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Hayek on the Business Cycle

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10/08/2008Joseph T. Salerno

Friedrich A. Hayek was barely out of his twenties in 1929 when he published the German versions of the first two works in this collection, Monetary Theory and the Trade Cycle and "The Paradox of Saving." The latter article was a long essay that was to become the core of his celebrated book and the third work in this volume, Prices and Production, the publication of which two years later made him a world-renowned economist by the age of thirty-two. But the young Hayek did not pause to savor his success. He was already hard at work on "Reflections on the Pure Theory of Money of Mr. J.M. Keynes," a lengthy critical review of John Maynard Keynes's two-volume Treatise on Money, which had been published in 1930. Hayek's two-part review appeared in late 1931 and 1932. There followed within a few years the other three works collected in this volume. "The Mythology of Capital" appeared in 1936 and was a response to Frank Knight's hostile criticisms of the Austrian theory of capital. A short article on "Investment That Raises the Demand for Capital" and the monograph Monetary Nationalism and International Stability were published in 1937.

These seven works taken together represent the first integration and systematic elaboration of the Austrian theories of money, capital, business cycles, and comparative monetary institutions, which constitute the essential core of Austrian macroeconomics. Indeed these works have profoundly influenced postwar expositions of Austrian or "capital-based" macroeconomics down to the present day.1 The creation of such an oeuvre would be a formidable intellectual feat over an entire lifetime; it is an absolute marvel when we consider that Hayek had completed it in the span of eight years (1929–1937) and still well shy of his fortieth birthday.

Hayek's amazingly precocious intellect and creative genius are on full display in these works. Thus, before the age of thirty, Hayek already had fully mastered and begun to synthesize and build upon the major contributions of his predecessors in the Austrian tradition. These included, in particular: Eugen von Böhm-Bawerk's theory of capital and interest; Knut Wicksell's further elaborations on Böhm-Bawerk's capital theory and his own insights into the "cumulative process" of changes in money, interest rates and prices; Ludwig von Mises's groundbreaking theories of money and business cycles; and the general analytical approach of the broad Austrian school from Menger onward that focused on both the subjective basis and the dynamic interdependence of all economic phenomena.

There is something else about Hayek that becomes apparent when reading his contributions in this volume. The young Hayek was a great economic controversialist, perhaps the greatest of the twentieth century. His entire macroeconomic system was forged within the crucible of the great theoretical controversies of the era. His opponents were some of the great (and not so great) figures in interwar economics: Keynes, W.T. Foster and W. Catchings, Ralph Hawtrey, Irving Fisher, Frank Knight, Joseph Schumpeter, Gustav Cassel, Alvin Hansen, A.C. Pigou, Arthur Spiethoff to name a few. Hayek took on all comers without fear or favor and inevitably emerged victorious. As Alan Ebenstein notes, "Hayek came to be seen in Cambridge, as Robbins and LSE's point man in intellectual combat with Cambridge."2

Hayek's prodigious dialectical skills and his relentless drive to root out and correct even the most entrenched economic errors are exhibited throughout this volume. Hayek's review of Keynes's Treatise on the Pure Theory of Money is the exemplar of disputation in theoretical economics. Keynes was Hayek's senior by a generation and at the time the leading economist in Great Britain and among the most famous public intellectuals in the Anglophone world. Keynes worked hard and long on his treatise, and clearly intended it to be his magnum opus, a dazzling leap forward in the theory of money based on "a novel means of approach to the fundamental problems of monetary theory." But Keynes's reach far exceeded his grasp given his parochial and stunted training in economic theory — one course in economics and the study of Alfred Marshall's clunky and disjointed textbook. Keynes's Treatise never stood a chance. For the brilliant and courageous young Hayek was waiting, pen in hand, to show up the Treatise as a theoretical dead end rather than the new departure in monetary theory Keynes had hoped for.

