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Monetary Central Planning and the State, Part 8: The Austrian Theory of Capital and Interest


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Time is an element inseparable from the human condition. Everything we do involves time. Just reading this article requires the use of a period of time. And the period taken up with reading it is not available to do other things that instead could be done with this slice of life.

The importance of time in the processes of production and in the evaluation of choices has been especially emphasized by many of the members of the Austrian school of economic thought, beginning with Carl Menger, the founder of the school.

But among the early members of the Austrian school, it was Eugen von Böhm-Bawerk who developed the first detailed analysis of the role of time in the processes of production and the process of human choice. The first two volumes of his master work on this theme, Capital and Interest, were published in the 1880s. The third volume, mostly replies to his critics, appeared in its final edition in 1914, shortly before his death.

The other major contributor to the Austrian theory of time in the early years of the 20th century was the American economist Frank A. Fetter. His analysis of the process of “time-valuation” was presented in two treatises: The Principles of Economics (1904) and Economic Principles (1915).

During the 1930s and 1940s, additional contributions were made by the following Austrian economists: Friedrich A. Hayek in Prices and Production (1931) and The Pure Theory of Capital (1941); Richard von Strigl in Capital and Production (1934); and Ludwig von Mises in Nationalökonomie (1940) and Human Action (1949).

Every one of our actions requires us to think about time and to act through time. Whether it is boiling an egg or constructing a spaceship to the stars, we are confronted with the necessity of waiting for the desired result to be forthcoming. We apply various means at our disposal that seem most appropriate to the tasks at hand and we try to bring about the desired ends we have in mind.

But the cause (the application of the means) always precedes the effect (the resulting end or goal); and between the initiating of that cause and its resulting effect, there is always a period of time, whether that time period is merely a few minutes or many years. Each of our plans, therefore, contains within it a period of production.

Rarely, however, can our production plans be completed in one step. Usually the resources at our disposal must go through various transformations in a number of stages of production before the consumer goods that we want are ready for use in their desired, finished form. A tree must be chopped down in the forest. The wood must be transported to and cut in the lumber mill. The cut wood must be taken to the pulp factory and manufactured into paper. The paper must be boxed and shipped to the printing shop. The paper must be cut to size and the print must be applied to the separate pages to produce the Freedom Daily that is in your hands after it has been sent to you through the mail. What is expressed in this simple example has its analog in every line of production for the manufacturing of every conceivable good.

To undertake these processes of production, however, requires a certain amount of savings. Resources and raw materials that might otherwise have been used to satisfy some of our wants in the more immediate present must be freed for more time-consuming production activities. First, some of these resources must be available for transformation into capital goods — tools, machinery, and equipment — with which workers who are not employed in the more direct manufacture of consumer goods can combine their efforts in more time-consuming or “round-about” production processes. Second, resources and consumer goods must be available for use by those employed in the production processes.

The more savings there is, the more numerous the processes of production that can be undertaken in society-and the longer they can be. And as a result, the greater will be the quantities and the qualities of the goods that will be available for our consumption uses in the future. Why? Because other things being equal, the more time-consuming or “round-about” the production process, the more productive (usually) are the resulting methods of production.

However, the longer the periods of production we utilize, the longer we have to wait for the desired goods we wish to use or consume. People, therefore, have to evaluate the sacrifice, in terms of waiting, they are willing to make to get a potentially greater and more desired effect that can only be attained by producing for a time further into the future.

The sacrifices of time people are willing to make often differ among individuals. And these differing evaluations of time open up opportunities for potential gains from trade. Those who are willing to defer consumption and the uses of resources in the present may find individuals who desire access to a larger quantity of resources and goods than their own income and wealth provides them with in the present. And this second group of people may be willing to pay a price in the future for the use of those resources in the more immediate present.

An intertemporal price emerges in the market as transactors evaluate and “haggle” over the value of time and the use of resources. The rate of interest is that inter-temporal price. The rate of interest reflects the time preferences of the market actors concerning the value of resources and commodities in the present in comparison with their value in the future.

As the price of time, the rate of interest brings into balance the willingness to save by some with the desire to borrow by others. But the rate of interest not only coordinates the plans of savers and investors. It also acts as a “brake” or “regulator” on the lengths of the periods of production undertaken with the available savings in the society.

