Keynes’s Notion of a Productive Structure Consisting of ONLY Two Stages Leads Him into the Trap of the “Paradox of Thrift”

Hayek, in his detailed critique of both volumes of Keynes’s A Treatise on Money (1930), accuses Keynes of entirely ignoring the theory of capital and interest, particularly the work of Böhm-Bawerk and the other theorists of the Austrian School in this regard. According to Hayek, Keynes’s lack of knowledge in this area accounts for the fact that he overlooks the existence of different stages in the productive structure (as Clark had done and Knight later would) and that he ultimately fails to realize that the essential decision facing entrepreneurs is not whether to invest in consumer goods or in capital goods, but whether to invest in production processes which will yield consumer goods in the near future or in those which will yield them in a more distant future. Thus Keynes’s notion of a productive structure comprised of only two stages (one of consumer goods and another of capital goods) and his failure to allow for the temporal aspect of the latter, nor for the consecutive stages which compose it, leads him into the trap of the “paradox of thrift,” the fallacious theoretical rationale which we explained in chapter 5.⁷⁶

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⁷⁶ It is important to remember that John Maynard Keynes himself explicitly and publicly admitted to Hayek that he lacked an adequate theory of capital. In Keynes’s own words:

Dr. Hayek complains that I do not myself propound any satisfactory theory of capital and interest and that I do not build on any existing theory. He means by this, I take it, the theory of capital accumulation relatively to the rate of consumption and the factors which determine the natural rate of interest. This is quite true; and I agree with Dr. Hayek that a development of this theory would be highly relevant to my treatment of monetary matters and likely to throw light into dark corners.

—Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stoup (Auburn, AL: Ludwig von Mises Institute, 2006), 560-561, 561n.

The Central Problem: How the Existence of Non-permanent Resources Increases the Permanent Income Stream

The non-permanent nature of all ‘wasting assets’ creates a problem which is not dealt with in the theory of timeless production. These assets cannot be directly used to contribute to the output of the time when they have ceased to exist. Insofar as their existence does help to maintain output permanently above the level at which it could be kept with the help of the permanent resources alone, it must do so in an indirect manner. If the fact that we have command over resources which remain useful only for a limited period of time did not help us to use the services of the permanent resources more effectively, it would be quite impossible to keep our income permanently above the level where it would stay if these non-permanent resources had never been available. We might stretch their use over a longer period of time, but ultimately we should inevitably exhaust them and should then have to be content with what services the permanent resources could render by themselves. It is this problem of why the existence of a stock of non-permanent resources enables us to maintain production permanently at a higher level than would be possible without them, which is the peculiar problem connected with what we call capital.

—F. A. Hayek, The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, ed. Lawrence H. White (Indianapolis: Liberty Fund, 2007), 74.

Hayek Also Distinguishes Between (a) Factors that Yield Fixed Streams of Service Each Period and (b) Factors Whose Use Today Diminishes their Future Usefulness

The second important distinction is between (a) factors that yield fixed streams of service each period—namely, simple labor and permanent non-labor input sources—and (b) factors whose use today diminishes their future usefulness and raises the problem of maintenance. The first group of factors, apart from labor, can be called economic “land” goods, whether given by nature (David Ricardo’s “original and indestructible powers of the soil”) or manmade (Hayek’s example in The Pure Theory of Capital was a railroad tunnel that will need no maintenance once excavated). The second group encompasses all impermanent capital goods, from one-use blasting caps to depletable natural resource deposits to imperfectly durable machines. The simplified production model of Prices and Production treated all value-adding inputs, being applied in consecutive stages to advance intermediate goods toward final consumption, as coming from type (a) factors. The model reduced type (b) factors, impermanent capital goods, to intermediate goods. Knight’s model neglected impermanent capital goods in a different way. Its construct of a perpetual capital stock implied that the maintenance or replacement of any impermanent tools is automatic, embodied in the decision about the permanent level of future consumption.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 11, Capital and Interest, by F. A. Hayek (Chicago: University of Chicago Press, 2015), xxv.

Hayek Distinguishes Between (a) INHERITED Capital Goods and (b) Intermediate Goods or Capital Goods TO BE PRODUCED

For Hayek’s model there are two important distinctions among factors of production. The first distinction is between (a) inherited capital goods, or goods already existing at the moment that a production plan is being made, and (b) intermediate goods, or capital goods (of greater or lesser permanence) to be produced as part of a sequence of production steps leading to final output. Hayek’s exposition in Prices and Production neglected inherited capital goods. It depicted the first production stage as involving only land and labor, which created intermediate goods that then progress through subsequent production stages toward final sales. Knight’s model, by abstracting from roundabout production, abstracts entirely from intermediate goods. It offers only undifferentiated capital (the inherited Crusonia plant), which instantly yields consumption.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 11, Capital and Interest, by F. A. Hayek (Chicago: University of Chicago Press, 2015), xxv.

