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9.2 The Intertemporal Structure of Capital

Hayek greatly simplified the Austrian vision of a capital-using economy by

modelling the economy’s production activities as a sequence of inputs and a

point output. Each element in the sequence is designated a ‘stage of production’,

the number of stages posited being largely a matter of pedagogical

convenience. This simple construction was first introduced as a bar chart with

the individual bars arrayed temporally, their (equal) widths representing increments

of production time. The length of the final bar represents the value

of consumable output; the attenuated lengths of the preceding bars represent

the values of the goods in process at the various stages of production.

Figure 9.1 shows ten stages of production arrayed from left to right. (In

the original Hayekian rendition, five stages were arrayed from top to bottom.)

The specific number of stages is not intended to quantify any actual,

empirically established detail about the economy’s production process but

rather to capture our general understanding that in many instances the

(intermediate) output of one stage is used as an input to a subsequent stage.

That is, vertical integration – and, certainly, complete vertical integration –

is not the norm. Hayek’s ‘stages’ do not translate cleanly into ‘firms’ or

‘industries’. Some vertically integrated activities may be carried out within

a single firm. An oil company, for example, may be engaged in exploring,

extracting, refining, distributing and retailing. A paper manufacturer, for

another example, may be supplying paper for blueprints and for greeting

cards, thus operating simultaneously in different stages. And there are obvious

deviations from the strict one-way temporal sequence: coal may be

used in the production of steel while steel is used in the production of coal.

Figure 9.1 The intertemporal structure of production

Stages of production


Early output




(This is the supposedly telling counter-example offered by Frank Knight in

his critical introduction to the English translation of Menger’s Principles.)

Still, as with all simple models, this Austrian model of the capital structure

is notable not for its many sins of omission but rather for the essential

truths that are captured by its construction.

Means are employed to achieve ends, and those means are temporally prior

to the corresponding ends. Production moves forward through time. Valuation,

however, emanates in the reverse direction. That is, the anticipated value

of an end attaches itself to the means capable of achieving that end. This is

Menger’s Law. The demand for the factors of production and hence for the

outputs of the intermediate stages of production is a derived demand. The

direction of valuation is implicit in Menger’s designation of consumption

goods as ‘goods of the first order’. The market values of goods of the second,

third and higher orders are ultimately derived from the anticipated value of

the first-order goods. But even with the doctrine of derived demand fully in

play, those values entail a systematic time discount consistent with the temporal

remoteness of higher-order goods.

The Austrian vision puts the entrepreneur in a key role. At a minimum, the

entrepreneur operating in some particular stage of production must anticipate

the demand for his own output, assessing the profitability of his activities with

due attention to the cost of borrowed funds. Longer-run planning may require

gauging the strength of demand several stages forward, including ultimately

the demand for the consumable output. Speculative activities may consist in

part in the movement of resources – in response to a change in credit conditions

– from one stage to another and possibly in the creation of new stages of

production that are of a higher order than the highest order of the existing

stages. The increasing ‘roundaboutness’, to use Böhm-Bawerk’s term, and the

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increasing significance of the time element in the production process, are

characteristic of developing (and developed) capitalist economies.

The attention to the temporal structure of production suggests that the time

element is an important variable in our understanding of how a decentralized

economy works to coordinate production activities with consumer preferences

and hence in our understanding of what might go wrong with the

coordinating mechanisms. The use of multiple stages of production gives full

play to marginalist thinking. Austrian macro is micro-friendly. The pattern of

resource allocation can be modified in systematic ways, changing the temporal

profile of production activities. A marginal decrease in late-stage activities

coupled with a marginal increase in early-stage activities has important implications

for the economy’s overall growth rate. Significantly, a related

pattern of marginal changes gives rise to boom and bust. Changes in the

intertemporal pattern of resource allocation have a claim on our attention,

according to the Austrians, even if these marginal changes cancel one another

out in some conventional macroeconomic aggregate such as investment spending

(in all stages) or total spending (by both consumers and the investment


The pattern of resource allocation associated with intertemporal equilibrium

exhibits a certain uniformity in terms of the value differentials that

separate the stages of production. The difference in the value of the output of

one stage and the value of the output of the next stage reflects, among other

things, the general terms of intertemporal exchange, expressed summarily as

the market rate of interest. With a given rate of interest, excessive stage-tostage

value differentials would present themselves as profit opportunities

which could be exploited only by reallocating resources toward the earlier

stages of production. In the limit, when all such profit opportunities have

been competed away, the relative prices of inputs used in the various stages

are brought into line with the equilibrium rate of interest. A summary graphical

rendering of the intertemporal capital structure takes the form of a triangle

encasing the sequence of stages that constitute such an intertemporal equilibrium.