For example, suppose we were to ask, what are the respective present values of a $100 return on investment either one year, two years, or three years from now, with a market rate of interest of, say, 10%? They would be, respectively, $90.91, $82.64, and $75.13. Now, suppose that people in the society had a change in their time preferences such that they now chose to save more, with the resulting greater supply of savings available for lending purposes decreasing the rate of interest to 7%. What, again, would be the present values of that $100 return on investment one, two, and three years from now? The present values would be, respectively, $93.46, $87.34, and $81.63.

The present value will have increased for all three of these potential investments, with their different time horizons. But the percentage increases in the present values of these three possible investment horizons would not be the same. On the one-year investment project, its present value will have increased by 2.8%. On the two-year investment project, its present value will have increased by 5.7%. And on the three-year investment, its present value will have increased by 8.6%. Clearly, the tendency from a fall in the rate of interest would be an increase in investments with longer periods of production.

If, instead, time preferences were to move in the opposite direction, with people choosing to save less, with a resulting increase in the rate of interest, longer-term investments would become relatively less attractive. If the rate of interest were to rise from 7% to 10%, the present values on a $100 return either one, two, and three years from now would decrease, respectively, by 2.7%, 5.4%, and 8%. This would make investments with shorter periods of production appear relatively more attractive.

In an economy experiencing increases in real income, decisions by income-earners to save a larger proportion of their income need not require an absolute decrease in consumption. Suppose income-earners’ time preferences were such that they normally saved 25% of their income. Out of an income of, say, $1,000, they would be saving $250. If their preference for saving were to rise to, say, 30%, with a given income of $1,000, their consumption would have to decrease from $750 to $700 to increase their savings from $250 to $300. However, if income-earners were to have an increase in their real income to, suppose, $1,100 and their savings preference were to increase to that 30%, then they would now save $330 out of their higher income. But consumption would also rise to $770. This is the reason why savings can increase for new capital formation and investments in even longer periods of production without any absolute sacrifice of consumption in a growing economy. Consumption increases with the higher real income, albeit less than it could have if income-earners had not chosen to save a greater percent of their income.

But if there were a decline in the demand for consumer goods and an increase in savings, what would be the incentive for producers to invest in more capital and productive capacity? This was a criticism leveled against Böhm-Bawerk at the turn of the century by an economist named L.G. Bostedo. He argued that since it is market demand that is the stimulus for manufacturers to produce and bring goods to the market, a decision by income-earners to save more and consume less destroys the very incentive for undertaking new capital projects that greater savings is supposed to facilitate. Bostedo concluded that greater savings, rather than being an engine for increased investment, served to retard investment and capital formation.

In 1901, in an article entitled “The Function of Savings,” Böhm-Bawerk replied to this criticism. “There is lacking from one of his premises a single but very important word,” Böhm-Bawerk pointed out. “Mr. Bostedo assumes . . . that savings signifies necessarily a curtailment in the demand for consumption goods.” But, Böhm-Bawerk continued,

“Here he has omitted the little word ‘present.’ The man who saves curtails his demand for present goods but by no means his desire for pleasure-affording goods generally. . . . For the principle motive of those who save is precisely to provide for their own futures or for the futures of their heirs. This means nothing else than that they wish to secure and make certain their command over the means to the satisfaction of their future needs, that is over consumption goods in a future time. In other words, those who save curtail their demand for consumption goods in the present merely to increase proportionally their demand for consumption goods in the future.”

But even if there is a potential future demand for consumer goods, how shall entrepreneurs know what type of capital investments to undertake and what types of greater quantities of goods to plan to offer on the market in preparation for that higher future consumer demand?

Böhm-Bawerk’s reply was to point out that production is always forward-looking — a process of applying productive means today with a plan to have finished consumer goods for sale tomorrow. The very purpose of entrepreneurial competitiveness is to constantly test the market, so as to better anticipate and correct for existing and changing patterns of consumer demand. Competition is the market method through which supplies are brought into balance with consumer demands. And if errors are made, the resulting losses or smaller-than-anticipated profits act as the stimuli for appropriate adjustments in production and reallocations of labor and resources among alternative lines of production.

When left free, Böhm-Bawerk argued, the market successfully assures that demands are tending to equal supply and that the time horizons of investments match the available savings needed to maintain the society’s existing and expanding structure of capital in the long run.

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    Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).