Eugen von Böhm-Bawerk – A man for his time, and ours

     

True to form Richard Ebeling has provided us with an engaging and informative introduction to the life and work of Eugen von Böhm-Bawerk. Richard’s extensive knowledge of the period and the details of the lives of the prominent economists has equipped him well to tell the story of this remarkable economist, and remarkable man. Though well-known during his life and the half-century following, Böhm-Bawerk is not someone known to contemporary economists in general – which is a great pity because, as Richard as clearly shown, his pioneering contributions are as relevant today as they were in his own time – and in some cases their relevance and applicability has grown, as I argue below.

Unlike most economists, then and now, Böhm-Bawerk had actual real world experience in government – lots of it. His observations echo much of what was to follow concerning the process of policy formation and implementation. He clearly anticipated the idea of rent-seeking.

Yet he remained a consummate scholar, exploring and extending the fundamentals of economics inherited from Menger. We see this in his still very informative writings on subjective value and price formation. In fact his discussion of how price get formed through an iterative process in real time is still underappreciated in a profession tied to the use of equilibrium constructs. And his masterful analysis of Marxism is worth reexamining in detail in the age of Thomas Piketty.

He is most well known for his work on capital and interest. In part this is because he made real advances explaining the nature and use of capital in open economies – and produced a three volume work on this. In part it is because he became embroiled in lengthy, involved controversies over the nature of interest and of capital. It was even rumored that Menger did not approve of Böhm-Bawerk’s particular formulation of time in production.

Böhm-Bawerk realized that time enters production in a crucial way. Since production takes time, the relationship between value and time must be considered. Time has to be “spent” in order to get results in the form of products that are useful to consumers, that are valued more highly than the combined value of what went into them over time. This suggests that if “more” time is to be taken to produce anything, there must be a reward. This comes in the form of a higher valued product. In Böhm-Bawerk’s terms, wisely-chosen roundabout production processes are more productive.

But what does it mean to take “more” time? Consideration of this leads one very quickly into difficult territory. To attempt to “quantify” the “time-taken” raises a whole host of difficult questions. When does the “time-period” begin – or end? It is not time per se that is taken. Rather it is work-time – the application of effort over time by different kinds of resources. So it is input-time that is relevant and must be measured. In what units? And so on. In order to simplify the matter, and hopefully make it tractable, Böhm-Bawerk suggested the concept of the “average period of production” (APP) – a conceptual measure of the “average amount of time” taken in the production of any product. Several scholars picked up on this aspect of Böhm-Bawerk’s work and made it the basis of criticism. But the APP has refused to die. Over the decades it is reappeared in various guises, explicitly or implicitly, in a series of “capital controversies”.

While Böhm-Bawerk admittedly used a concept to capture the role of time in production that is very limited in it applicability to real world processes, the essential idea is incredibly important and is a precursor to much work on the nature of production in the modern world. In truth the APP was a very small part of his voluminous discussion of capital and time as we actually experience them. His message remains very valid. And, surprisingly, even the APP can be profitably seen as a simplified version of a construct in regular use today in the field of corporate finance. It is an idea that Nicolas Cachanosky and I are working on, trying to extend its range of application.[52] Of which more below.

Consider first the basic idea that roundabout production is more productive than simple production. As pointed out by Ludwig Lachmann[53] roundaboutness is perhaps better understood as “complexity”. Roundabout production is complex production. It involves complicated, multi-level interactions over time, that cannot be easily captured, but are clearly understood to be present. As Ludwig von Mises explains,

An increase in the number of stages of production – that is, an increase in specialization – necessarily implies an increase in complexity in that those stages closer to the final product are more complex than those stages further from it. Complexity is related to specificity: the construction of artifacts for specialized purposes implies more internal structure, and more linkages between the stages. "Iron is less specific in character than iron tubes, and iron tubes less so than iron machine parts. The conversion of a process of production [to another purpose, in response to unexpected change] becomes as a rule more difficult, the farther it has been pursued and the nearer it has come to its termination, the turning out of consumers’ goods."[54]

Complex production structures such as we find in the modern world are nothing short of miraculous. They clearly cannot be designed by any human mind or even a committee of human minds. They are spontaneous orders, more particularly, complex-adaptive spontaneous orders. The complexity of the capital structure is related to and is embedded in other complex-adaptive systems, like capital markets, money, language, common law and practice, etc. Böhm-Bawerk’s insights paved the way for in-depth  consideration of these related phenomena.

