Austrian Scholars Conference Speech

This is a sneak preview for all those who will attend my session at the 2007 Austrian Scholars Conference

Since the early days of the Vienna school, dating back to Carl Menger, the Austrians have had a devoted connection to methodological individualism and the rejection of historical interpretation of data as a foundation for theory. It was important to understand the inner workings of a market and the importance of the role individual decisions played in the unraveling of the economic system. The use of statistical data, averages, aggregates, and other forms of interpreting economic events has always been shunned by the Austrian school. As a result, the strength of Austrian theory truly lies in its embrace of concepts that capture the heart of the market and a purposeful rejection of statistical methodology which does little more than misdirect the attention of fruitful study. It is this use of averages and aggregates that have brought about some of the most conflicting and foundation-less theories in the field of economics. Keynesianism is notorious for its incredible aggregation of economic data and all the confusion it has brought about for both non-Keynesians and Keynesians alike. Simply stated, the use of averages and aggregates in economic theory do nothing more than develop incorrect doctrines and remove the focus of economics away from individual decision and human action. That said, the embrace of averages and aggregates is not only applicable to non-Austrian economists, but can be found in the writings of Eugen Böhm-Bawerk and even in the early writings of Ludwig von Mises and Friedrich von Hayek. More specifically, what I am going to speak about is the past acceptance of the failed concept of the “average period of production.” Before this, however, it is of the utmost importance that some time be spent discussing the period of production and those elements that effect it.

The importance of capital theory in Austrian economics, especially when dealing with the Austrian theory of the business cycle, is undeniable. It is only through constant study and understanding of the workings of the structure of production in a modern economy that the field of economics can begin to understand that true effects of central banking monetary policy. Since the publishing of Principles of Economics in 1871 capital theory has been an integral part of Austrian market theories. All Austrians recall the Mengerian example of the bread industry and the subsequent explanation of higher order and lower order goods. That those goods that are closer to consumption are to be referred as “lower order goods” and that those farther away from the ultimate product are goods of a “higher order.” The need for this distinction lies in the fact that these intermediate goods respond differently to varying occurrences in the market and that there structure is inherently ordinal. In other words, in order to properly contemplate changes in the structure of production, one must acquaint oneself with the differing stages of production and how they interact with one another in order to produce the final output. Alfred Marshall in his Principles, attacked Menger’s use of the terms “higher” and “lower” order, stating that they were too ambiguous and that little of importance could be attached to them. His reasoning was that if a train can be used to transport bread, bread machinery, and parts used to make machinery which, in turn, produce bread, that this train would be at the same time a 2nd, 3rd, and 4th order good; this he deemed was a sheer impossibility. The counter-argument here is brought to light when we realize that Marshall was simply looking at the physical nature of the train and not the role the train was playing in the production of the various goods. In all reality, the train can be a good of a 2nd, 3rd, and 4th at the same time, all that is of importance is the role it plays in the creation of final output. In an economy where different processes are going on simultaneous and where there are interactions with all stages of production, it is only natural that some goods play a role in every stage of production. Therefore, what is important is not the physical attributes of any specific economic good but, instead, what must be noted is its contribution to the continuing, simultaneous production processes of the modern economy.

