The Keynes-Hayek Debate: Lessons for Contemporary Business Cycle Theorists

John I? Cochran and Fred R. Glahe

When the definitive history of economic analysis of the nineteen thirties comes to be written, a leading character in the drama . . . will be Professor Hayek. Hayeks economic writings . . . are almost unknown to the modern student; it is hardly remembered that there was a time when the new theories of Hayek were the principal rivals of the new theories of Keynes. Which was right, Keynes or Hayek? -Hicks Critical Essays in Monetary Theory

1. Introduction

Mankiw (1989) in a recent critical review of the real business cycle (RBC) literature argues that in the debate concerning the source and propagation of economic fluctuations there are today, as there were in the 1930s, two schools of thought: the classical and the Keynesian. However, in the 1930s Keynes was not the only writer to present a se1 . What is referred to as the Keynes-Hayek debates took place primarily in the early 1930s. The main exchanges were Keynes (1931a. 1931b). Hayek (1931a. 1931b, 1932a, 1932b) and Sraffa (1932a. 1932b). See also the correspondence between Hayek and Keynes in The Collected Writings of John Maynard Keynes, vol. 13, 257-66. The direct exchange ended with Keyness letter of 29 March 1932. I doubt if I shall return to the charge in Economica. I am trying to re-shape and improve my central position, and that is probably a better way to spend ones time than in controversy (CW 13:266). However, traces of the debate linger in the later writings of both the main participants. See Hayek [I9411 1975, chaps. 2527, 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, Department of Economics, University of Colorado at Boulder, Campus Box 256, Boulder CO 80309-0256. History of Political Economy 26:l 0 1994 by Duke University Press. CCC 0018-2702/94/$1.50

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rious challenge to the classical view. Friedrich A. von Hayek, building on the work of Ludwig von Mises (1912), developed a theory of the trade cycle in which monetary changes cause the cycle but successive changes in the real structure of production . . . constitute those fluctuations. Despite Hayeks Nobel Prize, and the renewed interest in his theories due to recent developments in the new classical macroeconomics, the contributions of Hayek and von Mises to monetary theory in the 1930s, while not unknown, continue to be ignored or mi sinterpreted. Modern economists generally are unaware of the major differences between the Hayek-von Mises theory of business cycles and the classical theory (both old and new). Writers in the new classical tradition have even been referred to as neo-Austrian (Laidler 1982; Lucas 1981). Like the classical school, the Hayek-von Mises approach emphasizes optimization of private economic agents, the adjustment of relative prices to equate supply and demand, and the efficiency of unfettered markets. Unlike the classical school, and similar to the Keynesian school, Hayek and von Mises believe that understanding the business cycle requires an understanding of how an economy can suffer a coordination failure on a grand scale.3 The Hayek-von Mises model provides a disequilibrium explanation of a cycle, whereas the new classical writers develop equilibrium models of the business cycle. Hayek, following von Mises, attempted to provide a microeconomic explanation of cycles (fluctuations). The new classical and new Keynesian (Gordon 1990) writers attempt to provide microfoundations for macroeconomic theory. The difference between these theories and the Hayek-von Mises cycle theory is significant. For many years, the original Keynes and the classics debate appeared 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 Keynesian revolution, a theory of a barter, not a monetary, economy. The Keynesian model was not compatible with the microeconomic model
2. Mankiw is not alone in this lapse in recent prestigious survey literature. For example, see Gordon 1990. 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 economic fluctuations 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 a transition from microeconomics to macroeconomics, and that his objections were against macroeconomics as such rather than just Keyness particular form of macrotheorizing.

Cochran and Glahe / Keynes-Hayek Debate 71 used by most economists, while the quantity theory of money and the classical model were compatible with the basic microeconomic framework. This chasm between microeconomic principles and macroeconomic practice (Mankiw 1990) led to attempts to make macroeconomics compatible with microeconomics. The classical framework was revived as the basis for alternative macroeconomic models. Keynesian economic reasoning was again challenged by classical reasoning. Many of the issues debated in the 1930s are once again being debated today. Whether active stabilization policy is a help or a hindrance to the operation of a market economy is again an open question. The nature and cause of observed fluctuations in the macro economy are the subject of serious theoretical inquiry? Keynes and Hayek were major participants in the original debates over these issues. Keynes presented a major challenge to classical reasoning that provided theoretical support for policy activism arguments. Hayek presented an alternative to the classical model that was also a clear antithesis to the Keynesian position, as was clearly recognized by Klein (1947, 52). Hayek argued specifically that (1) the shortrun real effects of a monetary policy expansion are temporary; (2) the real effects will be reversed; and (3) the ultimate result of an expansionary monetary policy will not be higher employment and greater economic stability, but the exact opposite. Many of the issues that were central in the Keynes-Hayek-classics debate were never resolved, particularly those issues relating to capital theory. The apparent simplicity of the Keynesian-type model developed from the Hicks-Hansen-Samuelson interpretation of Keynes seemed to make these controversies less important, or even unimportant for practical matters. Contemporary developments suggest that a reexamination of these issues may add to our knowledge of the operation of a market economy. Judgments about the appropriate use of policy are based on the policymakers understanding of market processes. The less complete our knowledge of the market process, the more likely it becomes that policy will be inappropriate. Current mainstream theorizing, whether in the classical or Keynesian tradition, ig5. Hayeks relevance in the current debates is supported by Machlup. In a largely unheeded comment, Machlup (1977b. 24) observed, Indeed some of the ideas which Hayek shows to be fallacious have gained in strength since the 1930s; a re-reading of Hayeks theses on stabilizing monetary policies might have a beneficial influence on the policy makers of the 1970s.

