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Hayek Saffra Debate 4a
Hayek Saffra Debate 4a
Abstract
While Hayek’s Prices and Production established his reputation as a business-cycle theorist,
Sraffa's 1932 review turned opinion against Hayek. A key argument of Sraffa's was that Hayek’s
idea of a natural rate of interest, reflecting only real relationships, was incoherent, because,
without money, there could be a multiplicity of commodity own rates, none of which can be
uniquely identified as the natural rate. Although Hayek failed to respond effectively to Sraffa,
Ludwig Lachmann later observed that Keynes's treatment of own rates in the General Theory
undercut Sraffa’s argument, Differences in own rates reflecting no more than expected price
appreciation plus the cost of storage and the service flow provided by the commodity. Thus, on
Keynes's analysis, the natural rate is well-defined. However, Keynes’s own-rate analysis only
partially rehabilitates Hayek. There being no inflation rate under barter, a unique money natural
rate cannot be specified.
Key words: barter economy; business cycles; intertemporal equilibrium; money; natural rate,
own rate
1
1 Introduction
The pivotal role of Piero Sraffa’s (1932a) review of F. A. Hayek’s Prices and Production
in turning opinion against Hayek’s theory of business cycles, and preparing the ground for the
economics.1Sraffa’s attack on Hayek’s restatement and elaboration of von Mises’s ([1912] 1953)
business-cycle theory, and Hayek’s failure to respond effectively created a powerful impression
Sraffa attacked Hayek’s cycle theory along two fronts, criticizing both Hayek’s idea of
neutral money, and Hayek’s proposal that, by keeping the money rate of interest equal to the
“natural” rate of interest,3 the monetary authority could render money neutral. Our attention in
this paper is directed toward Sraffa’s second criticism: that the “natural rate of interest” -- at least
According to Sraffa, Hayek’s notion of the natural rate of interest, namely, the rate of interest
determined by real forces in a pure barter equilibrium, all monetary influences having been
abstracted from, is incoherent, because no unique natural rate of interest exists in a growing
economy with savings and investment. If there is no unique natural rate, then Hayek’s proposal
for eliminating (or minimizing) business cycles by adopting a neutral monetary policy – setting
1
See, e.g., Lawlor & Horn’s (1992, n. 3) discussion of Lachmann’s recollection of the Hayek-
Sraffa debate (stating in part: “What is particularly interesting about Lachmann’s account . . . is
his view that Sraffa’s review was a critical factor in Hayek’s fall from stature as an economic
theorist in the 1930s.”).
2
The Sraffa-Hayek exchange has been reviewed extensively, e.g., by Kurz and Salvadori (2003),
Kurz (2003) and Desai (1995).
3
Note that Hayek (1931b) referred to the natural rate as the “equilibrium” rate of interest. For
Hayek, the terms appear to have synonymous, however his use of the terms in his reply to Sraffa
is problematic. See below section 6.
2
the bank (money) interest rate equal to the natural rate -- is logically incapable of
implementation.4
To show that no unique natural rate of interest exists in a barter economy, Sraffa starts by
asking how, in a barter economy in which no loans are executed in monetary terms, an interest
rate could even be expressed. His answer is that every loan would be contracted in terms of some
commodity, with a corresponding “own rate” of interest defined for each commodity in terms of
which a loan might be executed (Lawlor and Horn, p. 392).5 For example, the rate at which
current apples could be exchanged for future apples would define the “apple” own rate of
interest. But in any economy in which there are forward, as well as spot, commodity markets,
market arbitrage would ensure that the own rate for any commodity would exactly correspond to
the ratio of the forward to the spot prices of that commodity in terms of some numeraire.
While in a static equilibrium characterized by unchanging prices over time, own rates for
all commodities would be equal, Sraffa pointed out that the equality would not be preserved in a
growing economy with changing relative prices. Sraffa argued that the multiplicity of own rates
in a growing economy – and only a growing capital-using economy was susceptible to the kind
of business cycle that Hayek was analyzing – rendered the notion of a unique natural rate of
[I]n times of expansion and production . . . there is no such thing as an equilibrium (or
unique) natural rate of interest, so that the money rate can neither be equal to, nor lower
than it: the ‘natural’ rate of interest on producer’s goods, the demand for which has
relatively increased, is higher than the ‘natural’ rate on consumers’ goods, the demand for
which has relatively fallen (Sraffa 1932a, p. 51).
