Theory of Economics by Hayek - Essay Example

Hayeks Theory of Economics Introduction Born in Austria-Hungary, the Austalian Friedrick von Hayek was one of the most influential economists and philosopher of the 20th century (Boettke, Coyne, & Leeson, n.d), better known for his promotion of classical liberalism. Hayek’s pioneering work in the theory of money and economic variations as well as his profound inquiry of the relationship between socioeconomic and institutional forces won him a Nobel award in Economic Sciences. This paper will explore Hayek’s theory of economics while paying a closer focus to the essential aspects of the theory, its strengths and weaknesses, as well as the times when the Hayekian theory was effectively and ineffectively applied in the U.S. history. Overview of theory The Hayekian business-cycle theory is a fusion of the Austrian theories regarding money, capital as well as prices, generally conceptualized as the Austrian theory of business cycles, which itself was based on Mises’ theory of money and credit (Boeettke, 1992). The Austrian theory of trade cycles was inspired by Knut Wicksell’s contributions on the relationship between money and interest while Ludwig von Mises became the first economist to bring together Wicksell’s monetary dynamics with Bohm-Bawerk’s capital theory, which led to the first Australian trade-cycle theory. Hayek developed and made the theory official while reinforcing it with insights from David Ricardo and John Stuart Mill in 1967. Generally, Hayek argues that any monetary disturbance such as an increase in the stock of money reduces the interest rates to levels below the equilibrium thereby stimulating an increase in capital and reallocation of resources in the manufacture of intermediate (capital) goods rather than consumption goods (White, 1999). Consequently, this triggers a rise in the cost of capital goods and a subsequent drop in the price of capital goods, and later the entire structure of the production system, which entails the conversion of raw products into finished products for utilization by consumers, is completely shifted (Zera, 2013). In that respect, the Hayekian Economy theory demonstrates how a monetary disruption can prompt an inter-temporal disco-ordination in economic activities, the manner in which the disco-ordination eventually becomes recognized and addressed through money-induced disco-ordination. Hayek conceptualizes that the injection of new money through credit markets inhibits the level of interest thereby inducing an inter-temporal misallocation of resources, thus, leading to the production of capital goods that are good for a longer or time-consuming production structure rather than those that are more suitable to the prevailing shorter or less-time consuming structure (Garrison, 1986). The credit-financed capital restructuring increases the net economic activity that makes up the boom in the shorter term but overtime, the incomplete capital restructuring fails to match the available resources; the perceived shortages trigger the increase in the cost of uncommitted resources as well as the corresponding increase in the demand for credit. Consequently, the heightened costs impose the abandonment of the misallocated resources and the subsequent unemployment of the labor that was initially tied with the abandoned resources. A recovery in which market changes in relative prices and wages make it possible for the uncommitted capital and labour to be reabsorbed into the production structure comes after an inter-temporal disco-ordination of economic activities (the bust) has been established (Keeler, 2001). The Australian theory of trade cycle is based on the price theory, capital theory, as well as the monetary theory, which are brought together in Hayek’s formulation, into a coherent narration of cyclical fluctuations. Strengths of the Hayekian theory The Hayekian theory recognizes that in as much as prices are determined by the interaction between the different activities of all market participants, the same prices often do pass across crucial information to each of the market players regarding the valuations made by consumers as well as concerning the relative shortages of alternative resources. This particular Hayek’s insight, that the price system is a communications network, is widely acknowledged in the economics field by numerous other authorities, thereby lending credence to his economic theory. Similarly, Hayek’s economy theory stresses that interest rates facilitate inter-temporal co-ordination by clearing the market for loanable funds and matching saving with investment thereby leading to equilibrium (Butos & Koppl, 1993). For instance, Hayek conceptualizes that a lower interest rate attracts longer term investment and under the right conditions matches the specific consumption time pattern to the corresponding investment time pattern, thereby coordinating consumption and investment activities inter-temporally. Furthermore, the Hayekian formulation highlights that money can pose as saving when monetary authority cushions the supply of loanable funds with newly created money. A falsified low interest rate encourages investors to go for more loans yet income earners are not saving as much, thereby prompting inconsistencies between the pattern of investment and the amount of real saving as well as the pattern of consumption. The theory also highlights that capital goods are not only heterogeneous in nature, but they are also linked to one another through numerous levels of substitutability as well as complementarity; for instance, the higher-order capital goods (goods required at later stages) and the lower-order capital goods (goods at lower stages) are inter-temporal complements (Garrison, 1986). In that respect, a flawed low interest rate that prompts an overinvestment in higher order capital goods causes an inter-temporal disco-ordination that is only revealed later with the passage of time. Precisely, the Hayekian theory