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Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek; O'Driscoll, Gerald P., Jr.
438 paragraphs found.
Foreword, by Friedrich A. Hayek
On the Way

by Friedrich A. Hayek

To give a coherent account of the whole of the theoretical work of an economist who has not attempted to do so himself is sometimes a useful task. But the proof of its worthwhileness must be that the attempt at systematization leads beyond the point where the author discussed left off. On this standard Professor O'Driscoll, if the task he has undertaken was worth doing at all, has done it very well indeed.


It is a curious fact that a student of complex phenomena may long himself remain unaware of how his views of different problems hang together and perhaps never fully succeed in clearly stating the guiding ideas which led him in the treatment of particulars. I must confess that I was occasionally myself surprised when I found in Professor O'Driscoll's account side by side statements I made at the interval of many years and on quite different problems, which still implied the same general approach. That it seems in principle possible to recast a great part of economic theory in terms of the approach which I had found useful in dealing with such different problems as those of industrial fluctuations and the running of a socialist economy was the more gratifying to me as what I had done had often seemed to me more to point out barriers to further advance on the path chosen by others than to supply new ideas which opened the path to further development. Professor O'Driscoll has almost persuaded me that I ought to have continued with the work I had been doing in the 1930s and 1940s rather than let myself be drawn away to other problems which I felt to be more important. I cannot now really regret it, however, when I see that not only he but also a few others are pushing beyond the point where my own impetus had flagged; in fact their efforts are doing more to make me think again about those problems than I would otherwise have done.

F. A. Hayek
Obergurgl, Austria
September, 1975


To Lyla,
with affection

In writing this book, I decided in general not to consult with Professor Hayek. If the reinterpretation was to be authentic and worthwhile, it would necessarily involve my piecing together his ideas as they were presented and available. I wanted to assess Hayek's contributions, not what Hayek himself recalled contributing, or intended to contribute. I was thus especially pleased that when he gave me his impressions of the penultimate draft in the form of a foreword, he found my interpretation satisfactory.


The Liberty Fund's summer program enabled me to meet Professor Hayek for the first time, as he was a Senior Fellow in the program. It was particularly stimulating to meet him at that time, as he was in the midst of writing his three volume magnum opus, Law, Legislation and Liberty.



Axel Leijonhufvud first suggested to me that reexamining Hayek's contributions might be worthwhile. From the start, I sensed that Hayek's theories were misunderstood in important respects. One major reason was the tidal wave of the Keynesian revolution. Contributing to the eager acceptance of Keynes's message was a desperate desire for a cure for the economic ills of the Great Depression.


I cannot overemphasize that the Keynesian revolution also had profound and unfortunate effects on economic research. The profession lost interest in a whole range of issues to which the major theorists of the day had made important contributions (see Fritz Machlup, "Friedrich von Hayek's Contribution to Economics," Swedish Journal of Economics 76 [1974]: 508-509). Consequently, in the nine years between the publication of Keynes's General Theory and the end of World War II, the fortunes of various economists changed remarkably. These changes occurred much more rapidly, for instance, than did the acceptance of the so-called marginal revolution at the end of the nineteenth century (see Mark Blaug, "Kuhn versus Lakatos, or Paradigms Versus Research Programmes in the History of Economics," History of Political Economy 7 [Winter 1975]: 399-433).


In the Keynesian revolution Hayek was not merely misunderstood—he was victimized by myth making. With the acceptance of Keynesian economics, the history of economics was rewritten. Economics was divided into pre-Keynesian and Keynesian thought (and now we speak of post-Keynesian economics). Accepting Keynes's own solecistic usage, economists perceived Keynes's predecessors—with a few exceptions—as "classical" economists. In keeping with Keynes's original suggestion, Oskar Lange pictured economists before Keynes as believing in Say's law of markets (Oskar Lange, "Say's Law: A Restatement and Criticism," in Oskar Lange et al. eds., Studies in Mathematical Economics and Econometrics [Chicago: University of Chicago Press, 1942]). Belief in Say's law became, then, the hallmark of the classical system and the alleged source of all the great classical errors. Say's law not only was reinterpreted in a way that made it scarcely recognizable to an authentic classical economist, but also was made into a proposition that only a fool would accept. This defamation of Keynes's predecessors is what, I believe, Keynes and, even more, his followers accomplished in a decade (see W. H. Hutt, A Rehabilitation of Say's Law [Athens, Ohio: Ohio University Press, 1974]).


Classificatory schema of the "Keynesian-classical" variety are suspect to say the least. The lumping together of virtually all Keynes's predecessors obscures what distinguishes economists between the Marginal Revolution and the Keynesian revolution. Overlooked in particular are the many and diverse contributions to the theory of economic fluctuations by monetary specialists from the end of the nineteenth century to the 1930s and beyond. These economists include, inter alia, Ludwig von Mises, Gunnar Myrdal, D. H. Robertson, Hayek, and even Keynes himself in his Treatise on Money (1st ed., 1930 in The Collected Writings of John Maynard Keynes, vols. 5 and 6 [London: Macmillan & Co., 1971]). Each of these economists pointed to the failings of the quantity theory and offered revisions. They also contributed to the development of the theory of economic fluctuations. It is therefore misleading to describe them as classical or pre-Keynesian. Also these theorists developed certain parts of what is termed Keynes's critique of monetary economics to a greater extent than Keynes himself did.


There are, then, two basic reasons for reexamining Hayek's work today. First, a reassessment of his position in the development of economics is long overdue. His positive contributions to contemporary economic theory have not been fully appreciated. His ideas, which were pushed into the shadows of the Keynesian revolution, are no longer summarized in the leading textbooks. Second, the failure of current Keynesian or post-Keynesian theories of economic fluctuations to explain satisfactorily the simultaneous occurence of inflation and unemployment makes what Hayek said about this phenomenon seem more important.


My claim that Hayek was misunderstood by his contemporaries requires amplification. The Austrian school (of which Hayek was the leading representative at that time in Britain) had a foreign flavor to which British economists were unaccustomed. Furthermore, the lack of understanding led to a failure among Anglo-American economists to comprehend the larger import of Hayek's message. Hayek called for an entire restructuring of economic theory. In part, he was attempting to counter the revived interest in the general equilibrium theories—the neo-Walrasian and neo-Paretian theories of the 1930s as found, for example, in John R. Hicks's writings. However, economics, even before the widespread adoption of general equilibrium models, had unfortunately become virtually a branch of mechanics. The important problem of finding the social institutions that best coordinate economic activities had been lost sight of. Adam Smith, in his notion of the "invisible hand," called attention to the complex manner in which a prosperous social order is produced, although no one individual (or group of individuals) designed that order or intended that it be produced. Building on Smith, Carl Menger, the founder of the Austrian school, defined economics (and social science in general) as the study of the unintended consequences of human action. Hayek here followed in Smith's and Menger's footsteps.


In Hayek's view, economics begins where direct observation leaves off. The immediate impact of most economic decisions is apparent even to the untrained: a legal control holding price below the market-clearing price makes goods less expensive (in money terms); a minimum wage set above the market-clearing level raises the income of (employed) workers. Economics deals with the hidden aspects of these problems, or phenomena not readily understood to be aspects of these problems (for example, shortages and unemployment).


Economic institutions exist largely to facilitate the dissemination of information among actors. The study of the development of economic order depends, then, on assumptions concerning the flow of information. Standard theorems of resource allocation are only the starting point. Hayek often criticized economists for generally ignoring this institutional-informational problem.


In his lectures at the University of London in 1931 (Friedrich A. Hayek, Prices and Production, 2d ed. [London: Routledge & Kegan Paul, 1935]), Hayek appeared to be discussing recondite matters in monetary and capital theory. His subject matter, however, was unusually topical in light of the Great Depression. While his conclusions were provocative, these lectures were apparently unrelated to the wider problems of economic planning or to his other work on economic information. Yet they were intimately related, although writers continue to compartmentalize his work rather than study it in its entirety.


Hayek himself never demonstrated how all his ideas "hang together." Although this study is restricted to his economic writing, Hayek's later work on political and legal philosophy and even on the philosophy of perception is consistent with his earlier work on technical economics. A comprehensive treatment of Hayek's contributions might demonstrate that his book on economic fluctuations in 1931 led him to write Law, Legislation, and Liberty in the 1970s!


Secondary source material proved a poor guide for understanding Hayek's ideas. While I do not ignore the secondary source material, I restrict myself to what I consider to be the important errors of interpretation. I have also avoided any direct discussion of the Hayek-Frank H. Knight debates on the meaning and definition of capital. These debates are ancillary to the main theme of this book, though by no means irrelevant. Furthermore, Knight did not offer a theory of capital at all, in the sense of a theory of adjustment and investment in disequilibrium (see M. Northrup Buechner, "Frank Knight on Capital as the Only Factor of Production," Journal of Economic Issues 10 [September 1976]: 598-617). Rather, Knight's central argument about capital—that no sense can be made of a period of production or investment because of the simultaneity of production and consumption—really involved a series of tautologous propositions about the stationary state. Many have made this point, but none more forcefully than Fritz Machlup, who, moreover, pointed out that when Knight conceded—as he did—that disinvestment is possible, he conceded the whole argument to the Austrians (see Fritz Machlup, "Professor Knight and the 'Period of Production'," Journal of Political Economy 43 [October 1935]: 579-80).


In order that my remark that Knight's theory is not a theory of capital be understood, I shall quote from Hayek's own characterization of his endeavor in The Pure Theory of Capital:

Our main concern will be to discuss in general terms what type of equipment it will be most profitable to create under various conditions, and how the equipment existing at any moment will be used, rather than to explain the factors which determined the value of a given stock of productive equipment and of the income that will be derived from it. [P. 3]

Whatever Knight's "theory of capital" was, it was not a theory of capital in this sense. To offer it as an alternative to Hayek's theory is akin to offering a theory of supply as an alternative to a theory of demand. As Ludwig M. Lachmann has reminded us, we still do not have a theory of capital, though interest theories, misnamed "theories of capital," do go under this title (see L. M. Lachmann, "Reflections on Hayekian Capital Theory" [New York: mimeographed, 1975]).


To reiterate, the main theme of this book is the coordination of economic activities. Hayek's work is seen as variations of this theme. And taken together, his work is viewed as providing a basis for a radical alternative to the "neoclassical" paradigm of efficient allocation with timeless production, perfect anticipations, costless exchanges, (almost) instantaneous attainment of equilibrium, and a world of no institutions. In many ways, Hayek and his fellow Austrians harked back to classical political economy. But being subjective-value theorists and methodological individualists, they rejected the objective-value theory and methodological holism of Ricardian political economy. In doing so, they advanced the basic research program of Adam Smith. They shared with the Institutionalists a concern for the evolution of market institutions, but viewed this study as complementary to, rather than a substitute for, economic theory. They were foremost among the theorists of their day, but resisted limiting economics to the pure theory of equilibrium states. In the pages that follow, I hope to support these characterizations by explicating both the specific contributions and general approach of Hayek in particular. In doing so I will emphasize his monetary economics, wherein lie his greatest technical contributions. But since to do so would virtually falsify my own thesis, I will by no means limit myself to monetary economics. Instead, I will attempt to connect his many and diverse contributions to economics, and to show that they evidence an overall conception of economics as the study of decentralized planning and market coordination.

Chapter 1

The name John Maynard Keynes and the brand of economics that is called "Keynesian" are known to every practicing economist and economics student today. In contrast the work of Friedrich A. Hayek is practically unknown to the present generation. To older economists the name "Hayek" is but a reminder of past debates. Until the 1974 award of the Nobel Memorial Prize in economics (jointly to Professors Hayek and Myrdal) economists had lost interest in his works. Sir John Hicks commented on the neglect of Hayek's work:

When the definitive history of economic analysis during the nineteen-thirties comes to be written, a leading character in the drama (and it was quite a drama) will be Professor Hayek. Hayek's economic writings...are almost unknown to the modern student; it is hardly remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes. Which was right, Keynes or Hayek? There are still living teachers of economics, and practical economists, who have passed through a time when they had to make up their minds on the question; and there are many of them (including the present writer) who took quite a time to make up their minds. *1

Keynes was not the only economist to challenge the orthodoxy of the time, and the General Theory was not the only important work to do so. As Hayek wrote in a slightly different context: "We all had similar ideas in the 1920's." *7 Leijonhufvud pointed out that to describe the General Theory as a "clean break" is to miss the clear progression from the ideas of the Treatise.*8


A major premise of this work is that Hayek was correct in his contention that the ideas that bore fruit in the late depression period were conceived in the boom of the twenties. I shall reexamine the contribution of Hayek to this period of intense questioning of economic orthodoxy, especially in relation to the problem of the business cycle in a decentralized market economy.


Even before Hayek was awarded the Nobel Prize there was a revival of interest in his contributions to economics. Some credit for this revival belongs to Hicks, though he only examined Hayek's works dealing directly with business cycle theory (and erred in ignoring the analysis of the price mechanism as an information-transmitting device in a decentralized market economy). To Hayek, the price system, by disseminating available information to market participants at the least cost, tended to make mutually compatible the initially incompatible plans of individual actors in that system. His work forms a unified whole and must be appreciated as such.


It is impossible to assess adequately Hayek's business cycle theory, as Hicks attempted, without considering his work on the foundations of economic theory and the operation of the price system. Hayek's conception of how the market economy operates is most evident in his theoretical work about prices as transmitters of information. Even the contributors to the recent Festschrift honoring Hayek did not attempt such a reintegration. *9


I consider Hayek's work a radical criticism of the "Grand System" concept of economics. In presenting an overview of the state of economic theory during the 1920s, it is necessary to contrast the economic theory prevailing in Great Britain (and, to some extent, the United States) with that on the Continent. Shackle's description of economics during the 1920s is more applicable to British classical economics (as modified by William Stanley Jevons, Alfred Marshall, A. C. Pigou, and others) than it is to Continental economics.


There is another characteristic of Austrian economics that distinguishes it from the Lausanne school in particular: Austrian contributions could not be subsumed into what Shackle described as the "Grand System" because they focused attention on the element of adjustment time and consequently adopted the causal-sequential analysis of classical economics rather than the technique of mutual determination. *19 This rejection of mutual determination has been taken as evidence that their intellectual contribution was outdated. Furthermore it has led to the spurious claim that they ignored the mutual interdependence of economic factors. *20 To the contrary, their approach was a by-product of a concern with market processes rather than equilibrium states, a concern that attained its fullest development in the writings of Mises and Hayek. *21 Many of the positions viewed as characteristically Austrian may be traced to the work of these writers, whose work nonetheless represents the fullest development of this tradition.


Austrian and Swedish economists, familiar with the work of Menger and his disciples, pioneered the technique of dynamic analysis. Educated on the Continent, they, unlike their English counterparts, were aware of the Walras-Pareto tradition, and its limitations. Although the Swedish economists alone have been credited with "process analysis," Hayek was working along similar lines at the same time. In essence, the Swedish and Austrian economists were recasting economic theory so as to focus on the market process, by which disparate plans of individuals are equilibrated, rather than on equilibrium states.


In Sweden both Erik Lindahl and Gunnar Myrdal were refining the work of Wicksell; in Austria Mises and Hayek were extending the work of Eugen von Böhm-Bawerk and Wicksell. Thus in 1933 Hayek edited a work of non-German contributions, Beitrage zür Geldtheorie (Vienna, 1933), which contained articles by both Wicksell and Myrdal. Myrdal's contribution, "Der Gleichgewichtsbegriff als Instrument der Geldtheoretischen Analyse," did not appear in English until 1939. *22


Shackle argued for the simultaneity (if not the priority) of Myrdal's "Keynesian" analysis with Keynes's own; indeed, Shackle suggested that in some ways Myrdal's performance was more satisfying than that of Keynes in The General Theory. He also claimed priority for Myrdal in formulating and effectively employing the ex ante- ex post distinction. *23 But as a matter of priority in the history of thought, it is necessary to note the independent work of Hayek here; though, again, the Swedish and Austrian economists wrote under the common influence of the early Austrians. *24


Before the 1930s English economists were as ignorant of these later Continental developments as they were of the earlier ones. Hayek thus could say of Keynes's Treatise that it contained nothing new for a Continental economist (adding that the presentation was somewhat confusing). At the time of the Treatise, Keynes was apparently unaware of Böhm-Bawerk's capital theory, a fact Hayek underscored in his 1931 review of the work. *25



Hayek argued that a successful analysis of economic disequilibrium required a reformulation of the concept of equilibrium. He devoted considerable energy to this task. Through the late 1930s and the 1940s he published articles on the price mechanism and the social function of prices in transmitting knowledge. From one viewpoint, these articles are a continuation of the debate about economic calculation in a Socialist economy. From another, these writings, together with his work on economic calculation and on monetary theory, attempt to come to grips on different levels with a single basic problem; for his price theory may be interpreted as an extension of his business cycle theory. *26 All Hayek's work may thus be seen as flowing from a conception of social interaction with emphasis on economic allocation.


Is it proper to assess Hayek's lifework as the logical development of a single idea? Although much of his work on monetary theory and the business cycle was written before that on price theory, my impression is that he was systematically working out the basic assumptions of his monetary theories in response to criticisms and misunderstandings. *27 On several occasions Hayek expressed surprise that his English readers were not familiar with areas of economic knowledge that to him were commonplace.


Schumpeter's insight that a man's work depends on his total conception of the economic problem is apropos. *28 Thus, the purpose of this work is to elucidate Hayek's conception of the market process. Among other things, this elucidation may assist in the reformulation of macroeconomics.


Prices and Production (for complete citations see bibliography at the end of this book) was Hayek's first major work in English. First published in 1931, Prices and Production brought Hayek widespread recognition in England and introduced the Austrian business cycle theory to the British. Monetary Theory and the Trade Cycle was not translated and published until 1933, though it appeared in German in 1928. Expressing, as it does, Hayek's views on monetary theory in more detail, Monetary Theory and the Trade Cycle should be read before Prices and Production. Yet English readers did not have access to the earlier work until two years after the publication of Prices and Production.


Hayek was a major participant in the Socialist calculation debate and edited a volume on the subject in 1935 entitled Collectivist Economic Planning. Concomitantly, he was presenting his monetary, capital, and business cycle theory in journals. These researches on the business cycle and on the Socialist calculation question suggested the need for a firmer foundation for price theory. Hayek believed that the crucial role of prices in resource allocation was not fully appreciated. In a series of articles written between 1936 and 1946, he emphasized that prices serve two important functions: They communicate information about the relative scarcity of resources, and under certain assumptions they improve coordination of the plans of transactors. *29


The connection between Hayek's work on the price system and on resource allocation in a centrally planned economy is readily apparent. The connection that exists between work on monetary theory and on the theory of economic fluctuations may be less clear. However, Hayek saw the business cycle as resulting from the noncorrespondence of plans of savers and investors when important market signals—relative prices—are falsified by previous monetary disturbances.


Hayek restated his business cycle theory in 1939. *30 However, his magnum opus on capital theory, The Pure Theory of Capital, was not published until 1941. Again, this work elucidated the foundations for work that had been published years earlier.


In the 1940s Hayek turned his attention to other matters. He began working in the philosophy of science and the social sciences in general, on political philosophy, and on the theory of perception. Hayek confessed that by the 1950s he had lost interest in monetary theory. *31


This book will end where Hayek's interests changed. It will thus examine only about half of his total output. But to examine that half, we have to read Hayek in logical rather than chronological order.

Sir John Hicks, "The Hayek Story," Critical Essays in Monetary Theory (Oxford: Oxford University Press, The Clarendon Press, 1967), p. 203. (Hereafter, Critical Essays.)
Hayek to Milton Friedman, commenting on the latter's Henry Simons Lecture, wrote: "I believe you are wrong in suggesting the common element in the doctrine of Simons and Keynes was the influence of the Great Depression. We all held similar ideas in the 1920's. They had been more fully elaborated by R. G. Hawtrey who was all the time talking about the 'inherent instability of credit,' but he was by no means the only one.... It seems to me that all the elements of the theories which were applied to the Great Depression had been developed during the great enthusiasm for 'business cycle theory' which preceded it" (Milton Friedman, The Optimum Quantity of Money [Chicago: University of Chicago Press, 1969] p. 88n).

Not only was Hayek an active participant in these debates, but his consummate skill as a doctrine-historian and interpreter of economic theories is above dispute. For a compliment by a contemporary historian of the institutionalist school, whose section on Hayek can otherwise only be described as a series of misinterpretations and one-sided attacks, see Ben B. Seligman, Main Currents in Modern Economics, 3d ed. (New York: Free Press of Glencoe, 1963), pp. 342-43.

It is true that Carl Menger and Eugen von Böhm-Bawerk were read to a limited extent in the United States. Jacob Viner for one was familiar with the general Austrian approach ("Cost Curves and Supply Curves," in Readings in Price Theory, ed. George J. Stigler and Kenneth Boulding [Homewood, Ill.: Richard D. Irwin, 1952], pp. 198-226, esp. p. 200). Developments in the United States were less important at this time. The Austrians remained largely unknown in Great Britain, and to a great extent, despite the translation of Böhm-Bawerk's work and the best efforts of men like Viner, Irving Fisher, and J. B. Clark, in the United States as well. It must be remembered that the locus classicus of the Austrian school, Menger's Grundsätze, was not translated until 1950 (Carl Menger, Principles of Economics, trans. and ed. James Dingwall and Bert F. Hoselitz [Glencoe, Ill.: The Free Press, 1950]).

