Matias Vernengo on Marx’s Labour Theory of Value

Matias Vernengo explains the problems with Marx’s labour theory of value (LTV) as he sees them and why (in his view) Sraffa’s solution is the only viable interpretation of the idea of some labour-based value in prices:

“… [sc. Ricardo in his early writings presumed] that the economy produced corn (grain) with corn and labor, and the surplus was a physical amount of corn, so the rate of profit could be measured as ratio of corn (the surplus) to corn (the means of production advanced for production). He, then used, the labor theory of value as an approximation to the solution in his Principles, knowing that prices were not exactly proportional to the amounts of labor directly and indirectly used in production.

That was, also, essentially the role of the LTV in Marx’s volume I of his masterpiece Capital. That is, the LTV allows Marx to determine the rate of profit independently of prices. Note that Marx was also aware that relative prices determined by the amounts of labor directly and indirectly incorporated are incorrect once you have produced means of production. However, Marx thought that embodied labor redistributed by the process of competition meant that in the aggregate total surplus value corresponded to total profits, even if prices of production deviated from embodied labor. As a result, on the basis of the LTV it was still possible to obtain the correct rate of profit. As it turns out, there is no reason for positive and negative deviations of prices of production from the labor values to cancel out. You cannot argue with the algebra.

Marx had no way of knowing this. Only with Bortkiewicz, Dimitriev and Tugan-Baranovsky’s work, early in the 20th century, this was clearly understood. If in general commodities do not exchange at labor values, then there is no reason why that should be correct for two composite commodities that make the total physical surplus and the physical advanced means of production.

Sraffa's solution, based on the standard commodity (to be discussed in another post), shares with Ricardo's corn model the idea that one can measure the rate of profit as a share of a particular commodity (Sraffa’s being a composite commodity, that is, composed of several goods). It also shares with Ricardo the fact that only basics (commodities that enter the production of all goods including their own production), which for simplicity can be related to subsistence goods, affect the rate of profit, while non-basics, or luxury goods, are not relevant. Further, as noted by Sraffa too, his solution resembles Smith’s since the standard commodity can be seen as akin to the former's idea of labor commanded, that is relative prices are proportional to the amount of labor that they can command (buy). In that sense, Sraffa's prices are firmly based on a certain notion of the labor theory of value.”
Matias Vernengo, “Sraffa and Marxism or the Labor Theory of Value, what is it good for?,” Naked Keynesianism, August 14, 2012.

The central problem as it emerged in Classical economics and taken over by Marx was, according to Vernengo: how is the rate of profit determined independently of prices? (where the long-run, normal uniform rate of profit determines long-run prices). But it seems to me that the LTV was much more to Marx in volume 1 of Capital than just a way to “determine the rate of profit independently of prices.”

Marx really does try to explain individual commodity prices in terms of their abstract socially necessary labour time (SNLT) in volume 1, as in his absurd example of how rising unit SNLT in a reduced cotton crop after a spoiled crop is supposed to explain the rising price of cotton and even the price rise of cotton produced in previous production periods (Marx 1982: 317–318). When Marx says that exchange of commodities is an equality of value and that the cause of this equality is equal SNLT (Marx 1982: 127–129), how on earth can he say such a thing if he thinks that SNLT doesn’t actually determine individual commodity prices?

Right in Chapter 1 of Capital (vol. 1), Marx explains exchange value in these terms:

“We have assumed that the coat is worth twice as much as the linen. But this is merely a quantitative difference, and does not concern us at the moment. We shall therefore simply bear in mind that if the value of a coat is twice that of 10 yards of linen, 20 yards of linen will have the same value as a coat. As values, the coat and the linen have the same substance, they are the objective expressions of homogeneous labour.” (Marx 1982: 124).

If this was not meant to be an explanation of any real world exchange values at all, then Marx was one of the most incompetent economic writers ever, as Gray (1946: 320) notes.

But let us move on with the main points raised by Vernengo. First, Marx’s solution of saying that “in the aggregate total surplus value corresponded to total profits, even if prices of production deviated from embodied labor” was only published in volume 3 of Capital, so this seems to gloss over the contradiction between volume 1 and 3, which was noted by many people after volume 3 was published in 1894 such as V. K. Dimitriev, Werner Sombart, Achille Loria, Conrad Schmidt, Mikhail Ivanovich Tugan-Baranovsky, Ladislaus von Bortkiewicz, Peter Berngardovich Struve, and Eugen von Böhm-Bawerk. Even worse, some of these critics were actually Marxists themselves.

