Download The equilibrium approach to money and the business cycle

Hansjoerg Klausinger
HAYEK’S MONETARY AND CAPITAL THEORIES: PUZZLES AND CONTROVERSIES1
1. Prefatory notes and overview
The following paper represents an intermediate stage towards a final draft of introductions
to the two volumes of the Collected Works of F. A. Hayek devoted to the writings on business
cycles. For purposes of presentation I have chosen some of the puzzles and controversial themes
which I have come about in the course of my attempt at understanding Hayek’s monetary,
business cycle and capital theories. Due to the preliminary stage the reader is warned that the
sections of this paper deal with separate and rather isolated topics that do not yet constitute a
coherent whole; quotations and references may to some extent be incomplete, and some
references are to yet unwritten chapters.
These are the three topics to be dealt with here: (1) Hayek’s equilibrium approach to
money and the cycle, (2) his coping with the phenomenon of deflation during the 1930s, and (3)
the novel explanation of the cyclical mechanism that he put forth under the name of the “Ricardo
effect”.
What are the puzzles to which these topics give rise? On the first topic, the controversial
issue is to what an extent Hayek’s theories of the business cycle in a monetary economy are
based an equilibrium approach, and if so, on what a type of equilibrium, and if he thereby
anticipated modern notions of equilibrium in time. Finally, how successful was Hayek in
integrating money consistently into his scheme of equilibrium. These questions are reexamined in
the light of evidence from hitherto unused material found in the Hayek papers.
On the second topic, Hayek’s treatment of deflation, the puzzles consist in how Hayek
tried to integrate the phenomenon of deflation into his theory of the depression, and how his
extremely cautious stance on combating deflation by means of monetary policy can be made
1
Paper presented to the HOPE workshop at Duke University, Durham, NC, Dec 5,, 2008.
Preliminary; please do not quote.—Address of the author: Center for the History of Political
Economy, Duke University, Department of Economics, Box 90097, Durham, NC 27708, U.S.,
and Department of Economics, Vienna University of Economics and Business, Augasse 2–6, A
1090 Vienna, Austria. Email: [email protected].
1
consistent with his view on neutral money. In my tentative answer I point out that the integration
of deflation into his theoretical framework was less than complete, partly because the whole
framework and in particular the notion of neutral money were equilibrium concepts of not much
use for guiding policy in disequilibrium situations like a depression.
On the third topic, the Ricardo effect, I side with those who consider it rather an
aberration than progress in Hayek’s thought. As a venture into dynamic capital theory in a
monetary setting it proved singularly unsuccessful. Thus in this regard the task consists more in
sorting out the seminal questions posed by Hayek than in tracking the various versions and
refutations to which the whole controversy had given rise. The most interesting point might
consist in Hayek’s emphasis on the fragility of full employment, a position at the time shared by
most business cycle theorists, in spite of the contemporary emergence of Keynesian economics.
2. The equilibrium approach to money and the business cycle
The subject of this section is the significance of, or indeed Hayek’s grappling with, the
equilibrium framework as the point of departure for the analysis of money and the cycle.2 The
sources mainly used in this section are Hayek’s first paper on intertemporal equilibrium (Hayek
1928a), his habilitation thesis, Geldtheorie und Konjunkturtheorie (1929a), translated as
Monetary Theory and the Trade Cycle (1933a)3, and the monograph coming out from the lectures
at the LSE, Prices and Production (1931, second edition 1935). In addition, taking account of the
unpublished fragment of the “Geldtheoretische Untersuchungen” (Hayek [1929?])4 yields
considerable insights into Hayek’s thought of this period.
2
In Klausinger (2007) I have emphasised this equilibrium framework, that is, specifically the
notion of intertemporal equilibrium, as the guiding principle for interpreting Hayek’s writings on
money and the cycle. The following exposition is based on this thesis, yet modified by taking
account of additional archival sources and Hayek’s contemporaneous writings on capital theory.
3
Due to revisions by Hayek and due to some shortcomings of the translation the English version
is not always faithful to the German original. Note also the recent translation into English of
Hayek’s presentation of what came to be the first three chapters of Geldtheorie, cf. Hayek (2002
[1928b]).
4
An outline, the typescript of the first part and some additional material is preserved in the
Friedrich August Hayek Papers. The typescript consists of eight chapters, two of which are made
up of a slightly modified version of Hayek (1928a); plausibly the typescript should be dated
1929/30.
2
The basic tenet for interpreting Hayek’s writings on money and the business cycle in the
1930s is their firm foundation on an equilibrium approach, with equilibrium providing the
benchmark to which cyclical movements are to be related. This approach is pertinent to all of
Hayek’s work in this field, yet in differing degrees of emphasis and sophistication: the explicit
defence of the equilibrium approach and the attempt at providing a more thorough integration of
time and money into this framework in Hayek’s early writings from 1928 onwards; then
embracing a simplified, or short-cut, version in Prices and Production; and subsequently the
turning back to these foundational issues as a part of his venture into capital theory.5
Hayek’s examination—and eventually defence—of the equilibrium approach (in Hayek
1928a, 1933a [1929a]) formed part of the German-language debate on the proper methods for
business-cycle research, where both the relevance of a theoretical approach in general and an
equilibrium approach in particular were at stake. Hayek (1933a) took as the point of departure a
series of contributions by Adolf Löwe (1925, 1926, 1928, 1929), who had questioned the
adequacy of such an approach. Put simply the main point of Löwe (1926) consisted in the
criticism that the static character of the equilibrium system is in contradiction to the intrinsically
dynamic nature of the phenomenon of the business cycle. A precise definition of the meaning of
“static” and “dynamic” is to be found in Löwe:
The notion of “dynamics” is often used, following Anglo-Saxon and French terminology,
for processes of economic motion per se, in contrast to the narrower notion of “statics”
referring to a state of rest. Yet in the following I shall use these two notions, according to
Schumpeter, to denote two structurally distinct systems of motion, the one—statics—
tending towards an equilibrium at rest, while the other—dynamics—exhibits very
complicated tendencies of evolution, in any case opposed to an equilibrium at rest. (1925,
355n.1; my translation, emphasis in the original)
In Schumpeter’s terminology, of which Löwe (1925, 357) and also Hayek (1933a, 43 and
60n.) approved, the movements typical for the static and the dynamic system were referred to as
“adaptation” (or “adjustment”) versus “development”.
5
For this period cf. Hayek (1934b, 1936, 1941).
3
By “development” … we shall understand only such changes in economic life as are not
forced upon it from without but arise by its own initiative, from within. … [if] the data
change and … the economy continuously adapts itself to them, then we should say that
there is no economic development. (Schumpeter 1934, 63 [1926, 95–96])6
In any case, this distinction between statics and dynamics is not equivalent to the one
ascribed above to the “Anglo-Saxon-French” tradition, namely of statics as an analysis that
abstracts from time, and dynamics as that of (any) movements in time. Thus, following Löwe, the
static (or equilibrium) approach analyses the motion of the economy through time as representing
adjustments towards equilibrium.7 This is, however, not the typical feature of the cycle which in
reproducing itself does not exhibit a state to be characterized as “normal” or “equilibrium”.
Löwe’s suggested solution then was to substitute a dynamic for the static approach, and replace
equilibrium by the cyclical motion of the economy as the adequate framework of analysis.
Specifically, he identified technical progress as the driving force of the cycle responsible for
transforming the “closed system” of equilibrium economics into an “open system”.8
Hayek accepted Löwe’s criticism that the notion of an economic system characterized by
mere “adaptation” is incompatible with the explanation of the business cycle, yet he rejected
Löwe’s radical proposal. Rather, as will be discussed below, his solution lay in the introduction
of money, and of credit creation, impinging on the time structure of production, as the crucial
feature for producing—temporarily—such movements away from equilibrium that cannot be
explained by the static approach.
Yet, what is most important for an understanding of Hayek’s writings of the period, in
particular of Monetary Theory, is that in his notion of equilibrium and also in his terminology he
stuck closely to the terms as used by Löwe, and thus indirectly by Schumpeter. Hayek explicitly
6
See also Schumpeter (1908, 186; 1912, 103). Halm (1927, 126–128) in his review of
Schumpeter (1926) had pointed out that Schumpeter’s (and Löwe’s) definition of statics goes
beyond that put forward by Clark (see e.g. 1899, ch. 3).
In characterizing the “static system” Löwe (2002, 16 [1926, 179]) explicitly used the term
“stability” for describing its “tendency towards equilibrium”.
7
For the significance of Löwe’s challenge within the German debate cf. Hagemann (1994) and
Gehrke (1997); cf. also Besomi (2006) on the wider historical setting of the Löwe-Hayekcontroversy.
8
4
equated the “logic of equilibrium theory” with that of “static theory” (1933a, 42 and 43)9; it is
this equilibrium of static theory which he identified as “the object of pure economics” or of “pure
analysis” (ibid., 70),10 and of which in turn he considered the “tendency towards equilibrium”
(ibid.) a crucial feature. Similar to Löwe, Hayek also approved of Schumpeter’s characterization
of statics by a process of “adaptation” or “adjustment” reacting to a change in the economic data
(ibid., 60n. and 183). In the light of the controversies to which Hayek’s approach gave rise it is
important to clarify precisely the meaning that Hayek thereby associated with his concept of
equilibrium theory: Although he spoke of a static theory, he did not refer thereby to the timeless
equilibrium of statics in the usual sense, but to an equilibrium in time to which the economy
would return after any disturbance.11
This static equilibrium in time need not even be that of a stationary or steadily progressive
economy.12 Rather, already in 1928, Hayek had developed the notion of an intertemporal
equilibrium. Such an intertemporal equilibrium although applying to “an economic system
extended through time” (Hayek 1999a, 191 [1928a, 39]) he described as “static”: “All that needs
to be assumed for such a static equilibrium to occur is that the wants and the means of production
existing at every point in time are known to the individual economic subjects at the time they
frame their economic plan for the period as a whole” (ibid.), that is, this kind of equilibrium
requires the assumption of correct anticipations.13 Hayek related correct foresight to the changes
in economic data and he distinguished between three types of such changes, namely “those which
recur with precise periodicity; those which are of uniform tendency in both direction and extent;
9
In a footnote added to the English version Hayek (1933a, 42n.) identified equilibrium theory
with that of the Lausanne School, that is, of Walras.