Credit belongs to Lord Robbins for breaking down British intellectual insularity in the 1930s and bringing Continental developments to the attention of British economists. Hayek's invitation to lecture at the London School was a by-product of these efforts.

Ironically, the latter-day Austrians (that is, Ludwig von Mises and those who attended his seminar at the University of Vienna, including Hayek, Fritz Machlup, and Oskar Morgenstern among the younger generation) saw themselves as members of the same school in a geographical sense only. Otherwise, they considered themselves orthodox economists and applauded the demise of the Austrian school as a distinct intellectual entity. Clearly I do not accept the view that they then held; moreover, I think the course of history argues against their view.
On the subjective nature of economics, see Hayek, The Counter-Revolution of Science (New York: Free Press of Glencoe, 1955), pp. 25-35 and passim. See also Ludwig M. Lachmann, "Methodological Individualism and the Market Economy," in Roads to Freedom, ed. Streissler et al., pp. 91-94.
An incorrect inference should not be drawn from the fact that Hayek edited a volume in which Myrdal's now-famous essay appeared. Hayek, wanting to make available in German those essays "which had not been available in one of the generally understood languages," appealed to Lindahl. Lindahl was unable to supply Hayek with a new work, and instead had his student Myrdal submit an essay. In no sense then was Hayek influenced by Myrdal. And work that Hayek wrote subsequently can be understood, it will be argued, entirely in terms of his own earlier development. Hayek himself told me of the way in which Myrdal's piece came to be included in the volume in question; the information was conveyed in a letter dated 25 August 1974.
Friedrich A. Hayek, "Reflections on the Pure Theory of Money of Mr. J. M. Keynes," part 1, Economica 11 (August 1931): 277-80; J. M. Keynes, "A Reply to Dr. Hayek," ibid., 11 (November 1931): 394-95; Friedrich A. Hayek, "A Rejoinder," ibid 11 (November 1931): 401-2; and idem, "Reflections," part 2, ibid., 12 (February 1932): 25-26.
Many of the essays on the price system were reprinted in Individualism and Economic Order. A series of articles in Economica in the 1940s on his philosophy of the social sciences are incorporated into Counter-Revolution of Science. Generally overlooked, these articles are basic to Hayek's approach to economics. The Socialist calculation debate concerned the possibility of allocating resources by central authority, i.e., without the aid of a price system.
For the chronology of Hayek's work, see pp. 10-11.
Chapter 2

In this debate Hayek criticized both Marshallian economics (then dominant in Great Britain) and neo-Walrasian economics (to become dominant in Anglo-American economics). Hayek argued that neither of these orthodox paradigms gives adequate attention to the information problem inherent in economic activity.


In writings on the price system as a transmitter of information, Hayek developed a concept of equilibrium that referred to the consistency of the plans of transactors and to the information required to attain this consistency. Hayek also analyzed the problem of the allocation of resources over time. To some extent, Hayek set forth his conception of the role of prices to amplify his theory of the business cycle. Yet the relevance of his work on prices and markets to this theory of cyclical fluctuations has not been made explicit in the literature.


Throughout the 1930s and 1940s, Hayek was a major critic of the emerging professional consensus on economic research. In particular, he tried to separate the theoretical from the empirical (as he phrased it) in economics and delimit the tautological propositions of economic analysis from the potentially empirical elements. He argued that the tendency to limit economic theory to the development of static analysis would make it impossible to deal with disequilibrium conditions. His arguments often anticipated current criticisms of the cavalier treatment of disequilibrium states by economists.


Probably the London School's lack of a theoretical tradition led to its becoming the locus for the introduction of Walrasian (and Paretian) economics by Hicks, and of Austrian economics, first by Lionel Robbins and later by Hayek. Interest in Walrasian economics was revived amid the general upheaval in economics, though many of the ideas were "in the air" earlier, especially at the London School. *45 Hicks's revision in demand analysis has had more far-reaching consequences than were foreseen at the time.


To describe Hayek's views on the nature and character of formal theory as an attack on formal theory per se would be incorrect. *48 Walras necessarily streamlined his theoretical edifice. Given his purpose, problems of short-run market behavior were ignored. *49 Walras was not only an innovator in applying mathematical analysis to economic theory but also in introducing the concept of general equilibrium, along with a reconstruction of the entire classical edifice. The additional construction of a theory of disequilibria would have been more than could be reasonably expected in such a pioneering work.


Hayek believed that his contemporaries were not always in touch with the "fictions" and limitations inherent in general equilibrium theory and were prone to confuse statements about equilibrium with the theory of the approach to equilibrium. *50 To assert that it is as if "so and so is true" is not to construct a theory of what in fact does occur in markets. Indeed, the assertion may be a way to avoid analyzing the adjustment process in order to concentrate on another problem altogether.



Hayek did not object to the use of mathematics in the development of formal economic theory. In fact he treated the pure theory of consumer choice as a basically logical system that would be particularly susceptible to mathematical formalization. He contended that the purpose of formalizing theory was sometimes forgotten:

My criticism of the recent tendencies to make economic theory more and more formal is not that they have gone too far but that they have not yet been carried far enough to complete the isolation of this branch of logic ["the Pure Logic of Choice"] and to restore to its rightful place the investigation of causal processes, using formal economic theory as a tool in the same way as mathematics. *51

His objection was not to the progressive refinement of static theory but to "an excessive preoccupation with problems of the pure theory of stationary equilibrium." *52 This preoccupation was responsible for lack of attention to "causal processes" in the coordination of economic activity. Hayek's critique, though less strident and more succinct, was similar to Keynes's attack on A. C. Pigou. It is incorrect to assume that the actual market economy makes use of "logical implication" when "solving" problems in the context of general equilibrium analysis: "To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world." *53


Any analysis of disequilibrium or of adjustment behavior involves the factor of anticipations. Interest in this subject in the 1920s and 1930s suggests a relationship between problems of incomplete information and disequilibrium and those of expectations. Two Americans, Irving Fisher and Frank H. Knight, laid the groundwork. Hayek, building on the work of his teacher Ludwig von Mises, brought their contributions as well as those of the Swedish economists Gunnar Myrdal and Erik Lindahl to the attention of both his German and his English readers.


The trend of economic theory did not carry over. After World War II interest in expectations faded. The factors of expectations and incomplete information were excluded from hypotheses. As a result, economic theory was devoid of much empirical content (and any Keynesian content); little consideration was given to the conditions under which equilibrium would be attained in the real world. This weakness in economic theory subsequently led Hayek into more detailed analysis of economic models (particularly that of perfect competition). Because the essential outlines of the (now) orthodox economic paradigm were already visible by the late 1930s, his critical analysis is especially relevant today.


As is now widely recognized, the theory of perfect competition ignores the adjustment process required to attain equilibrium. Nor does the theory guarantee the attainment of that state (in the absence of some remarkably stringent assumptions). The theory of perfect competition is restricted because it only defines equilibrium values. The conventional (that is, neo-Walrasian) theory of value and price may be termed equilibrium theory. Recent work has attempted to extend economic theory to disequilibrium situations. *54 Hayek's early diagnosis of the problem has been largely ignored. Yet consideration of his diagnosis would, on the one hand, have speeded the development of theories of market adjustment; and, on the other hand, it would have helped theorists avoid the intellectual dead-end of attempting to develop such theories basically within an equilibrium model.


Using the "competitive case" as an example Hayek considered the standard assumptions in economic theory:

1. Complete knowledge of the relevant facts on the part of all transactors in the market
2. Free entry—that is, the absence of restraints or artifically imposed costs on the movement of resources and prices
3. A homogeneous commodity being supplied and demanded by a large number of potential sellers and buyers, none of whom expects to affect prices to any extent *55

Hayek commented on this approach as follows:

It will be obvious...that nothing is solved when we assume everybody to know everything and that the real problem is rather how it can be brought about that as much of the available knowledge as possible is used. This raises for a competitive society the question, not how we can 'find' the people who know best, but rather what institutional arrangements are necessary in order that the unknown persons who have knowledge suited to a particular task are most likely to be attracted to that task. *56

In this criticism, Kirzner followed Hayek's lead. Hayek concentrated on the first assumption in the theory of competition, that of perfect knowledge. In saying that knowledge of opportunities is "given," economists fail to specify to whom that knowledge is given.


As Hayek observed:

Datum means, of course, something given, but the question which is left open, and which in the social sciences is capable of two different answers, is to whom the facts are supposed to be given. Economists appear subconsciously always to have been somewhat uneasy about this point and to have reassured themselves against the feeling that they did not quite know to whom the facts were given by underlining the fact that they were given—even by using such pleonastic expressions as "given data." But this does not answer the question whether the facts referred to are supposed to be given to the observing economist or to the persons whose actions he wants to explain, and, if to the latter, whether it is assumed that the same facts are known to all the different persons in the system or whether the "data" for the different persons may be different. *60

An important consideration here is the use of the term equilibrium in economics: "Taking the word 'equilibrium' in its usual sense to mean an 'absence of motion,' we shall say that a market is in equilibrium if and only if market price and quantity traded are stationary over time." *62 The informational structure is implicit in such treatments. For all markets to be in equilibrium implies that the plans of a multitude of disparate transactors are mutually compatible. *63 What then is the requirement for mutual compatibility of plans? According to Hayek, "It appears that the concept of equilibrium merely means that the foresight of the different members of the society is in a special sense correct." *64


Complete and perfect foresight is most unlikely. *65 With decentralized decision making, each transactor must consider the planned actions of all other transactors on the basis of their information. It is not sufficient for an individual to have complete knowledge of all objective conditions (technology, resources, and so on). A subtle, though fundamental change has now occurred in the problem. What was originally assumed "given" to participants in the market was information about objective conditions—facts only available to the mind of each transactor— and only those facts. But complete knowledge is now seen to entail perfect foresight about what others will do given their limited information. Walrasian general equilibrium theory, while ostensibly about decentralized decision making, really only makes sense in the context of a single planner. The whole analysis is more applicable to a system of central planning than to a market economy. Hayek termed the change in the problem "insidious." The problem to be studied has been changed in a manner that maximizes the probability that no one will realize the "solution" is not a solution to the original problem, but to a new one altogether. *66


Perfect knowledge means correct foresight. But, as Hayek put it:

Correct foresight is then not, as it has sometimes been understood, a precondition which must exist in order that equilibrium may be arrived at. It is rather the defining characteristic of a state of equilibrium. *67

Hayek's essays on the price system and markets are prolegomena to any future study of economic systems and dynamic processes. They display an erudition and a depth of scholarship often lacking in works that admittedly make use of more modern research techniques. They show an appreciation of the economic problem as an ongoing social process. Furthermore these essays represent the theoretical foundation for Hayek's work on economic fluctuations and reveal the continuity of his thought in the area now divided into micro and macro economics. His conception of economics as the study of an interpersonal coordination problem is nowhere more evident than in his essays "Economics and Knowledge," "The Use of Knowledge in Society," and "The Meaning of Competition." *69


Lurking behind the assumption of "given knowledge" is another one important for the model of perfect competition. That is the notion of stationarity. The assumption that the market can actually attain stationary equilibrium involves an additional empirical hypothesis concerning the extent of change occurring at any moment. In Hayek's "vision" of a developed economy, the businessman is constantly struggling to keep costs from exceeding prices in the face of continuously changing conditions. Hayek noted how

easy it is for an inefficient manager to dissipate the differentials on which profitability rests and that it is possible, with the same technical facilities, to produce with a great variety of costs are among the commonplaces of business experience which do not seem to be equally familiar in the study of the economist. *70

In contrast with Hayek's view is the Schumpeterian one, in which recurring "clusters" of innovation require the attention of the entrepreneur from time to time. "Normal" conditions correspond to the usual construction of static equilibrium. *71


Elaborating on his interpretation of the term competition, Hayek said that "competition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis." *72 The reason the economist's construct of competition ends up meaning "the absence of all competitive activities," has to do with the assumption of stationarity. *73


The assumption of stationary conditions, implicit or explicit, appears under a number of guises. Hayek attributed the wide-spread belief in the possibility of rational allocation without a functioning price system to this assumption. *74 Specifically, static cost theory is much less applicable to allocation problems than is usually supposed. The market process involves constant adjustment to ever-changing data; important information consists of the planned actions of other transactors. Costs are ephemeral, and profit is ever-present income. *75 Capital is seldom replaced by capital of the same type or of the same value. Returns to owners of existing capital are quasi-rents, and have no definite relation to market rates of interest except insofar as accounting procedures take account of implicit revaluations of assets. It is a world in which a "Lerner Rule" would be unusable. *76


The meaning of "equilibrium" can be understood with reference to the plans of a single transactor: his plans are mutually consistent. *79 But how is it that the plans of disparate, individual decision makers are made mutually consistent? Hayek proposed that we instead speak of a tendency for this compatibility to come about. *80 " The division of knowledge" is at least as important as "the division of labor," yet the former has been "completely neglected, although it seems to me to be the really central problem of economics as a social science." *81

The problem which we pretend to solve is how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affairs in which prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals. *82

The missing link in the chain of reasoning is the mechanism that tends to bring decisions into closer correspondence: the price system. Hayek, in a classic metaphor, suggested that "we must look at the price system as...a mechanism for communicating information if we want to understand its real function." *83 The price system is the mechanism to be focused on in a study of the coordination problem.


What particularly recommends the price system to Hayek is the "economy of knowledge" with which it operates. It is nothing short of a "marvel":

The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same even or "normal" level. *84

In the Socialist calculation debates, Hayek argued that the market system, with its relatively cheap communication network, is the best possible method of allocating resources. In his work on cyclical fluctuations, Hayek also focused on the coordination problem, this time to explain periodic breakdowns in a system that is susupposed to work. Throughout all his work he maintained his conception of the "economic problem" as a coordination problem, for the analysis of which the method of "logical implication" is the appropriate tool. *89

On the milieu at Cambridge and at the London School of Economics, see Lord Robbins, Autobiography of an Economist (London: Macmillan & Co., 1971), pp. 105-6, 132-35. According to Hayek, Robbins played an important role in many of the developments that will be discussed.
Hicks noted that the concepts for Value and Capital were nurtured by what he termed a "sort of social process" at the London School in 1930-35. (John R. Hicks, Value and Capital [London: Oxford University Press, 1939], p. vi). Robbins discussed this social process in Autobiography of an Economist, pp. 129-32. Hicks and R. G. D. Allen referred to some of these concepts in "Reconsideration of the Theory of Value," Economica, n.s. 1 (February 1934): 52-76. There is irony in this story in that it was on Hayek's suggestion that Hicks investigated Pareto's indifference curve approach to demand theory. Hayek believed that Pareto's approach was in many ways superior to Marshall's (personal communication).

One can speculate why Hayek preferred Paretian over Marshallian demand theory. Paretian-Walrasian demand theory is more explicitly "choice-theoretic" and, thus, closer in spirit to the Austrian approach. On the distinction between Walrasian and Marshallian demand theory, see Leijonhufvud, "The Varieties of Price Theory: What Microfoundations for Macrotheory?" U.C.L.A. Discussion Paper No. 44 (Los Angeles: mimeographed, 1974).

17. Here one should remember that Hayek is the author of The Pure Theory of Capital (Chicago: University of Chicago Press, 1941).
Friedrich A. Hayek, "The Use of Knowledge in Society," in Individualism and Economic Order (Chicago: University of Chicago Press, 1948), pp. 89-91. (Hereafter, Individualism.)
Hayek, "Socialist Calculation III: The Competitive Solution," Individualism, p. 188.
Hayek, "The Use of Knowledge in Society," p. 91. Walras seemed aware of the point Hayek made here ( Elements, p. 106). See also J. M. Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace & World, 1936), pp. 272-79.
Hayek, "The Meaning of Competition," Individualism, p. 95. See also George J. Stigler, The Organization of Industry (Homewood, Ill.: Richard D. Irwin, 1968), pp. 5-16.
Hayek, "The Meaning of Competition," p. 95.
Lionel Robbins, An Essay on the Nature and Significance of Economic Science, 2d ed. (London: Macmillan & Co., 1935). "The book [i.e., Robbins's] has been so influential that its once challenging thesis will seem almost platitudinous to today's students. For that very reason, it should be recognized as an important part of the story of how choice-theory became the predominant—indeed, all but exclusive—paradigm of modern theoretical economics" (Leijonhufvud, "Varieties of Price Theory", 53n). Hayek convinced me that Robbins, in turn, was heavily influenced by the Austrian Richard von Strigl. Thus the earlier Austrians in part contributed to the development of a theoretical edifice they later came to reject.
Hayek, "Economics and Knowledge," Individualism, p. 39. Modern work on the technical issues involved in alternative assumptions about the dispersal of knowledge among economic actors, although accomplished within a neo-Walrasian framework, is of interest to the theorist. See Leonid Hurwicz, "The Design of Mechanisms for Resource Allocation," American Economic Review 63 (May 1973): 1-30.
Hayek, "The Use of Knowledge in Society," p. 77.
This section is based substantially on Hayek, "Economics and Knowledge," pp. 33-56, esp. pp. 35-45.
It might be likely if the third assumption were true and we were dealing with an essentially stationary world. This possibility led Hayek to wonder whether the third assumption might imply the first.
Hayek, "Economics and Knowledge." pp. 38-39.
Hayek, "The Use of Knowledge in Society," p. 82.
This could be overdrawn, of course, but there are differences. Stigler's view is essentially different from Hayek's": "These terms ['stable' and 'equilibrium'] were obviously borrowed from physics—has the economist made sure that they really make sense in economics? The answer is, let us hope, yes. The stability of equilibrium is indeed the normal state of affairs in a tolerably stable world" ( Theory of Price, p. 93). For further elaborations on the differences between the Austrian and the Schumpeterian conceptions of the entrepreneur, see Kirzner, Competition; Rothbard, Man, Economy, and State, 2 vols. (Princeton: D. Van Nostrand Co., 1962), 2: 493-94.
Hayek, "The Meaning of Competition," p. 94.
Much of Hayek's work on resource allocation was developed in the context of the Socialist calculation debates (Friedrich A. Hayek, ed., Collectivist Economic Planning [London: George Routledge & Sons, 1935]).
"To make a monopolist charge the price that would rule under competition, or a price that is equal to the necessary cost, is impossible, bacause the competitive or necessary cost cannot be known unless there is competition" (Hayek, "Socialist Calculation II:The State of the Debate (1935)," Individualism, p. 170).
One assumes that practitioners are not unaware of the theoretical problem and have a gestalt conception of markets significantly different from Hayek's. For sources on concentration and rates of return, see John S. McGee, In Defense of Industrial Concentration (New York: Praeger Publishers, 1971), p. 151n. For a criticism of the approach of many of these statistical studies, see Yale M. Brozen, "The Antitrust Task Force Deconcentration Recommendation," Journal of Law and Economics 13(October 1970): 279-92.
Hayek, "Economics and Knowledge," pp. 35-37.
Hayek, "The Use of Knowledge in Society," p. 86.
Hayek's mentor, Mises, was even more explicit on this point: "Action is always speculation.... In any real and living economy every actor is always an entrepreneur and speculator" (Ludwig von Mises, Human Action [New Haven: Yale University Press, 1949], p. 253).
Hayek, "Economics and Knowledge," p. 34.
Austrian economists have been viewed as unremitting critics of the use of mathematics in economic theory. What in fact Hayek objected to about this tool in analyzing allocation questions was the assumption that a transactor's knowledge is necessarily consistent with the facts, and with each other's plans (Hayek, "The Use of Knowledge in Society," pp. 89-91).

Chapter 3. The Monetary Theory

Chapter 3

Is there more to monetary theory than demand-and-supply analysis of money, or the determination of nominal income? In the post-World War I era monetary theory (specifically, the quantity theory) was criticized for overemphasizing the effects of an excess demand for money. According to Hayek and others, important phenomena were ignored if economists failed to significantly modify the analysis of the quantity theory, particularly in studying short-run economic fluctuations.


A historical background is essential for an understanding of the quantity theory as it appeared to monetary theorists in the early part of this century. Hayek's criticism of the quantity theory becomes meaningful once the character of the older quantity theory is properly delineated. And to the degree that the neo-quantity theory has kept essential features of the older quantity theory, Hayek's criticisms have more relevance today.


Hayek constructed his monetary theory upon the foundations laid by early British monetary theorists and Knut Wicksell and Ludwig von Mises. The specifically short-run character of Hayek's monetary analysis is significant, as is his use of the concept of the "neutrality of money." Let us now turn our attention to this development, and to monetary theory as it was at the beginning of the century.


It was against the quantity theory approach as described here that Wicksell and Hayek reacted. Their attitudes reflected the shift in emphasis from the study of economic growth to the study of cyclical fluctuations.


