A Retrospective Look at the Hayek Story: Roundaboutness

Home , Geoffrey Harcourt, Ludwig Lachmann, Roger Garrison, Roundaboutness, Steven Horwitz

A RETROSPECTIVE LOOK AT THE HAYEK STORY: ROUNDABOUTNESS,

STICKY CONSUMPTION, AND SEQUESTERED CAPITAL

BY JAMES E. MCCLURE*, DAVID CHANDLER THOMAS* AND LEE C.

SPECTOR*

Abstract

Friedrich Hayek’s business cycle theory, withered throughout the 1930s as he admitted that its underlying model of Böhm-Bawerkian roundaboutness was incomplete and inadequate. In 1934, Hayek started a two-volume book on capital theory, completing only one volume in 1941. Curiously, Hayek (1941) cites Hicks’ (1939) Value and Capital but not the financial measure of roundaboutness that Hicks suggested as a substitute for Böhm-Bawerkian roundaboutness. In 1967, Hicks criticized the inexplicable lags in The Hayek Story. Hayek maintained his view that consumption was sticky and responded to Hicks with a mound-of-honey analogy. Nevertheless, Hayek maintained that his business cycle theory was fundamentally correct and continued to hope that others might someday discover a capital structure theory to undergird it. Toward fulfilling Hayek’s hope, we suggest augmenting the canonical stages of production with a sequestered-capital stage where products are invented, productized, and inventoried prior to launch, uncoordinated by observable prices.

*Ball State University, Department of Economics.

This “preprint” is the peer-reviewed and accepted typescript of an article that is forthcoming in revised form, after minor editorial changes, in the Journal of the History of Economic Thought (ISSN: 1053-8372), issue TBA. Copyright to the journal’s articles is held by the History of Economics Society (HES), whose exclusive licensee and publisher for the journal is Cambridge University Press (https://www.cambridge.org/core/journals/journal-of-the-history-of-economic-thought ). This preprint may be used only for private research and study and is not to be distributed further.

The preprint may be cited as follows:

McClure, James E, David Chandler Thomas and Lee C. Spector. “A Retrospective Look at the Hayek Story: Roundaboutness, Sticky Consumption, and Sequestered Capital”. Journal of the History of Economic Thought (forthcoming). Preprint at SocArXiv, osf.io/preprints/socarxiv May 22, 2020[CITATION Hic39 \n \t \l 1033 ][CITATION Hay094 \n \t \l 1033 ] [CITATION Hic39 \n \t \l 1033 ]A Retrospective Look at The Hayek Story: ROUNDABOUTNESS, STICKY CONSUMPTION, AND SEQUESTERED CAPITAL1

By James E. McClure, David Chandler Thomas, and Lee C. Spector

I rather hoped that what I'd done in capital theory would be continued by others.

… [Completing it myself] would have meant working for a result which I already

knew, but I had to prove. Friedrich Hayek [CITATION Hay941 \p "p. 96" \n \t \l

1033 ]

I. INTRODUCTION

Soon after the 1929 stock market crash, Friedrich Hayek’s lectures at the London School

of Economics (LSE), highlighting an Austrian-school business cycle theory, inspired tremendous

enthusiasm. According to Ludwig Lachmann [CITATION Lac82 \p "p. 630" \n \t \l 1033 ],

“Hayek’s triumphal entry on the London stage with his lectures on Prices and Production,”

meant that, for a time, “all important economists there [at the LSE] were

Hayekians”[CITATION Lac82 \p "p. 630" \t \l 1033 ]. In his key LSE lectures, Hayek relied on

Eugen von Böhm-Bawerk’s idea of roundaboutness—greater roundaboutness, depending on

whether it were achieved by voluntary or “forced” saving, would enhance or diminish future

efficiency and living standards. The prominence of Hayek’s Prices and Production, as Mark

Skousen explains, was short-lived:

1 For comments and criticisms on earlier drafts, we thank Roger Garrison and Steven

Horwitz. Any remaining errors are ours. 1 Joseph Schumpeter said that Hayek’s little book “met with a sweeping success

that has never been equaled by any strictly theoretical book,” attracting young

disciples John Hicks, Abba Lerner, Nicholas Kaldor, G.L.S. Shackle, E.F.

Schumacher, and even Paul Sweezy. But within a few years, most wrote critically

of Hayek’s capital theory, ultimately joining the Keynesians, except for Sweezy,

who became a Marxist. [CITATION Sko05 \p "pp. 163-164" \t \l 1033 ]

Throughout the 1930s, Hayek’s explanation of business cycles withered under the blazing criticisms that Frank Knight2 and others had of the Böhm-Bawerkian model of capital roundaboutness that Hayek’s cycle-explanation was built upon.

Admitting inadequacies in the Böhm-Bawerkian undergirding of his business cycle thesis, Hayek began work in 1934 on a two-volume book on capital theory to provide solid undergirding for his thesis. John Hicks (1939), in Value and Capital, provided a financial measure of roundaboutness that overcame many of the apt criticisms that had been leveled at

Hayek’s Böhm-Bawerkian model. In 1941, Hayek published the first and only volume of his planned two-volume book. Although Value and Capital is listed in the bibliography of The Pure

Theory of Capital, Hayek (1941) makes no reference (in either the main-text or footnotes) to

2 For a detailed chronology and analysis of the debate between Knight and Hayek that took place in the 1930s see Avi Cohen [CITATION Coh031 \n \t \l 1033 ]. Piero Sraffa

[CITATION Sra321 \n \t \l 1033 ] [CITATION Sra321 \n \t \l 1033 ]was also highly critical of

Hayek’s Prices and Production, bluntly asserting that “a methodical criticism could not leave a brick standing in the logical structure built up by Dr. Hayek” [CITATION Sra32 \p "p. 45" \n \y

\t \l 1033 ]. For an insightful retrospective analysis of the duel between Hayek and Sraffa, see

Ludwig Lachmann [CITATION Lac86 \n \t \l 1033 ]. 2 Hicks’s (1939) theory of production process duration as an alternative to Böhm-Bawerkian roundaboutness. In 1967, John Hicks challenged, as inexplicable, assumed lags in The Hayek

Story (of business cycles). Hayek, who abandoned capital theory in 1941, avoided formal reengagement.

This paper offers a fresh look at Hayek’s abrupt 1941 turn away from seven years of trying to discover a theory of capital to replace his much criticized Böhm-Bawerkian model of roundaboutness. Curiously, although Hayek abandoned efforts to formalize a supporting capital theory, he continued to maintain that his thoughts on the nature and causes of business cycles were fundamentally sound. This paper considers this and two related puzzles: First, why did

Hayek disregard Hicks’ theory of duration? Second, why did Hayek dismiss Hicks’ criticism that

“The Hayek Story” was built upon inexplicable lags via a viscosity-of-honey analogy? In light of new knowledge and recent advances in Austrian economics, we suggest additional insight into

Hayek’s transformation.3

3 It has been over three decades since Bruce Caldwell’s [CITATION Cal881 \p "p. 538" \ n \t \l 1033 ] seminal analysis of the transformation of Hayek’s thinking from 1928 to 1942.

