It is a curious paper which shows the fundamental flaw in Hayek’s economic ideas that he had until the end of his life.
The fundamental flaw in Hayek’s economic theory is his emphasis on prices.
For Hayek, the “coordination of economic activities [sc. in modern economies] ... is due to our relying for guidance on prices formed on competitive markets which generate the indispensable signals which tell us what to do” (Hayek 2012: 333). Even at the end of his life, Hayek was stuck in the largely fictional neoclassical view of the role of prices in market economies: the idea that all or most prices are flexible and adjust towards their equilibrium values and tend to clear markets, and signal what to produce via profit and loss (Hayek 2012: 339, 345).
Hayek was only ever dimly aware of the existence and importance of fixprice markets (although he describes them briefly at Hayek 2012: 340 then dismisses the subject completely!). Hayek never understood the fact that in very many markets changes in supply are caused by “quantity signals,” not price signals. Quantity signals are (1) changes in the amount of the stock a business carries or (2) changes in demand.
As Nicholas Kaldor argued, normally in modern capitalist economies “in actual adjustment of supply and demand, prices play only a very subordinate role, if any [sc. role]” (Kaldor 1985: 25).
By the end of his life, Hayek was willing to recognise the problems with general equilibrium theory, but never abandoned his misguided and erroneous view of the role of flexible market-clearing prices:
“It is tempting to describe as an ‘equilibrium’ as ideal state of affairs in which the intentions of all participants precisely match and each will find a partner willing to enter into the intended transaction. But because for all capitalist production there must exist a considerable interval of time between the beginning of a process and its various later stages, the achievement of an equilibrium is strictly impossible. Indeed, in a literal sense, a stream can never be in equilibrium, because it is disequilibrium which keeps it flowing and determining its directions. Even an apparent momentary state of balance in which everybody succeeds in selling or buying what he intended, may be inherently unrepeatable, irrespective of any change in the external data, because some of the constituents of the stream will be results of past conditions which have changed long ago.” (Hayek 2012: 338–339).So while a general equilibrium state can never exist in the real world, nevertheless Hayek is still thinking of some market tendency towards equilibrium.
But it is clear that flexible, market-clearing prices and wages still have a fundamental role in Hayek’s theory:
“The price ‘gradients’, as I have called them, which keep the stream moving, are signals indicating momentary and passing conditions largely determined by events of the past; and how many of the potential productive forces the stream will be able to absorb will depend both on whether enough of these price signals or constellations of signals, stand at clear, indicating that in certain directions prices of output exceed prices of input, and whether the whole system of signals favours an increase or a decrease of the volume of the whole stream, and not merely the rate of flow at its mouth. Every price which is slow in adjusting itself to changes in local conditions may choke a particular streamlet and thereby impede the continuous movement of the whole. The degree to which the order will ever approach the unattainable ideal of equilibrium will depend on the speed of adaptation and of the communication process which brings it about.So the “order” in a capitalist system is still dependent on flexible prices and wages, and Hayek is here thinking of a tendency towards a market-clearing wage and price vector. Prices are an informational system that allow movement to greater coordination in a market system. Rising prices signal that more needs to be produced of a particular commodity. Falling prices that less needs to be produced. Price adjustment towards a stable level indicates supply and demand is coming into equilibrium.
This is much more important than the degree of perfection towards which it may tend: since the process of adaptation never ends, the average closeness to the ideal will be determined by the speed of the response to changes in the data. The fluctuations which are inevitable in an order brought about by feedback processes, which social structures share with biological ones, will always cause divergences from stability and it will be the speed, not the ultimate perfectness of adaptation which will determine the steadiness of the flow. Prompt movements in the right direction will do more to keep the stream flowing than any precise calculations of equilibrium conditions could do whose results would probably come too late to improve the flow. Inflexibility of prices, particularly of the prices of labour, can block many of the arteries on which the nourishment of society, and especially of the very people who endeavour to maintain their relative position, depend. Unemployment is not so much a function of ‘aggregate demand’ as of the elasticity of the price structure which, of course, all striving for a ‘just’ distribution obstructs.” (Hayek 2012: 339).
Yet the reality of modern capitalist production is widespread fixprice, not flexprice, markets (though obviously flexprice markets do exist). The whole Hayekian system is built on a house of sand in terms of its price theory.
It is sometimes asserted that Hayek rejected general equilibrium theory towards the end of his life (Caldwell 2004: 226-227).
The closest thing to a repudiation appears in Hayek’s statement in 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?Yet it is difficult to really find a clear and unambiguous repudiation of general equilibrium theory, because Hayek still adhered to the equilibrating role of market-clearing prices in his economic analysis.
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.”
What Hayek did believe – in contrast to Walrasian general equilibrium theorists – is that mathematics and Walrasian theory could not be used “determine and predict” the numerical values of a general equilibrium state beforehand by means of, for example, supply and demand equations (Lachmann 1983: 374). This was already stated in the The Pure Theory of Capital (1941), where Hayek asserted that it was 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 : 28).
Yet even in a world of disequilibrium prices, Hayek still believes that entrepreneurial activity drives these prices at least towards their market clearing values, even if one cannot predict such values with the Walrasian simultaneous equations of general equilibrium.
The same basic idea informs this statement Hayek made on April 9, 1975 in a talk to the American Enterprise Institute in Washington DC:
“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).BIBLIOGRAPHY
Caldwell, B. 2004. Hayek's Challenge: An Intellectual Biography of F.A. Hayek University of Chicago Press, Chicago and London.
Hayek, F. A. von. 1976 . The Pure Theory of Capital. Routledge and Kegan Paul, London.
Hayek, F. A. von. 2012. “The Flow of Goods and Services,” in H. Klausinger (ed.), The Collected Works of F. A. Hayek. Volume 8. Business Cycles. Part II. University of Chicago Press, Chicago and London. 331–346.
Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.
Lachmann, L. M. 1983. “John Maynard Keynes: A View from an Austrian Window,” South African Journal of Economics 51.3: 368–379.