Hayek and the Concept of Equilibrium

This subject is rather important for the validity and truth of Hayek’s trade cycle theory, and there seems to be confusion about the issue, especially from Austrians or internet Austrians trying to defend the Austrian business cycle theory (ABCT).

A commentator on the previous post argues that

Hayek’s model is not a static equilibrium theory. Hayek’s model is a dynamic model that, like Mises, utilizes the concept of a static state as a mental tool to understand the real world economy of constant changes. Hayek did not claim that markets do in fact clear. He argued that markets tend towards clearing, but because equilibrium is never reached, neither does clearing.

The belief that equilibrium is never reached was, of course, a position that Hayek held after the 1940s when he had adopted the idea of “spontaneous order” as a replacement for equilibrium analysis. But this comment conflates Hayek’s different and conflicting views on equilibrium in the course of his whole career, and confuses the issue by making it appear that Hayek held a consistent and unified position on equilibrium throughout his entire life. That is false.

Hayek’s view on equilibrium evolved over time, and the extent of the changes in his basic ideas has led some scholars to talk about Hayek I and Hayek II as phases in in his thought on methodology, and even three phases in his views on equilibrium (Gloria-Palermo 1999: 75). In the first phase down to 1937, Hayek thought that “all legitimate economic explanations should be based upon an analysis of equilibrium” (Gloria-Palermo 1999: 75; McCloughry 1984: viii). The second phase from 1937 to the 1940s involved Hayek’s attempt to redefine equilibrium as plan co-ordination, which occurred in his important paper “Economics and Knowledge” (Hayek 1937; Gloria-Palermo 1999: 75). From the 1940s, there was a third phase where Hayek broke with equilibrium analysis and created a new concept of “spontaneous order” as a method for studying coordination processes in market economies.

With respect to Hayek’s trade cycle theory, it is necessary to note that Hayek produced different versions of his theory in the course of his career, and the different works that Hayek wrote should be carefully distinguished:

(1) Hayek’s paper on intertemporal equilibrium:

F. A. Hayek, 1984 [1928]. “Intertemporal Price Equilibrium and Movement in the Value of Money,” in R. McCloughry (ed.), Money, Capital and Fluctuations. Early Essays, Routledge & Kegan Paul, London.

(2) The essay Monetary Theory and the Trade Cycle (1929) [English trans. 1933 by N. Kaldor and H.M. Croome] in Hayek 2008: 1–130).

(3) Hayek’s first version of ABCT from his LSE lectures in Prices and Production (London, 1931).

(4) Hayek’s 2nd edition of Prices and Production in 1935:

F. A. Hayek, von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

(5) Hayek’s further version of his trade cycle theory with significant changes in 1939:

F. A. von Hayek, Profits, Interest and Investment (London, 1939).

The prevailing model of equilibrium in the 1920s was a simplified Walrasian stationary equilibrium model, which influenced Hayek when he began his trade cycle theory work. In these stationary equilibrium models, change is exogenous and the system moves by an equilibrating process to a new equilibrium when exogenous shocks occur. But Hayek wanted to analyse endogenous changes through the role of money in modern economies, and he acknowledged that an intertemporal equilibrium approach was necessary in his paper “Intertemporal Price Equilibrium and Movement in the Value of Money” (1928). Curiously, he then simply abandoned that framework in the first edition of Prices and Production (1931) and instead used a Wicksellian monetary equilibrium concept. In doing so, Hayek “reverted to the stationary equilibrium approach, by adopting the simple stationary-equilibrium model put forward by Wicksell in Interest and Money as the starting point for his analysis” (Donzelli 1993: 57).

Now Wicksell had already used Walras’ theory of equilibrium and combined it with Bohm Bawerk’s theory of interest, to try and establish the conditions of monetary equilibrium (Loasby 1998: 54). Hayek’s theory in Prices and Production took that theory over:

“Among the many shortcomings of the original Prices and Production model, the most evident, and probably the most embarrassing to Hayek himself, was the use of a stationary equilibrium apparatus that was wholly at variance with those continual changes in relative prices, production techniques, and composition of output that constituted the distinctive feature of Hayek’s trade cycle theory and the main object of its purported explanations.

Hence, the first task Hayek set to himself in the early 1930s was to free … [General Equilibrium Theory] from the shackles of the stationary equilibrium approach (that he then used to call the «traditional» or «timeless» equilibrium approach), thereby turning the equilibrium construct into a tool suitable for discussing those «dynamic» aspects that lay at the very center of his trade cycle theory.” (Donzelli 1993: 59).

