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.
10 of 14

The Ricardo Effect


Every fixed capital is both originally derived from, and requires to be continually supported by a circulating capital.... No fixed capital can yield any revenue but by means of a circulating capital (Adam Smith, Wealth of Nations, pp. 266-67).



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


It should be a maxim of intellectual history that if an author changes the form of an argument—even with demonstrable improvement—he invites misinterpretation and the belief that he has "changed his mind."*6


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


His argument proceeded from four specific assumptions:

1. There is no mobility of labor between industries.
2. Money wages cannot be reduced.
3. Existing capital equipment is "fairly specific."
4. The money rate of interest is kept constant by the banking system.*13


It is the last assumption that defines the major difference between "Profits, Interest, and Investment" and Prices and Production. In Prices and Production, a rise in the loan rate of interest ended the boom and precipitated the crisis.*14 The possibility of a rise in the interest rate is precluded by assumption in the 1939 essay, yet the crisis occurs anyway.


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: 12 6 3 ½
For an annual rate
of return of:
6 6 6 6 6
Percent return after a rise in the price
of the consumption
14 8 5
For an annual rate of return of: 7 8 10 14 30


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


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



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


Once full employment is reached in industries producing consumer goods, the Ricardo effect begins to operate. Any further increase in the demand for consumer goods leads to the kind of factor substitution described previously. Most important, with capital specificity the demand is always for particular capital goods rather than for "capital."*34


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.


A single firm, faced with different rates of return on different investments, would attempt to equalize them at the margin (net of risk differences). The firm would borrow at the going rate of interest and invest in capital goods until the marginal rate of return on all investments is equal to the rate of interest. Kaldor assumed that this model applied to the economy as a whole.*38


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.


Entrepreneurs will not be successful in attempts to drive the various rates of return down to the (below equilibrium) rate of interest. For what is being supplied is an infinite quantity of credit, not an infinite quantity of labor and other factor services. Entrepreneurs' borrowing at the depressed rates of interest in order to maintain or extend the existing pattern of investments will promote a further rise in incomes and consumption demand. There will be no tendency for rates of return to become equalized. The reason is that factor scarcity necessitates the curtailment of some production (namely, consumer goods) to expand the production of other goods (namely, capital goods for capital deepening). The assumption is that planned saving out of increments to income will be less than planned investment. Consumption demand will be greater, ex post, than was anticipated by entrepreneurs in general.


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


Lured by rising prices of consumer goods, entrepreneurs may anticipate and plan for a greater rise in the future. But, insofar as they do, they will discover that prices of current period consumption output have risen faster than anticipated: "The faster entrepreneurs expected prices to rise, the more they would necessarily speed up this price rise beyond their expectations." The reason is that "any increase of money expenditure on the one kind of good [that is, labor services] is found to cause an increase of money expenditure on the other kind of good [that is, consumer goods]."*41


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.


Joseph Schumpeter resurrected the entrepreneur in revitalizing Walras's system to explain economic development. The analysis of the entrepreneurial role became a possible research program once again. But the Schumpeterian example was not followed by neo-Walrasians, and there was little further development of the entrepreneurial concept outside the Austrian school.


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


Changed profitability of different investments also increases uncertainty and makes entrepreneurs heavily discount future returns. This factor reinforces the tendency for entrepreneurs to capture short-run returns and pursue current opportunities that appear most profitable.*52


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.


Let us assume that n is the natural, or equilibrium, rate of interest; i is the nominal, or market, rate of interest; Equation. Click to enlarge in a new window.e is the expected rate of change in the price level per period

Equation. Click to enlarge in a new window.

Also assume that an expansionary monetary policy has depressed i below n, and a cumulative rise in incomes brings about a cumulative rise in prices.


