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.