Mises extended the Wicksellian theory by explicitly examining the differential impact on demand for consumption and capital goods brought about by a divergence between loan and natural interest rates. Most important, he distinguished between the effects on general and relative prices. But his business cycle theory is marred by the manner of presentation. Much of The Theory of Money and Credit deals with changes in the "inner value of money" ( innere objektive Tauschwert), which, as Hayek noted, is a somewhat confusing way of dealing with the neutrality of money. The terminology was bound to engender confusion among English readers. The "building block" quality of German undoubtedly makes clear the distinction Mises intended, for those fluent in German.


Hayek referred to Mises's theory as the Wicksell-Mises's theory and stated that progress in monetary theory would depend "partly upon the foundations laid by Wicksell and partly upon criticism of his doctrine." *59


Hayek broke completely with the quantity-theory approach. The defect in the quantity theory lay in its comparative static approach, lack of attention to adjustment problems, and consequent focus on movements in the price level to the detriment of any analysis of real disturbances. Hayek's criticism thus paralleled Wicksell's. *60 Instead of viewing the proportionality theorem as essential to the quantity theory, he characterized the whole approach of the quantity theorists as "a positive hindrance to further progress." *61 "Hardly any idea in contemporary monetary theory" was not known to writers in the early nineteenth century. *62 In forsaking the approach of microeconomics—"the 'individualistic' method" to which "we owe whatever understanding of economic phenomena we possess"-the quantity theorists were led astray. *63 The quantity-theory approach tended to lead to "three very erroneous opinions":

Firstly, that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money,-that they are at their "natural" level,-if the price level remains stable. Secondly, that a rising price level tends always to cause an increase of production, and a falling price level always a decrease of production; and thirdly, that "monetary theory might even be described as nothing more than the theory of how the value of money is determined." *64

Here Hayek attacked the very idea to which J. S. Mill had subscribed: that changes in the quantity of money (or the velocity of its circulation) affect only general prices and not relative prices. *65 Hayek saw the proposition that monetary disturbances affect real activity through price level changes to be the logical extension of Mill's analysis. The next step would be to view the business cycle as largely a movement in price levels, with real economic activity being affected only insofar as adjustment to a changing price level is costly. *66


One must be careful not to read more into the criticism than was there. Hayek regarded the quantity theory as unassailable as a comparative static proposition:

I do not propose to quarrel with the positive content of this theory: I am even ready to concede that so far as it goes it is true, and that, from a practical point of view, it would be one of the worst things which would befall us if the general public should ever again cease to believe in the elementary propositions of the quantity theory. *67

But like Wicksell, Thornton, *68 Malthus, *69 and many others before him, Hayek believed the quantity theory overlooked essential details. The quantity theory had "usurped the central place in monetary theory.... Not the least harmful effect of this particular theory is the present isolation of the theory of money from the main body of general economic theory." *70


Hayek deplored the lack of attention paid by quantity theorists to relative price changes. The title Prices and Production was surely chosen to emphasize this argument. Relative prices are what guide production, but, in the divorce of monetary theory from value theory, money is assumed to have no effect on relative prices. Thus by hypothesis money is viewed as having no influence on production. Such was the blind alley into which, Hayek argued, the quantity theory had led economists. Vestiges of the long-run, comparative static approach of classical value theory remained embedded in the quantity theory. It was to this barter model that ignored financial markets that Hayek objected.

The introduction of money does not interfere with the operation of any of the Laws of Value.... The relation of commodities to one another remains unaltered by money: the only new relation introduced is their relation to money itself; how much or how little money they will exchange for; in other words, how the Exchange Value of Money itself is determined. *71

Indeed, Hayek had applauded Keynes's first faltering departure from the quantity-theory approach:

That the new approach, which Mr. Keynes has adopted, which makes the rate of interest and its relation to saving and investment the central problem of monetary theory, is an enormous advance on this earlier position [the Cambridge cash-balance theory ], and that it directs the attention to what is really essential, seems to me to be beyond doubt. *73

Again, Hayek's objection to the quantity-theory approach was not a criticism of its positive content, but was, to paraphrase Keynes, an objection to the failure to cast works in this tradition in terms of ordinary economic categories. The quantity theory was an "obstacle" for two reasons: First, from a theoretical view-point, couching a monetary theory of the business cycle in terms of changes in the price level would prejudice readers against other monetary explanations. *74 Thus, the explanation of cyclical fluctuations in terms of changes in the price level was a "naive quantity-theory" explanation, *75 and economists of the stature of Spiethoff rejected all monetary explanations because they identified them with the "naive" quantity theory. *76 Second, the quantity approach led its adherents to erroneously conclude that stabilizing the price level would automatically stabilize economic activity. *77 But, as will be seen, the major policy conclusion of the Austrian theory of the business cycle is that stabilizing the price level will not, in general, stabilize economic activity.


Hayek saw Wicksell's and Mises's approach as one that permitted the intergration of monetary and value theory. The effect of money on pricing could be taken into account; moreover, money could be shown to have (short-run) effects because changes in the demand for or supply of money alter interest rates, intertemporal prices, and hence the allocation of resources. In current terminology, Hayek's was a theory in which "money mattered."


Hayek systematically criticized theories of cyclical fluctuations in which relative prices—particularly intertemporal prices—played no causal role. While at first he regarded the quantity theory as the chief impediment to progress, he subsequently shifted his attack to the Keynesian economics, or the income-expenditure approach. In Hayek's analysis, both the "naive quantity theory" and Keynesian macroeconomics are cut from the same cloth—the barter conception embodied in Mill's Principles. Both analyze economic disequilibrium with the tools of comparative static analysis. And both theories are inherently "macro"—they abstract from changes in relative prices.


To Hayek, Keynes erred in attempting to establish macroeconomic relationships without regard to "the microeconomic structure." *78 "The artifical simplification necessary for macrotheory...tends to conceal nearly all that really matters." *79 Keynes's Marshallian and quantity-theory backgrounds lived on in the work that Keynes thought was a "clean break."


Because of Hayek's acceptance of the long-run connection between money and prices, he constructed his business cycle theory as he did. Given his insistence that increases in the money supply (initially) alter relative prices, he was encouraged to seek a mechanism that would restore the original set of relative prices once altered. *80 The theorems of equilibrium states are tools to aid the monetary theorist in analyzing market tendencies. Analysis of market adjustment processes indicates when those tendencies may be realized and when thwarted. *81


Hayek initiated one of the great debates in monetary theory—the debate on the neutrality of money. Today, the concept of the neutrality of money is a bulwark of monetary theory. But the concept is taken to be about long-run effects. However, Hayek, like Keynes, Robertson, and others, wished to analyze the effects of monetary disturbances on economic activity before equilibrium is restored. Hayek, like Wicksell was concerned with "what occurs, in the first place, with the middle link in the final exchange of one good against another, which is formed by the demand of money for goods and the supply of goods against money." *82


Over the years, English economists, especially at Cambridge, demonstrated little sympathy with Wicksellian or Austrian analysis. Hayek's concept of the "neutrality of money" was also received with some hostility. Sraffa declared:

If Dr. Hayek had adhered to his original intention, he would have seen at once that the differences between a monetary and a non-monetary economy can only be found in those characteristics which are set forth at the beginning of every text-book on money. *86

To which Hayek responded: "I am, however, not quite sure whether Mr. Sraffa has perceived that the refutation of this idea is one of the central theses of my book." *87


And yet, Hayek employed the very same concept to demonstrate how changes in the quantity of money ordinarily affect interest rates, relative prices, and real economic activity. Indeed, Hayek attracted attention because he demonstrated how monetary disturbances could be nonneutral in their effects.


Hayek's analysis differs from that of contemporary monetary theorists because he focused attention on the short-run effects usually excluded, by assumption, from current theories. He maintained that monetary policy ordinarily has distributional effects that alter relative prices in a predictable way. In fact, an increased quantity of money will cause ex ante investment to be larger than ex ante saving. Ex post saving will equal ex ante investment. The difference between ex ante and ex post saving he termed "forced saving," which leads to an excess accumulation of capital that cannot be maintained. *90


Hayek's theory of economic fluctuations depends on the soundness of his argument about the nonneutrality of monetary policy; and his treatment of monetary disturbances is intelligible only in terms of his views on forced saving.


Hayek, as an expert on the history of the concept of forced savings, noted that it was first offered in criticism of early quantity-theory analysis. Thus, in commenting on Ricardo's analysis, Malthus stated:

Whenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former. The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of some others. This diminution is affected by the rise of prices, occasioned by the competition of the new notes, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrious classes,—all those who sell as well as buy,—are, during the progressive rise of prices, making unusual profits; and even when this progression stops, are left with the command of a greater portion of the annual produce than they possessed previous to the new issues. *91

Malthus's analysis contained insights that anticipated theoretical developments by Mises, Wicksell, Hayek, and others. An increased quantity of money represents an increased command over real resources. The new money units represent "so much additional capital" to entrepreneurs ("those who mean to employ them in the prosecution and extension of profitable business"). But at full employment, there is a resource constraint, and increased expenditures on capital goods must come at the expense of consumption. Consumers ("those who are only buyers") cannot purchase as many consumer goods as they could before. The mechanism is "the competition of the new notes," which leads to a rise in prices.


The schedules in figure 3.1 refer to planned magnitudes. Ex post, investment ( I) = I1 and saving ( S) is equal in value to investment, I1. Thus the forced saving is equal to the discrepancy between actual and planned saving ( I1 - S1). *95 Forced saving occurs during each period (in which the quantity of money increases) because of the nonneutral effects of the monetary disturbance. The assumption is that monetary expansion is primarily an increase in the amount of credit available to business. *96 As a consequence, the demand and supply functions that would exist in a barter situation are altered. As Hayek noted in an early work:

The difference between the course of events described by static theory (which only permits movements toward an equilibrium, and which is deduced by directly contrasting the supply of and demand for goods) and the actual course of events [is explained ] by the fact that, with the introduction of money (or strictly speaking with the introduction of indirect exchange), a new determining cause is introduced. Money...does away with the rigid interdependence and self-sufficiency of the "closed" system of equilibrium, and makes possible movements which would be excluded from the latter. *97

As Lutz noted, key differences exist between the work of Wicksell and Hayek, and that of modern monetary economists. Today, neutrality of money follows from standard assumptions of macro models. For Hayek, neutrality of money was a policy goal in a world in which these assumptions did not and could not apply. An important difference exists between monetary theorists concerned with perfecting models (often merely exercises in logic) and earlier monetary theorists trying to explain the world as they perceived it.

The logic of the argument of these more recent writers is unassailable. They have from the start excluded any possible effect of the reduced money rate of interest on the production process by their assumption of the "absence of distribution effects." This assumption allows them to disregard the phenomenon of "forced saving" (which presupposes a shift in income distribution in favour of entrepreneurs or of profit-receivers), and hence to disregard also the related increase in real capital formation. It means that the problem to which earlier writers had attached paramount importance is simply dropped out of the picture. Once we assume that there are "distribution effects," the question of what is the right monetary policy if it is desired to aim at the "neutrality" of money inevitably re-emerges. *102

Keynes's occasional references to Hayek and the Austrians may seem curious, if not quaint—anachronistic discussions of work with no contemporary significance: grist for the mills of historians of thought. *103


According to Keynes, "'Forced saving' has no meaning until we have specified some standard rate of saving." The reasonable thing to do would be to select "the rate of saving which corresponds to an established state of full employment....'Forced saving is the excess of actual saving over what would be saved if there were full employment in a position of long-period equilibrium'." *104 Keynes noted that to Hayek this definition was, in fact, the original meaning of the term. *105


Obviously, forced saving occurs only in disequilibrium. Hayek used the concept to analyze the impact of a monetary disturbance. *107 Forced saving is empirically important when the quantity of money is increased continually over a prolonged period of time, and the increases occur in the form of increases in the quantity of credit. Hayek investigated this kind of disturbance in Prices and Production, and it is to this analysis that we must now turn our attention.

Henry Thornton, An Inquiry into the Nature and Effects of the Paper Credit of Great Britain, ed. F. A. Hayek (London: George Allen & Unwin, 1939), p. 241 (hereafter, Paper Credit).
Richard Cantillon, quoted in Hayek, Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), p. 1.
The marginal product of investment is Wicksell's marginal productivity of capital, or Jevons's marginal yield of capital (Wicksell, Lectures, 1: 147-57; Ralph G. Hawtrey, Capital and Employment, 2d ed. [London: Longmans, Green & Co., 1952], p. 29; and Hayek, Pure Theory of Capital, p. 189). The term marginal product with reference to capital is a misnomer; what is usually meant is the rate of increase in output attributable to an increment to capital.
Mises's neglect by American economists is even more egregious than Hayek's. Thus, Mises never benefited from his idea of assisting German refugee intellectuals in finding positions, and he never held a regular academic position in the United States, doubtless because of political discrimination. Mises's place in economics is such that it deserves consideration in a separate work. On Mises's role in Beveridge's plan to help European refugee intellectuals, see Robbins, Autobiography of an Economist (London: Macmillan & Co., 1971), pp. 143-44.
Keynes is partly responsible for this neglect in Great Britain. Keynes admitted he understood in German what he already knew, yet he wrote an essentially negative review of Mises's monetary classic, though he later endorsed Mises's basic approach. As Hayek remarked, "He had reviewed L. von Mises' Theory of Money for the Economic Journal (just as A. C. Pigou had a little earlier reviewed Wicksell) without in any way profiting from it" (Hayek, "Personal Recollections of Keynes and the 'Keynesian Revolution,'" in A Tiger by the Tail, ed. Shenoy, p. 101). Keynes reviewed the Mises work in Economic Journal 24 (September 1914).
Mises, Theory of Money and Credit, pp. 339-66. The truly Misesian contribution commences on p. 349. If Prices and Production, a series of four lectures running over one hundred pages, was overly concise, pity the poor reader confronted with this theory explained in fewer than twenty (albeit lengthier) pages! On the "inner value of money," see Friedrich A. Hayek, Monetary Theory and the Trade Cycle, trans. N. Kaldor and H. M. Croome (1933; reprint ed. New York: Augustus M. Kelley, 1966), p. 117 (hereafter, Monetary Theory); see also translator's note in Theory of Money and Credit, p. 124.
Hayek, Monetary Theory and the Trade Cycle, p. 47; and Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), p. 26.
Hayek, Prices and Production, p. 4.
Ibid., p. 7. By "prices" Hayek means relative prices. Footnote reference to Hawtrey omitted.
Irving Fisher "The Business Cycle Largely a 'Dance of the Dollar,'" Quarterly Publication of the American Statistical Association, December, 1923; cited in Hayek, Monetary Theory and the Trade Cycle, p. 236n.
Hayek, Prices and Production, p. 3. The "elementary propositions" would be the ceteris paribus, long-run connection between money and prices.
Hayek, Prices and Production, p. 4.
Hayek, "Reflections on the Pure Theory of Money of Mr. J. M. Keynes," part 1, Economica 11 (August 1931): 270. Hayek was here reviewing The Treatise.
See the text below pp. 95-96, for a discussion of whether Hayek's was a monetary explanation.
Hayek, Monetary Theory, p. 105.
See Hayek, Prices and Production, pp. 28-29.
Hayek, "Personal Recollections of Keynes and the 'Keynesian Revolution,'" p. 102.
Friedrich A. Hayek, "Three Elucidations of the Ricardo Effect," Journal of Political Economy 77 (March/April 1969): 279-81.
See Hayek, "Economics and Knowledge," in Individualism and Economic Order (Chicago: University of Chicago Press, 1948), p. 45.
Piero Sraffa, "Dr. Hayek on Money and Capital," Economic Journal 42 (March 1932): 43.
Hayek, "Money and Capital: A Reply," Economic Journal 42 (June 1932): 238.
Cited by Hayek, Prices and Production, pp. 19-20.
Hayek, "A Note on the Development of the Doctrine of 'Forced Saving'," Profits, Interest, and Investment (New York: Augustus M. Kelley, 1970), p. 190.
Hayek, Prices and Production, pp. 87-88. Thus, forced saving is not a sum of money that consumers are forced to save. On this, see W. E. Kuhn, The Evolution of Economic Thought, 2d ed. (Cincinnati: South-Western Publishing Co., 1970), p. 386.
Strictly speaking, Hayek designated "forced saving" as the difference between consumption before the monetary disturbance and that after, or the difference between equilibrium saving and the higher level of investment, I1 (Hayek, Prices and Production, p. 57.) But in keeping with contemporary analysis, which focuses on planned magnitudes at current prices, I have defined forced saving somewhat differently in the text. The S function represents the supply of voluntary (i.e., planned) saving; it is not the standard "supply of loanable funds" curve. A chief purpose of this analysis is to distinguish between loanable funds composed of voluntary savings and those that are not.
"The case most frequently to be encountered in practice [is that] of an increase of money in the form of credits granted to producers" (Hayek, Prices and Production, p. 54).
Hayek, Monetary Theory, pp. 44-45.
It is possible to conceive of money in this context as the numéraire of Walras's system: "Money in this latter sense is introduced, after the relative prices have been determined, in the shape of a money equation which sets the general price level while leaving relative prices unaffected" (Lutz, "On Neutral Money," p. 107). But this concept of money would do violence to the work of Wicksell, Hayek, and others.
Ibid., p. 80. Keynes continued: "This definition would make good sense, but a sense in which a forced excess of saving would be a very rare and a very unstable phenomenon, and a forced deficiency of saving the usual state of affairs" ( General Theory, p. 80). It is the first two propositions (that is, that forced saving is "rare" and that it is "unstable") that are at issue. The third proposition is one of which I can make no sense, unless Keynes wished to maintain that we suffer chronic unemployment. Such cryptic remarks led Hayek to conclude that Keynes believed that unemployment was chronic and to criticize Keynes's "economics of abundance" ( Pure Theory of Capital, pp. 373-75).
Keynes here referred to Hayek's article "A Note on the Development of the Doctrine of 'Forced Saving'," reprinted in Profits, Interest, and Investment, pp. 183-97.
Keynes, General Theory, pp. 80-81. See the caveat in note 95 above. Keynes's treatment of forced saving is an instance of how his solecistic use of "classical" led him into error. He argued that "the usual classical assumption [is] that there is always full employment" ( General Theory, p. 191). What is true is that Ricardians were virtually always concerned with the long run, in which ex hypothesi there is full employment. In Keynes's terminology, forced saving theorists were "classical." Hence, the reasoning goes, they thought there was always full employment, etc. Keynes cited no reference on forced saving, except Hayek's note on the history of the concept. It is doubtful whether Keynes could have found any support for his argument.
Hayek, "Three Elucidations," pp. 279-80.

Chapter 4. Money and Prices

Chapter 4

Money and Prices

By the same act with which a bank increases the circulating medium of a country, it issues into the community a mass of fictitious capital, which serves not only as circulating medium but creates an additional quantity of capital to be employed in every mode in which capital can be employed (Lord Lauderdale, cited in Hayek, Profits, Interest, and Investment, p. 190).

Friedrich A. Hayek was invited to deliver the special university lectures at the London School of Economics during the 1930-31 session. In the space of four lectures, subsequently published under the title Prices and Production, he analyzed the microeconomics of the "typical nineteenth century business cycle." *1 What he actually did in less than 150 pages was potentially even more far reaching: he integrated monetary theory and price theory more fully than had been done before. *2 The goal of current work in the integration of macrotheory and microtheory is essentially the same as Hayek's, and I believe progress would have been much greater had the contributions of Hayek not been lost sight of in the aftermath of the Keynesian revolution.


The other major monetary theorists of the day were similarly engaged in a reexamination of business cycle theory. Notable among them were J. M. Keynes, D. H. Robertson, and R. G. Hawtrey in England; Irving Fisher and Henry Simons in the United States; Ludwig von Mises and Gunnar Myrdal on the Continent; and, indeed, virtually the entire membership of the Austrian and Swedish schools. The Continental and British monetary theorists—intellectually Hayek straddled these groups—were more intent than the Americans on finding microfoundations for their theories. These divergent thinkers had a common purpose: to achieve the integration of monetary and price theory. *3 All were profoundly dissatisfied with the state of monetary theory in its many variants. *4


Hayek's business cycle theory, as presented to his English readers, was a blend of monetary theory, capital theory, and price theory. The lectures were first published in 1931. (His 1928 work on the monetary questions raised by the study of cyclical fluctuations was not translated into English until 1933 and was therefore unavailable to his English audience.) *5 Hayek viewed the price mechanism as a system of signals and the "economic problem" as one of social coordination. However, these conceptions were undeveloped until his contributions to the Socialist-calculation debates and the tetrad on economic coordination, of which "Economics and Knowledge" was the first. *6 These articles for the most part were written after his initial work on cyclical fluctuations was translated into English.


Many of the substantive issues treated by Hayek can be examined without detailed development of Austrian capital theory. At times, Austrian capital theory can be so idiosyncratic that communication with those unfamiliar with it is impeded, as Hayek recognized in later writings. *7 Reference to its characteristic propositions will be made insofar as this aids in the subsequent analysis.


