Hayek on the Unsustainability of Inflation-Fed Booms

In writing my previous post on Hayek’s classically neoclassical 1969 elucidation of the Ricardo Effect, I came across a passage, which is just too marvelous not to share. To provide just a bit of context for this brief passage, the point that Hayek was trying to establish was that even a continuous and fully anticipated injection of money would alter the real equilibrium of an economy. On this point, Hayek was taking issue with J. R. Hicks who had argued that a fully anticipated increase in the money supply would have no real effects. I think that Hicks was basically right and Hayek wrong on this issue, but that is not the point that I want readers to take away from this post. The point to pay attention to is what Hayek says about the alleged unsustainability of inflationary booms. In the paragraph just before the passage I am going to quote, Hayek explains what happens when the monetary expansion that had been feeding an investment boom is terminated. According to Hayek, that readjustment in the relative prices of investment goods and consumption goods is the Ricardo Effect, causing “some of the factors which during the boom will have become committed producing very capital-intensive equipment [to] become unemployed.”

Hayek continues:

This is the mechanism by which I conceive that, unless credit expansion is continued progressively, an inflation-fed boom must sooner or later be reversed by a decline in investment. This theory never claimed to do more than account for the upper turning point of the typical nineteenth–century business cycle. The cumulative process of contraction likely to set in once unemployment appears in the capital-goods industries is another matter which must be analyzed by conventional means. It has always been an open question to me as to how long a process of continued inflation, not checked by a built-in limit on the supply of money and credit, could effectively maintain investment above the volume justified by the voluntary rate of savings. It may well be that this inevitable check only comes when inflation becomes so rampant – as the progressively higher rate of inflation required to maintain a given volume of investment must make it sooner or later – that money ceases to be an adequate accounting basis.

The built-in limit on the supply of money to which Hayek referred was the gold standard, manifesting itself in a tendency for monetary expansion to cause both an external and an internal drain on the gold reserves of the monetary authority. In a fiat-money system with a flexible exchange rate, no such limit on the supply of money exists. So according to Hayek, at some point, the monetary authority is faced with a choice of either increasing the rate of inflation to keep investment at its artificially high level or allowing investment to decline, triggering a recession. That is the upper turning point of the cycle. But he also says “the cumulative process of contraction like to set in once unemployment appear in the capital-goods industries is another matter which must be analyzed by conventional means.” I take this to mean that, according to Hayek, the monetary authority can limit the cumulative process of contraction that results when the current rate of inflation is fully anticipated and monetary expansion is not increased to accelerate inflation to a higher, as yet unanticipated, level. There is thus a recession associated with the stabilization of inflation, but monetary policy can prevent it from becoming cumulative. After the real adjustment takes place and the capital goods industry Is downsized, a steady rate of inflation can be maintained, with no further real misallocations. There is inflation, but no boom and recession. In other words, it’s the Great Moderation.  Hayek called it in 1969.

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40 Responses to “Hayek on the Unsustainability of Inflation-Fed Booms”


  1. 1 Xavier L. August 31, 2012 at 12:33 am

    I may be very wrong, but doesn’t this reasoning imply that the nominal rate and real rate are independent of each other, which is empirically wrong — as far as my knowledge goes.
    Or is the full anticipation of money injection a sufficient condition for it to be the case?

  2. 2 Frank Restly August 31, 2012 at 5:08 am

    “This is the mechanism by which I conceive that, unless credit expansion is continued progressively, an inflation-fed boom must sooner or later be reversed by a decline in investment.”

    The problem with this statement is that it makes the assumption that credit (debt) is the only means by which investment is financed. Hayek ignores equity financing.

    “It has always been an open question to me as to how long a process of continued inflation, not checked by a built-in limit on the supply of money and credit, could effectively maintain investment above the volume justified by the voluntary rate of savings.”

    The problem with this statement is that Hayek makes an assumption about cause (credit expansion) and effect (inflation) without factoring in productivity (Real GDP / Total Debt Outstanding). Or the same thing that Friedman alludes to – “Inflation is always and everywhere a monetary phenomenon”. Both Hayek and Friedman are wrong.

    Can credit expand in such a way as to put downward pressure on prices? Certainly. Is that type of expansion stable? That would depend on tax policy, private capital investment preferences, and a few other factors.

  3. 3 Bill Woolsey August 31, 2012 at 5:15 am

    If the inflation tax on real balances is used to fund some particular industry, then it can permanently impact the allocation of resources. This is sustainable. It seems to me that the production of capital goods can be subsidized with the revenues from that tax. I also think that borrowing could be subsidized by the tax.

    It could be that the revenue maximizing inflation rate (like the peak of a laffer curve) would have only a tiny impact on the allocation of resources. Further, the actual levels of inflation politically tolerable might have only a small effect as well.

    Anyway, this is different from the possible impact on the allocation of resources associated with an increase in the supply of credit that matches an excess supply of money. That effect doesn’t exist with a fully aniticipated “inflation,” because at the very same time that prices rise enough to keep the real quantity of money equal to the real demand for money, they are also reducing the real supply of credit. In other words, the increase in the nominal supply of credit that matches the increase in the nominal quantity of money is just sufficient, given the higher prices, to keep the real supply of credit unchanged.

    Now, if we consider the “public finance” view above, and the money disequilibrium view that follows, and we fail to cafefully distinguish them, we will end up with a confusion.

    I think the orthodox Austrians’ highly abstract arguments about how money must enter the economy somewhere and that the prices rise first there, and must stay ahead of the other prices is the public finance argument. What they fail to see is that yes, this does impact relative prices and it can last as long as inflation is maintained. The resources to expand the subsidized industry come from those free up because those holding money must reduce real expenditures below real income to offset the constant deprecation of real money balances.

