1. The Foundations of Capital Theory

In this section we will examine the basic tenets of capital theory which are essential to understanding the effects credit expansion exerts on the economic system.¹ We will begin by considering the subjectivist conception of human action as a series of productive stages intended to achieve an end.

HUMAN ACTION AS A SERIES OF SUBJECTIVE STAGES

We may begin by defining human action as any deliberate behavior or conduct.² A person acts to attain certain goals he/she feels are important. Value refers to the degree of subjective appreciation the actor assigns his goal, and the means is anything the actor subjectively considers adequate to accomplish it. Utility represents the subjective appraisal the actor makes of the means, in terms of the value of the goal he believes it will help him to achieve. Means must be scarce by definition: if the actor did not regard them as such in light of his objectives, he would not even take them into account before acting. Ends and means are not “given” (i.e., data) but instead result from the fundamental entrepreneurial activity of human beings, an activity which consists of creating, discovering or simply realizing which ends and means are relevant for the actor in each set of specific circumstances of time and place he encounters. Once the actor believes he has discovered which ends are worth accomplishing, he forms an idea of the means available to assist him. He then incorporates them, almost always tacitly, into a plan of action which he embarks upon through an act of will.

Consequently the plan is a mental picture, conjured up by the actor, of the different future stages, elements and circumstances his action may involve. The plan is the actor's personal evaluation of the practical information he possesses and gradually discovers within the context of each action. Moreover each action implies a continuous process of individual or personal planning through which the actor continually conceives, revises and modifies his plans, as he discovers and creates new subjective information on the goals he sets himself and the means he believes are available to assist him in reaching these goals.³

All human action is directed toward the attainment of an end, or consumer good, which can be defined as a good that directly and subjectively satisfies the needs of the human actor. The term first-order economic goods has traditionally referred to those consumer goods which, in the specific, subjective context of each action, constitute the goal pursued by the actor in performing the action.⁴ The achievement of these goals, consumer goods, or first-order economic goods, is necessarily preceded by a series of intermediate stages represented by “higher-order economic goods” (second, third, fourth, etc.). The higher the order of each stage, the further the good is from the final consumer good.

Furthermore all human action takes place in time, and we are not referring here to the deterministic or Newtonian sense of the word (i.e., merely physical or analogical), but to the subjective sense; that is, the actor's subjective perception of time within the context of his action. According to this subjectivist conception, the actor experiences the passage of time as he acts; in other words, as he realizes new ends and means, designs plans of action and completes the different stages which compose each action.

When human beings act, they inevitably synthesize memories of the past into new expectations and mental images for the future, regarding the different stages in the action process they will follow. This future is never predetermined, but instead the actor imagines, creates and builds it step by step. Therefore the future is always uncertain, since it has yet to be built, and the only part of it the actor possesses consists of specific ideas, mental images or expectations he hopes to realize through the completion of the stages he imagines will make up his personal action process. Furthermore the future is open to man's every creative possibility, and at any point the actor may modify his objectives or vary, rearrange and revise the stages of the action processes in which he is involved.

Hence in economics time is inseparable from human action. It is impossible to conceive of an action which does not take place in time, one that does not take time. Moreover the actor perceives the passage of time as he acts and goes through the different stages in his action process. Human action, which is always directed toward the attainment of a goal or the alleviation of a discomfort, invariably takes time, in the sense that it requires the realization and completion of a series of successive stages. Therefore what separates the actor from the achievement of his goal is the period of time required by the series of successive stages that compose his action process.⁵

The following tendency always exists with respect to the actor's subjective view of the future: as the time period required by an action increases (i.e., as the number and complexity of the successive stages which constitute the action increase), the result or aim of the action becomes more valuable. An action can acquire a greater subjective value—in terms of the number, duration, and complexity of stages involved—in two ways: by enabling the actor to achieve results he subjectively values more and could not achieve via shorter human actions; or by facilitating the attainment of more results than would be possible through shorter action processes.⁶ It is easy to understand the economic principle that human action processes tend to achieve aims of greater value the longer the processes last. Indeed if this were not the case, i.e., if the actor did not attach greater value to the results of longer actions, he would never undertake them and would opt for shorter actions instead. In other words, an actor is separated from his goal precisely by a certain length of time (i.e., by the time necessary to complete the set of stages in his action process). Thus, other things being equal, it is evident that human beings will always try to accomplish their goals as soon as possible, and they will only be willing to postpone the attainment of their ends when they subjectively believe that by doing so they will achieve more valuable objectives.⁷

We are now ready to discuss the logical notion of time preference, which establishes that, other things being equal, the actor prefers to satisfy his needs or reach his objectives as soon as possible. In other words, when the actor is faced with two goals of equal subjective value to him, he will always prefer the one he can attain in less time. Or to put it even more briefly, other things being equal, “present goods” are always preferable to “future goods.” The law of time preference is just another way of expressing the following essential principle: any actor, in the course of his action, tries to achieve the results of the action as soon as possible, and he is separated from his ends by a series of intermediate stages involving a certain time period. Hence the time preference is not a psychological or physiological concept, but necessarily follows from the logical structure of action present in the mind of all human beings. In short, human action is directed toward certain ends and the actor chooses the means to accomplish them. The goal is the actor's purpose in performing any action, and in any action, time is what separates the actor from the goal. Therefore the closer the actor is in time to his goal, the closer he is to achieving the objectives he values. The tendency described above and the time preference we have just explained are simply two different ways of expressing the same reality. According to the former, actors undertake time-consuming actions because they expect to thus achieve more valuable ends; according to the latter, other things being equal, actors always prefer the goods closer to them in time.⁸

Hence it is impossible to imagine a human action to which the principle of time preference does not apply. A world without time preference is inconceivable and would be absurd: it would mean people always preferred the future to the present, and objectives would be postponed, one after the other, just before they were reached, and therefore no end would ever be achieved and human action would be senseless.⁹

