Entrepreneurs’ Net Worth: Mises’s Praxeological Concept of Capital

In Human Action, Ludwig von Mises employed two radically different notions of capital. The first was equivalent to what accountants call net worth. In calculating her profit and loss, the individual conceives of her income in terms of a change in net worth. If we shift the focus to an income stream, net worth (capital) can be said to refer to the capitalized value of that stream. Thus, the concept of capital as net worth implies capital accounting. This notion was truly subjectivist and fully consistent with the subjective theory of value and cost that was initiated by the early Austrian economists. The second notion was produced material resources. Mises recognized that the basis for distinguishing produced material resources from other non-produced and non-material resources was not consistent with the Austrian theory of value and cost. With some caution, he nevertheless employed the second notion, especially in his discussion of the relationship between economic action and time. One possible explanation for this was his desire to deal with the capital controversies of the period. This paper carefully analyzes the passages in Human Action in which the capital goods notion is used. It argues that Mises unwisely restricted what could have been a broader discussion that would account for all resources (i.e., roughly higher-order goods, in Carl Menger’s terminology). The significance of this lies in the fact that modern neo-Austrian economists have apparently neglected Mises’s first notion and accepted his second notion of capital goods. Or they have ignored Mises altogether and employed the capital goods notion in their work. By doing so, they risk neglecting the subjective theory of value and cost in their discussions of the relationship between time and economic action. The paper also shows that some of Mises’s capital goods’ discussions are trivial and out of place. In Human Action, Ludwig von Mises used two concepts of capital – a revolutionary new praxeological concept and an old materialist concept. The main goal of using the old concept seems to have been to deal subjectively with the contemporary capital controversies in the old language, thereby showing the superiority of the praxeological view. The result, however, was that he seemed to implicitly endorse the materialistic concept in economic discussions, which is just the opposite of what he apparently intended. In this paper, I demonstrate how his use of the second concept led him (1) to present arguments that were less general than they could have been and (2) to make some statements about capital that were both trivial and misdirected. When combined with a recognition of the praxeological concept that Mises employed, this demonstration provides a strong case for the proposition that the best future policy for Austrian economists is to completely jettison the concept of material capital. Praxeological concepts place subjects’ perceptions, expectations, and plans about the phenomena above the study of the phenomena themselves. A good example of Mises’s praxeological thinking about economics is his criticism of Eugen Bohm Bawerk’s theory of interest. Bohm Bawerk’s theory was based partly on the assumption that more roundabout methods of production are more physically productive. Mises criticized it on the grounds that the productivity of methods of production should be defined in terms of (1) whether actors perceive the methods and, given that they do, (2) actors’ perceptions of the utility or income that they expect the methods to yield (Mises 1966: 488-9; Mises, 1974). Another example is his definition of capital. He points out that economists “erred in classifying ‘capital’ as an independent factor of production along with the nature-given material resources and labor” (Mises 1966: 493). He presents his argument best in his discussion of land. He writes the following: Entrepreneur's Net Worth: Mises’s Concept of Capital 2 See also ibid.: 640. Mises’s view is consistent with the subjectivist view of price and cost, or what is often called the subjective theory of value. This view can be found in the writings of Menger (1981), J. B. Clark (1899), Phillip Wicksteed (1910), Frank H. Fetter (1904a), Herbert Davenport (1908, 1914), and Frank Knight (1921). The modern theory of value and prices is not based on the classification of the factors of production as land, capital, and labor. Its fundamental distinction is between goods of higher and of lower orders, between producers’ goods and consumers’ goods...The law controlling the determination of the prices of the factors of production is the same with all classes and specimens of these factors...The only reason why the old economists were puzzled by this fact was that they operated with a general term land that neglects differences in productivity.(ibid.: 636) By using the term “good of higher order,” he is referring to Carl Menger, who wrote that for a thing to be a good, the user must know how the item can be used to satisfy what we would today call a want (Menger 1981: 52). For this reason, we can safely assume here that Mises meant value productivity. Given this interpretation, the last sentence means that the old economists’ concept of land neglects changes in consumer wants, other complementary resources, and knowledge. In other words, Mises is arguing that the old economists erred in their theory of value (i.e., the theory of price and cost) by assigning the resources “land” and “capital” positions in their analyses that is more or less important than their position in the eyes of actors. More specifically they misplaced their emphasis by neglecting the part that “land” and “capital” played in individuals’ calculations about how to best satisfy their wants. That Mises favored the praxeological approach to capital is confirmed by his most fundamental discussion of the subject: The calculating mind of the actor draws a boundary line between the consumer’s goods which he plans to employ for the immediate satisfaction of his wants and the goods of all orders – including those of the first order– which he plans to employ for providing by further acting, for the satisfaction of future