The Continuing Relevance of Austrian Capital Theory

0:00Good morning and welcome to our first named lecture, the F.A. Hayek Lecture. Our speaker this morning, Nikolai J. Foss, was invited by me to give this lecture. I had been familiar with some of his work and I thought I knew most of his work. But as it turns out, I was merely familiar with a fraction of it. Nikolai is one of the most productive Austrian scholars in Europe, if not in the world. He was born in Denmark. He has residences in both Denmark and Norway. He received his PhD degree from the Copenhagen Business School in 1993. Currently, he's the professor of strategy and organization at the Copenhagen Business School, a part-time professor of knowledge-based value creation at the Norwegian School of Economics and Business Administration, and the head of the Department of Strategic Management and Globalization at the Copenhagen Business School.

0:56He also holds part-time and visiting professorships at several other leading universities in Europe. He's the founder of the Center, now the Department of Strategic Management and Globalization at the Copenhagen Business School and currently serves as its director. Fors is a panel member of the European Research Council. He was one of the founders of the Danish Research Unit for Industrial Dynamics and a co-founder of the Libertarian-Conservative Center for Policy Studies, the most influential privately funded think tank in Denmark. Professor Faust's prodigious publications include 136 journal articles, 81 book chapters. In addition, he has authored or edited 22 books and several have been published by very high profile publishers such as Cambridge University Press and Oxford University Press.

1:49His work has been published in the Academy of Management Review, to Academy of Management Journal, Organization Science, and several other leading journals. And he serves on the boards of 18 journals. Several of his articles and books have been translated into Chinese, Spanish, and Russian. So I could go on and on, believe it or not. I had to edit this down. But without further ado, it's my great pleasure to introduce Nikolai Foss. Well, thanks a lot for the very kind introduction and the invitation. I'm particularly honored and delighted that this lecture is named after Friedrich Hayek.

2:35Back in the mid-1980s, while I was still an economics student and discovered Austrian economics, Hayek's works, particularly his knowledge essays, if you like, were really my first discoveries of Austrian economics. A discovery that was prompted by the writings on Keynes of Axel Leyenhoferd. If you're familiar with Leyenhoferd, he's a great Swedish now retired economist who tried to make sense of Keynes through a Hayekian lens. A project, I suppose, was pretty much doomed to failure. But that's what he tried to do and his book from 1968 on Keynesian economics and the economics of Keynes is most definitely worth a read for Austrians who are interested in macroeconomics.

3:27But back to Hayek, his works have influenced me ever since I discovered them about 30 years ago or 25. So it's only appropriate to pay homage to Hayek in this lecture and I shall really try to do so. One way I'll do that is by diverting from my usual business school professor presenting format, which is about jumping frenetically in front of my PowerPoint slides and strolling the aisles and so on. I'll adopt a relatively civilized posture and stand here and read my talk in an appropriate Germanic perhaps, style perhaps, Hayekian. But I should also pay homage in a more substantive way, namely by talking about a favorite Hayek topic, namely that of capital theory.

4:16As we all know, much of Hayek's early work, of course, concerns capital theory, either directly or more indirectly, as of course in Hayek's elaboration of Austrian business cycle theory. But I would go so far as to argue that capital theory may really be in some sense a foundation of all, virtually all Hayek's work in economics. This is obviously the case for what was intended to be the first volume of Hayek's projected but unfinished magnum opus, namely the Pure Theory of Capital, which as the title indicates is indeed a book about capital theory. some of you may have tried to read read it and you some of you may also know it's a true classic it's cited by very few people it's not read by even fewer and it is certainly I think unreadable one of the most one of the most difficulties difficult books I ever tried to read definitely I've argued myself in an old paper published back in 1996 in the history of political economy

5:24that capital theory played a crucial role in prompting Hayek's thinking about the challenge to economic theory represented by dispersed knowledge. Roughly the argument in my old paper is that the knowledge-based challenges of inter-temporal coordination of a structure of heterogeneous capital, Capital, which, as Roger Garrison has often told us, is the essence of Austrian macroeconomics, led Hayek to think carefully about the role of knowledge in economic affairs. So it's quite crucial, foundational even, to significant parts of Hayek's thinking. But there are many other interesting ways in which capital theory makes an essential and the potential connection to other parts of the Austrian corpus, as it were.