Compare Hayek’s reference to “the static system as presented by pure equilibrium theory”
(ibid., 186) with Schumpeter’s assertion that “the methods of pure economics are just sufficient
[to tackle the problems] of statics” (Schumpeter 1908, xix).
10
11
Hayek (1999a, 190 [1928a, 38]) rejected the idea that the equilibrium approach could only be
legitimately applied to an economy without a time dimension, as argued e.g. by Streller (1926), a
German advocate of this view.
12
The notion of a steadily progressive economy, where all the factors of production are
increasing at a uniform rate, had become common in contemporary literature, cf. e.g. Cassel
(1932, 32–41 [1921, 27–34]).
13
Of course, the same is tacitly assumed in the analysis of a stationary state.
5
and finally those whose unique occurrence can be confidently expected for a definite point in
time …” (1999a, 200 [1928a, 47]).
It is this notion of intertemporal equilibrium that Hayek carried over into his analysis in
Geldtheorie. For example, his reference to the “static course of events” (1928b, 292 and 1929a,
71, as translated in 2002, 195)14 is to be identified with an equilibrium in time that corresponds to
intertemporal equilibrium.15
Thus, according to Hayek the domain of static theory is the analysis of an economy
through time in its movement along, or after a change in data its return to, an equilibrium time
path. This analysis conforms to the procedure of “pure economic theory”, whose object is a nonmonetary economy, that is, one which is by definition free from any possibly disturbing
influences of money. Hayek denoted such an economy by the term “Naturalwirtschaft”, that is
“natural economy” (or, as translated in Hayek 1933a, “barter economy”).16 The idea of such an
equivalence between the equilibrium of static theory and that ruling in a natural economy as
described by pure economics is attested by numerous passages, e.g. when Hayek pointed out that
“the equilibrium inter-relationships of barter economy … must always be assumed by ‘pure
economics’” (1933a, 104).17
Hayek’s solution for how to explain the business cycle within an equilibrium framework
consisted in contrasting the domains of “statics” and “dynamics”, and correspondingly the natural
economy of pure economics and a monetary economy. Ideally a monetary economy could be
imagined such that given the same economic data its equilibrium (with regard to real
The translation, “a static economy”, in Hayek (1933a, 131) is inadequate as it lacks the
reference to a movement in time.
14
15
Cf. also the numerous references to Hayek (1928a).
Wicksell used the distinction between a “monetary” and a “natural economy” already in his
Geldzins und Güterpreise (cf. 1936, 156 [1898, 143]).—The term “Naturalwirtschaft” itself
derives from the German economist and member of the Older Historical School, Bruno
Hildebrand (1864), who thereby denoted a stage in economic development (from the natural to
the money and ultimately to the credit economy). However, as used by economic theorists, it
served as a simplified model of an economy, short of the introduction of money usually to be
postponed to the final book or chapter of a treatise. Note that Mises grew sceptical of the
analytical usefulness of this kind of “barter-fiction” as he called it in Mises (1949, 202–206
[1940, 189–194]).
16
17
See also Hayek (1931, 110) for a similar passage.
6
characteristics) coincided with that of a natural economy; to such a monetary economy money the
laws of statics would apply, and money could be said not exert an influence of its own, that is, to
be neutral.18 However, due to the possibility of changes in the volume of money, e.g. by credit
creation, or more generally due to the peculiar property of money of generating “one-sided”
changes in aggregate demand, not compensated for by changes in aggregate supply, money will
ever be prone to become non-neutral.19 Such a non-neutral monetary economy will crucially
deviate from the evolution of an economy described by the law of statics: After a change in data
it will break the tendency towards equilibrium and will rather—in a “dynamic” fashion—exhibit
a movements away from it which however will turn out as unsustainable and thus must
eventually be reversed.20 It is such movements that Hayek associates with the business cycle, and
the ultimate reversals with the crisis and the depression, and it is in this sense that he speaks of
“the monetary factors which cause the trade cycle” (Hayek 1935a, xiii).21
Yet, these relationships postulated by Hayek between statics and dynamics, intertemporal
equilibrium and the time structure of production, the natural and the monetary economy, although
suggestive, even in Hayek’ own view were in need of more elaborate analytical underpinnings.
These Hayek attempted to provide in the “Geldtheoretische Untersuchungen”, a treatise on
monetary theory, to which he devoted much effort in 1929/30 before he eventually abandoned the
project. In Geldtheorie (47n., 56 and 114) Hayek referred to this future work for answering some
of the still unresolved problems in this regard.22 It is therefore to Hayek’s attempt at rendering
these missing foundations to which we now turn.
The “Untersuchungen” start at the outset with the familiar distinction between statics and
dynamics according to which static theory establishes the norm of “correct prices” and (in
The term “neutrality” originated with Wicksell (1936, 102 [1898, 93]), from where it was taken
over by Hayek (cf. 1933a, 112).
18
19
See e.g. Hayek (1933a, 107–109).
20
Cf. Hayek (1933a, 131).
21
Cf. below (#) for the details of Hayek’s elaboration of the business cycle.
22
Only the last passage escaped, apparently, the revisions of Monetary Theory, and its translation
reads: “With regard to the problems of monetary theory in the narrower sense … I hope to
publish the results of a separate investigation concerning this problem elsewhere” (Hayek 1933a,
195), yet, obviously, at this time Hayek had no more any intention to do so.
7
response to changes in economic data) of “necessary price changes”.23 This leads Hayek to the
question about the prerequisites necessary for static theory to accomplish its task of providing the
correct price signals and thereby, if required, the proper incentives for a restructuring of
production and consumption. The answer lies in the notion of “simultaneity”. In essence, in order
to derive the results of static theory, all decisions must be concentrated in a single period, such
that in this sense all supplies and demands can be expressed simultaneously in the market.
Alternatively, when the links between such closed periods are correctly anticipated, such a single
period may be replaced by a sequence:
It must be assumed that the whole economic process can be split up into closed time
periods, so that between periods all economic activities repeat themselves and within
periods all acts of exchange are concentrated on a single and as regards time and place
homogenous market. (Hayek [1929?], ch. 3, p. 21)
The price system determined in each period is capable of repeating itself indefinitely as
long as the fundamental data do not change. (ibid., ch. 5, p. 8)24
Furthermore, Hayek makes clear that by the tendency towards equilibrium in the static system he
means nothing but instantaneous adjustment:
Here any change in the data leads to an instantaneous and final adjustment, as there are
no carry-overs inherited from the past and none of the factors determining the new
prices will … cease to persist in its effects. (ibid., ch. 5, p. 8)
At this juncture in the argument we may pause and ask if with this application of the static
method to equilibrium in time Hayek had indeed as suggested (e.g. by Milgate 1979) anticipated
the present-day type of dynamic models of equilibrium with perfect foresight. The answer might
be simply that although Hayek proposed the concept of intertemporal equilibrium and associated
it with correct foresight, he certainly could not have been aware of all the logical consequences
23
Cf. Hayek ([1929?], title of chapter 4). Here and in the following all translations from Germanlanguage sources are my own, if not indicated otherwise.
24
Later on in the text, Hayek reaffirmed his position, already spelled out in Hayek (1928a), that
under the assumption of correct foresight static theory will also be applicable beyond stationary
states (cf. Hayek [1929?], ch. 8, p. 3).
8
that followed from its consistent use. For example, he did not fully recognize the logical tension
between on the one hand imposing simultaneity on decisions by restricting them to “closed” time
periods and on the other hand extending the analysis to time paths of indefinite (indeed infinite)
lengths.25 Similarly, the kind of foresight to which Hayek referred appears different from perfect
foresight (as the term is now used) in that he considered it a property of individual cognition, not
as an interactive concept to be determined simultaneously with the equilibrium time path. Still
less might we impute to Hayek the adherence to an equilibrium concept that in order to make
current outcomes determinate must attribute to the actors a commonly shared perfect foresight
stretching into the infinite future.26 In all these regards Hayek’s was a rather incomplete
anticipation, and therefore it might be legitimate not to identify his condition of correct
expectations with the perfect foresight of later coinage.27
The main challenges that Hayek perceived to the applicability of static theory consisted in
the accommodation of the elements of time and money.28 He saw both as capable of destroying
the simultaneity required by static theory: money because of its breaking up direct exchange into
two principally autonomous (and asynchronous) transactions, and time because of the timeconsuming nature of production, that is, a time structure of production as e.g. represented by
successive stages of production.29
When Hayek first introduced the notion of intertemporal equilibrium in 1928, he had
circumvented the problem posed by the time structure of production by assuming firms to be
fully vertically integrated, and thus conceived of his analysis as that of a multi-product economy
without paying specific attention to the structure of production.30 Nevertheless, he supposed that
taking account of the time structure of production just constituted a special case of intertemporal
25
The notion of a sequence of budget constraints is absent from his analysis.
26
Yet, Hayek was aware that strictly speaking perfect foresight would require that all decisions
had to be made irrevocably at the beginning of a prospective time path, calling this “the most
extreme static assumptions imaginable” (Hayek 1936, 226 and 225).
27
In his reevaluation of equilibrium analysis (Hayek 1937a) he is explicit that foresight need not
extend into the indefinite future (41–42).
28
With due acknowledgment to Garrison (2001).
29
See below (#) for a more elaborate exposition.
30
On the limited domain of the 1928 version of intertemporal equilibrium cf. Hayek ([1929?], ch.
8, p. 2).
9
equilibrium and its integration into static theory should thus pose no crucial problem.31
Furthermore, in such an economy the interdependence between the prices of the means of
production and the prices of products highlights the indispensability of correct foresight as a
prerequisite for equilibrium: the prices of the means of production are both affected by the
expected prices of products and affect themselves the actual prices of products, so that in
equilibrium of course actual future must correspond to expected prices.32
In “Untersuchungen” we find also the unique occasion of an enquiry by Hayek into the
general adjustment patterns of an economy outside the realm of static theory. In this case,
although still abstracting from the use of money,33 an immediate return towards equilibrium after
any kind of disturbance will be impossible. The reason is that now decisions must be made
successively (instead of simultaneously), giving rise to potential causes for deviations from the
static course of events: incorrect price expectations may lead to maladjustments in the structure
of production; the redistribution of purchasing power during the process may change the pattern
of demand; finance constraints may retard the reaction to changes in demand as these will only be
transmitted successively from one stage of production to the next.34 Indeed, in the presence of
such “frictions a monetary economy might improve upon the workings of a natural economy by
creating a homogenous credit market and thus by facilitating the immediate transmission of a
change in demand at one specific stage to all other stages.35
31
Cf. ibid., ch. 8, p. 3 (crossed out in the typescript). Indeed, neither here nor later did Hayek
succeeded in bringing together the intertemporal equilibrium price relationships of (consumption)
goods over time with those implied by the structure of production, that is, of the price
relationships between the various stages of production, which Hayek usually analyses under
stationary conditions, cf. e.g. Hayek (1929b [translated as 1931c], 1931a, ch. 3). For example, the
latter problem had already been solved by the interest theories of Böhm-Bawerk and Fisher, yet
the rate of interest was conspicuously absent from Hayek’s (1928a) formulation of intertemporal
equilibrium, as noted by White (1999, 114).
