III. Neglect of Real for Monetary Aspects 7. KEYNES’S NEGLECT OF SCARCITY

Professor Hayek argues here that the Keynesian system rests implicitly on a denial of the existence of real scarcities, since it assumes that aggregate real output automatically changes in the same direction as total monetary expenditure—in other words, that every increase in money incomes automatically calls forth a corresponding supply of consumer goods and of investment goods.

Somewhat more careful consideration is needed of what exactly we mean here when we speak of an increase in investment. Strictly speaking, if we start from an initial equilibrium position where the existence of unused resources¹ is excluded by definition, an increase or decrease of investment should always mean a transfer of input from the production of consumers’ goods for a nearer date to the production of consumers’ goods for a more distant date, or vice versa. But where we assume that this diversion of input from one kind of production to another is accompanied, and in part brought about, by changes in total money expenditure, we cannot at the same time assume that prices will remain unchanged. It is, however, neither necessary nor advisable to adhere for our present purposes to so rigid a type of equilibrium assumption. At any rate, so far as concerns the impact effects of a rise in investment demand which we discussed in the last chapter, there is no reason why we should not assume that the additional input which is being invested has previously been unemployed, so that the increase in investment means a corresponding increase in the employment of all sorts of resources without any increase of prices and without a decrease in the production of consumers’ goods. This assumption simply means that there are certain limited quantities of various resources available which have been offered but not bought at current prices, but which would be employed as soon as demand at existing prices rose. And since the amount of such resources will always be limited, the effect of making this assumption will be that we must distinguish between the effects which an increase of investments and income will have while there are unused resources of all kinds available and the effects which such an increase will have after the various resources become successively scarce and their prices begin to rise.

Investment Demand and Incomes

The initial change from which we started our discussion in the last chapter, an invention which gives rise to a new demand for capital, means that with given prices the margin between the cost of production and the price of the product produced with the new process will be higher than the ruling rate of profit, i.e., that the marginal rate of profit on the former volume of production will have risen. The first result of this, as we have seen, will be that investment will increase, the marginal rate of profit will fall, and the cash balances will decrease till the desire for holding the marginal units of the decreased cash balances is again just balanced by the higher profits which may be obtained by investing them. This new rate of profit will be somewhere between the old rate and the higher rate which would exist if investment had not increased. But since this additional investment has been financed by a release of money out of idle balances, incomes will have increased, and as a consequence the demand for consumers’ goods will also increase, although probably not to the full extent, as some of the additional income is likely to be saved.

If we assume that there are unused resources available not only in the form of factors of production but also in the form of consumers’ goods in all stages of completion, and so long as this is the case, the increase in the demand for consumers’ goods will for some time lead merely to an increase in sales without an increase of prices. Such an increase of the quantity of output which can be sold at given prices will have the effect of raising the investment demand further, or, more exactly, of shifting our returns curve to the right without changing its shape. The amount that it will appear profitable to borrow and invest at any given rate of interest will accordingly increase; and this in turn will mean that, though some more money will be released from idle balances, the rate of interest and the rate of profit will be raised further. And since this process will have raised incomes still further, it will be repeated: that is, every further increase in the demand for consumers’ goods will lead to some further increase of investment and some further increase of the rate of profit. But at every stage of this process some part of the additional income will be saved, and as rates of interest rise, any given increase in final demand will lead to proportionally less investment. (Or, what is really the same phenomenon, only seen from a different angle, successive increases of investment demand will lead to the release of decreasing amounts of money from idle balances.) So the process will gradually slow down and finally come to a stop.

Final Position of Rate of Return

Where will the rate of interest be fixed in this final equilibrium? If we assume the quantity of money to have remained constant, it will evidently be above the rate which ruled before the initial change occurred and even above the somewhat higher impact rate which ruled immediately after the change occurred, since every revolution of the process we have been considering will have raised it a little further. But under our present assumptions there is no reason why, even when this process comes to an end, the rate of interest need have risen to the full extent to which it would have risen in the beginning had the supply of investible funds been entirely inelastic. Thus, under the conditions we have considered, the release of money from idle balances (and the same would of course be true of an increase in the quantity of money) may keep the rate of profit and interest lastingly below the figure to which it would have risen without any such monetary change.

