12
Apr
2019
Capital & Interest in the Austrian Tradition, Part 1 of 3
If you are a professional economist, you should at least give this a listen starting at 37:10. That’s the second half of the episode where I explain how Bohm-Bawerk’s critique of the “naive productivity theory of interest” can be correct, even though mainstream models routinely conclude that r=MPK.
Of course, if you call yourself an Austrian, then you are obligated to listen to the entire thing no later than August 10, 2019.
About Bohm-Bawerk’s tractor critique … let’s suppose I discover that rolling out black plastic sheeting between rows of vegetables will improve the productivity of crop yields by $500 per acre per year. At the time of this discovery, the same black plastic sheeting is used by the building industry and in various types of rubbish disposal and already has a market price … for argument’s sake suppose capital costs are $100 per acre to get the productivity gain, based on pre-discovery market prices. We could say that it lasts two years in the field before it needs replacement, and we can presume all other costs are built into the $500 per acre per year gain (for example extra labour to roll out the plastic is more than offset by less labour pulling weeds or something like that).
Further suppose this technique becomes common knowledge and plenty of farmers start to use it.
Bohm-Bawerk would be surprised unless the market price of black plastic sheet shot up to $1000 for what had previously cost only $100. If the cost was any lower, the plastic sheet would be greatly undervalued, given the equivalent rent value and all that. But why though? The existing manufacturers were making OK profits at $100 and they already have a market lined up … why not sell a bit more at the same price? Perhaps the price might even go up a little because of greater demand, but not a tenfold increase.
What actually happens is that once a new capital productivity improvement is known and gets widely used, the market price of the crop comes down, and you hit physical diminishing returns on investment (putting down twice as much plastic doesn’t help) and it balances out again, so you don’t make a gain of $500 per acre anymore, you might make a gain of $60 per acre and the input price goes up a little bit to $110 per acre and the farmer ends up with a small positive return on investment. Essentially … the application of that particular factor of production keeps growing until it runs up against saturation at some point (both physical productivity limits and falling prices).
Same applies to tractors of course … we saw after WWI when tractors were introduced, the price of tractors actually went DOWN driven by better mass manufacturing techniques, and the price of food also went down, because farmers were more productive … in a competitive market they push against the downward sloping demand curve and they stop buying tractors at the point where it isn’t worth having any more of them. Some farmers went out of business, unable to profitably supply into a falling market price of food. Demand for other factors such as diesel fuel, mechanics, etc goes up.
Bohm-Bawerk’s argument only works on a temporary basis where a whole new capital good is released into a market and in that case, yeah those type of capital goods do tend to be expensive, but there’s a bunch of risk involved at the supply side and typically the suppliers want to encourage early adoption, so they don’t attempt to capture the entire profit. Think of smart phone manufacturers who probably made much better than normal market return for a while at least.
Tel, did you just prove that nobody makes an interest return when they invest in inputs, in a production technique that’s been around for more than a year?
I won’t claim credit for the proof … it’s a standard long run equilibrium result based on a competitive market.
https://www.cliffsnotes.com/study-guides/economics/perfect-competition/long-run-supply
Competitive markets plus technological advancement over time drives down the price of goods. What’s controversial about that? Seems a bit inconsistent to believe this applies to finished product consumer goods but strangely does not apply to capital goods in earlier stages of production. Am I missing an important distinction somewhere?
as far as I can see you are not distinguishing between profit (which market forces will eliminate) and interest (which will persist) from the new technologies.
Tel, “economic profit” means profit above and beyond the market rate of interest. (This is admittedly a slippery concept in the real world.) It’s true that textbook discussions rarely stress this, but clearly it must be true that the prices of factors of production don’t get bid up to the “full value of the product” *measured at the moment of sale of the product*, but only its present-discounted value at the moment of purchase. You don’t see this distinction much in textbooks because they don’t assume production takes any time!
Suppose there’s a zero-coupon bond that will pay $1000 in 12 months. How much would an investor pay for it right now? Not the full $1,000, even in a competitive market for bonds.
