Austrian Capital Theory Was One of Those Subjects Verboten (Forbidden) at Chicago

The Chicago disdain for Hayek’s trade cycle and capital theories goes back, in part, to Frank Knight, who, according to James Buchanan, “dominated the intellectual atmosphere . . . . and who seemed to most of us, to epitomize the spirit of the university” (Shils 1991). Knight was a firm believer in individual freedom and free markets, but rejected the Austrian theory of capital, a theory which forms the basis of the Austrians’ macroeconomics and its interpretation of the cause and cure of the business cycle. Larry Wimmer reports that Austrian capital theory was one of those subjects verboten at Chicago.

It all goes back to a bitter debate between Knight and Hayek in the 1930s over capital theory and the business cycle. In Prices and Production, published originally in 1931, Hayek uses a “time structure of production” concept as the foundation of the business cycle theory that he and Ludwig von Mises employed to anticipate the Great Depression. . . .

Frank Knight admits that he “completely accepted it [the time-production process] for years, taught it in class lectures and expounded it in text materials,” including his Risk, Uncertainty and Profit (1921) but then abandoned it, perhaps after reading John Bates Clark's critique of Böhm-Bawerk. He became convinced that “all capital is inherently perpetual” and “homogeneous,” like a “perpetual fund” of synchronized consumption and production. Clark and Knight compare capital to a reservoir, with new production flowing in, and capital flowing out when used up. Knight follows Irving Fisher, who taught that capital and interest are stock-flow concepts, where capital is a permanent asset which yields future interest income. Knight, Fisher and Clark deny that capital is heterogeneous or that the production process lengthens or shortens during the business cycle (Knight 1934). Knight further elucidates this aggregate income/expenditure concept in his “circular flow diagram” that he developed, and which Paul Samuelson popularized in his textbook as an explanation of how the macro economy works (Patinkin 1981). Hayek responded by saying that Knight's “perpetual fund” view of capital is a “pseudo-concept.” According to Hayek, Knight assumes “perfect foresight” when he eliminates time entirely from the capitalistic process, and adopted a capital concept which “leaves us with the impression that there is a sort of substance, some fluid of definite magnitude which flows from one capital good to another” (Hayek 1936).

—Mark Skousen, Vienna and Chicago Friends or Foes? A Tale of Two Schools of Free-Market Economics (Washington, DC: Regnery Publishing, 2016), Kobo e-book.