4
Hayek’s policy prescription is equivalent to keeping constant the product of the money supply
and its velocity.
5
While Sraffa first developed the notion of the own rate, he did not call it that. Rather, as
discussed later, “own rate” is the term that Keynes used for that concept in the General Theory.
3
Facing this direct challenge to the coherence of the key concept of his theory, Hayek
offered a seemingly ineffective defense easily parried by Sraffa. Hayek’s weak response
provided the grounds on which economists could dismiss a theory that was both counterintuitive
and uncongenial to their policy preferences, but whose logic had initially seemed compelling.
Our thesis is that Hayek’s notion of a unique natural rate is not, as Sraffa charged,
incoherent. Moreover, the key to understanding the coherence of the natural rate was provided by
Keynes himself in chapter 17 of the General Theory, wherein he deployed Sraffa’s own-rate
analysis to show that individual own rates must converge toward an equilibrium rate of return
adjusted for the real-service yield of the asset, its expected rate of appreciation, and the cost of
storage.6 This equilibrium net rate of return corresponds to the natural rate about which Hayek
wrote. That Hayek’s notion of the natural rate is implicit in Keynes’s conceptualization of own
rates in chapter 17 was originally noted by Ludwig Lachmann (1956). The correspondence
between Keynes’s treatment of own rates and Hayek’s understanding of a unique natural rate of
interest deepens the puzzle about Hayek’s weak response to the charge of incoherence leveled by
Sraffa against Hayek’s conception of the natural rate of interest. In the course of spelling out the
differences between Hayek, Sraffa, and Keynes, we hope to shed light on the puzzle even though
The paper proceeds as follows. Section 2 discusses the historical context in which Sraffa
wrote his review. Section 3 provides a summary of Sraffa’s critique and Hayek’s response. In
Section 4, we explain how Hayek’s position on the natural rate is conceptually supported by
Keynes’s discussion of own rates and their tendency to equality in chapter 17 of the General
Theory. However, to establish that Hayek’s position about a unique natural rate was not, as
6
Majewski (1988) and Mongiovi (1990) discuss the influence of Sraffa’s work on the
development of Chapter 17 in the General Theory.
4
Sraffa alleged, incoherent does not mean that the natural rate provides an operational, much less
a useful, criterion for banking policy. Here we offer some further thoughts about alternative
criteria of neutral money which Hayek could have used in place of the conceptually coherent, but
Perhaps the key analytical concept developed by Hayek in his early work on monetary
theory and business cycles was the idea of an intertemporal equilibrium. Before Hayek, the idea
of equilibrium had been reserved for a static, unchanging, state in which economic agents
continue doing what they have been doing. Equilibrium is the end state in which all adjustments
to a set of initial conditions have been fully worked out. Hayek attempted to generalize this
business cycles – in which he was engaged. Hayek chose to formulate a generalized equilibrium
concept. He did not do so, as many have done, by simply adding a steady-state rate of growth to
factor supplies and technology. Nor did Hayek define equilibrium in terms of any objective or
measurable magnitudes. Rather, Hayek defined equilibrium as the mutual consistency of the
independent plans of individual economic agents.7 The potential consistency of such plans may
be conceived of even if economic magnitudes do not remain constant or grow at a constant rate.
Even if the magnitudes fluctuate, equilibrium is conceivable if the fluctuations are correctly
foreseen. Correct foresight is not the same as perfect foresight, correct foresight being only
7
The definitive statement of Hayek’s conception of intertemporal equilibrium is in Hayek
(1937), but he had already developed the idea a decade earlier in Hayek ([1928] 1984), thereby
anticipating economists of the Stockholm School, especially Lindahl (1933), who had also
formulated the concept of an intertemporal equilibrium in the early 1930s
5
contingently correct while perfect foresight is necessarily correct.8 Equilibrium requires only that
fluctuations (as reflected in future prices) be foreseen by all agents. It is not even necessary, as
Hayek (1937) pointed out, that future price changes be foreseen correctly, provided that
individual agents agree in their anticipations of future prices. If all agents agree in their
expectations of future prices, then the individual plans formulated on the basis of those
because the realization of those expectations would allow the plans formulated given those
expectations to be executed without need for revision. What is required for intertemporal
contingent anticipation not the result of perfect foresight, but of contingently, even fortuitously,
correct foresight.9 The seminal statement of this concept was made by Hayek in his 1937 paper.