32
Cf. Hayek ([1929?], ch. 8, p. 2).
33
The natural (or barter) economy which Hayek here examined was a hybrid one, neither the
ideal type of static theory, yet largely abstracting from the actual frictions of direct exchange.
34
Cf. Hayek ([1929?], ch. 8, p.15).
35
Cf. ibid., ch. 8, p. 24, where Hayek explains the absence of credit markets in the natural
economy by “the lack of circulating capital that can be traded in a homogenous unit of account”.
10
The crucial outcome of this enquiry, to which Hayek alluded cursorily in Geldtheorie,36
was the distinction between the immediate adjustment of the static system and the complicated
patterns caused by the successive adjustments outside statics, even without taking account of
those peculiar properties of money prone to cause the business cycle. At best, in such a dynamic
system equilibrium will be arrived asymptotically. Yet, as Hayek noted, asymptotic adjustment
means that indeed equilibrium will never be arrived at in finite time, and more importantly, the
adjustment path with all its imponderabilities may influence the end point to which the process
converges.37
As most of the analysis in the “Untersuchungen”, just sketched, remained unfinished, it is
not clear which conclusions Hayek eventually did draw from his venture into dynamic analysis.38
In any case, the shortcomings of his attempt to provide an analytical foundation for the
application of an equilibrium framework to money and the business cycle are obvious, insofar as
he was not able to justify some of the crucial theses put forward in Geldtheorie. Thus, the neutral
money economy is conspicuously absent from the “Untersuchungen”—none of the types of
monetary economies examined had the property of providing an exact counterpart to the static
system. Nor could the analysis of a monetary economy specify inasmuch the tendency towards
equilibrium will be disturbed only when money has become non-neutral.
In this regard, later on Hayek’s quest for a proper model of a neutral money economy
came to a provisional conclusion when he contented himself with the definition of the natural
36
See the passages where the closedness, or simultaneity of decisions, of the natural economy is
contrasted with the openness, or succession of decisions, of a monetary economy, e.g. Hayek
(1929a, 47 and 56; 1933a, 93–94 and 108–109).
Note the vagueness of Hayek’s concept of a “tendency towards equilibrium”, which should not
be identified with the modern notion of “stability”. Indeed, in the 1930s definite meanings of
such concepts had yet to evolve (cf. Weintraub 1991). Possibly Hayek’s awareness of the need
for clarification in this regard gave rise to the discussions at the LSE seminar in the 1930s that led
to Kaldor’s investigation into the “determinateness” of equilibrium (Kaldor 1934).
37
In some special constellations Hayek believed that in spite of all these complications “as a
whole the tendency to a new state of rest will not be disturbed decisively” (ibid., ch. 8, p. 19), yet,
in another passage, later crossed out in the typescript, he maintained that “deviations from the …
direct tendency to equilibrium” might be possible even in the absence of money (ibid., ch. 8, p.
23–24).
38
11
economy introduced by Johan Koopmans in 1933.39 Accordingly, the reference point for neutral
money is:
the ideal type of a pure natural economy to which the laws of equilibrium theories apply
… [whose object is] a hypothetical, and in reality unthinkable, state where simultaneously
the frictions which prevent full equilibrium because of a lack of a generally accepted
medium of exchange are assumed to be absent, as well as those specific changes resulting
from the actual introduction of such a medium of exchange (Koopmans 1933, 228 and
230; emphasis in the original)
In effect, Koopmans’ solution asserted the existence of such a neutral money economy, yet
stopping short of being able to specify the conditions under which its existence could be
consistently established. Hayek was apparently ready to adopt Koopmans’ suggestion and
repeatedly referred to it approvingly, and from now on identified the reference norm of “the
equilibrium theory developed under the assumption of barter”40 with Koopmans’ “ideal type”.
However, the insufficient foundation of this central concept of Hayek’s theory made it vulnerable
to the attacks of critics.
The intricacies of the analysis and the almost insurmountable obstacles to the task Hayek
had set himself in the “Untersuchungen”, namely the integration of money and the time structure
of production into his intertemporal equilibrium framework, might be one reason why some time
in 1930 he must have abandoned the whole project. Another one might have been Hayek’s
preoccupation in late 1930 with working out the model that was due to become the core
analytical device of his lectures in Cambridge and London of January 1931.41 In any case, in
Prices and Production, which resulted from these lectures, Hayek presented a much simplified
picture. He returned to the simple dichotomy of, on the one hand, the neutral money economy of
pure theory (or statics) and its tendency towards equilibrium, and on the other hand, a monetary
economy exhibiting deviations from neutrality and thereby the typical movements of the business
39
Koopmans’ contribution appeared in a volume edited by Hayek (1933c).
40
Cf. Hayek (1999a, 228–229 [1933b, 659]).
At this time, Hayek recounted, “I had for the first time a clear picture of this theory but had not
yet gone into all the complicated details. If I had progressed in working out an elaborate treatise, I
would have encountered any number of complications ... Since I was not yet aware of the
difficulties, I gave these incredibly successful lectures” (Hayek 1994, 77–78).
41
12
cycle. There were further simplifications, too: Although not inconsistent with the general
framework of intertemporal equilibrium, for the concrete analysis in Prices and Production
Hayek resorted to its time-honoured special case, the stationary economy.42 And finally the
complexity of the time structure of production was reduced to the average period of production.43
Thus, as Hayek was to concede in retrospect, for his model of 1931 he had traded off generality
for tractability, and in the end had arrived at a very special case indeed.
Yet, Hayek’s endeavour at synthesizing the theories of money and the cycle with that of
the structure of production, that is, the theory of capital proper, went beyond the simplifications
of Prices and Production.44 For the aim of the grand project on which he embarked in the mid of
the 1930s, and which resulted eventually in the Pure Theory of Capital of 1941, was nothing less
than a continuation of the efforts started in the “Untersuchungen”: Ideally it should not only have
comprised a pure theory designed to work out the implications of intertemporal equilibrium for
an economy characterized by a time-structure of production (nota bene: not reducible to an
average period of production). Rather what Hayek strived at was a truly dynamic theory taking
account of all the complications of time, money, and the interactions of past decisions and
expectations of the future on the structure of capital. Yet, unfortunately, such a dynamic theory of
capital was not to be written, neither by Hayek, nor it appears to me by anyone else.
3. Coping with deflation
Just at the time when Hayek had entered the scene as an economic theorist in Great
Britain, the economies of the major industrial countries found themselves in the midst of what
came to be known as the “Great Depression”,45 characterized by a slump in production, high rates
of unemployment, and a fall in prices accompanied by a shrinking circulation of money.46 As
soon as the fall in prices made itself felt, a debate on the proper reaction of monetary policy
42
Nevertheless, Hayek (1931a, 26) still referred to intertemporal equilibrium as a more general
and more fruitful concept than that of stationary equilibrium.
43
On the average period, see more below (#).
44
For later references to (intertemporal) equilibrium with perfect (or correct) foresight see Hayek
(1999a [1935b], 235 and 2007 [1941], 43–47).
45
Possibly due to Robbins (1934).
46
Facts & figures.
13
evolved, in particular on whether the authorities should respond by expansionist policies and
reflation. Indeed, policies of preventing and counteracting deflation appeared to follow from
Hayek’s stance, too, as neutral money to a first approximation corresponded to a policy of
stabilizing monetary circulation. Yet, as is well known, Hayek—and most of the economists
close to the Austrian school—refrained from any such proposals and were extremely cautious
with regard to expansionist monetary policies. Therefore the question to be addressed is how
Hayek conceived of the phenomenon of deflation and why he remained so inimical to antideflation policies.47
In order to answer this question it is necessary to reconstruct Hayek’s approach to
deflation. For Hayek’s views on deflation there does not exist a single major source, rather his
remarks are scattered throughout his theoretical writings of the period while other relevant
statements are contained in short notes and articles in newspapers, magazines and similar outlets.
Hayek’s concern with deflation started in 1931, when he began discussing it with Gottfried
Haberler, Fritz Machlup and Wilhelm Röpke in a correspondence, of which unfortunately only a
single letter survived.48 Consequently, deflation had not been dealt with in the main text of
Hayek’s two monographs, Geldtheorie (1929a) and Prices and Production (1931a), however
short passages were added to the prefaces of the respective English and German versions (Hayek
1933a, 1931b). Next, some reflections on deflation and on policies directed at it are to be found
in a contribution to the Deutscher Volkswirt on the fate of the gold standard (1932a, translated in
1999a), which originated from an unpublished letter to The Times,49 and in a comment on the
current monetary policy of the Fed (Hayek 1932b). In 1933 Hayek devoted a section of his
contribution to the Spiethoff Festschrift (1933c, translated in 1939a) to the problem of secondary
deflation, and dealt with reflation in a short paper destined for the London General Press (Hayek
1933d), yet only published the other year in German in an abridged version in the Viennese daily
Neues Wiener Tagblatt (1934d). The issue was once again taken up in some detail in Hayek’s
(1934a) reply to a survey article by Hansen and Tout (1933), included as an appendix in the
revised second edition of Prices and Production (1935), which otherwise contained no
47
The related question of the norm for the secular movement of prices in the presence of
technical progress will be dealt with in a separate section.
48
Hayek to Haberler (December 20, 1931), Gottfried Haberler Papers, box 65.
49
Now reprinted in Hayek (1965, 28–30).
