Austrians and the Market’s Tendency to Equilibrium

Austrian economists have four different concepts of equilibrium and it is my intention to analyse them in this post:

“Despite frequent assertions that Austrian economics is defined as ‘market process economics’ or ‘disequilibrium economics,’ the concept of equilibrium features prominently in causal-realist economics (Hülsmann, 2000; MacKenzie, 2008) At least four distinct equilibrium constructs appear in Austrian analysis. Following Mises’s terminology, as amended by Salerno (1994a), we can call them the plain state of rest (PSR), the fully arbitraged state of rest or Wicksteedian state of rest (WSR), the final state of rest (FSR), and the evenly rotating economy (ERE). Two of these, the PSR and WSR, describe real-world outcomes, while the FSR and ERE are what Mises called ‘imaginary constructions,’ hypothetical scenarios that do not obtain in reality, but are useful in economic reasoning, allowing the theorist to isolate the effects of particular actions or circumstances, holding all else constant.” (Klein 2010: 135).

In summary, the four concepts of equilibrium are as follows:

(1) the “plain state of rest”;

(2) the “Wicksteedian state of rest” or “fully arbitraged state of rest”;

(3) the “final state of rest,” and

(4) the “evenly rotating economy” (ERE).

(1), (3), and (4) were defined by Mises, and (2) developed subsequently by other Austrian economists.

These are examined below.

(1) The Plain State of Rest
First, the “plain state of rest”:

“People keep on exchanging on the market until no further exchange is possible because no party expects any further improvement of its own conditions from a new act of exchange. The potential buyers consider the prices asked by the potential sellers unsatisfactory, and vice versa. No more transactions take place. A state of rest emerges. This state of rest, which we may call the plain state of rest, is not an imaginary construction. It comes to pass again and again. When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market price too low or too high respectively have not sold or bought.” (Mises 2008: 245).

This “state of rest” is further described by Murphy and Gabriel:

“The plain state of rest is not an imaginary construction; it happens whenever there are no transactions, because no buyer wishes to acquire more units of the good or service at the price necessary to induce a seller to surrender more units. The plain state of rest is only transitory; it will be disrupted whenever preferences change and mutually advantageous exchanges once again exist.” (Murphy and Gabriel 2008: 107).

“Mises’s illustration … of the plain state of rest—namely, the daily close of a stock market—is rather unfortunate, for the market closes at a preordained time, and in principle there could be frustrated buyers and sellers who don’t exchange simply because of the closing bell. To make matters worse, Mises justifies his choice by pointing out (in footnote 9) that he is disregarding the fluctuations in stock prices over the course of the trading day. A better choice would have been a market in which prices remain fairly stable; then a period in which no sales took place (even though the market is ‘open’) would constitute a plain state of rest.” (Murphy and Gabriel 2008: 107).

Kirzner notes that the “plain state of rest” equilibrium is not a Marshallian partial equilibrium:

“The ‘supply and demand’ which are continually in equilibrium in Mises’s world, do not refer to the supply and demand schedules so basic to mainstream microeconomic theory. They refer simply to the circumstance that, in any situation, those potential transactors who have been aware of available mutually beneficial trade possibilities, will all certainly have moved to take advantage of these opportunities; once these opportunities have been grasped, market activity of course ceases, the plain state of rest has been attained.

To describe the price emerging from these exchange transactions as a ‘market-clearing price’ (Salerno, 1993, p. 121), is therefore misleading. Certainly the price permits all those who stand to gain by exchanging at this price and who are aware of this—to exchange to the point where no known remaining mutually gainful opportunities exist. But the term ‘market-clearing price’ (a term not used by Mises) is used in standard economics to refer to the exhaustion of all mutually gainful exchange opportunities under the hypothetical conditions of (relevant) omniscience. Standard economics indeed notoriously proceeds, in applying supply and demand theory to the real world, to operate as if conditions of relevant omniscience can be taken as given. Mises is certainly not making any such assumption of omniscience. His market prices are certainly not ‘market clearing prices’ (in the usual sense of that term). There is, one is able to reassure the puzzled reader, therefore no contradiction in his exposition. Real world market prices are not the equilibrium prices of standard economic theory. (Real world prices relate to equilibrium only in a very narrow sense, a sense to which no attention at all is given in standard theory.) Real world prices are indeed likely to be ‘false’ prices, setting off entrepreneurial-competitive activity modifying the pattern of resource allocation.” (Kirzner 2000: 167–168).

There is a sense in which an individual “plain state of rest” per se is a trivial notion of equilibrium as described here by Kirzner, which is different from and opposed to the alternative idea of equilibrium as one of supply and demand in a product market. But, despite Kirzner, Mises does have a clear belief in the tendency of free markets to produce supply and demand equilibrium via flexible prices (as we will see below).

Moreover, in the context of an economy with a flexible price system in the way Mises imagines, “plain states of rest” could be construed as specific steps in a sequence over time towards market-clearing prices, and this is how Salerno seems to understand the concept:

“prices ... are generated by the market process and serve as the data for economic calculation. These are realized prices; or, in other words, they are the actual outcome of the historical market process at each moment in time and are determined by the value scales of the marginal pairs in each market. They are, therefore, also market-clearing prices the establishment of which coincides with a momentary situation, what Mises calls the ‘plain state of rest’ (PSR), in which no market participant, given his existing marginal-utility rankings of goods and money and knowledge of prevailing prices, can enhance his welfare by participating in further exchange. However, despite their character as market-clearing prices, these are also disequilibrium prices. Thus as a consequence of the unavoidable errors of entrepreneurial forecasting and price appraisement under uncertainty, most goods are sold at prices that do not conform to their monetary costs of production, thereby generating realized profits and losses for producers.” (Salerno 1990: 121; cf. Salerno 2010: 141).

So prices are “disequilibrium prices” in the sense that they are not equal to marginal costs of production, but allow profit and loss. Kirzner criticises Salerno’s use of the term “market-clearing price” in the context of an individual “plain state of rest” since this is unlikely to be a true market-clearing price in the sense of a supply and demand equilibrium in a product market. But if “plain state of rest” prices are construed as “market-clearing prices” over time in a sequence as prices are adjusted toward the price at which there is supply and demand equilibrium, then Salerno’s use of the term “market-clearing price” is justifiable.

This appears to me how Salerno does conceive supply and demand equilibrium in product markets as a tendency to market-clearing prices over time:

“Mises conceives the market process as coordinative, ‘the essence of coordination of all elements of supply and demand.’ This means that the structure of realized (disequilibrium) prices, which continually emerges in the course of the market process and whose elements are employed for monetary calculation, performs the indispensable function of clearing all markets and, in the process, coordinating the productive employments and combinations of all resources with one another and with the anticipated preferences of consumers.” (Salerno 1993: 124).

(2) The “Wicksteedian State of Rest” or “Fully Arbitraged State of Rest”
This concept is explained by Klein:

“Lying between the … [sc. plain state of rest] and the … [sc. final state of rest] is the WSR [sc. Wicksteedian state of rest], a realistic concept in which trading takes place while preferences remain constant, with market participants revising their beliefs about other participants’ reservation prices until all feasible gains from trade are exhausted. Wicksteed’s (1910, pp. 219–28) fruit market provides the canonical example. By the end of each market day, a specified period in which preferences, stocks of goods, and the set of traders remains fixed, what Wicksteed calls ‘the equilibrating price’ has been achieved. In this situation, ‘the marginal position of the commodity in question is identical upon the relative scales of all who have secured a supply, and higher on them all than it is on the scales of any of those who have secured no supply’ (Wicksteed, 1910, p. 216). The market day is a hypothetical construct, in that it holds only as long as preferences, technical knowledge, stocks of goods available for exchange, and so on are held constant. And yet, the WSR is not a purely imaginary construction, as this process of equilibration takes place in real markets, at least over short periods of calendar time.” (Klein 2010: 138).

The “Wicksteedian state of rest” thus appears to be a supply and demand equilibrium in an individual product market.

(3) The Final State of Rest
Thirdly, we have the “final state of rest”:

“But now we go a step further. We pay attention to factors which are bound to bring about a tendency toward price changes. We try to find out to what goal this tendency must lead before all its driving force is exhausted and a new state of rest emerges. The price corresponding to this future state of rest was called the natural price by older economists; nowadays the term static price is often used. In order to avoid misleading associations it is more expedient to call it the final price and accordingly to speak of the final state of rest. This final state of rest is an imaginary construction, not a description of reality. For the final state of rest will never be attained. New disturbing factors will emerge before it will be realized. What makes it necessary to take recourse to this imaginary construction is the fact that the market at every instant is moving toward a final state of rest. Every later new instant can create new facts altering this final state of rest. But the market is always disquieted by a striving after a definite final state of rest.” (Mises 2008: 246).