CAPITAL AND CAPITAL GOODS

We may use the term capital goods to designate the intermediate stages of each action process, subjectively regarded as such by the actor. Or to put it another way, each of the intermediate stages in an actor's production process is a capital good. Hence this definition of capital goods fits in perfectly with the subjectivist conception of economics presented above. The economic nature of a capital good does not depend on its physical properties, but on the opinion of an actor, who believes the good will enable him to reach or complete a stage in his action process. Therefore capital goods, as we have defined them, are simply the intermediate stages the actor believes he needs to go through before achieving the purpose of his action. Capital goods should always be placed in a teleological context, in which the essential defining elements are the aim pursued and the actor's subjective view on the stages necessary to fulfill it.¹⁰

Hence capital goods are “higher-order economic goods,” or factors of production which subjectively materialize at each intermediate stage in a particular action process. Moreover capital goods arise from the union of three essential elements: natural resources, labor and time, all of which are combined in entrepreneurial action conceived and processed by human beings.¹¹

The sine qua non for producing capital goods is saving, or the relinquishment or postponement of immediate consumption. Indeed in an action process the actor will only be able to reach successive and increasingly time-consuming intermediate stages if he has first sacrificed the chance to undertake actions which would produce a more immediate result. In other words, he must give up the achievement of immediate ends which would satisfy current human needs (consumption). To illustrate this important concept, we will use the example given by Böhm-Bawerk to explain the process of saving and investment in capital goods carried out by an individual actor in an isolated situation, such as Robinson Crusoe on his island.¹²

Let us suppose that Robinson Crusoe has just arrived on his island and spends his time picking berries by hand, his only means of subsistence. Each day he devotes all of his efforts to gathering berries, and he picks enough to survive and can even eat a few extra daily. After several weeks on this diet, Robinson Crusoe makes the entrepreneurial discovery that with a wooden stick several meters long, he could reach higher and further, strike the bushes with more force and gather the necessary berries much quicker. The only problem is that he estimates it could take him five whole days to find a suitable tree from which to take the stick and then to prepare it by pulling off its branches, leaves, and imperfections. During this time he will be compelled to interrupt his berry picking. If he wants to produce the stick, he will have to reduce his consumption of berries for a time and store the remainder in a basket until he has enough to survive for five days, the predicted duration of the production process of the wooden stick. After planning his action, Robinson Crusoe decides to undertake it, and therefore he must first save a portion of the berries he picks by hand each day, reducing his consumption by that amount. This clearly means he must make an inevitable sacrifice, which he nevertheless deems well worth his effort in relation to the goal he longs to achieve. So he decides to reduce his consumption (in other words, to save) for several weeks while storing his leftover berries in a basket until he has accumulated an amount he believes will be sufficient to sustain him while he produces the stick.

This example shows that each process of investment in capital goods requires prior saving; that is, a decrease in consumption, which must fall below its potential level.¹³ Once Robinson Crusoe has saved enough berries, he spends five days searching for a branch from which to make his wooden stick, separating it from the tree and perfecting it. What does he eat during the five days it takes him to prepare the stick, a production process which forces him to interrupt his daily harvest of berries? He simply consumes the berries he accumulated in the basket over the preceding several week period during which he saved the necessary portion from his handpicked berries and experienced some hunger. In this way, if Robinson Crusoe's calculations were correct, at the end of five days he will have the stick (a capital good), which represents an intermediate stage removed in time (by five days of saving) from the immediate processes of the production of berries (by hand) which up to that point had occupied him. With the finished stick Robinson Crusoe can reach places inaccessible to him by hand and strike the bushes with force, multiplying his production of berries by ten. As a result, from that point on his stick enables him to gather in one-tenth of a day the berries he needs to survive, and he can spend the rest of his time resting or pursuing subsequent goals that are much more important to him (like building a hut or hunting animals to vary his diet and make clothes).

Robinson Crusoe's production process, like any other, clearly arises from an act of entrepreneurial creativity, the actor's realization that he stands to benefit, i.e., he can accomplish ends more valuable to him, by employing action processes which require a longer period of time (because they include more stages). Thus action or production processes yield capital goods, which are simply intermediate economic goods in an action process whose aim has not yet been reached. The actor is only willing to sacrifice his immediate consumption (i.e., to save) if he thinks that by doing so he will achieve goals he values more (in this case, the production of ten times more berries than he could gather by hand). Furthermore Robinson Crusoe must attempt to coordinate as well as possible his present behavior with his foreseeable future behavior. More specifically, he must avoid initiating action processes that are excessively long in relation to his savings: it would be tragic for him to run out of berries (that is, to consume all he has saved) halfway through the process of producing a capital good and without reaching his goal. He must also refrain from saving too much with respect to his future investment needs, since by doing so he would only unnecessarily sacrifice his immediate consumption. Robinson Crusoe's subjective assessment of his time preference is precisely what enables him to adequately coordinate or adjust his present behavior in relation to his future needs and behavior. On the one hand, the fact that his time preference is not absolute makes it possible for him to forfeit some of his present consumption over a period of several weeks with the hope of thus being able to produce the stick. On the other hand, the fact that he does have a time preference explains why he only devotes his efforts to creating a capital good he can produce in a limited period of time and which requires sacrificing and saving for a limited number of days. If Robinson Crusoe had no time preference, nothing would stop him from dedicating all of his efforts to building a hut right away (which, for example, might take him a month minimum), a plan he would not be able to carry out without first having saved a large quantity of berries. Therefore he would either starve to death or the project, out of all proportion to his potential saving, would soon be interrupted and abandoned. At any rate, it is important to understand that the real saved resources (the berries in the basket) are precisely the ones which enable Robinson Crusoe to survive during the time period he spends producing the capital good and during which he ceases to gather berries directly. Even though Robinson Crusoe is undoubtedly much more productive harvesting berries with his wooden stick than he is with his bare hands, there is also no doubt that the process of berry production using the stick is a more lengthy one in terms of time (it includes more stages) than the production process of berry picking by hand. Production processes tend to increase in length and duration (i.e., to become more complex and include more stages) as a result of the saving and entrepreneurial activity of humans; and the longer and more time-consuming these processes become, the more productive they tend to be.

