Hayek and Keynes

8/13/2019 Hayek and Keynes

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The Suntory and Toyota International Centres for Economics and Related Disciplines

The Pure Theory of Money. A Reply to Dr. HayekAuthor(s): J. M. KeynesSource: Economica, No. 34 (Nov., 1931), pp. 387-397Published by: Wileyon behalf of The London School of Economics and Political Scienceand The Suntory

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The PureTheory fMoney.A ReplytoDr. HayekBy J. M. KEYNES.

IIN an article recentlypublished in ECONOMICA (August, I931)1Dr. Hayek has invited me to clear up some ambiguitiesof termi-nologywhichhe finds n my Treatise on Money, and also othermatters. As he frankly says, he has foundhis difference ithme difficult o explain. He is sure that my conclusions arewrong (thoughhe does not clearly state whichconclusions),buthe finds t " extremelydifficulto demonstratehe exact pointofdisagreementand to state his objections." He feels that myanalysis leaves outessentialthings,buthe declaresthat" it is notat all easy todetect heflaw n theargument." What he has done,therefore,s to pickover theprecisewords haveused witha viewto discovering ome verbal contradiction r insidious ambiguity.I think I can show that most of my alleged terminologicalinconsistencies re either non-existent r irrelevant o mycentraltheme. But whenI have done this (which will attempt n someshort notes at the end of this article), I feel sure that I shallhave made littleor no progresstowards convincingDr. Hayek.For it is, not really my use of language or the fact that mytreatmentfalls far shortof a completeanalysis (as it certainlydoes) which s troublinghim. It is somethingmuchmorefunda-mental. And afterreading his article carefully, have no doubtat all what it is.

IIDr. Hayek has seriouslymisapprehended he characterofmyconclusions. He thinksthatmy centralcontention s somethingdifferentromwhatit really is. I deduce this from wopassagesin his article. The first page 290, the italics are mine) is asfollows: " The factthatmore (or less) moneyis being investedthan s being aved s equivalent o so muchmoney eing ddedReflectionsn the PureTheory fMoneyof Mr.J.M. Keynes."387

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388 ECONLOMIICA [NOVEMBERto (or withdracu nromji)ndutstrialircuilatioll,o that the total ofprofits, r thedifferenceetweenthe expenlditurend thereceiptsof the entrepreneurs,wlhichs tlleessenltial lement n the secondtermof the fundamental quations, will be equialto tlieniet ddi-tionlto (or siubtraction romii) he effecti- circulationt. It ishere,accordinlg o Mr. Keynes, that we findthemonetary ausesworkingfor a chaiige in the price level; andhe considersit themain advantage of his fundamentalequations that they isolatethis factor." The second passage is on page 292 " The differ-ence (between us) seems to lie in the fact that Mr. Keyinesbelieves thatit is possible to adapt the amnoult f money n circu-lation to what is necessary for the 4Maintelnancef existingcontractswithoutupsettingthe equilibrium betweenl aving andinvesting. But under tlle existinlgmonetary rganisationi,whiereall changes in the quantityofmnoneyn circulationtare broubhtabouit by m-eorer less mioney beinig lenit to entrepreneursthlants beinzg aved,2 any change in the circulation muistbeaccompaniedby a differenceetweensaving and investing."

These quotations may be supplementedby a passage fromDr. Hayek's Prices and Production (page 23) w-here he suc-cinctly states his own theory " It is perfectlyclear that, inorder that the supply and demand for real capital should beequalised, the banks must not lend more or less thl,an as beendepositedwiththemas savings. Anid thismeans niaturally hatthey must never change thte ainouint of their circuilation.3 Atthe same time, it is no less clear that, in order that the pricelevel may remain unchanged, the amount of money in circula-tioln must change as tlle volume of productioln ncreases ordecreases. The banks could eit7herkeep the demuand or realcapital withinthe limits set by the supply of savinlgs, or keepthe price level steady; but they cannot performboth functionsat once.NowT he passages which I have italicised in the firstof thesequotations are far removedfromthe theoryof my Treatise onMoney. It is essential to that theoryto deny these propositions-which Dr. Hayek puts in mnymouthand, to judge fromthesecond and thirdquotatiolns, elieves himself. No wonderthathe finds many of my colnclusions nconsistentwith them. Solong as a problemof this major magnitude is not cleared upbetweeln s, what is the use ofdiscussilng irritating termino-logy, which might not bother Dr. Hayek at all if he werenot, for these excellent other reasons, lookilngfor trouble?2 M5Vtalics. 3 Mv italics.



