Sunday, July 8, 2012

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

I was struck in a recent re-reading of Caldwell’s book on Hayek by this passage:
“Hayek’s starting point was a system that was in a state of (what might be called, following Blaug [1990a, 185-86]) total equilibrium. He would then show what sorts of things would have to happen for the system to fail to adjust properly (i.e., fail to return to equilibrium) when it was disturbed. This approach was logically impeccable. However, to insist on starting one’s analysis with a system that is in full equilibrium when that equilibrium implies that all resources are fully utilized seemed bizarre in the midst of the Great Depression” (Caldwell 2004: 163).
Bingo. This is one of the reasons, amongst others, why Hayek’s business cycle theory was judged to be flawed and unconvincing by the economists of his day, and why the Austrians lost out in the 1930s.

I suspect Hayek’s unrealistic assumption of an equilibrium starting point is also the reason why he sounded so ludicrous when he gave a talk at Cambridge around 1931:
“Immediately before giving his early 1931 lectures at LSE, which were his introduction to the school, Hayek gave a one-lecture to the Keynes-dominated Marshall Society at Cambridge. Richard Kahn, one of Keynes’ followers and later his literary executor, described the scene. Hayek had “a large audience of students, and also of leading members of the faculty. (Keynes was in London.) The members of the audience—to a man—were completely bewildered. Usually a Marshall Society talk is followed by a lively and protracted barrage of discussions and questions. On this occasion there was complete silence. I felt I had to break the ice. So I got up and asked, ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ ‘Yes,’ said Hayek. ‘But,’ pointing to his triangles on the board, ‘it would take a very long mathematical argument to explain why’” (Ebenstein 2003: 53).
This anecdote has always seemed strange, but I assume that Hayek here must have been thinking of an economy with full use of resources when he said that extra demand might increase unemployment: an assumption so utterly bizarre in the depths of the Great Depression, it is no wonder if people thought Hayek was crazy.


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

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


  1. Lord keynes, my guess would be because hayek thought that the increase in consumption raises the ratio of consumption to investment spending, and thus makes the production structure shorter and less roundabout. Hayek thought that unemployment could occur with a shrinking structure, and this thr extra unemployment would aggravate the problem

    1. From a position of full employment/full use of resources?

    2. Patch I think you have correctly identified Hayek's reasoning. Another way to express it might be any increase in consumption by definition results in a reduction in savings. It is savings that drives investment in per capita productivity improvements which in turn is what drives real wage growth. If all of a society's output is spent then an economy cannot grow. Given that at least a portion of production needs to be devoted to capital maintenance then either real wages must fall or unemployment increase.

  2. You will like this post:

  3. That is a remarkable post.

    It fascinating how, for all the Austrian smears about how Keynesianism is fascism, they largely ignore Hayek's support for a quasi-fascist third world dictator Pinochet.