But even if we put these concerns above aside, we come to the issue of whether Sraffa provided a viable way to embed the idea of a certain labour value in a coherent theory of prices and capitalism, where the rate of profit is determined independently of prices.

The trouble here is that Sraffa’s own economic model has serious problems, as identified in Post Keynesian critiques of Sraffianism such as Halevi and Kriesler (1991), Lee (1994: 325–327), Minsky (1990) and Robinson (1979).

Sraffa’s model excludes real world money (Davidson 2003–2004: 247; Hodgson 1981: 83–84), and even if one might pick some commodity to function only as a numèraire/unit of account in it, everyone knows that this isn’t real world money, just as it isn’t in neo-Walrasian general equilibrium models, as argued by Rogers (1989: 46–47). Once real world money and uncertainty are introduced into Sraffa’s long-run model, one cannot legitimately defend the idea that prices and the profit rate are determined by technological factors and the real wage (Hodgson 1981: 93). A monetary production economy with uncertainty means the determination of wages, prices and profits becomes highly complex and, for want of a better word, messy.

Even worse is the notion of Sraffian long-run prices, where there is a uniform rate of profit (Lavoie 2014: 176). Many other Post Keynesians would reject the idea that there is any actual tendency to an economy-wide uniform rate of profit (Lavoie 2014: 176), and not just because there are permanent, severe barriers to entry and free competition in many sectors of a real world capitalist economy (and not just based on monopoly but on fundamental factors such as capacity utilisation). In essence, (1) one cannot reduce actual mark-up pricing to a simple practice of a mark-up on labour costs (Lee 1994: 325) and (2) the rate of profit mark-up in each industry and business will be determined by many factors such as custom, convention, different desires and needs for various profit rates, different levels of competition, and what mark-up the market will bear, etc., and these factors will themselves vary in different times and places (Lee 1994: 325–326). Consequently the Marxist and Sraffian notion of a real world tendency in capitalism to long-run prices of production with a uniform rate of profit is untenable (Lee 1994: 326–327).

But, then, with a highly variable rate of profit (determined through prices and mark-ups) being a permanent condition of real world capitalism, it would seem that the profit rate is not independent of prices, and prices are not necessarily proportional to the amount of labor, given the failure of the system to converge to any long-run prices of production and the existence of permanent, different target profit rates in different industries that are never competed away. And we need only look at some real world mark-ups to see how absurd it is to think that prices or profits must be proportional to the amount of labour cost or time. If you are charging an astronomical mark-up of 2,000–4,000% (and get away with it in the long-run!), then many prices have only a tenuous relation to labour cost. Then when we add to this Philip Pilkington’s insightful observation that there is “a strongly subjective element in price formation that is manipulable on the supply-side (advertising and marketing etc.),” we can see that businesses can increase and maintain their mark-ups by affecting human psychology and subjective and intersubjective values.

All in all, if Sraffa’s model fails, then it cannot save Marxism, no matter how watered down a labour theory of value Sraffianism has.

BIBLIOGRAPHY
Davidson, Paul. 2003–2004. “Setting the Record Straight on ‘A History of Post Keynesian Economics,’” Journal of Post Keynesian Economics 26.2 245–272.

Halevi, Joseph and Kriesler, Peter. 1991. “Kalecki, Classical Economics and the Surplus Approach,” Review of Political Economy 3.1: 79–92.

Hodgson, G. 1981. “Money and the Sraffa System,” Australian Economic Papers 20: 83–95.

Lavoie, Marc. 2014. Post-Keynesian Economics: New Foundations. Edward Elgar, Cheltenham.

Lee, F. S. 1994. “From Post-Keynesian to Historical Price Theory, Part I: Facts, Theory and Empirically Grounded Pricing Model,” Review of Political Economy 6.3: 303–336.

Marx, Karl. 1982. Capital. Volume One. A Critique of Political Economy (trans. Ben Fowkes). Penguin Books, Harmondsworth, England.

