The Foundations of Modern Austrian Economics

Part 3, Essay 4

On Austrian Capital Theory

by Ludwig M. Lachmann

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”?
*35

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.

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.

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 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.”
*41

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.