Levin Interview with Friedrich Hayek (1980)

This is something of a find: Bernard Levin talks to Hayek at the University of Freiburg, in an interview broadcast on 31st May, 1980.




The opening introduction by Levin seems to me to be an incredible exaggeration of Hayek’s importance, but anyway some other comments also occur:

(1) What strikes me, above all, is that Hayek just sounds like a mainstream neoclassical in his emphasis on the role of prices: what is this but the Walrasian neoclassical view of an economy with a market-clearing price vector that converges to general equilibrium? In other writings at this stage of his career, Hayek was expressing a disillusionment with general equilibrium theory, yet here he just repeats that same tired old neoclassical equilibrium myths.

(2) This interview was conducted in the early years of Thatcher (Prime Minister of the UK from 1979–1990), who appealed to Hayek as one of her economic influences, though in practice her policy owed more to monetarism than Austrian economics.

(3) Hayek’s prescription of high unemployment and bankruptcy as a solution to stagflation evokes the worst nonsense of his liquidationism.

(4) Hayek’s discussion of his conception of liberty (from 19.00) is of some interest.

(5) Some of my posts relevant to this interview:

“Hayek on the Flaws and Irrelevance of his Trade Cycle Theory,” June 29, 2011.

“Did Hayek Advocate Public Works in a Depression?,” September 25, 2011.

“Hayek and the Concept of Equilibrium,” September 20, 2011.

Bruce Caldwell on the Flaw in Hayek’s Early Business Cycle Theory

I was struck in a recent re-reading of Caldwell’s book on Hayek by this passage:

“Hayek’s starting point was a system that was in a state of (what might be called, following Blaug [1990a, 185-86]) total equilibrium. He would then show what sorts of things would have to happen for the system to fail to adjust properly (i.e., fail to return to equilibrium) when it was disturbed. This approach was logically impeccable. However, to insist on starting one’s analysis with a system that is in full equilibrium when that equilibrium implies that all resources are fully utilized seemed bizarre in the midst of the Great Depression” (Caldwell 2004: 163).

Bingo. This is one of the reasons, amongst others, why Hayek’s business cycle theory was judged to be flawed and unconvincing by the economists of his day, and why the Austrians lost out in the 1930s.

I suspect Hayek’s unrealistic assumption of an equilibrium starting point is also the reason why he sounded so ludicrous when he gave a talk at Cambridge around 1931:

“Immediately before giving his early 1931 lectures at LSE, which were his introduction to the school, Hayek gave a one-lecture to the Keynes-dominated Marshall Society at Cambridge. Richard Kahn, one of Keynes’ followers and later his literary executor, described the scene. Hayek had “a large audience of students, and also of leading members of the faculty. (Keynes was in London.) The members of the audience—to a man—were completely bewildered. Usually a Marshall Society talk is followed by a lively and protracted barrage of discussions and questions. On this occasion there was complete silence. I felt I had to break the ice. So I got up and asked, ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ ‘Yes,’ said Hayek. ‘But,’ pointing to his triangles on the board, ‘it would take a very long mathematical argument to explain why’” (Ebenstein 2003: 53).

This anecdote has always seemed strange, but I assume that Hayek here must have been thinking of an economy with full use of resources when he said that extra demand might increase unemployment: an assumption so utterly bizarre in the depths of the Great Depression, it is no wonder if people thought Hayek was crazy.


BIBLIOGRAPHY

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

Ebenstein, A. O. 2003. Friedrich Hayek: A Biography, University of Chicago Press, Chicago, Ill. and London.

My Post on Praxeology gets some Attention

That is, over at a Mises.org forum thread:

http://mises.org/Community/forums/p/28381/459878.aspx

My original post is here. I am not very impressed by the resulting discussion, however.

One of the absurd (perhaps latent) assumptions made by internet Austrians is that praxeology is the only method held by Austrian economists. It never seems to sink in to the Misesians that pure apriorist praxeology was rejected by Hayek and by some of the Austrian school influenced by Hayek.

Note the comments that Hayek made in a letter to Terence W. Hutchison dated 15 May, 1983:

“I had never accepted Mises’ a priorism .... Certainly 1936 was the time when I first saw my distinctive approach in full clarity – but at the time I felt it that I was merely at last able to say clearly what I had always believed – and to explain gently to Mises why I could not ACCEPT HIS A PRIORISM” (quoted in Caldwell 2009: 323–324).

In a later interview, Hayek is quite explicit about his endorsement of a general Popperian method for economics:

“I became one of the early readers [sc. of Karl Popper’s Logik der Forschung, 1934]. It had just come out a few weeks before …. And to me it was so satisfactory because it confirmed this certain view I had already formed due to an experience very similar to Karl Popper’s. Karl Popper is four or five years my junior; so we did not belong to the same academic generation. But our environment in which we formed our ideas was very much the same. It was very largely dominated by discussion, on the one hand, with Marxists and, on the other hand, with Freudians. Both these groups had one very irritating attribute: they insisted that their theories were, in principle, irrefutable. Their system was so built up that there was no possibility – I remember particularly one occasion when I suddenly began to see how ridiculous it all was when I was arguing with Freudians, and they explained, “Oh, well, this is due to the death instinct.” And I said, “But this can’t be due to the [death instinct].” “Oh, then this is due to the life instinct.” … Well, if you have these two alternatives, of course there’s no way of checking whether the theory is true or not. And that led me, already, to the understanding of what became Popper’s main systematic point: that the test of empirical science was that it could be refuted, and that any system which claimed that it was irrefutable was by definition not scientific. I was not a trained philosopher; I didn’t elaborate this. It was sufficient for me to have recognized this, but when I found this thing explicitly argued and justified in Popper, I just accepted the Popperian philosophy for spelling out what I had always felt. Ever since, I have been moving with Popper” (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 18–19).

One really has to wonder what Hayek would have thought about the hordes of ignorant Austrians on the internet today, claiming that the inferences of praxeology (and I stress the “inferences,” not the starting axioms) are irrefutable, and praxeology has no need for empirical evidence (which is in fact a distortion of what even Mises conceded). If Hayek were alive today and gave us an honest answer to this, he would have to class such vulgar Misesian praxeologists as talking nonsense on a par with Marxism and Freudian psychology.

Yet another subject rarely considered is the epistemology of Willard Van Orman Quine (1908–2000) and its implications for Austrian praxeology.

If one sees any merit in Quine’s idea that there is no meaningful distinction between analytic or synthetic propositions (and I am not saying that I do), then it logically follows that the basis for the a priori status of the human action axiom is destroyed (in fact, the status of all alleged a priori propositions is fatally compromised). For Quine believed that no proposition is immune from possible revision of its truth by the test of experience, and that there is in fact no real a priori knowledge of reality.


BIBLIOGRAPHY

Caldwell, B. 2009. “A Skirmish in the Popper Wars: Hutchison versus Caldwell on Hayek, Popper, Mises, and methodology,” Journal of Economic Methodology 16.3: 315–324.

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.

Lionel Robbins and the Myth of Hayek’s Prediction of the Great Depression

In the introduction to the original edition of Prices and Production (London, 1931), Lionel Robbins made a bold claim for Austrian economists and Hayek’s predictive power:

“... I cannot think that it is altogether an accident that the Austrian Institut für Konjunkturforschung, of which Dr. Hayek is director, was one of the very few bodies of its kind which, in the spring of 1929, predicted a setback in America with injurious repercussions on European conditions” (Hayek 1931: xi-xii).

Robbins refers here to the Österreichische Konjunkturforschungsinstitut (Austrian Institute for Business Cycle Research). This opened in 1927, and Hayek was appointed as the first director (Hayek 1991: 125, n. 1; Steele 2001: 8–9; for the foundation of the Institute by Mises, see Hülsmann 2007: 575-576). Hayek wrote nearly all the monthly reports (“Monatsberichte” in German) of the institute for four years, and only obtained the assistance of Oskar Morgenstern as his collaborator in 1929 (Hayek 1991: 125, n. 1; Ebenstein 2003: 44; cf. Hülsmann 2007: 576: “Hayek himself wrote the first, very lengthy report [sc. of the “Monatsberichte”] ... Over the years, [sc. Hayek] ... relied more and more on contributions from others”).

Hansjörg Klausinger, in an excellent chapter in an edited monograph on Austrian economics, has recently charged that, “browsing through the monthly bulletins of the institute, it is difficult to discover anything that comes close to corroborating Robbin’s statement” (Klausinger 2010: 227). I am rather gratified that a reading of Klausinger (2010) confirms my own analysis of this very question here:

“Hayek and the Stock Market Crash of 1929: So Much for His Predictive Powers,” December 28, 2011.

I wrote this before reading Klausinger.

Klausinger also notes that Hayek’s “Monatsberichte” made very significant use of the “Harvard Economic Service” (a publication of the Harvard University Committee on Economic Research) and the Harvard barometer, and rarely engaged in much more than an “eclectic interpretation of these” (Klausinger 2010: 227).

