function or the assumption of a one-commodity world. Neo-Ricardian criticism emphasizes the need for a price system invariant to interest changes but can carry the matter no farther since the dynamics of the market process is beyond its reach.
In commodity markets prices are fixed directly and incomes indirectly. Each firm with its capital combination is always in disequilibrium and by its action in this state contributes to the continuous reshaping of the capital structure.
The individuality of each firm rests on the varying interpretations it places on the ceaseless stream of knowledge, different segments in the minds of different manager-entrepreneurs finding expression in the specific composition of their capital combinations. In time, output streams are switched on and off, and the composition of capital combinations is modified. New investment is but a by-product of the regrouping of existing capital resources. Hence the futility of all attempts to “measure” capital.
In dealing with the capital structure of society and its complex relationships with the capital combinations of the firms, we should be aware of the prototypical relationship it reflects between an aggregate and its particles, between the macrostructure and its microelements. If we criticize the inadequacy of macromodels, we should be able to show that we can do better. We must be able to deal with them without losing sight of their microbasis.
The capital structure of society is an aggregate of capital combinations, but only in a state of general equilibrium can the capital goods belonging to different firms be regarded as additive, when they stand to each other in a relationship of complementarity. It is, however, a type of complementarity different from that governing capital goods within the same capital combination. We have to distinguish between the planned complementarity of the latter, the result of entrepreneurial choice and decision, and the unplanned complementarity of capital resources at various stages of production, which is an outcome of the operation of the market process.
The capital structure of society is never completely integrated. The competitive nature of the market process entails incoherence of plans and limits the coherence of the resulting order. A tendency toward the integration of the structure does exist. Capital goods that do not fit into any existing combination are useless to their owners, are “not really capital,” and will soon be scrapped. “Holes” in the existing complementarity pattern, on the other hand, must cause price-cost differences and thus call for their elimination. But expectations of early change in the
present situation may impede the process of adjustment, and even when this does not happen, the forces of adjustment themselves may be overtaken by other forces.
One result of the recent discussion on “reswitching” is to the advantage of the Austrian school. As long as all capital is regarded as homogeneous, managers may respond to a marginal fall in the rate of interest by a marginal act of substitution of capital for labor. But heterogeneity of capital entails a regrouping of the existing capital combination; some capital goods may have to be discarded, others acquired. It is no longer a marginal adjustment that is called for but entrepreneurial choice and decision. As Pasinetti pointed out, “Two techniques may well be as near as one likes on the scale of variation of the rate of profit and yet the physical capital goods they require may be completely different.”
In a world of disequilibrium, entrepreneurs continually have to regroup their capital combinations in response to changes of all kinds, present and expected, on the cost side as well as on the market side. A change in the mode of income distribution is merely one special case of a very large class of cases to which the entrepreneur has to give constant attention. No matter whether switching or reswitching is to be undertaken, or any other response to market change, expectations play a part, and the individuality of each firm finds its expression in its own way. Yet only “reswitching” has of late attracted the interest of theoreticians. There is more in the world of capital and markets than is dreamt of in their philosophy.
Capital and Time; A Neo-Austrian Theory (Oxford: Clarendon Press, 1973), p. 12.
A History of Economic Analysis (New York: Oxford University Press, 1954), p. 847.
Quarterly Journal of Economics 80(November 1966):568-83.
Capital and Time, p. 45.
The Collected Works of Carl Menger, ed. Friedrich A. Hayek, 4 vols.(London: London School of Economics, 1936)3: 135-83.
Capital and Time, p. 12.
Economic Journal 79(September 1969):523.
Part 3, Essay 4, Toward a Critique of Macroeconomics