This leads us into the discussion of the period of production and the relevance of such a concept in the analysis of a modern economy. The period of production is simply that time-span which elapses between the raw beginnings of a good and its ultimate consumption. In the case of a knife, one can think of the mining of iron ore, the smelting of the metal, the molding of the iron into a knife, its sale to wholesale and then retail and its final use by the consumer. This entire process is encompassed in the period of production. As changes in certain elements occur, namely the rate of interest, there will be a direct effect on the length of the period of production. As the rate of interest decreases there will be this tendency to shift the period of production outwards, towards a lengthier structure of production. On the other hand, if there is an increase in the rate of interest there will be a shortening of the period of production. In both of these scenarios, market participants had dictated their will through the rate of interest as to how forward-looking entrepreneurs should become in their ventures. The rate of interest, which is governed largely by the time-preference schedule of individuals, will shift according to any changes in the saving patterns of society. If individuals begin to save more and decide to convert theses funds into investments, this will bring about a decrease in the rate of interest. Through higher rates of saving, individuals are indicating to entrepreneurs that they should become more forward-looking and elongate the period of production to accommodate increased future consumption. Vice-versa, if individuals become less thrifty, they will reduce the amount of funds they are willing to lend and, as a consequence, they will increase the rate of interest. In such a scenario, market participants have decided to be less future-oriented and are demanding more current consumption in exchange for less future consumption. This shift in the time-preferences of individuals comes up on the economic accounting books as a reduction in the profit margins of some business ventures and an increase in the profit margins of others. By a simple alteration in originary interest -that is the ratio between future and present consumption decided by social time-preference schedules- economic actors are decreasing the profitability of creating some goods in order to shift resources to the creation of others. It is this alteration in the period of production that manifests the will of market participants. That said, if individuals increase their consumption and reduce the supply of capital, there will be this regression in the overall standard of living and the production process will be said to be less “capitalistic.” As von Mises has taught us, it is only through a constant increase in the amount of funds, up and above the quantity needed to replace existing capital stock, which will elevate the standard of living and further isolate society from a hand-to-mouth existence. It only because of a lengthening of the period of production that society can, in the long-run, increase the standard of living of all individuals. Though a positive analysis of changes in originary interest explain the effects of such an alteration on the capital structure, it is the role of normative analysis to indicate what is best for society.

As has been discussed, it is correct and proper to speak of a shortening or an elongation of the structure of production with respect to changes in various factors, including but not limited to changes, originary interest. That said, all discussions of a period of production are not as fruitful. For instance, the Böhm-Bawerkian concept of the “average period of production” does little in properly expressing the extent and length of the structure of production. The average period of production was developed by Böhm-Bawerk as an alternative to what he saw as the absolute period of production. This “absolute” period of production was the estimation of a structure of production that dated back centuries, if not millennia. From the first achievements of primitive peoples to the technological advances of modern-day scientists, it can all be encompassed in an absolute period of production. The idea is that because of the early discoveries of primitive societies and efforts of ancient peoples, modern economic processes can exist. Böhm-Bawerk uses the example of a boy who “whittles a willow whistle with his pocket knife” and is enjoying the ultimate good of a production process whose initial stages can be dated back centuries in the past when the first hole was dug to make the iron mine. It was then that the iron collected from the ancient mine was molded, given its final touches and eventually sold to the boy. Even though this may seem correct, there are many fundamental problems with this approach to calculating the period of production. In general, the idea that a period of production can be traced into the past is nonsensical. As Ludwig von Mises writes in Human Action, “acting man does not look at his condition with the eyes of an historian” and that as a consequence “the length of time expended in the past for the production of capital goods available today does not count all.” In other words, economic actors value capital goods -and all goods for that matter- on account of how they can best satisfy their immediate or more remote wants. The value placed on capital goods is totally dependent on the originary interest of modern-day market participants and thus, any discussion of previous laboring is not applicable. Though modern-day capital stock has grown to such an extent, much due to the past saving of previous generations, this capital stock can immediately be withered away if a change in the time-preferences of individuals wills it so and consumers are driven to “consume” part of their capital stock. Therefore, it is important to understand that the period of production does not begin thousands of years in the past but instead, how Professor de Soto notes, “the first stage of production begins precisely at the moment the entrepreneur conceives of the final stage in the process (a consumer good or a capital good).”

