Category Archives: History of Thought

The Academic Legacy of Hayek’s Business Cycle Theory

Tomorrow, I’ll be taking the GRE; so, I’m behind in my reading — I’m still (slowly) working my way through R.W. Clower’s Monetary Theory (a great collection of essays) and David Glasner’s Free Banking and Monetary Reform. I’ve also started re-reading Daniel Kuehn’s recent piece for Critical Review, “Hayek’s Business Cycle Theory: Half-Right” (here is the working paper version). My intention is to ultimately comment on the whole thing, but for now I have a few words about a claim Daniel makes in the introduction,

[F]or decades most macroeconomists have considered Friedrich A. Hayek’s work on the business cycle inconsequential…

I’m not sure this is true.

In 1974, Friedrich Hayek and Gunnar Myrdal were awarded the Nobel Memorial prize, “for their pioneering work in the theory of money and economic fluctuations.” Why was Hayek awarded the Nobel prize for a theory that, according to Daniel, most macroeconomists have considered “inconsequential.”

Robert Lucas published “Unemployment in the Great Depression” in 1972, when he was developing an intertemporal theory of the business cycle (in 1979, he published “An Equilibrium Model of the Business Cycle“). Lucas and others would turn this into a “real business cycle” (RBC) model. While the dynamic forces of the business cycle are different than those suggested by Hayek, the intuition behind RBC is very similar to that of Austrian Business Cycle Theory (ABCT).

Both ABCT and RBC try to explain the business cycle within the context of rational agents, who are always trying to maximize their respective functions. In order to explain why rational agents end up acting in a way that leads to the business cycle, both Hayek and Lucas pointed to price distortions and both believed that ultimately only money could be responsible for an intertemporal disequilibrium (see Kyun Kim, Equilibrium Business Cycle Theory in Historical Perspective). In his 1977 paper, Lucas even modeled overinvestment leading to the business cycle.

In fact, Lucas went as far as to cite Hayek’s business cycle theory as one of the main intellectual precursors of real business cycle theory.

Another economist, although by that time he had probably lost most of his presence in the profession, who returned to Hayekian business cycle theory was John Hicks. In 1973, Hicks published Capital and Time, developing his own “neo-Austrian” theory. G.L.S. Shackle was another economist who continued to discuss and develop a Hayekian capital theory, relating it to the business cycle. Of course, both G.L.S. Shackle and John Hicks were directly influenced by Hayek, when the latter was still at the London School of Economics during the late 1930s and early 1940s.

Perhaps Hayek’s theory had been largely forgotten during the Keynesian Revolution of ~1940–1960, although I think even this claim is a stretch, but by the late 1960s, Hayek’s research program began to be taken in various directions. None of them in the direction an Austrian would prefer,  but still in ways directly linked to some of the basic building blocks of ABCT. So, I cannot agree with Daniel. Hayek’s business cycle research, whether explicitly or implicitly, has been front and center in macroeconomics since, at least, the 1970s. His 1974 Nobel Memorial prize represents this re-emergence in the academic debate.

Austrians who, at the time, were leading the school would know better than me, but it’s a shame that Austrians didn’t join the debate in the leading journals — that is, it’s a shame they didn’t adopt RBC’s modeling techniques to try to model their own story, at a time when their general approach began to spread throughout the profession. But, it seems to me there was much more emphasis in breaking away from equilibrium theory; that’s what I get from, for example, Rizzo’s and O’Driscoll’s The Economics of Time and Ignorance. Mises died in late 1973; Rothbard was the intellectual leader of the school and saw no benefits in going in the direction of RBC; Hayek was involved in social theory (he also published a couple of monographs on monetary theory, but this was a limited excursion); others were looking to pursue an intellectual relationship with the Post Keynesians; etc. I think we missed out on a golden opportunity, and we’re much worse off because of it.

Friedman and the Demand for Money

Milton Friedman argued that the demand for money is stable. But, he didn’t mean that the demand for money is constant, or that it fluctuates around a stable mean; rather, he posited a stable demand function, meaning a stable relationship between income, the price level, relative rates of return, and the demand for money,

The quantity theorist accepts the empirical hypothesis that the demand for money is highly stable — more stable than functions like the consumption function that are offered as alternative key relations. This hypothesis needs to be hedged on both sides. On the one side, the quantity theorist need not, and generally does not, mean that the real quantity of money demanded per unit of output, or the velocity of circulation of money, is to be regarded as numerically constant over time; he does not, for example, regard it as a contradiction to the stability of the demand for money that the velocity of circulation of money rises drastically during hyperinflations. For the stability he expects is in the functional relation between the quantity of money demanded and the variables that determine it… On the other side, the quantity theorist must sharply limit and be prepared to specify explicitly, the variables that it is empirically important to include in the function. For to expand the number of variables regarded as significant is to empty the hypothesis of its empirical content; there is indeed little if any difference between asserting that the demand for money is highly unstable and asserting that it as a perfectly stable function of an indefinitely large number of variables.