wants. The differentiation of means Entrepreneur's Net Worth: Mises’s Concept of Capital 3 The inclusion of entrepreneurial activity distinguishes Menger’s theory of capital as higher order goods from that of Mises. But aside from that, the author is unaware of another difference. and ends thus becomes a differentiation of acquisition and consumption, of business and household, of trading funds and of household goods. The whole complex of goods destined for acquisition is evaluated in money terms and this sum – the capital – is the starting point of economic calculation (Mises 1966: 260-1). Note that in this passage he defines all higher order goods as capital. This makes his concept of capital similar to that of Menger. Menger aimed to replace the classical tripartite division of factors of production with one in which each factor was assumed to have an “order” in relation to the final consumer good (the first-order good) that he posited would ultimately be produced with the factors. Thus, he distinguished between second-order goods which were needed to produce the final consumer goods, third-order goods which were needed to produce each second-order good, fourth-order goods which were needed to produce each third-order good, and so on (1981: 58-63). This classification scheme was totally independent of any assumption of materiality, of whether the factor was human or non-human, and of historical considerations. Indeed, his examples of higher order goods included not only all of the classical types of factors but also such things as firms, monopolies, copyrights, customer good-will (ibid.: 54-5), and entrepreneurial activity (ibid.: 172). He aimed to show that economists use the same procedure to derive the market prices of each of these distinguishable factors or production (ibid.: 165-74). In spite of Mises’s general commitment to the praxeological view, his treatise Human Action contains extensive discussions of capital goods, which he defines as intermediate products and material resources. This seems to reflect a pragmatic approach to communicating ideas. He writes: Entrepreneur's Net Worth: Mises’s Concept of Capital 4 See the discussion by Endres (1987: 291) about Menger’s opinion of Bohm Bawerk’s theory. Also see Mises’s criticism of Böhm Bawerk on the grounds of the theory’s materiality (Mises 1974). Virtually all of the other neo-Austrian economists have adopted a materialist concept of capital. Examples are provided below in footnote 20. See Gunning, 1997 and 1998a. I am not concerned here with the special uncertainty relating to the problem of human agency when an employer hires a worker. When [economics] distinguishes within the class of factors of production the original (nature-given) factors from the produced factors of production (the intermediary products) and furthermore within the class of original factors the nonhuman (external) factors from the human factors (labor), it does not break up the uniformity of its reasoning concerning the determination of the prices of the factors of production (Mises 1966: 636). The view of this paper is different. It will be argued that the praxeological usage and the material usage of the term capital are so different that for Mises to include both usages in his work was bound to achieve two negative consequences. First, it was bound to separate Menger’s theory of capital from the other Austrians who followed him, as if Bohm Bawerk’s theory was not a great blunder. Second, it was bound to detract from the major 20th century advance in the Austrian theory of value and cost. This is the discovery that subjective value theory assigns to the role of the entrepreneur all distinctly human money-seeking action under the conditions of the pure market economy. Entrepreneurship uses the same methods to appraise “original” resources as it does to appraise produced resources. The same is true for the appraisal of human and nonhuman resources. Moreover, the uncertainty with which entrepreneurship must deal is no different for produced, material resources than for other resources. By pragmatically accepting the distinction between original and produced resources and between human and non-human resources, Mises helped lead Austrian Entrepreneur's Net Worth: Mises’s Concept of Capital 5 Israel Kirzner, in particular, has deliberately chosen to de-emphasize appraisement and uncertainty (Kirzner1982 and Jack High 1982). Kirzner wrote that Mises’s contribution to entrepreneurship is may not be immediately obvious from Human Action (Kirzner 1994: 105). He went on to say that Mises portrays “the market as an entrepreneurial driven process.” It would be more correct to say that Mises describes the market economy as an entrepreneurial process or that his image of the market economy is that of an entrepreneurial economy, since he writes everyone is an entrepreneur (Mises 1966: 252-3). Accordingly, an understanding of his theory of entrepreneurship not only necessary in order to understand his image of the market economy, the two concept of congeneric. For the author’s view of the history of entrepreneurship in Austrian economics, see Gunning 1988b. Note that the claim is not that the material capital concept may lead one to disregard the idea that the market value of capital goods is the result of appraisals. It is that it may lead one to neglect the proper praxeological procedure of (a) assigning the act of making the appraisals to entrepreneurship and (b) representing subjectivity by assuming that different members of the “entrepreneur class” appraise differently. economies away from a praxeological theory of entrepreneurship. Moreover, by stressing materiality, Mises made it harder for the interpreter of the Austrian theory to identify the praxeological principle that the value of a resource corresponds to a subjective appraisal made by a particular individual acting in the entrepreneur role. The centrality of appraisement and the entrepreneur role is evident in Mises’s first definition of capital described above: entrepreneur’s net worth. Although he did not use this term, his meaning is evident in his discussion. Capital, he said, refers to the income-generating potential of the higher order goods from the viewpoint of an