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.
Cultivation of the history of thought is more necessary in economics than in the natural sciences because earlier discoveries in economics are more in danger of being forgotten; maintaining a
cumulative growth of knowledge is more difficult. In the natural sciences, discoveries get embodied not only in further advances in pure knowledge but also into technology, many of whose users have a profit-and-loss incentive to get things straight. The practitioners of economic technology are largely politicians with rather different motives. (Analogies between the market test and the ballot-box test have been fashionable in recent years, but the differences should not be forgotten.) In economics, consequently, we need scholars who specialize in keeping us aware of earlier contributions and so enable us to recognize earlier successes—and earlier mistakes—when they surface as supposedly new ideas. By exerting a needed discipline, specialists in the history of thought can contribute to the cumulative character of economics (Leland B. Yeager, “The Keynesian Diversion,”
Western Economic Journal 11 [June 1973:1]63).
The name John Maynard Keynes and the brand of economics that is called “Keynesian” are known to every practicing economist and economics student today. In contrast the work of Friedrich A. Hayek is practically unknown to the present generation. To older economists the name “Hayek” is but a reminder of past debates. Until the 1974 award of the Nobel Memorial Prize in economics (jointly to Professors Hayek and Myrdal) economists had lost interest in his works. Sir John Hicks commented on the neglect of Hayek’s work:
When the definitive history of economic analysis during the nineteen-thirties comes to be written, a leading character in the drama (and it was quite a drama) will be Professor Hayek. Hayek’s economic writings…are almost unknown to the modern student; it is hardly
remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes. Which was right, Keynes or Hayek? There are still living teachers of economics, and practical economists, who have passed through a time when they had to make up their minds on the question; and there are many of them (including the present writer) who took quite a time to make up their minds.
Hicks asked, “How was it that this happened?” I feel that there is ample reason to take up Hicks’s query, quite apart from an interest in the development of contemporary economic theory or in the reasons for present-day neglect of research problems once considered important. Such an inquiry may reveal new knowledge or, more precisely, as Yeager pointed out, may rediscover what the profession as a whole has forgotten.
Scientific development is typically viewed as a cumulative process of hypothesis formation, empirical testing, hypothesis reformulation, retesting, and so on. This process systematically rejects unsubstantiated hypotheses and accepts hypotheses not found inconsistent with the evidence. Over time, textbooks in each field incorporate important discoveries and delete past errors. At any given time a particular science embodies all ideas and theories currently known to be true and excludes those known to be untrue.
It has been argued that this description of scientific discovery is inaccurate. In a pathfinding work, T. S. Kuhn suggested that a science develops by a way of “revolutions.”
*2 Day-to-day scientific activity is seen as “filling the empty boxes” of accepted theory with empirical content. An accepted body of theory together with an accepted research methodology constitutes what Kuhn called a “scientific paradigm.”
Kuhn’s view recognizes the impossibility of treating all preconceptions and theorems as propositions subject to rejection at any time. In any science, then, there is a “core,” a body of theory not subject to dispute and a body of factual information accepted as true. One need only speculate on the state of economic knowledge if supply-and-demand analyses were treated as hypotheses, ever subject to testing and rejection. On the other hand, the prevailing orthodoxy influences scientists’ perceptions and
judgements; some questions are not raised or, if raised, are not to be regarded as “scientifically proper.” As a consequence, certain avenues of investigation are unexplored, and theoretical errors go undiscovered.
In Kuhn’s analysis, the scientific paradigm is abandoned when anomalous research results make it increasingly difficult to maintain the paradigm intact. Such findings may at first be rejected because they do not fit into orthodox theory, though other reasons may be given. Indeed, the discoverers may find themselves beyond the pale of science precisely because their findings are anomalous. Eventually, however, the paradigm cannot be maintained in the face of ever-increasing evidence. A new paradigm must be constructed, and since the resources of the profession are devoted to debating paradigms, scientific progress is retarded until a new orthodoxy emerges.
If this Kuhnian view is correct, there are two disturbing consequences. First, in the rejection of an established paradigm some knowledge may be lost; all verities in the old paradigm need not necessarily be incorporated into a new paradigm. Second, a paradigm may be rejected on the basis of anomalous findings although these findings can be made consistent with that paradigm. These insights will be made use of in this book.