Caldwell’s emphasis was upon the debates about capital theory in the 1930s and those that played out concurrently regarding the impossibility of the socialist calculation. Caldwell concluded that Hayek’s discovery that “standard equilibrium theory could be used in a defense of socialist planning” was pivotal in Hayek’s transformation: “…because no equilibrium model of the time could handle such an assumption [of subjectively-held and dispersed knowledge], it is understandable that Hayek felt it necessary to leave economics in an attempt to address the question of how plans could be coordinated in a world of subjective knowledge” [CITATION

Cal881 \p "p. 536" \t \l 1033 CITATION Cal881 \p "p. 536" \n \t \l 1033 ]. 3 II. HAYEK’S BUSINESS CYCLE STORY

In Prices and Production (P&P), Hayek [CITATION Hay31 \n \t \l 1033 ] offered an

explanation of business cycles that was built upon a Böhm-Bawerkian model of roundaboutness.

According to this theory, the original means of production (land and labor) are combined with

capital, where capital is defined in terms of intermediate products that progressively add value in

stages of production that ultimately mature into consumption goods.

A. THE LONGSTANDING APPEAL OF SAVING-DRIVEN ROUNDABOUTNESS

At a high level of abstraction, the underlying basic idea in the above, again of land, labor,

and capital being combined in successive stages that culminate in consumption goods, was so

straightforward and intuitive that John Hicks initially found it “irresistible”

Nearly everyone who comes to the study of capital falls victim to Böhm-Bawerk’s

theory at some stage or other. … [His] ideas give the subject an apparent clarity

which is, at first sight, irresistible. [CITATION Hic39 \p "p. 193" \t \l 1033 ]

Even Frank Knight, who “repeatedly and forcefully” [CITATION Hic39 \p "p. 193" \t \l 1033 ]

throughout most of the 1930s criticized the particular details of the Hayek model used in Prices

and Production, expressed similar thoughts about the “plausibility” of Böhm-Bawerkian

roundaboutness in the abstract:

On the face of it, there must be plausible reasons for holding that the use of more

capital is equivalent to the use of more time in production; otherwise the doctrine

would not have been so generally expounded and believed. It unquestionably

requires time to construct capital goods, and since these are subsequently used in

processes requiring time, to make a product, and are more or less used up, it is

natural to consider their production and use as an indirect in place of a direct

4 application of the productive capacity going into them, and to consider the time

involved in their creation, during which no final product is forthcoming, as added

to that of their use to form a total production period for final product.[CITATION

Kni35 \p "p. 79" \t \l 1033 ]

On its face, Knight agrees with Hicks that the concept of roundabout production has an unquestionable appeal.

The appeal of these ideas was built upon the common use by early capital theorists of engaging similes and examples to set the stage for analyses of capital in the complex, monetary economy. Here are three examples: In the first, the imagery of savages in trees is used to animate the notion that savings is a necessary condition for capital formation:

As capital, from its simplest form, to its most complicated state, means something

produced, for the purpose of being employed, as the means toward a further

production; it is evidently a result of what is called saving. Without saving there

could be no capital. If all labour were employed upon objects of immediate

consumption, all immediately consumed, such as the fruit for which the savage

climbs the tree, no article of capital, no article to be employed, as a means to

further production, would ever exist. [CITATION Mil26 \p "p. 19" \t \l 1033 ]

Following James Mill’s example, Stanley Jevons contrasts capital-assisted cultivation of corn with what might be accomplished with one’s fingers only:

Capital simply allows us to expend labour in advance. Thus, to raise corn we

need to turn over the surface of the soil. If we proceed straight to the work, and

use the implements with which nature has furnished us—our fingers—we should

spend an enormous amount of painful labour with very little result. It is far better,

5 therefore, to spend the first part of our labour in making a spade or other

implement to assist the rest of our labour. This spade represents so much labour

which has been invested, and so far spent; but if it lasts three years its cost may

be considered as repaid gradually during those three years. This labour, like that

of digging [with fingers], has for its object the raising of corn, and the only

essential difference is that it has to precede the production of corn by a longer

interval. [CITATION Jev88 \p "p. 226" \t \l 1033 ]

In this final example, Böhm-Bawerk uses an engaging, Robinson Crusoe simile to explain capital formation, via production and saving:

In Economic science there are three theories current concerning the formation of

capital. One ascribes the origination of capital to saving, another to production,

and a third to both factors. … In order to begin with the simplest conceivable

instance [of capital formation], let us imagine a recluse carrying on his economy

completely devoid of capital, somewhat after the manner of a Robinson Crusoe

cast ashore on a solitary island and entirely without resources of any kind. … Is

saving enough to give birth to capital? Certainly not. Our Robinson can save and

scrimp as he will with his fruit and berries, the most he can do is to amass a

treasure of stored up consumption goods. But it certainly will not gain for him a

single bow or arrow. It is quite obvious that those must be produced. Does

production then suffice for the origination of capital, and is the second theory [of

capital origination] correct? No more than the first. To be sure, once the point

has been attained of starting the production of capital goods, then the formation

of capital is as good as achieved. But before that period is attained something

6 else has to be done that is by no means a matter of course. Productive forces have

to be liberated for the proposed formation of capital and the only way to do that

is by saving. [CITATION Böh59 \p "p. 102; emphasis in the original" \t \l 1033 ]

Fast-forwarding from the nineteenth to the twenty-first century, a form of Hayek’s theory of roundaboutness remains in use and is widely seen as a valuable way of expositing a foundational understanding of capital structure macroeconomics at a high level of abstraction.4

Time-structure roundabout production is the cornerstone of Roger Garrison’s [CITATION

Gar012 \n \t \l 1033 ] seminal book Time and Money, which has played a major role in the revival of Austrian economics and its business cycle theory. In Figure 1 below, we reproduce, with minor modifications, Garrison’s [CITATION Gar012 \p "p. 47" \n \t \l 1033 ] presentation of a Hayekian triangle:

4 Nicholas Cachanosky and Peter Lewin provide this detailed explanation:

The number of stages of production that can be sustained by the market depends on the time preference of

consumers. For instance, a reduction in time-preference increases the supply of loanable funds and

reduces the interest rate in the market, other things being constant. This increase in savings allows for

extending the triangle by augmenting the financial capital needed to add stages of production. . . The

Hayekian triangle offers a simplification of capital theory in order to emphasize particular features such as

the effects of market interest rates on how long production takes in an economy.[CITATION Cac14 \p "p.

652" \t \l 1033 ] 7 FIGURE 1: STRUCTURE OF PRODUCTION (HAYEKIAN) TRIANGLE

In its general interpretation, Figure 1 is straightforward—producing consumer goods involves processes that take time and involve successive sequential stages. Such high-level interpretation of this modern Hayekian-triangle pairs well with classic discussions of the emergent cooperation facilitated by market processes. For example, the graphite inserted into the centers of pencils, that comes to reside there and, thereafter, in the hands of consumers via a process that plays out over time and distances involving mining, refining, manufacturing, distributing, and retailing: The graphite is mined in China and Sri Lanka. At the pencil factory, it’s mixed

with clay, heat, and other materials before it’s extruded, dried, and baked in a

kiln. People from different continents, different cultures, cooperate to bring these

materials together with waxes and kilns and equipment from across the world.

