I've suggested here more than once that most economists are -- deep down -- pretty terrible economists, folks who just don't understand their subject matter in all sorts of areas, especially where it matters most -- like capital theory. (Definition of modern "math jock" economics -- the economics of capitalism absent any understanding of, oh dear, capital.)
Recent Ph.D Robert Murphy illustates the problem:
I would like to conclude with a personal anecdote that illustrates the relevance of [economist] B�hm-Bawerk's critique. After I had reconciled the verbal logic of B�hm-Bawerk with the mathematical models of the mainstream, I wrote a first draft of one of my dissertation essays in which I explained away the apparent conflict by pointing out the tremendous importance of the mainstream's assumption of a single-good world. I handed in my draft to a renowned mainstream economist, just to make sure that I hadn't misunderstood neoclassical theory.
When I got my draft back, I was quite surprised to find that the professor had clipped a single piece of paper to the front. On it he had written something like, "This is the only interest theory that I, and just about everyone else, understand." Below he had drawn a simple diagram, with C(t) (i.e. consumption in period t) on the x-axis, and C(t+1) on the y-axis. There was a semicircle connecting the two axes, which denoted the production possibilities frontier (PPF) for present and future consumption through tractors.
The professor had drawn two dots on the PPF. The dot that was higher on the circle represented the tradeoff that was available through saving: By moving to the left on the x-axis, a person reduced current consumption in order to invest in tractors. By moving up on the y-axis, a person increased future consumption because of the marginal output of the tractors.
And now the crucial step: Because of the shape of the PPF, and because he had chosen points on the right side of the curve, it turned out that the leftward shift in present consumption was smaller than the upward shift in future consumption. Therefore, my professor thought that this simple diagram had shown a technological cause of interest: Because of the productivity of tractors, my professor was claiming that a small reduction in present consumption would cause a great increase in future consumption, i.e. a positive rate of interest.
What was so frustrating about this diagram was not that it was wrong per se, but that it completely overlooked B�hm-Bawerk's critique! My professor had completely overlooked the problem of pricing the tractors! Yes, the technological facts allow us to say that a given increment in future consumption (i.e. the gap on the y-axis) will require the present investment in a definite number of tractors; this is an engineering problem that does not involve subjective preferences.
However, just because we know how many tractors we need to buy in the present, we do not know how much such an investment will reduce our present consumption. In order to know this, we need to know the market price of tractors in terms of present consumption. By drawing the gap on the x-axis, my professor had just assumed that the tractors would cost less in terms of present consumption than their future output. In other words, my professor had assumed a positive rate of interest.
After several minutes of discussion, I finally got the professor to realize that he had been assuming away this difficulty. But he still refused to concede that physical facts alone could not explain a positive interest rate. No, instead he proclaimed: "Assume we can turn tractors into bananas one-for-one."
In conclusion, B�hm-Bawerk's critique of the na�ve productivity theory was a brilliant leap forward for subjectivist economics. Unfortunately, its lessons are as relevant today as they were in the 1880s.
Posted by Greg Ransom