Work by economists reexamining the so-called Keynes-versus-the-classics debate has led to another debate, one that might be termed the Keynes-and-the-Keynesians debate.
*3 Economists refer to both Keynes’s
General Theory and the ensuing debates as the Keynesian Revolution. The word
revolution implies a radical break with previous tradition. Early work on this revolution dealt with what Keynes was really saying and with how much and where it differed in general terms from what his predecessors had said. Interest then shifted to what Keynes’s predecessors really said: was there truly a “classical economics” or was this simply a straw man to make Keynes’s writings look significant.
An early finding of the original Keynes-versus-the-classics debate was that classical economics had never produced a consistent theory on macro issues. Hicks pointed this out as early as 1937, though writers of macro textbooks have since shown great
ingenuity in constructing a “classical economics” out of whole cloth. As a result of these investigations, it can be argued that Keynes not only made no major theoretical contributions but also made no original policy prescriptions. Indeed, Axel Leijonhufvud suggested that Keynes broke with the established paradigm of economics insofar as he focused on “income-constrained” processes, but that his theoretical contributions were perhaps not as innovative as his more exuberant followers would have it.
*5 For one, Keynes remained at heart a Marshallian; Marshallian economics was the only economics he really knew well. Leijonhufvud also argued that the innovative aspect of Keynes’s work lay elsewhere than in the areas covered in a standard Keynesian work. Keynes was innovative in his broad conception of how a market system operates and how it may break down.
Keynes was not the only economist to challenge the orthodoxy of the time, and the
General Theory was not the only important work to do so. As Hayek wrote in a slightly different context: “We all had similar ideas in the 1920’s.”
*7 Leijonhufvud pointed out that to describe the
General Theory as a “clean break” is to miss the clear progression from the ideas of the
A major premise of this work is that Hayek was correct in his contention that the ideas that bore fruit in the late depression period were conceived in the boom of the twenties. I shall reexamine the contribution of Hayek to this period of intense questioning of economic orthodoxy, especially in relation to the problem of the business cycle in a decentralized market economy.
Even before Hayek was awarded the Nobel Prize there was a revival of interest in his contributions to economics. Some credit for this revival belongs to Hicks, though he only examined Hayek’s works dealing directly with business cycle theory (and erred in ignoring the analysis of the price mechanism as an information-transmitting device in a decentralized market economy). To Hayek, the price system, by disseminating available
information to market participants at the least cost, tended to make mutually compatible the initially incompatible plans of individual actors in that system. His work forms a unified whole and must be appreciated as such.
It is impossible to assess adequately Hayek’s business cycle theory, as Hicks attempted, without considering his work on the foundations of economic theory and the operation of the price system. Hayek’s conception of how the market economy operates is most evident in his theoretical work about prices as transmitters of information. Even the contributors to the recent
Festschrift honoring Hayek did not attempt such a reintegration.
G. L. S. Shackle summarized the prevailing view of economists during the 1920s that their science was the “human counterpart of celestial mechanics.” According to Shackle, a “Grand System of Economics,” an orthodoxy, emerged after 1870. Economics became a theory of “general, perfectly competitive, full-employment stationary (or better, timeless) equilibrium.” It was an economics in which, for instance, the existence of money made little sense.
I consider Hayek’s work a radical criticism of the “Grand System” concept of economics. In presenting an overview of the state of economic theory during the 1920s, it is necessary to contrast the economic theory prevailing in Great Britain (and, to some extent, the United States) with that on the Continent. Shackle’s description of economics during the 1920s is more applicable to British classical economics (as modified by William Stanley Jevons, Alfred Marshall, A. C. Pigou, and others) than it is to Continental economics.
