Vol. 6, no. 2 (Fall), 1986

Hayekian Trade Cycle Theory: A Reappraisal

Roger W. Garrison*

I. Introduction
If general acceptance by the economics profession were the criterion for success or failure of a theory, the theory of the trade cycle attributed to F. A. Hayek(1) would have to be declared a failure. Many economists do not know what the theory is, and many are sure that the theory is fundamentally wrong-headed. Personal experience has taught me that these two categories are not mutually exclusive. Even those who recognize the logical integrity of the theory may have doubts about both its historical significance and its present-day relevance: The Hayekian theory might explain some aspects of some nineteenth- and early twentieth-century trade cycles, but it does not explain much, and it does not explain anything about modern fluctuations in economic activity.
        Yet, there remains a small minority of economists who see virtue and relevance in the Hayekian theory of the trade cycle. For this minority the theory enjoys a certain prominence within a broader theoretical framework. Expositors of Austrian Economics save the trade-cycle theory for their climactic chapter. Comparisons of the Austrians with the Keynesians or Monetarists invariably hinge on differing views about the nature and causes of cyclical fluctuations. And historical applications of Austrian monetary theory focus attention on the Great Depression. The status accorded the Hayekian theory of the trade cycle seems—especially to those outside the Austrian tradition—to be out of proportion to the significance of the phenomenon this theory is intended to explain.
        A half century after Hayek outlined its essential features, the theory has strong but narrow support. What follows is an attempt to account for this limited success. Section II provides a brief outline of the theory and suggests that, ironically, the many virtues of the theory are collectively an obstacle to a broader acceptance. Section III contrasts the Austrian view with the alternatives of Keynesianism, Monetarism and New Classicism, paying special attention to the notion of Rational Expectations. Section IV deals with the issue of expectations in the context of Hayek's theory. Section V considers some common objections to the Austrian view, and Section VI offers a summary assessment.

II. The Theory and Its Elements
The Austrian theory of the trade cycle draws heavily from Knut Wicksell's work on the relationship between money and interest. Ludwig von Mises (1953, pp. 357-66; also see 1966, pp. 538-86 and 1983, pp. 1-6) was the first to combine Wicksell's monetary dynamics with Böhm-Bawerk's capital theory so as to produce a distinctly "Austrian" trade-cycle theory. Hayek (1967) formalized the theory and bolstered it with the insights of David Ricardo and John Stuart Mill. In its essentials, the Hayekian theory shows how a monetary disturbance can induce an intertemporal discoordination of economic activities (the artificial boom), how the discoordination eventually comes to be recognized (the bust), and what adjustments are made necessary by the money-induced discoordination (the recovery).
        In brief, the injection of new money through credit markets suppresses the rate of interest causing resources to be intertemporally misallocated. Capital goods appropriate for a relatively lengthy, or time-consuming, structure of production are created at the expense of capital goods that would be more compatible with the existing, less time-consuming, structure. The credit-financed capital restructuring entails a net increase in economic activity, which constitutes the boom. But with the passage of time, the still-incomplete capital restructuring is revealed to be inconsistent with actual resource availabilities. The newly perceived scarcities are reflected in increased prices of uncommitted resources and in a corresponding increase in the demand for credit. These increased costs necessitate the liquidation or abandonment of misallocated capital. Labor which was complementary to the abandoned capital becomes unemployed. The bust is followed by a recovery in which market adjustments in relative prices and wages allow for the eventual reabsorption of unemployed capital and labor into the structure of production.
        The Austrian theory of the trade cycle draws from price theory, capital theory, and monetary theory. Hayek's formulation, in effect, "puts it all together." It allows the insights of the Austrian school, together with insights from other schools, to gel into a cohesive account of cyclical fluctuations. And it "puts it all together" in a theoretically satisfying and historically relevant way. Those who appreciate each element in the Hayekian theory and see how all the elements fit together will have a special appreciation for Hayek's achievement. They will see the trade-cycle theory as a veritable show-case for the contributions of the Austrian school.
        There is a high degree of complementarity among the several elements of the theory. Thus, those who reject any one element or fail to appreciate its significance will fail to appreciate the theory as a whole. More likely, they will be puzzled by it. The following identification of individual elements of the theory will help to establish the significance of each for the composite theory as summarized above.