individual. The concept is derived from the individual’s effort to employ capital accounting to calculate his profit and loss (ibid.: 260-1). This paper argues that Mises’s use of the term capital to refer to both entrepreneur’s net worth and to produced material objects was a serious tactical error. It claims that his discussion of capital goods is strained and misleading. He would have been well advised to omit it. The main Entrepreneur's Net Worth: Mises’s Concept of Capital 6 The term “neo-Austrian” was employed by Kirzner to describe a mix of different ideas of economists who associate themselves with “the revival of interest in the ideas of Carl Menger and the earlier Austrian School, particularly as these ideas have been developed through the work of Mises and Hayek” (Kirzner 1987: 149). purpose of the exercise is not to criticize Mises but to support the argument that within Mises’s writings is a subjectivist concept of capital that is superior to that of other Austrian economists. Space considerations prevent the author from demonstrating that this is so. The limited aim in this paper is to elucidate this concept and to demonstrate its presence in Mises’s work. Part one introduces the notion of capital as equivalent to an entrepreneur’s net worth and shows its relationship to capital accounting and monetary calculation. Part two contrasts the idea of capital as an entrepreneur’s net worth with capital goods and shows how Mises differentiated these terms in his initial discussion of the topic. Part three assesses most of Mises’s discussion on the relationship between capital goods and time. Part four presents a brief conclusion. 1. ENTREPRENEUR’S NET WORTH AND CAPITAL ACCOUNTING Mises’s most fundamental definition of capital is entrepreneur’s net worth. Since a person’s net worth cannot be calculated without using the capitalization formula, this definition assumes the use of capital accounting, as an instrument of monetary calculation. This concept of capital seems to have escaped the notice of modern neo-Austrians. Thus it is wise to describe Mises’s discussion of “capital” step by step. Entrepreneur's Net Worth: Mises’s Concept of Capital 7 Capital as an Entrepreneur’s Net Worth With the exception of a brief section on the procedure of economics, Mises devoted the first three parts of Human Action (about 25%) to an elucidation of praxeology. The rest of the book is about economics. He introduces the subject of capital as private net worth in chapter 10, where he discussed “Economic Calculation and the Market.” He first points out that “[t]he distinctive mark of economic calculation is that it is neither based upon nor related to anything which could be characterized as measurement” (Mises 1966: 209). This is because the exchange ratios which we have to deal with are permanently fluctuating. There is nothing constant and invariable about them. They defy any attempt to measure them. They are historical events, expressive of what happened once at a definite instant and under definite circumstances...Numbers applied by acting man in economic calculation do not refer to quantities measured but to exchange ratios as they are expected – on the basis of understanding – to be realized on the markets of the future to which alone all acting is directed and which alone counts for acting man (ibid.: 210). The point here is that individuals use money to compare prospective outcomes of alternative courses of action. Acting as an entrepreneur, an individual tries to obtain the greatest benefit through exchange. To compare different alternative courses of action, he attaches his own personal, subjective money tag to them. “How is the action likely to effect my revenues and costs?,” he asks. To anticipate future conditions, individuals use “understanding,” which in this context roughly means trying to put oneself into the shoes of other actors in an effort to predict their future behavior (ibid.: 51-58). When Mises goes on to discuss the purpose of economic calculation, he introduces the term “capital.” The task which acting man wants to achieve by economic calculation is to establish the outcome of acting by contrasting input and output...It is with regard to this problem that the fundamental notions of Entrepreneur's Net Worth: Mises’s Concept of Capital 8 See Frank Fetter (1904b) and Herbert Davenport (1914, chapter 14, 15). Both writers argue that a proper notion of capital is one that begins by understanding the capitalization process – the process through which the mind determines the present value of its expected future income. The views of these two writers on the role of capitalization in the economic process were not identical, however (Gunning, 1998b). economic calculation – capital and income, profit and loss, spending and saving, cost and yield – are developed (ibid.: 210-1, italics added). Capital here seems to refer to the present value of the future expected income. His point, which might easily be overlooked, is that in performing their calculations, individuals in the market economy use capital accounting. Capital accounting enables an individual to compare revenues and costs that are expected at different times. Without it, one could not construct the capital-income formula. Implicit in this, of course, is the presence of some means of discounting, like time preference ( a personal discount rate) or interest rates. Notice that if we want to make Mises’s use of the term capital consistent, we must regard capital as acting man’s net worth, or equity. Capital accounting then becomes the means that an actor uses to calculate net worth on the basis of expected income and a discount rate. One is reminded of what earlier economists called “the process of capitalization” as a necessary part of each individual’s decision making. Note further that because this definition of capital refers to all potential sources of future income, it is broad enough to include such things as rights to command other actors to perform tasks, rights to use other peoples’ land, accounts receivable, debts owed (on the negative side), and goodwill. Thus capital in this definition bears no resemblance to the concept of capital goods, which Mises introduces later in this discussion and