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Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek; O'Driscoll, Gerald P., Jr.
35 paragraphs found.

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]).

Chapter 1

Kuhn's view recognizes the impossibility of treating all preconceptions and theorems as propositions subject to rejection at any time. In any science, then, there is a "core," a body of theory not subject to dispute and a body of factual information accepted as true. One need only speculate on the state of economic knowledge if supply-and-demand analyses were treated as hypotheses, ever subject to testing and rejection. On the other hand, the prevailing orthodoxy influences scientists' perceptions and judgements; some questions are not raised or, if raised, are not to be regarded as "scientifically proper." As a consequence, certain avenues of investigation are unexplored, and theoretical errors go undiscovered.

Chapter 3

However, according to Harry Johnson, activity in monetary theory was again flourishing by 1962. *2 Increasing attention was paid to the work of the new monetary theorists. These theorists restricted their inquiry to three broad but interrelated areas: analysis of the demand for money, determination of the money stock (or the money supply function), and determination of aggregate nominal income. *3 Other important issues, such as those raised by the Patinkin debate having to do with the long-run neutrality of money, were generally abandoned. *4


Friedman expressed his conception of the quantity theory as follows: "The quantity theory is in the first instance a theory of the demand for money. It is not a theory of output, or of money income, or of the price level." *7 As he noted: "In order to have a complete model for the determination of money income, it would be necessary to specify the determinants of the structure of interest rates, of real income, and of the path of adjustment in the price level." *8 But if interest rates and real income are determined by forces other than the demand and supply for money, then Friedman's restatement yields a theory of the equilibrium level of money income despite his original disclaimer. *9


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.


Wicksell cited few writers in his study. He relied mostly on Ricardo and J. S. Mill for statements of the proportionality version of the quantity theory. In the chapter "Of the Value of Money, as Dependent on Demand and Supply" in the Principles, Mill provided a straightforward account of the quantity theory. *21 Mill started with the case of "the arrival of a foreigner in a place, with a treasure of gold and silver." *22 Prices eventually rise uniformly: "Prices would have risen in a certain ratio, and the value of money would have fallen in the same ratio." The reader is told that "this ratio would be precisely that in which the quantity of money had been increased." *23 The teachings of Ricardo and James Mill are evident in John Stuart Mill's work a generation later. But too much had taken place in the intervening years for the younger Mill to let the subject rest there. When he considered the effects of credit, he amended his previous analysis:

The proposition which we have laid down respecting the dependence of general prices upon the quantity of money in circulation, must be understood as applying only to a state of things in which money, that is, gold or silver, is the exclusive instrument of exchange, and actually passes from hand to hand at every purchase, credit in any of its shapes being unknown. When credit comes into play as a means of purchasing, distinct from money in hand, we shall hereafter find that the connexion between prices and the amount of the circulating medium is much less distinct and intimate, and that such a connexion as does exist no longer admits of so simple a mode of expression. *24

Let us grant, however, if not Mill then at least Ricardo was a genuine proponent of the quantity theory as defined by Wicksell and Schumpeter. *28 J. S. Mill's analysis of the "value of money," as determined by demand and supply, gave exposure to the quantity theory in the form of a proportionality theorem. But the result is curious: the strict quantity theory in the form of the proportionality theorem was severely criticized by J. S. Mill. Given Mill's position in economics, this should have been sufficient to bury the theory for at least fifty years. A lot of energy has been spent on a theory that by the middle of the nineteenth century had been rendered untenable—at least when stated in an unqualified form.


Any impact of changes in the supply of money or credit on the economy were regarded by quantity theorists as affecting spending directly. Henry Thornton is an example of someone who should not be classified as a "quantity theorist" because he did not conduct his monetary analysis in terms of the demand and supply of a subset of assets called "money." In fact, Thornton's specific contribution to monetary economics, aside from his criticism of the "real bills" doctrine, was his analysis of the indirect mechanism by which a monetary disturbance affects real economic activity. J. S. Mill started his monetary analysis by supposing "that to every pound, or shilling, or penny, in the possession of any one, another pound, shilling, or penny, were suddenly added." *37 Thornton, however, focused on monetary disturbance in capital markets and emphasized the gradual effects on spending by way of changes in the interest rates on marketable securities. "In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances." *38


To find "the right solution in this chaos of vague conceptions," Wicksell started his analysis-much as had Henry Thornton-by examining the effects of a monetary disturbance on market rates of interest. *51 The important question now is how more money enters the system. A lowering of market interest rates by an injection of money in the form of bank credit leads to increased investment. Changes in the demand-and-supply condition in commodity markets must then follow and thus changes in compositionof output. A larger fraction of national income is devoted to investment expenditures, and as a result the marginal productivity of investment declines. *52


Keynes also reacted against the division between monetary theory and value theory:

So long as economists are concerned with what is called the Theory of Value, they have been accustomed to teach that prices are governed by the conditions of supply and demand; and, in particular, changes in marginal cost and the elasticity of short-period supply have played a prominent part. But when they pass in volume II, or more often in a separate treatise, to the Theory of Money and Prices, we hear no more of these homely but intelligible concepts and move into a world where prices are governed by the quantity of money, by its income-velocity, by the velocity of circulation relatively to the volume of transactions, by hoarding, by forced saving, by inflation and deflation et hoc genus omne, and little or no attempt is made to relate these vaguer phrases to our former notions of the elasticities of supply and demand. *72