Let us be quite clear, however, about which of our assumptions this somewhat surprising result is due to. We have assumed that not only the supply of pure input but also the supply of final and intermediate products and of instruments of all kinds was infinitely elastic, so that every increase in demand could be satisfied without any increase of price, or, in other words, that the increase of investment (or we should rather say output) was possible without society in the aggregate or even any single individual having to reduce consumption in order to provide an income for the additional people now employed. Or, in other words, we have been considering an economic system in which not only the permanent resources but also all kinds of non-permanent resources, that is, all forms of capital, were not scarce. There is indeed no reason why the price of capital should rise if there are such unused reserves of capital available, there is even no reason why capital should have a price at all if it were abundant in all its forms. The existence of interest in such a world would indeed be due merely to the scarcity of money, although even money would not be scarce in any absolute sense; it would be scarce only relatively to given prices on which people were assumed to insist. By an appropriate adjustment of the quantity of money the rate of interest could, in such a system, be reduced to practically any level.

Mr. Keynes’s Economics of Abundance

Now such a situation, in which abundant unused reserves of all kinds of resources, including all intermediate products, exist, may occasionally prevail in the depths of a depression. But it is certainly not a normal position on which a theory claiming general applicability could be based. Yet it is some such world as this which is treated in Mr. Keynes’s General Theory of Employment, Interest and Money, which in recent years has created so much stir and confusion among economists and even the wider public. Although the technocrats, and other believers in the unbounded productive capacity of our economic system, do not yet appear to have realised it, what he has given us is really that economics of abundance for which they have been clamouring so long. Or rather, he has given us a system of economics which is based on the assumption that no real scarcity exists, and that the only scarcity with which we need concern ourselves is the artificial scarcity created by the determination of people not to sell their services and products below certain arbitrarily fixed prices. These prices are in no way explained, but are simply assumed to remain at their historically given level, except at rare intervals when ‘full employment’ is approached and the different goods begin successively to become scarce and to rise in price.

Now if there is a well-established fact which dominates economic life, it is the incessant, even hourly, variation in the prices of most of the important raw materials and of the wholesale prices of nearly all foodstuffs. But the reader of Mr. Keynes’s theory is left with the impression that these fluctuations of prices are entirely unmotivated and irrelevant, except towards the end of a boom, when the fact of scarcity is readmitted into the analysis, as an apparent exception, under the designation of ‘bottlenecks’.² And not only are the factors which determine the relative prices of the various commodities systematically disregarded;³ it is even explicitly argued that, apart from the purely monetary factors which are supposed to be the sole determinants of the rate of interest, the prices of the majority of goods would be indeterminate. Although this is expressly stated only for capital assets in the special narrow sense in which Mr. Keynes uses this term, that is, for durable goods and securities, the same reasoning would apply to all factors of production. In so far as ‘assets’ in general are concerned the whole argument of the General Theory rests on the assumption that their yield only is determined by real factors (i.e., that it is determined by the given prices of their products), and that their price can be determined only by capitalising this yield at a given rate of interest determined solely by monetary factors.⁴ This argument, if it were correct, would clearly have to be extended to the prices of all factors of production the price of which is not arbitrarily fixed by monopolists, for their prices would have to be equal to the value of their contribution to the product less interest for the interval for which the factors remained invested.⁵ That is, the difference between costs and prices would not be a source of the demand for capital but would be unilaterally determined by a rate of interest which was entirely dependent on monetary influences.

Basic Importance of Scarcity

We need not follow this argument much further to see that it leads to contradictory conclusions. Even in the case we have considered before of an increase in the investment demand due to an invention, the mechanism which restores the equality between profits and interest would be inconceivable without an independent determinant of the prices of the factors of production, namely their scarcity. For, if the prices of the factors were directly dependent on the given rate of interest, no increase in profits could appear, and no expansion of investment would take place, since prices would be automatically marked to make the rate of profit equal to the given rate of interest. Or, if the initial prices were regarded as unchangeable and unlimited supplies of factors were assumed to be available at these prices, nothing could reduce the increased rate of profit to the level of the unchanged rate of interest. It is clear that, if we want to understand at all the mechanism which determines the relation between costs and prices, and therefore the rate of profit, it is to the relative scarcity of the various types of capital goods and of the other factors of production that we must direct our attention, for it is this scarcity which determines their prices. And although there may be, at most times, some goods an increase in demand for which may bring forth some increase in supply without an increase of their prices, it will on the whole be more useful and realistic to assume for the purposes of this investigation that most commodities are scarce, in the sense that any rise of demand will, ceteris paribus, lead to a rise in their prices. We must leave the consideration of the existence of unemployed resources of certain kinds to more specialised investigations of dynamic problems.