In a modern economy, in which many economic agents simultaneously perform different functions, we will use the term capitalist to denote that economic agent whose function is precisely to save; in other words, to consume less than he creates or produces and to make available to workers the resources they need to live for the duration of the production process in which they participate. (Robinson Crusoe also behaved like a capitalist when he saved berries that later enabled him to survive while he produced his wooden stick.) Thus when the capitalist saves, he frees up resources (consumer goods) which can be used to sustain workers who direct their energies to productive stages further removed from final consumption, i.e., the production of capital goods.

Unlike in the example of Robinson Crusoe, production processes in a modern economy are extremely complex, and in terms of time, very lengthy. They incorporate a multitude of stages, all of which are interrelated and divide into numerous secondary processes that humans employ in the innumerable action projects they constantly launch.

For instance the process of producing a car consists of hundreds or even thousands of productive stages requiring a very prolonged period of time (even several years) from the moment the car company begins to design the vehicle (the stage furthest from final consumption), orders the corresponding materials from its suppliers, runs these materials through the different assembly lines, orders the different parts for the motor and all accessories, etc., until it arrives at the stages closest to consumption, such as transport and distribution to dealers, the development of advertising campaigns and the presentation and sale of the car to the public. So although when we visit the factory we see a finished vehicle emerge every minute, we must not deceive ourselves by thinking the production process of each car lasts one minute. Instead we should be aware that each car calls for a process of production lasting several years, a process comprised of numerous stages, beginning when the model is conceived and designed and ending when the car is presented to its proud owner as a consumer good. In addition, in modern societies humans have a tendency to specialize in different stages of the production process. An increasing division of labor (or to be more precise, of knowledge), both horizontal and vertical, causes the stages in the production process to be continuously broken down into other stages as the division of knowledge spreads and deepens. Specific companies and economic agents tend to specialize in each one of these stages. Apart from a stage-by-stage analysis, we can also examine the process by considering the many phases which occur at once. At all times each of the stages coexists with the others and therefore some people spend their time designing vehicles (the cars which will be available to the public in ten years), while others simultaneously order materials from suppliers, others work on assembly lines, and others devote their efforts to the commercial field (very close to final consumption), promoting the sale of vehicles that have already been produced.¹⁴

Therefore it is clear that, just as the difference between the “rich” Robinson Crusoe with the stick and the “poor” Robinson Crusoe without it lay in the capital good the former had obtained through prior saving, the essential difference between rich societies and poor societies does not stem from any greater effort the former devote to work, nor even from any greater technological knowledge the former hold. Instead it arises mainly from the fact that rich nations possess a more extensive network of capital goods wisely invested from an entrepreneurial standpoint. These goods consist of machines, tools, computers, buildings, semi-manufactured goods, software, etc., and they exist due to prior savings of the nation's citizens. In other words, comparatively rich societies possess more wealth because they have more time accumulated in the form of capital goods, which places them closer in time to the achievement of much more valuable goals. There is no doubt that an American worker earns a much higher wage than an Indian worker, but this is chiefly because the former has at his disposal and uses many more capital goods (tractors, computers, machines, etc.) than the Indian worker, and the goods he uses are of much higher quality. To put it another way, the longer the production process, the more productive it tends to be, as we have seen. The modern tractor plows the earth much more productively than the Roman plow. Nevertheless the tractor is a capital good whose production requires a set of stages much more numerous, complex and lengthy than those necessary to produce a Roman plow.

Capital goods in the extremely complex network which composes the real productive structure of a modern economy are not perpetual, but are always temporary in the sense that they are physically used up or consumed during the production process, or they become obsolete. In other words, wear on capital equipment is not only physical, but technological and economic as well (obsolescence). Hence capital goods must be preserved and maintained (in Robinson Crusoe's case, he must take care of his stick and protect it from wear). This means entrepreneurs must repair existing capital goods; and, even more importantly, they must constantly produce new capital goods to replace the old ones they are in the process of consuming. Depreciation refers to the wear capital goods undergo during the production process. A certain minimum level of saving is essential in order to compensate for depreciation by producing the capital goods necessary to replace ones that have worn out or depreciated. This is the only way for the actor to maintain his productive capacity intact. Moreover if he wishes to further increase the number of stages, lengthen the processes and make them more productive, he will have to accumulate even more than the minimum savings required to counteract the strict amortization rate, the accounting term for the depreciation of capital goods. To save, the actor must reduce consumption in relation to production. If his output is constant, he must curtail his actual consumption; however if his output is growing, he will be able to save (to accumulate capital goods) by keeping his volume of consumption relatively constant. Nevertheless even in this last case saving requires the sacrifice (as always) of the increasing volumes of potential consumption which a growing output would permit.

In every production process (i.e., series of successive stages or capital goods) it is possible to distinguish the stages which are relatively closer in time to the final consumer good from those which are relatively further from it. As a general rule capital goods are difficult to convert, and the closer they are to the final stage of consumption, the more difficult is their convertibility. Nonetheless the fact that capital goods are difficult to adapt does not mean the actor, in his action process, is not often forced to modify the objectives of his action, and consequently, to review and convert the stages he has already completed (i.e., to convert his capital goods as far as is practicable). In any case, when circumstances change or the actor changes his mind and modifies the aim of his action, the capital goods he has produced up to that point may become utterly useless or they may be useful only after a costly conversion. The actor could also find a way to use the goods, yet still feel that had he known in advance they would eventually be needed in a different production process, he would have made them in quite a different way. Finally, it is very rare for a capital good to be so removed from consumption, or for the circumstances to be such, that the good is perfectly useful in any alternative project.

