Böhm-Bawerk's History and Critique of Interest Theories

An overview of Eugen von Böhm-Bawerk's 'Capital and Interest'

Eugen von Böhm-Bawerk was one of the greatest economists to ever live and write, and his ‘history and critique of interest theories’, published as Capital and Interest, is one of his most important works. After listening to Robert P Murphy’s three-part series on Austrian Capital Theory, I was inspired to read through the entire tome. Since the length of the text is off-putting, I decided to summarise the major points here, with generous block quotes from the text to give a taste of his writing style and rhetoric. What follows is no substitute for the text itself, but my hope is that it captures the essence.

Introduction

Eugen von Böhm-Bawerk was an economist and self-taught student of Carl Menger, although he never directly studied under him. Along with Friedrich von Wieser (who eventually became his brother-in-law), he formed the ‘second generation’ of Austrian economists, functioning as a bridge between Menger and Mises. In 1886, he published an extensive critical history of interest theories, which was an important milestone in the development of the correct theory of capital and interest. Since the book is so long and dense, I have here excerpted choice sections of it with commentary in order to facilitate better understanding. The original text, however, is well worth reading for its brilliant rhetorical style alone. If this overview interests you (pun intended), free digital copies are available at the Mises Institute website here. Unless otherwise specified, all block quotes will be from Capital and Interest.

Capital and Interest is divided into seven ‘books’; the middle five cover broad classes of interest theories that are dealt with both as a class and individually. The first book is a properly historical account of the subject, and it also introduces the taxonomy of classes of interest theories that will be followed throughout the book.

1. The Development of The Problem

The fundamental (theoretical) problem of interest is defined and distinguished as follows:

From the theoretical problem of interest must be carefully distinguished the social and political problem. The theoretical problem asks why there is interest on capital. The social and political problem asks whether there should be interest on capital - whether it is just, fair, useful, good, - and whether it should be retained, modified, or abolished. While the theoretical problem deals exclusively with the causes of interest, the social and political problem deals principally with its effects. And while the theoretical problem is only concerned about the true, the social and political problem devotes its attention first and foremost to the practical and the expedient.

There are many ways that a theory of interest can fail; it may gloss over the phenomenon itself (as in the case of the ‘colourless theories’); it may stop at mere production itself, before the problem of distribution and thus fail at explaining the crucial issue (the ‘Naïve Productivity’, ‘Labour’, and ‘Fructification’ theories); it may go beyond the issue completely and doxastically insist upon a false reality in which distribution alone is the focus (the ‘Exploitation Theory’); or it may provide some hints towards the right answer but build upon shaky grounds or unsatisfactory explanations (The ‘Use’ and ‘Abstinence’ theories). In this regard Menger’s formulation of the Use theory is in a sense the ‘least wrong’ of all the theories, because it correctly identifies the fundamental question and proceeds towards establishing a coherent answer. However, some economists have argued that Böhm-Bawerk’s treatment of Turgot as a ‘Fructification’ theorist was mistaken, in which case he might come closest to clinching the title. We shall not pursue such points in this essay.

The first book largely goes over political and legal history, detailing how thinkers like Salmasius eventually overcame the orthodoxy and established the collection of interest payments as a legitimate venture, ushering in an age of prosperity. Only later in the book does Böhm-Bawerk reveal that the arguments Salmasius brought forth against the orthodox charge were fallacious, and that the historical ‘villains’ that held back civilisation with their prohibitions on usury were in fact the ones with the superior arguments! Note the radical point of departure: Böhm-Bawerk is not merely critiquing Salmasius’ particular justification for interest, but in fact siding with the orthodox scholars of the Church on the grounds of their superior argument.

The rest of the first book is devoted to the ‘colourless’ theories of interest; these were theories that did not consider the problem of interest to be something to be explained at all, and simply noted that in the absence of interest, capitalists would not engage in the activities that they do engage in. This ‘subjectivist’ explanation does not really account for the phenomenon and does not answer the fundamental problem. In further critiquing the primitive theories of interest, he points out something Austrians particularly ought to pay close attention to: subjectivism cannot be the final analysis to explain interest. The core of proper economic analysis is causal-realism, not merely subjectivism.

In explanation it cannot be enough to point in a superficial way to the state of demand and supply. For if demand and supply are at all times in such a position that this remarkable result takes place, the regular recurrence must rest on deeper grounds, and these deeper grounds demand investigation.

Thus Book 1 is important in clarifying the nature of the problem at hand and providing the taxonomy of interest theories that makes up the base structure of this text. There are five broad classes of theories of interest that Böhm-Bawerk explicates and critiques in turn - Productivity theories, Use theories, Abstinence Theories, Labour Theories, and Exploitation theories. Let us proceed in order.

2. The Productivity Theories

The first of the major classes of theories he sets out to demolish is the class of Productivity theories. This is the family of theories which attribute the phenomenon of interest naively to the increased productivity of capital. This group again misunderstands the problem, but unlike the Colourless theorists they are not innocently unaware, they are simply in error. This is because they fail to take into account the process of appraisal of the capital goods themselves. There are four possible formulations of such a theory listed as follows, each stronger than the one before:

1. Capital has the capacity of serving towards the production of goods.

2. Capital has the power of serving towards the production of more goods than could be produced without it.

3. Capital has the power of serving towards the production of more value than could be produced without it.

4. Capital has the power of producing more value than it has in itself.

It could do to extend this list further, but that would not help with analysis, and critiquing these will suffice for the purpose at hand. Recall that the fundamental problem is finding an explanation for why there is interest earned on capital. Thus the first two formulations do not even begin to address the problem, since the capacity to produce more goods does not explain why the capital held should be of lesser value than the surplus of goods that it generates.

