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Time Is Money: Capital and Interest

[The Austrian School of Economics: A History of Its Ideas, Ambassadors, and Institutions (2011)]


The up-and-coming Austrian School received support from abroad even during the Methodenstreit. Léon Walras mentioned already well-known supporters of the new value theory from among the Romance countries in the preface to his Théorie de la monnaie (1886). In English publications, the subjectivist theory of value was gaining increased acceptance as well (cf. Böhm-Bawerk 1889b). The fact alone that it had been discovered at almost the same time by three authors (Walras, Menger, and Jevons) was considered by Böhm-Bawerk to be substantive evidence of its veracity (Böhm-Bawerk 1891/1930, p. 132 n. 1). In contrast, Gustav Cohn (1840–1919), an advocate of the Historical School, interpreted this brisk publishing activity to mean that the discovery of the marginal utility constituted a "meager morsel" that would have to be shared by "a number of like-minded discoverers" (Cohn 1889, p. 23).

Yet within months, the derisive phrase "meager morsel" was impressively refuted. In 1889 alone, members of the Austrian School published a notable number of monographs offering productive suggestions for further development: Böhm-Bawerk, Positive Theorie des Kapitales (Positive Theory of Capital); Zuckerkandl, Zur Theorie des Preises ("On the Theory of Price"); Wieser, Der natürliche Wert (Natural Value); Schullern zu Schrattenhofen, Untersuchungen über Begriff und Wesen der Grundrente ("Analyses of the Concept and the Essence of the Ground Rent"); Sax, Neueste Fortschritte in der nationalökonomischen Theorie ("Recent Advancements in the Theory of Economics"); and Komorzynski, Der Wert in der isolirten Wirtschaft ("The Value in the Isolated Economy"). Böhm-Bawerk achieved the most lasting impact by far. With his Positive Theory, he not only laid the foundations for an "Austrian" theory of capital and interest, but made a critical contribution to the international reputation of the Austrian School. He became one of the most discussed and quoted economists of his time.

During a seminar led by Carl Gustav Adolf Knies (1821–1898) at the University of Heidelberg, Böhm-Bawerk, as a scholarship recipient, had already thoroughly considered the relationship between the present and the future by posing the question: why is a debtor prepared to pay the creditor interest for a loan on top of paying back the amount of the loan itself? He answered this by explaining that future goods have a lower value than present goods, and the result is a difference in value between the present and the future: between loan and repayment. Payment and return are deemed equivalent when the difference in value has been balanced by a "quantitative plus," namely, interest. Without specifying further, he argued that a "self-induced creation of capital value" (cited after Yagi 1983, p. 32), would make repayment of such amounts economically feasible for a debtor.

The publication of Positive Theory was preceded by a wide-ranging, virtually complete collection and appraisal of all the established theories of capital and interest. Böhm-Bawerk dealt with more than 150 authors and laid out an exemplary history of dogma, whose structure suggests that he had already put together a complete draft of Positive Theory (cf. Tomo 1994, p. 92). Die Geschichte und Kritik der Kapitalzinstheorien (1884) (History and Critique of Theories of Interest) would give the further development of the Austrian School direction in two ways in particular: first, Böhm-Bawerk subjected the socialist labor theories of value by Johann Karl Rodbertus (1805–1875) and Karl Marx (1818–1883) to a detailed and consistently deprecatory criticism, thus laying the foundation for the critique of Marxism in the Austrian School's tradition (Böhm-Bawerk 1890/1884, pp. 328–392). Second, he dismissed Carl Menger's utility theory, according to which capital rent is the remuneration for the hired use of capital. Böhm-Bawerk's objection was that Menger considered a "good" and the "disposal over goods" to be two separate value repositories, and would lead to an incorrect double count (ibid., p. 260). This was simply the logical outcome of his definition of the term "good," which differed from Menger's, and which Böhm-Bawerk had already presented in his revised postdoctoral thesis (cf. Böhm-Bawerk 1881/2006, pp. 16–17; and Menger 1950/2007, pp. 52–53). This divergence and its consequences resulted in the founder of the Austrian School's taking a detached view of its definitive theory of capital and interest throughout his life.