Thus we see the influence of the past on actions carried out today. Action, as we have defined it, is always prospective, never retrospective; and an actor considers a good a capital good based on a planned future action, not on the good's material properties nor on former action projects.¹⁵ Nevertheless the past undoubtedly influences future action, to the extent that it determines the current starting point. Humans commit countless entrepreneurial errors when conceiving, undertaking, and completing their actions; and consequently, they embark on subsequent actions from a present position they would have attempted to make different had they known about it in advance. However once events have unfolded in a certain way, humans always strive to make the best of their present circumstances with a view to accomplishing their goals for the future. While capital goods are difficult to convert, investors manage to provide them with considerable “mobility” through the juridical institutions of property and contract law, which regulate the different forms of transferring such goods. Thus the (extremely complex and prolonged) productive structure permits the constant mobility of investors, through the exchange and sale of capital goods in the market.¹⁶

We are now ready to consider the concept of capital, which from an economic viewpoint differs from the concept of “capital goods.” In fact we will define “capital” as the market value of capital goods, a value estimated by the individual actors who buy and sell capital goods in a free market.¹⁷ Thus we see that capital is simply an abstract concept or instrument of economic calculation; in other words, a subjective valuation of or judgment on the market value entrepreneurs attribute to capital goods and on the basis of which they continually buy and sell them, attempting to make a pure entrepreneurial profit with each transaction. Therefore in a socialist economy in which neither free markets nor market prices exist, it is perhaps feasible to speak of capital goods, but not of capital: the latter always requires a market and prices which are freely determined by the economic agents who participate in it. If it were not for market prices and the subjective estimation of the capital value of goods that compose the intermediate stages in production processes, in a modern society it would be impossible to estimate or calculate whether or not the final value of the goods to be produced using capital goods offsets the cost involved in the production processes, neither would it be possible to direct in a coordinated way the efforts of people who contribute to the different action processes.¹⁸

We have attempted elsewhere to demonstrate that all systematic coercion which impedes the free exercise of entrepreneurship prevents humans from discovering the information they need to carry out their actions.¹⁹ It also keeps them from spontaneously transmitting this information and coordinating their behavior with respect to the needs of others. This means that the coercive intervention which is characteristic of socialism, of state interventionism in the economy, and of the granting of privileges to certain groups against traditional legal principles, prevents to a greater or lesser extent the exercise of entrepreneurship, and hence the coordinated action of human beings; it also tends to generate systematic maladjustments in the framework of society. Systematic discoordination can be intratemporal; or, as in the case of human actions related to different stages of production processes or capital goods, intertemporal, such that human beings who cannot act freely tend to adjust their present behavior poorly to their future behavior and needs.

As we saw from Robinson Crusoe's isolated production process, intertemporal coordination is fundamental to all human action which takes time and especially to those actions related to capital goods; thus the great importance of permitting the free exercise of entrepreneurship in this area. In this way entrepreneurs constantly discover profit opportunities in the market, believing they see new possible combinations of capital goods, and considering these combinations to be undervalued with respect to the market price they estimate they will be able to obtain in the future for the consumer goods they produce. In short we are referring to a process of continual buying and selling, “recombination” and production of new kinds of capital goods, a process which generates a dynamic and very complex productive structure which always tends to expand horizontally and vertically.²⁰ Without free entrepreneurship, nor free markets for capital goods and money, it is impossible to make the necessary economic calculation regarding the horizontal and vertical extension of the different stages in the production process, resulting in widespread discoordinated behavior that throws society off balance and prevents its harmonious development. In entrepreneurial processes of intertemporal coordination, a leading role is played by an important market price: the price of present goods in relation to future goods, more commonly known as the interest rate, which regulates the relationship between consumption, saving and investment in modern societies, and which we will study in detail in the next section.

THE INTEREST RATE

As we have seen, other things being equal, humans always place present goods higher than future goods on their scale of value. However the relative intensity of this difference in subjective valuation varies substantially from one person to another; and it can even vary greatly throughout the life of one person based on changes in his circumstances. Some people have a high time preference and value the present greatly in relation to the future; thus they are only willing to sacrifice the immediate achievement of their ends if they expect or believe they will accomplish in the future goals they subjectively value very highly. Other people have a more limited time preference, and although they also value present goods more than future goods, they are more predisposed to relinquish the immediate achievement of their aims in exchange for objectives which they value only a little more and which will be reached tomorrow. This difference in the psychic intensity of the subjective valuation of present goods in relation to future goods, a difference reflected on each human actor's scale of value, means that in a market comprising many economic agents, each of which has his own distinct and variable time preference, multiple opportunities arise for mutually beneficial exchanges.

Hence people with a low time preference will be willing to give up present goods in exchange for future goods valued only a bit higher, and they will perform exchanges in which they will hand over their present goods to people with a higher time preference, i.e., people who value the present more intensely than they do. The creativity and alertness inherent in entrepreneurship give rise to a market process that tends to establish a market price for present goods with respect to future goods. We will use the term “interest rate” to denote the market price of present goods in relation to future goods. Given that in the market many actions are carried out using money as a generally-accepted medium of exchange, the interest rate is the price one must pay to obtain a certain number of m.u. immediately; this price reflects the number of units one must return in exchange at the end of the set term or time period. Generally, for reasons of custom, the price is expressed as a certain yearly percentage. For instance, an interest rate of 9 percent indicates that market transactions are conducted in such a way that it is possible to obtain 100 m.u. immediately (present good) in exchange for a promise to turn over 109 m.u. at the end of one year (future good).²¹

Therefore the interest rate is the price established in a market in which the suppliers or sellers of present goods are precisely the savers; that is, all those relatively more willing to relinquish immediate consumption in exchange for goods of greater value in the future. The buyers of present goods are all those who consume immediate goods and services (be they workers, owners of natural resources or capital goods, or any combination of these). Indeed the market of present and future goods, in which the interest rate is determined, consists of society's entire structure of productive stages, in which savers or capitalists give up immediate consumption and offer present goods to owners of the primary or original factors of production (workers and owners of natural resources) and to owners of capital goods, in exchange for the full ownership of consumer (and capital) goods of a supposedly higher value once the production of these goods has been completed in the future. If we eliminate the positive (or negative) effect of pure entrepreneurial profits (or losses), this difference in value tends to coincide with the interest rate.

From a legal standpoint, exchanges of present goods for future goods can take many forms. For instance, in a cooperative the workers themselves simultaneously act as capitalists, waiting until the end of the entire production process to acquire the ownership of the final good and its full value. Nevertheless in most cases workers are not willing to wait until the production process ends nor to take on the risks and uncertainties it entails. Thus instead of forming cooperatives, they prefer to sell the services of their productive effort in exchange for immediate present goods. They agree on a labor contract (an employment contract for another's account) according to which the person who advances them the present goods (the capitalist, saver or supplier of present goods) receives the full ownership of the final good once it has been produced. Combinations of these two different types of contract are also possible. This is not the proper place to analyze the different legal forms which the exchange of present goods for future goods takes in a modern society. Furthermore these forms do not affect the fundamental argument we advance in this book, though they are undoubtedly of great interest from a theoretical and practical standpoint.