Minsky, H. P. 1990. “Sraffa and Keynes: Effective Demand in the Long Run,” in Krishna Bharadwaj and Bertram Schefold (eds.), Essays on Piero Sraffa: Critical Perspectives on the Revival of Classical Theory. Unwin Hyman, London. 362–371.

Robinson, J. 1979. “Garegnani on Effective Demand,” Cambridge Journal of Economics 3: 179–180.

Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

The Labour Theory of Value and Animal Labour

Marx’s labour theory of value (LTV) in Volume 1 of Capital states that the exchange value of commodities is fundamentally caused by socially necessary labour time (SNLT). SNLT is supposed to be a cause of real world individual exchange values and prices. It is well known that there is a severe and blatant contradiction between volume 1 (1867) and volume 3 of Capital (1894). By volume 3 of Capital, Marx has retreated into a position on the relation between labour value and price where it only holds in a grossly unrealistic state where the profit rate is equalised and individual prices above or below labour values will cancel each other out in the aggregate to make the prices-equal-value equation hold.

But my comments below cut much deeper than complaints about the internally inconsistent and contradictory aspects of Marx’s work: they are a fundamental critique of the very conceptual coherence of Marx’s LTV and the idea of human SNLT.

In what follows, let us assume that the LTV is meant to be an empirical proposition and not some analytic statement (where it would true by definition, tautologous and empirically empty).

If the LTV is asserted as an empirical proposition, it seeks to explain empirically how the labour value in commodities is created.

I have already pointed to a fundamental problem identified by Piero Sraffa:

“There appears to be no objective difference between the labour of a wage earner and that of a slave; of a slave and of a horse; of a horse and of a machine, of a machine and of an element of nature (?this does not eat). It is a purely mystical conception that attributes to human labour a special gift of determining value. Does the capitalist entrepreneur, who is the real ‘subject’ of valuation and exchange, make a great difference whether he employs men or animals? Does the slave-owner?” (Sraffa, unpublished note, D3/12/9: 89, quoted in Kurz and Salvadori 2010: 199).

The fact is, as Sraffa notes, labour power in production is not limited to human beings: historically and to this day, animal labour was, and still is in developing nations, a fundamentally important source of labour power.

if Marx’s abstract socially-necessary labour time (SNLT) units were meaningful measures of every type of heterogeneous, concrete human labour, then many types of the labour performed by animals ought to be measurable in terms of SNLT units too, especially when human labour can be substituted for animal labour (e.g., horse mills could be replaced with mills where humans do the work, ploughs can be pulled by humans, and so could carts or carriages).

Why does a coherent, empirically grounded theory of labour value exclude animals? This is exactly the point that Piero Sraffa is raising in his criticisms of the labour theory of value.

And there many other questions too.

Marxists might complain that animals do not sell their labour and are owned by humans and are a type of capital good. But so what?

We could easily imagine a counterfactual situation in which large numbers of people in industrial economies do not sell their labour, are enslaved and worked to death to produce commodities, and treated as capital goods. Would the commodities produced by slave labour cease to have a SNLT value? If slave labour does still have a SNLT value, then it follows that even if people receive no wages and are owned as slaves, then this doesn’t change the fact that they produce labour value in commodities.

But we can say the same thing about animals: animals receive no wages either, so why does their labour not count as SNLT?

One could go on to argue that animals can’t speak or spend money, but one could easily imagine counterfactual situations in which humans are made to work without spending money or or never taught natural human language. Would their labour cease to create SNLT?

Finally, it is no good for Marxists to fall back on an analytic definition of the LTV, where it is just true by definition. I have no reason to accept an analytic definition I think is incoherent and not empirically relevant.

We can see here how the LTV has severe conceptual problems from the very beginning.

BIBLIOGRAPHY
Kurz, Heinz D. and Neri Salvadori. 2010. “Sraffa and the Labour Theory of Value: A Few Observations,” in John Vint et al. (eds.), Economic Theory and Economic Thought: Essays in Honour of Ian Steedman. Routledge, London and New York. 189–215.

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.

Skidelsky versus Selgin on Keynes and Hayek

The LSE debate between Skidelsky and Selgin is finally available as an audio file:

Keynes Vs. Hayek, BBC, 2011.

