Hayek on the Flaws and Irrelevance of his Trade Cycle Theory

There is a series of interviews conducted with Hayek late in his life, and published in 1983 as Nobel Prize-Winning Economist: Friedrich A. von Hayek (Regents of the University of California, 1983). That work makes rewarding reading. In one of the interviews, Hayek was asked about the legacy of his Austrian business cycle theory (ABCT):

HIGH: Have the economic events since you wrote on trade cycle theory tended to strengthen or weaken your ideas on the Austrian theory of the trade cycle?

HAYEK: On the whole, strengthen, although I see more clearly that there’s a very general schema which has to be filled in in detail. The particular form I gave it was connected with the mechanism of the gold standard, which allowed a credit expansion up to a point and then made a certain reversal possible. I always knew that in principle there was no definite time limit for the period for which you could stimulate expansion by rapidly accelerating inflation. But I just took it for granted that there was a built-in stop in the form of the gold standard, and in that I was a little mistaken in my diagnosis of the postwar development. I knew the boom would break down, but I didn’t give it as long as it actually lasted. That you could maintain an inflationary boom for something like twenty years I did not anticipate.

While on the one hand, immediately after the war I never believed, as most of my friends did, in an impending depression, because I anticipated an inflationary boom. My expectation would be that the inflationary boom would last five or six years, as the historical ones had done, forgetting that then the termination was due to the gold standard. If you had no gold standard—if you could continue inflating for much longer—it was very difficult to predict how long it would last. Of course, it has lasted very much longer than I expected. The end result was the same.

HIGH: The Austrian theory of the cycle depends very heavily on business expectations being wrong. Now, what basis do you feel an economist has for asserting that expectations regarding the future will generally be wrong?

HAYEK: Well, I think the general fact that booms have always appeared with a great increase of investment, a large part of which proved to be erroneous, mistaken. That, of course, fits in with the idea that a supply of capital was made apparent which wasn’t actually existing. The whole combination of a stimulus to invest on a large scale followed by a period of acute scarcity of capital fits into this idea that there has been a misdirection due to monetary influences, and that general schema, I still believe, is correct.

But this is capable of a great many modifications, particularly in connection with where the additional money goes. You see, that’s another point where I thought too much in what was true under prewar conditions, when all credit expansion, or nearly all, went into private investment, into a combination of industrial capital. Since then, so much of the credit expansion has gone to where government directed it that the misdirection may no longer be overinvestment in industrial capital, but may take any number of forms. You must really study it separately for each particular phase and situation. The typical trade cycle no longer exists, I believe. But you get very similar phenomena with all kinds of modifications.
(Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 183–186).

One cannot help but notice the illogic running through Hayek’s responses. First, Hayek is completely and embarrassingly wrong on two points:

(1) The golden age of capitalism (1945-1973) was not characterised by “rapidly accelerating inflation”: inflation was low, subdued and there was no tendency whatsoever towards its acceleration for virtually all the period. It was only in 1968 that inflation in many countries started to accelerate.

(2) The stagflation crisis of the 1970s was not caused by an Austrian business cycle: it was the result of (1) wage–price spirals, (2) the speculative activity caused by the break up of Bretton Woods in 1971, (3) negative supply shocks in the prices of commodities which could have been prevented had the US not dismantled its commodity buffer stock polices in the 1960s, and (4) the oil shocks (see “Stagflation in the 1970s: A Post Keynesian Analysis,” June 24, 2011).

Now, on the one hand, Hayek makes some surprising admissions:

(1) His original trade cycle theory assumed the existence of a gold standard, and that this would cause an automatic mechanism causing the end of a credit expansion.

(2) Hayek thought that the postwar boom would last only “five or six years,” and he was completely wrong.

(3) Hayek’s original theory assumed that capital would be directed to industrial expansion, but credit flows after 1945 were, and remain, rather different in nature, with credit flowing to important other sources as well. This can only mean that Hayek’s trade cycle effects would be less and less relevant, as he himself admits.

(4) Hayek recognises his theory had become far less relevant: “You must really study it separately for each particular phase and situation. The typical trade cycle no longer exists [my emphasis], I believe. But you get very similar phenomena with all kinds of modifications.”