Likewise, if there are some labor-hours, land, and raw materials that could be mixed together to produce a good that will sell for $1,000 in 12 months, even with competition nobody would pay a full $1,000 for all of those inputs right now.
I’m illustrating that a convergence process exists, and it is a process that Bohm-Bawerk’s tractor critique simply shrugs and ignores. He pulls a value out of the air and says, “What if a tractor costs this much? Why isn’t it something else?”
Well, insufficient information exists in his example to explain anything. You need that iterative concept where economic profits tend towards zero (and therefore physical productivity also hits diminishing returns on a per-factor basis, because those are linked) before you can make the next step towards solving the problem. Once you get that far, then and only then does it makes sense to consider the limiting factors where convergence is complete.
Now the classicals call it “the price of money” and the Austrians call it the price you pay a person to defer consumption. I don’t think there’s a significant conflict between those two, other than emphasis perhaps.
The point is you get investment to exactly the extent that someone in the economy is willing to invest. You can only grow your aggregate capital stock if there is sufficient physical surplus (i.e. production sans consumption) to MORE than cover maintenance on your existing capital stock. In the extreme case, suppose no one anywhere was interested in investment, there would be zero capital.
That’s OK, because the economy converges towards the preferences of the people. Let’s say everyone loves square goods, but really dislikes round goods … as a consequence the physical factors of production would steadily be restructured to make square things (no one would build lathes for example). Similarly, if everyone has a short time horizon and wants instant gratification, the economic processes will adjust to deliver what the market wants which is minimal capital investment, and the high interest rates that go along with that.
What I’m getting at here, is the physical productivity limitation never goes away, it merely adapts and restructures to fit the requirements. You will still be sitting at r = MEK in all situations … but that’s the nature of these marginal values, they adapt as the operating point slides along the curve. To put this in other words, people saying r = MEK are correct in describing the local picture and one more unit of capital vs one less unit of capital, but not accurate in describing the big picture because the world is nonlinear.
That’s same for labour too. Krugman makes this fallacy when he says, hey if the wages of wealthy people exactly equals their marginal productivity, then it would be a wash if all wealthy people stop working. There’s a confusion here between the marginal case (one wealthy person works one hour less) and the bulk case (all wealthy people stop working completely). Marginal theory tells you nothing about what happens in the bulk case.
It’s also fair to point out that in the real world convergence never happens. The “evenly rotating economy” is a theoretical construct … while in reality there’s always change and risk. Yes even government bonds have risk in the form of a soft bond default driven by inflation. The classicals accept that perfect competition is also hypothetical and never happens in practice … although rarely quantified in terms of how much difference this makes to profit margins. I haven’t read enough Bohm-Bawerk to know whether he assumes away some of these fiddly bits.
“Of course, if you call yourself an Austrian, then you are obligated to listen to the entire thing no later than August 10, 2019.”
Oh, I’ll be listening to all three parts way before then (already listened to the first, so far), and then keeping them forever.
I think this issue is huge – like make-or-break-Austrian-Economics huge. As you may remember, I hold firmly to the Pure Time Preference Theory of interest, and I actually got dinged awhile back for bringing it up in a way that was off topic.
At that time, I said this:
“An actual decision is made at T1, which means a separate decision is made at T2.
“The decision at T1 may be inspired by what may happen at T2, but only decisions – human action – are relevant to economics.
“T1 happens on its own demand schedule, and so does T2.
“Both of which are ordinally ranked.”
This comment was made with the part of your dissertation in mind that said that the existence of preferences for nominally negative interest rates disproves the part of the theory that says that present satisfaction is preferred to the same satisfaction in the future.
It so happens that I found a quote from Mises that is just a less clunky way of saying what I said above:
From Human Action:
“The judgments of value which determine the choice between satisfaction in nearer and in remoter periods of the future are expressive of present valuation and not of future valuation. They weigh the significance attached today to satisfaction in the nearer future against the significance attached today to satisfaction in the remoter future.