which is discussed below. On the contrary, it is virtually identical to an individual’s appraised value of what Menger called higher Entrepreneur's Net Worth: Mises’s Concept of Capital 9 order goods (Menger 1981: 55-58; 155). Indeed, this definition of capital appears to distinguish Mises from all other writers on capital in the Austrian tradition, excluding Menger. Capitalism as the Preserve of Capital Accounting Just before beginning his description of the “economics of the market society,” Mises writes a brief section telling how the theory of action can be applied in a society containing a division of labor, private property, and money. In such a society, “[m]onetary calculation is the guiding star of action.” It “is the method of calculating employed by people acting within the frame of society based on private control of the means of production.” “It is a mode of computation designed for ascertaining private wealth [net worth] and income and private profits and losses of individuals acting on their own behalf within a free enterprise society.” It “is the main vehicle of planning and acting in...free enterprise” (Mises 1966: 229-230). Monetary calculation reaches its full perfection in capital accounting...[by establishing] the money prices of the available means and confront[ing] this total with the changes brought about by action and by the operation of other factors (ibid.: 230). Up to this point in the book, Mises had not defined the entrepreneur. Thus, he did not mention entrepreneurship in these passages. However, since profit is the specific income of the entrepreneur (ibid.: 254), his use of the term “profits and losses” make it evident that he was writing here about what he would later in the book call the entrepreneur function, or entrepreneurship. In other words, monetary calculation involving capitalization is the province of entrepreneurship. Entrepreneurship makes the calculations; it plans and acts on the basis of expected profit and loss. Entrepreneur's Net Worth: Mises’s Concept of Capital 10 Mises goes on to discuss the term “capitalism.” He says that people have dubbed the system of free enterprise “capitalism” in order to deprecate or smear it. “However, this term can be considered very pertinent. It refers to the most characteristic feature of the system, its main eminence, viz., the role the notion of capital [read: capital accounting and the corresponding notion of an actor’s net worth] plays in its conduct” (ibid.: 230). 2. ENTREPRENEUR’S NET WORTH VS. CAPITAL GOODS We turn now to Mises’s more direct discussions of “capital,” specifically to the beginning of his chapter called The Market. The first section of the chapter defines the market economy as a “social system of the division of labor under private ownership of the means of production” (ibid.: 257). We focus on the second section, entitled Capital Goods and Capital, which comprises approximately five pages. Definition of Capital Goods Mises begins by describing a fundamental characteristic of human beings: “There is an impulse inwrought in all living beings that directs them toward the assimilation of matter that preserves, renews, and strengthens their vital energy” (ibid.: 259). Enhancing one’s vitality, Mises says, is conscious and purposeful. He goes on to say that man’s “ingenuity leads to the construction Entrepreneur's Net Worth: Mises’s Concept of Capital 11 See Menger: 54-55; 155; 172. of tools.” Then he discusses products that make it possible to lengthen the average period of time between the beginning and end of a production process. The products accumulated for this purpose are either intermediary stages in the technological process, i.e., tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods (ibid.: 260, italics added). It appears here that he means for capital goods to exclude the so-called natural resources, or land. He also seems to want to exclude what we now call “human capital” – physical and intellectual skills. Finally, he apparently means to exclude legal rights. Thus the set of items that constitute capital goods is much narrower than the set of higher order goods that Menger called capital. It is also narrower than Mises’s set of resources to which individuals apply capital accounting in making appraisals. Capital vs. Capital Goods Mises proceeds to distinguish between capital goods and capital. From the notion of capital goods one must clearly distinguish the concept of capital. The concept of capital is the fundamental concept of economic calculation, the foremost mental tool of the conduct of affairs in the market economy. Its correlative is the concept of income...The whole complex of goods destined for acquisition is evaluated in money terms, and this sum – the capital – is the starting point of economic calculation...That amount which can be consumed within a definite period without lowering the capital is called income. If consumption exceeds the income available, the difference is called capital consumption. If the income available is greater than the amount consumed, the difference is called saving. Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption (ibid.: 260-1, italics ad]ded). Entrepreneur's Net Worth: Mises’s Concept of Capital 12 It is essential to understand precisely what Mises means by “capital” in these statements. First, one should recognize that it refers to the money values. It is “the whole complex” in “money terms.” Thus it refers to the subjects’ money evaluations of the items in the complex. Second, since he writes of the “whole complex of goods destined for acquisition,” we must assume that the items he has in mind are not merely the material capital goods. We must assume that he has in mind all assets in terms of the future income that is expected to be derived from them. Mises writes as much: The calculating mind of the actor draws a boundary line between the consumer’s goods which he plans to employ for the immediate satisfaction of his wants and the goods of all orders – including those of the first order – which he plans to employ for providing by further acting, for the satisfaction of future wants (ibid.: 260). If a person uses up some of the natural fertility of his land, then this also is capital