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2.1 Naïve Theories

The theorist, then, who professes to explain interest must explain the emergence of Surplus Value. To wit: why is the gross return to capital invariably of more value than the portions of capital consumed in its attainment? Or, in other words, why is there a constant difference in value between the capital expended and its return?

Literally to ascribe to capital a power of producing value is thoroughly to misunderstand the essential nature of value, and thoroughly to misunderstand the essential nature of production. Value is not produced, and cannot be produced. What is produced is never anything but forms, shapes of material, combinations of material; therefore things, goods. These goods can of course be goods of value, but they do not bring value with them ready made, as something inherent that accompanies production. They always receive it first from outside - from the wants and satisfactions of the economic world. Value grows, not out of the past of goods, but out of their future.

Furthermore, there is no conception of how exactly it is that these capital goods are making their contribution. Interest theories that miss this middle step and simply assume that greater physical productivity translates to increased value output B ̈ohm-Bawerk terms as ‘naive’.

By what means capital or stock contributes towards wealth is not so apparent. What is the nature of the profit of stock, and how does it originate? are questions the answers to which do not immediately suggest themselves. They are indeed questions that have seldom been discussed by those who have treated on political economy, and important as they are, they seem nowhere to have received a satisfactory solution.

Thus, since capital goods are only valuable to the extent that they can be employed in producing valuable consumer goods, the Naïve Productivity theory, i.e formulations 1 and 2 above, do not even begin to address the problem at hand, which is to explain the differential or the net return to capital. The mere fact of productivity only explains why there is a gross return to capital in the form of interest.

2.2 Indirect Theories

The ‘indirect’ theories, in contrast, have a strict view of productivity in terms of physical output, but do not err in skipping over the explanation for why this should translate into surplus value. They therefore insert a characteristic middle term, with the special function of giving reasons why the increased quantity of products must involve a surplus in value.

Since many theorists take stock of this ‘characteristic middle term’ in distinct ways, the Indirect theories cannot be criticised as a whole. The heterogeneity of the critiques forces Böhm-Bawerk to consider each one separately.

2.2.1 Lauderdale and Malthus

Lauderdale, for instance, claims as grounds for the interest return the fact that the owner of real capital (that is, capital goods) is able to secure himself an income by displacing labour with capital and collecting what would otherwise have been wage outlays. However, would this explain interest? There is no reason provided as to why the owner of the ‘real capital’ would be able to purchase the equipment at a lower price than what it collects as revenue. Even if we accede to the claim that capital earns revenue on behalf of replaced labour, there is nothing here that would suggest why the capitalist would earn a net income by investing in the ‘real capital’. Suppose a machine replaces the labour of ten workers for one year, each of whom is paid an annual wage of $500. Why should the machine itself not cost up to $5000? And if it does, then there is no profit or interest income left over that supposedly accrues to the owner of said machine.

Following Lauderdale, Malthus too points toward a productivity theory of interest. He correctly identifies a succinct definition for profit, when he writes “The profits of capital consist of the difference between the value of the advances necessary to produce a commodity and the value of the commodity when produced”, but does not elaborate upon the cause of such a difference. Instead, we just get an imprecise version of Lauderdale’s theory.

2.2.2 Henry Carey and Peshine Smith

With Henry Carey, Böhm-Bawerk has no patience. In his words, Carey’s proposal is ‘one of the worst examples of confused thinking on a subject where there has already been much confusion’ and ‘one of those theories which, to my mind, cast discredit not only on their authors, but on the science that lets itself be seduced into credulous acceptance of them’. Without any theoretical discussion, Carey contents himself with an idyllic, pictorial description of Robinson Crusoe life. Up to a point, his discussion is faithful to Lauderdale, but then he not only confuses gross and net income, but also confuses both with real capital. With the notion that goods are valued according to the costs of their production, Carey notes that increases in productivity will lead to capital goods being produced at lower costs, and thus the rate of interest will fall (see if you can spot where each equivocation takes place in that sentence).

Similarly, Carey’s student Peshine Smith is taken to task for his dismissive approach to the problem, where he simply points out that both the capitalist and the labourer expect to gain their respective share out of their transaction, and that as a matter of fact they do. No formal explanation is provided, and thus profits (and wages) become mere semantic things; they are just terms we use to note the distinction between the income of each party.

2.2.3 Von Thünen

In favourable contrast stands the German theorist Von Thünen. Like Carey, he investigates the phenomenon of interest genetically, by analysing primitive economies. As a characteristic example of his conscientious thought, he pens down with exactitude the various assumptions of fact with which he starts. He begins his analysis with a hypothetical tribe with the knowledge and skill of civilisation but only the (abundantly present) gifts of nature to work with. All men are assumed to be equal in all productive respects, and sustain themselves by labour. He then stipulates that the standard of value to be used is one such person’s means of subsistence, with unit c such that 100c represents the means of subsistence for a year.

Now, if a man can produce 110c every year for ten years, consuming 100c each year, then he will have a 100c surplus and can spend a year living off of this stock, constructing capital goods like nets, a bow, and arrows. Armed with these, he can now accumulate 150c in the year that follows instead of the 110c from earlier. Now he only needs to devote two years to generate a stock of subsistence for a year. However, he already has a bow and arrows, so he can lend the next batch to someone who doesn’t have them. The receiver will be able to produce again 150c instead of 110c. This excess produce of 40c is what our capitalist earns as his net income. So not only does Thünen base his theory of interest on productivity, but also explains the height of this interest income by direct reference to the degree of efficiency that the capital enables.

