Euro. J.

History of Economic Thought 13:2 233 – 258 June 2006

Hayek and the General Theory*

Nicolò De Vecchi

1. Introduction
As is known, Hayek wrote a review of Keynes’s A Treatise on Money in 1931
and embarked on a debate with Keynes and Sraffa on the relationship
between saving and investment, the definition of the natural rate of
interest, the determinants of the money rate of interest and its relationship
with the level of real investment and output.1 On the contrary, he did not
review the General Theory. At different times he offered three reasons for his
decision: Keynes’s inconstancy in regard to theory; his own tiredness of
controversy; his disagreement with Keynes’s use of aggregates.2
There were no further direct clashes between the two economists after
the debate of 1931/32, which had amply demonstrated how irreconcilable
their theories were.3 This does not mean that Hayek did not take into
consideration the General Theory, just as Keynes bore Hayek’s thesis in mind
while he was preparing his last book. The interest each had for the other’s
work remained and their contrasting approaches endured.
This paper will focus on the development of Hayek’s reflections on the
General Theory. Hayek spent as much time on the General Theory as he had
on the Treatise. He ‘immediately’ started reading Keynes’s book, when he
received a copy from Keynes, and in a letter to Keynes he declared that
he was ‘puzzled’ by two issues: the treatment of the saving – investment
relationship and the liquidity preference theory. He even suggested that
he might prepare ‘some notes’ for the Economic Journal, if his doubts in
this regard remained after a more systematic reading of the work (Keynes
1979: 207 – 8). As already mentioned, he did not follow that up at the
time, but nonetheless he did not drop those two issues and he took the
opportunity to clarify the reasons for his disagreement later, while he was

Address for correspondence

Università di Pavia, Dipartimento di Economia Politica e Metodi Quantitative, Via,
S. Felice, 5, 27100 Pavia, Italia; e-mail: ndevecchi@eco.unipv.it
The European Journal of the History of Economic Thought
ISSN 0967-2567 print/ISSN 1469-5936 online Ó 2006 Taylor & Francis
http://www.tandf.co.uk/journals
DOI: 10.1080/09672560600708284
Nicolò De Vecchi

drafting some of his major works. An examination of Profits, Interest and

Investment (1939) and part IV (chap. XXV – XXVIII) of The Pure Theory of
Capital (1941) provides evidence that the contrast between Hayek and
Keynes continued to be keen, albeit latent and without public
confrontations comparable with that of 1931/32. In Profits, Interest and
Investment and in chapter XXV of The Pure Theory of Capital Hayek criticized
Keynes’s thesis on the positive effects of an increase in consumption on
investment and employment, again putting forward the opposite theory, in
which he also considered situations of underemployment. In chapters
XXVI – XXVIII of The Pure Theory of Capital he criticized the liquidity-
preference theory of the rate of interest4 and responded to Keynes’s
conclusions on the role played by the (money) rate of interest in
determining investment, output and employment. The ultimate aim of his
criticism was to reinforce the idea that low money rate of interest policies
and, more generally, the attempts to regulate the market destabilize the
economic system.
The two issues are dealt with in the following sections. Section 2 considers
the relationship between consumption, investment and employment. It
shows that, after the General Theory, Hayek used new arguments to his
contention that this relationship is inverse, and not direct, and that
he demonstrated that only exceptionally does greater consumption
favour investment: this happens immediately after a depression, when
unemployment and abundant unused reserves of all kinds of resources
exist. Section 4 shows how Hayek interpreted Keynes’s liquidity preference
theory, modified its meaning in order to adjust it to his own monetary
theory and rejected Keynes’s idea that the rate of interest is directly
dependent ‘solely’ on liquidity preference. He maintained that Keynes’s
theory only holds in an ‘extreme case’, whereas normally it is the investment
demand schedule, i.e. the rates of profit, which directly influence and
rule the money rate of interest. In sections 3 and 5 arguments that can
be inferred from Keynes’s theory are used to challenge both Hayek’s
criticisms.

2. Hayek’s first criticism of the General Theory: the relationship between

consumption, investment and employment
The pivot of Hayek’s theory of the trade cycle is that the money economies
with indirect production processes are subject to the risk of ‘capital
consumption’. In his early writings Hayek shows that in an economic system
with fully used resources and with investment fully financed by saving, any
factor ‘which may at any time increase the profitability of any group of

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enterprise’ is the possible original disturbance eliciting a cyclical fluctua-

tion (Hayek 1929: 182 – 3), but ‘the ‘‘necessary and sufficient’’ condition’
for that to happen is the presence of an ‘elastic’ money, which allows the
‘loosening’ of the link between saving and investment, identified by the
pure economic theory.5 The initial ‘change of data’ may be anything
(Hayek 1929: 168), but it engenders a crisis ‘only through the increase in
the means of credit which [it] inaugurates’ (Hayek 1929: 168). The elastic
currency enables rises in investment independently of voluntary saving and
changes in the proportion of expenditure on capital goods to the
expenditure on consumer goods. Production of new capital goods
increases, as does the income paid to the factors of production. This
allows an increase in the demand for consumer goods, resulting in an
increase in the relative price of the latter with regard to capital goods.
Income recipients are ‘forced’ to save, that is, they are induced to save by
the process artificially enabled by monetary factors. If no additional credit is
forthcoming, the proportion of money that entrepreneurs are able to
spend on capital goods must fall. Entrepreneurs are compelled not only to
stop adding to the existing capital, but also to abandon the completion of
the processes that produce capital goods, with the consequent waste of the
latter and the transformation of capital in income, i.e. consumption of
capital (Hayek 1932a, 1995: 195 – 6, 214 – 17). In Prices and Production Hayek
considers exogenous changes in the money supply as a possible original
impulse to the trade cycle6. In any case, whatever the original change of
data, always in the course of the process the fall in investment and
employment is connected with the increase in the demand for consumer
goods.
After the 1931/32 debate Hayek recognized the validity of some of
Keynes’s criticisms. He acknowledged that many concepts on which his
theory of the inverse relationship between consumption and investment is
founded – maintenance of capital, net income, net saving and net
investment – are not devoid of ambiguity.7 He therefore re-formulated his
theory and strengthened his thesis of the inverse relationship between
consumption and investment, by deepening the mechanism of the ‘Ricardo
Effect’,8 and devoting attention to the analysis of the disturbances
engendered by changes in the demand for consumer good in conditions
of full employment and in a context of entrepreneurial expectations that
may be disappointed. Moreover, he enriched his theory of the trade cycle
with an analysis of the revival phase during which workers are not fully
employed. The two questions are considered separately later. It is argued
that with these novelties Hayek set out to reinforce his opposition to
Keynes’s theory. Already in the Treatise Keynes had denied the existence of
an inverse relationship between consumption and investment. In the

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General Theory he had demonstrated that a decrease (increase) in

consumption modifies entrepreneurs’ expectations in such a way as to
trigger a decrease (increase) in investment and employment. In his view,
rises (falls) of demand for consumer goods may bring an economic system
in under-employment equilibrium closer to (further away from) full
employment. Hayek challenges these assertions on the following grounds:

1. In equilibrium, i.e. in absence of unused resources and unemployment,

a rise in the demand for consumers’ goods, which makes entre-
preneurs’ expectations false, not only reduces investment and employ-
ment, but it is more harmful to the economic system than a decrease
in the demand for consumers’ goods.
2. In the course of the recovery from a depression with very high
unemployment of material resources and labour, demand for
consumers’ goods may increase, triggering rises in investment and
employment. If so, what Keynes asserts in the General Theory holds, but
sooner or later the inverse relationship between consumption and
investment is confirmed, with the result that unemployment rises.