6:21There's, for example, an obvious relation between heterogeneous capital and the Misesian calculation problem. Mises was probably not led to the discovery of the calculation problem merely by noting the presence of heterogeneous capital in economy per se. Because even if capital were homogeneous, there would still be calculation problems left, for example, how much homogeneous capital, in this case, to devote to production now versus later. So calculation problems wouldn't evaporate if capital were homogeneous. But these calculation problems would surely be much more trivial compared to the situation with heterogeneous capital.

7:06So to Mises, the entrepreneur and heterogeneous capital goods are really complementary phenomena. To some extent, two sides of the same coin. As Mises says, and I quote, the various complementary factors of production cannot come together spontaneously. They need to be combined by the purpose of efforts of men aiming at certain ends and motivated by the urge to improve their state of satisfaction. Lachman, in the book on capital theory that Peter Klein mentioned earlier this morning, echoes Mises stating that, quote again, the entrepreneur's function is to specify and make decisions on the concrete form the capital resources shall have. Specifies, modifies the layout of his plant.

7:54As long as we disregard the heterogeneity of capital, the true function of the entrepreneur must also remain hidden. I think these various examples of the role that cattle theory play in Austrian economics offers to indicate that cattle theory is really fundamental in the sense of foundational and indispensable as part of Austrian economics on par with subjectivism, dispersed knowledge and entrepreneurial appraisement and that it is in fact intricately woven together with exactly these things. So the implications of capital heterogeneity, capital theory, go really much beyond the Austrian theory of the business cycle.

8:41Of course, my sense is that Austrians are perfectly aware that they stand apart on the issue of capital theory, insisting that there is meaningfully such a thing as capital theory, which goes beyond corporate finance and the theory of investment behaviour is almost a is a bit of an oddity in contemporary economics, as Roger Garrison again has noted. However, it seems to me that surprisingly Austrian capital theory is also a bit of an oddity in contemporary Austrian economics. So to illustrate just loosely, out of the 197 articles that were published in the Review of Austrian Economics From 2002 to 2011, both years included, only 11 dealt directly with capital theory.

9:37The quarterly journal of Austrian economics is doing better, but only slightly better. There are 189 articles in the same period and there are 15 of them that deal directly with capital theory. That's somewhat better performance. One may fear, of course, that this reflects a belief, even among Austrians, that Austrian Catall Theory somehow lost the historical debate that the Cambridge Catall controversies of the 1960s proved that this is just one big mess, that Schraffer and Knight really proved that Austrian Catall Theory was full of internal contradictions and so on. Whatever that may be, I want in this talk to argue that Austrian capital theory should make something of a comeback as a really crucial item on the Austrian research agenda.

10:34I should say that in arguing this point, I'm also wearing my management scholars hat, it should make a comeback as essentially a part of the theory of production. That is, the theory of the economic process of converting inputs to outputs perhaps rather than as a part of the theory of distribution or even the theory of interest. But as a part of the theory of production the Austrian theory of capital stresses the heterogeneous nature of capital assets, The subjective nature of capital as a part of the entrepreneur's plan and of course the time dimension of production.

11:21Thus understood, I think this is pretty uncontroversial, but thus understood at least, the Austrian theory of capital has opportunities for theoretical developments that are not yet fully explored. And what I shall do today is to examine some of those opportunities in the context of business firms, drawing on my work with Peter Klein, among others, and I should also argue that looking at heterogeneous capital in the context of business firms provide an important underpinning of our understanding of the sources of economic growth, a perennial issue in economics since Adam Smith. Here's my title, Austrian ideas on heterogeneity represent an important challenge to homogenizing assumptions in much of mainstream economics and in management theory.

12:19These ideas, these Austrian ideas, not only challenge, but they can also constructively further our thinking on firms and the growth process, Potentially establishing Austrian economics as a highly relevant voice in the contemporary discourse on firm organization and economic growth. Now in his treatise on Austrian Capital Theory, called Capital Theory and Disequilibrium, Peter Lewin notes that Austrian Capital Theory has become synonymous in literature with Boehm-Bawerkian Capital Theory. So capital theory is often equated with questions like, is capital a fund?