It is worth noting that the “loan market,” in which one may obtain a loan by agreeing to pay the corresponding interest rate, constitutes a relatively small part of the general market, in which present goods are exchanged for future goods and which encompasses the entire productive structure of society. Here owners of the original means of production (labor and natural resources) and capital goods act as demanders of present goods, and savers act as suppliers of them. Therefore the short-, medium-, and long-term loan market is simply a subset of that much broader market in which present goods are exchanged for future goods and with respect to which it plays a mere secondary and dependent role, despite the fact that the loan market is the most visible and obvious to the general public.²² It fact it is entirely possible to conceive of a society in which no loan market exists, and all economic agents invest their savings in production directly (via internal financing and retained earnings through partnerships, corporations, and cooperatives). Although in this case no interest rate would be established in a nonexistent loan market, an interest rate would still be determined by the ratio at which present goods are exchanged for future goods in the different intermediate stages in production processes. Under these circumstances the interest rate would be determined by the “rate of profit” which would tend to equal the net income at each stage in the production process, per unit of value and time period. Although this interest rate is not directly observable in the market, and even though in each company and in each specific production process it incorporates important external factors (such as the components of pure entrepreneurial profits or losses, and the risk premium), the profit generated in each stage of the entire economic system would tend to correspond to the interest rate, due to the typical entrepreneurial process of equalizing accounting profits over the different stages of the productive structure, assuming no further changes occur and all creative possibilities and opportunities for entrepreneurial profit have already been discovered and exploited.²³

In the outside world, the only directly-observable figures are what we could call the gross interest rate or market rate of interest (which coincides with the interest rate in the credit market) and the gross accounting profits generated by each production activity (i.e., net income). The first consists of the interest rate as we have defined it (also sometimes called the originary or natural rate of interest), plus the risk premium corresponding to the operation in question, plus or minus a premium for expected inflation or deflation; that is, for the expected decrease or increase in the purchasing power of the monetary unit used in exchanges of present goods for future goods and in calculations regarding such transactions.

The second figure, which is also directly observable in the market, represents gross accounting profits (i.e., net income) derived from the specific productive activity carried out at each stage of the production process. These profits tend to match the gross interest rate (or market rate of interest) as we have defined it in the preceding paragraph, plus or minus pure entrepreneurial profits or losses.²⁴ As in all markets entrepreneurial profits and losses tend to disappear as a result of competition between entrepreneurs; the accounting profits of each productive activity by time period tend to match the gross market interest rate. Indeed the accounting profits reported by each company for a financial year could be considered to include an implicit interest-rate component, with respect to the resources saved and invested by the capitalists who own the company. This implicit component, together with the risk factor and entrepreneurial profits or losses which result from the purely entrepreneurial activity of the business, give rise to accounting profits. From this perspective it is possible for a company to report accounting profits (i.e., net income) when it has actually suffered entrepreneurial losses, if accounting profits fail to reach the amount necessary to exceed the implicit gross-market-interest-rate component that applies to resources capitalists invest in their businesses throughout the financial year.

In any case, regardless of the external form interest takes, the key is to remember that as a market price or social rate of time preference, interest plays a vital role in the coordination of the behavior of consumers, savers, investors, and producers in a modern society. Just as it was crucial for Robinson Crusoe to coordinate his actions and refrain from dedicating to future goals an effort disproportionate to his stock of saved present goods, the same issue, intertemporal coordination, arises constantly in society.

In a modern economy, present and future behaviors are reconciled through entrepreneurial activity in the market where present goods are exchanged for future goods and the interest rate, the market price of one type of goods in terms of the other, is established. Thus the more plentiful the savings, i.e., the greater the quantity of present goods sold or offered for sale, other things being equal, the lower their price in terms of future goods; and consequently, the lower the market rate of interest. This indicates to entrepreneurs that more present goods are available, which enables them to increase the length and complexity of the stages in their production processes, making these stages more productive. In contrast, the fewer the savings, i.e., other things being equal, the less economic agents are willing to give up immediate consumption of present goods, the higher the market rate of interest. Thus a high market rate of interest shows that savings are relatively scarce, an unmistakable sign entrepreneurs should heed to avoid unduly lengthening the different stages in the production process and generating as a result discoordination or maladjustments which pose a great danger to the sustained, healthy and harmonious development of society.²⁵ In short the interest rate conveys to entrepreneurs which new productive stages or investment projects they can and should embark on and which they should not, in order to keep coordinated, as much as humanly possible, the behavior of savers, consumers, and investors, and to prevent the different productive stages from remaining unnecessarily short or becoming too long.

Finally we must point out that the market rate of interest tends to be the same throughout the entire time market or productive structure in society, not only intratemporally, i.e., in different areas of the market, but also intertemporally, i.e., in some productive stages relatively close to consumption as in other productive stages further from it. Indeed if the interest rate one can obtain by advancing present goods in some stages (for example, those closest to consumption) is higher than that one can obtain in other stages (for example, those furthest from consumption), then the entrepreneurial force itself, driven by a desire for profit, will lead people to disinvest in stages in which the interest rate or rate of profit is lower, relatively speaking, and to invest in stages in which the expected interest rate or rate of profit is higher.

THE STRUCTURE OF PRODUCTION

Although it is nearly impossible to illustrate with charts the extremely complex structure of productive stages that make up a modern economy, Chart V-1 represents a simplified version of this structure, and we include it with the purpose of clarifying the theoretical arguments we will later develop.