    Then, there is the monetary disequilibirum view, and that only happens with an excess supply of money. It doesn’t exist with a fully anticipated inflation. If price inflation is keeping up with money growth, then the real quantity of money matches the real demand for money and there is no excess supply of money.

    Anyway, the view of some Austrians that steady growth in nominal expenditure requires, or at least results in, an unsustainable allocation of resources (a bubble, like folks say these days,) is wrong.

    There could be a persistent effect on the allocation of resources, and while it might count as a misallocation (tax and subsidy schemes can have that effect,) it is sustainable. The monetary disequilibrium effects are not persistent, and if growth in spending on output remains steady, if any exist, they eventually go away.

    In my view, the most likely scenario where there is an impact on the allocation of resources due to monetary disequilibrium would be a regime change. The orthodox Austrian implicit assumption is that the regime is constant spending on output, and then any actual increase in spending growth is seen as a regime change to a shift to growing spending on output, and only gradually does pricing behavior adjust to the new regime.

    But in reality, we never had that regime, so assuming that pricing strategies are all based upon expectations that follow from a regime of constant spending on output is unrealistic.

    For the U.S. in 2008, we had come off of highly inflationary spending growth ((in the seventies) to more modest spending growth (the Great Moderation.)

    Imagining the the Great Moderation (or worse, 2002-2004) involved an acceleration of spending growth from a constant spending equilibrium is hopeless.

  4. 4 Greg Ransom August 31, 2012 at 9:42 am

    You are leaving out steps in the,mechanism — and you are leaving out the time length stages & relation to consumption which is the core of the mechanism.

    Bill writes,

    “I think the orthodox Austrians’ highly abstract arguments about how money must enter the economy somewhere and that the prices rise first there, and must stay ahead of the other prices is the public finance argument. What they fail to see is that yes, this does impact relative prices and it can last as long as inflation is maintained. The resources to expand the subsidized industry come from those free up because those holding money must reduce real expenditures below real income to offset the constant deprecation of real money balances.”

  5. 5 David Glasner September 2, 2012 at 2:12 pm

    Xavier, I’m sorry, I don’t know what you are referring to when you say “this reasoning.”

    Frank, Hayek did not assume that investment is financed exclusively by debt financing. His assumption was that monetary expansion would increase the amount of debt provided by banks to finance investment. Those aren’t the same. I believe that his implicit assumption was that equity financing would more or less remain constant while new money was used to provide loans to finance investment at interest rates lower than would otherwise have prevailed in the market.

    Bill, I basically agree that monetary expansion can go on indefinitely, perhaps having a distributional effect, and thereby changing the underlying real equilibrium. In that case money is not superneutral, but there is nothing unsustainable about the monetary expansion. Unsustainability is only an issue insofar as the monetary expansion is not correctly anticipated. That was pretty much the criticism that Hicks made of Hayek in his essay “The Hayek Story” to which Hayek was responding in his 1969 paper on the Ricardo Effect. I don’t think that Hayek successfully rebutted Hicks’s point.

    Greg, If I understand your point, which is probably a counterfactual assumption, you are implicitly assuming that there is some period of time in which the inflation resulting from monetary expansion is not foreseen. It is that unforeseen component of a monetary expansion that produces some sort of adjustment that must be reversed once the inflation is fully anticipated. Apart from that Bill’s argument stands.

  6. 6 Frank Restly September 2, 2012 at 3:42 pm

    David,

    “Frank, Hayek did not assume that investment is financed exclusively by debt financing.”

    Here is the statement that you originally quoted from Hayek:

    “This is the mechanism by which I conceive that, unless credit expansion is continued progressively, an inflation-fed boom must sooner or later be reversed by a decline in investment.”

    Just from this statement Hayek makes the following correlations:

    1. Credit expansion leads to an inflation-fed boom. Not necessarily true.
    2. An inflation fed boom is reversed by a decline in investment.

    First, not even close to true. In fact an inflation fed boom can be reversed by an increase in production to match the increase in demand that created the inflation in the first place. That increase in production can be accomplished through increased investment.

    Second, the only way that a credit expansion induced inflation fed boom ends with decreased investment is when credit contraction affects both supply and demand. And like I said, equity financing is available to suppliers. And so the inflation fed boom may end with credit contraction while leaving investment unchanged.

  7. 7 Greg Ransom September 2, 2012 at 3:51 pm

    The dimensions & some degrees of the flow of price increases & price decreases across the economics are ALWAYS unforeseen, as an epistemological NECESSITY.

    This is non-optional if you take the knowledge problem seriously even to the most minimal degree.

    The only way to dodge this epistemological fact about reality is to stipulate as dictate of “science” that the knowledge problem does not exist — which is essential to abandon all science for the land of magical thinking.

    And if you take seriously my point about heterogeneous production processes & non-optional epistemic limits on our knowledge, then Bill’s argument does not “stand”. It is shown to not engage the argument.

    Failure to engage an argument is not itself an argument for anything.\

    David writes.

    “Greg, If I understand your point, which is probably a counterfactual assumption, you are implicitly assuming that there is some period of time in which the inflation resulting from monetary expansion is not foreseen. It is that unforeseen component of a monetary expansion that produces some sort of adjustment that must be reversed once the inflation is fully anticipated. Apart from that Bill’s argument stands.”

  8. 8 David Glasner September 3, 2012 at 12:34 pm

    Frank, I agree with you that credit expansion does not necessarily lead to an inflation led boom, I was simply trying to evaluate Hayek’s reasoning given his premises.

