II.

Theories of Capital

The 18th-century French economists known as physiocrats were the first to develop a system of economics. Their work was developed by Adam Smith and emerged as the classical theory of capital after further refinements by David Ricardo in the early 19th century. According to the classical theory, capital is a store of values created by labour. Part of capital consists of consumers' goods used to sustain the workers engaged in producing items for future consumption. Part consists of producers' goods channelled into further production for the sake of expected future returns. The use of capital goods raises labour productivity, making it possible to create a surplus above the requirements for sustaining the labour force. This surplus constitutes the interest or profit paid to capital. Interest and profits become additions to capital when they are ploughed back into production.

Karl Marx and other socialist writers accepted the classic view of capital with one major qualification. They regarded as capital only the productive goods that yield income independently of the exertions of the owner. An artisan's tools and a small farmer's land holding are not capital in this sense. The socialists held that capital comes into being as a determining force in society when a small body of people, the capitalists, owns most of the means of production and a much larger body, the workers, receives no more than bare subsistence as reward for operating the means of production for the benefit of the owners.

In the mid-19th century the British economists Nassau William Senior and John Stuart Mill, among others, became dissatisfied with the classical theory, especially because it lent itself so readily to socialist purposes. To replace it, they advanced a psychological theory of capital based on a systematic inquiry into the motives for frugality or abstinence. Starting with the assumption that satisfactions from present consumption are psychologically preferable to delayed satisfactions, they argued that capital originates in abstinence from consumption by people hopeful of a future return to reward their abstinence. Because such people are willing to forgo present consumption, productive power can be diverted from making consumers' goods to making the means of further production; consequently, the productive capacity of the nation is enlarged. Therefore, just as physical labour justifies wages, abstinence justifies interest and profit.

Inasmuch as the abstinence theory rested on subjective considerations, it did not provide an adequate basis for objective economic analysis. It could not explain, in particular, why a rate of interest or profit should be what it actually was at any given time.

To remedy the deficiencies of the abstinence theory, the Austrian economist Eugen Böhm-Bawerk, the British economist Alfred Marshall, and others attempted to fuse that theory with the classical theory of capital. They agreed with the abstinence theorists that the prospect of future returns motivates individuals to abstain from consumption and to use part of their income to promote production, but they added, in line with classical theory, that the amount of returns depends on the gains in productivity resulting from accretions of capital to the productive process. Accretions of capital make production more roundabout, thus causing greater delays before returns are realized. The amount of income saved, and therefore the amount of capital formed, would accordingly depend, it was held, on the balance struck between the desire for present satisfaction from consumption and the desire for the future gains expected from a more roundabout production process. The American economist Irving Fisher was among those who contributed to refining this eclectic theory of capital.

John Maynard Keynes rejected this theory because it failed to explain the discrepancy between money saved and capital formed. Although, according to the eclectic theory and, indeed, all previous theories of capital, savings should always equal investments, Keynes showed that the decision to invest in capital goods is quite separate from the decision to save. If investment appears unpromising of profit, saving still may continue at about the same rate, but a strong “liquidity preference” will appear that will cause individuals, business firms, and banks to hoard their savings instead of investing them. The prevalence of a liquidity preference causes unemployment of capital, which, in turn, results in unemployment of labour.