Interest Rates and “Roundaboutness”: A Response to Hulsmann

JW Rich
12 min readMay 26, 2023

In his paper, “The Structure of Production Reconsidered”, Dr. Guido Hulsmann challenges the Austrian School orthodoxy on the question of capital theory and roundaboutness. The majority of Austrians since Eugen von Bohm-Bawerk have held that as interest rates decrease, and higher levels of investment are thereby induced, the economy as a whole becomes more “roundabout” — indicating that more time is elapsing between the start of a production process and its conclusion. Hulsmann, however, claims that the Austrian majority have it all wrong. Furthermore, they have it precisely backwards: lower interest rates correlate not to a more roundabout economy, but a less roundabout economy.

The way in which he demonstrates this is by making an important change to the traditional Hayekian triangle model of production — a change that completely flips the usual time-based capital relationship. In order to appreciate the significance of this change — and evaluate whether his novel view of capital is correct — we need to first review the traditional Austrian/Hayekian view of the economy.

The single most popular macroeconomic model in the Austrian School is unquestionably the famous Hayekian triangle:

This triangle depicts the structure of production in an economy. The base of the triangle represents the passage of time throughout production. As we move along the base from left to right, more time passes until it reaches the side of the triangle, when it is sold to the consumer. The side of the triangle represents the totality of consumer spending on finished goods at the end of the structure of production. The hypotenuse of the triangle represents the value of those goods, increasing as they move through the structure of production until they are eventually sold as finished goods.

This production structure does not remain constant, however. It changes along with changes in the interest rate. The interest rate is fundamentally a reflection of society’s time preferences — of how long they are willing to wait to enjoy consumption of goods. If society at large is more willing to wait to consume, they will increase their savings. This increased pool of savings will result in a lower interest rate. Entrepreneurs will be attracted by these lower interest rates to invest in long-term capital goods, the profitability of which is highly dependent on the interest rate. This increased investment results in a lengthier structure of production, which is represented in a longer base of the triangle:

While the decrease in consumer spending means less consumption in the short run, the increase in investment results in an increase in real productivity over time, which yields more consumption in the long-run. As this process of decreased interest rates and increased investment continues, living standards continue to rise and total wealth increases through continuous capital accumulation.

(As a quick aside, even though some Austrians take issue with the model of the Hayekian Triangle, such as Walter Block and William Barnett, Hulsmann’s critique is applicable even without the Hayekian Triangle. It’s inclusion is largely to provide a visual representation of Hulsmann’s main arguments.)

Thus goes the usual Austrian story, but Hulsmann begs to differ. In “The Production of Structure Revisited”, Hulsmann proposes an alternative to the traditional Hayekian triangle:

In Hulsmann’s model, the triangle abruptly cuts off before it intercepts the X-axis. While this looks bizarre, it is actually a more accurate representation of an economy’s capital production structure than its Hayekian counterpart. This is because the endpoint of the “triangle” represents the first funds paid out to the original factors of production — land and labor — at the very start of the economy’s production processes. However, if this point is intercepting the base of the triangle, that would imply that at the start of the production process, these factors are receiving no payment at all! Consequently, our Hayekian Triangle should instead be transformed into a much less elegant, but more accurate, capital trapezoid.

But once we adopt this new model, we are left with a peculiar result: the traditional Austrian “roundaboutness” relationship reverses itself. A change to a higher interest rate (as shown by a steeper upper slope) now results in a more roundabout capital structure — i.e. more stages of production going farther back in time! When we shift the model to a lower rate of interest, we see fewer stages of production! Hulsmann’s graphical illustration of these shifts, as well as his mathematical demonstration of this phenomenon are shown below:

In other words, what Hulsmann demonstrates is that for a given amount of Aggregate Spending, Consumption, and Saving in an economy, a lower interest rate actually results in fewer stages of production and a higher interest rate results in more stages of production.

The conclusion that Hulsmann draws from this discovery is that “This fact contradicts the core tenet of the time-preference theory of interest”. Hulsmann is absolutely correct. If his findings are true, then the Time Preference Theory of Interest, at least as it has been understood by Austrians and applied to capital theory, is simply no longer tenable. What Hulsmann seems to have accomplished here, just by shifting the Hayekian Triangle, undoes over a century of work from Austrian thinkers in the field of capital theory.