According to most histories of economic thought, the writings of the three “discoverers” of the doctrine of marginal utility (that is, Jevons, Léon Walras, and Carl Menger) are essentially the same. The contributions of each were synthesized by Marshall with what was worthwhile in classical economics. For a variety of reasons, the Marshallian system was replaced with the Hicks-Samuelson, neo-Walrasian, general equilibrium approach. The “new” microeconomics was eventually blended with Keynesian macroeconomics, and the resulting core of economic theory is described as the “neoclassical synthesis.” This is clearly a solecism:
a more accurate description of current economics would be neo-neoclassical. The neo-neoclassical economists were Jevons, Walras, Menger, and their followers. To insist that contemporary orthodox economics is founded on early marginalism is to minimize the influence of Hicks and Paul Samuelson and, by implication, to deny the revolutionary character of Keynes’s work.
This textbook view of economic thought is not only semantically inaccurate but also errs in claiming to capture the common denominator of the works by Jevons, Walras, and Menger. In effect the textbook approach emphasizes the conceptual similarities among these economists rather than the areas of disagreement. I maintain that the Marginal Revolution had three distinct phases, each developing along dissimilar lines in the twentieth century.
*11 Indeed, the history of twentieth-century economic thought is best understood if the thesis of a unified neoclassical economics is rejected.
In fact, regardless of one’s attitude about the unity of neoclassical economics, it was the Austrian variant that dominated thinking on the Continent during the first half of this century. Thus Knut Wicksell wrote in 1924:
Menger…was successful in establishing a school of enthusiastic and highly talented followers, the Austrian School, whose doctrines spread over the whole world, and for a period of fifty years set the course of all work and discussion in theoretical economics, and to some extent in fiscal theory too.
I would amend Wicksell by saying that Menger’s doctrines spread over the whole non-Anglo-Saxon world. Throughout the 1920s English economists remained largely ignorant of the Austrian school.
*14 On the Continent, however, economists in Germany, Austria, and Sweden communicated with one another, and a separate intellectual tradition developed. Swedish and Austrian economists in particular were doing original research on monetary theory, the business cycle, and dynamic equilibrium analysis.
Though there is undeniably a distinctly Austrian contribution, it is easier to specify aspects of this contribution than it is to
determine what differentiated economists of the Austrian school from other economists. Hicks emphasized their unique contributions to capital theory and also Menger’s important insights about the nature of money.
*15 James Buchanan detailed the Austrian roots of the London School of Economics’ tradition in cost theory—a tradition that consistently rejects the real cost doctrines that permeate many current discussions in economics.
*16 But what, if anything, is peculiarly “Austrian”?
From the beginning, that is, from the publication of Carl Menger’s
Grundsätze, economists identifying with the Austrian school insisted on following two procedures in economics: first, they were strict methodological individualists, and, second, they faithfully avoided injecting normative judgments into positive economic analysis.
*17 A by-product of their adherence to methodological individualism was their adoption of subjectivism as fundamental to explanation and discovery in economics.
*18 Their original advocacy of a sharp distinction between positive and normative economics is now widely accepted, no longer being peculiar to Austrian economics (though few economists are aware of the Austrian influence in this area). To the extent that individual economists compromised the principles of subjectivism and methodological individualism they became less distinctively Austrian.
There is another characteristic of Austrian economics that distinguishes it from the Lausanne school in particular: Austrian contributions could not be subsumed into what Shackle described as the “Grand System” because they focused attention on the element of adjustment time and consequently adopted the causal-sequential analysis of classical economics rather than the technique of mutual determination.
*19 This rejection of mutual determination has been taken as evidence that their intellectual contribution was outdated. Furthermore it has led to the spurious claim that they ignored the mutual interdependence of economic factors.
*20 To the contrary, their approach was a by-product of a concern with market processes rather than equilibrium states, a concern that attained its fullest development in the writings of Mises and Hayek.
*21 Many of the positions viewed as characteristically Austrian may be traced to the work of these
writers, whose work nonetheless represents the fullest development of this tradition.
Austrian and Swedish economists, familiar with the work of Menger and his disciples, pioneered the technique of dynamic analysis. Educated on the Continent, they, unlike their English counterparts, were aware of the Walras-Pareto tradition, and its limitations. Although the Swedish economists alone have been credited with “process analysis,” Hayek was working along similar lines at the same time. In essence, the Swedish and Austrian economists were recasting economic theory so as to focus on the market
process, by which disparate plans of individuals are equilibrated, rather than on equilibrium
In Sweden both Erik Lindahl and Gunnar Myrdal were refining the work of Wicksell; in Austria Mises and Hayek were extending the work of Eugen von Böhm-Bawerk and Wicksell. Thus in 1933 Hayek edited a work of non-German contributions,
Beitrage zür Geldtheorie (Vienna, 1933), which contained articles by both Wicksell and Myrdal. Myrdal’s contribution, “Der Gleichgewichtsbegriff als Instrument der Geldtheoretischen Analyse,” did not appear in English until 1939.