2.1. Chapter XXV of The Pure Theory of Capital is devoted to the first question9
It shows that capital consumption may be brought about not only by factors
that change the profitability of investment in a context of elastic money, but
also by changes in consumers’ decisions about the combination between
present income and ‘sources of future income’, or between consumption
and saving.10
Changes in the ‘willingness of people to save a certain proportion of a
given income’ do not make entrepreneurs’ expectations false, because they
are not likely to be ‘abrupt’ and ‘unexpected’. Quite different are the
consequences of changes in the ‘ability to save of certain classes of people’,
due to significant changes in the distribution of wealth and income (Hayek
1941: 343 italics added). There are two circumstances that can lead to
extensive redistributions: an ‘action of the Government’, that intervenes
with property levies and estate duties, or an ‘action of monopolistic groups’ –
first and foremost the combinations of labour – that trigger a ‘compulsory
transfer of income from capitalist to other classes’. Hayek emphasizes that in
both cases the interventions are imposed on the market (1941: 346 – 7).
They cause a fall in saving by the capitalist class, so that saving is lower than
investment. The immediate effects are similar to those caused by changes in
the profitability of investment in a context of elastic money. Hayek sets his
analysis in terms of the Ricardo Effect. After the redistribution of wealth the
relative prices of consumer goods rise and shorter production processes

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become more profitable. Some of the resources employed in the more

roundabout processes of production are shifted to the shorter processes, but
others will remain unused, because they can be used only in the longer
processes and only in cooperation with those that get shifted. This gives rise
to waste of resources and unemployment.
Hayek draws a political and an analytical conclusion from this analysis.
The former is that ‘once capital is definitely and irrevocably committed to a
certain purpose, any of the cooperating factors are capable, through
monopolistic combination, of forcing the capitalists to pass on to them part
of the gross returns which ought to be re-invested but which, if paid out as
income to non-capitalists, will be mostly consumed’. The analytical
conclusion is that the anti-Keynesian thesis that a rise in consumption will
inevitably lead to a fall in investment and in employment is confirmed
(Hayek 1941: 345 – 7).
The analysis of the opposite situation, in which saving exceeds
investment, reinforces this criticism of Keynes’s theory. The case of a
decreasing consumption is not symmetric to the one previously discussed
and it is ‘less likely to occur’ and ‘less apt to create serious difficulties’. As a
consequence of the decrease in consumption, the receipts that may be
expected from the sale of consumer goods will be reduced and the rate of
profit will fall in the sectors where these goods are produced. Changes in
the technique of production from shorter to longer processes of
production become profitable. These shifts can be introduced relatively
easily, because in general the resources used in shorter processes are less
specific than those employed in longer processes.11 It follows that the
equilibrium can be re-established without incurring in capital consumption
and unemployment phenomena as serious as those arising in the previous
case (Hayek 1941, 344 – 5).
This analysis is directed against the under-consumption theories, among
which Hayek classifies Keynes’s one (Hayek 1932: 157 note 4). If an
economy is in equilibrium (with full employment), the effects on
employment of the decrease of consumer goods demand are much less
serious than those produced by an increase, since the producers are able to
react better through changes in production techniques.

2.2. Under-employment situations

Profits, Interest and Investment contains the supplement to the trade cycle
theory expounded by Hayek in previous years. Hayek considers under-
employment situations. To those who criticized him because in Prices and
Production he did not take into account the existence of unused resources
and of unemployment, he replies that he considers it logically correct to

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start from a position of equilibrium in order to show how from such an

initial position cyclical fluctuations may be generated. Now he sets out to
supplement that analysis with an account of ‘how such cyclical fluctuations
once started, tend to become self-generating’. Hence, he deals with the cyclical
phases, focusing in particular on the recovery from a depression with very
high unemployment of material resources and labour.12 He shows that
recovery is characterized by an increase in the demand for consumer
goods, which causes a rise in investment and employment. So far he
accepts Keynes’s view. However, this phenomenon affects only some
industries, has a limited duration and is eliminated by subsequent changes
in the production processes, which confirm the inverse relationship
between consumption and investment with an increase in the unemploy-
ment rate.
Hayek starts by considering an economy in deep depression, with
exceptionally low profit rates and consumer goods prices (Hayek 1939:
38). He assumes limited labour mobility between industries, high
specificity of existing equipment to a particular method of production,
stickiness of money wages and constancy of the money rate of interest
(Hayek 1939: 5). Due to the low prices and the stickiness of money wages,
real wages are comparatively high and this induces entrepreneurs to
invest in highly labour-saving machinery. The artificially low money rate
of interest provides cheap financing. The increase in investment leads to
an increase in incomes and in consumer demand. Investment will
continue to take roundabout forms, employment will grow rapidly in
the investment goods industries and final demand will increase further
(Hayek 1939: 38 – 41).
Insofar as this increase of consumers’ goods demand is matched by
supply growing at the same pace, consumer goods prices do not rise, the
real wage does not fall and the more capitalistic types of investment remain
profitable. The supply of consumer goods will be less likely to keep pace
with demand the more capitalistic is the type of investment undertaken
(Hayek 1939: 48 – 9). It follows that the process of expansion considered up
to this point, during which consumption, investment and employment all
move in the same direction, cannot go on. The prices of consumer goods
will start rising, with a resulting reduction of the real wage and an increase
of the profit rate. If the money rate of interest remains constant, the
increase of profits in the consumer goods industries will stimulate
investment and employment further; but every further increase in
investment and employment will increase the discrepancy between demand
and supply of consumer goods. Profits in consumer goods industries
will increase too, and so on in a cumulative process (Hayek 1939: 55 – 7),
until the profit rate growth and the real wage reduction will lead to the

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use of more labour with the existing machinery and the installing of new
machinery of a less labour-saving type.
The introduction of less capitalistic methods of production cannot occur
indifferently in all industries, however. In fact, following the increase in
demand for consumer goods, the expected yield of investment goods will
increase, but not for all types of investment goods. It is obvious, notes
Hayek, that it will increase in the investment goods-producing industries
‘which without any further collaboration from labour will directly serve
consumption’. But it is not automatic that such an increase will take place
the more an industry produces machinery to make machinery and so forth
(Hayek 1939: 22). Ultimately ‘a fall in real wages will raise the value of the
less labour-saving machinery more than that of more labour-saving
machinery, and stimulate the production of the former at the expense of
the latter’. Those industries, the demand for whose products increases, will
successively reach full employment, the prices of their product will rise as
well as profits rise. They will change to less capitalistic methods of
production. The demand for products of the industries with more labour-
saving machinery will progressively decrease and a fall in total employment
will occur. In fact, the industries, witnessing a drop in the demand for their
goods, reduce production and generate unemployment, which cannot be
absorbed by the industries in which demand rises. These will look for new
workers but they will not find them, since labour is highly specific and its
mobility very limited; in this way employment cannot increase in these
industries, at least in the short run (Hayek 1939: 20 – 6). In the meantime,
unemployment in industries with more labour-saving machinery produces a
fall in incomes and in the demand for consumer goods; as a consequence,
also the capital goods-producing industries, which have less labour-saving
machinery and are closer to directly serving consumption, will reduce their
production and employment. Unemployment grows in the system, albeit
with smaller and smaller increments. Sooner or later ‘a new position of
temporary quasi-equilibrium would be reached in which, with a very low
general level of employment, the demand for consumer goods will once
again have become equal to current output, and output and production
will cease to shrink further’.13
Summing up, the original increase in the demand for consumer goods
certainly induces an increase in investment and employment within a
certain time interval and for some industries producing investment goods.
The final result, however, is consumption of capital and general
unemployment, contrary to what the General Theory states. In other words,
Hayek’s conclusion on the effects of an increase of demand for consumer
goods holds regardless of whether or not resources and labour are fully
employed. What matters in his reasoning is that any change in demand