In his Positive Theory, the publication of which was held up for years, Böhm-Bawerk defined "capital" as "a group of products destined to serve towards further production" or as "a group of intermediate products" (Böhm-Bawerk 1891/1930, p. 38). Based on this notion of capital, three kinds of capital yield were conceivable: revenue from a loan, revenue from renting out a durable good, or revenue from a production process. All three types of revenue could ultimately be explained by the subjectivist value theory. The starting point had been the observation that in general, present goods were valued more highly than future goods of equal kind and number. Two reasons can be cited. First, the ratio between demand and supply varies at different points in time because personal circumstances and future expectations are constantly changing (ibid., p. 249). Second, we systematically underrate our "future needs" as well as the "means to meet them." The causes of this misjudgment are our hazy picture of the future, our weakness of will, and our "consideration of the brevity and incertitude of life" (ibid., pp. 253–256; cf. Menger 1950/2007, pp. 150–152). Böhm-Bawerk concluded from all this that "we look at the marginal utility of future goods diminished, as it were, in perspective" and that thus "[t]he agio on present goods moves upwards." (Böhm-Bawerk 1891/1930, pp. 258–259).

There is a third reason for the upward pressure on this agio ("premium"), however, which does not reside in the sphere of the consumer but in that of the producer. According to Böhm-Bawerk, it is in the nature of capitalist production that the elementary economic productive forces — labor and land use, possibly also in combination with natural forces — are combined in such a way that consumer goods are created either directly or indirectly. As a general rule, such "indirect production" would also lead to a greater result in output. Thus one could use nothing but one's hands to break stones out of a rock face, or one could first extract iron, then use it to make hammer and chisel, and then get to work. An even greater and more time-consuming form of indirect production would be to take sulfur and sodium nitrate to manufacture gun powder, fill it into drilled holes and thus blast out the rocks. An operation like this would increase the result in output many times over (ibid., p. 19). However, this rule would only apply for a "wisely chosen capitalist process" (ibid., p. 82). With increasing diversity in production, the additional revenue would then decrease again after a certain point (ibid., pp. 85–86).1

Interest, according to Böhm-Bawerk, thus has psychological and productive–technical causes. It also exists independently of the prevailing economic and social system. A difference in value would exist between present and future goods even in a "socialist state." The "interest principle" can therefore in no way be conceived as "exploitation" because it is not a "historico-legal," category, "but an economic category, which springs from elementary economic causes" (ibid., pp. 367, 371; italics in the original).

Böhm-Bawerk, who considered the basic principles of his theory of capital and interest to be "unusually simple and natural" (Böhm-Bawerk 1891/1930, p. xxvi), had to supplement and expand his work considerably in order to combine the subjectivist value theory with his capital theory. He thus made a clear distinction between the reasons for the origin of interest and those which were responsible for the specific interest rate. Furthermore, as he had combined heterogeneous intermediate products and their variously long, indirect production paths under the term "capital," he had to introduce the term "average period." This was illustrated with a simple diagram of figures (ibid., p. 89). Moreover, he adopted Stanley Jevons's concept of "wage funds" (cf. Jevons 1871/1970, chap. 8) because the laborers involved in indirect production paths had to be supported for the duration of the production process (Böhm-Bawerk 1891/1930, pp. 318–319). Finally, the subjectivist value theory had to be reconciled with the law of costs, which states that in the long term, the market price of reproducible goods will equal the production costs (ibid., pp. 223–234). These and other "additions" meant that the basically elegant theoretical structure appeared more and more contrived and overburdened.

Nevertheless, Böhm-Bawerk's Positive Theory had an enormous impact internationally. It was translated into English as early as 1891, and into French soon afterward. In 1892, Swedish economist Knut Wicksell (1851– 1926) saw to its mathematical reformulation. By the turn of the century, Böhm-Bawerk was counted among the world's most famous and talked about economists (cf. Kurz 1994, p. 151). A second edition was published in 1900, and it contained a heftily expanded criticism of Marx. A third was published in 1913. Both editions included excursuses in which responses were given to objections that had been raised (cf. Böhm-Bawerk 1921, vol. 3). Finally, Friedrich von Wieser arranged for a fourth publication in 1921 — a complete edition in three volumes that was to be published under the title Kapital und Kapitalzins (Capital and Interest).