To Hayek there was one essential fact about the business cycle to be explained by any theory of economic fluctuations:

The task [of understanding the business cycle] is made rather easier by the fact that there does exist to-day, on at least one point, a far-reaching agreement among the different theories. They all regard the emergence of a disproportionality among the various productive groups, and in particular the excessive production of capital goods, as the first and main thing to be explained. *8

Gottfried Haberler, more than a decade later, had a similar view, though he no longer accepted the particulars of the Mises-Hayek account. He stated that there are "two features which can be observed in every cycle, probably without exception, although they are not implied by our definition of the cycle." They are (1) that cyclical fluctuations in production and employment are "accompanied by a parallel movement of the money value of production and transactions," and (2) "that cyclical fluctuations are more marked in connection with the production of producer's goods than in connection with the production of consumers' goods." *9


Hayek expanded on the theories of Wicksell and Mises to account for a particular phenomenon—the so-called volatility of investment, or the "disproportionality" in production. *10 A process of inflation, or more precisely "cyclical expansion," was seen to consist of a reallocation of resources from industries producing consumer goods (or "final output") to those producing intermediate products. If a cyclical expansion starts from conditions of actual general resource unemployment, then expansion could, for a time, occur in all industries simultaneously. Hayek did not see the expansion as being uniform in practice, and his theory attempted to account for this nonuniformity. He developed a theory of the transmission mechanism of monetary disturbances, in which a change in the growth rate of the money stock depresses the complex of market interest rates below an equilibrium level. *11 Investment is stimulated, and through the augmentation in money expenditures on capital goods factor incomes are bid up, and finally the prices of consumption output rise. The complex allocation questions involved in this process are analyzed in Prices and Production.


Hayek did not treat the "excessive production of capital goods" as the only feature of a business cycle, though he considered it the most important one. Any tendency for the prices of all goods to change was treated as a secondary phenomenon. He did not view changes in price levels as a necessary condition for a business cycle. *12


Hayek perceived the necessity for explaining the emergence of resource unemployment in any theory of cyclical fluctuations. However, his approach in Prices and Production created a good deal of controversy: he started with an assumption of full employment, that is, long-run equilibrium. He did not, however, assume that the economy would remain at full employment. His object was to focus on certain processes that he thought would occur during any actual cyclical upswing as full employment was approached. Indeed, if Hayek's analysis of the impact of changes in the growth rate of the money stock is correct, these processes are inevitable in such expansions.


In considering Hayek's approach, a distinction must be made between the methodological assumption of full employment and the empirical assumption of full employment. The methodological assumption of full employment has three distinct advantages. First, it is consistent with the general approach in other areas of economic theory. Starting from full employment (i.e., equilibrium) avoids attributing adjustments that would occur in any case to the disturbance under consideration. Next, it focuses attention on the problem to be analyzed—that of unemployment—and compels the theorist to deduce the emergence of unemployed resources rather than beg the question by assuming what needs to be explained. *13 Finally, it minimizes the possibility of constructing a theory—believed to be general—that is contingent on the existence of unemployed resources throughout the economy. *14 A number of critics, including a friendly expositor of Hayek's ideas, have failed to note the aforementioned distinction and Hayek's own strictures on the subject. *15


Hayek was not the first to be attacked for assuming full employment. After Keynes set the example of reconstructing theories out of whole cloth, the classical economists became subject to this charge. While economists of the nineteenth century undoubtedly wrote as though there were ordinarily no unemployed resources, I know of no major figure who denied the existence of unemployed resources. Furthermore many attempted to explain the phenomenon, even though it was not their chief policy concern. *16


In Prices and Production Hayek developed a "goods in process" model, in which land and labor services pass through successive stages of production until consumer goods finally emerge. A "stage" consists of some productive activity (for example, stamping out parts with a mold). An entire process of production consists of many stages with the goods processed at each stage called intermediate products. A change in the number of stages or the real-location of factors among stages is described as a change in the structure of production. *18 A consumer good yields all its services in a single period; by this definition Hayek circumvented the durable-goods problem. *19 His purpose was to emphasize an aspect of capital to which he felt insufficient attention had been paid. *20 This is the distribution of capital goods in time. In Hayek's metaphorical analysis, intermediate products flow as from tributaries into successive stages of production, and the value of intermediate products at any point in the stream is a function of time, f(t). The total value of the intermediate products is thus the integral of this function over a period r, equal to the length of the adopted process of production. Beginning at time x, the total value of the intermediate products is:

Equation. Click to enlarge in a new window.

According to Hayek, the output of consumer goods (that is, the rate at which consumer goods appear) is a function of this time interval, f(x+r). Thus the Hayek model is expressed purely in terms of flows. The reasons Hayek did not attempt to translate the model into one couched in terms of both stocks and flows are several.


First, there is the inherent difficulty of including durable goods in a model of this type: "The different instalments of future services which such goods are expected to render will...have to be imagined to belong to different 'stages' of production corresponding to the time interval which will elapse before these services mature." *21 Hayek also initially assumed that at each stage the intermediate products are exchanged for money; there is no vertical integration. If durable capital goods were included, the individual must be assumed to be renting the capital goods from himself. *22 Finally, and most important, Hayek felt that in ordinary analysis too much attention is accorded to the durability of particular capital goods in explaining the effects of changes in the rate of interest on its value.

It is not the individual durability of a particular good but the time that will elapse before the final services to which it contributes will mature that is regarded as the decisive factor. That is, it is not the attributes of the individual good but its position in the whole time structure of production that is regarded as relevant. *23

The model of Prices and Production emphasizes the "time structure of production." Hayek employed "Jevonian Investment Figures" as a pedagogic device to illustrate the production process:

Graph. Click to enlarge in a new window.

Figure 4.1

Was Hayek attempting to measure the aggregate capital stock in Prices and Production? The answer is in doubt. Although he did not produce such a measure, he created the impression that there is some basis for doing so. Thus, he referred to the "proportion between the amount of intermediate products... and the amount of... output" increasing as the duration of the production process increases. *25 He also described production as becoming more "capitalistic" as "the average time interval between the application of the original means of production and the completion of the consumers' goods increases." *26 While his use of "capitalistic" is loose, it suggests a capital-output ratio. What he actually measured was the value (in consumption output) to which an input will grow (that is, the compounded value of an investment).


Hayek's lack of precision in Prices and Production on this matter is notable on several counts. Even in terms of his own endeavor, he had no need to make use of aggregate concepts; indeed, he disparaged such aggregative procedures. He generally objected to the treatment of capital goods as homogenous. In The Pure Theory of Capital he pointed out that in principle it is impossible to measure capital stock by reference to an average period of investment, even if the rate of interest is already given. *27


I believe Hayek adopted a most "un-Hayekian" procedure in Prices and Production. He treated consumer goods as homogeneous if they are available in the same time period. Analysis applicable to the production of a particular consumer good is carried over to the aggregate output of consumer goods. He in effect adopted a one output-good model, though he was quite explicit at other places about the difficulties that arise from the existence of heterogeneous capital goods. Yet having treated consumption output as homogeneous, he also treated capital goods as inchoate consumer goods even though he specifically rejected this view at other times. In every other context Hayek was a trenchant critic of attempts to treat "capital" as a fund or as an amount of waiting. *28


Hayek was quite open about the deficiencies of Prices and Production. He considered himself fortunate to have received an offer to deliver the University of London lectures when he did. When the invitation arrived, he was convinced the central ideas of Prices and Production were correct, and he presented them in their simplicity.


In Prices and Production Hayek was almost offhand about the necessary conditions for equilibrium, or correspondence between the plans of consumers and producers: "The proportion of money spent for consumers' goods and money spent for intermediate products is equal to the proportion between the total demand for consumers' goods and the total demand for the intermediate product necessary for their continuous production." *29 In a lecture delivered less than three years after the University of London lectures, he was far more precise about the conditions for equilibrium. Describing his theory as "the 'Wicksellian' theory of crises" he remarked that it is "quite independent of any idea of absolute changes in the quantity of capital and therefore of the concepts of saving and investment in their traditional sense." Hayek continued:

The starting point for a fully developed [business cycle] theory...would be (a) the intentions of all the consumers with respect to the way in which they wish to distribute at all the relevant dates all their resources (not merely their 'income') between current consumption and provision for future consumption, and (b) the separate and independent decisions of the entrepreneurs with respect to the amounts of consumers' goods which they plan to provide at these various dates. Correspondence between these two groups of decisions would be characteristic of the kind of equilibrium which we now usually describe as a state where savings are equal to investments and with which the idea of an equilibrium rate of interest is connected. *30

For Hayek, the crucial question for business cycle theory was the mutual correspondence of the plans of savers and investors and those of consumers and producers. Before asking how an economy can be in disequilibrium, he sought to posit the theoretical conditions under which the system would be "in equilibrium." *31


This approach can, however, only be a beginning, for it is quintessentially macro in conception. Consequently, it ignores problems crucial to Hayek's analysis. The saving-investment analysis presented here involved the aggregation of the separate micro-investment functions. Hayek considered this procedure to be suspect in ignoring the shift effects on the separate investment demand curves of changes in the rate of interest (changes which merely move one down this constant aggregate investment function). Also according to Hayek:

Whether we are able to decide what savings and what investment are depends...on whether we can give the idea of maintaining capital intact a clear and realistic meaning... As soon, however, as one makes any serious attempt to answer this question, one finds not only that the concept of the maintenance of capital has no definite meaning, but also that there is no reason to assume that even the most rational and intelligent entrepreneur will ever in dynamic conditions be either willing or able to keep his capital constant in any quantitative sense, that is with respect to any of the measurable properties of capital itself. *34

An increase in the propensity to save, according to Hayek, will not initiate a cyclical expansion. *35 Rather, the phenomenon is useful in explaining the movement of relative prices during a credit expansion (that is, when voluntary saving has not changed). Whether an increase in saving is necessarily transmitted into increased investment is not considered. Like Wicksell, Hayek assumed that the financial sector does nothing to impede this process. *36


Hayek employed a discounted value of the marginal product theory of factor remuneration. Increased saving leads to a fall in the rate of interest. As a first approximation, the prices of land and labor services are bid up as the rate of interest falls. In this first approximation, land and particularly labor are treated as homogeneous.


To Hayek, a decrease in the interest rate may be translated into the proposition that both wage rates and land rents have risen relative to the prices of the products they help produce. As the interest rate falls, price margins between stages narrow, for real factor costs are increasing. The fall in prices of the products of the later stages of production is partly responsible for this narrowing of price margins. *39


Hayek's proposition must be distinguished from one particularly common misinterpretation. Were this a valid conceptual experiement, a fall in the rate of interest would, other things equal, increase the demand-price schedules for all assets. But formulating the experiment in ceteris paribus terms overlooks the mutatis mutandis conditions of the disturbance. The very process that affects the interest rate alters the size of the quasi-rents accruing to the heterogenous capital goods, which are combined according to particular expectations that will be falsified (by the assumed disturbance). This process is not to be relegated to the second order of magnitude, as is usually done. *40 In his criticism of Keynes's Treatise, Hayek observed:

Capitalization is not so directly an effect of the rate of interest; it would be truer to say that both are effects of one common cause, viz. the scarcity or abundance of means available for investment, relative to the demand for those means. Only by changing this relative scarcity will a change in the Bank Rate also change the demand price for the services of fixed capital. *41

In terms of Hayek's investment diagram, there will be a narrowing of the base and a lengthening of the vertical side. Increased investment will be distributed both as an increase in resources in early stages and an addition of new stages. Only by this process are rates of return on all investments equalized. The investment must take the form of capital "deepening" rather than capital "widening" in the absence of any unemployed land and labor.


The process of capital deepening will be accompanied by capital widening in particular industries. This fact is implied in the Hayek's schematic analysis in Prices and Production—more is invested in early stages and less in late stages. Capital deepening might be defined as capital narrowing in the later stages, concomitant with capital widening in earlier stages. *44


Pace Hawtrey, capital deepening may be analyzed without reference to aggregate capital measure. One need only say that capital will be invested in different ways and in different goods (and outline in what general direction changes will be made). Hayek particularly did not need to refer to an aggregate capital measure. But as late as 1941 he spoke, as did Hawtrey, of "providing an unchanged number of workmen with more (or more elaborate) equipment." *45 This situation results when the investment period tends to lengthen as a result of the same conditions that bring about a fall in interest rates. As interest rates fall, however, the relative prices of various capital goods change, and new types of capital goods are substituted. The units will be incommensurable, and we cannot be sure what will happen to the value of the capital stock. *46 Indeed, Hayek pointed out that changes in the structure of production may be analyzed without reference to aggregate capital stock or an average period of investment. *47 We need only speak of marginal adjustments in the pattern of investment.


Hayek was more circumspect in The Pure Theory of Capital than in Prices and Production. He pointed out that "most of the changes in productive technique are likely to involve changes in the investment periods of different units of input to a different degree and perhaps in different directions." *48 A "change in the length of the process" could be employed to describe a situation where changes are "predominantly in one direction." *49 Though Hayek slipped into less precise and less guarded modes of expression, his final opinion was as follows: "For our present purposes we do not need to know whether a whole process as such is longer or shorter than another." *50 Nor apparently do we need to know anything about the aggregate capital stock or capital per head.


A critical question for Hayek is whether the effects of an increase in saving in a money economy are the same as in a barter situation. Of the effects of an increase in saving in a money economy, he observed: "The effect thus one which fulfills the object of saving and investing, and is identical with the effect which would have been produced if the savings were made in kind instead of in money." *51 Of course, if the saving were made in kind, the process would not occur in the same way, unless we are to assume money does not facilitate exchange! "It is self-contradictory to discuss a proces which admittedly could not take place without money, and at the same time to assume that money is absent or has no effect." *52 The justifiable conclusion of Prices and Production is that changes from the increase in saving lead to a new stable equilibrium. This is not necessarily the equilibrium that would obtain in a barter situation, assuming attaining equilibrium would be possible. *53


Hayek always treated the distinction between real and monetary changes as fundamental. Real changes (for example, a change in tastes, or in time preference) lead to changes in money expenditures, which in turn bring about equilibrium reallocations. On the other hand, he treated monetary changes (for example, a change in the money supply) as "self-reversing" and the temporary equilibria created by such changes as "inherently unstable." *54 This is the principal thesis of Prices and Production, where Hayek contrasted the effects of an autonomous increase in the money stock with those of an increase in the rate of saving. *55


The immediate impact of an increase in the money stock (which by assumption is an increase in bank credit) is the same for transactors as a shift in the savings function. The reason is that both disturbances generate the same signals in the loan market—the interest rates fall. *56 In the case of a shift in the savings function, the resulting changes involve a transition to a new equilibrium of the kind assumed in barter theory. If fluctuations in savings are violent and frequent, cyclical fluctuations may be observed in the absence of additional monetary disturbances. But Hayek contended that "experience provides no ground for assuming that such violent fluctuations in the rate of savings will occur otherwise than in consequence of crises." *57


Hayek focused on the market signals employed by savers and investors in making their decisions, which, though independently arrived at, are interdependent. He sought to demonstrate how a general inconsistency of plans could come about. As he phrased it, "We might have to distinguish between what we may call justified errors, caused by the price system, and sheer errors about the course of external events." *58 He had an hypothesis: "It seems...more likely that they[entrepreneurs] may all be equally misled by following guides or symptoms which as a rule prove reliable." *59


The signals followed by market decision makers are relative prices, precisely because this procedure has a demonstrated survival value. However, there are times when they prove unde pendable, that is, there are periods of economic disequilibria in which relative prices function so as to discoordinate the economic activity of savers and investors. This observation neither supports the contention that decentralized decision making is inherently "irrational" nor explains why the price system can misfunction. For these explanations one must turn to capital and monetary considerations. The problem was aptly phrased by an expositor of Hayek's theories: continuous information-collecting and disseminating process, but it is the institutional framework that determines both the extent to which, and the degree of success with which, prices are enabled to perform this potential signalling or allocative function. *60

Let us assume for the moment that consumers' command over resources again increases at some point. There is no reason to expect that, once consumers' incomes rise, there will be any change in the desired consumption-saving ratio out of that level of income. But the constancy of saving necessitates a return to the previous, "less capitalistic" method of production. It is this contraction process that Hayek explained most fully in a series of articles on the Ricardo effect, an effect that we will examine in the following chapter.



Forced saving plays a crucial role in Hayek's malinvestment theory. *62 If saving, ex post, is greater than it would be at full employment, then so is investment. Hayek employed the theory of forced saving to demonstrate that under some conditions malinvestment would occur. The conclusion is hardly startling given the assumption that the rate of interest at which entrepreneurs can borrow is below the equilibrium (natural) rate of interest.


Yet a number of economists have had difficulty in perceiving how Hayek arrived at this conclusion. Hicks commented that, if forced saving takes place, "there has to be a lag of consumption behind wages." But he concluded that "obviously this lag is not acceptable." *63 Where did Hicks and Hayek part company?


Hicks continued to work on the problem. But their "parting of the ways was on the issue of the effects of money on decision making." Hicks argued subsequently that Hayek's analysis "was mixed up, in that exciting work, with monetary considerations that do not really belong." *64 No sense can be made of the arguments in Prices and Production if one adopts the view that the "monetary not really belong." Indeed, the monetary considerations probably are the most original contribution of the analysis. One could disagree with the details of the production theory and still accept the monetary theory. Prices and Production simply does not "work" without the monetary analysis—at least not as a theory of economic fluctuations. This is what Hicks in fact demonstrated in "The Hayek Story" and why the Hayek story must be retold.


Without the doctrine of forced saving induced by bank credit expansion, there is no logic to the lag of consumption behind income. Hicks tried "sticky wages" (which are not in Prices and Production—at least not wages "sticky upwards"), but noted that "if one pursues this line of thought, one is led towards a theory which is more like that of Keynes, or perhaps of Robertson, than of Hayek." *65


Forced saving occurs because entrepreneurs are given the means by the banking system to appropriate a larger portion of the economy's scarce resources. It must be emphasized that Hayek never dealt with a single "one shot" increase in the money supply. *70 In his response to Hicks's 1967 work, Hayek emphasized that the continual injection of money was in the form of business loans:

This process can evidently go on indefinitely, at least as long as we neglect changes in the manner in which expectations concerning future prices are formed. Whatever the lag between the impact effect of the new expenditures on a few prices affected immediately and the spreading of this effect to any other prices, the distortion of the "equilibrium" price structures corresponding to the "real" data must continue to exist. The extra demand which continually enters in the form of newly created money remains one of the constant data determining a price structure adjusted to this demand. However short the lag between one price change and the effect of the expenditure of the increased receipts on other prices, and as long as the process of change in the total money stream continues, the changed relationship between particular prices will also be preserved. *71

Two concepts come together in Hayek's theory: the Thornton-Wicksell analysis of the effects of a divergence between the loan and equilibrium rates of interest, and the doctrine of forced saving. Hicks tried to abstract from monetary considerations in his reconstruction of Hayek's argument:

The "reduction" of the market rate below the natural rate must therefore be interpreted as a disequilibrium phenomenon; a phenomenon that can only persist while the markets are out of equilibrium. As soon as equilibrium is restored, equality between market and natural rate must be restored. Thus there is no room for a prolonged discrepancy between market rate and natural rate if there is instantaneous adjustment of prices. Money prices will simply rise uniformly; and that is that. *72

It was to counteract this view that Hayek wrote the previously cited passage. Hicks's argument makes sense only in terms of a "one shot"increase in the money supply. There can be a discrepancy between the two rates of interest only if markets are out of equilibrium. Furthermore, equality "must be restored" once equilibrium is restored because that is how equilibrium is defined in the Wicksellian system! That "there is no room for a prolonged discrepancy between market rate and natural rate" is precisely the issue. *73 The inability of Hayek and Hicks to communicate on the issue stems from Hicks's contention that the monetary considerations "do not really belong." These considerations hold together the otherwise diverse strands of thought in the neo-Wicksellian analysis. *74 The process that Hicks summed up by saying "that is that" turns out to be the business cycle.