14
modifications of his views on the mechanism of depression. After discussing the limits set for
monetary policies within a framework of an international monetary system (Hayek 1937b),
Hayek for a last time returned to the topic of deflation in connection with the Ricardo effect
(Hayek 1939b).
As has already been pointed out before, according to Hayek’s theory the cause of the
crisis is the maladjustment in the structure of production initiated by the boom, such that the
period of production (representing a measure of capital intensity) has been lengthened beyond
what can be sustained by the rate of voluntary savings. The necessary relocation of resources and
its consequences constitute the crisis and the depression. Thus, the “primary” cause of the crisis is
this kind of “capital scarcity” while the depression represents an adjustment process by which the
capital structure is adapted. This process can, but need not, be accompanied by deflation. In this
specific meaning Hayek speaks of deflation as being “secondary”, for example, when referring to
“these (in a methodological sense) secondary complications which arise during the depression”
(1939a [1933c], 175), or maintains that “the process of deflation represents only a secondary
phenomenon caused by this [misdirection of production]” (1999a [1932a], 165).50 It should also
be clear that Hayek adhered to what just then started to become an idiosyncratic definition of
deflation, that is, deflation meant a decrease in (the circulation of) money as opposed to the more
common meaning of a decrease in prices (or the price level).51
A full understanding of the primary-secondary distinction as well as the policy
conclusions drawn from it requires a short investigation into contemporary German debate. The
origin of the terms derived most probably from Schumpeter, who in his writings on the business
cycle had distinguished from the outset between two types of liquidation (or depression): normal
and abnormal, primary and secondary, or later on between recession and depression.52 In this
vein, Röpke and Haberler used the distinction—often using “depression” and “deflation”
In a different context Hayek had already used the term “secondary” in Hayek (1999a, 215
[1928a, 63]); the first use of “secondary deflation” is in Hayek (1931b, xi; cf. also 1933a, 19;
1934a, 154).
50
51
The “circulation of money” refers to MV, the “left hand-side” of the quantity equation.
52
Cf. e.g. Schumpeter (1912, 455; 1926, 337 and 348; 1934, #). A similar notion was present in
Robertson’s distinction between “appropriate” and “inappropriate fluctuations in output”
(Robertson 1926, chs. 2 and 4), and Keynes used the terms “primary” and “secondary” in the
Treatise on Money (1971 [1930], 254–259).
15
interchangeably—to denote two phases of the cycle.53 The primary depression is characterized by
the reactions to the disproportionalities of the boom, and accordingly an important cleansing
function is ascribed to it; thus it is necessary to allow the primary depression to run its course. In
contrast, the secondary depression refers to a self-feeding, cumulative process, not causally
connected with the disproportionality that the primary depression is designed to correct. Thus the
existence of the secondary depression opens up the possibility of a depression phase
dysfunctional to the economic system, where an expansionist policy might be called for.54
Typical elements of the secondary depression are both deflation as an endogenous shrinkage in
the circulation of money and the vicious spiral of reductions in income and expenditure chasing
one another. Put into an equilibrium framework, the primary process is akin to an adjustment
directed towards equilibrium, the secondary process to its overtaking by a movement away from
equilibrium. Thereby, in the secondary depression criteria derived from equilibrium are prone to
mislead: with economic activity at an unprecedentedly low level “there will scarcely be any
investment that will not turn out to be a ‘faulty investment’”, and “there will hardly be any wages
which are not too high” to ensure profitable production (Röpke 1936, 130).
Looked at against the background of this debate, Hayek’s point of view is different in that
he does not consider deflation an indispensable element of the depression, links secondary
deflation with the existence of rigidities, and as a rule is anxious in advising against policies
directed to combat deflation.
Taking up the first point, Hayek entertains an agnostic position on the necessity of
deflation as an element of the adjustment process. With regard to the heavy fall in prices, of
which he was aware in 1931, he considered such a price fall, even of a strength so as to
undershoot the “non-inflationary” price level,55 as a typical feature of the depression, yet as one
that could be perfectly explained by “real” factors, that is, by a temporary excess supply of
consumers’ goods, e.g. from distress sales. In any case, he makes clear that the cause of the price
Röpke first used it in a review of Keynes’s Treatise (1931, 1746–1747), and then in his
monograph on crises and cycles (1932, translated 1936); cf. also Röpke (1933) and for a
summary Haberler (1934, 17). Outside Germany Dennis Robertson and Jacob Viner might be
listed as prominent adherents. For more details see Klausinger (2006).
53
54
See Klausinger (2006, 636).
55
That is, the price level that would have come about with a constant circulation of money. Note
that in this case technical progress would have required a fall in the price level.
16
fall at this early stage of the depression need by no means be sought in monetary factors, as
would be typical for adherents to “the ‘mechanical’ quantity theory” (1931b, xi).56 And on
another occasion he reiterates that: “The deflationary tendencies … are not a necessary
consequence of any crisis and depression” (1934a, 159–160). Furthermore, one might draw on
Hayek’s distinction, though part of an argument against reflation, between the harmful effects
stemming from changes in the price level (if generated by changes in monetary circulation) and
the irrelevance of the level itself.57 Hayek held to this view even after having taken into account
the distorting effects of an unexpectedly low (or high) price level on the redistribution of wealth
between debtors and creditors in the presence of long-term contracts fixed in terms of money.
Although Hayek turned these arguments against the belief in the need to reflate a price-level that
had fallen below its pre-depression level, it may be legitimately applied to the reverse situation of
an inflated price level (and circulation of money) in the boom. This is also reaffirmed by Hayek
(1933d, 2) pointing to “the evil effects” of Great Britain’s attempt after World War I “to use
deflation in order to restore prices to their pre-war level”.58 Accordingly there is no prima facie
proof that Hayek considered the return to a specific price level as indispensable for the task to be
fulfilled by the depression.59 However, there is also some evidence to the contrary: For example,
Haberler in his survey of business cycle theory lists Hayek among those who are “of the opinion
that the deflation is a necessary consequence of the boom” (1937, 59). The widely circulated first
draft of this survey (had included a similar characterisation Haberler 1934, 17), and yet Hayek in
a lengthy comment had not objected to this specific passages, although he had done so for
example on the subject of secondary deflation.60 In sum, no strong case can be made for either
position so that the designation of Hayek’s view as agnostic seems justified.
The idea of necessary deflation may be arrived at a different route when taking an open
economy, being part of the system of the gold standard, as the starting point. Then, after an
56
See also Hayek to Haberler (December 20, 1931).
57
Cf. Hayek (1933d, 1934d).
58
Yet, note that in contrast Machlup in 1933 was ready to accept the decrease in U.S. banking
deposits to its pre-inflation level of the 1920s as a “necessary consequence” and warned against
“deflation hysteria” (Machlup 1933, 317).
See White (2008, 753-754) for an opposite view based on the notion of an “unsustainable”
price level “given a fixed gold parity”; see also the next paragraph.
59
60
Cf. Hayek to Haberler, September 4, 1934, Gottfried Haberler Papers, box 66.
17
inflationary boom the condition for external equilibrium would force the return to a price level
consistent with purchasing power parity by means of deflation.61 Yet, the relevance of this
observation for Hayek’s approach towards deflation appears questionable. The single most
important argument against its relevance is just that Hayek did not say so, at least not prior to his
lectures on Monetary Nationalism (Hayek 1937b). Yet, 1937 was just when Hayek’s discussion
of deflation had come to a provisional conclusion, when deflation had ceased to be a topical
problem of economic policy, and when after all the last countries had left the gold standard.
Furthermore, Hayek had conducted all his analysis of the business cycle without taking account
of the complications of an open economy, and when speaking of the neutrality of money had
made clear from the outset (cf. e.g. Hayek 1999a, 220 [1928a, 69]) that it applied either to a
single closed (“isolated”) economy or to the world as a whole, yet not to an open economy as part
of an international monetary system. Thus, although concern with such a type of deflation within
the system of the gold standard appears justified, we do not find it in Hayek’s writings on
deflation.62
Having thus disposed of the necessity of deflation, how then did, in Hayek’s view, a
secondary deflation develop and what would have been the adequate policy responses to it? Here
the main point which Hayek reaffirms in any of his statements is the existence of “wage and price
rigidities”:
There can be little question that these rigidities tend to delay the process of adaptation and
that this will cause a ‘secondary’ deflation which will at first intensify the depression but
ultimately will help to overcome these rigidities. (1939a [1933c], 176)
From this passage (and from similar other ones) we can conclude that the remedying
effect of the (primary) depression could be successfully fulfilled, if there were not the obstacle of
rigid wages and prices. And that, in turn, it is the delay in this adaptation of the economy due to
rigidities that gives rise to secondary deflation. Thus, this deflation “is not a cause but an effect of
White (2008, 757) identified the deflation required by the gold standard as Hayek’s “initial” in
contrast to “secondary deflation” (see below the quotation from Hayek 1939a [1933c], 176).
61
The situation might be different for Hayek’s colleague, Lionel Robbins, whose arguments
against reflation in Great Britain were based on his worries about the repercussions on the
exchange rate (cf. e.g. Robbins 1932).
62
18
the unprofitableness of industry” (Hayek 1933a, 19).63 The most important rigidity in the
economic system to which Hayek referred is presumably the stickiness of wages. For in order to
bring the structure of production as inherited from the boom into accordance with the structure of
demand, a reduction of production costs and of the demand for consumers’ goods is required,
both to be furthered by wage cuts. Deflation by its effect on demand and unemployment may
perform a useful function in exerting pressure on wages, and thus contribute to the breaking up of
these rigidities.
Nevertheless, as Hayek notes, the policy conclusions to be derived from this supposition
are not clear-cut, but depend on the answers to two more queries, namely:
[F]irstly, whether this process of deflation is merely an evil which has to be combated, or
whether it does serve a necessary function in breaking these rigidities, and, secondly,
whether the persistence of these deflationary tendencies proves that the fundamental
maladjustment of prices still exists, or whether, once that process of deflation has
gathered momentum, it may continue long after it has served its initial function. (1939a
[1933c], 176)
On the first point, Hayek rejects any measures directed against deflation unless its
function has been fulfilled in eliminating the imbalances that had given rise to the crisis. He
expresses this most clearly on one of the first occasions to discuss this issue:
If deflation is induced [by the lack of profitability], then it will only stop when the costs of
production have decreased stronger than prices, and where this is not the case, combating
deflation will only delay the movement towards a new equilibrium. (Hayek to Haberler,
December 20, 1931)64
63
Hayek did not explicitly specify the link, the economic mechanism, whereby these rigidities
generated a process of deflation. Banning deflationary policies (as Hayek did), endogenous
deflation could be attributed to hoarding (which Hayek relegated to the special case of “induced”
deflation, see below) or to the contraction of credit (Schumpeter 1939, 156, referred to such a
process as “autodeflation”).
