Hayek as a liberal - His contribution to politics and economic

Seminar Paper 2005 34 Pages

Politics - International Politics - General and Theories










The present paper deals with Friedrich August von Hayek, one of the prominent liberal thinkers of the twentieth century. He engaged himself actively in economy, political philosophy, psychology, and epistemology. The Royal Swedish Academy of Sciences awarded Professor Hayek the Prize in Economic Science in Memory of Alfred Nobel for 1974 together with Professor Gunnar Myrdal ìfor theirpioneering work in the theory of money and economic fluctuations and for theirpenetrating analysis of the interdependence of economic, social and institutionalphenomenaî1.But his contribution does not limit only to economic.

Hayek developed his seminal explanation of business cycle based on classical macroeconomic theories of Knuth Wicksell and Ludwig von Mises. Theirs ideas are briefly presented in the first part of Chapter I. Further it will be discussed the essence of the theory of business cycle in terms of production structure and capital employment. In particular, the model demonstrates that boom-bust cycles are caused not by mysterious defects inherent in industrial capitalism, but by the unfortunate inflationary bank credit expansion propelled by central banks. Next section presents Hayekís ideas about the role of money in economy and intelligent monetary policy. The problem of price system in market economy, linking Hayekís economic and political articles and books is elaborated in section four of Chapter I. Critical remarks to his statements voiced by his adversaries and fellows are discussed directly in the main text. The rationale for such structure is to alleviate understanding of the subject.

In the next chapter one gets on overview of The Road to Serfdom, the book by which Professor Hayek deserved popularity from both sides of Atlantic. It linked the statism of communism, social democracy, and fascism, and demonstrated that, just as people who are best suited for any given occupations will rise to the top in those pursuits, so under statism, "the worst" would inevitably rise to the top. The attention is paid to the critical issues like alleged advantages of central planning and market economy, the idea of a unity of liberal tradition, and Hayekís view of post-war international order. The chapter includes statements from his debates with socialists.

The paper refers heavily to Hayekís works like Monetary Theory and Trade Cycle (1929), Prices and Production (1931), The Use of Knowledge in Society (1945), The Road to Serfdom (1944).


Friedrich von Hayek was born in Vienna on May 2, 1899 in family of Viennese intellectuals. His father, August was a medicine doctor teaching biology in the University of Vienna. His mother, Felicitas von Juraschek was from wealthy, conservative, land-owing family. Hayek was the oldest of three boys. Heinrich and Erich came one-and-a-half and five years after him.

In March 1917 Hayek entered the army. He was sent as an officer to the Italian front after seven months of training. He served for over a year in Italy until the warís end in November 1918.

Hayek came to the University when he was 19, just after the World War I. He was enrolled as a law student, but he attended with great interest lectures in economics and psychology. In the post-was time poverty was wide spread in Austria. Like his fellows in economic faculty Hayek wanted to get knowledge how to improve social conditions. The bookDie Gemeinwirtschaft, published in 1922 by Mises, impressed him. Its key idea of necessity of market for means of production shook popular at that time believes about socialism as appropriate way out for the crisis. Misesís sharp critics of central planning induced Hayek to accept a liberal concept of economics and politic.

While being a student, Hayek attended thePrivatseminarconducted by Mises. Mises developed earlier concepts of banking and monetary theory applying marginal utility principle to the value of money and drafted a theory of industrial fluctuations. He based his considerations on ideas of Swedish economist Knut Wicksell. Hayek also used Wicksellís ideas for his research on fluctuations, explaining the origin of the business cycle in terms of bank credit expansion and its transmission in terms of capital investments. Lectures to this topic helped him to get an invitation to the London School of Economics and took there a Chair in Economics and Statistics. In London Hayek popularised Austrian business cycle theory, which was accepted as preferred explanation for the Depression until Keynesian General Theory was published.

In early 1930ís Hayek disputed with Keynes over hisTreatise on Money. Despite Hayek was able to refute completely ideas of the Treatise, he never did this. One can attribute his reluctance partly to the personal charm of Keynes and partly to the role of ally against inflation, which Hayek ascribed to him. Furthermore, Hayek later explained that Keynes often changed his theoretical framework, so there was no point to belabour a deliberate critique, if Keynes might change his mind again.

With growing popularity Keynesian General Theory Austrian school underwent a decadence. The Austrian approach to capital theory, which was the pivot point in the business cycle theory, was heavily attacked by American scientists. The business cycle theory itself was regarded as obsolete in the light of enthusiasm of the General Theory. As well as this, prominent economists left Vienna, for personal and political reasons, so the Austrian school as such stopped to exist.

