Euro. J.

History of Economic Thought 15:1 105 – 127 March 2008

On the microeconomic foundations of

macroeconomics in the Hayek–Keynes
controversy

Abdallah Zouache

In economics you cannot convict your opponent of error; you can only convince him
of it. And, even if you are right, you cannot convince him, if there is a defect in your
own powers of persuasion and exposition or if his head is already so filled with
contrary notions that he cannot catch the clues to your thought which you are trying
to throw to him.
(Keynes, 1973a, vol. 13, p. 470)

1. Introduction
In line with works that adopt a methodological angle (Butos & Koppl, 1997;
Carabelli & De Vecchi, 2001), the aim of this article is to show that the
methodological component is central to understand the controversy
between Hayek and Keynes. This contribution to the literature on the
Hayek–Keynes controversy1 deals with an element – the micro-foundations
of macroeconomics – that has not received much attention in previous
writings. In this way, the paper clarifies the role of the methodological
factor in the rejection of Keynesianism by Hayek, a point that had
already been made, notably by Caldwell (1995, pp. 42–43, 2004, p. 176)
and Nadeau (2001, pp. 91–92), but that has not been analysed as

Address for correspondence

Department of Economics, Creuset-Cnrs, University Jean Monnet, Saint Etienne,
France; e-mail: zouache@univ-st-etienne.fr

1 Many discussions and interpretations of the Hayek–Keynes debate have been

suggested (see Hicks, 1967; Dostaler, 1991; Cochran & Glahe, 1994; Foss, 1994;
Tieben, 1994; Caldwell, 1995, 2004).
The European Journal of the History of Economic Thought
ISSN 0967-2567 print/ISSN 1469-5936 online Ó 2008 Taylor & Francis
http://www.tandf.co.uk/journals
DOI: 10.1080/09672560701858707
Abdallah Zouache

such2. Caldwell (2004) does not study in detail the methodological

foundations of the Hayek–Keynes debate. He does not include the
micro–macro discussion in his listing of the methodological debates of
the thirties (Caldwell, 2004, chap. 10). Moreover, Caldwell (2004) does not
link the methodological factor with the theoretical background; that is, the
theory of capital and money in both authors’ frameworks. While the paper
deals with a methodological issue, it espouses a theoretical approach in the
vein of Trautwein (1996), Dostaler (1991) or Hagemann & Trautwein
(1998) to analyse the famous controversy between Hayek and Keynes.
There is no unanimity among economists about the distinction between
micro and macro and the relationship between them. According to the
standard view, microeconomics studies the behaviour of individual economic
units and macroeconomics examines the relations between broad aggre-
gates. In its traditional interpretation, the expression ‘microeconomic
foundations of macroeconomics’ refers to the principle according to which
macroeconomic analysis must be founded upon individual behaviour
(Malinvaud, 1991, p. 22). It denotes the ultimate reference to individual
decisions and, accordingly, is connected to methodological individualism:
‘the methodological rule that says that in order to account for aggregate
phenomena one has to understand the individual decisions from which these
phenomena originate’ (Janssen, 1993, p. 4).
The paper embraces a different posture in that it considers that the key
question in the micro-foundations debate is what makes a general economic
theory. In that view, the methodological inquiry on micro-foundations can be
adjusted to deal with the problem of ‘the search for first principles’
(Coddington, 1983). Two lines of thought can thus be distinguished. The
‘orthodox neoclassical’ answer is that the explanations of all economic
phenomena, including levels of output and employment, should be derived
from the ‘first principles’ of inter-temporal optimization of consumption and
leisure. In this microeconomic perspective, ‘a study of the micro-foundations
of macroeconomics is coextensive with general equilibrium analysis’
(Weintraub, 1980, p. 10). The idea is that macroeconomics is the result of
aggregation of microeconomics, which is richer than macroeconomics
because it is more detailed. The ‘heterodox Keynesian’ answer is that one
should steer clear of the fallacy of composition and integrate macroeconomic
coordination failures that occur when individually rational behaviour leads to

2 Since my purpose is to highlight the fundamental opposition between Hayek and

Keynes, the controversy is not only studied with regard to the debate in Economica
and The Economic Journal. I also consider some of Hayek’s and Keynes’ subsequent
works, notably Hayek’s works on the organization of knowledge in a market
economy and Keynes’ General Theory.

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 The Hayek–Keynes controversy

socially sub-optimal outcomes. One might call this a demand for macro-
foundations of the analysis of individual economic decisions. Microeconomics
has to adapt to macroeconomics (and not the reverse), a view defended by the
post-Keynesian school (Weintraub, 1980, pp. 13–14). In that vein, it is the
coordination criterion (Leijonhufvud, 1981a) that counts to demarcate
microeconomics from macroeconomics. Microeconomics is the field that
studies coordinated outcomes, whereas macroeconomics deals with coordina-
tion failures. Thus, the term ‘micro-foundations’ would refer to microeco-
nomic contributions to the demonstration of macroeconomics failures.
This interpretation of the Hayek–Keynes controversy insists on two
elements that have been neglected in previous publications. First, the article
determines that the issue of micro-foundations was crucial in the opposition
between Hayek and Keynes. Indeed, Hayek’s theoretical critique of the
Treatise on Money, which is mainly concerned with capital theory and the role
of the interest rate in the coordination of saving and investment, is directly
influenced by a methodological position on Keynes’ aggregate style. In
particular, Hayek’s critique of Keynes’ capital theory implies that Keynes’
framework in the Treatise is totally without micro-foundations since it focuses
on the study of functional relations between aggregates. Second, the paper
reveals that Hayek’s methodological attack on the micro-foundations had an
impact on the making of the General Theory. When Keynes concedes Hayek’s
claim that the Treatise is without a capital theory, he implicitly admits that his
macroeconomic analysis must have microeconomic foundations. The General
Theory is therefore more concerned about the micro-foundations issue. In
particular, it will be shown that the concept of marginal efficiency of capital is
central to appreciate the influence of Hayek’s critique on Keynes. Finally, the
paper leads to the conclusion that the contrast between Hayek and Keynes is
the kind of micro-foundations that economists should adopt to explain
coordination failures.
The article is organized as follows. The second section contrasts Hayek’s
conception of the microeconomic foundations of macroeconomics with
Keynes’ approach of macroeconomics. The third section analyses the
evolution of Keynes’ attitude from the Treatise to the General Theory. If Hayek
was right with regard to the lack of micro-foundations in Keynes’ Treatise, he
failed to recognize that the General Theory offers a macroeconomic approach
with microeconomic foundations. Section 4 concludes.