64
Cf. e.g. similar passages in Hayek (1932b; 1933a, 19).
19
In particular, he accused the experiments of expansionist monetary policy that he discerned in the
United States in 1931/3265 as having delayed adjustment and thereby contributed to the length
and depth of the depression.
On the second point, Hayek did not take a definite stand, yet as a rule opted in his
prescriptions for caution, that is, against expansionist measures that could turn out as ill-timed.66
The problem of policies directed at stopping deflation lay in their similarity to “homoeopathic”
treatments, fighting the disease by a small dose of the means that caused it. Thus the danger must
be accounted for that the alleviation of the current depression might be traded off against the
exacerbation of the next one.67 In a similar vein, in the connection with the Ricardo effect Hayek
(1939b, 57–60) contrasts the unsustainability of full employment to be reached by expansionist
policies with the lower but stable level of employment arrived at otherwise, and likens the
attempt to aim at short-run maximum employment to “the policy of the desperado”—yet, in
special circumstances, like that of Germany in 1932, when there was severe deflation, even such
a policy could be justified (ibid., 64n.). Finally, it should be noted that Hayek, like most
contemporary economists, had to base his policy recommendations on much less reliable
empirical data, e.g. on monetary aggregates, than are now available. Yet, there is no conclusive
evidence that knowledge of such data would have modified his views.68
There is, however, one exception where Hayek was more ready to accept an active role
for expansionist policy. This is the case of “induced deflation”, or more specifically, of a
deflation of a self-reinforcing character due to “a general expectation of a continued fall of
prices”, which may give rise “to peculiar effects” in contradiction to the normal working of the
economic system (1939a [1933c], 177).69 These effects result from hoarding, and inasmuch as an
Cf. e.g. Hayek (1999a [1932a], 165; 1933a, 20). Of course, Hayek’s view is opposite to the
monetarist view of the Great Depression as caused by a “great contraction” in the money supply
(cf. Friedman and Schwartz 1963, ch. 7).
65
66
If on the one hand the harmful consequences of a premature implementation shall be avoided
and on the other hand such policies make no sense once deflation has stopped of its own, this
leaves only a narrow corridor of time anyway.
Cf. e.g. Hayek (1932b; 1934a, 154). The metaphor of “economic homoeopathy” is due to
Robbins (1932, 1081).
67
68
Cf. on this Klausinger (2005).
69
Cf. also Hayek (1934a, 158).
20
anti-deflation policy can bring about dishoarding that adds to the supply of saving and thus
mitigating the scarcity of capital, there was a chance of success for such “unorthodox” policies.
Yet, apparently, such success was predicated on a combination of circumstances rarely to be
fulfilled.
In any case, it was a characteristic feature of Hayek’s approach to deflation that he did not
succeed, or arguably even never felt the urgent need, in integrating it consistently into his
framework for explaining money and the cycle. Rather, his pronouncements on deflation
appeared as a series of afterthoughts. Significantly, he failed to relate his policy recommendations
towards deflation to the theoretical concept of neutral money, or to his more general discussions
on the aims of monetary policy.70 The reason might be found in that the notions of neutral money
or of a natural rate of interest, by their very nature, could only be legitimately used (or even
defined) with respect to a state of equilibrium. Yet, for an economy in depression, with a
maladjusted structure of production and price expectations that had lost their base in a firm view
of the future, these concepts became equivocal. As Robertson succinctly remarked in this regard:
Normality, and its symbol the ‘natural rate of interest’, seem to be like a path which is
plain enough to see while you are treading it, but which is exceedingly difficult to
rediscover once you have strayed away from it. (Robertson 1933, 239)
Consequently, Hayek would never have denied that starting from a state of equilibrium
deflationary developments had to be counteracted, or that deflationary policies should not be
actively pursued. Yet, things became much more complicated in the disequilibrium situation of
the depression: Deflationary policy on behalf of the monetary authorities was still to be rejected,
yet the existence of a kind of endogenous or secondary deflation appeared to constitute a much
less clear-cut case. Similarly, Hayek’s equilibrium-based theory simply could not provide the
tools for ascertaining the proper value for the money rate of interest (quite apart from its natural
value) to be set in midst of a depression.71 Faced with these insurmountable obstacles for deriving
70
Hayek was aware of the importance of other aspects besides neutral money, e.g. the stability of
the value of money in relation to long-term money contracts, when formulating monetary policy
(cf. Hayek [1929?], ch. 2, 16; 1999a [1933b], 230). Yet, in the case of deflation recognition of
these additional aspects should have made policy more, not less active in combating deflation.
71
Machlup (in a letter to Hayek, December 11, 1934, Friedrich Machlup Papers, box 43, folder
15) addresses this problem asking: “Which movements does the ‘natural rate’ make in the
21
concrete policy recommendations from the theoretical framework, Hayek eschewed the
“mechanical” application of constructions like neutral money, and in his ventures into policy
advice, ever preferred to err on the conservative side. Thus, when in doubt, he was inclined to
advise against expansionist policy or reflation.72
Hayek’s caution in this regard probably did not only derive from the theoretical model
employed, or rather from the lack of it. The speculation appears justified that equal importance
should be attached to his imputing to policy-makers an ever present susceptibility to inflationism,
the harmful consequences of which were all too present in his memory of the hyperinflations that
had haunted Central Europe in the 1920s. Moreover, in the face of the onslaught on economic
liberalism in so many Western countries, Hayek was not ready to sacrifice the adherence to sound
money, as a pillar of economic liberalism, to what he must have perceived as mere short-term
exigencies.
Summarizing the evidence, it appears that deflation was not an essential element of
Hayek’s theory of the cycle, nor in his view of the cleansing function of the depression. Yet, in
the presence of rigidities a secondary deflation might develop, which in breaking those rigidities
and in reestablishing a sustainable structure of the economy could play a useful role. As long as it
did so, and did not degenerate into an induced deflation driven by expectations of falling prices,
deflation should not be counteracted. Furthermore, such changes in the nature of deflation were
difficult to discern, and thus attempts at combating deflation were as a rule prone to be
premature, or excessive, and thereby the causes of new maladjustments. Consequently, the
utmost caution was required in advocating anti-deflationary measures, and indeed Hayek never
advocated any of them in practice.73
depression? What is the value of the equilibrium rate of interest before costs have been adjusted,
that is, the rate of return on capital is negative?” Note that when Hayek (1934c) proposed a
proper level for the rate of interest in Great Britain in 1934, he argued for raising it to the
expected future equilibrium level.
In marked contrast to Pigou (1933), the Keynesian archetype of a “classical economist”, who
had recommended: “When in doubt, expand.”
72
In retrospect Hayek recanted his earlier position on deflation stating flatly: “Such a ‘secondary
depression’ caused by an induced deflation should of course be prevented by appropriate
monetary counter-measures” (Hayek 1978, 210). Yet, in the light of the evidence presented above
it is difficult to agree with him, or with White (2008, 764–765), that his views of the 1930s were
primarily based on “political considerations”.
73
22
What then were the consequences of Hayek’s policy recommendations, emanating from
his view of deflation, in the face of the Great Depression? As regards actual policy-making, the
influence of Hayek, joined by Robbins and other members of the LSE faculty,74 must not be
overrated. Specifically, in Great Britain when Hayek arrived at the scene, most of the drama—
e.g. the pound’s going off gold—had already happened, and in general the resistance against
expansionist measures of fiscal and monetary policy in these days owed more to the conservative
“gold standard mentality”75 of politicians and bureaucrats than to the teachings of economists.
Although Hayek was anxious to put his weight behind the liberal agenda in public discussion,
there is little evidence for any direct impact on the policies of the 1930s, neither in Great Britain
nor in the U.S.76
On a different level, however, Hayek’s position on deflation and on the policies towards
depression had vital consequences indeed. For this became one of those fields where Hayek’s
view ever more evolved into stark opposition to the majority of public, and also of educated,
opinion. It has already been noted that with regard to the handling of secondary deflation (or
depression) there had been diverging opinions even within the Austrian school, as voiced e.g. by
Röpke and Haberler. Concentrating on Great Britain, it is easy to ascertain that in public debates
on monetary policy and reflation, or similarly on saving versus spending, Hayek and his
followers were soon outnumbered by the critics. It is important to note that this was true already
before the Keynesian revolution, and that the critics also included economists friendly to the
liberal cause.77 Significantly, at the end of the decade, although the Keynesian revolution had
reopened another cleavage among economists, Keynes’s adherents versus those denounced as
“classical economists”, Hayek remained almost alone in defending the Austrian position on
money and the cycle.78
74
Cf. the joint letter to The Times (Hayek et al. 1932) in response to MacGregor et al. (1932).
75
As has been argued by Eichengreen and Temin (2000).
76
On the U.S. see White (2008).
77
Cf. e.g. the broad support gathering behind a policy of reflation, as e.g. in the letters drafted by
Harrod and published in The Times (cf. Besomi 2003, items P3 and P4). Note also that in a letter
in favour of “wise spending” (instead of saving) Pigou (1932) was able to maintain that “on this
matter, economic opinion is practically unanimous”.
Klausinger (2008) tells the story of Kaldor’s evolution from disciple to adversary. See also
Howson (2008).
78
23
However, it would be an oversimplification to attribute Hayek’s failure only to lack of
political expediency, that is, to his unwillingness to offer the public a “tract for the times” that
suited the “trend of economic thinking”. In the end the crucial failure was theoretical, namely the
failure to integrate the phenomenon of deflation (and its secondary effects) into his theory of the
cycle, and to work out a theory of the depression on a par with his explanation of the upper
turning point, which many of the critics would have been ready to accept.79 In its narrow focus on
equilibrium, and on the real maladjustments caused by inflation and to be remedied by the
depression, Hayek’s theory completely neglected the possibility that under special circumstances
market processes might lack the supposed tendency towards equilibrium, due to a failure of
“effective demand”.80 Austrian economists like Haberler and Röpke had tried to supplement the
Hayekian core of the Austrian approach with a theory of secondary depression, thus
incorporating into the theory of the depression both functional market adjustments (as a rule) and
dysfunctional ones (as an exception). In the end, however, for the next decades to come the
Keynesian approach prevailed, that is, as seen from the Austrian point of view, an approach
based on a belief in the generic dysfunction of the market system.
