ama-gi: LSE's Hayek Society
Journal, vol. 5, no. 2 (Spring), 2003
Online at ama-gi
F. A. Hayek as "Mr. Fluctooations"
In Defense of Hayek's "Technical
Roger W. Garrison, LSE Visiting Hayek Fellow
As reported in Alan Ebenstein's recent biography
(2001), "Mr. Fluctooations" emerged as Hayek's nickname at LSE in the 1930s—because
he so often used that word, pronouncing it each time with a heavy Austrian
accent. And his lectures on industrial fluctuations were accompanied by
a full complement of graphics that depicted the economy's capital structure
and the effects of credit creation on that structure. One LSE student (Ben
Higgins) lamented that the significance of the lectures was "buried in
the cumbersome three-dimensional diagrams with which Hayek presented his
ideas and which made them seem like something in the field of engineering"
(Patinkin and Leith, 1978, p. 74).
of those 3-D diagrams and the insights they represented? Why did Hayek
see the economy's capital structure as being so central to our understanding
of industrial fluctuations? Just how did his ideas line up against those
being developed by John Maynard Keynes? And why did Hayek eventually all
but abandon the research program that had so energized him in those early
The initial lectures
that Hayek delivered at LSE in early 1931 set out his own understanding
of Ludwig von Mises's theory of the business cycle. These lectures, which
were the basis for his being awarded the Tooke Chair, appeared later that
same year as Prices and Production. It was a full decade later that
Hayek published The Pure Theory of Capital (1941), a long and tedious
volume that incorporated some of those 3-D diagrams (such as the one shown
here from p. 197). This book was intended to provide the theoretical undergirding
for his early work on business cycles. A follow-on volume to have been
titled The Dynamics of Capital (Hayek, 1983, p. 413) was never written.
It is not difficult to imagine, though, that
Dynamics would have
Prices and Production in full theoretical dress.
After the Pure
Theory, Hayek's interests shifted to the broader issues of his day.
His milestone "Economics and Knowledge" (1937) was also a stepping stone
from the economics of industrial fluctuations to the field of political
philosophy. Hayek became widely known for his 1944 Road to Serfdom
and for subsequent writings in the classical liberal tradition. In time,
all his pre-Road work became widely ignored. And if acknowledged
at all, his insights into the nature and significance of cyclical variation
were dismissively dubbed Hayek's "technical economics."
of the early Hayek—from his adversaries, his erstwhile defenders, and his
political-science allies—are prevalent in the literature. Keynes (1931,
p. 394) referred to Prices and Production as a "frightful muddle."
Joan Robinson (1972, p. 2), referring explicitly to the triangles that
punctuated Hayek's 1931 lectures, condemned his business cycle theory as
a "pitiful state of confusion."
whose 1934 Great Depression was a skillful application of Hayekian
theory to the boom and bust of the interwar period, recanted in his 1971
(p. 154), confessing that he would "willingly see [his 1934 book] forgotten."
Commenting on Hayek's "technical economics" during an interview (Ebenstein,
2001, p. 81), Milton Friedman emphasizes that he is "an enormous admirer
of Hayek, but not for his economics. I think Prices and Production
is a very flawed book. I think his capital theory book [The Pure Theory]
is unreadable. On the other hand, The Road to Serfdom is one of
the great books of our time."
provides only a brief and unsatisfying account of Hayek's early theorizing
about business cycles. In a chapter titled "LSE," he writes that "Hayek's
basic misconception of economic production was concerning the nature of
capital" (p. 54). In a subsequent chapter titled "Capital," Ebenstein indicates
that the essential aspect of Hayek's conception of a capital structure
is that capital is heterogeneous. He then brings this episode of Hayekian
thought to an abrupt end by noting that "If this empirical assumption of
capital's heterogeneity is false, [Hayek's] theoretical system of economic
activity falls" (p. 83). It is trivially true, of course, that homogeneous
capital would imply the absence of structure and hence the irrelevance
of any theory based on considerations of structure.
