Unmixing the Metaphors of Austrian Capital Theory
Money & Macro2

Unmixing the Metaphors of Austrian Capital Theory

The distinctiveness of Austrian capital theory (ACT) against competing theories of capital lies in (1) its process approach over time as opposed to a comparative statics approach, (2) its emphasis on relative prices as opposed to the general level of prices, and (3) its recognition of the importance of the heterogeneity of physical capital. On the strength of these analytical convictions, ACT has persisted into the 21st century as a robust, though marginal, perspective in macroeconomics.

Unfortunately, progress in the decades since its divergence from neoclassical capital theory has been sporadic at best. Severe conceptual problems have been masked by a sense that the pure axiomatic theory of capital is essentially complete, and that its conclusions are invariant the particular metaphors and paradigms used for capital. In fact much of ACT is not pure theory, and several important conclusions hinge on precisely on the simplifying metaphors used to make it operationalizable, particularly the choice of a point-output circulating capital model. Though some authors in the Austrian tradition have made important advances since Hayek (1931), no subsequent work gained widespread consensus as a canonical statement until Garrison (2001), essentially a formalization of Hayek (1931). Even those authors making progress in the intervening period have been on the whole conservative, preferring to leave the edifice intact despite significant revisions to the foundation.

This paper argues that further progress will consist in developing a flow-output model of capital centered around the investment project as the unit of analysis rather than the capital good. This approach is implicit in work by Lachmann, Lewin, and Cachanosky, particularly in the latter’s papers on financial duration. Nevertheless, for the most part they still lack a self-consciousness about their distinctiveness from the Hayek-Garrison point-output model, which remains standard in Austrian pedagogy. The attempt to maintain backward compatibility with the constructs used in point-output models can only retard further progress.

The following section surveys the conceptual problems that have arisen with ACT over the past century, and especially with the Austrian business cycle theory (ABCT) that largely motivates it, along with the various attempts to deal with these problems along the way. Most of these problems arise from capital theory’s pre-marginalist Ricardian heritage and the complementary decision to build up from an isolated Crusoe economy. The paper then argues that dealing with these problems has major implications for the conclusions of ABCT. In particular, if we are to preserve the analytical distinctives of ACT in light of these conceptual problems, it will be necessary to discard many of the important conclusions of ABCT, particularly the relevance of malinvestments as an explanation for business cycles and the necessary connection between boom and bust.

A Brief History and Critique of the Canonical Austrian Theory

Capital in its pure theory sense refers to the productive aspect of any good; that portion of its value that reflects its usefulness for future consumption as distinct from immediate consumption (Lachmann 1956: xv). It is distinct from the concept of the capital good, which refers to a good whose value is derived entirely (or at least predominantly) from capital value. Provided we remain at this level of abstraction, anything we say about capital will be valid for any form of capital, whether a durable good, a good-in-progress, land, human capital, financial capital, or anything else.1

In practice however, the capital value and the consumption value of a good are not disentaglable. To tell a relevant and operationalizable causal story requires a mid-level theory shaped by the choice of a paradigmatic capital good. This is the type of concrete good we have in mind when telling a causal story, and to which the capital aspect of all other goods can (in principle) be assimilated by analogy. Such a theory, though necessary to refer the results of capital theory to the real world, will not be axiomatically valid. To build up from the pure logic of choice in a Crusoe economy, therefore, is not a mere extension of that pure logic, but rather a definite choice as to the type of plan and capital good relevant to a theory of capital.

On this level, the development of capital theory since the beginning of the discipline of economics has been driven by the metaphors chosen by the classical economists and the dead ends they have led to. Historically there have been two important descents from pure theory relevant to capital theory: (1) the dimension of aggregation, and (2) the operationalization of time. Over the past century the paradigmatic capital good in economics has undergone two shifts corresponding to these two descents, respectively: (1) from a circulating to a durable capital concept, and (2) from a physical to a monetary capital concept. Both of these shifts can be thought of as efforts to replace the Ricardian metaphor for capital, which collapses these distinctions, with metaphors that take these distinctions more seriously.

It must be emphasized that many Austrian writers have been aware of some or all of these problems, or have at least made token acknowledgments of them. Nevertheless, their full implications for the workability of ACT have rarely been appreciated, and nothing approaching a solution has yet been integrated into its main body. At the risk of some tedium, therefore, the problems must be rehearsed and their full implications drawn out.

The Ricardian “Subsistence Fund” Model

The earliest macroeconomic model of capital, which in some respects is still the foundational metaphor of ACT, is the wage fund or subsistence fund, first developed in Mill (1848) and built on the Ricardian model of capital.2

The subsistence fund is a theoretical aggregate of deferred consumption in an economy, usually identified with savings, which is necessary to keep an economy above subsistence while investments are being made. Because investment locks up resources for a period of time, the theory goes, an economy must have a sufficient stock of accumulated goods (“free capital”) to pay wages and support consumption during this period. If it does, then these investments will lead to an increased equilibrium flow of consumption, though requiring a longer period of time to produce any single good. As the subsistence fund grows, longer – and therefore more productive – investments can be undertaken. If the fund is not sufficient to maintain subsistence consumption during this period, the investment must be liquidated and return to the previous production processes.

