Friedrich August von Hayek, The Economy of Capital

Friedrich August von Hayek’s The Economy of Capital is a magazine article first published in The Banker in October 1939, presented here in its documented 1997 republication. Written at the outbreak of war, it challenges the assumption that monetary authorities should keep interest rates as low as possible. Hayek distinguishes the ability to postpone a rise in rates from the economic desirability of doing so. His central claim is that interest performs an indispensable allocative function: it signals the scarcity of resources available for investment and helps direct them toward their most urgent uses. Suppressing that signal does not remove the underlying scarcity.

The article extends the argument of Hayek’s preceding contribution on pricing versus rationing. Its opening moves from monetary policy to a broader choice between allowing prices to indicate relative scarcity and replacing their guidance with detailed central regulation. Capital makes this choice harder to understand because it is not a single tangible resource. Hayek therefore develops his case through the timing of production rather than treating interest merely as a monetary phenomenon.

Investment always means sacrificing something in the near future to gain something at a more distant time.

This definition establishes why controlling labour, machinery, and raw materials does not by itself solve the problem of economizing capital. Against a position he attributes to Keynes, Hayek argues that knowing the relative values of concrete inputs is insufficient to determine their best use. A machine may save labour whose eventual cost exceeds the machine’s purchase price, yet still be an inappropriate investment: its cost must be incurred immediately, while the savings arrive over time. The ability to defer the benefits of present resources is itself limited.

Hayek makes the distinction concrete by comparing investments that release different numbers of workers over different periods. Steel invested in one machine might release ten workers annually for five years; another expenditure might release twenty workers for only two years. Even when the inputs have equal value in current production, their investment uses cannot be ranked from those input values alone. The decision also requires knowledge of available capital and the minimum return necessary to use it economically. His conceptual move is to distinguish the composition of resources from their allocation across time.

War sharpens this temporal problem. A conflict lasting only months might justify largely disregarding the following year’s needs; preparation for a three-year war requires husbanding capital to sustain output throughout that period. Hayek accordingly compares investments by both their returns and the time required to obtain them. An investment returning its principal plus eight per cent after one year takes precedence over one returning principal plus fourteen per cent after two years; the latter, in turn, takes precedence over a one-year return of six per cent. The point is not simply to maximize immediate output, but to discriminate among competing sacrifices of present resources.

And the available supply of capital can be reserved for the most urgent needs only if the price charged for it, that is the rate of interest, expresses its true scarcity.

Interest thus extends the ordinary principle of allocating resources where they contribute most to output. Hayek expects capital scarcity, and consequently the appropriate interest rate, to increase markedly in wartime. Armament production demands new equipment on a large scale, while the greater urgency of current needs makes sacrificing present output for distant benefits more costly. Low borrowing costs cannot dissolve either constraint.

The latter part of the article separates this allocation problem from the familiar question of encouraging saving. Hayek regards taxation as a particularly effective wartime means of increasing the savings available for public purposes, and doubts whether interest is ever chiefly important as an inducement to save.

Its main importance is always to regulate the allocation of the limited supply of capital to the purpose for which it can be used with the greatest advantage.

This distinction prevents the argument from becoming merely a demand for higher rewards to savers. Even if taxation secures additional resources, decisions remain about where and for how long to commit them. Cutting consumption offers only limited scope, especially because current output is needed both by the military and by civilians. Hayek therefore turns to the productive equipment accumulated during peace as another source of resources.

Existing equipment need not be directly convertible to military production to contribute to the war effort. Capital can be released by reducing what is put back into the productive process: curtailing amortisation or replacing worn equipment with cheaper, less durable, or less labour-saving alternatives. Such adjustments allow labour and materials otherwise devoted to maintaining civilian capital to be redirected toward urgently needed equipment. Yet Hayek rejects both stopping replacement altogether and imposing a uniform proportional reduction. Appropriate decisions depend on each production manager’s particular knowledge, disciplined by an interest rate reflecting capital’s scarcity.

A false rate of interest which does not express the true scarcity of capital will mislead private entrepreneurs just as much as the controlling authority.

The conclusion makes the argument relevant to both private enterprise and wartime administration. Hayek’s objection is not simply that public authorities might allocate badly: an artificially cheap price of capital can distort decisions under either arrangement. The article links the time structure of investment, the selective consumption of inherited capital, and decentralized knowledge within a concise argument about wartime priorities. Hayek expressly presents this as one neglected aspect of interest-rate policy. Its enduring significance lies in the distinction between making finance cheap and making real resources abundant: suppressing the price of investment can encourage plans that disregard the sacrifices their execution requires.