The Theory of Capital Explains How the “Invisible Hand” Arranges Enterprises to Organize the Allocation of Resources According to Consumer Demand

The argument is linked to recent findings by Braun (2015a) and Braun et al. (2016) who show that Austrian School economists developed two different bodies of capital theory. The better known one defines capital as a factor of production and concentrates on the physical activities of roundabout production processes that are common to all economic systems. In this paper, the term ‘Austrian theory of capital’ only applies to this theory. Capital in this sense will be called ‘physical capital’ whenever the possibility of confusion arises. It consists of concrete and heterogeneous capital goods — which is nothing but an alternate expression for production goods.

The second and less well-known theory of capital by Austrian school economists, however, constitutes an appropriate starting point for a historically specific theory. It concerns itself with the organisation of the economic system called capitalism. Capital is not considered to be a production factor, but a sum of money invested in business enterprises. It is regarded as the central tool of the economic calculations by profit-oriented enterprises. This theory explains how the invisible hand arranges for profit-oriented enterprises to organise the allocation of resources in the market economy according to consumer demand. It will be called the ‘historically specific theory of capital’. Capital in this sense is simply money invested in business assets and will sometimes also be called ‘business capital’.

A deeper analysis will bring to light that the Austrian theory of (physical) capital can be subsumed under the theory of business capital and, in this capacity, helps to shed further light on specific characteristics of capitalism.

—Eduard Braun, “The Theory of Capital as a Theory of Capitalism,” Journal of Institutional Economics 13, no. 2 (June 2017): 306.

The Trade-Off Between More Roundabout Ways of Production and the Needs of Present Consumption

Eugen von Böhm-Bawerk took over Menger’s (1871) discussion of the role of time in the production process and built his theory of interest upon it. Böhm-Bawerk (1889) too defined capital physically and in relation to the time-consuming production process, namely as ‘the complex of intermediate products which appear on the several stages’ of production. He also clearly worked out an important cornerstone of the Austrian theory of capital: the trade-off between more roundabout ways of production and the needs of present consumption. On the one hand, he argued, in the spirit of Menger (1871), production leads to better results when (wisely chosen) more roundabout (i.e. time-consuming) methods encompassing more intermediate stages of production are employed (Böhm-Bawerk, 1889). On the other hand, the ability of entrepreneurs to implement more roundabout methods of production is limited. There must be a fund of consumption goods — what Böhm-Bawerk called subsistence-fund — which supports the owners of the factors of production while the more roundabout production processes are getting installed (Böhm-Bawerk, 1889).

With this trade-off, Böhm-Bawerk outlined the problem area around which many later contributions to Austrian capital theory would revolve. Most notably, the Austrian Business Cycle Theory (ABCT) as developed by Mises (1912) and expanded on by Strigl (1934), Hayek (1935), Rothbard (1962) and Garrison (2001) is based on this aspect: absent productivity gains, a reduction in consumption is needed to lengthen the structure of production and to undertake more roundabout ways of production. If people do not save more yet the banking system, by artificially lowering the interest rate, makes entrepreneurs believe that savings have increased, the production structure is ‘lengthened’ despite a lack of savings. But this degree of roundaboutness seems to be sustainable because the interest rate is below its equilibrium or natural level; ultimately, these too roundabout methods of production prove to be unsustainable and their abandonment or truncation triggers an economic crisis.

—Eduard Braun, Peter Lewin, and Nicolás Cachanosky, “Ludwig von Mises's Approach to Capital As a Bridge between Austrian and Institutional Economics,” Journal of Institutional Economics 12, no. 4 (December 2016): 850-851.