Hayek on his Simplified Capital Theory Assumptions in Prices and Production

Consider the following correspondence between Keynes and Hayek that occurred in late 1931 and early 1932 on Prices and Production (1931):

To F. A. HAYEK, 25 December 1931

That is what I thought you meant and that is just my difficulty. For by the ‘effective circulation M’ in your first letter of Dec. 15 you seemed, judging by the context, to mean something which corresponded in some sense to what one might call ‘aggregate income’, which is not the same thing as aggregate money turnover. If M means money turnover, why must ‘a certain proportion pM be constantly reinvested in order to maintain the existing capital constant'? I am not able to perceive any particular relation between aggregate money turnover and the amount of capital replenishment required to keep capital constant.

J.M.K.

___________


From F. A. HAYEK, 7 January 1932

Dear Keynes,
Returning from the meeting in Reading and a few days stay in [the] country I find your letter of December 25th. The question which you put in it is, indeed, of the most central importance and if I had thought that you had any difficulties about this point I should have long ago tried to make it clearer. When, however, you wrote on p. 397 of your Economica article that you consider the replacement of ‘disinvestment’ as ‘investment’ I thought you saw the point.

If we take a stationary society where there is no saving and no net investment (in your sense) a constant process of reproduction of existing capital will go on which is necessary in order to maintain its amount constant. In the case of circulating capital this will mean that its total amount will have to be replaced at least once during every year, and in the case of fixed capital that a certain proportion of the total existing capital which wears out during each year will have to be replaced. If we take the simplest case to which I have unfortunately confined myself too much in Price[s] and Production, i.e. the case where, all the existing capital owes its existence to one of the reasons which make the existence of capital necessary, namely to the duration of the process of production—the other cause being the durability of many instruments of production—and where, therefore all capital is ‘circulating capital’ in the usual sense of this word—which is very misleading because this circulating capital is different from fixed capital only from the point of view of an individual and not for society as a whole—it is fairly clear that a continuous process of production requires in every stage a constant disinvestment and reinvestment so that, if we assume that goods pass from one stage of production to the next every period of time, there will be a constant stream of money directed to intermediate products which will be roughly as many times greater than the stream of money directed against consumption goods as the average number of periods of time which elapse between the application of the original factors of production and the completion of the consumption goods. (I apologise for this terrible ‘German’ sentence.) The proportion between the demand for consumption goods and the demand for intermediate products will however exactly correspond to the average length of the production process only on the assumption that the goods pass from one stage to the next in equal intervals corresponding to the unit period. What it will actually be depends upon the given organisation of industry, but given this organisation it will change with every change in the amount of capital existing—or, what means the same thing, the average length of the production period—and will remain different so long as the amount of capital remains at its new level (and not only so long as the amount of capital is changing).

The situation is not fundamentally different if we take the other ideal case where the existence of capital is entirely due to the other of the two causes, the durability of the instruments. If we assume that the actual process of production of the instruments as well as of the finished consumption goods takes no appreciable time so that only ‘fixed’ capital and no 'circulating' capital is existing, then it is again clear that, in order to maintain capital constant, such proportion of the existing machinery as wears out during a period will have to be replaced. In a stationary society this proportion will be determined by the amount of capital and its lifetime, and since the amount of capital existing at a moment of time will itself of necessity be equal to the discounted value of a year’s output of consumers’ goods times the average lifetime of the machines, the annual demand for machines will stand in a proportion to the annual output of consumers’ goods which is determined by the average duration of the machines.

The problem becomes, of course, a little more complicated if one combines, as one has to do to come nearer to reality, the two factors determining the existence of capital. The simplest way out seems to me to be to reduce both factors, ‘duration of the process’ in the narrower sense and the duration of the instruments, to the concept of the average length of the production process in a wider sense as the common denominator. I am conscious that I have treated the durability factor lightly too in Prices and Production, but I did so because I hoped to make it less difficult and because I assumed a greater familiarity with Bohm-Bawerk’s concepts of the average length of production than I ought obviously have done. I have, however, treated these problems at somewhat greater length in sections IX–XI of my ‘Paradox of Saving’.

Yours very truly,
F. A. HAYEK
(Moggridge 1973: 260–262).

These letters concern Hayek’s assumptions about the nature of capital goods in Prices and Production.

Repapis (2011: 721) argues that Prices and Production contains a serious oversimplification: that capital depreciates entirely after becoming productive – or all capital is circulating capital and fixed capital is ignored.

That assumption about real world capitalist economies is unrealistic, and Hayek admitted as much in these words in his letter to Keynes:

“The problem becomes, of course, a little more complicated if one combines, as one has to do to come nearer to reality, the two factors determining the existence of capital. The simplest way out seems to me to be to reduce both factors, ‘duration of the process’ in the narrower sense and the duration of the instruments, to the concept of the average length of the production process in a wider sense as the common denominator. I am conscious that I have treated the durability factor lightly too in Prices and Production, but I did so because I hoped to make it less difficult and because I assumed a greater familiarity with Bohm-Bawerk’s concepts of the average length of production than I ought obviously have done.”

Post Keynesian economics agrees with Austrian economics that capital goods are heterogeneous.

But heterogeneous capital can also have a significant degree of durability and substitutability. A capital structure in a capitalist economy where we find some important degree of adaptability, versatility and durability in the nature of capital goods means that the Austrian business cycle theory of Hayek, as propounded in Prices and Production, is not a realistic vision of modern economies.

George L. S. Shackle also pointed to this problem in Hayek’s business cycle theory:

“Hayek’s argument, viewing ‘capital goods’ as materials which only retain their physical identity through a process of fabrication into consumable form, overlooks the grip that durability has in constraining the business man’s choice of productive methods. The span of the nine-year business cycle, to which his theory was meant to apply, is not long enough for a wholesale discarding of existing equipment during the latter half of its upward phase, say two or three years.” (Shackle 1981: 240).

All in all, this problem with capital theory is yet another flaw in Hayek’s theory of economic cycles.

BIBLIOGRAPHY

Hayek, Friedrich August von. 1931. Prices and Production. G. Routledge & Sons, London.

Moggridge, D. (ed.). 1973. The Collected Writings of John Maynard Keynes (vol. 13). Macmillan for the Royal Economic Society, London.

Repapis, Constatinos. 2011. “Hayek’s Business Cycle Theory During the 1930s: A Critical Account of its Development,” History of Political Economy 43: 699–742.

Shackle, George L. S. 1981. “F. A. Hayek, 1899– ,” in D. P. O’Brien and J. R. Presley (eds.), Pioneers of Modern Economics in Britain. Macmillan, London. 234–261.