4. The Ricardo effect and the stability of full employment
When in 1938 Hayek was busy working on the Pure Theory of Capital, he planned to
include a sketch of what a dynamic theory in a monetary setting was supposed to look like. Yet,
this sketch soon evolved into a separate piece of work on its own. The next year he wrote to
Machlup:
I have worked since Christmas on a great essay on business cycle theory. Originally it
should have been the final chapter of my capital book, yet it has grown far beyond that
and will now be published in a volume of essays under the title Profits, Interest and
Investment.81
Cf. Haberler’s critical treatment of Hayek’s theory of the depression (Haberler 1934, 17; 1937,
57–61). Still in 1934, Haberler (in a letter to Hawtrey, October 17) understood that with regard to
the analysis of the depression “he [Hayek] himself has modified his ideas in this respect very
much”—yet must have been disappointed by the revised edition of Prices and Production.
79
80
Cf. Lachmann (1939, 68) for a perceptive interpretation.
81
Hayek to Machlup, April 4, 1939, Fritz Machlup Papers, box 43, folder 15/16.
24
This is the origin of the title essay of Hayek (1939a), which introduced the Ricardo effect82 as a
novel element into his theory of the cycle. Three years later, reacting to criticism,83 Hayek (1942)
supplemented his essay by an attempt at clarification. These two essays became for a long time
Hayek’s last words on the subject of the business cycle, and in fact their reception turned into a
formidable fiasco, and to some extent rightly so.84 In the following we investigate the conundrum
of the Ricardo effect.
Although Hayek (1939b) occasionally alludes to his objecting the thrust of recent writings
by Kaldor (1939) and of Keynes’s General Theory (1936), the real target of his essay is the view
of investment as a derived demand, and thus of increases in consumption bringing forth of
necessity increases in the demand for investment goods. Evan Durbin, one of Hayek’s colleagues
at the LSE, had referred to this presumption as the “English view” (Durbin 1933, 147).85 Indeed
as Durbin’s overall approach provides in some respects the background against which Hayek’s
attempt is to be understood, a short sketch of it appears worthwhile.86 Durbin subscribes to part of
Hayek’s explanation of the cycle in considering inflationary induced overinvestment as the cause
of structural maladjustment, yet differs from Hayek in two respects: First, conforming to the
82
As pointed out by Kaldor (1942, 364–367) the attribution to Ricardo is in fact a misnomer; cf.
also Gehrke (2003).
83
Cf. Kaldor (1939), Wilson (1940), and even Haberler (1941, 481–491).
84
Cf. the devastating critique by Kaldor (1942). Hayek himself appears not to have felt satisfied
with his work: He noted that his preoccupation with other topics (his Abuse of Reason project and
the nucleus of The Road to Serfdom) made it “more and more difficult to keep up with current
economic literature”, and that his task as editor of Economica “forced [him] again and again
(already with the Ricardo effect) to bring things out before I am really ready” (Hayek to
Machlup, July 31, 1941, and August 8, 1942). It seems also plausible that at this time Hayek
suffered from bouts of capital theory-fatigue. From January to March 1941 he discussed the
Ricardo effect and some issues of Keynesian theory in correspondence with Joan Robinson,
ultimately giving rise to the memorable exclamation that: “It would be easier to clear up
differences if you could believe that one could differ from you without being a complete fool. But
I have read too much monetary controversy to be either surprised or offended” (Hayek to
Robinson, March 24, 1941, Joan Violet Robinson Papers, 7/194).
Accordingly, “the demand for capital is derived from the price level of consumption goods”
(Durbin 1933, 149).
85
86
During the 1930s Durbin gave a regular course on business cycle theory at the LSE (cf.
Howson 2008). His 1933 book was followed by another on credit policy (Durbin 1935), where he
advocated the social control of credit. In the debate on socialist economic calculation he figured
as a proponent of “market socialism” and as Hayek’s opponent in this respect, cf. Caldwell
(2007, 24–28).
25
“English view” he posits that increases in the price level of consumption goods positively affect
the demand for investment goods, and, secondly, he uses as the starting point of his analysis of
the cycle an economy with unused resources. Consequently, he disagrees with Hayek’s 1931
view on the upper turning point. According to Durbin, it is not the shift towards consumption—
which in his view rather stimulates than stifles the demand for investment goods and sets in
motion a cumulative process of inflation—but the end of monetary expansion that makes the
boom collapse. Thus he characterises the boom by credit creation ongoing at a money rate of
interest below the natural rate and taking place in the face of considerable surplus capacity in the
investment goods sector, yet with capacity in the consumption sector rapidly becoming scarce. As
long as inflation is permitted to rise continuously, there is nothing like a “natural end” to the
boom, yet when sooner or later inflation is stopped, the crisis sets in. For the depression phase
Durbin advises against inflation, which would only aggravate the problem of the top-heavy
structure of the economy, but sees the solution either in wage cuts (in favour of saving) or in a
rebalancing of the sectoral structure, that is, a shift from the production of capital goods to that of
consumption goods. Yet he is doubtful on the practicality of the latter solution because of the
well-known obstacles to the mobility of labour (in Great Britain) (cf. Durbin 1933, 180–183).
Hayek’s aim in 1939 is to give a more general explanation of the upper turning point, and
of the cycle as a whole, than in his earlier work. Accordingly, Hayek (1939b, 5–6) assumes credit
elastically supplied at a given rate of interest and unused resources of labour, immobile between
sectors (or stages);87 in the boom the scarcity of labour makes itself felt in the consumption well
before the investment industries; and the money wage is rigid. Finally Hayek stipulates a relation
between consumption and investment demand conforming to the “English view”, or what he
(ibid., 18–20) termed, misleadingly, “the acceleration principle”. All in all, a family resemblance
of Hayek’s model to Durbin’s can hardly be missed.88 The new features of the model are crucial
87
Hayek (1939b) distinguishes between industries producing consumption and investment goods
and moreover between different stages of production within the investment sector. In the
following we will use as a short-cut the terms consumption and investment “sectors”, and by
“investment demand” we will denote the demand for the goods produced and for the means
employed in the various stages within the investment sector. We follow Hayek in denoting stages
as “later” or “earlier” according to their distance from consumption, the stage producing
consumption goods being the “last” stage.
Moss and Vaughn’s (1986, 557) attribution of “standard Keynesian assumptions” to Hayek’s
model appears less convincing.
88
26
for explaining the upper turning point. For without credit creation and with the circulation of
money fixed, eventually the rate of interest will rise sufficiently to choke off investment demand.
Alternatively, when there is full employment of resources, physical constraints will keep the
output of investment goods from growing (except, at the expense of consumption goods), and at
the same time wages will start rising.89 Thus in this latter scenario unlimited credit creation
would end up in (accelerating) inflation, and the moment an attempt were made to stop inflation,
by raising the interest rate, the boom must break down. Yet, what Hayek is now set to prove is
the inevitability of the breakdown of an inflationary boom, even when these limiting factors are
absent, that is, with unlimited credit creation (given rate of interest),90 and with less than full
employment. In this regard, Hayek’s model of the Ricardo effect is not in contradiction to his
earlier view, but is designed as supplementing it.91
Thus the core of the model is built by the relationship between consumption and
investment demand where Hayek combines the Ricardo effect with the working of the
accelerator. Consequently, on the one hand an increase in consumption demand (raising prices
and profits in the consumption sector) leads via the mechanism of the accelerator to an increase
in investment demand. On the other hand, Hayek posits that a rise in the profit rate will induce a
less capitalistic structure of production, the Ricardo effect.92 Thus the aggregate change in the
demand for investment depends on the interaction between these two effects. Now Hayek argues
that inevitably, some way before full employment in the investment sector is reached, the Ricardo
effect will overcompensate the accelerator, so that in aggregate the demand for investment
89
In this case, a positive relationship between consumption and investment demand, of course,
does not imply that in the course of the process consumption output would be reduced to zero (cf.
Hayek 1942, 144; 1969, 284–285). Hayek’s belief in the Ricardo effect as necessary to keep
consumption from shrinking to zero appears to be based on the confusion that the negative
relationship between the (equilibrium) outputs of consumption and investment goods (at full
employment) is predicated upon a negative relationship between the corresponding (ex ante)
demands.
90
The experience of a long period of low and stable interest rates in Great Britain might have
convinced him of the new version being more “realistic”.
In this regard, Kaldor’s (1942, 361) allegation that Hayek’s new view is in contradiction to his
earlier one is ill-founded.
91
“Less capitalistic” is used synonymously with “less capital-intensive”, “less roundabout” or
with denoting “shorter processes” of production, all these implying the use of a scalar measure of
capital. Hayek (1942, 131) introduces the concept of the “rate of turnover” (as the reciprocal of
the average period of production) to describe the structure of capital.
92
27
decreases thereby initiating the crisis. However, as we will see, the Ricardo effect will not be able
to do the work it is supposed to do. It will either be ineffective, or effective only in those
circumstances where it cannot overcompensate the accelerator.
Before going into detail, some peculiarities of Hayek’s construction of the accelerator
shall be pointed out. First, it is not unequivocally stated in the text, yet certainly can be imputed
to Hayek without doing violence to his intention, that what should be accomplished is the
explanation of the change, not the level, of investment demand. Consequently, the outbreak of the
crisis is to be attributed to a decrease in investment demand, not to its falling short of a specific
level. Secondly, although Hayek uses the term “acceleration principle”, his formulation does not
correspond to the usual presentation of this hypothesis. Again, deriving from his preoccupation
with the “English view”, he conceives of it as a relation between the levels of consumption and
investment, whereas the accelerator maintains such a relation between consumption and the
capital stock (in the consumption sector), and thus between the change in consumption and (net)
investment, or the (planned) change in the capital stock.93 Another point for reflection, to be
postponed after the discussion of the Ricardo effect proper, is how Hayek’s assumptions on the
structure of production accord with his use of the accelerator.