“The uneasiness which acting man wants to remove as far as possible is always present uneasiness, i.e., uneasiness felt in the very moment of action, and it always refers to future conditions. The actor is discontented today with the expected state of affairs in various periods of the future and tries to alter it through purposive conduct.”
So when (to borrow from one of your examples) someone prefers to accept less than he has now for the future, given that he will be choosing between two possible futures in which both interest rates are negative, that’s only because he has a higher preference for preserving what he *will* have in the future than consuming in the present, *and* it means that, at the moment he is choosing to have less for the future, he is choosing the better of the two interest rates, as he sees them.
He wants as much for the future as possible, and that’s a positive “real” interest rate (in the psycic profit sense).
(Note that this also answers the critique that the PTPT “… involves an aggregation just as heroic as that performed by any mainstream macroeconomist. After all, the PTPT compares the utility received from ‘present goods’ with utility from ‘future goods.’”)
You have a ready reply to the “psychic profit sense” (my words, not yours) in your dissertation, and I’ll tackle that one:
“Second, the claim completely eliminates money from the explanation of interest. Interest is seen as a ‘real’ phenomenon;25 the premium in money loans is considered a symptom, not the cause, of interest. In all other respects, Austrians are mindful of the “driving force” of money,26 going so far as to argue that profit
and loss are not really meaningful concepts in a world devoid of money (e.g. Mises 1966, pp. 201-206). Yet strangely, this does not stop Austrians from commenting on the magnitude of time preference independent of any mention of money prices.”
I don’t understand why Mises would say that interest makes no sense without money, but if he did say that in the sense that you understand it, then he would have to be wrong given that the concepts of profit and loss are not, fundamentally, a monetary phenomenon, and given that interest is just profit and loss that is realized in the future as opposed to the moment of action. (Psychic Profit + Time = Psychic Interest?)
And just for other readers, here’s a good explanation of what is meant by Psychic Profit from Rothbard:
In Defense of “Extreme Apriorism”
[www]https://mises.org/library/defense-extreme-apriorism
“The fourth — and by far the least fundamental — postulate for a theory of the market is the one which Professors Hutchison and Machlup consider crucial — that firms always aim at maximization of their money profits. As will become clearer when I treat the fundamental axiom below, this assumption is by no means a necessary part of economic theory. From our axiom is derived this absolute truth: that every firm aims always at maximizing its psychic profit. This may or may not involve maximizing its money profit. Often it may not, and no praxeologist would deny this fact.”
So, the preference for negative money interest rates does not, itself, disprove the PTPT and neither would negative (or zero rates) in terms of nominal goods.
Profits and interest are always of a Psychic nature, but may not necessarily manifest in nominally positive terms.
The implication being that real-world physical productivity does assert itself on our decision making (not pure time preference). The only reason someone would choose an option that he/she dislikes is because no better option is available … so the productivity theory of interest never goes away, it merely can be changed by human will, to some extent.
For example, the interest rate of fresh strawberries (as measured in fresh strawberries) is always negative. With refrigeration it is slightly less negative. Suppose you have important guests coming next week and you know they expect to be served strawberries, in your particular situation it’s better to get a delivery of fresh strawberries the morning before the guests arrive (future strawberries) than it is to have a load of strawberries right now. However, maybe that’s not an option (we are familiar with a modern economy where anything can exchange for anything else anytime, but suppose that isn’t available, maybe transport costs are very high and you live in a remote community).
If you can only get strawberries now, and your choice is limited to either put them in the refrigerator or put them on the bench, well in that case BOTH options impose negative real returns, but at least with the refrigerator you might have something left over for the guests.
I will follow up by pointing out that people put a lot of effort into inventing refrigeration BECAUSE it gives better physical productivity for food storage and this is a really big thing. Everything you put in the refrigerator will eventually go bad (negative real return) but those negative returns still seem attractive when you compare to what people could achieve before refrigeration was available.
Of course we also have supermarkets, interstate shipping, out of season fruit, and all sorts of other technology that are essentially different solutions to the same problem.
“… BECAUSE it gives better physical productivity for food storage and this is a really big thing.”