The idea was restated by J. R. Hicks (1939), puzzlingly without mention of Hayek, by whom, as
8
Hayek (1937) explains that the equilibrium concept can be weakened so that even correct
foresight is not necessary. All that is required is that the individual expectations of economic
agents be consistent so that they could be validated by some possible future contingency. The
resulting plans would then constitute an equilibrium relative to the information possessed by the
agents at a given moment. Even if the expectations are eventually disappointed, the plans
formulated were in equilibrium with respect to each other in the sense that they were mutually
consistent and could have been realized had the expected state of the world been realized.
9
By defining correct foresight as a contingent outcome rather than as an essential property of
economic agents, Hayek elegantly avoided the problems confounding Oskar Morgenstern
([1935] 1976) in his discussion of the meaning of equilibrium.
10
See Milgate (1979) for further discussion. It may also be worth mentioning that a likely source
of Hayek’s insight into the conditions for intertemporal equilibrium was his “Austrian”
perspective into production as an intertemporal process in which complementary inputs of fixed
and working capital and labor are combined in more or less roundabout production processes
yielding a final output only after applying inputs. However, the Austrian insight into the
conditions for intertemporal equilibrium does not necessarily imply that the substantive
explanation of intertemporal disequilibrium proposed by Hayek and other Austrians offers a
better understanding of all aspects of business cycles than alternative theories.
6
Starting from a state of intertemporal equilibrium, Hayek traced the disturbing influence
of money on the intertemporal structure of price relationships, and hence, on the intertemporal
correspond to the Wicksellian natural rate matching the rates of intertemporal substitution in
production processes via the choice among production processes of varying degrees of capital
intensity and roundaboutness. Insofar as banks provide entrepreneurs with financing for
investment projects without utilizing the voluntary savings of households, the equilibrium
reconciliation of intertemporal plans to produce and consume would be disturbed, implying that
future prices would deviate from the expected values characterizing the equilibrium price
revised.
Credit expansion by banks was characterized by Hayek as bank lending at a market rate11
below the natural rate. As a consequence, the relative price of investment goods would fall in
terms of consumption goods, reflecting excessive accumulation of capital associated with the
increased relative prices of current consumption goods reflecting the shift of output from
11
The bank rate of interest, sometimes referred to as the “actual,” “money,” or ‘market” interest
rate, is the rate banks charge borrowers of credit for financing capital investment
12
An anonymous referee somehow misunderstood our summary of the analysis in Prices and
Production as asserting that Hayek viewed the business cycle as an intertemporal equilibrium
phenomenon. We make no such assertion. In our view intertemporal equilibrium provides the
benchmark of comparison against which the disturbances introduced by credit expansion are
7
For Hayek, the money-induced lengthening of the capital structure is the key causal
factor generating the business cycle, the price-level effect on which Wicksell ([1898] 1936) and
Keynes (1930) had focused, being of secondary importance. Hayek argued that, because a
money-induced lengthening of the capital structure was unsustainable, the crisis, or upper-
turning point of a cycle, would occur when the intertemporal inconsistencies of plans occasioned
some plans unexecutable and triggering a cascade of further disappointments and plan revisions
and a state of general economic discoordination. Such an unraveling of plans constitutes the
For Hayek, therefore, the key policy prescription for banks in general, and especially a
central bank, is to keep the market rate of interest equal to the natural rate associated with a state
of intertemporal equilibrium. Hayek maintained that such an interest-rate policy would make
money “neutral,” eliminating its distorting effect on the real determinants of intertemporal
expansion.13 The problem, of course, is that the natural rate of interest is unobservable, making
3 Sraffa’s critique
being analyzed. Deviations from intertemporal equilibrium create countervailing forces that
make the initial deviations unsustainable causing a transitory adjustment path toward a new
intertemporal equilibrium. The cycle corresponds to a deviation from and a movement back to an
intertemporal equilibrium path. However, keeping the money interest rate equal to the
“equilibrium” interest rate corresponding to an intertemporal equilibrium time path would avoid
at least some of the deviations from intertemporal equilibrium that occur.
13
That is, with the rate of interest held at the natural rate, a monetary expansion by banks to
finance investments in excess of voluntary savings would not occur, a state of affairs that could
obviously never obtain in a barter equilibrium.