2. The issue of microeconomic foundations in the Hayek–Keynes debate

The first point examines to what extent the micro-foundations issue is
crucial in the Hayek–Keynes debate. The second point explores Hayek’s

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view according to which macroeconomics ‘which seeks causal connections

between hypothetically measurable entities or statistical aggregates’
(Hayek, 1988, p. 98) has no legitimacy in business cycle theory.

2.1. Micro-foundations and Hayek’s critique of Keynes

Hayek’s critique (1931a,b, 1932a,b) is founded upon the postulate that
business cycle theory must depart from individual behaviour. Hagemann &
Trautwein (1998, p. 298) are right when they characterize Hayek’s business
cycle theory as a combination of Böhm-Bawerk’s capital theory, Wicksell’s
cumulative process, Cantillon and Ricardo effects. But Hayek’s review of
Keynes is above all influenced by the Austrian conception of micro-
foundations. The inter-temporal relations between individual choices in a
production economy represent the essence of this Austrian interpretation
of microeconomic foundations.
Individual choices are analysed through the Austrian concept of the
structure of production represented by the famous Hayekian triangles
(Hayek, 1931c, pp. 38–40). In line with the Austrian tradition, Hayek (1931c)
conceives production as a temporal process. In particular, capital is defined
by time (Kurz, 2000, p. 269). The structure of production describes the
distribution of capital among stages of production. Two products are distinct
because they are located at two different stages of the production process
(Hayek, 1931c, pp. 36–38). The role of time does not only arise through the
temporal specification of quantities in the economic system (ibid., p. 40).
Time also intervenes in consumers’ saving decisions. An act of saving means a
postponement of consumption into the future. In order to satisfy this future
consumption, entrepreneurs should invest in production goods. Then, in
Hayek’s view, business cycle analysis does not have to stop the investigation
into the static study of a level of production. It must focus on the temporal
production process that examines the insertion of these quantities in the
economic system. Now, according to Hayek (1931a, p. 279), Keynes’ (1930)
work totally ignored the ‘Austrian’ foundations of Knut Wicksell’s (1936)
theory. In particular, Hayek (1931a) maintained that Keynes did not explain
the origin of profits. This was coupled with Keynes’ muddled definition of
investment. However, it was Keynes (1898) who initiated the English
translation of Interest and Prices (Wicksell, 1936) done by his closest researcher
R.F. Kahn. Moreover, as a saving-investment approach to income fluctua-
tions, the Keynes of the Treatise was among the authors who belong to the
Wicksell connection (Leijonhufvud, 1981b, p. 133).
With regard to profits, Hayek (1931a, p. 273) agrees with Keynes (1930)
to consider them as the mainspring of change in the economic system. But
he disagrees with the idea according to which only aggregate profits lead to

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a change in production. In Hayek’s thought, profit is a microeconomic

phenomenon that has to be explained from the study of the relative supply
and demand for goods so that it cannot be defined at the level of
entrepreneurs as a whole (Hayek, 1931a, p. 275). In other words, without
understanding the micro-foundations of profits, one cannot understand its
essence. A macroeconomic theory of profits can therefore make little sense.
Keynes’ false conception of profits finds its roots in his dubious
explanation of investment (Hayek, 1931a). And Keynes’ obscure analysis
of investment arises from a fallacious theory of capital (Hayek, 1931a, p.
276). Relative movements of intermediary goods at different stages of
production are integrated in Keynes’ notion of aggregate capital. But, the
possibility of fluctuations between these stages is neglected (ibid., p. 274).
In a horizontal analysis of the production process, a lack in a stage of
production is not directly balanced by a surplus in another stage. In
particular, losses at intermediary goods stages are not offset by profits at
consumption goods stages. Thus, Hayek’s criticisms rested upon the idea
that Keynes’ definition of investment as a global variable neglected the
variations of investment in the different stages of production. Moreover,
the investment process is not a static process but an inter-temporal one,
unlike Keynes’ conception:

An explanation of the causes which make investment more or less attractive should
form the basis of any analysis of investment. Such an explanation can, however, only be
reached by a close analysis of the factors determining the relative prices of capital goods in the
different successive stages of production – for the difference between these prices is the
only source of interest. But this is excluded from the outset if only total profits are
made the aim of the investigation. Mr. Keynes’ aggregates conceal the most
fundamental mechanisms of change.
(Hayek, 1931a, p. 277, italics added)

2.2. The methodological foundations of Hayek’s critique

To what extent is Hayek’s opprobrium derived from a particular
methodological view on the microeconomic foundations? Does Hayek’s
attack signal that he is a precursor of the modern micro-foundations view
(Lucas, 1977, 1980)? This section proves that Hayek’s critique of Keynes on
the micro-foundations does not lead the Austrian economist to a consistent
understanding of micro-foundations. To be more specific, it seems that
there is a conflict inside Hayek’s business cycle theory between the
neoclassical and the Austrian foundations.
Concerning the neoclassical underpinnings, in its methodological
individualism Hayek’s Austrian approach is clearly congruent with the
orthodox view of neoclassical economics (then called ‘the Lausanne