These too are the ancestors of the pencil. [CITATION Ins12 \t \l 1033 ]

B. HAYEK’S THEORY OF FORCED-SAVING AND INDUSTRIAL FLUCTUATIONS

It was Hayek’s [CITATION Hay29 \n \t \l 1033 ] extensive critique of the William

Foster and Waddill Catchings theory that voluntary saving (by consumers and/or businesses) caused economic cycles that inspired Lionel Robbins to invite Hayek to give the lectures at the

London School of Economics that were subsequently published as Prices and Production.5

Hayek is somewhat bewildered by the Foster and Catchings theory because:

5 See: Stephen Kresge[CITATION Kre94 \p "pp. 9-10" \n \t \l 1033 ]. 8 The proposition that saving can only bring about an increase in the volume of

production by enabling a greater and more productive “roundaboutness” in the

methods of production has been demonstrated so fully by the classical analysis of

Böhm Bawerk that it does not require further explanation.[CITATION Hay123 \p

"p. 156" \t \l 1033 ]

The confidence that Hayek shows here is understandable. As explained in the previous section, the primitive-peoples analogies that were used to make the case that saving was necessary to the process of capital formation had great appeal. Unfortunately, as will be explained later in this paper, Hayek’s confidence that Böhm-Bawerkian roundaboutness applied just as readily to modern industrial economies was premature.

The cause of economic cycles for Hayek was forced-saving rather than voluntary-saving.

His explanation of the trade cycle (i.e., industrial fluctuations) began with his acceptance of the finding “that, so long as we neglect monetary factors, there is an inherent tendency towards an equilibrium of the economic system.” He then proceeded in Prices and Production to show that

“monetary factors may bring about a kind of disequilibrium in the economic system—which could not be explained without recourse to monetary factors” [CITATION Hay321 \p "p. 238" \t

\l 1033 CITATION Hay321 \p "p. 238" \n \t \l 1033 ]. In particular, Hayek hypothesized that the immediate effect of an excessive expansion of monetary credit would be to disturb the stages of production from an equilibrium state in which the intermediate products, flowing through each stage of production, were just sufficient to provide the anticipated amount to the next stage and maintain equipment.

Hayek argued that excessive credit expansion by the monetary authority would cause the rate of interest to fall below the natural rate, sending entrepreneurs, operating across the stages of

9 production, the same signal that would arise from increased saving. Hayek argued that the reaction of entrepreneurs to the monetary authority’s excessive credit expansion would be the same as if the interest rate had fallen naturally (that is, as a result of consumption freely curtailed and savings voluntarily increased). In either case, Hayek anticipates new investment will take place in early stages (see Figure 1). The difference between the cases, according to Hayek, is that: When consumption is freely curtailed so that saving rises voluntarily, late stage investment falls proportionately. But when the monetary authority is the source of the additional credit, late stage investment is largely unchanged due to the “considerable lag between the increase in the money used for production and the corresponding increase in the income of the factors—and the consequent increase in the demand for consumers’ goods” [CITATION Hay321 \p "p. 242" \t \l

1033 CITATION Hay321 \p "p. 242" \n \t \l 1033 ].6

The disproportionate response in favor of early stages caused by excessive credit expansion does away with the proportionality that equilibrium across the stages of production requires. Hayek uses the term “forced saving” to describe disproportionate investments in early

6 For an lucid analysis of Hayek’s business cycle theory that distinguishes its four elements—time structure of production, Wicksellian price flexibility, non-neutrality of money, and capital disproportionality—see Harold Hagemann and Hans-Michael Trautwein [CITATION

Hag98 \n \t \l 1033 ]. Although they acknowledge that Hayek’s attempt to combine these elements was unsuccessful, they remain hopeful that his work will spur others to discover a defensible business cycle theory: “Hayek could not convince the profession that his business- cycle theory is consistent and relevant. Nevertheless, his early research programme continues to be of interest … [T]he issues raised by Hayek’s brickworks and their destruction remain to be built into a theory that will be general enough to withstand such criticism” [CITATION Hag98 \p

"p. 310" \t \l 1033 ]. 10 stages. This term was chosen to contrast these malinvestments with those early-stage investments that arise in proper proportion when prompted by voluntary increases in saving arising from freely curtailed consumption.

Key to the disproportionality in Hayek’s theory and the capital consumption that it causes, is the aforementioned “considerable lag” of wage increases behind the early-stage capital goods expenditures toward which entrepreneurs direct the expansive credits. Albeit

“considerable” in Hayek’s mind, this lag is finite: “… even the money used for the purchase of new capital goods must ultimately be paid out to the factors … but [incomes] will rise to the full extent only when all the new money has passed backwards through the successive stages of production.” [CITATION Hay321 \p "p. 242" \n \t \l 1033 ]. Capital consumption (wastage) is the consequence of this capital expenditure boom that Hayek anticipates: As the credit expansion slows or ends, as it inevitably must, and as wages rise, as they ultimately must, then “the proportion of his money receipts which is left to every individual entrepreneur to spend on capital goods is no greater than before [the boom when there was less capital to be maintained].”

In closing this section, consider the primitive-people simile that Hayek used in P&P to facilitate understanding of how malinvestment into an excessively roundabout production process leads to capital consumption:

The situation would be similar to that of a people on an isolated island, if, after

having partially constructed an enormous machine which was to provide them

with all necessities, they found out that they had exhausted all their savings and

available free capital before the new machine could turn out its product. They

would then have no choice but to abandon temporarily the work on the new

process and to devote all their labor to producing their daily food without any

11 capital. Only after they had put themselves in a position in which new supplies of

food were available could they proceed to attempt to get the new machine into

operation. [CITATION Hay31 \p "p. 272" \t \l 1033 ].

In this simile, Hayek harkens back to the idea of a subsistence fund of food being capital as

William Stanley Jevons defined it—again, capital being anything that “allows us to expend

labour in advance.” Jevons [CITATION Jev88 \p "p. 224" \n \t \l 1033 ] illustrated subsistence

fund capital by highlighting this explanation by Mill [CITATION Mil26 \p "p. 9" \n \t \l 1033 ]:

If the Man who subsists on animals cannot make sure of his prey in less than a

day, he cannot have less than a whole day’s subsistence in advance. If hunting

excursions are undertaken which occupy a week or a month, subsistence of

several days may be required.

III. HAYEK’S ABANDONMENT OF CAPITAL THEORY

As we emphasize in the introduction, Hayek’s business cycle theory lost traction

throughout the 1930s as he agreed with critics about inadequacies in the theory’s undergirding

Böhm-Bawerkian model of roundabout production. To understand these inadequacies in context,

consider the schematic that Hayek[CITATION Hay31 \p "p. 233" \n \t \l 1033 ] used in Prices

and Production to illustrate his model of roundaboutness:

12 FIGURE 2: HAYEK’S MODEL OF ROUNDABOUTNESS IN PRICES AND PRODUCTION

One inadequacy of Figure 2 that Hayek eventually acknowledged was its distinction between original means of production and intermediate products. Knight [CITATION Kni35 \p

"pp. 78-82" \n \t \l 1033 CITATION Kni35 \p "p. 78-82" \n \t \l 1033 ] argued that Hayek had, in drawing this distinction, adopted a subsistence-fund doctrine whose assumptions were “almost entirely false to the facts of modern industrial life” [CITATION Kni35 \p "p. 81" \t \l 1033 ].