13:06What's the nature of the earning of capital? What determines these earnings and so on? And one of the latest restatements and refinements of Austrian capital theory, namely Rothbard's and Man Economy and State, of course deals with these important questions as well. These are conceptual questions obviously, they're distributional, and they are quite often couched in a macro-language. If you look at Boehm-Bawerk and Hayek, at least in prices and production, there are impressions of a leaning to the macro side. Hayek Boehm's concentric circles, if you remember them in his Capital Interest Treatise, Hayek's triangles in prices and production, Of course, allowful imply perhaps capital heterogeneity of capital goods at least between those stages of production.

14:04Very little is actually being said about heterogeneity within the stages of production. But there are also notions of the average period of production, the total value of flow capital and so on. They are macronotions. And these macronotions are still pretty much the notions that are associated in the mind of mainstream economists, at least those few mainstream economists who have heard about Austrian capital theory with Austrian capital theory. So try reading Mark Blauch's Economic Theory of Retrospect, where he deals with and smashes I think there's a danger that these macro concepts may direct attention away from something very basic and very, very important in Austrian capital theory, namely the fundamental heterogeneity of capital.

15:07It seems to me that heterogeneity is a theme that becomes increasingly important in Austrian thinking and Capital from about the mid-1930s. My guess, my conjecture, if you like, is that the development and the fate of Austrian business cycle theory in the interwar period played a role here. So in, for example, Boehm-Bawerk's basic stationary state, the specificities and the complementarities between all sorts of heterogeneous capital goods are very easily missed Because all productive operations proceed smoothly as they must in a stationary state.

15:53The downturn of the business cycle, on the other hand, which Hayek had difficulties theorizing I think, is very much about capital goods that simply cannot be profitably deployed to other users for which they are not really fit. Because as Dennis Robertson said in his variation on Austrian business cycle theory, work on the new Cunardos will be suspended. We are left with a big mass of heterogeneous capital goods that just cannot be easily deployed. So heterogeneity in the downturn suddenly becomes of overriding importance. This is the Aquitania, supposedly the most beautiful of them all.

16:39It survived both the boom-bopped cycles of meddling politicians and the German torpedoes before it was finally retired from service in 1950. But the point here is that from... There's a conjecture again, a conjecture in doctrinal history. But I would like to go further into this. And perhaps Roger Garrison or someone else here has thoughts on this. It seems to me that from about the mid-1930s, is we see an increasing interest among Austrians in the heterogeneity properties of capital. I think Richard von Striegel in Capital und Produktion is a really good example. Lachmann's 20 or so years later Capital and Structure is another good example.

17:24So is Kirzner's neglected an essay on capital and Pierre Luin's contemporary work pretty very much exemplifies this very strong emphasis on heterogeneity as perhaps the important aspect of Austrian capital theory. Now it seems to me that the key notion in all of this is the Mengerian one that capital goods are essentially forward-looking components of multi-period plans and as Mises argued this conceptualization in itself invalidates the aggregation of capital goods. As Mises says, the totality of the produced factors of production is merely an enumeration of physical quantities of thousands and thousands of various goods.

18:12Such an inventory is of no use to acting. So as I indicated already, this emphasis on heterogeneity and the subjectivity of capital goods in the entrepreneurs' production plan seemed to me to move the theory of capital somewhat away from its traditional concerns with distribution and with interest theory and move it more towards the theory of production. But it's a special kind of theory of production I'm talking about here. Austrian capital theory has actually often been compared to the economics of the classical economists.

18:59Higgs, as you may know, famously made the argument that the Austrians and the classicists shared pretty much the same emphasis on capital as a fund. In the process, he lumped together Boehm-Bawerk and Hayek with Clark and Knight rather absurdly. Israel Kirzner has a great comment on this in the 1976 book. I think it's the... Is that the Salter-Royalton one or is it the later one? I think it's the Sparadero one. But the point here is that the classical theory of capital is a part of the theory of production. The classical theory of distribution, sorry, the classical theory of production, on the other hand, is a theory of the progressive division of labor.

19:44And it seems to me that the Austrian emphasis on heterogeneous capital aligns closely with this aspect of classical economics, the progressive division of labour aspect, as Alan Young argued in a famous paper many years ago, both involve time and heterogeneity and therefore the need for coordination. Both the classical theory of production and the Austrian theory of capital are sharply opposed to the way production is portrayed in modern economics, what we may call the production function U. Here's Axel-Lyon Hoofwood, whom I mentioned earlier, and here's how he characterizes The view of production in modern mainstream economics, the production function view.