Hayek's blistering review essay is a positive thrill to read. He relentlessly scrutinizes and exposes the shaky and patchwork structure of Keynes's theoretical arguments and then dismantles it brick by brick, leaving nothing standing. Keynes's reaction reveals just how deeply Hayek's review cut as well as his own cavalier attitude toward intellectual pursuits. Keynes's reply to the first part of Hayek's essay, which dealt with the first, purely theoretical volume of the Treatise, was not properly a reply at all but a critique of Hayek's book Prices and Production. Upon publication six months later of the second part of Hayek's article, which focused on the second, applied volume of the Treatise and in which Hayek was a bit more complimentary, Keynes remarked to Hayek, "Oh never mind, I no longer believe all that."3 Yet Keynes was not done. A month later, Keynes, as chief editor of the Economic Journal, published a nasty review of Hayek's Prices and Production written by one of Keynes's more uncomprehending and rabid disciples, Piero Sraffa. Keynes's fellow Cambridge economist, Arthur C. Pigou, was aghast at this behavior. Without naming names, Pigou wrote, "A year or two ago, after the publication of an important book, there appeared an elaborate and careful critique of a number of passages in it. The author's answer was, not to rebut the criticism, but to attack with violence another book, which the critic had himself written several years before. Body-line bowling. The methods of the duello. That kind of thing is surely a mistake."4

In "The Mythology of Capital," Hayek took on the long and bitter crusade against the Austrian theory of capital waged by Frank Knight, fifteen years Hayek's senior, an eminent American economist and the founder and leader of the early Chicago School. Hayek fittingly adopted as the introductory quotation of his article a statement by Eugen von Böhm-Bawerk, not coincidentally the greatest economic disputant of the nineteenth century and Hayek's chief influence in capital theory. Hayek's quotation of Böhm-Bawerk read, "With every respect for the intellectual qualities of my opponent, I must oppose his doctrine with all possible emphasis, in order to defend a solid and natural theory of capital against a mythology of capital." This is actually a concise statement of the early Hayek's general method of attaining theoretical breakthroughs: he would carefully develop the correct theoretical position and then use it as a weapon with which to strike down the fallacies of his opponents. In this article he proceeded to demolish Knight's claim that capital, once accumulated, was a permanent fund that perpetually and automatically reproduced itself without regard to human purposes and the prevailing conditions of scarcity. Hayek trenchantly characterized Knight's notion of capital as "a pseudo-concept devoid of content and meaning, which threatens to shroud the whole problem in a mist of words."

"The Paradox of Saving," which was for Hayek "the beginning of a continuous development of thought" that shaped his research agenda throughout the 1930s, was a critique of the underconsumptionist approach to depression. Specifically, Hayek was responding to two American writers, Waddill Catchings and William Trufant Foster, who had co-authored a series of essays and tracts on the topic in the 1920s and even offered a $5,000 prize for the best critique of their doctrine in 1925. In the course of his point-by-point refutation of their argument, Hayek integrated Böhm-Bawerk's analysis of the period of production with Mises's theory of the business cycle and provided the latter theory with an explicit basis in capital theory for the first time.

The other works in this volume, although they were not overtly controversial pieces, followed much the same pattern as his critiques of Keynes, Knight, and Foster and Catchings. Hayek wrote Monetary Theory and the Trade Cycle as an explication of the monetary causes of the business cycle. However, in order to do so, he believed that he had to "save the sound elements in the monetary theories of the trade cycle" by refuting those naïve quantity theorists who posited a simplistic and mechanical connection between the aggregate money supply and the average price level. Thus he took out after the price "stabilizers" like Irving Fisher and Gustav Cassel who were the forerunners of the modern monetarists. He identified "the critique of the program of the 'stabilizers'" as "the central theme of this book." Nor did Hayek tread lightly in verbalizing his criticisms. He placed the blame for "the exceptional severity and duration of the depression" squarely on central banks', particularly the Fed's, "experiment" in "forced credit expansion" first to stabilize prices in the 1920s and then to combat the depression in the early 1930s. Hayek defiantly declared: "We must not forget that, for the last six or eight years [up to 1932] monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown."

