Cochran & Clahe on Keynes-Hayek Debate[1]

8/3/2019 Cochran & Clahe on Keynes-Hayek Debate[1]

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The Keynes-Hayek Debate: Lessons forContemporary Business Cycle TheoristsJohn I? Cochran and Fred R . Glahe

When the definitive history of economic analysis of the nineteenthirties comes to be written, a leading character in the drama . . . willbe Professor Hayek. Hayeks economic writings . . . are almostunknown to the modern student; it is hardly remembered that there wasa time when the new theories of Hayek were the principal rivals of thenew theories of Keynes. Which was right, Keynes or Hayek? -HicksCritical Essays in Monetary Theory

1. IntroductionMankiw (1989) in a recent critical review of the real business cycle(RBC) literature argues that in the debate concerning the source andpropagat on of economic fluctuations there are today, as there werein the 1930s, two schools of thought: the classical and the Keynesian.However, in the 1930s Keynes was not the only writer to present a se-

1 . What is referred to as the Keynes-Hayek debates took place primarily in the early1930s. The main exchanges were Keynes (1931a. 1931b). Hayek (1931a. 1931b, 1932a,1932b) and Sraffa (1932a. 1932b). See also the correspondence between Hayek and Keynesin The Collected Writings of John Maynard Keynes, vol. 13, 257-66. The direct exchangeended with Keyness letter of 29 March 1932. I doubt if I shall return to the charge in Eco-nomica. I am trying to re-shape and improve my central position, and that is probably a bet-ter way to spend ones time than in controversy (CW 13:266). However, traces of the debatelinger in the later writings of both the main participants. See Hayek [I9411 1975, chaps. 25-27, especially 369-80; and Keynes 1936, 182-84, 192-93, 320-24, 328-29, 376.Correspondence may be addressed to Professor John I? Cochran, Department of Economics,Metropolitan State College, Denver CO 80204 and to Professor Fred R.Glahe, Departmentof Economics, University of Colorado at Boulder, Campus Box 256, Boulder COHistory of Political Economy 26:l 0 1994 by Duke University Press. CCC 0018-2702/94/$1.5080309-0256.


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70 History of Political Economy 26:1 (1994)rious challenge to the classical view. Friedrich A. von Hayek, buildingon the work of Ludwig von Mises (1912), developed a theory of thetrade cycle in which monetary changes cause the cycle but succes-sive changes in the real structure of production . . . constitute thosefluctuations. Despite Hayeks Nobel Prize, and the renewed interestin his theories due to recent developments in the new classical macro-economics, the contributions of Hayek and von Mises to monetarytheory in the 1930s, while not unknown, continue to be ignored ormi sin terpreted.Modern economists generally are unaware of the major differencesbetween the Hayek-von Mises theory of business cycles and the clas-sical theory (both old and new). Writers in the new classical traditionhave even been referred to as neo-Austrian (Laidler 1982; Lucas1981). Like the classical school, the Hayek-von Mises approach em-phasizes optimization of private economic agents, the adjustment ofrelative prices to equate supply and demand, and the efficiency of un-fettered markets. Unlike the classical school, and similar to the Keynes-ian school, Hayek and von Mises believe that understanding thebusiness cycle requires an understanding of how an economy can suf-fer a coordination failure on a grand scale.3 The Hayek-von Misesmodel provides a disequilibrium explanation of a cycle, whereas thenew classical writers develop equilibrium models of the business cy-cle. Hayek, following von Mises, attempted to provide a microeco-nomic explanation of cycles (fluctuations). The new classical and newKeynesian (Gordon 1990) writers attempt to provide microfoundationsfor macroeconomic theory. The difference between these theories andthe Hayek-von Mises cycle theory is significant.For many years, the original Keynes and the classics debate ap-peared settled. Keynesian economics became the macroeconomics.Hayeks challenge to both the classics and Keynes was forgotten.However, microeconomics continued to be, as it was before the Keynes-ian revolution, a theory of a barter, not a monetary, economy. TheKeynesian model was not compatible with the microeconomic model

2 . Mankiw is not alone in this lapse in recent prestigious survey literature. For example,3 . This contrast of classical and Keynesian theory comes from Mankiw 1989.4. Macro theory replaced micro theory as the tool used in attempts to explain economicfluctuations or cycles. Hayek himself admits he was slow to recognize this change in

method. Hayek, as quoted in Glahe 1975, argued that The General Theory really marked atransition from m icroeconom ics to macroeconomics, and that his objections were againstmacroeconomics as such rather than just Keyness particular form of macrotheorizing.

see Gordon 1990.


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Cochran and Glahe / Keynes-Hayek Debate 71

used by most economists, while the quantity theory of money andthe classical model were compatible with the basic microeconomicframework.

This chasm between microeconomic principles and macroeco-nomic practice (Mankiw 1990) led to attempts to make macroeco-nomics compatible with microeconomics. The classical frameworkwas revived as the basis for alternative macroeconomic models. Keynes-ian economic reasoning was again challenged by classical reasoning.Many of the issues debated in the 1930s are once again being debatedtoday. Whether active stabilization policy is a help or a hindrance tothe operation of a market economy is again an open question. The na-ture and cause of observed fluctuations in the macro economy are thesubject of serious theoretical inquiry?

Keynes and Hayek were major participants in the original debatesover these issues. Keynes presented a major challenge to classical rea-soning that provided theoretical support for policy activism argu-ments. Hayek presented an alternative to the classical model that wasalso a clear antithesis to the Keynesian position, as was clearly recog-nized by Klein (1947, 52). Hayek argued specifically that (1) the short-run real effects of a monetary policy expansion are temporary; (2) thereal effects will be reversed; and (3) the ultimate result of an expan-sionary monetary policy will not be higher employment and greatereconomic stability, but the exact opposite.

