Hayek's Critique of The General Theory: a New View of tHe Debate betweeN Hayek aND keyNes

Abstract

Hayek is seen as one of the main opponents of Keynes because of the debate about macroeconomics that they had in the early thirties. A few years after this controversy, Keynes published The General Theory (1936), and Hayek was expected to criticize Keynes' new model. But, surprisingly, Hayek decided to remain silent and let his opponent go unchallenged. He regretted it ever after. However, this paper argues that in Hayek's work after 1936, there is a criticism of The General Theory that to a certain extent has remained unnoticed. Thus, this approach reopens the great debate between Hayek and Keynes just where they had apparently left it, that is, after the publication of The General Theory.

Full text

288
Ha y e k ’s Critique o f Th e General
Theory: a Ne w View o f tHe Debate
betweeN Ha y e k aND keyNes
Da v i D Sa n z Ba S
ABSTRACT: Hayek is seen as one of the main opponents of Keynes
because of the debate about macroeconomics that they had in the early
thirties. A few years after this controversy, Keynes published The General
Theory (1936), and Hayek was expected to criticize Keynes’ new model.
But, surprisingly, Hayek decided to remain silent and let his opponent go
unchallenged. He regretted it ever after. However, this paper argues that
in Hayek’s work after 1936, there is a criticism of The General Theory that to
a certain extent has remained unnoticed. Thus, this approach reopens the
great debate between Hayek and Keynes just where they had apparently
left it, that is, after the publication of The General Theory.
KEYWORDS: Keynes, prices, business cycles, macroeconomic
policy, unemployment
JEL CLASSIFICATION: E12, E3, E6, E24
Dr. Sanz Bas (davidsanzbas10@gmail.com) is a professor of economics at Universidad
Católica “Santa Teresa de Jesús” de Ávila (Spain) and is a member of the Juan de
Mariana Institute. The author thanks Bruce Caldwell for allowing him to quote from
Hayek’s article “The Flow of Goods and Services.” Permission to quote from the
papers of F. A. Hayek was granted by the estate of F. A. Hayek. The author also
thanks Jorge Vigara, Jennifer Nylen and James Nylen for their help with the English
translation of this article.
VOL. 14 | N
O.
3 | 288–310
FALL 2011
The
Qu a r t e r l y
Jo u r n a l of
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David Sanz Bas: Hayek’s Critique of The General Theory
INTRODUCTION
The confrontation between John Maynard Keynes and
Friedrich August Hayek is one of the most famous in the
history of contemporary economic thought. The debate took
place between 1931 and 1932, and its object was a book written
by Keynes called Treatise on Money (1930). Although this debate is
paramount, many of those who read this debate for the rst time
could be disappointed for three reasons. First, Treatise on Money
is not a very well-known book, and moreover, if we compare it
with The General Theory, its inuence has been small. Second,
Treatise on Money is an obscure book that is dicult to read. This
led Hayek and Keynes to misunderstand each other (indeed one
of the main topics discussed in this debate was the denition of
saving and investment). This fact is also a strong handicap for
anyone willing to study the debate. Third, saying that there was a
debate between Hayek and Keynes in 1931–1932 is exaggerating
what actually happened. During that time period, Hayek wrote a
systematic review of Treatise on Money consisting of three articles
(two of them very extensive). In response, Keynes wrote only a
short article essentially accusing his Austrian rival of misinter-
pretation. Therefore, it would be appropriate to say that it was
a somewhat one-sided debate. In March 1932 this controversy
ended with Keynes’ sudden withdrawal, arguing that he was
retiring to “re-shape and improve” his “central position” (Keynes,
1932, p. 172). Therefore, we may say Hayek was the winner of
this rst engagement.1
In 1936, four years after this controversy, Keynes published
a new book called The General Theory of Employment, Interest and
Money, in which he presented a new elaboration of his model.
This book became one of most inuential economics treatises ever
written. For most governments and economists throughout the
world, it was a milestone in both economic theory and economic
policy. Undoubtedly, as a direct consequence of The General Theory,
Keynes became an immortal gure in economics.
1 It is true that in 1932 there was a debate between Sraa and Hayek, and Sraa
presented some criticisms of Hayek’s model; however, the Hayek-Keynes
controversy in 1931–1932 ended with Keynes’ retreat, so it may be said that Hayek
won this rst round.

