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What One Economist Knew

May 8 marks the 117th anniversary of the birth of Friedrich Hayek, the most renowned member of the so-called Austrian School of economics, who won the Nobel Prize in 1974. Hayek was the “whole package,” as they say, writing the immensely popular book The Road to Serfdom while also writing technical works such as The Pure Theory of Capital. In honor of his birthdate it’s worthwhile to review some of Hayek’s major achievements, which are still relevant today.

Perhaps the major theme running throughout Hayek’s career in formal economics concerned knowledge. For example, in a 1945 American Economic Review article titled “The Use of Knowledge in Society,” Hayek wrote that the “economic problem of society” was not merely one of allocating “given” resources, the way a standard textbook might define things. Rather, Hayek argued that the true economic problem is “how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know.”

This emphasis on dispersed knowledge was one of Hayek’s key contributions to the debate over socialism during the 1930s. Specifically, Hayek argued that one of the key functions of private property and market prices was to allow individuals to communicate information to each other in an economical manner. For example, if a tin mine collapses, then everyone around the world needs to cut back on their usage of tin. Some speculators will hear about the collapse and will push up the price of tin, hoping to profit from their knowledge. It is the rise in price that induces all consumers of tin to consider alternatives; they don’t need to know why tin is scarcer, they just need to know that it is.

Yet without the communication network provided by free market prices, socialist planners could not effectively mobilize the dispersed knowledge held by millions of citizens in their country. There would be no practical way to transmit the localized “knowledge of time and place” from various farmers, factory operators, truck drivers, retail outlet managers, and so on, up through the chain of command, so that the central planners could draw up an efficient use of resources. The socialist economists who thought otherwise were relying on unrealistic mathematical models of the economy which completely ignored the true economic problem, because they assumed all of the relevant information was “given” to the central planner.

Hayek’s contributions in the debate over socialism built upon those of his mentor, Ludwig von Mises. In the same way, Hayek’s work on business cycle theory—which was a major factor in his Nobel award—also elaborated the Misesian framework.

Unlike Keynesians, the Austrian economists believe that modern recessions are not simply the result of inadequate “demand,” meaning that people aren’t spending enough. Rather, in the Austrian account an economy first experiences an unsustainable boom period, after which a recession is physically necessary. Recessions are “real” phenomena, driven by poor investments of resources during the boom period.

In this context, one of Hayek’s pedagogical contributions was a graphical device that is now called a “Hayekian triangle.” This diagram, first introduced in his 1935 book Prices and Production, shows how the economy can be broken up into “stages.” Labor and raw materials are applied in the earliest stages in order to create goods that are then sold to the next stage, where more labor and inputs from Nature are applied. As we move along the leg of the triangle, the market value of the goods-in-process continues to grow, indicated by the expanding height of the triangle.

With this graphical framework, Hayek could illustrate the Austrian conception of a long-term production process, in which intermediate capital goods leave one stage and enter the next, where they only gradually “ripen” into finished consumer goods. Coupled with his understanding of how market prices mobilize dispersed knowledge and guide production, Hayek showed that artificially low interest rates could cause resources to flow into the wrong sectors. The sustainable flow of goods through the production pipeline would be distorted, and eventually would require a crash in output in order to rebalance the system.

In this essay I have only scratched the surface of the economic contributions of Friedrich Hayek, who was one of the most important social scientists of the 20th century. His essays on knowledge, and his work on business cycle theory, are far more important today than the latest journal articles.

Robert P. Murphy is a Research Fellow at the Independent Institute and Research Assistant Professor with the Free Market Institute at Texas Tech University.

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