    Greg, We are working within a model which is abstracting from some of the complexities of reality. Every economist does, that’s what every theory does. Just because I assume that inflation is correctly anticipated does not mean that I am assuming that knowledge is complete. I (and Bill) are engaging with Hayek on the level that he was engaging with Hicks. Your lecturing about epistemological NECESSITY (excuse me for shouting, I meant necessity) heterogeneous production processes and non-optional epistemic limits on our knowledge could just as easily have been directed towards Hayek’s 1969 paper on the Ricardo Effect as toward me and Bill.

  9. 9 Greg Ransom September 4, 2012 at 2:29 pm

    David, you are willfully ignoring my point — Hayek’s point — about the difference between a math construct and a causal explanation.

    The point you are making has nothing to do with the conversation, beyond pointing out a pathology of “models” that abstract way from the element which could possibly provide the causal explanatory component in economic science.

    What don’t you understand about Hayek’s point?

    It’s a simple one.

    David,

    “Greg, We are working within a model which is abstracting from some of the complexities of reality. Every economist does, that’s what every theory does.”

  10. 10 Greg Ransom September 4, 2012 at 2:31 pm

    Sorry, I’ve confused conversational threads. Disregard the above.

  11. 11 Greg Ransom September 4, 2012 at 2:33 pm

    In the relevant dimension you are making the equivalent of such an assumption, wouldn’t you agree?

    David writes,

    “Just because I assume that inflation is correctly anticipated does not mean that I am assuming that knowledge is complete.”

  12. 12 David Glasner September 4, 2012 at 7:45 pm

    Greg, You wrote:

    “In the relevant dimension you are making the equivalent of such an assumption, wouldn’t you agree?

    “David writes,

    “’Just because I assume that inflation is correctly anticipated does not mean that I am assuming that knowledge is complete.’”

    Um, no. As Hayek explained in 1937, an intertemporal equilibrium exists when the individual expectations of economic agents happen to be correct. That contingent possibility does not logically entail that those economic agents are endowed with perfect foresight. It is a logically conceivable contingency that serves to define a hypothetical state of events that we use to derive certain economically meaningful propositions. Hayek used that construct in discussing Hicks’s position in his 1969 paper on the Ricardo Effect, I was simply asserting that I disagreed with Hayek’s assertion about the logical implications of such a model.

  13. 13 John September 5, 2012 at 3:59 am

    The idea that one is engaging with Hayek on any level (there is no level on which to engage Hayek for there is nothing to engage), or that anything above is meaningful in any way is farce just as it is farce to label the “great moderation” as inflation, no boom, no recession or that Hayek called such.

    The economy has bee broken since the 1970s, incapable of a true “boom.” A substantial factor has been that oil taxes—imbedded in the price of oil—have gone up by a factor of 50. Those dollars have never sought any natural or unnatural rate of interest. They have been used solely to meet the political objectives of oil producers. Most certainly they were never circulated back into our economy as investments in any sense that Hayek thought of investment, which we dismantled and shipped to China.

    Go read Kahneman and come to grip with the fact that you have no idea what you are talking about. The economy is a confidence game played on a chess board of real assets with real people as tokens.

    Go look at pictures of the Great Pyramids or the Roman Forum or the Great Wall. We have no way to know the value of an assets either 15 minutes from now or 5000 years from now, when they turn out to be priceless.

    Hayek did not understand that, in fact, assets have no value, ever, that in a global economy the only long run asset are the skills and knowledge of the people of a country.

    He should have realized that, following WWII, when the US wrote off billions an billions of assets at once (cutting up airplanes and mothballing ships) that his thoughts above were meaningless.

    You have everything backwards. Instead of worrying about “mal-investment,” the entire focus should always be on keeping everyone working, constantly improving the skills and knowledge of the entire populace, while at the same time using taxes and inflation to write off debts as promptly as possible.

    Look at where we are, today. You gone on and on and on about Bernanke, which is foolish. QE3, in whatever form or targeting, isn’t going to do a damn thing because there is no write off of private housing debt. We have millions and millions of people whose balance sheet has to be repaired, which QE3 will not do nor will so-called targeting. If Bernanke wanted to do something he should buy an then forgive all the student debt in the country. Or buy all the mortgage debt and forgive 25%, across the board.

  14. 14 Greg Ransom September 5, 2012 at 1:40 pm

    Hayek is talking about the real world, a real world necessarily structured in particular ways by that fact that plans are future oriented.

    Hayek _never_ assumes that the real world is in an intertemporal equilibrium.

    Hayek says _explicitly_ that the pure logic of a choice built into a GE construct could only apply to the plans of a _single_ human being — see Hayek’s The Pure Theory of Capital.

    Hayek in the passage you quote is assuming the inevitability of a _disequilibrium_ situation, and he is assuming that the boom phase is a temporary meshing of plans that will inevitable lead to a point where that coordination cannot be sustained at anticipated relative prices and profits, leading to a new re-shuffling of efforts at plan coordination as the time structure of the economy necessarily contracts.

    Hayek uses math constructs etc only as a mental aid to picture the structure of the coordination, not to map its actual reality in the real world.

    And Hayek again and again warns that if you don’t use the math constructs for his purposes, you will fail to understand the phenomena, you will mistake pure math constructs for the real world.

    David writes,

    “Um, no. As Hayek explained in 1937, an intertemporal equilibrium exists when the individual expectations of economic agents happen to be correct. That contingent possibility does not logically entail that those economic agents are endowed with perfect foresight. It is a logically conceivable contingency that serves to define a hypothetical state of events that we use to derive certain economically meaningful propositions. Hayek used that construct in discussing Hicks’s position in his 1969 paper on the Ricardo Effect, I was simply asserting that I disagreed with Hayek’s assertion about the logical implications of such a model.”