It’s really big *because* they value increased consumption in the future. But at a certain point, it will not make sense to increase production.
You may want to have the food-storage security of being able to weather a depression, and so you buy 25-year food storage containers and stuff your house with them.
But you’re not going to stuff your *whole* house with them because you still need to use the shower in the forseeable future, etc.
Sure, every time I buy a unit of long term food storage I’m trading off present consumption for future consumption (although I could eat it tomorrow, or any day) probably at negative rates since I can buy better fresh food for less money if I’m eating it today.
But a pure time preference theory could not explain buying a limited number of such containers “just in case” instead of buying all of them. Using the shower in the present day and the near future must therefore rank higher than consumption in the long term future, risk-adjusted for the possibility that food could be in short supply, perhaps, sometime.
In order to get room for decision making on the margin you need to consider some non-linearity and diminishing return there too.
Look at this example: a farmer wants to buy a new tractor, and has good reason to believe there is better than average profit to be made from the tractor. The plans are all drawn up, and the farmer is ready to buy, unfortunately there’s a storm and the crop gets damaged this year. It’s a risk that can happen. Profits are going to be quite low this year. The farmer considers a loan but the money markets are not looking kind and they impose high premiums because his business is a bit marginal. The farmer could spend all the remaining money and buy the tractor but that would not leave sufficient for normal upkeep on the business … so the farmer decides to cancel the purchase and spend the remaining money on more short term concerns to keep the business operational.
Next year is a much better year! Luck is with him, profits are good and the farmer once more considers buying the tractor. There is sufficient money available now for the capital purchase and all the other regular upkeep to keep the business turning over so the farmer decides to buy that tractor. Has the farmer’s time preference changed? Not really, it’s exactly the same as last year. Has anything about the tractor changed? No, the price and capabilities are the same as last year.
However, on the margin a tractor is useless if the business is bankrupt so achieving that much has a very high return if you consider the potential negative consequence of losing the whole business. Therefore the farmer’s first preference is doing all those things that immediately need doing, and his second preference is investment in additional capital. As more surplus profit becomes available, people are willing to spend it on more long term speculative returns. Survive first, invest second.
“But a pure time preference theory could not explain buying a limited number of such containers “just in case” instead of buying all of them.”
Sure, it can.
He values taking showers in the near term more than he (at the present moment) expects to value a future with more food storage but having taken fewer showers.
Badabing, badaboom.
“The implication being that real-world physical productivity does assert itself on our decision making (not pure time preference).”
No, it’s the preference that makes the supply valuable. My “important” guests (important to me, that is) can expect strawberries all they want, but if I don’t care about frustrating them, no supply is going to change that.
It’s the fact that my guests *are* valuable to me that determines what I will be willing to pay for strawberries.
And that will be true for any supply, even a super-abundant supply. I may normally be able to get them super cheap because there’s so much of them, but because I value a certain form of delivery, and within a certain time frame, I may be willing to pay way more for them.
All economic valuations start with the subjective ends of the acting individual; He is already willing to pay up to X (or at least X), so the supply merely determines what he is able to get away with paying. The supply of a good does not determine his subjective valuation of that good.
But if you were buying roof tiles, and the option was buy cheap today or get an expensive special delivery in two weeks you would probably buy them today … even if you don’t need them for two weeks (maybe you need to schedule the materials to be available for a workman at a specific time).
Point being that the intrinsic nature of tiles makes them easy to store with minimal loss … the market builds itself around the product, not the other way around.
“… the market builds itself around the product, not the other way around.”
The market for tiles exists because of the demand for tiled roofs.
As Joseph Salerno has said, when discussing Menger’s Theory of Imputation (paraphrase): “If nobody valued diamonds, diamond mines would have no value”.
(At least not as diamond mines, I would clarify.)
I can’t find the exact quote, but he says it in the following video:
The Birth of the Austrian School | Joseph T. Salerno
[www]https://www.youtube.com/watch?v=dZRZKX5zAD4
Economic value is imputed to physical things *from* the subjective ends of the individual.