The Importance of Capital in Economic Theory

However, the classical understanding of capital and its place in economic theory was muddled. Even though it was refined in light of the new marginal productivity theory of pricing, the increasing formalism of economics in the 20th century led many economists to lose the new insights.

This article outlines these developments and explains why many of today’s economists would benefit from a better understanding of the nature of capital. The issue is important not just for the basic theory of income distribution, but also for understanding complex topics such as business cycles.

Capital Defined

A standard definition of capital is “produced means of production,” which is a physical concept. However, economists also use the term “capital” to mean a sum of money. Thus, there is a crucial distinction between financial capital and capital goods. Economists often use the same term, “capital,” to refer to either concept. For example, the owner of a laundromat might say, “I have $300,000 of capital invested in my business.” She means that if she sold all of the business’s assets and paid off all of its liabilities (such as a mortgage on the property held by the bank), she would be left with $300,000 in money. Here, “capital” obviously is a financial concept involving market prices and is denominated in money units.

However, an economist might say, “In addition to the two workers and the land on which the building sits, the laundromat uses capital in the form of the washing machines, the dryers, and the vending machines that dispense detergent and dryer sheets.” In this case, “capital” means physical goods, and these cannot be aggregated into a single number.

The distinction between financial capital and physical capital goods is crucial and underscores all the issues to follow.

Interest is NOT the Return to Physical Capital

The classical economists had a three-fold classification for income and the factors of production: Land earned rent; labor earned wages; and capital earned interest (or profit). This classical scheme survives to this day: In everyday language, “rent” is what a person pays to the landlord; “wages” are the income accruing to workers selling their labor services; and, in many economic models, interest is equal to the “marginal product of capital.”

However, as economists such as Frank Fetter and Irving Fisher have pointed out, these neat classifications collapse in light of modern price theory.1 For example, suppose that a real estate tycoon owns a large plot of farmland that he rents out to sharecroppers for $100,000 per year. Clearly, those annual payments of $100,000 are “rents” and are due to the marginal productivity of the land.

However, suppose that the market price of the land is $1 million. Therefore, if the owner continues to hold the land (rather than selling it outright) and merely rents it out, the landlord is implicitly investing $1 million of his financial capital in the piece of real estate, on which he is earning a 10-percent return. If very safe, long-term bonds were yielding 12 percent, the owner might seriously consider selling his real estate and switching his (financial) capital into the bonds, where it would earn a higher return. Judged from this perspective, then, it seems that even the sharecroppers’ annual payments to a landlord are a particular form of interest income. This simple example shows that it is wrong to view “interest” as a particular type of income that accrues only to the owners of physical capital goods; interest accrues to the owner of pure land, too, as a percentage rate of return on the “capitalized present value” of the land.

Interest is NOT the “Marginal Product of (Physical) Capital”

Although the example in the previous section seems simple enough, its lesson is relevant even for today’s PhD economists. Relying on simplified mathematical models, they have been taught that in a competitive market economy, the real interest rate equals the “marginal product of capital,” just as surely as the real wage rate equals the “marginal product of labor.”

The logic here is straightforward: If a firm hires a worker for an additional hour, its output will increase by a certain amount. If the labor market is competitive, the firm must pay the worker a wage corresponding to the market value of this increment in the firm’s physical output.

By the same token—as modern economists typically reason—if the firm hires an extra unit of capital, then physical output will increase, and so the firm must pay the owners of this capital an interest payment corresponding to the market value of this increment in physical output.

However, this typical logic confuses physical capital goods with financial capital. If a firm hires a specific capital good for a unit of time, the payment is the rental price of the capital good. For example, suppose that a warehouse pays $100,000 per year to an independent company that maintains fleets of forklifts. These annual payments are clearly due to the “marginal product” of the forklifts; the warehouse can sell more of its own services to its customers when it has use of the forklifts.

However, these technological facts tell us nothing about the rate of interest enjoyed by the owners of the forklifts. In order to determine that, we would have to know the market price of the forklifts. For example, if the forklifts that the independent company rents out to the warehouse could be sold on the open market for $1 million, then their owners would enjoy a 10-percent return each year on their invested capital. But if the forklifts could be sold for $2 million, then the $100,000 payments—due to the “marginal product” of the forklifts—would correspond to only a 5-percent interest rate. As this simple example illustrates, knowledge of the marginal product of capital, per se, does not allow us to pin down the rate of interest. The relationship between the productivity of capital and the interest rate is not directly analogous to the relationship between the productivity of labor and the wage rate.2

Application to Business Cycles

The reflections in this essay, thus far, may seem to be theoretical or “philosophical” curiosities with little practical application. However, the failure to appreciate the heterogeneous nature of the economy’s capital structure can lead to serious policy mistakes.

