The Economics of Ludwig von Mises: Toward a Critical Reappraisal

Ludwig von Mises and

The Theory of

Capital and Interest

Israel M. Kirzner

Students of Misesian economics often agree that the theory of capital and interest occupies a central and characteristically Austrian position in the general Misesian system. That is the reason Frank H. Knight, in his lengthy and critical review article of the first complete exposition of that system,
*82 chose to concentrate on “the theory of capital and interest” after deciding to confine his review to “some one main problem which at once is peculiarly central in the structure of theory, and on which [his] disagreement with the author reaches down to basic premises and methods.”
*83 In that article Knight identified Mises as the foremost exponent of the Austrian position on capital and interest. In a 1945 article Friedrich A. Hayek also alluded to Mises as the most thoroughgoing among the Austrians on these problems.
*84

And yet, in his published works, Mises appears to have devoted little attention to the theories of capital and interest until relatively late in his career. His influence on these matters was largely confined to his oral teaching and seminar discussions. As late as 1941 (presumably without having seen Mises’
Nationalökonomie, published in 1940), Hayek remarked in his
Pure Theory of Capitalthat, while Mises’ “published work deals mainly with the more complex problems that only arise beyond the point at which [this book]
ends,” Mises had nonetheless “suggested some of the angles from which the more abstract problem is approached [in this book].”
*85

Apart from a 1931
Festschrift paper on inconvertible capital,
*86 Mises’ published work on capital and interest prior to 1940 is confined (apart from casual
obiter dicta) to a few brief pages in his
Socialism*87 On the other hand, there is an intriguing, somewhat cryptic footnote in the second (1924) edition of his
Theory of Money and Credit*88 It makes clear that since 1912 Mises (1) had given much critical though to the theory of interest, (2) now considered Eugen von Böhm-Bawerk, while “the first to clear the way that leads to understanding of the problem,” nonetheless to have presented a theory that was
not satisfactory, and (3) hoped to publish “in the not-too-distant future” his own special study of the problem. It is certainly unfortunate that Mises never published such a study and that we are forced to rely on a relatively meager collection of scattered remarks in his larger works in order to understand what he considered unsatisfactory about Böhm-Bawerk’s position. Fortunately, while his later works do not include a detailed critical discussion of Böhm-Bawerk’s writings, they do provide us with a complete theoretical treatment of the problems of capital and interest, thereby justifying Knight’s claim that the theory of capital and interest occupies a central position in the Misesian system. In what follows I shall first summarize Mises’ own views on the problems of capital and interest and then discuss the extent to which his views differed from those of Böhm-Bawerk and knight. In so doing we shall discover that Mises’ later position is, as was noted by both Knight and Hayek, characteristically and consistently Austrian.

1.
MISES ON CAPTAL AND ON INTEREST:

a. Interest is
not the specific income derived from using capital goods;
*89 nor is it “the price paid for the services of capital.”
*90 Instead,
interest expresses the universal (“categorial”) phenomenon of time preference and will therefore inevitably emerge also in a pure exchange economy without production.

d.
Capital goods are produced factors of production; they are “intermediary stations on the way leading from the very beginning of production to its final goal, the turning out of consumer’s goods.”
*91

e. It is decidedly
not useful to define
capital as the totality of capital goods. Nor does the concept of a
totality of capital goods provide any insight into the productive process.

f. Capital goods are the results of earlier (i.e., higher) stages of production and therefore are not factors of production in their own right apart from the factors employed in their production. Capital goods have no productive power of their own that cannot be attributed to these earlier productive factors.