This critical excursion was unfortunately made necessary by the confusion which has reigned on this subject since the appearance of Mr. Keynes’s General Theory.

(The Pure Theory of Capital, pp. 370–76)

8. IMPORTANCE OF REAL FACTORS

The following passage is the concluding section of a long, intricate and very closely argued exposition of the influence of price changes on the relative profitability of investment in the different stages of production; it demonstrates that it is the relative scarcities of types of goods in relation to the monetary expenditure on them that ultimately determine these prices and price changes. The whole discussion presents a sharp contrast to the ‘en bloc’ thinking of the macro-approach.

We will conclude the present treatment by once more stressing the fact that, though in the short run monetary influences may delay the tendencies inherent in the real factors from working themselves out, and temporarily may even reverse these tendencies, it will in the end be the scarcity of real resources relative to demand which will decide what kind of investment, and how much, is profitable. The fundamental fact which guides production, and in which the scarcity of capital expresses itself, is the price of input in terms of output, and this in turn depends on the proportion of income spent on consumers’ goods compared with the proportion of income earned from the current production of consumers’ goods. These proportions cannot be altered at will by adjustments in the money stream, since they depend on the one hand on the real quantities of the various types of goods in existence, and on the other hand on the way in which people will distribute their income between expenditure on consumers’ goods and saving. Neither of these factors can be deliberately altered by monetary policy. As we have seen, any delay by monetary means of the adjustments made necessary by real changes can only have the effect of further accentuating these real changes, and any purely monetary change which in the first instance deflects interest rates in one direction is bound to set up forces which will ultimately change them in the opposite direction.

Significance of Rate of Saving

Ultimately, therefore, it is the rate of saving which sets the limits to the amount of investment that can be successfully carried through. But the effects of the rate of saving do not operate directly on the rate of interest or on the supply of investible funds, which will always be influenced largely by monetary factors. Its main influence is on the demand for investible funds, and here it operates in a direction opposite to that which is assumed by all the under-consumptionist theories. It will be via investment demand that a change in the rate of saving will affect the volume of investment. Similarly, it will be via investment demand that, if monetary influences should have caused investment to get out of step with saving, the balance will be restored. If throughout this discussion we have had little occasion to make explicit mention of the rate of saving, this is due to the fact that the effects considered will take place whatever the rate of saving, so long as this is a given magnitude and does not spontaneously change so as to restore the disrupted equilibrium. All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumers’ goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumers’ goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income, and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved.⁶

The relative prices of the various types of goods and services, and therefore the rate of profit to be earned in their production, will always be determined by the impact of the monetary demand for the various kinds of goods and the supplies of these goods. And unless we study the factors limiting the supplies of these various types of goods, and particularly if we assume, as Mr. Keynes does, that they are all freely reproducible in practically unlimited quantities and without any appreciable lapse of time, we must remain in complete ignorance of the factors guiding production. In long-run equilibrium, the rate of profit and interest will depend on how much of their resources people want to use to satisfy their current needs, and how much they are willing to save and invest. But in the comparatively short run the quantities and kinds of consumers’ goods and capital goods in existence must be regarded as fixed, and the rate of profit will depend not so much on the absolute quantity of real capital (however measured) in existence, or on the absolute height of the rate of saving, as on the relation between the proportion of the incomes spent on consumers’ goods and the proportion of the resources available in the form of consumers’ goods. For this reason it is quite possible that, after a period of great accumulation of capital and a high rate of saving, the rate of profit and the rate of interest may be higher than they were before—if the rate of saving is insufficient compared with the amount of capital which entrepreneurs have attempted to form, or if the demand for consumers’ goods is too high compared with the supply. And for the same reason the rate of interest and profit may be higher in a rich community with much capital and a high rate of saving than in an otherwise similar community with little capital and a low rate of saving.