20:40He says that the neoclassical constant returns production function does not describe production as a process, i.e. as an ordered sequence of operations. It's more like a recipe for bouillabaisse, where all the ingredients are dumped in a pot. Well, it's heated up, this is a function, and the output X is ready. This abstraction from the sequencing of tasks is largely responsible for the well-known fact that neoclassical production theory gives us no clue to how production is actually organized. Smith's Division of Labor, the core of his theory of production, slipped through modern production theory as a ghostly technological change coefficient or as an equally ill-understood and the economies of scale, the property of the function.

21:30Now, what's the U of capital that is implied in the neoclassical production function U? I've discussed this at length with my more mainstream colleagues and they argue that, you know, as a purely mathematical approach, the production function U is capable of handling both heterogeneity and time. In actuality, I think it is not. And this is perhaps best seen in modern mathematical macroeconomics models, of course mainstream macro models given their focus on economy-wide phenomena, you know, gross domestic and national products, employment, growth rates and so on, they tend to focus on aggregates, industries, sectors, whole economies, aggregation in turn, per definition.

22:24leads to some kind of homogenization. As a minimum, there must be some shared unit that the relevant items can be measured in terms of. Often, however, the assumption is explicitly made that everything within the aggregate is homogeneous. So mainstream macroeconomic theories, whatever their stripe, all adopt the assumption that production, firms, industries and the economy are homogeneous and fungible. So labor means homogenous labor units. Capital has the same interpretation. You know, Paul Samuelson, later Robert Solow, it's Paul Samuelson to the left in the slide, adopted the imagery of Smoog from a comic called Lil Abner that some of you may recall.

23:18Smoogs are identical creatures, you can see them at the top of the slide. Identical creatures shaped like bowling pins with legs. And they, of course, adopted this imagery to capture exactly this kind of homogeneity. So, Samuelson essentially said, for many purposes, it's perfectly fine to treat capital as if capital was shmoo. I think the plural of this is shmoo, naturally, but there's a whole website dedicated to, you know, to Lille Abner and these subtle details of High Interest to Capital Theorists, obviously. This is a kind of reasoning, as Ludwig Lachmann reminded us, that originated pretty much with David Ricardo, who, of course, founded a very useful simplification in theorizing about distributional concerns and other things in the United Kingdom 200 years ago.

24:10It can be, but sometimes, and perhaps usually, economists' assumption of schmoo-like capital, in particular and homogeneity in general sacrifices explanatory scope on the altar of the tractability that formal mathematical economists so adore. And the underlying, the subtext is, you know, the heterogeneity of capital doesn't really matter that much. Let's proceed as if capital was schmoo. So let me give you a few examples of why capital heterogeneity seriously matters. Examples that go beyond the Austrian business cycle theory. And I'll go as away from macroeconomics down to the level of firms and then again from firms up to the level of economic growth.

25:04Now, so the bottom line here is that the Austrian perspective on heterogeneity as something quite essential has mostly been lost in contemporary macroeconomic discussion. There's a great quotation from Kenneth Bolding who had certain Austrian leanings from his review of Samuelson's Foundations of Economic Analysis, the review and book was published in 1948. And Bolding says the following, it's a question of acute importance for economics as to why the macroeconomics predictions of the mathematical economists have been on the whole less successful than the hunches of the mathematically unwashed, this seems very contemporary, doesn't it?

25:52The answer seems to be that when we write for instance, let I, Y and capital I stand respectively for the interest rate, income and investment, we stand committed to the assumption that the internal structures of these aggregates or averages are not really important for the problem in hand. In fact, of course, they may be very important, and no amount of subsequent mathematical analysis of the variables can overcome the fatal defect of the heterogeneity. And as I said, this sounds very, very contemporary, because so much of the discussion surrounding, for example, the stimulus packages in the US and in Europe has occurred at a very high level of aggregation.