290 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
When The General Theory was published in 1936, Hayek was
expected to criticize Keynes’ new model. However, surprisingly,
Hayek decided to remain silent and let his opponent win. This lack
of a response has always puzzled historians of economic thought.
What would have happened if the intellectual battle between
Hayek and Keynes had been renewed in 1936? Nobody knows for
sure. But, probably, if there had been any further debate and Hayek
had been the winner once again, this fact would have greatly
inuenced the subsequent development of economic theory and
economic policy and, perhaps, we would all live in a very dierent
society now. As Keynes himself once said:
…the ideas of economists and political philosophers, both when they are
right and when they are wrong, are more powerful than is commonly
understood. Indeed, the world is ruled by little else. Practical men, who
believe themselves to be quite exempt from any intellectual inuences,
are usually the slaves of some defunct economist. (Keynes, 1936, p. 382).
However, what I want to argue in this paper is that in Hayek’s
work after 1936, there is a criticism of The General Theory that to a
certain extent has remained unnoticed. Thus, this paper picks up
the great debate between Hayek and Keynes just where they had
apparently left it, that is, after the publication of The General Theory.
This perspective on the debate is completely dierent from the one
traditionally taken. The vast majority of authors who have studied
this controversy have examined the debate between Hayek and
Keynes in 1931 and 1932,2 while I have focused on the hidden
criticism by Hayek of The General Theory.
Before discussing Hayek’s main criticisms of The General Theory,
it may be useful to present a brief summary of the book.
A SUMMARY OF The General Theory
The 1930s were marked by a deep depression with high rates of
unemployment and a sharp decline in production. These conditions
led many economists to reconsider the causes of unemployment
and economic uctuations. This is the context in which Keynes
2 See, for example, Argandoña (1988), McCormick (1992), Tieben (1997), Selgin (1999),
Feito (1999), Cochran and Glahe (1999), Tadeu (2000) and Skidelsky (2006).

291
David Sanz Bas: Hayek’s Critique of The General Theory
presented his theory. The key idea of The General Theory is that
there is a direct and positive relationship between employment
and aggregate expenditure. Thus, according to Keynes, total
demand determines the employment level in an economy and,
therefore, the existence of unemployment indicates that aggregate
demand is insucient to employ all the productive factors. As a
consequence, full employment is dened as a situation where the
expenditure level was sucient to employ everyone. Keeping this
in mind, one question arises: are there, in a capitalist economy, any
mechanisms to ensure at all times an adequate and sucient level
of aggregate demand? To Keynes, the answer is negative mainly
for two reasons.
First, Keynes argues that there is a psychological law that
supposedly encourages individuals to save a rising proportion of
their income as it increases. He states that, in general, a person with
a high income tends to consume a smaller proportion of it than one
with a low income. Thus, at a macro level, Keynes observed that
a society with a growing real income tends to increase its savings
more than proportionately. In other words, a society’s marginal
propensity to consume tends to be reduced, and consequently
the society’s investment multiplier will be lower. Therefore, in
this situation, in order to maintain a constant level of spending
it would be necessary for investment to increase in order to make
up for this secular decline in consumption. But, for Keynes, there
is no mechanism in the market capable of connecting savings and
investment. According to The General Theory, the reason is that
investment does not depend on savings. Instead, it depends on
both business expectations and the liquidity preference of creditors
(which determines the interest rate). Thus, for Keynes there is
no guarantee that the secular increase in the propensity to save,
which normally tends to occur when the social income increases,
will be made up for by any increase in current investment. Keynes
concludes that capitalism is doomed to suer a systematic lack of
demand and, therefore, a chronic problem of unemployment.
Second, Keynes explains that the economic future is always
uncertain and it makes entrepreneurs act more with an animal
instinct (“animal spirits”) than with rational calculation. The
General Theory explains that business expectations are changeable
and capricious, so investment (and therefore aggregate spending

292 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
and employment) will always be volatile, leading the market
process to continually suer strong economic uctuations
For these reasons, he concluded that in an unhampered capi-
talist system, the volume of market demand will be insucient
and volatile, and for this reason, the unemployment rate will
also tend to be high and volatile. However, Keynes believed that
the government could address these deciencies in the market
through the control of aggregate spending. Therefore, following the
pattern of aggregate demand determination outlined in The General
Theory, Keynes recommended several measures. First, he proposes
the greatest possible reduction of interest rates to encourage private
investment as far as possible. As a second measure, since people
with a higher income are more likely to save, the government
should impose a redistributive tax system to divert income from
the wealthy to people with a greater propensity to consume—that
is, those with a lower income. This way, the investment multiplier
would be higher. This is Keynes’ justication of progressive tax
systems. As a third measure, the government should make public
investments to supplement private investments in case the latter
were insucient.3
In Keynes’ view, through these mechanisms the government
could ensure that the volume of aggregate expenditure will always
remain sucient to maintain full employment.
3 Keynes also said “I conceive, therefore, that a somewhat comprehensive sociali-
sation of investment will prove the only means of securing an approximation to
full employment” (Keynes, 1936, p. 378). However, Keynes probably meant to say
that this would be the only solution once the protable investment opportunities
had been exhausted. In the meantime, reduction of interest rates, redistribution
of incomes and complementary public investment policies would be Keynes’
solutions to unemployment. Indeed, “[i]n 1938 Keynes recommended that the
British government set up a Board of Public Investment, whose function would be
to make plans for increases in public investment to supplement private investment
whenever an economic recession threatened” (Dillard, 1948, p. 157). This might
show that, for Keynes, socialization of investment would be just a medium-term
to long-term solution. Finally, although Hayek explicitly criticized Keynes for
his socialist views in The Fatal Conceit (1988) and may have indirectly criticized
him in The Road to Serfdom (1944), I do not want to stress this point in this paper
because Keynesians usually defend public investment as a complement to private
investment, and they usually do not propose a “comprehensive socialisation”
of investment. Therefore, I think that these complementary public investment
policies are the critical issue that must be discussed.