— Milton Friedman, “The Quantity Theory of Money: A Restatement,” in R.W. Clower, Monetary Theory (Middlesex: Penguin, 1973), pp. 108–109.

When economists argue that Friedman was wrong, and that the demand for money is not stable, what they mean is that the same function that fits the data between, say, 1940–50 cannot predict the demand for money between, say, 1980–90.

Money as a Capital Good

I remember, in response to a Hans-Hermann Hoppe article, Walter Block was wondering whether he and William Barnett were wrong to classify money as a capital good, rather than in its own category of general medium of exchange.

For what it’s worth, Milton Friedman is on his side,

To the ultimate wealth-owning units in the economy, money is one kind of asset, one way of holding wealth. To the productive enterprise, money is a capital good, a source of productive services that is combined with other productive services to yield the products that the enterprise sells. Thus the theory of the demand for money is a special topic in the theory of capital; as such, it has the rather unusual feature of combining a piece from each side of the capital market, the supply of capital, and the demand for capital.

— Milton Friedman, “The Quantity Theory of Money: A Restatement,” in R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), p. 95.

Yeager on Why Money Disequilibrium is Unique

A longer-than-usual excerpt,

Exceptions hinging on excess demands for non-currently produced goods other than money are not inconceivable but would be economically unrealistic. In the General Theory, Keynes remarks that a deficiency of demand for current output might be matched by an excess demand for assets having three “essential properties:” (a) their supply from private producers responds slightly if at all to an increase in demand for them; (b) a tendency to rise in value will only to a slight extent enlist substitutes to help meet a strengthened demand for them; (c) their liquidity advantages are large relative to the costs of holding them. Another point that Keynes notes by implication belongs explicitly on the list: (d) their values are “sticky” and do not adjust readily to remove a disequilibrium.

Money is the most obvious asset having these properties. Keynes asks, however, whether a deficiency of demand for current output might be matched by an excess demand for other things instead, perhaps land or mortgages, Other writers have asked, similarly, about other securities, works of art and jewelry.

My answer is no. Such things might be in excess demand along with but not instead of money. Money itself would also be in excess demand. One reason is that all other exchangeable things trade against money in markets of their own and at their own prices expressed in money. (This is rue even of claims against financial intermediaries if their interest rates count as corresponding, inversely, to prices.) An excess demand for a good or a security tends to remove itself through a change in price or yield. If, however, interest rates should resist declining below the floor level explained by Keynes and Hicks, people would no longer prefer additional interest-bearing assets to additional money, and any further shift of demand from currently produced goods and services to financial assets would be an increase in the excess demand for actual money in particular. (If stickiness or arbitrary controls should keep prices and yields of financial assets from adjusting and clearing the market, the situation would be essentially the same as in the case of price rigidity of other assets…). The monetary interpretation of deficient demand for current output thus does not depends on any precise dividing line between money and assets; if money broadly defined is in excess demand, money narrowly defined must be in excess demand also. Unlike other things, money has no single definite price of its own that can adjust to clear a market of its own; instead, its market value is a reciprocal average of the prices of all other things. This “price” tends to b sticky for reasons almost inherent in the very concept of money.

— L.B. Yeager, “The Medium of Exchange,” in R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), pp. 51–53.

Money and Economic Calculation

A second difficulty arises in barter. At what rate is any exchange to be made? If a certain quantity of beef be given for a certain quantity of corn, and in like manner corn be exchanged for cheese, and cheese for eggs, and eggs for flax and so on, still the question will arise — how much beef for how much flax, or how much of any one community for a given quantity of another? In a state of barter the price-current list would be a most complicated document, for each commodity would have to be quoted in terms of every other commodity, or else complicated rule-of-three sums would become necessary. Between one hundred articles there must exist no less that 4950 possibles ratios of exchange and all these ratios must be carefully adjusted so as to be consistent with each other, else the acute trader will be able to profit by buying from some and selling to others.

All such trouble is avoided if any one commodity to be chosen and its ratio of exchange with each other commodity be quoted. Knowing how much corn is to be bought for a proud of silver and also how much flax for the same quantity of silver, we learn without further trouble how much corn exchanges for so much flax. The chosen commodity becomes a common denominator or common measure of value, in terms of which we estimate the values of all other goods, so that their values become capable of the most easy comparison.

