In the “Mengerian” Approach to Capital and Interest the ENTIRE Explanatory Burden Is Assigned to Consumer Valuations

In that controversy [Cambridge Capital Controversy] mainstream neoclassical theory was under relentless attack by economists seeking to reverse the marginalist revolution and to return to the classical perspective. The critics, especially insofar as they were following Sraffa (1960), argued for an economics in which the objective conditions of production determine economic events, with virtually no role assigned to consumer demand. We wish to emphasize that what was overlooked in that debate was the existence of a third theoretical approach (a “Mengerian” approach) to capital and interest issues, in which the entire explanatory burden is assigned to consumer valuations.

—Israel M. Kirzner, author's introduction to Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 5.

The Worst Outgrowth of the Use of the Mythical Notion of Real Capital Was the Spurious Problem of the Productivity of Real Capital

 Mises’s adoption of Menger’s concept of capital made it possible for him to avoid the pitfalls in interest theory that stem from the capital-income dichotomy. In everyday lay experience the ownership of capital provides assurance of a steady income. As soon as capital is identified as some aggregate of factors of production, it becomes tempting to ascribe the steady income that capital ownership makes possible as somehow expressing the productivity of these factors. This has always been the starting point for productivity theories of interest. Knight’s permanent-fund-of-capital view of physical capital is simply a variant of those theories that view interest as net income generated perpetually by the productivity of the abstract capital temporarily embodied in particular lumps of physical capital. The capital stock, in this view, is a permanent tree that spontaneously and continuously produces fruit (interest). Mises was explicit in concluding that this erroneous view of interest results from defining capital as an aggregate of produced factors of production. “The worst outgrowth of the use of the mythical notion of real capital was that economists began to speculate about a spurious problem called the productivity of (real) capital.” It was such speculation, Mises made clear, that is responsible for the “blunder” of explaining “interest as an income derived from the productivity of capital.”

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 143-144.

On the Böhm-Bawerkian Distinction Between “Originating Forces” and “Determining Forces” of Interest

 “Some writers,” Fisher wrote, “have chosen, for purposes of exposition, to postulate two questions involved in the theory of the rate of interest, viz., (1) why any rate of interest exists and (2) how the rate of interest is determined.” Fisher dismisses this distinction as being unilluminating, “since to explain how the rate of interest is determined involves the question of whether the rate can or cannot be zero.” The purpose of the present section of this paper is (a) to present the case for the distinction criticized by Fisher—a distinction in fact made by Böhm-Bawerk, as we shall see—and (b) to show how failure to understand the rationale for the distinction has generated the widespread modern bewilderment with PTPT [Pure Time-Preference Theory of Interest] referred to earlier.

No better defense for Böhm-Bawerk’s distinction need to be found than the lucid discussion that he himself provided. Böhm-Bawerk was criticizing Fisher for not distinguishing between “originating forces” and “determining forces.” “All interest-originating causes undoubtedly are also determining factors for the actual rate. But not all rate-determining factors are also interest-creating causes. . . . When we inquire into the causes of a flood we certainly cannot cite the dams and reservoirs built to prevent or at least mitigate inundations. But they are a determining factor for the actual water-mark of the flood. . . . Similarly, there are other circumstances besides the actual interest-creating causes that bring about or enhance the value advantage of present goods over future goods.”

—Israel M. Kirzner, “The Pure Time-Preference Theory of Interest: An Attempt at Clarification,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 161.

Economists Fall into the Error of Defining Capital As REAL CAPITAL, As an Aggregate of PHYSICAL THINGS

Böhm-Bawerk defined capital as the aggregate of intermediate products (i.e., of produced means of production) and in so doing was criticized by Menger. Menger sought “to rehabilitate the abstract concept of capital as the money value of the property devoted to acquisitive purposes against the Smithian concept of the ‘produced means of production.’” As early as his work on Socialism (1923), Mises emphatically endorsed the Mengerian definition. In Human Action he pursued the question even more thoroughly, though without making it explicit that he was objecting to Böhm-Bawerk’s definition. Economists, Mises maintained, fall into the error of defining capital as real capital, as an aggregate of physical things. This is not only an empty concept but one that has been responsible for serious errors in the various uses to which the concept of capital has been applied. 