293
David Sanz Bas: Hayek’s Critique of The General Theory
HAYEK’S CRITICISM OF The General Theory
Hayek did not answer when Keynes published The General
Theory, and he regretted it ever after (Hayek, 1983, p. 251). However,
throughout his work after 1936 there are many explicit or implicit
critical references to Keynes’ ideas. There are criticisms of The
General Theory in many of his works, including Monetary Nationalism
and International Stability (1937),4 “Prot, Interest and Investment”
(1939),5 The Pure Theory of Capital (1941),6 “The Campaign against
4 In the second page of Monetary Nationalism and International Stability, Hayek states:
“But let me say at once that when I describe the doctrines I am going to criticize
as Monetary Nationalism I do not mean to suggest that those who hold them
are actuated by any sort of narrow nationalism. The very name of their leading
exponent, Mr. J. M. Keynes, testies that this is not the case” (Hayek, 1937, p. 2).
That shows us that Hayek had Keynes in mind when he wrote this great essay.
5 There are at least two hints in “Prot, Interest and Investment” that show that this
essay is a direct critique of The General Theory although it is not explicitly stated.
First, Hayek says, “I hope to show why under certain conditions, contrary to a
widely held opinion, an increase in the demand for consumers’ goods will tend to
decrease rather than to increase the demand for investment goods” (Hayek, 1939,
p. 3). He then explicitly mentions Keynes, “[i]t is rather instructive that the most
elaborate and inuential work dealing with these problems in recent years, Mr.
Keynes’ General Theory, does not contain, as far as I can see, any discussion of
how a change in nal demand aects the yield of the various types of investment
goods” (Hayek, 1939, 13n). And second, “Prot, Interest and Investment” is a
reconstruction of the Hayekian model with some “Keynesian assumptions” as a
starting point: “We shall start here from an initial situation where considerable
unemployment of material resources and labour exists, and we shall take account
of the existing rigidity of money wages and of the limited mobility of labour.
More specically, we shall assume throughout this essay that (…) money wages
cannot be reduced (…) and nally, that the money rate of interest is kept constant”
(Hayek, 1939, p. 5). In my opinion, Hayek tried to present a new model capable of
beating The General Theory using Keynes’ assumptions of idle resources, a constant
interest rate and sticky wages. In short, I believe that Hayek wrote “Prot, Interest
and Investment” to challenge the Keynesian model. Indeed, Keynes wrote some
letters in September and October of 1939 to Hayek after the publication of this
essay and he asked him to clarify certain points. However, the war started and
Keynes’ attention turned to the problems of the war economy.
6 This book contains many explicit references to Keynes and to The General Theory
especially in chapters XXV–XXVIII and appendix III. Indeed, it is likely that
Hayek did not review The General Theory in 1936 because he preferred to nish
his new model rst (The Pure Theory of Capital) that would refute Keynes’ theories.
However, he was not able to complete it and in 1941 he decided to publish what he
had written so far. Then he gave up his eort in completing his new model. Bruce
Caldwell supports this hypothesis (Caldwell, 1998, p. 276).

294 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
Keynesian Ination” (1974), The Fatal Conceit (1988) and many
other articles.7 There are two features of Hayek’s criticisms. First,
they are scattered throughout the period of time from 1937 to 1988.
Despite this, the consistency of these criticisms is remarkable.
And second, it is a comprehensive criticism because it attacks The
General Theory from many dierent angles, such as economic
cycles, capital theory, theory of interest rates, methodology, wages
and employment and international economics.
I will now explain some of Hayek’s main objections to The General
Theory. First, I will highlight the four fundamental mistakes Hayek
believed Keynes had made in his model, and then I will explain his
four main criticisms of The General Theory.
KEYNES’ FOUR FUNDAMENTAL ERRORS
1. The theory of capital and the role of time
From Hayek’s point of view, the major deciency in The General
Theory is that it is not based on a theory of capital (Hayek, 1941, pp.
46–49). According to Hayek, the market is a network of millions
of companies that complement and coordinate with each other
intertemporally and synchronically, forming an extremely complex
production structure. In order to understand how and why this
structure is coordinated or discoordinated, we need to apply a
theory allowing us to study the way it works. However, Keynes
does not study this production structure, but suppresses it in the
concept of aggregate investment. This is why Hayek thought that
Keynes was not able to understand the causes of and the solutions
to economic uctuations.
7 After the triumph of Keynes’ ideas among the academia and among politicians,
Hayek wrote many articles in which he explained why the Keynesian demand
policies were dangerous. In most of them he explicitly mentioned Keynes. See:
“Bad and Good Unemployment Policies” (1944), “Full Employment Illusions”
(1946), “Full employment, Planning and Ination” (1950), “Ination Resulting
from the Downward Inexibility of Wages” (1958), “Unions, Ination and Prots”
(1959), “The Outlook for the 1970s: Open or Repressed Ination?” (1970), 1980s
Unemployment and the Unions. The Distortion of Relative Prices by Monopoly in the
Labour Market (1980), etc.