Hayek remained at the L.S.E. until 1950, when he joined the Committee on Social Thought at the University of Chicago. There he ceased to work on economic theory, concentrating instead on psychology, philosophy, and politics, and Austrian economics entered a prolonged eclipse.

When the 1974 Nobel Prize in economics went to Hayek, interest in the Austrian school was suddenly and unexpectedly revived. The rediscovery of Hayek by the economics profession was nonetheless a decisive event in the renaissance of Austrian economics. Hayek's writings were taught to new generations, and Hayek himself appeared at the early Institute for Humane Studies conferences in the mid-1970s. He continued to write, producingThe Fatal Conceitin 1988, at the age of 89. Hayek died in 1992 in Freiburg, Germany, where he had lived since leaving Chicago in 1961.

Chapter I. Hayekís Contribution to Economics

1.1. Macroeconomic Introduction

It seems to be convenient to make a brief introduction in classic theory of fluctuation and explain crucial relationships and terms. The key issue is the assumption that prices, expressed as an exchange rate of one good to others, are flexible in the long run, i.e. they adjust to changes of supply and demand over time. In the short run, to the contrary, they are rigid. Note, one considers here prices not only for consumer goods, but also for commodities, labour, and capital as well.

Next, macroeconomics deals with theaggregated supplyandaggregated demand. The latter labels demand of economic agents (e.g. households, firms, and government) on all available assets in the entire economy. In other words, demand of households on food and comfort, and firmsí demand on labour, half-finished products, electricity, additional credits and so on. By the same token, aggregated supply implies the gross domestic product that is produced materialized value in the economy.

Further, consider the nature of the above-mentioned terms. The both lines depicted in price level - income output space react differently, i.e. move either upwards, or downwards, on changes of the same factors. Generally, is accepted the equilibrium equation: MV=PY, where M stands for money supply, V presents the speed of income turnover, and P, and Y label price level and production volumes respectively.

The curve of aggregated demand is plotted for a certain amount of money in economy.

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Figure 1.Aggregated Demand Curve.

It shows thus possible combinations of P and Y for the defined value of M. If the money supply changes, then change combinations of P and Y, that is the curve moves up or down. In case the central bank, for example decreases the amount of money, than, as follows from the equation, the nominal output PY goes down. Another influential variable is the speed on income turnover, but it is not such important for the purpose of this paper.

Aggregated supply per se provides no information about theactuallevel of prices and output. It relates solely the total goods range to the price level. However, the classical approach, one can regard Hayek to great extent as one of its representatives, assumes that aggregated supply does not depends on price level in the long run, but only on the capital and labour endowment and available production technology. Hence, the curve is vertical.

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Figure 2.Aggregated Supply in the Long Run

The vertical aggregated supply suffices the classical dichotomy, because it implies independence of output from money supply. The secular output defined in such a manner is labelled as the full employment level or, alternatively, natural level of output.

In contrast, aggregated supply in the short run is absolutely flexible with regard to prices. In extreme case it is horizontal. It assumed that prices in the enough short period of time are stark and firm are ready to sell so much as consumers want to buy at the given price level.

The short-run equilibrium is determined by the intercept of the horizontal SRAS (short run aggregated supply) and falling aggregated demand curve. In this case changes of aggregated demand affect the production volumes unlike to the long run perspective.

Decrease of amount of circulating medium pushes the aggregated demand toward the point of origin and production of goods contracts (recall price rigidity in the short run).

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Figure 3.Production changes in short run

Up to this point one can recapitulate the following: if one takes the long time period, then prices are flexible, the aggregated supply curve is vertical, and changes of aggregated demand affect only the price level. In the short run prices are stark, the aggregated supply is flat, and changes of aggregated demand affect the production in the considered economy.

Assume now the economy is in equilibrium (intercept point A): the long run and

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Figure 4.Adjustment of economy to short-run equilibrium

short run equilibrium are concordant with each other. Suppose further the money supply declination. The intercept of AD and SRAS moves toward B. Because of price rigidity in short period firms reduce the output Y and set redundant labour and capital free. Weak demand (the part of solvent consumers, workers and firms has become smaller) depresses prices downwards in the long perspective. Thus, the economy moves to the new equilibrium (point C), although prices are lower compare to the old (A ) equilibrium2.

1.2. Hayekís Interpretation of Business Cycle

One can present the business cycle theory by Hayek as a shortening and lengthening of the period of production. The starting point of his analysis is an equilibrium. Here, the production forces- capital and labour- could be employed in two ways: either to manufacture consumer goods immediately and labour intensive, or to postpone benefits in time and invest in long term capital goods.

illustration not visible in this excerpt

Figure 5.Production structure (ìHayekian triangleî).

