Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek
By Gerald P. O'Driscoll
Axel Leijonhufvud first suggested to me that reexamining Hayek’s contributions might be worthwhile. From the start, I sensed that Hayek’s theories were misunderstood in important respects. One major reason was the tidal wave of the Keynesian revolution. Contributing to the eager acceptance of Keynes’s message was a desperate desire for a cure for the economic ills of the Great Depression…. [From the Introduction]
First Pub. Date
Kansas City: Sheed Andrews and McMeel, Inc.
Foreword by Friedrich A. Hayek.
The text of this edition is copyright © 1977, The Institute for Humane Studies.
Axel Leijonhufvud first suggested to me that reexamining Hayek’s contributions might be worthwhile. From the start, I sensed that Hayek’s theories were misunderstood in important respects. One major reason was the tidal wave of the Keynesian revolution. Contributing to the eager acceptance of Keynes’s message was a desperate desire for a cure for the economic ills of the Great Depression.
The orthodox economics of the 1930s seemed incapable of guiding policymakers, although even the textbooks of the day did deal with the problem of unemployment which was of so much concern to policymakers (see J. Ronnie Davis,
The New Economics and the Old Economists [Ames, Ia.: Iowa State University Press, 1971]). Then, however, as now in crisis situations economists were more likely to abandon economic principles entirely than to reformulate them.
Without becoming embroiled in the Keynes and the Keynesians debate (see Axel Leijonhufvud,
On Keynesian Economics and the Economics of Keynes [New York: Oxford University Press, 1968]), I believe it is important to point out how most economists—particularly most American economists—received Keynes’s message. With the adoption of Keynesian economics, the difficult problems of monetary and capital theory that occupied the profession during the entire post-World War I period would be simplified. By supposing that aggregate consumption is a function of current (national) income and that savings and investment together determine the level of national income, the world suddenly was made intelligible in very simple terms. Such issues as “forced saving,” the difference between the money and natural rates of interest, and the investment period became irrelevant.
I cannot overemphasize that the Keynesian revolution also had profound and unfortunate effects on economic research. The profession lost interest in a whole range of issues to which the major theorists of the day had made important contributions (see Fritz Machlup, “Friedrich von Hayek’s Contribution to Economics,”
Swedish Journal of Economics 76 : 508-509). Consequently, in the nine years between the publication of Keynes’s
General Theory and the end of World War II, the fortunes of various economists changed remarkably. These changes occurred much more rapidly, for instance, than did the acceptance of the so-called marginal revolution at the end of the nineteenth century (see Mark Blaug, “Kuhn versus Lakatos, or Paradigms Versus Research Programmes in the History of Economics,”
History of Political Economy 7 [Winter 1975]: 399-433).
In the Keynesian revolution Hayek was not merely misunderstood—he was victimized by myth making. With the acceptance of Keynesian economics, the history of economics was rewritten. Economics was divided into pre-Keynesian and Keynesian thought (and now we speak of post-Keynesian economics). Accepting Keynes’s own solecistic usage, economists perceived Keynes’s predecessors—with a few exceptions—as “classical” economists. In keeping with Keynes’s original suggestion, Oskar Lange pictured economists before Keynes as believing in Say’s law of markets (Oskar Lange, “Say’s Law: A Restatement and Criticism,” in Oskar Lange et al. eds.,
Studies in Mathematical Economics and Econometrics [Chicago: University of Chicago Press, 1942]). Belief in Say’s law became, then, the hallmark of the classical system and the alleged source of all the great classical errors. Say’s law not only was reinterpreted in a way that made it scarcely recognizable to an authentic classical economist, but also was made into a proposition that only a fool would accept. This defamation of Keynes’s predecessors is what, I believe, Keynes and, even more, his followers accomplished in a decade (see W. H. Hutt,
A Rehabilitation of Say’s Law [Athens, Ohio: Ohio University Press, 1974]).
schema of the “Keynesian-classical” variety are suspect to say the least. The lumping together of virtually all
Keynes’s predecessors obscures what distinguishes economists between the Marginal Revolution and the Keynesian revolution. Overlooked in particular are the many and diverse contributions to the theory of economic fluctuations by monetary specialists from the end of the nineteenth century to the 1930s and beyond. These economists include,
inter alia, Ludwig von Mises, Gunnar Myrdal, D. H. Robertson, Hayek, and even Keynes himself in his
Treatise on Money (1st ed., 1930 in
The Collected Writings of John Maynard Keynes, vols. 5 and 6 [London: Macmillan & Co., 1971]). Each of these economists pointed to the failings of the quantity theory and offered revisions. They also contributed to the development of the theory of economic fluctuations. It is therefore misleading to describe them as classical or pre-Keynesian. Also these theorists developed certain parts of what is termed Keynes’s critique of monetary economics to a greater extent than Keynes himself did.
There are, then, two basic reasons for reexamining Hayek’s work today. First, a reassessment of his position in the development of economics is long overdue. His positive contributions to contemporary economic theory have not been fully appreciated. His ideas, which were pushed into the shadows of the Keynesian revolution, are no longer summarized in the leading textbooks. Second, the failure of current Keynesian or post-Keynesian theories of economic fluctuations to explain satisfactorily the simultaneous occurence of inflation and unemployment makes what Hayek said about this phenomenon seem more important.
My claim that Hayek was misunderstood by his contemporaries requires amplification. The Austrian school (of which Hayek was the leading representative at that time in Britain) had a foreign flavor to which British economists were unaccustomed. Furthermore, the lack of understanding led to a failure among Anglo-American economists to comprehend the larger import of Hayek’s message. Hayek called for an entire restructuring of economic theory. In part, he was attempting to counter the revived interest in the general equilibrium theories—the neo-Walrasian and neo-Paretian theories of the 1930s as found, for example, in John R. Hicks’s writings. However, economics, even before the widespread adoption of general equilibrium models,
had unfortunately become virtually a branch of mechanics. The important problem of finding the social institutions that best coordinate economic activities had been lost sight of. Adam Smith, in his notion of the “invisible hand,” called attention to the complex manner in which a prosperous social order is produced, although no one individual (or group of individuals) designed that order or intended that it be produced. Building on Smith, Carl Menger, the founder of the Austrian school, defined economics (and social science in general) as the study of the
unintended consequences of human action. Hayek here followed in Smith’s and Menger’s footsteps.
In Hayek’s view, economics begins where direct observation leaves off. The immediate impact of most economic decisions is apparent even to the untrained: a legal control holding price below the market-clearing price makes goods less expensive (in money terms); a minimum wage set above the market-clearing level raises the income of (employed) workers. Economics deals with the hidden aspects of these problems, or phenomena not readily understood to be aspects of these problems (for example, shortages and unemployment).
In this view, economics is intimately concerned with institutions—social, political, and economic; for it is these institutions that shape the operative economic forces and determine the outcome. Economics must then be theoretical
and institutional if it is to elucidate social phenomena. Whether a satisfactory economic order will emerge depends on the operation of these institutions and thus on their precise nature. Individual decision making and market prices may or may not produce coordinated results; the outcome depends on the functioning of these institutions. Economic systems, market or otherwise, simply do not work in isolation. These insights have gained wider acceptance in recent years. But the realization that institutions matter all too often involves grafting
ad hoc observations on to a theory in which institutions are not strictly relevant.
Economic institutions exist largely to facilitate the dissemination of information among actors. The study of the development of economic order depends, then, on assumptions concerning the flow of information. Standard theorems of resource allocation
are only the starting point. Hayek often criticized economists for generally ignoring this institutional-informational problem.
In his lectures at the University of London in 1931 (Friedrich A. Hayek,
Prices and Production, 2d ed. [London: Routledge & Kegan Paul, 1935]), Hayek appeared to be discussing recondite matters in monetary and capital theory. His subject matter, however, was unusually topical in light of the Great Depression. While his conclusions were provocative, these lectures were apparently unrelated to the wider problems of economic planning or to his other work on economic information. Yet they were intimately related, although writers continue to compartmentalize his work rather than study it in its entirety.
Hayek himself never demonstrated how all his ideas “hang together.” Although this study is restricted to his economic writing, Hayek’s later work on political and legal philosophy and even on the philosophy of perception is consistent with his earlier work on technical economics. A comprehensive treatment of Hayek’s contributions might demonstrate that his book on economic fluctuations in 1931 led him to write
Law, Legislation, and Liberty in the 1970s!
Secondary source material proved a poor guide for understanding Hayek’s ideas. While I do not ignore the secondary source material, I restrict myself to what I consider to be the important errors of interpretation. I have also avoided any direct discussion of the Hayek-Frank H. Knight debates on the meaning and definition of capital. These debates are ancillary to the main theme of this book, though by no means irrelevant. Furthermore, Knight did not offer a theory of capital at all, in the sense of a theory of adjustment and investment in disequilibrium (see M. Northrup Buechner, “Frank Knight on Capital as the Only Factor of Production,”
Journal of Economic Issues 10 [September 1976]: 598-617). Rather, Knight’s central argument about capital—that no sense can be made of a period of production or investment because of the simultaneity of production and consumption—really involved a series of tautologous propositions about the stationary state. Many have made this point, but none more forcefully than Fritz Machlup, who, moreover,
pointed out that when Knight conceded—as he did—that disinvestment is possible, he conceded the whole argument to the Austrians (see Fritz Machlup, “Professor Knight and the ‘Period of Production’,”
Journal of Political Economy 43 [October 1935]: 579-80).
In order that my remark that Knight’s theory is not a theory of capital be understood, I shall quote from Hayek’s own characterization of his endeavor in
The Pure Theory of Capital:
Our main concern will be to discuss in general terms what type of equipment it will be most profitable to create under various conditions, and how the equipment existing at any moment will be used, rather than to explain the factors which determined the value of a given stock of productive equipment and of the income that will be derived from it. [P. 3]
Whatever Knight’s “theory of capital” was, it was not a theory of capital in this sense. To offer it as an alternative to Hayek’s theory is akin to offering a theory of supply as an alternative to a theory of demand. As Ludwig M. Lachmann has reminded us, we still do not have a theory of capital, though interest theories, misnamed “theories of capital,” do go under this title (see L. M. Lachmann, “Reflections on Hayekian Capital Theory” [New York: mimeographed, 1975]).
To reiterate, the main theme of this book is the coordination of economic activities. Hayek’s work is seen as variations of this theme. And taken together, his work is viewed as providing a basis for a radical alternative to the “neoclassical” paradigm of efficient allocation with timeless production, perfect anticipations, costless exchanges, (almost) instantaneous attainment of equilibrium, and a world of no institutions. In many ways, Hayek and his fellow Austrians harked back to classical political economy. But being subjective-value theorists and methodological individualists, they rejected the objective-value theory and methodological holism of Ricardian political economy. In doing so, they advanced the basic research program of Adam Smith. They shared with the Institutionalists a concern for the evolution of market institutions, but viewed this study as complementary to, rather than a substitute for, economic theory. They were foremost among the theorists of their day, but resisted limiting
economics to the pure theory of equilibrium states. In the pages that follow, I hope to support these characterizations by explicating both the specific contributions and general approach of Hayek in particular. In doing so I will emphasize his monetary economics, wherein lie his greatest technical contributions. But since to do so would virtually falsify my own thesis, I will by no means limit myself to monetary economics. Instead, I will attempt to connect his many and diverse contributions to economics, and to show that they evidence an overall conception of economics as the study of decentralized planning and market coordination.