The subsistence fund is a powerful metaphor. Just as the classical English economists insisted against the mercantilists that it was goods rather than money as such that made an economy wealthy, so they insisted that clear-eyed economic analysis be done in terms of goods rather than money. Money was understood as a “veil” that coordinated (and was isomorphic to) the more fundamental movement of goods, and could thus be ignored provided it does not get “out of order” (Mill 1848: 488). The loan market, therefore, was understood to be in its essentials a market where idle resources (the subsistence fund) could be rented out. Even if any particular person could borrow beyond his means, this always required someone with idle resources willing to lend.

In its original form, the subsistence fund was intended as an explanation for economic growth and the distribution of incomes. ABCT uses it to explain features of business cycles: artificially low interest rates induce entrepreneurs as a whole to undertake investments for which the subsistence fund is insufficient. There remain, however, a number of issues that call into question whether the subsistence fund is a coherent metaphor for an economy in any respect. First, does it make sense to think of an economy as possessing an accumulated subsistence fund? And second, does it make sense to think of a production process in terms of waiting?3

Both questions, in fact, can only be answered in the affirmative by homogenizing capital. If capital is not intrinsically homogenous, as in a corn economy model, it can be aggregated along some dimension, a pragmatic simplification taking us out of the realm of pure theory. For Ricardo, and continuing well into the Marginalist era, this dimension was embodied labor time. This is the crucial simplifying assumption behind Ricardian economics, and the reason it sits so uncomfortably beside the Marginalist elements grafted on by Böhm-Bawerk and later Austrians.4

Over the first several decades of the twentieth century, the labor-time issue came up repeatedly in attempts to advance formulations of ACT and ABCT. In particular, the attempt to reformulate it in more strictly marginalist terms drove the transitions (1) from Böhm-Bawerk’s point-input-point-output model to Hayek’s flow-input-point-output model in the 1920s and 1930s, (2) from circulating capital models to durable capital models in the 1930s and 1940s, and (3) from physical-unit to monetary-unit models of capital following the Cambridge Controversy in the 1960s and 1970s. We take these transitions in turn.

Roundaboutness and the Circulating Capital Metaphor

The Ricardian apparatus at the base of the subsistence fund model centers on relatively homogenous factors of production, namely capital, labor, and (in older expositions) land, and the determination of the incomes of the owners of these factors. Capital was defined as “produced means of production” and contrasted with the other two “original” factors of production, these having analytical priority due to their role in producing capital as well as consumption goods.

Though the “produced means of production” definition was found to be unsatisfactory early in the development of capital theory (Fetter 1900), Mises (1966: 493) and Hayek (1931) both carried through the Ricardian conclusion that increases in real income must eventually redound to owners of the original factors of production, land and labor, and not to owners of capital. Capital itself, it was argued, was not productive, but rather embodied the productivity of the original factors of production. Thus, in zero-profit equilibrium, income would transmit up the supply chain, with increases accruing only to the labor and land applied at each stage of production.

With the analysis thus focused on incomes accruing to original factors of production through a linear supply chain, a circulating capital paradigm follows almost as a matter of course. A circulating capital model regards the paradigmatic capital good as a good in progress (e.g. Hirshleifer 1970: 159), as opposed to a durable capital model, where the paradigmatic good is a tool used in the production of other goods. In a circulating capital model, goods in progress receive input from factors of production over several stages. To the extent that durable capital was involved, this could be thought of as the indirect application of original factors over an increased number of stages.

One influential set of paradigmatic goods-in-progress comes from Böhm-Bawerk ([1891] 1930), namely, growing trees or aging wine. This metaphor was the core of Böhm-Bawerk’s point-input-point-output (PIPO) model: one invests a certain amount of value at an initial point (say, planting a tree), which accumulates value over time but at a diminishing rate. The choice problem, then, is to find the optimal harvest time, when the marginal benefit of waiting just begins to outweigh its marginal cost. The trees in the process of growing were understood to be capital, which become consumption goods when harvested. And because the higher productivity of roundabout production was supposed to hold only at the possibilities frontier, “wisely chosen” capitalistic processes (ibid: 82, 86) could be assimilated to the trees-and-wine paradigm.

Trees, however, were never a particularly intuitive metaphor for industrial processes, nor waiting itself as a factor of production. As Lachmann (1956: 84) points out, “there are [also] many examples of goods (fruit, flowers) which are spoiled by the lapse of time.” The paradigmatic capital good had to be broadened to account for goods-in-progress for which the services of original factors over time, rather than time as such, accounted for increasing value.

