Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek

O'Driscoll, Gerald P., Jr.
(1947- )
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Kansas City: Sheed Andrews and McMeel, Inc.
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Foreword by Friedrich A. Hayek.

by Friedrich A. Hayek

On the Way


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.


There are many people who deserve thanks for the assistance that they have rendered. If it is possible to make such a judgement, my greatest intellectual debt is to Axel Leijonhufvud. This debt is far greater than the usual one to the chairman of one's dissertation committee. During the period of time I was at U.C.L.A., he was always available to give advice on a wide range of problems. He seemed to have an infinite supply of time, and a way of avoiding the inessentials and moving right to the heart of a problem. Much of what is worthwhile in this book is due to what I learned in and out of the classroom from him, and to his stern criticisms of earlier drafts of my Ph.D. dissertation. He is to be especially absolved from responsibility for any remaining errors, as I am quite aware of the areas where we disagree.


Professor Robert Clower was also willing to give of his time whenever asked for assistance. Since Professor Clower does not have the dubious distinction of ever having been officially associated with this project, he is certainly protected from all blame. But my appreciation for his assistance, rendered at critical junctures, cannot be adequately expressed. I would also like to thank the other members of my dissertation committee, Professors Sam Peltzman and Thomas Sowell, for the help they rendered along the way.


My experience at U.C.L.A. provided great intellectual stimulation. The constellation of great minds was truly awe inspiring. One had the sense of economics being once again made a lively and interesting field in which to work. This sense of excitement was infectious, and the graduate students greatly benefited. It would be impossible to name all of the faculty and staff who, in discussions and otherwise, provided help and stimulation.


The economics department at Iowa State University proved to be a very congenial place in which to carry forth the preparation of this book from my dissertation. Dudley Luckett has helped in ways he undoubtedly does not realize, by his willingness to discuss subjects whose connection with this book he could not then have known. I early learned that the cognoscenti in the department attended Charles Meyer's informal luncheon seminars in the Cardinal Room. I have benefited immensely from the many discussions he and I have had over lunch and at other times.


Professor Israel Kirzner gave encouragement and aid for this project at a time when they were both needed. Professor Ludwig M. Lachmann was also kind enough to read and comment on my dissertation. I very much appreciate the help that both of them have rendered.


The Liberty Fund provided me with a fellowship for the summer of 1975, for which I am profoundly grateful. This fellowship not only enabled me to attend to my typescript full time, but put me in the company of other scholars interested in the same general area. As part of the fellowship, I spent the summer at the Institute for Humane Studies in Menlo Park, California. I benefited from the helpful comments of the other fellows, including Roger Garrison, Richard Ebeling, and Gary and Eugenie Short. Miss Sudha R. Shenoy, in particular, deserves thanks for having read and edited the dissertation in its entirety. George Pearson and Kenneth S. Templeton, Jr., of the Institute for Humane Studies arranged for this program. Neil McLeod of the Liberty Fund saw to the funding. And the staff of the Institute, particularly Ellen Burton and Martha Heitkamp, saw to it that all went smoothly. I wish to thank all of them.


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.


Professor Murray N. Rothbard is largely responsible for interesting me in the contributions of the Austrian school. One might say that he predisposed me to write this work. He himself has contributed to the tradition, and his works were often valuable sources for further references. He also read and commented on my dissertation, for which I am especially grateful.


As the deadline for delivery of the typescript approached, the third floor typing staff in the economics department at Iowa State University performed heroic feats, beyond the call of duty. Mrs. Betty Ingham organized a veritable typing brigade. Denise Collins, Diana Grimm, Mrs. John Kooistra, and she typed furiously and efficiently, even at night and on weekends. There is no way that I can express my appreciation for what they did. And I am most grateful to the department for providing such fine support.


My wife, Lyla, was more than the proverbial constant source of support. She took an active part in editing and rewriting at various stages. And she did this despite the fact that she at all times had her own work to do. I gratefully dedicate this book to her.

Gerald P. O'Driscoll, Jr.
Santa Barbara, California
February 1976



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.


The orthodox economics of the 1930s seemed incapable of guiding policymakers, although even the textbooks of the day did deal with the problem of unemployment which was of so much concern to policymakers (see J. Ronnie Davis, The New Economics and the Old Economists [Ames, Ia.: Iowa State University Press, 1971]). Then, however, as now in crisis situations economists were more likely to abandon economic principles entirely than to reformulate them.


Without becoming embroiled in the Keynes and the Keynesians debate (see Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes [New York: Oxford University Press, 1968]), I believe it is important to point out how most economists—particularly most American economists—received Keynes's message. With the adoption of Keynesian economics, the difficult problems of monetary and capital theory that occupied the profession during the entire post-World War I period would be simplified. By supposing that aggregate consumption is a function of current (national) income and that savings and investment together determine the level of national income, the world suddenly was made intelligible in very simple terms. Such issues as "forced saving," the difference between the money and natural rates of interest, and the investment period became irrelevant.


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).


In this view, economics is intimately concerned with institutions—social, political, and economic; for it is these institutions that shape the operative economic forces and determine the outcome. Economics must then be theoretical and institutional if it is to elucidate social phenomena. Whether a satisfactory economic order will emerge depends on the operation of these institutions and thus on their precise nature. Individual decision making and market prices may or may not produce coordinated results; the outcome depends on the functioning of these institutions. Economic systems, market or otherwise, simply do not work in isolation. These insights have gained wider acceptance in recent years. But the realization that institutions matter all too often involves grafting ad hoc observations on to a theory in which institutions are not strictly relevant.


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.

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