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I93I] T1H PURE THEORY OF MONEY 389Dr. Hayek has missed, or at least does not discuss, the criticalpoint at which our arguments part company. Having passedthis by, but findinghimselfbeing led down strangeand distaste-ful paths, he tries to preventhimself frombeing dragged alongany furtherby representingthe molehills in the pathway asmountains.Dr. Hayek holds himself, nd impliesthat I also hold, thatanact of monetary xpansion-meaning by this a transference romthe inactive deposits to the active deposits the total quantityofmoney being unchanged,or an increase in the total quantityofmoney the quantityof the inactive depositsbeing unchanged4-is not merely a possible cause of investment xceeding saving,but (I) that t is a necessarycause of this and (2) that the amountofthemonetary xpansionexactly measuresthe excess of invest-ment over saving and hence is exactly equal to the amountof profits in my terminology). Will Dr. Hayek reconsider womatters -(i) what passage can he quote from my Treatisewhich justifies him in attributing he above theoryto me? (ii)what proof an he offerwhich ustifieshim in holding t himselfIn my Rejoinder to Mr. D. H. Robertson,published in theEconomic Journalfor September, I93I, I have endeavouredtore-state n a clearerway what my owntheory ctually is. If thetotal quantity of money be supposed constant, Dr. Hayek'stheorycomes to the same thingas the theorythat the excess ofsaving over investment is measured by the increase of theinactive deposits,which, in the above article, I have attributedto " somereaders" though did notthenknowthat Dr. Hayekwas among them.Since Dr. Hayek has notbeen alone amongstcompetent riticsofmyTreatise in falling nto this misapprehensionor intosomemore subtle variationof it), it must be my own fault, at leastin part. I suspect that it may be partly due to the fact thatwhen first egan to workon Book III of my Treatise I believedsomethingresembling hismyself. My ceasing to believe it wasthe critical point in my own developmentand was the germfromwhich much of my eventual theorywas workedout. It isextraordinary hat I should not have made this clear, because Iwas acutely consciousof the differencef general outlookwhichthe change of view involved; and after had adopted this newview, I was at greatpains to bringthe restofmyworkinto line

4 This is what his words mean in the firstpassage quoted above, but inthe passage I have quoted from Prices and Production Dr. Hayek simplifiesthis (vide the words italicised) into an increase in the total quantity ofmoney, but perhaps certain qualifications are to be understood.



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390 ECONOMICA [NOVEMBERwith it. But traces of old trains of thought are not easilyobliterated,and certainpassages which I wrote some time ago,may have been unconsciouslycast into a mould less obviouslyinconsistentwith llmy wn formerviews thain heywould be if Iwere writingnow.Yet I doubt f it is all my fault. For anyone broughtup in theold Quantity-of-Money, Velocity-of-Circulation schools ofthought,whether t be CambridgeQuantityEquations or FisherQuantityEquations, this seems to be, forsome obscure reason,a difficultransitionto make. Indeed I foundit so myself. Ifthe true theorywere what Dr. Hayek believes it to be, thetransitionwould be-easy. If, on the otherhand, my theory sright,not only is the angle of approach different,ut it is difi-cult to see just what the relationshipis betweenthe new viewand the old. Thus thosewho are sufficientlyteeped in the oldpoint of view simply cannot bring themselves to believe thatI am asking themto step into a new pair of trousers,and willinsist on regardingit as nothingbut an embroideredversionofthe old pair which they have been wearing foryears. Even so,I could neverhave expected, f it had notbeen formore than oneexperience to the contrary,that a competenteconomistcouldread my Treatise carefullyand leave it withthe idea that it wasmy view that the difference etween saving and investmentcould be exactlymeasured by changes in the quantityof money,whether t be in the inactive circulationor the active circulationor the total circulation,correctedor uncorrectedforchanges inthevelocitvofcirculationor the volume ofoutputor the numberoftimes intermediate roductschange hands.At any rate this-and notwhether may have used the wordinvestment in a differentense in one chapterfromwhat Ihave in another-is the issue which Dr. Hayek and I ought todebate.- He has taken as the self-evidentbasis of his theory(" it is perfectlvclear that " is his own phrase) a propositionwhich I deny. But we have lnothithertogot to grips, becauseany denial ofhis own doctrinehas seemedto him so unthiinkable,that even thousands of words of mine directedto its refutationhave been water off duck's back, and whilsthe notices that Ihold conclusiolnsnconsistentwith t, he seems still unaware thatI have disputed t from he outset.The point, put very briefly, s, firstly, hat money may beadvanced to entrepreneursdirectlyby thebanks, or through henew issue marketor by the sale by themoftheirexistingassets)either to meet losses or to providefor new investment, nd that



