capital: G. R. Steele on “The Pure Theory of Capital”


Hayek represents Keynes’s idea – that new investment is profitable only when there is an increase in consumers’ demand – as ‘part of the same widespread fallacy to which the businessman is especially prone’ (Hayek, 1978, p. 213). The error lies in applying what holds for a single industry, to industry as a whole:

“[w]hile, of course, the relative magnitude of the demand for equipment of a particular industry will depend upon the demand for the product of that industry, it is certainly not true to say that the demand for capital goods in general is directly determined by the magnitude of the demand for consumers’ goods” (Hayek, 1935, p.143).

Any dependency of investment upon consumption applies only to existing techniques; it cannot be relevant to ‘investment which can increase productivity per head of worker by equipping a given labour force with more capital equipment’ (Hayek, 1978, p. 213). That first possibility might relate, for example, to investing in a second shop (with an assistant) to meet an increased demand for sweets; and the second possibility might relate to investment in automatic sweet dispensers. The latter would be ‘encouraged by low product (consumer good) prices (which makes it necessary to save on labour costs) and discouraged by high ones’ (Hayek, 1978, p. 213). Indeed, by Hayek’s formal analysis, a general rise in consumption goods’ prices enhances the relative profitability of less roundabout processes; and vice versa.

Hayek’s economic theory is predicated upon the assumption of full employment, which he defends as relevant even to an economy in recession:

“[a]n analysis on the assumption of full employment, even if the assumption is only partially valid, at least helps us to understand the functioning of the price mechanism, the significance of the relations between different prices and of the factors which lead to changes in these relations. But the assumption that all goods and factors are available in excess makes the whole price system redundant, undermined and unintelligible” (Hayek, 1972, p. 103).

Where resources are fully employed, there is an obvious trade-off between the provision of goods for current consumption and the provision of goods for future consumption. Advance through economic growth can be achieved only by present sacrifice. Any attempt to force growth by monetary expansion has immediate inflationary implications that cannot be ignored. Yet, according to Keynes’s General Theory, this difficulty is absent in the presence of widespread unemployment among productive factors.

Keynes argues that, with high unemployment, a bond-financed credit-led investment boom could achieve quantity adjustments (that is, higher levels of output) without the consequences that derive from forced saving. This is not to say that consumption goods prices would not be affected. Indeed, more highly priced consumption goods were expected to reflect diminishing returns to labour and higher unit costs. Involuntarily unemployed labour would acquiesce in the real wage reductions that this implies, and so there would be no inflationary impetus. However, the case was made by default, because Keynes failed to show the processes of adjustment. Investment instantaneously raises aggregate real income and the instantaneous multiplier provides the exact amount of new saving to finance the original investment. However, in admitting the practical limitations of this instantaneous multiplier, Keynes discusses the extreme case, where new investment expenditure is a total surprise so that, in the first instance, no additional consumption goods are available to meet the increase in demand. Then, the efforts of those newly employed in the capital-goods industries to consume a proportion of their increased incomes will raise the prices of consumption-goods … causing a postponement of consumption (Keynes, 1936, p. 123).

Keynes saw the postponement of consumption (‘forced saving’) as temporary, lasting for the time necessary to allow consumption goods industries to increase their production. Consumption would then rise above its normal level – to compensate for the temporary postponement – before reverting back to that normal level. While recognising that these adjustments were relevant to the analysis of business cycles, Keynes maintains that they do not in any way affect the significance of the theory of the multiplier … nor render it inapplicable as an indicator of the total benefit to employment to be expected from an expansion in the capital-goods industries (Keynes, 1936, p. 124); and, as if haunted by this problem, he states that ‘[p]rice-instability arising in this way does not lead to the kind of profit stimulus which is liable to bring into existence excess capacity’ (Keynes, 1936, p. 288). Why not? For some unexplained reason, the unexpected abnormal profits would be universally recognised to be windfall gains accruing to those just fortunate enough to have products ‘at a relatively advanced stage of production’.

Keynes describes no route that avoids the consequences of forced saving. Furthermore, his ‘aggregations conceal the most fundamental mechanisms of change’ (Hayek, 1931, p. 277) and implicitly deny the importance of the composition of any idle resources that are readily available. Appropriate resources must be immediately to hand in the form of factors of production, in the form of work in progress at every stage of completion and in the form of consumption goods. Only then might there be no bottlenecks, nor shortfalls in levels of production to meet new demands from formerly unemployed workers. Yet, the message of Keynes’s General Theory is that higher levels of investment might be financed by monetary expansion; that is, without inflation and without any significant shortfall in the provision of consumption goods.

Such events are only made possible by the unrealistic assumption of elastic and appropriate supplies of factor inputs and intermediate products. That such propositions were countenanced reflects upon the limited objectives of Keynes’s General Theory. Investment appraisal, periods of gestation, cash flow, pay-back periods, and problems of finance are not pertinent to the problem of raising aggregate expenditure to a level that generates full employment. That narrow focus has led and continues to lead economic policy to be targeted upon full employment, with little consideration of the consequences for the composition of production or the implications for cyclical activity or economic growth.

from G. R. Steele, “Hayek’s Pure Theory of Capital” (pdf) forthcoming in Gerald O’Driscoll, Jr. (ed) The Elgar Companion to Hayekian Economics.

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