Many of the issues that were central in the Keynes-Hayek-classicsdebate were never resolved, particularly those issues relating to capitaltheory. The apparent simplicity of the Keynesian-type model devel-oped from the Hicks-Hansen-Samuelson interpretation of Keynesseemed to make these controversies less important, or even unimpor-tant for practical matters. Contemporary developments suggest that areexamination of these issues may add to our knowledge of the opera-tion of a market economy. Judgments about the appropriate use of pol-icy are based on the policymakers understanding of market processes.The less complete our knowledge of the market process, the morelikely it becomes that policy will be inappropriate. Current main-stream theorizing, whether in the classical or Keynesian tradition, ig-

5 . Hayeks relevance in the current debates is supported by Machlup. In a largely un-heeded comment, Machlup (1977b. 24) observed, Indeed some of the ideas which Hayekshows to be fallacious have gaine d in strength since the 1930s; a re-reading of Hayeks theseson stabilizing monetary policiesmight have a beneficial influence on the policy makers of the1970s.


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72 History of Political Economy 26:l (1994)nores what Hayek (1941) referred to as the interaction of the capitalproblem and the monetary problem. This interaction of monetarychanges and changes in the structure of production is at the core of theHayek-von Mises trade cycle theory. If this interaction is important,Hayeks ([1933al 1966, 23) pessimistic assessment of deliberatemanagement continues to be relevant:

But whatever may be our hope for the future, one thing of which wemust be painfully aware at the present time . . . a fact whichno writer on these problems should fail to impress upon hisreaders . . . is how little we really know of the forces which we aretrying to influence by deliberate management; so little indeed that itmust remain an open question whether we would try if we knewmore.The Keynesian, Hayek-von Mises, and classical models present dif-

ferent interpretations of the operations of the market process. Section2 reconstructs the criticisms of the classical-type models presented byHayek and Keynes and summarizes the key elements in the originaldrama. Section 3 argues that many of these criticisms are also validcriticisms of the more modern approaches to macroeconomics (newclassical economics including real business cycle theory) that havechallenged Keynesian economics. It will be shown that the capital the-ory issues first raised by Hayek could be beneficially reintroduced intothe current macro debate. Section 4 provides concluding commentsand offers avenues for further research as suggested by the Hayek-vonMises approach. A reexamination of questions (which are not ad-dressed by either the classical or Keynesian-type models) about the op-eration of a market economy, raised by Hayek and von Mises,promises to enhance our understanding of economic fluctuations, eco-nomic growth, and the process of capital accumulation.

2. The Drama: The Opp osing Visionsof Hayek and KeynesBoth Hayek and Keynes felt that a monetary economy differed from abarter economy in key ways? These important differences were re-

6. The difference between a money and a barter economy is an essential ingredient inany analysis of economic fluctuations. . . . Though the formulation of the problem may


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lated to the use of money and the role of time in the economic process.Hayek ([1933a] 1966, [1931c] 1935) in particular argued that the pre-dictions of the model of pure theory (Walrasian general equilibrium)could not be directly applied to a real world economy. The further de-velopment of monetary (macro) economics required that the wholefield of study be redone in order to investigate what changes in theconclusions of pure theory are made necessary by the introduction ofindirect exchange (Hayek [193 lc] 1935, 127).7 Both Hayek andKeynes attempted such an investigation, and both used a Wicksellian-type model as the basis of their investigation. But Keyness work ledto policy conclusions that were completely opposed to Hayeks policyrecommendat ions.A central issue in the Keynes-classics, Hayek-classics, and theKeynes-Hayek debates was the automatic self-adjusting tendencies ofa market economy as modeled by the rigid interdependence and self-sufficiency of the closed system of equilibrium (Hayek [1933al1966, 44). In a market system prices convey information that affectseconomic behavior. In equilibrium, the information conveyed byprices causes economic agents to act in such a way that the plans of alltransactors are mutually consistent 78 In the classical model, pricessuccessfully perform this coordination task. Even when external cir-cumstances are unstable, changes in data lead to changes in prices thatmove the economy to a new equilibrium. Behavior is coordinated andconsistent with the changing environment. The classical system, withperfectly flexible prices and wages, is a self-adjusting system.

Hayek ([1933al 1966) argued that the self-adjusting tendencies maybe temporarily suspended in a monetary economy. A theory of per-strike one as Keynesian, in no way can Keynes be credited with this particular insight. Ifwe have paraphrased anyone, it is Hayek (ODriscoll and Rizzo 1985,201).

7. Keynes quotes this passage from Hayek after he states. I am in full agreement, also,with Dr. Hayeks rebuttal of John Stuart Mills well-known dictum that there cannot, inshort, be intrinsically a more insignificant thing, in the economy of society than money(Keynes 1931a. 395-96).

8. This view of the role of prices and equilibrium is developed from the work of Hayek.In his writings on the price system as a transmitter of information, Hayek developed a con-cept of equilibrium that referred to the consistency of the plans of transactors and to the in-formation required to attain this consistency (ODriscoll 1977, 17). See Hayek 1948, chaps.2,4.

9. Real business cycle theory attempts to explain economic fluctuations as adjustmentsto a series of such data changes or shocks (Rush 1987, 23-24). See Hayek [1931c] 1935,55 , for a critique of this type of approach to the trade cycle.


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74 History of Political Economy 26: 1 (1994)fectly coordinated economic activity, that is, equilibrium theory, couldnot be directly used to explain the actual observed movements of eco-nomic activity during the trade cycle. The phenomena of the trade cy-cle were more likely the result of imperfectly coordinated economicactivity. lo The problem presented to economic theory by the businesscycle was why, in response to a single change in the data, a cycle oc-curs. Why does the economy adjust by first moving away from whatwould be the new equilibrium and then, only later, correct and movetoward the equilibrium consistent with the new external circum-stances? During events that make up a cycle prices are misdirectingproduction. In the Hayekian model, just as in Keynesian explanationsof fluctuations or cycles, economic activity is not coordinated duringa cycle.

Hayeks approach is a clear contrast to both modern real businesscycle theory and older classical exogenous shock theories of fluctua-tions. Modern real business cycle theory argues that a general equilib-rium growth model can be used to explain fluctuations as optimal(equilibrium) adjustments to shocks, that is, changes in the data.While not denying the possible importance of such adjustments,Hayek ([1933a] 1966) felt that such equilibrium explanations of cyclesare essentially noneconomic explanations, since what are treated asdata in an economic model are often classified as such because theydelimit what the economist can explain from what he considers outsidethe task of economics to explain.