it too obvious to have to prove that there is a capital structure—a structure
that can be modified but not instantly and not costlessly. The costs of
restructuring capital are easily absorbed during a policy-induced boom
when credit is cheap and profit expectations are high. But after the bust,
the costs of undoing the misallocations caused by unduly cheap credit take
the forms of business losses, bankruptcies, and unemployment.
of the production process entails a temporal sequence of activities that
transform inputs into consumable output. Capital of various sorts—plant
and equipment, tools and machinery, raw materials and goods in process—are
put to use in the various stages of production. The structure of capital,
then, is defined in terms of this temporal arrangement of heterogeneous
capital goods. For pedagogical purposes, Hayek divides the economy's production
process into a finite number of stages, such that the output of one stage
constitutes the input of the next—with the final stage yielding consumable
output. Though simplistic, the notion of a sequence of stages served the
purpose of incorporating into his theorizing the time element of the production
This, then, is
the significance of the capital structure—and of those 3-D diagrams: Capital
structure captures the time element. The analytically simplest way to deal
with production time is the Hayekian triangle—a right triangle in which
the stages of production are arrayed along the horizontal leg and the market
value of the final output is represented by the height of the vertical
leg. Capital restructuring, as might be induced by a change in the rate
of interest, is represented by a change in the shape of the triangle. In
hindsight, we might make the judgment that the simplicity of the Hayekian
triangle is its greatest virtue.
Not long after
Hayek delivered the 1931 lectures, however, he became aware of all the
modifications and qualifications that would be required for his analytics
to capture the many features of the economy's capital structure and hence
to better serve as a basis for theorizing about the production process.
But actually making those modifications and qualifications—that is, writing
Pure Theory of Capital—did not have the intended effect of strengthening
his analytical framework; rather it had the effect of weakening his stature
and credibility on the issues of money and business cycles. Keynes, we
can imagine, could have set out to do something similar. His Chapters 6
and 7 of the General Theory ("The Definition of Income, Saving and
Investment" and "The Meaning of Saving and Investment") could well have
been elaborated into a book-length, pure-theory treatment complete with
some very complicated diagrams depicting all the interconnected stocks
and flows. Instead, the qualifications, nuances, and imponderables acknowledged
in those chapters were set aside in favor of the simple circular flow of
income and expenditures.
For driving home
the basics of macroeconomics, simplest is best. The time-consuming production
process that lies at the root of Hayek's analytical framework stands in
stark contrast with the circular flow that lies at the root of Keynes's.
This contrast is perfectly and memorably symbolized by the Hayekian triangle
and the Keynesian circle. For Keynes, the time element—the period of analysis—is
an arbitrary accounting period, conventionally taken to be one year. What
matters for him is the relationship within any given period between
earning money and spending it. Time in a more substantive sense comes into
play only as expectations about the level of expenditures in future periods.
both the circular flow of income and expenditures and the logic of the
Keynesian system—readily lends itself to the conclusion that expectations
are self-fulfilling and that market economies are unstable. The only two
auxiliary propositions needed—both supplied by Keynes—is that expectations
about the profitability of current investment spending are essentially
baseless and that those expectations are subject to dramatic changes.
The Hayekian triangle
has its own logic—and one very different from that of the Keynesian circle.
Hayek was able to show that the allocation of resources among the temporally
sequenced stages of production corresponds to a particular temporal pattern
of consumable output. If this resource allocation is consistent with the
preferred pattern of consumption, then the ongoing economic activity (earning
incomes by working in the various stages and spending those incomes on
final-stage output) is sustainable. Further, ordinary market-driven movements
in the rate of interest nudge the economy towards this internally consistent
and temporally sustainable pattern of producing and consuming. The system
is not inherently unstable.
was guided from the beginning by a critical methodological maxim: We must
first explain how an economy can possibly work right before we can meaningfully
ask what might go wrong. Hayek's theory of industrial fluctuations respected
this maxim and followed straightforwardly as a matter of logic: If the
interest rate is held below its market, or "natural," rate by credit expansion,
the decisions of producers will be inconsistent with the preference of
consumers. The economic expansion will be unsustainable. The boom will
end in a bust. Only with a market-determined rate of interest can cyclical
variations be avoided.
