Must-Read: David Glasner says smart things about what Hayekian business cycle theory would have been had Hayek based his business cycle theory on his own insights into the price mechanism, rather than following the path he did, of attempting to reanimate a zombie version of the monetary overinvestment cycle.

It has always struck me as very strange: monetary overinvestment business cycle theories have very strong implications about how price systems are incapable of handling coordination problems. Yet the entire thrust of the rest of Hayek’s economics is on how price systems are often able to do so rather well…


The defining characteristic of an intertemporal equilibrium is that agents all share the same expectations… over their planning horizons…. [Thus] the optimizing plans of the agents are consistent, because none of the agents would have any reason to change his optimal plan as long as price expectations do not change, or are not disappointed as a result of prices turning out to be different from what they had been expected to be…. If agents have different information, so that their expectations of future prices are not the same, the plans on which agents construct their subjectively optimal plans will be inconsistent and incapable of implementation without at least some revisions….

[But] if markets for current delivery and for existing assets are in equilibrium in the sense that prices are adjusting in those markets to equate demand and supply in those markets, how can we understand the idea that  the optimizing plans that agents are seeking to implement are mutually inconsistent? The classic attempt to explain this intermediate situation which partially is and partially is not an equilibrium, was made by J. R. Hicks in 1939 in Value and Capital, when he coined the term “temporary equilibrium” to describe a situation in which current prices are adjusting to equilibrate supply and demand in current markets even though agents are basing their choices of optimal plans to implement over time on different expectations of what prices will be in the future….

For Hayek the Hicksian temporary-equilibrium construct would have been the appropriate theoretical framework within which to formulate a monetary analysis consistent with equilibrium analysis. Although there are hints in the last part of The Pure Theory of Capital that Hayek was thinking along these lines, I don’t believe that he got very far, and he certainly gave no indication that he saw in the Hicksian method the analytical tool with which to weave the two threads of his analysis…. [If] agents understand that their… plans may have to be revised… [and] recognize that… not all debt instruments (IOUs) are equally reliable… it [will be] profitable for some… to specialize in debt assessment… financial intermediaries….

In adjusting their plans when they observe that their price expectations are disappointed, agents may… increase sales or decrease purchases of particular goods and services… [or] scrap their old plans, replacing them with completely new plans… [which] may cause other agents to conclude that the plans that they had expected to implement are no longer profitable and must be scrapped…. But here’s the problem. There is no guarantee that, when prices turn out to be very different from what they were expected to be, the excess demands of agents will adjust smoothly to changes in current prices… violating a basic assumption—the continuity of excess demand functions—necessary to prove the existence of an equilibrium…. C. J. Bliss made such an argument in a 1983 paper (“Consistent Temporary Equilibrium” in the volume Modern Macroeconomic Theory edited by  J. P. Fitoussi) in which he also suggested, as I did above, that the divergence of individual expectations implies that agents will not typically regard the debt issued by other agents as homogeneous. Bliss therefore posited the existence of a “Financier” who would subject the borrowing plans of prospective borrowers to an evaluation process….

Explicitly introducing banks that simultaneously provide an economy with a medium of exchange… while intermediating between ultimate borrowers and ultimate lenders seems to be a promising way of modeling a dynamic economy that sometimes may—and sometimes may not—function at or near a temporary equilibrium… with reasonably high employment, increasing per capita output and income, and reasonable price stability…. A macroeconomic model should be able to account in some way for the diversity of observed macroeconomic experience. The temporary equilibrium paradigm seems to offer a theoretical framework capable of accounting for this diversity of experience and for explaining at least in a very general way what accounts for the difference in outcomes: the degree of congruence between the price expectations of agents….

This, I think, is the insight underlying Axel Leijonhufvud’s idea of a corridor within which an economy tends to stay close to an equilibrium path. However if the economy drifts or is shocked away from its equilibrium time path, the stabilizing forces that tend to keep an economy within the corridor cease to operate at all or operate only weakly, so that the tendency for the economy to revert back to its equilibrium time path is either absent or disappointingly weak. The temporary-equilibrium method, it seems to me, might have been a path that Hayek could have successfully taken in pursuing the goal he had set for himself early in his career: to reconcile equilibrium-analysis with a theory of business cycles. Why he ultimately chose not to take this path is a question that, for now at least, I will leave to others to try to answer.