Moreover although this chart is not strictly necessary for explaining the essential theoretical arguments, and in fact, authors of the stature of Ludwig von Mises never used it in their presentation of the theory of capital and of business cycles,²⁶ traditionally many theorists have considered it helpful to use simplified charts of the stages in real production processes (like Chart V-1) in order to clarify their arguments.²⁷

The stages of the productive structure reflected in Chart V-1 do not represent the production of capital goods and consumer goods in physical terms, but rather their value in m.u. To the left of the chart we assume that the productive structure is composed of five stages whose “order number,” in keeping with Menger's classic contribution, increases with the distance from the final stage of consumption. Thus the first stage comprises “first-order economic goods” or consumer goods which, in our chart, are exchanged for the value of one hundred m.u. The second stage is composed of “second-order economic goods,” or the capital goods closest to consumption. The third, fourth, and fifth stages continue this pattern, and the fifth stage is the furthest from consumption. In order to simplify the explanation, we have supposed that each stage requires the time period of one year, and therefore the production process in Chart V-1 would last five years from its beginning in the fifth stage (the furthest from consumption) to the final consumer goods in the first stage. There are two ways to consider the stages in our outline: we can regard them as consecutive, as the set of productive stages which must be gone through before arriving at the final consumer good after five years (the diachronic point of view); or can we view them as simultaneous, as a “photograph” of the stages taking place at one time in the same financial year (the synchronic point of view). As Böhm-Bawerk indicates, this second interpretation of the chart (as a representation of the production process in the form of a set of synchronized stages) bears a strong resemblance to the age pyramids formulated with data from the census. These pyramids represent cross-sections of the real population, which is classified by ages. In them we can also see the change in the number of people of each age who remain alive (mortality table); this second interpretation means viewing the stages as consecutive.²⁸

The arrows in our diagram represent the flows of monetary income which at each stage in the production process reach the owners of the original means of production (labor and natural resources) in the form of wages and rents, and the owners of capital goods (capitalists or savers) in the form of interest (or accounting profit). Indeed if we begin at the first stage in our example, consumers spend 100 m.u. on consumer goods, and this money becomes the property of the capitalists who own the consumer goods industries. One year earlier, these capitalists had advanced from their savings 80 m.u. corresponding to the services of fixed capital goods and to circulating capital goods produced by other capitalists in the second stage of the production process. The first capitalists also pay 10 m.u. to the owners of the original means of production (labor and natural resources) which they hire directly in the last stage, corresponding to the production of consumer goods (this payment to the owners of the original means of production is represented on our chart by the vertical arrow that begins to the right of last step [100 m.u.] and extends to the upper right-hand box containing 10 m.u.). Since the capitalists of the consumer goods stage advanced eighty m.u. to the owners of the capital goods of the second stage, and ten m.u. to workers and owners of natural resources (a total of 90 m.u.), at the end of one year when these capitalists sell the consumer goods for 100 units, they obtain an accounting profit or interest derived from having advanced 90 m.u. from savings a year earlier. This difference between the total amount they advanced, 90 m.u. (which they could have consumed, yet they saved and invested it), and the amount they receive at the end of a year, 100 m.u., is equal to an interest rate of approximately 11 percent per year (10:90 = 0.11). From an accounting standpoint, this sum appears as profit on the income statement drawn up to reflect the entrepreneurial activity of capitalists of the consumer goods stage (represented by the box at the lower right-hand corner of Chart V-1).

We can follow the same reasoning with respect to the rest of the stages. Hence for example, the capitalists who own the intermediate goods of the third stage advanced at the beginning of the period 40 m.u. in payment for capital goods produced in the fourth stage, as well as 14 m.u. to owners of the original means of production (labor and natural resources). In exchange for the 54 m.u. they have advanced, the capitalists become owners of the product which, once it is finished, they sell to capitalists of the second stage for 60 m.u., earning a differential of six m.u., which is their accounting profit or interest; it is also close to 11 percent. This pattern repeats itself in each stage.

The upper portion of the chart shows the amounts which the capitalists advance at each stage to the original means of production (workers and owners of natural resources) and which add up to a total of 70 m.u. (18+16+14+12+10=70 m.u.). In a column on the right-hand side, we indicate the monetary sums obtained as accounting profits at each stage. These profits reflect the accounting difference between the m.u. advanced by the capitalists of each stage and those they receive for the sale of their product in the following stage. As we know, this accounting profit tends to coincide with the interest derived from the amount the capitalists of each stage save and advance to capitalists of earlier stages and to the owners of the original means of production. The total of the accounting differences between income and expenses at each stage adds up to 30 m.u., which when added to the 70 m.u. received by the original means of production, equals 100 m.u. of net income, which coincides exactly with the amount spent on final consumer goods during the period.

SOME ADDITIONAL CONSIDERATIONS

We must now discuss some important additional considerations regarding our outline of the stages in the production process:

1. The arbitrary selection of the time period of each stage.

First we must state that the decision to make each stage last one year was purely arbitrary, and any other time period could have been chosen. We decided on one year because that is the business and accounting period most commonly used, and therefore it makes the proposed illustrative outline of productive stages easier to understand.

2. The avoidance of the erroneous concept of “average period of production.”

Second, we should indicate that the five-year duration of the production process in our example is also purely arbitrary. Modern production processes are highly complex, as we know, and they vary greatly from one sector or business to another, with respect to the number and duration of stages. At any rate, it is unnecessary and pointless to refer to an “average period of production,” since a priori estimates of the length of any particular production process depend on the specific process itself. We know that capital goods are actually the intermediate stages in a production process initiated by an entrepreneur. From a subjective point of view, a production process always has a beginning, the specific moment at which the actor first perceives that a particular goal is worthwhile to him, and a certain set of intermediate stages which he conceives in advance and later attempts to carry out as he acts. Hence our analysis is not based on the idea of an “average period of production” and is therefore immune to criticism of that concept.²⁹ In fact all production periods have a specific origin and cannot be traced back indefinitely in time; instead each stops at the very moment a certain entrepreneur took up the pursuit of an aim which constituted the imagined final stage in his process.³⁰ Thus 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 identifying the beginning of the first stage, it is totally irrelevant whether or not the production process in question involves the use of capital goods or factors of production completed in advance, yet which no one had ever imagined would eventually be used in such a process. Moreover it is unnecessary to trace back indefinitely in time the conception of a set of stages in a production process because any capital good produced in advance which nevertheless remains unused for a specific purpose for any length of time, ultimately becomes another “original” resource, so to speak, similar in this respect to all other natural resources that generate income, yet are viewed by the actor as just another initial factor in his course of action.³¹ In short all production processes are invariably prospective, they have an identifiable beginning and a foreseeable end, and their duration varies according to the process in question yet is never infinite nor undetermined. Therefore the retrospective calculation of supposed, phantasmagoric average periods of production is meaningless.