He cleanly avoids the obvious pitfalls: no value productivity is naively assigned to the physical productivity of capital, and there is no confusion between the gross and net incomes that said capital enjoys. However, he implicitly assumes that this return covers the cost of renewing capital as well as the surplus interest return. Indeed, Thünen simply assumes that 40c is left over after deduction of whatever is necessary to replace the real capital. It is not so self-evident why this capital must be self-replenishing, and certainly not a realistic assumption as pertains to the world as we know it. Now if, over the lifetime of the bow and arrow, a hunter is able to increase his yearly income by 100c before it wears out, then there is no reason why economic value of the bow and arrow should not go up to 100c. On the other hand, if competition presses down the price, then there is no reason why the price should stay above costs of production. There is no explanation for why a stable middle ground would be achieved.

Thünen provides the clearest exposition of the indirect productivity theory, but he too fails at the crucial step of explaining the surplus value. Furthermore, the assumption of ‘units’ of subsistence flies in the face of subjective value theory as expounded by Menger. Still, Thünen’s work represents a pinnacle of the indirect theories that was not to be seen again.

2.2.4 Strasburger

The Productivity theories are heavily criticised by the proponents of the Exploitation theory, the Socialists. Finally, Strasburger posits a reformulation of interest theory in response. His explanation for the net income accrued to capital is that capital allows us access to natural powers which, while readily available to everyone, can only be harnessed through these capital goods. Think electricity, a natural power, harnessed through machinery and put to productive use in factories. In order to enjoy the benefits of such employment, he who has no capital must give over the product of his own labour to the capitalist for the work of the natural powers, hence interest.

His premises may be readily granted; the role of capital goods in harnessing natural powers makes sense logically and is also readily observable. You would not be reading my overview of Capital and Interest right now if it weren’t for the computer I am using to type it up. It could also be granted that capital goods are specific and scarce enough to command a return on the market. But the fundamental problem of interest has not been addressed. These premises tell us nothing about the existence and height of interest returns to capital, because they again only explain gross returns accruing to it and not the value differential that arises with regularity. The payment for natural powers can only accrue to the capitalist as a constituent portion of a gross return, which, over and above that payment, contains a second payment for expenditure of labour. Thus Strasburger, too, misses the point and stops his explanation right before the point where it should legitimately begin.

2.3 Summing up

In summation, Böhm-Bawerk points out that all the Productivity theorists miss the phenomenon to be explained, i.e net income - for the phenomenon that is observed trivially, i.e gross income. The metaphor of a log and the water it floats on is imaginative and apt for this discussion.

If a log is thrown across a flooded stream the level of water below the log will be less than the level of water above the log. If it is asked why the water stands higher above the log than below, would any one think of the flood as the cause? Of course not. For although that flood causes the water above the log to stand high, it tends at the same time, so far as that is concerned, to raise the level of the water below the log just as high. It is the cause of the water being “high”; what causes it to stand “higher” is not the flood, but the log.

Now what the flood is to the differences of level, the productive power of capital is to surplus value. It may be an adequate cause of the value of the product of capital being high, but it cannot be the adequate cause that the product is higher in value than the capital itself, seeing that it feeds and raises the level of the capital in the same way as it does that of the product. The true cause of the “plus” in this case also is a log, and a log which has not been so much as mentioned by the Productivity theories proper.

The productivity of capital goods explains the height of prices, not the differential, or surplus, that accrues to capital goods. Simply creating another stream of value corresponding to capital (the infamous triumvirate of wages to labour, rent to land, interest to capital) does not even begin to address the fundamental problem. Among Böhm-Bawerk’s predecessors, only Menger really understood this, because Menger alone had the right conception of valuation.

3 The Use Theories

The Use theories are an offshoot of the productivity theories that quickly grew into a class of their own. These theorists latch on to one of the core conceptual problems of the Productivity theorists and attempt to provide an answer - that of the causal exposition of how capital goods contribute towards wealth. Thus Böhm-Bawerk acknowledges his mentor Menger’s contribution here, although he ultimately rejects his theory of interest.

The superiority of Menger to all his predecessors consists in this, that he builds his interest theory on a much more complete theory of value, a theory which gives an elaborate and satisfactory answer to the very difficult question of the relation between the value of products and that of their means of production.

On the ‘complete theory of value’ and its relevance to the problem of interest:

Does the value of a product depend on the value of its means of production, or does the value of the means of production depend on that of their product? So long as economists did not see clearly on this preliminary question, their treatment of the interest problem could scarcely be more than uncertain groping. How could any one possibly explain in clear outline a difference in value between two amounts - expenditure of capital and product of capital - if he did not even know on which side of the relation to seek for the cause, and on which side for the effect?

The fundamental concept that the early (pre-Menger) Use theories employ is the fact that of the ‘productive services’ of capital. Since these services are valuable, and since they cannot be obtained from their owners without compensation, they must be paid for, and this explains the phenomenon of interest. Thus the ‘surplus value’ of the products of capital, and with it interest, originates in the necessity of paying independently for this independent sacrifice in production, the ‘services of capital.’ This is the Say-Hermann conception of the Use theory of interest; the productive services that capital goods provide are counted as goods to be valued and obtained through pecuniary exchanges, wherefrom profit emerges.