  15. 15 Greg Ransom September 5, 2012 at 1:45 pm

    David writes,

    “After the real adjustment takes place and the capital goods industry Is downsized, a steady rate of inflation can be maintained, with no further real misallocations. There is inflation, but no boom and recession.”

    David then says,

    “I was simply asserting that I disagreed with Hayek’s assertion about the logical implications of such a model.”

    Hayek’s claims about inflation are not logical implication from a GE model.

    Hayek’s claims are causal implications from structural twisting of the net of relative prices and profits in the real world, a structure which is _never_ exactly in the form of a math or logical structure, but which necessarily has the structure of any forward oriented partial meshing of human plans oriented toward future production and consumption.

    I can’t but ask you to attempt to read what I’ve just written with an open mind — do some work using the principle of charity to think through the ideas I’ve just written.

    These ideas are both implicit and explicit in Hayek.

    If you won’t take to the time comprehend those ideas, you won’t be engaging either Hayek or myself in a conversation that has much to do with Hayek’s work.

  16. 16 Greg Ransom September 5, 2012 at 1:53 pm

    Hayek’s claim is that inflation produces a “hill” in the _causal_ structure of production like pouring honey produces a hill where it is poured onto a flat table — end the pouring and the hill will go away.

    This “hill” produced by inflation is in the real world, it doesn’t exist in a GE math construction.

    But Hayek’s claim is stronger than the honey/hill example. Hayek’s claim is that it take ever increasing inflation to maintain the hill, for a variety of reasons having to do with the need to keep stretching the dis-equilibrium net of relative prices and profits to maintain the hill.

    None of this picture fits into a GE math construct, as Hayek was well aware, and never argued.

    It lies outside of any GE construct, but elements of the structure can be perceived with basic marginalist logic applied to production goods of alternative lengths and alternative outputs.

    The fact that this stretched net of relative prices and profits out of equilibrium does not fit into a GE math construct was at the heart of the problem situation which led to Hayek’s famous 1937 and 1945 papers and his 1941 book as Hayek was well aware.

  17. 17 David Glasner September 5, 2012 at 6:40 pm

    John, You obviously don’t like Hayek. That’s your prerogative. Of course, I could be wrong, but it doesn’t seem to me that your antipathy is based on a close reading of his work.

    Greg, I agree that Hayek never assumes that the real world is in intertemporal equilibrium, but he does believe that an understanding of the properties of an intertemporal equilibrium can help us gain an understanding of the real world.

    You said:

    “Hayek says _explicitly_ that the pure logic of a choice built into a GE construct could only apply to the plans of a _single_ human being — see Hayek’s The Pure Theory of Capital.”

    This is clearly not the case. The whole point of “Economics and Knowledge” is to explain how an intertemporal equilibrium is conceptually possible when individual expectations are the same so that their optimizing plans would be mutually consistent and excecutable if their expectations turn out to be correct.

    Hayek doesn’t assume that disequilibrium is inevitable in any logical sense. Equilibrium is extremely improbable but not logically impossible. The Hayekian boom is a disequilibrium phenomenon, not an instance of intertemporal equilibrium. So you are mixing up two conceptually distinct states of affairs.

    Please give me one example of the warnings about the use of mathematical constructs that you are attributing to him. I think that your paraphrase may not be capturing what I would regard as his essential argument.

    You said:

    “Hayek’s claims about inflation are not logical implication from a GE model.
    “Hayek’s claims are causal implications from structural twisting of the net of relative prices and profits in the real world, a structure which is _never_ exactly in the form of a math or logical structure, but which necessarily has the structure of any forward oriented partial meshing of human plans oriented toward future production and consumption.”

    Hayek starts from an equilibrium and then posits a disturbance that disrupts the equilibrium. The disturbance for some reason (which is not always made clear, but is usually associated with the insufficiency of gold reserves available to a central bank or the banking system under the gold standard rather than an inherent feature of the economic system) is only temporary which implies that system must revert back to the original equilibrium. That’s Hayek’s formal theoretical structure, and that’s the argument with which I am engaging. I may not be doing Hayek or you justice in staying within this theoretical framework, but, much as a admire Hayek and enjoy exchanging ideas with you about him, Hayek is not my primary theoretical or practical interest at the moment, and you’ll just have to accept my limitations. Sorry, but that’s the best I can do.

    In my reading of Hayek’s 1969 paper, the “hill” metaphor was advanced to counter Hicks’s claim, that a fully anticipated inflation would not affect relative prices. Hayek responds to Hicks not by telling Hicks that his proposition cannot be analyzed with the tools that Hicks is working with, but by asserting that the continuous flow of money required to validate the expectations of future inflation would have to cause an ongoing alteration in the structure of relative prices. I disagree with Hayek and agree with Hicks, except perhaps up to a second order effect associated with reduced amount of non-interest-bearing currency demanded at the higher expected rate of inflation. Your interpretation of Hayek doesn’t correspond to the kind of argument that Hayek was making in response to Hicks. And my point was, even if we grant Hayek’s hill metaphor, there is nothing unsustainable about the relative price change associated with the “hill,” so there is no reason why the flow of money and the hill could not be maintained for an indefinitely long period of time with no more likelihood of a business cycle than if Hayek’s constant nominal GDP (neutral money) rule were being implemented.

  18. 18 Greg Ransom September 6, 2012 at 8:59 am

    This certainly is not the point of “Economics and Knowledge”.

    David writes,

    “The whole point of “Economics and Knowledge” is to explain how an intertemporal equilibrium is conceptually possible when individual expectations are the same so that their optimizing plans would be mutually consistent and excecutable if their expectations turn out to be correct.”