Yet another rate of interest is needed—Fisher's realized, or real rate of interest, p, where p = i-Equation. Click to enlarge in a new window.. If the per period rate of change in the price level is correctly extrapolated into the future, then i = p + Pe; and Equation. Click to enlarge in a new window. = Equation. Click to enlarge in a new window.e. But the real rate will nonetheless be lower than it was prior to the inflationary disturbance. The so-called inflation premium is "added on" to a market rate that is lower than the equilibrium (natural) rate of interest, that is, (i + Equation. Click to enlarge in a new window.e) < (n + Equation. Click to enlarge in a new window.e). The fact that market participants may succeed in protecting themselves against the effects of a generally depreciating currency provides no basis for concluding either that inflation will be neutral in its effects on the allocation of resources or that capital malinvestment can be avoided.*53


The entire Fisherian analysis is irrelevant to the present problem and is of little relevance in an ongoing inflation of any magnitude. The reasons are several, though interrelated and reenforcing. Each market participant is concerned with the market prices facing him and the expected costs he will incur. In each contract the creditor and debtor are concerned with different subsets of relative prices and weigh the importance of individual price changes differently. They form expectations about different prices, and they attach different degrees of importance to each particular price change. Moreover, the data each individual (creditor or debtor) considers are subjective, and each will interpret them differently.


Not only do market-day equilibria represent the temporary balancing of bullish and bearish expectations—the divergent views of those who expect higher and those who expect lower rates of inflation—but also these temporary equilibria are resultants of expectations about different events. What inflation premium could protect both parties to a debt contract? What indexation scheme could protect all or even most market participants? The questions are of course purely rhetorical.*54


The whole notion of a balanced, anticipated inflation is a pure fiction resulting from a question-begging assumption and a methodological error. The question-begging assumption is that inflation is even-handed in its effects and is superimposed on a situation of long-run equilibrium. The existence of equilibrium in the form of anticipated inflation is deduced from the assumption of equilibrium. "The statement that, if people know everything, they are in equilibrium is true simply because that is how we define equilibrium. The assumption of a perfect market in this sense is just another way of saying that equilibrium exists but does not get us any nearer an explanation of when and how such a state will come about."*55


The methodological error involves the use of the Marshallian representative individual who buys the typical market basket and is confronted by prices increasing at the average rate. This construct leaves in doubt whether there are any atypical individuals, any gainers or losers in the process. The fact is that there are no representative individuals in an inflationary process.


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.


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 conception is fanciful, as is the model of a perfectly anticipated inflation. But the conception does illustrate how seemingly unrelated arguments converge. The argument over economic allocation without prices is relevant to the theory of inflation. It is relevant because inflation threatens to destroy the mechanism for economic calculation upon which a complex economy depends for its continued existence. Inflation is not merely a technical issue, nor are its effects frictional ("imperfect adjustment"). Rather, the inflation problem threatens the very fabric of a developed society.



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.


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.


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.


The crisis consists of a rise in the prices of raw materials, and labor services relative to the prices of fixed capital.*59 Moreover, the same factor—rising consumption demand—that causes these price movements results in declining demand for capital goods specific to the earlier stages of production. A price "squeeze" in the capital goods industries results. Adjustment to these changes takes time, and in the process affects employment and output.


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.


A tradition in British political economy was concerned with the proportion between fixed and circulating capital. In Principles of Political Economy (especially the chapter "Of Circulating and Fixed Capital"), J. S. Mill examined the impact of a change in the proportion between fixed and circulating capital, the total quantity (in real terms) remaining constant.*60 "All increase of fixed capital, when taking place at the expense of circulating, must be, at least temporarily, prejudicial to the interests of the labourers."*61 What interests us about Mill's analysis is his description of fixed capital created at the expense of circulating capital as a social loss, defined in terms of the workers displaced by this process. This misallocation of resources is not related to a discussion of prices and interest rates. The exposition is quintessentially macro in approach, indeed, a retrogression to mercantilist modes of thinking because processes are described without any consideration of what price incentives may have brought them about. Capitalists switch investments from circulating to fixed capital without specified changes in parameters. And the implications, except for labor employment, are not pursued. Nor does he make a connection with the role interest rates play in preventing the conversion of circulating into fixed capital. Furthermore, he fails to make the connection between the problem being discussed and the discussions of forced saving, which are common in British monetary theory and with which this problem is linked.*62


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.


In this analysis, consumption demand need not decline in absolute terms. Whether a slowing down in consumption demand will lead to a rise in real wage rates depends on the level nominal wage rates have reached. This in turn depends on whether entrepreneurs anticipate a higher rate of growth in consumption demand than actually obtains.


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.


Determining the importance of the Ricardo effect would have one tangible benefit that I have not seen discussed. The Ricardo effect offers an explanation of the Phillips curve phenomenon. The observed relationship between the rate of change of wages and unemployment occurs if workers suffer a short-run money illusion but in the long run react only to changes in real magnitudes. This approach to the Phillips curve has become quite popular. If the rate of increase in nominal wage offers is higher than expected, the worker will assume he is being offered a greater command over society's output; unemployment will decrease as more workers accept employment at the going wage rate. When workers realize that the prices of consumer goods are increasing as fast as wage rates, unemployment will once again increase. There will then be "high" unemployment and "high" inflation. The Phillips curve will shift, as it were, from A to B.*82

Equation. Click to enlarge in a new window.

Figure 5.1


The Ricardo effect provides an alternative analysis. The initial decrease in unemployment rates is attributed to a characteristic investment boom fueled by monetary expansion. However, the decrease in the unemployment rate need not be associated with an increase in nominal wage offers as implied by the Phillips curve analysis offered above. Whether these two magnitudes are associated in this way depends on the short-run elasticity of the various labor supply functions. As an empirical matter the two magnitudes are associated in this way.


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.


Declining rates of increase in wages would, in the short run, be associated with rising unemployment rates as maladjustments are eliminated. In particular, rising unemployment is the mechanism that initially slows the growth of consumer demand and that triggers the reverse operation of the Ricardo effect, which leads to an increase in investment and recovery.


The point of this last section has been to breathe some life into a concept that is in danger of being consigned to the dusty volumes of the history of thought. If the Ricardo effect can be employed to develop an analysis that avoids the controversy over the worker-search hypothesis, the short-run money-wage-illusion hypothesis, the shifting Phillips curve, et hoc genus omne, it will have proved itself worthy of researchers' attention.



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.


Particularly, as governments become relatively larger and more important borrowers and dispersers of loanable funds, it is increasingly difficult to argue that monetary inflation necessarily causes malinvestments of any special type. One could plausibly argue, for instance, that most of Great Britain's inflation in the 1970s is due to government deficits, and that most government expenditures in that country are unambiguously stimulating consumption. The changing and selective impact of the concomitant inflation means, however, that economic decision making is continuously being discoordinated. We know that the real value of pensions is being destroyed by the process of that inflation. Also we have strong theoretical reasons (quite aside from casual empiricism) to believe that production decisions are thoroughly discoordinated. The former we know from the quantity theory. The latter is a purely Hayekian insight.



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


Prices of goods produced with "machine-intensive" processes are less affected by changes in wage rates than those produced by a "labor-intensive" process. Substitution will occur toward or away from machines, depending on whether wage rates rise or fall.


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


Baumol also offered a textbook treatment of the Ricardo effect,*96 as well as having written an earlier contribution on the subject.*97 Though he was doubtful about the operation of the effect in his early article, his mathematical analysis in Economic Theory and Operations Research constitutes a defense of the effect for the simple point-input, point-output case.



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.


The reason Mill's fourth proposition appears fallacious to modern commentators has to do with two profound changes in economic thinking that occurred in the aftermath of the Keynesian revolution. First, there is the widespread adoption of the Walrasian general equilibrium approach, in which all activities occur simultaneously, and production is assumed to be timeless. As Robert Eagly showed, Walras's approach supplanted classical sequential analysis.*108 But once we move out of a world of general equilibrium, we can neither ignore the time-consuming nature of production nor continue to avoid causal sequential analysis. First capital is accumulated or saved and then (and only then) is labor demanded.


The second change coincides with Keynes's use of saving ambiguously as both saving, narrowly defined, and hoarding. Non-spending is, by definition, not a source of demand. And generalized non-spending is countered by an increase in spending (on anything). This the classical economists certainly knew. But to confound the two concepts of saving and hoarding as Keynes did is to promote a loss of understanding about other issues. This is the explanation for the loss of interest in J. S. Mill's fourth proposition.


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.

Notes for this chapter

"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.
Leijonhufvud argued that misinterpretations of Keynes may be attributed in part to this same process (On Keynesian Economics and the Economics of Keynes [New York: Oxford University Press, 1968], pp. 15-24).
Nicholas Kaldor, "Professor Hayek and the Concertina Effect," Economica, n.s. 9 (November 1942): 359 (hereafter, "Professor Hayek").
Ludwig M. Lachmann, "A Reconsideration of the Austrian Theory of Industrial Fluctuations," Economica, n.s. 7 (May 1940): 180.
Friedrich A. Hayek, "A Comment," Economica, n.s. 9 (November 1942): 383-85.
Hayek, "Profits, Interest, and Investment," p. 3.
Ibid., p. 3.
Ibid., p. 6.
Ibid., p. 5.
Hayek, Prices and Production, pp. 89-91. The rise in the interest rate was precipitated by the cessation in the expansion of bank credit.
Ibid., pp. 94-95, 106.
Leijonhufvud, Keynesian Economics, pp. 50-54.
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.
Wicksell, Lectures on Political Economy, ed. Lionel Robbins (London: Routledge & Kegan Paul, 1935), 1: 154 (emphasis in original).
Hayek, "Profits, Interest, and Investment," p. 8. Footnote reference omitted.
Ibid., p. 8. There is a correction in the table as reproduced, along with minor changes in wording.
Ibid., p. 6.
Ibid., p. 10. 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).
Haberler's judgment is that capital and labor are usable only in fixed proportions in the short run (Prosperity and Depression, 3d ed. [Lake Success, N. Y.: United Nations, 1946], p.489).
After the General Theory appeared, numerous studies focused on whether changes in the nominal wage rate are correlated with changes in the purchasing power of these wages or move in opposite directions. Lorie Tarshis finally pointed out that employers are not interested in the purchasing power of the workers' wage, but in the impact of a given wage on a firm's rate of return (that is, the real cost of a given wage) ("Changes in Real and Money Wages," Economic Journal 49 [March 1939]: 150-54).
Hayek, "A Comment," p. 383; see also idem, Prices and Production, pp. 72-92.
For example, see J. Hirshleifer, Investment, Interest, and Capital (Englewood Cliffs, N.J.: Prentice-Hall, 1970), p. 35.
The assumption of one good with two uses (consumption and investment) means there are no relevant effects of a change in the interest rate. The pure substitution between consumption and investment that occurs in a schmoo model is more characteristic of a pure exchange economy than of a production economy.
See pp. 70-79.
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.
In a situation of less than full employment, consumption output will undoubtedly expand. But it will expand too little, that is, there will be a "disproportionality" in production.
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).
Nicholas Kaldor, "Capital Intensity and the Trade Cycle," Economica 6 (February 1939): 40-66; see also Tom Wilson, "Capital Theory and the Trade Cycle," Review of Economic Studies 7 (June 1940): 169-79.
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.
More precisely, the product of the money supply and velocity (that is, M.V) must continue to expand at the same rate (or higher).
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.
This lecture ("Price Expectations, Monetary Disturbances, and Malinvestments,") was reproduced in Profits, Interest, and Investment. As far as I can ascertain, it was not available in English until 1939.
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.
Mises's theory of the entrepreneur has been amplified by Kirzner in Competition and Entrepreneurship.
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!
Axel Leijonhufvud, "Costs and Consequences of Inflation," mimeographed (Los Angeles, April 1975) pp. 10-19.
Hayek, "Economics and Knowledge," p. 46.
