It is well known that Hayek abandoned general equilibrium theory after the 1940s for the concept of a “spontaneously emerging market order.” But Hayek’s views on equilibrium also evolved over time, and some scholars feel it is necessary to divide Hayek’s career into
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.
While Hayek developed an intertemporal equilibrium theory in 1928 in his paper “Intertemporal Price Equilibrium and Movement in the Value of Money” (Hayek 1984 [1928]), he did not use this in
Prices and Production (1931). Instead, “he 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” [my emphasis] (Donzelli 1993: 57). In
Prices and Production, an initial stationary state moves to disequilibrium and then moves via boom and bust into a new stationary state. This might be viewed as an application of Hayek’s intertemporal equilibrium theory of 1928 where perfect foresight is needed as an assumption (Foss 1995: 353). Hayek’s definition of monetary stability is a state where voluntary savings equal voluntary investment. The unique natural rate of interest is taken over from Wicksell via Mises.
An equilibrium state is the starting point of a real world economy allegedly subject to Hayek’s Austrian trade cycle (Loasby 1997: 54: “Hayek began ... with a monetary expansion ... impinging on a perfectly co-ordinated economy”). 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).
U. Witt has identified the severe problem running through Hayek’s reliance on general equilibrium for his trade cycle theory:
“It is an irony that the perfectionist endeavour turned out to run into troubles which, it is claimed here, developed into a crisis of the whole program. In Mises’s understanding (general) equilibrium is a fictitious, imaginary construction useful as a logical basis of comparative statics … Though often arguing similarly in this respect, Hayek takes a different position. While Mises’s apodictic apriorism did not require Mises to derive empirical hypotheses, it is quite clear, e.g., from Hayek (1933) that he aimed at empirically meaningful propositions about the business cycle. For this reason, he was forced to identify general equilibrium in some way or other with an empirical state of the economy, and his theory indeed seems to suggest the state of the markets in the pre-upswing stage of the business cycle. However, in an empirical economic theory it is difficult to determine the conditions under which general equilibrium should be observable. It is even more obscure to see how individual imaginations of, and plans for, future events come to be coordinated so that prices can converge to their equilibrium values. The latter question is crucial in an individualistic approach where subjective expectations are supposed to play a key role.” (Witt 1997: 49).
In other words, Hayek came to see that perfect information and foresight were necessary to explain the convergence back to an equilibrium state as the upswing turned to a bust. The existence of subjective expectations in the real world and the non-existence of equilibrium states are severe stumbling blocks to Hayek’s theory.
Hayek’s assumptions go much further than the idea of a starting equilibrium state. They also assume:
(1) The flexibility of prices and perfect or near perfect adjustments in prices in response to demand and supply;
(2) frictionless markets, and perfect price information on the part of agents (Witt 1997: 47).
None of these assumptions can be taken seriously: prices are not perfectly flexible, and in reality agents
ex ante expectations can be severely disappointed
ex post, and Knightian uncertainty causes subjective expectations.
Karl Gunnar Myrdal (1898–1987) had already levelled this criticism against Hayek in a paper in 1933 (Myrdal 1933: 385; Foss 1995: 354), and Hayek’s famous paper “Economics and Knowledge” (1937) can be seen as the beginning of his attempt to answer these criticisms (Witt 1997: 49).
The problematic role of expectations for Hayek’s trade cycle theory was already being raised
within the Austrian school in the 1930s, as Ludwig Lachmann related in an Austrian Economics Newsletter (AEN) interview:
“AEN: You have talked a number of times about the importance of expectations in business cycle theory. What first drew your interest to expectations as far as the business cycle question was concerned.
Lachmann: Talking to Paul Rosenstein-Rodan, who was then a lecturer at University College, London – not technically in the London School of Economics – but he gave a course on the history of economic thought to which all of us who were research students then went. It was Rosenstein-Rodan who in discussing Austrian trade cycle theory with me said, ‘Ah yes, but whatever happens in the business cycle is in the first place determined by expectations.’ And then he told me of the work that had been done in Sweden.”
Ludwig Lachmann, “An Interview with Ludwig Lachmann,” The Austrian Economics Newsletter, Volume 1, Number 3 (Fall 1978), Mises.org.
Lachmann heard of the work of the
Stockholm school from Paul Rosenstein-Rodan: the Stockholm school at this time was being influenced by Gunnar Myrdal’s incorporation of Knightian uncertainty into economic theory (and Lachmann himself later came to examine the role of expectations, see Lachmann 1943 and 1945).
In fact, Hayek delivered a lecture called “Price Expectations, Monetary Disturbances and Malinvestments” on December 7, 1933 in Copenhagen (first published in German in 1935; English trans. Hayek 1939) where he responded to Myrdal’s criticisms. Here he began to modify his ideas on the equilibrium interest rate and the concept of equilibrium itself, which was more fully developed in his paper “Economics and Knowledge” (Hayek 1937). Hayek needed to free himself from the stationary equilibrium approach and construct a dynamic approach suitable for his trade cycle theory (Donzelli 1993: 59; others like Myrdal, Ohlin, Lindahl, and Hicks also freed themselves from the stationary equilibrium approach in the 1930s, and rediscovered the Walrasian instantaneous equilibrium approach; see Donzelli 1993: 60). In his 1933 paper in Copenhagen, Hayek had revived his “intertemporal equilibrium” idea, even though this was really “a temporary equilibrium notion with perfect foresight” (Donzelli 1993: 60). The meshing of plans with correct foresight defined as equilibrium in “Economics and Knowledge” (Hayek 1937) is also a reflection of this.
By the time of
The Pure Theory of Capital, Hayek asserts it is necessary to “abandon every pretence that [sc. equilibrium] … possesses reality, in the sense that we can state the conditions under which a particular state of equilibrium would come about” (Hayek 1976 [1941]: 28). In abandoning equilibrium, Hayek was in effect abandoning his early trade cycle work, and it is no surprise that he never returned to it:
“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-step 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).
Witt is correct.
But I would go further than Witt: Hayek’s intellectual journey in repudiating equilibrium theory requires that his business cycle theory is essentially worthless as a real world explanation of cycles.
Appendix: Hayek’s Exposition of ABCT
It is useful to list the various works where Hayek developed his trade cycle theory:
(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).
(6) F. A. Hayek, 1942. “The Ricardo Effect,” Economica 9: 127–152.
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