Unanticipated Intertemporal Change in Theories of Interest by Robert P Murphy A dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy Department of Economics New York University May 2003 _ Mario Rizzo Dedicated to the memories of Sir John Hicks and Friedrich Hayek ii Acknowledgements These essays were written over the course of several years, and are much clearer because of the careful reading and helpful suggestions of Mario Rizzo, Alberto Bisin, Boyan Jovanovic, John Leahy, and Andrew Caplin I would also like to thank Peter Lewin, Jeffrey Herbener, Paul Birch, Thomas McQuade, David Harper, and Gene Callahan for the extensive comments they provided on early drafts of the essays, and I would like to thank Israel Kirzner for his discussions on the pure time preference theory Members of the NYU Austrian Colloquium also provided helpful comments, as well as others whom I am surely forgetting I am grateful for the freedom I had to dwell on these matters in the laissez-faire academic environment of the NYU Austrian fellowship The first essay was written while I was a summer fellow at the Ludwig von Mises Institute in Auburn, Alabama Finally I would like to thank my grandmother, Catherine Kelly, for providing me with a place to stay, and my fiancée, Rachael, for tolerating my divided attention, while I explored a topic that has been rightly called the “black hole of economics.” iii Preface This book is a collection of three separate essays that I wrote while on the Austrian fellowship at New York University My interest in this area started when I had to prepare a paper for the NYU Austrian Colloquium Initially I wanted to work on the Austrian business cycle theory, but I soon found that my dissatisfaction with the Austrian approach to interest was such that I had to divert my attention to pure capital and interest theory I presented my (lengthy) paper, “Interest in the Austrian Tradition,” to the Colloquium Much of the work in this book is merely an elaboration of that original paper Although they were written as stand-alone essays, the essays should be read in order, as the later ones build upon the earlier (However, the reader who is able and willing to read the mathematical appendix should probably so immediately after the first essay.) A central theme running throughout the papers is that economists have traditionally paid insufficient attention to the problems of change, and in particular unanticipated change, in their theories of interest The first essay introduces the impressive work on capital and interest theory by Eugen von Böhm-Bawerk In it I explain Böhm-Bawerk’s views and his celebrated critique of what he called the nạve productivity theories of interest As I read iv Bưhm-Bawerk’s work for the first time, I slowly began to suspect the negative verdict given him by the profession I hope that my (qualified) defense of his work will cause subsequent historians of economic thought to reevaluate his pioneering contributions The second essay is a critique of the Austrian “pure time preference theory” of interest I claim that the Austrians focus too narrowly on one aspect of BöhmBawerk’s work, and have caused needless confusion in their writings I further argue that, ironically, the pure time preference theory is deficient on precisely those criteria of economic theory that are quintessentially Austrian, such as heterogeneity of goods, uncertainty of the future, and dynamic processes through time In the third essay I widen my focus I claim that a fundamental problem with Böhm-Bawerk’s theory was his aggregation of goods according to their date of availability This component of his work led to the modern “real” approach to interest theory, which explains the premium on money loans as the outward expression of the underlying intertemporal exchange of real commodities Drawing on the insights of the so-called “radical subjectivists,” I offer a completely different explanation of interest rates, viewing them as purely monetary phenomena reflecting the uncertainty of the future v Finally, in a mathematical appendix I formalize Bưhm-Bawerk’s arguments against the nạve productivity theories Using general equilibrium models, I show that the standard one-good mainstream growth models completely overlook BöhmBawerk’s insights in this area This book is intended to address a gap in economics Somewhere between common sense and calibrated models, there is a loose collection of principles that help us judge the merits of any particular economic theory I have dedicated the book to John Hicks and Friedrich Hayek, for they were excellent role models for the purpose I had chosen In particular, their work was a constant reminder that even metatheoretical musing can be rigorous, and indeed must be RPM April, 2003 vi Table of Contents Dedication ii Acknowledgements iii Preface iv List of Tables viii Chapter One A (Qualified) Defense of Böhm-Bawerk’s “Third Cause” of Interest Chapter Two Some Problems with the Pure Time Preference Theory of Interest 58 Chapter Three A Monetary Approach to Interest Theory 127 Appendix Dangers of the One-Good Model 178 References 191 vii List of Tables Table Output of Labor in Processes of Various Durations 23 Table Equilibrium Real Exchange Ratios 105 Table Equilibrium Money Prices 106 Table Umbrella Counterexample to Claim VI 112 Table Equilibrium Real Exchange Ratios 131 viii Chapter One A (Qualified) Defense of Böhm-Bawerk’s “Third Cause” of Interest INTRODUCTION In the late nineteenth century, Eugen von Böhm-Bawerk’s magisterial work (1959 [1889]) on capital and interest provided the foundation upon which virtually all modern theories are built In his first volume, History and Critique of Interest Theories, Böhm-Bawerk classified and (in his mind) refuted all previous explanations Böhm-Bawerk thought a proper theory of interest must explain the apparent undervaluation of future goods For example, if a machine is expected to yield annual rents of $1,000 for ten years, why does it sell now for less than $10,000? To answer this question was to provide a theory of interest, for only with such an undervaluation would it be possible for a capitalist to invest in machines (for example) and reap a flow of returns (over time) greater than his initial investment The naïve productivity theory With the task of the interest theorist so formulated,1 Böhm-Bawerk found the existing doctrines of his time to be inadequate In particular, Böhm-Bawerk criticized what he termed the “naïve productivity theory” of interest The naïve productivity theory2 explained the net return earned by an investor, by reference to the productivity of the capital goods in which he invests For example, a farmer might purchase a tractor for $8,000, even though it will last ten years and increase his profits by $1,000 for each of those years The twenty-five percent3 return on the investment would be due (according to the naïve productivity theory) to the fact that tractors are productive; more can be produced with a tractor than without one Böhm-Bawerk considered this reasoning to be completely fallacious, for it conflated physical productivity with value productivity Yes, the physical productivity of the tractor explains why more crops can be harvested with it than without But the tractor’s physical productivity does not (by itself) explain why the value placed on the tractor (i.e its price of $8,000) should be lower than the value placed on its future products (i.e the marginal revenue of $10,000) The net rate of The specific problem was to explain, “Whence and why does the capitalist receive this endless and effortless flow of wealth?” (I, p 1, italics removed) Actually, the “second variant” of nạve productivity theories, in Bưhm-Bawerk’s classification; see below In fact the return would be more than twenty-five percent, because of compounding The rest of the analysis disregards this complication, and assumes the farmer will have $10,000 when the tractor is discarded ... that the particular quota of the total product which falls to the share of capital, that is to say, the gross yield of capital, is normally of greater value than the capital expended in its acquisition... capital is regularly followed by the appearance of surplus value actually furnish adequate proof that capital possesses a power to create value? Certainly not! No more than the regular rising of the. .. is able and willing to read the mathematical appendix should probably so immediately after the first essay.) A central theme running throughout the papers is that economists have traditionally