Keynesian Theory ‘Demoted’ the Interest Rate from the Rôle of Guiding Intertemporal Allocation to that of Rewarding the Sacrifice of Liquidity

Keynesian theory depicted current income as proximately determined by current expenditure (Y = C + I + G) rather than by prior production. The ‘circular flow’ supplanted capital theory in macroeconomics. Current-period analysis displaced intertemporal analysis. The interest rate no longer played an equilibrating rôle. Left to its own devices, the economy could readily get stuck at a level of expenditure too small to achieve full employment. Smithies found it remarkable (note his apparently sneering use of quotation marks) that “Professor Hayek’s point of view is that a ‘real’ economy, if left to itself, will automatically achieve ‘equilibrium’ and that the disturbances that occur in real life are due to the subversive influence of money.” Keynesian theory, as Uhr put it, ‘demoted’ the interest rate from the rôle of guiding intertemporal allocation to that of rewarding the sacrifice of liquidity. Though it never became mainstream doctrine, some Keynesians nearly overthrew the idea that capital is scarce, and needs to be carefully allocated, in favour of the ‘secular stagnation’ thesis that remunerative uses of capital are or soon will be hard to come by.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, by F. A. Hayek (Indianapolis: Liberty Fund, 2007), xxxi.