Hayek's Ricardo Effect: A Second Look

I  In this article we review a long-standing controversy in twentieth-century economic thought: the debate over Hayek's Ricardo effect. Hayek developed his interpretation of the Ricardo effect in the context of his theory of business cycles primarily in the late 1930s and early 1940s. At that time Hayek's use of the familiar proposition was held up to close scrutiny by many talented critics, including Nicholas Kaldor, H. D. Dickinson, and R. G. Hawtry, all of whom, according to Hayek, failed to understand what he was saying. (1) In each case Hayek countered their criticism with a restatement of his proposition which in turn failed to satisfy the critics. (2) Indeed, this apparent miscommunication was still taking place as late as 1969 when Hayek wrote his last piece on the Ricardo effect in answer to a criticism leveled by Sir John Hicks. The purpose of our article is to discover whether in this debate it was Hayek who was out of step with the profession or the profession that was out of step with Hayek. We shall argue that the reason that Hayek's argument seemed so elusive to his contemporary colleagues (and some later critics) was that his method of analysis was foreign to their way of thinking. While English economists in the 1930s (especially after Keynes published the General theory) were concerned primarily with the static problem of balancing income and expenditure flows at acceptable levels of employment, Hayek was attempting to develop a dynamic theory of business cycles that involved tracing out the path of adjustment of the capital stock of an economy from one equilibrium state to another. This problem of describing the transitional process only became the subject of serious professional attention long after the debate over the Ricardo effect was concluded. (3) In the course of our exposition, we will demonstrate that Hayek's Ricardo effect was not, in Blaug's words, "only another instance of the vice of neoclassical economics: the hasty application of static theorems to the real world." (4) Indeed, we shall argue that this is the last accusation one could logically hurl at Hayek's analysis. The very reason why Hayek encountered so much difficulty in communicating his message was precisely that he was not presenting an exercise in comparative statics but was rather hypothesizing a particular adjustment process where the final equilibrium state depended upon the particular path of adjustment followed in the economy. In recent years the founders of the 'new classical economics' have praised the broad outlines of Hayek's approach to the business cycle. Robert Lucas pointed out that as early as 1929 Hayek articulated what remains today the single most important theoretical question in business cycle research. Hayek asked, How can cyclical phenomena be incorporated "into the system of economic equilibrium theory?" (5) Lucas goes on to regret the unfortunate Keynesian diversion of research effort from a thoroughgoing theory of the business cycle to what, in Lucas's words, is the "simpler question of the determination of output at a point in time" (6) It is well known that Hayek also regretted the unfortunate "Keynesian diversion" and resisted the redirection of research away from what he considered to be one of the most important macroeconomic questions: how production structures adjust to the underlying demand conditions and savings patterns of the community. It was this concern that made him wary of an economic theory that made it appear possible to push an economy into a perpetual state of boom. (7) He feared that instead of perpetual boom, inflationist policies would only result in short-term, illusory gains followed by a collapse with all of its undesirable macroeconomic effects. Hayck's approach (much like the modern approach of Lucas and others) was to derive macroeconomic consequences from an analysis of the self-interested behavior of market participants. …