This is easily verified. In a report from November 1928, we have the following (with my translation of the German):

“Harvard Economic Service meint, daß, wenn nicht unerwartete, jetzt nicht erkennbare Faktoren zu einer Liquidation am Effektenmarkt führen sollten, die ersten Monate 1929 eine neue Anspannung am Kapitalsmarkt bringen dürften. Die Kreditsituation sei als heikel und schwierig, nicht aber als gefährlich zu bezeichnen. Doch wenn die Krediterweiterung weiter fortgesetzt wird, wird man in einem Jahr einer noch viel schwierigeren und heikleren Situation gegenüberstehen. Die Position der Federal Reserve-Banken ist allerdings stark genug, um noch längere Zeit Kreditexpansion betreiben zu können und die Zeit der großen Wirtschaftskrise dürfte noch recht weit entfernt sein, wenn dies auch vorübergehende kleinere Liquidationsperioden nicht ausschließt.”

“[The] Harvard Economic Service thinks that factors not now apparent/recognizable, if not unexpected/unforeseen, should lead to a liquidation effect on the market, [and] the first months of 1929 may be expected to bring a new strain in the capital market. The credit situation is to be described as awkward and difficult, but not as dangerous. But, if the credit expansion is continued, we will face in a year an even more difficult and awkward situation. The position of the Federal Reserve banks, however, is strong enough to be able to conduct credit expansion for quite some time, and a time of great economic crisis is likely to be still quite far away, even if this does not exclude periods of temporary smaller liquidation.”
Monatsberichte des österreichischen Institutes für Konjunkturforschung, 2. Jahrgang, Nr. 11. (26 November, 1928). p. 174.

As I have said before, what is clear is that American forecasters were predicting some kind of crisis in 1929. Hayek picked up on that, and noted it here.

Moreover, Hayek thought that a “great economic crisis is likely to be still quite far away” (“großen Wirtschaftskrise dürfte noch recht weit entfernt sein”). “Still quite far away” (“noch recht weit entfernt”) sounds like a number of years to me, not one year. This is yet another problem for the view that Hayek was some kind of prescient oracle.

There is a second relevant passage in an October 26, 1929 issue of the Monatsberichte (my translation follows):

“Jedoch besteht derzeit kein Grund, einen plötzlichen Zusammenbruch der New Yorker Börse zu erwarten. Allerdings ist es nicht ausgeschlossen, daß nunmehr das Ende der geradezu phantastischen Kurssteigerungen gekommen ist und das Niveau langsam abbröckeln dürfte.

Die Kredit Möglichkeiten sind jedenfalls augenblicklich noch sehr große und es erscheint daher die Gewähr gegeben, daß eine ausgesprochen krisenhafte Zerstörung des jetzigen hohen Niveaus nicht befürchtet werden müßte. Zur Zeit werden europäische Gelder bereits in großen Beträgen abgezogen, so daß der Dollarkurs gedrückt ist.”

“However, at present there is no reason to expect a sudden crash of the New York stock exchange. However, it is not impossible that the end of the absolutely amazing price increases has arrived, and [that] the [price] level should slowly crumble. The credit possibilities/conditions are, at any rate, currently very great, and therefore it appears assured that an outright crisis-like destruction of the present high [sc. price] level should not be feared. At the moment, European funds are already being withdrawn in large amounts, so that the value of the [US] dollar is down.” Monatsberichte des österreichischen Institutes für Konjunkturforschung, 3. Jahrgang, Nr. 10 (26 October, 1929), p. 182.

There is a strong likelihood that Hayek wrote this, or possibly as a co-author with Oskar Morgenstern (it is clear from p. 186 of the issue that Hayek is listed as the editor: “Verantwortlicher Schriftleiter: Dr. Friedrich A. Hayek”).

So here a few days before the historic stock market crash of October 28, 1929 (Black Monday) and October 29 (Black Tuesday), a crash which continued until November 13, 1929, we have Hayek predicting

(1) no “sudden crash of the New York stock exchange”;
(2) the possibility of a slow fall in stock market prices, and
(3) an “outright crisis-like destruction of the present high [sc. price] level should not be feared.”

All wrong.

Hansjörg Klausinger (2010: 227) concludes that we still lack “convincing evidence of a prediction that conformed to what Robbins suggested in his foreword.”

And Klausinger is entirely correct. The Austrians’ predictive powers regarding the Great Depression are grossly exaggerated, and Hayek’s in particular.


BIBLIOGRAPHY

Ebenstein, A. O. 2003. Friedrich Hayek: A Biography, University of Chicago Press, Chicago and London.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1991. The Collected Works of F. A. Hayek. Volume 3. The Trend of Economic Thinking: Essays on Political Economists and Economic History (ed. W. W. Bartley and S. Kresge), Routledge, London.

Hayek, F. A. von. 1994. Hayek on Hayek: An Autobiographical Dialogue (eds. S. Kresge and L. Wenar), Routledge, London.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Klausinger, Hansjörg. 2010. “Hayek on Practical Business Cycle Research: A Note,” in H. Hagemann, T. Nishizawa, Y. Ikeda (eds.), Austrian Economics in Transition: From Carl Menger to Friedrich Hayek, Palgrave Macmillan, Basingstoke. 218–234.

Steele, G. R. 2001. Keynes and Hayek: The Money Economy, Routledge, London and New York.

Hayek and the Stock Market Crash of 1929: So Much for His Predictive Powers

In 1927, the Österreichische Konjunkturforschungsinstitut (Austrian Institute for Business Cycle Research) was opened and Friedrich August von Hayek was appointed as the first director (Hayek 1991: 125, n. 1; Steele 2001: 8–9; for the foundation of the Institute by Mises, see Hülsmann 2007: 575-576). Hayek wrote nearly all the monthly reports (“Monatsberichte” in German) of the institute for four years, and only obtained the assistance of Oskar Morgenstern as his collaborator in 1929 (Hayek 1991: 125, n. 1; Ebenstein 2003: 44; cf. Hülsmann 2007: 576: “Hayek himself wrote the first, very lengthy report [sc. of the “Monatsberichte”] ... Over the years, [sc. Hayek] ... relied more and more on contributions from others”).

You can find PDFs of the Monatsberichte here:

Monatsberichte, Historisches Volltextarchiv ab 1927.

Now it is said that in a report from November 1928 Hayek predicted a great economic crisis (“großen Wirtschaftskrise”) in America. Let’s turn to the relevant passage, with my translation of the German following:

“Harvard Economic Service meint, daß, wenn nicht unerwartete, jetzt nicht erkennbare Faktoren zu einer Liquidation am Effektenmarkt führen sollten, die ersten Monate 1929 eine neue Anspannung am Kapitalsmarkt bringen dürften. Die Kreditsituation sei als heikel und schwierig, nicht aber als gefährlich zu bezeichnen. Doch wenn die Krediterweiterung weiter fortgesetzt wird, wird man in einem Jahr einer noch viel schwierigeren und heikleren Situation gegenüberstehen. Die Position der Federal Reserve-Banken ist allerdings stark genug, um noch längere Zeit Kreditexpansion betreiben zu können und die Zeit der großen Wirtschaftskrise dürfte noch recht weit entfernt sein, wenn dies auch vorübergehende kleinere Liquidationsperioden nicht ausschließt.”

“[The] Harvard Economic Service thinks that factors not now apparent/recognizable, if not unexpected/unforeseen, should lead to a liquidation effect on the market, [and] the first months of 1929 may be expected to bring a new strain in the capital market. The credit situation is to be described as awkward and difficult, but not as dangerous. But, if the credit expansion is continued, we will face in a year an even more difficult and awkward situation. The position of the Federal Reserve banks, however, is strong enough to be able to conduct credit expansion for quite some time, and a time of great economic crisis is likely to be still quite far away, even if this does not exclude periods of temporary smaller liquidation.”
Monatsberichte des österreichischen Institutes für Konjunkturforschung, 2. Jahrgang, Nr. 11. (26 November, 1928). p. 174.

The first thing that sticks out like a sore thumb is the opening clause:

“Harvard Economic Service meint, daß, …” or “[the] Harvard Economic service thinks that … .”

Hayek is quoting from “The Harvard Economic Service,” a publication of the Harvard University Committee on Economic Research: this committee published a quarterly journal on economic statistics, and from 1922 began to provide business forecasting through a weekly newsletter with economic data and analysis.

Apparently, it was a forecast by the American Harvard Economic Service that Hayek is quoting in predicting that some problems would emerge on the US capital market in the first months of 1929. Indeed, Hayek himself on a trip to the US in 1923 had been impressed with empirical business cycle research at Columbia University, and this may have inspired the founding of the Austrian Institute for Business Cycle Research later in 1927 (Overtveldt 2007: 341; Hayek 1994: 6-8, 59; Ebenstein 2003: 43).

So are Hayek’s subsequent statements also derived from information he read in the Harvard Economic Service? If so, Hayek has no great predictive power here: he was relying on American research.

Here is the crucial statement:

“The position of the Federal Reserve banks, however, is strong enough for the credit expansion to be conducted for some time, and a time of great economic crisis is likely to be still quite far away, even if this does not exclude periods of temporary smaller liquidation.”

Was this Hayek’s own prediction? Until we look at the weekly (or perhaps quarterly) issues of the Harvard Economic Service, we can’t know. What is clear is that American forecasters were predicting some kind of crisis in 1929. Hayek picked up on that, and perhaps made this inference. Let’s assume that it was Hayek’s own prediction: in November, 1928 – about a year from the most devastating economic collapse seen in the US and the world – Hayek thought that a “great economic crisis is likely to be still quite far away” (“großen Wirtschaftskrise dürfte noch recht weit entfernt sein”). “Still quite far away” (“noch recht weit entfernt”) sounds like a number of years to me, not one year. This is yet another problem for the view that Hayek was some kind of prescient oracle.