(1) Prices are signals.
While prices are determined by the interplay of the activities of all market participants, they convey essential information to each market participant—about the changing valuations made by consumers and about the relative scarcities of alternative resources (Hayek, 1948b.) This particular insight—that the price system is a communications network—is well recognized by the profession. Less well recognized is the fact that price changes do not come clearly marked "nominal" or "real."(2) The price theorist can conceptually distinguish between a real price change and a money-induced price change in a simple and unambiguous way. But the market participant cannot. The market participant does not possess a "knowledge of the real factors" that would allow him to sort out the nominal and the real; he in fact depends upon nominal price changes to tell him what the real factors are. Thus, price signals provide the basis for economic coordination; price signals falsified by monetary manipulation create a basis for economic discoordination.

(2) The interest rate facilitates intertemporal coordination
The interest rate clears the market for loanable funds. It matches saving with investment. These statements are acceptable summaries of the function of the interest rate, but they severely understate its importance. Changes in the interest rate—caused, for instance, by changes in savings propensities—affect not only the total amount of investment but also the pattern of investment. A lower interest rate encourages investing for the more remote future. Under favorable circumstances, the interest rate allows the preferred time pattern of consumption activity to be translated into a corresponding time pattern of investment activity; it coordinates the two kinds of activities intertemporally (Hayek, 1984).

(3) Money can masquerade as saving.
When the monetary authority pads the supply of loanable funds with newly created money, it drives a wedge between saving and investment. An artificially low rate of interest induces investors to borrow more while income-earners are saving less. And the falsified interest rate causes the time pattern of investment to be inconsistent with the amount of real saving and with the preferred pattern of consumption (Hayek, 1967, pp. 54-60; Also see O'Driscoll, 1977, pp. 70-82). Monetary manipulation creates unfavorable conditions which give rise to intertemporal discoordination. Credit expansion whets the appetite of producers causing them—collectively—to bite off more than they can chew, to undertake more time-consuming production projects than can be completed.

(4) Capital is characterized by intertemporal complementarity.
Capital goods are heterogeneous in nature and are related to one another by various degrees of substitutability and complementarity. Given the time consuming nature of the investment process, the problem of investment—from a societal point of view—is one of committing some resources to the early stages of the processes while reserving enough resources for the later stages. The capital goods associated with the early and the late stages, or alternatively: higher-order capital goods and lower-order capital goods, are intertemporal complements. Intertemporal discoordination triggered by an artificially low interest rate manifests itself initially as overinvestment in higher-order capital goods. But only the passage of time and the subsequent scarcity of (complementary) lower-order capital goods will reveal this intertemporal discoordination (Hayek, 1967, pp. 85-100; Also see O'Driscoll and Rizzo, 1985, pp. 160-87 and Lachmann, 1978, 117-18 and passim).

(5) The Ricardo Effect.
In its original form, the Ricardo effect pertained to the substitution of machinery for labor in response to changes in the rate of interest. Machinery represented the long-term factor of production, and labor the short-term factor of production. In the context of Hayek's trade-cycle theory, the substitution is between higher-order capital goods and lower-order capital goods. During the early phase of the cycle, an artificially low rate of interest favors investment in capital goods of higher order. The subsequent scramble for the complementary lower-order capital goods causes their prices to be bid up sharply. Increased demands in credit markets—called "desperation borrowing" in the Monetarist literature—drives the interest rate up.(3) The sharply increased interest rate severely discourages further investment in higher-order capital goods and encourages the liquidation of some partially completed production projects (Hayek, 1948a and 1977).

(6) Mill's Fourth Fundamental Proposition.
John Stuart Mill's cryptic aphorism, "Demand for commodities is not demand for labor," warns us against the simplistic incorporation of derived demands into macroeconomic theorizing. Some such notion of derived demand, whereby the demand for final output and the demand for the factors of production always move in the same direction, characterizes virtually all modern macroeconomic theories. The recognition that the two demands can move in opposite directions characterizes the Austrian formulation and constitutes one of the most fundamental differences between the Austrian theory and its rivals.
        In accordance with Mill's Fourth, a decrease in the current level of consumption does not necessarily mean a decrease in the demand for labor (and for other factors of production); a decrease in the current level of consumption may mean instead an increase in the level of saving, an increase in the level of future consumption, and a corresponding shift of resource demand away from the production for current-period consumption and toward the production for future-period consumption (Hayek, 1941, pp. 433-39). There may even be a net increase in the current demand for capital and labor.
        Hayek and other Austrian theorists have heeded Mill's Fourth by recognizing that in a given period consumption spending and investment spending can—and, in conditions of full employment, must—move in opposite directions. In fact, it is the shifting of resources between consumption and investment activities—and between the different stages of the production process—in response to changing intertemporal consumption preferences that allows the economy to achieve intertemporal coordination. And it is the similar shifting of resources in response to monetary manipulations that constitutes intertemporal discoordination.