8
Hayek developed these ideas in a series of publications in the late 1920s and early 1930s,
including most notably his 1931 LSE lectures, subsequently published as Prices and Production
(1931c), and his two-part review (1931a, 1932a) of Keynes’s Treatise on Money, exposing
conceptual problems in the analytical framework of the Treatise. Stung by Hayek’s criticisms,
Keynes (1931) issued an ill-natured response, quickly shifting from a reply to Hayek’s criticisms
into a personal attack on Hayek and Prices and Production, an attack deplored even by Keynes’s
Perhaps realizing that his reply to Hayek had misfired, Keynes, then editor of the
Economic Journal, recruited the formidable Piero Sraffa to write a formal review of Prices and
Production. It is hard to imagine that Sraffa would have written a negative review on order, but
Keynes was probably not displeased with the review that Sraffa sent him.
suggested that the capital distortion identified by Hayek was produced not by an increase of the
quantity of money, but by a change in its distribution (Sraffa 1932a, pp. 48-49). He further
argued that the accumulation of capital induced by forced saving was not necessarily
unsustainable, as Hayek had asserted; the augmented capital stock financed by monetary
expansion might well drive the natural rate of interest down to the level of the reduced money
rate, an outcome that von Mises ([1924] 1953) himself had acknowledged was not impossible.
Our concern in this paper, however, is not with Sraffa’s critique of Hayek’s account of
how monetary expansion creates an unsustainable distortion of the capital structure, but with
Sraffa’s argument that Hayek’s conception of the natural rate of interest was incoherent. Sraffa
argued that Hayek’s definition of the natural rate as the rate that would exist in a barter economy
with no medium of exchange is inconsistent with the necessity for barter loans to be executed in
9
terms of real commodities rather than a medium of exchange embodying generalized purchasing
power over all commodities. For any commodity in terms of which a loan might be contracted,
there would be an own rate of interest, the rate corresponding to the ratio of the forward and spot
prices of that commodity (quoted in terms of some other commodity) (Sraffa 1932a, pp. 50-51).14
Inasmuch as the ratio of the forward to the spot prices of any commodity was market-
determined, Sraffa argued that there could be circumstances in which the ratios of forward to
spot prices for commodities would not be equalized. If so, Sraffa argued, it is meaningless to
assert, as Hayek did, that the banking system causes the market interest rate to diverge from the
natural rate. For even in the pure barter economy, from which Hayek claimed to derive the
natural rate of interest, a shift in demand could cause a divergence between ratios of spot to
forward prices so that own rates would not be equal. If there are multiple own rates for different
commodities, then there is no unique natural rate, so it is incoherent to attribute a deviation of the
market rate from the natural rate to the behavior of the banking system.
It will be instructive to follow Sraffa as he uses the own-rate analysis against Hayek,
because there is more to his argument than the bare assertion that the separate own rates for each
commodity may be unequal. After quoting Hayek’s assertion that, in a money economy, the
money (nominal) rate of interest may diverge from the equilibrium (natural) rate, Sraffa offers
Sraffa was correct in observing that individual own rates might deviate from their (static)
equilibrium values owing to some change in demand or supply. However, such deviations are
not, as Sraffa suggested, analogous to the deviations from equilibrium associated with a
monetary disturbance, the deviations that had been the focus of Hayek’s attention and analysis.
Deviations from equilibrium owing to fluctuations in the supply of real commodities would not
persist; market forces would operate immediately to restore an equilibrium with all own rates
again equalized, a tendency not mentioned by Sraffa, though two paragraphs later Sraffa did
In equilibrium the spot and forward prices coincide, for cotton as for any other
commodity; and all the “natural” or commodity rates are equal to one another, and to the
money rate. But if, for any reason, the supply and the demand for a commodity are not in
equilibrium (i.e. its market price exceeds or falls short of its cost of production), its spot
and forward prices diverge, and the “natural” rate of interest on that commodity diverges
from the “natural” rates on other commodities. (Sraffa 1932a, 50)
Evidently thinking of a static equilibrium in which prices remain unchanged, rather than the
intertemporal equilibrium in terms of which Hayek was thinking, Sraffa posits a change in
demand, and tries to follow the effect of the change in demand on the relationship between spot
11
Sraffa inferred from the shift in demand and consequent price adjustment that own rates
of interest need not be equalized, thereby demonstrating that a unique natural rate does not exist.