consumption, so long as he put a price on that fertility. The same is true for “human capital” and legal rights. If Mises had anything else in mind, he would have, at some stage, criticized Menger’s definition of capital. Monetary Calculation and Capital Goods Could Capital Goods Exist Before Monetary Calculation? Mises applies his concept of capital as an accounting tool by discussing a common error. First he describes an unobjectionable metaphor. He notes that writers tend to look back in time and apply the accounting concept to earlier times when there was no market economy and, therefore, no economic calculation. “[W]e may say metaphorically that (the savage ancestors of the human race) too used capital.” This applies as well to the primitive husbandmen’s “reluctance to kill a pregnant Entrepreneur's Net Worth: Mises’s Concept of Capital 13 hind” and the “uneasiness felt by even the most ruthless warriors in cutting fruit trees...”(ibid.: 261). This is a metaphor because, in these early times, no money existed and therefore no capital accounting could occur. The metaphor can be misused. In particular, it was misused by “[s]ome economists [who] concluded that ‘capital’ is a category of all human production...and that it does not depend upon the practice of monetary calculation.” This is an error because the concept of capital cannot be separated from the context of monetary calculation and from the social structure of a market economy in which alone monetary calculation is possible. It is a concept which makes no sense outside the conditions of a market economy (ibid.: 262). Real Capital Another error is the concept of real capital. Mises points out that the concept of a sum of the various resources is an “empty concept” because it is “of no use to acting.” It is “merely an enumeration of physical quantities of thousands and thousands of various goods.” Mises’s point is that without specifying (1) a system of markets and prices and (2) calculating minds to appraise the resources, there is no way to determine the relative importance of these various goods to economic actors. He goes on to criticize the idea of the “productivity of capital” as one that is based on the empty concept of real capital. Then he criticizes those who “explain interest as an income derived from the (empty concept of the) productivity of capital” (ibid.: 263). Private and Social Capital Mises finishes off this section by discussing the vacuousness of the concept of social capital: Entrepreneur's Net Worth: Mises’s Concept of Capital 14 Mises continues the discussion at ibid.: 521. In my view, the concept of social capital is dealt with much more clearly by Davenport (1908: 141-55). By praxeological entrepreneur, I mean entrepreneurship as the driving force of the market economy. This is the functional, or broad, concept that Mises describes on p. 252-3. It is worth noting that Davenport defines private capital as follows: Private capital, that form of capital with which actual business is concerned, includes, as we have seen, all forms of durable private wealth – all such property of any individual as requires an appreciable period of time for the rendering of its services, – all possessions any of the incomes of which are so far remote in time that some of these suffer in present price estimation by the very fact of this remoteness, – all wealth the present worth of which involves the application of the principle of time discount, – all wealth remunerated according to the dollar-time unit. Private capital is merely those private possessions which are bases of private income. This capital is productive, truly, – acquisitive, gainful, – but not necessarily so in the social sense of contributing to the general welfare or of increasing the aggregate of incomes, but only of increasing the owner’s income (Davenport 1914: 335). People began to mediate upon a concept of social capital as different from private capital. Starting from the imaginary construction of a socialist economy, they were intent upon defining a capital concept suitable to the economic activities of the general manager of such a system. However...in a socialist economy there are capital goods but no capital (ibid.: 264). Mises writes here that although the socialist manager can designate some goods as capital goods, there is no capital because the socialist society contains no prices or economic calculation. It is worth pausing to consider the broader implications of this statement. By emphasizing the privateness of capital, Mises appears to imply that the only concept of capital that is relevant in a market economy is private capital – the entrepreneur’s net worth calculated, through capital accounting, by a particular individual acting in the role of the praxeological entrepreneur. Nevertheless, he mentions the entrepreneur only once in this section. He says that “[t]he notion of capital...is a device of capitalists, entrepreneurs, and farmers eager to make profits and to avoid losses” (Mises 1966: 264). This economizing on the use of the term “entrepreneur” is puzzling in light of the fact that in the previous chapter, Mises had clearly recognized the central role that the Entrepreneur's Net Worth: Mises’s Concept of Capital 15 entrepreneur function plays in the explanation of economic interaction. He could have included a reference to the function of the entrepreneur in all of his discussions of capital. But he did not. In my view this was a serious tactical error. All of the major points in this chapter that relate to economic interaction under the conditions of the market economy hinge on the reader’s taking what Davenport called “the entrepreneur point of view” of capital (Gunning 1998b, 350-1). Yet it seems that one must read between the lines in order to receive this message from Mises. 