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affects relative prices because it takes time to produce goods in the

required quantities. He notes that relative price changes induced by
variations of the demand for consumer goods seem to have no place in the
General Theory.14
Hayek emphasizes that his analysis re-proposes the ‘fundamental truth’
of two ‘classical maxims’ stated by JS Mill and denied by Keynes in the
General Theory: namely, ‘that a scarcity of capital means a scarcity of
consumer goods and that demand of commodities (¼ consumer goods) is
not demand for labour’ (Hayek 1939: 33). He adds that low money interest
rate policies – or, more generally, any intervention aimed at stimulating
consumer good demand – ‘must appear as the arch-enemy of stability,
causing in the end much greater fluctuations, probably even of the rate of
interest, than are really necessary’ (Hayek 1939: 70).

3. An assessment of Hayek’s arguments in the light of the General Theory

The analysis of the cycle set out in Profits, Interest and Investment and in
chapter XXV of The Pure Theory of Capital is based on the cornerstone
principle of the whole Hayekian theory: ‘ultimately [ . . . ] it is the rate of
saving which sets the limits of the amount of investment that can be
successfully carried through’ (Hayek 1941: 393 italics added). Any
interference in the dependence relationship of investment on saving
generates first a disequilibrium between the monetary incomes that are
destined for the purchase of consumer goods and the supply of consumer
goods that is compatible with the given resources and the given production
technique, and then a change of the methods of production with waste of
material and human resources. ‘This phenomenon of a scarcity of capital
making it impossible to use the existing capital equipment appears to me
the central point of the true explanation of crises [ . . . ] That the cause of
this should be not an insufficient but an excessive demand for consumer
goods is apparently more than a theoretically untrained mind is really
persuaded to accept’ (Hayek 1935b: 149).
Among the bad persuaders of the theoretically untrained minds who
support the opposite thesis Hayek includes Keynes. He may have consi-
dered Keynes himself as among the theoretically untrained minds.15
Keynes subverts the relationship between consumption and investment.
In the Treatise on Money he shows that the act of individual saving can-
not produce either an increase of aggregate saving, nor still less an
increase in aggregate investment. The direct effect of saving is a reduction
of consumption demand and, hence, a reduction of the income of others
down to a level at which their saving declines by an equal amount,

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without an increase in aggregate saving and with a decrease in aggregate

income. The individual act of saving enriches the individual responsible for
it, but not the community as a whole, whose saving is unchanged (Keynes
1930: 134 – 58, 1979: 106). Having cleared the way from the dependence of
investment on saving (Keynes 1930: 127 – 31, 143 – 5, 154 – 8), in the General
Theory Keynes introduces the theory of entrepreneurial expectations in
order to point out the causes of investment variations, and the multiplier
theory to show the dependence of saving on investment. As a consequence,
also the traditional opposition between consumption and investment is
thwarted. A reduction in the demand of consumer goods will certainly
induce negative effects on investment, because it reduces aggregate income
and worsens entrepreneurial expectations, whether the economy is in full
employment equilibrium, or underemployment equilibrium. The contrary
holds for an increasing demand of consumer goods, bar the case of full
employment equilibrium.
Only one of the conclusions on the relationship between consumption
and investment drawn in Profits, Interest and Investment and in chapter XXV
of The Pure Theory of Capital is shared by Keynes: that regarding the effects
caused by a demand for consumer goods exceeding the supply in full
employment equilibrium. Only in this case is the scarcity of resources
principle valid for both Keynes and Hayek. In all the other cases the
conclusions that Keynes reaches are at odds with those of Hayek, because
they are based on the theoretical premise that investment does not depend
directly on saving but on expected demand, on which the decisions of
higher consumption have a positive effect, and vice versa.
Hayek does not seem to grasp the fundamental role of expectations in
the General Theory, nor does he seem to be interested in the theory of
expectations that Keynes presents in chapters 5, 11 and 12. This is
surprising, especially in view of the fact that it was during these same years
that he elaborated in more depth his theory of knowledge. In any case he
avoids clashing with Keynes on this terrain.16 In order to show that Keynes’s
positive relation between consumption and investment is mistaken, he
relies on the fact that in the General Theory Keynes adopts an aggregate
analysis. As has been seen, Hayek acknowledges that an increase of
consumer goods demand stimulates investment during the recovery after a
deep depression, but accuses Keynes of not asking himself ‘how a change in
final demand affects the yield of the various types of investment goods’
(Hayek 1939: 13 note 1 italics added). For Hayek production does not
increase indiscriminately in all sectors, thereby giving rise to a generalized
process of wastage of material resources and labour.
Keynes reads the 1939 essay with great attention and starts a
correspondence with Hayek17 that closely resembles the one of 1931/32.

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The tones are equally mild on both sides. Questions and answers are
formulated with equal analytical precision. Comprehension difficulties are
identical.18 Most of Keynes’s questions concern clarifications, which Hayek
duly provides.19 Keynes also suggests, as very often happens when he deals
with theories by other economists, that all assumptions be set out in order
to allow the reader to verify their content and their consistency.20 Keynes’s
most important question is whether Hayek, when he considers the effects of
an increase of consumer goods demand, is dealing with ‘a momentary
maladjustment’ or with ‘a new long-period equilibrium’. Hayek replies
that in Profits, Interest and Investment he is not concerned with a question
of merely long-term equilibrium, but rather that he is thinking of the
short-term adjustments, which are typical of the analysis of cumulative
processes.21
The question and its reply suggest a criticism of Hayek’s theory moving
from a reasoning developed in the General Theory. In chapter 20 Keynes
stresses that he has proceeded in his analysis by taking into account the
effects on employment of variations in aggregate effective demand, whereas
it would be more correct to consider how demand is distributed among the
different industries, whose products have different employment elasticities.
By following a disaggregated analysis it would be possible to realize that
employment grows according to the way the increase of aggregate demand
is distributed among different industries, and that many factors contribute
to determine the result. Therefore, relative prices vary and profits of some
industries increase at the expense of others. It is from this very situation
that Hayek draws the thesis that less capitalistic processes are adopted in
the industries that find an increasing demand, with a disadvantage for the
industries with more labour-saving machinery, which witness a continuous
fall of demand. On the contrary, Keynes notes that prices and profits
instability that derives from an increase of aggregate demand ‘cannot affect
the actions of entrepreneurs, but merely directs a de facto windfall of wealth
into the laps of the lucky ones’ (Keynes 1936: 288). By adopting Keynes’s
view, an increase in the demand for consumer goods changes relative
prices, as Hayek stresses,22 but the process described by Hayek appears out
of proportion to the entity of its source. An increase in the demand for
consumer goods cannot induce entrepreneurs to such significant actions
as immediate and continuous changes in production methods.
In the trade cycle theory set out in Profits, Interest and Investment
entrepreneurs limit their actions to the choice among alternative produc-
tion methods and are continuously seeking more profitable methods of
production. Fundamentally, they act according to the movements of profit
rate and of real wage, i.e. given that the money wage is assumed rigid –
according to the variations of relative prices.23 Their reactions are