  19. 19 Greg Ransom September 6, 2012 at 9:05 am

    Hayek is clear. There is no GE equilibrium. It’s completely fictional.

    Hayek is clear on this in The Pure Theory of Capital and elsewhere.

    The great scientific “problem situation” engaged by Hayek is just what uses the GE construction can have, if any, in science, given the fact that is is a pure logic, and is empty of causal and empirical content.

    The problem situation was brought to a head by overlapping problems in cycle theory, the central planning literature, and Hayek’s work on capital theory.

    David writes,

    “Hayek doesn’t assume that disequilibrium is inevitable in any logical sense. Equilibrium is extremely improbable but not logically impossible.”

  20. 20 Greg Ransom September 6, 2012 at 9:12 am

    Hayek’s work early and late goes into the scarcity & pricing problems that are only revealed across time in the course of the business cycle.

    All of this is ignored in the argument made by yourself & by Hicks.

    Perhaps Hayek failed to bring front and center all of this assume background.

    But is is always at the heart of his argument, and taken for granted in his work.

    I haven’t read the 1969 piece is some time. I’ll see what Hayek left out.

    Hayek is not famous for make clear the explanatory framework he takes from granted, which comes from a completely different background than those he is talking to. Hayek often talked in later years about the significance of this.

    And note well. This is _completely_ typical of cross-paradigm conversations, as explained by Thomas Kuhn.

    What we have are rival explanatory frameworks. These little side engagements often obscure what is really at issue and what the deep contest of scientific explanatory systems is really about.

    David writes,

    “And my point was, even if we grant Hayek’s hill metaphor, there is nothing unsustainable about the relative price change associated with the “hill”.”

  21. 21 John September 6, 2012 at 9:01 pm

    David, I have the great power of a 1978 under of macro, which someone recently described as being on target.

    I have picked up and promptly put Hayek down, for the pattern of his writing is reversed. He has a goal and bends everything toward that goal. Beyond that he offers only meaningless generalizations and self evident propositions.

    I intended to ask a very serious question, one which Hayek never considered and which you avoid.

    At the end of WWII we wrote off several years of GDP production, planes, ships, tanks, trucks, etc., leaving ourselves with public debt to GDP of 150%

    We recovered very nicely and kept pretty much right on running, economically.

    The conclusion that I draw form that is that, if you keep people working any mistakes can be written off, which pretty much pitches all this mal-investment crap out the window.

    Now, where am I wrong—I don’t believe I am. I pretty much stand by my statement—that it is the skills and confidence of people that matter, not savings or investment or assets.

    I can offer a second example, How did the Egyptians build the Great Pyramids without modern finance? Talk about mal-investment.

    In sum, my two cents is that Hayek couldn’t withstand hard cross examination.

    Continue on with your posting if you want, but my two cents is that someday some bright woman or man is going to figure out what has happened the last 10 years, or longer, and the answer will have nothing to do with Hayek.

    Most people realize that when theories run into reality, you need who new ways of thinking, but not so with economists.

  22. 22 David Glasner September 7, 2012 at 9:59 am

    Greg, The entire analysis of the Pure Theory of Capital is an analysis of intertemporal equilibrium, so I have no idea what you are talking about. Provide me one citation from the Pure Theory of Capital in which Hayek says he is not assuming intertemporal equilibrium. Hayek’s cycle theory theory consists in an analysis of departures from and reversion to intertemporal equilibrium.

    I agree with you that Hayek certainly recognized that his method of equilibrium analysis was severely limited, and that he was eager to develop an alternative analytical framework within which to analyze economic phenomena, but I am not aware of any systematic economic analysis (i.e., something more than a mere critique of the work of others e.g., Keynes) that he ever carried out of such a character. If you are aware of one, please provide an example.

    John, You said:

    “I have the great power of a 1978 under of macro, which someone recently described as being on target.”

    Sorry, I am unable to make any sense of this sentence. Are there words missing?

    “At the end of WWII we wrote off several years of GDP production, planes, ships, tanks, trucks, etc., leaving ourselves with public debt to GDP of 150%

    “We recovered very nicely and kept pretty much right on running, economically.

    “The conclusion that I draw form that is that, if you keep people working any mistakes can be written off, which pretty much pitches all this mal-investment crap out the window.”

    I largely agree with that. I am not a great fan of the version of Hayek’s business cycle theory that he gave in the 1930s. I think he modified it subsequently in ways that made it less obviously inconsistent with the counterexample you are providing. I assume that you threw in your second example just as a rhetorical flourish, and I am going to leave it alone. Hayek’s importance as an economic theorist does not depend on the validity of his theory of business cycles. I am also going to leave your little jab at economists alone.

  23. 23 John September 7, 2012 at 8:12 pm

    David,

    First, thank you for your reply.

    3 or 4 months ago their was a nice paper going around about the very solid state of macro economics in 1978, which was my last year on a college campus, formally studying the subject. Google will probably find it for you, if you have an interest.

    As for my rhetorical devices, I find them very useful. The mere existence of the Great Pyramids is a historical lesson of immense proportion. At the time, many would have had to have viewed them as Mal-investment. Now, we know they are priceless.

    The lesson, for me is Biblical. Economists worry too much about tomorrow. We have not idea whether what we do today will be mal-investment or the salvation of us all. We need to get people to work and then worry about what lies before us, not letting the perfect be the enemy of the good.

  24. 24 Greg Ransom September 8, 2012 at 9:33 pm

    Hayek is self-evidently _not_ talking about a Arrow-Debreu IGE math construct when he talks about a “fluid equilibrium” in his 1969 paper, when discussing a steady-state disequilbrium situation made possible by an constantly increasing flow of money/credit into one point of the system.

