Hayek Admitted That His Business Cycle Theory Stands Or Falls On Sraffa’s Challenge to Forced Savings

The next problem concerned Hayek’s analysis of forced savings. Recall that in the Austrian theory of the cycle the lengthening of the structure of production, begun under a regime of forced savings, never gets completed. It is always the case that rising consumer prices signal firms that their earlier decision to employ more roundabout methods was in error. Firms abandon their incomplete capital projects and thereby precipitate the crisis. But isn’t it possible that the transition to more capital-intensive production methods could be completed in time? Might not the consumer goods produced by using more roundabout methods come onto line just as consumer demand begins to rise? In short, why must the traverse to a new structure of production always be interrupted before completion? 

Hayek admitted in his reply that “it is upon the truth of this point that my theory stands or falls.” And, sadly for Hayek, his insistence that the traverse could never be completed strikes many current commentators as being the chief deficiency of his theory of the cycle. The general consensus is that, while the scenario painted by Hayek is a possible one, he neither demonstrated its necessity nor gave adequate attention to the lags implicit in the process of adjustment that he portrayed. Hayek’s theory fits some, but not all, trade cycles: It is not, as Hayek purported it to be, a general theory of the cycle.

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 9, Contra Keynes and Cambridge: Essays, Correspondence, by F. A. Hayek (Indianapolis: Liberty Fund, 1995), 38-39.

De-Homogenizing Mises and Hayek: Hayek Believes that the Banks Are NOT “GUILTY” of Causing Business Cycles

There is another grave problem with Hayek’s 1933 analysis. He believes that the banks are not “guilty” of causing business cycles also because he thinks that in the early stages the “natural rate of interest” or profit on the market increases, and that the banks are not astute enough to realize it, so that they only pull the loan rate of interest below the natural rate, that is, by not raising their loan rates fast enough to match changes in the natural rate. The difficulty with this is that it misconceives the Misesian (1912) insight. The problem is not one of omission, rather it is one of commission; it is not that the banks are too passive and ignorant about finding the right loan rate to match the natural rate. Instead, it is that they actively expand credit beyond the cash in their vaults, thereby pushing the loan rate below the natural rate. In short, the Misesian view is that the banks don’t have to search for the natural rate in order to avoid generating the business cycle; all they have to do is not expand credit beyond their cash holdings. This is surely a much easier task. The banks’ insistence on expanding credit generates the business cycle, and makes them responsible and thus “guilty” as charged.

—Walter Block and Kenneth M. Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 83.

J. S. Mill Warns Us Against the Simplistic Incorporation of Derived Demands into Macroeconomic Theorizing

 John Stuart Mill’s cryptic aphorism, “Demand for commodities is not demand for labor,” warns us against the simplistic incorporation of derived demands into macroeconomic theorizing. Some such notion of derived demand, whereby the demand for final output and the demand for the factors of production always move in the same direction, characterizes virtually all modern macroeconomic theories. The recognition that the two demands can move in opposite directions characterizes the Austrian formulation and constitutes one of the most fundamental differences between the Austrian theory and its rivals. 

In accordance with Mill’s Fourth Proposition, a decrease in the current level of consumption does not necessarily mean a decrease in the demand for labor (and for other factors of production); a decrease in the current level of consumption may mean instead an increase in the level of saving, an increase in the level of future consumption, and a corresponding shift of resource demand away from the production for current-period consumption and toward the production for future-period consumption (Hayek 1941, pp. 433-39). There may even be a net increase in the current demand for capital and labor.

Hayek and other Austrian theorists have heeded Mill’s Fourth Proposition by recognizing that in a given period consumption spending and investment spending can—and, in conditions of full employment, must—move in opposite directions. In fact, it is the shifting of resources between consumption and investment activities—and between the different stages of the production process—in response to changing intertemporal consumption preferences that allows the economy to achieve intertemporal coordination. And it is the similar shifting of resources in response to monetary manipulations that constitutes intertemporal discoordination.

—Roger W. Garrison, “Hayekian Trade Cycle Theory: A Reappraisal,” Cato Journal 6, no. 2 (Fall 1986): 441-442.