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mechanical (Maclachlan 1993: 150), particularly in the passage from

depression to recovery (Hayek 1939: 35 – 7), and they do not pay attention
to the general economic situation24 and to changes in income. Hayek
introduces expectations in his theory, but they do not take on a significant
role in the analysis of entrepreneurial behaviour, because he assumes that
the expected yields will as a rule move in the same direction as current
yields. He declares that he does not want to raise the problem ‘whether
that is the case or not’ (Hayek 1939: 12 note 1, 17). The assumption is
maintained in the course of the analysis and is very extreme, particularly in a
crisis situation, when uncertainty is high and entrepreneurs lack sufficient
elements to be able to infer future prices and demand. It is, therefore, highly
doubtful that they will take on the burden of starting the recovery by simply
hoping in a constant trend for their yields, and that they will be even
inclined to increase their capital endowments by choosing more capitalistic
processes when demand is very low and unemployment very high.

4. Hayek’s second critique of the General Theory: the rejection of the

liquidity preference theory of the rate of interest
Hayek distinguishes two stages of economic research, which are different in
content and method of analysis. The first – the pure theory – deals with the
‘ideal’ position of equilibrium. It considers only ratios between prices of
goods independently of monetary influences. It describes the conditions of
stability of the economic system that are determined ‘by the technical
structure of the material equipment in existence and by the tastes of the
people’. It determines the prices that are required ‘to enable people to go
on with the plans they have made’ (Hayek 1941: 32 – 6). The second – the
monetary theory – introduces the monetary phenomenon. It shows how
money alters the real ratios of exchange determined by pure theory. It
explains the instability phenomena and the trade cycles affecting actual
economies.
The Pure Theory of Capital deals with capital, as defined by the Austrian
School, and it is a contribution to pure theory. This means that it focuses on
‘that part of the subject which belongs to equilibrium analysis proper’
(Hayek 1941: 3 – 4). Among the assumptions that are at the root of the pure
theory, Hayek emphasizes that concerning agents’ knowledge. ‘The
entrepreneurs make definite and detailed plans for fairly long periods
[ . . . ] in the certain expectation that they will be able to adhere to all their
plans’, so that money works as mere counter. It is not necessary to hold
it with the aim of postponing the decision as to when to buy or to pay
for something (Hayek 1941: 29).

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The resolution to keep the research strictly within the limits of ‘pure’
theory and to keep the monetary problems that are connected with the
economic process ‘outside the compass’ of The Pure Theory of Capital (Hayek
1941: 4) is not fully maintained by Hayek. Part IV of the book deals with the
money rate of interest: a topic that belongs to the monetary theory and is
totally extraneous to the pure theory of capital. It is true that Hayek
presents his book as an ‘Introduction to the Dynamics of Capitalistic
Production’ and he adds that ‘it stops deliberately short of some of the most
important problems that fall within that wider context’ (Hayek 1941: 3).
Nevertheless, part IV remains an anomaly with regard to the previous text.
To justify it Hayek notes that, insofar as he was moving within equilibrium
analysis, he has used the term rate of interest to indicate ‘a ratio between
the prices of the factors of production and the expected prices of their
products, which stands in a certain relationship to the time interval
between the purchase of the factors and the sale of the product’ (Hayek
1941: 38, 353). Usually, though, ‘rate of interest’ indicates the rate at which
money can be borrowed. As a consequence, ‘it would hardly be appropriate
to leave our subject without giving a somewhat more definite indication of
how the rate of interest we have been discussing and the money rate of
interest are related’ (Hayek 1941: 353 – 4).
This justification for the insertion of problems related to the money rate
of interest in a treatise on the pure theory of capital is not very convincing.
There remains the suspicion that part IV is above all destined to show that
the liquidity preference theory presented by Keynes in the General Theory
must be rejected as a general theory of the interest rate. The exposition
strategy, the continuous mixture of positive analysis and of criticisms of
Keynes and the polemical character of the final result all suggest that this is
Hayek’s real, immediate goal. For Hayek it is undeniable that in a monetary
economy the quantity of money and the liquidity preference determine the
money rate of interest, as Keynes maintains. But these are not at all its sole
or even its main determinants. If anything, they are disturbance factors with
regard to the main determinants of the money rate of interest: the
profitability of investments and the willingness to save.
In the following sections, for the sake of clarity, Hayek’s theory on the
determinants of the money rate of interest will be outlined and then his
critiques of Keynes will be separately discussed.

4.1. Hayek’s theory on the determinants of the money rate of interest

In order to avoid terminological confusions, Hayek calls the rate of interest
in equilibrium analysis ‘rate of profit’, or ‘rate of return’ on investments,
and he designates the money rate of interest as ‘rate of interest’.

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The question is whether and to what extent in a monetary economy the

changes in the quantity of money and ‘the varying desires of people to hold
money’ affect the interest rate and prevent it from assuming the value,
which is determined by the profitability of investment and the willingness to
save. Hayek further limits the focus of the analysis and he assumes the
quantity of money as given, because he wants to deal with the relationship
between the quantity of money people hold and the rate of interest.
He first analyses a monetary economy in inter-temporal equilibrium. The
matching between money expenditure in one period and the amount of
money spent during the preceding period of equal length is continuous,
and people are absolutely certain about the future, so that they formulate
definite plans. There is no need to hold money, and the rate of interest
corresponds to the rate of profit determined by equilibrium analysis
(Hayek 1941: 355).
If a less rigid definition of equilibrium is adopted, and if it is assumed that
individuals’ plans are definite only up to a certain date and that only up to
that point they are mutually compatible, it turns out that individuals will
hold money stocks to face the more uncertain future for which they cannot
plan. This happens even more so outside equilibrium. Here, the
assumption of certainty about the future is excluded, and money is not
only used to transact current business, but it also takes on the function of
‘general reserve of command over resources’ (Hayek 1941: 357).
Hayek identifies at least two reasons why agents decide to hold
liquid stocks: they want ‘to take advantage of unforeseen opportunities’
(Hayek 1941: 358, 359) and they ‘intend to use money for particular
purposes some time later and cannot conveniently invest it in the meantime’
(Hayek 1941: 361). The first motive hinges on a totally uncertain future,
in the sense that it is not possible to make any forecast about it. The
second presumes that an individual might know of investment opportunities
that are far in the future and he keeps a liquid position until these
opportunities materialize. To denote the first motive Hayek adopts the term
‘liquidity preference’ from Keynes.
To establish to what extent liquidity preference, thus defined, contri-
butes to determining the rate of interest, Hayek stresses that, while the
expected returns of investments in goods and in money loans are more
or less well defined, the return from the holding of cash, ‘being by its
nature [ . . . ] an expectation of various uncertain possibilities, is less easily
measured’ (Hayek 1941: 358). Thus, Hayek deems it convenient to relate
the amount of cash balances a person is willing to hold ‘to the amount
of profit or interest which he could expect to earn if he invested that
money now in goods or loans, and which he consequently sacrifices
in order to keep himself in a position to take advantage of more