Hayek further argued that in an economy subject to monetary dis-turbances, cycles can occur because prices may give false signals.Monetary changes can cause cyclical movements in economic activity.

The obvious, and (to my mind) the only possible way out of this di-lemma, is to explain the difference between the course of events de-scribed by static theory (which only permits movements towards anequilibrium, and which is deduced by directly contrasting the sup-ply of and demand for goods) and the actual course of events, by thefact that with the introduction of money (or strictly speaking withthe introduction of indirect exchange), a new determining factor isintroduced. Money being a commodity which, unlike all others, is10. Gordon (1990) has argued that an essential theme of Keynesian and new Keynesianmacroeconomics is the inability of a market economy to coordinate econo mic activity; fluc-

tuations represent an absence of continuous market clearing.


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incapable of finally satisfying demand, its introduction does awaywith the rigid interdependence and self-sufficiency of the closedsystem of equilibrium, and makes possible movements which wouldbe excluded from the latter. (Hayek [1933a] 1966,44-45)

In other words, monetary changes are not neutral. Monetary changesalter relative prices in such a way that plans based on these false pricesdirect the use of resources so that economic activity is not coordi-nated. Prices could systematically contain wrong information, whichwould then lead economic activity away from equilibrium. Productionis misdirected. Hayek ([193Ic] 1935) felt that it is the task of monetarytheory to investigate all the repercussions of the influence of money onrelative prices and production: Its task is nothing less than to cover asecond time the whole field which is treated by pure theory under theassumption of barter, and to investigate what changes in the conclu-sions of pure theory are made necessary by the introduction of indirectexchange (127).

Keynes and Hayek presented two challenges to economic modelbuilders: the role of money and the role of time (expectations) in eco-nomic dynamics. However, the two are not unrelated; in an equili-brium with perfect foresight there would be no place for money(Hicks 1982, 7). The use of money and the existence of uncertainty gohand in hand. Both writers felt that they had pointed out major flaws inclassical reasoning. If the criticisms of Keynes or Hayek are correct,the faith in, orjustification for, self-adjustingmarkets in a monetary eco-nomy cannot be based on the existence of equilibrium in a perfect fore-sight, perfect competition, economic model (or its modern rationalexpectations equivalent). The predictions embodied in an equilibriummodel of pure theory cannot be directly applied to the real world. Thedescription of the economic process through time will require a differ-ent model.

The alternative models of Keynes and Hayek used the Wickselliansaving-investment approach as a basic tool of analysis. The explana-tions of the economic process and the policy prescriptions they offered

1 I . Keynes 1936, chaps. 2, 14. Hayek has argued, What I had done had often seemed tome more to point out barriers to further advance on the path chosen by others (Hayek inODriscoll 1977, ix).

12. The Wicksell mechanism in the Treatise on Money i s obvious. For a justification ofthis view concerning The Generul Theory see Laidler [I9723 1975 or Leijonhufvud 1968,321-22.


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76 History of Political Economy 26:l (1994)

were dramatically opposed. As Hicks (1967b, 204) points out, Wick-sell plus Keynes said one thing, Wicksell plus Hayek said quite an-other. Either model, Wicksell plus Keynes or Wicksell plus Hayek,said one thing, and the classical model said quite another.Each economist believed that the conclusions of the other werebackward. The mystery to each writer was how the other, workingfrom what appeared to be a similar basic model, could come to thepolicy conclusions he did. The disagreement about policy was the out-ward manifestation of a fundamental disagreement about the natureof a market economy, particularly concerning the role and functionof capital.

This fundamental disagreement is related to Wicksells questionabout the operation of credit institutions in a monetary economy. Inthe economy of pure theory, the equilibrium rate of interest, whatWicksell called the natural rate, would depend on the supply and de-mand for capital. The money rate in a monetary economy depends onthe scarcity or excess of money. How are the two related? The answergiven depends critically on the underlying capital theory, whether thetheory is made explicit or not.

Hayeks explanation of an upper turning point of a cycle requires ablend of monetary and capital theory.13 In the Austrian view, mone-tary disturbances alter relative prices. The relative prices that are usu-ally affected by monetary changes are intertemporal prices, such asinterest rates and the rate of profit.14 A monetary injection in the formof an extension of credit to entrepreneurs causes forced savings. Asforced savings occur, the boom is followed by crisis and developingunemployment.

A monetary injection that enters the market as an additional supplyof money credit should lower the market rate of interest relative to theequilibrium rate of interest. 5 Entrepreneurs would now have increased

13. In Hayeks view, the Austrian cycle was never intended to be anything but an expla-nation of the upper turning point (Hayek [19691 1978, 174).

14. Hayek believed the rate of profit to be the ultimate determinant of the form of invest-ment. The rate of profit is equivalent to what in the real analysis was called a rate of interest,the margin between prices and costs. These margins that Hayek refers to are the key relativeprices that are altered by monetary changes. Changes in the money rate of interest alter thepattern of the flow of expenditure on goods and services which then affects the direction ofproduction by altering price margins and relative profitability.

15. The same argument would follow if the increased money did nothing but keep thecurrent rate from increasing as investment demand increased.


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Cochran and Glahe / Keynes-Hayek Debate 77purchasing power with which to increase investment spending. Thelower market rate causes projects that were previously viewed by en-trepreneurs as unprofitable to now appear to be profitable, and invest-ment should increase. To this point there is nothing unusual about theanalysis. However, in the Hayek-von Mises model, the new invest-ment projects should be longer than existing projects. Also, thelower rate changes the relative profitableness of the different factorsof production for the existing concerns (Hayek [1931c] 1935, 86).The form of investment, both new and renewed, changes.

