Böhm-Bawerk and the So-Called Naïve Productivity Theory of Interest (Part 1)

One of the most important contributions Böhm-Bawerk made in understanding interest was in his identification and framing of the phenomenon under scrutiny. Specifically, Böhm-Bawerk argued that the task of the economic theorist was to explain why owners of capital could regularly earn a net return on their assets, even though, unlike laborers, they apparently did nothing to earn this interest income. After this starting point, Böhm-Bawerk transformed the task by showing that it was equivalent to explaining why there was an apparent premium—what he called agio—in intertemporal exchanges, those that involve goods from different time periods.

We can illustrate Böhm-Bawerk's approach with the example of a tractor. Typically, a capitalist who invests in a tractor, either directly or by lending funds to a farmer, can earn an interest return on the investment; that is, he will have more wealth, measured in money terms, after the tractor has been used to harvest crops. What Böhm-Bawerk realized was that this phenomenon—the growth in financial wealth through investment in the tractor—relies on an apparent undervaluation of the tractor.

To see this, suppose that the tractor is expected to yield an additional $1,000 worth of revenue every year, and that it will last ten years before being junked. Böhm-Bawerk argued that the only reason a capitalist could earn money through ownership of the tractor is that its initial purchase price is less than $10,000. Only in that case could an investor use an initial amount of financial wealth and turn it into a greater subsequent amount (ten years later). In other words, if the capitalist had to spend a full $10,000 upfront to buy the tractor, and then it increased the harvest on the farm to allow for an extra $1,000 in crops to be earned each year for a decade, the capitalist would only break even, recouping his initial $10,000 investment. To earn a positive rate of return, the initial purchase price had to be less than the $10,000. If, for example, a new tractor had a purchase price of only $5,000, then the capitalist would effectively double his money over the course of 10 years for an annualized rate of return of about 7 percent.

By this procedure, Böhm-Bawerk had transformed his original question. Rather than asking, “Why do capitalists earn an effortless flow of interest income?” he could instead wonder, “Why is it that the initial purchase prices of capital goods systematically fall short of the future income their use is expected to yield?” Against this metric, Böhm-Bawerk measured all of the explanations of interest that economic theorists had offered before his own writing.

—Robert P. Murphy, Choice: Cooperation, Enterprise, and Human Action (Oakland, CA: Independent Institute, 2015), e-book.