This BBC audio file has been edited, and we do not have the whole debate here. The entire unedited podcast of the debate will be available next week on the LSE events website.

Professor George A. Selgin was the main defender of Hayek, which was a good choice by whoever organised this debate. I rather like Selgin’s work on fractional reserve banking; he is an intelligent libertarian, and is in a class of his own, over and above other Austrians, quite frankly.

Let’s review the debate below:

(1) Skidelsky’s Opening Remarks
Skidelsky’s makes some excellent points:

(i) Hayekian liquidationism was tried in Weimar Germany from 1931–1933: this caused a severe deflationary depression causing untold suffering and bringing the Nazis to power:

“Economic breakdown [sc. during the Great Depression] led to political upheaval which in turn destroyed the international status quo. Germany was the most striking example of this complex interaction. Without the depression Hitler would not have gained power. Mass unemployment reinforced all the resentments against Versailles and the Weimar democracy that had been smouldering since 1919. Overnight the National Socialists were transformed into a major party; their representation in the Reichstag rose from 12 deputies in 1928 to 107 in 1930. The deflationary policies of the Weimar leaders sealed the fate of the Republic” (Adamthwaite 1977: 34).

“Austerity and the Weimar Republic,” June 5, 2011.

(ii) Hayek changed his mind late in life, and admitted he had been wrong in supporting the effects of a “secondary deflation” after 1930:

“Hayek on Secondary Deflation,” January 24, 2011.

By failing to respond to these points in any coherent way, the apologists for Hayek in this debate clearly lost it in my mind. I think Skidelsky swept the floor in the first few minutes, and there was not much left for him to do but show why the Austrian business cycle theory (ABCT) is false to complete his demolition of them, though Skidelsky unfortunately failed to do this. Later in the debate Skidelsky (19.30) points out that without economic security, when millions of peoples’ lives are destroyed by deflationary depression, our political freedom is endangered: and he is right.

(2) Jamie Whyte’s Response to Skidelsky (7.02–)
Whyte’s talk is a feeble “rebuttal” to Skidelsky. Let’s take some of his outright errors:

“since Keynesian policies were last popular and unsuccessful in the 1970s…”

This strange statement demonstrates both ignorance and factual error: if Whyte means that Keynesian stimulus was unsuccessful during the severe negative supply shocks under the first and second oil crises, he has shown basic ignorance of what Keynesian policy even is. You do not use stimulus in a period where very severe supply shocks have occurred: in these circumstances demand contractions are in order. And when the oil crises ended Keynesian stimulus was used quite successfully in a number of countries, so even here Whyte is wrong. If Whyte wants a successful example of Keynesian stimulus after the second oil shock, he needed to look no further than Reaganomics after 1982.

“… as it did during the Great Depression, the Keynesian policies followed by the Hoover and Roosevelt administrations, which were supposed to shorten the length of the downturn, caused it to be the longest in known history” (10.11– )

This is one of the most pathetically false statements in the whole debate. Why? What we call the Great Depression in the US was technically the severe contraction that occurred from 1929–1933 under Hoover.

While it is true that Hoover was a proponent of a type of corporatism and adopted a number of limited interventions from 1929–1933, Hoover did not engage in any remotely effective Keynesian countercyclical fiscal policy, as I have shown here:

“Herbert Hoover’s Budget Deficits: A Drop in the Ocean,” May 24, 2011.

The idea that Hoover adopted “Keynesian policies” is pure nonsense, an insult to the intelligence.

When Roosevelt came into office a weak recovery was just beginning. Roosevelt’s policies stabilised the financial system, created employment for considerable numbers of people and, to the extent that he tried countercyclical fiscal policy, he was successful. Of course, not all aspects of the New Deal were constructive. It was, to some extent, the result of the corporatist mentality that had permeated the American business elite in the 1920s. But it also had very beneficial aspects, and fiscal policy was one of them. The US experienced a recovery and falling unemployment in every year of Roosevelt’s administration until 1937, when Roosevelt foolishly listened to the advocates of austerity and tried budget balancing. The effect was to plunge the economy back into recession in 1937. The real failure of Roosevelt’s New Deal was simply that expansionary fiscal policy was not great enough to stimulate the economy back to full employment. Roosevelt was too timid.