Chastened by Knight, Hayek distanced himself from this distinction:

It is quite erroneous to regard propositions concerning greater productivity of

roundabout methods as depending upon the possibility of identifying the

contribution of the “original” factors. [CITATION Hay36 \p "p. 208" \t \l 1033 ]

13 A second feature of Figure 2, its delineation of a definite average period of production,7 was problematic—leading to this lucid criticism by Knight:

Even with reference to such primitive agricultural conditions the really critical student

(such as hardly exists) might have had disturbing queries in connection with treating quantity of capital as a matter of length of production cycle. In fact, the quantity of the capital bears no simple or definite relation either to its durability or to any definable time interval. Taking population as given, raising more plants of the same growth period will also require more " stock," but will not affect the length of the [production] cycle, while the addition to total production of new varieties of shorter growth, say yielding two harvests per year instead of one, will involve an increase in the capital, while shortening the average cycle [period of production]. [CITATION Kni35 \p "p. 81" \t \l 1033 ]

Hayek [CITATION Hay36 \p "p. 206" \n \t \l 1033 ] conceded:

It is not proposed, and is in fact inadmissible, to reduce the description of the range of periods for which the different factors are invested to an expression of the type of a single time dimension such as the average period of production.

Two other inadequacies implicit in Figure 2 were highlighted by Hayek [CITATION

Hay342 \n \t \l 1033 ]himself[CITATION Hay342 \n \t \l 1033 ] in the preface of the second edition of Prices and Production. First, he lamented that: “I had to leave durable goods simply out of account” [CITATION Hay342 \p "p. 195" \n \y \t \l 1033 ]. Second, he acknowledged

7 In Figure 2, the average period of production is two. This may be determined either by:

1) dividing the four intermediate product stages in half; or 2) by finding the ratio of the total of intermediate products, 8+16+24+32=80, divided by the amount of consumers’ goods, forty. 14 that its assumption that the stages were constructed of equal length had drawn sharp criticism because it imposed

… a somewhat one-sided treatment of the problem of the velocity of circulation of

money. It implied more or less that money passed through the successive stages at

a constant rate which corresponded to the rate at which the goods advanced

through the process of production, and in any case excluded consideration of

changes in the velocity of circulation or the cash balances held in the different

stages. The impossibility of dealing expressly with changes in velocity of

circulation so long as this assumption [of separate stages of equal length] was

maintained served to strengthen the misleading impression that the phenomena I

was discussing would be caused only by actual changes in the quantity of money

and not by every change in the money stream, which in the real world are

probably caused at least as frequently, if not more frequently, by changes in the

velocity than by changes in the actual quantity. It has been put to me that any

treatment of monetary problems which neglected in this way the phenomenon of

changes in the desire to hold money balances could not possibly say anything

worthwhile. [CITATION Hay342 \p "p. 195" \t \l 1033 ]

The opening paragraph of the preface of the second edition of Prices and Production is revealing. In it, Hayek [CITATION Hay342 \p "pp. 191-192" \n \t \l 1033 ] does three things:

First, he offers an explanation of the inadequacy of the theory of industrial fluctuations in Prices and Production—the University of London’s invitation to deliver four lectures on the topic had

15 led to “an irresistible temptation” to publish “oversimplified” ideas prematurely.8 Second, Hayek celebrates the criticism that made him realize that the underlying “‘Austrian’ theory of capital” in

Prices and Production needed “to be developed in far greater detail” to be applicable. Third,

Hayek expressed the hope that, as a consequence of all the criticisms that Prices and Production had inspired, a “more exhaustive” and “satisfactory” treatment of the “problems” of Prices and

Production might be forthcoming at some “later” date.9

Although 1934 marks the last revision of the final edition of Prices and Production, it does not mark the end of Hayek’s efforts to resolve its inadequacies. Quite the contrary: In 1934,

Hayek began a seven-year quest to write a two volume book on “Austrian” capital theory for the purpose of resolving the inadequacies of the Böhm-Bawerkian model of roundabout production in Prices and Production. Hayek only ever worked on one of the two volumes planned, The

Pure Theory of Capital, which was published in 1941. Asked in 1994 about his incomplete capital theory project, Hayek reflected that:

I had been criticized for the fact that in Prices and Production I had a very

inadequate theory of capital; that in this crude Böhm-Bawerkian form of an

average period of production, it was inadequate. So I started writing a great book

on capital and money, which ultimately dealt with the monetary phenomenon. It

8 The second edition of Prices and Production was left “on the whole unchanged” from the first edition, which Hayek acknowledged provided only an incomplete elaboration of “the outlines of a theory of industrial fluctuations” in advance of his realization of “all the difficulties which such an elaboration presented” [CITATION Hay342 \p "p. 191" \t \l 1033 CITATION

Hay342 \p "p. 191" \n \t \l 1033 ].

9 “But the time for that more exhaustive treatment of these problems has not yet come”

[CITATION Hay342 \p "p. 191" \t \l 1033 CITATION Hay342 \p "p. 191" \n \t \l 1033 ]. 16 took me very much longer than I thought; I worked seven years on the thing. I

was dead tired of the subject before I got to the monetary aspects. [CITATION

Hay941 \p "pp. 90-91" \t \l 1033 ]

Nevertheless, Hayek continued to maintain that Böhm-Bawerk had been fundamentally correct, notwithstanding the inapplicability of Böhm-Bawerkian roundaboutness to the real- world:

[W]hile Böhm-Bawerk was fundamentally right, his exposition in terms of an

average period of production was so oversimplified as to mislead in application.

And that if we want to think the Böhm-Bawerk idea through, we have to introduce

much more complex assumptions. Once you do this, the things become so damned

complicated it’s almost impossible to follow it. [CITATION Hay941 \p "p. 141" \t

\l 1033 ]

Hayek’s quest to construct a defensible “Austrian” theory of the time structure of capital by replacing Böhm-Bawerk’s average period of production with “much more complicated” assumptions was a dead-end.10 Hayek’s use of profanity in the above quotation is highly unusual;

10 Cohen and Geoffrey Harcourt[CITATION Coh03 \n \t \l 1033 ] provide a clear analysis of the key difficulties economists have encountered, and still face, in trying to create a consistent theory of capital that is not oversimplified. Capital heterogeneity is one of these difficulties that, as they explain, posed problems for Hayek in particular: “In the 1930s [capital theory] controversies, Hayek insisted that decreases in the interest rate prompt more roundabout, capital-intensive production, even though he could not prove this in heterogeneous goods models. Hayek (1941, pp. 141-142) freely acknowledged: ‘All attempts to reduce the complex structure of waiting periods … are bound to fail, because the different waiting periods cannot be 17 indeed it is the only case we are aware of in which he profanely expressed anger and/or

frustration. So ended Hayek’s seven year quest—he abandoned an incomplete theory of capital

in 1941.11

IV. HAYEK’S DISREGARD OF HICKS’ SUGGESTION AND CRITICISM

Böhm-Bawerk was not talking complete nonsense. [CITATION Hic39 \p "p. 219" \t \l 1033 CITATION Hic39 \p "p. 219" \n \t \l 1033 ]