A “final state of rest” price is a market clearing price and (apparently) a price equal to marginal cost.

For Mises, the real world exhibits a tendency towards this ideal state of equilibrium, or, as Mises says, the market “at every instant is moving toward a final state of rest.”

But there is some ambiguity here: is the “final state of rest” a situation where all prices in all product markets have reached their market-clearing and equilibrium values? Or it is only meant to refer to an individual product market?

Vaughn understands the “final state of rest” in the former sense:

“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.” (Vaughn 1994: 81–82).

However, Murphy and Gabriel seem unclear on whether Mises thinks of the “final state of rest” as a general state of equilibrium:

“the final state of rest is indeed an imaginary construction. It refers to the situation in which all of the effects of a particular disturbance have run their course, and the price in question has reached its final price. If a new report causes half of the smokers to quit cold turkey, a plain state of rest in the cigarette market will soon emerge at a much lower price. However, as cigarette manufacturers scale back their operations and the glut of inventory is reduced to the new level (appropriate for the cut in customers), a new final price will emerge (that may be higher or lower than the previous final price, depending on the specifics). (Murphy and Gabriel 2008: 107–108).

Despite this, the “final state of rest” involves market clearing prices in the sense of supply and demand equilibrium.

(4) The Evenly Rotating Economy (ERE)
This is described by Mises in these terms:

“The imaginary construction of the final state of rest is marked by paying full regard to change in the temporal succession of events. In this respect it differs from the imaginary construction of the evenly rotating economy which is characterized by the elimination of change in the data and of the time element. (It is inexpedient and misleading to call this imaginary construction, as is usual, the static economy or the static equilibrium, and it is a bad mistake to confuse it with the imaginary construction of a stationary economy.) The evenly rotating economy is a fictitious system in which the market prices of all goods and services coincide with the final prices. There are in its frame no price changes whatever; there is perfect price stability. The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers' goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today. The system is in perpetual flux, but it remains always at the same spot. It revolves evenly round a fixed center, it rotates evenly. The plain state of rest is disarranged again and again, but it is instantly reestablished at the previous level. All factors, including those bringing about the recurring disarrangement of the plain state of rest, are constant. Therefore prices—commonly called static or equilibrium prices—remain constant too.” (Mises 2008: 247–248).

We further read that it is a state where there is no profit and loss (Mises 2008: 249) and where there is no uncertainty whatsoever about the future, and nobody holds cash for precautionary motives (Mises 2008: 250).

The evenly rotating economy, then, is a purely “imaginary construction” (Mises 2008: 247) and real world market economies do not have a tendency towards it. So it need not detain us.

(5) Analysis
Despite constant changes in the data and disequilibrating phenomena, nevertheless for Mises the market economy is constantly tending towards new “final states of rest” (in which values have changed owing to changes in current market data).

But this seems like a rather weak notion of equilibrium. If an economy does not ever attain a long-run convergence to a particular “final state of rest,” but consists of multiple short-period convergences to one “final state of rest” quickly thwarted as the economy must adjust to a new convergence to yet another new “final state of rest,” then it is difficult to see why Mises can declare that markets have any strong or effective long-run self-equilibration.

What, then, is Mises left with, if he wants to argue that market economies have a strong tendency to equilibration?

Mises has two fundamental processes as follows that cause an economy to have a tendency to coordination, which may run deeper than his short period convergences to shifting “final states of rest”:

(1) a flexible price and wage system, in which prices and wages have a tendency to move towards market clearing values in the sense of demand and supply equilibrium, even if the overall economy never reaches a “final state of rest.”

That is to say, prices and wages are flexible and determined by supply and demand in trades between buyers and sellers. Increased demand drives prices upwards, and decreased demand drives prices downwards. Demand curves are well behaved and each product market has a market-clearing price that would equate quantity demanded by buyers with quantity supplied by sellers to eliminate surplus or shortages of goods.

This demand and supply equilibrium tendency is also held to include the market for loanable funds, so that saving and investment are supposed to be coordinated by a market clearing interest rate.

(2) the entrepreneurial pursuit of profit, which has a tendency to drive profits towards zero as firms and businesses compete against each other by noticing profit differences, and by moving in and out of markets to exploit high profits.

Factor (1) above is fundamentally important.

Supply and demand equilibrium is a crucial concept in Mises’s thought and theory, as can be seen from a few selected passages:

(1) “The price structure of the market decides what will be produced, how, and in what quantity. Through the structure of prices, wages, and interest rates the market brings supply and demand into balance and sees to it that each branch of production will be as fully occupied as corresponds to the volume and intensity of the effective demand. Thus capitalist production derives its meaning from the market. Of course, a temporary imbalance between production and demand can occur, but the structure of market prices makes sure that the balance is reestablished in a short time. Only when the mechanism of the market is disturbed by external interventions is the effect of market prices on the regulation of production prevented; they are disturbances that no longer can be remedied by the automatic reactions of the market, disturbance that are not temporary but prolonged.” (Mises 2002a [1931]: 170).

(2) “Entrepreneurs try to supply those goods whose sale promises them the highest possible profit. But it is the market that decides where profits are earned and losses suffered. If consumers demand more of a product, then its price rises; if they demand less, then the price falls. If entrepreneurs produce only those goods whose sale promises to bring them profits, then that means they are following the wishes of the consumers. It is the market, therefore, that directs a capitalist economy, based on the private ownership of the means of production. The changing prices of the market bring supply and demand into equilibrium. The market price—called the ‘natural price’ by the Classical economists and the ‘static price’ by modern economists—finds its level at a point at which no prospective buyer who is ready to pay the market price leaves the market unsatisfied, and no prospective seller who is willing to accept the market price leaves the market with unsold goods.” (Mises 2002b [1933]: 209).

(3) “Price control measures paralyze the working of the market. They destroy the market. They deprive the market economy of its steering power and render it unworkable.

The price structure of the market is characterized by its tendency to bring supply and demand into balance. If the authority attempts to fix a price different from the market price, this situation cannot prevail. In the case of maximum prices, there are potential buyers who cannot buy although they are ready to pay the price fixed by the authority, or even to pay a higher price. Or there are—in the case of minimum prices—potential sellers who cannot find buyers even though they are willing to sell at the price established by the authority, or even to sell at a lower price. The price is no longer the means of segregating those potential buyers and sellers who may buy or sell from those who may not. A different principle of selection has to come into operation. It may be that only those who come first or those who occupy a privileged position due to particular circumstances (personal connections, for instance) will actually buy or sell. But it may also be that the authority itself takes over the regulation of distribution. At any rate the market is no longer able to provide for the distribution of the available supply to the consumers. If chaotic conditions are to be avoided, and if neither chance nor force is to be relied upon to determine distribution, the authority has to undertake this task by some system of rationing.” (Mises 1998 [1940]: 26).

(4) “The aim of price control is to decree prices, wages, and interest rates different from those fixed by the market. Let us first consider the case of maximum prices, where the government tries to enforce prices lower than the market prices.

The prices set on the unhampered market correspond to an equilibrium of demand and supply. Everybody who is ready to pay the market price can buy as much as he wants to buy. Everybody who is ready to sell at the market price can sell as much as he wants to sell. If the government, without a corresponding increase in the quantity of goods available for sale, decrees that buying and selling must be done at a lower price, and thus makes it illegal either to ask or to pay the potential market price, then this equilibrium can no longer prevail. With unchanged supply there are now more potential buyers on the market, namely, those who could not afford the higher market price but are prepared to buy at the lower official rate. There are now potential buyers who cannot buy, although they are ready to pay the price fixed by the government or even a higher price.” (Mises 2010 [1944]: 61).

(5) “The crisis from which the world is suffering today is the crisis of interventionism and of national and municipal socialism; in short, it is the crisis of anticapitalist policies. Capitalist society—there is no difference of opinion about this—is governed by the workings of the market process. Market prices bring supply and demand into balance and determine the direction and extent of production. The capitalist economy gets its meaning from the market. If the function of the market as regulator of production is permanently undermined by an economic policy that attempts to set prices, wages, and interest rates other than in the way the market forms them, then a crisis will surely occur.” (Mises 2002c [1932]: 191).

(6) “The characteristic feature of the market price is that it equalizes supply and demand. The size of the demand coincides with the size of supply not only in the imaginary construction of the evenly rotating economy. The notion of the plain state of rest as developed by the elementary theory of prices is a faithful description of what comes to pass in the market at every instant. Any deviation of a market price from the height at which supply and demand are equal is – in the unhampered market – self-liquidating.” (Mises 2008: 756–757).