Now Hayek is said to have predicted an economic crisis in the US in a February 1929 report (Steele 2001: 9; Huerta de Soto 2006: 429, n. 28 speaks of a 1929 prediction in the Monatsberichte, but gives no month). However, I cannot as yet find any such prediction. The report is here:

Monatsberichte des österreichischen Institutes für Konjunkturforschung, 3. Jahrgang, Nr. 2. (26 February 1929).

Let’s turn to the second relevant passage. This can be read in the 26 October 1929 issue of the Monatsberichte (my translation follows):

“Jedoch besteht derzeit kein Grund, einen plötzlichen Zusammenbruch der New Yorker Börse zu erwarten. Allerdings ist es nicht ausgeschlossen, daß nunmehr das Ende der geradezu phantastischen Kurssteigerungen gekommen ist und das Niveau langsam abbröckeln dürfte.

Die Kredit Möglichkeiten sind jedenfalls augenblicklich noch sehr große und es erscheint daher die Gewähr gegeben, daß eine ausgesprochen krisenhafte Zerstörung des jetzigen hohen Niveaus nicht befürchtet werden müßte. Zur Zeit werden europäische Gelder bereits in großen Beträgen abgezogen, so daß der Dollarkurs gedrückt ist.”

“However, at present there is no reason to expect a sudden crash of the New York stock exchange. However, it is not impossible that the end of the absolutely amazing price increases has arrived, and [that] the [price] level should slowly crumble. The credit possibilities/conditions are, at any rate, currently very great, and therefore it appears assured that an outright crisis-like destruction of the present high [sc. price] level should not be feared. At the moment, European funds are already being withdrawn in large amounts, so that the value of the [US] dollar is down.” Monatsberichte des österreichischen Institutes für Konjunkturforschung, 3. Jahrgang, Nr. 10 (26 October, 1929), p. 182.

There is a strong likelihood that Hayek wrote this, or possibly as a co-author with Oskar Morgenstern (it is clear from p. 186 of the issue that Hayek is listed as the editor: “Verantwortlicher Schriftleiter: Dr. Friedrich A. Hayek”).

So here a few days before the historic stock market crash of October 28, 1929 (Black Monday) and October 29 (Black Tuesday), a crash that continued until November 13, 1929, we have Hayek predicting

(1) no “sudden crash of the New York stock exchange”;
(2) the possibility of a slow fall in stock market prices, and
(3) an “outright crisis-like destruction of the present high [sc. price] level should not be feared.”

All utterly wrong.

All in all, I don’t see any great miracles of prediction here. There also remains the possibility that Hayek’s November 1928 prediction of a “great economic crisis … likely to be still quite far away” (“großen Wirtschaftskrise dürfte noch recht weit entfernt”) was something he read in the Harvard Economic Service, or that he inferred this from their own prediction of some kind of market liquidation in 1929.


BIBLIOGRAPHY

Ebenstein, A. O. 2003. Friedrich Hayek: A Biography, University of Chicago Press, Chicago and London.

Hayek, F. A. von. 1991. The Collected Works of F. A. Hayek. Volume 3. The Trend of Economic Thinking: Essays on Political Economists and Economic History (ed. W. W. Bartley and S. Kresge), Routledge, London.

Hayek, F. A. von. 1994. Hayek on Hayek: An Autobiographical Dialogue (eds. S. Kresge and L. Wenar), Routledge, London.

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Overtveldt, J. van. 2007. The Chicago School: How the University of Chicago Assembled the Thinkers who Revolutionized Economics and Business, Agate, Chicago.

Steele, G. R. 2001. Keynes and Hayek: The Money Economy, Routledge, London and New York.

Hayek’s Natural Rate on Capital Goods, Sraffa and ABCT

Consider this passage from Hayek’s Prices and Production (2nd edn.; 1935):

“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.

Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; …” (Hayek 2008 [1935]: 215).

This passage illustrates a fundamental reason why Sraffa’s critique of Hayek was so important. In Sraffa’s analysis of Hayek’s theory, we see that

(1) the relevant market for the “demand for and the supply of capital” is the market for capital goods. Depending on how one defines “saving” (see Pollin 2003: 304–308) and “investment,” the demand for capital that is met results in investment (if savings is defined simply as “income not spent,” savings can exceed investment when money or even goods are held without lending for capital goods investment).

(2) By the words

“because the demand for and the supply of capital do not meet in their natural form but in the form of money,”

Hayek is referring to the idea of loans being made in natura (in real commodities), as opposed to in money terms.

(3) A state where loans are made in in natura is a barter state (or, more correctly, a credit/debt transaction where real goods are lent out and repayed with interest with some other goods later). What would a rate of interest be when loans are made in goods? The rate of interest would be the rate on loans of a physical commodity or commodities (Sraffa 1932: 49–51). In a world of heterogeneous goods as factor inputs (including capital goods) which is out of equilibrium, there could be as many natural rates on each commodity considered as a factor input (or capital good) as there as such commodities (Barens and Caspari 1997: 288).

(4) Which one of these rates would in fact be the “natural rate”? There is no unique natural rate, but multiple rates. Any monetary rate could be both above and below a number of multiple natural rates, or, as Lachmann stated, “it is evidently possible for the money rate of interest to be lower than some [sc. multitude of commodity rates] but higher than others” (Lachmann 1994: 154). In short, one should agree with Robert P. Murphy, who concludes that “canonical ABCT does need to be updated, in light of a crippling objection raised early on by Piero Sraffa (1932a, 1932b) [my emphasis]” (see “Multiple Interest Rates and Austrian Business Cycle Theory,” p. 1).

(5) It therefore makes no sense to speak of a monetary rate of interest diverging from the unique Wicksellian natural rate of interest (or what Hayek calls the equilibrium rate), because there is no such rate outside of an imaginary equilibrium position.

(6) If some average of multiple natural rates were constructed, would this get Hayek out of his conundrum? No. As Sraffa argued,

“I pointed out that only under conditions of equilibrium would there be a single rate; and that when saving was in progress there would at any one moment be many ‘natural’ rates, possibly as many as there are commodities; so that it would be not merely difficult in practice, but altogether inconceivable, that the money rate should be equal to ‘the’ natural rate. And whilst Wicksell might fall back, for the criterion of his ‘money’ rate, upon an average of the ‘natural’ rates weighted in the same way as the index number of prices which he chose to stabilise, this way of escape was not open to Dr. Hayek, for he had emphatically repudiated the use of averages. Dr. Hayek now acknowledges the multiplicity of the ‘natural’ rates, but he has nothing more to say on this specific point than that they ‘all would be equilibrium rates.’ The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates.” (Sraffa 1932b: 251).

Lachmann also noted that Wicksell’s natural rate could be interpreted as an average of actual own-rates in a barter economy (Lachmann 1978: 76–77), and later tried to defend the natural rate idea.

For Lachmann’s attempts to salvage the notion of a natural rate, see Lachmann (1978: 75–77) and Lachmann (1986: 225–242). See Robert P. Murphy (2003) and Murphy’s paper “Multiple Interest Rates and Austrian Business Cycle Theory” for why Lachmann’s solution does not work.

BIBLIOGRAPHY

Barens, I. and V. Caspari, 1997. “Own-Rates of Interest and Their Relevance for the Existence of Underemployment Equilibrium Positions,” in G. C. Harcourt and P. A. Riach (eds.), A “Second Edition” of The General Theory (Vol. 1), Routledge, London. 283–303.

Hayek, F. A. von, 1932. “Money and Capital: A Reply,” Economic Journal 42 (June): 237–249.

Hayek, F. A. von, 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.

Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City. pp. 75–77.

Lachmann, L. M. 1986. “Austrian Economics under Fire: The Hayek-Sraffa Duel in Retrospect,” in W. Grassl and B. Smith (eds.), Austrian Economics: Historical and Philosophical Background, Croom Helm, London. 225–242. [reprinted in Lachmann 1994: 141–158.]

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London. 141–158.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”

Pollin, R. 2003. “Saving,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, Edward Elgar, Cheltenham, UK and Northhampton, MA, USA. 304–308.

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.


UPDATED BIBLIOGRAPHY ON THE HAYEK–SRAFFA DEBATE

Barens, I. and V. Caspari, 1997. “Own-Rates of Interest and Their Relevance for the Existence of Underemployment Equilibrium Positions,” in G. C. Harcourt and P. A. Riach (eds.), A “Second Edition” of The General Theory (Vol. 1), Routledge, London. 283–303.

Bellofiore, R. 1998. “Between Wicksell and Hayek: Mises’ Theory of Money and Credit Revisited,” American Journal of Economics and Sociology 57.4: 531–578.

Burger, P. 2003. Sustainable Fiscal Policy and Economic Stability: Theory and Practice, Edward Elgar, Cheltenham, UK.

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

Cottrell, A. 1993. “Hayek’s Early Cycle Theory Re-examined,” Cambridge Journal of Economics 18: 197–212.

Harcourt, G. C. and P. A. Riach. 1997. A “Second Edition” of The General Theory (Vol. 1), Routledge, London.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1932. “Money and Capital: A Reply,” Economic Journal 42 (June): 237–249.

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

Hicks, J. R. and J. C. Gilbert. 1934. Review of Beiträge zur Geldtheorie by F. A. von Hayek, Economica n.s. 1.4: 479–486.