3. CAPITAL GOODS AND TIME Mises’s chapter on “Action in the Passing of Time” contains a more extensive discussion of capital goods. He does not begin this treatment until he has completed two lengthy chapters on the market and prices and another long chapter on exchange involving money. The main purpose of the chapter seems to be to define the concept of capital goods in terms of an individual’s time preference. In other words, he wants to develop a definition of capital goods that requires the user of this term to think of an individual’s time preference. In doing this he decides to adopt the “convention” of limiting the capital goods concept to material goods that are produced during a plan to satisfy a want in the future. He does not define capital goods as material goods that have already been produced. He defines them as material goods that a person plans to produce. I will argue that Mises’s decision to define capital goods in this way is an error in two related senses. First, the main principles that can be derived from relating to time preference are more Entrepreneur's Net Worth: Mises’s Concept of Capital 16 general than is suggested by the use of this definition. As a result, the ordinary reader is likely to miss the full significance of his effort to link appraisals to time preference. Second, by neglecting to emphasize the generality of the principles, Mises diverts attention away from one of his most important contributions to economic theory – his praxeological concept of the entrepreneur. I will try to illustrate these points by critiquing most of the points he makes in this chapter. Capital Goods and Production In the first section of the chapter, Mises asserts that the accumulation of capital goods is necessary before people can begin to use longer periods of production than they are currently using. People eager to embark upon processes with a longer period of production must first accumulate, by means of saving, that quantity of consumers’ goods which is needed to satisfy, during the waiting time, all those wants the satisfaction of which they consider more urgent than the increment in well-being expected from the more time-consuming process. Accumulation of capital begins with the formation of stocks of consumers’ goods the consumption of which is postponed for later days (Mises 1966: 491). Here he says that in order to make the production period longer than it otherwise would be, individuals must save a larger part of their stocks of durable consumers’ goods than they otherwise would. This, he says, is part of the process of capital accumulation. A stock of consumers’ goods need not be integrated economically into the “orbit of production.” A person may simply put aside some consumers’ goods with the goal of consuming them at a later time. To be integrated economically into production, they must be employed as means of subsistence (ibid.). Once they are integrated into the orbit of production, the surpluses “are Entrepreneur's Net Worth: Mises’s Concept of Capital 17 replaced first by the intermediary products of a process with a longer period of production and then later by the consumers’ goods which are the final product of these processes” (ibid.). The intermediary products.., the produced factors of further production...change hands in the course of events; they pass from one plant to another until finally the consumers’ goods reach those who use and enjoy them.(ibid.: 492) Mises’s main aim in this section is to illustrate the limits placed by time preference on what he calls capital accumulation. He achieves this by considering the case in which production processes with longer periods of production are technologically superior. He begins by pointing out that individuals would accumulate stocks of durable consumers’ goods even if processes requiring a longer period of time were not technologically superior, that is, even if the longer processes did not result in a greater physical output of desirable goods than shorter processes. The reason is that accumulation makes it “feasible to aim at goals which could not be thought of before on account of the length of the production period required” (ibid.: 490). Nevertheless, technological processes with a longer period are superior. However, if technological processes with a longer period are superior, why do actors not always prefer the longer processes? The answer is time preference. “What restricts the amount of saving and investment is time preference” (ibid.: 491). No one would want to “accumulate all of the capital” that is possible to accumulate, since everyone has a preference for not only distant future goods but also near future goods. To see how Mises negotiates the terminology problem, consider the following statement about capital accounting and capital goods. All of these ventures and processes are intellectually controlled by capital accounting, the acme of economic calculation in monetary terms. Without the aid of monetary calculation men could not even learn whether – apart from the length of the period of production – a definite process promises a higher Entrepreneur's Net Worth: Mises’s Concept of Capital 18 productivity than another...Capital accounting starts with the market prices of the capital goods available for production, the sum of which it calls capital...It is the indispensable compass of production in the market economy (ibid.). By saying that “capital accounting starts with the market prices of capital goods available for production,” he makes it appear as if capital accounting does not apply to the resources that are not capital goods – land, to intellectual and physical skills, and to legal rights. Surely, however, he does not mean this. Critique We must begin by endorsing, and even embracing, Mises’s main point that time preference limits the willingness of people to embark on lengthier production projects than those that they choose. But now we must question the wisdom of distinguishing between durable consumers’ goods, intermediary products and other resources (or higher order goods). Why insist that the shift to longer periods of production must start with the formation of stocks of consumers’ goods and that it must pass through stages in which people use tools and produce resources of further production. Surely, the shift can occur without this. If we begin with a stationary system, we can imagine several kinds of changes that could lead an individual to shift to longer production periods without his producing additional stocks of consumers’ goods or intermediary products. First, there could be an increase in the physical productivity of the more lengthy processes that is completely