Keynes Suggested that Hayek Was Trapped in an Old Framework in which Only Changes in Credit Could Cause Savings to Differ from Investment

For Keynes’s second claim was that Hayek had misunderstood in a fundamental way the thrust of the Treatise [on Money], and that many of Hayek’s criticisms were therefore misdirected. What Hayek had missed, according to Keynes, was the claim that savings and investment could “get out of gear” within the framework of the Treatise [on Money] for any of a number of reasons that were independent of changes in the amount of credit in the system. Keynes suggested that Hayek’s misreading was due to his being trapped within an old framework, one in which only changes in credit could cause savings to differ from investment. Exposing Hayek’s flawed framework was then Keynes’s excuse for reviewing Prices and Production. . . . 

But Keynes’s claims notwithstanding, many sources of disturbance were possible within Hayek’s model, too. One reason that Keynes may have missed this point is that he focused on Prices and Production, where the origins of the cycle take a back seat to the changes in the structure of production that constitute the cycle. In the fourth chapter of his earlier (and at that time available only in German) Geldtheorie und Konjunkturtheorie [Monetary Theory and the Trade Cycle], Hayek described things other than the actions of banks that could cause, in Keynes’s later terminology, the “marginal efficiency of capital” curve to shift. But Keynes was right to say that for Hayek, the effects of the shift will necessarily be transmitted through the credit system: It cannot be otherwise in a monetary economy.

—Bruce Caldwell, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 9, Contra Keynes and Cambridge: Essays, Correspondence, by F. A. Hayek (Indianapolis: Liberty Fund, 1995), 29-30.

On the Böhm-Bawerkian Distinction Between “Originating Forces” and “Determining Forces” of Interest

 “Some writers,” Fisher wrote, “have chosen, for purposes of exposition, to postulate two questions involved in the theory of the rate of interest, viz., (1) why any rate of interest exists and (2) how the rate of interest is determined.” Fisher dismisses this distinction as being unilluminating, “since to explain how the rate of interest is determined involves the question of whether the rate can or cannot be zero.” The purpose of the present section of this paper is (a) to present the case for the distinction criticized by Fisher—a distinction in fact made by Böhm-Bawerk, as we shall see—and (b) to show how failure to understand the rationale for the distinction has generated the widespread modern bewilderment with PTPT [Pure Time-Preference Theory of Interest] referred to earlier.

No better defense for Böhm-Bawerk’s distinction need to be found than the lucid discussion that he himself provided. Böhm-Bawerk was criticizing Fisher for not distinguishing between “originating forces” and “determining forces.” “All interest-originating causes undoubtedly are also determining factors for the actual rate. But not all rate-determining factors are also interest-creating causes. . . . When we inquire into the causes of a flood we certainly cannot cite the dams and reservoirs built to prevent or at least mitigate inundations. But they are a determining factor for the actual water-mark of the flood. . . . Similarly, there are other circumstances besides the actual interest-creating causes that bring about or enhance the value advantage of present goods over future goods.”

—Israel M. Kirzner, “The Pure Time-Preference Theory of Interest: An Attempt at Clarification,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 161.

Kirzner’s Defense of the Pure Time-Preference Theory of Interest Amounts to an Affirmation of “Methodological Essentialism”

It will be observed that our defense of PTPT [Pure Time-Preference Theory of Interest] against the bewilderment evinced by its various critics, amounts to a partial affirmation of what has sometimes been termed “methodological essentialism.” Several historians of thought have noticed that for Menger, economic science is a search for the reality underlying economic phenomena— for their essence (das Wesen). In a letter to Walras, Menger asks, “How can we attain to a knowledge of this essence, for example, the essence of value, the essence of land rent, the essence of entrepreneur’s profit . . . by mathematics?” This search for essences, reflecting a philosophical approach attributed to Aristotelian influence, would focus, then, not on the land rent paid for a particular parcel of real-estate in a particular year, but upon those essential features of land rent that would be common to all examples of the phenomenon. Similarly an essentialist approach to the interest problem as posed by Böhm-Bawerk would focus not on the list of elements which together determine specific interest rates, but on those elements upon which the interest phenomenon essentially depends, elements without which the phenomenon could in fact not exist. PTPT finds these essential elements for the interest phenomenon in time preference.

—Israel M. Kirzner, “The Pure Time-Preference Theory of Interest: An Attempt at Clarification,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 163-164.