The Ricardian device allowed just this. Capital goods could be collapsed into homogenous units of labor-time, resulting in an “average period of production” across an economy. More capitalistic production embodied more of the original factors (or, as Mises [1966: 493] put it, “labor, nature, and time stored up”), and thus more cumulative waiting between the start of a production process and the end. Strigl ([1934] 2000) therefore could argue that roundaboutness is nothing more than the division of labor: specialization entails more labor units being employed on capital goods rather than directly on consumption goods, and can thus be understood as increased total waiting.5

Among Austrian writers, this collapsing and homogenization coexisted for a long time with an explicit emphasis on the heterogeneity of capital, with the latter serving to obscure the former. As Lachmann (1956: 73) argued,

On the one hand, no other economist saw more clearly than [Böhm-Bawerk] the essential heterogeneity of all capital… On the other hand, his theory is essentially an attempt to reduce this ‘complex’ to a common denominator and to measure all changes in it in the single dimension of time… [H]e failed when he tried to introduce the incongruous element of single-dimension measurement into a theory conceived in terms of heterogeneous products.

Later Austrian writers did become aware of particular difficulties in Böhm-Bawerk’s exposition. The average period of production, though used uncritically in Hayek (1929), was later called a “meaningless abstraction” in Hayek (1936) and an “empty concept” in Mises (1966: 489) – and this was the consensus among those sympathetic to Böhm-Bawerk’s project. If the Ricardian device for collapsing capital goods into waiting time was invalid, a new capital metaphor would be necessary.

This was the impetus for the development of Hayek’s flow-input-point-output (FIPO) model, carried through in Garrison (2001) and still the prevailing metaphor for capital in expositions of ABCT. In this model, a good passes through various “stages of production” with its value increasing in each stage, hence the flow input, and results in a final good at the end of the process, hence the point output.

In spite of this advance however, Hayek’s model was essentially conservative. Economists had begun by this point to prefer a durable capital metaphor, where the paradigmatic capital good was a good used in the production of other goods rather than a good in progress. Nevertheless, rather than build an exposition centered around a durable capital metaphor, Hayek in numerous places (1929; 1931: Preface; 1932b: §XII) insisted that the issues in circulating and durable capital models were, aside from some expository differences, identical in all essential economic respects, and endeavored to “abstract from the existence of durable goods” (1931: ch. 2). To produce a durable capital good is understood as an additional stage in the production of the good in which the capital good aids. Roundaboutness, now unmoored from its original Ricardian grounds, lived on in an essentially unchanged model, as synonymous with capital intensity.6

The basic problem, however, was that the circulating capital metaphor, passing from Ricardo through Böhm-Bawerk and Hayek, depended implicitly on the labor theory of value to aggregate physical capital to a single scalar value, whether understood as a unit of time, labor time, or capital more generically – a point noted as early as Fetter (1902) but never fully internalized until Sraffa (1960), when the roundaboutness metaphor lost currency among non-Austrians for other reasons.7 In spite of Hayek’s awareness of difficulties with Böhm-Bawerk’s approach – difficulties which he later admitted he underestimated (1941: 3-4) – Lachmann’s assessment of the latter above could just as well be applied to Hayek’s approach. The tools developed with the circulating capital metaphor in mind, particularly the average period of production but also more abstract concepts like ‘roundaboutness’, could not, in the end, be rescued. If the Ricardian edifice – which Hayek (1933) took to be synonymous with “economic theory” – was to be rescued, capital could not be reduced to time or labor units. The roundaboutness metaphor, therefore, is nonoperational.

Unfortunately, with the cold reception of Hayek’s (1941) (by most accounts) convoluted attempt to work through the difficulties of the Ricardian framework, and the near-total abandonment of capital theory by neoclassical economists in the wake of the controversy, progress on ABCT stalled. Even modern retellings, such as Garrison (2001), find it easier to use these older and less apologetically Ricardian constructs from Hayek’s earlier work on the topic (1931).

Monetary versus Physical Units on Capital

If problems with the circulating capital metaphor vitiated the roundaboutness concept, issues raised during the Cambridge Capital Controversy made it clear that capital intensity, even divorced from a notion of roundaboutness, was not conceptually viable. Capital theory could not, therefore, simply replace roundaboutness with capital intensity; a more fundamental reconceptualization would be necessary.

Sraffa (1960, ch. 12) showed that capital intensity could not be understood as a one-dimensional scalar. In particular, if the flow of inputs into the production of a good was not constant, the optimal technique might vary in unpredictable ways as the interest rate fell. If two production techniques could not be unambiguously ordered as to capital intensity, the simple Ricardian story, where saving and investment work through capital to determine long run income, could not be applied to actual industrial processes. Samuelson (1966) summarizes the issue:

The phenomenon of switching back at a very low interest rate to a set of techniques that had seemed viable only at a very high interest rate involves more than esoteric technicalities. It shows that the simple tale told by Jevons, Böhm-Bawerk, Wicksell, and other neoclassical writers – alleging that, as the interest rate falls in consequence of abstention from present consumption in favor of future, technology must become in some sense more “roundabout,” more “mechanized,” and “more productive” – cannot be universally valid.

Samuelson goes on to provide arithmetical examples of reswitching for both circulating and durable capital models. Even before Sraffa’s proof, however, Lachmann (1956: xiv) could claim that “most economists agree today that except under equilibrium conditions, a ‘quantity of capital’ is not a meaningful concept.” Though the main target of the reswitching debate was neoclassical capital theory, the Austrian theory – now bereft of both the roundaboutness metaphor and the capital intensity concept – was an important casualty,8 and no doubt this gave an air of obsolescence to ACT.