The new pattern of expenditure following the monetary injection atfirst lowers margins between sales prices and costs; it lowers realrates or what Hayek in his later works ([1939] 1975, [1941] 1975)preferred to call the rate of profit. Methods of production that takemore time to complete but are more productive6(more output per unitof input) have a relative advantage over projects that take less time butare also less productive ([19411 1975, 388-89). Investment projectsbecome longer, more labor saving, and/or more durable.

Two paradoxes appear. Processes or methods of production thatwere profitable at a higher interest rate (rate of profit) are not profit-able (not as profitable as other methods) at the lower rate. In the re-verse case, it will be argued that when either the rate of profitincreases or the market rate of interest (or both) increases, the pro-cesses that were preferred at the lower rate of profit will no longer beprofitable. Changing rates of profit (or changing interest rates) changeboth the quantity and the form of investment.

These monetary-caused changes in price margins will be temporaryin nature. As the money expenditure flows through the system, the pat-tern of expenditure based on the tastes of consumers will tend to reas-sert itself. The monetary injections eventually spread through thesystem and become money income. Input owners with unchanged realdemands for consumption goods and now higher money incomes com-pete for a reduced supply of consumer goods. The flow of expenditureon consumer goods increases relative to the flow of expenditure oncapital goods. The prices of consumer goods increase relative to costs.

The increase in the price of consumer goods signals the onset of thecrisis. The increased profit margins on consumption goods need not be

16. Here Austrian logic enters. Time preferences are positive; the present is preferred tothe future. Longer processes must therefore be more productive even to be considered in therealm of possible choices.


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78 History of Political Economy 26: 1 (1994)accompanied by a higher market rate of interest in order to cause a cri-sis. Hayeks ProJits, Interest, and Investment describes a processwhere the market rate of interest plays no role in the development ofthe crisis. The rise in the price of the product (or the fall in realwages) will lead to the use of relatively less machinery and other capi-tal and relatively more of direct labor in the production of any givenquantity of output (Hayek [1939] 1975, 10). Investment will be madein shorter processes, less durable goods, and in less labor-savinggoods. Demand for inputs in these processes will intensify, but at thesame time demands for inputs in longer, more durable, or more labor-saving processes will decline. The net demand for inputs in investmentindustrieswill decrease (Hayek [1941] 1975, 387). Layoffs and idle ca-pacity should develop in these industries. This response of entrepre-neurs to the changed price margins Hayek calls the Ricardo effect.I7However, it is more likely that an increase in the rate of interest willplay a significant role. Higher interest rates affect entrepreneurial deci-sions in a manner similar to the Ricardo effect. As the boom pro-gresses, entrepreneurs will need progressively larger increases in thesupply of money credit to maintain the new structure of production.This increased demand for credit and the less liquid positions of banksshould cause the market rate of interest to increase. Hayeks Pricesand Production describes the process where the rate of interestincreases.Modern interpreters of the Hayekian crisis theory argue that thesecond scenario is the more likely. We suggest, further, that in -vestment cycles typically end in a credit crunch, with a comparativelysudden and simultaneous financial crisis for numerous firms(ODriscoll and Rizzo 1985, 210).

Time and the nature of capital goods make it impossible to transferall the resources used in longer processes to shorter processes. Someresources which cannot be transferred will become idle. Some capitalis specific, that is, it is not adaptable to other uses.* Resources are17. See Moss and Vaughn 1986 for a discussion of Hayeks use of the Ricardo effect inhis trade cy cle theory. See a lso Hayek [19391 1975. (19421 1948, [19691 1978. Hayeks use of

the Ricardo effect does not imply that an increase in the rate of interest plays no role in thedownturn. The Ricardo effect was provided to show how the system would act if the rate ofinterest failed to act at all (Hayek [I9393 1975. 6).

18. Specific capital is not necessarily identical with the concept of fixed capital. A per-fectly specific capital good has no alternative uses. Such goods may be also fixed capital


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complementary. The expected future returns can be realized only ifthese resources can be combined with other resources. The availablesupply of free capital, capital goods available for new and renewedinvestment, is scarce. This supply of free capital cannot be quicklyaugmented because the amount currently available is primarily deter-mined by decisions made in the past.

The increased proportional demand for consumption goods creates asituation where nonspecific resources (free capital and most labor) aremore urgently needed for provision of goods ready for consumption inthe near future. Prices of these goods rise as the larger price marginsin the later stages of production allow these industries to bid resourcesaway from earlier stages. This increase in the price of needed laborand complementary resources further erodes the competitive positionof firms in earlier stages of production. The demand for the productsof such firms is declining, while the cost of needed complementaryresources is rising. Complementary resources are available only in in-sufficient quantities and at higher prices. It may become either eco-nomically or physically impossible to complete the longer, moreproductive processes.

The firms in such industries are forced to shut down. Plant andequipment become idle because the needed complementary resourcesare not available at prices that justify continued production. Some cap-ital becomes redundant because the current supply of other capitalgoods (and perhaps labor or other original factors of production) is notsufficient to meet the needs for current consumption demands and stillallow the completion of some longer processes of production. Laborand other complementary resources are laid off. The amount releasedis in excess of the rate at which these resources can be absorbed in ex-panding industries. Unemployment and idle capacity increase beyondwhat can be regarded as frictional levels. The complementary re-sources needed to make these workers employable do not currently ex-ist. Only with the passage of time, as the investment errors of the pastare corrected and the economy completes its adjustment to the existingsuch as an existing plant that is useful in only one process for producing one type of output.However, variable inputs may a lso be sp ecif ic if these inputs have no alternative uses .

19. Once unemployed resources develop, a secondary deflation (Hayek [19391 1975,176) or Keynesian-type collapse is likely. How will the rest of the decline look? It will ap-pear to be Keynesian. . . . Unemployment spreads because of an income-constrained pro-cess. The Keynesian process, however, begins in the middle of the decline (O Drisco ll andRizzo 1985. 210-11).


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80 History of Political Economy 26: 1 (1994)real conditions, will the appropriate kinds of complementary goodsbecome available, making these workers again employable.