(The Pure Theory of Capital, pp. 393–96)

9. DANGERS OF THE SHORT RUN

This extract, the closing paragraphs of The Pure Theory of Capital, concludes a long discussion of the interaction of real and monetary factors influencing interest-rate changes. Professor Hayek again stresses the superficiality of an analysis that confines itself to the immediate monetary impact of any policy and neglects its real long-term effects.

The importance of the real factors is increasingly disregarded in contemporary discussion. But even without further continuing the discussion of the role money plays in this connection, we are certainly entitled to conclude from what we have already shown that the extent to which we can hope to shape events at will by controlling money is much more limited, that the scope of monetary policy is much more restricted, than is today widely believed. We cannot, as some writers seem to think, do more or less what we please with the economic system by playing on the monetary instrument. In every situation there will in fact always be only one monetary policy which will not have a disequilibrating effect and therefore eventually reverse its short-term influence. That it will always be exceedingly difficult, if not impossible, to know exactly what this policy is does not alter the fact that we cannot hope even to approach this ideal policy unless we understand not only the monetary but also, what are even more important, the real factors that are at work. There is little ground for believing that a system with the modern complex credit structure will ever work smoothly without some deliberate control of the monetary mechanism, since money by its very nature constitutes a kind of loose joint in the self-equilibrating apparatus of the price mechanism which is bound to impede its working—the more so the greater is the play in the loose joint. But the existence of such a loose joint is no justification for concentrating attention on that loose joint and disregarding the rest of the mechanism, and still less for making the greatest possible use of the short-lived freedom from economic necessity which the existence of this loose joint permits. On the contrary, the aim of any successful monetary policy must be to reduce as far as possible this slack in the self-correcting forces of the price mechanism, and to make adaptation more prompt so as to reduce the necessity for a later, more violent, reaction. For this, however, an understanding of the underlying real forces is even more important than an understanding of the monetary surface, just because this surface does not merely hide but often also disrupts the underlying mechanism in the most unexpected fashion. All this is not to deny that in the very short run the scope of monetary policy is very wide indeed. But the problem is not so much what we can do, but what we ought to do in the short run, and on this point a most harmful doctrine has gained ground in the last few years which can only be explained by a complete neglect—or complete lack of understanding—of the real forces at work. A policy has been advocated which at any moment aims at the maximum short-run effect of monetary policy, 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 tomorrow and the day after.

Betrayal of Economists’ Duty

I cannot help regarding the increasing concentration on short-run effects—which in this context amounts to the same thing as a concentration on purely monetary factors—not only as a serious and dangerous intellectual errors, but as a betrayal of the main duty of the economist and a grave menace to our civilisation. To the understanding of the forces which determine the day-to-day changes of business, the economist has probably little to contribute that the man of affairs does not know better. It used, however, to be regarded as the duty and the privilege of the economist to study and to stress the long-run effects which are apt to be hidden to the untrained eye, and to leave the concern about the more immediate effects to the practical man, who in any event would see only the latter and nothing else. The aim and effect of two hundred years of continuous development of economic thought have essentially been to lead us away from, and ‘behind’, the more superficial monetary mechanism and to bring out the real forces which guide long-run development. I do not wish to deny that the preoccupation with the ‘real’ as distinguished from the monetary aspects of the problems may sometimes have gone too far. But this can be no excuse for the present tendencies which have already gone far towards taking us back to the pre-scientific stage of economics, when the whole working of the price mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices aroused interest. It is not surprising that Mr. Keynes finds his views anticipated by the mercantilist writers and gifted amateurs: concern with the surface phenomena has always marked the first stage of the scientific approach to our subject. But it is alarming to see that after we have once gone through the process of developing a systematic account of those forces which in the long run determine prices and production, we are now called upon to scrap it, in order to replace it by the short-sighted philosophy of the business man raised to the dignity of a science. Are we not even told that, ‘since in the long run we are all dead’, policy should be guided entirely by short-run considerations? I fear that these believers in the principle of après nous le déluge may get what they have bargained for sooner than they wish.