The issue, again, is one of aggregation. Following the classical economists, capital theory was one of the last holdouts in continuing to insist on analysis in physical terms. In this case, the purpose of the insistence was that aggregating capital in value terms makes the capital stock a function of the interest rate. In Ricardian analysis, however – formalized as the Cobb-Douglas production function of neoclassical theory – diminishing returns to capital in physical terms pin down the interest rate at the productivity of the marginal piece. To abandon physical aggregation of capital was to admit that the quantity of capital was a function of the interest rate, and not vice versa, and therefore to abandon the Ricardian project of income determination by ownership class.9 Though conservatism had carried Ricardo through the middle of the century, if capital could only be meaningfully aggregated in value terms, the edifice would have to – at last – be abandoned totally.

Unfortunately, the Ricardian edifice continues to be used pedagogically and in actual theory. Neoclassical growth theory – in an unbroken line from Solow (1956) to Acemoglu (2009) – continues to model the interest rate as the marginal productivity of (physical) capital. Austrian capital theory – in an unbroken line from Böhm-Bawerk ([1891] 1930) to Garrison (2001) – continues to draw on the roundaboutness metaphor. If ACT is to be made conceptually viable, it will have to dismantle the remaining vestiges of the Ricardian edifice.

Toward a Coherent Austrian Capital Theory

Even if no particular reconstruction of the Austrian theory has yet surpassed the Hayek-Garrison exposition, a number of authors have made important steps toward a more analytically satisfactory ACT, even if we still lack both a full statement of the amended theory and a reevaluation of its original claims. Though the former would be a book-length task, this section takes some steps toward the latter by delineating a distinct Lachmann-Lewin-Cachanosky model from the standard Hayek-Garrison model.

The Duration Concept

One important corrective has been developed in Lewin & Cachanosky (2015, 2018) and Cachanosky & Lewin (2016, 2018), who build on Hicks (1939; 1973) to provide an alternative concept to replace the average period of production and its long succession of abortive replacements: namely, financial duration.

Duration, in its modified or Macaulay form, represents the semi-elasticity of the capitalized value of a stream of income with respect to the interest rate (see Cachanosky and Lewin 2016 for a derivation). In this respect it captures much of what the ‘average period of production’ concept was meant to: industries with a longer duration will be more sensitive to changes in interest rates, and therefore more prone to malinvestment under the guidance of misleading intertemporal price signals. The important difference is that the quantity responding to changes in the interest rate is not a (physical) quantity or aggregate of capital, whether measured in time or labor time, but capital value. As Lewin and Cachanosky (2018) point out, by making “capital intensity” a function of the interest rate rather than vice versa, the Ricardian project of determining the incomes of various classes of owners is rendered defunct, precisely the break necessary to put ACT on firmer footing.

Lewin and Cachanosky trace through several implications of the duration concept for ACT. In the first place, the time structure of production as a series of stages is an untenable holdover of the circulating capital metaphor. Contra Mises’ (1966: 333) attempt, Lewin (1999: 64) sums up the conceptual problems with arranging capital goods by order:

The formula is crucially dependent on being able to identify the stages of production. It is assumed that the process begins at stage 1 and ends at stage n. In this way any kind of “looping” (coal is used in the production of iron and vice versa), where the output of one stage becomes available as an input of an earlier stage, is ruled out. Second, if the output is a flow (as it usually is), then we must also have some way to connect inputs that occur at time periods n–t with precisely that output that arrives at time period n and separate them from those that need to be connected to outputs occurring at time periods n+j where j is an index of time periods occurring after n. In other words, if the production process is a flow input—flow output process, a set of inputs are used to produce jointly a set of outputs occurring over time and the measuring of T becomes more problematic. Similarly, we must be able to identify the amount of labor time l that is used. This obviously presumes that it is possible to reduce any labor heterogeneity to comparable terms, like efficiency units, and then to measure the number of such units supplied per period of time.

Even so, the main thrust of Lewin and Cachanosky is conservative, preferring to repair the foundation without modifying the edifice. They argue that financial duration “captures what it was that the Austrians struggled to express” (2018) and that, besides some infelicitous metaphors like the time structure of production, and some misidentification of where malinvestments would arise (2016), the basic logic of ABCT is sound. Lewin (1999), after the above quote, is unwilling to abandon the roundaboutness metaphor because “even where we have a simultaneous and perfectly synchronized production process, considerations of the time structure and the decisions related to it must still enter” (p. 66). The vision of Böhm-Bawerk’s critics of “consumption and investment tak[ing] place at the same time”, he argues, “is valid only for an economy that has reached a state of stationary equilibrium.”