Kurz, H. D. 2000. “Hayek-Keynes-Sraffa Controversy Reconsidered,” in H. D. Kurz (ed.), Critical Essays on Piero Sraffa’s Legacy in Economics, Cambridge University Press, Cambridge. 257-302.

Kyun, K. 1988. Equilibrium Business Cycle Theory in Historical Perspective Cambridge University Press, Cambridge. p. 36ff.

Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City. pp. 75–77.

Lachmann, L. M. 1986. “Austrian Economics under Fire: The Hayek-Sraffa Duel in Retrospect,” in W. Grassl and B. Smith (eds.), Austrian Economics: Historical and Philosophical Background, Croom Helm, London. 225–242. [reprinted in Lachmann 1994: 141–158.]

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London. 141–158.

Lawlor, M. S. and Horn, B. 1992. “Notes on the Hayek–Sraffa Exchange,” Review of Political Economy 4: 317–340.

Lawlor, M. S. 1994. “The Own-Rates Framework as an Interpretation of the General Theory: A Suggestion for Complicating the Keynesian Theory of Money,” in J. B. Davis (ed.), The State of Interpretation of Keynes, Kluwer Academic, Boston and London. 39–90.

Milgate, M. 1979. “On the Origin of the Notion of ‘Intertemporal Equilibrium,’” Economica n.s. 46.181: 1–10.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”

Myrdal, G. 1965 [1939]. Monetary Equilibrium, Augustus M. Kelly, New York.

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

ABCT and the Flow of Credit

In the 1970s, Hayek attempted to analyse stagflation. In doing so, he acknowledged the limitations of his earlier Austrian business cycle theory (ABCT) in explaining the 1970s crisis, because the flows of credit and monetary expansion were of a different type from those he had dealt with in his earlier work:

“There is one special difficulty about accounting for the present situation. In the misdirection of labour and the distortion of the structure of production during past business cycles, it was fairly easy to point to the places where the excessive expansion had occurred because it was, on the whole, confined to the capital goods industries. The whole thing was due to an over-expansion of credit for investment purposes, and it was therefore possible to regard the industries producing capital equipment as those which had been over-expanded.

In contrast, the present expansion of money [sc. in the 1970s], which has been brought about partly by means of bank credit expansion and partly through budget deficits, has been the result of a deliberate policy, and has gone through somewhat different channels. The additional expenditure has been much more widely dispersed. In the earlier cases I had no difficulty in pointing to particular instances of overexpansion; now I am somewhat embarrassed when I am asked the question, because I would have to know the particular situation in a particular country, where the additional money flows went in the first place, etc. I would also have to trace the successive movements of prices which indicate these flows. In consequence, I have no general answer to the question.” (Hayek 1978: 212).

And this remains a severe flaw in the Austrian trade cycle theory: the original theory assumes credit expansion goes to businesses investing in capital goods, and has no role for loans for consumer durables or debt-fuelled asset bubbles. Karen Vaughn has already drawn attention to the latter failing of ABCT (Vaughn 1994: 87–88).

Even Hayek himself made a remarkable qualification of his theory with respect to conditions after the Second World War:

“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. 184–186).

Hayek’s belief that a proper application of his trade cycle theory to the modern world requires looking at the direct of credit expansion “separately for each particular phase and situation” is one lost on most modern Austrians. Instead, they flog the dead horse of Hayek’s 1930s theory, which he himself admitted had lost its relevance in modern economies.

The modern Austrians present a fossilised Hayekian relic of a theory derived from Prices and Production (1931; 2nd edn. 1935) and Profits, Interest and Investment (1939), as can be seen in Roger W. Garrison’s Time and Money: The Macroeconomics of Capital Structure (Routledge, London, 2002). Hayek himself by the 1970s had moved on from believing his 1930s work on trade cycles could be simply applied to the modern world, at least not without serious modification.

And one further observation should be made: a monetary theory that examines business cycles by looking at the flows of credit to debt-financed asset bubbles already exists: it is called Irving Fisher’s debt deflation theory (Fisher 1933), which has been developed in Hyman Minsky’s financial instability hypothesis (FIH) (Minsky 1982; 2008). This has been further developed in Post Keynesian economics, most notably by Steve Keen.

This is the true monetary theory of the trade cycle when credit flows to speculation that creates asset bubbles and their collapse spills over into severe effects on the real economy. This theory explains many 19th century trade cycles, the Great Depression, Japan’s lost decade, and now the mess that many Western nations are in.


BIBLIOGRAPHY

Fisher, I. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.

Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

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

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London

Hayek, F. A. von. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas, Routledge & Kegan Paul, London.

Minsky, H. P. 1982. Can “It” Happen Again?: Essays on Instability and Finance, M.E. Sharpe, Armonk, N.Y.

Minsky, H. P. 2008 [1975]. John Maynard Keynes, McGraw-Hill, New York 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.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Did Hayek Advocate Public Works in a Depression?

The answer to the question posed in the title of my post depends on the proper interpretation of passages in Hayek’s essay “The Campaign Against Keynesian Inflation” (in New Studies in Philosophy, Politics, Economics, and the History of Ideas, London, 1978, pp. 191–232) and in “The Gold Problem” (published in 1937; see Hayek 1999: 169–185).

The context of the first passage is clearly Hayek’s response to the charge that he advocated deflationary depression as a solution in the early 1930s:

“… a ‘secondary depression’ caused by an induced deflation should of course be prevented by appropriate monetary counter-measures. Though I am sometimes accused of having represented the deflationary cause of the business cycles as part of the curative process, I do not think that was ever what I argued. What I did believe at one time was that a deflation might be necessary to break the developing downward rigidity of all particular wages which has of course become one of the main causes of inflation. I no longer think this is a politically possible method and we shall have to find other means to restore the flexibility of the wage structure than the present method of raising all wages except those which must fall relatively to all others. Nor did I ever doubt that in most situations employment could be temporarily increased by increasing money expenditure. There was one classical occasion when I even admitted that this might be politically necessary, whatever the long run economic harm it did.

The occasion was the situation in Germany in, I believe, 1930 when the depression was beginning to get quite serious and a political commission—the Braun Committee—had proposed to combat it by reflation (though that term had not yet been coined), i.e., a rapid expansion of credit. One of the members of the committee, in fact the main author of the report, was my late friend, Professor Wilhelm Röpke. I thought that in the circumstances the proposal was wrong and wrote an article criticising it. I did not send it to a journal, however, but to Professor Röpke with a covering letter in which I made the following point:

‘Apart from political considerations I feel you ought not—not yet at least—to start expanding credit. But if the political situation is so serious that continuing unemployment would lead to a political revolution, please do not publish my article. That is a political consideration, however, the merits of which I cannot judge from outside Germany but which you will be able to judge.’

Röpke’s reaction was not to publish the article, because he was convinced that at that time the political danger of increasing unemployment was so great that he would risk the danger of causing further misdirections by more inflation in the hope of postposing the crisis; at that particular moment this seemed to him politically necessary and I consequently withdrew my article.

To return, however, to the specific problem of preventing what I have called the secondary depression caused by the deflation which a crisis is likely to induce. Although it is clear that such a deflation, which does no good and only harm, ought to be prevented, it is not easy to see how this can be done without producing further misdirections of labour. In general it is probably true to say that an equilibrium position will be most effectively approached if consumers’ demand is prevented from falling substantially by providing employment through public works at relatively low wages so that workers will wish to move as soon as they can to other and better paid occupations, and not by directly stimulating particular kinds of investment or similar kinds of public expenditure which will draw labour into jobs they will expect to be permanent but which must cease as the source of the expenditure dries up.” (Hayek 1978: 210–212).

A more striking statement by Hayek on public works can be found in another passage in Hayek’s essay “The Gold Problem” (originally published in 1937 as “Das Goldproblem,” but available in an English translation in Hayek 1999: 169–185):

“Even though there are many concerns about organizing public works ad hoc during a depression, everything speaks in favour of having public agencies perform during a depression whatever investment activities need to be carried out in any case and can possibly be postposed until then. It is the timing of these expenses that presents a problem, since funds are often extremely hard to raise in the midst of a severe depression and the accumulation of reserves in good times generally faces the objections mentioned above. There is little question that in times of general unemployment the state must intervene to mitigate genuine hardship either by disbursing unemployment compensation or, as in earlier times, by legislation to help the poor. (Hayek 1999 [1937]: 184).

I would be curious to see other discussion of these passages in the scholarly literature, and especially the last one. Ebenstein, for example, maintains that Hayek was still disinclined to support public works though he conceded that they might work (Ebenstein 2003: 70–71; cf. Guest 1997: 59).¹ In The Road to Serfdom (1944), Hayek appears to accept the possibility of public works spending even if “in experimenting in this direction we shall have carefully to watch our step if we are to avoid making all economic activity progressively more dependent on the direction and volume of government expenditure” (Hayek 2001 [1944]: 126).²

If fact, if Hayek really meant what he said in “The Gold Problem” all the rubbish one sees in Russ Roberts and John Papola’s Keynes vs. Hayek rap videos should be doubly embarrassing to them. In these videos they try and smear Keynesian countercyclical policy as “central planning,” yet it would appear that Hayek may actually have supported such a policy in a depression. Evidently the good Professor Roberts and Mr Papola should have read their Hayek more carefully. Perhaps they should make a new video exposing Hayek as a “wicked” and “evil” central planner, himself advocating policies that would take us down the dreaded road to serfdom.

