Friday, July 18, 2014

John Hicks on Hayek’s Business Cycle Theory

John Hicks (1967) is a short essay on Hayek’s Austrian business cycle theory (ABCT). The paper is quite interesting because it gives the verdict of a neoclassical synthesis Keynesian on the Austrian business cycle theory.

One must note carefully that this is an exercise in abstract neoclassical and Austrian economics theorising, not empirical economics: for the Wicksellian natural rate of interest cannot even be defined outside of a world with one commodity (see Rogers 1989: 32 with n. 6; 43) – so from the beginning Hicks missed one of the fatal flaws in Hayek’s theory because of his neoclassical background.

Hicks remembered that Hayek’s theory got considerable traction in the 1930s and was even, at one point, a rival to Keynes’ (Hicks 1967: 203).

Keynes had published his Treatise on Money in 1930, and Hayek gave his famous lectures at the London School of Economics (LSE) from February 1931, and the first edition of Prices and Production was published in September 1931 – at a time when the world was hit by the Great Depression and there was growing interest in theories of the business cycle (Hicks 1967: 204).

Both Keynes and Hayek were intellectual heirs of Wicksell: but each had come to different conclusions on economic issues and policy prescriptions (Hicks 1967: 204).

Hicks thinks that Hayek in his Wicksellian model made the assumption that prices (including wages) were “perfectly flexible” (Hicks 1967: 206), but this assumption made his whole theory incoherent, because if prices were flexible and even if the bank rate fell below the Wicksellian natural rate, then price adjustments to clear markets would bring the whole system back into equilibrium quickly.

As Hicks said:
“Thus there is no room for a prolonged discrepancy between market rate and natural rate if there is instantaneous adjustment of prices. Money prices will simply rise uniformly; and that is that.” (Hicks 1967: 207).
Hicks considers what would happen in Hayek’s theory, as follows:
(1) a credit expansion and reduction of the market rate of interest below the Wicksellian natural rate;

(2) real investment rises, which causes a rise in producers’ goods prices;

(3) money wages rise;

(4) consumption rises and consumer goods’ prices rise, but the rise in prices will (according to Hicks) dampen the excessive real investment, so that there is a “nil effect” (Hicks 1967: 207–208).
But Hayek’s theory, again according to Hicks, does not allow step (4): despite wage rises, demand for consumption goods fails to rise and consumer goods’ prices do not rise (Hicks 1967: 208). There must therefore be a lag in consumption after money wages rise.

Whether Hicks really understood Hayek’s ABCT and the intricacies of Austrian capital theory is open to debate, and Hayek responded to Hicks in the article “Three Elucidations of the Ricardo Effect” (1969).

In this, Hayek replied to Hicks that disequilibrium in relevant product markets continues because of the continuous “inflow of new money” into the system “at a given point and at a constant percentage rate” (Hayek 1969: 279). Though this concedes Hicks’ point that a “single non-recurrent” injection of new money would only have transient economic effects, Hayek maintained that his theory involves long-term and continuous injections of new money (Hayek 1969: 279–280). Moreover, Hayek’s theory does assume Cantillon effects and certain lags in price adjustment.

But there is an interesting issue here: the price and wage rigidities and the ABCT.

Under the simplistic model of Austrian and neoclassical theory, if prices and wages really were perfectly flexible (and all sorts of other problems with expectations, uncertainty and fixed nominal debt were assumed away), then the rise in consumer goods’ prices would cause less demand for such goods, and demand would fall and savings would increase, making a space for the higher order capital investments originally induced by the lowering of the bank rate of interest below the Wicksellian natural rate.

Likewise, the rise in factor prices would dampen demand for them, returning equilibrium to those markets. That is, I suppose, what Hicks was thinking of here: that wage and price flexibility and the law of demand would cause the Wicksellian natural rate to adjust and actually fall to the bank rate.

Vasséi (2010: 213) seems to make a similar neoclassical criticism of Mises’ business cycle theory.

Unfortunately, all this is like arguing about how many angels can fit on the head of a pin: ultimately, it is of very little interest to an empirical economics concerned with the real world, rather than unrealistic abstract models.

BIBLIOGRAPHY
Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Hayek, F. A. von. 1969. “Three Elucidations of the Ricardo Effect,” Journal of Political Economy 77.2: 274–285.

Hicks, J. R. 1967. “The Hayek Story,” in J. R. Hicks, Critical Essays in Monetary Theory, Clarendon Press, Oxford. 203–215.

O’Driscoll, Gerald R. Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek. Sheed Andrews and McMeel, Kansas City.
http://www.econlib.org/library/NPDBooks/ODriscoll/odrCP.html

Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

Vasséi, Arash Molavi. 2010. “Ludwig von Mises’s Business Cycle Theory: Static Tools for Dynamic Analysis,” in Harald Hagemann, Tamotsu Nishizawa, Yukihiro Ikeda (eds.). Austrian Economics in Transition: From Carl Menger to Friedrich Hayek. Palgrave Macmillan, Basingstoke. 196–217.

11 comments:

  1. Great post. I'm curious what an Austrian response to this would be. It seems to be quite damaging to their story.

    ReplyDelete
    Replies
    1. "I'm curious what an Austrian response to this would be"

      Denial.

      Delete
  2. LK,

    You say "Under the simplistic model of Austrian and neoclassical theory, if prices and wages really were perfectly flexible ..."


    Are you claiming here that Austrians think that prices are perfectly flexible ? If so, can you provide a quote from a leading Austrian that backs up your claim?

    Its pretty obvious that ABCT is based on assumptions of a certain degree of price stickiness (and monetary disequilibrium) - the theory doesn't work without it.

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  3. "Are you claiming here that Austrians think that prices are perfectly flexible ?"

    No, I am not claiming they think prices in the real world are perfectly flexible.

    I am speaking of what they think would happen IF prices and wages were perfectly flexible: that is, rapid market clearing.

    ReplyDelete
    Replies
    1. So one can rewrite your statement "Under the simplistic model of Austrian and neoclassical theory, if prices and wages really were perfectly flexible ..."

      as

      "Under the simplistic Austrian model that doesn't assume prices and wages are perfectly flexible if prices and wages really were perfectly flexible ...."

      There is a name for this kind of technique: Its called "just making stuff up"

      Delete
    2. No, it isn't. The meaning of the original statement should be quite clear -- to people who actually have some knowledge of Austrian theory and my own writings here.

      The notion that I meant to say or imply that Austrians really think that all real world prices are perfectly flexible is a stupid misunderstanding.

      Delete
    3. LK .Noah Smith and Bob Murphy seem to be engaged in an argument:
      http://noahpinionblog.blogspot.se/2014/07/austrianism-wrong-inconceivable.html

      Delete
    4. Jan,

      Yes, I have read that debate, but it is rather weak and Noah Smith doesn't seem to have a good grasp on Austrian theory.

      Someone should direct him to my critiques!

      Delete
    5. Yes i thought just the same,Noah Smith doesn´t seem to know much about Austrian theory,and you definitly know more about them than any of us.Actually i was just to write a comment that directed him to your your blog,but i saw someone allready done that. But i don´t think it´s likely Bob Murphy engage in a debate with you again.It didn´t work out so well for him last time,i will remember :) !!

      Delete
  4. Why does ABCT require prices to be perfectly flexible?

    ReplyDelete
    Replies
    1. It doesn't, but the *tendency* to equilibrium underlying the theory does require some degree of price flexibility, though Austrians think there are lags, Cantillon effects and some price rigidities here and there.

      But your comment suggests you don't really understand the issues or the points above.

      Delete