3. Fixed and circulating capital goods.

A third pertinent observation about our portrayal of productive stages is that it includes not only fixed capital goods, but also circulating capital goods and durable consumer goods. From a human actor's prospective point of view, the distinction between fixed and circulating capital goods is irrelevant, since it is largely based on the physical characteristics of the goods in question and depends especially upon whether or not these goods are considered to have been “completed.” Indeed when fixed capital goods are incorporated into a production process, they are considered “completed,” while circulating capital goods are thought to be semi-manufactured or in an “intermediate” process of production. However according to the subjectivist view on production processes aimed at consumption, both fixed and circulating capital goods constitute intermediate stages in an action process which only concludes when the final consumer good satisfies the desires of consumers; therefore, economically speaking, it is senseless to distinguish between the two.

The same can be said for “inventories” or stocks of intermediate goods held on hand at each of the productive stages. These stocks, which are considered a part of circulating capital, constitute one of the most significant components of the value of each stage in a process of production. Furthermore it has been demonstrated that as the economy evolves and prospers, these stocks become more important because they enable different businesses to minimize the ever-latent risk of unexpected shortages or “bottlenecks” which prolong delivery periods. In this way, inventories make it possible for clients at all levels (not only at the level of consumption, but also at the level of intermediate goods) to have at their disposal a growing variety of products to choose from and acquire immediately. Hence one manifestation of the lengthening of production processes is precisely a continual increase in inventories or stocks of intermediate goods.

4. The role of durable consumer goods.

Fourth, durable consumer goods satisfy human needs over a very prolonged period of time. Therefore they simultaneously form a part of several stages at once: the final stage of consumption and various preceding stages, according to their duration. In any case, for our purposes it is irrelevant whether the consumer himself must wait a certain number of years or stages before taking advantage of the latest services his durable consumer good can perform. Only when these services are directly received do we reach the last stage of Chart V-1, the stage of consumption. The years the owner spends caring for and maintaining his durable consumer good so that it will continue to perform consumer services for him in the future correspond to the stages which appear above and are increasingly distant from consumption: stage two, three, four, etc.³² Thus one of the manifestations of the lengthening of production processes and of the increase in their number of stages consists precisely of the production of a larger number of durable consumer goods of increasing quality and durability.³³

5. The trend toward the equalization of the rate of accounting profit or interest at each stage.

The fifth fundamental point we must emphasize is the following: In the market there exists a trend (driven by the force of entrepreneurship) toward the equalization of the rate of “profit” in all economic activities. This occurs not only horizontally, within each production stage, but also vertically, between stages. Indeed when there are disparities in profits, businessmen will devote their effort, creative capacity and investment to those activities which generate relatively higher profits, and they will stop devoting these things to activities which yield lower profits. Significantly, in the example from Chart V-1, the rate of accounting profit, or relative difference between income and expenses, is the same at each stage, i.e., approximately 11 percent per year. If the situation were otherwise; that is, if in one of the stages the rate of accounting profit or interest were higher, then disinvestment would take place, and productive resources would be withdrawn from the stages with a lower rate of profit and directed to those with a higher rate of accounting profit. This redirection of resources takes place until the greater demand for capital goods and original means of production in the receiving stage results in an increase in spending on these components in that stage; and the greater influx of its final goods tends to reduce their prices, until the differential between income and expenses decreases, giving rise to a rate of profit equal to that of other productive stages. This microeconomic reasoning is key to understanding modifications made to the number and length of productive stages; we will later examine these changes.

6. Gross and net investment and saving.

Sixth, although in the example from Chart V-1 the total net income received by owners of the original means of production and by capitalists in the form of profit or interest (100 m.u.) coincides exactly with the sum spent over the period in consumer goods (and thus net saving is equal to zero), there is a significant volume of gross saving and investment. In fact gross saving and investment are reflected in Table V-1, which indicates for each stage, at the left-hand side of the table, the supply of present goods offered by savers in exchange for future goods. At the right-hand side, we find the corresponding demand for present goods experienced by the providers of future goods, mainly owners of the original means of production (labor and natural resources) and the capitalists of earlier stages. We can observe from the table that gross saving, or the total supply of present goods, equals 270 m.u.: overall gross saving which takes place in the economic system and is 2.7 times greater than the amount spent during the year on final consumer goods. This gross saving is identical to the gross investment of the financial year in the form of spending by the capitalists on natural resources, labor, and capital goods from prior stages in the production process.³⁴

7. Gross and net income for the year.

Seventh, we could view Chart V-1, our outline of the different stages in the production process, as an illustration of the flow of both capital goods and money. Indeed capital goods “flow downward,” i.e., from the stages furthest from consumption to the stages closest to it, and money “flows” in the opposite direction. In other words, m.u. are first used to pay for final consumer goods, and from that point they gradually move up the scale of productive stages until they reach those stages furthest from consumption. Therefore to obtain the gross monetary income for the period, we total, from bottom to top, all of the transactions (in terms of m.u.) conducted during the period. Details appear in Table V-2.