The purpose of the Ricardo effect is then to present the reaction of the structure of
production to an increase in demand of the final product, the consumption good. In Hayek’s
framework when the demand for consumption goods increases, this means an increase in prices
due to an inelastic supply. With the money wage (and the rate of interest) given by assumption,
the product wage in the consumption sector must fall and the profit rate rise. For this case, Hayek
shows by means of a numerical example (cf. Hayek 1939b, 9) that if goods are produced by
simultaneously utilizing processes of different capital intensity, then due to the lower product
wage the profit rate will rise for all these processes, but will rise the largest in the least capitalistic
processes. Thus the less capitalistic the processes the more profitable have they become through
the rise in prices. It is this observation on which Hayek bases the Ricardo effect, that is, the thesis
that for a given wage and rate of interest a rise in the profit rate will induce the transition to a less
capitalistic structure of production.
93
This misconception is the more astonishing as Hayek (cf. 1939b, 50n.2) refers approvingly to
Frisch’s (1931) formulation of the accelerator, which is crystal clear in this respect.
28
Hayek is explicit in pointing out that with the Ricardo effect the profit rate fulfils the task
that he in his earlier writings had ascribed to the rate of interest (Hayek 1939b, 39n.). This
statement, however, when critically examined, proves indeed alarming. Already at first glance, it
appears doubtful that a firm should respond to a rise in the revenue (and with given costs, the
profits) it expects to accrue from a production process, that is, to a rise in the rate of profit, in the
same way as to a rise in the costs of financing this process, that is, to a rise in the rate of interest.
A comparison between the mechanism supposed to work in Hayek’s earlier writings (e.g. Hayek
1931a) with that of the Ricardo effect facilitates the understanding of the problem. According to
the earlier model, for simplicity’s sake starting from a stationary equilibrium, a decrease in the
money rate of interest leads to an excess of the profit rate over the money rate; with unchanged
prices (of products and means of production) all the activities that hitherto have generated zero
profits now become profitable, which induces an increase in the scale of those activities, and
simultaneously a switch to longer processes. Abstracting from monetary complications, the
increased demand will raise the prices of the means of production, and of wages, and thus
reestablish the zero profit condition.94 The reverse will happen when the money rate increases:
Profits turn into losses, and there is an incentive to switch to shorter processes. This is, by the
way, Hayek’s explanation of the upper turning point and of the crisis in Prices and Production.
Now taking Hayek’s model of 1931, would it exhibit a Ricardo effect? An increase in
prices and thereby in the rate of profit will again make all activities profitable (or more profitable
than before), and thus increase the demand for all means of production, that is, demand directed
at all the preceding stages of production. Moreover, with the rate of interest fixed, there is no
incentive for capital intensity to change. Thus placing the Hayekian firms of 1931 into the
Hayekian economy of 1939 would not give rise to a Ricardo effect. For, indeed, the numerical
example on which Hayek based his argument is deceptive. After the rise in product prices the
profit rates in all (shorter and longer) processes, although to a different extent, exceed the rate of
interest. Thus it is profitable to increase the scale of activities in all these (shorter and longer)
processes, and that until the (marginal) rate of profit has been brought down to the rate of
interest—which is, of course, how a profit maximum is achieved. Moreover, with the rate of
In Hayek’s (1931a) flow-input-point-output-model the permanently lower rate of interest
results in a higher real wage made possible by the more productive use of labour in “longer”
processes.
94
29
interest unchanged, the profit maximum will be arrived at the same structure of production as
before. In the contemporary terminology of Hawtrey (1937), the increased demand for
consumption goods will bring forward “capital widening”, but no “capital enshallowing”.95
An alternative and instructive way to arrive at the same result is to look at the situation of
a firm producing consumption goods and using as inputs besides labour the products of all the
preceding stages of production.96 The condition for a profit maximum requires that for labour and
each of the products of the earlier stages the discounted value of its marginal product be equal to
its price.97 Of course, the same applies at all the other stages of production. Then, a rise in the
price of the consumption good creates an excess of the discounted value of the marginal products
over the respective prices and thereby will as a rule give rise to increased demands for the
products of all stages. In turn the outputs and/or the prices in these earlier stages will rise, and
thus the increase in demand will spread from the later to the earlier stages. It is also obvious from
these conditions that a rise in the rate of interest would work just in the opposite direction.
Although one must be aware that due to possible interdependencies between the marginal
products “unexpected outcomes” might ensue,98 a Ricardo effect cannot be derived from this
model.99
Thus it seems plain that the Ricardo effect cannot be rescued in the context of Hayek’s
original model. However, in his reponse to this kind of criticism Hayek (1942) came forward
95
The above amounts, of course, just to a reformulation of the criticism by Wilson (1940) and
Kaldor (1942). For a reevaluation of the criticism on the Ricardo effect see also Blaug (1996,
521–527).
96
This is the description in Hayek (1939b, 21–23); accordingly, the input-output-matrix of the
economy will be triangular.
The formula for the stage of consumption goods, pMPi  pi (1  r ), which is implied in
Hayek’s discussion of the “price fan” (Hayek 1931a, 1935), had already been hinted at by
Taussig (). (i = 1…n indicates the products of the respective stages of production, i = n+1
denoting labour, p(i) the respective prices, p the price of the consumption good, MP the marginal
products, and r the rate of interest.)
97
98
In particular, when taking the results of the Cambridge capital controversy into account, to be
dealt with in another section.
99
If the scarcity of labour keeps the rise in labour demand from being realized and thereby its
marginal product from falling, nevertheless such a situation would be associated with an excess
demand for the other means of production.
30
with the idea of placing firms in a different setting than usual. He argues that the traditional
assumption of perfect competition is unrealistic, in particular with regard to credit markets and
the pervading role of risk, and thus that some form of credit rationing must be postulated.100
Accordingly, individual firms will face an upward sloping supply curve instead of an infinitely
elastic one, or in an extreme case might not have any access to credit at all. In the latter case of
complete credit rationing, firms can react only by reallocating the capital they already own to
different uses. In this case Hayek’s numerical example (of 1939b) suggests that the Ricardo effect
is trivially valid: with an increase in prices it indeed pays to shift capital to shorter processes
where they generate on average higher profit.101 In the more general case of credit rationing, with
an upward sloping credit supply to the individual firm, a redirection of capital to shorter
processes will result, too, when at the profit maximum the rate of profit is geared to the higher
rate of interest. Yet, as closer inspection shows, with the introduction of credit rationing Hayek
salvaged the Ricardo effect at the expense of its intended use for explaining the upper turning
point. It is obvious that the case of complete credit rationing cannot be integrated into Hayek’s
model of the cycle: If firms are fully rationed, investment as determined by the interaction of
credit demand with a vertical credit supply will be zero anytime, so there is neither a boom at the
outset nor a need to explain its end. Similarly, for the more general case: Here credit rationing
will become only effective to the extent that investment demand has indeed increased, and thus it
will be a source of mitigating, but not of reversing, such increases.102 Indeed what effect there is
of credit rationing should be perceived more properly as that of a rise in the effective rate of
interest than that of a rise in the rate of profit.
The crucial argument can be clarified once more with the help of the marginal product
condition for a profit maximum. Hayek referred to it (in Hayek 1942, 141), and earlier had used a
simplified version to depict it graphically (Hayek 1935, 80, fig 7; 2007a [1941], 271, fig. 26).103
100
However in his discussion of perfect competition Hayek is inclined to confuse individual and
market experiments when arguing about infinitely elastic supply (cf. Hayek 1942, 146).
101
For a mathematical proof of the Ricardo effect with complete credit rationing see Baumol
(1967).
102
Kaldor’s (1942) refutation of the Ricardo effect is based on this reasoning.
103
In this version Hayek had assumed that in all stages output is produced solely from labour and
the product of the preceding stage (corresponding to an input-output-matrix where the only non31
Drawing on these conditions some commentators have tried to demonstrate the validity of the
Ricardo effect as an explanation of the upper turning point by showing that, indeed, in this profit
maximum a higher profit rate, equated to a higher interest rate, will result in a less capitalistic
structure of production.104 However, this is based on the confusion of an exogenous increase in
the rate of interest—which, indeed, makes production less capitalistic and reduces investment
demand, with an increase in the rate of interest induced by a rise in the profit rate—which makes
production less capitalistic and, in the end, must be associated with investment demand higher
than before.105
Belatedly, Hayek (1969) put forward a reinterpretation of the Ricardo effect, perhaps
already implicit in his earlier work,106 which avoids the pitfalls pointed out by his critics. He now
associates the extent of credit rationing not with the level of current investment, but with the sum
of past investments of the whole boom, as indicated e.g. by “the proportion of the total
indebtedness of a borrower to his equity” (ibid., 282). Then the longer the boom lasts, the greater
the risk perceived by the banks and the stronger the rationing of credit will become. Thus during
the course of the boom the credit supply curve faced by the investing firms will shift upwards,
and the rising rate of interest will induce a switch to shorter processes and in the end even reduce
the aggregate of investment demand. This may indeed consistently explain the upper turning
point, yet there is a long way from the Ricardo effect induced by a rise in the rate of profit to this
type of effect induced by a rise in the rate of interest due to changes in the perception of risk in
zero entries occur in the main diagonal), and identical marginal product schedules across all
stages.
Cf. Moss and Vaughn (1986, 561) insisting that with credit rationing “the scale [i.e.
accelerator] effect cannot outweigh the substitution [i.e. Ricardo] effect”, and Birner (1999, 808–
809); Birner is explicit in denoting the distinction between the profit rate and the interest rate as
“immaterial” (810n.12).
104
105
Kaldor (1942, 376–377) reminded on a similar occasion of the necessity to distinguish
between movements along a curve (that is, in our example a rise of the interest rate leading to
lower investment demand) and the shift of a curve (that is, an upward shift of the demand curve
along an upward sloping supply curve leading to a higher interest rate associated with higher
investment).
Hayek’s awareness of the risk problem might have been sharpened by Kalecki’s work
published in Economica (cf. Kalecki 1937, especially 442).
106
32
the course of the boom.107 Yet, this explanation has not only become almost indistinguishable
from the earlier one, where investment is stopped by a rise in the rate of interest engineered by
the central bank, but has also been completely divorced from the determination of investment
demand by the profits earned in the consumption sector—in fact, any justification for a persistent
demand for investment during the boom would do. So in the end the Ricardo effect was salvaged
by giving up most of what had distinguished it from other explanations of the upper turning point.