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uncertain possibilities’ (Hayek 1941: 358 – 9). This allows him to renounce
expressing liquidity as a function of the rate of interest, which can be
obtained by financing a current investment at a given time: given the
quantity of money, ‘the amounts of money people will be willing to
spend [ . . . ] out of their given cash holdings’ will increase as the interest
rate increases (Hayek 1941: 363). The relationship is direct: it looks like
a supply curve and indeed it is the supply curve of investible funds.25
Its slope represents people’s propensity to release money from idle
balances.26 Next to this, Hayek introduces an investment demand
schedule in real terms, i.e. a decreasing demand function, which indicates
the relationship between the scale of investment and the expected rate
of return at a given time. If the productivity of investment increases,
and with it the expected rate of return27 – e.g. as a consequence of an
innovation – the investment demand schedule is raised, so that the
intersection point between the two curves moves, which means that
the interest rate increases. The higher this increase is, the less people are
willing to release money from idle balances.28 Hayek concludes that, given
the quantity of money,

1. the rate of interest is primarily a function of investment demand;

2. the desire to hold money contributes to determine the rate of interest,
in the sense that it loosens the connection between the rate of interest
and the profitability of investment. The less people are willing to
reduce their desire to hold money, the more the rate of interest comes
close to the level that it would reach if its sole determinants were the
profitability of investment and the willingness to save;29
3. when the desire to hold money is perfectly elastic,30 and people are
willing to finance all changes in the amount of investment, variations of
investment demand do not affect the rate of interest.

Hayek points out that in the real world this last case is wholly exceptional. It
arises only if the rate of profit has already fallen so low ‘as only just to
compensate for the extra risk of lending or investing in real assets
compared with holding money’. Any increase in the rate of profit imme-
diately induces people to release money, and the rate of interest does not
change (Hayek 1941: 365 – 6).
Finally, Hayek shows that the release of money from idle balances and
the consequent increase in the size of the money stream, which meets the
stream of goods, does not only have the immediate effects just described.
In the long run it turns out to be destabilizing for the economic system.31
As previously seen, whether or not the resources are fully used, sooner or
later the increase of the money stream induces an increase in the prices of

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consumer goods, changes in the methods of production, fluctuations in

investment and employment, and, finally, consumption of capital.32 It can
be added here that the more the rate of interest is restrained in its rise by
monetary factors, the more ‘the adjustments made necessary by real
changes’ will be delayed33 and the more the economic system becomes
unstable.

4.2. Keynes’s interest rate and price theories

In his analysis Hayek criticizes both Keynes’s interest rate and price
theories.
As for the former theory, Hayek accuses Keynes of not taking into
account all the components of money demand. As well as the money that
people hold because they want ‘to take advantage of unforeseen oppor-
tunities’, or because they have decided to use them some time later and in
the meantime they cannot conveniently invest them, there is the money
that is necessary ‘to transact the business promising any given rate of
return’ (Hayek 1941: 361). This last component of money demand is
relevant to show that investment demand directly influences the rate of
interest. Keynes considers only the first component of the total demand
for money (Hayek 1941: 360), as if the other two were taken as constant
or were lumped together. In this way liquidity preference conceals
the influence of productivity on the rate of interest (Hayek 1941: 360 – 2,
368). In Hayek’s view, this conclusion brings about several negative
consequences.
First, Keynes’s theory turns out to be only compatible with the excep-
tional case in which the desire to hold money is perfectly elastic and the
supply of investible funds is horizontal. Moreover, Keynes considers only
the immediate consequences of a release of money from idle balances and
he has nothing to say about future effects.34 It is true – Hayek notes – that a
release of money from idle balance may keep the rate of interest (and the
marginal rate of profit) ‘lastingly below the figure to which it would have
risen without any such monetary change’, and hence it would generate an
increase of investment without a corresponding decrease of consumption
and without increases in the prices of consumers’ or capital goods. But this
‘somewhat surprising result’ (Hayek 1941: 373) stems from a particular
assumption that has been introduced: the infinite elasticity of supply of all
factors of production and of all final and intermediate products. This
assumption holds only in a deep recession: only in this phase of the cycle
investment and consumption can increase together in real terms, as Keynes
states. However, things change as soon as the supply ceases to be elastic and
the principle of resources scarcity comes in force again. If the release of

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Nicolò De Vecchi

money from idle balances continues to keep the rate of interest low, a
process of change of production methods is triggered, which brings about
consumption of capital (Hayek 1941: 399).
The General Theory is anything but ‘general’ as it incorrectly substitutes an
‘economics of abundance’ for the economics of scarcity. It creates ‘stir and
confusion among economists and even the wider public’, and offers
support to ‘the technocrats and other believers in the unbounded
productive capacity of our economic system’. In Hayek’s view, Keynes’s
interest rate theory is a good example of the limits of the General Theory.
Excluding the relationship between interest rate and productivity of
investment, Keynes ends up by taking into consideration only economies
‘in the depths of a depression’ (Hayek 1941: 373 – 5, 395 – 6, 398 – 9).
Hayek adds that by abandoning the principle of ‘real scarcity’ underlying
equilibrium analysis (Hayek 1941: 374) Keynes is led to formulate a
confused and erroneous price theory. Hayek’s reasoning is as follows.
Keynes assumes that the prices of the factors of production are downwards
rigid, and he justifies this assumption by replacing the real scarcity with an
‘artificial scarcity created by the determination of people not to sell their
services and products below certain arbitrarily fixed prices’. Actually,
Keynes assumes unlimited supplies of factors at these prices, and so he gives
up the only mechanism capable of equating the marginal rate of profit and
the given rate of interest, that is, the variations of the prices of production
factors as a function of their relative scarcity. On the other hand, Keynes
states that the prices of durable goods and securities can be determined
only by capitalizing their future yields and, hence, he makes them depend
on a previously given interest rate. To be consistent, Keynes should have
dealt in the same way with production factor prices. By doing so, however,
he would have reached the paradoxical result of making the difference
between the product price and its production cost – the rate of profit –
depend on the rate of interest, and the expansion of investment on the
money supply and on liquidity preference, rather than on real productivity
(Hayek 1941: 374 – 6).