Prices and Production, often seen as the companion volume to Monetary Theory and the Trade Cycle, developed in much greater detail the synthesis of Misesian business-cycle and Böhm-Bawerkian capital theory that Hayek first sketched out in "The Paradox of Saving." Once again, Hayek's positive contribution, i.e., a fully developed statement of Austrian business cycle theory, was at least partially motivated by his intent to engage and refute what he regarded as an economic fallacy, specifically, the Anglo-American version of the quantity theory. After summarizing that theory in three propositions, he referred to them as "delusions" that "make it possible to assume that we can neglect the influence of money [on the real structure of production] so long as the value of money is assumed to be stable." In the short article on "Investment that Raises the Demand for Capital," Hayek drew out the subtle implications of an accepted proposition regarding the sunk costs of already invested capital to show the complete inadequacy of simplistic monetary explanations of the business cycle that treat capital as an abstract homogeneous aggregate and ignore the intricate interrelationships among the concrete goods composing the capital structure. Again, Hayek was not gentle in his rhetoric. He insisted that his positive restatement of the proposition in question rendered it "so obvious as to put its logical correctness beyond dispute," which meant that "much of the purely monetary analysis of the trade cycle now current is built on very insufficient foundations."

In Monetary Nationalism and International Stability, Hayek extended Mises's monetary theory to provide a groundbreaking analysis of the international operation of the pure gold standard and the widely misunderstood role of international monetary flows therein. Hayek also identified the systemic flaw in the classical gold standard — a centralization of gold reserves in the hands of national central banks or "the national reserve system" — that led to its destruction by monetary policy. Thus Hayek argued that the demise of the gold standard in 1931 was caused by the influence on monetary policy achieved by the ideas of "Monetary Nationalism" after World War I. Wrote Hayek, "[L]ong before the breakdown of the international gold standard in 1931, monetary policy all over the world was guided by the ideas of monetary nationalism." In critically analyzing the proposals of the monetary nationalists for a regime of fluctuating national fiat currencies, Hayek presented the first comprehensive case against so-called freely fluctuating exchange rates, which has yet to be improved upon. Integrating his argument with Austrian business cycle theory, he demonstrated that fluctuating exchange rates do not prevent the international transmission of macroeconomic fluctuations as long as there exists free trade in all orders of capital goods as well as in consumer goods — even if governments under the influence of monetary nationalism are able to impede international capital flows.

As always, Hayek was not shy about identifying the individuals to whom his critical remarks applied. Thus he characterized Keynes's disciple and later biographer Roy Harrod as "one of the most ardent advocates of monetary nationalism." Hayek also harshly criticized Charles R. Whittlesey for whom "almost the whole argument in favor of monetary nationalism is based on the assumption that different national currencies are different commodities and that consequently there ought to be variable prices of them in terms of each other." Ever the dialectician, Hayek proceeded to point out the naïve fallacy vitiating Whittlesey's argument: "No attempt is made to explain why or under what conditions and in what sense the different national moneys ought to be regarded as different commodities, and one can hardly avoid the impression that the author has uncritically accepted the difference in denomination as proof of a difference in kind."

This last work, which was a slight volume of fewer than one hundred pages, was basically the reproduction of a series of lectures that Hayek delivered at the Graduate Institute of International Studies in Geneva. We can only speculate what course the Keynesian Revolution and, indeed, the economic history of the Western world would have taken had Hayek discontinued work on his abortive Pure Theory of Capital to "undertake the larger investigation" that his friends (viz., LSE economists Lionel Robbins, Frank Paish and Frederic Benham) advised "the subject deserves." Hayek himself believed that it "would certainly have been a much bigger and much better book" had he incorporated their suggestions. If Hayek, who was at the peak of his academic fame and analytical and rhetorical powers, had revised and expanded the lectures into a proper book, Monetary Nationalism and International Stability might have become the Austrian tract for the times that rivaled the General Theory and derailed the Keynesian juggernaut right at the outset. This was Hayek's great missed opportunity and not, as he often later lamented, the narrowly technical review of the General Theory he failed to write.