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193I] THE PURE THEORY OF MONEY 39Istatisticsof the quantity of money do not enable us to distin-guish between he two cases; and, secondly to indicatea generalprincipleby means of an illustration),that, if, desiring to bemore liquid I sell Consols to my bank in exchange for a bankdeposit and my bank does not choose to offset his transactionbut allows its depositsto be correspondinglyncreased,thequan-tity of money is changed without anything having happenedeither to saving or to investment.

IIIIt will be worth while to pursue the matter a little further.For reading Dr. Hayek's ECONOMICA article in the light of hisbook Prices and Production, and re-readingMr. Robertson'sEconomic Journialrticlein the light of Dr. Hayek's two contri-butions, I fancy that I see at last where the stumbling-blockreally is. Let me try,therefore,o bringmatters o an issue bystating what I believe to be Dr. Hayek's fundamentaltheoryand by explaininghow, if I am right that this is what he holds,

it differs rom my theory. I would add that Mr. Robertson'soriginal theorywas, I think, substanitially he same as thatwhich I am imputing to Dr. Hayek; though Mr. Robertsonmay have now moved somewhat away from t." Voluntary" saving, according to Dr. Hayek, always findsits way into investment. This is so because (in his view5) anincreaseof saving means (cet. par.) a net increase of purchasingpowerdirectedto the buyingof whatI call " investment oods "but which Dr. Hayek calls " intermediateproducts and Mr.Robertson calls " machines."' It does not, however, followfrom this (Dr. Hayek continues) that voluntary saving andinvestmentre always equal. For ifthebanking system ncreasesthe supply of money, additional funds will be available forinvestmentn excess oftheamountprovidedbyvoluntary aving,withthe resultthat investmentwill exceed saving, and contrari-wise if the banking system decreases the supply of money.5 This is clearly assumed in pp. 45, 46, of his Prices and Production. Dr.Hayek must have overlooked the fact that it is fundamental to my positionto deny this, because, if he had noticed something so much opposed to hisown theory, he must surely have criticised it. I need not pursue myreasons here, as it is precisely the same point which has been the subjectof discussion between Mr. Robertson and myself n the September EconomzicJottrnal.6 Dr. Hayek not only implies that an increase of purchasing powerdirected as the result of an increase of saving to the buying of intermediateproducts must be spent on newly produced intermediate products, but alsoon newly produced intermediate products which would not have been pro-

duced otherwise. At least I cannot make sense of Chapter TI of his Pricesand Production except on this assumption.



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392 ECONOMICA [NOVEMBERThus, in his view, a disequilibriumbetweensaving and invest-ment s necessarilytheresultofaction on thepartof thebankingsystem,7 nd, if we start froma positionof equilibrium,cannotpossibly arise otherwise. Sometimeshe assumes that the excess(or deficiency) f investment s exactly equal to the change inthe quantityof money-though thereare passages in his Pricesand Productionwhichseem to me to be inconsistentwiththis-in which case investment s equal to voluntarysaving plus (orminus) the change in the quantityof money. Investmentdue toan increase in the quantity of money involves the public in acorresponding mountofwhat may be called '" forced saving.Thus (to quote fromDr. Hayek's Prices and Production,page45) "a transition o moreor less capitalisticmethodsof produc-tion . . . may come about in one of two ways: either as aresult of changes in the volume of voluntary saving (or itsopposite), or as a result of a change in the quantityof moneywhich alters the funds at the disposal of entrepreneurs,orthepurchase of producers' goods." Thus it is only a departureon the part of the banking systemfromwhat Dr. Hayek callsneutrality,which s capable ofupsetting he equilibriumbetweensaving and investment, and holding this view Dr. Hayeknaturallyasks me (ECONOMICA, page 293) : " How can the (new)moneyget into circulationwithout reatinga discrepancybetweensaving and investment?"Thus Dr. Hayek conceives of the flowof purchasing poweras beingmade up ofthe incomes(howdefined do notknow, .e.whether qual tomyE or myE + Q or to neither)of the factors fproductionplus the new money' (if any) createdby the bankingsystem. This double stream s thendividedbetweenconsumers'goods and producers'goods. If saving is increased, ess purchas-ing power is directed towardsconsumers' goods with the resultthat theirprice falls. At the same timemorepurchasingpowermust be directedpari passu towards producers' goods with theresultthat-I am not sure at thispointwhetherDr. Hayek holdsthat theirpricerises orthatthequantityproduced s increasedorthat a different ind of producers' goods is produced, but theargumentof Prices and Production,Chapter II, seemsto require

