Mises Daily Articles
The Abstinence Theory of Interest
In a previous article, I explained Eugen von Böhm-Bawerk's conception of the "interest problem." Specifically, why could a capitalist earn an effortless flow of real wealth, year after year, from his fund of capital? To state the problem in an equivalent form, why is it that a capitalist can spend, say, $1,000 on labor and raw materials, in order to create a product that will sell in one year for $1,100? Why don't the prices of the inputs get bid up to the full $1,100, eliminating the dividend reaped by the capitalist?
In my earlier article, I gave Böhm-Bawerk's solution: Present goods are more subjectively valuable than future goods, and hence the market price of a present good is higher than the price for a claim on the same good to be delivered in the future. (For example, people might pay $1,100 for a computer available today, but they might pay only $1,000 now for a computer that will be delivered in one year.)
Although I eventually explained Böhm-Bawerk's solution, I first outlined his famous refutation of the "naïve productivity theory" of interest. As most Austrians are well aware, the naïve productivity theory explained the interest return to capitalists by the fact that capital is productive. People can produce more with capital goods than without them, and so (the naïve productivity theorist argued) it is perfectly sensible that a capitalist who invests $1,000 in capital goods can sell their eventual product for $1,100, since the capital goods have increased the quantity (and hence value) of the final product.
Böhm-Bawerk's famous critique of this theory was brilliant in its own right, and laid the foundation for the modern Austrian "pure time preference theory" of interest. (See my previous article, linked above, for more details.) However, the naïve productivity theory was only one of many theories that Böhm-Bawerk exploded in Vol. I (History and Critique of Interest Theories) of his collection, Capital and Interest. In this essay I will deal with a completely different explanation, the "abstinence theory" of interest, and with Böhm-Bawerk's characteristically brilliant refutation of it.
The Abstinence Theory of Interest
Let us first review the phenomenon to be explained: Why is it that a capitalist can apparently spend a certain amount of money on factors of production (land, labor, capital goods), combine them according to a technological recipe in order to yield a physical product, and then sell this product for more money than he originally spent on the inputs? Why doesn't competition between producers drive up the prices of the inputs, until the total costs of production for any good exactly equal the sale price of the good?
The abstinence theory (best articulated by Nassau Senior) explained this empirical regularity by the existence of a missing factor of production. Once we account for this missing factor, and for the price it must be paid, then the final price of the product does exactly equal the total costs of its production.
Senior held that alongside the original factors of land and labor stood another factor, abstinence, which he defined as "the conduct of a person who either abstains from unproductive use of what he can command, or designedly prefers the production of remote to that of immediate results" (qtd. in Böhm-Bawerk p. 180).
In Senior's view, recognition of the factor of abstinence would explain the interest return to capitalists. Just as labor is an essential input for production, so too is it necessary that capitalists abstain from consuming their capital in order to finance production. The laborers receive wages for their contribution, and the capitalists receive interest payments for theirs. Just as the laborers must be compensated for their irksome (yet essential) toil, so too must the capitalists be compensated for their unpleasant (yet essential) abstinence from present enjoyments.
Contrary to his treatment of most other authors, Böhm-Bawerk was very sympathetic with Senior's theory. This is not surprising, since Senior's theory is quite similar to Böhm-Bawerk's own. Despite this similarity, Böhm-Bawerk nonetheless thought the abstinence theory was flawed: "I consider it an error in logic to present the renunciation of gratification, or abstinence in the abstract, as a second and independent sacrifice, apart from the labor that is sacrificed in production" (p. 184, italics original).
Before proceeding, let us be clear as to why this observation (if correct) would prove fatal to Senior's theory. Recall that Senior is claiming that a final product sells for more than the costs of labor and materials that went into its construction, because in addition to these costs we must consider the costly abstinence on the part of the capitalist. In other words, when scarce resources are devoted to a product that will not be available until a delay of one year, the true economic cost of this decision is the value of the resources plus the psychic discomfort of the capitalists who must postpone consumption for twelve months.
Now, if Böhm-Bawerk is correct, then this explanation involves a double counting. That is, the cost of abstinence (if it exists) is already included in the cost of the other factors of production. Thus Senior's theory is faulty. He has not explained the higher price of final goods relative to their costs of production, because his alleged missing component of abstinence is already accounted for.