In summary, a crisis develops when changes in the money supplycause the money rate of interest to differ from the equilibrium or natu-ral rate. Money enters the system in such a way that the normal opera-tion of credit institutions generally causes the money rate to be lowerthan the natural rate. A market interest rate below the natural rate willlead to malinvestment: investment projects that cannot be completedas planned. A normally reliable price, the interest rate, leads entre-preneurs to make plans that are not consistent with consumer prefer-ences. Intertemporal choices will not be coordinated. As the realfactors eventually overcome purely monetary factors, the scarcity ofreal capital, created by the overextension of investment (capital goodsindustries) due to the artificial lowering of the market rate of interest,eventually affects the operation of the economy by altering the rateof profit that can be earned in diferent lines of production. Whenentrepreneurs redirect production into patterns more consistent withconsumer preferences, the initial effects of the monetary disturbanceare reversed.

A constant rate of increase in the effective quantity of moneywould, at first, stimulate the economy. However, the increased activitycannot be sustained. Market adjustments would eventually reverse theinitial effects of the monetary expansion. A crisis occurs even if therate of increase in the money supply is not slowed. The increased ac-tivity could be maintained for a longer period only if credit (and themoney supply) increased at a progressive rate (Hayek [1969] 1978,174; [1939] 1975, 147-48), producing an accelerating rate of infla-tion. Employment created by expansionary monetary policies ishighly unstable. Some of the implications of the Hayek-von Mises

.

20. Detailed discussion of malinvestment can be found in Hayek [1931c] 1935, Cochran1985, Garrison 1987, and Bellante and Garrison 1988. In-depth discussion of the impor-tance of capital theory in an Austrian explanation of the upward turning point of a cycle in-duced by monetary expansion can be found in Cochran 1985, Bellante and Garrison 1988,and Skousen 1990.

21. The need to expand the money supply at an accelerating rate to maintain the initialoutput effects of an expansionary monetary policyhad been part of the Austrian business cy-cle (Hayek-von Mises) theory long before the development of the natural rate model and theaccelerationist hypothesis. See Hayek [1939] 1975, 147 and Cochran 1985, 143-44. How-ever, accelerating inflation will eventually bring on monetary collapse as money ceases tobe an adequate accounting basis (Hayek [1969] 1978).


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Cochran and Glahe / Keynes-Hayek Debate 81model concerning the effects of an expansionary policy duplicate thepredictions about the ultimate effects of active policy in natural ratemodels. Active policy can be a cause, not a cure, of recession.22

Hayeks conclusions were highly controversial. In the short runmonetary changes are not neutral. Monetary expansions can and willcause investment booms. However, in the long run, readjustments ofthe economy to entrepreneurial errors caused by the monetary expan-sion create a crisis. The ultimate effect of a monetary expansion maybe increased, not reduced, unemployment. In the long run, monetaryexpansion as a method of increasing production is not only ineffective,but may be a cause of disequilibrium and the emergence of unem-ployed resources. The active policy of today creates greater instabilityin the economy, not greater stability.

These conclusions led Hayek (1979a, 4) to reject and oppose fromthe outset the kind of full employment policy propagated by LordKeynes and his followers. Hayeks analysis implies that the time toprevent a crisis is during the boom, when the errors occur. Monetaryfactors temporarily suspend the operation of market forces, causingoverexpansion. Extensive malinvestment needs to be curtailed if per-sistently high unemployment is to be prevented. The way to avoid ex-tensive malinvestment is to avoid overly expansionary monetarypolicies. Stable, full employment can be maintained only if the struc-ture of production is in line with the intertemporal plans of consumers.A crisis can be prevented by not allowing the boom to proceed toofar.23 This is the most important role of policy. The achievement ofthis goal will depend more on the nature of the monetary institutionsthan on policy activism. An economic system with an elastic currencywill always be subject to some fluctuations due to the nature of themoney creation process. The operat ions of a developed bankingfinan-cia1 system will tend to retard the operation of the interest rate brake(Hayek [1933al 1966). Economists need to study different monetary

22. Hayek (119391 1975) also attempts to show why a monetary expansion begun, not atfull employment, but during a recession leads to a cycle. To our knowledge no natural rate orequilibrium business cycle model has addressed this same issue.23. Keynesian insights that ignore the structure of production lead to exactly the oppositeconclusion. Keynes (1936, 322) was implicitly criticizing Hayek when he argued, The rightremedy for the trade cycle is not to be found in abolishing booms and thus keeping us perma-nently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom. Hayeks ((19391 1975) use of the Ricardo effect was an attempt to explain the futilityof using a money and interest rate policy in an attempt to maintain a quasi-boom.


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82 History of Political Economy 26: 1 (1994)institutions to determine which type of institutional arrangement ismost likely to minimize this tendency for the market rate to be reducedbelow the natural rate.24 The more automatic the system can be madethe better. The maintenance of a stable economy requires a fine bal-ance of restraint and action. In ordinary times a more or less auto-matic system of regulating the quantity of money (Hayek 1979a, 18)is more likely to keep expansion from proceeding too far. Monetarypolicy and monetary institutions should prevent wide fluctuation in theeffective quantity of money. But policymakers and monetary institu-tions must be flexible enough to ensure the convertibility of all kindsof near-money into real money, which is necessary if we are to avoidsevere liquidity crises or panics; for this the monetary authoritymust be given some discretion (Hayek 1979a, 18).

Keyness theory of capital (or lack thereof) led his analysis in a dif-ferent direction. Keynes (1936, 242-44) felt that the money rate wasthe determining factor. The real variables would be forced to adjust tothe money rate. The money rate equals the natural rate when the de-mand for and supply of money capital perfectly reflect the demand forand supply of real capital. Keynes came to feel that the natural ratewas irrelevant (unknowable) in an economy with developed financialmarkets. Fundamental uncertainty about the future and a desire for li-quidity would continually create situations that would make it impos-sible for market institutions to coordinate intertemporal economicactivity.