7 It should be explained to those who have not read Dr. Hayek's bookthat he does not regard as " action " on the part of the banking system, i.e.as a departure by them fromneutrality,changes in the quantity of monevrequired to offset hanges in the velocity of circulation or in the number oftimes that intermediate products change hands before reaching theconsumer.8 Beyond what is required to offsetchanges in the velocity of circulationand in the number of times that intermediate products change hands.



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I93I] THE PURE THEORY OF MONEY 393that there will be an output of a different ind of producers'goods.9Dr. Hayek concludes-and indeed it follows f one allows himhis initial assumptions-that the necessaryconditionof avoidingCreditCycles is forthebanking systemto maintainthe effectivequantityof money (interpreting his in Dr. Hayek's quite in-telligiblesense) absolutelyand for ever unaltered.My analysis is quite different romthis; as it necessarilymust be, since, in my view, saving and investment as I definethem)can get out ofgear without ny change on the part ofthebanking systemfrom" neutrality as definedby Dr. Hayek,merelyas a resultof the public changingtheir rate of saving orthe entrepreneurs hangingtheirrate of investment, herebeingno automaticmechanism n theeconomic ystem as Dr. Hayek'sview would imply theremust be) to keep the two rates equal,providedthat the effectiveuantityofmoney s unchanged.As I conceive it, a changing price-level-due to a change inthe relationbetween saving and investment, osts of productionbeing unchanged-merely redistributespurchasing power be-tween those who are buying at the changed price-level andthosewho are selling at it, as comparedwithwhat would havehappenedif therehad notbeen a change in the relationbetweensaving and investment. I am not sure that Dr. Hayek seesclearly the two sides of the account. Has he, moreover, ppre-hended the significanceof my equation S + Q I, namely thatsavings plus profits re always exactly equal to the value of newinvestment? It followsfromthis that, if we define ncome toinclude Profits, and Savings as being the excess of Incomethus defined verexpenditureon consumption, hen Savings andthe Value of Investmentare identically the same thing. Heappears to conceive of Savings and Investment as not beingidentical and yet shrinks fromdefiningthem accordingly.Dr. Hayek and Mr. Robertson both make use of the term"saving ' or " voluntarysaving." But thoughthey criticisemy definition f " saving," I am not aware that they havepreciselydefined t themselves. I thinkthat it mighthelp thedebate to get on if Dr. Hayek would consider exactly what hemeans by " voluntarysaving on page 45 of his Prices andProduction. It is argued that it is paradoxical on my part toexcludewindfallprofits nd losses frommydefinition f income.

9 Vide page 45 "A transitionto more capitalistic methods of productionwill take place if the total demand forproducers' goods (expressed in money)increases relativelyto the demand for consumers' goods."



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394 ECONOMICA [NOVEMBERBut I suggest that it is still more paradoxical to include themini ncome; for n this case, given the value ofthe current utputof investmentgoods, the amount of the community's incomedepends on how much it is saving, since any increase (or de-crease) in " voluntary saving will have the effect fdecreasing(or increasilng)he community'sncomeby an equal amount.