In order to clarify his observation, Böhm-Bawerk constructs a simple example, a version of which I will now offer: Suppose that a man must decide what to do with his day of labor. He can devote it to a project that will yield its result immediately (at the end of the day), or he can devote his labor hours to a project that will not yield its results until some future date. Suppose that if the man devotes his day to fishing, in the evening he will have 10 fish to show for it. On the other hand, imagine that if the man devotes his day of labor to planting apple seeds, he will have 100 apples to show for it but only after waiting one decade.
In this scenario, asks Böhm-Bawerk, what is the true cost of either decision? It is clear that the cost of obtaining the fish is one day of labor. (Thus, the equilibrium price of 10 fish must be equal to a day's wages, since any entrepreneur can hire a man for a day and then have 10 fish.)
But what if the man decides to plant the apple seeds? According to Senior, the full cost of the apples is not merely a day's labor, but a day's labor plus a decade of uncomfortable abstinence. In other words, if the man wants apples, not only must he toil and sweat for a day planting seeds, but he must also wait a decade before seeing the fruits of his labor. (Thus, the equilibrium price of 100 apples would be more than a day's wages, because an entrepreneur would have to pay a worker his wages upfront, but then wait a decade before recouping his investment.)
Unfortunately, such reasoning is simply wrong. The cost of a decision is always the subjective value placed on the next-best alternative. If the next-best alternative to working all day to catch fish is to simply relax, then the cost of catching the fish is the value our hypothetical man places on a day's leisure. In the same way, if the man desires apples and detests fish, then the cost of his decision to plant apple seeds is again the value of a day's leisure.
When reckoning the cost of planting the seeds, our man should not consider the delay in the availability of the apples. On the contrary, the decade-long delay influences the benefits of the decision to plant the seeds. This is where the time element truly comes in, through the value placed (at the moment of decision) on present fish versus future apples. Senior has tried to deal with the time element in the wrong place, so to speak.
Even though this refutation is perfectly sound, Böhm-Bawerk acknowledges that it doesn't quite leave the reader convinced. The abstinence theory seems so compelling; surely it must be basically correct! In order to alleviate the doubts of his reader, Böhm-Bawerk offers the following, devastating argument.
In reference to our scenario above, Senior (we recall) must argue that the cost associated with obtaining the fish is a day's labor, while the cost of obtaining the apples is a day's labor plus a decade of abstinence. Now, Böhm-Bawerk says, suppose that our man chooses in favor of the apples, and devotes his day to planting seeds. That evening, a great storm comes and completely ruins his field.
In this unfortunate case, what is the cost of the man's decision to plant the seeds? It is quite clearly one day's labor: the man has wasted a day toiling, and now (because of the storm) has nothing to show for it. He could have spent the day relaxing, and would have been in the same position after the storm. Since there will now be no apples forthcoming, the mental anguish associated with waiting for their arrival forms no part of the costs of his decision to plant the seeds.
But if this is true, Böhm-Bawerk asks, how can it possibly be that without the storm, the cost of the man's decision involves his abstinence for one decade? Indeed, if the decision to plant seeds is more costly because of the ten-year delay, then the decision to plant seeds must be infinitely costly after the storm, since now the man will have to wait for all of eternity to reap the fruits of his decision!
Of course this type of reasoning is fallacious. As the storm example so clearly illustrates, the discomfort of waiting is not an additional cost that must be included with the labor expended on a roundabout production process. The next-best use of a resource is the same, regardless of the date of availability of the end to which the resource is devoted.
We have seen that Nassau Senior's abstinence theory of interest, though superficially plausible, could not withstand the withering scrutiny of Eugen von Böhm-Bawerk. Senior was on the right track; individuals do take into account the length of various possible production techniques. However, this consideration influences the (present) value placed on the final output goods to be consumed; it does not influence the cost of expending resources in the present.
When an entrepreneur invests in factors of production that will yield consumption goods in one decade, he earns an interest dividend because presently available goods have a higher subjective value than future goods. When he purchases the factors of production, he really is exhausting the full market price of the consumption goods that they will eventually yield. However, at the moment when he actually buys the factors, those consumption goods are only future goods, and consequently their market price at that moment is less than what their market price will be when the entrepreneur actually sells them to consumers. In short, the entrepreneur is only paying for land, labor, and capital goods. He does not need to buy an additional input called "abstinence."