But let’s turn to more serious points that emerge from these passages above:

(1) Hayek appears to have opposed deflationary depression in Weimar Germany in the early 1930s because of the political harm it would do, which presumably refers to the rise of Hitler and his Nazi party. He showed great astuteness there, a quality lacking in many of his modern Austrian progeny. Hayek’s solution was apparently increasing employment temporarily “by increasing money expenditure.”

(2) If Hayek really wanted to provide “employment through public works at relatively low wages so that workers … move as soon as they can to other and better paid occupations” by government deficit financing or by money creation, then how is his solution to secondary deflation fundamentally different from a Keynesian one? The answer is that it would not be: Hayek comes very close here to advocating a Keynesian solution to the depression, if (and I emphasise this) the political considerations warrant it. This is still quite a startling insight.

(3) This statement from Hayek shows a side to him that should be driven home to modern Austrians:

“There is little question that in times of general unemployment the state must intervene to mitigate genuine hardship either by disbursing unemployment compensation or, as in earlier times, by legislation to help the poor.”

That should warm the heart of any social democrat. We should reclaim the Hayek who wrote that sentiment. Hayek was a Classical liberal who accepted the argument for a minimal state and here even state welfare for people in distress. If Hayek was pressed, how would he have justified such government welfare in ethical terms? I suspect he would have appealed to some utilitarian/consequentialist ethical theory, a theory which Mises also adhered to. Hayek was really far from the insanity of modern Rothbardian anarcho-capitalists with their natural rights propertarian ethical theory, which, when taken to its logical conclusion, would entail the destruction of our species.

Of course, it really doesn’t matter to me whether Hayek advocated quasi-Keynesian policies in a depression in some circumstances. I think his economics is mostly wrong. But the sight of Hayek advocating public works spending is certainty of historical interest. It certainly puts Hayek in a different category from the hordes of Rothbardian Austrians urging liquidationism as the right solution in cases of recession or depression in all circumstances.

George Selgin in his recent LSE debate with Skidelsky took Keynesians to task for (allegedly) smearing Hayek as a supporter of liquidationism in the early 1930s. But now it looks like Keynesians could turn the tables on Selgin: it was not mere monetary stabilisation that Hayek urged but fiscal policy. Is that what Selgin would support in a deep depression or to stop a deep depression from happening?

It is relevant here to note that the Austrian radical subjectivist Ludwig Lachmann also believed that a Keynesian solution to a deep depression could have worked:

“Policies based on Keynesian macro-economic recipes might have succeeded (had they then been tried) in 1932 and did succeed in 1940 because it so happened that at the bottom of the Great Depression as well as during the Second World War all sectors of the economy were equally affected. In 1932 any kind of additional spending on whatever kind of goods would have had a favourable effect on incomes because there was unemployment everywhere, as well as idle capital equipment and surplus stocks of raw materials.” (Lachmann 1973: 50).

Notes
(1) Ebenstein says: “Hayek became considerably more integrated with the rest of economic academia, at least with respect to practical policy and personal comity—though not with respect to emerging mathematical method—after his initial grand entry at the London school of Economics. While he did not backtrack from his fundamental analyses, he countenanced and even advocated that activist monetary policies could be appropriate policy and that even public works might have a role to play in evening out the vagaries of the business cycle— though he was disinclined to take the latter direction because it ‘might lead to much more serious restrictions of the competitive sphere.’” (Ebenstein 2003: 70–71).

(2) I would also note that Hayek’s support for monetary stabilisation in his earlier writings is inconsistent with his call for monetary denationalisation later in life. How would the state prevent a collapse in the money supply when it had no control over it?

BIBLIOGRAPHY
Ebenstein, A. O. 2003. Hayek’s Journey: The Mind of Friedrich Hayek, Palgrave Macmillan, New York and Basingstoke.

Guest, C. 1997. “Hayek on Government: Two Views or One?,” History of Economics Review 26: 51-67.

Hayek, F. A. von. 1937. “Das Goldproblem,” Österreichische Zeitschrift für Bankwesen 1.9 (September): 255–271. [English translation in Hayek 1999].

Hayek, F. A. von. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas, Routledge & Kegan Paul, London.

Hayek, F. A. von. 1999. “The Gold Problem” (trans. G. Heinz), in S. Kresge (ed.), The Collected Works of F. A. Hayek. Volume 5. Good Money, Part 1. The New World, Routledge, London. 169–185.

Hayek, F. A. von. 2001 [1944]. The Road to Serfdom, Routledge, London.

Lachmann, L. M. 1973. Macro-Economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-Foundations and its Consequences, Institute of Economic Affairs.

ABCT without a Unique Natural Rate of Interest?

Well, this would be an improvement on that absurd theory, if it were possible.

A commentator on the last post complains that the Austrian business cycle theory (ABCT) – don’t you know?! – doesn’t even need a unique natural rate of interest / equilibrium rate of interest, despite the fact that every exposition of the theory I have seen relies on exactly that concept.

One can see this in Hayek’s Prices and Production:

“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks. Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; if they raise the money rate above the equilibrium rate—a case of less practical importance—they exert a depressing influence on prices.” (Hayek 2008 [1931]: 215).

One should note that emphasis on a single “equilibrium” or “natural” rate here. Roger Garrison, the leading modern exponent of ABCT, uses the same concept called a market-clearing or equilibrium rate:

“The supply and demand for loanable funds … identify a market-clearing, or equilibrium, rate of interest ..., at which saving (S) and investment (I) are brought into equality.” (Garrison 2000: 39).

On that same page in Time and Money: The Macroeconomics of Capital Structure (2000), Garrison makes it clear that this rate is essentially the Wicksellian rate causing intertemporal equilibrium.

So where are the Austrian scholars expounding their trade cycle theory with Sraffa’s multiple natural rates? The only work I have ever seen that could be seen as an improvement on the standard Austrian theory is that of Robert Murphy in this paper:

Robert P. Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory.”

Commenting on the Hayek–Sraffa exchange in 1932, Murphy points out the following:

“In his brief remarks [sc. in reply to Sraffa], Hayek certainly did not fully reconcile his analysis of the trade cycle with the possibility of multiple own-rates of interest. Moreover, Hayek never did so later in his career. His Pure Theory of Capital (1975 [1941]) explicitly avoided monetary complications, and he never returned to the matter. Unfortunately, Hayek’s successors have made no progress on this issue, and in fact, have muddled the discussion. As I will show in the case of Ludwig Lachmann—the most prolific Austrian writer on the Sraffa-Hayek dispute over own-rates of interest—modern Austrians not only have failed to resolve the problem raised by Sraffa, but in fact no longer even recognize it.

Austrian expositions of their trade cycle theory never incorporated the points raised during the Sraffa-Hayek debate. Despite several editions, Mises’ magnum opus (1998 [1949]) continued to talk of “the” originary rate of interest, corresponding to the uniform premium placed on present versus future goods. The other definitive Austrian treatise, Murray Rothbard’s (2004 [1962]) Man, Economy, and State, also treats the possibility of different commodity rates of interest as a disequilibrium phenomenon that would be eliminated through entrepreneurship. To my knowledge, the only Austrian to specifically elaborate on Hayekian cycle theory vis-à-vis Sraffa’s challenge is Ludwig Lachmann.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 11–12).

Murphy, to his credit, has pinpointed a very severe problem with modern ABCT (and I suppose it’s not a surprise to readers if I say he’s become one of favourite Austrians, not least of all because he supports a monetary theory of the interest rate).

Murphy denies the existence of a unique natural rate, but he has yet to produce any work showing how ABCT actually works with its non-existence. On pp. 19–23 of his discussion of the subject in a very simple model, Murphy provides his attempt to show how an inflationary increase in the money supply can cause “people in earlier periods to consume too much,” but even he admits this is “not really an illustration of the Misesian trade cycle theory,” because his model does not “really exhibit malinvestments in longer production processes.” Murphy leaves the creation of such a model for his future research. He’s done no such research as yet. Nor has any other Austrian.

BIBLIOGRAPHY

Garrison, R. W. 2000. Time and Money: The Macroeconomics of Capital Structure, Routledge, London and New York.

Hayek, F. A. von, 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.

Robert P. Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory.”

Robert P. Murphy on the Pure Time Preference Theory of the Interest Rate

The Austrian scholar Robert P. Murphy has made his PhD thesis available on his blog:

Robert P. Murphy, “Is Keynes from Heaven or Hell,” 7 July 2011.

The PhD is a study with three separate essays dealing with Austrian capital and interest rate theory. In the second essay, Murphy critiques the pure time preference theory of the interest rate (Murphy 2003: 58–126), and, in his third chapter, he supports a view of interest rates as purely monetary phenomena (Murphy 2003: 127–177).

In taking a monetary theory of the interest rate, Murphy is far closer to Keynes than the views of many of his fellow Austrians, and indeed in his blog post above he cites Keynes’ remarks on interest in Chapter 13 of the General Theory with measured approval (Robert P. Murphy, “Is Keynes from Heaven or Hell,” 7 July 2011).

Murphy’s PhD is also worth reading in its own right. Some highlights follow.

On p. 107 (n. 33), Murphy identifies some hypocrisy from Henry Hazlitt, who had condemned Keynes’s concept of “own rates of interest” as a “strange” idea and “nonsense,” even though Rothbard uses a similar concept in his analysis of interest in capital goods markets. Murphy contends that the pure time preference theory of interest rates “encourages exactly the type of thinking that Hazlitt finds so absurd” (Murphy 2003: 107, n. 33).