Menger’s conception differs from these more primitive theories, in light of his imputation theory of value in which the valuation of higher order goods is derived from marginal subjective valuations of consumer goods. In terms of the ‘order’ of capital goods in the Mengerian capital structure, the anticipated value of the product is the standard not only for the existence, but also for the amount of the value of its means of production. Finally, since the (subjective) value of goods is also the basis for their price, the price, or, as some people call it, the ‘economical value’ of goods, is regulated by the same principle. How, then, does the value differential come about, if the value of the complementary capital goods is nothing but the value of the final product? Menger gives the following answer:

The transformation of means of production into products (or, shortly, Production) always demands a certain period of time, sometimes long, sometimes short. For the purposes of production it is necessary that a person should not only have the productive goods at his disposal for a single moment inside that period of time, but should retain them at his disposal and bind them together in the process of production over the whole period of time. One of the conditions of production, therefore, is this: the disposal over quantities of real capital during definite periods of time.

This disposal, insofar as it is demanded, may command a price on the market, i.e become an economic good, which now earns a return under the usual causal-realist analysis. But now, calling back to Salmasius and the orthodox scholars, Böhm-Bawerk critiques the Use theorists on the same grounds that the Church Orthodoxy used to critique usury! In this stroke of brilliance, he reveals that Salmasius’ case for usury could not stand against the orthodoxy’s argument that the ‘use’ of capital is not metaphysically separable from the good itself and thus cannot be considered an independent ground for interest.

The canonists maintained: Property in a thing includes all the uses that can be made of it; there can, therefore, be no separate use which stands outside the article and can be transferred in the loan along with it. The defenders of loan interest maintained that there was such an independent use. And Salmasius and his followers managed to support their views with such effectual arguments that the public opinion of the scientific world soon fell in with theirs, and that to-day we have but a smile for the “short-sighted pedantry” of these old canonists.

Böhm-Bawerk is well aware of the gravity of this, and of just how radical a case he is making against the Use theorists. In his words, it “seems to put me in the position of attacking a res judicata, a case long ago carried up through all courts, and long ago decided conclusively against me.” He writes further, in his qualified defense of the canonists:

Now fully conscious that I am laying myself open to the charge of eccentricity, I maintain that the much decried doctrine of the canonists was, all the same, right to this extent; that the independent use of capital, which was the object of dispute, has no existence in reality. And I trust to succeed in proving that the judgment of the former courts in this literary process, however unanimously given, was in fact wrong.

The rest of the Use theorists do not fair so well under the onslaught that Böhm-Bawerk unleashes upon them; the failure to distinguish between Gross and Net returns to capital seems to be the Achilles heel of most, if not all, interest theories. But distinguishing the ’use’ from ’productive services’ of capital, in many different forms (Nutzung/Gebrauch), is the particular crucial error of the Use theorists.

All the authors of that school, from Say to Knies, when they begin to speak of the use of capital, first of all allude to the material services which capital actually renders. Then under cover of this they get the reader to admit that the ”use of capital” does really exist; that it exists as an independent economic element, and even possesses an independent economical value. That this independence is not the independence of a second whole beside the good itself, but only that of an independent and separable part of the content of the good, the rendering of the service being always attended by a diminution in the value of the good itself; and that the remuneration of this service is a gross interest - all this is kept in the background.

There is an interesting analogy here to Coase’s theory of the firm, in which he explains the firm through the analysis of transaction costs. Yet if transaction costs are used to explain the existence of the firm, then they cannot explain the prevalence in the face of equilibrating tendencies that move transaction costs to zero. Which is not to say that they don’t play a role, but that they may not fully explain the phenomenon at hand.

To go back to Salmasius for a brief moment: why did he err so grievously in his theoretical arguments yet come upon the correct political position on the allowance of the practice of usury? According to Böhm-Bawerk, it was the result of two intellectual errors exactly canceling each other out.

...the first error that Salmasius had made, in the fiction of the identity between the capital received and the capital paid back, he rectified by a second; he retained that fiction as regards the loan of money, and held that in this case the borrower possessed the “use” of the loaned goods all the time of the loan.

However, the Use theorists came closer than most, especially Menger, who at last put the problem on firm footing as fundamentally a problem of value. This is freely acknowledged by Böhm-Bawerk.

But if it has not had the good fortune to solve the interest problem, the Use theory has contributed more than any other to prepare the way towards it. While many other theories went wandering in ways that were quite unfruitful, the Use theory managed to gather together many an important piece of knowledge. I might compare it with some of the older theories of natural science; with that combustion theory of ancient times that worked with the mystical element Phlogiston; or with that older theory of heat that worked with a Warm Fluid. Phlogiston and warm fluid turned out to be fabulous essences, just as the “net use” turns out to be. But the symbol which in the meantime our theorists put in the place of the unknown something, helped in the same way as the ‘x’ of our equations to discover a number of valuable relations and laws revolving about that unknown something. It did not point out the truth, but it helped to bring about its discovery.

4 The Abstinence Theories

Another theory that contains a grain of truth is Nassau Senior’s Abstinence theory of interest. The name of the theory really explains it in essence. However, it is heavily critiqued by the Socialists, in particular by Lasalle, whose vicious (although false) rhetoric is acknowledged by Böhm-Bawerk as well, and we quote it here:

The profit of capital is the ‘wage of abstinence.’ Happy, even priceless expression! The ascetic millionaires of Europe! Like Indian penitents or pillar saints they stand: on one leg, each on his column, with straining arm and pendulous body and pallid looks, holding a plate towards the people to collect the wages of their Abstinence. In their midst, towering up above all his fellows, as head penitent and ascetic, the Baron Rothschild! This is the condition of society! How could I ever so much misunderstand it!

There is not much else here; the strongest and subtlest criticisms are levelled against the productivity and use theories, so the rest is almost just housekeeping. The full critique of the exploitation theory even is only found in his later work Karl Marx and the Close of his System, because the third volume of Kapital was not yet out when Böhm-Bawerk was writing this book. However, it is important to understand exactly why mere abstinence does not solve the problem, precisely because it comes so close to the truth.