The demand for capital schedule in the model of pure theory isbased on perfect entrepreneurial foresight. In an economy operating inhistorical time, such foresight does not exist. The demand for capitalschedule will depend on entrepreneurial expectations, which maychange at any time. The demand for capital schedule used by Keynesmay or may not accurately reflect the demand for capital schedule im-plied by pure theory.

The supply of money capital would depend on factors related to thedemand and supply of money. The volume of savings will have only anindirect effect on this supply of money capital. New savings may beused to satisfy requirements for liquidity or as a source of money capi-tal. The available money capital is influenced by the publics demand

24. Hayeks work points toward what Buchanan (1989) refers to as a constitutional ap-proach to monetary problems. The search is not for a proper policy but for an appropriatemonetary framework. See Hayek [19691 1978 and 1984b.


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for liquidity. These demands for liquidity create a general tendency forthe rate of interest to exceed the natural rate. The rate of interest in amarket economy is not self-adjusting at a level best suited to the so-cial advantage but constantly tends to raise too high (Keynes 1936,351). In other words, banks and credit institutions can maintain therate of interest at a level not consistent with the natural rate, and as arule the rate will tend to be above the natural rate.

Even if expectations are essentially correct, a money rate in excessof the natural rate would cause investment to be less than the levelneeded to maintain a full employment equilibrium. If entrepreneursunderestimate future returns, the level of investment will also be lessthan the level required for full employment, even if the money rate isequal to the natural rate. In either case there will be underinvestment,and it is underinvestment, not overinvestment (malinvestment), thatcauses involuntary unemployment in Keyness model. Disturbanceswill be amplified, not corrected, because consumption and investmentwill change in the same direction.

Keynes felt that monetary influences will persist. Hayek felt thatthey cannot; real forces will eventually dominate the purely monetaryinfluences. If Keynes is right, the effects of a Keynesian policy changeare permanent; policy may be needed and will be effective. If Hayek isright, the effects of policy are not permanent; policy will not only beineffective in the long run but also cause future instability.

Keyness position became the accepted norm. Economists who ac-cepted Hayeks view virtually disappeared. Despite Hayeks bglief thatthe Keynesian position would be temporary, that it would suhside andbe replaced by other forms of analysis based on a stream of securedknowledge which may be temporarily submerged but certainly notstopped by the present flood of dilettante literature (Hayek [193911975, 182), the Keynesian policy position continued to dominate mac-roeconomic thought for most of the postwar period.

3. Classical ResurgenceMilton Friedmans Quantity Theory of Money: A Restatement(1956) began the revival of classical-type models and policies, charac-terized by Johnson (1971) as the monetarist counterrevolution. Theneoclassical synthesis developed by Don Patinkin aided the recoveryof economic models similar to the classical-type of analysis. Patinkin


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84 History of Political Economy 26: 1 (1994)

(1965, xxv) argued that if real balance effects were incorporated intoKeynesian-type models, it was Keyness model that was the specialcase, not the classical model. An economic system with perfectly flex-ible wages and prices should have a full employment equilibrium. Ifunemployment persists, money wages must be too high. The criticalassumption in Keyness theory, it is concluded, is that wages are rigiddownwards. The theoretical conclusions of the classical model were~ a l i d a t e d . ~ ~his classical revival has culminated in the new classicaleconomics (the natural unemployment rate hypothesis, rational expec-tations, and most recently real business cycle models) and supply-sideeconomics. 6

The natural unemployment rate hypothesis and its later develop-ments in rational expectations forms purported to show that any fullyanticipated monetary policy would be ineffective. Gordon (1976, 192)argues the natural rate theory was novel, not by associating moneywith inflation, but rather in its claim that changes in the rate of mone-tary growth would not cause the rate of unemployment to permanentlydiverge from its natural rate without a continuously accelerating in -flation or deflation. The central feature of the discussion is not theWicksell mechanism, but the Phillips curve and the natural rate of un-employment hypo the~ is .~~The supposedly unique or new aspect of the natural unemploymentrate hypothesis is its prediction about policy.28The theory implies thatthe effects of a nonaccelerating monetary disturbance will be self-

25 . Two notes: (a )Keynes argues that unemployment caused by rigid wages is consistentwith classical reasoning (1936, 16, 257). In a Patinkin-type model the Keynesian explanationof unemployment reduces to the classical explanation. Keynes accepted the diagnosis thatunemployment implied a real wage in excess of the equilibrium real wage, but rejected theidea that cuts in money wages would unambiguously reduce real wages and hence increaseemployment. Unemployment could persist even if money wages were flexible (chap. 2) . ( b )This is Leijonhufvuds interpretation of Keynesian economics, incorporated into the neo-classical synthesis, not his interpretation of the economics of Keynes.26. For a discussion of differences in these modern classical approaches see Hoover1984.27. Leijonhufvud has argued that neoclassical Keynesians have forgotten their roots inthe savings-investment mechanism. They have no effective counter to Friedman-type mone-tarism. Someone whose beliefs consist of neoclassical growth, variable velocity Monetar-ism, and unemployment caused by lags in wage adjustment should not fight Milton Friedmanbu t join him. The savings-investmentmechanism provides a basis for debate. Unless the realrate of interest goes to its natural level, unemployment will not home in on its natural level(Leijonhufvud 1981, 184-85).28. See. however, note 21 on the priority of Hayek-von Mises on this novelty.


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reversing. An expansion of the money supply at a constant rate willcause the economy to first expand and then, without any further exog-enous changes, contract; vice versa for a monetary contraction. Thenatural rate theory, like the Hayekian theory, explains a cycle in termsof a response to a single shock. In the long run, the policy is in -effective; real phenomena ultimately dominate purely monetaryinfluences.