From pp. 100–107, one can read Murphy’s critique of the idea that a uniform rate of originary interest would arise amongst all individuals and in goods markets.

It is only in the imaginary “evenly rotating economy” (ERE), a stationary general equilibrium with “a world of certainty and unchanging conditions over time” (Murphy 2003: 103), that a uniform rate of originary interest would emerge. In a dynamic general equilibrium the uniform rate need not emerge.

Here Murphy invokes the Hayek–Sraffa exchange, and Ludwig Lachmann’s possible solution to the problem of the unique natural rate:

“What is much less clear to us is to what extent Hayek was aware that by admitting that there might be no single rate he was making a fatal concession to his opponent. If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium?” (Lachmann 1994: 154).

“It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would be profitable to borrow in barley and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say steel, it is no more profitable to lend in wheat than in barley. This does not mean that actual own-rates must all be equal, but that their disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates” (Lachmann 1994: 154).

Murphy rejects Lachmann solution:

“Lachmann is defending Hayek from Sraffa’s claim that there is no reason for a unique ‘natural rate of interest.’ But Sraffa’s whole point was that there are, in principle, just as many natural rates as commodities; the fact that the rates in terms of any one commodity, such as steel, must be equal does not rescue Hayek. (One cannot explain the trade cycle as a deviation of the money rate of interest from ‘the’ natural rate of interest if the rate calculated in terms of steel is different from the natural rate calculated in terms of copper.) … arbitraging alone will not establish a unique real rate of interest in the way Lachmann seems to think.” (Murphy 2003: 102, n. 27).

According to Murphy, arbitrage would not lead to equalization of natural rates. As far as I can see, Murphy does not explore the consequences of this for the Hayekian versions of the Austrian trade cycle theory: if there is no unique natural rate of interest or tendency for such a unique rate, what becomes of the theory? This was the point of Sraffa’s critique of Hayek’s Prices and Production (Sraffa 1932a and 1932b).

Murphy concludes that interest is “quite simply the price of borrowing money or (what is the same thing) the exchange rate of present versus future money units” (Murphy 2003: 176).


BIBLIOGRAPHY

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.

Ludwig Lachmann on Government Intervention

I have recently read this interesting passage in a book by Gene Callahan:

“Because of his focus on uncertainty, Lachmann came to doubt that, in a laissez-faire society, entrepreneurs would be able to achieve any consistent meshing of their plans. The economy, instead of possessing a tendency toward equilibrium, was instead likely to careen out of control at any time. Lachmann thought that the government had a role to play in stabilizing the economic system and increasing the coordination of entrepreneurial plans. We call his position ‘intervention for stability.’” (Callahan 2004: 293).

The question immediately arises: what government interventions did Lachmann support?

I have yet to find passages in Lachmann’s writings that support government interventions “for stability.” Lachmann appears to have accepted a small state, as in Mises’s Classical liberal conception of government:

“[sc. Lachmann thought that] … government intervention in economic affairs should be minimal. The role of government should be as circumscribed as possible and conform to the classical liberal ideal of supporting the free market by strengthening the institutions of private property and voluntary business contract.” (Grinder 1977: 22).

Perhaps Lachmann’s idea of interventions for stability refers to the admission by some Austrians that an economy can suffer a “secondary deflation” that will plunge it into unnecessary suffering, and that some kind of monetary stabilisation is required.

This appears to have been Hayek’s position late in life, as he retreated from his liquidationist extremism:

“Although I do not regard deflation as the original cause of a decline in business activity [sc. after 1929], such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

In saying this, Hayek presumably would have accepted a monetarist solution of stabilizing the money supply by open market operations and other interventions.

The effects of “secondary deflation” are also acknowledged by Roger Garrison:

“Deflation caused by a severe monetary contraction is another matter. Strong downward pressures on prices in general put undue burdens on market mechanisms. Unless, implausibly, all prices and wages adjust instantaneously to the lower money supply, output levels will fall. Monetary contraction could be the root cause of a downturn - as, for instance, it seems to have been in the 1936–7 episode in the USA. The Federal Reserve, failing to understand the significance of the excess reserves held by commercial banks, dramatically increased reserve requirements, causing the money supply to plummet as banks rebuilt their cushion of free reserves. But what caused the money supply to fall at the end of the 1920s boom? The monetarists attribute the monetary contraction to the inherent ineptness of the central bank or to the central bank’s (ill-conceived) attempt to end the speculative orgy in the stock market, an orgy that itself goes unexplained. In the context of Austrian business cycle theory, the collapse in the money supply is a complicating factor rather than the root cause of the downturn. In 1929, when the economy was in the final throes of a credit-induced boom, the Federal Reserve, uncertain about just what to do and hampered by internal conflict, allowed the money supply to collapse. The negative monetary growth during the period 1929 to 1933 helps to account for the unprecedented depth of the depression.” (Garrison 2005: 515).

“The problem of policy-induced intertemporal discoordination can easily get compounded by a loss of business confidence and/or by a collapse of the banking system. These complicating factors can cause the economy to suffer a general economic contraction.” (Garrison 2002: 249).

A more interesting admission is made by Jesus Huerta de Soto:

“As Austrian economists in general and Mises in particular demonstrated as early as 1928, in the specific event that idle resources and unemployment are widespread, entrepreneurs, relying on new loans, may continue to lengthen the productive structure without provoking the familiar reversion effects, until the moment one of the complementary factors in the production process becomes scarce.⁶⁶ At the very least, this fact shows Keynes’s so-called general theory to be, in the best case, a particular theory, applicable only when the economy is in the deepest stages of a depression with generalized idle capacity in all sectors.”⁶⁷
….
⁶⁶ Mises, On the Manipulation of Money and Credit, p. 125 (p. 49 of Geldwertstabilisierung und Konjunkturpolitik, the German edition).

⁶⁷ For Roger Garrison, the true general theory is that of the Austrians and “Keynesian theory [we would also say monetarist theory] becomes a special case of Austrian theory.” See Garrison, Time and Money, p. 250.

(Huerta de Soto 2006: 553).

Of course, Huerta de Soto then goes on to deny that government intervention will work in such circumstances, but the concession that he attributes to Garrison - that Keynes’ theory might work “when the economy is in the deepest stages of a depression with generalized idle capacity in all sectors” - is quite an admission. What else was the Great Depression?

To return to Lachmann, I am curious to know if other people have read anything of Lachmann’s arguments for government interventions “for stability.”


BIBLIOGRAPHY

Callahan, G. 2004. Economics for Real People: An Introduction to the Austrian School (2nd edn), Ludwig von Mises Institute, Auburn, Ala.

Garrison, R. W. 2002. Time and Money: The Macroeconomics of Capital Structure, Routledge, London.

Garrison, R. W. 2005. “The Austrian School,” in B. Snowdon and H. R. Vane (eds), Modern Macroeconomics: Its Origins, Development and Current State, Edward Elgar, Cheltenham.

Grinder, W. E. 1977. “In Pursuit of the Subjective Paradigm” [Introduction], in L. M. Lachmann, Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. by W. E. Grinder), Sheed Andrews and McMeel, Kansas City.

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala.

ABCT and Full Employment

In Money, Bank Credit and Economic Cycles (Auburn, Ala., 2006), Jesus Huerta de Soto attempts to defend the Austrian business cycle theory (ABCT) against the charge that it fails to consider what happens when idle resources are available:

“Critics of the Austrian theory of the business cycle often argue that the theory is based on the assumption of the full employment of resources, and that therefore the existence of idle resources means credit expansion would not necessarily give rise to their widespread malinvestment. However this criticism is completely unfounded. As Ludwig M. Lachmann has insightfully revealed, the Austrian theory of the business cycle does not start from the assumption of full employment. On the contrary, almost from the time Mises began formulating the theory of the cycle, in 1929, he started from the premise that at any time a very significant volume of resources could be idle. In fact Mises demonstrated from the beginning that the unemployment of resources was not only compatible with the theory he had developed, but was actually one of its essential elements.” (Huerta de Soto 2006: 265–508).

But Huerta de Soto has done nothing here but engage in a sleight of hand: the charge against ABCT is that its cycle effects do not occur if the factor inputs and consumer goods required by expanded demand are not scarce. That an economy might not be at full employment and may have idle resources when the money supply is expanded does answer the question of how the cycle effects happen, if the relevant factor inputs continue to remain abundant, either through domestic production through increasing capacity utilization, idle stocks or even by international trade.

Moreover, the claim that “unemployment of resources was not only compatible with … [the trade cycle theory Mises] had developed, but was actually one of its essential elements” is not supported by a reading of Mises. All that Mises does is admit the fact that capitalist economies do have idle resources, but then says that his cycle effects require that this abundance declines and the relevant factor inputs become scarce. In “Monetary Stabilization and Cyclical Policy” (1928) Mises has the following to say:

“Since it always requires some time for the market to reach full ‘equilibrium,’ the ‘static’ or ‘natural’ prices, wage rates and interest rates never actually appear. The process leading to their establishment is never completed before changes occur which once again indicate a new ‘equilibrium.’ At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under ‘static equilibrium.’ With the revival of business and productive activity, these reserves are in demand right away. However, once they are gone, the increase in the supply of fiduciary media necessarily leads to disturbances of a special kind. In a given economic situation, the opportunities for production, which may actually be carried out, are limited by the supply of capital goods available. Roundabout methods of production can be adopted only so far as the means for subsistence exist to maintain the workers during the entire period of the expanded process. All those projects, for the completion of which means are not available, must be left uncompleted, even though they may appear technically feasible—that is, if one disregards the supply of capital. However, such businesses, because of the lower loan rate offered by the banks, appear for the moment to be profitable and are, therefore, initiated. However, the existing resources are insufficient. Sooner or later this must become evident. Then it will become apparent that production has gone astray, that plans were drawn up in excess of the economic means available, that speculation, i.e., activity aimed at the provision of future goods, was misdirected.” (Mises 2006 [1978]: 110).