Hayek, "Three Elucidations of the Ricardo Effect," Journal of Political Economy 77 (March/April, 1969): 282. Lord Robbins gave a brief account of the favorable impact of these lectures ( Autobiography ofan Economist [London: Macmillan & Co., 1971], p. 127). Hayek was almost immediately offered the long-vacant Tooke Chair at the London School of Economics.
The locus classicus for Hayek was Ludwig von Mises's Theorie des Geldes und der Umlaufsmittel (1912) ( The Theory of Money and Credit, tr. H. E. Batson [Irvington-on-Hudson, N. Y.: Foundation for Economic Education, 1971]).
Hayek recognized the similarity of enterprise among these figures. In a letter to Milton Friedman he remarked: "We all had similar ideas in the 1920s. They had been most fully elaborated by R. G. Hawtrey who was all the time talking about the 'inherent instability of credit' but he was by no means the only one" (Friedman, Optimum Quantity of Money [Chicago: Aldine Publishing Co., 1969], p. 88n).
Hayek, Monetary Theory and the Trade Cycle (New York: Augustus M. Kelly, 1966).
Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1948), pp. 33-56. The other articles, all reprinted in this same volume, are "The Facts of the Social Sciences," "The Use of Knowledge in Society," and "The Meaning of Competition."
Hayek, Profits, Interest, and Investment (New York: Augustus M. Kelley, 1970), pp. 6-7.
Hayek, Monetary Theory, p. 54 (emphasis original).
Obviously Spiethoff influenced all Continental economists studying the business cycles at this time. Although both Mises and Hayek emphasized the monetary factors operating causally in the cycle, both mentioned Spiethoff in their works,though often to disagree with him. Also both contributed articles to Spiethoff's Festschrift (Schumpeter, History of Economic Analysis [New York: Oxford University Press, 1954], pp. 815-17, 1126-28).
It would be more precise to speak of changes in the rate of growth of credit, as these were the analytically important changes in Hayek's Misesian (or neo-Wicksellian) theory. Thus, while he was chiefly concerned with changes in bank deposits or credit money, he did not treat the amount of credit as rigidly determined by the stock of money, even though he viewed economic fluctuations as being initiated by monetary disturbances.
Hayek, Monetary Theory, pp. 103-6. On the attitude of the modern Austrian school toward price levels, see Schumpeter, History, pp. 701n, 1089, 1095.
See Hayek's own justification of this procedure in Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), pp. 32-36.
Hayek felt that Keynes, for one, was guilty of this error in The General Theory. Hayek at first appraised that work as providing theorists with "the economics of abundance." Twenty-five years later, he argued that Keynes's analytical framework was one in which "the whole price system [was] redundant, undetermined and unintelligible" (Sudha R. Shenoy, ed., A Tiger by the Tail [London: Institute of Economic Affairs, 1972], p. 103).
Haberler, Prosperity and Depression, p. 63n; and Fritz Machlup, "Friedrich von Hayek's Contributions to Economics," Swedish Journal of Economics 76 (1974): 506.
One example is to J. S. Mill's exposition of the effects of a sudden conversion of circulating into fixed capital ( Principles, pp. 93-97). Mill's analysis is reflected in Hayek's monetary explanations of the following century.
Hayek, Prices and Production, pp. 36-40. Throughout Hayek was concerned with the allocation of consumption over time; he did not consider the effects of a change in tastes for consumer goods to be consumed in a given time period. Thus, at times, "homogeneous consumption services" could be substituted for "consumers' goods."
The durable-goods problem was of particular importance for the Austrian school. Wicksell was the first to point out that the durable-goods problem is identical with the Marshallian joint-supply problem (Wicksell, Lectures on Political Economy, ed. Lionel Robbins [London: Routledge & Kegan Paul, 1935], I:260). D. K. Benjamin and Roger Kormendi rediscovered this fact in "The Interrelationship between the Markets for New and Used Durables," Journal of Law and Economics 18 (October 1974): 381-401. See also Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941), pp. 66-67.
Hayek, Prices and Production, pp. x-xii; see also Hayek, Pure Theory of Capital, pp. 46-49.
Hayek, Prices and Production, p. 40n.
Hayek, Pure Theory of Capital, p. 48.
Hayek, Prices and Production, pp. 38-42. Hayek said that Jacob Marshak suggested the term "Jevonian Investment Figure." Jevons as well as Wicksell and Ackerman used similar figures (ibid., p. 38n). The similarity to Wicksell's approach is particularly striking (Wicksell, Lectures, 1: 151-54). See also W. Stanley Jevons, Theory of Political Economy, ed. R. D. C. Collison Black (Baltimore: Penguin Books, 1970), p. 231.
Hayek, Prices and Production, pp. 41-42.
Hayek, Pure Theory of Capital, pp. 199-200.
Ibid., pp. 3-13, 93-94. Much of this reflects the still very strong influence of Böhm-Bawerk's thinking on Hayek.
Hayek, Prices and Production, p. 46.
Hayek, "Price Expectations, Monetary Disturbances, and Malinvestment," Profits, Interest, and Investment, pp. 153-54 (hereafter, "Price Expectations"). In pointing out that his theory was "quite independent of any idea of absolute changes in the quantity of capital," Hayek noted that his theory did not depend on being able to measure the capital stock or (to deal with the question that concerned him at this point) on giving any determinate meaning to the maintenance of capital.
Hayek was following his own dictum in "Economics and Knowledge" that "before we can explain why people commit mistakes, we must first explain why they should ever be right" ( Individualism, p. 34).
The two methods involve hypothetical experiments: the increase in the propensity to save assumes a constant money supply, and the increase in the money supply assumes a given propensity to save. Hayek took into account the complexities introduced by an elastic supply of trade credit ( Prices and Production, pp. 115-18).
Hayek, "Price Expectations," pp. 152-154.
Hayek placed no emphasis on the interest elasticity of saving. "The factors which affect an individual's willingness to save are the regularity and certainty of his income, the security of the investment opportunities available to him, and the possibility of investing in his own business... It seems that in the short run the willingness to save varies very little and that it is particularly not much affected in the aggregate by changes in the rate of interest" ( Profits, Interest, and Investment, p. 169). The inclusion of this essay in Encyclopedia of the Social Sciences in 1935 suggests that it must have represented the consensus of the profession, for new theories are not usually introduced in such articles. The dependence of saving on income is referred to as "self-evident commonplace" (ibid., p. 53n).
This analysis is from Hayek, Prices and Production, pp. 75-77. An application of resources to the early stages would allocate circulating capital to more productive operations. Production for consumption would take longer (measured from the first application of labor and land services). Fewer consumption goods would be available immediately and more would be available ultimately. This is precisely what consumers desire when they increase their propensity to save. If net value productivity is involved in extending the number of stages, the output of consumer goods will eventually increase (see note 39 below).
An investment period is "the interval between the application of a unit of input and the maturing of the quantity of output due to that input" (Hayek, The Pure Theory of Capital, p. 69). The concept is most applicable to what Frisch called a "point input-point output" model. For a continuous input-point output, or point input-continuous output model, Hayek used joint-demand analysis (for factors in the first case) and joint-supply analysis (for the services in the second case) (ibid., p. 67). Hayek did not give the Frisch citation there.
Hayek, Prices and Production, pp. 79-83. According to Hayek, the discounted value of the marginal product of nonspecific factors will increase for a second reason: the superiority of "roundabout," or "capitalistic," methods of production, which insures that total output of consumer goods will increase once the new process has been completed. This controversial and typically Austrian proposition is not essential for what follows, though one wonders why investment would ever become "more capitalistic" if this were not true.
Hayek, "Reflections on the Pure Theory of Money of Mr. J. M. Keynes," part 2, Economica 11 (February, 1932): 25; and Gerald P. O'Driscoll, Jr., "Hayek and Keynes: A Retrospective Assessment," Iowa State University, Staff Paper no. 20, 1975), esp. pp. 24-26.
Hawtrey, Capital and Employment, 2d ed. (London: Longmans, Green & Co., 1952), p. 31; see also Hayek, Pure Theory of Capital, p. 286.
Hayek, Pure Theory of Capital, pp. 286-87.
Hayek, The Pure Theory of Capital, pp. 69-70, 76-78.
Hayek, Prices and Production, p. 53.
Hayek, Pure Theory of Capital, p. 31.
"Monetary changes a peculiar sense self-reversing and the position created by them is inherently unstable.For sooner or later any deviation from the equilibrium position—as determined by the real quantities—will cause a swing of the pendulum in the opposite direction" (Hayek, Pure Theory of Capital, p. 34).
He made the simplifying assumption that the entire increase in the money stock took the form of "credits granted to producers"; this was "the case most frequently to be encountered in practice" (Hayek, Prices and Production, p. 54). In fact Hayek's assumption is not unrealistic, even today. Most loans granted by commercial banks are for productive purposes. Consumer and personal loans are of growing importance in commercial bank portfolios (from approximately 18% in 1947 to approximately 25% in 1970). But even for this category of loans, shifts in consumer spending are induced by interest rate changes. For the portfolio statistics, see Colin D. Campbell and Rosemary G. Campbell, An Introduction to Money and Banking (New York: Holt, Rinehart & Winston, 1972), pp. 84, 89.
Wicksell demonstrated that the following analysis is no less valid if the changes in the money stock are induced by changes in the natural rate of interest, the money rate being constant ( Lectures, 2:202-18). Hayek at one point chided Mises for emphasizing the autonomous nature of changes in the money stock ( Monetary Theory, pp. 148-52). Machlup was too generous in crediting Hayek with an amendment to Wicksell in this issue. Machlup would have Hayek correcting Wicksell by pointing out that a cumulative process can be initiated by a rise in the natural rate of interest (Machlup, "Friedrich von Hayek's Contributions to Economics," p. 501). Yet Wicksell treated this case as typical ( Lectures, 2:205).
Hayek, "Price Expectations," p. 143.
Hayek, "Price Expectations," p. 141.
Hayek, Prices and Production, p. 57.
Haberler called the class of theories of which Hayek's is an instance "Monetary Over-Investment Theories" ( Prosperity and Depression, p. 33). Malinvestment is both illuminating and descriptively more accurate. The cyclical process in Hayek's work is generated when appropriate investments (given the equilibrium rate of interest) are made. Whether in some sense more capital is purchased with the increased investment expenditures is of secondary importance.
Hicks, "The Hayek Story," in Critical Essays in Monetary Theory (New York: Oxford University Press, Clarendon Press, 1967), p. 208.
Hicks, "A Neo-Austrian Growth Theory," Economic Journal 80 (June 1970): 277. Sir John is speaking here about Prices and Production. It must be pointed out that he amended his views in successive reassessments of Hayek and the Austrian school. But I believe that Hayek and Hicks still disagree about the role of Hayek's monetary considerations.
Hicks, "The Hayek Story," p. 210. Hicks characterized this approach as downright "un-Hayekian."
Ibid., p. 211. Streissler, in reinterpreting Hayek, follows a path similar to that taken by Hicks ( Roads to Freedom [New York: Augustus M. Kelley, 1969], pp. 245-85).
"Of course, if the expenditure of the additional money in investment were a single non-recurrent event, confined to a single month, the effects would be of transient character" (Hayek, "Three Elucidations," p. 279).
Hicks, "The Hayek Story," p. 206.
Hicks emphasized that prices in Prices and Production were "perfectly flexible, adjusting instantaneously, or as nearly as matters" ("The Hayek Story," p. 206). This flexibility is not a necessary condition for Hayek's theory, and I do not think he assumed any such thing. Even if prices were perfectly flexible, his conclusions would not change. But Hicks did not appreciate the analogy Hayek employed ("Three Elucidations," pp. 281-82).
Hayek and Hicks apparently parted company over their interpretations of Wicksell. Hicks interpreted Wicksell's system as being in neutral equilibrium ("The Hayek Story," pp. 205-7). I believe that most students of Wicksell would have to disagree with Hicks's interpretation. In any case, the difference in interpretations may be reduced to disagreement over the importance of monetary analysis.

Chapter 5. The Ricardo Effect

Chapter 5

However much Prices and Production furthered Hayek's career, it led to confusion, debate, and even bewilderment. At the time, most would surely have said that Hayek's reputation would be made as a monetary theorist. Few today think of him as a monetary theorist. *1 Not only did the Keynesian revolution have an effect, but also Hayek's 1931 exposition left much unexplained. In addition, Prices and Production had a Continental flavor on which Hicks has remarked. *2 Had Hayek's audience been familiar with Austrian capital theory, communication would have been easier. But there was no way he could have reviewed Austrian capital theory in the time allotted to his original London lectures. *3


During the 1930s Hayek became embroiled in the controversy over resource allocation under socialism. *4 In the 1930s he was on the editorial board of Economica. In 1939 he returned explicitly to the task that he had begun in Prices and Production and wrote an essay he regarded "as a revised version of the central argument of [ Prices and Production], but treated from a different angle on somewhat different assumptions." *5


The 1939 essay received two extended reviews in Economica. In the first Nicholas Kaldor contended that Hayek's essay offered "a new version of his theory that in many ways radically departed from, and contradicted, the first." *7 In the other, Ludwig M. Lachmann observed that Hayek had disposed of major criticisms of Prices and Production and attributed some of the confusion over Hayek's earlier work to his readers' proclivity to frame the argument in static terms. *8 Hayek believed that he had made no substantive changes in the 1939 essay. *9 Thus, when his essay was published, Hayek's contemporaries were uncertain whether the 1939 work extended the 1931 theory or replaced it altogether. It is to this latter question that we must next turn.


One feature of Hayek's 1939 work that provoked controversy was his introduction of the expression "The Ricardo Effect." Many evidently could not perceive the presence of this effect in his earlier work. The questions at issue are the following: To what extent was Hayek's earlier discussion of industrial fluctuations related to his later discussions? Was Hayek's argument concerning the Ricardo effect sound? What applicability might the Ricardo effect have to the modern economy? Was the effect really in Ricardo's Principles as Hayek claimed?


Hayek was straightforward in explaining the purpose of his 1939 essay:

In this essay an attempt will be made to restate two crucial points of the explanation of crises and depressions which the author has tried to develop on earlier occasions. In the first part 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. In the second part it will be shown why these conditions will regularly arise as a consequence of the conditions prevailing at the beginning of a recovery from a depression. *10

In developing his thesis, Hayek made one radical change from the argument in Prices and Production. Instead of beginning with full employment and the economy in a "stationary state," as he had in Prices and Production, Hayek began by assuming the economy was in the depths of depression. *11 He then traced out a sequential path by which full employment is reached. His new approach was calculated to dispel the criticism of his earlier "assumption" of full employment and at the same time extend the analysis of Prices and Production. Furthermore, he was determined to abandon even the appearance of static analysis; his stated intention was to show how cyclical fluctuations "tend to become self-generating, so that the economic system may never reach a position which could be described as equilibrium." *12


The thesis in Prices and Production also allows for some specificity of capital, imperfect mobility of workers, and less than perfectly flexible wages. *15 In fact, the first three assumptions of the 1939 essay are overly stringent. Employment responses will occur if prices are less than perfectly flexible and labor less than perfectly mobile. *16 In a sense, Hayek caricatured Prices and Production to demonstrate that his thesis in that work depended neither on resource or price flexibility nor on a rise in the interest rate.


According to Hayek, the crisis occurs when the rising factor incomes generated by the previous expansion lead to an increase in consumer demand. In turn, prices of consumer goods are raised relative to prices of specific capital goods. This point is the same in both versions of Hayek's theory. *17 In Prices and Production, increases in the money supply bring about a decrease in market rates. Capital deepening occurs as price margins narrow between stages of production. But factor incomes rise at the same time. Repeated injections of money (in the form of bank credit) may maintain the "lengthened" production structure (that is, prevent capital enshallowing), but once these injections cease or the rate of increase is slowed, market interest rates rise. At the same time a rise in consumer demand causes relative prices to return (approximately) to their pre-expansion values; consumption output increases and the structure of production is once again "shortened." *18


In 1939 Hayek attempted to demonstrate that, even if increasing consumer demand is not accompanied by a rise in the market rate of interest, the crisis (that is, the sudden decrease in demand for certain types of investment goods) will nonetheless occur. Herein is the vital difference between the two formulations of Hayek's theory. For at least two reasons, Hayek's analysis in 1939 of the case where the rate of interest may not rise was not mentioned in 1931. First, by 1939 the gold standard had been abandoned. In this situation discrepancies in interest rates are possible for longer periods than when the domestic money stock is closely tied to the quantity of international reserves. Second, Hayek wanted to demonstrate that his theory was not a purely monetary theory of the business cycle. In his 1939 essay he stated that monetary changes are not necessary for a cyclical downturn, real factors alone being sufficient. He had not been successful in previous attempts to distinguish his theory from purely monetary theories, though he had much earlier noted the differences:

I have become less convinced that the difference between monetary and nonmonetary explanations is the most important point of disagreement between the various Trade Cycle theories.... It seems to me that within the monetary group of explanations the difference between those theorists who regard the superficial phenomena of changes in the value of money as decisive factors in determining cyclical fluctuations, and those who lay emphasis on the real changes in the structure of production brought about by monetary causes, is much greater than the difference between the latter group and such so-called non-monetary theorists as Professor Spiethoff and Professor Cassel. *19

As Machlup stated: "The fundamental thesis of Hayek's theory of the business cycle was that monetary factors cause the cycle but real phenomena constitute it." *20


Once full employment is attained, rising consumer demand will lead to a rise in the rates of return in industries producing consumer goods relative to rates of return in capital goods industries. In such situations, it is the (expected) rates of return in different stages that influence the form that investments take rather than the absolute level of the loan rate of interest or the difference between the loan rate and natural rate. To Hayek, an infinitely elastic supply of credit cannot in the long run determine the marginal rate of return on capital. *21


The investment decision facing entrepreneurs is one of choosing an appropriate rate of turnover for investment. In what follows one must remember the Austrian conception of capital as " saved-up labour and saved-up land." *22 Thus, Hayek's analysis assumes "that the labour used directly or indirectly (in the form of machinery, tools, and raw materials), in the manufacture of any commodity is applied at various dates so that Ricardo's 'time which must elapse before the commodity can be brought to the market' is two years, one year, six months, three months, and one month respectively for the various amounts of labour used." *23 Labor can be employed directly or indirectly in the form of capital with a longer or shorter investment period. Only in equilibrium will the rates of return on investments of different periods be the same.


Hayek presented a table to illustrate the effects of a rise in consumer demand (relative to costs) on the rates of return for various investments. The equilibrium annual rate of return (ignoring compounding effects) on labor invested for different periods is 6 percent. *24 It is then assumed that the price of the product increases by 2 percent (due to the rise in consumption demand, generated by the previous rise in factor incomes):

 2 yrs.1 yr.1/2 yr.1/4 yr.1/12 yr.
Percent return on each turnover:1263½
For an annual rate
of return of:
Percent return after a rise in the price
of the consumption
For an annual rate of return of:78101430

Hayek used this table as a pedagogic device to illustrate market tendencies that would be realized to the extent his assumptions adequately reflected reality. *25 Certain adjustments are implied:

A rise in the price of the product (or a fall in real wages) will lead to the use of relatively less machinery and other capital and of relatively more direct labour in the production of any given quantity of output. In what follows we shall refer to this tendency as the "Ricardo Effect." *26

A change in the price of the product relative to the money wage rate is a change in the "real wage." The analysis is a somewhat roundabout way of referring to the effects of an increase in the value of the marginal product relative to the wage rate in some areas of labor employment and a decrease in others. *27 By "real wages" Hayek did not mean the nominal wage rate divided by the cost of living. He was concerned with the ratio of the nominal wage rate to the price of the specific product being produced rather than consumed by the worker. The Ricardo effect is thus a basic microeconomic proposition. *28


The Ricardo effect had the same importance in Hayek's 1939 formulation as changes in price margins had in Prices and Production.*30 A rise (decline) in real wages corresponded to a narrowing (widening) of the price margins. In the earlier work, a change in the interest rate altered the allocation of resources only by way of a change in price margins. Microeconomists often contend that the interest rate is a ratio of prices. *31 But in practice macroeconomists often ignore this relationship. *32 A change in the interest rate leads to systematic changes in the relation of consumer goods prices to capital goods prices and of the prices of various kinds of capital goods to one other. Changes in the relative prices of (heterogeneous) capital goods are at least as significant as the change in the price of "consumption" relative to "capital" enunciated in the so-called sophisticated macromodels. However, this former type of change is generally ignored. Nor do changes in the prices of capital goods depend entirely on durability. Other things being equal, the more durable an asset, the greater will be the sensitivity of its present value to changes in the interest rate. But, as Hayek emphasized, one must not overlook how that capital good is used in the structure of production. *33


Hayek's analysis does not depend on the assumption of full employment of all factors. In the model presented in "Profits, Interest, and Investment," availability of additional factors of a given type in the capital goods industries does nothing to alleviate an excess demand for those factors in the consumer goods industries; the elimination of excess demand is excluded by the assumption of factor immobility in the short-run formulation of that model. But this stringent assumption, which has been criticized, obscures the operation of the Ricardo effect in the more general case. If factors are generally mobile and used in combination (that is, are complementary), and if some factors are used in both capital and consumer goods industries, then a rise in demand for one or more of these general nonspecific factors in consumer goods industries will produce characteristic effects. In other words, once one nonspecific (complementary) factor becomes fully employed and is bid away from firms producing capital goods, the Ricardo effect will operate. Many other factors may be in excess supply, but if none is perfectly substitutable in the short run for the factor in question, the cyclical expansion of capital goods industries must be choked off.


In the process that Hayek described, increasing incomes of factor owners leads to an increasing demand for goods in relatively short supply, namely, consumer goods. Resources have been attracted into the production of capital goods at the expense of consumption output. *35 These capital goods would have been profitable to produce, ex post, only at higher rates of planned saving. Increasing consumption in the current period implies that the prices of consumer goods and of capital goods specific to the stages nearest to final output will rise relative to the current wage rate. The value of the marginal product of labor in these stages will rise relative to the current wage. Thus, real wage rates will fall. This basic story is not very different from that in Prices and Production.*36


If labor were completely immobile in the short run, then, as the demand for consumer goods increased, the rates of return would rise in some industries and fall (even become negative) in others. As long as the factor immobility assumption is strictly adhered to, there will be unemployment in some industries, and the demand for labor will be high in others. *37 But Hayek never envisioned this type of underemployment equilibrium. For Hayek the process does not end at this point.


Hayek responded that it is a non sequitur to apply the model of a single firm to the model of the entire economy. In so doing, the resource constraint is violated. An interest rate below the equilibrium rate will lead to a progressive rise in incomes. The process will continue until the rise in the rates of return in the consumer goods industries dominates the effects of the low money rate of interest. *39 As long as the market rate of interest is below the equilibrium level, the marginal propensity to spend (that is, the marginal propensity to consume plus the marginal propensity to invest) will be greater than one. And if relative prices continue to be "wrong," there should be some mechanism (other than a change in the market rate of interest) that will lead to a correction.