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nores what Hayek (1941) referred to as the interaction of the capital problem and the monetary problem. This interaction of monetary changes and changes in the structure of production is at the core of the Hayek-von Mises trade cycle theory. If this interaction is important, Hayeks ([ 1933al 1966, 23) pessimistic assessment of deliberate management continues to be relevant: But whatever may be our hope for the future, one thing of which we must be painfully aware at the present time . . . a fact which no writer on these problems should fail to impress upon his readers . . . is how little we really know of the forces which we are trying to influence by deliberate management; so little indeed that it must remain an open question whether we would try if we knew more. The Keynesian, Hayek-von Mises, and classical models present different interpretations of the operations of the market process. Section 2 reconstructs the criticisms of the classical-type models presented by Hayek and Keynes and summarizes the key elements in the original drama. Section 3 argues that many of these criticisms are also valid criticisms of the more modern approaches to macroeconomics (new classical economics including real business cycle theory) that have challenged Keynesian economics. It will be shown that the capital theory issues first raised by Hayek could be beneficially reintroduced into the current macro debate. Section 4 provides concluding comments and offers avenues for further research as suggested by the Hayek-von Mises approach. A reexamination of questions (which are not addressed by either the classical or Keynesian-type models) about the operation of a market economy, raised by Hayek and von Mises, promises to enhance our understanding of economic fluctuations, economic growth, and the process of capital accumulation.

2. The Drama: The Opposing Visions of Hayek and Keynes

Both Hayek and Keynes felt that a monetary economy differed from a barter economy in key ways? These important differences were re6. The difference between a money and a barter economy is an essential ingredient in any analysis of economic fluctuations. . . . Though the formulation of the problem may

Cochran and Glahe / Keynes-Hayek Debate 73 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 predictions of the model of pure theory (Walrasian general equilibrium) could not be directly applied to a real world economy. The further development of monetary (macro) economics required that the whole field of study be redone in order to investigate what changes in the conclusions of pure theory are made necessary by the introduction of indirect exchange (Hayek [ 193lc] 1935, 127).7 Both Hayek and Keynes attempted such an investigation, and both used a Wickselliantype model as the basis of their investigation. But Keyness work led to policy conclusions that were completely opposed to Hayeks policy recommendat ions. A central issue in the Keynes-classics, Hayek-classics, and the Keynes-Hayek debates was the automatic self-adjusting tendencies of a market economy as modeled by the rigid interdependence and selfsufficiency of the closed system of equilibrium (Hayek [1933al 1966, 44). In a market system prices convey information that affects economic behavior. In equilibrium, the information conveyed by prices causes economic agents to act in such a way that the plans of all transactors are mutually consistent In the classical model, prices successfully perform this coordination task. Even when external circumstances are unstable, changes in data lead to changes in prices that move the economy to a new equilibrium. Behavior is coordinated and consistent with the changing environment. The classical system, with perfectly flexible prices and wages, is a self-adjusting system. Hayek ([ 1933al 1966) argued that the self-adjusting tendencies may be temporarily suspended in a monetary economy. A theory of per.78

strike one as Keynesian, in no way can Keynes be credited with this particular insight. If we 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, in short, 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 concept of equilibrium that referred to the consistency of the plans of transactors and to the information 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 adjustments to a series of such data changes or shocks (Rush 1987, 23-24). See Hayek [1931c] 1935, 5 5 , for a critique of this type of approach to the trade cycle.

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fectly coordinated economic activity, that is, equilibrium theory, could not be directly used to explain the actual observed movements of economic activity during the trade cycle. The phenomena of the trade cycle were more likely the result of imperfectly coordinated economic activity. lo The problem presented to economic theory by the business cycle was why, in response to a single change in the data, a cycle occurs. Why does the economy adjust by first moving away from what would be the new equilibrium and then, only later, correct and move toward the equilibrium consistent with the new external circumstances? During events that make up a cycle prices are misdirecting production. In the Hayekian model, just as in Keynesian explanations of fluctuations or cycles, economic activity is not coordinated during a cycle. Hayeks approach is a clear contrast to both modern real business cycle theory and older classical exogenous shock theories of fluctuations. Modern real business cycle theory argues that a general equilibrium 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 cycles are essentially noneconomic explanations, since what are treated as data in an economic model are often classified as such because they delimit what the economist can explain from what he considers outside the task of economics to explain. Hayek further argued that in an economy subject to monetary disturbances, 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 dilemma, is to explain the difference between the course of events described by static theory (which only permits movements towards an equilibrium, and which is deduced by directly contrasting the supply of and demand for goods) and the actual course of events, by the fact that with the introduction of money (or strictly speaking with the introduction of indirect exchange), a new determining factor is introduced. Money being a commodity which, unlike all others, is
10. Gordon (1990) has argued that an essential theme of Keynesian and new Keynesian macroeconomics is the inability of a market economy to coordinate economic activity; fluctuations represent an absence of continuous market clearing.