With respect to Hayek’s presentation of the Austrian trade cycle theory in Prices and Production, the evidence does not support Huerta de Soto either. Hayek explicitly conceded that he had assumed full employment 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).

There is no way to deny this fact. The starting point in Prices and Production was in fact the assumption of an economy in full employment equilibrium.

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).

The assumption of “full activity of the elementary economic interconnections as shown by the equilibrium theory” is nothing but a static equilibrium assumption of full employment.

In a letter written to John Hicks in 1967, Hayek confirms that his theory required the assumption of full employment at the beginning of the process:

“Hicks to Hayek, November 27, 1967
...
We have (a) full employment, (b) static expectations, (c) ‘equilibrium’ at every stage, so that demand = supply in every market, prices being determined by current demand and supply. Add to these the Wicksell assumption, of a pure credit economy and we clearly find that if there were in lags, the market rate of interest cannot be reduced below the natural rate in an equilibrium position; ...

Friedrich August Hayek, Good money, Volume 6, p. 100.

Hayek to Hicks, December 2, 1967
... I accept assumption (a), full employment .... (Hayek 1999: 102).

BIBLIOGRAPHY

Hayek, F. A. von. 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London

Hayek, F. A. von. 1975 [1939]. Profits, Interest and Investment, Augustus M. Kelley Publishers, Clifton, NJ.

Hayek, F. A. von, 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.

Hayek, F. A. von, 1999. Collected Works of F.A. Hayek, Volume 6: Good Money, Part II: The Standard, Routledge, London.

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises’s Three Concepts of Equilibrium

Equilibrium can be a tricky subject, as different economists have different definitions of the concept. Mises employs 3 different concepts, as follows:

“[sc. Mises] posits not one, but three notions of equilibrium that he claims underlie his analysis. The first, the ‘plain state of rest,’ is a temporary state in which all currently desired transactions have been made and, for the moment, no one wants to trade. His example of such a state is the close of the trading day in the stock market ....

The second equilibrium notion Mises employs is the “final state of rest,” the state toward which the market tends if there is no change in the data. This apparently is Mises’ analogue to general equilibrium. Whereas the plan state of rest is a phenomenon that is routinely found in markets, the final state of rest is an “imaginary construction” in that it can never be achieved in reality, although it is a necessary analytic tool for understanding the direction of price changes.

Finally, Mises posits yet a third equilibrium notion, the “evenly rotating economy,” or the “ERE.” This, too, is an imaginary construction of what the market would be like if there were no changes in the data. In this construction, however, people continue to be born, to live and to die, and capital is accumulated at a rate just sufficient to maintain current patterns of consumption and investment. It is a condition in which the same products are consumed and produced over and over again, and all prices equal the prices established in the final state of rest .... Whereas the first two notions have their analogues in contemporary economics, the ERE seems to be unique to Mises.” (Vaughn 1994: 81–82).

Mises describes the nature of money in the ERE:

“Then there is a second deficiency. In the imaginary construction of an evenly rotating economy, indirect exchange and the use of money are tacitly implied. But what kind of money can that be? In a system without change in which there is no uncertainty whatever about the future, nobody needs to hold cash. Every individual knows precisely what amount of money he will need at any future date. He is therefore in a position to lend all the funds he receives in such a way that the loans fall due on the date he will need them. Let us assume that there is only gold money and only one central bank. With the successive progress toward the state of an evenly rotating economy all individuals and firms restrict step by step their holding of cash and the quantities of gold thus released flow into nonmonetary—industrial—employment. When the equilibrium of the evenly rotating economy is finally reached, there are no more cash holdings; no more gold is used for monetary purposes. The individuals and firms own claims against the central bank, the maturity of each part of which precisely corresponds to the amount they will need on the respective dates for the settlement of their obligations. The central bank does not need any reserves as the total sum of the daily payments of its customers exactly equals the total sum of withdrawals. All transactions can in fact be effected through transfer in the bank’s books without any recourse to cash. Thus the ‘money’ of this system is not a medium of exchange; it is not money at all; it is merely a numeraire, an etheral and undetermined unit of accounting of that vague and indefinable character which the fancy of some economists and the errors of many laymen mistakenly have attributed to money. The interposition of these numerical expressions between seller and buyer does not affect the essence of the sales; it is neutral with regard to the people’s economic activities. But the notion of a neutral money is unrealizable and inconceivable in itself. If we were to use the inexpedient terminology employed in many contemporary economic writings, we would have to say: Money is necessarily a ‘dynamic factor’; there is no room left for money in a ‘static’ system. But the very notion of a market economy without money is self-contradictory.” (Mises 1996: 249)

The ERE was not used by Hayek as his equilibrium model in Prices and Production, although there are of course similarities (and the ERE does appear in later Hayekian versions of ABCT). I do not think Wicksell’s model in his monetary equilibrium theory is an ERE either (if readers think I am wrong, I would like to hear why).

Hayek makes it clear in Prices and Production that he working in the general equilibrium tradition, which would be Mises’s “final state of rest”:

“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 2008: 225).

Wicksell had already used Walras’ theory of general equilibrium and combined it with Bohm Bawerk’s theory of interest, to try and establish the conditions of monetary equilibrium (Loasby 1998: 54). Hayek developed an intertemporal equilibrium theory in 1928 in his paper “Intertemporal Price Equilibrium and Movement in the Value of Money” (Hayek 1984 [1928]), but did not use this in Prices and Production. 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” (Donzelli 1993: 57). This was a stationary equilibrium model:

“Wicksell’s theory of monetary equilibrium, whose influence was to be crucial, was built on the foundations of his critique of the Quantity Theory. He effectively believed that the velocity of circulation of money proper was unstable since, under certain institutional conditions, it is possible to reduce the use of money through control of credit and thus to affect its velocity of circulation. The demand for credit of the banking system is governed by the difference between two rates: the supply price of bank credit, or money rate of interest, and a rate which Wicksell defined first as a ‘natural rate’, which would equalise savings and investment in an economy without money, and then as a ‘normal’ rate: the equilibrium interest rate on loanable funds in a monetary economy …. Hayek retained the idea of a disparity between these rates as a driving force behind the processes of expansion and contraction, as well as the role of credit in allowing a demand for produced and non-produced investment goods in excess of voluntary savings. Demand is then pushed above the value of goods supplied, leading to increased prices and a rationing of consumers – a forced saving. Equality of these interest rates represents monetary equilibrium.” (Hénin 1986: 39)

BIBLIOGRAPHY

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.

Hayek, F. A. 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.

Hayek, F. A. von, 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.

Hénin, P.-Y. 1986. Macrodynamics: Fluctuations and Growth: A Study of the Economy in Equilibrium and Disequilibrium, Routledge & Kegan Paul, London.

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.

Mises, L. 1996. Human Action: A Treatise on Economics (4th revised edn), Mises Institute, Auburn, Ala.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Austrian Business Cycle Theory (ABCT) and the Natural Rate of Interest

The Austrian business cycle/trade cycle theory that Hayek proposed in the early 1930s took up Knut Wicksell’s hypothetical “natural rate of interest” and uses that concept in its analysis. In ABCT, the market rate of interest (a monetary rate) falls below the natural rate (the return on capital). As resources are drawn away from production in lower-order stages that produce consumer goods, there is inflation in consumer goods relative to capital goods, and then interest rates rise. This supposedly causes a crisis as many investments in higher-order stages of production cannot be profitably maintained, resulting in liquidation and higher unemployment.

What does the “natural rate of interest” mean? It can have different meanings:

“Earlier writers defined the natural rate of interest concept in various ways. Hayek originally defined the natural rate as the rate of interest that would prevail if savings and investment were made in natura; that is, without any distortionary monetary effects [i.e., without money]. Mises (1978, p. 124) defined the natural rate of interest as the equilibrium rate for the capital structure.^* Later treatments defined the natural rate as the real marginal productivity of capital or as the interest rate which equalizes ex ante savings and investment” (Cowen 1997: 95).
^* This can be found in Mises 2002 [1978]: 129–130.

In the early work of Hayek, he used a Wicksellian definition of the natural rate of interest, and we can cite Knut Wicksell’s explanation of the concept and how monetary equilibrium occurs:

“The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yields on the newly created real capital, will then be the normal or natural rate. It is essentially variable. If the prospects of employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. At the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices remain unchanged” (Wicksell 1934: 193).

The natural rate or “the expected yields on the newly created real capital” is the analogue of the marginal efficiency of capital (Uhr 1994: 94).