In The Pure Theory of Capital Hayek put this more succinctly:

In long-run equilibrium, the rate of profit and interest will depend on how much of their resources people want to use to satisfy their current needs, and how much they are willing to save and invest. But in the comparatively short run, the quantities and kinds of consumers' goods and capital goods in existence must be regarded as fixed, and the rate of profit will depend not so much on the absolute quantity of real capital (however measured) in existence, or on the absolute height of the rate of saving, as on the relation between the proportion of the incomes spent on consumers' goods and the proportion of the resources available in the form of consumers' goods. For this reason it is quite possible that, after a period of great accumulation of capital and a high rate of saving, the rate of profit and the rate of interest may be higher than they were before—if the rate of saving is insufficient compared with the amount of capital which entrepreneurs have attempted to form, or if the demand for consumers' goods is too high compared with the supply. And for the same reason the rate of interest and profit may be higher in a rich community with much capital and a high rate of saving than in an otherwise similar community with little capital and a low rate of saving. *40

In presenting a theory of the inflationary process, Hayek provided a model in which it was meaningful to speak of the self-perpetuating characteristics of an inflation, or of rising prices fueled by inflationary expectations, or even of a "wage-price spiral." Though not developed as theories, these characterizations are descriptive of particular phases of a Hayekian inflationary process. For example, as entrepreneurs bid up factor costs, an observer within the system may believe that rising prices result from rising incomes, which in turn are being generated by rising wage rates. This phenomenon might even be described as "wage-push inflation." The superficial observation is that in the later stages of an inflationary process wages push prices up, or that inflationary expectations are keeping the inflation going. The economist, however, would know that at the root of the price inflation is the inflation of the monetary and credit media. Changed expectations alter the form of the inflationary process; they move the economy from one phase (say, an investment boom) to another phase (say, a relative expansion of consumer goods industries) in the expansionary part of the business cycle. But all these changes presuppose an expansion of the means of payment. *42 It is by no means necessary that this expansion continue to occur in the money stock, narrowly defined. Whether this in fact is the case is entirely a question of institutions and each unique historical manifestation of the business cycle.


Hicks observed that price expectations were not treated explicitly in Prices and Production because "their day had not yet come." *43 But even in the 1930s, Hayek was sensitive to the criticism that expectations played no role in his theory. *44 Nonetheless he devoted less space in his work on cyclical fluctuations to an explicit consideration of expectations than did Lindahl, Myrdal, Shackle, Lachmann, or, for that matter, Keynes himself. Yet Hayek's theory is about the inconsistency of plans—about unfulfilled expectations. This point should have received wider recognition, especially after Hayek's work on the role of prices in communicating information for the coordination of economic activity. In fact, it was in a lecture delivered in 1933 on cyclical fluctuations that Hayek first presented the thesis of his later "Economics and Knowledge." *45 In Prices and Production and also in subsequent works, for example, "Profits, Interest, and Investment," Hayek explained how entrepreneurs are induced to make investment decisions largely inconsistent with the saving decisions made by income recipients in general. But Hayek's formal work on the coordination problem has been grouped with his work on economic calculation under socialism. It is instructive, however, to read his work on economic coordination in conjunction with that on cyclical fluctuations because the two subjects are interconnected.


Hayek was explicit about the nature of investors' expectations: "Most investments are made in the expectation that the supply of capital will for some time continue at the present level." *46 The "supply of capital" is ambiguous and suggests that capital is a homogeneous fund—a concept hardly consistent with Hayek's own views on capital theory. The point is that entrepreneurs make investments not only on the expectation that funds will be available at the prevailing interest rate to complete that investment project, but also on the expectation that funds will be available to complete complementary investments in other stages, so that there will finally emerge a complete structure of production. "These further investments which are necessary if the present investments are going to be successful may be either investments by the same entrepreneurs who made the first investment, or—much more frequently—investments in the products produced by the first group by a second group of entrepreneurs." *47 As Hayek argued in "Economics and Knowledge," an individual's plans are necessarily mutually consistent. *48 But different entrepreneurs may be led into making inconsistent production plans by faulty price signals. The coordinating mechanism for these decisions can fail to operate in an equilibrating fashion. According to Hayek, the business crisis occurs when entrepreneurs can no longer attract the funds to complete or maintain a given structure of production.


Hayek acknowledged that entrepreneurs may react to a rise in the price of consumer goods and a fall in real wages in the consumer goods industries by anticipating an even larger price rise in the future. They may for a time have "elastic" expectations and react to a rise in the prices of consumer goods by increasing investment for the future production of consumer goods as opposed to increasing current output of consumer goods. Since when consumer prices rise, there is full employment in the industries producing consumer goods, these two increases cannot occur simultaneously. However, if entrepreneurs discover that they have continually underestimated the yield from increasing the output of consumer goods in the immediate future, they will revise their pattern of behavior, even if the loan rate of interest would otherwise prompt them to borrow and invest for the more distant future. *49 Hayek's capitalists are not wont to entrust their funds to entrepreneurs who consistently pass up the more lucrative investment opportunities.


No discussion of Hayek's treatment of expectations would be complete without consideration of the role of entrepreneurship in his theory. Hayek himself contributed little to the theory of entrepreneurship. This failure is surely partly due to short shrift generally given to the entrepreneurial function in economics. This lacuna is ironic, given the theoretical importance assigned to the undertaker as far back as Cantillon and J. B. Say. But in classical British political economy it was the capitalistic function that occupied center stage. Moreover, Walras introduced the notion of timeless equilibrium, which renders unintelligible both the entrepreneurial and capitalistic functions. The roughly simultaneous attack by J. B. Clark—an attack renewed by Frank Knight—on the concept of an investment period obscured the need for theories of the entrepreneurial and capitalistic roles.


It was to the twentieth-century Austrians that the task of developing entrepreneurial theory was left by default. Hayek only slowly developed and articulated his own conception of competition and the market as a process. As late as 1946 in his article "The Meaning of Competition," Hayek's entrepreneur is a mere shadow in the wings, even though he is the moving force in the competitive process. I believe that the word entrepreneur does not even appear in that essay.


Mises had already developed his conception of the entrepreneur as a moving force in the market economy in the 1940 German edition of Human Action: A Treatise on Economics. The Misesian entrepreneur is not a refurbished version of Schumpeter's innovator-entrepreneur, but has the day-to-day responsibility of discovering discrepancies between prices and costs and of constantly reevaluating past methods of production. He is a discoverer of existing opportunities. *50 The presence of the Misesian entrepreneur is needed to make Hayek's concept of the business cycle more plausible; for Hayek relied on the market system to produce the "right" expectations in the face of monetary disturbances that systematically distort expectations.


To repeat, entrepreneurs are misled by market signals that should indicate increased voluntary saving and react accordingly by changing their investment plans and adopting production processes consonant with a relatively high level of saving. That these expectations are erroneous is discovered as the real forces (the desired saving-consumption ratio) surface. That market forces dominate a purely monetary disturbance is plausible only in terms of a theory of entrepreneurship. The Austrian school (in this regard Schumpeter should perhaps be classified an Austrian) is the only one to emphasize the importance of entrepreneurship. But even Mises's ideas need elaboration to fit Hayek's analysis of the Ricardo effect. Two complex questions are involved: first, to what extent do actors, specifically entrepreneurs, learn from experience; and, second, upon what basis do entrepreneurs form expectations when important market signals, such as the interest rate, prove misleading. While these questions are superfluous to a perfectly coordinated economic model they are essential to a model of an imperfectly coordinated economy.


To the extent that Hayek's reasoning is sound, the Ricardo effect is operative even at a constant market rate of interest. As real wage rates fall in the consumer goods industries, labor is substituted for capital equipment, and less labor-saving capital is substituted for more labor-saving capital:

The effect of this rise in the rate of profit in the consumers' goods industries will be twofold. On the one hand it will cause a tendency to use more labour with the existing machinery, by working overtime and double shifts,...etc., etc. On the other hand, insofar as new machinery is being installed, either by way of replacement or in order to increase capacity, this, so long as real wages remain low compared with the marginal productivity of labour, will be of a less expensive, less labour-saving or less durable type. *51

One type of expectation formation does not affect Hayek's basic analysis, though a great deal of attention has been devoted to it in recent years. This is the effect of anticipated inflation of nominal interest rates. In Hayek's theory, where changes in the price level play no causal role, anticipations of such changes, whether correct or incorrect, also play no causal role.


In Hayek's theory, rising prices (particularly of consumer goods) result from a maladjustment in relative prices; the result is a planned output that is not synchronized with the planned demand for those goods. Even if transactors correctly anticipate the average rate of price increases—that is, if higgling and haggling in the securities market produce a consensus—then the stipulated rate of return for nominally dominated assets will increase once and for all. Assuming that in general transactors lower desired real money balances in an anticipated inflation, prices will increase on a once and for all basis. *56 But relative prices remain out of line with desired saving, and it is the maladjustment of relative prices that constitutes the inflationary problem.


A typical Hayekian crisis is characterized by "a scarcity of capital." The paradox that a decline in the production of capital goods occurs because capital is in short supply seemingly delighted Hayek. By this way of expressing his ideas he focused attention on the insights of some of the "common sense" observations of the British monetary tradition of which he was so fond. *57


In Prices and Production, Hayek emphasized the responsiveness of wage rates to an excess demand for labor at relevant stages of production, and labor mobility between stages. *58 In 1939, however, the emphasis was on the role of raw materials. Increasing consumption demand results in increasing demand for nonspecific (circulating) capital, particularly raw materials. Raw materials constitute the typical component of capital that is "turned over" rapidly. Users of highly labor-saving or durable machinery find themselves unable to compete for complementary factors, such as raw materials. The producers of such machinery find themselves in a similar situation as the demand for their products decreases. In short, the Ricardo effect induces businessmen to make more intensive use of labor and less durable machinery. Even where uses can be found for the relatively labor-saving machinery and durable capital goods in question, producers of these capital goods suffer. For while the stocks of capital goods can be used, they will not be maintained or replaced. Furthermore, this process occurs in the face of a changing pattern of demand for capital goods.


It is not so much a matter of too much investment in money terms (or real terms, if this could be meaningfully measured), as of investment applied in the wrong areas. Without the availability of complementary circulating capital (for example, raw materials) at prices that permit a profit, the durable equipment (machinery) is eventually regarded as malinvested capital. In terms of Hayek's investment diagram, it is impossible to complete all stages on the way to a finished production structure. An unfinished production structure is incapable of producing consumption output. To the degree that investments have been made in incorrect anticipation of a finished production structure, capitalists incur losses. As capital goods are rearranged to fit a structure that can be finished, the value of the existing goods will generally be less than their earlier selling price; in some cases, the prices may fall to zero. In the language of classical analysis, too much revenue has been converted to fixed capital. The existing capital goods (machinery) is not all usable—at least not for the original purpose—because the raw materials (and, in the case of a mobile labor force, the labor services) are not available. In real terms, there is an undersupply of nonspecific capital relative to the amount of machinery and current consumption demand.


Hayek's emphasis on circulating capital and not on fixed machinery in Prices and Production is less of a lacuna than it might seem. In Hayek's later formulation, where fixed capital is worked into the model, circulating capital turns out to be the important link in the causal process.


The interrelation of the notion of forced saving and the capital structure was not perceived until certain aspects of classical capital theory were made coherent by Böhm-Bawerk, Wicksell, Mises, and finally Hayek. *63 Nonetheless, the effects of an increase in fixed relative to circulating capital existed for all to see; it remained only for Hayek to give clearer expression to the problem that Mill had dimly seen.


The assumption of labor immobility that Hayek employed in 1939 was a way of assuring that shifts in demand would have an impact on output and employment; for he wished to emphasize that employment in capital goods industries depends "at least as much on how the current output of consumers' goods is produced as on how much is produced." *64 At full employment, rising demand for consumer goods causes the demand for certain types of capital equipment to decline, especially that specific to methods of production that are only profitable at low rates of interest. Demand for labor increases at some stages of production (and in some industries) and declines in others. Wage rates rise in some stages (industries) because of increasing demand for labor there, while unemployment occurs elsewhere. *65


In his later work, Hayek undertook a more extensive explanation of general unemployment in a depression. Generalized unemployment begins with unemployment in capital goods industries. As the incomes of factors previously employed fall, the demand for current output also decreases. Where many economists today would part company with Hayek is in his insistence that strong forces in the market process reverse a cyclical decline already under way.


As unemployment emerges in the capital goods industries, the rate of increase in consumer demand, and hence in the prices of consumer goods, slows. National income may even decline. In terms of the Ricardo effect, if consumption demand actually declines, prices of consumer goods fall relative to nominal wage rates, and real wage rates rise. At some point in this process, it would pay to substitute machinery for labor. Operating in reverse, the Ricardo effect restores full employment by making the production of capital goods once more profitable. Presumably, the stringent assumptions concerning structural rigidities could be relaxed, though Hayek did not pursue this possibility.


It must be emphasized that Hayek did not envision a significant money wage deflation in the course of the depression; he accepted the proposition that money wage rates are "sticky." In fact, he feared that real wage rates could rise so much that the cyclical revival would recur with malinvestment. *66


There is more to a business cycle of course than changes in the allocation of resources between stages of production. Markets always produce changes in such aggregates as labor employment. Hayek insisted that changes in these aggregates cannot be analyzed in terms of the aggregates themselves. He admitted that there are macro variables but denied the possibility of macro-analysis; for Hayek and the Austrian school in general there is only microanalysis. To him, there are no fixed relationships between macro variables. *67 Nonetheless, he considered the explanation of unemployment to be of an important goal of business cycle analysis. *68


Is Hayek's analysis applicable to a deep depression, such as that of 1929-33? It was certainly a period in which deflation and unemployment were fairly general. Yet in an earlier work Hayek remarked: "There is no reason to assume...that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom." *69 Nonetheless, this "secondary phenomenon" became of utmost importance in the 1930s. While Hayek ranked it as of secondary importance, he did not fail to recognize the phonomenon. *70


Robertson explicitly attempted to link Keynes's analysis with Hayek's. *71 Others treated Keynes's Treatise on Money and Hayek's Prices and Production as similar in approach. *72 According to Robertson, Hayek explained why a turning point occurs, that is, why a cyclical expansion, once begun, cannot continue. Keynes concentrated on the secondary deflation process, the existence of which depends on a crisis (as explained by Hayek's analysis). Robertson did not treat the analyses of Prices and Production and The General Theory as mutually exclusive. Rather, the two analyses refer to different aspects of one and the same process. *73 The failure of either side in the Keynes-Hayek debates to make use of Robertson's attempted reconciliation is to be regretted.


Throughout the 1930s, Hayek opposed both monetary and fiscal measures designed to hasten a return to full employment. Reflation treats a symptom as a cause and ignores the maladjustments that are at the root of the depression. Indeed, if monetary policy succeeds in depressing the market rate below the equilibrium rate, it perpetuates the maladjustments. *74 Hayek viewed fiscal policy as stimulating consumption, whereas maladjustments are caused by planned saving's falling short of planned investment. He had little faith in either monetary or fiscal remedies as a permanent solution to widespread unemployment. *75


Hayek treated the general deflationary process of the Great Depression as a secondary phenomenon produced by previous maladjustments. Once this process has begun, however, little opposition can be offered to expansionary policy. If unemployment is truly general, little can be said against a policy that tends to increase employment. In this regard, however, he made an important point:

It may perhaps be pointed out here that it has, of course, never been denied that employment can be rapidly increased, and a position of "full employment" achieved in the shortest possible time by means of monetary expansion—least of all by those economists whose outlook has been influenced by the experience of a major inflation. All that has been contended is that the kind of full employment which can be created in this way is inherently unstable, and that to create employment by these means is to perpetuate fluctuations. There may be desperate situations in which it may indeed be necessary to increase employment at all costs, even if it be only for a short period.... But the economist should not conceal the fact that to aim at the maximum of employment which can be achieved in the short run by means of monetary policy is essentially the policy of the desperado who has nothing to lose and everything to gain from a short breathing space. *76

By 1933 most Western countries were ruled by what Hayek termed "desperados." If Hayek was accurate in his assessment of the consequences, it would be difficult to argue that the unemployment Western countries experienced after World War II justified "buying" a little employment. A rapid increase in employment, fueled by a monetary expansion, with market rates of interest depressed below the natural rate, leads to maladjustments. These maladjustments, in turn, lead to successive cyclical downturns. The cyclical process becomes self-perpetuating and proceeds to the "stop-go cycle," a familiar phenomenon in Great Britain and one becoming familiar in the United States.


Hayek's business cycle corresponds more to a Juglar cycle than, say, to a National Bureau of Economic Research reference cycle. Though two minor recessions occurred in the 1920s, Hayek treated the period as one long expansion, particularly of capital accumulation; had the expansion ceased in 1927, he believed the depression would have been mild. For the Great Depression to be viewed correctly, the actions of the Federal Reserve System in 1927 would have to be treated as "unprecedented" in their attempts to halt a contraction process with an otherwise limited effect. *77


The monetary shocks that occurred later were virtually unprecedented in their severity and could not have been foreseen. Hayek's purpose was to demonstrate how cyclical fluctuations may occur even in the absence of changes in the "general" price level. In his analysis of neutral money, Hayek concluded that the only way to prevent cyclical disturbances was to prevent investment booms. His policy conclusion was consistent with his earlier views and has a modern ring to it:

If we have to steer a car along a narrow road between two walls, we can either keep it in the middle of the road by fairly frequent but small movements of the steering wheel; or we can wait longer when the car deviates to one side and then bring it back by more or less violent jerks, probably overshooting the mark and risking collision with the other wall; or we can try to keep the steering wheel stiff and let the car bang alternately into either wall with a good chance of leading the car and ourselves to ultimate destruction. *78

Hayek subsequently returned to this theme:

I find myself in an unpleasant situation. I had preached for forty years that the time to prevent the coming of a depression is the boom. During the boom nobody listened to me. Now people again turn to me and ask how the consequences of a policy of which I had constantly warned can be avoided. *79

In Prices and Production Hayek did not take up the question of how long a cyclical expansion might last. He assumed that reserve losses or price inflation would eventually compel banks to raise the loan rate. *80 He subsequently argued that even if banks maintained interest rates below the equilibrium level, the operation of the Ricardo effect would bring the expansion to an end. In his discussion of expectations, he was somewhat vague on timing matters, as is characteristic of most macroeconomic theories. In 1969 Hayek appeared less sanguine about whether the Ricardo effect would check an expansion in the absence of a rise in market interest rates. To him, it was "an open question" how long investment expenditures could be maintained in excess of planned saving. The actual check might only come when price inflation was so great that "money ceases to be an adequate accounting device." "But this cannot be further discussed without raising the problem of the effect of such changes on expectations—a problem which I do not wish to discuss here." *81 The thorny problem remained.


In later stages of the upswing, rising money wage offers may well be associated with declining (Ricardian) real wage rates. While real labor costs are not identical with real wage rates in the sense of purchasing power, declining real labor costs in the consumer goods industries imply a decline in the purchasing power of these wages. To the extent that real labor costs fall in the consumer goods industries, the purchasing power of wages paid in those industries will also decline. The fall in real labor costs provides a stimulus to increased employment in these industries. However, the operation of the Ricardo effect at this point in a business cycle involves declining employment in industries producing capital equipment. At some point total employment may fall, and the unemployment rate rise. But even if total employment does fall, we would see it accompanied by continually high rates of wage and consumer goods' price increases. High unemployment occurs despite (or more accurately because of) the "high" rate of inflation. The existence of an inflationary recession is explained as a natural consequence of the Mises-Hayek theory of economic fluctuations. Indeed, it might be argued that Mises and Hayek were talking about the Phillips curve phenomenon—interpreted in this way—long before that phenomenon in its statistical form had been named as such. Such an explanation proceeds without recourse to a money illusion, a stratagem that economists ordinarily shun.


The major contribution of Hayek's 1939 and 1942 publications is his emphasis on the details of the adjustment process. Indeed, as it evolved, the Hayek-Mises analysis became a theory of inflation in the tradition of Richard Cantillon; that is, Hayek offered a hypothesis as to the kind of sequential price adjustment that occurs between the time a new source of demand, in the form of newly issued money or freshly granted credit, enters the system and the long-run adjustment of the quantity theory takes place. His theory represented an alternative to the cash-balance approach of the neo-quantity theorists, in which imperfect anticipation of the price level is all that is emphasized.


Prices and Production was cast as if the market system were essentially stable and shocks were chiefly if not exclusively monetary. During the 1930s Hayek, in reconstructing ideas, returned to the Mengerian conception of the market as a metaphor for interdependent planning under uncertainty, where time is accorded a crucial theoretical position. In so doing, he attacked the static equilibrium concept of Walrasian and Paretian theory. *83 Next he emphasized the problem of the acquisition and dissemination of knowledge. *84 Not until 1946, in a lecture entitled "The Meaning of Competition," did Hayek clarify his concepts of competition as a dynamic process and of markets existing in an environment of constant change.