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School’) even though there are fundamental methodological differences

between the Austrians and the Walrasians elsewhere. Apart from the first
lecture in Prices and Production, Hayek’s early research programme is – more
clearly – spelt out in his long essay on ‘Inter-temporal Equilibrium’ of 1928
and in his book on Monetary Theory and the Trade Cycle (Hayek, 1933a).
Then, following Lucas’s own reference to Hayek as ‘a leading example’ of
the inter-war business cycle theorists (Lucas, 1977, p. 213), Laidler (1982,
pp. 77–86) labels the new neoclassical research programme as neo-
Austrian. The well-known quotations from Monetary Theory and the Trade
Cycle (Hayek, 1933a, p. 33, 42) and Prices and Production (Hayek, 1931c, pp.
4–6) reveal a methodological relationship between Hayek and Lucas on the
idea that a study of business cycles must depart from an equilibrium
framework3. Nevertheless, there may be essential differences between
Hayek’s conception and the now dominant concepts of micro-foundations,
as propagated essentially by Friedman (1968) and Lucas (1977, 1980).
First, Hayek does not adhere to the modern sense of micro-foundations
as analytical frameworks that are stringently and systematically based on the
optimizing behaviour of individual agents. Second, Hayek’s concept of
equilibrium is utilized with a disequilibrium bias that presumes an
examination of the tendency towards equilibrium (Cottrell, 1994, p. 202;
Trautwein, 1996). ‘In short, new-classical macroeconomics sees equilibrium
analysis as the fundamental and at present only framework adequate for
generating the growth of scientific economics. For Hayek, on the other
hand, there is a clear sense of the limitations of equilibrium analysis’
(Butos, 1985, p. 337). Third, Hayek attempts to offer an endogenous
explanation of the cycle whereas money is fully exogenous in Lucas’
business cycle theory (Cottrell, 1994, p. 201; Trautwein, 1996; Hagemann &
Trautwein, 1998, pp. 301–302).
But Hayek’s critique also meets the modern ‘micro-foundations view’
when it completely rejects Keynes’ aggregate method. Indeed, macro-
economics – defined as the theory of the relation between aggregate
variables – has no place in Hayekian economics since all economic theory
must be expressed in terms of the individual subject. In that sense,
macroeconomics does not exist as an economic discipline:

If, therefore, monetary theory still attempts to establish causal relations between
aggregates or general averages, this means that monetary theory lags behind the
development of economics in general. In fact, neither aggregates nor averages do act

3 ‘For Hayek Paretian general equilibrium was the pivot of economic theory, the
centre of gravity towards which all major economic forces tended’ (Lachmann,
1986, p. 227). In other words: ‘Hayek equilibrium is ‘‘neoclassical’’ market
clearing equilibrium in all markets’ (ibid., p. 229).

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upon one another, and it will never be possible to establish necessary connections of
cause and effect between them as we can between individual phenomena, individual
prices, etc. I would even go so far as to assert that, from the very nature of economic
theory, averages can never form a link in its reasoning.
(Hayek, 1931c, p. 5)

Hayek’s approach falls within the reductionist credo: ‘according to which

no explanation of economic phenomena is truly satisfactory if it does not
reduce the phenomena to a question of individual actions by basic decision-
making units’ (Howitt, 1987, p. 273). Hayek suggests an utmost interpreta-
tion of reductionism because, first, economists cannot explain business
cycles without ultimately referring to the individual agent and, second,
business cycles are not a macroeconomic issue. He thus defends the
primacy of microeconomics and the pointlessness of a macroeconomic
approach.
However, is Hayek’s version specific enough compared to the modern
view? If, on one hand, micro-foundations do not mean rational optimiza-
tion and, on the other hand, macroeconomics does not exist, how does
Hayek tackle the micro-foundations issue? Hayek responds to this question
via two ingredients taken from Austrian theory: the structure of production
and subjectivism.
In the first place, if one considers Hayek’s early grasp of micro-foundations,
the most substantial point in Hayek’s rejection of aggregate concepts is their
lack of inter-temporal structure. Now, inter-temporal equilibrium is the pivot
of Hayek’s business cycle theory (Hayek, 1928). Keynes’ concession that he
did not deal with the ‘first principles’ of interest theory in the Treatise (see
below) can nevertheless be read as a correct defence as much can be said
about credit cycles, banking behaviour and monetary policy even without
giving an explicit analysis of inter-temporal consumption. But Keynes’
defence is no longer correct when his aggregate-based theory misses
important aspects of how the mismatch between the demand and supply of
capital goods can affect the structures of prices, production and employment
and thereby also their levels – and the course of the credit cycle.
Indeed, in Hayek’s view, not only do aggregate relationships not exist but
they cannot be constant and are modified over time because of the
inherent tendency of the microeconomic structure of production to
change. Variations in the structure of production are mainly represented by
changes in relative prices that constitute the microeconomic signal
pertinent to the coordination of individuals’ decisions. Relative prices
inform entrepreneurs about consumers’ subjective intentions and, as a
result, indicate how resources must be distributed among the different
stages of production. Therefore, understanding business cycles requires an
examination of the patterns of relative prices of capital and consumption

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goods. Now, changes in relative prices are not carefully thought about in
Keynes’ (1930) aggregate fundamental equations whereas they constitute the
main sources of monetary perturbations. Hayek (1931a) fundamentally
criticized Keynes (1930) to have done away with the relative price between
consumption and investment goods. As a consequence, Keynes (1930) forgot
to establish the conditions under which investment and consumption vary
inversely in the short run. If the economy is in a situation of full employment,
the resources needed to increase the production of consumption goods
come from the investment sector (Hayek, 1931a, p. 286).
Second, Hayek’s methodological conception of the micro-foundations in
his controversy with Keynes cannot be grasped without taking into
consideration his epistemological conception of the subjective knowledge.
Even if Hayek deepened his conception of knowledge mainly after the
controversy in his famous 1937 article on ‘Economics and Knowledge’, it
seems that the subjective element was already present in the business cycle
theory he developed between 1928 and 1931:

For so long as we use different methods for the explanation of values as they are
supposed to exist irrespective of any influence of money, and for the explanation of
that influence of money on prices, it can never be otherwise. Yet we are doing nothing
less than this if we try to establish direct causal connections between the total quantity of
money, the general level of all prices and, perhaps, also the total amount of production.
For none of these magnitudes as such ever exerts an influence on the decisions of
individuals; yet it is on the assumption of knowledge of the decisions of individuals that
the main propositions of non-monetary economic theory are based. It is to this
‘‘individualistic’’ method that we owe whatever understanding of economic phenom-
ena we possess; that the modern ‘‘subjective’’ theory has advanced beyond the classical
school in its consistent use is probably its main advantage over their teaching.
(Hayek, 1931c, p. 4)