Whyte’s claim that Keynesian macroeconomic policy has insufficient empirical evidence is rubbish. Virtually every Western country on earth used Keynesianism from 1945–1973, and we had the most prosperous period in modern human history in terms of unparalleled real GDP growth, productivity growth, and real wage growth.

(3) Selgin’s Remarks

Curiously, Selgin concedes that Hayek eventually supported quantitative easing and monetary stabilisation as a policy needed in the early 1930s. What, then, becomes of the need to liquidate malinvestments required by Hayek’s trade cycle theory? Did Hayek think that the malinvestments had cleared by 1930? Was, then, all the suffering after 1930 unnecessary?

Selgin presents a caricature of Keynes at 17.20 onwards, claiming that Keynes advocated injecting money into an economy by building pyramids or digging holes in the ground. Keynes, of course, did not seriously advocate this: he said that if you could find nothing else of use to do with the money, then (facetiously) said you might do those things.

Selgin’s main point in his talk is little more than an attempt to revive the moribund Austrian business cycle theory (ABCT). This theory in the form developed by Hayek relies on the Wicksellian natural rate of interest, and posits that when the bank rate of interest falls below the unique natural rate of interest, unsustainable malinvestments occur that lead to a bust (for a summary of ABCT, see Garrison 1997).

However, Piero Sraffa had already demonstrated in 1932 that outside of a static equilibrium there is no single natural rate of interest in a barter or money-using economy, and Hayek never really addressed this problem for his trade cycle theory.

There is in fact one Austrian honest enough to admit how damaging Sraffa’s critique of Hayek was: Robert Murphy. Murphy points out the following:

“In his brief remarks [in Hayek 1932], 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).

But even Lachmann’s (1994: 154) proposed solution does not work:

“Lachmann’s demonstration—that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest—does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to ‘the’ real rate of interest.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 14).

The Austrian business cycle theory is false, as I have shown here in numerous posts:

“Austrian Business Cycle Theory: The Various Versions and a Critique,” June 21, 2011.

“Austrian Business Cycle Theory (ABCT) and the Natural Rate of Interest,” June 18, 2011.

“Robert P. Murphy on the Sraffa-Hayek Debate,” July 19, 2011.

“Vaughn on Mises’s Trade Cycle Theory,” June 29, 2011.

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

“ABCT and Full Employment,” July 1, 2011.

With the recognition that a Hayekian trade cycle theory explanation of the Great Depression is a worthless explanation, most of Selgin’s arguments also collapse.

I had a brief exchange with Selgin on the issue of Sraffa’s critique of Hayek on the Cobdencentre.org blog here:

John Phelan, “Hayek vs Keynes at the LSE,” 27 July 11.

Selgin stated that

“Sraffa’s supposed ‘refutation’ of Hayek has itself been convincingly refuted. See Joseph Conard’s discussion of commodity ‘own rates of interest’ in his Introduction to the theory of interest (1959), pp. 123-7, the gist of which is that, contrary to what Sraffa and Keynes claimed, ‘With given and uniform expectations the rates of interest on different commodities are identical in equilibrium, provided only that they be measured in the same standard.’”

This is not, however, any “refutation” of Sraffa. I don’t deny that Hayek’s business cycle theory uses Wicksellian monetary equilibrium theory, nor did Sraffa. Sraffa already admitted that a unique natural rate would exist in an imaginary, fantasy world of static equilibrium or what Mises later called his Evenly Rotating Economy [ERE]. But a unique natural rate in static equilibrium is irrelevant to the real world. The “unique natural rate of interest” in a growing money-using economy or even a growing barter economy does not exist. Therefore, in the former case, there is simply no natural rate the bank rate can equal to allegedly prevent the cycle effects from happening.

What is particularly peculiar is that Selgin is an advocate of free banking: a financial system where banks have the power to create fiduciary media over and above the stock of commodity money. On a purely logical level, if Selgin advocates the Austrian business cycle theory (ABCT), then his support for a free banking system would (on the logic of ABCT) be a recipe for perpetual malinvestment!