In a pure theory sense, duration does capture much of the intuition behind the roundaboutness metaphor and the average period of production intended to quantify it. Nevertheless it is not simply a drop-in replacement. Though it is possible to attach the meaning of duration to the term ‘roundaboutness’, the constellation of nonoperational metaphors surrounding the latter, and their pedagogical persistence, suggest the desirability of replacement rather than rehabilitation. Lewin and Cachanosky’s (2018, §V) “financial reformulation” of ABCT, for example, in addition to swapping out financial duration for the average period of production, employs a flow-output durable capital metaphor that departs fundamentally from the circulating capital metaphors used in the Hayek-Garrison model. Lachmann, in his corpus, largely does the same, though without an explicit duration concept. Both employ a durable capital paradigm unselfconsciously; indeed, it is not clear that any of these authors have fully appreciated the ramifications of the different paradigm. Most commentators have accordingly overlooked this essential difference, without which it is all too easy to fall back into Ricardian habits.10

Duration and Durable Capital

The flow-input-flow-output (FIFO) paradigm suggested by Lewin above entails substantially different metaphors for capital than either Hayek’s flow-input-point-output (FIPO) or Böhm-Bawerk’s point-input-point-output (PIPO) models. If the paradigmatic capital good in a PIPO model is trees, and the paradigmatic capital good in a FIPO model is a good-in-progress (say, a brick, to which is added successively larger structures), only a FIFO model commits to a paradigmatic durable capital good receiving inputs and delivering outputs synchronously. Only this way can we capture the synchronous quality of production without resorting to a Knightian model that assumes the reconciliation of plans in a market that a capital theory ought to explain (as averred by Hayek [1936] and Kirzner [1966]).

This substitution is not, by itself, sufficient to solve the issues raised so far. So long as we regard durable capital as stored up labor time, another detour taken by original factors of production in the process of their transformation into consumption goods, “there is no essential difference between the circulating-capital and [durable]-capital models” (Bruno et al. 1966). However, regarding capital in this manner is precisely this analytical step that has proven so problematic in Austrian capital theory. It is not circulating capital as such that poses so many intractable problems; rather, it is symptomatic of Ricardian habits of thought. Durable capital as the paradigmatic capital good will be necessary, but not sufficient, for a productive reorientation.

What would such a reorientation look like? Most importantly, the unit of analysis in capital theory will not be the capital good, but rather the investment project. Rather than resulting in a final consumption good as in point-output models, the investment process in a flow-output model is understood to result in a production process (or changes to an existing one) that itself generates a flow of goods. Rather than focusing on the time-structure of production as a stock of capital, a FIFO capital theory would focus on the flow of investment – and without the diversion to “original” factors of production. As Knight (1934, §12) pointed out, though somewhat obscurely, the original factors to which the income from a capital project is imputed are not those gifts of nature present at the beginning of time, but rather those present at the initiation of that project. That these factors were themselves produced with the aid of land and labor is irrelevant except to the extent that they were produced with the income from this project in view, in which case the project’s boundaries would include them too. To use Crusoe as a pedagogical device, therefore, is systematically misleading if we wish to develop a capital theory with reference to market economies.

This argument builds on Lachmann (1956), who sets out to analyze capital theory with the plan as the basic unit of analysis. But it matters what we take to be the paradigmatic plan. Kirzner (1966), for example, is scrupulously plan-centric, but because he begins from a Crusoe economy, the paradigmatic plan in his analysis is something like “produce a good” – a point-output model that still fixates on the application of ‘original factors’ and reproduces all the Ricardian modes of expression. To take the project instead as our paradigmatic plan places Lachmann’s suggestion in the context of a flow-output model that was only implicit in his work. Once the capital structure is in place, production itself, along with capital maintenance, are routine, in the sense of being foreseen as part of the original plan.11 This allows us take seriously both the insurmountable problems with Ricardian circulating capital metaphors, without giving up on the distinctives of the Austrian process approach. Indeed, Lachmann (1956: 14) specifically identifies analysis based on plans as identical with an Austrian process approach. To develop this line further is fundamentally Hayekian in spirit,12 even if it does not follow Hayek’s own analysis in many particulars.

A flow-output model with durable capital at the center is the more natural setting for the duration concept. It is hardly sensical to speak of the duration of a piece of circulating capital, except in a highly stylized arithmetical example. In real-world usage, it is not the durable capital itself that has a duration, but rather investment in durable capital; a capital project. In other words, it is not the stock of capital to which the Austrian malinvestment story applies, but marginal changes to the capital structure. To imagine a factory receiving inputs and producing outputs synchronously, as Knight did, does not require the economy as a whole to be in equilibrium, nor does it require plans to be pre-reconciled. It requires only that we regard particular investments as starting from a given baseline capital structure, the result of previous investments.

To call the duration of an investment “roundaboutness” is to strain the metaphor to the breaking point. Roundaboutness, in its straightforward meaning, pertains to and suggests a circulating capital metaphor, goods in progress taking detours through a longer production process, and is therefore misleading in the context of a durable capital FIFO model. “Time is germane to [the problems of capital],” Lachmann (1956: 111) argues, not as the dimension of capital-intensity, but “as the dimension in which capital resources are turned from one mode of use to another.” Investment will be required in order to change the composition of any stock of capital, and as noted before, it is not generally possible to say whether the resulting configuration is more or less capital intensive (or roundabout) than the previous. This being the case, it should be obvious that regarding capital as an aggregate stock is a distraction from the essential relevance of time to capital theory: not that production takes time, but that investment takes time, regardless of its ultimate effect on the capital-intensity of the production process. Stages of production are irrelevant to the story except as an aspect of the general structure of complementarity within the capital structure that constrains the sorts of investments that can be made.

