Frank Fetter and the Austrian Theory of Capital

Mathew McCaffrey recent's examination of the work of Frank Fetter, in general and in relation to the Austrian theory of capital (including McCaffrey 2016 and 2019), addresses a valuable neglected part of the history of economic thought. One may hope that owing to his efforts, Fetter's work will become better known, especially among Austrians.

As McCaffrey points out, Fetter's work is remarkable in its simplicity and range, providing a complete and comprehensive account of the theory of income distribution among the owners of productive resources (factors of production). In this he was "more Austrian" than some Austrians themselves (for which reason some indeed see him as an Austrian economist, though he himself eschewed all labels). For example, his theory of capital is completely consistent with the subjectivism of value in a way that Böhm-Bawerk's was not, and it anticipated in every respect later contributions of Mises and Rothbard. In fact, Rothbard's capital theory (2009) is pretty much a reworking and more accessible account of Fetter's capital theory.

In other respects, as McCaffrey points out, Fetter was decidedly un-Austrian, for example in the embrace of Progressive agenda items. In this, as McCaffrey says, Fetter's views remain something of a paradox.

I want here to confine myself to capital theory, the subject I know best in relation to Fetter's work, leaving open the possibility of weighing in on other aspects of this work in future posts. In talking about his capital theory, I want to underline what McCaffrey and others have said, to explain it by expanding on some aspects, and also to suggest some hitherto unnoticed implications.

Capital and Income

In common with Irving Fisher (1906), Fetter's capital theory revolves around the distinction between stocks and flows. Stocks of productive resources, when wisely employed, yield flows of valuable goods and services over time. The purpose of employing productive resources (labor, production goods, natural resources) is to earn an income (profit) from the sale of the valuable goods they produce. Clearly, then, these employed resources derive their value from the income they are expected to produce. The value attributed (imputed) to these productive resources is in fact the "capitalized value" of the income they are expected to produce. In modern terminology we call this the present value of the expected income flow from using the resource combination, or the discounted cash-flow, the NPV (net present value), or alternatively the CV (capital value) of the productive combination (or project or business unit).

This is really a very simple and nowadays familiar conception of how production works. But in the context of Austrian capital theory and capital theory generally, it is notable for a number of important reasons.

It is the antidote to two aspects Ricardian economics and all that has descended from it.

A. Cost of production.

First and perhaps most obvious, it disposes of Ricardo's cost-of-production theory of capital. Fetter's theory, like Menger's, is forward-looking. Cost is determined by (subjective) value, the value that consumers put upon the consumption goods produced by the supply-chain of productive resources, not the other way round.

B. Rent.

Second and much less obvious -- and unique to Fetter, though picked up by Rothbard -- Fetter demystifies the theory of rent in the process disposing of the Ricardian theory of rent – which is notable for its capacity to confuse. For Ricardo rent refers to the net earnings landowners receive from the sale of their product; this obviously depends on the productivity of the land in question, giving rise to the concept of differential rent, being that some pieces of land are more productive and scarce than others. In Ricardo, land is the only productive resource whose earnings are determined by "market value." So it is special. By contrast, Fetter uses the word rent in a familiar way: as the payment for "renting" a productive resource. It is not at all special. It is exceedingly common and essential to understanding capital, income, profits, and interest.

Recall the distinction between stocks and flows. A stock of production goods (raw materials, machinery, buildings, etc.), when wisely employed and combined with land and labor over time, produces a flow of valuable goods for sale. The easiest way to understand rent is to consider the employment of labor. Labor cannot be purchased because, absent slavery, humans beings own themselves. However, labor services can be purchased. Labor is rented. The rental rate paid to labor for its services is the wage rate. (Rothbard 2009)

Perfectly analogous to this, the stock of things that we call "capital goods" yielding a flow of services in production must be seen to earn a rental rate. If a copy machine is rented by a producer (a business), the periodic rent paid on it, which is the price of the services purchased, are the "wages" of the copy machine. This remains true even if the producer owns the copy machine. The producer should think of the earnings of the copy machine as the rent the producer pays himself (the rent he would have to pay someone else were he renting it or what he would receive were he renting it out). This rent he charges himself should include the economic depreciation of the machine and other considerations that cannot be explored here. (But see Lewin and Cachanosky 2019, section 5.)

The important takeaway is that in completely reformulating and considerably simplifying the notion of rent, Fetter provides the wherewithal for a complete accounting (in all senses of that word) of all kinds of earnings. In fact, there is no categorical difference between the earnings of the different kinds of productive resources – "land, labor, and capital": they all earn rent, the price they are paid for the sale of their services in employment.

Which brings us to the second notable implication of Fetter's vision of capital, namely, the notion of capital itself. And here too there are two aspects in which Fetter's theory is remarkable in its simplicity. The first has precedent in Austrian capital theory; the second is contentious.

A. Capital as value.

As McCaffrey tells us in his lead essay:

Fetter rejected the standard definition of capital as the produced means of production and advanced his own definition in which capital is "the market value expression of individual claims to incomes." This value is "the sum, in terms of dollars, of … the worth of all available and marketable intangibles … as well as the worth of claims to the uses of physical forms of wealth." (Fetter 1930-1935 [1977], 149) With both land and capital, Fetter offered original conceptions of long-debated economic terms, and his views provide the basis for much fruitful discussion.... [Italics added].

Pay attention to the italicized words. Fetter has a concept of capital that is clearly value-based. The only other Austrian to have one was Mises, who defines capital as follows:

Capital is the sum of the money equivalent of all assets minus the sum of the money equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit. It does not matter in what these assets may consist, whether they are pieces of land, buildings, equipment, tools, goods of any kind and order, claims, receivables, cash, or whatever. [Mises, 1949, 262]

To show that the two definitions are in fact equivalent one needs to appeal to the notion of discounted value at any point in time in the production process. This in fact is a missing element in all Austrian capital theorists. It is clearly implicit in all their work and is sometimes mentioned, but it is never analyzed to bring out its centrality. Its importance is clearly brought out in John Hicks's ruminations on Austrian capital theory. (Hicks 1939)

The importance, though, is that, like Mises, Fetter has a value-conception of capital. Capital does not refer to physical things themselves but to the idea of what those things are worth in certain situations. Had this approach (shared by Irving Fisher) been adopted instead of the usual neoclassical standard physical conception, much if not all the controversial questions surrounding capital and its earnings could have been avoided. (See Lewin and Cachanosky 2019 generally.)

B. Human Capital.

Finally, I think it is clear, though not previously observed, that Fetter's definition of capital allows for no categorical distinction between the various productive resources (factors of production) as regards their "capital-nature." Fetter is clear that there is no relevant distinction between land and produced means of production ("capital goods"). But he does not extend this to labor. In other words, he stops short of the concept of human capital – as does Mises, though in many places Mises does refer, using other words, to what is human capital. The question of whether the Austrians have neglected human capital, and if so why, is an interesting one.

Frank Fetter and the Austrian Theory of Capital

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Part of: Matthew McCaffrey, “Frank Fetter and the Austrian Tradition in the United States” (January 2019)