So, in the view of Mises, the tendency of either the unhampered market or a real world market towards any “final state of rest” depends fundamentally on a flexible price and wage system that coordinates quantity demanded with quantity supplied in product markets and the labour market.

The action of entrepreneurs who pursue profits is the second most important coordinating mechanism, which (allegedly) causes a tendency for profits to be driven towards zero.

Since neither element is in fact a strong characteristic of modern real world market economies, it follows that the Austrian view of market equilibration is false.


BIBLIOGRAPHY
Ebeling, Richard M. (ed.). 2002. Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Klein, Peter G. 2010. The Capitalist & the Entrepreneur: Essays on Organizations & Markets. Ludwig von Mises Institute, Auburn, Ala.

MacKenzie, D. W. 2008. “The Equilibrium Analysis of Mises, Hayek, and Lachmann,”
http://mises.org/journals/scholar/mackenzie12.pdf

Mises, L. von. 1998 [1940]. Interventionism: An Economic Analysis. The Foundation for Economic Education, Irvington on Hudson, NY.

Mises, L. von. 2002a [1931]. “The Economic Crisis and Capitalism,” in Richard M. Ebeling (ed.), Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind. 169–173.

Mises, L. von. 2002b [1933]. “Planned Economy and Socialism,” in Richard M. Ebeling (ed.), Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind. 208–212.

Mises, L. von. 2002c [1932]. “The Myth of the Failure of Capitalism,” in Richard M. Ebeling (ed.), Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind. 182–191.

Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von. 2010 [1944]. Omnipotent Government: The Rise of the Total State and Total War. Ludwig von Mises Institute, Auburn, Ala.

Murphy, Robert P. and Amadeus Gabriel. 2008. Study Guide to Human Action. A Treatise on Economics: Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Salerno, Joseph T. 1990. “Ludwig von Mises as Social Rationalist,” Review of Austrian Economics 4: 26–54.

Salerno, Joseph T. 1993. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6.2: 113–146.

Salerno, Joseph T. 1994. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought,” Review of Austrian Economics 8.1: 71–115.

Salerno, Joseph T. 2010. Money, Sound and Unsound. Ludwig von Mises Institute, Auburn, Ala.

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

Hayek on the “Use of Knowledge in Society”

The “knowledge problem” according to Hayek consists in explaining how a market economy overcomes the problem of dispersed, decentralised knowledge of supply and demand and the many individual plans and preferences of both consumers and producers. His classic article on the subject was published in 1945 in the American Economic Review (35.4 [1945]: 519–530).

But, curiously, various Austrians – mainly Misesians and Rothbardians – are unsatisfied with Hayek’s paper. Even Kirzner complains that in the “Use of Knowledge in Society” Hayek made “it appear that the function of prices in communicating knowledge was a function that is filled, in principle, also in the state of equilibrium” (Kirzner 2000: 157).

Salerno argues that Hayek’s “knowledge problem” is different from Mises’s “socialist economic calculation” problem, and even Kirzner concedes that Mises did not formulate the “calculation problem” in terms of knowledge (Kirzner 2000: 158).

What is Hayek’s argument?

The economic data for a whole society are never given to a single mind (Hayek 1945: 519) or given to any person “in its totality” (Hayek 1945: 520). A rational economic order is characterised by a state of affairs in which the relevant information exists “solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess” (Hayek 1945: 519). Planning is obviously done by very many individuals in a decentralised manner (Hayek 1945: 521).

Therefore the “various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process” (Hayek 1945: 520). At the same time, specific knowledge of “particular circumstances of time and place” is also very important (Hayek 1945: 521): that is, the knowledge that individual business people have of their markets, stocks, trades and capital goods, and so on.

In dealing with economic change, the best people to make the decisions are those who know their businesses, resources and markets: the “man on the spot,” as it were (Hayek 1945: 524).

Yet business people need to fit their decisions into the “whole pattern of changes of the larger economic system” (Hayek 1945: 525).

For Hayek, the price system communicates this knowledge (Hayek 1945: 526). As an example, Hayek thinks of an increase in demand for tin. The price of tin rises: buyers of tin now know they must economise tin.

What are the problems with Hayek’s theory?

We can set the problems out below:

(1) the implied assumption of Hayek’s argument (so his Misesian critics argue, perhaps not unfairly) is an economy near equilibrium, or (that is to say) in a “proximal equilibrium” state.

(2) the failure of Hayek to understand the role of Knightian uncertainty;

(3) the role of fixprice markets and administered prices, and

(4) the destabilising role of speculation in prices.

First, the role of “proximal equilibrium.” Hayek briefly nods his head at the reality that price adjustments in the real world are never “perfect” as in equilibrium analysis (Hayek 1945: 527), but his actual theory does require reasonably flexible – if not perfect – price adjustments in all markets. It is no surprise that even Austrian critics of Hayek complained that his theory treats the world as if it is in a state of “proximal equilibrium.”

Salerno contends that:

“as Hayek points out, in order for prices to fulfill their knowledge-disseminating and plan-coordinating functions, the economy must subsist in a state of what I will call ‘proximal equilibrium,’ wherein realized prices are always fairly accurate indicators of future prices.” (Salerno 1993: 128; cf. Horwitz 2004: 314–315).

That is a wholly unrealistic idea.

Secondly, more serious difficulties emerge in Hayek’s neglect of Knightian uncertainty:

“Uncertainty for Hayek means that each individual decision maker only has a small piece of the puzzle. However, as a whole, the aggregated set of all decision makers have a complete set of all relevant knowledge. There are no pieces missing, lacking or unavailable from the puzzle. Market prices organize and synthesize the aggregate amount of knowledge so that market price signals, understood only by savvy, knowledgeable entrepreneurs, [eliminate] … any uncertainty.” (Brady 2011: 14).

“Keynes, Knight and Schumpeter deny Hayek’s claim that the market generates price vectors which concentrate the knowledge so that savvy, knowledgeable entrepreneurs can act on this information and solve the problem of uncertainty. Uncertainty means vital important information is missing. Pieces from the puzzle are missing and will not turn up in the future” (Brady 2011: 14).

“Hayek could not accept the standard concept of uncertainty as defined by Keynes, Knight and Schumpeter because it would then be impossible for market prices to concentrate knowledge that did not exist. In conclusion, nowhere in any of Hayek’s three articles on Knowledge in Economics in 1937, 1945 and 1947 does Hayek deal with the standard view that uncertainty means knowledge that is not there.” (Brady 2011: 15).

Thirdly, factor (3) above – the extensive role of fixprice markets – means Hayek’s vision is deeply flawed.

Prices that remain essentially rigid in response to demand changes (quite frequent in the real world) cannot have the knowledge-communicating role of Hayek’s theory.

And finally Hayek’s theory never considers the destabilising role of commodity speculation. How can relevant information be communicated if prices are distorted by speculative activity, and therefore are not related to underlying supply and demand?

Finally, there is one statement in the paper that Hayek never develops:

“We must look at the price system as such a mechanism for communicating information if we want to understand its real function—a function which, of course, it fulfils less perfectly as prices grow more rigid. (Even when quoted prices have become quite rigid, however, the forces which would operate through changes in price still operate to a considerable extent through changes in the other terms of the contract.)” (Hayek 1945: 526).

It never occurs to Hayek that, in the advanced capitalist economies of his day, prices had already grown rigid in many markets because of administered prices. Yet economic coordination continued to occur, and economic growth and markets continued to function, and after 1945 far better than in previous periods.

And what other forms of the business contract allow economic coordination without flexible prices? Hayek never tells us, but in reality it is “quantity signals” that are the fundamental factor in fixprice markets that equate supply and demand, but Hayek never understood that.

Probably he never properly understood it at any point in his life.

In short, the price system mostly has a secondary coordination role in modern markets: “in actual adjustment of supply and demand, prices play only a very subordinate role, if any” (Kaldor 1985: 25).

BIBLIOGRAPHY

Brady, Michael Emmett. 2011. “Comparing J.M. Keynes’s and F. von Hayek’s Differing Definitions of Uncertainty as it Relates to Knowledge,” January 30.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1751569

Hayek, F. A. von. 1945. “The Use of Knowledge in Society,” American Economic Review 35.4: 519–530.

Horwitz, S. 2004. “Monetary Calculation and the Unintended Extended Order: The Misesian Microfoundations of the Hayekian Great Society,” Review of Austrian Economics 17.4: 307–321.

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Salerno, Joseph T. 1993. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6.2: 113–146.

The Divide in Austrian Economics on Equilibrium

There is arguably a split in Austrian economics on the issue of equilibrium (Vaughn 1994: 162). Lewin (1999: 27) speaks of a “rift within the subjectivist Austrian family” on the issue of a tendency to equilibrium.