Isolated and vague versions of the Abstinence theory had been around for a while; mostly they took the form of asserting that interest was necessary because the capitalist would not engage in investment otherwise. Senior distinguishes between two “primary” instruments of production: labour and natural agents. But these cannot attain to complete efficiency if they are not supported by a third element. This third element Senior calls ‘Abstinence’, by which he means “the conduct of a person who either abstains from the unproductive use of what he can command, or designedly prefers the production of remote to that of immediate results”.

He recognises that Capital is not a simple original factor, since it is itself the product of other factors. Thus if we are to assign something in it the ability to generate a return, apart from the powers of labour and nature we can only name Abstinence. To quote Senior:

In an improved state of society the commonest tool is the result of the labour of previous years, perhaps of previous centuries. A carpenter’s tools are among the simplest that occur to us. But what a sacrifice of present enjoyment must have been undergone by the capitalist who first opened the mine of which the carpenter’s nails and hammer are the product! How much labour directed to distant results must have been employed by those who formed the instruments with which the mine was worked! In fact, when we consider that all tools, except the rude instruments of savage life, are themselves the product of earlier tools, we may conclude that there is not a nail among the many millions annually fabricated in England which is not to a certain degree the product of some labour for the purpose of obtaining a distant result, or, in our nomenclature, of some abstinence undergone before the conquest, or perhaps before the Heptarchy.

The indemnification for this sacrifice is what we observe as interest return. Using Ricardian analysis, Senior notes that the price a good sells at must include not only the compensation to labour in terms of wages, but also a return to the capitalist on account of his Abstinence cost, since total cost of production must include both. Regardless of this antique manner of theorising (antique from the vantage point of the current year) there is undoubtedly some truth to the Abstinence doctrine; it cannot be denied that capital accumulation requires a degree of abstinence and willingness to forego present consumption in favour of investment. However, the existence and height of the interest return in no meaningful way relates to the ‘abstinence’ that the capitalist employs. Lasalle in his scathing critique of this ‘priceless expression’ points this out in a most colourful manner.

Thus, although the Abstinence theory has a grain of truth, it suffers from a hasty generalisation on Senior’s part. Secondly, he expresses a theory that is essentially correct in an unnecessarily moral tone that leaves it vulnerable to attack, especially given the extent to which he generalises it and ignores perverse cases. It is a logical blunder to consider the postponement of gratification to have any independent productive power, or a ‘sacrifice’ independent of the ‘sacrifice’ of labour involved in production. Finally, he is working in a Ricardian framework in which he explains the value of goods by their costs, which we know as marginalists is flawed.

Böhm-Bawerk also criticises Bastiat on similar grounds, but since his theory of interest is largely an inferior copy of Senior’s, we will not tread the same ground again here.

5 The Labour Theories

The Labour theory of interest is not to be confused with the Labour theory of value; the latter is part of the Exploitation theory of interest, which is dealt with in the next section. This section is very short, since the theories are largely unimpressive. The entire section on Labour theories is a mere sixteen pages. Primarily advocated by James Mill and M’Culloch, it is another hangover from the days of Ricardo/Smith and the classical tendency to trace everything back to labour.

In this Ricardian tradition, James Mill puts down the proposition that the exchange value of goods is regulated by costs of production. However, capital is, as we have seen, not independently productive but itself the result of past labour inputs. Mill gets over this disturbance by stipulating profit to be the wage of ‘indirect’ labour on behalf of the capitalist. The owner of a machine that took a hundred days to build is ‘using’ up this stored labour, and profit is the compensation for this input just as a wage is the compensation for direct labour inputs. The problem is clear - this theory again only explains the gross rental price of capital goods and not the net revenue that the capitalist may accrue. This is even putting aside the issues with the costs-of-production approach to price theory. M’Culloch puts forward a similar theory.

Mill and M’Culloch, however, only comprise the ‘English group’. There is also a ‘French group’ that includes Courcelle-Seneuil (this is a single person, not two people), who best expounds the theory they subscribe to. According to him, there are two kinds of labour - muscular labour, and the labour of saving. In the latter lies an act of intelligence, or foresight, that by its nature commands a portion of the revenue. This approach is in some respects similar to Senior’s Abstinence theory. However, this group emphasises more the ‘pain’ that accompanies the act of refraining from consumption, which is analogous to the stress exerted upon the muscles in physical labour. Courcelle-Seneuil concludes with the formal deliverance:

We consider then that saving is really, and not simply metaphorically, a form of industrial labour, and consequently a productive power. It demands an exertion which, it is true, is purely of a moral kind, but it is all the same painful. It has therefore as much right to the character of labour as an exertion of the muscles has.

Interest is the remuneration for this labour of abstention, and its height is determined by ‘the laws of supply and demand’! It is clear now that this is simply an inferior formulation of Senior’s theory and we may summarily dismiss it on that ground. Apart from the French and English groups there is also a German group of ‘Katheder Socialists’, but they only provide a socio-political justification and not an economic explanation for interest, which as we have seen does not quite address the fundamental problem. It may be true that in the absence of interest, there would be no incentive for private actors to come forward and play the role of the capitalists, but that is not what an economic theory of interest should seek to explore. Rather, it must be an explanatory one. Interest is a function of simple ownership, not labour or ‘just deserts’.

That it is the Ricardian framework under-girding all these disparate theories is pointed out explicitly by Böhm-Bawerk in his final words of the section.

That economists should fall into various kinds of Labour theories can only be explained by the custom prevalent ever since Adam Smith and Ricardo of tracing all value to labour. To enable them to force interest also into the unity of this theory, and ascribe to it the origin which they supposed to be the only legitimate one, they did not hesitate at the most far-fetched and artificial explanations.