The present volume thus presents the combative and assertive, yet always polite, Hayek, fully confident in the superiority of the intellectual armamentarium supplied by his great predecessors in the Austrian tradition and in his own ability to wield it. Here we look in vain for the irenic and temporizing Hayek who was later to dedicate a book to "the Socialists of All Parties."5 The former Hayek seemed to completely disappear sometime after the publication of the Pure Theory of Capital in 1941. It is an open question whether this radical change in attitude was the result of a strategic choice that corresponded to Hayek's shift out of economics into the broader field of social theory. Hayek himself lent credence to this interpretation in later reflections:

"When it proved that … the General Theory … conquered most of the professional opinion, and when in the end even some of the colleagues I most respected supported the wholly Keynesian Bretton Woods agreement, I largely withdrew from the debate, since to proclaim my dissent from the near unanimous views of the orthodox phalanx would merely have deprived me of a hearing on other matters about which I was more concerned at the time."6

Hayek's transformation may also have been a temperamental response to the crushing blow to his reputation as an economist caused by the overwhelming success of the Keynesian Revolution. Hayek also provided some evidence for this view of the matter in another one of his reminiscences:

I had a period of twenty years in which I bitterly regretted having once mentioned to my wife after Keynes's death that now Keynes was dead, I was probably the best-known economist living. But ten days later it was probably no longer true. At that very moment, Keynes became the great figure, and I was gradually forgotten as an economist.7

Part of the Economic Crisis Book Kit

Many laboring in the thriving cottage industry of Hayek biographers, critics and interpreters have commented on the transition from a "Hayek I" to a "Hayek II" that began in the late 1930s, portraying it as almost wholly an intellectual re-orientation and change in research interests. Few, if any, have recognized the radical alteration in analytical procedure and rhetorical style that characterized this transformation. This is evident by comparing the works in this volume with later essays penned by Hayek II, e.g., those anthologized in his Studies in Philosophy, Politics and Economics.8 However Hayek I re-emerged almost immediately after receiving the Nobel Prize in 1974 fully armed and with renewed passion for intellectual combat. In a remarkable flurry of articles, pamphlets, booklets, and interviews, he aggressively demolished the intellectual case for postwar Keynesianism and confidently offered new and radical proposals for extricating the Western industrial nations from the stagflationary mire into which they had floundered under the guidance of Keynes's disciples.9

The republication of these works in a single volume is a magnificent event that fills a yawning gap in the Austrian macroeconomic literature and provides modern Austrians with a model of how to advance economic theory through reasoned debate and criticism.

  • 1. See, for example, Murray N. Rothbard, Man, Economy, and State: A Treatise on Economics Principles, 2 vols., 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 1993), pp. 273-559; Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure (New York: Routledge, 2001); Jesus Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute 2006).
  • 2. Alan Ebenstein, Friedrich Hayek: A Biography (New York: Palgrave, 2001), p. 61.
  • 3. As reported in F.A. Hayek, Hayek on Hayek: An Autobiographical Dialogue, ed. Stephen Kresge and Leif Wenar (Chicago: University of Chicago Press), p. 90.
  • 4. A.C. Pigou quoted in ibid., p. 88.
  • 5. F.A. Hayek, The Road to Serfdom (Chicago: University of Chicago Press, 1976).
  • 6. F.A. Hayek, Choice in Currency: A Way to Stop Inflation (London: Institute for Economic Affairs, 1976), p. 11.
  • 7. Hayek, Hayek on Hayek, p. 143.
  • 8. F.A. Hayek, Studies in Philosophy, Politics and Economics (New York: Simon and Schuster, 1969)
  • 9.
    The most noteworthy of Hayek's post-Nobel works are: F.A. Hayek, Full Employment at Any Price (London: Institute of Economic Affairs, 1975); idem, Choice in CurrencyA Discussion with Friedrich von Hayek (Washington, D.C.: American Enterprise Institute for Public Policy Research, 1975); and idem, Denationalisation of Money — The Argument Refined: An Analysis of the Theory and Practice of Concurrent Currencies, 2nd ed. ((London: Institute of Economic Affairs, 1978).

Contact Joseph T. Salerno

Joseph Salerno is academic vice president of the Mises Institute, professor emeritus of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics.