Austrian Economics Forum Spring 2011 #2--Capital and Interest

At the end of the last post, a few questions were posed. Namely, "What are the necessary and sufficient conditions for the formation of interest rates?" "What determines the height of interest rates?" and "Can productivity influence the height of interest rates?"

The Clark/Knight position has been adopted by mainstream economists for several reasons.  At the top of the list is the point that homogeneous capital is easier to model than heterogeneous capital.  With homogeneous capital, the interest rate must equal the value marginal product of capital.  With this equality, we need only to look at what constitutes supply and demand in this market.

For the Clark/Knight position, there are two sides that need to come together to create an interest rate.  The first is the subjective side of time-preference.  Some people are natural born savers while others need to spend as soon as they get it into their hands.  Knight says that the demand side is the subjective, "time-preference" side.  (As an aside, Knight must be thinking of not the loanable funds market, but of the bond market.  Otherwise, his analysis on pages 421-422 is backwards.  So the demand for bonds, or the "desire to save money" is the time-preference side.)  The other side, the supply side, is the "'technical' side of the situation."  The supply of bonds, or the demand to borrow money, is based upon the objective productivity of capital.  Knight argues that this is the same analysis that is found "any elementary text-book," which shows "the relation between utility and cost."  He argues that there is no difference between the interest rate market and a goods market, where the supply of goods is objective and the demand for them is subjective.  He says that it is the same as the Marshallian scissors that create the market equilibrium price and quantity.

The Austrians have a different view of equilibrium, not only in the interest rate market, but in the regular goods and services markets as well.  On the demand side of any market, the mainstream and the Austrians agree that it is governed by subjective preferences.  In the (Knight's) bond market, it is time-preference, and in any goods market, it is subjective utility.  However, on the supply side of a goods market, Austrians argue that it, too, is governed by subjective preferences and not objective factors.  Of course, objective factors-like the amount available-do contribute to the final market price, but the core of the supply side of the market is still rooted in subjective utility. 

Let me explain.  From the Axiom of Human Action, we can deduce the Law of Diminishing Marginal Returns when we posit that we live in a world of scarcity.  Due to scarcity, we are forced to choose.  We choose according to our preference scale.  As we work down the scale, the marginal benefit of the next item picked must be less than the one above.  It is from the Law of Diminishing Marginal Returns that we deduce the demand curve. 

The derivation of the supply curve and the derivation of the demand curve have similar beginnings.  Again we recognize that we live in a world of scarcity and are forced to choose.  However, instead of starting at the top of the preference scale and working our way down, we work in reverse.  We start at the bottom and work our way up.  We ask what is the opportunity cost of the item that has the lowest utility.  Now if we lost that item, we ask what is the opportunity cost after that loss.  From this analysis, we derive the Law of Increasing Opportunity Costs.  It is from this law, that we are able to derive the Law of Supply and the supply curve.  Thus, both sides of the market are determined by subjective valuations. (For more on this see my lecture on Praxeology, Supply and Demand.)

So the Austrian position is that for goods markets, both demand and supply are subjectively determined.  It is not the meshing of the subjective on one hand and the objective on the other.  So, it should come as no surprise that the Austrians reject the Clark/Knight position that interest rates are created by the combination of subjective forces on one side and objective forces on the other.  Instead, Austrians have argued that Time Preference is the dominant force on both the demand and supply sides.

The title of this is the Pure Time-Preference Theory (PTPT) of interest rates.  This theory is not without criticism and does have some flaws that need to be worked out, but the general idea is that time-preference fulfills "the necessary and sufficient" requirements for interest rates to emerge.  The difficulty of this is found in the qualifying restriction of "ceteris paribus." 

What exactly is held constant and what is not?  During the discussion, one person argued against time-preference because there are certain things that he desired in the future, but did not want them now.  Rothbard uses the example of a person wanting breakfast at breakfast time (the future) and not in the evening (now).  And he also uses the example of a person who wants ice in the summer (the future) but not in the winter (now).  Rothbard argues that these examples violate the ceteris paribus restriction.  Not everything else has been held constant.  The person who doesn't want breakfast now, isn't hungry now.  However, he will be hungry in the morning.  What's changed?  Well, his appetite has changed.  Additionally, the person who doesn't want ice now is comparing to different seasons and thus not holding everything else constant.  What's changed?  The seasons have changed. 

All that time-preference is attempting to say is that people prefer sooner to later, holding everything else constant.  The trick is in holding all those other things constant.  Mises says that time-preference is a praxeological category of action.  In other words, its just how humans are built.  The debate over the finer points on this issue can be brought up at another time.