Shackle argued for the simultaneity (if not the priority) of Myrdal’s “Keynesian” analysis with Keynes’s own; indeed, Shackle suggested that in some ways Myrdal’s performance was more satisfying than that of Keynes in
The General Theory. He also claimed priority for Myrdal in formulating and effectively employing the
ex post distinction.
*23 But as a matter of priority in the history of thought, it is necessary to note the independent work of Hayek here; though, again, the Swedish and Austrian economists wrote under the common influence of the early Austrians.
Before the 1930s English economists were as ignorant of these later Continental developments as they were of the earlier ones. Hayek thus could say of Keynes’s
Treatise that it contained nothing new for a Continental economist (adding that the presentation was somewhat confusing). At the time of the
Treatise, Keynes was apparently unaware of Böhm-Bawerk’s capital theory, a fact Hayek underscored in his 1931 review of the work.
In Shackle’s “Grand System,” economics deals with long-run phenomena. Whatever reasons economists may have had for couching their analyses in these terms, the result proved unsatisfactory for coping with the disequilibrium problems that increasingly occupied economists in the post-World War I period. It is to this set of short-run phenomena that I now turn.
Hayek argued that a successful analysis of economic disequilibrium required a reformulation of the concept of equilibrium. He devoted considerable energy to this task. Through the late 1930s and the 1940s he published articles on the price mechanism and the social function of prices in transmitting knowledge. From one viewpoint, these articles are a continuation of the debate about economic calculation in a Socialist economy. From another, these writings, together with his work on economic calculation and on monetary theory, attempt to come to grips on different levels with a single basic problem; for his price theory may be interpreted as an extension of his business cycle theory.
*26 All Hayek’s work may thus be seen as flowing from a conception of social interaction with emphasis on economic allocation.
Is it proper to assess Hayek’s lifework as the logical development of a single idea? Although much of his work on monetary theory and the business cycle was written before that on price theory, my impression is that he was systematically working out the basic assumptions of his monetary theories in response to criticisms and misunderstandings.
*27 On several occasions Hayek expressed surprise that his English readers were not familiar with areas of economic knowledge that to him were commonplace.
Schumpeter’s insight that a man’s work depends on his total conception of the economic problem is apropos.
*28 Thus, the purpose of this work is to elucidate Hayek’s conception of the market process. Among other things, this elucidation may assist in the reformulation of macroeconomics.
Prices and Production (for complete citations see bibliography at the end of this book) was Hayek’s first major work in English. First published in 1931,
Prices and Production brought Hayek widespread recognition in England and introduced the Austrian business cycle theory to the British.
Monetary Theory and the Trade Cycle was not translated and published until 1933, though it appeared in German in 1928. Expressing, as it does, Hayek’s views on monetary theory in more detail,
Monetary Theory and the Trade Cycle should be read before
Prices and Production. Yet English readers did not have access to the earlier work until two years after the publication of
Prices and Production.
Hayek was a major participant in the Socialist calculation debate and edited a volume on the subject in 1935 entitled
Collectivist Economic Planning. Concomitantly, he was presenting his monetary, capital, and business cycle theory in journals. These researches on the business cycle and on the Socialist calculation question suggested the need for a firmer foundation for price theory. Hayek believed that the crucial role of prices in resource allocation was not fully appreciated. In a series of articles written between 1936 and 1946, he emphasized that prices serve two important functions: They communicate information about the relative scarcity of resources, and under certain assumptions they improve coordination of the plans of transactors.
The connection between Hayek’s work on the price system and on resource allocation in a centrally planned economy is readily apparent. The connection that exists between work on monetary theory and on the theory of economic fluctuations may be less clear. However, Hayek saw the business cycle as resulting from the noncorrespondence of plans of savers and investors when important market signals—relative prices—are falsified by previous monetary disturbances.