6 The Exploitation Theories

On the Socialist Exploitation theory, Böhm-Bawerk begins with these words:

We come now to that remarkable theory the enunciation of which, if not the most agreeable among the scientific events of our century, certainly promises to be one of the most serious in its consequences. It stood at the cradle of modern Socialism and has grown up along with it; and to-day it forms the theoretical centre around which move the forces of attack and defence in the struggle of organising human society.

He tackles two major proponents of the theory in question, namely Rodbertus and Marx.

6.1 Rodbertus

Böhm-Bawerk minces no words with regards to Rodbertus:

To come now to criticism of Rodbertus’ system. Without circumlocution I may say at once that I consider the theory which it contains to be an entire failure. I am convinced that it suffers from a series of grave theoretical defects which I shall endeavour to set forth in the following pages as clearly and as impartially as may be.

In his critique of Rodbertus, Böhm-Bawerk constructs an instructive numerical example. Before we get to that, however, there are some obvious criticisms to get out of the way. And before even that, let us lay out Rodbertus’ system in terms of its basic premises, because the Exploitation theory is a particularly pernicious one that, in various forms, infects modern discourse as well. It will do well to spell out what is merely implicit in the minds of most people. The fundamental premise of the system, that “Labour alone is productive”, is explicated as follows:

1. Only those goods are economical goods which have cost labour; all other goods, be they ever so useful or necessary to mankind, are natural goods, and have no place in economical consideration.

2. All economic goods are the product of labour and labour only; for the economic conception they do not count as products of nature or of any other power, but solely as products of labour; any other conception of them may be physical, but it is not economic.

3. Goods, economically considered, are the product solely of that labour which has performed the material operations necessary to their production. But to this category belongs not merely that labour which immediately produces the goods, but also that labour which first creates the instrument by which the goods are made.

Thus the actual labourers who produce the entire product in the shape of goods have, at least “according to the pure idea of justice,” a natural and just claim to obtain possession of this entire product. But this comes with two rather important limitations. First, the system of the division of labour, under which many co-operate in the production of one product, makes it technically impossible that each labourer should receive his product in natura. There must therefore be substituted, for the claim to the whole product, the claim to the whole value of the product, that is its exchange value on the market. However, the capitalist extracts his rent out of the sum that must be due to the workers, and the only reason workers consent to such an exploitative arrangement is Hunger (capitalised - no pun intended). To quote Rodbertus further:

The form which this compulsion originally took was slavery, the origin of which is contemporaneous with that of agriculture and landed property. The labourers who produced such a surplus in their labour-product were slaves, and the master to whom the labourers belonged, and to whom consequently the product itself also belonged, gave the slaves only so much as was necessary for the continuance of their labour, and kept the remainder or surplus to himself. If all the land, and at the same time all the capital of a country, have passed into private property, then landed property and property in capital exert a similar compulsion even over freed or free labourers.

This rent increases with labour productivity, since according to the Exploitation theory the worker is only paid a ‘subsistence’ wage, and the rest of his produce goes into the capitalists’ pockets.

At the outset, we must take issue with the very first stone Rodbertus lays in his framework; what exactly does he mean by the phrase “economical consideration”? If he is using the term in the normal way, then surely the proposition falls flat immediately. The lucky hiker who discovers an ore deposit or gold nugget has not performed any labour, yet the deposit or nugget is surely under ‘economic consideration’. Economic consideration emanates from the fact of scarcity. Surprisingly, Rodbertus never addressed such an obvious retort to his theory.

All this is so obvious that we might fairly expect Rodbertus to have taken every precaution to guard this, his first and most important fundamental proposition, against such objections. In this expectation, however, we are disappointed. With peculiar carelessness he is content on almost every occasion to assert this proposition in the tone of an axiom. Sometimes he appeals on its behalf to the authority of Adam Smith and Ricardo, and only on one single occasion does he say anything that might be construed as an attempt to give it any real foundation.

In typical scholastic fashion, however, Böhm-Bawerk decides that this is not a satisfactory critique, and so helps Rodbertus out by devising a form of the initial proposition that is much stronger and more defensible, then proceeds to demolish this stronger system.

Not to make an unfair use of Rodbertus’ first mistake, I shall, in the whole of the following examination, put all the hypotheses in such a way that the consequences of that mistake may be completely eliminated. I shall assume that all goods are produced only by the co-operation of labour and of free natural powers, and by the assistance exclusively of such objects of capital as have themselves originated only by the co-operation of labour and free natural powers, without the intervention of such natural gifts as possess exchange value. On this limited hypothesis it is possible for us to admit Rodbertus’ fundamental proposition that goods, economically considered, cost labour alone.

Next to the idea that labour “according to the pure idea of justice” must be paid the full value of its product Böhm-Bawerk also concurs. However, the socialists draw the wrong conclusion from this truism. He specifies the blunder and then illustrates it by means of a numerical example.

The perfectly just proposition that the labourer should receive the entire value of his product may be understood to mean, either that the labourer should now receive the entire present value of his product, or should receive the entire future value of his product in the future. But Rodbertus and the socialists expound it as if it meant that the labourer should now receive the entire future value of his product, and they speak as if this were quite self-evident, and indeed the only possible explanation of the proposition.

Suppose the production of a steam engine worth $550 takes five years, and assume first that a single labourer is doing all the work. At the end of five years, he will receive the full amount. It is important to note that this amount is due at the end of five years, when the steam engine has been completed. Thus, if he wants money after, say, a year, what amount is due to him?