(7) Two kinds of knowledge.
Monetary manipulation can fool market participants into behaving differently than they would otherwise behave. This fooling, of course, would not be possible if market participants had enough knowledge—knowledge about consumer preferences, resource availabilities, and technology, about the plans of other market participants, and about how all these plans will affect one another as the market process unfolds. It is true but trivial that if market participants were already in possession of all the information that the price system conveys, then distortions of price signals could not cause cyclical fluctuations—or any other kind of disequilibrium. Hayek's distinction (1948b, pp. 79-80) between two kinds of knowledge allows us to take account of what market participants can and cannot reasonably be expected to know. The distinction is that between the knowledge of the particular circumstances of time and place (i.e. normal market information coupled with various degrees of entrepreneurial insights) and scientific knowledge (i.e. an understanding of how the economic system works—knowledge of the structure of the economy). Market participants can reasonably be expected to have the first kind of knowledge, but not the second kind. Given their knowledge of the particular circumstances of time and place, they can be induced by market-determined prices to behave "as if" they understood the structure of the economy. But they cannot be expected to correct for money-induced price distortions on the basis of an actual understanding of the economy's structure.

        Each of these seven elements contributes in an important way to a full understanding of the Hayekian theory of the trade cycle. To reject any one element is to threaten the logical consistency of the theory. But the acceptance of all seven elements still leaves unanswered many questions about the relative merits of the Hayekian theory in comparison with alternative theories, as well as questions about the role of expectations and about the historical applicability and significance of the theory.

