Classical economists such as Adam Smith, David Ricardo, John Stuart Mill and Karl Marx introduced the concepts of time and capital to economics. They developed the labor theory of value, thereby assuming that the historical process of accumulated labor would determine the value of capital goods. By the end of the nineteenth century, a number of economists had started to question this approach to capital theory. Carl Menger proposed a completely different theory, focusing instead on the role of expectations. He used this new theory as an argument against the labor theory of value; the subjective preferences of consumers rather than labor inputs were for Menger the ultimate source of economic value, including the value of capital. According to Menger, historical circumstances have made goods available in the present, and these circumstances mostly reflect producers’ expectations of future profits. Subsequently, Eugen von Böhm-Bawerk and Knut Wicksell formulated dynamic models that showed that the expected future flow of returns would determine the value of capital. They linked this to an optimality condition that required the expected growth rate of the capital value to equal the interest rate on loanable funds. In this chapter, we show that markets for works of art offer an especially lucid illustration of the importance of expectations and the irrelevance of labor inputs. Frank Knight was the first economist to analyze the structural uncertainty of long-term expectations, while Irving Fisher showed that the credit market is essential for investors in real capital. Fisher suggested the possibility of using a two-stage decision process. In the first stage, the investor would aim to maximize the expected value of a project. The second stage would make the investor aim at an optimal solution by becoming a borrower in the credit market. Wicksell and later John Maynard Keynes modeled the dual problem of an equilibrium interest rate and another interest rate that arises within the banking system as a cause of inflation or unemployment. Only much later was this to become the main concern of central banks.
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