26:44So despite the highly populous failures of the particular financial institutions, AIG, Lehman Brothers and so on, government officials spoke in terms of the banking system, the financial system, the economy as a whole. Henry Paulson told Congress, you'll probably remember that back in September 2008, that radical steps were needed to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families. American families' financial well-being, the viability of businesses, both small and large, and the very health of our economy. So, for example, the discussion of frozen credit markets focused on high-level indicators with a focus on total lending, not the composition of lending across individuals, firms and industries.

27:42The Federal Reserve System's actions noted by Bernanke were needed to increase liquidity and stabilize markets and so on and so forth. But it seems clear that a decline in average home prices, reductions in total lending, volatility in asset price indexes and so on reveals very little about the prices of particular homes, the cost of capital for specific borrowers, and the prices of individual assets. So in analyzing the credit crisis, the critical question really is, which loans aren't being made to whom and why? Indeed, it's impossible perhaps to understand the origins of the credit crisis without looking at the lending practices of government-sponsored enterprises like Freddie Mac and Fannie Mae, and I don't really need to tell you this, and the various policies that encourage lenders to lower their underwriting standards on the assumption, on the assumption that in a sense all borrowers were really equally credit worthy. So there is a sense in which assumptions about homogeneity during of course a period of rapid central bank credit expansion is at the root of the

29:02and the current financial crisis. The critical issues here are the composition of lending, not really the amount. Total lending, total liquidity, average equity prices and the like, all obscure the key questions about how resources are being allocated across sectors, firms and individuals, whether bad investments are being liquidated and so on. The aggregate notions homogenize, and in doing so, they suppress critical information about relative prices. The main function of capital markets, after all, is not really to moderate the total amount of financial capital. It is to allocate capital across activities, of course.

29:52Now, if not all borrowers are the same, it's even more true that not all banks are the same. And yet the Treasury's Troubled Assets Relief Program was designed explicitly on the premise that the banking system itself, rather than the individual banks, was in trouble. To avoid signaling the financial conditions of specific banks to the market, the Treasury insisted that all large banks take top funds, whether they want it or not, as you would recall. Some 250 banks ultimately refused to participate in this. Such programs, of course, create strong adverse selection problems. Banks that followed more prudent lending policies did not invest in complex mortgage-based securities and the like. They have little incentive to take government subsidies accompanied by government control of future lending and investment and even practices such as executive compensation.

30:49By bolstering inefficient banks creating incentives to keep issuing mortgages that ought not to be issued in the interest of reviving the macroeconomy policies such as the top scheme are repeating the mistakes that caused the problems in the first place. And it all has to do with assumptions about homogeneity. Of course, generally, the US stimulus packets and similar schemes and proposals around the world are characterized by Keynesian-style reliance on macroeconomic aggregates. The common wisdom still really is that the bank crisis led to a collapse of effective aggregate demand, and only massive increases in government expenditure and certainly debt can kickstart the economy.

31:41But in a world of heterogeneous capital resources, spending on some assets, but not others, alters the pattern of resource allocation in the economy, and in a sort of path-dependent process, the overall performance of the economy in the future. In a world of capital heterogeneity, our world, capital assets just cannot be costlessly shifted from one activity to another activity, as many of these schemes tacitly presuppose. And this is particularly the case in a modern economy in which so much capital is embodied in industry-specific, firm-specific and worker-specific capabilities, for example, human capital.

32:37So there is a strong potential here for really deploying Austrian ideas on capital heterogeneity effectively in the context of a critique of conventional macroeconomics and crisis management. And I think we can all agree that this is a very worthwhile use indeed. The function of economics, as Mises reminds us, as a weapon in the service of exploding fallacies and nonsense, is not one of its least important social functions. But there are also sort of a little bit more constructive implications in a sense for the building of theory of the Austrian insistence on capital heterogeneity.

33:28Specifically, there seem to me to be very strong implications, theory implications, of the very point that capital assets just cannot be costlessly shifted from one activity to another activity. I argued earlier that we may think of the Austrian theory of capital as a theory of production, which seems to me to imply that the firm level becomes relevant. Indeed, the idea that resources, firms and industries are very different from each other, that capital and labor are specialized to specific activities and projects, that people are, in terms of human capital, are really distinct is key in the theory and practice, of course, of management, notably strategic management.