295
David Sanz Bas: Hayek’s Critique of The General Theory
According to Hayek, the absence of a theory of capital meant
that in the model developed in The General Theory, time is not
considered as a relevant variable. In the Keynesian world, when
demand increases, a parallel increase in the supply of goods
appears almost instantaneously. Therefore, for Keynes, the
structure of production does not need a signicant amount of time
to produce the necessary additional nal goods to meet additional
consumer demand (Hayek, 1941, pp. 395–396). Thus, The General
Theory never considered that a shortage of supply may occur. In
Hayek’s opinion, this approach is wrong. According to him, time
is a central variable in understanding any production process. The
dynamic “balance” of any structure of production depends on an
adequate coordination between the “ripening” of investments in
the form of nal goods and services and the income generated by
such investments in the form of nal demand. Thus, for Hayek,
the biggest economic problem is that consumers should be willing
to “wait” long enough to allow the consumer goods to emerge in
nal markets. Otherwise the phenomenon of ination will appear,
and, as it will be explained later, this phenomenon will seriously
endanger the sustainability of the production structure. This is
why, for Hayek, savings are so important (Hayek, 1939, pp. 38–56;
1941, pp. 334–350).
2. Monetary analysis vs. real analysis
In Hayek’s opinion, Keynes focuses his analysis mainly on the
monetary surface of the market process while he neglects analyzing
the underlying real process. Hayek believes that Keynes considers
the market exclusively as a set of monetary ows and, therefore, in
The General Theory everything is explained through the variation of
monetary expenditure. For Hayek, this approach to the economic
problem makes it impossible to construct theories to understand
the market process. In fact, in Hayek’s words, “[i]t is not surprising
that Mr. Keynes nds his views anticipated by the mercantilist
writers and gifted amateurs:8 concern with the surface phenomena
8 Hayek is referring to the chapter of The General Theory called “Notes on Mecan-
tilism, the Usury Laws, Stamped Money and Theories of Under-Consumption”
where Keynes states that the precursors of his theory are the mercantilists and
Silvio Gesell and J. A. Hobson.

296 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
has always marked the rst stage of the scientic approach to our
subject.” (Hayek, 1941, p. 410)
3. The macroeconomic approach
Keynes’ model is clearly macroeconomic. According to Hayek,
though, this approach is wrong, as it hides the fundamental
mechanisms of change in the market from the economist. In his
view, in order to understand the market process, economists
need to study the economy from the point of view of the actors
involved. Therefore, the relevant things are relative prices and
the investment structure, and not concepts such as aggregate
investment or the level of wages. Thus, Keynes’ theory would not
be enough to explain the market process (1966, pp. 285–289; 1988,
pp. 98–100).
4. Short-term versus long-term
The General Theory is a model focused primarily on the short
term. Hayek criticized Keynes because, in his opinion, only entre-
preneurs have much to say in the short term, and economists do
not have much to contribute in this eld. In his view, an economist
has the privilege and duty to analyze the medium term and long
term eects of the economic policies undertaken. For Hayek, the
Keynesian philosophy of “in the long run, we are all dead” is the
height of scientic irresponsibility, and leads to policies which may
give good results in the short term but can be extremely harmful in
the long run. In Hayek’s words,
...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.
(Hayek, 1941, p. 410)

297
David Sanz Bas: Hayek’s Critique of The General Theory
THE FOUR MAJOR CRITICISMS OF HAYEK TO The
General Theory
According to Hayek’s analysis, these are the four fundamental
errors committed by Keynes. Thus, the Keynesian theory is awed
due to these initial errors. Hayek articulated numerous criticisms
of The General Theory throughout his life, but it is worth drawing
attention to four on which he placed a special emphasis.
1. Relationship between employment and aggregate demand
The foundation on which The General Theory rests is the alleged
existence of a direct positive relationship between aggregate
demand and employment. According to this, unemployment
would always be solved by increasing aggregate expenditure.
However, in Hayek’s view, this hypothesis, which at rst glance
may seem true, is totally wrong, and this is precisely Keynes’
biggest mistake:
The conventional picture on which the whole of Keynesian analysis is
based which represents the connection of nal demand and employment
as analogous to the relation between the suction applied at one end of a
pipe and its intake at the other end, is thus very misleading. [However]
Between the two lies an elastic or variable reservoir, the size of which is
determined by a set of circumstances largely neglected in the Keynesian
analysis. (Hayek, 1981)
According to Hayek, there are three reasons why there is not a
direct connection between the aggregate demand and employment:
The rst reason is the structure of production: in a modern
economy only a fraction of workers are employed in the nal
stage of production, so a good share of the productive resources
(labor, capital goods, etc.) do not have a direct relationship with
nal markets. For example, if we think of all those companies that
are dedicated to producing highly specialized capital goods, raw
material extraction or research and development, it is obvious
that the demand policies proposed by Keynes (which will cause
spending increases primarily in nal good markets) will not have a
direct eect on these companies working further from consumption.
Therefore, the increase in consumption demand will not primarily

