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.