Cochran and Glahe / Keynes-Hayek Debate 75 incapable of finally satisfying demand, its introduction does away with the rigid interdependence and self-sufficiency of the closed system of equilibrium, and makes possible movements which would be excluded from the latter. (Hayek [1933a] 1966,44-45) In other words, monetary changes are not neutral. Monetary changes alter relative prices in such a way that plans based on these false prices direct the use of resources so that economic activity is not coordinated. Prices could systematically contain wrong information, which would then lead economic activity away from equilibrium. Production is misdirected. Hayek ([ 193Ic] 1935) felt that it is the task of monetary theory to investigate all the repercussions of the influence of money on relative prices and production: Its task is nothing less than to cover a second time the whole field which is treated by pure theory under the assumption of barter, and to investigate what changes in the conclusions of pure theory are made necessary by the introduction of indirect exchange ( 127). Keynes and Hayek presented two challenges to economic model builders: the role of money and the role of time (expectations) in economic dynamics. However, the two are not unrelated; in an equilibrium with perfect foresight there would be no place for money (Hicks 1982, 7). The use of money and the existence of uncertainty go hand in hand. Both writers felt that they had pointed out major flaws in classical reasoning. I If the criticisms of Keynes or Hayek are correct, the faith in, orjustification for, self-adjustingmarkets in a monetary economy cannot be based on the existence of equilibrium in a perfect foresight, perfect competition, economic model (or its modern rational expectations equivalent). The predictions embodied in an equilibrium model of pure theory cannot be directly applied to the real world. The description of the economic process through time will require a different model. The alternative models of Keynes and Hayek used the Wicksellian saving-investment approach as a basic tool of analysis. The explanations 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 to me more to point out barriers to further advance on the path chosen by others (Hayek in ODriscoll 1977, ix). 12. The Wicksell mechanism in the Treatise on Money is obvious. For a justification of this view concerning The Generul Theory see Laidler [I9723 1975 or Leijonhufvud 1968, 321-22.

76 History of Political Economy 26:l (1994) were dramatically opposed. As Hicks (1967b, 204) points out, Wicksell plus Keynes said one thing, Wicksell plus Hayek said quite another. 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 were backward. The mystery to each writer was how the other, working from what appeared to be a similar basic model, could come to the policy conclusions he did. The disagreement about policy was the outward manifestation of a fundamental disagreement about the nature of a market economy, particularly concerning the role and function of capital. This fundamental disagreement is related to Wicksells question about the operation of credit institutions in a monetary economy. In the economy of pure theory, the equilibrium rate of interest, what Wicksell called the natural rate, would depend on the supply and demand for capital. The money rate in a monetary economy depends on the scarcity or excess of money. How are the two related? The answer given depends critically on the underlying capital theory, whether the theory is made explicit or not. Hayeks explanation of an upper turning point of a cycle requires a blend of monetary and capital theory.13 In the Austrian view, monetary disturbances alter relative prices. The relative prices that are usually affected by monetary changes are intertemporal prices, such as interest rates and the rate of profit.14 A monetary injection in the form of an extension of credit to entrepreneurs causes forced savings. As forced savings occur, the boom is followed by crisis and developing unemployment. A monetary injection that enters the market as an additional supply of money credit should lower the market rate of interest relative to the equilibrium rate of interest. j 5 Entrepreneurs would now have increased
13. In Hayeks view, the Austrian cycle was never intended to be anything but an explanation 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 investment. 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 relative prices that are altered by monetary changes. Changes in the money rate of interest alter the pattern of the flow of expenditure on goods and services which then affects the direction of production by altering price margins and relative profitability. 15. The same argument would follow if the increased money did nothing but keep the current rate from increasing as investment demand increased.

Cochran and Glahe / Keynes-Hayek Debate 77 purchasing power with which to increase investment spending. The lower market rate causes projects that were previously viewed by entrepreneurs as unprofitable to now appear to be profitable, and investment should increase. To this point there is nothing unusual about the analysis. However, in the Hayek-von Mises model, the new investment projects should be longer than existing projects. Also, the lower rate changes the relative profitableness of the different factors of 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 at first lowers margins between sales prices and costs; it lowers real rates or what Hayek in his later works ([1939] 1975, [1941] 1975) preferred to call the rate of profit. Methods of production that take more time to complete but are more productive6(more output per unit of input) have a relative advantage over projects that take less time but are also less productive ([ 19411 1975, 388-89). Investment projects become longer, more labor saving, and/or more durable. Two paradoxes appear. Processes or methods of production that were profitable at a higher interest rate (rate of profit) are not profitable (not as profitable as other methods) at the lower rate. In the reverse case, it will be argued that when either the rate of profit increases or the market rate of interest (or both) increases, the processes that were preferred at the lower rate of profit will no longer be profitable. Changing rates of profit (or changing interest rates) change both the quantity and the form of investment. These monetary-caused changes in price margins will be temporary in nature. As the money expenditure flows through the system, the pattern of expenditure based on the tastes of consumers will tend to reassert itself. The monetary injections eventually spread through the system and become money income. Input owners with unchanged real demands for consumption goods and now higher money incomes compete for a reduced supply of consumer goods. The flow of expenditure on consumer goods increases relative to the flow of expenditure on capital goods. The prices of consumer goods increase relative to costs. The increase in the price of consumer goods signals the onset of the crisis. The increased profit margins on consumption goods need not be
16. Here Austrian logic enters. Time preferences are positive; the present is preferred to the future. Longer processes must therefore be more productive even to be considered in the realm of possible choices.