What prevents the development of objective and measurable aggregate

variables is that knowledge is subjective. The macroeconomic method
developed by Keynes in the Treatise is in complete opposition to the
Austrian tradition that adopts subjectivism as a preliminary foundation of a
theoretical study of the business cycle. Hayek’s opinion (Hayek, 1931c,
pp. 4–6) is that economic theory has ‘by nature’ a microeconomic
character and deals with the study of the behaviour of individual agents. A
macroeconomic variable is micro-founded if it is derived from subjective
choice. Accordingly, the microeconomic dimension developed in Hayek’s
critique (Hayek, 1931a,b, 1932a,b) finds its roots in the subjectivist
individualism from which every business cycle analysis must begin.
‘Price expectations, monetary disturbances and malinvestment’, which
was written in 1933 by Hayek in response to Myrdal’s comments on Price and
Production (Hayek, 1931c), allows one to corroborate the connection

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between Hayek’s business cycle theory and his subjectivism. In that paper,
entrepreneurs cannot predict households’ saving plans. They take their
decisions from information transmitted by the bank system, especially
through credit expansion that is conceived by Hayek as a false signal. It
leads to expectations mistakes that cause ‘malinvestments’ that temporarily
deform the structure of production. Relative prices are thus seen as
information vectors that concentrate the dispersed and pertinent knowl-
edge. The system of prices appears as a coordination device that allows the
convergence of dispersed knowledge towards a unique item of information.
This convergence forms the market process. Among the most important
prices that contain the information necessary for a perfect coordination,
one finds the natural rate of interest and the relative price of consumption
and production goods. The natural rate of interest indicates the future
yields of new investments. The relative price of consumption goods and
production goods informs entrepreneurs of households’ preferences. The
bank rate of interest is a false signal since it is not derived from market
competition. It is arbitrarily fixed by banks and thus does not contain the
adequate information for entrepreneurs.
The aggregate level is not an acceptable level of analysis but that does not
mean that economists cannot propose an investigation of the economic
system. An analysis has microeconomic foundations when it is founded
upon an exploration of the system of individual beliefs. In his beginnings,
Hayek was less radical as regards the adoption of a macroeconomic
approach. The complete rejection of macroeconomics came later with the
success of the Keynesian revolution. Hayek’s first works (1929, 1931c) can
thus be viewed as an attempt to incorporate the Austrian micro-foundations
tradition in a methodological individualism perspective.

3. The issue of microeconomic foundations in Keynes’ analysis:

From the Treatise to the General Theory
The impact of Hayek’s review on the General Theory has been studied in
several publications4. But the methodological implications of Keynes’
acceptance of Hayek’s criticisms had not been really explored. Indeed,
the aim of Keynes (1936) is to develop a macroeconomic (‘general’) level
of analysis alternative to the classical theory. But Hayek (1931a,b)
highlighted the limits of an aggregate reasoning. When Keynes (1931a,
pp. 394–395) concedes Hayek’s claims relative to capital theory in the
Treatise, he indirectly acknowledges that Hayek’s critique on the lack of

4 See for instance Mongiovi (1990).

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microeconomic foundations is legitimate. How did Keynes react to this

issue in the General Theory?

3.1. Keynes’ conception in the Treatise

Hayek’s (1931a,b) critique is accurate concerning the Treatise because the
theoretical framework initiated in this work did not really have
microeconomic foundations. There are actually some attempts by Keynes
to explain rational individual behaviour of key agents in the Treatise as in
chapter 11 on the behaviour of entrepreneurs (Keynes, 1930, vol. 5, pp.
143–145) or in chapter 14 on real balances (Keynes, 1930, vol. 5, pp. 199–
205). Thus, Keynes (1930, vol. 5, p. 143) specifies that windfall profits
influence entrepreneurs’ investment choices. He also examines the role
of bankers’ and depositors’ decisions on the volume of cash balances
(Keynes, 1930, vol. 5, p. 201). Nonetheless, it seems that Keynes’ analysis
in the Treatise has clearly a macroeconomic flavour for at least three
reasons.
The first reason is that the fundamental equations are in line with the
quantity theory tradition: ‘on which we have all been brought up’
(Keynes, 1930, vol. 5, p. 120). The Treatise ‘as a whole is very much a
work still recognizably in the Quantity Theory tradition, despite its
emphasis on problems of the short run’ (Leijonhufvud, 1981b, p. 161,
173). In the Treatise on Money, Keynes’ aim is to go beyond the original
quantity theory (represented by Fisher’s quantity equation). One of the
main contributions from Keynes (1930) is to show that the process of
price determination cannot be analysed without referring to the interest
rate and to the distinctions between incomes and profits on the one
hand and saving and investment on the other hand. In this way, Keynes
(1930) breaks the dichotomy between the real and the monetary
spheres, which was the hallmark of the original quantity theory, a
programme that he would promote later as a monetary theory of
production (Keynes, 1933, p. 408). Nevertheless, Keynes (1930) retains
one methodological dimension from the quantity theory: it is a global
theory that has no specific concern with the issue of microeconomic
foundations.
The second reason is that Keynes (1930) defines capital as an aggregate
variable that combines a list of items that consist of various interconnected
categories. According to Keynes: ‘the increment of investment in any
period is the net increase of the items belonging to the various categories
which make up the aggregate of real and loan capital’ (Keynes, 1930, vol. 5,
p. 117). The essence of capital is not that it is the result of a production
process but that it represents ‘material wealth existing at any time’ (Keynes,

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1930, vol. 5, p. 115). The controversy with Hayek supports this conception
of capital as an aggregate item:

Keynes’ reaction to the overinvestment theory of Hayek’s Prices and Production was,
simply, that while overinvestment in the past might have been regrettable, he could
not see that it should cause any problems in the present; the only result would be to
leave us with more capital in the present-and so much the better off for it. His
argument reveals, of course, an aggregative concept of capital on his part that would
hardly be tolerated in Cambridge of later days.
(Leijonhufvud, 1981b, p. 173, fn. 62)

The third reason is that Keynes’ business cycle analysis proceeds from
Wicksell’s macroeconomic equilibrium where investment is equal to saving
(Keynes, 1930, vol. 5, p. 142). Keynes’ approach is clearly macroeconomic
since the analysis is conducted in terms of relations between global
magnitudes. When savings exceed investment, firms suffer losses, prices
decrease and the economy enters into recession (Keynes, 1930, vol. 5,
pp. 141–142). Inversely, when investment is higher than savings, firms make
profits and the economy enters into a boom period. Booms and slumps are
the result of the fluctuations of the credit terms around their equilibrium
position (Keynes, 1930, vol. 5, p. 165).
In contrast, when Keynes (1936) proposes a macroeconomic method in
the General Theory, macroeconomic phenomena are derived from agents’
behaviour. In that sense, the General Theory gives a greater role to the micro-
foundations of aggregate behaviour.