Certainly not the full $550 as Rodbertus seems to be implying. He will only receive the amount commensurate to the work he has done over this one year. Now superficially one would think this amount ought to be a fifth of the total expenditure, that is $110, but this is not true. The amount $110 is merely a fifth of the value of the engine when it is completed. What the labourer has done so far is only produce an intermediate good that will be transformed into a steam engine after four years.

The exact discount rate to be applied in ascertaining the outlay to the labourer cannot be detailed or justified without anticipating Böhm-Bawerk’s own theory of interest, but suffice it to say that present goods, ceteris paribus, are valued more than future goods, and this justifies the fact that the outlay to the labourer falls short of $110. It would be instructive for interested readers to go over further details of the example themselves, so I will not reproduce it here. Further critiques are made upon the insoluble contradictions in Rodbertus’ system, but they are not essential to the purpose of learning more about theories of interest.

6.2 Marx

On a historical note, I ought to emphasise that Böhm-Bawerk is writing this before the third volume of Marx’s Kapital has been released; thus the major heavy lifting with regard to Marxism only comes in his later work Karl Marx and the Close of his System, where the phrase ‘close of his system’ only refers to the fact that all volumes of Kapital have been published; it is not a snide comment on the irrelevance of Marx. But his major critique of Marxian exploitation theory, the argument from time preference, is essentially the argument laid out against Rodbertus earlier. In the contemporaneous period, however, Marx primarily justifies his theory of value by appealing to the ‘third thing’ argument, which roughly states that two things exchange only if they are ‘equal’, and if they are distinct goods then they must be equal to some ‘third thing’ in value. To quote:

Use values constitute the matter of wealth, whatever be their social form. In the social form we are about to consider they constitute at the same time the material substratum of exchange value. Exchange value in the first instance presents itself as the quantitative relation, the proportion in which use values of one kind are exchanged for those of another kind, a relation constantly changing with time and place. Hence exchange value seems to be something accidental and purely relative, and an intrinsic value in exchange seems a contradiction in terms.

To reformulate:

1. (Premise 1) Things have an Exchange Value that is distinct from their Use Value

2. (Premise 2) Things exchange with other things in varying proportions

3. (Conclusion) Exchange Value must have a content distinct from those forms of expression. Since this cannot be any physical characteristic of the goods in question, the only thing common to them is that they are products of labour, thus the exchange value of goods is nothing but abstract labour.

There will be quite a few acronyms in this section. As labour is the source of all value, Marx continues, the amount of the value of all goods is measured by the quantity of labour contained in them, or in labour time. But not by that particular labour time which the individual who made the good might find necessary, but by the “socially necessary labour time” (SNLT). This Marx explains as the “labour time required to produce a use value under the conditions of production that are socially normal at the time, and with the socially necessary degree of skill and intensity of labour”. It is only the quantity of socially necessary labour, or the labour time socially necessary for the making of a use value, that determines the amount of the value.

Marx finds the problem of interest in the two possible flow patterns of commodity circulation: Commodity-Money-Commodity (CMC) and Money-Commodity-Money (MCM). While CMC flows simply facilitate exchange by overcoming the problem of double coincidence, MCM flows have the perverse result that the person engaging in these transactions ends up with more money than he started with. If, however, SNLT is the sole determinant of value, then this is a contradiction, as the intermediate commodity, produced by a fixed amount of SNLT, cannot be worth two different sums of money. Finally, the interest problem poses itself in an abridged form as Money-Money′ or MM′ with M < M′. Thus, from the premise that exchanges involve equality, Marx derives a contradiction in the form of a quantity that is equal to a quantity greater than itself. A serious mathematician or logical thinker would consider such a reductio ad absurdum grounds to reject the premise, but Marx instead employs this contradiction in his materialist dialectic to pronounce the truth of his Exploitation theory of interest. I am compelled to concur with Böhm-Bawerk when he says “I have seldom read anything to equal this for bad reasoning and carelessness in drawing conclusions”. It flies not only in the face of subjective value theory and marginalist analysis, but also makes trivial errors such as mistaking disregarding the genus (Use-value-in-general) for disregarding the particular manifestations of it (Use-value-of-the-good-in-question). It is ridiculous to suppose that use value has nothing to do with why people engage in exchange.

To his credit, though, Marx proceeds about the rest of his analysis in a most consistent manner. Labour power is the only commodity with the peculiar property of being the source of value, but it is itself traded on the market in accordance with the SNLT required to produce it, that is the labour time required for mere subsistence and continuation of the labourer’s productive capacity. Thus, in this gap between the SNLT required to sustain labour and the SNLT that labour power provides lies the surplus value that the capitalist seizes upon. By trading in this peculiar commodity with productive capacity, the capitalist can make his seemingly impossible gains.

Now despite the fanciful window dressing and materialist dialectics, it is clear that the Marxist framework is largely in agreement with Rodbertus’ and thus subject to all critiques formerly levelled against the latter. However, the doctrine of reducing all value to labour has much greater emphasis in Marx, who also claims that the truth of this rests on the works of Adam Smith and Ricardo. We have already seen this, but it is not altogether true.

The doctrine is certainly found in their works, but Smith contradicts it multiple times, and Ricardo only insists upon its validity in limited spheres under many restrictive assumptions. The sheer number of exceptions to this law alone ought to have consigned it to the waste-bin of economic theory. But it is certainly not accorded the status in the Classicals’ analysis that it is bestowed by Marx in his. Ricardo admits that, even in the case of commodities for which his law of costs applies, time also plays a role in determining exchange value along with labour. Thus Smith and Ricardo state the doctrine in such uncertain and vague ways that it is unfair to attribute strong versions of it, like the one found in Marx, to them entirely. They simply asserted it as if it were self-evident and thus never justified or qualified their analysis. It would be instructive for interested readers to go over the lengthy excerpts Böhm-Bawerk provides in this section and stop blaming Adam Smith for the Labour Theory of Value.