On the one hand, the early Hayek, Mises, Kirzner, and Rothbard see markets as having a real tendency to equilibrium states (whether defined as some Walrasian general equilibrium state in Hayek’s pre-1937 work, Hayek’s “plan coordination” after 1937, Mises’s “final state of rest”, or Rothbard’s evenly rotating economy [ERE]).

From 1937, Hayek redefined equilibrium from the notion of a set of market clearing prices to the new concept of “plan coordination,” a situation where individual plans are coordinated (Vaughn 1994: 169). This state of affairs means that an economy might be on a path toward a type of equilibrium without all markets having to clear (Vaughn 1994: 169). Hayek’s notion of plan coordination was taken up and used by Kirzner, Lavoie, Garrison and other later Austrians (Vaughn 1994: 169; O’Driscoll and Rizzo 1996: 80). Indeed, according to Charles W. Baird (1987: 197), “Hayekian equilibrium” or “plan coordination” is “the notion that most Austrians consider useful.”

Furthermore, Hayek’s work on the Austrian trade cycle theory (pre-1937) was done when he was using Walrasian general equilibrium theory, and, as I have demonstrated in the previous post, once Hayek saw the problems with general equilibrium theory the difficulties in his business cycle theory became insuperable.

And one can’t help but notice that, in Hayek’s later statements and thought, he does not entirely dispense with the idea of market clearing equilibrium prices as an explanation of unemployment either. In a talk to the American Enterprise Institute in Washington DC on April 9, 1975 Hayek sounds like a neoclassical:

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

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

The primary cause of the appearance of extensive unemployment, however, is a deviation of the actual structure of prices and wages from its equilibrium structure. Remember, please: that is the crucial concept. The point I want to make is that this equilibrium structure of prices is something which we cannot know beforehand because the only way to discover it is to give the market free play; by definition, therefore, the divergence of actual prices from the equilibrium structure is something that can never be statistically measured.” (Hayek 1975: 6–7).

This demonstrates that, despite his 1937 notion of “plan coordination,” Hayek was still capable of reverting to neoclassical equilibrium ideas as late as 1975.

The stream of Austrian economics that asserts the idea of a tendency to equilibrium may well be more a supplement to neoclassical economics than a replacement (Vaughn 1994: 166). For example, Kirzner’s entrepreneurial theory is one method by which Austrians can posit a real world tendency to market coordination.

Occupying an intermediate position are Rizzo and O’Driscoll. They rejected even Hayek’s “plan coordination” idea (which they saw as just another type of static equilibrium concept: O’Driscoll and Rizzo 1996: 80–82). Instead, Rizzo and O’Driscoll argue that markets have a tendency to “pattern coordination,” a weaker concept of economic coordination which consists merely of some degree of order in which individual actions “are coordinated with respect to their typical features, even if their unique aspects fail to mesh” (O’Driscoll and Rizzo 1996: 85).

On the other side of the Austrian school are Ludwig Lachmann and those influenced by him. Vaughn argues that Lachmann thought that markets are subject to both disequilibrating and equilibrating tendencies, but took no position on exactly what tendency dominates the market system (Vaughn 1994: 160; see also Prychitko 1993: 375). Prychitko holds that there is no a priori basis on which to assert that markets tend to equilibrium states (Prychitko 1993: 375).

Whether there is an inherent tendency to disequilibrium is a different question, of course.

Even a Post Keynesian economist like Paul Davidson does not argue that free market economies are inherently disequilibrating (Davidson 1993: 436). Rather, Post Keynesians argue that there is nothing in market systems that ensure that the economy will converge automatically to full employment equilibrium (Davidson 1993: 436). For Keynes, the most serious flaws in capitalism were as follows:

“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” (Keynes 1936: 372).

BIBLIOGRAPHY

Baird, Charles W. 1987. “The Economics of Time and Ignorance: A Review,” The Review of Austrian Economics 1.1: 189–206.

Davidson, P. 1993. “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2–3: 423–444.

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

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money. Macmillan, London.

Lewin, Peter. 1999. Capital in Disequilibrium: The Role of Capital in a Changing World. Routledge, London.

O’Driscoll, G. P. and M. J. Rizzo. 1996. The Economics of Time and Ignorance (2nd edn.). Routledge, Oxford, UK.

Prychitko, D. 1993. “After Davidson, Who needs the Austrians: Reply to Davidson,” Critical Review 7.2–3: 371–380.

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

Shackle on Keynes on Equilibrium

An interesting anecdote about Keynes from George L. S. Shackle:

“Keynes spared his readers, even in the deliberately provocative General Theory of 1936, the ultimate force of his conclusion, that rational conduct is an illusion and unrelated to the realities of business. That final smashing of the idol was reserved for his last version of the theory of unemployment, the Quarterly Journal reply to his critics. He nowhere speaks, I believe, of ‘rational conduct’ in those terms. His summary statement, uttered in speech, was ‘Equilibrium is blither.’” (Shackle 1972: 233; see also Shackle 1974: 39).

I am not sure, however, who or what work is the ultimate source for this “equilibrium is blither” saying.


BIBLIOGRAPHY

Shackle, G. L. S. 1972. Epistemics and Economics: A Critique of Economic Doctrines, Cambridge University Press, London.

Shackle, G. L. S. 1974. Keynesian Kaleidics: The Evolution of a General Political Economy, Edinburgh University Press, Edinburgh.

The Austrian View of the Market’s Tendency to Equilibrium

I will summarise the various Austrian views on the tendency to equilibrium below:

(1) Mises
For Mises, the real world exhibits a tendency to an ideal state of equilibrium, or, as Mises says, the market “at every instant is moving toward a final state of rest”:

“This final state of rest is an imaginary construction, not a description of reality. For the final state of rest will never be attained. New disturbing factors will emerge before it will be realized. What makes it necessary to take recourse to this imaginary construction is the fact that the market at every instant is moving toward a final state of rest. Every later new instant can create new facts altering this final state of rest. But the market is always disquieted by a striving after a definite final state of rest.” (Mises 1998: 246).

For more discussion of Mises’s view, see my post here.

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

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

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

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

From this, is it obvious that Hayek, throughout most of his career, believed in a tendency to equilibrium. Whether, once Hayek replaced general equilibrium with the notion of “spontaneous order,” he still thought that the market has a strong tendency to coordination or “spontaneous order” is unclear.

See my post here for more on Hayek’s views on equilibrium.

(3) Rothbard
Rothbard thought that the economy always moves towards an equilibrium state but never reaches it:

“The final equilibrium state is one which the economy is always tending to approach. If our data—values, technology, and resources—remained constant, the economy would move toward the final equilibrium position and remain there. In actual life, however, the data are always changing, and therefore, before arriving at a final equilibrium point, the economy must shift direction, towards some other final equilibrium position. Hence, the final equilibrium position is always changing, and consequently no one such position is ever reached in practice. But even though it is never reached in practice, it has a very real importance. In the first place, it is like the mechanical rabbit being chased by the dog. It is never reached in practice and it is always changing, but it explains the direction in which the dog is moving.” (Rothbard 2009: 320–322).

For more on this, see here.

(4) Gerald P. O’Driscoll and Mario J. Rizzo’s The Economics of Time and Ignorance.
Rizzo and O’Driscoll invoke the concept of pattern co-ordination as an alternative to equilibrium, and see markets as tending to pattern co-ordination (or, that is, some degree of order rather than a strict neoclassical equilibrium state [Prychitko 1993: 374]).

O’Driscoll and Mario J. Rizzo’s The Economics of Time and Ignorance was an attempt to salvage Austrian economics from what they viewed as the nihilism of Lachmann’s radical subjectivist position.

It should be noted how they (O’Driscoll and Rizzo 1996 [1985]: 80-82) see Hayek’s “plan coordination” as just another type of static equilibrium concept.

(5) Ludwig Lachmann and the Radical Subjectivists
Lachmann’s view was that markets do not have an inherent tendency to equilibrium (however defined). It appears that some think that Lachmann’s ultimate views are unclear. Vaughn thinks he regarded markets as subject to both disequilibrating and equilibrating tendencies, but took no position on exactly what tendency dominates the market system (Vaughn 1994: 160; see also Prychitko 1993: 375).

Prychitko holds that there is no a priori basis on which to assert that markets tend to equilibrium states (Prychitko 1993: 375). We have entered a world where expectations may diverge or converge, but even converging expectations are no “guarantee of overall equilibrating tendencies” (Prychitko 1993: 375).

Further Reading
“Mises’s Three Concepts of Equilibrium,” June 23, 2011.

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

“Hayek and Equilibrium as a Starting Point for an Austrian Trade Cycle ,” September 21, 2011.