298 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
aect the demand for workers by these entrepreneurs (Hayek,
1939, pp. 22–24).
The second reason is what Hayek termed the “Ricardo eect”:
the permanence of a productive structure requires the permanence
of a parallel structure of relative prices. Hayek noticed that
Keynesian demand policies have the special feature of modifying
the pricing structure so as to promote investments with reduced
maturity periods (i.e., less intensive capital investments). Hayek
explains that, after applying Keynesian demand policies, this
peculiar modication takes place in relative prices, and as a result,
many entrepreneurs will modify their production strategies and
will try new, less capital intensive (and therefore more protable
in relative terms given the new pricing structure) production
strategies. This change in production strategies will result in
a change in the composition of the demand for capital goods of
those entrepreneurs, and will also reduce the aggregate amount
of money devoted to buying higher-order capital goods in the
market. Therefore, Hayek notes, many entrepreneurs will stop
buying capital goods from their usual suppliers. As a result, these
suppliers will lose part of their market and many will be forced
to lay o workers or even to cease business. Hayek named this
phenomenon the Ricardo eect.9 Thus, the change in relative
prices caused by Keynesian demand policies will encourage a
spontaneous process of disinvestment and, therefore, many of the
business rms and jobs that were needed before to produce these
specialized capital goods which now will have signicantly lower
demand will become useless. Hayek concludes that the demand
policies proposed by Keynes will lead to an absolute reduction
in the volume of employment (Hayek, 1939, pp. 8–16 and pp.
24–37; 1941, pp. 345–346 and 433–439; 1942, pp. 220–243; 1966, pp.
285–289).
Finally, the microeconomic approach also shows that the belief
that there is a direct relationship between aggregate spending
and employment is wrong. Hayek explains that unemployment is
usually concentrated in certain sectors, industries and production
9 Hayek named it the “Ricardo eect” because David Ricardo was the rst economist
who talked about the substitution between labor and capital goods when there
were price changes.

299
David Sanz Bas: Hayek’s Critique of The General Theory
stages (for example, let us assume that unemployment is mainly
concentrated in sectors A, B, C, D and E) (Hayek, 1950, pp. 275–276).
For the Keynesian employment policies to be able to create new
jobs in those specic sectors of the market, it would be necessary
for entrepreneurs and consumers to voluntarily decide to spend
the additional revenue received from these Keynesian policies in
those sectors that are in crisis. However, Hayek explains that “[i]f
expenditure is distributed between industries and occupations in a
proportion dierent from that in which labour is distributed, a mere
increase in expenditure need not increase employment.” (Hayek,
1950, p. 272) Hayek thinks that it is an illusion to believe that these
policies would solve the unemployment problem, as the holders
of the additional money will spend their money where they
consider it most appropriate and not necessarily in areas where
there is unemployment (for example, they might decide to spend
their money in sectors O, P, Q, R, S and T). Indeed, Hayek points
out that it is very unlikely for individuals to choose to spend their
money in the specic sectors that are in crisis, since these sectors
are in crisis precisely because entrepreneurs and consumers are
not willing to buy the output oered by these sectors at current
prices. For example, if American consumers and entrepreneurs
had more money to spend today, it is unlikely that the bulk of
that money would be directed to the purchase of houses. It would
be more likely spent in other sectors such as on mobile phones
where there is no unemployment. However, Hayek admits that if
the increase in aggregate expenditure is large enough, then a part
of it would eventually reach those sectors in crisis and tempo-
rarily increase employment rates there. In Hayek’s words, “Even
though, during the process of increasing incomes [i.e. of applying
Keynesian policies], enough expenditure may ‘spill over’ into the
depressed sectors temporarily there to cure unemployment, as
soon as the expansion comes to an end the discrepancy between
the distribution of demand and the distribution of supply will
again show itself” (Hayek, 1950, p. 272). But this would always
happen at the expense of a high ination rate (because in this
situation there would be several “shortages of supply” in many
sectors) and, furthermore, this “remedy” against unemployment
would lead to the outbreak of a dangerous process of accelerating
ination with two possible endings: either it would cause a severe
inationary recession, or the government would approve extensive

