The Guiding Light of Economic Calculation—and Its Fundamental Notion of Capital—Makes Possible All of the Wonders of Capitalism

The guiding light of economic calculation—and its fundamental notion of capital—makes possible all of the wonders of capitalism. In the words of Mises:

The system of market economy has never been fully and purely tried. But there prevailed in the orbit of Western civilization since the Middle Ages by and large a general tendency toward the abolition of institutions hindering the operation of the market economy. With the successive progress of this tendency, population figures multiplied and the masses’ standard of living was raised to an unprecedented and hitherto undreamed of level. The average American worker enjoys amenities for which Croesus, Crassus, the Medici, and Louis XIV would have envied him.

As the last sentence in the above quotation indicates, Mises utterly rejects the Marxist claim that capitalism is a social system that exists to serve the capitalists. On the contrary, Mises conceived of the market economy as a system in which not the entrepreneurs or capitalists were in charge, but ultimately the consumers. . . .

One of the standard objections to the market economy is that it allegedly allows the wealthy elite to control everyone else. In the Marxist framework, the system is dubbed capitalism since the capitalists control the means of production; they are running the show. In contrast, the hapless workers are “wage slaves” who have the nominal freedom to quit their jobs, yes, but hardly enjoy true freedom since they will starve if they lose their paycheck. Just as the old aristocratic system had been swept aside by the movement for political democracy, the Marxists tried to sell the masses on the idea that socialism represented economic democracy that would complete the emancipation of man.

Mises sought to turn this typical view of the market on its head with his notion of consumer sovereignty. For Mises, the notion that the factory owner or landowner controlled the economy was absurd and reflected a naïve understanding of economics.

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

Capital Makes sense Only in a Monetary Economy Since Capital Is Computed Only by Adding and Subtracting Money Prices of Assets and Liabilities

Remember that Mises thought it was important to integrate the crucial role of money in a market economy from the ground floor, as it were. Money is not neutral, and it is misleading to conceive of the market economy as if it were a giant network of barter exchanges. The crucial concept of capital makes sense only in a monetary economy since capital could be computed only by resort to adding and subtracting the money prices of various assets and liabilities. It’s true, the indispensable tool of economic calculation refers to physical things and how they are deployed; such considerations are necessary for Robinson Crusoe, as well as a socialist state. But the point is that a complex society requires a market and its attendant money prices for the various means of production and consumer goods, if there is to be any hope of efficient use of resources; the socialist dictator wouldn’t be able to objectively tell whether he were increasing or decreasing the amount of wealth at his disposal. In Mises’s succinct statement: “In a socialist economy there are capital goods, but no capital.”

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

The Central Intellectual Concept in Economic Calculation Is Capital; Mises Defines Capital in the Way that an Accountant Would

The central intellectual concept in economic calculation is capital. In this respect, the Marxists were right to call the market economy capitalism, though of course they intended the label as derogatory rather than complimentary. The Marxists wanted to brand the market economy as one that served only the interests of a small group of exploiters, whereas Mises appreciates the term because it recognizes that only in a market economy can individuals resort to the indispensable mental tool of economic calculation.

It’s important to note that Mises defines capital in the way that an accountant or businessperson would: Capital is quoted in monetary units, and is equal to the total market value of all assets minus the total market value of all liabilities. Loosely speaking, to calculate how much capital is invested or tied up in a particular business entity, the accountant estimates how much money would be left over after first selling all of the business assets and then paying off all of the business debts.

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

The Rate of Interest Is NOT Set in the Loan Market; Interest Is a General Phenomenon Pervading All Sectors of the Market

Another possible objection to Mises’s treatment of interest is that it focuses on real goods rather than money. After all, isn't interest related to how much the lender charges on a loan of money? Why isn't the interest rate simply the price that balances the supply and demand for loanable funds?

Here the answer is that Mises, following Böhm-Bawerk, views interest as a general phenomenon that pervades all sectors of the market. From this perspective, it’s not the case that the rate of interest is “set” in the loan market, and then ripples out to other markets where people adjust their behavior based on the interest rate. On the contrary, in a market free from outside interference, individuals’ subjective time preferences manifest themselves in every market. Time preference influences the supply and demand in the loanable funds market, but time preference also regulates how much a home builder will pay today for the lumber, shingles, nails, and so on that will yield a house to be sold in a year’s time. The implied rate of return on a production project—in other words, the percentage excess of the total revenues compared to the total monetary expenses—is called originary interest. Originary interest is ultimately determined by subjective time preference because it reflects the fundamental difference in valuation between present and future goods.

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

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.