“Equilibrium Amongst the Austrians,” January 28, 2012.


BIBLIOGRAPHY

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

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

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.

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

Mises, L. 1998. Human Action: A Treatise on Economics. The Scholar’s Edition. Mises Institute, Auburn, Ala.

O’Driscoll, Gerald P. and Mario J. Rizzo. 1996 [1st edn. 1985]. The Economics of Time and Ignorance (2nd edn.), Routledge, Oxford, UK.

Prychitko, D. 1993. “After Davidson, Who needs the Austrians: Reply to Davidson,” Critical Review 7.2–3: 371–380.

Rothbard. M. 2009. Man, Economy, and State: A Treatise on Economic Principles. Scholar’s Edition (2nd edn.), Ludwig von Mises Institute, Auburn, Ala.

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

Catalán, Straw Man Arguments and Mises’s View of Equilibrium

Jonathan F. Catalán responds to my last post here:

Jonathan Finegold Catalán, “Sloppy Interpretations,” Economic Thought, 9 June, 2012.

It is unfortunate that the response is attacking nothing but a straw man version of my arguments. This is easily demonstrated, as follows:

(1) Catalán says:

“... blogger ‘Lord Keynes’ unconvincingly continues the argument that Mises was predominately an equilibrium economist.”

I say no such thing. I do not deny that Mises was different from neoclassical economists on the position of equilibrium. I have always accepted that Mises never thought that the ERE or a state of general equilibrium is ever reached in the real world.

(2) Catalán says:

“The world of equilibrium is a world without change; it is purely imaginative. ‘Lord Keynes’ fails to recognize that the evenly rotating economy, as used by Mises, is merely an explicitly fictitious mental construct meant to derive the origins of certain economic relationships. It is nothing more than an ideal type. In the real world, replete with constant change, this fictitious relationship obviously fails to hold.”

I have never asserted that Mises thinks that the ERE is a real world phenomenon. Catalán has simply made this up. In fact, nearly a year ago I wrote a post on Mises’s concepts of equilibrium, and explicitly recognised that, for Mises, the ERE is a fiction:

“Mises’s Three Concepts of Equilibrium,” June 23, 2011.

(3) What I assert is that Mises believed in a “strong tendency towards general equilibrium as a real phenomenon of the market economy,” although the actual state is never reached.

Belief in a tendency to equilibrium is completely compatible with the view that Mises believed that an actual equilibrium state is never reached. I take it that Catalán can understand the difference between (1) a tendency towards general equilibrium, and (2) actual equilibrium as a real world state.

This is exactly what Ludwig Lachmann was saying here:

“Professor Hayek and Mises both espouse the market process, but do not ignore equilibrium as its final stage. The former, whose early work was clearly under the influence of the general equilibrium model, at one time appeared to regard a strong tendency towards general equilibrium as a real phenomenon of the market economy. Mises, calling the Austrians ‘logical’ and neoclassicals ‘mathematical’ economists, wrote: ‘Both the logical and the mathematical economists assert that human action ultimately aims at the establishment of such a state of equilibrium and would reach it if all further changes in data were to cease’ ... It is this view of the market process as at least potentially terminating in a state of long-run general equilibrium that now appears to require revision.

In a kaleidic society the equilibrating forces, operating slowly, especially where much of the capital equipment is durable and specific, are always overtaken by unexpected change before they have done their work, and the results of their operation disrupted before they can bear fruit. Restless asset markets, redistributing wealth every day by engendering capital gains and losses, are just one instance, though in a market economy an important one, of the forces of change thwarting the equilibrating forces. Equilibrium of the economic system as a whole will thus never be reached. Marshallian markets for individual goods may for a time find their respective equilibria. The economic system never does. What emerges from our reflections is an image of the market as a particular kind of process, a continuous process without beginning or end, propelled by the interaction between the forces of equilibrium and the forces of change. General equilibrium theory only knows interaction between the former.” (Lachmann 1976: 60–61).

“Potentially terminating in a state of long-run general equilibrium” is Lachmann’s way of referring to a tendency towards general equilibrium, not the state of equilibrium itself (or the ERE). Even Lachmann’s “equilibrating forces,” I would argue, should be distinguished from a fundamental and strong tendency of the real world market to general equilibrium, because the “equilibrating forces,” as Lachmann says, are thwarted by change, uncertainty and subjective expectations of economic agents which are liable to shift. If the “equilibrating forces” did in fact work consistently and in a reliable way, there would be a strong tendency to general equilibrium in market economies. But they do not.

Once the distinction between

(1) a tendency towards general equilibrium, and
(2) actual equilibrium as a real world state

is understood, some kind of serous argument is possible.

But straw man arguments refute nothing.


BIBLIOGRAPHY

Lachmann, Ludwig M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54–62.

Did Mises believe in a Tendency to Equilibrium?

This issue is relevant to debates in the comments section of Unlearningecon’s thought-provoking post “On The Similarities Between Austrian and Neoclassical Economics”.

The answer, in my view is, yes, and the Austrian school had its own serious debates from the 1970s to early 1990s when Lachmann’s ideas on the non-existence of any tendency to general equilibrium (or what he called the kaledic economy) were starting to be taken seriously. We need only think of George A. Selgin’s Praxeology and Understanding (1990) where Lachmann’s kaleidic view is opposed to most other Austrians like Kirzner, etc.:

“Central to the current controversy in Austrian economics is the debate concerning whether or not the market harbors a tendency toward equilibrium. The skeptical position, represented by Lachmann, is that no such tendency exists. It is opposed in particular by Kirzner, who attempts to defend the more traditional, praxeological position.” (Selgin 1990: 37).

A passage in Method, Process, and Austrian Economics: Essays in Honor of Ludwig von Mises is also relevant:

“Commentators in the Austrian literature have emphasized and discussed the contrast between Hayek’s view that the tendency to equilibrium is an empirical matter and Mises’s view that it follows logically from the ‘activities of enterprising men.’” (Kirzner [ed.] 1982: 88).

The passage of Mises referred to here is in Human Action:

“Both the logical and the mathematical economists assert that human action ultimately aims at the establishment of such a state of equilibrium and would reach it if all further changes in data were to cease. But the logical economist knows much more than that. He shows how the activities of enterprising men, the promoters and speculators, eager to profit from discrepancies in the price structure, tend toward [p. 356] eradicating such discrepancies and thereby also toward blotting out the sources of entrepreneurial profit and loss. He shows how this process would finally result in the establishment of the evenly rotating economy. This is the task of economic theory. The mathematical description of various states of equilibrium is mere play. The problem is the analysis of the market process.” (Mises 1998: 352-353).

So I am going to say that Mises did indeed adhere to the view that there is a strong tendency to equilibrium in the real world, even if that state never comes about.

This is exactly what Ludwig Lachmann criticised Mises and Hayek for: the view that there is a tendency towards general equilibrium, while Lachmann himself concluded that the economy is an on-going, open-ended “market process” with subjective knowledge and subjective expectations:

“Professor Hayek and Mises both espouse the market process, but do not ignore equilibrium as its final stage. The former, whose early work was clearly under the influence of the general equilibrium model, at one time appeared to regard a strong tendency towards general equilibrium as a real phenomenon of the market economy. Mises, calling the Austrians ‘logical’ and neoclassicals ‘mathematical’ economists, wrote: ‘Both the logical and the mathematical economists assert that human action ultimately aims at the establishment of such a state of equilibrium and would reach it if all further changes in data were to cease’ … It is this view of the market process as at least potentially terminating in a state of long-run general equilibrium that now appears to require revision.” (Lachmann 1976: 60).

In this, Lachmann was entirely correct, and for that (and other reasons too) he has always struck me as Austrian economist worthy of respect, even if I do not agree with him on other issues. (It is not often I defend Austrians!)

There was a time when certain moderate subjectivist Austrians saw merit in constructive mutual dialogue with Post Keynesians. I am thinking here of Gerald P. O’Driscoll and Mario J. Rizzo’s book The Economics of Time and Ignorance (Oxford, UK, 1st edn., 1985; 2nd edn. 1996), where we read:

“[i]t is evident that there is much more common ground between post-Keynesian subjectivism and Austrian subjectivism …. the possibilities for mutually advantageous interchange seem significant” (O’Driscoll and Rizzo 1985: 9).

Of course, Paul Davidson, one of the leading Post Keynesians, was not especially impressed (Davidson 1989 and 1993). “Mutually advantageous interchange” does not seem to have progressed very far since then.

BIBLIOGRAPHY

Davidson, P. 1989. “The Economics of Ignorance or Ignorance of Economics?,” Critical Review 3.3/4: 467–487.

