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Böhm-Bawerk vs. the Neoclassical School

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In general the neoclassical school has followed a tradition which predated the subjectivist revolution and involves a productive system in which the different factors of production give rise, in a homogeneous and horizontal manner, to consumer goods and services. No thought whatsoever is given to the immersion of these factors in time and space throughout a temporal structure of productive stages, an aspect Austrian theorists typically do take into account. The above static framework provided the structure for the work of John Bates Clark (1847–1938), who carried it to its logical conclusion. Clark was Professor of Economics at Columbia University in New York, and his strong anti-subjectivist reaction in the area of capital and interest theory continues even today to serve as the foundation for the entire neoclassical-monetarist edifice.

Indeed Clark considers production and consumption to be simultaneous. In his view production processes are not comprised of stages, nor is there a need to wait any length of time before obtaining the results of production processes. Clark regards capital as a perpetual or permanent fund which “automatically” generates profits in the form of interest. According to Clark, the larger this social fund of capital, the lower the interest. The phenomenon of time preference in no way influences interest in his model. Moreover, it is Clark’s view which Knight, Stigler, Friedman and the rest of the Chicago School subscribe to wholeheartedly.

It is evident that Clark’s concept of the production process consists merely of a transposition of Walras’s notion of general equilibrium to the field of capital theory. As we know, Walras developed an economic model of general equilibrium which he expressed in terms of a system of simultaneous equations intended to explain how the market prices of different goods and services are determined. From the Austrian perspective, the main flaw in Walras’s model is that it involves the interaction, within a system of simultaneous equations, of magnitudes (variables and parameters) which are not simultaneous, but which occur sequentially in time as the actions of the agents participating in the economic system drive the production process forward. In short, Walras’s model of general equilibrium is a strictly static model which relates magnitudes that are heterogeneous from a temporal standpoint: the model fails to account for the passage of time, and instead describes the interaction of supposedly concurrent variables and parameters which never arise simultaneously in real life.

Logically, it is impossible to explain real economic processes using an economic model which omits the aspect of time and in which the study of the sequential initiation of market processes is conspicuously absent. It is surprising that a theory such as the one Clark defends, has nevertheless become the most widely accepted in economics up to the present day and appears in most introductory textbooks. Indeed nearly all of these books begin with an explanation of the “circular flow of income” model, which describes the interdependence of production, consumption and exchanges between the different economic agents (households, companies and so on). Such explanations completely exclude the role of time in the development of economic events. In other words, this model rests on the assumption that all actions occur at once, a false and groundless “simplification” which not only prevents the solution of the real, vital economic issues, but also constitutes an almost insurmountable obstacle to their discovery and analysis by economics scholars.

Eugen von Böhm-Bawerk reacted immediately against the objectivist stance of Clark and his school. For instance, Böhm-Bawerk describes Clark’s concept of capital as “mystical” and “mythological”, pointing out that production processes never depend upon a mysterious, homogeneous fund, but instead invariably rely on the joint operation of specific capital goods which entrepreneurs must always first conceive, produce, select and combine within an economic process that takes time. Furthermore, according to Böhm-Bawerk, Clark views capital as a sort of “value jelly”, or fictitious notion. With remarkable foresight, Böhm-Bawerk warned that acceptance of such an idea was bound to lead to grave errors in the future development of economic theory. Indeed Böhm-Bawerk predicted with great prescience that if Clark’s circular, static model were to prevail, the long-discredited doctrines of underconsumption would inevitably revive, and when Keynes and his school appeared, BöhmBawerk was proven right.

Böhm-Bawerk also considers theories which, like Clark’s, base interest on the marginal productivity of capital to be untenable. In fact, according to Böhm-Bawerk, theorists who claim that interest is determined by the marginal productivity of capital are unable to explain, among other points, why competition among the different entrepreneurs does not tend to cause the present value of capital goods in the market to match that of their expected output, thus eliminating any value differential between costs and output throughout the production period. As Böhm-Bawerk correctly indicates, the theories based on productivity are merely a remnant of the objectivist conception of value, according to which value is determined by the historical cost incurred in the production processes of different goods and services. However prices determine costs, not vice versa, and knowledge of this fact reaches at least as far back as Luis Saravia de la Calle. Economic agents incur costs because they believe that the value they will be able to obtain from the consumer goods they produce will exceed these costs. The same principle applies to each capital good’s marginal productivity, which is ultimately determined by the future value of the consumer goods and services the capital good helps to produce. By a discount process this value yields the present market value of the capital good (which is completely unrelated to its cost of production).

