Friedrich A. Hayek, “Investment That Raises the Demand for Capital” (1937)

This file is a single-author theoretical journal article. Hayek offers a narrow analytical intervention in trade-cycle theory: he does not explain every boom and crisis, but clarifies a proposition behind monetary overinvestment theories. His target is the static inference that a larger quantity of capital goods must lower the return on further investment.

It will surprise nobody to find the source of this confusion in the ambiguity of the term "capital."

The ambiguity matters because “capital” can mean aggregate value or the concrete quantity and arrangement of capital goods. In equilibrium this distinction can be suppressed; in dynamics it cannot. Hayek therefore shifts the analysis from total investment to the temporal and technical form investment takes.

The main thesis of this article will be that the effect which the current production of capital goods will have on the future demand for investable funds will depend not so much on the quantity of capital goods produced, as on the kind of capital goods which are produced or on the particular forms which current investment takes, and that an increase in the current output of capital goods will frequently have the effect not of lowering but of raising the future demand for investable funds, and thereby the rate of interest.

The first section develops this through the idea of investment chains. A plant or machine is often profitable only if later complementary investments occur; current investment therefore embodies an expectation that future funds will remain available at the assumed rate.

The success of current investment will depend upon this expectation being fulfilled.

Hayek’s decisive move is to treat earlier specific capital as sunk. Once built, its owners may accept prices covering little more than operating cost. The interest and amortization they expected to earn are effectively transferred to later stages, so “completing investments” may bear rates that would have made the original project irrational. Demand for funds is thus tied to the ratio between what has already been built and what remains to complete.

Obviously then, the demand for capital at any particular moment depends not so much on the productivity that the existing structure of real capital would have if completed—the long-term schedule of the productivity of investment—as on the proportion between that part of it which has already been completed and that part which has yet to be added to complete it.

The numerical example gives the paradox precision. If projects were begun under a 4 percent expectation, a later 5 percent rate—the rate that would have prevented them if foreseen—need not stop them. Already-produced equipment may make completion worthwhile at much higher rates. Hayek’s hydroelectric plant illustrates this: the plant itself may become unprofitable while still creating demand for motors and other complementary capital. He also rejects the objection that nonreplacement of earlier-stage equipment frees funds, since reduced amortization can lower the supply of investable funds.

The final section asks what produces this urgent demand for completion. The general cause is mistaken expectation about future saving or loanable funds; the practically central cause is temporary credit expansion. By allowing investment at a pace that cannot be maintained, credit expansion encourages entrepreneurs to choose forms of capital that require continued funding.

It is not so much the quantity of current investment but the direction it takes—the type of capital goods being produced—which determines the amount of future investment required if the current investments are to be successfully incorporated in the structure of production.

Hayek’s relevance lies in his critique of any theory that treats the “marginal efficiency of capital” as a simple decreasing function of the amount of capital goods or the current rate of investment. Past investment may make further investment more, not less, profitable; a late-boom rise of interest can therefore arise from real demand created by prior malinvestment, not merely from monetary restriction. Monetary disturbance matters because it reshapes the time-structure of production.

It shows, moreover, that a purely monetary analysis, which runs in terms of mere rates of investment without analyzing the concrete structure of these investments and the influence which monetary factors can have on this real structure of production, is bound to neglect some of the most significant elements in the picture.