Davidson, P. 1993. “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3: 423–444.

Kirzner, Israel M. (ed.). 1982. Method, Process, and Austrian Economics: Essays in Honor of Ludwig von Mises, Lexington Books, Gower, Lexington, Mass.

Lachmann, Ludwig M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54–62.

Mises, Ludwig von. 1998. Human Action: A Treatise on Economics. The Scholar’s Edition, Ludwig von Mises Institute, Auburn, Ala.

O’Driscoll, G. P. and M. J. Rizzo, 1996. The Economics of Time and Ignorance (2nd edn), Routledge, Oxford, UK.

Selgin, George A. 1990. Praxeology and Understanding. Ludwig von Mises Institute, Auburn, Ala.

Equilibrium Amongst the Austrians

When Schumpeter published his first major work Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie (Leipzig, 1908), the influence of Walrasian general equilibrium theory was apparent. Schumpeter accepted the existence of general equilibrium states, and the alleged long-term tendency to Walrasian general equilibrium. It should also be noted that Schumpeter’s “circular-flow model” is a kind of general equilibrium, basically in a stationary state.

Yet, of course, Schumpeter was not technically an Austrian: he may have studied under Eugen von Böhm-Bawerk (and obtained a PhD in 1906), but was converted to the rival neoclassical Walrasian school.

In fact, it is notable that the Austrian Hans Mayer (a student of Wieser) attacked Schumpeter’s first major work for making general equilibrium a real state (Shionoya 1997: 157; Mayer 1911).

But other Austrians were soon lost to the Walrasian equilibrium tradition. Hayek before 1936 is also best seen as a neoclassical equilibrium theorist (Gloria-Palermo 1999: 75; McCloughry 1984: viii; cf. Arena 2003: 316). In fact, Hayek’s Austrian business cycle theory (ABCT) was the product of his neoclassical phase, and he himself stated that he originally held that his “theory of the trade cycle ... ought to be organically superimposed upon the existing theory of equilibrium” (Hayek 1975 [1939]: 137). But Hayek’s Austrian trade cycle theory is an equilibrium theory that falls apart once equilibrium is seen to be unsound, and this is why Hayek essentially abandoned his trade cycle work after about 1940.

B. Tieben (2009: 264) has noted the divisions within the Austrian school on the issue of equilibrium. In my view, there are two broad traditions:

(1) Mises and Rothbard held that actual equilibrium states do not exist, but accepted a long term tendency to general equilibrium, even if the state was never attained, and Mises’s Evenly Rotating Economy (ERE) was a purely imaginary state.

(2) By contrast, Ludwig Lachmann criticised Mises for the view that there is a tendency towards general equilibrium, and Lachmann concluded that the economy is an on-going, open-ended “market process” with subjective knowledge and subjective expectations. Other Austrians influenced by Lachmann (e.g., Boettke, Horwitz, and Prychitko) adopt the idea of a market economy as an open-ended, evolutionary process, or “evolutionary ordering process” (Tieben 2009: 264).

This is clearly seen in a passage from 1976 article by Lachmann:

“Professor Hayek and Mises both espouse the market process, but do not ignore equilibrium as its final stage. The former, whose early work was clearly under the influence of the general equilibrium model, at one time appeared to regard a strong tendency towards general equilibrium as a real phenomenon of the market economy. Mises, calling the Austrians ‘logical’ and neoclassicals ‘mathematical’ economists, wrote: ‘Both the logical and the mathematical economists assert that human action ultimately aims at the establishment of such a state of equilibrium and would reach it if all further changes in data were to cease’ ... It is this view of the market process as at least potentially terminating in a state of long-run general equilibrium that now appears to require revision.”
In a kaleidic society the equilibrating forces, operating slowly, especially where much of the capital equipment is durable and specific, are always overtaken by unexpected change before they have done their work, and the results of their operation disrupted before they can bear fruit. Restless asset markets, redistributing wealth every day by engendering capital gains and losses, are just one instance, though in a market economy an important one, of the forces of change thwarting the equilibrating forces. Equilibrium of the economic system as a whole will thus never be reached. Marshallian markets for individual goods may for a time find their respective equilibria. The economic system never does. What emerges from our reflections is an image of the market as a particular kind of process, a continuous process without beginning or end, propelled by the interaction between the forces of equilibrium and the forces of change. General equilibrium theory only knows interaction between the former.” (Lachmann 1976: 60-61).

By these words, it appears Lachmann is saying that there is no tendency towards general equilibrium in a market economy.

Other Austrians invoke the concept of pattern/plan co-ordination as an alternative to equilibrium (e.g., the later Hayek, Rizzo and O’Driscoll), while those who follow Lachmann (the radical subjectivist tradition) would probably hold that there is no reliable, long term tendency to pattern/plan co-ordination or full employment “equilibrium” in a free market economy.

Indeed, the Austrian school is itself split between the Lachmann-wing and the moderate subjectivists. The latter have not properly dealt with the consequences of radical uncertainty and subjective expectations:

“Kirzner initially saw his project as improving neoclassical economics and providing a ‘story’ as to how markets adjust, whereas the kaleidic Lachmann-inspired wing (including Shackle and Loasby) seems to have been reaching out to Post keynesians such as Davidson. Indeed, in their debate with Davidson … both Prychitko (1993) and Torr (1993) acknowledged the tension between the kaleidic wing of Lachmann, Shackle and Boulding, with their stress on divergent and disequilibrating expectations, and the more dominant, market-as-an-equilibrating-process axis of Mises, Hayek and Kirzner” (Dunn 2008: 136).

BIBLIOGRAPHY

Arena, R. 2003. “Beliefs, Knowledge and Equilibrium: A Different Perspective on Hayek,” in S. Rizzello (ed.), Cognitive Developments in Economics, Routledge, London and New York. 316–337.

Dunn, S. P. 2008. The ‘Uncertain’ Foundations of Post Keynesian Economics, Routledge, London.

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

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

Lachmann, Ludwig M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54–62.

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

Mayer, H. 1911. “Eine neue Grundlegung der theoretischen Nationalökonomie,” Zeitschrift für Volkswirtschaft Sozialpolitik und Verwaltung 20: 181ff.

Schumpeter, J. A. 1908. Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie, Duncker & Humblot, Leipzig.

Shionoya, Y. 1997. Schumpeter and the Idea of Social Sciences, Cambridge University Press, Cambridge.

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

Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations

It is well known that Hayek abandoned general equilibrium theory after the 1940s for the concept of a “spontaneously emerging market order.” But Hayek’s views on equilibrium also evolved over time, and some scholars feel it is necessary to divide Hayek’s career into three phases in his views on equilibrium (Gloria-Palermo 1999: 75). In the first phase down to 1937, Hayek thought that “all legitimate economic explanations should be based upon an analysis of equilibrium” (Gloria-Palermo 1999: 75; McCloughry 1984: viii). The second phase from 1937 to the 1940s involved Hayek’s attempt to redefine equilibrium as plan co-ordination, which occurred in his important paper “Economics and Knowledge” (Hayek 1937; Gloria-Palermo 1999: 75). From the 1940s, there was a third phase where Hayek broke with equilibrium analysis and created a new concept of “spontaneous order” as a method for studying coordination processes in market economies.

While Hayek developed an intertemporal equilibrium theory in 1928 in his paper “Intertemporal Price Equilibrium and Movement in the Value of Money” (Hayek 1984 [1928]), he did not use this in Prices and Production (1931). Instead, “he reverted to the stationary equilibrium approach, by adopting the simple stationary-equilibrium model put forward by Wicksell in Interest and Money as the starting point for his analysis” [my emphasis] (Donzelli 1993: 57). In Prices and Production, an initial stationary state moves to disequilibrium and then moves via boom and bust into a new stationary state. This might be viewed as an application of Hayek’s intertemporal equilibrium theory of 1928 where perfect foresight is needed as an assumption (Foss 1995: 353). Hayek’s definition of monetary stability is a state where voluntary savings equal voluntary investment. The unique natural rate of interest is taken over from Wicksell via Mises.