78 History of Political Economy 26: 1 (1994) accompanied by a higher market rate of interest in order to cause a crisis. Hayeks ProJits, Interest, and Investment describes a process where the market rate of interest plays no role in the development of the crisis. The rise in the price of the product (or the fall in real wages) will lead to the use of relatively less machinery and other capital and relatively more of direct labor in the production of any given quantity of output (Hayek [1939] 1975, 10). Investment will be made in shorter processes, less durable goods, and in less labor-saving goods. Demand for inputs in these processes will intensify, but at the same time demands for inputs in longer, more durable, or more laborsaving processes will decline. The net demand for inputs in investment industries will decrease (Hayek [1941] 1975, 387). Layoffs and idle capacity should develop in these industries. This response of entrepreneurs to the changed price margins Hayek calls the Ricardo effect.I7 However, it is more likely that an increase in the rate of interest will play a significant role. Higher interest rates affect entrepreneurial decisions in a manner similar to the Ricardo effect. As the boom progresses, entrepreneurs will need progressively larger increases in the supply of money credit to maintain the new structure of production. This increased demand for credit and the less liquid positions of banks should cause the market rate of interest to increase. Hayeks Prices and Production describes the process where the rate of interest increases. Modern interpreters of the Hayekian crisis theory argue that the second scenario is the more likely. We suggest, further, that investment cycles typically end in a credit crunch, with a comparatively sudden and simultaneous financial crisis for numerous firms (ODriscoll and Rizzo 1985, 210). Time and the nature of capital goods make it impossible to transfer all the resources used in longer processes to shorter processes. Some resources which cannot be transferred will become idle. Some capital is specific, that is, it is not adaptable to other uses.* Resources are
17. See Moss and Vaughn 1986 for a discussion of Hayeks use of the Ricardo effect in his trade cycle theory. See also 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 the downturn. The Ricardo effect was provided to show how the system would act if the rate of interest failed to act at all (Hayek [I9393 1975. 6). 18. Specific capital is not necessarily identical with the concept of fixed capital. A perfectly specific capital good has no alternative uses. Such goods may be also fixed capital

Cochran and Glahe / Keynes-Hayek Debate 79 complementary. The expected future returns can be realized only if these resources can be combined with other resources. The available supply of free capital, capital goods available for new and renewed investment, is scarce. This supply of free capital cannot be quickly augmented because the amount currently available is primarily determined by decisions made in the past. The increased proportional demand for consumption goods creates a situation where nonspecific resources (free capital and most labor) are more urgently needed for provision of goods ready for consumption in the near future. Prices of these goods rise as the larger price margins in the later stages of production allow these industries to bid resources away from earlier stages. This increase in the price of needed labor and complementary resources further erodes the competitive position of firms in earlier stages of production. The demand for the products of such firms is declining, while the cost of needed complementary resources is rising. Complementary resources are available only in insufficient quantities and at higher prices. It may become either economically or physically impossible to complete the longer, more productive processes. The firms in such industries are forced to shut down. Plant and equipment become idle because the needed complementary resources are not available at prices that justify continued production. Some capital becomes redundant because the current supply of other capital goods (and perhaps labor or other original factors of production) is not sufficient to meet the needs for current consumption demands and still allow the completion of some longer processes of production. Labor and other complementary resources are laid off. The amount released is in excess of the rate at which these resources can be absorbed in expanding industries. Unemployment and idle capacity increase beyond what can be regarded as frictional levels. The complementary resources needed to make these workers employable do not currently exist. Only with the passage of time, as the investment errors of the past are corrected and the economy completes its adjustment to the existing
such as an existing plant that is useful in only one process for producing one type of output. However, variable inputs may also be specific 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 appear to be Keynesian. . . . Unemployment spreads because of an income-constrained process. The Keynesian process, however, begins in the middle of the decline (ODriscoll and Rizzo 1985. 210-11).

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real conditions, will the appropriate kinds of complementary goods become available, making these workers again employable. In summary, a crisis develops when changes in the money supply cause the money rate of interest to differ from the equilibrium or natural rate. Money enters the system in such a way that the normal operation of credit institutions generally causes the money rate to be lower than the natural rate. A market interest rate below the natural rate will lead to malinvestment: investment projects that cannot be completed as planned. A normally reliable price, the interest rate, leads entrepreneurs to make plans that are not consistent with consumer preferences. Intertemporal choices will not be coordinated. As the real factors eventually overcome purely monetary factors, the scarcity of real capital, created by the overextension of investment (capital goods industries) due to the artificial lowering of the market rate of interest, eventually affects the operation of the economy by altering the rate of profit that can be earned in diferent lines of production. When entrepreneurs redirect production into patterns more consistent with consumer preferences, the initial effects of the monetary disturbance are reversed. A constant rate of increase in the effective quantity of money would, at first, stimulate the economy. However, the increased activity cannot be sustained. Market adjustments would eventually reverse the initial effects of the monetary expansion. A crisis occurs even if the rate of increase in the money supply is not slowed. The increased activity could be maintained for a longer period only if credit (and the money supply) increased at a progressive rate (Hayek [1969] 1978, 174; [1939] 1975, 147-48), producing an accelerating rate of inflation. Employment created by expansionary monetary policies is highly unstable. Some of the implications of the Hayek-von Mises