However, Hulsmann’s findings are not quite what they seem. The strict facts of what he has demonstrated are true, but they do not invalidate the nucleus of Austrian Capital Theory as he claims. They instead merely force a refinement from those in the camp of the Pure Time Preference Theory of how we should conceive of changes in the interest rate within the structure of production.

Before we can work towards incorporating Hulsmann’s insights, it would behoove us to first clearly explain and dissect how he arrives at his inverted roundaboutness relationship. The first crucial assumption is that within the model the three variables of Aggregate Spending, Consumption, and Saving are all assumed as fixed (these numbers do vary slightly in the calculations, as shown in the table above, but these small variations are just the result of rounding that can be ignored). As shown in the table of calculations above, each one of the production structures starts off with the same payment of 158, which corresponds to the fixed consumption on final goods of 158. From there, the payments decrease as we go farther back into the production structure into less valued intermediate goods. However, the important factor is how quickly these payments decrease in size. Whenever the rate of interest is high, then the payments decrease in size very quickly. When the rate of interest is low, they decrease very slowly. This can also be seen on the graphical representation of the multiple interest rates above, where the slope of the higher interest rates are much steeper than the lower interest rates.

The rate of decline in the payments for each stage of production is all-important, as the size of those payments will effectively determine how many stages the production structure will be able to sustain. For example, if we look above at Hulsmann’s calculations, we can use that given a consumption of 158 and a savings of 453, we get the following structures with interest rates of 14.5% and 30.5%, respectively:

Structure at 14.5% interest rate: 158–137- 120–105–91

Structure at 30.5% interest rate: 158–121–92–71–54–41 -31–24–18

The lower interest rate can only maintain a production structure of five stages, while the higher interest rate can maintain nine stages. This is only possible because the factor payments drop off precipitously in the higher interest rate structure as compared to the lower interest rate structure. The second payment amounts to 137 in the lower interest rate structure, compared to only 121 under higher interest rates — a difference of 16. The third payment is even more pronounced: 120 versus 92 — a difference of 28.

In other words, the reason that the higher interest rate production structure can maintain more stages is because they are paying those stages less than the lower rate structures are. The result is that the same amount of money spent goes farther, resulting in more stages. I find that a crude, but helpful analogy for conceptualizing this mechanism is by thinking in terms of jam and toast. If we are spreading a certain amount of jam over the surface of a piece of toast, how much of the toast we will be able to cover is dependent on the thickness of the jam. If we start out with a thick layer, but thin the jam out as we move across the toast, then we will be able to cover much more of the surface than if we kept the jam layer relatively thick. The same “spreading” dynamic applies to capital and production structures. If we have a high interest rate (progressively thinner spread), then we will be able to extend the funds (jam) out farther than if we have a lower interest rate (consistently thicker spread of jam).

Jam and toast notwithstanding, we are now left with a question: can the Pure Time Preference Theory make sense of these results? While it is unexpected to see the stages of production increase with higher interest rates, this is a result that corresponds to a time preference theory viewpoint. The reason why there are more stages is because the payments attributed to these stages are smaller. The reason these payments are smaller, however, is because these intermediate goods that still require time before they are completed are viewed as less valuable. This aligns with the reason why these payments are smaller in the first place: high interest rates, which are themselves a result of increased time preferences and a reduced willingness of individuals to put off consumption in the future. The result of this increased preference for the present over the future is that future goods — or present intermediate goods — are less valuable. The farther away they are from the present and the deeper they are in the production structure, the less valuable they are.

This general insight is present in other mainline Austrian works as well. It was first perceived by Hayek in “Prices and Production” and later expounded upon by Rothbard in “Man, Economy, and State” . However, it was applied in terms of changes in factor prices with changes in the interest rate. Below is a graphical illustration of the response of factor prices to a lowering of the interest rate from “Man, Economy, and State”:

But if time preference theorists can explain Hulsmann’s discovered inversion of the roundaboutness relationship, how does this fit into the larger time preference understanding of capital and interest? Superficially, this doesn’t seem as if it is possible. After all, the entire reason why Hulsmann’s discovery is so problematic for time preference theorists is that it flips accepted Austrian capital theory on its head. An explanation of Hulsmann’s findings is possible, but in order to demonstrate it, we have to examine more closely the assumptions inherent in his capital model.