Austrians present the case that time-preference is not only a necessary condition for the formation of interest rates, it is also sufficient.  Money does not have to be present for the formation of interest rates.  Neither does exchange have to occur or even for there to be more than one person to have an interest rate govern intertemporal actions.

In Böhm-Bawerk's The Positive Theory of Capital (the second of three volumes on capital and interest), he states that the productivity of capital not only influences the height of interest rates, he argues that it is the most important factor.  Ingo Pellengahr (1996) argues that Böhm-Bawerk was not contradicting his earlier work.  (In the first volume he explicitly rejects the productivity theory of capital as the core of interest rates.)  Pellengahr states that Böhm-Bawerk was actually asking two separate questions.  In the first volume, Böhm-Bawerk was asking an essentialist question, "What is the origin and fundamental core of the formation of interest rates?"  In other words, he was examining the necessary and sufficient conditions for the formation of interest rates.  In the second volume, he changes his focus to a functionalist question of what influences the height of interest rates.  Several Austrians have agreed to this distinction.  However, this position of compromise is rejected by Fetter, Mises, Rothbard and Kirzner.

The Pure Time-Preference approach argues the case in this way...

First, we have to make a distinction between rents and interest return.  Every factor of production earns a return—a rent.  This return (rent) is the price that must be paid to a factor of production, which equals its marginal product.  Thus, every factor earns a rent that is equal to its marginal product.  Suppose that there is a machine that can produce a return of $10,000/year for 10 years.  Why is the price of this machine not $1,000,000 today?  The answer is that the future values need to be discounted back to the present.  Marginal productivity explains the height of the factor’s rental price.  However, it does not explain why these rents should be discounted across time.

Rothbard (1977 p.7) explains it this way, “Roundaboutness is an important aspect of the productivity of capital goods.  However, while this productivity may increase the rents to be derived from capital goods, it cannot account for an increase in the rate of interest return, that is, the ratio between the annual rents derived from these capital goods and their present price.  That ratio is strictly determined by time preference.” 

And so most Austrians reject the idea that changes in productivity and roundaboutness determine the height of interest rates.  Of course, we might want to qualify it by limiting the analysis to real interest rates in equilibrium, as opposed to nominal rates in disequilibrium.  Nevertheless, it seems that the debate amongst Austrians is more a definitional problem than that of an outright rejection of Böhm-Bawerk's analysis.

There is one last point to be made.  In the Kirzner article, he says that there does not exist a detailed criticism of Mises on Böhm-Bawerk's theory of capital and interest.  He is wrong.  Mises does critique Böhm-Bawerk in Nationalökonomie, pages 439-444.  That section has been translated into English and appears at the end of the book Mises Made Easier, by Percy and Bettina Bien Greaves, pages 150-157.

Austrian Economics Forum Spring 2011 #2--Prologue

This past session was one of the more exciting for me because it dealt with one of my favorite topics, Capital and Interest Theory.  There were about 10 of us in attendance this week (Cordato, myself and about 8 students).  There were two readings for this session: Frank Knight's book review of Mises' Nationalökonomie, "Professor Mises and the Theory of Capital," and Israel Kirzner's response to that article, "Ludwig von Mises and the Theory of Capital and Interest." 

Knight's article was published in Economica in November 1941, and instead of actually reviewing the book he launches into a large discourse on Austrian Capital and Interest Theory.  It is rather bizarre for a book review to focus on only one issue, but this is not the only instance of Knight doing this.  Knight was asked to write the introduction to the English translation of Menger's Principles of Economics (1950).   It was one of the most vitriolic introductions I have ever read, or even heard of.  Instead of praising Menger and his unique contributions economic science, he launched into another attack on Austrian Capital and Interest Theory.  (Subsequent editions have jettisoned this introduction in favor of a laudatory piece by Hayek.)

Before jumping into the articles, some background is necessary.  Austrians and the mainstream have clashed on this topic several times before 1941.  In 1889, Eugen von Böhm-Bawerk published his second of three volumes on capital and interest, The Positive Theory of Capital.  It was translated into English in 1891.  He argues in favor of the use of heterogeneous capital in model formulation and a theory of interest rates, which are the product of time-preference and the productivity of capital.  (The influence of the productivity of capital on interest rates is still a topic of debate in Austrian circles today.)