Goods Are Capital Goods Or Consumers’ Goods Depending ONLY on the Purpose for Which They Are Purchased and NOT on their Physical Characteristics

Closely paralleling the concepts of productive expenditure and consumption expenditure are the concepts of producers’ goods and consumers’ goods.

Producers’ goods or, what is a synonymous expression, capital goods, are goods purchased for the purpose of making subsequent sales.

Consumers’ goods are goods purchased not for the purpose of making subsequent sales. 

The distinction between capital goods and consumers’ goods is exclusively one of the purpose for which the goods are purchased—for business purposes or not for business purposes—and not at all a matter of their physical characteristics. The roast beef purchased by a restaurant and the washing machine purchased by a laundromat are both capital goods. Exactly the same kind of roast beef and washing machine purchased by a housewife are consumers’ goods.

The reason that the purpose for which they are purchased is the crucial distinction has already been indicated. Physically, the roast beef and the washing machine are consumed, whether purchased for business purposes or purchased not for business purposes. In both cases, there is, in this instance, a physical production that takes place in which the goods are consumed: the raw roast beef is consumed in producing a cooked one, and the washing machine is consumed in producing cleaned clothes. And thus, both for the housewife and for the business enterprises, there is even a productive consumption in the physical sense.

But beyond the physically productive consumption comes a physically unproductive consumption: the cooked roast beef is eaten and the cleaned clothes get dirty in the wearing. At this point, all trace of the goods purchased by the housewife has simply disappeared from her possession. (In the case of durable goods, such as the washing machine, all trace of the relevant portion of the good’s life has disappeared). But by this same point, or earlier, the restaurant and laundromat have obtained the means of replacing, and more than replacing, the goods they have purchased. The goods they have purchased, when one allows for their replacement by way of purchase, with funds earned from their very own employment, and not consumed—they are replaced by virtue of their own use, together with a surplus.

The roast beef of the restaurant and the washing machine of the laundromat, by virtue of being purchased for the purpose of making subsequent sales, and then by way of using the resulting sales proceeds to make replacement purchases, are reproductively employed. The restaurant’s roast beef and the laundromat’s washing machine are, as it were, employed in the production of roast beefs and washing machines, or their equivalent in other goods, as wheat seed is employed in the production of wheat. And thus in the fullest sense they represent wealth employed in the production of wealth, and are capital goods, even though from a strictly physical standpoint, a roast beef cannot be used to produce roast beefs, and a washing machine cannot be used to produce washing machines. 

—George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1998), 445.

Hayek Discusses a SHRINKAGE of the PRICE MARGINS When an Increase in the Rate of Saving Lowers the Equilibrium Rate of Interest

To assist in the explanation of these structural changes which occur periodically under a system of capitalistic production, Hayek invokes an ingenious relationship between changes in the rate of interest, and the changes which take place in the relative values of different goods, used at different stages in the process of production. He states that there will be a difference between the value of a unit of output from one stage of production and the value of the unit of output at the succeeding stage, — and this difference he calls a “price margin.” Thus for any stage, the selling price of its output exceeds the value of the input of raw materials, labour, etc., by an amount which constitutes the source of interest whilst,  “in a state of equilibrium, these margins are entirely absorbed by interest.” This would seem to follow from Hayek’s particular interpretation of economic equilibrium as depending on a certain relationship between the prices of producers’ goods and the prices of consumers’ goods, a relationship which will be solely determined by the preference of consumers as between saving and spending,

Every given structure of production, i.e., every given allocation of goods as between different branches of production requires a certain definite relationship between the prices of the finished products and those of the means of production. In a state of equilibrium, the difference necessarily existing between these two sets of prices must correspond to the rate of interest. . . . 

Under barter conditions, the rate of interest, and thus these price relationships, will be unlikely to diverge from their equilibrium values since “. . . the reciprocal gains and sacrifices of saving borrowing and lending are concretely juxtaposed and deviations from an equilibrium position are more obviously and more directly carry their penalties with them.” Likewise in a money economy, in which the supply of credit is kept equal to the supply of savings, there will tend to be a close correspondence between changes in price margins and in the rate of interest.

An increase in the rate of saving which lowers the equilibrium rate of interest will, Hayek suggests, involve a corresponding shrinkage of the price margins. This is because greater saving leads both to a reduction in the demand for consumers’ goods which reduces their prices, and the prices of the goods at the stages immediately preceding; and also to a rise in the demand for, and in the price of, products at the earlier stages, and the latter change is transmitted towards the later stages, (but with diminishing intensity), until the price margins are again all equal, and equivalent to a lower rate of interest.

—G. F. D. Palmer, “The Trade Cycle Theories of R. G. Hawtrey and F. A. von Hayek, with Particular Reference to the Rôle Attributed by Each to the Rate of Interest” (master’s thesis, University of Cape Town, July 1951), 27-29.