III. Alternative Views
Challenges to the Hayekian theory were based first on Keynesianism, then Monetarism, and now on the New Classicism. Keynes (1936, pp. 320-29) faulted his contemporaries (Hayek and Robertson) for believing that the interest rate was too low during the boom. He was convinced that it was too high. Keynes could not understand why they advocated nipping the boom in the bud; he suggested instead that it was the bust whose bud should be nipped. The logical connection between the boom and the bust was not seen by Keynes because he failed to treat the rate of interest as a device for facilitating intertemporal coordination. He believed, instead, that the interest rate is a highly psychological, highly conventional, phenomenon and is determined by the interplay between the supply and the demand for money.
        Monetarists recognize the role of the interest rate in achieving intertemporal coordination, but downplay the possibility that monetary manipulations distort the interest rate. In formal theory, questions about interest-rate effects are skirted by assuming that newly created money is introduced into the economy in ways other than through credit markets, such as by means of a helicopter drop (Friedman, 1969a, p. 4). In applied theory, the injection effects of monetary expansion—whatever their actual form—are trivialized as "first-round effects." Attention is directed instead to the long-run effects of money creation on nominal incomes and the level of prices.
        When attention is focused specifically on the issue of monetary dynamics—the "transmission mechanism" in the terminology of Monetarism (Friedman, 1976)—the analysis is typically confined to the labor market. Lagging adjustments in the perception of real wages allow for trading-off unemployment for inflation as suggested by the Phillips curve. While squaring the existence of short-run negatively sloped Phillips curves with a vertical long-run Phillips curve, the Monetarists simply neglect the possibility of intertemporal discoordination within market for capital goods.
        The New Classicists accept the Monetarists propositions about the long run and argue that the assumption of "rational expectations" allow those propositions to apply to the short run as well (Maddock and Carter, 1982. Also see Butos, 1985, and Lucas 1981). In effect, the New Classicists deny the significance of Hayek's distinction between two kinds of knowledge. Market participants behave "as if" they actually know the structure of the economy. They react to monetary expansions in ways that compensate for price and interest-rate distortions. So long as expectations about future price and interest-rate movements are not systematically in error, there will be no intertemporal discoordination—and no discoordination of any other kind that can be attributed to the monetary expansion. In this view, a Hayekian trade cycle anticipated is a Hayekian trade cycle avoided.
        The rational-expectations argument is nothing new to Austrian theory. In fact, Mises (1953, p. 419) recognized the kernel of truth in this argument long before the appearance of John Muth's classic article. He warned the advocates of inflationary finance against ignoring Lincoln's dictum: You can't fool all the people all the time. In the early 1940s Ludwig Lachmann (1977) called the Austrian theory into question on the basis of what was, in effect, a rational-expectations argument. The rise of the New Classicism in the last several years has refocused attention on the role of expectations in trade-cycle theory. Without doubt, the course of the trade cycle is influenced in a fundamental way by the expectations of market participants. But the idea of rational expectations is not quite the show stopper that the New Classicists believe it to be. Again, the critical difference between New Classicism and Austrianism lies in differing treatments of the knowledge problem.
        It is peculiar for economists to assume that market participants know, or behave "as if" they know, the structure of the economy. After all, economists have had disagreements among themselves for more than two-hundred years about how the economic system works. Some believe that the economy works in the manner envisioned by Keynes or by his many interpreters, some believe that the economy is more accurately depicted by the Classical model, and some believe that the economic relationships identified by the Austrians are essential to the understanding of the economy's structure. There are important differences even within each of these three theoretical frameworks, and there exist still other, more radical, alternatives such as Marxism and modern Institutionalism.
        It would be an amazing feat for market participants either individually or collectively to single out not only the correct theoretical framework but also the parametric values that are currently applicable. And if they actually performed this feat (or behaved "as if" they had performed it), the question of just how they did it would be the most challenging question the economics profession has yet faced.
        Visions of the economy that are based on the assumption of rational expectations can be put into perspective by the use of a simple Venn diagram—so simple that it is not necessary to actually draw it. Let one circle represent "what economists know"; let a second circle represent "what market participants know." The two circles overlap but do not coincide. The area common to both circles represents the common knowledge that makes a science of economics possible. It represents, for instance, the knowledge that under normal market conditions a surplus of some particular commodity means the price is too high and that a shortage means the price is too low. The area unique to market participants includes entrepreneurial insights and what Hayek (1948b, p. 81) called knowledge of the particular circumstances of time and place. The area unique to economists includes knowledge of the structure of the economy.(4)
        This Venn diagram allows for the identification of two fundamental ways in which economists can go awry. (1) They can deny the existence of knowledge unique to market participants. With this fundamental misperception, economists believe that it is possible to construct and implement a comprehensive economic plan—one that will coordinate economic activities at least as well as and possibly better than the market itself. (2) They can deny the existence of knowledge unique to economists. With no unique knowledge of their own, economists fail to see how policies that have systematic effects on the price system can have systematic effects on the activities of market participants. Rational expectations would enable the market participants to make corrections for all such effects. But the possibility that market participants can form such rational expectations is on a par with the possibility that central planners can devise rational economic plans. And rejecting both possibilities requires only that the significance of the Venn diagram be recognized.(5)

