I am writing a review of Israel Kirzner’s Competition and Entrepreneurship, to be published on this blog probably some time next week, so a short post will have to do. Besides, thinking about Kirzner’s book has me thinking about this topic.

Traditionally, the rate of interest is pivotal to the process of intertemporal coordination. When individuals save more, the rate of interest falls, individuals increase their borrowings, and demand is transferred from the late to the earlier stages (the latest state being directly prior to consumption). Perhaps the most famous critique of this view is Keynes’, who thought that the rate of interest was not a good coordinator of savings and investment. And, when this coordination process breaks down, we suffer an output gap (i.e. the business cycle). This line of reasoning has often been used to put in doubt the logic behind Austrian business cycle theory. So, the debate has hinged on the rate of interest.

I’ve long thought that the rate of interest is actually not that important. I have argued that in the boom phase it’s not a lower rate of interest that we should be looking for, but for the rate of credit expansion. I think this view is supported by Mises, in Human Action, albeit not as explicitly. More to the point, I’ve also made the argument that we should re-think the theory that it’s the rate of interest that is the key price in intertemporal coordination. It’s an argument that should be well received by Austrians. When all we need to do is solve a system of equations, the rate of interest is key to intertemporal coordination. But, this is not how coordination actually works. Kirzner introduces entrepreneurship as the main process behind coordination. The pricing process is important, in that it disciplines poor decisions and rewards the good ones, but this is an ex post role, not an ex ante one (prices have an ex ante role in optimization problems). Why haven’t we exported this concept to the theory of capital?

Of course, who am I to challenge professional Austrian economists who have thought about these issues as a career? But, consider the following passage from Hayek’s Pure Theory of Capital,

It will be evident by now that savings are actually required only at the time when, in consequence of a past diversion of input from the production of consumers’ goods to the production of capital goods, the current output of consumers’ goods is falling off.

— p. 276.

The conditions for intertemporal equilibrium are pretty tight. Savings are only actually needed when the supply of consumers’ goods begins to fall. That is, after the initial investments were made. Investment is an act of entrepreneurship, because the investor has to guess where the demand curves for different types of goods will be at the point in the future when his output will be made available, so to speak. If the rate of interest on loans is decided by the rate of savings, the interest rate will fall after the relevant investment has been made. It doesn’t make sense, then, that the rate of interest plays an ex ante role in coordination. It can only act as part of the disciplining mechanism of the pricing process.

While I haven’t read everything written on capital theory, I’ve read quite a bit, and I’ve never seen this approach adopted. Why? (Coincidentally, one book I have yet to read — and I will be doing so at some point early next year — is Kirzner’s Essays on Capital and Interest.)