On two occasions in particular, Hayek appears to be dismissive of ideas presented by

John Hicks. The first, is Hicks’ publication in 1939 of an alternative, financial measure to Böhm-

Bawerk’s average period of production which Hicks suggested as a means by which the

Austrians could side-step objections raised by Frank Knight. On the second occasion, in 1967,

Hicks questions what he sees as inexplicable lags in an article entitled “The Hayek Story.” These

two occasions will be discussed in turn below:

A. HAYEK’S DISREGARD FOR HICK’S MEASURE OF AVERAGE PERIOD

In response to the deconstruction of the Böhm-Bawerkian average period of production

(APP) that Hayek presented in Prices and Production, John Hicks[CITATION Hic39 \n \t \l

1033 ] developed an alternative measure, average period (AP). Because Hicks’ measure is

determined by financial streams rather than the length of time it takes to produce consumers’

reduced to a common denominator in purely technical terms’ ”[CITATION Coh03 \p "p. 212" \t

\l 1033 ].

11 A common misreading of Caldwell’s[CITATION Cal881 \n \t \l 1033 ] seminal

analysis of “Hayek’s Transformation” has led many to conclude that “Hayek abandoned

economics” entirely in 1941. For alternative corrections of this misperception see: Peter Boettke

[CITATION Boe171 \n \t \l 1033 ] and James McClure and David Chandler Thomas

[CITATION McC184 \n \t \l 1033 ]. 18 goods, it avoids Knights’ objection that additional capital did not necessarily imply that

production would require more time. For the stream of payments( x0 ,x1 ,x2 ,...+xv ), Hicks

[CITATION Hic39 \p "p. 186" \n \t \l 1033 ] defines the capital value of this stream as

2 3 v x0+βx1+2 β x2+3 β x3+...+ β xv, where β denotes the discount ratio 1/(1+i), and where “i” is the interest rate. Hick’s Average Period is the elasticity of this capital value with respect to the discount ratio, again β, which is:

2 3 v βx1+2β x2+3 β x3+...+β xv 2 3 v x0+βx1+2 β x2+3 β x3+...+β xv

Hicks emphasizes that his average period measure resolves objections that Knight raised about the Böhm-Bawerkian capital theory that Hayek’s P&P was built upon.

His [Böhm-Bawerk’s] theory was valid enough for the cases he was considering;

it ought to be possible to find a generalized concept which will meet Professor

Knight’s objections, and will yet include Böhm-Bawerk’s argument as a special

case. . . . we have it in our hands already. We have already, in the course of our

argument, come across an average period which is proof against these [Knight’s]

objections. [CITATION Hic39 \p "p. 219" \t \l 1033 ].

In the sentence following the above quotation, Hicks makes it crystal clear that he thought that the Austrians (Böhm-Bawerk, Hayek, and all those advancing the capital-consumption-based business cycle theory) were onto an underlying truth that they could not explain. Hicks says of his average period, “it was this which the Austrians were looking for” [CITATION Hic39 \p "p.

219" \t \l 1033 ].

Furthermore, Hicks provides the following illustration that his measure of average period yields a lengthening result similar to that emphasized by traditional Austrian capital theory:

19 Suppose that the production undertaken by a particular firm consists simply in

the simultaneous carrying out of a number of quite separate processes, each of

which takes n weeks from first to last. Suppose (initially) that the firm is in

stationary equilibrium, with mn of these processes being carried on together; m

new processes are started every week, to replace the m processes which are

finished at the beginning of the week; thus the streams of total inputs and total

outputs are both constant over time. The firm contents itself with no more than

mn processes for reasons of risk; risk-coefficients increase as the scale of output

expands; the entrepreneur declines to undertake extra processes, because their

capitalized value (allowance being made for risk) would be negative. Now

suppose that the rate of interest falls; the capitalized value of a new process will

then be raised; and it may become profitable to undertake some extra processes,

which were not profitable previously. Now there is absolutely no reason why the

new processes should not have identically the same technical character as the

old; nevertheless, in spite of that, just because they are new processes,

undertaken only because the rate of interest has fallen, their inception must raise

the average period of the plan. [CITATION Hic39 \p "pp. 223-224" \t \l 1033 ]

Given that Hicks published his measure of average period in 1939, the question arises:

What did Hayek say about it in 1941 in The Pure Theory of Capital? The answer: Not one word.

Importantly, Hayek’s silence in The Pure Theory of Capital about Hicks’ measure of average period was not because Hayek was unaware of the book within which Hicks’ had discussed this measure—Hicks’ Value and Capital is listed in Hayek’s[CITATION Hay094 \n \t \l 1033 ]

20 bibliography. Nor, as recent scholarship affirms,12 was it because Hicks was incorrect to claim his, average period, measure overcame Knights’ objection to the average period of production measure that Hayek used in Prices and Production.

C. Hayek’s Unhelpful Explanation of the Lag in his Business Cycle Theory

After decades of his average period measure being ignored by the Austrians as a substitute for their average period of production, Hicks wrote a book chapter on Hayek’s explanation of industrial fluctuations, somewhat glibly entitled “The Hayek Story.”13 There,

Hicks observes that Hayek’s business cycle theory was built under the mantel of Wicksell’s theory of the “cumulative process.”

In Wicksell, the ‘Cumulative Process’ is a matter of prices. When the ‘market

rate’ of interest is reduced below the natural rate, prices rise. Nothing is said

about the movement of quantities (inputs and outputs). On the bearing of his

construction on the causation of Trade Cycles, Wicksell is open-minded. Hayek

was asking the question: what happens to quantities in a Wicksellian process? He

took his model very ‘pure’: much purer than Wicksell himself had been

12 See: Cachanosky and Lewin [CITATION Cac14 \n \t \l 1033 ]; Cachanosky and

Lewin [CITATION Cac18 \n \t \l 1033 ]; and Lewin and Cachanosky [CITATION Lew18 \n \t

\l 1033 ].

13 Setting title aside, Hicks[CITATION Hic \p "p. 201" \n \t \l 1033 ] was grappling with an interesting multi-faceted history of thought puzzle: How was it that Hayek’s ideas on business cycles “are almost unknown to the modern student” given that “the new theories of Hayek were the principal rival of the new theories of Keynes [in the 1930s]” and that many “teachers of economics, and practical economists,” had taken “quite a time to make up their minds [regarding

“which was right, Keynes or Hayek?].” 21 accustomed to take it. Prices (all prices) are perfectly flexible, adjusting

instantaneously, or as nearly as matters. Price expectations are not introduced

explicitly, for in 1930 their day had not yet come. [CITATION Hic \p "p. 206" \t \l

1033 ]

Rethinking Hayek’s credit expansion theory of the business cycle in this light, Hicks reasoned that if the market rate of interest fell below the natural rate, then nominal prices would increase uniformly and leave real quantities unaffected. Similarly, Hicks (pp. 207-08) argued that if wages and prices are flexible, as Hayek had assumed, then, although a credit expansion would raise nominal savings and investment, the real economy would be unaffected. The initial effect of credit expansion may be to reduce the rate of interest below the natural rate, causing the money value of investment to increase along with the price of producers’ goods, however, the money value of labor, which is also a producer good, must increase as well. Nominal wages will therefore rise, and consumption spending will, Hicks argued, increase nearly instantaneously.