This change in perspective gives us a framework to appreciate not only the role of time in coordinating plans and expectations, the essential contribution of the Austrian process approach, but also the simultaneity of consumption and production once the investment period is complete, which addresses Knight’s concerns. Time is relevant because the primary goal of investment is not capital maintenance (as in the steady state), but alteration of the capital structure.13

Hints of this paradigm can in fact be found in canonical accounts, even without being clearly distinguished from earlier circulating capital metaphors. Mises’ scrupulousness to remain on the level of pure theory (1966: 547), for example, approaches close to it if (and only if) we take “embarking on projects” to mean adjustment of the capital structure rather than production of some particular object, although the reference to “the saving of the public” hearkens back to the subsistence fund metaphor:

[The interest rate] shows [the entrepreneur] how far he can go in withholding factors of production from employment for want-satisfaction in nearer periods of the future and in dedicating them to want-satisfaction in remoter periods. It shows him what period of production conforms in every concrete case to the difference which the public makes in the ratio of valuation between present goods and future goods. It prevents him from embarking upon projects the execution of which would not agree with the limited amount of capital goods provided by the saving of the public.

However, he still descends from pure theory in critical points without apparently realizing the significance of doing so, for example in arraying goods by their distance from final consumer goods (p. 333; 559). Lachmann, likewise, made a great step forward in “contriv[ing] to tell the story of roundaboutness without mentioning time” (1956: 84), but his explanation of the business cycle as resulting from inflexible prices is so general as to be of little practical use, and his description of the division of capital as an increase in the stages of production through which raw materials pass (p. 82) is an unfortunate atavism.

Implications for Business Cycle Theory

One point which has been suggested by various authors on various grounds is that, in light of difficulties with the structure of production concept, “higher order” industries – i.e. those further up the supply chain – may be the wrong place to look for a boom.14 The story of expectations disappointed by the failure of complementary circulating capital goods to appear partway through the productive process only makes sense in the context of a highly stylized model of production – the sort of model Austrians tend to look askance at in other contexts.

More important, however, is the implication that the Austrian business cycle story – however valid its causal chains – is not necessarily a business cycle story at all once we correct the theoretical shortcomings. It is significant that though Lachmann wrote at length about capital theory throughout his career, he hardly raised the question of business cycles at all after 1941.

If we were to restate the ABCT story in light of the necessary modifications to ACT, it would be something like: rises in interest rates can cause previously viable investments-in-progress to become nonviable, if they should need to refinance in the interim. Such a story is sensical. But aside from the pervasiveness of the interest rate as a price in the economy, it is unclear why this should be of more theoretical import than any other speculative failure to anticipate future price movements. By comparison, exchange rates are a similarly pervasive price in small open economies. Any current exchange rate necessarily indicates an immediate-run balance between speculators anticipating a rise and those anticipating a fall. Any motion, therefore, is bound to disappoint a substantial fraction of speculators. And yet, these continual failures only result in a crisis under special circumstances. It is unclear why speculative failures to anticipate the movement of interest rates in particular should carry such outsize economic significance. The perception of interest rates being (in the short run) under the control of the central bank, and its connection (in the short run) with the volume of circulation, appears to have led Austrian writers to assign these particular failures far more importance than is warranted.

The connection with the volume of spending, however, warrants a more thorough discussion. The canonical Austrian story, drawing on Wicksell, offers a rather more specific proximate trigger. The central bank (or private banks with an elastic currency issue) holds interest rates below the ‘natural rate’, i.e. the rate that equilibrates saving and investment, which leads to a mispricing of the value of waiting. An investment boom results, which – being inconsistent with consumer preferences – eventually forces interest rates higher, and liquidating these investments.

Notice how much of this fleshed-out story – as compared to the skeletal story in the prior paragraph – depends on nonviable concepts above. In the first place, the ‘natural rate’ concept depends crucially on analysis in physical terms (see the discussion in Hayek 1931; 1932a and Sraffa 1932), in a way that does not – in light of the difficulties above – translate readily into a monetary economy. Second, the concept of saving underlying the natural rate concept is a Ricardian economy where saving is accumulated in physical terms, with the interest rate a declining function of the size of the subsistence fund (=saving) (see Harwick 2019b). An unsustainable investment boom is one where entrepreneurs are induced to deplete the subsistence fund. However, if the Ricardian metaphor is nonoperational in a monetary economy, the natural rate of interest is also nonoperational, and whether an investment boom is unsustainable or not cannot be referred to it.

A second potential connection is between currency issue and interest rates in the short run. Quite apart from interest rate movements, a monetary expansion can generate a boom if it causes real money balances to rise before prices do. If this is not correctly perceived as a temporary boom, the short-run increase in general profitability can be imputed to the prices of capital goods, inducing overinvestment in those capital goods which will turn out to be unwarranted by the pattern of consumer demand once prices do begin to rise and choke off demand.