5. An assessment of Hayek’s notions of uncertainty and money rate

of interest in the light of the General Theory
The link between part IV of The Pure Theory of Capital and the preceding
three parts of the book is rather weak. From an analytical perspective, part
IV can only be justified by Hayek’s intention to confirm the thesis that the
money rate of interest is essentially determined by the real productivity. In
general the scholars of Hayek who deal with The Pure Theory of Capital show

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only moderate interest for this part of the book, or they found that it is
written too hastily, or else that it lacks constructive results.35 Not even if it
is read as an attempt by Hayek to criticize the liquidity preference theory
espoused by Keynes in the General Theory can it be judged positively. It is
possible to show that Hayek’s criticisms that are set out in the previous
section of this paper are based on a misunderstanding both of Keynes’s
concept of liquidity preference and of Keynes’s explanation of price
formation.
Starting with the second point, it should be noted that Hayek is right when
he points out that Keynes modifies the current price theory, according to
which, exchange values are determined by consumers’ preferences and
relative scarcity of goods, but he is wrong when he states that Keynes
presents a confused price theory. Keynes simply excludes that the theory of
money can be presented as an extra chapter of the theory of value, and, on
the contrary, demonstrates that the theory of value is just one component of
the monetary theory of production.36 In the General Theory he not only
determines the interest rate independently from the prices of goods, but he
even inverts the causal order: it is the prices of capital assets that depend on
their prospective yields37 and on the rate of interest, which is necessary to
determine their capitalization. Hence, ultimately, the prices of capital assets
depend on ‘all those elements of doubt and uncertainty, interested and
disinterested advice, fashion, convention and what else you will which affect
the mind of the investor’, on the liquidity preference and on the money
policies.38 They move ‘until they offer an equal apparent advantage to the
marginal investor in each of them’, who is wavering between holding them,
or holding money loans, or holding money (Keynes 1973b, 117). It follows
that, for Keynes, also the difference between prices and production costs –
i.e. the rate of profit – is not determined solely by real productivity and by
the investment demand schedule, but it also depends on the rate of
interest.39 This result appears ‘paradoxical’, and hence wrong, to Hayek,
because he does not refuse to separate the monetary theory of production
from equilibrium analysis.
To show in what sense Hayek misunderstands the Keynesian concept of
liquidity preference and, consequently, the liquidity preference theory of
the rate of interest, one must realize that Keynes rests his theory of money
on the simple, technical definition of the rate of interest as ‘the percentage
excess of a sum of money contracted for forward delivery [ . . . ] over what
we may call the ‘‘spot’’ or cash price of the sum thus contracted for forward
delivery’ (Keynes 1936: 222, 167, 1973b: 116, 202, 206, 215). He, then,
defines the rate of interest as ‘a measure of the unwillingness of those who
possess money to part with their liquid control over it’ (Keynes 1936: 167,
1973b: 214). Its value is fixed ‘at the level which, in the opinion of those

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who have the opportunity of choice – i.e. of wealth-holders – equalizes the

attraction of holding idle cash and of holding the loan’ (Keynes 1973b:
213), given the available quantity of cash (Keynes 1936: 167).
A ‘necessary condition’ for people’s willingness to be liquid is ‘uncertainty
as to the future of the rate of interest’.40 Hayek interprets Keynes’s uncer-
tainty and liquidity preference in a very reductive way by stating that people
prefer to be liquid because they wish ‘to take advantage of unforeseen
opportunities’. Hayek’s notion of uncertainty is similar to Keynes’s, because
both exclude the assumption of a calculable future. But the similarities
stop there.41
Keynes refers to a specific cognitive situation of those who operate in an
organized market for dealing in debts. These agents are uncertain, because
they have a partial, limited knowledge of the future value of the rate of
interest, and they have a low ‘state of confidence’.42 It follows that on the
market for dealing in debts ‘different people will estimate the prospects
differently’. It will not be the ‘‘‘best’’ opinion’, i.e. the estimate of those
who possess superior knowledge to the ordinary, to determine it, but the
‘predominant opinion’, i.e. the mass psychology.43 It is on the grounds of
these estimates that the interest rate will be determined. For Hayek, people
are uncertain simply because they lack knowledge about the future: those
who decide to hold money are not able to form a reasonable judgement on
future possibilities of using wealth. Therefore, he presents Keynes’s interest
theory as a particular case of his own theory, according to which the
liquidity preference is only a disturbance factor that ‘loosens’ the close
dependence of the interest rate on the profit rate.
Another misunderstanding of Keynes’s theory is revealed by Hayek’s
statement that Keynes determines the interest rate by resorting solely to
liquidity preference, as if the interest rate could be inelastic to money
demand induced by changes of investment. Actually, Keynes denies a
‘simple or direct relationship’ (Keynes 1973b: 12) between the actual or
expected productivity of capital and the rate of interest, but he firmly
states that the rate of interest is determined by the total demand and total
supply of liquid resources, where the total demand includes ‘the inactive
demand due to the state of confidence and expectation on the part of
the owners of wealth, and the active demand due to the level of activity
established by the decisions of entrepreneurs’.44 For Keynes, active demand
affects the interest rate, because it is a demand for liquid cash in exchange
for a deferred claim, like inactive demand, although with two qualifications.
First, the influence of the actual and planned investment on the interest
rate is relevant only ‘if other factors are kept unchanged’, i.e. if neither
money supply nor liquidity preference vary. This is a very restrictive
assumption, because it is very likely that the state of confidence in interest

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rate forecasts will change, after significant changes of actual or expected

profitability of investment. It follows that the effect on interest rate of an
increase of active demand cannot be unequivocally determined.45 Last, but
not least, by stressing that the link between the rate of interest and the
actual and expected productivity of capital is indirect, Keynes denies that
an increase of the marginal productivity of the capital assets or of the
loanable funds induces an interest rate increase ‘through increasing the
competition of borrowers to obtain the use of loanable funds’.46 In other
words, he challenges what Hayek and others firmly defend, i.e. that the rate
of interest depends on the scarcity of loanable funds relative to the demand
for them, and hence on productivity of investment and on the willingness
to save.47

6. Conclusions
After the 1931/32 debate petered out, Hayek did not give up his battle
against Keynes’s policy prescriptions. He opposed them all his life and he
emphasized different aspects of his trade cycle theory at different times to
support his anti-interventionism.
Prices and Production is the antithesis of the Treatise on Money. Hayek
formulates a theory of the trade cycle to prove that ‘it is probably an illusion
to suppose that we shall ever be able entirely to eliminate industrial
fluctuations by means of monetary policy’ (Hayek 1931: 125). In the General
Theory he identifies two innovations with regard to the Treatise on Money: the
analysis of the saving – investment relationship in the presence of
unemployment and the liquidity preference theory of the rate of interest.48
He criticizes them, but it has been seen that the General Theory contains
valid analytical arguments to counter his criticisms.
On the political level, Hayek concludes that the policy prescriptions
suggested in the General Theory are always destabilizing, even in the de-
pression phase of the cycle. After the General Theory he opposes all Keynes’s
suggestions of public intervention, aside from monetary policy: financial
policies and distribution policies to stimulate consumers’ demand, deficit
spending, public interferences in entrepreneurial investment activity. Not
just monetary policy, but any deliberate management against the market
competition must be avoided and the best cure for the adjustment of
the economic system is to favour prices and wages flexibility (Hayek 1950:
275 – 6, 1975: 17 – 18).
After 1941 Hayek continued to firmly contest Keynesian policy
prescriptions, but he decided to ‘largely’ withdraw from the theoretical
debate (Hayek 1976: 219) and to turn to the social theory of the

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Nicolò De Vecchi

spontaneous order to uphold his political opposition to Keynes. Part IV of

The Pure Theory of Capital is the last act of his anti-Keynesian polemic as a
theoretical economist.