— W.S. Jevons, “Barter,” in R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), pp. 27–28.

Pigou’s Dynamic Equilibrium

The term “stationary state,” as used by economists, is…not linguistically apt. The idea that it was meant to convey is not, as the word suggests, that of non-motion but that of rotation at a constant speed, neither accelerating nor decelerating. Consider then an economy in a stationary state in that sense, or, what comes to the same thing, in any state restricted to a time interval short enough to allow accelerations or decelerations as may be taking place to be ignored. In a moving picture of this all the several stocks…remain constant in size. No additions to or subtractions from any of them take place, which implies that there is no net investment or disinvestment and no change in the size of the population of working age. The shape of the waterfall is unvarying, but the place occupied at one moment by this drop in the next moment occupied by that one.

— A.C. Pigou, “Money, A Veil,” in R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), p. 31.

On Socially Conservative Economists

Bryan Caplan observes that there are few socially conservative economists, despite that it’s not too difficult to think of economic arguments that could be applied towards supporting socially conservative values. (Socially conservative will henceforth be referred to as SC.)

There is quite a bit of SC economic “theory” out there. For example, many people still oppose immigration, because immigrants will drive “American wages” down, or they will cause unemployment among natives. Milton Friedman famously argued that immigration cannot be unregulated as long as there exists a welfare state (although, Friedman would probably rather dismantle the welfare state than restrict immigration; and, the empirical evidence is mixed on immigrants’ net contribution to the welfare system [e.g. Griswold [2012] & Auerbach and Oreopoulos [1999]).

Conservatives often oppose gay marriage on the basis that it destroys the sanctity of the institution. The economic argument is implicit: gay marriage produces a negative externality. There is a similar argument against drug legalization, although perhaps it’s not the typical rationale: the drugged impose costs on others, whether it’s their family, victims of violent crime, automobile accidents, et cetera. The conservative case for a big warfare state is also, implicitly, economic: the probabilistic cost of invasion (whether of our homeland, our overseas assets, or our allies) is higher than the cost of supporting a large military apparatus.

It’s true, however, that most economists do not seem to support these positions. Why is that? I have a few ideas.

(1) Economists are trained to think through an issue, consider the different factors that are related to it, and then pass judgment after a comparative analysis. In other words, economists are generally very good at thinking through ideas that have an economic flavor to them. They’re also trained to test these ideas. The evidence often comes up against SC economic theories. I already mentioned some of the evidence of the economic and fiscal impact of immigration. This one is more contested, but another example is Donohue’s and Levitt’s paper on the impact of abortion on crime. Likewise, the evidence just does not seem to support current U.S. drug policy. The general implication is that SC economic theory is not good economic theory, and most economists can see through superficial rationalizations of bad social rules/policies.

(2) Whether the method is explicit or implicit in their research, economists are trained to be methodological individualists. We have an appreciation for the individual that others may not have developed to the same extent. Our normative opinions might reflect our training as economists. This includes the beliefs that value is subjective and that economics is a positive — rather than a normative — science. Because we often don’t share the same moral values as SC, because of our training and otherwise, we may be more likely to believe that the negative externalities caused by social activity that SCs oppose is overexaggerated. Or, we may disagree that there is a negative externality at all.

(3) How does the distribution of normative social beliefs change between those with relatively little education and those with relatively high education (and, I suppose by education I have in mind something more-or-less intellectual, rather than training in some set of technical skills)? If it does, my guess is that economists fit the belief distribution of the latter. This distribution would be one that is skewed right, if we put 100% socially conservative on the right. There may also be some selection bias: the socially liberal are more likely to become economists. This could be, because established economic theory has a generally socially liberal bend to it.

Related to (3), my guess — again, I haven’t seen the evidence — is that the aggregate U.S.’ belief distribution curve is skewed right, although perhaps to a lesser degree than the relatively highly educated. U.S. conservatives tend to be opposed to government regulation, and this probably carries through to the bulk of regulation on the family. Just to clarify, there are clearly social regulations that conservatives support, but the set of these regulations is probably smaller than in other countries. U.S. conservatives, after all, are less likely to support something like fascism or dictatorship, which seems to correlate with the kind of extreme social regulations that you could make a conservative argument for (e.g. the enforcement of family values by the government). Conservatives may not seem socially liberal to us, but they may seem socially liberal to a conservative in Russia. In fact, my prior is that societies become more liberal, more cosmopolitan, and more open as they become more pluralistic, partially because pluralism institutionalizes differing degrees of respect for others’ values and opinions.

I’m not surprised that there are probably relatively few socially conservative economists. It’s what we would expect.