Hayek restated his business cycle theory in 1939.
*30 However, his
magnum opus on capital theory,
The Pure Theory of Capital, was not published until 1941. Again, this work elucidated the foundations for work that had been published years earlier.
In the 1940s Hayek turned his attention to other matters. He began working in the philosophy of science and the social sciences in general, on political philosophy, and on the theory of perception. Hayek confessed that by the 1950s he had lost interest in monetary theory.
This book will end where Hayek’s interests changed. It will thus examine only about half of his total output. But to examine that half, we have to read Hayek in logical rather than chronological order.
Critical Essays in Monetary Theory (Oxford: Oxford University Press, The Clarendon Press, 1967), p. 203. (Hereafter,
The Structure of Scientific Revolution (Chicago: University of Chicago Press, 1963); see also Axel Leijonhufvud,
On Keynesian Economics and the Economics of Keynes (New York: Oxford University Press, 1968), pp. 5-6. (Hereafter,
Keynesianism: Retrospect and Prospect (Chicago: Henry Regnery Co., 1963); Robert Lekachman,
The Age of Keynes (New York: Random House, 1967); Hicks,
Critical Essays; J. Ronnie Davis,
The New Economics and the Old Economists (Ames, Iowa: Iowa State University Press, 1971) (hereafter,
The New Economics). On Keynes and the Keynesians, Axel Leijonhufvud,
Keynesian Economics; Hershel I. Grossman, “Was Keynes a ‘Keynesian’?”
Journal of Economic Literature 10 (March 1972): 26-30; and G. L. S. Shackle, “Keynes and Today’s Establishment in Economic Theory: A View,”
Journal of Economic Literature 11 (June 1973): 516-19.
The New Economics, passim. See also idem, “Henry Simons, the Radical: Some Documentary Evidence,”
History of Political Economy 1 (Fall 1969): 388-94. Also relevant is the discussion in Leijonhufvud,
Keynesian Economics, pp. 31-35.
Keynesian Economics, pp. 24ff; 37-38; and passim. Yeager argued that Keynes cannot be easily credited with what Leijonhufvud claimed for him (cf. Leland Yeager, “The Keynesian Diversion,”
Western Economic Journal 11 [June 1973]: 150-63).
The Optimum Quantity of Money [Chicago: University of Chicago Press, 1969] p. 88n).
Not only was Hayek an active participant in these debates, but his consummate skill as a doctrine-historian and interpreter of economic theories is above dispute. For a compliment by a contemporary historian of the institutionalist school, whose section on Hayek can otherwise only be described as a series of misinterpretations and one-sided attacks, see Ben B. Seligman,
Main Currents in Modern Economics, 3d ed. (New York: Free Press of Glencoe, 1963), pp. 342-43.
Treatise and the
General Theory in Leijonhufvud,
Keynesian Economics, pp. 15-31.
Roads to Freedom (New York: Augustus M. Kelley, 1969); but see Ludwig M. Lachmann, “Methodological Individualism and the Market Economy,” ibid., pp. 89-103.
The Years of High Theory (Cambridge: Cambridge University Press, 1967), pp. 4-5. “Money is the refuge from specialized commitment, the postponer of the need to take far-reaching decisions.” Yet in orthodox theory, money was but a “veil” (ibid., p. 6).
Economic Inquiry 14 (December 1976): 511-24.
Leijonhufvud’s “grand conclusion” lends support to my own argument: “Let us be done with the term ‘neoclassical theory'” (Leijonhufvud, “Varieties of Price Theory,” pp. 2, 47).
Mark Blaug noted that the so-called marginal revolution was composed of three distinct revolutions—”the marginal utility revolution in England and America, the subjectivist revolution in Austria, and the general equilibrium revolution in Switzerland and Italy” (“Was There a Marginal Revolution?” in
The Marginal Revolution in Economics, ed. R. D. Collison Black, A. W. Coats, and Craufurd D. W. Goodwin [Durham: Duke University Press, 1973], p. 14).
Selected Papers on Economic Theory, ed. Erik Lindahl (London: George Allen & Unwin, 1958), p. 193.