The natural rate model and the rational expectations hypothesishave led to the development of the new classical theories of macroeco-nomics. These theories are built on a microeconomic foundation,where the decisions of economic agents are based on real, not mone-tary, variables, and where economic agents are successful maximizersholding rational expectations (Hoover 1988, 13-14). However, themacroadjustment processes developed in these models are still in theform of causal relationships between broad aggregates. Furthermore,as in Keynesian models, questions concerning the capital problem andthe time structure of production are essentially ignored. The explana-tion of the observed correlation between changes in money andchanges in provided by these new classical models either in -volves reverse causation and endogenous money3 or could easily havebeen written years ago (contrast Gordon 1976, 202, with Warburton[19461 1951, 299). While lack of microfoundations is a valid criticismof early post-Keynes macro models, the differences between old andnew classical models on this point may be more cosmetic than real.The major difference in the approaches (old and new classical) hasbeen described as follows:

Money is a veil, or, to put it more technically, all real equations arehomogeneous of degree zero in prices so only relative prices matter,and they and only they are what can be determined by the real equa-tions of general equilibrium. (By the way the real question is not so29. Economists, since at least the 1930s, have recognized that classical-type models with

long-run monetary neutrality properties must in some way explain what Hayek ([193 c]1935, I ) and Warburton ([I9461 1951, 297) regarded as an accepted fact; namely, that mon-etary fluctuations play a dominant role in fluctuations in business activity. Barro (1990, 3)argued that originally the difficulty for new classical economists seemed to be to reconcileequilibrium models, which tend to generate close approximations to monetary neutrality,with a strong role for monetary disturbances in business cycles.

30. Real business cycle research is still groping with this issue. Plosser (1989) argues thatthe role of money in RBC models is little understood and remains an open issue. See alsoLucas 1987, 70 and chap. 7.


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86 History of Political Economy 26: 1 (1994)

much whether that argument is true as whether it is relevant incalendar time. It is important to realize this. Failure to realize ithas triggered innumerable wasted words.) Twenty-five years later,it is argued that the rate of change in money prices is a veil. There-fore only unexpected inflation can be geared to real things. Youmight say that the rate of change of a veil is a veil. (Solow [1976]1978, 147)The search for microfoundat ons for macroeconomics has resulted

in a return to the type of macro-model building against which Keynesand Hayek were reacting in the 1930s, albeit in a more sophisticatedform. These more sophisticated, mathematical models have three dis-tinct forms:

1 . A natural rate monetary disequilibrium form as developed byFriedman, in which the disturbance and the maladjustment are bothnominal (Leijonhufvud 1983). Monetary disturbances coupled with ri-gidities in the system create maladjustments between the absoluteprice level and the level of money wages. Disequilibrium continuesuntil prices and wages both fully adjust to the monetary change. Whilea monetary expansion (unanticipated) at a constant rate can lead to aninitial expansion and a consequent contraction, a recession is usuallyexplained by an adjustment of the economy to a reduction (either unan-ticipated or anticipated but not credible, i.e., not believable) in therate of growth in the money supply.2. An equilibrium business cycle form in which unanticipatedmonetary changes alter anticipated real rates of return. The shock isnominal but the maladjustment is real (Leijonhufvud 1983). Micro-foundations are provided in terms of a model where economic agentsmaximize subject to budget and information constraints. Cycles areexplained as equilibrium responses to unanticipated changes in mone-tary variables. 3. A real business cycle form where shocks are real and no mal-adjustments occur. Fluctuations occur as the economy responds tocontinuous shocks. The cycle, as in (2), represents equilibrium adjust-

3 I . Turning points in a cy cle can be explained in both forms I and 2 in terms of the ad-justment of the economy to a single exogenous change (an unanticipated monetary distur-bance). In this way both forms attempt, as Hayek did in his model, to provide aneconomic explanation of a cycle, a cycle caused by a single shock, not by a series ofshocks. Neither Hayek-von Mises nor forms I and 2 preclude fluctuations caused by contin-uous chang es in the data as in form 3.


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ments. Correlation between money and real activity is usually ex-plained by reverse causation. Money is endogenous and has no causalinfluence on real activity in either the short run or the long run.

Many of Hayeks criticisms of the old classical approach also applyto the new classical approach. In both the new classical and the olderclassical models, the price effects of the policy change influence alllines of production; the effect analyzed is upon the volume of produc-tion in The effects of monetary changes on the distributionof the money spending stream and the structure of production are ig-nored. Hayek believed that the manner in which money enters or,leaves the spending flow is important to the adjustment path of theeconomy. If monetary changes are analyzed as if they were helicop-ter drops, the analysis can present a misleading picture of the short-run adjustment process. The critical issue that separates Keynes andHayek and the new and old classical schools relates to the importanceof the transmission mechanism. Keynes and Hayek (and others in theWicksell tradition) argue that the mechanism is extremely important.Writers in the classical tradition tend to downplay the importance ofthe transmission process and the role of monetary institutions. NewKeynesians seem to have forgotten this important underpinning ofKeyness analysis.

4. ConclusionsWhile both the Hayek-von Mises model and the Keynesian model ex-plain the emergence of unemployed resources, the Hayekian modelimplies policy ineffectiveness, as do the new classical models.33 Spe-cifically, the Hayekian model implies the following: (1) monetarychanges are self-reversing. A mynetary expansion at a constant ratewill cause first an expansion, then a contraction of the economy;34(2 )monetary policy is ineffective in the long run; and (3) the increasedemployment initially caused by a monetary expansion can only

32. Hayek ([1931c] 1935, 6). See Cochran 1985, chap. 2, for a detailed discussion ofHayeks criticism of the quantity theory as a tool of econom ic analysis.

33. Coase (1982. 1 I ) implies that these policy conclu sion s provided adequate grounds formany econom ists to originally reject Hayeks model.

34 . Like the newer models the downturn will occur even if the money supply continues toincrease at a constant rate. But an actual slowdown in the rate of increase will accelerate thecrisis. See ODriscoll and Rizzo 1985.