An equilibrium state is the starting point of a real world economy allegedly subject to Hayek’s Austrian trade cycle (Loasby 1997: 54: “Hayek began ... with a monetary expansion ... impinging on a perfectly co-ordinated economy”). Hayek explicitly stated that he had assumed full employment equilibrium in Prices and Production (1931):

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

U. Witt has identified the severe problem running through Hayek’s reliance on general equilibrium for his trade cycle theory:

“It is an irony that the perfectionist endeavour turned out to run into troubles which, it is claimed here, developed into a crisis of the whole program. In Mises’s understanding (general) equilibrium is a fictitious, imaginary construction useful as a logical basis of comparative statics … Though often arguing similarly in this respect, Hayek takes a different position. While Mises’s apodictic apriorism did not require Mises to derive empirical hypotheses, it is quite clear, e.g., from Hayek (1933) that he aimed at empirically meaningful propositions about the business cycle. For this reason, he was forced to identify general equilibrium in some way or other with an empirical state of the economy, and his theory indeed seems to suggest the state of the markets in the pre-upswing stage of the business cycle. However, in an empirical economic theory it is difficult to determine the conditions under which general equilibrium should be observable. It is even more obscure to see how individual imaginations of, and plans for, future events come to be coordinated so that prices can converge to their equilibrium values. The latter question is crucial in an individualistic approach where subjective expectations are supposed to play a key role.” (Witt 1997: 49).

In other words, Hayek came to see that perfect information and foresight were necessary to explain the convergence back to an equilibrium state as the upswing turned to a bust. The existence of subjective expectations in the real world and the non-existence of equilibrium states are severe stumbling blocks to Hayek’s theory.

Hayek’s assumptions go much further than the idea of a starting equilibrium state. They also assume:

(1) The flexibility of prices and perfect or near perfect adjustments in prices in response to demand and supply;

(2) frictionless markets, and perfect price information on the part of agents (Witt 1997: 47).

None of these assumptions can be taken seriously: prices are not perfectly flexible, and in reality agents ex ante expectations can be severely disappointed ex post, and Knightian uncertainty causes subjective expectations.

Karl Gunnar Myrdal (1898–1987) had already levelled this criticism against Hayek in a paper in 1933 (Myrdal 1933: 385; Foss 1995: 354), and Hayek’s famous paper “Economics and Knowledge” (1937) can be seen as the beginning of his attempt to answer these criticisms (Witt 1997: 49).

The problematic role of expectations for Hayek’s trade cycle theory was already being raised within the Austrian school in the 1930s, as Ludwig Lachmann related in an Austrian Economics Newsletter (AEN) interview:

“AEN: You have talked a number of times about the importance of expectations in business cycle theory. What first drew your interest to expectations as far as the business cycle question was concerned.

Lachmann: Talking to Paul Rosenstein-Rodan, who was then a lecturer at University College, London – not technically in the London School of Economics – but he gave a course on the history of economic thought to which all of us who were research students then went. It was Rosenstein-Rodan who in discussing Austrian trade cycle theory with me said, ‘Ah yes, but whatever happens in the business cycle is in the first place determined by expectations.’ And then he told me of the work that had been done in Sweden.”
Ludwig Lachmann, “An Interview with Ludwig Lachmann,” The Austrian Economics Newsletter, Volume 1, Number 3 (Fall 1978), Mises.org.

Lachmann heard of the work of the Stockholm school from Paul Rosenstein-Rodan: the Stockholm school at this time was being influenced by Gunnar Myrdal’s incorporation of Knightian uncertainty into economic theory (and Lachmann himself later came to examine the role of expectations, see Lachmann 1943 and 1945).

In fact, Hayek delivered a lecture called “Price Expectations, Monetary Disturbances and Malinvestments” on December 7, 1933 in Copenhagen (first published in German in 1935; English trans. Hayek 1939) where he responded to Myrdal’s criticisms. Here he began to modify his ideas on the equilibrium interest rate and the concept of equilibrium itself, which was more fully developed in his paper “Economics and Knowledge” (Hayek 1937). Hayek needed to free himself from the stationary equilibrium approach and construct a dynamic approach suitable for his trade cycle theory (Donzelli 1993: 59; others like Myrdal, Ohlin, Lindahl, and Hicks also freed themselves from the stationary equilibrium approach in the 1930s, and rediscovered the Walrasian instantaneous equilibrium approach; see Donzelli 1993: 60). In his 1933 paper in Copenhagen, Hayek had revived his “intertemporal equilibrium” idea, even though this was really “a temporary equilibrium notion with perfect foresight” (Donzelli 1993: 60). The meshing of plans with correct foresight defined as equilibrium in “Economics and Knowledge” (Hayek 1937) is also a reflection of this.

By the time of The Pure Theory of Capital, Hayek asserts it is necessary to “abandon every pretence that [sc. equilibrium] … possesses reality, in the sense that we can state the conditions under which a particular state of equilibrium would come about” (Hayek 1976 [1941]: 28). In abandoning equilibrium, Hayek was in effect abandoning his early trade cycle work, and it is no surprise that he never returned to it:

“Hayek’s changing assessment of the importance of equilibrium theory has some consequences for our story. The most telling of these concerns Hayek’s trade cycle theory, a paradigmatic example of equilibrium theory, one that Witt (1997, 48) describes as ‘an impressive example of allied price theoretical reasoning that may even delight a Chicago equilibrium economist.’ But, as Witt goes on to observe, if one rejects the usefulness of equilibrium analysis, then Hayek’s step-by-step story of how the cycle unfolds, one in which ‘each single stage necessarily had to be followed by the next one’ (46), can no longer be maintained. Witt concludes that Hayek’s cycle theory may well be incompatible with his later theory of spontaneous orders, a concern that others have voiced” (Caldwell 2004: 228).

Witt is correct.

But I would go further than Witt: Hayek’s intellectual journey in repudiating equilibrium theory requires that his business cycle theory is essentially worthless as a real world explanation of cycles.

Appendix: Hayek’s Exposition of ABCT

It is useful to list the various works where Hayek developed his trade cycle theory:

(1) Hayek’s paper on intertemporal equilibrium:

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

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

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

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

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

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

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

(6) F. A. Hayek, 1942. “The Ricardo Effect,” Economica 9: 127–152.

BIBLIOGRAPHY

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

Caldwell, B. J. 2002. “Wieser, Hayek and Equilibrium Theory,” Journal des Economistes et des Etudes Humaines 12.1: 47–66.

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

Donzelli, F. 1993. “The Influence of the Socialist Calculation Debate on Hayek’s view of General Equilibrium Theory,” Revue européenne des sciences sociales 31.96.3: 47–83.

Ebenstein, A. 2001. Friedrich Hayek: A Biography, Palgrave, New York.

Ellis, H. S. 1934. German Monetary Theory, 1905–1933, Harvard University Press, Cambridge.

Foss, N. J. 1995. “More on ‘Hayek’s Transformation’,” History of Political Economy 27: 345– 364.

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

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

Hayek, F. A. von. 1939. “Price Expectations, Monetary Disturbances and Malinvestments,” in F.A. Hayek, Profits, Interest and Investment, Routledge, London.

Hayek, F. A. von. 1942. “The Ricardo Effect,” Economica 9: 127–152.

Hayek, F. A. von. 1945. “The Use of Knowledge in Society,” American Economic Review 35.4: 519–530.

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

Hayek, F. A. von. 1976 [1941]. The Pure Theory of Capital, Routledge and Kegan Paul, London.

Hayek, F. A. von. 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.

Lachmann, L. M. 1943. “The Role of Expectations in Economics as a Social Science,” Economica n.s. 10.37: 12–23.

Lachmann, L. M. 1945. “A Note on the Elasticity of Expectations,” Economica n.s. 12.48: 248–253.

Loasby, B. J. 1997. “Co-ordination Failure in Economic Theory: Economists in the 1930s,” in A. Jolink and P. Fontaine (eds.), Historical Perspectives on Macroeconomics: 60 Years After the General Theory. Routledge, London. 53–64.

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

Moss, L. S. and Vaughn, K. I. 1986. “Hayek’s Ricardo effect: A Second Look,” History of Political Economy 18: 545–565.

Myrdal, G. 1933. “Der Gleichgewichtsbegriff als Instrument der geld-theoretischen Analyse,” in F. A. Hayek (ed.), Beitrage zur Geldtheorie, Vienna. 361–487.

Myrdal, G. 1939. Monetary Equilibrium, William Hodge, London.

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

Shackle, G. L. S. 1939. “Review of Contemporary Monetary Theory by R. J. Saulnier,” Economic Journal 47: 501–502.

Witt, U. 1997. “The Hayekian Puzzle: Spontaneous Order and the Business Cycle,” Scottish Journal of Political Economy 44: 44–58.

Hayek and Equilibrium as a Starting Point for an Austrian Trade Cycle

As I pointed out in the last post, Hayek’s views on equilibrium changed in the course of his life. But in his early 1930s work on trade cycle theory he clearly assumed a state of equilibrium as a real world initial position in an economy subject to an Austrian trade cycle. I say this because a commentator on the last post persists in denying what is perfectly obvious. Readers who read the comments on that post will find a useful example of the irrational, obstinate and ridiculous fervour of “internet” Austrians, attempting to deny basic facts.