By 1946 Hayek had abandoned monetary and capital theory and was on the verge of abandoning economic theory altogether. Thus his conception of constantly changing conditions as endemic to real world situations was never fully developed in his work on business cycle theory. *85 There is, for instance, a definiteness to the sequence of price adjustment even in his 1942 article, "The Ricardo Effect," that I do not think would have appeared in later work on the subject. Indeed, in subsequent work, *86 there is a markedly different tone. To Hayek, the significant feature is the peculiarly discoordinating aspect of monetary disturbances. To the degree that his empirical hypothesis about the way money enters the economic system is correct, this hypothesis might be subject to statistical confirmation. But his theory of economic coordination is independent of this empirical hypothesis. The chief conclusion of his analysis is that monetary disturbances are inherently non-neutral in their effects. Moreover, these disturbances interfere with the coordinating and equilibrating forces of a market system.


It would be of great scientific interest if we could establish that monetary disturbances typically lead to malinvestment in "longer" or "more roundabout" structures of production. I suspect this may be true of nineteenth-and even twentieth-century business cycles. But our inability to demonstrate this empirically could scarcely count against the theoretical insights offered by Hayek's analysis of inflation. First, monetary disturbances have non-neutral effects and, hence, discoordinate economic activity. Second, the consequent malinvestments mean that there are disproportionalities in production, which in a world of stocks and flows, have to be "worked off." Third, attempts to maintain the existing pattern of investments through monetary and fiscal policy only perpetuate—do not stabilize—economic fluctuations. Finally, theories that focus exclusively on price levels and aggregate output (and employment) overlook essential features of macroeconomic activity.



Nicholas Kaldor argued that: "The proposition of Ricardo and that attributed to him by Professor Hayek are not the same—the assumptions are different, the mode of operation is different, and the conditions of validity are quite different." C. E. Ferguson raised the same issue: "The so-called Ricardo Effect never appeared in the works of Ricardo. It was the invention of Hayek." *87


The question of whether Hayek invented the Ricardo effect is easy to adjudicate by examining the section in Ricardo's Principles to which Hayek referred.

In proportion to the durability of capital employed in any kind of production the relative prices of those commodities on which such durable capital is employed will vary inversely as wages; they will fall as wages rise, and rise as wages fall; and, on the contrary, those which are produced chiefly by labour with less fixed capital, or with fixed capital of a less durable character than the medium in which price is estimated will rise as wages rise, and fall as wages fall. *88

Now according to Hayek (1939):

It is here that the "Ricardo Effect" comes into action and becomes of decisive importance. The rise in the prices of consumers' goods and the consequent fall in real wages means a rise in the rate of profit in the consumers' goods industries, but, as we have seen a very different rise in the time rates of profit that can now be earned on more direct labour and on the investment of additional capital in machinery. A much higher rate of profit will now be obtainable on money spent on labour than on money invested in machinery.
The effect of this rise in the rate of profit in the consumers' goods industries will be twofold. On the one hand it will cause a tendency to use more direct labour with the existing machinery, by working over time, and double shifts, by using outworn and obsolete machinery, etc., etc. On the other hand, insofar as new machinery is being installed, either by way of replacement or in order to increase capacity, this, so long as real wages remain low compared with the marginal productivity of labour, will be of less expensive, less labour-saving or less durable type. *89

I can think of no more straightforward statement of Hayek's concept of the Ricardo effect, specifically of its operation in the latter part of a cyclical upswing. The effect comprises both a substitution of labor for machinery and of circulating for fixed capital in response to a fall in the real wage rate. Hayek used the effect exactly as Ricardo had, albeit in a different context. It is clearly out of place to call it the "Hayek effect." *90


Mark Blaug's is undoubtedly the standard textbook treatment of the Ricardo effect. I do not believe, however, that Blaug correctly followed Hayek's argument at all points. According to Blaug, for instance, "Neither the wage rate, the rental per machine, nor the rate of interest have altered in the case Hayek analyzes." *91 Blaug also implied that Hayek assumed that a rising supply curve of loanable funds faces each firm! *92 In fact, Hayek did not assume constancy of the money wage rate, the rental price of machinery, or the interest rate. The rental prices of the various heterogeneous machines change as the quasi-rents (and hence, the rental demand) change for the machines because of changing demand conditions. *93 In his 1942 article, Hayek went through the analysis both for a rising supply curve of funds and of an infinitely elastic supply of funds. *94 Blaug apparently used the assumptions of one case to criticize the conclusions of the other! Finally, Hayek analyzed the effects of a rise in the price of the product relative to the given wage rate. This does not mean that wage rates cannot rise, though in his 1939 paper he assumed that they at least cannot fall in the short run. Rather the analysis of the Ricardo effect must be conceived of as dynamic, demonstrating wage and price changes—and employment and output changes—that occur in the course of a process.


Blaug generally employed comparative static analysis to criticize Hayek's analysis of a dynamic process of adjustment. Blaug, moreover, employed aggregative concepts that Hayek specifically eschewed (as, for example, "'the' rental price per machine"). He apparently felt that, because Hayek borrowed a substitution effect from Ricardo, he also borrowed Ricardo's long-run comparative static analysis. Blaug's casting of Hayek's dynamic analysis into comparative static terms is his most egregious error. As a result, he entirely missed Hayek's argument about the discoordinating features of a disequilibrium rate of interest. *95


The classical economists were able to identify important problems in capital theory but were often unable to handle them satisfactorily. We have already noted J. S. Mill's efforts to analyze the effects of converting circulating into fixed capital. On one issue, Mill anticipated Hayek completely: whether the demand for final output also constituted the demand for labor. His views are expressed in his famous "fourth fundamental proposition respecting capital":

Demand for commodities is not demand for labour. The demand for commodities determines in what particular branch of production the labour and capital shall be employed; it determines the direction of labour; but not the more or less of the labour itself, or of the maintenance or payment of the labour. These depend on the amount of capital, or other funds directly devoted to the sustenance and remuneration of labour. *98

This doctrine or theorem of Mill's is as controversial today as it was in his time. In an oft-quoted passage, Leslie Stephen remarked that "the doctrine [is] so rarely understood, that its complete apprehension is, perhaps, the best test of an economist." *99 Obviously, Hayek's theory accepted the fundamental thesis of J. S. Mill's proposition. Indeed, Hayek offered an even stronger statement of the theorem than did Mill. *100


It is a matter of debate whether Hayek accurately restated Mill's proposition. Like Say's law, it has been restated so often that there is danger critics will lose sight of the author's words and debate an interpretation of it. *101 Though Hayek's restatement obviously embodies Hayek's own views on what Mill said, it is, in my opinion, a restatement that is faithful to Mill's intention. First, Hayek understood "demand for commodities" to mean the "demand for consumers' goods." Second, the question is whether an increase in demand for current consumption raises the demand for land and labor services. *102 Hayek developed the argument in real terms (as did Mill):

An increase in the demand for consumers' goods in real terms can only mean an increase in terms of things other than consumers' goods; either more capital goods or more pure input or both must be offered in exchange for consumers' goods, and their price must consequently rise in terms of these other things; and similarly a change in the demand for labour (i.e., pure input) in real terms must mean a change of demand either in terms of consumers' goods or in terms of capital goods or both, and the price of labour expressed in these terms will rise. But since it is probably clear without further explanation that if the demand for capital goods in terms of consumers' goods falls, the demand for labour in terms of consumers' goods must also fall (and vice versa), and that if the demand for labour in terms of capital goods rises (or falls) it must also rise (or fall) in terms of consumers' goods, we can leave out the capital goods for our purpose and conclude that an increase in the real demand for consumers' goods can only mean a fall in the price of labour in terms of consumers' goods, or that, since an increase in the demand for consumers' goods in real terms must be an increase in terms of labour, it just means a decrease in the demand for labour in terms of consumers' goods. *103

Combining the essential logic of Mill's fourth proposition regarding capital with Ricardo's analysis in the Principles, and adding to the classical analysis the inheritance of Austrian capital theory and Mises's monetary contributions, Hayek fashioned an original and still unappreciated theory of economic fluctuations.


Hayek concluded that an increase in demand for consumers' goods decreases the demand for units of labor, whereas for Mill the demand for labor is unaffected by this change; Hayek's formulation may thus appear to be an inaccurate restatement of Mill's proposition. But I see more agreement between the two theories than is at first apparent. Mill stated that "the more or less of the labour....depend on the amount of capital." This statement embodies the classical wages-fund doctrine. In the case Hayek examined, an increase in the demand for consumers' goods takes place at the expense of capital in the form of the wages-fund. Thus, the demand for labor falls, using Mill's own analysis.


It is true that if all factors are available without limit at current prices (and these prices remain constant), any increase in demand (in both nominal and real terms) will meet with a corresponding increase in supply. But this is a very odd case indeed to set up as the general case. For in this situation, by assumption, changes in prices, wages, costs, and interest rates are simply inoperative. It is a situation that renders the whole price system purposeless. However, it is precisely changes in relative prices that insure that "demand for commodities is not demand for labour." *104 To invoke this case as a basis for criticizing either Mill's or Hayek's theory is to engage in a question-begging procedure.


It is certainly possible to accommodate modern teaching to Mill's and Hayek's views. Mill noted that if labor were under-employed ("supported, but not fully occupied"), then an increase in demand for commodities (that is, consumer goods) may serve to increase "wealth." But this occurs only because the increased output is at a sacrifice of no other output, and no capital need be withdrawn from other occupations. *105 Rather the increased demand for commodities becomes savings, out of which factors in excess supply are hired. But the recipients of the revenue must make a decision whether or not to engage in this saving. Mill was careful to note something that is easily forgotten in income-expenditure approaches to this problem.

The demand does not, even in this case, operate on labour any otherwise than through the medium of an existing capital, but it affords an inducement which causes that capital to set in motion a greater amount of labour than it did before. *106

Hayek emphasized the same point:

Few competent economists can ever have doubted that, in positions of disequilibrium where unused reserves of resources of all kinds existed, the operation of this principle is temporarily suspended, although they may not always have said so. But while this neglect to state an important qualification is regrettable and may mislead some people, it involves surely less intellectual confusion than the present fashion of flatly denying the truth of the basic doctrine which after all is an essential and necessary part of that theory of equilibrium (or general theory of prices) which every economist uses if he tries to explain anything. The result of this fashion is that economists are becoming less and less aware of the special conditions on which their arguments are based, and that many now seem entirely unable to see what will happen when these conditions cease to exist, as sooner or later they inevitably must. *107

Hayek's analysis of the operation of the Ricardo effect is, in essence, a refutation of the proposition that as a general rule demand for commodities is a source of an immediate demand for labor.


Finally, Keynesian tradition cannot accommodate a malinvestment theory such as Hayek's. A theory in which everything turns on factor scarcities and changing relative prices makes no sense in a theory in which relative prices are assumed (at least as a first approximation) to play no role and where, in sophisticated versions, bottlenecks are largely fortuitous events, unrelated theoretically to such basic factors as factor scarcity. Yet it is precisely out of such stern stuff as resource scarcity that Hayek constructed his theory.

"Hayek is perhaps at his best as a historian of economic doctrine, but his impact on political philosophy has been much more powerful" (Kuhn, Evolution of Economic Thought, 2d ed. [Cincinnati: South-Western Publishing Co., 1970].
" Prices and Production was in English, but it was not English economics. It needed further translation before it could be properly assessed" (Hicks, "The Hayek Story," in Critical Essays in Monetary Theory [New York: Oxford University Press, Clarendon Press, 1967] p. 204). However, some of the economics in Prices and Production was classically British; these parts seemed to engender an equal amount of controversy. Ironically, Hicks was later to make the very same point: "The 'Austrians' were not a peculiar sect, out of the main stream; they were in the main stream; it was the others who were out of it." And: "The concept of production as a process in not specifically 'Austrian.' It is just the same concept as underlies the work of the British classical economists, and it is indeed older still—older by far than Adam Smith" ( Capital and Time [Oxford: Oxford University Press, Clarendon Press, 1973], p. 12).
Hayek, Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), pp. vii-ix.
Hayek was the editor of Collectivist Economic Planning (London: George Routledge & Sons, 1935).
Hayek, Profits, Interest, and Investment (New York: Augustus M. Kelley, 1970), p. vii. The first essay, from which the title was taken, was the new contribution. Reprints of articles on capital theory and business cycle theory were also included.
Nicholas Kaldor, "Professor Hayek and the Concertina Effect," Economica, n.s. 9 (November 1942): 359 (hereafter, "Professor Hayek").
Friedrich A. Hayek, "A Comment," Economica, n.s. 9 (November 1942): 383-85.
Hayek, "Profits, Interest, and Investment," p. 3.
Hayek, Prices and Production, pp. 89-91. The rise in the interest rate was precipitated by the cessation in the expansion of bank credit.
See Hayek, Prices and Production, pp. 85-96.
Hayek dealt with the effects of changes in the rate of increase in the money stock, not just changes in the money stock. But since he started from a position of a zero rate of growth in Prices and Production, he at times talked of absolute changes (ibid., pp. 54-55, 149-50).
Hayek, Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley, 1966), p. 41n. He also distinguished between underconsumption explanations and malinvestment theories. A reading of this work is essential for an understanding of Hayek's theory of economic fluctuations.
Machlup, "Friedrich von Hayek's Contributions to Economics," Swedish Journal of Economics 76 (1974): 504.
In the 1939 work, Hayek employed the term time rate of profit to refer to the various rates of return on real capital. He subsequently dropped this terminology.
Hayek, "Profits, Interest, and Investment," p. 8. Footnote reference omitted.
"We are here concerned with the relations between the costs of labor and the marginal product of that labor" (Hayek, "The Ricardo Effect," in Individualism and Economic Order [Chicago: University of Chicago Press, 1948], p. 253).
Hayek, "A Comment," p. 383; see also idem, Prices and Production, pp. 72-92.
Hayek usually referred to output specificity of capital. But the analysis in Prices and Production and subsequent work in capital theory draws attention to the fact that capital goods are used in specific combinations. This aspect of Austrian capital theory received special attention from Ludwig M. Lachmann in Capital and Its Structure.
Hayek, Prices and Production, pp. 89ff. The implication is that the purchasing power of the wages of at least some labor would fall in this latter part of a cyclical expansion. Hayek did not pursue the matter since it was not important theoretically ("The Ricardo Effect," p. 242n).
Of the changing demand for labor of different types, Hayek remarked: "Even if aggregate demand for labour at the existing wage level (if to express it as an aggregate has any meaning under the circumstances) continues to increase, it will be an increase in the demand for kinds of labour of which no more is available, while at the same time the demand for other kinds of labour will fall and total employment will consequently decrease" ("Profits, Interest, and Investment," p. 26).
The process will continue until "the rise in the rate of profit becomes strong enough to make the tendency to change to less durable and expensive types of machinery dominant over the tendency to provide capacity for a larger output" (Hayek, "Profits, Interest, and Investment," p. 33).
Hayek, Pure Theory of Capital (Chicago: University of Chicago Press, 1941), p. 396.
Hayek, "The Ricardo Effect," p. 240, 242.
Hicks, "The Hayek Story," p. 206.
Hayek, "Price Expectations, Monetary Disturbances, and Malinvestments," Profits, Interest, and Investment, p. 155. Hayek responded here to an earlier criticism by Myrdal.
Hayek, "Price Expectations," p. 142.
Ibid., pp. 142-43. Hayek assumed that capital goods can only be used in specific combinations (though not necessarily only one combination). This point was emphasized by Lachmann; see note 34 above.
"Actions of a person can be said to be in equilibrium insofar as they can be understood as part of one plan." And "For a society, then, we can speak of a state of equilibrium at a point of time—but it means only that the different plans which the individuals composing it have made for action in time are mutually compatible" (Hayek, "Economics and Knowledge," pp. 36, 41).
Hayek, "Profits, Interest, and Investment," pp. 16-18.
Hayek, "Profits, Interest, and Investment," p. 14.
"On the principle of 'making hay while the sun shines,' provision for the profits to be made in the near future will take the precedence" (Hayek, "The Ricardo Effect," p. 250). Hayek was attempting to ascertain the relevant rate of discount—the market interest rate or the rate of return on real capital in different stages—when the market rate is not an equilibrium rate.
This analysis is similar to that of William P. Yohe and Denis S. Karnosky, "Interest Rates and Price Level Changes, 1952-69," Federal Reserve Bank of St. Louis Review 51 (December 1969): 31-32. Indeed, in a neo-Wicksellian theory such as Hayek's, if i were not less than n there would be no inflation to anticipate!
Hayek, "Economics and Knowledge," p. 46.
Hayek, "Profits, Interest, and Investment," p. 33.
Hayek, Prices and Production, pp. 92-93.
This model must be amended to take into account capital heterogeneity and complementarity. Particular durable capital goods may be used in otherwise labor-intensive methods of production to meet current consumption demand. Nonetheless, either less durable reproductions or new less durable machines will be used for replacements of these capital goods. In either case the replacement demand will be for a different type of machine and will cause production and employment effects, which is the crucial point for Hayek.
Mill apparently discovered the forced-saving doctrines relatively late; he added a footnote in 1865 to the sixth edition of Principles ( Principles, p. 512). See also Hayek, "A Note on the Development of the Doctrine of 'Forced Saving'," Profits, Interest, and Investment, pp. 193-94.
Hayek, Prices and Production, pp. 22-23.
Hayek, "Profits, Interest, and Investment," p. 24.
Ibid., pp. 25-26; see also note 37 above. Hayek was reluctant to aggregate the demand for labor, just as he was reluctant to aggregate the demand for investment. In an analysis of the process of adjustment in a cyclical expansion, the changing pattern of demand is important. The analysis would be impossible in terms of the "aggregate demand for labor" or the "aggregate demand for capital."
Speaking of Keynes, Hayek remarked: "His final conceptions rest entirely on the belief that there exist relatively simple and constant functional relationships between such 'measurable' aggregates as total demand, investment, or output, and that empirically established values of these presumed 'constants' would enable us to make valid predictions. There seems to me, however, not only to exist no reason whatever to assume that these 'functions' will remain constant, but I believe that microtheory had demonstrated long before Keynes that they cannot be constant but will change over time not only in quantity but even in sign. What these relationships will be, which all macro-economics must treat as quasi-constant, depends indeed on the micro-economic structure, especially on the relations between different prices which macro-economics systematically disregards. They may change very rapidly as a result of changes in the micro-economic structure and conclusions based on the assumption that they are constant are bound to be very misleading" ("Personal Recollections of Keynes," in Shenoy, A Tiger by the Tail (London: Institute of Economic Affairs, 1972), pp. 101-2).
"The existence of...unused resources is itself a fact which needs explanation. It is not explained by static analysis and, accordingly, we are not entitled to take it for granted" (Hayek, Prices and Production, p. 34).
"If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that, by reversing the deflationary process, we can regain lasting prosperity" (Hayek, Monetary Theory, p. 19).
According to Ludwig M. Lachmann, Hayek observed as early as 1933 that while maladjustments bring on depressions, the disequilibrium process results in secondary deflationary processes. Hayek did not pursue this issue, though, if he had, it would have made communication easier (personal communication).
Both Keynes's and Hayek's analyses were Wicksellian in character and relied on inappropriate rates of interest. But in Hayek's analysis the boom is caused by a market rate below the natural rate. The crisis occurs when high consumer demand makes it unprofitable to maintain the current investment structure. In Keynes's analysis the crisis occurs when market rates lag behind a falling natural rate. Thus, at the turning point, market rates of interest may be too low in Hayek's analysis and too high in Keynes's. See also Robertson, Essays.
Any fiscal policy that directly stimulates consumption is the least desirable: "The scarcity of capital, which, of course, is nothing else but the relatively high price of consumers' goods, could only be enhanced by giving the consumers more money to spend on final products" (Hayek, Prices and Production, p. 154). See also Hayek, "Profits, Interest, and Investment," pp. 62-63.
Hayek, "Profits, Interest, and Investment," pp. 63n-64n.
Hayek, Prices and Production, pp. 161-62.
Hayek, "Profits, Interest, and Investment," pp. 70-71. The "steering wheel" is the rate of interest on loans. He was not advocating "fine tuning" with monetary policy, but permitting (instead of impeding) the adjustment of market rates to natural rates of interest.
F. A. Hayek, "Inflation, the Misdirection of Labour and Unemployment," Full Employment at Any Price? (London: Institute of Economic Affairs, 1975), p. 15.
Hayek, Prices and Production, pp. 89-90.
Hayek, "Three Elucidations of the Ricardo Effect," Journal of Political Economy 77 (March/April, 1969): 282.
Hayek, Profits, Interest, and Investment, pp. 135-56; and idem, "Economics and Knowledge," pp. 33-56.
The static quality of most of The Pure Theory of Capital has often been noted. What is generally ignored, however, is that this was to be the first of two volumes, the second being a volume on dynamic capital problems—Hayek's real interest. But when it came time to write it, his interests had turned elsewhere. It might be argued that Lachmann's Capital and Its Structure has served in its stead.
Full Employment at Any Price? which contains Hayek's Nobel Lecture, is one example.
Kaldor, "Professor Hayek," p. 364; and C. E. Ferguson, "The Specialization Gap: Barton, Ricardo, and Hollander," History of Political Economy 5 (Spring 1973): 6.
Hayek, "Profits, Interest, and Investment," pp. 13-14; see also table on p. 131.
Hayek, "Profits, Interest, and Investment," p. 14.
Hayek, "The Ricardo Effect," pp. 235-38, 238-43.
Leslie Stephen, History of English Thought in the Eighteenth Century, p. 297; quoted in Hayek, The Pure Theory of Capital, p. 434.
Hayek, Pure Theory of Capital, pp. 435-36. For an exposition of Hayek's use of "pure input" and other concepts integral to a complete discussion of these issues, see ibid., pp. 51-57, 65-66.
Hayek, Pure Theory of Capital, p. 439.
Chapter 6



When writing this book, I have attempted to develop Hayek's ideas in a logical fashion, which, as previously noted, means departing at times from a strict chronological presentation of Hayek's ideas. In this logical and historical development, I have noted the controversies in which Hayek was involved. I did so, not for the purpose of entering these controversies on one side of the debate, but to elucidate and explain his position in these debates, so as to contribute to the development of his ideas. One controversy above all, however, merits special attention—the long controversy between Hayek and Keynes, and later, the Keynesians. By examining Hayek's Gestalt-conception of economics, as applied to the issues raised in this debate, one can go a long way toward understanding Hayek's dissatisfaction with the development of twentieth-century economics. In so doing, I shall also be presenting in more detail some themes at which I have thus far only hinted.


