A comment from Lord Keynes’ blog motivated me to write this post, in which the commentor states something along the lines of thinking of the Austrian Business Cycle as central to Austrian economics. And while it is wrong to think of the ABC as the center of Austrian economics, it is perfectly understandable. There is all this hype of the ABC and how it is a good tool to use to kind of predict downturns in the economy. For the most part, virtually all Austrians agree with the ABC in one way or another, whether they believe it to be a universal theory (one which applies to all downturns) or whether they believe it to be a partial explanation to downturns (one which applies to downturns sometimes). It is also a perfectly understandable to make this mistake because even Austrians get confused what the theory explains. Time and time again, we hear Austrians accusing Keynesians on not having a capital theory, and when one asks the Austrian, ‘What is your capital theory,’ the response is typically the ABC, but as I will point out soon, this is misleading.
What is a central aspect of Austrian economics is not the ABC but capital theory. The ABC is a capital-interest theory at best but it does not follow from that, that it is a capital theory. It should also be noted that Carl Menger, the founder of the Austrian school, despised capital-interest theory, in which he considered Bohm Bawerk’s theory as one of the greatest errors ever committed. Menger did not really accept the Bohm Bawerkian link between capital and interest, and better yet, disagreed on what ‘capital’ means. Now the details on the issues is a bit hazy, and even Lachmann had troubles understanding fully Menger’s theory of capital. And thus, to be fair, my sources to reach this conclusion come from J. Schumpeter and L. Lachmann because much of Menger’s writings are in German and are not translated and I do not read German. Two works by Menger that would be beneficial to this debate about capital are: Zur Theorie des Kapitals (On the Theory of Capital) and possibly the second edition to Menger’s Principles of Economics, which contains much of his personal notes on economics. That said though, it is clear that Menger disliked Bohm Bawerk’s capital-interest theory and they had different definitions on what capital actually meant.
So what is capital? Lachmann interprets Menger to say that capital is whatever the market says it is, which is essentially the true definition of capital. Lachmann explains further the theory of capital in his book Capital and Its Structure. In a very simplistic layman version: Capital is just stuff. Stuff in which we can break apart, combine with other stuff (capital), create new combinations, and finding new ways to use the stuff we have to create more stuff. The combination of stuff will change over time, this is inevitable. We will never achieve a perfect combination of stuff, and therefore, the stuff that we create now might be extremely useful today and extremely useless tomorrow. But not to fear, because the useless stuff today maybe the extremely useful stuff tomorrow. And when the existing combinations of stuff is useless all together, one can take the stuff apart and create new combinations using the useless stuff. This is the structure of what stuff is in the market.
So what is so important about the structure of this stuff, what is the point of the above passage? The point is to get one out of the mindset that capital is some K variable in a production function. It is not something we can take as a constant when describing the competitive market. We cannot just graph a Solow Growth model and come out with the optimum amount of capital given some constraints and a Cobb-Douglas production function. In short, to accept the above passage is the start to reject certain objective measures on capital, and is to reject major aspects of neoclassical economics.
We know from this that (1) capital is heterogeneous, but not only in its properties, but how one uses capital. There can be a single item in the market, yet these items, while are the same in properties, may not be the same because of the different uses they deliver in the market. And because in a competitive market, where there are lots of items were one can keep, take apart, destroy, combine etc., what we can do in the marketplace is almost limitless. (2) Time is a huge factor, but must be treated differently than how the neoclassicals use it. To create a graph and to use variable T as time, and to label certain points as t1, t2,t3,etc is ignoring reality! Combinations of things to create X might please us today, but tomorrow might be discarded by the same person. Thus, the preferences of people are subjective, each person trying to achieve what they think is best in the given situation, but why do we discard things? Expectations! Subjectively, people in the marketplace try to establish the most efficient combinations of stuff to satisfy their wants, but the most efficient combination we can think of today might be useless tomorrow because we may learn new things in the market, whether it is by market prices, or some gut feeling. (3) Every combination of stuff is imperfect, there are always new knowledge, new thoughts, new agents, etc. to enter the market and influence the existing data that we might have currently, or better yet, the data that we have knowledge of. To accept that there is some perfection in combination is to say that there is an optimum combination where expectations, time, preferences, and subjectivity are irrelevant and useless. The continuous change that we just described in the structure of capital ends at some point, but this cannot be so, and therefore to accept equilibrium is to reject human action! And what can be more absurd than to ignore human action when talking economics? (4) Probably the most controversial part, which I think needs a lot more research on: the flaws of objectivity. Sure in a world where all combinations are consistent with each other, one in which human action can go no further in progress, one in which the continuous process of the market is nonexistent (I am describing the state of equilibrium) there is a case to be made for a universal capital stock where all the things are aggregated (whether by monetary terms or quantity) but what is the case in disequilibrium where the future is unknown but not unimaginable, this is to say, what is the case in a world where capital is subjective due to realities of the real world?
This is true Austrian capital theory! This is what is at the center of Austrian economics, not some business cycle that is questionable due to certain neoclassical assumptions (for example, the validity of the loanable funds theory, or given set of expectations).