In an attempt to distance himself from the unattractive “absolute” period of production, Böhm-Bawerk sought to develop an alternative method of reaching a more proper period of production. As a consequence, Böhm-Bawerk developed the “average period of production” which takes a weighted arithmetic mean of all investment periods in an effort to illustrate the intensity of “roundaboutness” in any given economy. By using this average, Böhm-Bawerk believed that it was much simpler to understand the extent of a society’s capital stock and the sophistication of an economy’s productive structure. Any lengthening of the structure of production would come about as a positive shift of the average period of production and vice-versa with respect to a shortening of the structure of production. The problem with this approach was correctly summed up in a 1902 submission to the Quarterly Journal of Economics by Frank Albert Fetter in which he notes that Böhm-Bawerk’s average period of production commits a serious fallacy, namely the fallacy of averages. The average period of production fails because it indicates that the average length of time of the totality of the production process found in an economy has a direct connection to the extent of an economy’s output. As Fetter shows, some different industries have differing maturities with respect their production inputs. If capital is moved around so that it will increase the overall yield of an economy, it may decrease the average period of production. Under such a scenario, the average would have decreased indicating a decrease in economic output but in all reality output has been increased due to this negative shift in the average period of production.

Hayek also had his qualms with the concept of an average period of production. In part, his writing The Pure Theory of Capital had to do with his detachment from the average period of production. Hayek wrote that “while Böhm-Bawerk was fundamentally right, his exposition in terms of an average period of production was so oversimplified as to mislead in application.” Hayek argued that because of the nature of the average period of production, only when all capital goods are homogenous will there be a definite connection between the quantity of capital and the overall level of output. If different capital goods were weighted in value, this weighing process would have to factor in the rate of interest, something the average period of production does not include. Hayek also notes a point given by Knut Wicksell in his Lectures on Political Economy where he uses the existence of compounding interest as a counter to the average period of production. Because of compounding interest, the matured value of any production process is directly dependent on the rate of interest and not only simple interest. Hayek understood that the market is made up of complex phenomena and to assume homogenous capital or simple interest is quite unrealistic. Therefore, it must be concluded that, as Hayek puts it, “the amount of waiting involved in a particular investment is not simply proportional to the length of the investment period and the value of the input invested, but is dependent also on the rate of interest.” In addition, the mere fact that the implementation of different inputs in different ways at varying rates of interest will produce distinctly different averages makes the whole attempt of arriving at such an average pointless.

One last thing I must speak about that I have discussed in my paper is a critique given by Sir John R. Hicks in his work on capital theory, titled Value and Capital. In his literature, Sir Hicks attacks Böhm-Bawerk’s average period of production as being fundamentally incorrect. Though the average period of production is faulty, Sir Hicks’ reasons for the incorrectness of the concept is theoretically unsound. Sir Hicks believes that Böhm-Bawerk was wrong in stating that the average period of production could be discussed in terms of a period of time (e.g. 5.6 years, 2.5 years, etc.) and that in order to properly make use of the concept, it must be stripped of its time-based nature. Sir Hicks writes that “once the Austrian theory is put behind us, the only important thing which emerges is the general conclusion....that changes in the rate of interest affect the ‘tilt’ or crescendo of the production plan.” John Hicks disagreement with the average period of production was not due to the illegitimacy of discussing the structure of production in terms of a single average but, instead, that this average was in terms of a time-interval. To Sir Hicks, simply discussing a shift in the crescendo or height of the average period of production was sufficient and that referring to a period of time is pointless. What is important to note is that the use of an average in discussing periods of production is what is fundamentally wrong and not simply its time dimension. As analyzed, the problem inherent in the average period of production is due to what Frank Fetter saw as the “fallacy of averages.” Sir Hicks published a book later in his life titled Capital and Time: A Neo-Austrian Theory in which he again discusses, yet much more briefly, the average period of production and does not claim to reject any of his previously stated arguments.

In sum, it is necessary and proper for any economic school of thought to develop a correct theory of capital and understand how various different elements may effect the structure of production. For the Austrian school, Böhm-Bawerk laid the foundation for the brilliant expositions of capital theory found in Hayek’s The Pure Theory of Capital and Mises’ Human Action. Though Böhm-Bawerk’s refutations of various incorrect interest theories and his deduction of time-preference as a determinant of capital value are to be forever remembered, there were some concepts present in Capital and Interest that has, still to this day, had a negative influence on what Rothbard believed was capital theory in its “real form.”