300 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
price controls that would transform the market economy into a
planned economy. These ideas will be elaborated upon later.
For all these reasons, Hayek states that there is no direct rela-
tionship between aggregate spending and employment levels. This
conclusion is particularly important because it is a shot between
the eyes of The General Theory. Indeed, according to Hayek, the
Keynesian system was built upon a monetary illusion: “[i]t is all too
naïve a way of thinking to believe that, since, if all workmen were
employed at current wages, total income would reach such and such
a gure, therefore, if we can bring income to that gure, we shall
also necessarily have full employment” (Hayek, 1950, p. 272).
2. Market and economic coordination
The debate between Hayek and Keynes is a debate about the
existence or absence of coordination mechanisms on the market.
According to Keynes, money would be a broken joint of the capi-
talist machinery that prevents savings from becoming investment
(Garrison, 1984, p. 203). Thus, according to his vision, the government
should in one way or another induce the holders of money to
spend it and not hoard it in order to maintain a socially acceptable
level of employment and investment. Hayek’s view is dierent.
Money is like a joint that might become loose (“loose joint”) and
this is why there can be booms and recessions (Hayek, 1941, p. 408).
Nevertheless, once such a lack of coordination becomes evident,
Hayek explains that the market has two mechanisms to correct
these situations: the price system and entrepreneurship (Hayek,
1945; 1946b). Indeed, the outbreak of the crisis proves that there
are forces in the market system tending to correct the underlying
lack of coordination. So, there is a spontaneous tendency in the
market toward economic coordination (Hayek, 1936). However,
Hayek warns that this trend may be temporarily blocked if the
price system is distorted or entrepreneurship is restricted. These
processes are not understood by Keynes as his view of economics
only takes into consideration the aggregate magnitudes while
ignoring the role of prices as highly ecient transmitters of infor-
mation (Hayek, 1936; 1945).
Moreover, contrary to what Keynes thought, there is no
danger of the growing trend of the propensity to save. According

301
David Sanz Bas: Hayek’s Critique of The General Theory
to Hayek’s theory, a richer society needs more capital per worker
and, therefore, a greater volume of savings. Thus, the growing
propensity to save is not a macroeconomic problem but a necessary
condition to achieve a more prosperous society. Keynes also argued
that capital accumulation is the way to achieve a more prosperous
society, but he did not realize that the structure of production needs
to be constantly renewed and, consequently, a growing volume of
savings would become necessary (Hayek, 1931, pp. 32–54; 1939,
pp. 38–63; 1944b, pp. 154–155).
3. The solution to economic crises
Keynes thought unemployment could be corrected through
increases in aggregate spending. In his view, if spending increased
suciently, unemployed workers would get their former jobs and
the economic crisis would be overcome. Hayek contends that this
strategy forgets the fact that crises occur precisely because the
productive resources were incorrectly allocated during the previous
economic boom. Therefore, reestablishing the same distribution of
resources will not be a solution, as the outbreak of the crisis has
proven. The solution to economic crises requires a process both of
liquidation of wrong investments and reallocation of productive
resources (workers, capital goods, etc.) (Hayek, 1939, pp. 57–60;
1980). In Hayek’s words:
If the real cause of unemployment is that the distribution of labour
does not correspond with the distribution of demand, the only way to
create stable conditions of high employment which is not dependent on
continued ination (or physical controls) is to bring about a distribution
of labour which matches the manner in which a stable money income
will be spent (Hayek, 1950, p. 273)
Thus, if we compare the strategies of these two economists, we
discover that they are complete opposites: Keynes intended to
create and/or redirect ows of market spending to sectors where
workers are unemployed so that they can recover their jobs, while
Hayek proposes that the workers and other productive resources
are the ones to move towards expenditure ows that are sponta-
neously created in the market on a basis of consumer preferences.
We can infer from this that Keynes’ solution at its best will be
unsustainable in the medium and long term and Hayek’s will