IV. Expectations in the Hayekian Theory
Each market participant pursues his individual interests on the basis of the knowledge of his own circumstances coupled with the information conveyed to him through the price system. If a monetary disturbance has created systematic distortions in the price system, market participants will be basing their choices and actions on misinformation, and the economy will be characterized by discoordination. To be sure, expectations about future movements or countermovements in prices come into play.(6) Market participants will respond to a change in the rate of interest or to a price change in different ways depending upon whether or not they suspect that the change is attributable (in large part or in whole) to some policy move on the part of the central bank. But in the context of Hayek's theory, the claim that expectations will simply nullify the effects that monetary policy would otherwise have had cannot be supported.
        First, assume that some—but not all—market participants know that credit expansion triggers an artificial boom and that such an expansion is currently under way. They rationally expect, then, that the boom will eventually end and that widespread economic losses will be suffered. (Not even the economists can predict just when the bust will occur and just who will suffer the losses.) Yet, for the individual market participants (especially for the ones who understand the economics of booms and busts), there are profits to be made by responding to the distorted prices in near-conventional ways. The fact that production processes are not characterized by complete vertical integration gives scope for profiting from the early stages of production processes even if each production process taken as a complete sequence of stages turns out to be unprofitable. Resources can be profitably misallocated in response to a distorted price so long as the resources are sold before the bust. To argue that the expectation of an eventual bust would prevent the boom from materializing is analogous to arguing that similar expectations with regard to a chain letter would prevent the chain letter from being initiated.
        Second, even if all market participants understood the economics of booms and busts, they would have no method of accurately correcting for money-induced distortions. Here the analogy between the price system and a communications network—between price signals and radio signals—can be pushed further: Knowing that a signal is being jammed is not the same thing as knowing what the unjammed signal is. During a monetary expansion the price of iron ore, for instance, may rise by eight percent. This eight percent rise may consist of an increase in the real price of iron ore (due to coincidental changes in the underlying real factors) of two percent plus a money-induced price rise of six percent. Or it may consist of some other combination of real and money-induced changes whose algebraic sum is eight percent. Possibly the most plausible assumption that market participants could make is that there have been no changes in the underlying real factors since the beginning of the monetary expansion. Economic activity based upon this assumption is analogous to a "dead reckoning" on the basis of the most recent unjammed signal. After a protracted period of monetary manipulation, the economy may well find itself considerably off course. The ensuing readjustments would conform in the large—if not in the small—to those that Hayek originally envisioned.
        Third, the claim—based on a weak form of the rational-expectations assumption—that there would be no systematic undercompensation or overcompensation for money-induced distortions across markets, even if true, is no basis for complacency. Resources are allocated—or misallocated—on the basis of price differences, not price averages. Resources would be allocated away from activities in which there was an overcompensation for money-induced price changes and into activities where there was an undercompensation.
        Further, even if the market-clearing price in a particular market reflects the "correct" amount of compensation (such that the total volume of trade is unaffected by monetary manipulation) there is still an element of discoordination. The market process imposes a certain uniformity of price for a given good. Each market participant pays the same price. But during monetary disturbances, each market participant has a different idea about how changes in the price are divided between real and money-induced changes. The market process imposes no uniformity here. The absence of uniformity of perceived real price changes gets translated by market participants acting on the basis of differing perceptions into a discoordination of economic activity.(7)

V. Some Common Objections
The range and variety of objections to the Hayekian theory of the trade cycle reflect the richness and complexity of the theory itself. There are objections found in the literature or heard in the classroom that call into question each of the seven elements discussed in Section II. The following discussion, however, looks beyond the theory's individual elements and deals with questions based upon considerations of method and history:
        1. Does Occam's Razor provide a justification for rejecting the Austrian view in favor of some simpler alternative?
        2. What empirical evidence is there to substantiate the Austrian theory?
        3. Does the Hayekian theory account for the length and depth of the Great Depression?
        4. Can the depression be wholly attributed instead to the fact that Federal Reserve ineptly allowed a severe contraction of the money supply?

(1) The Question of Complexity
Complexity per se is not a virtue. No one prefers the Hayekian theory over alternative theories because of its complexity. But cyclical fluctuations are themselves complex, and any trade-cycle theory that fails to recognize this fact is unlikely to contribute to our understanding of them. Understanding the market forces that generate fluctuations requires that we draw upon and integrate insights from price theory, monetary theory, and capital theory. This integration is precisely what Hayek accomplished. He built his theory on a solid microeconomic foundation; he identified the effects of credit expansion on relative prices; and he drew on capital theory to show why the boom was inherently unsustainable and why the bust was characterized by an excess of higher-order capital goods and a shortage of lower-order capital goods.
        Occam's Razor allows us to choose on the basis of simplicity between two alternative theories that account for the same phenomena. For a given explanatory power, the simpler the better. But Occam's Razor does not allow us to reject a complicated theory that explains a complicated phenomenon in favor of a simple theory that explains a simple phenomenon. The proposition, for instance, that given wage and price rigidities, a monetary contraction will be accompanied by unemployment is a relatively simple proposition—and a valid proposition, as far as it goes. But it is simply not in competition with the Hayekian theory of the trade cycle. It does not constitute an alternative explanation of the intertemporal discoordination that characterizes business cycles.(8)

