Hayek on Market-Clearing Prices and Wages in his 1975 Talk to the American Enterprise Institute

On April 9, 1975, Hayek gave a talk to the American Enterprise Institute in Washington DC, where he was introduced by Gottfried von Haberler (Hayek 1975: 1–2), and was asked to speak on the early stagflationary crisis then affecting Western economies.

In that talk, Hayek attacked the idea that employment is “a direct and simple function of what is called aggregate demand” (Hayek 1975: 4), even though he proceeded to concede two important instances where aggregate demand was the “dominating factor in determining the level of employment” (Hayek 1975: 4), as I mention in the previous post.

Hayek then returns to the pre-Keynesian explanation of unemployment as mainly a consequence of the supply and demand mismatches in and between individual labour markets and the deviation of prices and wages from their market clearing values.

But for Hayek you cannot statistically prove this:

“The alternative explanation of extensive unemployment—which, until the middle of the ’30s, was fairly widely accepted and which, I believe, is still the true and correct one—has the unfortunate property of not being verifiable by statistical methods. To an economist today, however, only that is true which can be proved statistically, and everything that cannot be demonstrated by statistics can be neglected; hence, the true theory has been disregarded.

You may be puzzled by the assertion that there should be a true theory which cannot be statistically confirmed. The explanation is somewhat complex and I can indicate it only very briefly. I have made the subject the main content of my Nobel Memorial lecture, which I delivered in Stockholm four months ago, but I will try to put it concisely. It is a very good illustration of a more general phenomenon, namely, that with modern scientistic prejudices about what is to be accepted a valid argument, it can happen that a false theory is regarded as true because there is some statistical evidence in its favor, and that the true theory is rejected because, by its very nature, it cannot be supported by statistical evidence—which is the only kind of observation which counts for that point of view.

That’s a point on which you probably have some doubt. Can there be a theory the conclusion of which cannot, by its nature, be statistically supported? I believe I can give you, in this case, an example which, to me, is fairly convincing.

What was the traditional pre-Keynesian view about the causes of extensive unemployment? Generally speaking, it was the assumption of a discrepancy between the distribution of demand among different industries and the distribution of labor and other resources among these industries. As the result of that discrepancy, there will be a lack of correspondence between demand and supply in many sectors, an insufficient demand in some of them and an excessive demand in others; and, as always happens in the case of a discrepancy between demand and supply, resources of all kinds will be idle.

These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due to some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, somewhat misleadingly, we call an equilibrium structure, and second, that labor is reallocated according to these new prices.

Lacking such price readjustment and resource reallocation, the original unemployment may then spread by means of the mechanism I have discussed before, the “secondary contraction,” as I used to call it. In this way, unemployment may eventually become general.

The primary cause of the appearance of extensive unemployment, however, is a deviation of the actual structure of prices and wages from its equilibrium structure. Remember, please: that is the crucial concept. The point I want to make is that this equilibrium structure of prices is something which we cannot know beforehand because the only way to discover it is to give the market free play; by definition, therefore, the divergence of actual prices from the equilibrium structure is something that can never be statistically measured.

The theory which asserts that unemployment is an effect of a deviation of the actual price structure from the equilibrium structure is thus a theory that cannot be confirmed by statistics. It’s the kind of theory which I believe you find in many other fields of economics. What we can confirm from daily observation are the elements from which a theory is built up, our knowledge of the behavior of individuals in various situations. But we cannot test statistically the resulting conclusions, which are derived from these empirical data about individual behavior.

In contrast, the modern fashion demands that a theoretical assertion which cannot be statistically tested must not be taken seriously and has to be discarded. As a result of this belief, a theory which, in my opinion, is the true explanation has been discarded as not adequately confirmed, and a false theory has been generally accepted merely because it happens to be the only one for which statistical evidence, even though very inadequate evidence, is available.” (Hayek 1975: 6–7).

This passage is one that is grossly misunderstood by vulgar Austrians, or, to be specific, one astonishingly ignorant one.

The central concept above is the notion of a tendency towards a set of wages and prices that clears markets, despite what vulgar Austrians say. In such a price vector, flexible wages will clear the labour market too.

For Hayek, as for other Austrians, market agents will attempt to find such market clearing values that will equate demand and supply by a learning and trial-and-error process, and people cannot necessarily know what such equilibrium prices will be in advance, as described by Kirzner, Shapiro and Greaves:

“As Austrian economist F. A. Hayek emphasized, the market process we have been describing in entrepreneurial terms can also usefully be understood in terms of learning. The process through which the market tends to generate the ‘right’ quantity of a commodity, and the ‘right’ price for it, can be seen as a series of steps during which market participants gradually tend to discover the gaps or errors in the information on which they had previously been basing their erroneous production and/or buying decisions. Buyers who had overestimated the willingness of producers to produce and sell the commodity had been ‘incorrectly’ refusing to offer higher prices (that they would indeed have been prepared to pay); those who had underestimated that willingness were ‘incorrectly’ offering higher prices than were in fact needed to inspire sellers to produce. Sellers who had overestimated the willingness of buyers to buy were ‘incorrectly’ asking higher prices (and were producing more units of the commodity than it was ‘really worthwhile’ to produce), and so on. The market process is one in which, driven by the entrepreneurial sense for grasping at pure profit opportunities (and for avoiding entrepreneurial losses), market participants, learning more accurate assessments of the attitudes of other market participants, tend toward the market-clearing price-quantity combination.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

“Persons with goods or services they hope to sell must continually experiment to discover the ‘market price’ of any particular item. As the students will have learned from the classroom auctions, it is possible to determine, by continued bargaining, the price at which an item will ‘clear the market’ at any particular moment. At that price, determined by the relative eagerness and subjective values of owners or potential sellers and would-be buyers, the number of units of a good or service wanted and the number offered will be the same. But no one can know in advance what this price will be.” (Greaves 1984: 51).