Economists Fall into the Error of Defining Capital As REAL CAPITAL, As an Aggregate of PHYSICAL THINGS

Böhm-Bawerk defined capital as the aggregate of intermediate products (i.e., of produced means of production) and in so doing was criticized by Menger. Menger sought “to rehabilitate the abstract concept of capital as the money value of the property devoted to acquisitive purposes against the Smithian concept of the ‘produced means of production.’” As early as his work on Socialism (1923), Mises emphatically endorsed the Mengerian definition. In Human Action he pursued the question even more thoroughly, though without making it explicit that he was objecting to Böhm-Bawerk’s definition. Economists, Mises maintained, fall into the error of defining capital as real capital, as an aggregate of physical things. This is not only an empty concept but one that has been responsible for serious errors in the various uses to which the concept of capital has been applied. 

Mises’s refusal to accept the notion of capital as an aggregate of produced means of production expressed his consistent Austrian emphasis on forward-looking decision-making. Menger had already argued that “the historical origin of a commodity is irrelevant from an economic point of view.” Later Knight and Hayek were to claim that emphasis on the historical origins of produced means of production is a residual of the older cost-of-production perspectives and inconsistent with the valuable insight that bygones are bygones. Thus, Mises’s rejection of Böhm-Bawerk’s definition reflects a thoroughgoing subjective point of view.

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 139-140.

Many of the Criticisms Leveled Against the Austrian Theory of Capital and Interest Are IRRELEVANT When It Is Cast in Terms of FORWARD-LOOKING Decisions

Mises took Böhm-Bawerk to task for not recognizing that time should enter analysis only in the ex ante sense. The role time “plays in action consists entirely in the choices acting man makes between periods of production of different length. The length of time expended in the past for the production of capital goods available today does not count at all. . . . The ‘average period of production’ is an empty concept.” It may be remarked that here Mises identified a source of perennial confusion concerning the role of time in the Austrian theory. Many of the criticisms leveled by Knight and others against the Austrian theory are irrelevant when the theory is cast explicitly in terms of the time-conscious, forward-looking decisions made by producers and consumers.

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 138.

In Mises’s View, Böhm-Bawerk’s Theory Failed to Do Justice to the Universality and Inevitability of Time Preference

Mises, while paying tribute to the “imperishable merits” of Böhm-Bawerk’s seminal role in the development of the time-preference theory, sharply criticized the epistemological perspective from which Böhm-Bawerk viewed time as entering the analysis. For Böhm-Bawerk time preference is an empirical regularity observed through casual psychological observation. Instead, Mises saw time preference as a “definite categorial element . . . operative in every instance of action.” In Mises’s view, Böhm-Bawerk’s  theory failed to do justice to the universality and inevitability of the phenomenon of time preference. 

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in Essays on Capital and Interest: An Austrian Perspective, ed. Peter J. Boettke and Frédéric Sautet, The Collected Works of Israel M. Kirzner (Indianapolis: Liberty Fund, 2010), 138.

To Understand Hayek’s “The Pure Theory of Capital” Is to Question the Relevance of Mainstream Economics

The protracted and interwoven development of Hayek’s capital theory and business cycle theory was set against the background of an intense rivalry between Hayek and Keynes in the 1930s. Hayek had seen that ‘an elaboration of the still inadequately developed theory of capital was a prerequisite for a thorough disposal of Keynes’s argument’ (Hayek, 1983, p. 46); and, in retrospect, he considered it an error of judgement that he had given no time to an immediate and studious critique of Keynes’s General Theory. So, in addition to serving Hayek’s own exposition of a monetary theory of business cycles, The Pure Theory of Capital serves to expose the fallacy of the central tenet of Keynes’s General Theory — one that sits firmly in the mainstream of modern economics — for a ‘direct dependence of investment on final demand’ (Hayek, 1983, p. 48). Yet, Hayek’s exposé remains generally ignored, with the effect that Keynesian demand management (macroeconomics) together with marginal analysis (microeconomics) remain the dominant instruments of economic analysis. The issues could scarcely be more important. To understand The Pure Theory of Capital is to question the relevance of mainstream economics.

—Gerald R. Steele, “Hayek’s Pure Theory of Capital,” in Elgar Companion to Hayekian Economics, ed. Roger W. Garrison and Norman Barry (Cheltenham, UK: Edward Elgar Publishing, 2014), 71-72.