(2) The Question of Empirical Validity
Another common objection is based upon the perceived lack or paucity of empirical research that lends support to the Hayekian theory. Was there a systematic misallocation within the market for capital goods during the boom that preceded the Great Depression? Where is your data? This mode of questioning is evidence of a misunderstanding of the relationship between Hayekian theory and historical experience. Sharply stated, Hayek's theory is not a theory in search of data. The question of why cyclical booms are characterized by an overinvestment in fixed capital (the most conspicuous form of higher-order capital goods) is a question that predates any theoretical account—Austrian or otherwise—of this phenomenon. And historical accounts of the economic developments during the 20's leave little doubt that this boom was so characterized. Lionel Robbins (1934, p. 46), for instance, charts the output of producers' goods and the output of consumers' goods for the late 1920's. Using U.S. data he shows that the former rises with respect to the latter in a way that squares with the Hayekian theory.
        Charles Wainhouse (1984) has recently employed the now-popular Granger-Sims technique to show that movements in the interest rate, the volume of credit, and in the relative prices of consumer goods and producer goods during the 1960s and 1970s are consistent with the Hayekian theory. But while this study provides an added increment of confidence in the theory, it is unlikely to constitute a decisive margin. Those who question the applicability of Hayek's theory to the episode of the Great Depression are unlikely to change their view on the basis of these Granger-Sims tests.
        The broader methodological issues concerning the relationship between theory and history cannot be addressed here at any length. The commonly encountered perception, articulated at the Cato conference by the panel chairman, that "the Austrians believe that facts are irrelevant" is, of course, a misperception. What the Austrians reject is the present-day economists' adaptation of positivism in which history, stripped of all nonquantifiable elements, unilaterally tests theory. Following Mises (1969), modern Austrian economists recognize that theory and history are complementary disciplines.

(3) The Question of Explanatory Power
        Still another common objection is based upon the inability of the Hayekian theory to account for the extraordinary depth and length of the Great Depression or to account for all economic downturns (Haberler, 1976, p. 25; Yeager, 1986, p. 380), The theory is being faulted, in effect, for not explaining more than it actually does explain. It certainly cannot be argued that Hayek and his followers claimed too much for the theory. Hayek's principal contribution to the development of the Austrian theory was in the form of lectures at the University of London in 1930-31—well before it was known just how deep (twenty-five percent unemployment) and just how long (1929-1939) the depression would be. The best-known accounts of the Great Depression from an Austrian point of view are those by Lionel Robbins (1934) and Murray Rothbard (1975). Robbin's book, originally published in 1934, deals with events up through 1933; Rothbard's book, though originally published in 1963, traces the course of events no further than 1932. Neither of these authors can be accused of trying to push the Hayekian theory too far.
        Nor is there any reason to try to push the theory too far in this respect. Explanations for the depression's extraordinary depth and length are not in short supply: There was the severe monetary contraction that followed on the heels of the initial downturn, the Smoot-Hawley tariff, and the many counterproductive programs and policies of the Hoover and Roosevelt administrations—programs and policies aimed at cartelizing industry, subsidizing loans to failing firms, destroying agricultural output, and otherwise preventing wages and prices from adjusting to the existing market conditions.
        Hayek's theory demonstrates that an economic boom fueled by credit expansion contains the seeds of its own undoing. But to endorse this theory is not to deny that many of the complications and exacerbations of the economic bust are to be attributed to unique historical events.

(4) The Question of the Impact of Federal Reserve Policy
And finally, the Hayekian theory is rejected by some (Haberler, 1976, p. 26 and Yeager 1986, p. 380) on the grounds that one of those unique historical events, the severe monetary contraction, completely swamped the effects of the intertemporal discoordination identified by Hayek. Economists, it is argued, should focus attention on the contraction and its consequences. This trivialization of Hayek's insights is puzzling for two reasons. First, the monetary contraction was a unique historical event only in the sense that it was not made inevitable by the preceding boom. The central bank might have avoided the monetary contraction, in which case economic recovery—intertemporal recoordination—would have been achieved much more quickly. But surely, it was the disruption in economic activity associated with the discoordination in capital markets that set the stage for Federal Reserve's mismanagement of the money supply.
        Second, it is not clear why we should expect economists to direct our attention to the most salient features of the Great Depression. Economic difficulties and hardships whose proximate cause was the collapse of the banking system can be seen by historians and even by journalists. We do not expect a meteorologist to direct our attention to the six feet of snow lying on the ground. The crystalization in the upper atmosphere that preceded the storm is his proper concern. Accordingly, the economists' proper concern is with those characteristics of the boom that can precipitate a bust. Hayek's theory has a claim on our attention that is not diminished by the events, however dramatic, that were subsequent to the initial downturn.