Selgin also complains that low interest rates in the US fuelled the bubbles in the 1990s and 2000s: but he totally ignores the role of effective financial regulation in preventing the flow of credit to speculative investments which cause bubbles. When many nations dismantled the previous system of effective financial regulation in the 1980s and 1990s, this is precisely when asset bubbles and financial instability emerged again in Western economies.

Selgin makes the truly absurd claim that “there’s been no episode of a depression cured by fiscal expansion” (33.09). Jamie Whyte makes the same ignorant statement: he claims “the Keynesians’ position has been tried many times and it doesn’t work” (39.11). Really?

What on earth do Selgin and Whyte think happened in the US, and many other countries, in 1939–1945? Now in these years we were driven by the crisis of WWII to have wasteful command economies driven into massive fiscal expansion by war, but this episode showed us beyond any shadow of a doubt that massive fiscal expansion cures depression.

What is a tragedy is that in the 1930s and even now we are unable to have government spending on the same scale required, in constructive public works programs, infrastructure and social spending, jobs programs, and R&D outlays, to stimulate our economies back into full employment.

When Selgin complains that the banks are dysfunctional, he is of course right. Selgin is also right in railing against the crony capitalist bailout of America’s banks by Bush in 2008. What he ignores is that progressives, Post Keynesians, and even many New Keynesians did not support the form in which the bailout took: instead, they proposed a very different type of bailout to clean the financial system up and re-regulate it effectively.

What was badly needed in his debate was a clear Post Keynesian set of policy solutions. First, Post Keynesians already have a theory to explain the type of cycle that plunged us into the crisis in 2008: this is Hyman Minsky’s financial instability hypothesis, a far more convincing explanation of many business cycles, where asset bubbles and excessive private debt are driving the boom. Hyman Minsky’s financial instability hypothesis theory has been developed by the Post Keynesian Steve Keen, and by the heterodox economist Richard C. Koo (in the context of Japan’s lost decade).

What was required in 2008-2009 was a bailout that also cleared the banks of bad assets and non-performing loans without collapsing the economy, as in, for example, the Swedish model of fixing their financial system in the early 1990s:

“The Swedish Solution: Sweden’s Bank Bailout versus Japan’s and the US’s,” May 20, 2011.

In comments below (on this post), Selgin endorses a similar type of intervention to stabilise the financial system that could have been used in 2008, and in this he might very well agree with James Galbraith. In this video below (from 1.50 minutes), Galbraith tells us what should have been done in 2008: a pass-through receivership for the major banks by federal regulators.



Post Keynesians would go further: we also need to reduce the unsustainable level of private debt. This might even require writing off or restructuring a great deal of mortgage debt, credit card debt, and personal and business debt (the central bank’s power to create money can be used to protect depositors and other creditors, where necessary, to prevent catastrophic bankruptcies of creditors). After the issue of excessive private debt has been addressed, more Keynesian stimulus on a large scale is needed, as well as employment programs to deal with unemployment directly.

All in all, a good debate, but there were many issues that could also have been raised. In my view, the Keynesians won.

Links on the Debate

Victoria Chick, Douglas Coe, and Ann Pettifor, “Eight Fallacies in the LSE Keynes/Hayek Debate,” http://www.primeeconomics.org/?p=635
A very nice review of the debate from the Keynesian side, and some myths debunked.

“Hayek vs Keynes at the LSE,” 27 July 11,
http://www.cobdencentre.org/2011/07/hayek-vs-keynes-at-the-lse/
A review of the debate from the Austrian perspective.

George Selgin, “Behind the Scenes at the Hayek v. Keynes Debate,” August 3rd, 2011
http://www.freebanking.org/2011/08/03/behind-the-scenes-at-the-hayek-v-keynes-debate/
George Selgin gives some background on the debate.

Keynes v Hayek, and why Keynes had to win,
http://www.taxresearch.org.uk/Blog/2011/08/04/keynes-v-hayek-and-why-keynes-had-to-win/


Note: Apology to Selgin

Please note that I had originally written above:

Selgin tells us that the solution he wanted in 2008 was to “liquidate Bear Stearns, liquidate Fannie Mae and Freddie Mac. Liquidate, in short, the whole sub prime apparatus … and, yes, that would have meant letting insolvent banks … go bust.”

In other words, he wanted to see the financial sector collapse, and this would have plunged the world into a deflationary depression. Since Selgin’s Austrian trade cycle theory (ABCT) is incoherent, his economic justification for such a collapse is non existent ...