34:24It seems to me that Austrian ideas on capital find, therefore, a close parallel in management thinking on firms as bundles of heterogeneous resources, assets and activities. Peter Lewin has recently argued that Austrian capital theory We may therefore form the basis for what he calls a capital-based theory of the firm. Of course, as Peter and I told you this morning, Peter Klein and I have developed similar arguments in a string of papers, many of which are essentially summarized in this book, Organizing Entrepreneurial Judgment. To get a basic idea of some of our over-arguments, consider the world of Samuelsonian schmoo, the world in which capital is indeed homogeneous.

35:20This is a world where individuals face very low costs of searching for assets. For example, capabilities of potential takeover targets or suppliers, assets that may fit existing operations. They don't really have any cost of measuring or ascertaining the inherent characteristics of assets because one asset is just like another capital asset. There are trivial costs if any of coordinating assets and so on and most of those very real problems of exchange and organization that economists put under the transaction cost rubric they simply disappear. that go away in a world of homogeneous capital assets.

36:10So per implication, the understanding of the sources of transaction costs in a modern economy involves, it seems to me, the understanding of capital heterogeneity and its implications. Conversely, it also seems to me that a significant part of the problems of what Joseph Salerno calls, and drawing on Ludwig von Mises obviously, called entrepreneurial appraisement, and indeed a significant part of the Misesian calculation problem itself involve transaction costs. This is an argument that Peter Klein made in a great paper in 1996, and I believe the Rio of Austria in economics. So to some, namely those of us who specialize in the economics of the firm, or like me, work in business schools, These ideas are inherently attractive.

37:02They matter a lot to me and to Peter. But many of you may not be interested in firms, management, strategy per se. What you're interested in may be the economy-wide implications of these ideas, linking together, for example, capital heterogeneity and transaction costs. So are there economy-wide implications of these ideas? It seems to me that there are plenty of absolutely important economy-wide implications of looking carefully at capital heterogeneity at the firm level. For example, John Matsusaka has argued that the processes of mergers and divestments matter to the overall performance of the economy and which antitrust authorities are very interested in.

37:57These processes should be understood as experimental learning processes that must be undertaken precisely because it is not obvious exactly what is the efficient combination of a bundle of highly heterogeneous capital assets. These micro-level processes, they are essentially entrepreneurial ones because an important part of the entrepreneur's role is to arrange and organize heterogeneous resources. Peter quoted Lachman's take on this this morning. I'll do it again because it's a great quotation. So what Lachman says is, we are living in a world of unexpected change, hence capital combinations will be ever-changing, will be dissolved and reformed in this activity, we find the real function of the entrepreneur.

38:53On the aggregate level, and I hope you'll excuse me for indulging in a little bit of mainstream economics terminology now, just a temporary lapse, I hope I'll be excused. But these processes are what make the economy track its moving production possibility frontier, as a mainstream economist would say, improving the efficiency with which resources are utilized. So these dynamic firm level processes have been estimated to account for about half of so-called aggregate productivity growth. It's been found that the automatic restructuring of industries in developed countries really imply a very serious penalty in terms of foregone growth.

39:42So the constraints, the incentives, the opportunities faced by appraising entrepreneurs trying to combine heterogeneous capital assets must really ultimately enter as an absolutely crucial element in the understanding of economy-wide phenomena connected, for example, to economic growth. Now, much of the understanding of the growth process in mainstream economics has been based on models of accumulating Samuelsonian smooth along equilibrium growth paths. So, the accumulation of homogeneous capital, essentially.

40:28There are applications of Austrian capital in the context of growth theory that do allow for heterogeneity, but otherwise portray growth as a smooth process of accumulation of physical capital along, again, an equilibrium growth path. Hicks' work, John Hicks' work from the 1970s, is a good example of that. Hicks, in fact, interpreted the Austrian cycle theory as fundamentally a theory of how this kind of smooth equilibrium growth can be disturbed by government intervention. And according to Hicks, that's a famous essay from 1967 where Hicks looks back at his career and how he interacted with Hayek.

41:13And to Hicks, the essence of the Hayek story, as he called it, was that no one really understood that Hayek was fundamentally talking about growth, which seems to me to be a rather far-fetched interpretation of Hayek. Now, of course, also those who have taken a different approach to the growth process, one that perhaps Austrians would be more sympathetic to, they argue that the growth process is driven by improvements in total factor productivity, which is again an aggregate umbrella term for a host of very diverse, very heterogeneous processes is that to a large extent takes place on the firm level.