Thus the origin and existence of interest must be independent of capital goods, and must rest, as we have already stated, on human beings’ subjective time preference. It is easy to comprehend why theorists of the Clark-Knight School have made the mistake of considering the interest rate to be determined by the marginal productivity of capital. We need only observe that interest and the marginal productivity of capital become equal in the presence of the following: first, an environment of perfect equilibrium in which no changes occur; second, a concept of capital as a mythical fund which replicates itself and involves no need for specific entrepreneurial decision-making with respect to its depreciation; and third, a notion of production as an instantaneous “process” which hence takes no time. In the presence of these three conditions, which are as absurd as they are removed from reality, the rent of a capital good is always equal to the interest rate. In light of this fact, it is perfectly understandable that theorists imbued with a synchronous, instantaneous conception of capital have been deceived by the mathematical equality of income and interest in a hypothetical situation such as this, and that from there they have jumped to the theoretically inadmissible conclusion that productivity determines the interest rate, and not vice versa, as Austrians precisely assert. Members of the Austrian school hold that varying marginal productivity (that is, the value of the future flow of returns) determines only the market price of each capital good, a price which will tend to equal the present, discounted (at the interest rate) value of this flow of expected returns. At the same time an increase (or decrease) in the interest rate (determined by time preference) will give rise to a decrease (or increase) in the present value (market price) of each capital good (regardless of its historical cost of production) via the corresponding process of discounting (at the interest rate) the expected future flow of returns, and precisely until this amount coincides with the interest rate (and the necessary depreciation rate).

So, in contrast with the hyperrealism of the historicists, Böhm-Bawerk now condemns the hyporealism, or rather the total lack of realism, in Clark and his acolytes’ static conceptualization of capital. Every production process takes time and, before the end is achieved, it is necessary to go through a number of stages which take the form of a highly heterogeneous and variable set of capital goods. In no case do these goods automatically replicate themselves, but instead they are gradually created as a result of concrete entrepreneurial actions and a series of decisions, the absence of which would even lead to the consumption and disappearance of existing capital goods.

Furthermore, as we have already indicated, Böhm-Bawerk maintains that the price of capital goods is not determined by their historical cost of production, but instead by the estimate, discounted at the interest rate, of the value of their future productivity, and thus it is productivity which invariably tends to follow interest (determined by time preference), and not vice versa.

Neoclassical economists believe that capital supply and demand jointly determine the interest rate in equilibrium, that subjective considerations of time preference determine supply, but that entrepreneurs determine demand based on the marginal productivity of capital (that is, based on predominantly objective considerations). This approach parallels the one that Marshall developed to explain price determination in the market, and that Böhm-Bawerk and the Austrian school reject and emphasize that when entrepreneurs demand funds, they act as mere intermediaries for workers and owners of factors of production, who are the final demanders of present goods in the form of wages and rents, and in exchange they transfer to entrepreneurs the ownership of future goods of greater value (which will only become available when the process of production concludes).

Consequently, from the perspective of Austrian economists, both sides – the supply of capital goods and the demand for them – depend on subjective considerations of time preference. This line of argument, in the area of interest rate determination, echoes the one that Böhm-Bawerk employed with Marshall when he criticized Marshall for his desire to preserve, at least on one side of the process of price determination, the old objectivist, Ricardian conception characteristic of the classical school of economics.

Excerpted from The Austrian School: Market Order and Entrepreneurial Creativity

Contact Jesús Huerta de Soto

Jesús Huerta de Soto, professor of economics at King Juan Carlos University, is Spain's leading Austrian economist, and a Senior Fellow of the Mises Institute. As an author, translator, publisher, and teacher, he also ranks among the world's most active ambassadors for classical liberalism. He is the author of Money, Bank Credit, and Economic Cycles, as well as Socialism, Economic Calculation and Entrepreneurship (Edward Elgar 2010), The Austrian School (Edward Elgar 2008) and The Theory of Dynamic Efficiency (Routledge 2009).

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