3.2. On the influence of Hayek’s attack on the General Theory

The thesis defended in this section is that Hayek’s criticism urged
Keynes to bring forth a sounder capital theory, which involved a sharp
turn on the micro-foundations issue in the General Theory. As a
consequence, one can say that Hayek’s attack of the Treatise had a
significant influence on the making of the General Theory even if Keynes
rejected Hayek’s micro-foundations. This effect can be appreciated in
several stages.
The first stage relates to Keynes’ exchange of letters after the debate in
Economica that clearly illustrates Keynes’ concern about capital theory. It
begins with 12 letters exchanged between Hayek and Keynes from
December 1931 to March 1932, including a letter from Hayek to Keynes
on Christmas Day and a response from Keynes the same day. In this
correspondence, Keynes asks Hayek to clarify some of the arguments he
used during the controversy and, notably, the case when existing capital is
maintained constant (Keynes, 1931b, vol. 13, p. 258). But in a letter dated

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29 March 1932 (Keynes, 1932, vol. 13, p. 266), Keynes announces to

Hayek that he is ‘trying to re-shape and improve’ his ‘central position’,
which is ‘probably a better way to spend one’s time than in controversy’.
However, Keynes’ consideration about capital persevered in his corre-
spondence with Robertson between 1931 and 1935. This correspondence
testifies to the influence of Hayek’s critique of Keynes regarding the
theory of capital:

This 3-cornered debate, all of us talking different dialects, has become so complicated
that I hesitate to say whether or no you are representing me aright! For if I haven’t
learnt to talk the ‘savings and investment’ tongue, neither have I learnt to talk the
‘goods of higher and lower orders’ tongue of Vienna! Hayek’s ‘producers’ goods’ are
different from, or rather much more comprehensive than, my ‘machines’ and I much
prefer to deal in terms of your ‘non-available output’, with its two subdivisions of
‘increment of fixed capital’ and ‘increment of working capital’. ( . . . ) At any rate I
can’t make it too plain that I have never asserted that in the course of cyclical change
the prices of consumption goods and of investment goods are at all likely to be found
in fact moving in opposite directions. I do on the other hand think there is a good
deal to be learnt from their relative movements in the various phases of the cycle; and
it’s in connection with this that I suspect that Hayek, in his pp. 45 ff. and 70 ff., though
I can’t make sense of them as they stand, has got hold of something real, which needs
to be synthesised with your and my ‘wasted savings’ notions in order to get a complete
theory of fluctuations.
(Robertson to Keynes, 4 October 1931, cited in Keynes, 1973a, pp. 271–272)

Keynes sent Robertson first drafts of the General Theory, where he grapples
with the Austrian micro-foundations. In his comments, Robertson differs
from Keynes on the analysis of the coordination between saving and
investment. In Robertson’s words: ‘I don’t think savings and value of
investment can get out of gear without a ‘‘departure of the banking system
from neutrality’’, but I do think savings and volume of investment can. I
think, by the way, that H’s [Hayek] charge that you use ‘‘output of
consumption goods’’ in different senses on p. 130 and p. 135 (Treatise)
[Keynes, 1930, vol. 5, pp. 118, 121–122] is, for what it’s worth, correct’
(Robertson to Keynes, 4 October 1931, cited in Keynes, 1973a, pp. 271–
272). Keynes responds that:

Savings and the value of investment can get out of gear without a departure of the
banking system from neutrality in Hayek’s sense (i.e. the gross value of money
corrected for changes in Fisherine velocity of circulation, and, if you like, the number
of times half-finished products change hands).
(Keynes, 1973a, p. 273)

Indeed, Keynes is interested in the value of investment, whereas

Robertson and Hayek focus on the volume of investment.

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 The Hayek–Keynes controversy

Furthermore, Robertson criticizes Keynes for not being fair with Hayek
in the first drafts of the General Theory:

While holding no particular brief for the Austrian jargon, I can’t help feeling that in
your criticism of it you are thinking too much of what you and I have called the
‘period of production’ — viz. the ‘working capital’ period, with fixed instruments
given. I would heartily agree that improvements in efficiency tend to shorten this
period, e.g. by making it possible to sow 2 crops a year, to reduce inventories etc. But
if by ‘starting up input’ one means, as the Austrian mean, mining the ore which is
going to make the machines which make the . . . reaping machines to harvest the
crops, then it is surely a different story.
(Robertson to Keynes, 10 February 1935, cited in Keynes, 1973a, p. 507)

