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

1

The Controversies of the 1920s

INTRODUCTION

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.
*1

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.

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.
*4

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.
*6

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
Treatise.*8

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.

THE PROBLEM IN PERSPECTIVE

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.
*9

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.
*10

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.
*12

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.
*13

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.

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.
*22

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 ante–
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.
*24

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.
*25

HAYEK ON EQUILIBRIUM

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.

CHRONOLOGY OF WORKS

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.
*29

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.
*31

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.