In his discussions about capital and interest, Mises did not, to any extent, name the specific authors with whom he took issue. As Knight observed (with respect to the entire volume that he was reviewing) Mises’ exposition of capital and interest “is highly controversial in substance, and in tone, though the argument is directed toward positions, with very little debate or
Auseinandersetzung with named authors.”
*92

2.
MISES AND THE BÖHM-BAWERKIAN THEORY

We have already seen that, as early as 1924, Mises had indicated dissatisfaction with Böhm-Bawerk’s theory. This may come as a surprise to those who—quite mistakenly—believe that the Austrian position on most questions of economic theory, and especially on the theory of capital and interest, is a monolithic one. The truth of the matter is that, while the suggestive brilliance of Böhm-Bawerk’s contribution won international recognition as typifying the work of the Austrian school, it was by no means acceptable to other leading representatives of that school. It is by now well known, as reported by Joseph A. Schumpeter, that Carl Menger considered Böhm-Bawerk’s theory of capital and interest to have been “one of the greatest errors ever committed.”
*93 Referring specifically not only to Menger but also to Friedrich von Wieser and Schumpeter himself, Hayek remarked that those “commonly regarded as the leaders of the ‘Austrian School’ of economics” did not accept Böhm-Bawerk’s views.
*94 So we should not be overly surprised at Mises’ disagreement with his own mentor’s teachings.

Mises’ disagreements with the Böhm-Bawerkian theory reflect a consistent theme. Mises was concerned with distilling Böhm-Bawerk’s basic ideas from the nonsubjective, technical, and empirical garb in which they had been presented. Mises tried to show
that Böhm-Bawerk’s basic ideas flowed smoothly out of his own praxeological approach, or, in other words, that they could be cast in a strictly subjectivist mold. Knight (correctly) characterized Mises as taking an extreme Austrian position on interest by refusing to attribute any explanatory role to the objective, or physical, conditions governing production in a capital-using world. As the Austrian theory of value depends on utility considerations, with no recognition accorded objective costs, so, too, Knight explained, the Misesian theory of interest depends entirely on subjective time preference, with no influence attributed to physical productivity.
*95One is reminded of Hayek’s penetrating comment concerning the nature of Mises’ contribution to economics. Remarking that “it is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism,”
*96 Hayek cited Mises as the economist who most consistently carried out this subjectivist development: “Probably all the characteristic features of his theories…follow directly…from this central position.”
*97 More specifically, Mises’ theory of capital and interest is in disagreement with Böhm-Bawerk’s on the following points:

a. On the role of time: Mises, while paying tribute to the “imperishable merits” of Böhm-Bawerk’s seminal role in the development of the time-preference theory, sharply criticized the epistemological perspective from which Böhm-Bawerk viewed time as entering the analysis. For Böhm-Bawerk time preference is an empirical regularity observed through casual psychological observation. Instead, Mises saw time preference as a “definite categorical element…operative in every instance of action.”
*98 In Mises’ view, Böhm-Bawerk’s theory failed to do justice to the universality and inevitability of the phenomenon of time preference. In addition, Mises took Böhm-Bawerk to task for not recognizing that time should enter analysis only in the
ex ante sense. The role that time “plays in action consists entirely in the choices acting man makes between periods of production of different length. The length of time expended in the past for the production of capital
goods available today does not count at all….The ‘average period of production’ is an empty concept.”
*99 It may be remarked that here Mises identified a source of perennial confusion concerning the role of time in the Austrian theory. Many of the criticisms leveled by Knight and others against the Austrian theory are irrelevant when the theory is cast explicitly in terms of the time-conscious,
forward-looking decisions made by producers and consumers.
*100

b. On the role of productivity: As already mentioned, Mises sharply deplored the concessions Böhm-Bawerk made to the productivity theorists. To Mises it was both unfortunate and inexplicable that Böhm-Bawerk, who in his critical history of interest doctrines had “so brilliantly refuted” the productivity approach, himself fell, to some extent, into the same kinds of error in his
Positive Theory. There is some disagreement in the literature on the degree to which Böhm-Bawerk in fact allowed productivity considerations to enter his theory. The issue goes back at least to Frank A. Fetter’s remark in 1902 that it “has been a surprise to many students of Böhm-Bawerk to find that he has presented a theory, the most prominent feature of which is the technical productiveness of roundabout processes. His criticism of the productivity theories of interest has been of such a nature as to lead to the belief that he utterly rejected them….[But] it appears from Böhm-Bawerk’s later statement that he does not object to the productivity theory as a partial, but as an exclusive, explanation of interest”.
*101 Much later Schumpeter insisted that productivity plays only a subsidiary role in what is in fact wholly a time-preference theory.
*102 It is of some interest to note that when Böhm-Bawerk considered the alternative roles for productivity in a time-conscious theory, he came out squarely for an interpretation that placed productivity and “impatience” on the same level.
*103 Böhm-Bawerk made it very clear that he was not willing to identify his position with that of Fetter, who espoused a time-preference theory of interest without any mention of productivity considerations. Böhm-Bawerk remarked that “Fetter himself espouses a [theory which] places him on the outer-most wing of the purely ‘psychological’ interest theorists—
‘psychological’ as opposed to ‘technical.’ He moves into a position far more extreme than the one I occupy….”
*104