Even for those previously unfamiliar with Hayek's monetary writings, it should be clear by now that he was generally quite critical of both Keynesian thought and the quantity-theory tradition. It has long perplexed scholars that Hayek never wrote a detailed and critical review of The General Theory. This is in sharp contrast to his treatment of Keynes's Treatise. The absence of such a review must certainly not be taken as a sign of acquiescence. If anything, one has good reason to suppose that Hayek had more sympathy with the earlier rather than the later work of Keynes. In the Treatise, Keynes was still explicitly writing as a monetary theorist; we know that the neo-Wicksellian overtones of that work were appealing to Hayek. *1 We also know that Hayek found little that was appealing in The General Theory. For while he wrote no formal review of Keynes's new magnum opus, he did outline the sources of his dissatisfaction with that work in the final pages of The Pure Theory of Capital.*2 He there paved the way for the never-completed second volume of that work on the dynamic aspects of capital theory, Hayek's real interest. *3


One can say that Hayek's major technical criticism of The General Theory is the absence of theoretical capital discussions in that work. Hayek had earlier accused Keynes of postulating Wicksellian conclusions without accepting the Böhm-Bawerkian capital theory upon which these conclusions were based. *4 Keynes surprisingly accepted this rather harsh judgment and promised to rectify matters in the future. Patinkin has told us that "of course [he] did [do this] in The General Theory." *5


However important he felt the technical flaws of The General Theory were, Hayek had a far more fundamental disagreement with the argument of that book. He objected to the whole conception of Keynes's system, to the very idea that there can be a theory of output as a whole, or of aggregate demand, aggregate supply, etc. Here we are entering into the most general considerations concerning the nature of economic theory. To do so, we require a framework of analysis.


Keynes returned to a classical, macroeconomic mode of thinking in The General Theory. Viewed by a radical microtheorist and subjectivist such as Hayek, Keynes's new work was not so much revolutionary as counter-revolutionary. Hayek was opposed to the macroeconomic formalism and nascent Ricardianism of The General Theory. His disagreement with Keynes was now more fundamental and methodological, rather than particular and technical. This state of affairs surely made a formal review of Keynes's new work most difficult, particularly since Hayek probably did not work out his own thoughts immediately upon publication of The General Theory.


Hayek's change of interests may also be thus explained. For he fairly abruptly ceased writing on monetary theory proper. He saw that his dissatisfaction with the New Economics (which to him was Very Old Economics) could only be brought out in work on the fundamentals of economics. Accordingly, he began a project on scientific methodology in the early 1940s, and he has moved further in this direction in his interests ever since. His Nobel Laureate lecture represents the culmination of this intellectual phase. *16 Nowhere else has he more clearly spelled out his disagreement with macroeconomic thinking as fundamental and methodological.


Viewed historically, this Gestalt-conception, which, to repeat, I think is Hayek's, has great merit. We do not have a consistent microtheoretic discipline. We would have had if the Lausanne and Austrian schools had maintained a natural intellectual alliance. But ironically the very figure who brought Walrasian and Paretian economics to the attention of Anglo-American economists also provided us with an apparent synthesis of macroeconomic (i.e., Keynesian) and general equilibrium economics. This is no place to consider in detail Sir John Hicks's role in the evolution of modern economic thinking. *17 But it is the place to pose a problem that is suggested by the previous historical analysis, an analysis, to repeat, that also aids in our understanding of Hayek's response to the publication of The General Theory.


The problem concerns the recent endeavors to provide microfoundations for macroeconomics. The results have been none too impressive so far, despite the otherwise impressive credentials of those engaged in this search. It may all be a matter of time; there is no denying the possibility. But if the historical view presented here is correct, then the recent macroeconomic research program is all a futile effort. In the view offered here, the microeconomic mode of analysis is radically opposed to the macroeconomic. A coherent economic theory could only be developed by the unqualified acceptance of one mode and the concomitant rejection of the other. The protagonists of Cambridge (U.K.) understand this fact, I believe. It is not clear that their counterparts among the neoclassicals do also. Friedrich A. Hayek and Piero Sraffa, who have perhaps never agreed on anything else before, may both be in error. But the possibility that they are correct certainly should give one pause.


This historical analysis should not be completely new to one who has read Prices and Production. For the analysis is presented there in a very summary form. Of course, the analysis presented in Prices and Production could make no reference to the Keynesian revolution and such later developments. But Hayek had said much of what I am now repeating here in dealing with the monetary theory then most representative of Ricardian thinking—the quantity theory, particularly the Fisherian version. Some of the relevant passages have been quoted earlier in this book in the course of developing Hayek's criticisms of the quantity theory. There I focused the technical aspects of his dissent. Here I wish to emphasize the methodological aspects.


Hayek argued that:

For so long as we use different methods for the explanation of values as they are supposed to exist irrespective of any influence of money, and for the explanation of that influence of money on prices, it can never be otherwise [that progress in monetary theory will be hindered]. Yet we are doing nothing less than this if we try to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production. For none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of non-monetary economic theory are based. It is to this "individualistic" method that we owe whatever understanding of economic phenomena we possess; that the modern "subjective" theory has advanced beyond the classical school in its consistent use is probably its main advantage over their teaching.
If, therefore, monetary theory still attempts to establish causal relations between aggregates or general averages, this means that monetary theory lags behind the development of economics in general. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. *18

Hayek need have altered little in the above in order for it to serve as his criticism of Keynesian economics. Indeed, the similarity between the quantity theory and Keynesian economics leads us to a related topic.


Second, Keynesianism and the quantity theory (or Keynes and the Classics) represents a non-exhaustive choice. *20 As is always true of such fallacious choices, the arguer is thereby given great license with the facts. While Keynesian economic theory can be expressed in terms of the quantity theory and vice versa, the tradition represented by Hayek can be expressed in terms of neither theory. For the variables of neither theory encompass those of Hayek's theory; and the variables of these other theories do not even enter directly into Hayek's analysis. In fact, one could argue that the choice in monetary theory is between premarginalist Ricardian thinking and a consistent marginalist and subjectivist approach. This is not to deny that a good deal of marginalism and subjectivism is present in modern monetary theory; but so too is a good deal of Ricardian macro-formalism. For one who doubts this, I can only suggest reading Hayek's Monetary Theory and the Trade Cycle, or Monetary Nationalism and International Stability, and comparing it with almost any modern treatise on money. The best comparison here might even be between Mises's Theory of Money and Credit (the locus classicus in this tradition) and modern monetary thought.


I would emphasize once again that many of Ricardo's insights in capital theory and some even in monetary and value theory play an important role in Hayek's own analysis. Many have noted the Ricardian or classical roots of Austrian capital theory. What I have endeavored to juxtapose is Ricardian macro-formalism, or Ricardian methodology, and consistent methodological individualism and subjectivism. The Cambridge rediscovery of Ricardo has focused precisely on what are to economists in the Austrian tradition the most objectionable features of Ricardianism (for example, analysis by social classes rather than individuals and manipulation of aggregate variables rather than attention to the relevant micro signals). Insufficient attention is thereby paid to the interesting (to Austrian economists) Ricardian insights on capital (for example, the importance of the period of production) and value theory (for example, see chapter 5 on the Ricardo effect).

See Hayek, "Reflections on the Pure Theory of Money of Mr. J. M. Keynes," part 1, Economica 11 (August 1931): 270.
Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941), pp. 369-76.
See Hayek, The Pure Theory of Capital, p. 3;also, verbal communication.
See Hayek, "Reflections," part 1, 277-80.
On Keynes's treatment of capital, see Leijonhufvud, Keynesian Economics, pp. 187-314. Noteworthy is Keynes ambivalence on Austrian capital theory: "It is significant that whereas Keynes (like Cassel) was quite critical of Böhm-Bawerk, his 'observations' on capital stress the roundaboutness notion of the Austrians" (Leijonhufvud, Keynesian Economics, p. 250n).

Keynes's unsettled and ambivalent feelings toward capital-theoretic questions show in a letter to R. F. Kahn (1 February 1932) about his correspondence with Hayek: "What is the next move? I feel that the abyss yawns—and so do I. Yet I can't help feeling that there is something intersting in it [Hayek's theory]" (Donald Moggridge, ed., The Collected Writings of John Maynard Keynes, 25 vols. [London: St. Martin's Press, 1973] 13: 265).

Hayek, "The Pretence of Knowledge," in Full Employment at Any Price? (London: Institute of Economic Affairs, 1975), pp. 30-42.
Hayek, Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), pp. 4-5.
Chapter 7

Neoclassical economics represents a demonstrable improvement over Ricardian analysis, insofar as the former advanced our understanding of those phenomena least understandable in the Ricardian approach. *28 The so-called Marginalist Revolution provided a basis for a solution to Ricardian lacunae. All three variants of neoclassicism, the Walrasian, Austrian, and Jevonian, focused on utility as an explanation of demand and made use of the older concept of the margin to explain pricing. The Austrians, particularly Wieser, developed the idea that costs are forgone opportunities, not coefficients of production dictated by physical laws of production. Their consistent methodological subjectivism enabled the later Austrians, particularly Mises and Hayek, to perceive that the only relevant forgone opportunities are those perceived by the individual decision maker. The pure logic of the economic short run and that of the long run were seen to be the same and to have no necessary connection with any laws of production that so occupied the Ricardians.


By building on the foundations laid by Mises, and indirectly by Wicksell, Hayek provided a microfoundation for monetary theory. He did so by showing that monetary theory could be viewed as an extension of the barter theory of price, rather than approached macroeconomically in the Ricardian tradition. For Hayek, the quaesitum of monetary theory is not the determination of the value of money, but the determination of the effects of monetary disturbances on (relative) prices and production. Moreover, Hayek's microfoundations and his general theoretical approach are independent of his specific empirical hypothesis about precisely how monetary disturbances typically operate. That is, the approach can be readily adopted to changing institutional arrangements (for example, the increasing role of government expenditures) and thus take account of changing consequences for the real sector of monetary disturbances.


Hayek worked out the fundamentals of the problem in much more detail. This is most obvious in the case of the analysis of investment demand, but it is even more true in his analysis of prices as signaling devices and the role of changes in the array of relative prices on entrepreneurial expectations. In this regard, Hayek always treated changes in expectations as endogenous, whereas Keynes saw them more as an exogenous element in the market system.


The second area of concern was cost and supply theory. This area involved a number of problems, related by the common element of an ill-defined cost theory. The literature is too vast and diverse to cite here, but it covered such problems as the relation between costs and supply and the disappearing supply curve in monopoly. The aspect of this general problem that interests us here is the question whether opportunity costs are subjective or objective in nature. Hayek's interest in this issue can be seen as one with his interest in monetary questions. He wanted to develop a consistently methodological individualist and subjectivist theory of the coordination of economic activities. It would not do to leave cost theory hanging in the air, as it were, borrowed from Ricardian economics. The problems with inherited cost theory become apparent in the Socialist-calculation debate. Costs are not data for the individual, given to him as they are to the economist as ideal observer who constructs the models of decision making. Different transactors have different perceptions of the data and acquire different bits of knowledge about relevant opportunities. Moreover, even if all individuals, mirabile dictu, had the same experiences, they would interpret these differently. It is as if each of us saw part of some production function. Even if some central allocator costlessly and instantaneously collected all our perceptions as they occurred, he would discover that they did not make up one common production function. If perceived opportunities differ, the criterion of allocating according to costs—as though costs were a unique and measurable magnitude—is seen as non-operational, illusory, and, hence, irrelevant. *33


In particular, Mises and Hayek went a long way toward solving a theoretical problem that besets economists today—the integration of monetary and value theory. Whatever else can be said about Hayek's monetary economics, his work does consist of a monetary theory erected upon a consistent microfoundation. Whatever else can be said about almost any other monetary theory of economic fluctuations, it lacks that consistency. Since an avowed purpose of macro and monetary theory today is to provide a microfoundation for the analysis of economic fluctuations, this alone recommends a reconsideration of Hayek's work. It is true that an acceptance of his approach involves abandoning some of what is presently taken for granted (for example, monetary theory is the determination of the value of money). But once one accepts the fact that something is not quite right with the grand neoclassical synthesis, one is virtually committed to abandoning something substantial in the orthodox research program. The only question is what.


It would be to go far beyond the scope of this book to outline in detail a new Austrian or Hayekian research program. Such a program is really only in the first stage of development. *34 This is partly because Hayek's attention turned elsewhere at a crucial moment, and because the Keynesian revolution swept aside many of the interesting questions that would surely be addressed in such a research program. In a very real sense, the program will be whatever those who choose to work in a Hayekian framework make it.


Above all else, Hayek emphasized a microeconomic approach to economic questions. Conventional macroeconomic models with constant functional relationships that can be mechanically manipulated are virtually ruled out of such a program. *35 It is doubtful that there can ever be a Hayekian alternative to the Hicksian cross. *36 This is true, not because Hayek's theory is needlessly complex, but because the world is too complex to picture it accurately in simplistic formulae. So long as economists are wedded to the contrary idea, so long will progress in the theory of economic fluctuations be stalled. In this, I should say, there is affinity between Hayek's views and those of Professor G. L. S. Shackle and the other Keynesians who agree with Shackle's radical interpretation of Keynes. *37


Conversely, one area that seemingly cries out for attention is the sequence of effects in an inflationary expansion. Here one must distinguish carefully between Hayek's theory of economic fluctuations and his empirical hypotheses concerning the effects of an inflation of the money stock. His theory is in the Cantillon tradition, which, broadly speaking, emphasizes distribution effects. Hayek's hypothesis concerns where and how injections of money and credit enter the economy. He looked to private investment as the key variable. It would not be surprising if since 1931 there had been important changes in the paths taken in the inflation process. As an example, federal spending is a much more important part of the economy than it was in 1931. A substantial part of increases in the money stock, broadly or narrowly defined, is typically due to monetization of the debt. What is the net effect of government spending on the "consumption-investment" ratio? Does it stimulate investment or consumption relatively more? And particular kinds of private investment more than others? Do particular sectors, industries, or even firms usually gain first in such an inflation? These are the kinds of questions that will undoubtedly be addressed in a Hayekian research program in monetary theory. *38


Hayek recently commented: "But though there is no longer a distinct Austrian School, I believe there is still a distinct Austrian tradition from which we may hope for many further contributions to the future development of economic theory." *40


There certainly are areas in which Hayek and his fellow economists have had an identifiable impact on current economic thought. One could scarcely call orthodox cost theory "Austrian," but some versions contain strong Austrian elements. As James Buchanan has argued, there is really a separate and distinct approach to cost theory, in which the subjective element is strongly emphasized. *41 Though never incorporated entirely into orthodox economic theory as such, this approach, heavily influenced by the twentieth-century Austrians, represents a lively alternative.

For the methodological subjectivist, it is an essential feature of human affairs that this be so. And the social scientist must take account of this, as Hayek long ago noted: "In the social sciences the things are what people think they are. Money is money, a word is a word, a cosmetic is a cosmetic, if and because somebody thinks they are" ("The Facts of the Social Sciences," in Individualism and Economics Order [Chicago: University of Chicago Press, 1948], p. 60).
See Hayek, "Personal Recollections of Keynes," in A Tiger by the Tail, ed. Sudha R. Shenoy (London: Institute of Economic Affairs, 1972), pp. 101-2.
Hayek, "The Place of Menger's Grundsätze in the History of Economic Thought," in Carl Menger and the Austrian School of Economics, J. R. Hicks and W. Weber, eds. (Oxford: Oxford University Press, The Clarendon Press, 1973), p. 13.

Hawtrey, Ralph G. "The Trade Cycle and Capital Intensity." Economica, n.s. 7 (February 1940):1-15.

——. "Professor Hayek's Pure Theory of Capital." Economic Journal 51 (June-September 1941):281-90.

——. Capital and Employment. 2d ed. London: Longmans, Green & Co., 1952.


Hayek, Friedrich A. "Reflections on the Pure Theory of Money of Mr. J. M. Keynes." Part 1. Economica 11 (August 1931):270-95.

——. "A Rejoinder." Economica 11 (November 1931):398-403.

——. "Reflections on the Pure Theory of Money of Mr. J. M. Keynes." Part 2. Economica 12 (February 1932):22-44.

——. "Money and Capital: A Reply." Economic Journal 42 (June 1932):237-49.

——. "The Trend of Economic Thinking." Economica 13 (1933):121-37.

——. Monetary Theory and the Trade Cycle. 1933 Reprint. Translated by N. Kaldor and H. M. Croome. New York: Augustus M. Kelley, 1966.

——. Prices and Production. 2d ed. London: Routledge & Kegan Paul, 1935.

——. Profits, Interest, and Investment. 1939 Reprint. New York: Augustus M. Kelley, 1970.

——. The Pure Theory of Capital. Chicago: Univeristy of Chicago Press, 1941.

——. "A Comment." Economica, n.s. 9 (November 1942):383-85.

——. The Road to Serfdom. Chicago: University of Chicago Press, Phoenix Books, 1944.

——. "Time Preference and Productivity: A Reconsideration." Economica, n.s. 12 (February 1945):22-25.

——. Individualism and Economic Order. Chicago: University of Chicago Press, 1948.

——. The Counter-Revolution of Science. New York: Free Press of Glencoe, 1955.

——. The Constitution of Liberty. Chicago: University of Chicago Press, 1960.

——. The Sensory Order. Chicago: University of Chicago Press, Phoenix Books, 1963.

——. Studies in Philosophy, Politics, and Economics. New York: Simon & Schuster, Clarion Books, 1969.

——. "Three Elucidations of the Ricardo Effect." Journal of Political Economy 77 (March/April 1969):274-85.

——. Law, Legislation and Liberty, Vol. I: Rules and Order. Chicago: University of Chicago Press, 1973.

——. ed. Collectivist Economic Planning. London: George Routledge & Sons, 1935.


Kaldor, Nicholas. "Capital Intensity and the Trade Cycle." Economica, n.s. 6 (February 1939):40-66.

——. "The Trade Cycle and Capital Intensity: A Reply." Economica, n.s. 7 (February 1940):16-22.

——. "Professor Hayek and the Concertina Effect." Economica, n.s. 9 (November 1942):359-85.


Keynes, J. M. "A Rejoinder." Economic Journal 41 (September 1931):412-23.

——. "A Reply to Dr. Hayek." Economica 11 (November 1931):387-97.

——. The General Theory of Employment, Interest, and Money. 1936 Reprint. New York: Harcourt, Brace & World, Harbinger Books, 1965.

——. "Relative Movement of Real Wages and Output." Economic Journal 49 (March 1939):34-52.


Machlup, Fritz. "Professor Knight and the 'Period of Production.'" Journal of Political Economy 43 (October 1935):577-624.

——. "The Period of Production: A Further Word." Journal of Political Economy 43 (October 1935):808.

——. "Friedrich von Hayek's Contributions to Economics." Swedish Journal of Economics 76 (1974):498-531.


Marget, Arthur W. "Review of Friedrich A. Hayek, Prices and Production; and Preise und Produktion." Journal of Political Economy 40 (April 1932): 261-66.


O'Driscoll, Gerald P., Jr. "The Specialization Gap and the Ricardo Effect: Comment on Ferguson." History of Political Economy 7 (Summer 1975):261-69.

——. "Hayek and Keynes: A Retrospective Assessment." Iowa State University Working Paper No. 20. Ames, Iowa: Photocopy, 1975.

——. "Spontaneous Order and the Coordination of Economic Activities." Menlo Park, Calif.: Photocopy, 1976.


Sraffa, Piero. "Dr. Hayek on Money and Capital." Economic Journal 42 (March 1932):42-53.


Thornton, Henry. An Inquiry into the Nature and Effects of the Paper Credit of Great Britain. Edited by F. A. Hayek. London: George Allen & Unwin, 1939.