302 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
result in a new, more sustainable productive structure, which will
also be consistent with consumers’ preferences.
Hayek’s work focused on carefully studying the consequences of
spending policies proposed in The General Theory, and he reached
the following conclusions:
First, the creation, modication and/or maintenance of streams
of expenditure by the government will maintain and even increase
the amount of misplaced productive resources (Hayek, 1971, pp.
128–129). According to Hayek, new enterprises will be created
and the corresponding productive resources will nd their place
(workers, capital goods, etc.) because of these articial ows of
expenditure. When these spending streams change direction or
disappear (which is very likely to happen when spending comes
from a political decision), then much of the employment created
by those streams of spending will become useless again. Therefore,
a self-sustaining economy can only be built on the basis of expen-
diture ows arising from the real preferences of consumers. In
Hayek’s words:
The chief point I want to bring out is that the longer the ination
lasts, the greater will be the number of workers whose jobs depend
on a continuation of the ination, often even on a continuing accel-
eration of the rate of ination. Not because they would not have found
employment without the ination, but because they were drawn by the
ination into temporarily attractive jobs which after a slowing down
or cessation of the ination will again disappear. (Hayek, 1974, pp.
204–205)
Second, Keynesian spending policies will lead to shortages of supply
as the production of goods and services is never instantaneous.
The sudden increase in the spending ow on consumer markets
caused by the demand policies recommended by Keynes will not
correspond to a parallel ow of nal goods and services, which
will bring about increases in consumer prices, i.e. ination. This,
in addition to the spontaneous process of economic disinvestment
(Ricardo eect), will create tensions within the labor market. Hayek
admits that thinking that workers will suer in the short-term
from some degree of “monetary illusion” is reasonable (assumed
also by Keynes) and therefore initially nominal wages will not rise
(Hayek, 1937, pp. 52–53; 1958, p. 298). But, in the medium term, this

303
David Sanz Bas: Hayek’s Critique of The General Theory
assumption is inadmissible because the trade unions will start to
demand higher wages to protect their purchasing power. Also, the
entrepreneurs will begin to increase the wages of the workers in a
competitive bidding process for the existing workers (Hayek, 1958,
p. 296). It is naïve to think that if Keynesian spending policies are
implemented, nominal wages will remain stable in the medium
term. In Hayek’s words:
Where Lord Keynes went wrong was in the naïve belief that workers
would let themselves be deceived by this [inationary policy that
reduces real salaries] for any length of time, and that the lowering of the
purchasing power of wages would not at once produce new demands for
higher wages—demands which would be even more irresistible when it
was recognized that they would not be allowed to have any eect on
employment (Hayek, 1959, p. 282).
In addition, Hayek detects a corrupting eect on trade unions
derived from the employment policies defended in The General
Theory that Keynes did not consider: since the Keynesian
philosophy exempts trade unions from any responsibility with
regard to the unemployment rate, it is very likely that trade
unions will continually demand higher wages to improve their
purchasing power (Hayek, 1944a, p. 141; 1974, p. 204). These
two combined eects (the absence of “monetary illusion” in the
medium term and the corrupting eect on trade unions) will
tend to generate dangerous wage-price spirals: the demands for
higher wages will be answered by the economic authorities with
further expansionary policies to deliberately boost consumer
prices and compensate employers for their increasing labor costs.
In this scenario, the workers will ask for even higher wages and
the economic authorities will again answer with higher monetary
expansion and so on. So, Hayek argues that Keynesian policies
tend to produce a process of continuous acceleration in the rate of
ination. Consequently, in the long run, there will come a time when
this process of accelerated growth of prices will become socially
unsustainable and politicians will have to make a decision (Hayek,
1958, pp. 296–297): either to control prices by decree and maintain
Keynesian expenditure policies, actually suppressing the market
economy itself and leading to an economy of “German socialism”
(in Mises’s terminology) (Hayek, 1971, pp. 129–131); or eradi-

304 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
cating the Keynesian spending policies and facing an inationary
recession or stagation.10
And third, Hayek argues that Keynesian policies pose a serious
risk for international economic relations. He states that ination
caused by Keynes’ spending policies will lead to high volatility in
exchange rates, which will be harmful both for trade and interna-
tional investment. In addition, Hayek points out that a monetary
policy which aims to permanently reduce the national rate of
interest (which is one of Keynes’ main recommendations) is
only compatible with a policy of semi-autarky (Hayek, 1937, pp.
54–72). There are three arguments that support this statement.
First, if the national rate of interest is lower than the foreign rate
of interest, this would cause a “ight of capital” which would
lead to huge depreciation in the rate of exchange. This would
force economic authorities to increase the interest rate. Therefore,
in order to maintain this Keynesian policy of low interest rates,
authorities would have to prohibit free capital movements
(Hayek, 1937, pp. 66–67). Second, if the national rate of interest
is lower than the foreign rate of interest and capital movements
are not allowed, capitalists would use regular international
trade practices to conceal the export of capital. This would force
authorities to try to prevent it by imposing strict international
trading regulations (Hayek, 1937, p. 67). Finally, Hayek contends
that interest rates aect the price structure of capital goods and
thus, ceteris paribus, capital goods would be more expensive in the
country with articially low interest rates. In this situation, there
would be a tendency to import foreign capital goods because
they would be cheaper and to begin more capital intensive
production processes. This would increase the demand for credit
in that country and “unless the central bank is willing to allow an
indenite expansion of credit, it will be compelled (...) to raise its
own rate of interest, even if any outow of capital has been eec-
tively prevented” (Hayek, 1937, p. 70). In short, a single country
cannot maintain a permanent reduction in its interest rate and
participate in the international economy; thus, Keynesianism in a
10 As Sudha R. Shenoy points out, Hayek had predicted the appearance of the 1970s
stagation, almost 30 years before it happened. See Hayek (1946, pp. 145–146).