    He’s talking about a stable disequilibrium make up of the structure of production and consumption in the real world. He’s not taking math-world, he’s talking our world.

    You say,

    “Greg, The entire analysis of the Pure Theory of Capital is an analysis of intertemporal equilibrium, so I have no idea what you are talking about.”

    Hayek specifically talks about an intermediate fieldbetween stationary state economics and the problems of dynamics, which Hayek calls “equilibrium analysis in the wider sense.” This wider domain has elements of IE, but it also has stuff that clearly isn’t purely mathematically tractable IE / GE.

    These aspects Hayek describes using the picture of a river flowing with various currents blending in and out, involving new production techniques and old production goods never replicated, something not captured in a fix, static IE / GE construct.

    There are all sorts of things in PTofC that don’t fit into Arrow-Debreu, and Hayek’s account of the uses of GE constructs and thinking is very clear on the limitation of that thinking, and how it relates to what really matters, the actual causal processes of the real world.

    Hayek is explicit in what the “analysis” of the Pure Theory of Capital is an analysis of:

    “What we need is a theory which helps us to explain the interrelations bewteen the actions of different members of the community during the period _before_ the material structure of productive equipment has been brought to a state which will make an unchanging, self-repeating process possible.”

    This clearly is a dynamic “river like” flow process, not a GE construct.

  25. 25 Greg Ransom September 8, 2012 at 9:44 pm

    “I have long felt that the concept of equilibrium itself and the methods which we employ in pure analysis have a clear meaning only when confined to the analysis of the actions of a single person.” — F. A. Hayek

    Hayek repeats the core of this judgment in various forms repeatedly throughout his career.

  26. 26 Greg Ransom September 8, 2012 at 9:48 pm

    Please re-read The Pure Theory of Capital. The whole book is about that alternative method — as are his 1937, 1945, 1946 and 1968 articles etc on the nature of the problem raising patterns of economics and the nature of contingent causal explanation in economics.

    David writes,

    “I agree with you that Hayek certainly recognized that his method of equilibrium analysis was severely limited, and that he was eager to develop an alternative analytical framework within which to analyze economic phenomena, but I am not aware of any systematic economic analysis that he ever carried out of such a character. If you are aware of one, please provide an example.”

  27. 27 Tas von Gleichen September 9, 2012 at 9:25 am

    All of the sudden a light went on when I saw the word Great Moderation. Kind of weird, but I guess that happens. Great article Thanks!

  28. 28 David Glasner September 9, 2012 at 7:45 pm

    John, If you had been one of the slaves conscripted to build the pyramids, you might feel a bit less positively about them than you seem to at present. But I take your point that it is not always easy to project what the value of a public works project will turn out to be.

    Greg, I did not suggest that Hayek was talking about an Arrow-Debreu e equilibrium. As for the rest of your comment, I don’t accept your distinction between a math world and our world. Any theoretical model involves some abstraction from reality.

    Thanks for your quotation from the Pure Theory of Capital (care to provide a page citation?). Here’s mine:

    “This sort of fictitious state of equilibrium, which (irrespective of whether there is any reason to believe that it will actually come about) can be conceived to comprise any sort of planned change, is indispensable if we want to apply the technique of equilibrium analysis at all to phenomena which are ex definition absent in a stationary state. It is in this sphere alone that we can usefully discuss equilibrium relations extending over time, and in which consequently the pure theory of capital mainly falls, and the latter might almost be said to be identical with the whole of this intermediate field between the theory of the stationary state and economic dynamics proper.” (pp. 18-19)

    If you read your quotation in the light of mine, you will see get a very different understanding of what Hayek was saying from what you might otherwise gather. Hayek is not thinking about a complete market version (Arrow-Debreu) of GE, but he is absolutely working with a GE paradigm.
    Your next quotation from “Economics and Knowledge” (p. 35 in Individualism and Economic Order) is from the introductory section of the paper, simply ignoring the fact that Hayek is working in that paper to expand the concept of equilibrium to take into account a wider range of conduct than the analysis of the action of a single person. See the following statement at the beginning of section 5.

    “For a society, then, we can speak of a state of equililbrium at a point of time – but it means only that the different plans which the individuals composing it have made for action in time are mutually compatible. And equilibrium will continue, once it exists, so long as the external data correspond to the common expectations of all members of the society. The continuance of a state of equilibrium in this sense is then not dependent on the objective data being constant in an absolute sense and is not necessarily confined to a stationary process. Equilibrium analysis becomes in principle applicable to a progressive society and to those intertemporal price relationships which have given us so much trouble in recent times.” (p. 41)

    As my quotation above from the Pure Theory of Capital indicates, I believe that the dominant mode of analysis in the Pure Theory of Capital was intertemporal equilibrium analysis.

    Tas, You’re welcome.

  29. 29 prestopundit@gmail.com September 9, 2012 at 11:17 pm

    Hayek isn’t ambiguous. He cites recognition of the difference between the “givens” of any theoretical construct and the real world causal factor of learning or changes in tacit understanding/judgment of the significance of local conditions and changing relative prices as _the_ outstanding insight of his scientific

    The whole _point_ of Hayek’s 1937 & 1945 papers is that _any_ formal model or theoretical construct build out of “givens” or “given data” assumes what Hayek called “the God’s eye view” and Wittgenstein similarly called “the bird’s eye view” — everything is within a closed system, everything is logically “given” to one mind, the mind of the person working through the steps of the “model” or math construct.

    Hayek’s _whole_ point is that the causal world of price signals and adaptive learners in the market _can’t_ be ‘modeld” in a system of givens.