42:04There's been long been recognized that this total factor productivity is about much more than technology, technology in the sense of recipe-like advances in scientific knowledge. There's been a lot of attention of course to R&D in the economics of growth since Solow's work in the 1950s, but it's not R&D, of course, that in itself drives growth. Innovations that emerge from R&D research and development drive growth. And in turn, innovations are introduced by enterprising individuals, by entrepreneurs. And of course, innovations at the firm level have many other sources than the R&D function.

42:54and they include your process innovations, innovations of management practices, innovations of organizational practices. All these processes are entrepreneurial ones. They amount to appraising, combining, recombining heterogeneous assets in the uncertain pursuit of profitable opportunities. The economy-wide level implications of productivity advances and improvements in resource utilization, that is, increases in total factor productivity. Surprisingly, because we know that the entrepreneur is the prime mover of progress, it's only very recently that growth economists have begun to take seriously the entrepreneurial function in the economy, Model it, measure it the way they go about things.

43:51And the reason lies exactly in something I talked about earlier, namely the dominance of the production function framework in mainstream economics, and therefore also in growth economics. If production factors are assumed to be homogeneous within categories, capital, labor, land, and production is always at its efficient frontier. There is, of course, extremely little for entrepreneurs to do. Everything has been taken care of already by assumptions of perfect knowledge and equilibrium and so on. Of course, capital in actuality is heterogeneous and the combination of those heterogeneous capital assets requires technical and commercial processes that in a very real sense are experimental.

44:48The optimum combination of inputs, capital inputs for example, just isn't a datum. And what is at any moment the optimum combination will change as a result of changes in the underlying scarcities. As Lachman reminds us. These processes again are driven by the judgment and the appraisement of capitalist entrepreneurs. So the basic message here is entrepreneurship matters to economic growth because entrepreneurship influences these processes that we put under the rubric of total factor productivity, at least if we are economic growth theorists.

45:33So it seems to me that there really is an opportunity for engaging profitably, even with some of those, you know, suspect mainstream types to talk about growth, because they are interested in these ideas about capital heterogeneity. Now, something related has to do with the influence of institutions on growth, which has been a huge theme in recent growth economics. So there are scholars who argue that institutions rule, they specifically rule in the sense that institutions overwhelm all other determinants of growth. It's not always entirely clear why this is so. So there are missing micro-foundations for many of these arguments, I think.

46:24But a key reason to expect institutional quality to affect growth positively is that it has to do with the transaction cost dimensions of the Misesian calculation problem. So institutions matter because they influence transaction costs through reduced uncertainty of economic transactions and productivity enhancing incentives. The institutional economist Douglas North tells us that the major role of institutions in a society is to reduce uncertainty by establishing a stable, not necessarily efficient, but stable structure to human interaction. The overall stability of an institutional framework makes complex exchange possible across both time and space.

47:16In turn, higher certainty implies lower transaction costs because the costs of entering into embarking, monitoring, protecting, contractual rights, ownership rights, they're reduced. This increases the expected value of projects and makes them more likely to be undertaken. So, this in turn establishes a link to total factor productivity, which I talked about earlier. We know that increases in total factor productivity, the efficiency with which factors of production are used, result from new processes, new modes of organization, ways of better allocating resources to their preferred users and so on.

48:04Given all this, the flexibility with which appraising entrepreneurs can carry out these processes becomes highly important to the growth performance of the economy. And no classical economists capture this by the notion of the aggregate elasticity of factor substitution. And this is, again, this is a measure of the flexibility of the economy, for example, with respect to reacting to external shocks. The aggregate elasticity of substitution, the flexibility of the economy is endogenous. Austrian capital theory would seem to me to matter here greatly because it suggests that there may be inherent technical constraints that reduce flexibility and flexibility, because what Lachman called multiple specificities may obtain.

49:04But the bottom line here is that this endogeneity of the elasticity of substitution, the flexibility with which we can combine and recombine, for example, heterogeneous capital assets, is influenced by institutional determinants. For example, those that we sometimes call freedom variables, such as the quality of the legal framework, sound money, how secure property rights are, and so on. So they influence the flexibility of the economy, which in turn leads to high factor productivity, because it means that resources can be more easily allocated to highly valued users.