The Hayekian triangle in Figure 9.1 keeps the many complexities of

capital theory at bay while keeping in play the overall time element in the

production process.

The extreme level of simplification warrants some discussion. First, we

note that the triangle’s hypotenuse, which tracks the value of the yet-to-be

completed consumables, rises linearly from no value at all to the full market

value of the consumables. Yet we know that the interest rate is expressed in

percentage terms and, starting from some initial input value, allows for compounding.

Clearly – and contrary to the Hayekian triangle – such percentage

value differentials imply that the cumulative value should be tracked by a

curve that rises exponentially from some initial value to some final value.

Here, linearity wins out on the grounds of its being simpler in construction

yet adequate to the task. It is also true to Hayek’s original formulation. We

need to recognize, however, that the triangle would be inadequate for dealing

with any issue for which the compounding effect is critical. Ambiguities

about the precise relationship between the interest rate and the overall degree

of roundaboutness arise when the effects of compound interest are factored

in. These and related ambiguities concerning capital intensity lay at the heart

of the Cambridge capital controversy (see Harcourt, 1972), a protracted and,

ultimately, sterile debate that attracted much attention a few decades ago. But

for dealing with the business cycle and related macroeconomic issues, the

triangle, simple as it is, does just fine.

Second, the horizontal leg of the triangle, which invites us to imagine a

sequence of unit time intervals, does not translate readily into calendar time.

In application, an early stage of production consists only partly in goods in

process – pine saplings that mature over time into lumber or wine that

undergoes an ageing process. Earliness is also implicit in durable capital

goods or even in human capital. These factors of production are categorized

as early-stage because they will have a yield over an extended future. The

heterogeneity of capital warns against trying to create a single metric, such as

some average period of production, or to quantify in some other way the

production time for the macroeconomy. Still, many early-stage activities and

late-stage activities are readily discernible. Inventory management at retail is

a late-stage activity. Product development is an early-stage activity. Increases

in the time dimension of the economy’s capital structure might take the form

of shifting resources from relatively late to relatively early stages, of creating

capital goods of greater durability, or of simply changing the mix of goods

produced in favour of those involving more time-consuming (but higheryielding)

production processes.

Third, the vertical leg of the Hayekian triangle, which represents the value

of consumable output, implies that consumption occurs at a single point in

time at the end of the production process. This is not to deny the existence of

consumer durables. But expanding the intertemporal aspect of the macroeconomy

to include consumption time would complicate matters without

adding much to the analysis. The triangle focuses attention on the particulars

of production and on aspects of the market process that lose much of their

relevance once the goods are in the hands of the consumer. The notion of

‘stages of consumption’ would be contrived if not meaningless.

In application there is a fine line – in Austrian theory as in more conventional

theory – between an investment good and a consumer durable.

Residential housing, whether or not owner-occupied, is universally categorized

as investment, the rental value (actual or implicit) of its services

qualifying as consumption. Owner-driven automobiles, however, despite their

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considerable durability and implicit lease value, are categorized as consumption

goods. Instances can be imagined in which a consumable (for example a

light truck purchased new for non-commercial use) is later sold into an early

stage of production (for example as a work truck). But as a general rule,

goods delivered into the hands of consumers stay in the hands of consumers.

Attention to these and related matters may be necessary in particular applications

of the Austrian theory, but the theory itself is based on the vision of a

multi-stage production process that yields a consumable output.

In its simplest interpretation, Figure 9.1 represents a no-growth economy.

Gross investment, financed by saving, is just enough to offset capital depreciation.

With given tastes and technology, the macroeconomy settles into an

intertemporal equilibrium and produces consumption goods at an unchanging

rate. More typically, saving and gross investment exceed capital depreciation,

allowing the economy to grow at every margin. If we can assume for the

moment an unchanging rate of interest, the growth can be represented by a

triangle of increasing size, its general shape remaining the same.

The pay-off to Hayekian triangulation, however, comes from allowing for

changes in the triangle’s shape. More conventional macroeconomic constructions

make the implicit assumption of structural fixity or structural irrelevance.

In the Austrian theory, changes in saving behaviour have implications for the

allocation of resources within the economy’s capital structure. In turn, the

changing shape of the triangle affects the time profile of consumable output.

The natural focus of the analysis is on intertemporal coordination and possible

causes of intertemporal discoordiantion.