We see from this table that the gross income for the period is equal to 370 m.u. Of this amount, 100 m.u. correspond to net income, which is spent entirely on final consumer goods; and 270 m.u. correspond to the total supply of present goods or gross saving, which coincides with the total gross demand for present goods during the period. The following relationship exists between gross income and net income for the period, according to the calculation made in Table V-2: gross income is equal to 3.7 times the net income for the period. That is, a relationship exists between the number of m.u. spent on consumer goods and the much larger number spent on capital goods. This proportion is represented in Chart V-1 by the unshaded area corresponding to the final stage, that of consumer goods, versus the shaded areas pertaining to the other stages (including the net monetary income of the factors of production, shown at the top). Hence it is an unquestionable fact that the amount of money spent on intermediate goods during any time period is much larger by far than the amount spent during the same period on consumer goods and services. It is interesting to note that even minds as brilliant as Adam Smith committed unfortunate errors when it came to recognizing this fundamental economic fact. Indeed, according to Adam Smith,

the value of the goods circulated between the different dealers, never can exceed the value of those circulated between the dealers and the consumers; whatever is bought by the dealers, being ultimately destined to be sold to the consumers.³⁵

CRITICISM OF THE MEASURES USED IN NATIONAL INCOME ACCOUNTING

The sum of gross income, as we have defined and calculated it, along with its distribution over the different stages in the production process, is crucial for a correct understanding of the economic process which takes place in society. In fact the structure of the stages of capital goods and their value in m.u. are not measures which, once obtained, can be automatically and indefinitely maintained regardless of human decisions made by entrepreneurs who must deliberately and continually choose whether to increase, hold steady or reduce the productive stages undertaken in the past. In other words, whether a certain structure of productive stages remains the same or changes, becoming narrower or broader, depends solely upon whether the entrepreneurs of each stage subjectively decide it is worthwhile to reinvest the same percentage of the monetary income they have received, or instead, they believe it is more beneficial to them to modify this proportion by increasing or decreasing it. In the words of Hayek:

The money stream which the entrepreneur representing any stage of production receives at any given moment is always composed of net income which he may use for consumption without disturbing the existing method of production, and of parts which he must continuously re-invest. But it depends entirely upon him whether he re-distributes his total money receipts in the same proportions as before. And the main factor influencing his decisions will be the magnitude of the profits he hopes to derive from the production of his particular intermediate product.³⁶

Therefore no natural law forces entrepreneurs to reinvest their income in the same proportion in which they have invested in capital goods in the past. Instead, this proportion depends on the specific circumstances present at each moment, and in particular on the entrepreneurs’ expectations regarding the profit they hope to obtain at each stage of the production process. This means that, from an analytical standpoint, it is very important to focus on the evolution of the amounts of gross income as reflected in our diagram, and to avoid concentrating exclusively on net values, as is the custom. So we see that even when net saving equals zero, a productive structure is maintained by considerable gross saving and investment, the sum of which is several times larger than even the amount spent on consumer goods and services during each productive period. Therefore the key is to study gross saving and investment, i.e., the aggregated value, in monetary terms, of the stages of intermediate goods prior to final consumption, an amount which remains hidden if we focus exclusively on the evolution of accounting figures in net terms.

This is precisely why we should be especially critical of traditional national income accounting measures. For example, the traditional definition of “gross national product” (GNP) contains the word “gross,” yet in no way reflects the true gross income spent during the year on the entire productive structure. On the one hand, GNP figures hide the existence of different stages in the production process. On the other hand, what is even more serious and consequential is that the gross national product, despite the “gross” in its name, does not reflect the total gross monetary spending which takes place in all productive stages and sectors of the economy. This is because it is based solely on the production of goods and services delivered to final users. In fact it rests on a narrow accounting criterion of added value which is foreign to the fundamental truths of the economy; it only adds the value of consumer goods and services and of the final capital goods completed during the year. It does not incorporate the other intermediate products which make up the stages in the production process and which pass from one stage to another during the financial year.³⁷ Hence gross national product figures only include a small percentage of the total of capital goods. Indeed GNP incorporates the value of the sales of fixed or durable capital goods, such as real estate, industrial vehicles, machinery, tools, computers, etc., which are finished and sold to their final users during the year, and thus are considered final goods. However it in no way includes the value of circulating capital goods, intermediate non-durable products, nor of capital goods which are not yet finished or if so, pass from one stage to another during the process of production. In contrast, our gross output figure from Table V-2 incorporates the gross production of all capital goods, whether completed or not, fixed, durable or circulating, as well as all consumer goods and services produced during the financial year.

In short the Gross National Product is an aggregate figure representing added values, and it excludes intermediate goods. The only reason national accounting theorists offer for using this figure is that with this criterion they avoid the problem of “double counting.” Yet from the standpoint of macroeconomic theory, this argument rests on a narrow accounting concept applicable to individual companies and is very dangerous, as it excludes from the computation the enormous volume of entrepreneurial effort which each year is dedicated to the production of intermediate capital goods, the bulk of economic activity but not at all worth evaluating, according to GNP figures. To get an idea of the amounts involved, it suffices to consider that the gross output (calculated according to our criterion) of an advanced country like the United States is equal to more than twice the country's official GNP.³⁸

Therefore traditional national income accounting figures tend to eliminate at a stroke the central role intermediate stages play in the process of production; specifically, these measures ignore the undeniable fact that the continuance of intermediate stages is not guaranteed, but results from a constant, uncertain series of concrete entrepreneurial decisions which depend on expected accounting profits and on the social rate of time preference or interest rate. The use of GNP in national income accounting almost inevitably implies that production is instantaneous and requires no time, i.e., that there are no intermediate stages in the production process and that time preference is irrelevant with respect to determining the interest rate. In short the standard measures of national income completely do away with the largest, most significant part of the production process, and moreover they do so in a disguised manner, since, paradoxically and despite the label “gross,” they cause non-experts (and even most experts) in the field to overlook the most significant part of each country's productive structure.³⁹

If national income accounting measures were modified and made truly “gross,” they would include all intermediate products, and it would be possible to follow the proportion of the amount spent each year on consumer goods and services to the amount spent at all intermediate stages. This ratio is ultimately determined by the social rate of time preference, which establishes the proportion of gross saving and investment to consumption. Clearly the weaker the time preference, and therefore the more savings generated in society, the larger the proportion of gross saving and investment to final consumption. At the same time, a strong time preference means interest rates will be high, and the ratio of gross saving and investment to consumption will decrease. Adequate intertemporal coordination of the decisions of economic agents in a modern society requires that the productive structure adapt to different social rates of time preference quickly and efficiently, something the entrepreneurial spirit itself, driven by the search for profit, tends to guarantee, as entrepreneurs try to equalize profit over all stages. If we wish to find a statistical measure which, instead of concealing, sheds as much light as possible on this important intertemporal coordination process, we must replace the current gross national product estimate with another such as gross national output, as defined here.⁴⁰