“ … no real-world firm really has the ‘power’ to suspend the law of demand and supply—that is, to avoid ending up with a surplus for overpricing its product, or to avoid less-than-maximum profits by underpricing its product and realizing a shortage.

Sooner or later, after trial-and-error searching for the market-clearing price, every real-world firm finds itself eventually having to ‘take’ the market price that actually clears its supply. Thus real-world firms are ‘price-takers’ no less than firms in pure competition, the only difference being this: [perfect competition] firms ‘take’ their [price] from the market right from the start (they have perfect knowledge!), whereas real firms ‘take’ their [price] only after trial-and-error search in the market. Irony of ironies: real firms are, in an ultimate sense, pricetakers, too!” (Shapiro 1985: 365–366).

To sum up, both Austrians and Walrasian neoclassicals have similar ideas about the need for flexible wages and prices, but the Austrian view about the tendency to market clearing is different in the following ways:

(1) market agents cannot necessarily know the market clearing prices in advance;

(2) Austrians do not think market agents have perfect knowledge or “rational expectations”;

(3) most prices are not market-clearing prices nor equilibrium prices (in the sense of being equal to marginal cost) but disequilibrium prices, but there exists a tendency for prices and wages to move towards market clearing values by arbitrage, the action of alert entrepreneurs, and a learning and trial-and-error process;

(4) according to Hayek, the involuntary unemployment caused by the “deviation of the actual price structure from the equilibrium structure … cannot be confirmed by statistics.”

BIBLIOGRAPHY
Greaves, Bettina B. 1984. Free Market Economics: A Syllabus. Foundation for Economic Education, Irvington-on-Hudson, NY.

Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A. von Hayek. American Enterprise Institute, Washington.

Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

Shapiro, Milton M. 1985. Foundations of the Market Price System. University Press of America, Inc. Lanham, MD and London.

Hayek the Evil Inflationist!

… or that is what I would call this post if I were a Misesian or Rothbardian Austrian economist.

I refer to the passage below from a talk that Hayek gave on April 9, 1975 to the American Enterprise Institute in Washington DC, in which he had been asked to speak on 1970s inflation.

Early in this talk Hayek said that he rejected the Keynesian view that employment is “a direct and simple function of what is called aggregate demand” (Hayek 1975: 4), even though he proceeded to concede two important instances where aggregate demand was the “dominating factor in determining the level of employment”:

“Let me say, first, that there are two circumstances in which changes in aggregate demand are indeed the dominating factor in determining the level of unemployment; and these two circumstances have governed the development of the theory.

The first one was an accidental historic situation—but an historic situation that determined the climate of opinion in the country which then dominated economic theory. In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.

This particular situation, however, while it largely explains the growth of Keynes’s own views, would not be sufficient to explain their wide acceptance.

The second situation in which it is true that an increase of employment requires an increase in aggregate demand is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction. The original substantial unemployment lends to a shrinkage of demand that causes more unemployment, and so on; it releases a deflation due to the ‘inherent instability of credit’ (to use the terminology of a once very influential but now undeservedly almost forgotten economist who died a few days ago, R. G. Hawtrey).

Once you have the kind of situation in which there already exists extensive unemployment, there is thus a tendency to induce a cumulative process of secondary deflation, which may go on for a very long time. I am the last to deny — or rather, I am today the last to deny—that in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was compatible with a functioning economy. Perhaps I should even then have understood that this possibility no longer existed. I think it disappeared in 1931 when the British government abandoned its attempt to bring wages down by deflation, just when it seemed about to succeed. After that attempt had been abandoned, there was no hope that it would ever again be possible to break the rigidity of wages in that way.

I still believe that we shall not get a functioning economy until wages again become flexible, but I think that we shall have to find different techniques for that purpose. I would no longer maintain, as I did in the early ’30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognisable function whatever, and that there is no justification for supporting or permitting a process of deflation.” (Hayek 1975: 4–5).

This is Hayek’s mea culpa and a repudiation of his 1930s liquidationism.

But what policy does Hayek recommend to avoid deflation? He does not here specify how, but elsewhere makes it clear that he supported monetary intervention (like Milton Friedman) and (probably) a guarded and conservative use of fiscal policy involving public works expenditure. In one word: inflation.

Most interesting is Hayek’s implicit admission that inflation was the right course for the British economy in the 1920s after the disastrous return to the gold exchange standard at too high a parity:

“In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.”

So Hayek, after all his attacks on Keynes in the 1930s, essentially admitted Keynes was right, at least on these points at any rate.

BIBLIOGRAPHY
Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A Von Hayek. American Enterprise Institute, Washington.