Keynes’ answer is revealing: ‘God knows what the Austrian means by

‘‘period of production’’. Nothing, in my opinion’ (Keynes, 20 February
1935, cited in Keynes, 1973a, p. 517).
Nevertheless, in a letter to Sraffa and Kahn sent on 1 February 1932,
Keynes concedes that, even if ‘the abyss yawns’, he ‘can’t help feeling that
there is something interesting in it’. This letter may explain why Keynes
returns to Hayek’s roundaboutness of production in the General Theory.
The second stage refers to the preparatory notes of the General Theory that
include many references to the Austrian theory of capital (Keynes, 1973b, pp.
111–120). Chapter 17 of the General Theory is partly an answer to the Hayekian
critique. With chapter 16, it should be interpreted as an attempt from Keynes
to give a sense to the Austrian theory of capital (Mongiovi, 1990). From which
micro-foundations does Keynes derive his response to Hayek?
First, Keynes’ response stems from Sraffa’s thought on micro-founda-
tions. Indeed, two main actors from the Cambridge Circus intervened in
the debate with Hayek. On the one hand, Robinson (1933) proposes to
clarify Keynes’ (1930) concepts of saving and investment. Although
Robinson’s article did not appear in Economica until February 1933, it was
first written in the summer of 1931 (Keynes, 1973a, p. 268). In addition,
Sraffa attacks Hayek’s theory in the March issue of the Economic Journal.
This charge would be followed by an exchange between Sraffa and Hayek
in the June issue of the Economic Journal. Sraffa agrees with Hayek that a
general price level is not an index appropriate to the study of business
cycles (Syron-Lawlor & Horn, 1992, p. 323). But, and quite ironically, when
Hayek criticizes Keynes’ capital theory as being without micro-foundations,
Sraffa emphasizes the absence of sound micro-foundations in Hayek’s
capital theory. In Sraffa’s view, there is not a unique natural rate but as
many natural rates as there are commodities (Sraffa, 1932; see Syron-Lawlor
& Horn, 1992, p. 331). If consumers and entrepreneurs are identical, there
is no room for Hayek’s distinction between consumer goods and producer
goods (Sraffa, 1932, fn. 45; cf. Kurz, 2000).

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Abdallah Zouache

Keynes’ first reaction (in summer 1934) is to vote for Sraffa’s micro-
foundations. If there are many natural rates of interest, ‘forced saving or
analogous phrases employed more recently (e.g. by Professor Hayek or
Professor Robbins) have no definite relation to the difference between
investment and ‘‘saving’’ in the sense intended in my Treatise on Money’
(Keynes, 1973a, p. 478). This position would be corroborated in the final
version of the General Theory, especially in chapter 17, which confirms the
influence of Hayek’s critique on Keynes via Sraffa:

I am now no longer of the opinion that the concept of a ‘natural’ rate of interest,
which previously seemed to me a most promising idea, has anything very useful or
significant to contribute to our analysis. It is merely the rate of interest which will
preserve the status quo; and, in general, we have no predominant interest in the status
quo as such.
(Keynes, 1936, p. 243)

Keynes’ second reaction is to come back to classical micro-foundations to

tackle the Austrian concept of roundaboutness. In Keynes’ view, it is not
time that defines the yield of a process of production but the scarcity of
capital. In the draft of chapter 11 of the General Theory written in mid-1934
(Keynes, 1973a), one finds a response to Hayek’s Austrian version of the
micro-foundations when Keynes makes an allusion to Böhm-Bawerk’s
roundaboutness of production:

Before leaving, however, this part of our analysis into the nature of investment, I should
like to emphasise again that it is the scarcity of capital which is the essential reason why it
has a yield. It is true that some lengthy or roundabout processes are efficient. But so are
some short processes. Lengthy processes are not efficient because they are lengthy, any
more than short processes are efficient because they are short. Some lengthy processes
would be very inefficient, for there are such things as spoiling or wasting with time. With
a given labour force there is a definite limit to the quantity of labour embodied in
roundabout processes which can be used to advantage. Apart from many other
considerations, there must be a due proportion between the amount of labour
employed in making machines and the amount employed in using them. The ultimate
quantity of value will not increase indefinitely, relatively to the quantity of labour
employed, as the processes adopted become more and more roundabout.
(Keynes, 1973a, pp. 454–455)

The General Theory emphasizes the idea that, contrary to the Austrian
conception of capital, the efficiency of a structure of production is not
linked to the time delay between the decision to invest and the act of
consumption. Efficiency depends on the scarcity of capital:

It is much preferable to speak of capital as having a yield over the course of its life in
excess of its original cost, than being productive. For the only reason why an asset offers

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 The Hayek–Keynes controversy

a prospect of yielding during its life services having an aggregate value greater than its
initial supply price is because it is scarce; and it is kept scarce because of the
competition of the rate on interest on money. If capital becomes less scarce,
the excess yield will diminish, without its having become less productive-at least in the
physical sense.
(Keynes, 1936, p. 213)

Keynes’ solution to Hayek’s micro-foundations challenge is to appeal to

the classical value theory that presumes that ‘everything is produced by
labour, aided by what used to be called art and is now called technique, by
natural resources which are free or cost a rent according to their scarcity or
abundance’ (Keynes, 1936, p. 213). Within that framework, past labour
embodied in assets ‘also command a price according to their scarcity or
abundance’ (ibid.). In that case, roundabout processes are not always
efficient since ‘the ultimate quantity of value will not increase indefinitely,
relatively to the quantity of labour employed, as the process adopted
become more and more roundabout, even if their physical efficiency is still
increasing’ (Keynes, 1936, pp. 214–215).

3.3. Capital theory and lack of micro-foundations: The key role of Keynes’ marginal
efficiency of capital
It must be noted that Hayek’s methodological critique is not only addressed
to the Treatise. Indeed, a long time after the controversy with Keynes, Hayek
considered that one of the leading failures in the General Theory was its lack
of microeconomic foundations:

My disagreement with that book did not refer so much to any detail of the analysis as
to the general approach followed in the whole work. The real issue was the validity of
what we now call macro analysis, and I feel now that in a long run perspective, the
chief significance of The General Theory will appear that more than any other single
work it decisively furthered the ascendancy of macroeconomics and the temporary
decline of microeconomic theory.
(Hayek, 1966, pp. 98–99)

Furthermore, in part IV of The Pure Theory of Capital (1941, p. 374) –

which can be read as a review of the General Theory5 – Hayek criticizes
Keynes’ ‘economics of abundance’ that denies the crucial role of price
variations. It cannot be disputed that, in contrast to Hayek (1931c), Keynes
(1936) admits the legitimacy of a macroeconomic analysis. Keynes’ universe

5 I thank Carlo Zappia, who has indicated to me that, contrary to what is usually
thought, we have Hayek’s review of the General Theory in the last part of the Pure
Theory of Capital.