Certainly Mises offered a theory of interest fully as “extreme” as the one developed by Fetter. Later we shall consider Mises’ denial that capital productivity has any role in interest theory.

c. On the definition of capital: Böhm-Bawerk defined capital as the aggregate of intermediate products (i.e., of produced means of production)
*105 and in so doing was criticized by Menger.
*106 Menger sought “to rehabilitate the abstract concept of capital as the money value of the property devoted to acquisitive purposes against the Smithian concept of the ‘produced means of production.'”
*107 As early as his work on
Socialism (1923), Mises emphatically endorsed the Mengerian definition.
*108 In
Human Action he pursued the question even more thoroughly through without making it explicit that he was objecting to Böhm-Bawerk’s definition. Economists, Mises maintained, fall into the error of defining capital as
real capital—an aggregate of physical things. This is not only an “empty” concept but also one that has been responsible for serious errors in the various uses to which the concept of capital has been applied.

Mises’ refusal to accept the notion of capital as an aggregate of produced means of production expressed his consistent Austrian emphasis on forward-looking decision making. Menger had already argued that “the historical origin of a commodity is irrelevant from an economic point of view.”
*109 (Later Knight and Hayek were to claim that emphasis on the historical origins of produced means of production is a residual of the older cost-of-production perspectives and inconsistent with the valuable insight that bygones are bygones.
*110) Thus, Mises’ rejection of Böhm-Bawerk’s definition reflects a throughgoing subjective point of view.

In addition, Mises’ unhappiness with the Böhm-Bawerkian notion of capital is due to his characteristically Austrian skepticism toward economic aggregates. As Mises wrote, “[The] totality of the produced factors of production is merely an enumeration of physical quantities of thousands and thousands of various goods. Such an inventory is of no use to acting. It is a description of a part of the universe in terms of technology and topography and has no
reference whatever to the problems raised by the endeavors to improve human well-being.”
*111 Lachmann suggested that a similar objection to the questionable practice of economic aggregation may have been the reason for Menger’s own sharp disagreement with Böhm-Bawerk’s theory.
*112

In place of the Böhm-Bawerkian notion of capital, Mises took over Menger’s definition of the term. Thus, in
Human Action, Mises emphasized at great length that the measurement of capital has significance only for the role it plays in economic calculation. The term denotes, therefore, an accounting concept and depends for its measurement upon a system of market prices: Mises explained that “the capital concept is operative as far as men in their actions let themselves be guided by capital accounting.”
*113 At another places Mises wrote: “Capital is the sum of the money equivalent of all assets minus the sum of the money equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit.”
*114 It follows, in Mises’ words, that capital “is inescapably linked with capitalism, the market economy. It is a mere shadow in economic systems in which there is no market exchange and no money prices of goods of all orders.”
*115 We shall return to several implications of Mises’ substitution of the Mengerian capital concept for Böhm-Bawerk’s definition.