It is dubious that transactors seek to dispose of one subset of nominal assets (that is, money) in an anticipated inflation, though it is perfectly plausible for the category "nominal assets" taken as a whole. Robert Clower criticized the argument to the contrary at a UCLA Money Workshop in the 1972-73 academic year. See also Leijonhufvud, "Costs and Consequences of Inflation," pp. 43-46.
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, Principles of Political Economy, ed. Sir William Ashley (Clifton, N. J.: Augustus M. Kelley, 1973), pp. 91-100; this chapter is the sixth chapter of book 1 and comes after Mill's fundamental propositions on capital. Of the three sections in this chapter, two (eight out of ten pages) deal with the proportion between fixed and circulating capital.
Ibid., p. 94.
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."
Ibid., pp. 62-63.
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).
D. H. Robertson, "Industrial Fluctuations and the Natural Rate of Interest," Essays in Monetary Theory (London: P. S. King & Son, 1940), pp. 83-91.
See C. A. Phillips, T. F. McManus, and R. W. Nelson, Banking and the Business Cycle (New York: Macmillan Co., 1937), pp. viii, 115-16. See also G. L. S. Shackle's Foreword to Knut Wicksell, Value, Capital, and Rent, trans. S. H. Frowein (London: George Allen & Unwin, 1954), pp. 7-8.
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.
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).
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.
The relationship between changes in wages and unemployment was observed by A. W. Phillips in "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," Economica 25 (November 1958): 283-99.
Hayek, Profits, Interest, and Investment, pp. 135-56; and idem, "Economics and Knowledge," pp. 33-56.
In "The Use of Knowledge in Society."
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.
David Ricardo, Principles of Political Economy, ed. F. W. Kolthammer (New York: E. P. Dutton, 1948), p. 27. Also: "In proportion as fixed capital is less durable it approaches to the nature of circulating capital" (ibid., p. 24).
Hayek, "Profits, Interest, and Investment," pp. 13-14; see also table on p. 131.
For a fuller exposition of the argument, see O'Driscoll, "The Specialization Gap and the Ricardo Gap: Comment on Ferguson," History of Political Economy 7 (Summer 1975): 261-69.
Mark Blaug, Economic Theory in Retrospect, rev. ed. (Homewood, Ill.: Richard D. Irwin, 1968), p. 546.
Hayek, "Profits, Interest, and Investment," p. 14.
Hayek, "The Ricardo Effect," pp. 235-38, 238-43.
"The Ricardo Effect" (1942) should not be read apart from "Profits, Interest, and Investment" (1939), as Blaug evidently did (judging from his criticisms and his bibliography). The 1942 work is a virtual amendment to the 1939 work and is not completely understandable by itself. Significantly, Blaug did not mention "Profits, Interest, and Investment" in his bibliography on the Ricardo effect; he did, however, cite Kaldor's "Capital Intensity and the Trade Cycle" (1939), but as though it were a criticism of work that postdated it by three years (Blaug, Economic Theory, pp. 571-72).
William J. Baumol, Economic Theory and Operations Research, 2d ed. (Englewood Cliffs, N.J.: Prentice-Hall, 1965), pp. 431-33.
William J. Baumol, "The Analogy between Producer and Consumer Equilibrium Analysis, Part II: Income Effect, Substitution Effect, and Ricardo Effect," Economica 17 (February 1950): 69-80.
Mill, Principles, p. 79 (emphasis in the original).
Leslie Stephen, History of English Thought in the Eighteenth Century, p. 297; quoted in Hayek, The Pure Theory of Capital, p. 434.
James H. Thompson, "Mill's Fourth Fundamental Proposition: A Paradox Revisited," History of Political Economy 7 (Summer 1975): 188.
Thompson offered a good summary of the various interpretations that have been put on the proposition (ibid.).
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.
Ibid., p. 436.
J. S. Mill did not rely on changes in relative prices in elucidating the fourth proposition. (See Thompson, "Mill's Fourth Fundamental Proposition," p. 188).
Mill, Principles, p. 87.
Ibid., p. 88.
Hayek, Pure Theory of Capital, p. 439.
Robert Eagly, Structure of Classical Economic Theory (New York: Oxford University Press, 1974), pp. 126-38.

Chapter 6. Was the Marginal Revolution Aborted?

End of Notes

10 of 14

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