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Abdallah Zouache

in the General Theory is composed of aggregates such as aggregate

employment. Moreover, Keynes’ (1936) macroeconomics does not pay
enough attention to the micro-foundations of certain aggregate variables.
For example, Keynes (1936) does not explain the passage from the
individual to the aggregate propensity to consume. But it seems unfair to
argue that Keynes is not interested in microeconomic decisions in the
General Theory. In comparison to the Treatise, the General Theory discloses a
macroeconomic analysis with microeconomic foundations. Hayek’s mistake
is due to his reductionist interpretation of the micro-foundations.
Indeed, Keynes (1936, p. 293) distinguishes a microeconomic theory
dealing with the allocation of a given amount of resources and a
macroeconomic theory that determines the level of production and
employment in an aggregate economy. In Keynes’ (1936) view, the
independence of macroeconomics (the ‘theory of output and employment
as a whole’) relative to microeconomics (the ‘theory of value and
distribution’) results from the belief that the whole has not to be reduced
to the sum of its parts. Keynes rejects the fallacy of composition that extends
‘to the system as a whole conclusions which have been correctly arrived at in
respect of a part of it taken in isolation’ (Keynes, 1936, p. XXXII). The thesis
defended in the General Theory (1936) is that the passage from the
microeconomic to the macroeconomic level has consequences that can
only be grasped through the study of the economy as a whole6.
The traditional interpretation – shared by Hayek – asserts that the
individual does not matter in Keynes’ analysis (1936), which first of all
furnishes an aggregate view of the economic system7. Keynes’ macro-
economic analysis (1936) is considered as a theory without micro-
foundations (Lucas, 1980). Nevertheless, it seems that Keynes’ study of
aggregate phenomena in the General Theory is founded upon an analysis of
the behaviour of individual agents for at least two reasons.

6 This generalization is above all a generalization of Marshall’s framework because:

‘his [Marshall] theory of output and consumption as a whole, as distinct from his
theory of the production and distribution of a given output, was never separately
expounded’ (Keynes, 1936, p. XXIX).
7 See for example Kriesler (1997, p. 305): ‘In other words, Keynes is arguing for the
independence of microeconomic and macroeconomic factors. Macroeconomic
factors, by themselves, explain the volume of employment and output, independent
of microeconomic factors, which explain its composition. ( . . . ) Microeconomic
factors are taken as referring to those factors which determine price and output
of individual firms and industries, in other words, they determine the
composition of a given output and are determined by the structure of product
markets. Macroeconomic factors, on the other hand, determine the volume of
total output and employment. Keynes believed that this occurred independently
of the microeconomic factors’ (Kriesler, 1997, p. 305).

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 The Hayek–Keynes controversy

First, even if the General Theory puts forward a macroeconomic approach,

there is the reference to an aggregation procedure. Keynes (1936) is
conscious of the limitation of an aggregate analysis:

Anyone looking back at the development of Keynes’ economic thought must be

struck by his keen awareness of the aggregation problems involved in building macro-
models. He took great pains in making his assumptions clear and in performing his
aggregations in an explicit manner. It is strange, indeed, that he should be regarded
as the man who created a brand of macroeconomics completely divorced from the
theory of value.
(Leijonhufvud, undated, p. 2)

Keynes (1936) bears in mind the risk to regard aggregates as

homogeneous quantities, especially the aggregate output of goods and
services: ‘a non-homogeneous complex which cannot be measured, strictly
speaking, except in certain special cases, as for example when all the items
of one output are included in the same proportion in another output’
(Keynes, 1936, p. 38). Although Keynes (1936) does not advance a concise
method of aggregation, his proposal to make use of the wage and money
units illustrates his attempt to find the conditions of aggregation of
microeconomic phenomena (Keynes, 1936, p. 43).
Second, in the General Theory, the main macroeconomic variables are
deduced from the decisions of economic units. In particular, the theoretical
edifice that supports the General Theory – the principle of effective demand –
arises from producers’ behaviour. The principle of effective demand assumes
that the level of production is obtained from entrepreneurs’ expectations of
the level of demand (Keynes, 1936, pp. 24–25). Peter Howitt (1990, p. 72)
goes as far as to argue that the aim of the theory of effective demand is to
offer alternative microeconomic foundations to determine the level of
employment. Even the Austrian economist Ludwig M. Lachmann admits that
Keynes attributes importance to the divergence of individuals’ expectations
on which the pattern of investment decisions depends (Lachmann, 1973,
p. 51).
In that perspective, the concept of marginal efficiency of capital is a key
piece in the story since it can be viewed as an attempt by Keynes to respond
to Hayek’s attack on the lack of a capital theory in the Treatise. Now, Keynes’
marginal efficiency of capital is a microeconomic notion (Pasinetti, 1997, p.
206). Each entrepreneur makes forecasts on the future yield of many
prospective investment projects. If finance is accessible, it is rational for the
entrepreneur to carry out the investment projects that yield a rate of return
higher than the prevailing rate of interest (Keynes, 1936, chap. 11). Total
investment is no longer an addition of items as in the Treatise (Keynes, 1930,
vol. 5, p. 117) but a function derived from the sum of all entrepreneurs’

121
Abdallah Zouache

decisions. Furthermore, there is an explicit aggregation procedure in the

formation of the aggregate concept of marginal efficiency of capital:

For each type of capital we can build up a schedule, showing by how much investment it
will have to increase within the period, in order that its marginal efficiency should fall to
any given figure. We can then aggregate these schedules for all the different types of
capital, so as to provide a schedule relating the rate of aggregate investment to the
corresponding marginal efficiency of capital which that rate of investment will establish.
(Keynes, 1936, p. 136)

In an appendix to chapter 14, Keynes (1936) presents a survey of

previous analysis of the rate of interest. In section III of this appendix,
Keynes explains that he rejects the Austrian micro-foundations of capital
because they lead to a muddle between the rate of interest and the
marginal efficiency of capital:

A peculiar theory of the rate of interest has been propounded by Professor von Mises
and adopted from him by Professor Hayek and also, I think, by Professor Robbins;
namely, that changes in the rate of interest can be identified with changes in the
relative price levels of consumption-goods and capital-goods. It is not clear how this
conclusion is reached. But the argument seems to run as follows. By a somewhat drastic
simplification the marginal efficiency of capital is taken as measured by the ratio of the
supply price of new consumers’ goods to the supply price of new producers’ goods.
This is then identified with the rate of interest. The fact is called to notice that a fall in
the rate of interest is favourable to investment. Ergo, a fall in the ratio of the price of
consumers’ goods to the price of producers’ goods is favourable to investment.