    In other words, the way in which formal ‘theoretical’ marginalist models “abstract from reality” is that they _abstract away from the essential causal process of the market_, i.e. real world price signals and real world learners whose unique and individual judgment of local conditions and changing relative prices is always undergoing learning, according to no fixed mathematical formula which can be build of fixed and univocal or universal, objective, timeless, shared, God’s eye view “givens”.

    David writes,

    “Any theoretical model involves some abstraction from reality.”

  30. 30 prestopundit@gmail.com September 9, 2012 at 11:18 pm

    Let’s add the word _career_ in there … as _the_ outstanding insight of his scientific career.

  31. 31 Greg Ransom September 9, 2012 at 11:33 pm

    Let me be more pointed.

    Learning is open-ended and goes outside and beyond any fixed set of “givens” in a fixed “theoretical model” or logical construct.

    This is an insight Hayek shares with Kuhn, Popper, Polanyi, Wittgenstein, and others.

    A theoretical/logical/math “model” or construction is alway constructed out of sets of givens, givens to one mind working through the model, stipulated givens.

    Kuhn & Polanyi & Hayek & Popper’s insight in the failure of the Carnap model of science turns on this recognition that learning is not fix and understanding is not limited to a prior set of “givens” in a formal system — perception is theory-laden and understanding is transformed by creative conceptual novelty.

    The rejection of the formalist dogma united Wittgenstein on understanding language, Kuhn on understanding science & Hayek on understanding economics.

    The statement that “Any theoretical model involves some abstraction from reality” is pulled out of the drawer for a singularly unhelpful and science-blocking reason, to rationalize uses of formal constructs to block acknowledgment of the central causal element of economics which cannot be formalized, limned in a mathematically tractable system or put into a ‘theoretical model”, i.e. learning in the context of local conditions and changing relative prices, the imperfect causal signaling role of prices, the valuational structure of constantly adapting production processes across time involving technological innovation, entrepreneurial miscalculation, obsolescence, wearing out, resource surprises, etc.

  32. 32 Greg Ransom September 9, 2012 at 11:39 pm

    This distinction is at the core of Hayek’s 1937 paper, and it’s a point Hayek made as early as his 1929 book _Monetary Theory and the Trade Cycle_.

    This whole distinction if the grounds for Hayek’s repeated remark that formal math/logical economics fails when it comes to bringing out the role and character of price signals, and fails when it comes to learning, the central causal explanatory element in economics.

    David writes,

    “I don’t accept your distinction between a math world and our world.”

  33. 33 John September 10, 2012 at 7:12 am

    David you write:

    “John, If you had been one of the slaves conscripted to build the pyramids, you might feel a bit less positively about them than you seem to at present. But I take your point that it is not always easy to project what the value of a public works project will turn out to be.”

    1. You do not fully take my point that it is not always easy to project what the value of a public works project will turn out to be.

    My point is that the future is so unknowable that we have economics backward. Today, and into the past, economics has been caught up in avoiding bad investments. Instead, we should concentrate our intellectual efforts on how to more quickly and easily write off bad investments, once made.This would permit us to keep everyone working, all the time.

    This is but an extension of the old saw that a bank with no bad loans makes no loans at all.

    2. This is why to pay any attention to Hayek is wrong. He feared inflation, much like wild animals fear fire. The is nothing to fear about inflation, once one understands it is a tool and the uses to which it can be put—to write off bad investments so that we keep everyone working.

    You and many others forget that Monday, July 9, 2007 Prince confirmed by POV:

    The Musical Chairs Theory of Markets (Chuck Prince Edition)

    Ciitgroup CEO Charles Prince, in an exclusive interview with the Financial Times, said something I expect he will come to regret:

    Chuck Prince on Monday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, saying Citigroup was “still dancing”.

    The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

    The mistake the Fed made was in ever letting illiquidity appear.

    Economics is game of confidence, played entirely between people ears. The idea of taking away the punch bowl is a metaphor or analogy that needs to go. Instead we need to keep the bunch bowl open and look for better aspirin and stronger morning after hair of the dog drinks (taxes and inflation)

  34. 34 David Glasner September 12, 2012 at 2:56 pm

    Greg (aka prestopundit), I disagree with your understanding of Hayek’s view of what is entailed by any formal model. What Hayek did was to provide a more parsimonious set of informational assumptions from which to derive the results of those models. The question is not whether the information is given but whom it is given to. Your diatribe about unhelpful science blocking reason is no less applicable to the Pure Theory of Capital than to more explicitly mathematical works on capital theory by other authors. I agree that there are limitations to what economic models can do, and one should be aware of those limitations. That is the message that I take from Hayek, not that economic models are useless.

    John, Did you mean to write “my POV” instead of “by POV?” If so, not everyone would accept Prince as a reputable authority on the subject. Nevertheless, I don’t dismiss what you are saying, and I agree that Hayek’s anti-inflationism was too inflexible, even in his post-Great Depression phase, though I think you may be erring in the opposite direction.

  35. 35 John September 13, 2012 at 8:20 am

    David

    You are correct. My POV.

    Prince is absolutely reliable on what he said. Bankers will dance as long as there is music playing. They have no choice. They cannot foresee the future and it might not stop. Where, then, will they be?

    My essential argument is that present economics always sees the glass half empty. It sees unknowns and risk—inflation, for example—so it argues, don’t act. I see unknowns and risk and say act, accepting that you may be wrong and will have to act quickly to write off your errors.

    You say I may be erring in the opposite direction. I would most certainly agree that at present we don’t have the tools for doing that for which I argue. That is my point. Since Keynes, economists have been working on the wrong problem. Instead of fighting Keynes, economists should have been working to make his insights—of which the great one is the paradox of thrift work—work.