Notes
* I thank the two anonymous referees for useful suggestions and criticisms. The usual
disclaimer applies.
1 Hayek 1995: 121 – 225. There are several accounts of this debate; see for example
Dostaler 1990, 1991, Klausinger 1991, Cochran and Glahe 1994, Caldwell 1995: 21 –
31, Kurz 1995.
2 Hayek 1976: 219, 1995: 59 – 61, 240 – 1, 251 – 2, McCormick 1992: 170 – 1, Caldwell
1995: 40 – 5, 1998; Howson 2001.
3 As is shown in section 3 a brief but significant correspondence on analytical matters
took place between 20 September and 20 October 1939, but it was not accompanied
by a public debate.
4 Moss and Vaughn 1986: 557, McCormick 1992: 170, Cochran and Glahe 1994: 69
note 1, Burczak 2001: 61. Zappia 2001: 350 mentions this criticism.
5 Hayek 1929: 139 – 41, 187 – 8, 196 – 7. Hudson (1988: 181 – 3) stresses this role of
money in Hayek’s theory of the trade cycle: for Hayek money is ‘the causal factor
which is imminent to the system itself’, whereas entrepreneurial expectations are the
exogenous factor.
6 Hagemann and Trautwein (1998: 302, 306) observe that exogenous monetary
changes take on importance in Hayek’s later writings and they show that this
‘indicates a fundamental problem of construction in Hayek’s attempt to wed the
business cycle with general equilibrium theory in such a way that the long-run
neutrality of money is preserved’.
7 This topic cannot be discussed here. Hayek keeps these concepts in 1932a, but he
questions them in 1935a (mainly pp. 123 – 8) and in 1935b: 152. Keynes’s criticism is
focused on these concepts first in the 1932 correspondence (Hayek 1995: 164 – 73)
and then in the General Theory (Keynes 1936: 60, 79 – 81).
8 The ‘Ricardo Effect’ asserts that ‘in conditions of full employment an increase in the
demand for consumers’ goods will produce a decrease of investment, and vice versa’
(Hayek 1969: 274), i.e. there is a tendency of using less labour-saving methods of
production as a consequence of the increase of consumers’ goods prices and of a fall
in real wages, and vice versa. As Moss and Vaughn 1986 and Birner 1999 show, Hayek
explicitly introduces this mechanism in 1934/35. Hagemann and Trautwein (1998:
381 n.5) note that already in a footnote of the German edition of Hayek 1931 the
cyclical changes in the production periods are compared to playing a concertina, and
that in an appendix of the second English edition Hayek connects his theory of the
trade cycle with Ricardo’s doctrine of the conversion of circulating into fixed capital.
For a synthetic exposition see Hayek 1942, 1969, Hagemann and Trautwein 1998. For
a discussion of the Ricardo Effect in the context of the contemporary loanable funds
theories see Maclachlan 1993: 146 – 54.
9 Hayek deals with this topic already in 1932b: 195, 1932c: 140 – 2, 1935a: 125 – 9,
1935b: 143.
10 Hicks 1967b criticizes Hayek’s model in which the process is activated by a credit
expansion, because, for it to work, some sort of assumption is necessary to justify a
large lag of consumption behind wages. Hayek (1969: 277 – 82) replies to these

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criticisms. Hicks adds that Hayek’s model is valid if it is interpreted as ‘an analysis – a
very interesting analysis – of the adjustment of an economy to changes in the rate of
genuine saving’ (210). Chapter XXV of The Pure Theory of Capital perfectly meets these
requirements.
11 Here lies the fundamental difference with regard to the case of an increase in the
demand for consumer goods. Because of this difference there is no symmetry
between the two cases.
12 Hayek 1939: 5 – 6 italics added. See also pp. 3 and 42 note 1. Hayek indicates this as
the ‘main difference’ between the 1939 work and older versions of his cycle theory.
The other difference is that the analysis of the effects generated by an increase in the
demand of consumers’ goods on investment and employment is done by considering
variations of real variables, such as the rate of profit and the real wage. On these
analytical novelties see Haberler 1946: 481 – 91.
13 Hayek 1939: 35 – 7. In the meantime the prices of consumer goods decrease, so that
the real wages will start rising, thereby setting the conditions for the upward
movement to start again.
14 See the letter to J. Robinson, dated 6 March 1941 (Ingrao and Ranchetti, 2005: 403 – 4).
15 See, for instance, Hayek 1995: 247 – 8: ‘Paradoxical as this may sound, [Keynes] was
neither a highly trained economist nor even centrally concerned with the deve-
lopment of economics as a science. In the last resort he did not even think much of
economics as a science, tending to regard his superior capacity for providing
theoretical justifications as a legitimate tool for persuading the public to pursue the
policies which his intuition told him were required at the moment’.
16 One of the reasons McCormick (1992: 185) mentions for Hayek not having reviewed
the General Theory is ‘the belief that investment depended on final demand whereas
Keynes emphasized the importance of expectations’.
17 This correspondence consists of three letters by Keynes with as many replies by Hayek
and it takes place between 20 September and 20 October 1939 (Ingrao 2005: 241 – 3).
18 On this aspect of the 1931/32 controversy between Hayek and Keynes see Tieben
1997: 110 – 21.
19 See Keynes’s letter of 20 September 1939 and Hayek’s answer of 24 September 1939
(Ingrao 2005: 241 – 2).
20 See Keynes’s letter of 20 September 1939 (Ingrao 2005: 241 – 2).
21 See Keynes’s letter of 16 October 1939 and Hayek’s answer of 20 October 1939
(Ingrao 2005: 243).
22 Hayek’s statement that Keynes ignore the changes in relative prices following changes
in consumer goods demand is thus not correct.
23 Also Haberler (1946: 488 – 90) criticizes Hayek’s confidence in the possibility of
rapid changes in the relative utilization of capital and labour: ‘it seems to the present
writer that professor Hayek tremendously overestimates the short-run possibility of
substituting labour for capital and vice versa in response to changes in the rate of
profit (or the rate of interest) [ . . . ] It would seem that factors other than changes in
the profit rate are much more important in determining the volume of investment’.
24 Moss and Vaughn 1986: 358 – 9 justify this behaviour by noting that Hayek imagines a
firm that is construed ‘as a ‘‘portfolio of investment projects’’’ and an entrepreneur
who manages ‘a number of on-line investment projects’. Entrepreneurs ‘calculate the
rate of return on each separate project and then allocate money capital among the
projects so as to equalize returns at the margin’.
25 Hayek (1941: 390) defines this function ‘the supply of investible funds at increasing
rates of interest due to the release of money from idle balances’.