Hayek’s assumption of a real world full employment equilibrium state is confirmed in a letter that Hayek wrote to John Hicks in 1967, regarding the assumptions of his theory, where Hayek confirms that his theory required equilibrium and full employment as the initial stage at the beginning of the process leading to the trade cycle:

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 no lags, the market rate of interest cannot be reduced below the natural rate in an equilibrium position; ....

Hayek to Hicks, December 2, 1967

I accept assumption (a), full employment. I am not sure that I quite know what (b) ‘static expectations’ means, but if it means that at each stage of the process everybody acts in the expectation that future prices will be the same as present prices, I accept that too – though we shall see that these expectations must be disappointed.

Of (c) I can accept that at each stage in every separate market demand = supply in the sense that at the ruling price all buyers and sellers buy and sell as much as they want to buy at that market, but not in the sense that any change in the supply which a change in price will bring about in the course of time has already taken place or that prices correspond to the marginal costs at which producers now begin to produce.

Nor need there [be] at any but the initial stage an overall equilibrium between the different markets, because a change of price necessary to secure equality between demand and supply in any one market will make at the next stage a change of other prices inevitable as a result of the changed receipts in the first market being spent.

Let us now start with a system in full stationary equilibrium: constant prices and no net saving or investment and no changes in the supply of factors or tastes and a constant flow of money (which may be a token or partly credit money) ... (Hayek 1999: 100–102).

Moreover, Hayek, on pages 265–266 of Prices and Production, explicitly tells us his purpose in the book:

“My present task is to fill in the details of that rough sketch and to show what happens in the interval before a new equilibrium is attained.” (Hayek 2008: 265–266).

If Hayek thought at this stage in his career that equilibrium states can never occur in the real world, then what was point of his trade cycle theory?

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

Hayek on the Flaws and Irrelevance of his Trade Cycle Theory

There is a series of interviews conducted with Hayek late in his life, and published in 1983 as Nobel Prize-Winning Economist: Friedrich A. von Hayek (Regents of the University of California, 1983). That work makes rewarding reading. In one of the interviews, Hayek was asked about the legacy of his Austrian business cycle theory (ABCT):

HIGH: Have the economic events since you wrote on trade cycle theory tended to strengthen or weaken your ideas on the Austrian theory of the trade cycle?

HAYEK: On the whole, strengthen, although I see more clearly that there’s a very general schema which has to be filled in in detail. The particular form I gave it was connected with the mechanism of the gold standard, which allowed a credit expansion up to a point and then made a certain reversal possible. I always knew that in principle there was no definite time limit for the period for which you could stimulate expansion by rapidly accelerating inflation. But I just took it for granted that there was a built-in stop in the form of the gold standard, and in that I was a little mistaken in my diagnosis of the postwar development. I knew the boom would break down, but I didn’t give it as long as it actually lasted. That you could maintain an inflationary boom for something like twenty years I did not anticipate.

While on the one hand, immediately after the war I never believed, as most of my friends did, in an impending depression, because I anticipated an inflationary boom. My expectation would be that the inflationary boom would last five or six years, as the historical ones had done, forgetting that then the termination was due to the gold standard. If you had no gold standard—if you could continue inflating for much longer—it was very difficult to predict how long it would last. Of course, it has lasted very much longer than I expected. The end result was the same.

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. 183–186).

One cannot help but notice the illogic running through Hayek’s responses. First, Hayek is completely and embarrassingly wrong on two points:

(1) The golden age of capitalism (1945-1973) was not characterised by “rapidly accelerating inflation”: inflation was low, subdued and there was no tendency whatsoever towards its acceleration for virtually all the period. It was only in 1968 that inflation in many countries started to accelerate.

(2) The stagflation crisis of the 1970s was not caused by an Austrian business cycle: it was the result of (1) wage–price spirals, (2) the speculative activity caused by the break up of Bretton Woods in 1971, (3) negative supply shocks in the prices of commodities which could have been prevented had the US not dismantled its commodity buffer stock polices in the 1960s, and (4) the oil shocks (see “Stagflation in the 1970s: A Post Keynesian Analysis,” June 24, 2011).

Now, on the one hand, Hayek makes some surprising admissions:

(1) His original trade cycle theory assumed the existence of a gold standard, and that this would cause an automatic mechanism causing the end of a credit expansion.

(2) Hayek thought that the postwar boom would last only “five or six years,” and he was completely wrong.

(3) Hayek’s original theory assumed that capital would be directed to industrial expansion, but credit flows after 1945 were, and remain, rather different in nature, with credit flowing to important other sources as well. This can only mean that Hayek’s trade cycle effects would be less and less relevant, as he himself admits.

(4) Hayek recognises his theory had become far less relevant: “You must really study it separately for each particular phase and situation. The typical trade cycle no longer exists [my emphasis], I believe. But you get very similar phenomena with all kinds of modifications.”

The qualification that each historical cycle must be examined to see if it can in fact be explained by ABCT, since there is the possibility that it might not be, was also stressed by Israel M. Kirzner (see “Kirzner on Austrian Business Cycle Theory,” May 30, 2011). Yet when modern Austrians are pressed to identify real world cycles that are not explained by ABCT, most of them are reduced to dumbfounded silence.

Having admitted that his “typical” trade cycle no longer existed, Hayek never admitted what he should have, had he been more honest: that his trade cycle theory had serious flaws and, even if it had been relevant before 1931, it had become largely irrelevant.

Bruce Caldwell puts his finger on exactly this point:

“If one takes seriously ... [sc. Hayek’s] later work on the theory of complex phenomena, then one cannot make precise predictions about the path that a cycle must take, which is what his original cycle theory purported to do. In my opinion, Hayek began to recognize the difficulties with his approach as he responded to critics while laboring over The Pure Theory of Capital ... As noted earlier, he gave hints about those limitations in his 1978 oral-history reminiscences ... and again (and more provocatively) a few years later in his fiftieth-anniversary address .. at the London School of Economics (LSE). His ultimate position seems to have been very close to that of T. W. Hutchison ... , who expressed doubts about whether a general theory of the cycle was possible at all.” (Caldwell 2004: 326).

By recognising that his trade cycle theory was not a general theory of cycles, Hayek in fact eventually had the same view as Ludwig Lachmann, Joseph Schumpeter and Israel M. Kirzner: ABCT cannot be used to explain all business cycles (Batemarco 1998: 222).

And there is a further issue here. Hayek’s original trade cycle theory used static equilibrium theory, and also assumes that all markets do in fact clear (Caldwell 2004: 324), partly by glossing over the role of uncertainty and assuming perfect foresight. But severe problems with Hayek’s static equilibrium theory had already emerged in the 1930s:

“by the middle of the 1930s, problems with [Hayek’s] static equilibrium theory had become ever more evident, as questions of the role of expectations came to the fore and, and, with them, the recognition that earlier models had assumed perfect foresight” (Caldwell 2004: 224).

“Hayek’s changing assessment of the importance of equilibrium theory has some consequences for our story. The most telling of these concerns Hayek’s trade cycle theory, a paradigmatic example of equilibrium theory, one that Witt (1997, 48) describes as ‘an impressive example of allied price theoretical reasoning that may even delight a Chicago equilibrium economist.’ But, as Witt goes on to observe, if one rejects the usefulness of equilibrium analysis, then Hayek’s step-by-set story of how the cycle unfolds, one in which ‘each single stage necessarily had to be followed by the next one’ (46), can no longer be maintained. Witt concludes that Hayek’s cycle theory may well be incompatible with his later theory of spontaneous orders, a concern that others have voiced” (Caldwell 2004: 228).

In light of all this, one can also only agree with Bruce Caldwell that Hayek’s trade cycle theory is now “chiefly of antiquarian interest” (Caldwell 2004: 325).

To conclude, I link to a video below where Bruce Caldwell, Philip Mirowsky and Robert Skidelsky discuss Keynes versus Hayek on the Great Depression, as well as issues related to Hayek’s trade cycle theory (in the first half of the discussion).

Caldwell makes another valid point: Hayek needed a dynamic theory of a capital-using monetary economy, and he did not have the mathematic skills to do this. Around 1936/37, Hayek’s engagement with the socialist calculation debate caused him to pay more attention to the knowledge problem, and how this was also relevant to his business cycle theory.

At the end of the video there is some discussion about the scope for constructive dialogue between Austrians and Post Keynesians (from 13.19 minutes).




BIBLIOGRAPHY

Batemarco, R. J. 1998. “Austrian Business Cycle Theory,” in P. J. Boettke (ed.), The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK. 216–336.

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

Witt, U. 1997. “The Hayekian Puzzle: Spontaneous Order and the Business Cycle,” Scottish Journal of Political Economy 44: 44–58.