Mises’s refusal to accept the notion of capital as an aggregate of produced means of production expressed his consistent Austrian emphasis on forward-looking decision-making. Menger had already argued that “the historical origin of a commodity is irrelevant from an economic point of view.” Later Knight and Hayek were to claim that emphasis on the historical origins of produced means of production is a residual of the older cost-of-production perspectives and inconsistent with the valuable insight that bygones are bygones. Thus, Mises’s rejection of Böhm-Bawerk’s definition reflects a thoroughgoing subjective point of view.

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 139-140.

Many of the Criticisms Leveled Against the Austrian Theory of Capital and Interest Are IRRELEVANT When It Is Cast in Terms of FORWARD-LOOKING Decisions

Mises took Böhm-Bawerk to task for not recognizing that time should enter analysis only in the ex ante sense. The role time “plays in action consists entirely in the choices acting man makes between periods of production of different length. The length of time expended in the past for the production of capital goods available today does not count at all. . . . The ‘average period of production’ is an empty concept.” It may be remarked that here Mises identified a source of perennial confusion concerning the role of time in the Austrian theory. Many of the criticisms leveled by Knight and others against the Austrian theory are irrelevant when the theory is cast explicitly in terms of the time-conscious, forward-looking decisions made by producers and consumers.

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 138.

In Mises’s View, Böhm-Bawerk’s Theory Failed to Do Justice to the Universality and Inevitability of Time Preference

Mises, while paying tribute to the “imperishable merits” of Böhm-Bawerk’s seminal role in the development of the time-preference theory, sharply criticized the epistemological perspective from which Böhm-Bawerk viewed time as entering the analysis. For Böhm-Bawerk time preference is an empirical regularity observed through casual psychological observation. Instead, Mises saw time preference as a “definite categorial element . . . operative in every instance of action.” In Mises’s view, Böhm-Bawerk’s  theory failed to do justice to the universality and inevitability of the phenomenon of time preference. 

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 138.

“Capital Reversal” Creates Serious Difficulties for the Neoclassical Theory of Interest

In the course of the Cambridge debate it was the reswitching and capital reversal paradoxes which cast the deepest shadow upon the mainstream neoclassical theory of distribution. Yet, as we shall see, these paradoxes present no problem at all for the explanation of interest contained in the Misesian theory of capital and interest.

The problem posed for the neoclassical theory by the phenomenon of ‘capital reversal’ is well known. Capital reversal occurs when a change in the rate of interest is associated with a seemingly ‘perverse’ change in adopted production technique — for example, when a reduction in the interest rate implies a switch to ‘the less, not the more, time-consuming, or roundabout or capital-intensive technique’ (Yeager, 1976). The capital reversal is at least theoretically possible was conceded by major exponents of the neoclassical position in the 1960s (Saumelson, 1966; Ferguson, 1969). That this concession implies serious difficulties for the neoclassical view of interest as the supply-and-demand price of a productive service, has been emphasized by many writers.

—Israel M. Kirzner, introduction to Essays on Capital and Interest: An Austrian Perspective (Cheltenham, UK: Edward Elgar Publishing, 1996), 7.

Mises’s Redirection of Capital and Interest Theory Along Mengerian Lines Was Brutally Attacked by Knight

It was thus Mises, in his 1940 Nationalökonomie rediscovery and further development of Fetter’s pure time-preference theory of interest, who was to refine Böhm-Bawerkian theory and redirect it along Mengerian lines. In his slashing review article on Mises’s book, Knight (1941) perceptively recognized this — and saw it as grounds for dismissing Mises’s entire approach to the theory of capital and interest. In other words, Knight was attacking Mises not only because he was, like Böhm-Bawerk and Fisher, emphasizing the role of time in production (whereas for Knight the foundation of wisdom in this area consists in recognizing that ‘in a stationary economy, all production and consumption are strictly simultaneous; the waiting period is zero; there is none’: ibid., p. 420). Rather, he was attacking Mises for his ‘original and naive or absolute “Austrianism”’ (ibid., p. 422) — by which he apparently meant Mises’s Mengerianism. (This reading of Knight's attack is reinforced by his own explicit rejection of Mises’s frequent and favourable references to Menger’s conception of the ‘order’ of goods. On Knight's sweepingly dismissive attitude to this conception of Menger’s, see also his highly critical introduction to the 1950 English edition of Menger’s 1871 Grundsätze (p. 25).) For Knight, Mises’s cardinal sin was not so much is emphasis on the role of time per se, as his denial of primary explanatory significance to the objective productivity of time.

—Israel M. Kirzner, introduction to Essays on Capital and Interest: An Austrian Perspective (Cheltenham, UK: Edward Elgar Publishing, 1996), 4.