Transition from one production method to another one with longer or shorter cycle determines the structure of production (see figure 5). The area of the triangle presents an amount of semi-manufactured good need to be available at any point of time to facilitate production of certain number of consumer goods. The more time consuming the production cycle is, the more ìcapitalisticî is the economy, and that is, the more capital is invested in production. In other words, the higher the processing degree of products consumed by ultimate buyer, i.e. the longer the way of raw materials to the households, the more capital must be employed along the value chain.

Hayek distinguishes the reasons for production enlargement. Suppose consumers have changed their preferences and become more future-oriented, and decrease their current demand and thus save. Increased saving gets translated through market mechanisms and entrepreneurial foresight into higher demands for inputs in the relative early stages of production. The demand for output as a whole, then, is neither higher, nor lower than before the preference change. Rather, the pattern of demand has changed in a way that is conveniently depicted in figure 6. The consumer-demand leg of the triangle has become shorter and the production leg has become longer. These actions, aggregated across the economy, induce increasing demand on capital goods and thus elongation of the production cycle.

illustration not visible in this excerpt

Figure 6.Lengthening of production time3.

The starting point of the business cycle is redundancy of loanable funds that depress interest rate under the equilibrium level with purpose to find a borrower for the money. An investment expansion comes off and thus capital goods are demanded.

The increase in demand for capital goods indicates that in the entire economy the aggregate demand dominates the aggregate supply. This means higher benefits to the same non-specific resources in higher stages. Assuming that resources are limited and firms cannot expand endlessly, manufacturers face a dilemma whether not to respond on the increased demand for capital goods and produce further consumer and capital goods in the initial proportion, or reallocate capacities in favour of demanded goods at expense of consumer goods (see figure 6). Hayek argues that latter will happen.

But when you keep aggregate supply fixed, that is firms do not lay off workers, that means consumer income is kept fixed - thus consumer demand for consumer goods has not dropped. But the supply of consumer goods has dropped. Thus, there will be what Hayek called "forced savings": consumers are forced to save simply because there are no more consumer goods to buy. This increase in savings, one must note, will fund the initial expansion in credit.

Hayek augments his thoughts yet further and suggests that supply is not perfectly fixed and new resources are employed. Herewith the general output expansion comes to the point, i.e. production of both consumer and industrial goods will rise. On the other hand, output expansion means higher income and thus higher consumer demand. As a result, consumers demand more consumer goods and place pressure on the consumer goods industry to produce more.

This can persist until full employment is reached. Then the aggregate supply constraint comes in force. Assuming proportions are not changing, the rising demand for consumer goods leads to rising prices in the consumer goods industry relative to capital goods. This is merely the expression of forced savings again. The aftermath of this is as follows. The rising prices of consumer goods make the consumer goods industry more profitable relative to the capital goods industry. They can thus begin to outcompete the capital goods industry on the (now very tight) factor markets: i.e. consumer goods industries will start getting the labour and capital that the capital goods industry used to command. This bidding war leads to a rise in factor costs overall - rises in wagesandrises in the money loan rate. This is the peak of the cycle.

Hayek suggested the rising costs in the economy and the relatively poorer position of the capital goods industry will lead make them less profitable to begin with; furthermore, the rising loan rate will only lead to a decrease in investment and thus a decrease in demand for their products. In short, faced with lower profit and lower demand, the capital goods industry will shrink in size relative to the consumer goods industry. The downswing is on.

During the downswing, as the capital-goods industry shrinks, people who were employed by that sector will be laid off. That will lead to a decline in the demand for consumer goods, which now will lead to shrinkage in the consumer goods industry. But the shrinkage in the consumer goods industry means that now investment demand will drop even further (as consumer goods firms also demand capital). That will lead to a further shrinkage of capital goods production and so on. As a result of the general collapse in output and collapse in investment demand, loan able funds will again start piling up unused at the banks and there thus money (loan) rate will start falling. A point will come, argued Hayek, when the loan rate will collapse below the natural rate and investment picks up again. This way, the trough is reached and the capital goods industry begins producing again- and thus expansion arises.


1 http://nobelprize.org/economics/laureates/1974/presentation-speech.html on March 11, 2005

2 Cp: Markiw, Gregory N., Makroˆkonomik, Stuttgart 2003, 5-th edition, pp 283-291.

3 See: Roger W. Garrison, Hayekian Triangles and Beyond in: Hayek, Co-ordination and Evolution: His Legacy in Philosophy, Politics and Economics, and the History of Ideas, edited by Birner, J. and Rudi van Zijp, London: Routledge, 1994. pp. 109-25.


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Hayek Political Economical Liberalism



Title: Hayek as a liberal - His contribution to politics and economic