The model used in Prices and Production was a stationary equilibrium model where an equilibrium state with full use of resources as a starting point was assumed:

“it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency toward an equilibrium. For it is this concept alone which permits us to explain fundamental phenomena like the determination of prices or incomes, an understanding of which is essential to any explanation of fluctuation of production. If we are to proceed systematically, therefore, we must start with a situation which is already sufficiently explained by the general body of economic theory. And the only situation which satisfies this criterion is the situation in which all available resources are employed.” (Hayek, Prices and Production in Hayek 2008: 225).

Hayek explicitly stated that he had assumed full employment equilibrium in Prices and Production (1931):

“As it is sometimes alleged that the ‘Austrians’ were unaware of the fact that the effect of an expansion of credit will be different according as there are unemployed resources available or not, the following passage from Professor Mises’ Geldwertstabilisierung und Konjunkturpolitik (1928, p. 49) perhaps deserves to be quoted: ‘Even on an unimpeded market there will be at times certain quantities of unsold commodities which exceed the stocks that would be held under static conditions, of unused productive plant, and of unused workmen. The increased activity will at first bring about a mobilisation of these reserves. Once they have been absorbed the increase of the means of circulation must, however, cause disturbances of a peculiar kind.’ In Prices and Production, where I started explicitly from an assumed equilibrium position, I had, of course, no occasion to deal with these problems. (Hayek 1975 [1939]: 42, n. 1).

In Monetary Theory and the Trade Cycle (1929) [English trans. 1933 by N. Kaldor and H.M. Croome]), Hayek had also made it perfectly clear full employment equilibrium was his starting point:

“The purpose of the foregoing chapter was to show that only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations—a condition not fulfilled by any theory based exclusively on “real” processes. If this is true then at the outset of theoretical exposition, those monetary processes must be recognized as decisive causes. For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements that are capable of relaxing these rigid interrelationships.” (Hayek 2008: 47).

By the time of his 1937 paper “Economics and Knowledge” (Economica n.s. 4.13 [1937]: 33–54), Hayek offered a revised definition of equilibrium:

“For a society then we can speak of a state of equilibrium at a point of time – but it means only that compatibility exists between the different plans which the individuals composing it have made for action in time. And equilibrium will continue, once it exists, so long as the external data correspond to the common expectations of all the members of the society. The continuance of a state of equilibrium in this sense is then not dependent on the objective data being constant in an absolute sense, and is not necessarily confined to a stationary process. Equilibrium analysis becomes in principle applicable to a progressive society and to those inter-temporal price relationships which have given us so much trouble in recent times.

These considerations seem to throw considerable light on the relationship between equilibrium and foresight, which has been somewhat hotly debated in recent times. It appears that the concept of equilibrium merely means that the foresight of the different members of the society is in a special sense correct. It must be correct in the sense that every person’s plan is based on the expectation of just those actions of other people which those other people intend to perform, and that all these plans are based on the expectation of the same set of external facts, so that under certain conditions nobody will have any reason to change his plans. Correct foresight is then not, as it has sometimes been understood, a precondition which must exist in order that equilibrium may be arrived at. It is rather the defining characteristic of a state of equilibrium. Nor need foresight for this purpose be perfect in the sense that it need extend into the indefinite future, or that everybody must foresee everything correctly. We should rather say that equilibrium will last so long as the anticipations prove correct, and that they need to be correct only on those points which are relevant for the decisions of the individuals. But on this question of what is relevant foresight or knowledge, more later.” (Hayek 1937: 41–42)

Hayek makes it clear in a footnote that his new definition separates the concept of equilibrium from that of a stationary state (Hayek 1937: 41, n. 1), and this is a dynamic conception of equilibrium. The problem for Hayek then became how people acquire the knowledge they need to co-ordinate their plans. Hayek’s last phase was to realise that equilibrium modelling is a wholly inadequate solution to that problem.

By the 1940s, through his engagement with the Socialist calculation debate, Hayek had revised his opinion of the usefulness of equilibrium concepts again, and had begun to introduce the idea of “spontaneous order” to replace equilibrium analysis (Donzelli 1993: 80; Tieben 2009: 494). By the end of his career, Hayek stated quite clearly that equilibrium states do not exist in the real world:

“It is tempting to describe as an “equilibrium” as ideal state of affairs in which the intentions of all participants precisely match and each will find a partner willing to enter into the intended transaction. But because for all capitalist production there must exist a considerable interval of time between the beginning of a process and its various later stages, the achievement of an equilibrium is strictly impossible. Indeed, in a literal sense, a stream can never be in equilibrium, because it is disequilibrium which keeps it flowing and determining its directions.

Even an apparent momentary state of balance in which everybody succeeds in selling or buying what he intended, may be inherently unrepeatable, irrespective of any change in the external data, because some of the constituents of the stream will be results of past conditions which have changed long ago.” (Hayek quoted in Caldwell 2004: 226–227).