20. Detailed discussion of malinvestment can be found in Hayek [1931c] 1935, Cochran 1985, Garrison 1987, and Bellante and Garrison 1988. In-depth discussion of the importance of capital theory in an Austrian explanation of the upward turning point of a cycle induced 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 initial output effects of an expansionary monetary policyhad been part of the Austrian business cycle (Hayek-von Mises) theory long before the development of the natural rate model and the accelerationist hypothesis. See Hayek [1939] 1975, 147 and Cochran 1985, 143-44. However, accelerating inflation will eventually bring on monetary collapse as money ceases to be an adequate accounting basis (Hayek [1969] 1978).

Cochran and Glahe / Keynes-Hayek Debate 81 model concerning the effects of an expansionary policy duplicate the predictions about the ultimate effects of active policy in natural rate models. Active policy can be a cause, not a cure, of recession.22 Hayeks conclusions were highly controversial. In the short run monetary changes are not neutral. Monetary expansions can and will cause investment booms. However, in the long run, readjustments of the economy to entrepreneurial errors caused by the monetary expansion create a crisis. The ultimate effect of a monetary expansion may be increased, not reduced, unemployment. In the long run, monetary expansion as a method of increasing production is not only ineffective, but may be a cause of disequilibrium and the emergence of unemployed resources. The active policy of today creates greater instability in the economy, not greater stability. These conclusions led Hayek (1979a, 4) to reject and oppose from the outset the kind of full employment policy propagated by Lord Keynes and his followers. Hayeks analysis implies that the time to prevent a crisis is during the boom, when the errors occur. Monetary factors temporarily suspend the operation of market forces, causing overexpansion. Extensive malinvestment needs to be curtailed if persistently high unemployment is to be prevented. The way to avoid extensive malinvestment is to avoid overly expansionary monetary policies. Stable, full employment can be maintained only if the structure of production is in line with the intertemporal plans of consumers. A crisis can be prevented by not allowing the boom to proceed too far.23 This is the most important role of policy. The achievement of this goal will depend more on the nature of the monetary institutions than on policy activism. An economic system with an elastic currency will always be subject to some fluctuations due to the nature of the money creation process. The operat ions of a developed bankingfinancia1 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 at full employment, but during a recession leads to a cycle. To our knowledge no natural rate or equilibrium business cycle model has addressed this same issue. 23. Keynesian insights that ignore the structure of production lead to exactly the opposite conclusion. Keynes (1936, 322) was implicitly criticizing Hayek when he argued, The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasiboom. Hayeks ((19391 1975) use of the Ricardo effect was an attempt to explain the futility of using a money and interest rate policy in an attempt to maintain a quasi-boom.

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institutions to determine which type of institutional arrangement is most likely to minimize this tendency for the market rate to be reduced below the natural rate.24The more automatic the system can be made the better. The maintenance of a stable economy requires a fine balance of restraint and action. In ordinary times a more or less automatic system of regulating the quantity of money (Hayek 1979a, 18) is more likely to keep expansion from proceeding too far. Monetary policy and monetary institutions should prevent wide fluctuation in the effective quantity of money. But policymakers and monetary institutions must be flexible enough to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics; for this the monetary authority must be given some discretion (Hayek 1979a, 18). Keyness theory of capital (or lack thereof) led his analysis in a different direction. Keynes (1936, 242-44) felt that the money rate was the determining factor. The real variables would be forced to adjust to the money rate. The money rate equals the natural rate when the demand for and supply of money capital perfectly reflect the demand for and supply of real capital. Keynes came to feel that the natural rate was irrelevant (unknowable) in an economy with developed financial markets. Fundamental uncertainty about the future and a desire for liquidity would continually create situations that would make it impossible for market institutions to coordinate intertemporal economic activity. The demand for capital schedule in the model of pure theory is based on perfect entrepreneurial foresight. In an economy operating in historical time, such foresight does not exist. The demand for capital schedule will depend on entrepreneurial expectations, which may change at any time. The demand for capital schedule used by Keynes may or may not accurately reflect the demand for capital schedule implied by pure theory. The supply of money capital would depend on factors related to the demand and supply of money. The volume of savings will have only an indirect effect on this supply of money capital. New savings may be used to satisfy requirements for liquidity or as a source of money capital. The available money capital is influenced by the publics demand
24. Hayeks work points toward what Buchanan (1989) refers to as a constitutional approach to monetary problems. The search is not for a proper policy but for an appropriate monetary framework. See Hayek [ 19691 1978 and 1984b.