VI. A Summary Assessment
The Hayekian theory of the trade cycle offers insights into the workings of the economy that are as valuable today as they were a half century ago. But prospects for widespread acceptance of the Austrian view remain dim. Nor is the theory likely to be used as a basis for policy prescription. As in so many other instances where policy makers confront economic issues, considerations of political expediency and of economic soundness cut in opposite directions. The short-run political gains associated with an artificial boom take precedence over the long-run stability associated with monetary responsibility.
        But the Hayekian theory of the trade cycle is also unlikely to be wholly forgotten. Those who are willing to discover just what the theory is, how all its elements fit together, and what it can—and cannot—explain will find their efforts rewarded. They will have a understanding of the market mechanisms that can achieve an intertemporal coordination of economic activities and of the consequences of interfering with those mechanisms.


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*The post-conference draft of this paper was prepared with the benefit of critical assessments by Gerald P. O'Driscoll, Jr., Murray N. Rothbard, and Leland B. Yeager as well as by the formal discussant, Michael D. Bordo. Helpful comments from Donald J. Boudreaux and Roger Koppl are also gratefully acknowledged.

1. The title phrase "Hayekian trade cycle theory" was suggested by the editor of the Cato Journal. Murray Rothbard has reminded me that in its heyday it was known as the Mises-Hayek theory of the business cycle. There is no dispute in the present paper over names and credits. The more broadly conceived "Austrian theory of the business cycle" would serve just as well.

2. In the Austrian literature, the difference between a nominal price and a real price involves more than a simple adjustment for expected changes in the price level. Important differences are attributable to "injection effects," which vary across goods and exist independent of any actual or expected change in the general level of prices. The relevant contrast is between actual money prices and prices that are consistent with the underlying real factors.

3. Note that this bidding up of the rate of interest at the end of the boom is quite independent of any rise in the general level of prices. That is, the Ricardo effect is distinct from the more-widely-recognized Fisher effect.

4. The relative size of the intersection, the area common to both circles, is determined endogenously—by the interaction between economics and politics. No doubt, the size of the common area is positively related to the extent of government intervention: With increasing intervention, market participants find it more worth their while to learn how the market process works and how it is affected by government policy; and economists cum policy makers find it increasingly necessary to understand the particulars of the markets that are being affected by government interventions.

5. Thus, the Venn diagram helps to reconcile the fact that the rational-expectations approach to understanding business cycles has important Hayekian roots (see, e.g. Lucas, 1981, pp. 215) with the realization that the New Classicists' vision of how the market process works and how policy can affect it is fundamentally at odds with Hayek's own vision. The New Classicism incorporates the Hayekian insight that the price system facilitates the use of knowledge in society but fails to maintain the distinction between the two kinds of knowledge identified by Hayek. For a complementary view of the relationship between Lucas and Hayek, see Butos (1985).

6. See Hayek, 1975c, for an early recognition of the importance of expectations in trade cycle theory.

7. This aspect of money-induced discoordination as it relates directly to the rate of interest is clearly recognized by Leijonhufvud (1984, pp. 31f.) The market imposes a uniformity on the nominal rate of interest but not on the way in which that nominal interest rate is divided, in the minds of individual market participants, between the real rate and the inflation premium. My own formulation consists of a simple extension of this important insight from the interest rate itself to the interest-dependent prices of capital goods.

8. Strictly speaking, to qualify as a theory of cyclical fluctuations, the theory must account for at least one endogenous turning point. It must show, for instance, how an artificial boom contains the seeds of its own undoing. We can compare on a one-to-one basis the self-reversing processes identified by Hayek and by Friedman. One focuses on the market for capital goods and spells out the cyclical process in terms of Hayekian triangles; the other focuses on the market for labor and spells out the cyclical process in terms of short-run and long-run Phillips curves. But an account of monetary disequilibrium—even of snowballing monetary disequilibrium--that is triggered by an exogenous contraction of the money supply does not constitute a theory of cyclical fluctuations.