Uneasy Money

Commenting on my post earlier this week in which I called Hayek a neoclassical economist, Paul Krugman provided this informal description of what it means to be a neoclassical economist. I wouldn’t say that his description is exactly right, but in the spirit of neoclassicism that Krugman himself deploys in his description, I would say that, for my purposes, Krugman’s description is good enough. Here’s what Krugman said:

So, what is neoclassical economics? There’s a historical definition, having to do with the “marginal revolution” of the late 19th century and all that, but what I think we mean in practice is economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players. If nobody has market power, this comes down to the textbook picture of perfectly competitive markets with all the marginal whatevers equal.

Some economists really really believe that life is like this — and they have a significant impact on our discourse. But the rest of us are well aware that this is nothing but a metaphor; nonetheless, most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point or baseline, which is then modified — but not too much — in the direction of realism.

That description struck a nerve, because in writing my previous post, I had looked up a couple of passages where I recalled that Hayek had deployed very neoclassical kinds of arguments. One passage was in the perhaps the last article that Hayek ever published in a top-rank economics journal, a 1969 paper entitled “Three Elucidations of the Ricardo Effect,” published in the Journal of Political Economy. In the introduction to the paper, Hayek explains:

[A]s the general thesis of what I have called the “Ricardo Effect” may not now be familiar to all readers, I shall first restate it in a manner which, though not wholly unobjectionable, I have often found to more readily intelligible than the more precise statement I have given on earlier occasions.

Hayek then continues in the next paragraph with following description of the structure of his model:

The theorem called the Ricardo Effect asserts that in conditions of full employment an increase in the demand for consumer goods will produce a decrease of investment, and vice versa. The manner in which this result is produced can be conveniently represented in a diagram corresponding to the familiar representations of the production function. In this diagram, however, the total stock (fixed and circulating) of capital is measured, on the abscissa; and the total stream [aka flow] of input, including all that is required to maintain the stock of capital at the level most profitable in the circumstances, is measured on the ordinate. We shall assume for the present purposes that this production function is linear and homogeneous. Since the magnitudes represented along the two co-ordinates both consist of variable combinations of heterogeneous goods and services, these can of course be represented in value terms. This would be strictly legitimate only if we could assume that the prices of the various goods and services involved remain constant. In fact, however, the changes which we will consider necessarily involve some changes in the relation between these prices. Hence the slightly unsatisfactory nature of the technique, to which I have referred before, derives. It seems to me, however, that this defect does not seriously detract from the validity of the conclusions which can be derived in a comparatively simple manner by these methods. Readers who wish to see a more exact demonstration will have to refer to my 1942 article. But for the present purposes, I trust that this simplified exposition will suffice. I have long found it effective in teaching, but because of this defect, have refrained from putting it into print.

Sounds an awful lot like Krugman’s description of neoclassicism to me. (If you want to see Hayek’s diagram, you need to follow the JSTOR link to the JPE article, or get a hold of Hayek’s New Studies in Philosophy, Politics, Economics, and the History of Ideas (p. 167)

For another example of Hayek’s neoclassicism see volume 2 of Law Legislation and Liberty, pp. 117-19. It would be tedious to reproduce the whole passage here. But it is worth reading just to see how Hayek deployed standard neoclassical production theory in an elegant and compact exposition of the theory of general equilibrium and Pareto-optimality.