Cochran and Glahe / Keynes-Hayek Debate 83 for liquidity. These demands for liquidity create a general tendency for the rate of interest to exceed the natural rate. The rate of interest in a market economy is not self-adjusting at a level best suited to the social advantage but constantly tends to raise too high (Keynes 1936, 351). In other words, banks and credit institutions can maintain the rate of interest at a level not consistent with the natural rate, and as a rule the rate will tend to be above the natural rate. Even if expectations are essentially correct, a money rate in excess of the natural rate would cause investment to be less than the level needed to maintain a full employment equilibrium. If entrepreneurs underestimate future returns, the level of investment will also be less than the level required for full employment, even if the money rate is equal to the natural rate. In either case there will be underinvestment, and it is underinvestment, not overinvestment (malinvestment), that causes involuntary unemployment in Keyness model. Disturbances will be amplified, not corrected, because consumption and investment will change in the same direction. Keynes felt that monetary influences will persist. Hayek felt that they cannot; real forces will eventually dominate the purely monetary influences. If Keynes is right, the effects of a Keynesian policy change are permanent; policy may be needed and will be effective. If Hayek is right, the effects of policy are not permanent; policy will not only be ineffective in the long run but also cause future instability. Keyness position became the accepted norm. Economists who accepted Hayeks view virtually disappeared. Despite Hayeks bglief that the Keynesian position would be temporary, that it would suhside and be replaced by other forms of analysis based on a stream of secured knowledge which may be temporarily submerged but certainly not stopped by the present flood of dilettante literature (Hayek [19391 1975, 182), the Keynesian policy position continued to dominate macroeconomic thought for most of the postwar period.

3. Classical Resurgence
Milton Friedmans Quantity Theory of Money: A Restatement (1956) began the revival of classical-type models and policies, characterized by Johnson (197 1) as the monetarist counterrevolution. The neoclassical synthesis developed by Don Pat inkin aided the recovery of economic models similar to the classical-type of analysis. Patinkin

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(1965, xxv) argued that if real balance effects were incorporated into Keynesian-type models, it was Keyness model that was the special case, not the classical model. An economic system with perfectly flexible wages and prices should have a full employment equilibrium. If unemployment persists, money wages must be too high. The critical assumption in Keyness theory, it is concluded, is that wages are rigid downwards. The theoretical conclusions of the classical model were ~ a l i d a t e dThis classical revival has culminated in the new classical .~~ economics (the natural unemployment rate hypothesis, rational expectations, and most recently real business cycle models) and supply-side economics.26 The natural unemployment rate hypothesis and its later developments in rational expectations forms purported to show that any fully anticipated monetary policy would be ineffective. Gordon (1976, 192) argues the natural rate theory was novel, not by associating money with inflation, but rather in its claim that changes in the rate of monetary growth would not cause the rate of unemployment to permanently diverge from its natural rate without a continuously accelerating inflation or deflation. The central feature of the discussion is not the Wicksell mechanism, but the Phillips curve and the natural rate of unemployment h y p o t h e ~ i s . ~ ~ The supposedly unique or new aspect of the natural unemployment rate hypothesis is its prediction about policy.28The theory implies that the effects of a nonaccelerating monetary disturbance will be self25. Two notes: (a) Keynes argues that unemployment caused by rigid wages is consistent with classical reasoning (1936, 16, 257). In a Patinkin-type model the Keynesian explanation

of unemployment reduces to the classical explanation. Keynes accepted the diagnosis that unemployment implied a real wage in excess of the equilibrium real wage, but rejected the idea that cuts in money wages would unambiguously reduce real wages and hence increase employment. Unemployment could persist even if money wages were flexible (chap. 2). ( b ) This is Leijonhufvuds interpretation of Keynesian economics, incorporated into the neoclassical synthesis, not his interpretation of the economics of Keynes. 26. For a discussion of differences in these modern classical approaches see Hoover
1984.

27. Leijonhufvud has argued that neoclassical Keynesians have forgotten their roots in the savings-investmentmechanism. They have no effective counter to Friedman-type monetarism. Someone whose beliefs consist of neoclassical growth, variable velocity Monetarism, and unemployment caused by lags in wage adjustment should not fight Milton Friedman but join him. The savings-investmentmechanism provides a basis for debate. Unless the real rate 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.

Cochran and Glahe / Keynes-Hayek Debate 85 reversing. An expansion of the money supply at a constant rate will cause the economy to first expand and then, without any further exogenous changes, contract; vice versa for a monetary contraction. The natural rate theory, like the Hayekian theory, explains a cycle in terms of a response to a single shock. In the long run, the policy is ineffective; real phenomena ultimately dominate purely monetary influences. The natural rate model and the rational expectations hypothesis have led to the development of the new classical theories of macroeconomics. These theories are built on a microeconomic foundation, where the decisions of economic agents are based on real, not monetary, variables, and where economic agents are successful maximizers holding rational expectations (Hoover 1988, 13-14). However, the macroadjustment processes developed in these models are still in the form of causal relationships between broad aggregates. Furthermore, as in Keynesian models, questions concerning the capital problem and the time structure of production are essentially ignored. The explanation of the observed correlation between changes in money and changes in provided by these new classical models either involves reverse causation and endogenous money3 or could easily have been written years ago (contrast Gordon 1976, 202, with Warburton [19461 1951, 299). While lack of microfoundations is a valid criticism of early post-Keynes macro models, the differences between old and new classical models on this point may be more cosmetic than real. The major difference in the approaches (old and new classical) has been described as follows: Money is a veil, or, to put it more technically, all real equations are homogeneous of degree zero in prices so only relative prices matter, and they and only they are what can be determined by the real equations of general equilibrium. (By the way the real question is not so
29. 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 ([193lc] 1935, I ) and Warburton ([I9461 1951, 297) regarded as an accepted fact; namely, that monetary 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 reconcile equilibrium 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 that the role of money in RBC models is little understood and remains an open issue. See also Lucas 1987, 70 and chap. 7.