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Nicolò De Vecchi

26 The function is vertical if the desire to hold money is perfectly inelastic, i.e. cash
balances are rigidly fixed and independent of the money rate of interest; horizontal if
the desire to hold money is perfectly elastic, i.e. enough cash balances will be released
to keep the money rate of interest always constant.
27 Hayek (1941: 364) considers indifferently the expected rate of return or the pro-
ductivity of investment, (or rate of profit). This stems from his assumption that the
expectations on future yields depend on the behaviour of current yields.
28 In other words, the closer the function is to being vertical: see note 26.
29 Hayek (1941: 393 – 4) notes that ‘the rate of saving sets the limits to the amount of
investment that can be successfully carried out’. It will affect the volume of investment
via investment demand and it will operate indirectly on the money rate of interest or
on the supply of investible funds.
30 In other words, when the function is horizontal: see note 26.
31 This does not happen only if the desire to hold money is perfectly inelastic. In this
case the money rate of interest corresponds to the rate of profit determined by the
equilibrium analysis.
32 Hayek (1941: 386 – 92) re-expresses this process in different terms than Hayek 1939,
in as much as he uses the functions of investment demand and of investible funds
supply.
33 Hayek 1941: 393, 407. The money supply is taken as given. If one assumes that it could
vary, a further element preventing the money rate of interest from rising is added.
34 Connected to this criticism is another criticism that Hayek formulates against
Keynes’s economic policy (Hayek 1941: 407 – 10), which will become a recurring
feature of his subsequent polemical writings. Hayek accuses Keynes of favouring a
short-run monetary policy, because he sees only the immediate effects of money
quantity variations, ‘completely disregarding the fact that what is best in the short run
may be extremely detrimental in the long run, because the indirect and slower effects
of the short-run policy of the present shape the conditions, and limit the freedom, of
the short – run policy of to-morrow and the day after’.
35 Hawtrey (1941: 290) believes part IV is not sufficiently developed owing to war time
pressures. Smithies (1941: 778) comments that ‘it almost gives the impression of
having been included as an afterthought’. F. Lutz (1943: 302) deems it to be
‘excellent’, but he deals exclusively with the other parts of The Pure Theory of Capital,
which contains Hayek’s theory of interest in real terms. Steedman (1994: 7) considers
part IV ‘hardly adequate to its topic’.
36 Keynes 1936: 31 – 2, 292 – 4: ‘Thus the analysis of the propensity to consume, the
definition of the marginal efficiency of capital and the theory of the rate of interest
are the three main gaps in our existing knowledge which it will be necessary to fill.
When this has been accomplished, we shall find that the theory of prices falls into its
proper place as a matter which is subsidiary to our general theory’. For Keynes his
theory is ‘a theory of value and distribution, not a separate theory of money’. It is
worth recalling here that Hicks (1935) establishes a relationship between the theory
of prices and production and monetary theory, which is opposite to the relationship
proposed by Keynes. Hayek (1995: 57 – 9) affirms that Hicks’ A Suggestion for
Simplifying the Theory of Money ‘still seems to me more than the General Theory the most
valuable result of the monetary discussions of the period’. On this topic, see Kohn
1986: 1202: ‘While Hicks considered the theory of money to be no more than a
particular chapter in the theory of value, Keynes believed just the opposite: that the
whole of the theory of value was just a special case of the monetary theory of
production’. See also Townshend 1937: 159 – 61.

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37 Keynes 1973b: 116 – 7. See also Townshend 1937: 159: capital assets prices ‘as well as
money and monetary assets, have a value to hold for future exchange (i.e. for security
or for speculation), causally independent of their value in present exchange, and
determined by, and varying with, expectation’.
38 Keynes 1936: 137, 1973b: 106 – 7, 117, 213 – 4. Keynes had already clearly expressed
these arguments in the Treatise on Money (1930: xxvii).
39 Keynes 1936: 137, 1973b: 118, 122. See also Leigh 1951, Chick 1987.
40 Keynes 1936: 168. More appropriately: ‘as to the complex of rates of interest for
varying maturities which will rule at future dates’ (ibid.).
41 The methodological differences between Hayek and Keynes in treating uncertainty
and expectations are the subject of many recent studies. See the references indicated
in Carabelli and De Vecchi 2001.
42 For the notions of ‘uncertainty’, ‘state of confidence’ and ‘weight of an argument’ in
the General Theory see Keynes 1936: chapter 12, and in particular pages 148 – 9, where
reference to the Treatise on Probability is explicit. See also Carabelli 1988: 55 – 9 and
McCormick 1992: 178 – 82. On the literature about Keynes’s analysis of uncertainty
see Dow 1995. On the relationship between changes in ‘weight’ or ‘confidence’ and
changes in liquidity preference see Winslow 1995.
43 Keynes 1936: 169 – 70, 198 – 9. People who dissent from the predominant opinion and
believe that the future rate will be above or below the rate ‘assumed by the market’
will sell or buy capital assets other than cash, thereby contributing to raising or
lowering the interest rate with regard to the value assumed by the market.
44 Keynes 1973b: 230 italics added. ‘It is only to the extent that increased investment
requires larger active balances that it reacts on the rate of interest – a reaction which
can be prevented by increasing the quantity of money [ . . . ]. I have many pages on
the theme that increasing investment involves increasing output and that this kicks
back on the rate of interest by draining away more money into the active circulation’
(ibid.: 91). On this issue, see also Keynes 1936: 168 – 72, 203 – 4, 1973a: 522 – 3, 631,
1973b: 4, 11 – 13, 21 – 2, 115 – 6, 221, 223 – 6.
45 ‘If the liquidity preferences of the public (as distinct from the entrepreneurial
investors) and of the banks are unchanged, an excess in the finance required by
current ex ante output (it is no necessary to write ‘‘investment’’ since the same is true
of any output which has to be planned ahead) over the finance released by current ex
post output will lead to a rise in the rate of interest; and a decrease will lead to a fall. I
should not have previously overlooked this point, since it is the coping-stone of the
liquidity theory of the rate of interest’ (Keynes 1973b: 220).
46 Keynes 1973a: 522 – 3. See also 1936: 165, 184 – 5, 1973b: 202, Townshend 1937: 157 – 8.
47 Keynes 1973b: 222: ‘given the state of expectation of the public and the policy of the
banks, the rate of interest is that rate at which the demand and supply of liquid
resources are balanced. Saving does not come into the picture at all’. For the sake of
completeness, note that Keynes does not exclude that variations of saving can affect
the interest rate (Keynes 1936: 218 – 9), but this occurs ‘because in economics
everything affects everything else’ (1936: 245 – 7, 1973b: 11).
48 Hayek does not manifest any interest for other two key topics of the General Theory: the
expectations theory (key to understanding Keynes’s entrepreneurs’ investment
and liquidity preference theories) and the discussion of the ‘own rates of interest’
(a direct consequence of Sraffa’s criticism of Hayek).
This approach to the General Theory is shared by other commentators of Keynes,
for example Hicks (1967a: 198 – 201) and Leijonhufvud (1981: 164 – 73). These
scholars emphasize the importance of the ‘Wicksellian connection’, which is present

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in the Treatise on Money, do not challenge the notion of the natural rate of interest
and, as a consequence, accept Keynes’s liquidity preference theory with many
reservations.

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Abstract
Hayek did not review the General Theory, but he criticized it in Profits, Interest
and Investment (1939) and in part IV of The Pure Theory of Capital (1941).
First, he showed that only exceptionally does greater consumption favour
investment and employment. Second, he rejected Keynes’s liquidity
preference and maintained that only in an ‘extreme case’ might it be
said that Keynes’s theory of the rate of interest is valid. Although he
correctly identified the gist of Keynes’s theoretical innovation, his criticisms
were already implicitly answered in the General Theory.

Keywords
Hayek, ‘General Theory’, Keynes, liquidity preference, consumption,
investment

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