By this means a link is established between increased saving by an individual and increased
aggregate investment. For it is common ground that increased individual saving will
cause a fall in the price of consumers’ goods, and, quite possibly, a greater fall than in
the price of producers’ goods; hence, according to the above reasoning, it means a
reduction in the rate of interest which will stimulate investment.
(Keynes, 1936, pp. 192–193, italics added)

But, in Keynes’ view, investment is stimulated either by a raising of the

schedule of the marginal efficiency or by a lowering of the rate of interest.
However, if there are several natural rates of interest, as indicated in
Sraffa (1932), which is the relevant one? In Keynes’ view (1936), the money-
rate of interest is the significant rate of interest because money is ‘par
excellence ‘‘liquid’’’ (Keynes, 1936, vol. 7, p. 234) since it has two special
features. First, money has a very small elasticity of production (Keynes,
1936, vol. 7, p. 230) and, second, money has an elasticity of substitution
equal, or nearly equal, to zero (Keynes, 1936, vol. 7, p. 231).
When the money-rate of interest is a macroeconomic variable in Hayek’s
framework (it is fixed by the banks), Keynes derives it from individual

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 The Hayek–Keynes controversy

behaviour. Indeed, the interest rate is determined by agents’ preference for

liquidity and represents the price that balances individuals’ decisions to
hold wealth in money or other assets, including bonds and equities.
Although Keynes may have failed to provide rigorous micro- and macro-
foundations to his interest theory based on liquidity preference (Leijon-
hufvud, 1981b), the micro-foundations of interest theory through money
demand gave important impulses to further developments of monetary
theory and finance theory (Tobin, 1958).
Finally, what matters is the economic reasoning related to those
divergent views on micro-foundations. In Keynes’ theory, there is always
an alternative to the ownership of real capital-assets, namely, the ownership
of money and debts, so that the prospective yield with which the producers
of new investment have to be satisfied is different from the prospective yield
set by the current rate of interest (Keynes, 1936, p. 213). As a result, the
monetary prospective yield (the monetary rate of interest) can differ from
the real prospective yield (marginal efficiency of capital) so that
macroeconomic coordination failures can emerge in the economy, leading
to involuntary unemployment. Keynes’ central message in the Treatise is
confirmed in the General Theory: the quantity of money can change without
affecting savings and investment because an autonomous financial sphere
exists. But now, the macroeconomic message – capitalist economies are
subject to macro coordination failures – is derived from micro-economic
foundations.

4. Conclusion
Compared with the former literature on the Hayek–Keynes controversy,
this interpretation gives rise to two results.
The first result is that the Hayek–Keynes controversy cannot be
thoroughly analysed without an assessment of the methodological feature
here interpreted with regard to the question of the microeconomic
foundations in business cycle theory. In that sense, this article teaches that
the debate on the microeconomic foundations of macroeconomics was
crucial right from the beginning of macroeconomics. This a priori
contemporary idée fixe – macroeconomics must be based on sound micro-
foundations – finds its origin notably in Hayek’s major theoretical attack
against the Treatise on Money (1930). Like Milton Friedman (1968) and
Robert E. Lucas (1977, 1980), Hayek insisted on the importance of studying
business cycles from microeconomic foundations. But, by micro-founda-
tions, Hayek first of all meant the reference to individual decisions whereas

123
Abdallah Zouache

contemporary standard macroeconomic literature thinks of micro-founda-

tions in terms of optimizing behaviour.
The second result is that Hayek’s review had a methodological impact
on the making of Keynes’ General Theory. Hayek was right with regard to
the lack of microeconomic foundations in the Treatise. But he was wrong
to maintain this critical view on Keynes’ methodological foundations after
the publication of the General Theory. Indeed, even if Keynes’ last book
does not advance a completed investigation on the micro-foundations
issue, one cannot argue, as Hayek (1966) did a long time after the
publication of the General Theory, that Keynes (1936) built his analysis
without referring to individual decisions. In Keynes’ mind (1936), a
macroeconomic approach examines the relations between aggregates in
a complex system of behavioural and structural interactions, of which
one must conserve the image of a global order without ignoring that this
order is the result of individual interactions. Finding an alternative to
the classical theory implies the establishment of a macroeconomic
framework that explores the aggregate implications of individual
behaviour. In that sense, Keynes (1936) was concerned with the issue
of micro-foundations.
Finally, the key opposition between Hayek and Keynes is that they suggest
two alternative conceptions of the micro-foundations. From a methodolo-
gical viewpoint, because of his extreme reductionism, Hayek denies that a
macroeconomic level of analysis is appropriate to explain business cycles. In
contrast, Keynes assigns to macroeconomics, seen as the study of functional
relationships between aggregates, a specific duty to display coordination
failures. From a theoretical standpoint, Hayek’s theory of capital is based
upon the Austrian interpretation of micro-foundations. It leads to the view
that coordination failures can only arise if money disrupts the micro-
economic conditions that determine the inter-temporal equilibrium. To
respond to Hayek’s challenge, Keynes is forced to refer to the classical
tradition – thanks to Sraffa (1932) – to define the marginal efficiency of
capital. Because of the fallacy-of-composition problem, individual decisions
can lead to sub-optimal aggregate outcomes, and especially involuntary
unemployment.

Acknowledgements
I wish to thank Hans-Michael Trautwein for many valuable comments he
raised on previous versions of this paper. The author is also grateful to two
anonymous referees for their comments. Finally, the article has benefited
from discussions with Robert Nadeau and Harald Hagemann.

124
 The Hayek–Keynes controversy

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Abstract
This article contributes to the literature on the Hayek–Keynes controversy
on two points. The first contribution is to show that the question of the
micro-foundations of macroeconomics is crucial to understand the Hayek–
Keynes controversy. The second contribution is to reveal that Hayek’s
attack on the micro-foundations issue had a methodological impact on the
making of the General Theory especially via the concept of marginal
efficiency of capital. The paper concludes that what finally contrasts Hayek
and Keynes is the kind of micro-foundations that economists should adopt
to explain business cycles.

Keywords
Keynes-Hayek, microeconomic foundations, capital

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