correlates with the Ricardo Effect, which entails the substitution of machinery for labor in reaction to alterations in interest rates; in the Hayekian formulation, the higher order capital goods replace the lower-order capital goods in the initial phase off the cycle in reaction to the artificially low interest rates. Consequently, this triggers a scramble for, and the subsequent shortage of the limited lower-order capital goods, which forces their prices to go up while prompting increased demands for credit due to desperation borrowing; consequently, this causes the interest rates to rise sharply thereby discouraging further investment in higher-order capital goods while causing a liquidation of the longer-term capital goods. Weaknesses the Hayekian theory Criticisms of the Hayekian theory draw from the Keynesianism, monetarism, as well as the New Classism fields; firstly, Keynes has faulted the theory for assuming that interest rates will always be low during a boom period and recommending the nipping of the boom in the bud (Garrison, 1986). Monetarists, on the other hand, have faulted Hayek’s theory for assuming that monetary manipulations could potentially distort interest rates and completely dismiss the possibility of what Hayek considers inter-temporal disco-ordination in the markets for capital goods. The New Classists question the importance of Hayek’s distinction between two types of knowledge by arguing that market players somewhat act with a certain knowledge of the economic structure and respond to monetary changes in a manner that makes up for the occasional price and interest rate distortions. Essentially, the New Classist theorists highlight that as long as the rational expectations regarding future price and interest rate fluctuations are not systematically flawed then no inter-temporal disco-ordination can be caused. Furthermore, economist Paul Krugman faults the Hayekian theory for failing to account for the changes in unemployment through the business cycle (Krugman, 1998). The theory assumes that business cycles emerge out of the misallocation of resources and that the reallocation of resources during busts will increase employment in consumption industries, if total spending is matched to total income in an economy. Effectively application of the Hayekian theory in US history The Hayekian views have enjoyed great dominance in the US since the 1970s, particularly the idea that the government should only play a limited role in the economy system; evidently, the influence of Hayek’s ideas and the Chicago School of economics, which remains the avid supporter of Hayekian principles can be felt up to date. Precisely, the period 1978-2008 can be described as the age of Hayek in the history of the U.S since two crucial political adherents of the Hayekian principles, Reagan and Thatcher (Simpson, n.d), dominated this period. Hayek strongly believed that economic freedom is achieved through free markets and less government control or intervention, a view that has been promoted by the Chicago School thereby establishing the strong foundation of the US economy’s firm belief in the system of free markets. Hayek theorized that under central planning by the government, there hardly any opportunity for economic calculations to be made, that is, it not possible to make rational decisions concerning capital allocations and investment due to the lack of a price system to test alternatives (Rodrigues, 2012). Ineffective application of the Hayekian theory in US history The Hayekian theory suffered great defeat in the period following the Second World War, when the question of the appropriate role of the government in the economy had just emerged in the face of Keynes theories that championed for a central government role in the economy. According to Keynes, government’s deficit spending by borrowing money to invest in public works would yield employment opportunities that would eventually increase purchasing power of citizens while any attempt to limit government spending would only worsen the situation. After World War II, both the U.S. and U.K governments adopted the Keynesian model of central planning and regulation of the economy while seeking full employment; in the U.S. particularly, Keynes’s influence was greater during the Roosevelt administration that avidly pursued what came to be recognized generally as the Keynesian economic policies. Hayek’s theory was largely ignored and unheeded in this period by most people, except for a few supporters, despite his having published his pioneering work, The Road to Serfdom in 1944; Hayek’s ideas that increasing the role of the government in the economy would undermine democracy were rendered obsolete within a few years. Conclusion Overall, the Hayekian theory was effectively applied in the in the U.S. from 1970s, unlike in period following the Second World War, when the Keynesian principles were highly influential both in the U.S. and in the UK. Generally, the Hayekian economic theory offers profound insights into the operation of the of the economy, which are as sound and relevant today like they were nearly half a century ago when the theory first gained its ground and popularity; however, there is little hope for a widespread adoption and application of the Hayekian principles. Even so, it is highly unlikely that the Hayekian theory can be totally forgotten since it clearly explains the market conventions that can potentially promote inter-temporal co-ordination of economic activities, as well as the repercussions of altering those conventions. References Boeettke, P. (1992). Friedrich A. Hayek (1899-1992). fee. Retrieved from: http://www.fee.org/the_freeman/detail/friedrich-a-hayek-1899-1992 Boettke, P.J., Coyne, C.J., & Leeson, P.T. (n.d). The Continuing Relevance of F.A. Hayek’s Political Economy. Retrieved from: http://www.peterleeson.com/Continuing_Relevance_of_Hayek.pdf Butos, W.N. & Koppl, R.G. (1993). 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