Friedrich August von Hayek (1899-1992)
Hayek wrote his PhD thesis on the problem of imputation. He participated in Mises’s so-called “private seminar” and in 1927 he was appointed to the directorship of the Austrian Institute of Business Cycle Research, founded by Mises.
In 1929 he published Geldtheorie und Konjunkturtheorie (Monetary Theory and Theory of Economic Fluctuations), in which he elaborated on Mises’s approach to the problems under consideration. He submitted the book as a habilitation thesis to the University of Vienna and was appointed to a lectureship (Privatdozent) there. In 1931 Lionel Robbins invited him to the London School of Economics to give four lectures, which were then published as Prices and Production (Hayek 1931b). These lectures had both a critical and a constructive part: the former was directed at Keynes’s Treatise on Money and sought to refute the idea that the economic system was demand-constrained, whereas the latter was concerned with cross-breeding the Austrian theory of capital and interest, the Misesian theory of money and the Paretian theory of general equilibrium. Robbins also published a paper by Hayek in Economica, the London School of Economics (LSE) journal, which contained a frontal assault on Keynes (Hayek 1931a). This led to a famous controversy with Piero Sraffa in the Economic Journal, then edited by Keynes, which according to several observers Hayek lost and may have prompted him to turn to social philosophy, a field in which he made important contributions. In 1932 Hayek was appointed to the Tooke Chair at the LSE. In a final attempt to turn the defeat in the controversy with Sraffa into a victory, Hayek worked on capital theory and economic dynamics, but had to admit that the Bohm-Bawerkian approach he had endorsed could not generally be sustained. This becomes clear in his 1941 book on The Pure Theory of Capital, which may be considered his last major contribution to pure economic theory. In 1944 he published The Road to Serfdom and three years later was one of the founders of the Mont Pelerin Society. From 1950 to 1962 he held the chair in Social and Moral Sciences at the University of Chicago. His influential book, The Constitution of Liberty, was published in 1960. In 1974 he was awarded, together with Gunnar Myrdal, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, not least, and somewhat ironically, for his “pioneering work in the theory of money and economic fluctuations”.Competition, Hayek insisted, is a procedure for discovering facts, which, without such procedure, would remain unknown and therefore could not be used. This concept of competition stands in striking contrast to the conventional concept of perfect competition in mainstream economics, in which all “data” are assumed to be known to all agents, that is, there is perfect information. In Hayek’s view nothing could be further from the truth. Hayek drew the following conclusions: first, the outcomes of the process are typically unpredictable and bound to frustrate some agents by disappointing their expectations; second, conventional microeconomics does not perform all that well when confronted with the real world, because it ignores the fact just mentioned. The competitive process will result in prices that reflect the widely dispersed and fragmented information, a knowledge which no single individual can possibly ever possess, not least because some information reflected in prices is tacit.
As regards the theory of economic fluctuations and unemployment, Hayek (1931b) disputed Keynes’s emphasis on the role of aggregate effective demand: the source of crises and depressions are, on the contrary, interventions by governments and central banks, which lead to a misallocation of capital and labour and trigger crises. Hayek’s explanation of the world depression in the late 1920s and early 1930s can be said to revolve around his view of the problem of the choice of technique, which derives from Bohm-Bawerk’s theory of capital.
A money rate of interest fixed by the banking system that is lower than what he called the “equilibrium rate” prompts producers to embark on more roundabout processes of production, that is, lengthen the period of production and thus increase capital intensity. This requires a redirection of productive resources away from industries that are close to the maturing of consumption goods to industries that are far from it (invoking Menger’s hierarchy of goods). This is effectuated by bidding up the prices of these resources. However, since the preferences of agents have not changed, the prices of consumption goods, whose flow of output is being diminished, will rise, which, in turn, implies “forced saving”: consumers would like to consume more but are prevented from doing so because of an insufficient supply. Yet with rising prices of consumption goods profitability in the industries producing them will increase and provide an incentive to expand their production. This necessitates redirecting productive resources from spheres far away to spheres close to the maturing of consumption goods and reverses the tendency towards a lengthening of the production period. The mute witnesses of the misallocation of capital and labour are prematurely abandoned investment projects - investment “ruins” - and unemployed workers. The misguided development due to too low a money rate of interest becomes obvious and the productive capacity of the economy shrinks: the problem is not a lack of effective demand, as Keynes maintained, but a lack of effective supply. If banks in response to the inflationary pressure that has built up eventually decide to increase the money rate of interest again, the system, Hayek contended, will return to its old equilibrium position. The attempt to boost the economy by means of a policy of easy money is thus argued to be self-defeating: after a costly detour in which productive resources have been wasted the system gets back to where it started.Keynes who had difficulty warding off Hayek’s attack because he was not familiar with its building blocks (the contributions of Bohm-Bawerk, Mises and Pareto) asked Piero Sraffa to rush to his rescue. This Sraffa (1932a) did. First, he rejected Hayek’s basic proposition that a divergence between the money rate and the “equilibrium rate” of interest is a characteristic feature of a monetary economy. Second, in a barter economy, he observed, loans would be made in terms of all sorts of commodities. There would be a single (uniform) rate of interest compatible with equilibrium, but there will generally be at any moment as many “natural” (or “commodity” or “own”) rates of interest as there are commodities, though they would not be equilibrium rates. He explained that in equilibrium the spot and forward price coincide for all commodities, and all commodity rates are equal to one another and to the money rate. However if, for whichever reason (the weather, for example), the supply and the demand for a commodity are not in equilibrium, its spot and forward prices diverge, and the “commodity” rate of interest on that commodity diverges from the “commodity” rates on other commodities. This will trigger adjustment processes (as they have been discussed by the classical economists in terms of the process of gravitation of market prices to their natural levels) that will tend to remove the discrepancy between spot and forward prices and bring about a new equilibrium. Third, Hayek’s idea that the economy will return to its old equilibrium ignores the fact that the banking policy will in the meantime have changed the distribution of wealth and income among agents and thus one of the data defining a Paretian equilibrium (the other two being the preferences of agents and the technical alternatives of production). Fourth, Hayek’s idea that “voluntary saving” can be strictly discriminated from “forced saving” is naive. Sraffa concluded that Hayek had not argued correctly and was unable to explain the facts he purported to explain.
Sraffa’s criticism had dealt a serious blow to Hayek’s explanation of economic fluctuations and, not surprisingly, had pleased Keynes a great deal. In more recent times Hayek’s theory has been invoked again in attempts to explain what has been dubbed “the great recession” in the aftermath of the bursting of the financial bubble in 2007. The theory is however difficult to reconcile with important empirical facts, in particular, the fact that in recessions and depressions we generally do not observe an increase in employment in the consumer goods industries, as Hayek contended. An overall slack demand is reflected not least in the underutilisation of productive capacity in the consumer goods sector.