305
David Sanz Bas: Hayek’s Critique of The General Theory
single country is only compatible with a policy of semi-autarky.11
Ironically, Keynes came to the same conclusion some years before
(Keynes, 1933, pp. 240–241).
Hayek’s conclusion is that Keynesian spending policies are not
a solution to unemployment or economic crises. On the contrary,
they are a real threat to economic stability (Hayek, 1974; 1980).
4. The validity of the Keynesian theory: the economics
of abundance
Hayek thought that one of the big mistakes in The General Theory
is its complete neglect of the concept of scarcity (Hayek, 1941, pp.
371–376). Keynes believed that the demand policies he proposed
would reduce unemployment and would not produce crowding
out eects on the market. According to his view, the creation of
employment would by no means adversely aect third parties, as
the additional workers would contribute to an increase in the wealth
of that society. This is why Keynes believed that unemployment
had a huge social opportunity cost. In Hayek’s opinion, Keynes
forgets the basic principle of economics: the scarcity of means.
Hayek admits that demand policies could increase employment
(at least temporarily), but to employ these previously unemployed
workers, employers will need to use (and therefore demand) addi-
tional inputs such as fuel, machinery, buildings, raw materials,
specic workers who may not be available in the unemployment
lists, etc. Thus, in order to employ idle workers it will always be
necessary to demand other complementary inputs that may be
scarce. Therefore, the increase in employment brought about by the
policies of Keynesian demand will result in increases in demand for
various scarce inputs, whose prices will increase and, consequently,
this will cause many entrepreneurs to face unexpected increases in
their costs as some marginal companies will be forced to close. Thus,
demand policies will tend to crowd out some private investment.
Besides, in this process the income of some factors of production
will increase and, as a consequence, the demand for nal goods
will increase more than the supply of goods and services available.
11 Of course, if there is an international coordination of monetary policies, it will be
possible to maintain a policy of low interest rates everywhere.

306 The Quarterly Journal of Austrian Economics 14, No. 3 (2011)
Therefore, there will be a shortage of supply) causing ination and
the Ricardo eect. For all these reasons, Hayek believed that
Keynes’ argument was, in general, false.
However, Hayek points out that Keynes’ argument
would be valid only in a situation in which there would
be available idle reserves of all types of workers, all types of capital
goods and stocks of nished goods and semi-nished products of
all kinds. According to Hayek, while this situation continued, the
application of Keynes’ policies would be totally adequate and would
not cause further damage. Hayek states that in such a scenario of
“abundance of means” or “full unemployment” (Hayek, 1966, p.
286), demand policies may encourage entrepreneurs to hire new
workers and to demand additional inputs and, given the abundance
of means, their prices would not increase. Consequently, there
would be no crowding out eects on the market. Additionally, the
increased income of the productive factors would increase the nal
demand for goods, but given the existence of stocks available to
them, this would not cause ination or the Ricardo eect. Thus,
in a “full unemployment” situation, it would be advisable and
feasible to undertake Keynesian demand policies; though, Hayek
points out that as soon as this situation of “abundance” ended,
such policies would again be extremely dangerous.
But, is there any context in which the economy of “full unem-
ployment” is conceivable? Hayek said that it is only conceivable in
the deepest phase of a great depression when the overall decline
in economic activity may have created a temporary situation in
which there were unemployed workers of all kinds, a stockpile
of capital goods of all types ready for use, and available stocks
of nished goods. Hayek contends that in the framework of this
dramatic situation, which at most could last for a few months,
Keynesian policies would not be harmful, but even recom-
mended. Therefore, Hayek concludes that The General Theory is
actually a “particular theory” which would be valid exclusively
in the deepest stage of the worst depressions when the “economy
of abundance” is conceivable, but only in these exceptional situ-
ations. In Hayek’s words,
…such a situation [of “full unemployment”], in which abundant unused
reserves of all kinds of resources, including all intermediate products,

307
David Sanz Bas: Hayek’s Critique of The General Theory
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’ General Theory of Employment, Interest and Money
(Hayek, 1941, pp. 373–374).
For these reasons, I conclude that the theories of Keynes and
Hayek could even be considered complementary if Keynes’
theory would only be limited to these special situations of “full
unemployment” and Hayek’s theory to normal situations of
unemployment and full employment.
These are some of Hayek’s major criticisms of The General Theory.12
CONCLUSIONS
In conclusion, there is a criticism by Hayek of The General Theory
that is scattered throughout his work after 1936, that, to a certain
extent, has remained unnoticed. This criticism is very consistent
and addresses Keynes’ theory from dierent angles. Indeed, in
my opinion, Hayek presented very strong arguments against the
principles on which the crowning work of Keynes rests. Thus, I
believe that the study of this critique is paramount and may help
us to understand and face the current economic crisis.
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