86 History of Political Economy 26: 1 (1994)

much whether that argument is true as whether it is relevant in calendar time. It is important to realize this. Failure to realize it has triggered innumerable wasted words.) Twenty-five years later, it is argued that the rate of change in money prices is a veil. Therefore only unexpected inflation can be geared to real things. You might say that the rate of change of a veil is a veil. (Solow [1976] 1978, 147) The search for microfoundations for macroeconomics has resulted in a return to the type of macro-model building against which Keynes and Hayek were reacting in the 1930s, albeit in a more sophisticated form. These more sophisticated, mathematical models have three distinct forms: 1. A natural rate monetary disequilibrium form as developed by Friedman, in which the disturbance and the maladjustment are both nominal (Leijonhufvud 1983). Monetary disturbances coupled with rigidities in the system create maladjustments between the absolute price level and the level of money wages. Disequilibrium continues until prices and wages both fully adjust to the monetary change. While a monetary expansion (unanticipated) at a constant rate can lead to an initial expansion and a consequent contraction, a recession is usually explained by an adjustment of the economy to a reduction (either unanticipated or anticipated but not credible, i.e., not believable) in the rate of growth in the money supply. 2. An equilibrium business cycle form in which unanticipated monetary changes alter anticipated real rates of return. The shock is nominal but the maladjustment is real (Leijonhufvud 1983). Microfoundations are provided in terms of a model where economic agents maximize subject to budget and information constraints. Cycles are explained as equilibrium responses to unanticipated changes in monetary variables. 3. A real business cycle form where shocks are real and no maladjustments occur. Fluctuations occur as the economy responds to continuous shocks. The cycle, as in (2), represents equilibrium adjust-

3 I . Turning points in a cycle can be explained in both forms I and 2 in terms of the adjustment of the economy to a single exogenous change (an unanticipated monetary disturbance). In this way both forms attempt, as Hayek did in his model, to provide an economic explanation of a cycle, a cycle caused by a single shock, not by a series of shocks. Neither Hayek-von Mises nor forms I and 2 preclude fluctuations caused by continuous changes in the data as in form 3.

Cochran and Glahe / Keynes-Hayek Debate 87 ments. Correlation between money and real activity is usually explained by reverse causation. Money is endogenous and has no causal influence on real activity in either the short run or the long run. Many of Hayeks criticisms of the old classical approach also apply to the new classical approach. In both the new classical and the older classical models, the price effects of the policy change influence all lines of production; the effect analyzed is upon the volume of production in The effects of monetary changes on the distribution of the money spending stream and the structure of production are ignored. Hayek believed that the manner in which money enters o r , leaves the spending flow is important to the adjustment path of the economy. If monetary changes are analyzed as if they were helicopter drops, the analysis can present a misleading picture of the shortrun adjustment process. The critical issue that separates Keynes and Hayek and the new and old classical schools relates to the importance of the transmission mechanism. Keynes and Hayek (and others in the Wicksell tradition) argue that the mechanism is extremely important. Writers in the classical tradition tend to downplay the importance of the transmission process and the role of monetary institutions. New Keynesians seem to have forgotten this important underpinning of Keyness analysis.
4. Conclusions

While both the Hayek-von Mises model and the Keynesian model explain the emergence of unemployed resources, the Hayekian model implies policy ineffectiveness, as do the new classical models.33 Specifically, the Hayekian model implies the following: (1) monetary changes are self-reversing. A mynetary expansion at a constant rate will cause first an expansion, then a contraction of the economy;34(2) monetary policy is ineffective in the long run; and (3) the increased employment initially caused by a monetary expansion can only
32. Hayek ([1931c] 1935, 6). See Cochran 1985, chap. 2, for a detailed discussion of Hayeks criticism of the quantity theory as a tool of economic analysis. 33. Coase (1982. 1 I ) implies that these policy conclusions provided adequate grounds for many economists to originally reject Hayeks model. 34. Like the newer models the downturn will occur even if the money supply continues to increase at a constant rate. But an actual slowdown in the rate of increase will accelerate the crisis. See ODriscoll and Rizzo 1985.