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88 History of Political Economy 26:1 (1994)be maintained if the money supply continues to increase at a progress-ive rate.35

In contrast to the new classical view, Hayeks predictions depend onthe monetary change affecting different sectors unequally, and the pathof the economy following a monetary disturbance is a disequilibrium,not an equilibrium, path. According to Hayek, the distribution of themoney expenditure flow is altered from the equilibrium distributiondetermined by the underlying real factors by the monetary disturbance,whether the disturbance is the result of a deliberate policy change (ex-ogenous money) or whether the monetary change is a passive responseof the banking system to some real shock (endogenous money).36 Thisinitial alteration of the spending pattern in the economy will affect rel-ative prices and should redirect the employment of resources into di-rections consistent with the new unsustainable pattern of spending.However, the relative price changes brought about by the monetaryfactors are not equilibrium relative prices; the prices are not consistentwith the underlying real factors. As economic agents discover thatplans are not coordinated, real forces will reassert themselves. Thereal effects of the monetary disturbance are reversed as entrepreneurialerrors caused by the false prices are discovered and reversed. Theactual dynamic adjustment of the system depends on how and wherethe new money enters the system.37

Hayek felt that monetary changes are most likely to initially disruptthe distribution of resources between provision for the more distant fu-ture (activities that create resources, not final consumption goods) andprovision for the immediate future; the monetary disturbance causes

35. In the natural rate and new classical models points I and 3 apply only to unantici-pated monetary changes. Only point 2 would apply to fully anticipated policy changes. Inthe Hayek-von Mises model the real responses (points 1 and 3) to a monetary change de-pend on the initial distribution effects of the monetary change (how and where the newmoney enters the system). The explanation of the emergence of unemployed resources at theupper turning point requires a blend of monetary and capital theory.36. See Hayek [1933a) 1966 and Cochran 1985.95-102.37. Proponents of Austrian (Hayek-von Mises) cycle theory who emphasize the rela-tive price changes and downplay the capital theory aspects of the Hayek-von Mises modelleave the theory open to criticisms similar to Haberler (1938, 67). Why doesnt the orig-inal change in relative prices cause disruption of production and unemployment or why, ifresources flow smoothly into the expanding industries as relative prices change, do not theresources flow smoothly back to the original industries when the relative price change re-verses itself.


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problems coordinating what is usually termed saving and investment.On this point Keynes and Hayek virtually agree.

Macroeconomic maladjustments are felt in the labor market, but de-velop because of problems coordinating economic activity throughtime. Capital markets of a monetary economy operate differently thando the capital markets of pure theory. The interest rate cannot be reliedupon to effectively coordinate decisions regarding the creation ofcapita^.^'

Leijonhufvud (1981, 13 1-202) has argued that the correct Keynes-ian response to the challenge of the new classical approach is the re-introduction of the savings-investment mechanism to the policyeffectiveness debate. The formulation of the Keynesian model in termsof the neoclassical synthesis forced Keynesians to formulate policy ar-guments from empirically observed rigidities instead of from strongtheoretical arguments. One such defense, the stable Phillips curve, hasproved indefensible (Mankiw 1990).39

Coordinated economic activity requires that not only unemploymentbe at its natural rate, but also the rate of interest be at its natural rate (Lei-jonhufvud 1981 135). The economy cannot be in equilibrium if thecapital market is not in equilibrium. Keynesians need to return to theirforgotten roots. The reintroduction of the Wicksell mechanism into thepolicy effectiveness debate brings the debate essentially back to itsplace in the 1930s.The work of the third participant in the original de-bates, Hayek, should be seriously reexamined, and attempts should bemade by both modern Austrians and mainstream theorists to addressthe difficult theoretical issues first examined by von Mises but intro-duced to the English-speaking world by Hayek.

Hayeks model is a definitive alternative to Keynesian (old and new)and classical (old and new) models. Hayek arrives at policy conclu-sions that are similar to new classical, including RBC, conclusions,and his analysis avoids some of the pitfalls of the natural rate stories.

38. The instabilities of the market economy, in both Hayeks and Keyness models, arerelated to the markets ability to create resources. that is, increase future production capa-bilities. Capital is valuable because capital is scarce. In Hayeks model the instabilities occurbecause the market econom y tends to extend the resource-creating branches in excess of cur-rent capab ilities. In Keyness, the instabilities develop because the market system tends toretard resource-creating capabilities of the economy below current capabilities (see Minsky1985 for this interpretation of Keynes).39. However, the Phillips curve defense of Keynesian policy did precipitate the new pol-icy effectiveness debate.


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90 History of Political Economy 2 6 1 (1994)Hayek does not rely on quits to explain increased unemployment; in-stead, his argument shows why excess capacity and layoffs may be-come prevalent. In addition, his analysis does not rule out Keynesian-type contractions following the initial crisis.Open-minded debate concerning issues presented in the Keynes-Hayek paradigm clash could further understanding if only by makingus more aware of how little we really know about certain key aspectsdetermining the course of economic events.

Crucial questions about the role of money and time cannot be effec-tively addressed in simple quantity equation-type models or in generalequilibrium growth models with a single homogeneous capital good.The crucial roles of money and time cannot be effectively addressed inmodels without also addressing issues in capital theory and the timestructure of production. Discussion about policies affecting full em-ployment and economic stability will be inadequate if related problemsin capital theory are at the same time ignored. The allocational effi-ciency and stability efficiency properties of a market economy dependon decisions to use current resources to produce additional resources(Minsky 1985).This critical issue is at the heart of both Keyness andHayeks analyses. A redirection of the policy effectiveness debatealong these lines could greatly enhance our understanding of a mone-tary production economy.

It is only through a greater understanding of the forces actuallyshaping events in a monetary production economy that we can makerational decisions about policy and monetary institutions. As Lucas(198 1 , 235) has argued, an understanding of what a business cycle isand how it occurs is a prerequisite to determining how to deal with thebusiness cycle. While real business cycle research adds to our under-standing of the stochastic nature of fluctuations, and new Keynesian(Gordon 1990) research into the microeconomics of sticky pricespromises to add to our knowledge concerning the role of market im-perfections in aggregate fluctuations, these studies should not pre-clude, and may be complementary to, studies examining the moneyand capital problem. Given the current malinvestment associatedwith the S and L banking crisis, it may be time to attempt to answerHickss rhetorical question, or at least to reexamine critical unan-swered theoretical questions concerning the roles of capital, interest,and money in the economy that were first raised during the Keynes-Hayek-classics debate.


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