3.
MISES AND THE CLARK-KNIGHT TRADITION

If Mises’ writings on capital and interest diverge from Böhm-Bawerk’s theory, they certainly imply a total rejection of the principal alternative to that tradition, the approach developed in the writings of both Clark and Knight. The Clark-Knight concept of capital and the productivity theory of interest came under sharp attack in Mises’ major (later) works. As we have mentioned, Knight’s review article of Mises’
Nationalökonomie consisted almost entirely of an attack on Mises’ theory of capital and interest, coupled with a restatement and clarification of his [Knight’s] own position. By enumeration Mises’ various objection to the Clark-Knight view,
we acquire, at the same time, a more complete understanding of Mises’ disagreement with Böhm-Bawerk. The reason is that the Knightian theory of interest is, as Knight proclaimed, completely opposed to the “absolute Austrianism” of Mises’ approach. And what Mises found objectionable in Böhm-Bawerk’s theory were, again, just those points in it which he saw as incompatible with a consistently Austrian perspective. So that it is entirely understandable why Mises’ position with regard to Böhm-Bawerk’s theory is clarified by his criticisms of Clark’s and Knight’s views. We may group Mises’ objections to the Clark-Knight position as follows:

a. The Clark-knight concept of capital: Mises had little patience with the notion of capital as a self-perpetuating fund, which he (and others) declared to be sheer mysticism.
*116 “An existence,” Mises wrote, “has been attributed to ‘capital,’ independent of the capital goods in which it is embodied. Capital, it is said, reproduces itself and thus provides for its own maintenance….All that is nonsense.”
*117

It is easy to see how foreign the motion of the “automatic maintenance of capital” must have appeared to Mises. An approach that concentrates analytical attention—as Austrian economics does—on the purposive and deliberate decisions of individual human beings when accounting for all social economic phenomena must treat the notion of capital as a spontaneously growing plant as not merely factually incorrect but simply absurd.
*118 Moreover Mises sensed that such Knightian ideas can lead men to quite dangerous mistakes in public policy, when they ignore the institutional framework and incentive system needed to encourage those deliberate decisions necessary for maintaining the capital stock and enhancing its continued growth.
*119

The Misesian critique of the Clark-Knight view and his endorsement of the Mengerian capital concept suggest what Mises might have said about Hicks’ recent classification of the views of economists concerning the aggregate of productive assets as being either “fundist” or “materialist.”
*120 Mises would have rejected a fundism that, by submerging the separate physical capital goods.
ends up concentrating on some supposed quality apart from the goods themselves. He would have argued that the recognition of the time-conscious plans of producers does not require that we submerge the individualities of these goods into, say, a notion such as the average period of production. And, as we have seen, he rejected out of hand the Clarkian view—in Hicks’ opinion a “materialist” view—that, by abstracting from the multiperiod plans needed to generate output with capital goods, sees these goods spontaneously generating perpetual flows of net income. In fact, Mises would argue, the entire fundist-materialist debate is predicated on the quite unfortunate practice of directing attention to the aggregate of physical goods. The only useful purpose for a capital concept consists strictly in its accounting role as a tool for economic calculation—a role enormously important for the efficient operation of a productive economy. It was, Mises would insist, Böhm Bawerk’s failure to see all this (and his willingness to accept the basis for a fundist-materialist debate) that lent credence to a Clark-Knight view of the real-capital concept,. Which implied the mythology of a kind of fundism (“perpetual capital”) that Böhm-Bawerk himself did
not accept. In rejecting Böhm-Bawerk’s definition of capital in favor of the Mengerian definition, Mises rendered the Hicksian classification inapplicable to his own work.

b. Trees and fruit: Mises’ adoption of Menger’s concept of capital made it possible for him, to avoid the pitfalls in interest theory that stem from the
capital-income dichotomy. In everyday lay experience the ownership of capital provides assurance of a steady income. As soon as capital is identified as some aggregate of factors of production, it becomes tempting to ascribe the steady income that capital ownership makes possible as somehow expressing the
productivity these factors. This has always been the starting point for productivity theories of interest. Knight’s permanent-fund-of-capital view of physical capital is simply a variant of those theories that view of physical capital is simply a variant of those theories that view interest as net income generated perpetually by the productivity of the abstract capital temporarily embodied in particular lumps of physical capital. The capital stock, in this view, is a permanent tree that spontaneously and continuously produces fruit
(interest)
*121 Mises was explicit in concluding that this erroneous view of interest results from defining capital as an aggregate of produced factors of production. “The worst outgrowth of the use of the mythical notion of real capital was that economists began to speculate about a spurious problem called the productivity of (real) capital.” It was such speculation, Mises made clear, that is responsible for the “blunder” of explaining “interest as an income derived from the productivity of capital.”
*122

The Mengerian concept of capital as an accounting tool enables us to steer clear of such blunders. The accounting concept comes into play only as reflecting a particular motive that calculating human beings display: “The calculating mind of the actor draws a boundary line between the consumer’s good which he plans to employ for the immediate satisfaction of his wants and the goods…which he plans to employ for providing by further acting, for the satisfaction of future wants.”
*123 There is no implication whatsoever that the flow of income thus achieved for consumption purposes—through the careful deployment of capital—is the automatic fruit of the productivity of capital.

c. The structure of the productive process: Perhaps at the core of Mises’ rejection of the Clark-Knight productivity theory of interest lies his wholehearted support of the Mengerian insight that the productive process consists of deploying goods of higher order toward the production of goods of lower order. “It is possible to think of the producers’ goods as arranged in orders according to their proximity to the consumers’ good for whose production they can be used. Those producers’ goods which are the nearest to the production of a consumers’ good are ranged in the second order, and accordingly those which are used for on the production of goods of the second order, in the third order and so on.”
*124 The purpose of such a scheme of classification is to demonstrate “how the valuation and the prices of the goods of higher orders are dependent on the valuation and the prices of the goods of lower orders produced by their expenditure.
*125This fundamental approach to the pricing of productive factors is able, Mises explained, to lay aside the reasoning of the productivity theorists.
The prices of capital goods mustreflect the services expected from their future employment.*126 In the absence of time preference the price of a piece of land (or of a capital good)—that is, the price in terms of consumer goods—would equal the undiscounted sum of the marginal values of the future services attributed to it. The productive capacity of a factor cannot (without time preference) account for a flow of interest income on its market value. The phenomenon of interest arises because, as a result of time preference, factor prices reflect only the
discounted values of their services. “As production goes on, the factors of production are transformed or ripen into present goods of a higher value.”
*127 For Mises, the important economic characteristic of capital goods is not merely that they can be employed in future production, but that the relationship they bear to their future products is one of higher-order goods to goods of lower order. It is this factor that vitiates the productivity theory.

Knight’s refusal to grant merit to this reasoning must be seen as a consequence of rejecting Menger’s position that factors of production are really
higher-order goods. “Perhaps the most serious defect in Menger’s economic system…is his view of production as a process of converting goods of higher order into goods of lower order.”
*128 Because of Knightian view of the productive process emphasizes the reptitive “circular flow” of economic activity while denying the paramount importance of a
structural order linked to final consumer demand, it is possible to simply ignore the Austrian critique of the productivity theory of interest. In essence, that is what Knight did.

4.
MISES, CAPITALISTS, AND ENTREPRENEURSHIP

One final observation concerning Mises’ theory of capital and interest is in order. At all times Mises stressed what he termed the “integration of catallactic functions” that takes place in the real world. Real-world capitalists, Mises constantly reminds us, must of necessity—like landowners, laborers, and consumers—be also
entrepreneurs.“A capitalize [besides investing funds] is always also vir-
tually an entrepreneur and speculator. He always runs the chance of losing his funds.”
*129 It follows that “interest stipulated and paid in loans includes not only originary interest but also entrepreneurial profit.”
*130

In other words, entrepreneurship exists in capital-using production processes, not only in the usual sense that an entrepreneur-producer borrows or otherwise assembles capital as part of his entrepreneurial function, but also in the more subtle sense that the capitalists themselves, in lending their capital to entrepreneur-producers, are necessarily acting “entrepreneurially.” while this does not prevent us from analytically isolating the pure capitalist and pure entrepreneurial functions, it does mean that in the real world ordinary interest and entrepreneurial profit are never found in isolation from one another.