The reason why so much space is devoted to a critique of the Exploitation theory is that it occupies a peculiar place in the history of economic thought, where despite its weaknesses it emerged as a prevalent explanation for the phenomenon of interest. This is partly due to the weakness of alternative theories, but mostly because of its convenient socio-political ramifications that appeal to the heart rather than to the head. Böhm-Bawerk eloquently explains:

That in spite of its inherent weakness the Exploitation theory found, and still finds, so much credence, is due, in my opinion, to the coincidence of two circumstances. The first is that it has shifted the struggle to a sphere where appeal is usually made to the heart as well as to the head. What we wish to believe we readily believe. The condition of the labouring classes is indeed most pitiful; every philanthropist must wish that it were bettered. Many profits do in fact flow from an impure spring; every philanthropist must wish that such springs were dried up. In considering a theory whose conclusions incline to raise the claims of the poor, and to depress the claims of the rich, - a theory which agrees partly, or it may be entirely, with the wishes of his heart, - many a one will be prejudiced in its favour from the first, and will relax a great deal of the critical severity that, in other circumstances, he would have shown in examining its scientific basis.

7 Conclusion

The final section of Capital and Interest deals with so-called ‘eclectic theories’ that are mere historical curiosities from the perspective of the twenty-first century. Since logical consistency sat so lightly upon the heads of these eclectics, we need not go into the particulars, though as always interested readers are encouraged to read this section (and perhaps the entire book) for themselves. There are still great writers who fall under this label, such as Henry George, who revives a version of the ‘Fructification theory’ that Böhm-Bawerk rejects in Turgot. Another interesting point of note is that later Austrians like Rothbard criticised B ̈ohm-Bawerk for misinterpreting the work of Turgot, whom they believe actually advocated a proto-Austrian time preference theory of interest. In the conclusion, Böhm-Bawerk reiterates the fundamental problem of interest:

Let us, in conclusion, consider the subject as a whole. We have seen the rise of a motley array of interest theories. We have considered them all carefully and tested them thoroughly. No one of them contains the whole truth. Are they on that account quite fruitless ? Taken all together, do they form nothing but a chaos of contradiction and error, that leaves us no nearer the truth than when we started? Is it not rather the case that, through the tangle of contradictory theories, there runs a line of development which, if it has not itself led to the truth, has at least pointed the way in which truth is to be found ? And how runs the line of this development?

I cannot better introduce the answer to this last question than by asking my readers once more to put clearly before their minds the substance of our problem. What really is the problem of interest?

The problem is to discover and state the causes which guide into the hands of the capitalists a portion of the stream of goods annually flowing out of the national production. There can be no question then that the interest problem is a problem of distribution.

However, this is not to say that considerations of production do not play a role in the analysis. It is only in an integrated view of the production process that the capable economist can slice the Gordian knot and cut to the heart of this phenomenon of interest. Böhm-Bawerk then proceeds to point out the subtle traps that have ensnared theorists before, thus summarising both the specific and the general errors we have encountered throughout this critical history of interest theories:

Whoever treats the problem as a simple problem of production breaks off his explanation before he has come to the principal point. Whoever treats it as a problem of distribution, and distribution only, begins it after the principal point is passed. It is only the economist who undertakes to clear up those remarkable rises and falls of value, where the rises are surplus value, who can hope, in explaining them, to explain interest in a really scientific way. The interest problem in its last resort is a problem of value.

Emphasising the Mengerian vision of economics as a causal-realist discipline grounded in subjective value, he further elaborates upon the failures of his predecessors:

Those which seek to explain interest by the external machinery of the theory of costs have to carry a heavy handicap in the assumption that value grows out of production. Their explanation always leaves something over to explain. Just as certain as is the fact that the fundamental forces which set in motion all economical efforts of men are their interests, egoistic or altruistic, so certain is it that no explanation of the economical phenomena can be satisfactory where the threads of explanation do not reach back unbroken to these fundamental and undoubted forces. This is why the cost theories fail. In thinking that they find the principle of value - of that guide and universal intermediate motive of human economical affairs - not in a relation to human welfare, but in a dry fact of the external history of the manufacture of goods, in the technical conditions of their production, they follow the thread of explanation into a cul-de-sac, from which it is impossible to find a way to the psychological motive to which every satisfactory explanation must go back. This condemnation applies to the majority of the interest theories we have been considering, however different the individual theories may have been.

Finally, he concludes by hinting at his own Positive Theory of Interest (pun intended).

On the foundation thus laid I shall try to find for the vexed problem a solution which invents nothing and assumes nothing, but simply and truly attempts to deduce the phenomena of the formation of interest from the simplest natural and psychological principles of our science.

I may just mention the element which seems to me to involve the whole truth. It is the influence of Time on human valuation of goods. To expand this proposition must be the task of the second and positive part of my work.

The ‘nub and kernel’ of B ̈ohm-Bawerk’s positive theory, which we will not detail here, is the fact that present goods are more valuable than future goods of equal kind and quality. This value differential between present and future goods is realised as interest when dealing with inter-temporal pecuniary exchanges. Again, the interested reader is directed to read The Positive Theory of Capital by the Austrian maestro Eugen von Böhm-Bawerk. For more details and insights on modern theories of interest, see episodes 26, 28, and 31 (in that order, since it is a three-part series) of the Bob Murphy Show, hosted by Robert P Murphy, who is in my humble opinion one of the greatest living economists on the face of this earth.