IVThe readerwill perceivethatI have been driftingntoa reviewof Dr. Hayek's Prices and Production. And this being so, Ishould like, if the Editor will allow me, to considerthis book alittle further. The book, as it stands, seems to me to be oneof the most frightfulmuddles I have ever read, withscarcely asound proposition in it beginning with page 45, and yet itremains a book of some interest,which is likely to leave itsmark on themind ofthe reader. It is an extraordinary xampleof how, startingwith a mistake, a remorseless ogician can endup in Bedlam. Yet Dr. Hayek has seen a vision, and thoughwhen he woke up he has made nonsense of his storyby givingthe wrong names to the objects which occur in it, his KhublaKhan is not without nspiration nd mustset thereaderthinkingwiththe germsof an idea in his head.My notionof the real nature of the contribution o economictheorywhich Dr. Hayek is making brings me back, however,to what seems to me to be the underlyingcause of the secondvein of discontentwith myselfrunning throughDr. Hayek'sECONOMICArticle. Dr. Hayek complains that I do not myselfpropound any satisfactorytheoryof capital and interest andthat I do notbuild on any existingtheory. He means by this, Itake it, the theory of capital accumulation relatively to therate of consumption nd the factorswhichdetermine he naturalrateof interest. This is quite true; and I agree with Dr. Hayekthata development f this theorywould be highlyrelevanttomytreatmentof monetarymattersand likely to throw light intodark corners. It is very possible that, ookingback aftera satis-factory heoryhas been completed,we shall see that the ideaswhich B6hm-Bawerk was driving at, lie at; the heart of theproblemand that the neglectof'him by English pre-warecono-mistswas as mistakenas theirneglectof Wicksell. But there sno such theoryat present, and, as Dr. Hayek would- gree, athoroughtreatment f it might ead one rathera long way frommonetarytheory. Nevertheless, substantially I concede Dr.Hayek's point. I agree with him that a clear account of the



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I93I] THE PURE THEORY OF MONEY 395factorsdetermining he natural rate of interestought to have aplace in a completedTreatise on Money,and thatit is lacking inmine: and I can only plead that I had much to say forwhichsuch a theoryis not required and that my own ideas about itwere still too muchin embryoto deservepublication. Later on,I will endeavourto make good this deficiency.Now it is preciselyto this theory hatDr. Hayek seems to meto be attempting o contribute n Lecture II of his Prices andProduction. In this lecturehe has been proceeding,so far as Ican make out, on some such tacit, ssumptionas that at everymomentof time the market rate of interest s equal to what thenatural rate of interestwould be if the prevailingrelationshipof capital to consumptionwere to be permanent,and if entre-preneurswere acting on this latter assumption,withoutothererrorsof forecasting;and he the'nconsiderswhat would happenin an economic organisation satisfyingthe above assumptionwhen the rateofnewinvestmentn factfluctuates.At least, I have found no other interpretationwhich makessense of the argument, or leaves it anythingbut a series ofbaffling on-sequiturs. If I am wrong, hope that some autho-rity, such as ProfessorRobbins, who is confidenthat he under-stands what Dr. Hayek means in pages 45-64 of his book, willact as an interpreter. If I am right, it would followthat Dr.Hayek is not here dealing with the case, with which I wasmainly pre-occupied,of what happens when the marketrate ofinterestdeparts from the natural rate, and that our theoriesoccupy-as I believe they do-different terrains. A little conl-siderationof his problem, however,brings out the point thatthe term" natural rate of interest is not altogetherfreefromnambiguity. I have defined t by referenceto the rate whichwould at any moment equalise saving and investment,aftertaking accountof the existing psychologyofthe market, nclud-ing errorsof forecasting, nd irrespective f whetheror not thethenprevailingrate of investment s expectedto be permanent.WXTe ight call this the " short-period natural rate. Butclearly there is also the othertype, namely that envisaged byDr. Hayek, which we might call the " long-period naturalrate. It seems to me that Dr. Hayek's methodsmay be suitablefor nalysingsomeof theconditionswhichdetermine his " long-period" natural rateofinterest.I am in full agreement,also, with Dr. Hayek's rebuttalofJohnStuart Mill's well-knowndictum that " there cannot, inshort,be intrinsically more nsignificanthing, n theeconomy



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396 ECONOMICA [NOVEMBERof society,than money," which he expresses admirably in thefollowingpassage fromhis last lecture (p. iio): " it meansalso that the task of monetary heory s a much wider one thanis commonly assumed; that its task is nothing less than tocover a second time the whole fieldwhich is treated by puretheoryunder the assumptionof barter,and to investigatewhatchanges in the conclusions of pure theory are made necessaryby the introduction f indirectexchange. The first tep towardsa soluttionfthis problem s to release monetary heoryfrom hebonds which a too narrowconceptionof its task has created."

