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Saturday, April 1, 2000

The Hayek-Keynes Debate: Lessons for Current Business Cycle Research by John P. Cochran and Fred R. Glahe

A Worthwhile Text for Educated Readers

Edwin Mellen Press • 1999 • 200 pages • $89.95

Unlike some, this book’s title accurately reveals the theme and goal of the text. The authors have set for themselves an admirable task. In a book of only about 200 pages they review the debates that occurred during the 1930s between F. A. Hayek and John Maynard Keynes over the cause of business cycles, explain in detail both to what extent and why these two famous economists disagreed, and then argue that most of the recent work on cycle theory is deficient precisely because it ignores the insights offered by Hayek many years ago. In short, this is not a book designed for the lay reader. It does not inundate the reader with econometrics or differential equations, but it does presuppose a knowledge of economics.

Cochran and Glahe set the stage by noting that today’s conventional macroeconomics is flawed by a troubling group of propositions. Macroeconomics asserts that investment and consumption are positively related in the short run and inversely related in the long run, and yet the long run “emerges as a seamless sequence of short runs.” This paradox is the legacy of the Keynesian detour taken in the 1930s. Both Keynes and Hayek rejected the classical emphasis on the long run. Indeed, both reasoned within the same broad frame work, namely the savings-investment approach used by Swedish economist Knut Wicksell. The Wicksellian view proposes that the key to the puzzle is the process by which ex ante investment can differ from ex ante saving owing to departures of the market rate of interest from the “natural rate” of interest. Keynes argued that the underlying real economic factors, as embodied in the natural rate, need not dominate. The market rate of interest could be maintained indefinitely at a level different from the natural rate. And since he believed that banks could keep the market rate above the natural rate, Keynes concluded that the principal problem was too little investment.

Hayek, building on the pioneering work of his mentor, Ludwig von Mises, argued that in the short run, increases in the “money stream” (the stock of money times the rate at which it is spent) would drive the market rate of interest below the natural rate and induce an over-investment in capital goods.

This “malinvestment” could not be sustained in the long run because it represented a production structure that was inconsistent with consumers’ time preferences (the ratio of consumer goods to capital goods that they desire). For Hayek, the natural rate of interest, which reflects consumers’ time preferences, must eventually win out. All of this is indicative of the crucial fact that Hayek wove together monetary theory and capital theory into a coherent whole. It must be admitted that both Hayek and Keynes were aware that the real world of time, money, and uncertainty required an analytical departure from the pure barter models of classical economics. However, Hayek understood, as did Mises, that capital is heterogeneous, often specific to a particular firm or project, and driven by changes in relative prices. Keynes understood little or none of this. Indeed, he seemed mystified by Hayek’s explanation of the interface between money and capital.

The Hayekian approach to cycles differs even from that espoused by other, seemingly like-minded economists, such as the monetarists and New Classicals, in that “the method of analysis is diametrically opposed . . . the key features of Hayek’s analysis are absent in models that use the national income concept as a starting point for macroeconomic analysis.” Hayek’s is a microeconomic explanation of what most economists believe can only be explained in terms of macroeconomic aggregates. Like all Austrians, Hayek was convinced that aggregates or averages cannot be causally related to one another. Only individual actions can be made truly intelligible, so to comprehend business cycles fully economists should focus on relative prices rather than the price level, the structure of production rather than the level of aggregate production, and disequilibrium in the short run as well as equilibrium in the long run.

I found this book to be a very worthwhile addition to the existing literature on business cycles. Although most of the text is devoted to Hayek and Keynes, there are brief but insightful presentations of classical theory, monetarism, real business cycles, and rational expectations. Nevertheless, the authors make it clear why the explanation of cyclical phenomena offered by Hayek and other Austrians is superior to all others. Only the Austrians have successfully combined monetary and capital theory. And if macroeconomics is ever to be meaningful, it must address these “issues in capital theory and the time structure of production.”

The next time I teach a university course on business cycles I intend to use this book as the main text.

Larry Sechrest is associate professor of economics at Sul Ross State University, Alpine, Texas.