88 History of Political Economy 26: 1 (1994)

be maintained if the money supply continues to increase at a progressive rate.35 In contrast to the new classical view, Hayeks predictions depend on the monetary change affecting different sectors unequally, and the path of the economy following a monetary disturbance is a disequilibrium, not an equilibrium, path. According to Hayek, the distribution of the money expenditure flow is altered from the equilibrium distribution determined by the underlying real factors by the monetary disturbance, whether the disturbance is the result of a deliberate policy change (exogenous money) or whether the monetary change is a passive response of the banking system to some real shock (endogenous money).36This initial alteration of the spending pattern in the economy will affect relative prices and should redirect the employment of resources into directions consistent with the new unsustainable pattern of spending. However, the relative price changes brought about by the monetary factors are not equilibrium relative prices; the prices are not consistent with the underlying real factors. As economic agents discover that plans are not coordinated, real forces will reassert themselves. The real effects of the monetary disturbance are reversed as entrepreneurial errors caused by the false prices are discovered and reversed. The actual dynamic adjustment of the system depends on how and where the new money enters the system.37 Hayek felt that monetary changes are most likely to initially disrupt the distribution of resources between provision for the more distant future (activities that create resources, not final consumption goods) and provision for the immediate future; the monetary disturbance causes

35. In the natural rate and new classical models points I and 3 apply only to unanticipated monetary changes. Only point 2 would apply to fully anticipated policy changes. In the Hayek-von Mises model the real responses (points 1 and 3) to a monetary change depend on the initial distribution effects of the monetary change (how and where the new money enters the system). The explanation of the emergence of unemployed resources at the upper 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 relative price changes and downplay the capital theory aspects of the Hayek-von Mises model leave the theory open to criticisms similar to Haberler (1938, 67). Why doesnt the original change in relative prices cause disruption of production and unemployment or why, if resources flow smoothly into the expanding industries as relative prices change, do not the resources flow smoothly back to the original industries when the relative price change reverses itself.

Cochran and Glahe / Keynes-Hayek Debate 89 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 develop because of problems coordinating economic activity through time. Capital markets of a monetary economy operate differently than do the capital markets of pure theory. The interest rate cannot be relied upon to effectively coordinate decisions regarding the creation of

capita^.^'
Leijonhufvud ( 1981, 131-202) has argued that the correct Keynesian response to the challenge of the new classical approach is the reintroduction of the savings-investment mechanism to the policy effectiveness debate. The formulation of the Keynesian model in terms of the neoclassical synthesis forced Keynesians to formulate policy arguments from empirically observed rigidities instead of from strong theoretical arguments. One such defense, the stable Phillips curve, has proved indefensible (Mankiw 1990).39 Coordinated economic activity requires that not only unemployment be at its natural rate, but also the rate of interest be at its natural rate (Leijonhufvud 198 1 135). The economy cannot be in equilibrium if the capital market is not in equilibrium. Keynesians need to return to their forgotten roots. The reintroduction of the Wicksell mechanism into the policy effectiveness debate brings the debate essentially back to its place in the 1930s. The work of the third participant in the original debates, Hayek, should be seriously reexamined, and attempts should be made by both modern Austrians and mainstream theorists to address the difficult theoretical issues first examined by von Mises but introduced 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 conclusions 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, are related to the markets ability to create resources. that is, increase future production capabilities. Capital is valuable because capital is scarce. In Hayeks model the instabilities occur because the market economy tends to extend the resource-creating branches in excess of current capabilities. In Keyness, the instabilities develop because the market system tends to retard resource-creating capabilities of the economy below current capabilities (see Minsky 1985 for this interpretation of Keynes). 39. However, the Phillips curve defense of Keynesian policy did precipitate the new policy effectiveness debate.

90 History of Political Economy 2 6 1 (1994)

Hayek does not rely on quits to explain increased unemployment; instead, his argument shows why excess capacity and layoffs may become prevalent. In addition, his analysis does not rule out Keynesiantype contractions following the initial crisis. Open-minded debate concerning issues presented in the KeynesHayek paradigm clash could further understanding if only by making us more aware of how little we really know about certain key aspects determining the course of economic events. Crucial questions about the role of money and time cannot be effectively addressed in simple quantity equation-type models or in general equilibrium growth models with a single homogeneous capital good. The crucial roles of money and time cannot be effectively addressed in models without also addressing issues in capital theory and the time structure of production. Discussion about policies affecting full employment and economic stability will be inadequate if related problems in capital theory are at the same time ignored. The allocational efficiency and stability efficiency properties of a market economy depend on decisions to use current resources to produce additional resources (Minsky 1985). This critical issue is at the heart of both Keyness and Hayeks analyses. A redirection of the policy effectiveness debate along these lines could greatly enhance our understanding of a monetary production economy. It is only through a greater understanding of the forces actually shaping events in a monetary production economy that we can make rational decisions about policy and monetary institutions. As Lucas (198 1, 235) has argued, an understanding of what a business cycle is and how it occurs is a prerequisite to determining how to deal with the business cycle. While real business cycle research adds to our understanding of the stochastic nature of fluctuations, and new Keynesian (Gordon 1990) research into the microeconomics of sticky prices promises to add to our knowledge concerning the role of market imperfections in aggregate fluctuations, these studies should not preclude, and may be complementary to, studies examining the money and capital problem. Given the current malinvestment associated with the S and L banking crisis, it may be time to attempt to answer Hickss rhetorical question, or at least to reexamine critical unanswered theoretical questions concerning the roles of capital, interest, and money in the economy that were first raised during the KeynesHayek-classics debate.

Cochran and Glahe / Keynes-Hayek Debate 91

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