independent of human choice. The best example might be agricultural production due to systematic and relatively permanent changes in Entrepreneur's Net Worth: Mises’s Concept of Capital 19 weather conditions. Second, people might use their brain power to discover ways to increase the physical productivity of either or both the shorter and more lengthy production processes. Third, people might deliberately change their desires for the products of the longer vs. the shorter production processes. (It might be argued that this, in fact, is a change in time preference. Whatever we call it, Mises did not consider it.) Fourth, people might improve their physical or intellectual skill in producing products. The only initial state in which Mises’s implications are logically correct is one in which none of these four events can occur without first accumulating consumers’ goods and then producing intermediate products. Such an initial state is characterized by such extreme scarcity that people are unwilling to wait at all yet sufficient goods are produced without waiting to insure their survival. This initial state is conceivable but it is not relevant to the conditions of any society that we know or have known. We are forced to conclude that nothing is gained building an image of an individual or an economy in which the accumulation of consumers’ goods and intermediary products as antecedent to the shift to production processes with longer periods of production. Praxeology, as the basis of a procedure for describing historical events, demands that changes be described in terms of action – either in terms of the action that causes historical events, action that responds to changes due to non-action, or both. We describe changes in action under the conditions of the market economy by referring to entrepreneurial appraisals and decisions and to how individuals deal with the uncertainty entailed in their decisions. Mises’s choice to focus on produced material resources inclines us to forget the entrepreneur point of view. Entrepreneur's Net Worth: Mises’s Concept of Capital 20 The important point is that, as quoted above, “[t]he modern theory of value and prices is not based on the classification of the factors of production as land, capital, and labor” (ibid.: 636). We can illustrate how time preference affects choices within the framework of the modern theory of value and prices without using the concept of the accumulation of capital goods. We need not step outside the theory and we are liable to forget entrepreneurship if we do. Capital Goods as Time Stored Up Notwithstanding Mises’s focus on capital goods and not on the other resources in the previous section, he goes on in the next section to remind his readers of one of the most important insights of the subjective theory of value: that all resources are treated identically by the calculating mind. The businessman might adopt a superficial rule of thumb in distinguishing (1) “nature-given material factors, (2) the human factor – labor, and (3) capital goods – the intermediary factors produced in the past” (ibid.: 492). However, “it was a serious mistake for the economists to agree with the businessman’s superficial view...The...factors of further production produced in the past...are not an independent factor.” Having reminded readers of this, he goes on to the major subject of this section. He writes that the resources produced in the past “are the joint products of the cooperation of the two original factors – nature and labor – expended in the past” (ibid.: 493). He uses this observation to launch a critique of the view that capital goods are “labor and nature stored up.” We can see why this view is wrong, he points out, by comparing the price faced Entrepreneur's Net Worth: Mises’s Concept of Capital 21 by a purchaser of a particular capital good, e.g., a machine, to the sum of the prices of the resources needed to produce the machine. When a man chooses to buy the machine, he is not buying stored labor and nature; he is buying “time stored up.” A person who buys the machine instead of the resources used to produce it, is “nearer the goal of production” (ibid.). Note that the argument here is forward-looking. Someone who purchases a machine in accord with his plans to produce goods in the future, he says, expects his purchase to save time because otherwise he would need to take the time to produce the machine. He does not mean to say that the machine represent time from the past, only that it saves time in the future. Although this is what he means, his words are easily misunderstood. Critique The critique is that this line of reasoning applies not only to machines but to all kinds of resources, so long as the resource, or its substitute, is available in the market. First, the purchase of durable consumers’ goods, as compared with producing them, may save time. Similarly, the purchase of more fertile land, compared with the purchase of less fertile land and the production of irrigation and fertilization goods, may save time. Finally, the purchase of skilled labor, compared with unskilled labor combined with a training program, may save time. Thus, a more accurate statement is that the purchase of a resource, compared to producing it or to choosing an alternative where time must be sacrificed to produce a substitute, enables a person to be “nearer to the goal of production.” This is a truism that has nothing specifically to do with capital goods. Nothing is gained by using the Entrepreneur's Net Worth: Mises’s Concept of Capital 22 Besides Knight, Mises cited writings on capital in professional journals by Hayek and Machlup. See “capital” in the index of Human Action. Knight’s disaffection with time preference was not a reaction to the Austrian theory. In his first major work, Knight asserted that time preference, or discount, has only an indirect effect on the interest rate and only over a long period of time. It is negligible “in relation to the total term “capital goods” here and there is a risk that much will be lost. The best way to show that an existing resource is time stored up is to refer to how entrepreneurship sets the price of the resource in question relative to how it sets the prices of the resources