by Gene Callahan
Imagine that you saunter to the faculty cafeteria one day and sit down at a table already occupied by two theoretical physicists. You discover them deep in a debate. One says he has developed the wind-driven theory of leaf fall that portrays the path of a leaf, once it has left its parent tree, to be determined almost entirely by the wind. The other fellow has a gravity-driven model of leaf fall, which has it that it is gravity controlling the show. You are somewhat amazed by the fierceness of their debate, and by the fact that they just keep going on at the level of theory. Finally, exasperated, you ask, “Has it ever occurred to either of you that you are both right? That both things are at play in the fall of leaves? And that rather than having this bitter argument, you’d both be better off working together, to see which of your theories works best at which times? For instance, it seems to me that, on a very still day, the gravity theory is going to be highly accurate. However, during a hurricane, it will apply hardly at all, while the wind theory will be almost the whole story?”
That little tale is a metaphor for how I have come to view the debate between the followers of Keynes and the followers of Hayek over how to describe the business cycle. Both of them have logically coherent models that plausibly describe some things that might result in an economic downturn. The real dispute between them ought to be, “To what extent do (or did) each of our models apply to this (or some past) economic downturn?” Instead, the dispute too often proceeds as if the goal is to crush the rival model, rather than to find out what models work where and when.
It seems obvious to me that, if a nuclear war took place tomorrow that wiped out three-quarters of the world’s population, economic activity would suffer a severe setback due to a collapse of aggregate demand. Similarly, if the government of the US chose to subsidize peacock farming to the tune of a trillion dollars a year, and then a new party in power suddenly withdrew that subsidy, economic activity would suffer a severe setback due to a sectoral imbalance. And, in historical reality, the most die-hard Austrian ought to be willing to admit that Rome, from 200 CE to 400 CE, suffered from a collapse of aggregate demand, as the population was repeatedly decimated by plague. And even Paul Krugman admits that there are times when economies suffer from sectoral imbalances in the capital structure: “I like this story [by Bob Murphy, of sectoral imbalance], and there are probably other cases besides China 1958-1961 to which it applies.”
Krugman proceeds to ask: “But what reason do we have to think that it has anything to do with the business cycles we actually see in market economies?” And this is exactly the right question, as Pete Boettke acknowledges. (And please note Mario Rizzo’s remark in the comments on Pete’s post that finding the Austrian model useful is not at all the same as finding it is the only model that is useful!) In Weberian terms, both the Hayekian and the Keynesian cycle theory have explanatory adequacy: both, if their assumptions hold true, would explain why an economic downturn would take place. So the issue that ought to be under discussion is: when, and to what extent, do these two theories have what Weber would call causal adequacy, meaning, is the ideal type they depict not merely plausible, but does it also help to describe various actual social goings-on?
As Roger Garrison notes, they key differentia of the Keynesian and the Hayekian models is the ability of wages and interest rates to adjust to a drop in the willingness to invest on the part of businesses. Do wage rates and interest rates adjust sufficiently, in the face of a drop in investment spending, to maintain equilibrium, or do they not? Moreover, if they do adjust, how fast do they do so? (No Austrian should dare to give the answer “instantaneously”!) If they don’t perfectly adjust, or if they adjust only slowly, how far out of equilibrium do they get? And why in the world should we believe the answer to these questions is the same for every business downturn?
Is our aim, as economic theorists, to defend our initial position come what may, or to advance our understanding of economic reality? If the latter, shouldn’t we be open to empirical evidence as to what model (or combination of models) most closely captures the current historical reality? Because I can’t help but believe that the key points of divergence between Keynes and Hayek are empirical matters, and can’t be answered on the plane of pure theory.