Of particular interest is the question of the role of money and monetary policy. Both Mises and Friedrich Hayek saw in Böhm-Bawerk’s ideas on capital, implications for the effectiveness (or otherwise) of monetary policy. The manipulation of the aggregate of money and credit by central banks was likely to change the capital-structure – the structure of production and employment – in dysfunctional ways. Specifically, by reducing interest rates and the cost of borrowing money, such policies encourage the undertaking of production projects that are “too long” and cannot be sustained. The capital-structure, whose details cannot be understood or predicted, becomes in crucial respects unsustainable, and an economic cycle results. Thus, counter-cycle macroeconomic policy must, in taking account of this, face the possibility of that such policies may exacerbate rather than mitigate cycles. Adherents of this view – known as the Mises-Hayek – or Austrian – theory of the business cycle – point to the current crisis (and many other past crises) as an instance.

Significantly, Austrian Business Cycle Theory uses, in some form or other, the idea implied in the APP. In formulating this Böhm-Bawerk tried to capture in quantitative terms the average amount of time taken in any production project. As can be easily shown, except for the most simple of cases, this is impossible. As soon as one considers the relationship between capital and time, value enters the analysis and a purely physical (quantitative) measure is impossible. Astoundingly, Böhm-Bawerk’s essential error lies not in his attempt to take account of time considerations in the mind of the investor/entrepreneur as expressed in some simple formulation, but, rather, in his attempt to do so by confining his attention to a strictly physical measure. As John Hicks[55] pointed out as early as 1939 a valid form of the APP does exist. It is exactly that same construct developed by Frederick Macaulay[56] in 1938 known as “duration”. Duration (D) is most easily understood as “the average amount of time for which one has to wait for $1” in any investment. It is obviously a value construct, not a physical one. It is in a meaningful sense a measure of the “length” of the project – or, at least, some aspect of the length. It captures an important aspect of what is in the investor’s mind as he contemplates his investment.

Significantly, D is also a measure of the elasticity of the (present) value of the project. It measure how any  estimate of net present value changes with a change in the interest rate. Thus, one can reformulate the Austrian Business Cycle theory very revealingly in terms of D, using a concept that originates with Böhm-Bawerk’s work.

Böhm-Bawerk also wrote definitively on the nature of interest. He explained, as Richard has shown, how interest accounts for the “surplus value” that results from (successful) production – the surplus left over after accounting for the cost of all the services of all the inputs. In equilibrium, where there is no profit left for the entrepreneur, this surplus is pure interest, the payment for borrowing resources over time – made possible by the increase in value from production over time. It is, as we say today, the time-value of money; and it exists before we humans have time preference. We prefer earlier satisfactions to later ones and have to be compensated for foregoing the former. Interest is not profit, and it is not the return to capital. In spite of Böhm-Bawerk’s, and later others’ (like the American economist Frank Fetter’s) decisive demonstration of this, mistakes are still routinely made about this by trained economists and others.

It is a pleasure to be able to reconsider just some of the work of this remarkable economist.

[52.] Nicolas Cachanosky and Peter Lewin, “Roundaboutness is Not a Mysterious Concept: A Financial Application to Capital Theory,” Review of Political Economy, 2014. http://dx.doi.org/10.1080/09538259.2014.957475

[53.]Ludwig M. Lachmann, Capital and its Structure (Kansas City: Sheed Andrews and McMeel, 1978). </titles/96>. On "a higher degree of complexity" see </titles/96#Lachmann_0720_301>.

[54.] L. Mises, Human Action Chicago, IL: Henry Regnery, 1949; 1998 edn, Auburn, AL: Ludwig von Mises Institute, p. 500. Online version: Ludwig von Mises, Human Action: A Treatise on Economics, in 4 vols., ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2007). Vol. 2, Chap. 10. Action in the Passing of Time, 5: The Convertibility of Capital Goods </titles/1894#Mises_3843-02_952>.

[55.] J.R. Hicks, Value and Capital. (Oxford: Oxford University Press, 1939), p. 186.

[56.] F. R Macaulay, The Movements of Interest Rates. Bond Yields and Stock Prices in the United States since 1856. (New York: National Bureau of Economic Research, 1938). See also P. Lewin and N. Cachanosky, “The Average Period of Production History Of An Idea,” SSRN file:///C:/Users/plewin/Downloads/SSRN-id2479408%20(2).pdf