I was wrong. Due apologies to Professor Selgin.

George Selgin has corrected me in comments below: he did not support a financial sector collapse in 2008 by these remarks, but instead advocates a policy something like the Swedish bailouts of early 1990s, as well as the normal method by which the FDIC deals with insolvent banks: allowing deposits to be “guaranteed by the government, the banks are then liquidated, shareholders wiped out, senior management fired, assets than sold off to pay for the losses. Whatever is left over goes to the bondholders.”

In urging this, I can only agree completely. In fact, I note that James Galbraith supported almost the same policy, in the video above.


BIBLIOGRAPHY

Adamthwaite, A. P. 1977. The Making of the Second World War, Allen & Unwin, London and Boston.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 23–27

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

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

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

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.

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.

Hayek and the Myth of Neutral Money

Hayek’s version of the Austrian trade cycle theory adopted the Wicksellian notion of “neutral money.” This appears to have been one of Hayek’s fundamental ideas in developing the trade cycle theory, and he presents his case for neutral money as a concept in a 1928 essay:

Hayek, F. A. von, 1928. “Das Intertemporale Gleichgewichtssystem der Preise und die Bewegungen des Geldwertes,” Weltwirtschaftliches Archiv 2: 33–76.

The extent to which Hayek urged neutral money as a actual monetary policy is unclear. But, as late as 1933, Hayek appeared to be still urging the idea of attempting to make money neutral (or, that is to say, trying to implement monetary policy that would approach the situation of “neutral money”), though he is not as optimistic about it:

Hayek, F. A. von, “Über ‘neutrales Geld,’” Zeitschrift fur Nationalökonomie 4 (1933): 659–661, translated in F. A. von Hayek, Money, Capital & Fluctuations: Early Essays (ed. R. McCloughry), Routledge & Kegan Paul, London, 1984.

Hayek had already come up against the critique of Sraffa in 1932 and by the time of the 2nd edition of Prices and Production (2nd edn; Routledge and Kegan Paul, 1935) he was starting to distance himself from neutral money, and admitting it was never a practical monetary policy.

And by the time of Denationalisation of Money: The Argument Refined. An Analysis of the Theory and Practice of Concurrent Currencies (1990; 1st edn 1976), Hayek is quite clear that any attempt to create neutral money in the real world is pointless:

“Although I have myself given currency to the expression ‘neutral money’ (which, as I discovered later, I had unconsciously borrowed from Wicksell), it was intended to describe this almost universally made assumption of theoretical analysis and to raise the question whether any real money could ever possess this property, and not as a model to be aimed at by monetary policy. I have long since come to the conclusion that no real money can ever be neutral in this sense, and that we must be content with a system that rapidly corrects the inevitable errors.” (Hayek 1990: 87–88).

Sraffa is vindicated:

“The starting-point and the object of Dr. Hayek’s inquiry is what he calls ‘neutral money’; that is to say, a kind of money which leaves production and the relative prices of goods, including the rate of interest, ‘undisturbed,’ exactly as they would be if there were no money at all. This method of approach might have something to recommend it, provided it were constantly kept in mind that a state of things in which money is ‘neutral’ is identical with a state in which there is no money at all: as Dr. Hayek once says, if we ‘eliminate all monetary influences on production ... we may treat money as non-existent’” [Prices and Production, p. 109]. .... (Sraffa 1932: 42).

BIBLIOGRAPHY

Hayek, F. A. von, 1928. “Das Intertemporale Gleichgewichtssystem der Preise und die Bewegungen des Geldwertes,” Weltwirtschaftliches Archiv 2: 33–76.

Hayek, F. A. von, 1933. “Über ‘neutrales Geld,’” Zeitschrift fur Nationalökonomie 4: 659–661.

Hayek, F. A. von, 1984. Money, Capital & Fluctuations: Early Essays (ed. R. McCloughry), Routledge & Kegan Paul, London.

Hayek, F. A. von, 1990. Denationalisation of Money: The Argument Refined. An Analysis of the Theory and Practice of Concurrent Currencies (3rd edn; 1st edn 1976), The Institute of Economic Affairs, Westminster, London.

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

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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