A subordinate issue, not to be completely overlooked, consists in the question how the
structure of production had to be specified to be consistent with the alleged working of the
Ricardo effect. Hayek (1939b, 21–23) describes production as going on in a series of stages of
production with labour assumed to be specific to each stage, that is, completely immobile
between stages.108 Under this assumption Hayek tries to demonstrate that a redirection of
demand, from the earlier to the later stages, may at one point result in the simultaneous presence
of unemployment in the earlier and full employment—giving rise to an inelastic supply curve—in
the later stages (ibid., 29). This seems to require besides specificity some lack of substitutability
of means of production as between stages, too. Yet, from the profit maximum conditions referred
to above it should be clear that with strict complementarity in the consumption sector an increase
in demand, with production rigidly fixed by the scarce labour input, would not bring forth any
derived demand, with all marginal products but that of labour becoming zero. Thus, for a
redirection of demand, like that the Ricardo effect was supposed to bring about, it would still
have been difficult enough to specify the structure of production in a way consistent with the
desired results, that is, with the proper mix of specificity and complementarity required.109
Turning to its reception, the Ricardo effect must be considered exceptionally
unsuccessful. Almost as soon as published, it was criticized first by Wilson, then demolished by
Note that this interpretation has some similarity with the “financial instability hypothesis”, cf.
e.g. Minsky (1986).
107
This is reminiscent of Durbin’s remark on the lack of mobility experienced in Great Britain’s
recent past.
108
109
In his rescue attempt (Hayek 1942) modified the specification of production: He now assumes
that all production goes on in firms that are fully vertically integrated and indeed at the end of his
analysis of the Ricardo effect admits that he is unable to “visualise precisely how it will be
brought about” without this assumption (148). Moreover, the notion of immobility of labour
appears difficult to capture when a single firm comprises all stages of production.
33
Kaldor’s onslaught, and the following years saw little debate of it, in particular as Hayek
remained silent on these issues for more than two decades. Yet, in other regards, Hayek’s
contribution addressed a vital theoretical issue, intensely debated among contemporaries, namely
the stability, or sustainability, of full employment. These ongoing discussions110 indicate that—at
this time—the methodological reorientation that in the end characterized the success of the
Keynesian approach had not yet been completed. Thus, on the one hand, the Keynesian theses
(and the policy conclusions derived from it) were still analysed from the point of view of the
business cycle, that is, as a question of stabilizing the boom, or of maintaining full employment
reached near the end of the boom period. On the other hand, these analyses took account of the
structure of production, whether in trying to base it on capital theoretic foundations or, more
modestly, in keeping to the distinction between two sectors producing, respectively, consumption
and investment goods.111
In this setting Hayek’s essay must be seen as part of this discussion, combining the
interaction between consumption and investment demand, a sectorial structure characterized by
some measure of specificity and complementarity of the factors of production, and—albeit
sketchily—the effects of investment on equipment nd productive capacity, based on a simplified
version of Austrian capital theory, and garnished by that indigestible ingredient, the Ricardo
effect. Specifically, for the short run with labour immobile between sectors, Hayek (1939b, 59)
had distinguished between “stable employment” and full employment.112 Because of the remnant
effects of past booms the investment sector typically will be bigger (relative to the consumption
sector) than compatible with the rate of (voluntary) saving at full employment. Consequently, the
level of employment when the capacity constraint in the consumption sector becomes binding
constitutes a kind of barrier beyond which employment cannot be sustainably raised. Hayek
ascribes this lack of sustainability to the Ricardo effect. Durbin, as has already been noted, had
110
Cf. e.g. the contributions by Harrod (1936), Kaldor (1938, 1939), and eventually Hicks
(1950), to the theory of the trade cycle.
As is clear from the very first reviews (cf. e.g. Hicks 1937, Meade 1937) Keynes’s General
Theory was at the outset also perceived of as a two-sector-model. Leijonhufvud’s (1968) reinterpretation of the economics of Keynes caused a stir when bringing this to light again.
111
Again, Hayek thereby did not refer to “stability” in the modern sense, but to the existence of
an “equilibrium” level of employment, that is, one “which … can be lastingly maintained” (ibid.,
61).
112
34
derived from similar assumptions a state of generalized excess demand for goods, driving the
economy into inflation that ultimately must be stopped at the price of a crisis. Thus, both pointed
to the problem that the preservation of a state of full employment required not only a specific
level of (effective) demand but also a proper distribution of demand as between sectors.113
Kaldor (1938), just on the way of being converted into a full-blown Keynesian, also
contributed to this strand of the literature. In a model deviod of Austrian capital theory he
entertained his own second thoughts on the stability of full employment. Although bringing about
full employment is in his view just a matter of the proper stimulation of effective demand, he
notes that under “certain conditions, a state of full employment will be inherently unstable” (ibid.,
642). And again this is so because in the presence of equipment and labour specific and
complementary in the two sectors “full employment presupposes a division of real income
between real consumption and real investment in a certain proportion” (ibid., 664, emphasized in
the original). From this starting point Kaldor goes on to distinguish types of possible causes for
instability: In the short-run, with production constrained by given equipment, “excess saving”,
where a lack of consumption demand spills over into investment, corresponds to the traditional
Keynesian case (of “underconsumption”). Conversely, “excess investment” exhibits the wellknown features of a cumulative inflationary process (like Durbin’s case). In the longer run, when
the capacity build-up in the consumption goods sector is taken into account, the economy faces
again the dangers of either excess saving or excess investment, as the investment determined by
the equipment required for keeping pace with the increase in consumption demand must be
matched by the saving generated by rising income. Yet, even if these conditions are fulfilled, due
to the strict complementarity between equipment and labour, the next obstacle arises when labour
specific to the consumption sector becomes the scarce factor. Because of the resulting excess
equipment in producing consumption goods investment demand slumps and again full
employment cannot be sustained.114 For the last case, were it not for complementarity, remedies
113
Although referring to a different context—the distribution among regions—one might feel
reminded of, among all authors, Keynes’s warning that “[w]e are in more need today of a rightly
distributed demand than of a greater aggregate demand” (Keynes 1982 [1937], 385).
Kaldor considers this an example of a “temporary exhaustion of investment opportunities”
(653), an explanation to which Hayek had strongly objected: “Once the cumulative process has
been entered upon the end must always come through a rise in profits in the late stages and can
114
35
might be sought in the adjustment of factor prices, e.g. a higher wage and a lower interest rate
making up for an increase in capital intensity and thus an increase in investment demand.
Alternatively, one must foster hope that, as Kaldor puts it, “Providence decrees that there should
be an adequate rate of technical progress” (ibid., 653). The possible ways out of this dilemma
suggested by Kaldor are familiar: tax policies working on the income distribution or the transfer
of labour between sectors. Kaldor’s conclusion might sound strange in the ears of latter-day
Keynesians in its likening the task of sustaining the boom, and thereby full employment, to a
“steeplechase, where the horse is bound to fall at one of [the] obstacles” (ibid., 657).
In the course of the contemporary debate, Samuelson (1939) formalized the interactions
within the demand side115 and, more importantly, Harrod (1936) addressed the question of the
compatibility of demand side equilibrium with the growth of productive capacity, in what was to
become known as “Harrod’s Problem”.116 A crucial lesson to be learnt from Harrod’s approach,
in particular relevant for Hayek’s undertaking, is that he derived both the existence, and
instability, of an equilibrium time path balancing the effects of multiplier and accelerator, and the
unsustainability of full employment—without any recourse to a Ricardo effect. Furthermore,
Harrod in effect also takes account of Kaldor’s stability problem. The trajectory followed by
Kaldor’s economy when the capacity of the consumption sector expands, steering clear between
excess saving and excess investment, corresponds to Harrod’s “warranted rate of growth”. If this
rate exceeds “the natural rate of growth”, that is the rate of growth of the efficiency of labour,
then labour scarcity will be inevitable and make full employment unsustainable.117 The
precariousness of equilibrium within the Harrod model, later on characterized as “knife-edge”
(Solow 1956, 65), accords well with what Kaldor considered a resort to providence caring for the
appropriate rate of technical progress.
never come from a fall in profits or an exhaustion of investment opportunities” (Hayek 1939b,
56).
See also Haberler’s favourable account of this approach in the third edition of his study
(Haberler 1941, 474–477).
115
116
Cf. Harrod (1939, 1948). Harrod built on the variability of coefficients and on non-linear
functional relationships for his explanation of the trade cycle. Thus, Besomi (1999, see especially
the “Epilogue”) warns of interpreting Harrod’s writings from the retrospective view of the so
called “Harrod-Domar growth model” as not doing justice to his work.
117
In the reverse case technological unemployment would arise, the solution of which—one
might remember—Kaldor once in 1932 had rested optimistically on the flexibility of wages.
36
The need for providence was of course predicated upon the neglect of flexible factor
prices working on factor proportions based on the assumptions of specificity and
complementarity. With these assumptions discarded, Solow (1956) was able to demonstrate the
existence of a steady-state equilibrium growth path. His achievement could be judged as the
answer not only to Harrod’s problem, but also to Kaldor’s and to Hayek’s endeavours with the
traverse. The solution was made possible by translating the problem into a framework of a perfect
foresight, one-commodity intertemporal equilibrium malleable-capital model.118 However, by
getting rid of the complexities that had riddled the models of Hayek (and Kaldor) and had left
them both interesting and intractable, something important was lost in this translation.
In any case, this “solution” is indicative of the evolution in “macroeconomic” thought
during the years of Hayek’s silence on matters of money and the cycle that followed his
investigation into the Ricardo effect, an evolution whereby equilibrium replaced a processoriented and aggregates a structural approach.119
Contemporaneously, this solution also incorporated the idea of the “neoclassical synthesis”
according to which “the achievement of full employment requires Keynesian intervention but that
neoclassical theory [as represented by Solow’s contribution] is valid when full employment is
reached”, as critically noted by Arrow (1967, 735).
118
119
In his defence of the Ricardo effect in its various manifestations Hayek always maintained the
inadequacy of the equilibrium framework used by its critics. In any case, the effect provided
Hayek—among others—with the impetus to focus on a process approach of which Hayek (1981)
is a pertinent example.
37
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———. 2006. “Tendency to Equilibrium, the Possibility of Crisis, and the History of Business
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