Consider the policy arguments over the business cycle. Many free-market economists embrace “Real Business Cycle” (RBC) theory, which holds that the typical business cycle is due to “real” shocks to the fundamentals of the economy, such as technology or resource supplies. In RBC models, recessions are actually the “optimal” response to these real shocks, and government interventions (through monetary or fiscal “stimulus”) will only hinder the economy’s adaptation to the new information.3

Although formal RBC models are internally consistent and obey “rational expectations,” many economists find them implausible in explaining real-world recessions. Keynesian economists chortle at the attempt to characterize long periods of high unemployment and other idle resources as a “rational” response to the underlying fundamentals. To illustrate just how silly they think the RBC approach is, Keynesians will refer sarcastically to the Great Depression as “the Great Vacation.”4 Their point is that the 1930s were clearly marked by a deficiency in Aggregate Demand, rather than workers “optimally” choosing to withdraw their labor from the market in response to new information.

Keynesians have another line of attack against the attempt of some free-market economists to explain recessions as an “optimal response” to new information about the fundamentals.5 When there is a financial crash, and people suddenly realize that they aren’t as wealthy as they previously thought, then isn’t the optimal response to work more? Sure, we can come up with a model in the spirit of RBC that “works,” but doesn’t it defy common sense? Keynesians often point out that the U.S. had the same number of (or more!) workers and machines in 2009 as it did in 2008; there was no technological reason that actual GDP needed to fall so much because “potential GDP” should have risen on the original trajectory.6

Framed in terms of macroeconomic aggregates, the Keynesians do seem to have a strong case against the RBC theorists and other free-market economists who think the economy should be “left alone to sort things out” during a recession. If we use a model that represents the capital stock by a single number (call it “K”), then it’s hard to see why a boom period should lead to a “hangover” recessionary period. Yet if we adopt a richer model that includes the complexities of the heterogeneous capital structure, we can see that the “excesses” of a boom period really can have long-term negative effects. In this framework, it makes sense that after an asset bubble bursts, we would see unusually high unemployment and other “idle” resources, while the economy “recalculates,” to use Arnold Kling’s metaphor.7

Mises’s Analogy of a Master Builder

The best way I know to explain the relevance of capital theory to business cycles is based on Ludwig von Mises’ analogy of a master builder, which I adapt and extend for our purposes.8

Imagine a master builder who has a collection of bricks, shingles, panes of glass, lumber, workers, and other inputs. Based on his information, he draws up blueprints for a grand house. However, his blueprints assume that he has 10,000 bricks at his disposal, when, in reality, he has only 9,000. This “investment project” is physically unsustainable. No matter what he does, the builder will not be able to complete the house depicted in the blueprints.

Now suppose that the workers realize this discrepancy at some point. They consider telling the master builder, but they don’t want to upset the optimism of the work site. Look how happy all the carpenters and bricklayers are! It would be a terrible blow to morale to reveal the terrible reality. So the underlings use tarps and other devices to keep the housing project alive.

Nonetheless, at some point, the illusion must break. The moment the master builder realizes that there is a 1,000-brick discrepancy between his blueprints and the physical stockpile, his immediate reaction will be to yell to all the subcontractors, “STOP WORKING!”

The master builder will then survey the house-in-progress and the available virgin materials. He will alter the blueprints in order to make the best house possible, in light of the “malinvested” resources during the artificial period. Once he redesigns the blueprints, the idle workers on the site only gradually reintegrate into the construction process. For example, to get the work site ready for a general resumption of activities, certain key tasks might need to be performed first. In addition, some specialized workers—perhaps the guy who knows how to install Jacuzzis—might end up being quite superfluous in the revised, more-modest blueprint.

To broaden the analogy, note that prolonging the artificial “housing boom” only makes the “bust” period that much worse, as more and more resources become locked into specific configurations, as conceived in an unattainable blueprint. Moreover, once the error becomes manifest, the optimal response is an immediate halt in production. Workers and other resources become idle and only gradually return to work. This outcome occurs because of the role that capital goods play; it has nothing to do with the workers’ preferences for leisure or a change in technology. Thus, the standard RBC story, when embedded in a model with a heterogeneous capital structure, is much more plausible as a diagnosis of, say, the actual U.S. housing bubble and crash.

Conclusion

Although capital plays a central role in economic theory and in the world, many economists have historically given it insufficient attention. Even economist Piketty’s bestselling book explicitly devoted to capital still relies on a very simplistic conception of capital as a single aggregate. A proper appreciation of the heterogeneous structure of capital shows the weakness in standard theoretical approaches, which employ “simplifications for analytical convenience” that actually obscure the economic reality. To cite just two benefits, the more nuanced appreciation of capital clarifies important questions of income distribution and also provides a much more compelling explanation of the possible limitations of monetary and fiscal policy in boosting employment during recessions.