VThere remainDr. Hayek's criticismsof my use of terms,onwhich I offer he followingnotes:(I) It is not the case, as Dr. Hayek alleges on the top ofpage 274, that I contrastwith the prices paid forthe factorsofproductiononly the prices of finishedconsumption-oods. Dr.

Hayek forgetsthat " new investmentgoods " include, on mydefinition,unfinishedconsumptiongoods. Nevertheless, Mr.Hawtrey has pointed out to me that changes in the values ofunfinishedgoods largely cancel out in my price-levelof output.It is olnly," he poinits ut, " in the case where the ilncrementof investment ncludes some net addition to the stock of un-finishedproducts that the price-level in Mr. Keynes' funda-mental equations reflects he pricesofunfinished roductsat all,and in the case where there is a net reduction n the stock ofunfinishedproductsthe price-level s influenced n the conztrarydirectionto the prices of intermediateproducts. Practicallywecan treat Mr. Keynes' price-levelas the price-levelof finishedgoods, subject onlyto a slightcorrection or unifinishedroductsin certain cases." Thus this point deservedmore explanationthan I gave it in mybool.(2) Is Dr. Hayek's point at the bottomof page 275 and thetop ofpage 276 that I oughtto include in myQ2profits risingfrom the ownershipof old capital goods which have risen invalue as well as those arising fromcurrentlyproduced capitalgoods? For certainpurposesI should see no objectionto amalga-matingthetwotypesofprofit;but forotherpurposes, n particu-lar where we are dealing with the price-levelof output (whichby its very nature distinguishesnew capital fromold capital)it is obviouslynecessaryto distinguishthem.(3) It is not the case that I separate the process of the repro-



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I93I] THE PURE THEORY OF MIONEY 397duction of the old capital from the addition of new capital(p. 278). I reckon the wearingout of old capital as " disinvest-ment" and its replacement s " investnient," nd allow forthisin reachingmy totals of net outputand of net investment.(4) In the firstparagraph of page 279 Dr. Hayek perhapsoverlooksmv distinctiollbetweenthe cost of investment nd thevalue of investment. But both here and elsewhere (p. 281)Dr. Hayek also criticisesthe conception f "quantityofcapital"as being invalid on the groundthatthe differelntypesofspecificgoods constitutingcapital are not always identical, and whennon-identicalare non-commensurable. But this is simply thesame problem s thatofthe colnceptionf " price-level and theassociated conceptionof real-wageswhen the complex of goodsrefers o changes in its make-up. Trhis have discussed at greatlengthin Book II of my Treatise, and it arises of course in alltypes of monetary heoryalike.(5) An examinationof the contextto which Dr. Hayek refersin the firsthalf of page 28i shows that the olle refersto thevalue of current nvestment, nd the otherto the value of totalinvestment.(6) I confess to the verbal confusionof which Dr. Hayekcomplainsat thebottom fpage 28i. The objectofthedefinitiolnon page I30, as can be seelnfromthe context, s to distinguishbetween he outputof consumption-goods,s defined lnpage I27and, by implication,on page I35, which includes only filiishedconsumption-goodsoming on the market, fromthe productio1of consumption-goodswhich representsthe work done duringany period on goods whichwill eventuallyemerge as consump-tion-goods. Unluckily, while I speak of the productionof coni.-sumption-goodsn the first ectioln fthe paragraph in question,in the secondsentence speak of " that of colnsumption-goods,"not noticingthat grammaticallythat refersback to the expres-sion " output or production," used four lines previously inconnectionwith " capital goods." If Dr. Hayek will read " theproductionof consumption-goods (instead of " that of con-sumption-goods) in the second sentence of the paragraph aswell as in the first entencehis mindwill be at rest. Trhis s aslip of thepenwhichmay, I fear,have held up manyreadersfora moment. But that it should have leftDr. HIayek in a perma-nent confusionas to what I mean by " outputof consumption-goods" on page I35 and throughoutmy book is a symptom,I feel,of how thick a bank of fog still separates his mind frommine.

Hayek and Keynes

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