49:53Now there are huge litigates in economic history that essentially make a number of these points in a verbal manner that perhaps formal growth economists are not particularly fond of. But they are going in the right direction. They stress the importance of entrepreneurial activity, of property rights being well defined and enforced. I have in mind work by Douglas Northigan, by Joel MacKayer and so on. So well-defined and enforced property rights matter because they reduce the transaction costs of carrying out entrepreneurial activities. So again, with secure property rights, there are low costs of searching for, negotiating with and concluding bargains with owners of those capital inputs that enter into entrepreneurial ventures.

50:47Similar reasoning applies to sound money. Inflation, particularly erratic inflation, jams the signalling effect of relative prices, harms the process of allocating resources to their most highly valued uses and therefore negatively influences total factor productivity and therefore economic growth. For many reasons, the size of the government, of course, also influences total factor productivity. If, for example, economic activities in certain industries or sectors have been nationalised, the scope for entrepreneurship in those industries or sectors is correspondingly reduced because nationalisation so often implies a public monopoly.

51:37And most parts of the western world, this is a case of child care, health care, care for the elderly and so on. And as Mises of course reminds us, the effective nationalization of all of these industries means that the operation of the price mechanism becomes severely hampered. and eliminating entrepreneurship and reducing therefore the adaptability of these industries to adapt to changing circumstances. Christian Bjornskog, a Danish colleague and myself have tried to make these ideas empirical and subject him to statistical testing.

52:30We argue in these two papers essentially that economic freedom, including the rule of law, easy regulations, low taxes, limited government and interference in the economy, that these things are good, not just for more reasons, but because they allow entrepreneurial experimentation with combining productive factors to take place in a low transaction cost manner. So this micro-mechanism that I have sketched from institutions to experimental processes of combining heterogeneous capital assets on the level of firms up to economic growth are things that we try to talk about in an empirically informed manner in these two papers that are shown here.

53:30So again, the argument is that institutions of liberty increase the aggregate elasticity of substitution. They increase the overall flexibility of the economy, which translates into increasing total factor productivity and therefore growth. And we assess these ideas empirically again. So we build a panel data set of 25 countries from 1980 to 2005. And we test the influence of entrepreneurship and institutions on total factor productivity. And we find, lo and behold, that entrepreneurship very strongly, significantly, influence total factor and Productivity, and that some, not all, of the institutions of liberty, sound money, for example, as well as classical liberal economic policies more broadly, liberal economic policy regimes, promote growth and productivity across these countries.

54:36And I don't summarize these arguments to try to convince you, I'm not sure I can convince that many of you that this is the way we should do Austrian economics at all. This is about pretty conventional positivist hypothesis testing. We draw on a lot of pretty mainstream economics, but the point here is that there are certain key Austrian ideas that you can actually place in more of a mainstream economics argument. and perhaps this is one way to sell some key Austrian ideas to the mainstreamers. At least that's what we try to do in this paper, these two papers.

55:21Right, so to sum up here, what I've been doing, I have made a plea essentially for the continuing relevance of Austrian Capital Theory. Historically, Austrian capital theory has, of course, been a central research area in Austrian economics. And, substantively, it is an integral part of Austrian economics. It has, however, had a reputation of being, I think, a particularly difficult part of the Austrian corpus. And, perhaps for this reason, it could be argued that it is one of the least intensely researched areas in the Austrian revival of the last four decades.

56:09I think it's time to change that. The Austrian capital theory has the potential to make interesting advances. I think there's still a lot to do with respect to understanding the role of heterogeneous assets in entrepreneurial appraisement. There are many fertile links to related thinking in management theory and other parts of economics, as I've argued, such as, perhaps, empirical growth economics. So perhaps Austrian Capital Theory can serve a strategic purpose for Austrians, namely by extending the theorizing into new areas while sort of keeping intact a central core of Austrianism. There's definitely room in the Austrian tent for applied research on anarchism and pirates.

57:00There's room for telling, instructing mainstream economists about how they should do economics. There's room for integrating Austrian economics and complexity theory, we call it Bryce, and other trendy topics. But the core of Austrian economics remains mundane topics such as capital theory. Theory. And I'll stop here. Thank you.