In the traditional Hayekian model of the capital structure, the interest rate decreases because the time preferences for society as a whole has lowered. This results in an increase in savings, and a subsequent decrease in consumption. This interest rate dynamic is very different from that used by Hulsmann. In Hulsmann’s model, consumption and savings remain static. The only variable that experiences any change is the interest rate. One could of course imagine any interest rate existing alongside any amount of savings and consumption. However, changing only the interest rate does not capture the same dynamic present in the traditional Hayekian model. In Hulsmann’s examples, we are simply choosing the interest rate we want to input into the model, holding all else equal. This does not accurately reflect the actual mechanics of shifting interest rates, as a shift from a higher interest rate to a lower interest rate would be accompanied by an increase in savings and a decrease in consumption, which is not reflected in the “shifts” in Hulsmann’s model (In “The Structure of Production Reconsidered”, Hulsmann does detail several examples of how there could be a decrease in time preferences which does not substantial alter the interest rate, as the supply of present goods increases in concert with a decrease in the demand for present goods. As interesting as these examples are, they can only be considered fringe cases, as if every change in time preferences “canceled” itself out, then time preferences would cease to be functionally affect the economy in any form)

Despite its flaws, the Hayekian triangle very clearly illustrates the nature of roundaboutness. An increase in roundaboutness requires one to voluntarily undergo more time-consuming production processes for the sake of a higher total output in the end. Doing so effectively means a decrease in consumption along with an increase in the time spent in production. This is represented graphically by a decrease in the height of the triangle along with an increase in its base. This shift of resources and spending from the lower order goods to the higher order goods is the core aspect of a more roundabout production process. Hulsmann, however, effectively excludes this from happening in his model. Consumption is not allowed to decrease. The height of the triangle (or trapezoid, in Hulsmann’s case) remains static. Why should it be any surprise, then, that the usual rules of roundaboutness seem to no longer apply? Hulsmann’s assumption of constant consumption effectively prevents the economy from actually becoming more roundabout, as there is nowhere for the goods to be drawn down in order to push the production structure outward into time.

To help clarify the importance of this point, it would behoove us to return to the jam and toast analogy. In the traditional Hayekian framework, the way that we can spread more jam over a piece of toast is by both decreasing the thickness of our starting layer (lowered consumption) as well as decreasing the rate at which our jam layer thins out (the interest rate and decreasing payments to stages of production). Hulsmann assumes, however, that the thickness of the starting layer of jam is fixed. It shouldn’t be any surprise, then, that whenever he raises the rate at which his jam layer thins out that he is able to cover more of the toast (more roundabout production process). Clearly, it is this crucial assumption that is driving his conclusion. However, it is this assumption that also alienates his model of capital from the Hayekian model used by the majority of Austrians.

Consequently, Hulsmann’s conclusions are not the earth-shattering revelations that he presents them to be. They are fascinating results in their own right, as he was the first to point out that the roundaboutness relationship can be reversed. However, the grounds for this reversal (the assumption of fixed consumption and saving) do not undermine the explanatory power of the Pure Time Preference Theory of Interest. As has been shown, the Hayekian/Time Preference Model of capital can explain and integrate Hulsmann’s results without any problems or contradictions.

Again, I do not believe Hulsmann’s findings are worthless or of no material significance. What his paper does is help further our understanding of capital mechanics and the relationship of the interest rate to the structure of production. What it does not do, however, is overturn our understanding of these topics — especially in the case of representing the capital structure with a trapezoid instead of a triangle.

That “The Structure of Production Reconsidered” was written by Hulsmann should be no surprise. He has built something of a reputation of attacking Austrian School orthodoxy from an Austrian perspective. While I am not always in agreement with his conclusions (as I am sure has been made clear), I always appreciate the effort made. Placing ideas and concepts, even those accepted by the majority, under careful scrutiny and consideration should never be considered verboten by anyone. Questioning an idea often leads to a greater appreciation of that idea, and a further understanding of its place within a broader intellectual corpus. The ideas of the time preference theory of interest and the capital structure are no different. While Hulsmann’s attacks on the traditional Austrian views of interest and capital do not hit the mark, they do allow for us to have a greater appreciation of the nature of these ideas and how their relevance continues even today.