need to produce it or its substitutes. Capital Goods and Choice: A Digression Given that reasoning about capital goods applies to all higher order goods, why did Mises want to retain the concept of capital goods at all? One possible answer is that professional economists had become accustomed to using this language. One apparent goal of Mises’s discussion of capital goods was to deal with some of the relevant economics literature. Among other things, he wanted to “explode the objections against the time preference theory” raised by Frank Knight (ibid.: 492n). In a 1934 paper Knight had argued that the concept of time preference and a period of production are mere details that have no fundamental importance for understanding the market interest rates. He wrote that because individuals capitalize all expected streams of consumption wealth into a present value, the important fact is the size of this value, not the particular times at which the various income streams are expected or desired to be realized. Among other things, he used this argument to disparage the Austrian theory of the trade cycle, as presented by F. A. Hayek (Knight, 1934: 286). Knight also recognized the fact that the subjective value theory had debunked Entrepreneur's Net Worth: Mises’s Concept of Capital 23 demand for capital” (Knight, 1921: 330n). See Knight 1944, 33n. Knight did not always adhere to this position, however, as evidenced by his numerous papers on capital in which he explained interest by referring to the productivity of capital. Indeed, this explanation was the basis for his highly critical review of Mises’s 1940 German book, which was later to be transformed into Human Action. See Knight 1941, especially p. 412-13. the classical classifications of the resources. However – and this is a point that Mises must have recognized – Knight continued to use it in his professional writings to refer to material goods (Knight 1921: 124-5n). To refute Knight, Mises had to show why time preference is important, regardless of the market value of the resources that the current generation of entrepreneurs had inherited from their predecessors. So he pointed out that “[w]e are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today” (Mises 1966: 492). Because of this, we are better off. He went on to point out that, regardless of this, entrepreneurship must still adjust to time preference. Unfortunately, his discussion seems less clear on the issue than I am suggesting here. As important as it may have seemed to deal with criticisms of Austrian time preference theory, Mises’s reference to capital goods in this passage and in others must be regarded as unfortunate. To introduce the notion of capital goods in an argument that time preference must be accounted for in the theory of value is unnecessary and misleading. Whether the current generation inherits numerous tools and durable consumers’ goods, bountiful land, a store of encyclopedic knowledge, a system of legal rights, or nothing; individuals will appraise what they regard as the Entrepreneur's Net Worth: Mises’s Concept of Capital 24 Mises was indeed misinterpreted. Murray Rothbard championed a mistaken interpretation of Mises’s time preference theory of interest and, in the process, criticized Frank Fetter for dropping the distinction between land an capital. Rothbard’s error has been repeated by Peter Lewin in a recent book on capital. See Lewin, 1999, 103-106. Especially see note 6 on p. 103. resources in accord with their expectations about the particular times at which the resources can help to produce future goods. If time preference changes so that consumers are more forward-looking (for example, if they begin to regard the wealth of future generations as relatively more important), they will send a signal to entrepreneurship that longer-term investments are more profitable relative to shorter-term investments than they previously were. They will want to save more and for a longer period. This will, other things equal, cause the rates of interest on long term loans to fall relative to short-term loans. It may not affect the size of the present capitalized market value of the resources but it will be a crucial element in entrepreneurial decisions. This digression is essential if one hopes to comprehend Mises’s writings on capital goods in light of the subjective theory of value. In every case where Mises uses the term “capital good” the reader should substitute: “an item, action, characteristic of action, legal right or expectation based on reputation that entrepreneurship plans to use in producing future money income.” Why, one might ask, would a writer so aware of the subjective value theory as Mises take such a huge risk of being misinterpreted? We have already mentioned his apparent desire to deal with the “capital controversies” in the professional literature. If this answer is correct, then it would be wise to state that problem with which Mises aimed to deal before completing our interpretation of Mises on capital goods. Entrepreneur's Net Worth: Mises’s Concept of Capital 25 This was the starting point for two later Austrian writers on capital goods. See Ludwig Lachmann 1978 [1956]: 8 and Israel Kirzner 1966: 47. The “Capital Goods” Problem Mises conceived of the “problem of capital” in relation to a theory of plan revision in light of changes that occur after a decision has been made to produce definite capital goods. We now turn to this problem. As stated by Mises, the problem is best represented by using the term “data.” He introduces this term with regard to what he calls the “convertibility of capital goods”: The convertibility of capital goods is the opportunity offered to adjust their utilization to a change in the data of production...As the conversion of capital goods from the employment originally planned to other employments becomes necessary through the emergence of unforeseen changes in the data, it is impossible to speak of convertibility in general without reference to changes in the data which have already occurred or are expected. A radical change in the data could make capital goods previously considered to be easily convertible either not convertible at all or convertible only with difficulty (ibid.: 504).