Whether or not rational entrepreneurs will be misled this way has been the subject of a great deal of debate. But more importantly, even supposing that there is such a “cluster of errors”, there is no reason to think that the liquidation of these investments at the end of a boom will necessarily lead to a recession. There is certainly some opportunity cost for reassigning specific capital, and real income will be to some degree lower than if the boom had not happened. But where in this story is a sudden crash? It is hard to imagine that the failure of the marginal investments previously induced by a monetary expansion would diminish real income suddenly and sufficiently enough to constitute the main explanation for recessions.

A third potential connection might answer the previous challenge by bringing in financial markets. A series of realized bad investments can ramify through financial markets, forcing financial firms to contract their issues of broad monies and financial assets (see Harwick 2019a). This can cause a decline in real money balances, slow spending until prices fall, and a rise in interest rates due to a scarcity of liquidity. In principle the liquidation of marginal investments following a boom could snowball in this way, reminiscent of an Austrian business cycle, though to my knowledge no recession has been demonstrated to have been triggered by a previous overinvestment in exactly this manner.

Even supposing such a story, however, the causal chain differs in important ways from the classical Austrian story. Most importantly, the snowball effect is critical. It is not the malinvestments being liquidated that constitutes a recession; rather, the recession forces the liquidation of more investments than would be warranted by the end of a boom. In this sense, a central bank could fruitfully prevent those further liquidations through monetary expansion at the beginning of a recession without propping up the previous nonviable investments, as both Mises and Hayek feared. The object of monetary policy, therefore, is not to set an interest rate matching saving to investment – indeed, it is not clear what that would mean outside of a Ricardian model – but to supply a quantity of money matching money demand so as to avoid the general pressure on prices that leads either to overspending or underspending.


For much of its life, and especially since Mises, Austrian capital theory has been subservient to the needs of the business cycle theory. The business cycle theory, however, is crucially reliant on just those parts of the capital theory that depart from pure theory and do not survive more rigorous specification. By using Lewin and Cachanosky’s duration concept to build a flow-input-flow-output model centered on durable capital as the paradigmatic good, we can give flesh to Lachmann’s fruitful suggestion to use the investment project, rather than the capital good, as the appropriate unit of analysis in capital theory, without abandoning the distinctive process orientation of the Austrian approach, and leave behind once and for all the vestiges of Ricardian analysis that have retarded progress for over a century now.

It remains for future work to evaluate the relative importance of ABCT-adjacent causal processes such as those suggested in the previous section. With a more theoretically satisfactory approach to the problems of capital theory, without being stymied by the variety of paradoxes that beset the capital theorists of previous generations, the difficulties inherent to applied capital theory have the potential to become much more soluble.


  1. Other uses in economics, such as ‘social capital’, are more analogies than proper instances of capital, as they do not generally have a market value.
  2. Böhm-Bawerk ([1891] 1930: 419) distinguishes his own subsistence fund concept from the earlier and cruder wage fund concept of the English economists. While granting his specific criticisms of Mill and Ricardo regarding wage dynamics, for our purposes the essential metaphor is the same between them.
  3. For a more thorough critique of the subsistence fund concept see Harwick (2019b).
  4. Hayek (1936) at various points both asserts that capital can only be sensibly measured in value terms and not physical, and criticizes Knight’s use of value units to homogenize capital into a fund. Yeager (1976) retains the “attractive quasi-homogeneity” of capital by retreating to pure theory and defining it quasi-tautologically as the thing (whatever that may be) which embodies waiting as a factor of production. It is not clear that this is more operationalizable than the more classical Ricardian device, or even that it suggests a paradigmatic capital good (though Yeager does seem attached to the circulating capital metaphor).
  5. Critics who took the higher productivity of roundabout production as equivalent with technical progress asked why such progress should be interpreted as lengthening rather than shortening waiting – i.e. allowing for a more favorable tradeoff between time and output. For this reason both Strigl ([1934] 2000: 86ff, esp. fn. 49) and Hayek (1931, fn. 62; 1936) emphasize that roundaboutness is more productive for a given level of technology. Lachmann (1956: 82) argues that the higher productivity of roundabout production inheres in the division of capital rather than the division of labor, strictly speaking.
  6. The translator of Hayek’s (1929) “The ‘Paradox’ of Saving” from its original German brings attention to his rendering of Kapitalintensität (an obvious cognate to “capital intensity” in English, though Hayek [1939: 17] thought this rendering “somewhat too literal”) as “roundaboutness” (Ibid.: 234). This does not match Böhm-Bawerk’s ([1891] 1930) terminology, for whom “roundabout production” was translated from Productionsumwegen (“detours in production”). Hayek did, however, use “roundabout processes” in his English work (e.g. 1931).
  7. Hayek (1936) appears to admit all these problems, and yet insist on the meaningfulness of a concept which (in his view) cannot even be in principle quantified or operationalized.
  8. Besides their common wage-fund heritage, the affinity between Austrian and Neoclassical capital theory as antagonists to the reswitching debate can be seen in Schibuola (2014), where Garrison’s account of ABCT is reprised using the Solow growth model in place of the Hayekian triangle, with largely the same results.
  9. Oddly, the Cambridge (UK) antagonists to the debate, though correct about the basic incompatibility between marginalism and the Ricardian income-determination project, preferred to reject the former to preserve the latter.
  10. Ironically, O’Driscoll & Rizzo (1985), the most influential book explicitly advancing Lachmann’s research agenda, contains in its chapter on business cycles (ch. 8) a markedly Hayekian and pre-Lachmannite exposition of ABCT which would later be developed into Garrison (2001). Ebeling (2015), similarly, even states that Lachmann “remain[ed] true to the Böhm-Bawerkian emphasis on capital goods as intermediate goods within time-structures of production”, despite the fact that the lack of this emphasis is precisely what separates Lachmann from preceding Austrian capital theorists.
  11. Hayek (1936) in arguing against Knight’s conception of capital as intrinsically perpetual emphasizes that capital maintenance is not routine; that capital equipment is not necessarily replaced with identical items, and that active decisions are involved at each step. This seems like an overstatement. For our purposes, we can say that planned replacement with an identical item is a routine extension of the original plan, and replacement with different equipment would be a relevant change to the capital structure in our sense.
  12. Interestingly, Hayek (1936, fn. 33) suggests avoiding the use of the term ‘capital’ altogether.
  13. This simultaneity is distinct from the steady state logic Lewin criticizes; indeed, it fits comfortably within what Wagner (2010) named a neo-Mengerian approach to economics:

    Suppose that 95 percent of enterprises are operating within their execution phases, leaving five percent of enterprises at nodal positions where they are either creating or revising plans. This kind of situation would generate observations that would fit with the reasonably predictive properties of models of static equilibrium. An established furniture manufacturer that also owned its forests would confront the world in pretty much simultaneous fashion. During any year, or other time span, it would be planting trees, harvesting trees, buying and repairing equipment, and making furniture, all of it appearing to be simultaneous. . . . The source of the motion [in an economy] . . . is the five percent of enterprises not in stasis at any particular instant that are eroding the static reposes of the other enterprises.

  14. Cachanosky & Lewin (2016) argue that investments of long duration “do not correlate coherently” with what were understood by previous Austrian authors as higher-order stages of production. Salter & Luther (2016) argue that, in the context of a rational expectations model, whether the boom occurs in higher-order industries or somewhere else has little relevance to the Austrian story. Luther & Cohen (2014; 2016) discuss some of the difficulties in operationalizing the stages of production concept in the context of empirical work.


CapitalEugen Von Böhm-BawerkF.A. HayekFrank FetterIsrael KirznerLudwig LachmannLudwig Von MisesPaul SamuelsonPeter LewinRichard Von StriglRoger Garrison


Facebook Twitter Reddit StumbleUpon


  • 1

    Raymond Niles

    Oct 16, 2014 at 3:20 | Reply

    Im thinking about this. It is interesting.

    I agree with your general point that the focus must be on investment. How hard — i.e., how much investment does it require — to reconfigure production? If the change in demand is large and it requires significant amounts of investment to alter a production process, a huge price change will happen in that industry (either a bubble or a collapse).

    So, I think you are right that it is the time for investment (to alter a production process), not the time for producing goods, that matters.

    Does this mean that “roundaboutness” or a time-structure of production is no longer valid? It may be that this concept is confusing when trying to understand the role of capital in the business cycle. For conceptual clarity, one may want to jettison the Bohm-Bawerkian framework, or most of it, as you suggest. (I am still not sure about this.)

    However, it is still true that time is a valid concept when thinking about these things. For example, investment comes from savings, the size of which is a function of time. The more time there is to save, the larger the amount that can be invested. Thus, a large investment is also a more “time-consuming” process.

    From your earlier post, it is clear that bubbles form when large changes in demand confront an industry that requires a large investment to change output (e.g., housing). Such large investment is time-consuming.

    So, we may be able to rescue the concept of roundaboutness, not by applying it to capital stocks, but by applying it to the levels of investment required to alter an industry.

    However, an industry that takes a lot of investment to alter is also one with a large embedded capital structure. Consider the stock of housing, as an example. Then we are back to roundaboutness. It applies to both the stock of capital and to the quantity of investment required to alter output in that industry.

    Does this mean that Bohm-Bawerk is rehabilitated? Probably not. I think that your focus on investment as opposed to capital stock is important and may represent an improvement to ABCT.

  • 2

    Jim Caton

    Oct 16, 2014 at 22:13 | Reply

    This all fits very well with Lachmann and sits well with me, at least mostly. Time structure of production is not so significant to coordination in equilibrium. It does matter out of equilibrium where market actors must form new expectations concerning the profitability of particular ventures and must wait to see if they correctly judged market conditions and interpreted prices. Once in equilibrium, the time element is only important in that the processes are constantly rolling over in a sustainable manner. That’s boring anyhow.

    What is significant is that the structure of production must change to meet certain needs. The time element is important in that it effects profit margins of producers, but this is taken care of well enough with a run-of-the-mill financial framework. Austrian theory is special because of its emphasis on capital structure. Changes to it take time both to plan and integrate. The idea of stages of production is partly a hangover from equilibrium theorizing – otherwise profit margins make nonsense… – and as you aptly point out, Ricardo.

Leave a Reply

More Content