    This is why I have no use for Hayek. There is nothing productive in his approach or concerns. He is the penultimate advocate for keeping the glass half full, because the only way to fill the glass is by government action, which is really Smith’s concept of insurance or risk spreading. This was Smith’s keen insight more than 200 years ago. The way to growth is through risk spreading. Common sense tells us that entrepreneurs do not take risk. They will tell you they do everything possible to eliminate risk.

    Look at the growth created in housing, 2000 – 06, by risk spreading.

    In sum, seriously, give up the past. What sort of an intellectual effort is it to have blog on monetary policy in the spirit of R. G. Hawtrey

    Why don’t you have a blog on how we could avoid crony capitalism by giving equity kickers to tax payers or some such? The Green Bay Packers have been a reasonably successful business model. We all have limitations. I do not have the answers about how to better write off risk, so that we can take more of it, but I sure can see the problem. You should have also. What inference should you have drawn by the World’s unlimited demand for safe assets? Obviously, that your economics was not up to task including the economics of R. G. Hawtrey

  36. 36 Greg Ransom September 14, 2012 at 9:45 pm

    How said they were useless? I didn’t.

    I said you fail to grasp how Hayek used models — and what he asserted they could not do.

    And Hayek certainly did suggest that economists mistake the models for the phenomena, and that economists mistake conceptual requirements of modeling for characteristics of the world which don’t exist in the world — that is a consistent and ongoing theme in Hayek, beginning as early as 1929.

    David writes,

    “That is the message that I take from Hayek, not that economic models are useless..”

  37. 37 Greg Ransom September 14, 2012 at 9:50 pm

    David writes,

    ” What Hayek did was to provide a more parsimonious set of informational assumptions from which to derive the results of those models.”

    No.

    Hayek pointed out all sorts of things which could never be identified as “information” or as the sort of think modeled as “givens” in economic constructs.

    And Hayek assumes even in his earliest work talking about movements from one equilibrium production structure to another equilibrium production structure, that the “transverse” or “adaptation” or “adjustment process” was a causal, learning process that wasn’t something modeled in math.

    I really see no evidence in Hayek’s work, David, for you view on this. It’s utterly disconnected from what Hayek actually wrote, as far as I can understand what you are claiming.

  38. 38 David Glasner September 23, 2012 at 2:00 pm

    John, Thanks for your perspective. You are probably expecting too much of me; I am still struggling to get to where Hawtrey got to. Just because you don’t like where someone winds up does not mean that you cannot gain from following the path that took him there, so I would not be as quick to dismiss Hayek as you are, even if I strongly disagree with some of his policy conclusions.

    Greg, Perhaps you didn’t say they are useless, but when you say that they are purely mathematical constructs with no connection to the real world, you are sharply limiting what they can teach us about the real world. I would probably be among the lower percentiles if you ranked economists by their belief that their models provide accurate descriptions of the real world, but part of being a good economist is understanding how to apply those models to the real world. Physicists also are challenged in applying abstract concepts to explaining real world phenomena. Hayek did not just provide a more parsimonious set of informational assumptions from which to derive results from those models. But that was one of the things that he did do. Hayek was certainly not the only one that understood that there was very little dynamic content in economic theory, and that the theory did not provide any rigorous account for how there could be a transition from one equilibrium to another.

    Samuelson’s explanation of the idea of comparative statics in The Foundations is certainly a classic recognition of that point, and attempts to derive what he called empirically meaningful hypotheses from an empirical assumption, lacking an explicit theory of the transition between equilibrium points, that in the real world there would usually be a systematic process taking the economy from one equilibrium to another when subjected to a “small” parameter change.

    We are each of us focusing on particular aspects of his work that perhaps resonate most strongly in our minds, so each of us is seeing the other miss something that the other thinks important. There was a lot going on inside his brain.

  39. 39 John October 8, 2012 at 6:30 am

    David

    It seems to me that Hayek just entirely fails to understand inflation, which works in two entirely different ways.

    First, and not talked about by Hayek, inflation repairs the balance sheets of debtors, as collateral asset prices rise.This is how QE3 might work.At a micro foundation level, I just got an email from a good size regional bank which has a new refinance program for businesses that own their own building and lot. Hayek had no understanding of this kind of inflation. Current creditors are repaid their loans with dollars that have less value.

    Under no circumstances does inflation matter here, since banks can create money, as long as they can meet any gov’t demand for reserves.

    Second, there is consumption inflation, of the Martin Wolf style. The government drops money from the sky, consumers grab the Ben’s from the air and rush to the local grocery store to buy bread.

    Here, inflation is an information arbitrage play. If the local grocery is smart enough they will raise prices to keep from being de-stocked by consumers freshly armed with cash.If prices are not raised enough, the grocery will be de-stocked. At that point the owner will have a choice. Go out of business or order more. IOW, helicopter drops are an arbitrage on sticky prices. As long as prices are sticky, helicopter drops will continue work.

    In sum, Hayek knew nothing about inflation. His reasoning was backwards. He was against inflation for personal reasons so he developed his arguments to, surprise, be against inflation.

    He was completely wrong.

    The correct answer about inflation is the Soros doctrine. We have so little knowledge and are so stupid that we will have a very hard time knowing what inflation is too much, too little etc. Thus, we ought to abandon inflation targets and instead concentrate on unemployment.

    Regardless how many problems there are with the Phillips curve, it still works. Gov’t should print enough money until everyone is working and then keep it there.

    The problem with Hayek is that he wholly disregards the fact that unemployment causes greater damage over the short and long run than any inflation.


  1. 1 Hayek outside equilibrium « Increasing Marginal Utility Trackback on August 30, 2012 at 10:32 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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