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 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


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

The concept of the neutrality of money (and thus, indirectly, the concept of forced saving) has frequently been criticized. Piero Sraffa's review of Prices and Production was hostile, as I have noted. Others, such as Koopmans and Classen grappled with the theoretical problems raised by the analysis. *98 Again, in the work of recent years dominated by The General Theory, that part of the Wicksellian tradition concerned with relative prices and so-called distributional effects of monetary policy has been virtually ignored. Of the efforts to save the concept of neutrality of money, Patinkin's is perhaps the most valiant among contemporary writers. But he was hoisted on his own petard. In any comparison between a barter and a money economy, the excess demand functions will necessarily differ. Patinkin considered a barter economy as the limiting case of a money economy, that is, one in which the money supply is progressively reduced to zero.

As the nominal quantity of money approaches zero, so does the price level—and at the same rate. Hence the real quantity of money remains unaffected. Thus the limiting position that we have defined as a barter economy is one in which there exists the same real quantity of money as in a money economy. *99

Originally neutrality was defined in terms of a congruence between the demand and the supply functions in a barter and a money economy. This comparison is obviously untenable: there is at least one commodity in a money world that is absent from a barter world. *100


Friedrich Lutz correctly concluded that an important issue was raised by the early neutrality theorists, an issue that becomes obvious in analyzing the conditions under which a change in the supply of or demand for money will affect relative prices and quantities of nonmoney goods. *101

"Ricardian comparative statics and concentration on long run equilibrium assumed away many transitional monetary phenomena, especially in Ricardo's Principles—though his polemical pamphlets and correspondence dealt with such problems, even if sometimes somewhat grudgingly" (Sowell, Classical Economics Reconsidered, p. 53). For a cost-of-production theorist, the ultimate effects of a change in the demand for a commodity money can only be analyzed by taking into account the effects on the cost of production (Mill, Principles, pp. 499-506.) But this was too long a run even for Mill and Ricardo. Both analyzed money in terms of demand and supply. Senior remained consistent, however, and insisted on analysis in terms of the cost of production of the metal (Schumpeter, History, p. 702).
The proportionality theorem does not follow from demand-and-supply analysis without further explanation (Schumpeter, History, p. 703; Wicksell, Lectures, 2: 141-44). On the nature of Ricardo's question, see Wicksell, Lectures, 2: 175-76.
Chapter 4

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
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.
It is questionable whether we want to measure market value when we try to measure capital. A number of writers (for example, Robert Dorfman and Abba Lerner) questioned this procedure, noting that we do not follow it with other factors, and that, if we did, some results would be paradoxical. For instance, were the demand for labor to be inelastic, an increase in supply would diminish the value of labor employed in production (Kirzner, Essay on Capital [New York: Augustus M. Kelley, 1966], p. 135).
Chapter 5

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


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


Real wages may fluctuate irrespective of their measurement in terms of a unit of general purchasing power. Statisticians have often been confused about what constitutes the relevant real wage in economic analysis of the business cycle. The wage as measured in units of industrial output is what is important for labor demand, whereas the wage as measured in units of consumables is relevant to labor supply. *29


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


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

The very term anticipated inflation is misleading. What is anticipated in an anticipated inflation? For an inflation to have no effect on real activity (to be neutral), the precise sequence of price changes must be anticipated. If transactors could predict the exact sequence of price changes, they could predict every future price. To do so they must have direct access to future demand and supply conditions in each market. If such knowledge were possible, why would we use prices at all? Prices reflect the balancing of opinions as to future events. All the inefficiencies of a market system are tolerated because it is the least inefficient way of transmitting decentralized information. If the market could adapt perfectly to an inflation, then the power to choose the "correct" prices is being attributed to the market. In other words, in a fully anticipated inflation this power is attributed to every (representative) individual. If, however, the representative individual is privy to the information required to correctly anticipate prices in every period, society would be well served to pick out a representative individual at random and make him an economic dictator. Markets could be dispensed with and resources allocated by fiat. No one would have to worry about the future rate of inflation, since there would not be any prices, just allocation orders.


The capital goods in short supply consist mostly of raw materials. An excess demand for raw materials emerges because in the previous cyclical upswing capital was malinvested in fixed machinery as a consequence of forced saving.


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.


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
Robertson outlined a scenario in which the rate that in the short run equilibrates the supply of voluntary savings and the demand for investable funds falls below the natural rate of interest during the deflation process. An expansionary monetary policy at this point merely brings the market rate down to the short-run equilibrium rate. Clearly this short-run equilibrium rate is not the natural rate of interest (Robertson, Essays, pp. 83-91).
Chapter 6

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.


The Ricardians were concerned to some extent with the theory of the demand for output as a whole, despite their adamant stand on the general glut question. To deny that the demand for output as a whole could ever be insufficient is not to deny that there is an aggregate demand. Aggregate demand was constituted by aggregate supply for the Ricardians and worked its way through the medium of aggregate money turnover, MV. It might be true that a motto for Ricardians could have been, "we can safely neglect the aggregate demand function." *13 But the Ricardians certainly had the concept of a demand for output as a whole. Their approach was simply different from the modern one. And of course their approach was not all that well worked out, either; as a consequence, most modern "classical" macroeconomic paradigms are largely the construction of textbook authors.