Helping a Great Economist: Friedrich von Hayek

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Hayek (1899-1992) is best known today for his vigorous defense of classical liberalism. However, he saw himself as primarily an economist, carrying on the neoclassical macro tradition. His careful analysis with in that framework of the role played by changing prices in the rational coordination of agent plans is recognized as an important contribution to stabilization theory. I believe that he constructed, remarkably early in his career, the best business-cycle model produced by the famous Austrian School. He shared the 1974 Economics Nobel Prize for his “pioneering work in the theory of money and economic fluctuations and… penetrating analysis of the inter-dependence of economic, social and institutional phenomena”.

Original Great Idea      

In his The Clash of Economic Ideas (2012), Lawrence White captures the essence of Austrian School business cycles:  “The Mises-Hayek theory was first and foremost a theory of the ‘upper turning point’; it aimed to explain why the cheap-credit boom must give way to bust…. The recession is a corrective period in which the needed readjustments take place. The firms that made nonviable investments must wind them down, perhaps go bankrupt, laying off workers and idling machines, leading to above-normal unemployment and unused capacity until those workers and machines are reabsorbed into more sustainable employment elsewhere. The more rapidly the economy adjusts wages and prices and reallocates resources, the shorter the recession will be.” (pp.76-77)

Hayek’s model can be understood as an early detailed version of the market-centric general-equilibrium model of business cycles (enriched by rational market frictions) that dominates New Keynesian thinking today Throughout its existence, neoclassical macro theory has never microfounded meaningful wage rigidity (MWR) and, therefore, could never explain involuntary job loss and other critical characteristics of recessions in modern highly-specialized economies

GEM Helping Hand

Hayek published his business-cycle theory in 1931. Criticism of his market-equilibrium model was increasingly vigorous as the Great Depression persisted. The cyclical lengthening and shortening of the structure of production, an unlikely cause of garden-variety recessions, cannot possibly account for the size and nature of employment-production variations in the dramatic 1930s collapse. However, a lesser ambition of the Austrian School, i.e., describing the role of unfulfilled expectations with respect to investment projects toward the end of credit expansions, is much more plausible and helps elucidate some recurring characteristics of periodic macro instability. That the evidence indicates that confidence-rooted modeling of investment expectations powerfully motivates acute instability provides common ground for Keynesian and Austrian macrodynamics.

Hayek eventually later apologized for his Depression-era stabilization advice (1975), especially his opposition to monetary expansion to counter deflation, which he attributed to his naïveté about the nature of labor pricing in increasingly specialized economies: “At that time [early 1930s] I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed.”

The most useful helping hand for Hayek is provided the GEM Project’s microfounded meaningful wage rigidity (MWR). Given rationally suppressed labor-price recontracting in information-challenged workplaces, sufficiently adverse nominal-demand disturbances induce forced layoffs and same-direction changes in employment and output. Combined with the necessarily long lag from the onset of chronically high unemployment to wage givebacks, Hayek would have had a much more powerful take on the Great Depression.

Is the Game Worth the Candle?

Yes, if for no other reason than to facilitate the use of Hayek’s model to help describe cyclical activity of firms that can effectively monitor employee on-the-job behavior. Cumulative score of the Helping-Hand game: Worth it: 11 (Lewis, Solow, Harris-Todaro, Bernanke, Lucas, Samuelson, Kerr et al, Okun, Hicks, Sraffa, Hayek). Not worth it: 0.

Blog Type: New Keynesians Saint Joseph, Michigan

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