The increased demand for consumer goods will cause their prices to increase until, relative to producers’ goods, they are the same as before the credit expansion—restoring equilibrium with

Wicksellian swiftness.

According to Hicks, Hayek’s boom would end almost before it began. Recall from the discussion in Section II. B. above: Hayek’s explanation of the credit-expansion boom hinges upon the existence of a “considerable lag between the increase in the money used for production and the corresponding increase in the income of the factors—and the consequent increase in the demand for consumers’ goods” [CITATION Hay321 \p "p. 242" \t \l 1033 CITATION Hay321 \ p "p. 242" \n \t \l 1033 ]. Responding to the criticism of this lag by “Sir John,” Hayek pressed

Hicks that its existence could be illustrated by an analogy regarding the viscosity of honey:

22 I find it useful to illustrate the general relationship by an analogy which seems

worth stating here, though Sir John (in correspondence) did not find it helpful.

The effect we are discussing is rather similar to that which appears when we pour

a viscous liquid, such as honey, into a vessel. There will, of course, be a tendency

for it to spread to an even surface. But if the stream hits the surface at one point,

a little mound will form there from which the additional matter will slowly spread

outward. Even after we have stopped pouring in more, it will take some time until

the even surface will be fully restored. It will, of course, not reach the height

which the top of the mound had reached when the inflow stopped. But as long as

we pour at a constant rate, the mound will preserve its height relative to the

surrounding pool—providing a very literal illustration of what I called before a

fluid equilibrium.[CITATION Hay69 \p "p. 281" \t \l 1033 ]

So the question arises: Why did Hayek press Hicks with this analogy that Hicks found

“unhelpful”? Given Hicks’ apparently flippant chapter title, again, The Hayek Story, and given

Hayek’s seemingly glib reference to Hicks as “Sir John,” one possible answer is that Hayek’s mound-of-honey analogy was merely Hayek engaging in Tit-for-Tat—giving an unserious response to a disrespectful critic. But for reasons explained in the subsection below, this answer seems at best incomplete.14

14 Another reason (beyond those that will be discussed in the next subsection) is that

Hayek was a scholar who demonstrated a willingness to change his mind not only about the particulars of Böhm-Bawerkian roundaboutness (discussed in detail earlier in this paper) undergirding his business cycle theory, but also about particular aspects of his business cycle theory itself. Antonio Magliulo provides this important example of Hayek changing his mind 23 D. HAYEK’S HONEY ANALOGY AND DISREGARD FOR HICK’S AVERAGE PERIOD

MEASURE

Beyond Hayek just being flippant with “Sir John,” what else might explain his mound-of- honey analogy? Well-known Austrian business cycle theorist Roger Garrison[CITATION

Gar04 \p "p. 344" \n \t \l 1033 ], referred to the lags in Hayek’s theory as “unsolved mysteries” and offered this explanation:15

Hayek never realized that the element of overconsumption was critical in

responding effectively to the criticisms offered by Sraffa and (later) John Hicks.

Instead of allowing for overconsumption, Hayek (1969) offered his mound-of-

honey analogy to support the notion of a substantial lag between the increased

investment spending and the subsequent increase in consumption. (Pouring

money into the economy is like pouring honey into a vat: Where the honey hits the

surface, a mound forms and persists as long as the pouring continues.)

[CITATION Gar04 \p "p. 336" \t \l 1033 CITATION Gar04 \p "p. 336" \n \t \l

1033 ] regarding policymaker’s behavior during the “secondary deflation” phase of the cycle: “In the

1930s he stated that the policymakers had made a mistake in impeding the spontaneous readjustment of the market with expansionary policies. On the contrary, in the 1970s he claimed that they made a mistake in allowing the deflation to go on without expansionary policies.

[CITATION Mag16 \p "pp. 31-58" \l 1033 CITATION Mag16 \l 1033 ]

15 “The basis for—and the duration of—the lag [in Hayek’s theory] between the initial movements along the frontier and the subsequent counter-movements are left as unsolved mysteries. And in the absence of a lag, the [monetary] policy-induced boom is nipped in the bud by market forces.” [CITATION Gar04 \p "p. 344" \t \l 1033 ] 24 To avoid the lags in consumption that Hicks criticized, Garrison followed Mises, rather than

Hayek, in his explanation of the credit-inspired boom and bust.

The Garrison/Mises explanation of the business cycle has been a standard and important component of the Austrian-school canon for decades. This explanation assumes that the boom is characterized not only by early stage malinvestment, but also by concurrent, immediate, unlagged overconsumption.16 The boom turns to bust because the concurrent expansion of both early and late stages of production in Figure 1 deprives the middle stages of the resources necessary to allow the enlarged amount of early-stage, intermediate products to ever mature into consumers goods. In this way, the Garrison/Mises explanation of the business cycle overcomes

Hicks’ criticism in The Hayek Story.

Unfortunately, as explained in detail and at length by McClure and Thomas[CITATION

McC181 \n \t \l 1033 ], such overconsumption is at odds with the now large body of evidence that indicates that consumption is sticky.17 Crucially, the lags in Hayek’s theory cease to be the

16 Note Garrison’s comparison of Mises and Hayek regarding how the boom plays out:

“The essential problem of the credit-induced boom is repeatedly summarized by Mises with variations of the phrase malinvestment and overconsumption. The aspect of the problem identified by the first term of this phrase is [the only one] recognized and emphasized by Hayek.

The misallocation of resources—too many resources committed to the early stages of production

—is the malinvestment” [CITATION Gar04 \p "p. 327; emphasis in the original" \t \l 1033 ].

17 See McClure and Thomas (2018) for a review of the literature that significantly and robustly indicates that, as an empirical matter, consumption is sticky. The Bureau of Economic

Analysis (BEA) uses a cash-basis approach to calculate consumption. This approach can reflect what appears to be greater volatility across the boom-bust cycle than if a more accurate accrual- basis approach were applied. To report a more accurate measure, the purchases of durable goods 25 “unsolved mysteries” that Garrison thinks them to be, once it is evinced that Hayek had reached largely the same conclusion about consumption by simple observation—that consumption is sticky. Two pieces of evidence are these:

First, we see that Hayek, in a book review of Trade, Depression, and the Way Out by

Ralph Hawtrey [CITATION Haw31 \n \t \l 1033 ], emphatically disagreed with Hawtrey’s presumption that changes in consumption are a leading rather than a lagging indicator of depression:

Against all empirical evidence, he insists that “the first symptom of contracting

demand is a decline in sales to the consumer of final purchases” (p. 36). In fact,

of course, depression has always begun with a decline in the demand, not for

consumers’ goods but for capital goods, and the one marked phenomenon of the

present depression was that the demand for consumers’ goods was very well

maintained for a long while after the crisis occurred. [CITATION Hay32 \p "p.

127" \t \l 1033 ]

Secondly, in a review article about Hayek’s industrial fluctuations theory, Alvin Hansen and Herbert Tout emphasize that Hayek was in the company of a diverse set of other business cycle theorists in the 1930s who all emphasized that “empirically” industrial (rather than consumptive) fluctuations were the drivers:

Empirically, we know that the most salient characteristic of cyclical movements

of business is the fluctuation in the production of capital goods. This fact presents must be capitalized as deferred consumption and then depreciated over time. The result of this approach is an even smoother or stickier consumption series than that used in the literature to measure stickiness. 26 a challenge to the economist, and the problems which it suggests have been

attacked by methods as diverse as those of Spiethoff and Cassel, Aftalion and

J.M. Clark, Schumpeter and Robertson. [CITATION Han33 \p "p. 119" \t \l

1033 ]

Hence, Garrison’s mystery is largely solved. Hayek maintained that consumption demand changes lagged booms and busts in capital goods demand because he, like others, had observed a characteristic pattern. Unwilling to theorize against observation, Hayek did not include immediate overconsumption in his explanation of the boom, as the Mises/Garrison model does, as a way of overcoming Hicks’ criticism.

Still, there remains the puzzle that Hayek did not resolve of how to explain the lags with

Wicksellian price flexibility in play. We think that this may very well be the reason that

Hayek[CITATION Hay094 \n \t \l 1033 ], in The Pure Theory of Capital, offers not a word of discussion about Hicks’ average period measure. Recall from our earlier discussion that Hicks’ average period does provide a way around Knight’s criticisms of the Böhm-Bawerk average period of production measure Hayek emphasized in Prices and Production. We suggest two reasons to explain why Hayek eschewed Hicks’ average period:

First, we cannot see how Hicks’ average product measure would have offered Hayek a solution to the puzzle of how to explain the lag in consumption demand at the outset of the boom in his model without resort to an inexplicable suspension of Wicksellian price flexibility.

Secondly, neither Hicks, nor Hayek seem to have thought so either. As far as we have been able to determine, neither one of them ever thought of Hicks’ average period measure as a way to explain the lag in consumption demand over the cycle.

27 V. OVERLOOKING SEQUESTERED CAPITAL

To set the stage for this section’s modification of the Hayek story—making sequestered

capital the earliest component of the capital structure—a recap of our discussion so far is useful:

Both Hicks and Knight argued that Hayek’s theory in Prices and Production, which was

motivated by Robinson Crusoe imagery and primitive agriculture scenarios, was inapplicable to

the modern industrial economy. Hayek[CITATION Hay094 \n \t \l 1033 ] ignored

Hicks’[CITATION Hic39 \n \t \l 1033 ] average period measure, despite its usefulness as a way

to avoid Knight’s criticisms of the Böhm-Bawerkian model of roundaboutness found in Prices

and Production. Hayek[CITATION Hay69 \n \t \l 1033 ] pressed Hicks [CITATION Hic \n \t \

l 1033 ] with an analogy about the viscosity of honey in response to[CITATION Hic \n \t \l

1033 ] criticism of the lags that Hayek hypothesized in his explanation of industrial fluctuations.

Hicks’ average period is never considered as a means of resolving the lags in Hayek’s theory—

neither by Hayek, nor Hicks, nor by us, nor by anyone else.

An explanation for the Hayek lag has emerged in recent research in Austrian economics.

A key omission has been discovered in the time structure of capital as it has traditionally been

conceived of by Austrian business cycle theorists from Hayek and Mises in the twentieth century

to Garrison in the twenty-first. In this tradition, the pre-market stages in which new products are

being invented, productized, and inventoried prior to being priced and put on the market in

observable quantities for sale, are completely ignored. This omission is significant for three

important reasons:

First, in the modern economy, enormous amounts of capital are at work in pre-market,

research and development efforts to, again: invent, productize, and amass pre-product-launch

inventories. Secondly, these pre-market stages, which precede the production of already-on-the-

28 market intermediate products, are, by definition, the earliest components of the time structure of capital. Pre-product-launch endeavors, by definition, precede the appearance of priced, new products being available for sale in the marketplace. Thirdly, and perhaps most significantly, capital usages in new-product research and development (R&D) endeavors are fundamentally different from capital being used in enterprises that are in competition with others selling priced products that are already on the market. Capital used in new-product R&D is sequestered— meaning that it is uncoordinated by the knowledge of competitors’ prices and output availabilities.

Recently, Nicholas Curott, McClure, and Thomas [CITATION Cur19 \n \t \l 1033 ] reformulated Garrison’s Misesian model of the business cycle so that both sticky consumption and sequestered capital are in play. For purposes of comparison and contrast with Figure 1 and

Figure 2 that we discussed above, consider this one from their article:

FIGURE 3: HAYEKIAN TRIANGLE WITH SEQUESTERED CAPITAL AS THE EARLIEST COMPONENT

29 In Figure 3, the stages of production correspond to the already on-the-market

“intermediate products” that Hayek relates in Figure 2 and the stages “mining, manufacturing, distributing, and retailing” that Garrison delineates in Figure 1. As seen in Figure 3, Curott et al. have included a pre-production, sequestered capital stage that precedes the on-the-market stages that the Hayek and Garrison theories bring into play.

The arrows in Figure 3, illustrate why pre-production capital is called sequestered capital.

The lateral arrows in Figure 3 illustrate informational signaling between laterally competing firms across the stages of production. Firms with products on the market are able to observe one another’s prices and output sales and distributions. On the other hand, firms engaged in new- product R&D, those in pre-production (see Figure 3), are uninformed in these ways regarding laterally competing firms.18 The horizontal arrows illustrate, that across the stages of on-the- market production, price and output information is coordinating the step-by-step processes. As noted in a previous example, graphite is taken from mines in China through refining, manufacturing, and distribution to eventually become the cores of retailed pencils. Notice that there is only a one-way arrow extending into the pre-market stages from the stages of production.

This is for two reasons; 1) because pre-production R&D is informed about the step-by-step processes taking place across the observable stages of production; and 2) because the step-by- step processes within the pre-market stages are sequestered.

The discovery of sequestered capital is pivotal to our understanding of Hayek’s abandonment of capital theory, of his disregard for Hicks’ average product measure, and of criticism of the lags in Hayek’s business cycle theory. Lacking sequestered capital as the earliest

18 The horizontal arrows in Figure 3, as explained by Curott et al., illustrate information about prices that flow freely across the stages of production and into, but not out of, pre- production stages. See Curott et al. for a complete discussion. 30 component of the structure of capital, Hayek was unable to create a theory of capital capable of supporting his explanation of the business cycle without suspending Wicksellian price flexibility

(so that disproportionate malinvestments could pile up in the early stages of production).19

Hayek argued that the key problem with non-monetary disproportionality theories of the trade cycle was that it was a “misconception of the deliberations that regulate the entrepreneur’s actions and of the significance of the price mechanism” to think that “under free competition… more and more people try to profit by the favorable situation, all ignoring one another’s preparations…” Hayek[CITATION Hay122 \p "p. 30" \n \t \l 1033 ]. Hayek’s criticism here makes a great deal of sense when the criticism is considered within the stages-of-production framing that Hayek applied when thinking about business cycles. In these stages, lateral competitors observe one another’s prices and production and the step-by-step processes by which intermediate goods are maturing into consumers’ goods.

Again, Figure 3 illustrates these informational flows regulating the actions of entrepreneurs via the presence of both horizontal and vertical arrows. But in the pre-production stages, the stages that Hayek deliberately excluded from his analyses,20 the “significance of the

19 Ironically, in Monetary Theory and the Trade Cycle, Hayek poses the following rhetorical question regarding non-monetary disproportionality explanations of the trade cycle that never answer the following question: “why do the forces tending to restore equilibrium become temporarily ineffective and why do they only come into action again when it is too late?” [CITATION Hay122 \p "p. 31" \t \l 1033 ] This is, in essence, the question that Hicks posed to Hayek about the lagged increase in consumers’ income and consequent demand in his business cycle theory.

20 “New inventions and new needs, however, although they are often adduced as explaining the accelerated and excessive growth of capital goods industries, cannot be dealt with 31 price mechanism” as a regulator of the actions of entrepreneurs is extremely limited. This is seen by the dearth of arrows in the sequestered capital triangle in Figure 3—illustrating that a dearth of market information about competitors’ activities applies to entrepreneurial usages of capital in this space.

Finally, it should be noted that the sequestered capital extension of Hayek’s business cycle theory offers an explanation of the timing of the bust that is lacking in all renderings of the

Austrian business cycle. The bust occurs when signals regarding the quantities of capital emerge, informing market participants of malinvestment and of its extent. McClure and Thomas

[CITATION McC172 \n \t \l 1033 ] use the sequestered capital extension of Austrian business cycle theory to explain the timing of the Tulipmania boom and bust: The Tulipmania boom occurred in the fall of 1636, when the bulbs were planted—sequestering information about the quantity of capital developing underground. The bust occurred in the spring of 1637, when the tulip bulbs sprouted (signaling to market participants the quantity of capital developing underground).21

on the same footing. They only represent a special group of the many possible causes from which the cumulative process described above may originate” [CITATION Hay122 \p "p. 31" \ t \l 1033 CITATION Hay122 \p "p. 31" \n \t \l 1033 ]. Here Hayek sets aside independent consideration of inventions and new goods, but still lumps them in with the cumulative process theories that he is criticizing for not understanding the coordinating power of the price mechanism.

21 Additionally, in an unpublished manuscript, McClure, Thomas, and Steven Horwitz provide an explanation of the timing of the collapse in the prices of blind investment trusts in

1929, concurrent with the historic crash of the stock market that year. 32 VI. CONCLUDING COMMENTS

Research on business cycle theory soared following the stock market crash in 1929. From

1928-1931, Friedrich Hayek’s theory emerged and gained traction in a series of publications.22

Throughout the remainder of the 1930’s, Hayek’s theory lost ground as he had to admit to critics

that his underlying model of Böhm Bawerkian roundaboutness was “inadequate” and

“oversimplified.” In 1934, Hayek resolved to write a “great book,” consisting of two volumes, on

capital theory that would undergird his business cycle theory. In 1941, Hayek published only the

first of the two volumes, which ignored John Hicks’[CITATION Hic39 \n \t \l 1033 ] average

period measure of roundaboutness, and abandoned forever his efforts to write the book’s second

volume. Subsequently, in response to criticism by Hicks [CITATION Hic \n \t \l 1033 ], Hayek

[CITATION Hay69 \n \t \l 1033 ] responded in a way that Hicks found “unhelpful” –

analogizing the lag of increased consumption behind early-stage investment during an

unsustainable credit expansion boom with the time it takes a mound of honey to spread out after

it ceases to be poured. In 2004, calling this analogy an “unsolved mystery,” Roger Garrison

(2001 & 2004) argued that a Misesian explanation of the credit cycle, which assumes immediate

overconsumption during the boom, be used rather than Hayek’s to avoid its inexplicable lag.

This paper revisited Hayek’s transformation during the 1930s in an attempt to gain

additional insights stemming from recent advances in Austrian economics which: 1) recognize

the large body of evidence that indicates that consumption is a lagging rather than a leading

indicator, consistent with Hayek’s thinking, and 2) revise the time structure of capital to bring

new-product R&D (sequestered capital) into play as the earliest component of the capital

22 In particular, we have emphasized: Hayek [CITATION Hay122 \n \t \l 1033 ], Hayek

[CITATION Hay29 \n \t \l 1033 ], and Hayek [CITATION Hay311 \n \t \l 1033 ]. 33 structure, which Hayek excluded. This retrospective analysis suggests possible answers to a variety of questions:

First, Hayek appears to have been aware, as an empirical matter, that consumption is sticky. Could this have been the reason for his unwillingness to assume, as Mises and later

Garrison did, that immediate overconsumption occurred during the boom? Further, this offers a plausible explanation for Hayek’s unhelpful mound-of-honey response to Hicks’ criticism of lagging consumption in Hayek’s theory. That is, this offers an explanation to what Garrison saw as an important “unsolved mystery.”

Second, Hayek never mentions Hicks’ average period measure of roundaboutness in The

Pure Theory of Capital, despite Hayek’s[CITATION Hay094 \n \t \l 1033 ] bibliographic listing of Value and Capital, in which Hicks[CITATION Hic39 \n \t \l 1033 ] presents this measure.

Why? As we explained, it is plausible that this was because Hicks’ average period measure did not provide Hayek with an explanation of the lagging (sticky) consumption that his explanation of the business cycle entails.

Finally, the recent discovery of sequestered capital as the earliest component of the

Hayekian triangle (see Figure 3) offers a retrospective validation of the hope against hope that sustained Hayek during his seven-year effort to rethink Böhm Bawerkian roundaboutness:

[W]hile Böhm-Bawerk was fundamentally right, his exposition in terms of an

average period of production was so oversimplified as to mislead in application.

And that if we want to think the Böhm-Bawerk idea through, we have to introduce

much more complex assumptions. Once you do this, the things become so damned

complicated it’s almost impossible to follow it. [CITATION Hay941 \p "p. 141" \t

\l 1033 ]

34 Hayek was fundamentally right that the structure of capital was crucial to understanding the nature and causes of industrial fluctuations. Unfortunately, as a result of overlooking sequestered capital as the earliest component of the structure of capital, as shown in Figure 3, he spent seven years studying only the figure’s stages of production. As we explained above, with sequestered capital as the earliest component of the structure of capital, malinvestment and sticky consumption, which Hayek maintained were characteristics of the credit expansion boom, pose no conflict with Wicksellian price flexibility (because there are, by definition, no priced products in the sequestered capital stages). Is it any surprise that Hayek, who defined the stages of production as the entire structure of capital, abandoned his quest to discover a theory of capital that would undergird his explanation of business cycles?

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CITATION Hay321 \p "p. 242" \t \l 1033 CITATION Hay321 \p "p. 242" \n \t \l 1033 : , (F.

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CITATION Kni35 \p "p. 81" \t \l 1033 : , (Knight 1935, p. 81),

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CITATION Hic39 \p "p. 186" \n \t \l 1033 : , (1939, p. 186),

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