(The Pure Theory of Capital, pp. 407–10)

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¹This means unused resources which could be had at the ruling market price. There will of course always be further reserves which will be offered only if prices rise.

²I should have thought that the abandonment of the sharp distinction between the ‘freely reproducible goods’ and goods of absolute scarcity and the substitution for this distinction of the concept of varying degrees of scarcity (according to the increasing costs of reproduction) was one of the major advances of modern economics. But Mr. Keynes evidently wishes us to return to the older way of thinking. This at any rate seems to be what his use of the concept of ‘bottlenecks’ means; a concept which seems to me to belong essentially to a naive early stage of economic thinking and the introduction of which into economic theory can hardly be regarded as an improvement.

³It is characteristic that when at last, towards the end of his book, Mr. Keynes comes to discuss prices, the ‘Theory of Price’ is to him merely ‘the analysis of the relations between changes in the quantity of money and changes in the price level’ (General Theory, p. 296).

⁴Cf. General Theory, p. 137: ‘We must ascertain the rate of interest from some other source and only then can we value the asset by “capitalising” its prospective yield’.

⁵The reason why Mr. Keynes does not draw this conclusion, and the general explanation of his peculiar attitude towards the problem of the determination of relative prices, is presumably that under the influence of the ‘real cost’ doctrine which to the present day plays such a large role in the Cambridge tradition, he assumes that the prices of all goods except the more durable ones are even in the short run determined by costs. But whatever one may think about the usefulness of a cost explanation of relative prices in equilibrium analysis, it should be clear that it is altogether useless in any discussion of problems of the short period.

⁶The rate at which a given amount of new investment will contribute during any given interval of time to the output of consumers’ goods stands of course in a very simple relation to the proportion between any new demand and the amount of investment to which it gives rise: the latter is simply the reciprocal value of the former. For a fuller discussion of the relationship between this ‘quotient’ and the ‘multiplier’ with which the ‘acceleration principle of derived demand’ operates I must again refer to Hayek (Profits, Interest and Investment, pp. 48–52).

It cannot be objected to this argument that, since investment automatically creates an identical amount of saving, the situation contemplated here cannot arise. The irrelevant tautology, that during any interval of time the amount of income which has not been received from the sale of consumers’ goods, and which therefore has been saved (namely, by those who spent that income), must have been spent on something other than consumers’ goods (and therefore ex definitione must have been invested), is of little significance for this or for any other economic problem. What is relevant here is not the relation between one classification of money expenditure and another, but the relation of two streams of money expenditure to the streams of goods which they meet. We are interested in the amount of investment because it determines in what proportions (in terms of their relative costs) different kinds of goods will come into existence. And we are interested to know how these proportions between quantities of different kinds of goods are related to the proportions in which money expenditure will be distributed between the two kinds of goods, because it depends on the relation between these two proportions whether the production of either kind of good will become more or less profitable. It does not matter whether we put this question in the form of asking whether the distribution of income between expenditure on consumers’ goods and saving corresponds to the proportion between the relative (replacement) costs of the total supply of consumers’ goods and new investment goods, or whether the available resources are now distributed in the same proportion between the production of consumers’ goods and the production of investment goods as those in which income earned from this production will be distributed between the two kinds of goods. Whichever of the two aspects of the question we prefer to stress, the essential thing, if we want to ask a meaningful question, is that we must always compare the result of investment embodied in concrete goods with the money expenditure on these goods. It is never the investment which is going on at the same time as the saving, but the result of past investment, that determines the supply of capital goods to which the monetary demand may or may not correspond. Playing about with the relationships between various classifications of total money expenditure during any given period will lead only to meaningless questions, and never to any result of the slightest relevance to any real problem.

I do not wish to suggest that the recent discussions of the various meanings of these concepts have been useless. They have helped us to make clear the conditions under which it is meaningful to talk about relations between saving and investment. But now that the obscurities and confusions connected with these concepts have been cleared up, the meaningless tautological use of these concepts ought clearly to disappear from scientific discussion. On the whole question, and the recent discussions about it, compare now the excellent exposition in the new Chapter 8 of the second edition of Professor Haberler’s Prosperity and Depression (Geneva: League of Nations, 1939).