Readings in Price Theory, ed. George J. Stigler and Kenneth Boulding [Homewood, Ill.: Richard D. Irwin, 1952], pp. 198-226, esp. p. 200). Developments in the United States were less important at this time. The Austrians remained largely unknown in Great Britain, and to a great extent, despite the translation of Böhm-Bawerk’s work and the best efforts of men like Viner, Irving Fisher, and J. B. Clark, in the United States as well. It must be remembered that the
locus classicus of the Austrian school, Menger’s
Grundsätze, was not translated until 1950 (Carl Menger,
Principles of Economics, trans. and ed. James Dingwall and Bert F. Hoselitz [Glencoe, Ill.: The Free Press, 1950]).
Credit belongs to Lord Robbins for breaking down British intellectual insularity in the 1930s and bringing Continental developments to the attention of British economists. Hayek’s invitation to lecture at the London School was a by-product of these efforts.
Capital and Time (Oxford: Oxford University Press, Clarendon Press, 1973). On Menger, see John R. Hicks,
Theory of Economic History (New York: Oxford University Press, 1969), p. 63; see also Boris P. Pesek and Thomas R. Saving,
Money, Wealth, and Economic Theory (New York: Macmillan Co., 1967), pp. 47-48, for an appreciation that includes Ludwig von Mises.
Cost and Choice (Chicago: Markham Publishing Co., 1969).
The Counter-Revolution of Science (New York: Free Press of Glencoe, 1955), pp. 25-35 and passim. See also Ludwig M. Lachmann, “Methodological Individualism and the Market Economy,” in
Roads to Freedom, ed. Streissler et al., pp. 91-94.
The Structure of Classical Economic Theory (New York: Oxford University Press, 1974), pp. 126-38. Menger noted that: “The idea of causality…is inseparable from the idea of time. A process of change involves a beginning and a becoming, and these are only conceivable as processes in time. Hence it is certain that we can never fully understand the causal interconnections of the various occurrences in a process, or the process itself, unless we view it in time and apply the measure of time to it. Thus…time is an essential feature of our observations” (
Principles of Economics p. 67). He concluded this section by discussing the significance of uncertainty in the process of man producing in time. In Menger the clash with the static/general equilibrium approach of Léon Walras is unequivocal. Erich Streissler argued that “Menger’s
Grundsätze was an attempt to sketch a theory of economic development” (“To What Extent Was the Austrian School Marginalist?” in
Marginal Revolution, ed. Black et al., p. 164).
Production and Distribution Theories (New York: Macmillan Co., 1941), p. 181. For a strident attack on Stigler’s position, see Murray N. Rothbard,
Man, Economy, and State, 2 vols. (Princeton: D. Van Nostrand Co., 1962), 1: 279, 451n.
Monetary Equilibrium (London: William Hodge & Co., 1939).
The Years of High Theory, pp. 94-128. Shackle subsequently described Myrdal’s achievement as providing a “language” that renders Keynes’s fundamental equations (in the
Treatise) intelligible (“The 1974 Nobel Prize for Economics,”
Science 186 [Nov. 15, 1974]: 622).
Economica 11 (August 1931): 277-80; J. M. Keynes, “A Reply to Dr. Hayek,” ibid., 11 (November 1931): 394-95; Friedrich A. Hayek, “A Rejoinder,” ibid 11 (November 1931): 401-2; and idem, “Reflections,” part 2, ibid., 12 (February 1932): 25-26.
Individualism and Economic Order. A series of articles in
Economica in the 1940s on his philosophy of the social sciences are incorporated into
Counter-Revolution of Science. Generally overlooked, these articles are basic to Hayek’s approach to economics. The Socialist calculation debate concerned the possibility of allocating resources by central authority, i.e., without the aid of a price system.
History of Economic Analysis [New York: Oxford University Press, 1954], pp. 41-43).
Individualism and Economic Order.
Profits, Interest, and Investment (New York: Augustus M. Kelley, 1970). Reprint of 1939 edition.
A Tiger by the Tail [London: The Institute of Economic Affairs, 1972], p. 112).
Chapter 2. The Coordination Problem