Menger, whose notion of capital fundamentally differed from Böhm-Bawerk's, took up an extremely critical stance. In small circles he even went so far as to call Böhm-Bawerk's theory "one of the greatest errors ever committed" (Schumpeter 1954, p. 847 n. 8). There has been much speculation as to what might have led to Menger's stern rejection. It could hardly have been Böhm-Bawerk's insufficiently consistent subjectivism, as even Menger's definitions of value theory contained some residual objectivism (cf. Gloria-Palermo 1999, pp. 39–50; Mises 1960/2003, pp. 177, 183–185). A distinctive dividing line, however, were their differing methodological approaches. Menger took Böhm-Bawerk to task for the "obvious artificiality" of some of his theories (Menger 1915/1970, pp. 11, 16). Böhm-Bawerk did indeed demonstrate an almost unconcerned, pragmatic-eclectic attitude when it came to methodological questions. Characteristic of this attitude was his rejection of the use of mathematics in economics. This was not for fundamental epistemological reasons, as was the case with Menger, but because he, along with most of his faculty colleagues, utterly lacked the necessary mathematical skills (cf. Böhm-Bawerk 1894c, pp. 163–165). Furthermore, Positive Theory seems in some respects to point in the direction of modern macroeconomics. Unlike other key works of the "Austrians," it contains an unmistakable tendency to create highly abstract aggregates, and demonstrates a hearty propensity to quantify, albeit in the modest guise of simple forms of calculation.

Böhm-Bawerk's theory was also met with reservation, or even rejection, by the successive generations of the Austrian School. The twenty-eight-year-old Joseph A. Schumpeter (1883–1953) developed his own "dynamic theory of interest" (Schumpeter 1912/1934/1961, pp. 157–211), which must have appeared to Böhm-Bawerk as a defamation of middle-class economic morality and a heralding of inflationist daredevil policies. Böhm-Bawerk rejected it with rare forcefulness (Böhm-Bawerk 1913a; Böhm-Bawerk 1913b). Schumpeter's response was accordingly subdued (Schumpeter 1913, pp. 599–639). In the context of Böhm-Bawerk's seminars, Ludwig von Mises (1881–1973) also made the criticism that his theory of capital and interest had proceeded on the assumption of a "neutrality of money." According to Mises, Böhm-Bawerk moved far beyond his published theories by the end of his life (cf. Mises 1978/2009, p. 47; also Elster 1923, p. 164).

It was finally Emil Sax who, in Der Kapitalzins (1916) ("Interest on Capital"), presented the first comprehensive critique of Böhm-Bawerk and compiled all of the arguments that future authors would raise against him. Böhm-Bawerk's theory of capital and interest was "a chain of thought too elaborately spun out, and, owing to its unevenness, unable to withstand a tensile test" (Sax 1916, p. 229). Above all, Sax believed he could prove that each of three reasons for a value difference between present and future goods was questionable, that durable goods (fixed capital) as such could not yield any interest, that the term "average roundabout production process" ("durchschnittlicher Produktionsumweg") was too indeterminate, and that the Positive Theory did not account for compound interest. Thus, Der Kapitalzins documented just another step in the drifting apart of the Austrian School at the height of its international eminence. External events such as Menger's permanent withdrawal from university activity, Böhm-Bawerk's death in 1914, and the outbreak of the war, however, scarcely allowed this internal split to come to the surface (cf. Elster 1923, p. 163).

In the last analysis, no economist of note agreed with Böhm-Bawerk on every point. But for decades his work continued to have an unusually inspiring and fruitful impact (cf. Schumpeter 1954, p. 930; Kurz 2000, p. 153). Among the representatives of the Austrian School, Böhm-Bawerk was always revered as one of the greats. The generation of academics who came after World War I felt compelled to qualify his work and make manifold changes or other shifts in emphasis. But this did little or no harm to the remarkable fascination with which Böhm-Bawerk's theory of capital and interest is treated to this very day. This undiminished appeal might be due to the fact that Böhm-Bawerk's monumental theory reveals a glimpse of the "hidden logic" or the "grammar of economic phenomena" (Orosel 1986, pp. 127–128).

This article is excerpted from The Austrian School of Economics: A History of Its Ideas, Ambassadors, and Institutions (2011), chapter 6: "Time Is Money: The Austrian Theory of Capital and Interest."

  • 1Böhm-Bawerk borrowed the concept of "productive diversion" and its "additional revenue" from a number of predecessors, whose ideas he developed and formulated more stringently. Later it would turn out that John Rae (1796–1872), a Scotsman who had emigrated to Canada and fallen into oblivion, had already pre-empted the Positive Theory on key points in 1834. cf. Böhm-Bawerk 1890/1959, pp. 208–240.
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