The qualification that each historical cycle must be examined to see if it can in fact be explained by ABCT, since there is the possibility that it might not be, was also stressed by Israel M. Kirzner (see “Kirzner on Austrian Business Cycle Theory,” May 30, 2011). Yet when modern Austrians are pressed to identify real world cycles that are not explained by ABCT, most of them are reduced to dumbfounded silence.

Having admitted that his “typical” trade cycle no longer existed, Hayek never admitted what he should have, had he been more honest: that his trade cycle theory had serious flaws and, even if it had been relevant before 1931, it had become largely irrelevant.

Bruce Caldwell puts his finger on exactly this point:

“If one takes seriously ... [sc. Hayek’s] later work on the theory of complex phenomena, then one cannot make precise predictions about the path that a cycle must take, which is what his original cycle theory purported to do. In my opinion, Hayek began to recognize the difficulties with his approach as he responded to critics while laboring over The Pure Theory of Capital ... As noted earlier, he gave hints about those limitations in his 1978 oral-history reminiscences ... and again (and more provocatively) a few years later in his fiftieth-anniversary address .. at the London School of Economics (LSE). His ultimate position seems to have been very close to that of T. W. Hutchison ... , who expressed doubts about whether a general theory of the cycle was possible at all.” (Caldwell 2004: 326).

By recognising that his trade cycle theory was not a general theory of cycles, Hayek in fact eventually had the same view as Ludwig Lachmann, Joseph Schumpeter and Israel M. Kirzner: ABCT cannot be used to explain all business cycles (Batemarco 1998: 222).

And there is a further issue here. Hayek’s original trade cycle theory used static equilibrium theory, and also assumes that all markets do in fact clear (Caldwell 2004: 324), partly by glossing over the role of uncertainty and assuming perfect foresight. But severe problems with Hayek’s static equilibrium theory had already emerged in the 1930s:

“by the middle of the 1930s, problems with [Hayek’s] static equilibrium theory had become ever more evident, as questions of the role of expectations came to the fore and, and, with them, the recognition that earlier models had assumed perfect foresight” (Caldwell 2004: 224).

“Hayek’s changing assessment of the importance of equilibrium theory has some consequences for our story. The most telling of these concerns Hayek’s trade cycle theory, a paradigmatic example of equilibrium theory, one that Witt (1997, 48) describes as ‘an impressive example of allied price theoretical reasoning that may even delight a Chicago equilibrium economist.’ But, as Witt goes on to observe, if one rejects the usefulness of equilibrium analysis, then Hayek’s step-by-set story of how the cycle unfolds, one in which ‘each single stage necessarily had to be followed by the next one’ (46), can no longer be maintained. Witt concludes that Hayek’s cycle theory may well be incompatible with his later theory of spontaneous orders, a concern that others have voiced” (Caldwell 2004: 228).

In light of all this, one can also only agree with Bruce Caldwell that Hayek’s trade cycle theory is now “chiefly of antiquarian interest” (Caldwell 2004: 325).

To conclude, I link to a video below where Bruce Caldwell, Philip Mirowsky and Robert Skidelsky discuss Keynes versus Hayek on the Great Depression, as well as issues related to Hayek’s trade cycle theory (in the first half of the discussion).

Caldwell makes another valid point: Hayek needed a dynamic theory of a capital-using monetary economy, and he did not have the mathematic skills to do this. Around 1936/37, Hayek’s engagement with the socialist calculation debate caused him to pay more attention to the knowledge problem, and how this was also relevant to his business cycle theory.

At the end of the video there is some discussion about the scope for constructive dialogue between Austrians and Post Keynesians (from 13.19 minutes).




BIBLIOGRAPHY

Batemarco, R. J. 1998. “Austrian Business Cycle Theory,” in P. J. Boettke (ed.), The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK. 216–336.

Caldwell, B. 2004. Hayek’s Challenge: An Intellectual Biography of F.A. Hayek, University of Chicago Press, Chicago and London.

Nobel Prize-Winning Economist: Friedrich A. von Hayek. Interviewed by Earlene Graver, Axel Leijonhufvud, Leo Rosten, Jack High, James Buchanan, Robert Bork, Thomas Hazlett, Armen A. Alchian, Robert Chitester, Regents of the University of California, 1983.

Witt, U. 1997. “The Hayekian Puzzle: Spontaneous Order and the Business Cycle,” Scottish Journal of Political Economy 44: 44–58.