Appendix 1: Hayek on General Equilibrium

Here is Hayek on the concept of general equilibrium from an interview as transcribed in the book Nobel Prize-Winning Economist: Friedrich A. von Hayek (1983, pp. 187-188):

“HIGH: To what extent do you think that general-equilibrium analysis has contributed to the belief that national economic planning is possible?

HAYEK: It certainly has. To what extent is very difficult to say. Of the direct significance of equilibrium analysis to the explanation of the events we observe, I never had any doubt, I thought it was a very useful concept to explain a type of order towards which the process of economics tends without ever reaching it. I’m now trying to formulate some concept of economics as a stream instead of an equilibrating force, as we ought, quite literally, to think in terms of the factors that determine the movement of the flow of water in a very irregular bed.”

Appendix 2: Austrian Presentations of ABCT
I have added an updated list here of the Austrian books and articles where ABCT is given in various versions:

(1) The version of Mises in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]), pp. 349–366. (It is unclear to me if this appears in the original German edition, Theorie des Geldes und der Umlaufsmittel [Munich and Leipzig, 1912] or the 2nd German edition published in 1924.)

(2) Mises’s version in Monetary Stabilization and Cyclical Policy (1928) in Mises 2006 [1978], The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (Ludwig von Mises Institute, Auburn, Ala.), p. 99ff.

(3) Hayek’s essay Monetary Theory and the Trade Cycle (1929) [English trans. 1933 by N. Kaldor and H.M. Croome] in Hayek 2008: 1–130).

(4) Hayek’s paper on intertemporal equilibrium:

F. A. Hayek, 1984 [1928]. “Intertemporal Price Equilibrium and Movement in the Value of Money,” in R. McCloughry (ed.), Money, Capital and Fluctuations. Early Essays, Routledge & Kegan Paul, London.

(5) Hayek’s first version of ABCT from his LSE lectures in Prices and Production (London, 1931).

(6) Hayek’s second version of ABCT in Profits, Interest and Investment (London, 1939).

(7) Hayek’s discussion in The Pure Theory of Capital (London, 1941).

(8) Hayek’s 2nd edition of Prices and Production in 1935.

(9) The version of Mises in Human Action: A Treatise on Economics (Auburn, Ala., 1998), pp. 568–583.

(10) Rothbard’s development of ABCT in Man, Economy, and State: A Treatise on Economic Principles (Ludwig von Mises Institute, Auburn, Ala., 2004 [1962]), pp. 994–1008; and in Economic Depressions: Their Cause and Cure (Ludwig von Mises Institute, Auburn, Ala. 2009 [1969]).

(11) M. Skousen’s interpretation in The Structure of Production (New York, 1990).

(12) Gerald P. O’Driscoll and Mario J. Rizzo in The Economics of Time and Ignorance (2nd edn; Routledge, Oxford, UK., 1996), pp. 198–213.

(13) The most recent developments of ABCT, as in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure (London and New York, 2000). A summary can be found in Garrison (1997).

(14) the exposition in Jesus Huerta de Soto, Money, Bank Credit and Economic Cycles (trans. M. A. Stroup; Ludwig von Mises Institute, Auburn, Ala, 2006), pp. 265–508.

BIBLIOGRAPHY

Butos, W. N. 1985. “Hayek and General Equilibrium Analysis,” Southern Economic Journal 52.2: 332–343.

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

Donzelli, F. 1993. “The Influence of the Socialist Calculation Debate on Hayek’s view of general equilibrium theory,” Revue Européenne des Sciences 31.96.3: 47–83.

Gloria-Palermo, S. 1999. The Evolution of Austrian Economics: From Menger to Lachmann, Routledge, London and New York.

Hayek, F. A. 1937. “Economics and Knowledge,” Economica n.s. 4.13: 33–54.

Hayek, F. A. 1941. The Pure Theory of Capital, Macmillan, London.

Hayek, F. A. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

Loasby, B. J. 1998. “Co-ordination Failure: Economic Theory in the 1930s,” in P. Fontaine and A. Jolink (eds), Historical Perspectives on Macroeconomics: Sixty Years After the General Theory, Routledge, London. 53–64.

McCloughry, R. 1984. “Editor’s Introduction,” in F. A. von Hayek, Money, Capital & Fluctuations: Early Essays (ed. by R. McCloughry), Routledge & Kegan Paul, London. vii–x.

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.

Salerno, J. T. 2002. “Friedrich von Wieser and Friedrich A. Hayek: The General Equilibrium Tradition in Austrian Economics,” Journal des Economistes et des Etudes Humaines 12.2: 357–377.

Tieben, B. 2009. The Concept of Equilibrium in Different Economic Traditions: A Historical Investigation, PhD Thesis, Tinbergen Institute.