The concept of the Wicksellian natural rate is defined by Frank Shostak:

“There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.”
Shostak, F. 2008. “The Myth of the Neutral Interest Rate Policy,” Mises.org, February 8
http://mises.org/daily/1743

Philippe Burger provides another explantion:

“Wicksell ... defines the natural interest rate as: ‘The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital, will then be the normal or natural real rate.’ ... The natural interest rate equals the marginal product of capital at full employment. A reduction in the market rate (through an increase in the money supply) below the natural rate may stimulate investment. However, as the economy is assumed to be at full employment (everyone willing to accept a wage equal to the marginal product of labour has employment), it also causes inflation for the period during which the natural rate exceeds the market rate” (Burger 2003: 63).

If the natural rate is conceived in real terms (or, in Latin, in natura), we have a barter economy where real commodities are loaned out and repaid in kind, and the supply of real commodities for loan equals the amount demanded. In a monetary economy, credit money via fractional reserve banking and the fiduciary media it creates create a media that provides real resources but without freeing up those resources in real terms. Now one problem with this analysis is that the natural interest rate concept depends on the assumption that an economy has no significant idle resources and it has full employment. In reality, economies frequently have unused capacity, idle resources and unemployment, and an economy open to trade will be able to import both factor inputs and capital goods, which can ease inflationary pressures.

But moving to historical criticisms of Hayek’s influential presentation of ABCT in Prices and Production (London, 1931), there was an important exchange between Sraffa and Hayek that can be read in Sraffa (1932a), Hayek (1932), and Sraffa (1932b). (For Kaldor’s attack on Hayek, see Kaldor 1939, 1940, 1942.)

One important criticism of Sraffa was as follows:

“Dr. Hayek’s theory of the relation of money to the rate of interest is mainly given by way of criticism and development of the theory of Wicksell. He states his own position as far as it agrees with Wicksell’s as follows: ‘In a money economy, the actual or money rate of interest may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.’ An essential confusion, which appears clearly from this statement, is the belief that the divergence of rates is a characteristic of a money economy: and the confusion is implied in the very terminology adopted, which identifies the ‘actual’ with the ‘money’ rate, and the ‘equilibrium’ with the ‘natural’ rate. If money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might be at any one moment as many ‘natural’ rates of interest as there are commodities, though they would not be ‘equilibrium’ rates. The ‘arbitrary’ action of the banks is by no means a necessary condition for the divergence; if loans were made in wheat and farmers (or for that matter the weather) ‘arbitrarily changed’ the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate. In order to realise this we need not stretch our imagination and think of an organised loan market amongst savages bartering deer for beavers. Loans are currently made in the present world in terms of every commodity for which there is a forward market. When a cotton spinner borrows a sum of money for three months and uses the proceeds to purchase spot, a quantity of raw cotton which he simultaneously sells three months forward, he is actually ‘borrowing cotton’ for that period. The rate of interest which he pays, per hundred bales of cotton, is the number of bales that can be purchased with the following sum of money: the interest on the money required to buy spot 100 bales, plus the excess (or minus the deficiency) of the spot over the forward prices of the 100 bales. In equilibrium the spot and forward price coincide, for cotton as for any other commodity; and all the ‘natural’ or commodity rates are equal to one another, and to the money rate. But if, for any reason, the supply and the demand for a commodity are not in equilibrium (i.e. its market price exceeds or falls short of its cost of production), its spot and forward prices diverge, and the ‘natural’ rate of interest on that commodity diverges from the ‘natural’ rates on other commodities.” (Sraffa 1932a: 49).

Thus there could only be a single “natural rate of interest” in a one commodity economy, and, in an expanding economy, equating a market rate with a natural rate has no meaning. When an economy is not in equilibrium, where it is moving from one equilibrium to another, there will be as many natural rates as commodities and “under free competition, this divergence of rates is as essential to the effecting of the transition as is the divergence of prices from the costs of production; it is, in fact, another aspect of the same thing” (Sraffa 1932a: 50). Hayek appeared to acknowledge this:

“Mr. Sraffa denies that the possibility of a divergence between the equilibrium rate of interest and the actual rate is a peculiar characteristic of a money economy. And he thinks that ‘if money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might, at any moment, be as many “natural” rates of interest as there are commodities, though they would not be equilibrium rates.’ I think it would be truer to say that, in this situation, there would be no single rate which, applied to all commodities, would satisfy the conditions of equilibrium rates, but there might, at any moment, be as many 'natural' rates of interest as there are commodities, all of which would be equilibrium rates; and which would all be the combined result of the factors affecting the present and future supply of the individual commodities, and of the factors usually regarded as determining the rate of interest” (Hayek 1932).

In reply, Sraffa noted:

“Dr. Hayek now acknowledges the multiplicity of the ‘natural’ rates, but he has nothing more to say on this specific point than that they ‘all would be equilibrium rates’. The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates” (Sraffa 1932b).

If the market rate of interest in an expanding economy must equal the “natural rate of interest,” how can it do so if there are many natural rates? Yet this is the central element of ABCT, even in modern expositions of it, as in R. W. Garrison (1997):

“The natural rate of interest is the rate that equates saving with investment. The bank rate diverges from the natural rate as a result of credit expansion” (Garrison 1997: 24).

A bank rate (market rate) can only diverge from a natural rate, if there was one natural rate of interest. But the concept of the natural rate of interest requires that there be multiple such “natural rates.” That this is a serious problem for the Hayekian version of the Austrian business cycle theory is acknowledged by Lachmann

“What is much less clear to us is to what extent Hayek was aware that by admitting that there might be no single rate he was making a fatal concession to his opponent. If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium?” (Lachmann 1994: 154).

And what becomes of ABCT? In order for natural rates to obtain, money and modern banking would have to be abolished, and the loans conducted in real commodities. This in fact appears to Lachmann’s solution to the conundrum:

“It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would be profitable to borrow in barley and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say steel, it is no more profitable to lend in wheat than in barley. This does not mean that actual own-rates must all be equal, but that their disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates” (Lachmann 1994: 154).

In other words, the solution is a barter economy where modern banking is dismantled and goods are loaned out, and, if one commodity comes to serve as a numéraire, it will no longer have a store of value function and only function as a medium of exchange – a totally unrealistic world.

Finally, we can note how Hayek seems to have changed his defintion of the natural interest rate in later work:

“Hayek ... in his later and most systematic statement of capital theory, appears to accept this criticism of Sraffa’s and to abandon the strict in natura definition he had offered in earlier writings” (Cowen 1997: 95, n. 16).

And his attempt to devise a trade cycle theory free from the problems identified by his critics must be judged a failure:

“The combined effect was to start Hayek on a long process of rethinking his views. He hoped to reconstruct a more suitable capital-theoretic foundation, then turn to the problem with which he started, explicating the role of money in a dynamic capital-using economy. After seven years of work, he produced a four-hundred-page book, The Pure Theory of Capital [1941] ..., but still the task was unfinished .... Throughout the 1930s, Hayek kept responding to his critics, making adjustments to his models along the way, and this in turn brought fresh criticism and new adjustments. According to his own assessments, however, his efforts to build a dynamic equilibrium model of a capital-using monetary economy never reached fruition. His intended second on dynamics never appeared. As he suggested, by the late 1930s Hayek had turned his attention to ‘more pressing problems’” (Caldwell 2004: 180).

By the 1940s, Hayek had turned away from dynamic equilibrium theorising and moved to writing about the social sciences, philosophy, classical liberal political theory, and social philosophy.


Appendix: Mises and the Wicksellian Natural Rate of Interest Concept?

It seems that Mises also relies on the Wicksellian “natural interest rate” concept:

“At the end of ... [The Theory of Money and Credit] (388-404), Mises combined his theory of interest and his understanding of banking practice to point to a theory of economic crises. Following on Wicksell, he identified the gap between the natural rate of interest and the money rate as the consequence of credit expansion” (Vaughn 1994: 40).

But, according to Hülsmann,

“Wicksell defined the natural rate of interest as the rate that would come into existence under the sole influence of real (non-monetary) factors) ... He also defined it as the rate at which the price level would remain constant ... Both distinctions led to great confusion among later theorists, but Mises’s business cycle theory seemed to show that it was useful to make some such distinction. In Human Action he would eventually show that the relevant distinction is between the equilibrium rate of interest and the market rate. Both rates are monetary rates and can therefore coincide” (Hülsmann 2007: 253, n. 79).

What happened is that Mises changed his mind (Maclachlan 1996), and abandoned the Wicksellian natural interest rate concept he had used in the Theory of Money and Credit and adopted a new “originary interest rate” theory:

“Originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself. There prevails a tendency toward the equalization of this ratio for all commodities. In the imaginary construction of the evenly rotating economy the rate of originary interest is the same for all commodities” (Mises 1998: 523).

But, as late as 1928 in Monetary Stabilization and Cyclical Policy, Mises is still using the Wicksellian natural interest rate:

“In conformity with Wicksell’s terminology, we shall use ‘natural interest rate’ to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. ‘Money rate of interest’ will be used for that interest rate asked on loans made in money or money substitute.” (Mises 2006 [1978]: 107–108).

“The ‘natural interest rate’ is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing ‘natural interest rate’” (Mises 2006 [1978]: 109).

This seems to reinforce the point that the Wicksellian natural interest rate concept as used in Mises’ earlier work had to be abandoned. But it is still used in Hayekian forms of ABCT. To the extent that Mises’ presentation of ABCT in the Theory of Money and Credit and Monetary Stabilization and Cyclical Policy (1928) relies on the Wicksellian natural interest rate concept, it must be judged as worthless as Hayek’s Prices and Production.

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