In response to Böhm-Bawerk, John Bates Clark wrote an article called, "The Genesis of Capital" in November 1893.  In it, he argued that capital should be considered as a homogeneous fund.  Imagine a self-perpetuating pool of water that has some water flowing in and some water flowing out.  The difference of these two flows determines if the level in the pool rises or falls.  Instead of focusing on the actual water in the pool, all that is needed is for the economist to focus on the height of the water level.  The same should be done with capital, we simply measure the volume, the inflow and outflow; and determine if we are accumulating capital or depleting it.

Böhm-Bawerk replied to this position in January 1895 and argued that production has a structure, which is based upon the complementarities and substituabilities of the capital goods.  When the types of capital goods change, the structure of production must also change.  So capital must be modelled in a heterogeneous manner.  Clark responded in April 1895, to which Böhm-Bawerk countered in July 1895, which was then rebutted by Clark in October 1895.  Neither side yielded and the divide remained.  The debate cooled-off for about 10 years and then in November 1906, it cycled through another very similar round of back and forth without really settling the issues.

The other major point of debate between the two sides centered on the nature and formation of interest rates.  This debate has changed because the modern Austrian position is no longer represented by Böhm-Bawerk, but rather by Fetter, Mises and Rothbard.  We'll come back to this discussion in the next post.

For a second time, the debate died down, for about 20 years.  It wasn't until the 1930s, that the debate reemerges between Hayek and Knight.  Hayek argued that heterogeneous capital is the best way to examine economic phenomena, while Knight agreed with Clark's position that heterogeneity is completely unnecessary.  (One of the best articles representing the Austrian side during this exchange is Hayek's "The Mythology of Capital.")   

Earlier in 1941, Hayek published his The Pure Theory of Capital.  While it is just pure speculaiton on my part, I think that Hayek's book must have been weighing on the mind of Knight as he wrote his review of Mises' book.  (Knight even mentions Hayek's book in a footnote--p. 420.) 

In the light of this background, we now come to the focus of this forum.  We started by asking the questions, "What is necessary and sufficient for the formation of interest rates?" "What determines the height of interest rates?" and "Can productivity influence the height of interest rates?"  At the outset, only Cordato and I argued that productivity cannot influence the height of interest rates.  By the end, several more joined our side.

The answers to these questions and more will be in the next post found here.

Stop Me, Before I Engineer Again!

This post is based upon the local newspaper's article: "Citizen Activist Grates On State Over Traffic Signals" found here.

Here's the summary of the story.  In North Raleigh, the city is going to widen a few streets and some nearby residents would like additional traffic signals to ease the new traffic patterns.  The group petitioned the City Council.  The City Council agreed and said if the DOT agrees, then the signals will go up.

The DOT said that the traffic conditions did not warrant new signals.  So, the residents put together a report for the DOT and not only did the DOT reject it, the Chief Engineer for State DOT said that the report contained "engineering-quality work in a report that was not signed by a licensed professional."

"When you start applying the principles for trip generation and route assignment, applying judgments from engineering documents and national standards, and making recommendations," that's technical work a licensed engineer would do, the chief engineer said.

Then the DOT has asked the Engineers Licensing Board to investigate the residents who wrote the report!  The Executive Director of the board said that the investigation will take 3 to 4 months.  He said there is a potential for violation if DOT and the public were misled by "engineering-quality work"- even if the authors did not claim to be engineers.

If the author of the report, a resident who simply wants a traffic light, is found to have practiced engineering without a license, the director said, the likely action would be ... drum roll please ... a letter telling him not to do it again.

How much money are we going to waste pursuing this mockery of justice?  All to assuage a bruised ego and to protect this fiefdom?

In North Carolina, we have more than 183 professions that require a license.  There are some doozies on this list like: Cemetary Sales Contractor, Chick Dealer, Boxing/Kickboxing/"Toughman" Promoter, Egg Dealer, Electrologist, Embalmer, Fee-Based Practicing Pastoral Counselor, Fruit and Vegetable Handler, Histologic Technician, Librarian, Public Weighmaster, Recreational Therapist, Senior Parachute Rigger, and so on.  You can find them listed here.

And the list continues to grow because later this year, a license will be needed if you want to braid hair for money.

The state carves out these little areas of benefit for special groups, all to the detriment of the general public.  Each of these licenses creates a mini-fiefdom, a protected class.  These licenses do not protect the customer.  They protect the producer from competition. 

Competition is the consumers' best friend.  It is high time to repeal these licenses and open the economy to competition.  Let the consumer determine who the best egg dealer is.  Let the market determine who the best Fruit and Vegetable Handler is. 

Or to put it another way, do you think that we can really live in a society with an unlicensed librarian?  I'm thinking, "Yes, we can!"