The sharp difference
between the Keynesian and Hayekian frameworks would have been fairly easy
for Hayek to exploit in a review of Keynes's General Theory: Keynes's
system is inherently unstable while Hayek's system is potentially stable
but particularly vulnerable to the destabilizing pro-growth policies of
the central bank. Though Hayek never actually reviewed Keynes's book, he
does in fact argue in precisely this vein in the closing pages of his Pure
Theory (p. 408), where he recognizes that money constitutes a "loose
joint" in our modern complex credit structure: "But the existence of such
a loose joint is no justification for concentrating attention on that loose
joint and disregarding the rest of the mechanism, and still less for making
the greatest possible use of the short-lived freedom from economic necessity
which the existence of this loose joint permits."
account of boom and bust had an essential and compelling logic about it,
his interests turned to other matters, beginning even before the publication
of his book on capital. His 1937 article is commonly regarded as a major
shift in his thinking—a shift that calls his own earlier work on industrial
fluctuations into question. An alternative interpretation, however, is
that Hayek became increasingly aware of the significance of the methodological
maxim that he had always respected and that Keynes and many others had
In the early LSE
years Hayek was concerned with the question of how the market process had
to operate if the preferences of consumers were to get transformed into
the production plans of producers and how credit expansion could interfere
with this process. In his later writings he was concerned with the question
of how this same market process could in fact operate even though the information
on which it is based is incomplete and dispersed throughout the economy.
Hayek was fully
aware of this second question well before his going to LSE. In fact, by
his own account (Hayek, 1994, p. 1), he was already working with and under
the influence of Mises when Mises's Socialism, which dealt at length
with the issue of economic calculation, appeared in 1922. Hayek may have
believed at this early point that the economics profession had or soon
would understand the full significance of Mises's book. His own efforts,
then, could focus on the intertemporal coordination made possible by unhampered
credit markets and the intertemporal discoordination caused by misguided
bank policy. If anything, the 1937 article marks Hayek's realization that
the profession had in fact not absorbed Mises's insights at all. Hayek's
fellow economists could not appreciate Prices and Production because
they lacked a fundamental understanding of the market economy. In an attempt
to overcome this obstacle, Hayek began to deal in a more explicit way with
the coordination of individual plans on the basis of dispersed and incomplete
With this alternative
interpretation, Hayek's "technical economics" and his subsequent political
philosophy can be seen as exhibiting a certain continuity of thought—the
later phase involving more fundamental and even remedial concerns. This
interpretation is consistent with Hayek's own retrospective offered in
the foreword to Gerald O'Driscoll's
Economics as a Coordination Problem:
The Contributions of Friedrich A. Hayek (1977, p. ix): "That
it seems in principle possible to recast a great part of economic theory
in terms of the approach which I had found useful in dealing with such
different problems as those of industrial fluctuations and the running
of a socialist economy [is] gratifying to me.... Professor O'Driscoll has
almost persuaded me that I ought to have continued with the work I had
been doing in the 1930s and 1940s rather than let myself be drawn away
to other problems which I felt to be more important."
However much we
admire Hayek's writings in political philosophy, we can still lament that
"Mr. Fluctooations" didn't stay the course in his efforts to provide a
full-fledged alternative to the emerging Keynesian orthodoxy.
Roger W. Garrison is Professor
of Economics at Auburn University, Auburn, Alabama (USA) and Visiting Hayek
Fellow at LSE during May/June 2003. He is the author of Time and Money:
The Macroeconomics of Capital Structure (London: Routledge, 2001)
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