What Sraffa overlooked, however, is that the deviation between own rates in his example is
entirely accounted for by the anticipated changes in the prices of individual commodities. Thus,
the alleged divergence of own rates to which Sraffa drew attention is simply the distinction
between the real and the nominal rate of interest long recognized by economists and formally
derived by Fisher (1896). What Sraffa called a multiplicity of own rates, was in fact a
commodities for which demand was increasing or decreasing. The natural rate, expressed as a
real rate, (i.e., abstracting from expected price changes) remains unique in Sraffa’s exercise.
Sraffa went on to observe that Hayek could have avoided the problem of a non-unique
average of the money prices of individual commodities. Hayek could then have similarly defined
the natural rate as a weighted average of the own rates of individual commodities (Sraffa 1932a,
p. 51). But that option, as noted by Sraffa (1932b, p. 251), had been foreclosed to Hayek by his
rejection of statistical price levels in his review of Keynes’s Treatise on Money.15 The
observation is correct, but Sraffa misunderstood its significance, overlooking the distinction
between the unique natural (real) rate and the multiplicity of nominal rates consistent with the
natural rate, depending on expected appreciation or depreciation. There is nothing special about
15
See Hayek (1931a). Andrews (2011) provides a comprehensive discussion of this issue.
12
It may be helpful to provide an algebraic exposition of our argument about the
uniqueness of the real own rate of interest, even under Sraffian conditions. Consider a barter
economy with two commodities, tomatoes and cucumbers, whose prices are expressed in terms
of a third commodity, onions, which serves as the numeraire. Let us begin with an initial
equilibrium, expressing own rates of interest for tomatoes and cucumbers, as follows:
Where it and rt are the nominal and real own rates of interest for loans in terms of tomatoes and ft
and st are the future and spot prices for tomatoes expressed in terms of the numeraire, onions.
Similarly, ic and rc are the nominal and real own rates of interest for loans in terms of cucumbers
and fc and sc are the future and spot prices for cucumbers expressed in terms of the numeraire,
onions.
In a static equilibrium with unchanging prices, spot and forward prices are the same, so
it = rt
ic = rc.
If borrowers and lenders are indifferent between borrowing or lending in terms of one
commodity or another, then it must be the case that the real rates (which is what borrowers and
lenders care about) are equal, i.e., rt = rc. The equality of real rates established by arbitrage
Thus, in static equilibrium all real and nominal own rates are equal, and the natural rate
of interest is unique and well-defined. However, Sraffa argued that a deviation from static
16
In Fisher (1896), the ratio of the forward price to the spot price is expressed as (1 + a), where
“a” denotes the expected rate of appreciation in the price of the commodity, i.e., the ratio of the
forward to the spot price.
13
equilibrium, causing a temporary increase in the price of one commodity and a decrease in the
price of another would cause the spot and forward prices of each commodity to diverge, thereby
causing own rates of interest expressed in terms of the two commodities to diverge. Because the
own rates of two different commodities were no longer equal, Sraffa concluded that there could
be multiple own rates of interest, rendering the concept of a natural rate of interest incoherent.
Sraffa’s argument for the multiplicity of own rates hinged on the existence of forward
markets for the commodities in terms of which loans are made. The ratios of forward to spot
prices imply arbitrage constraints on the own rates, eliminating any advantage of borrowing or
lending one commodity instead of another, and ensuring that all borrowers and lenders are
indifferent between a loan contracted in terms of one commodity or another. But the indifference
conditions implied by arbitrage means that Sraffa’s argument for a multiplicity of own rates
collapses.
Consider the sort of case posited by Sraffa: a shift in demand between tomatoes and
cucumbers raising the spot price of cucumbers and lowering the spot price of tomatoes. Sraffa
asserted that the deviation from long-term equilibrium would be temporary, implicitly assuming
horizontal long-run supply curves for both commodities. Given that the prices of cucumbers and
tomatoes can only temporarily deviate from their long-run equilibrium values, the forward and
spot prices for both cucumbers and tomatoes would no longer be equal, forward cucumber prices
being below and forward tomato prices above their spot values.
The following relationships must hold after a demand shift causes spot prices to diverge
14
where starred variables represent post-demand-shift values. Because the shift in demand raises
the spot price of cucumbers and reduces the spot price of tomatoes, while leaving forward prices
unchanged, we have
Since (ft/st) = (fc/sc), it follows that (ft/s*t) > (fc/s* c). From this inequality, Sraffa concluded
that, after a disturbance of static equilibrium, there is no longer a unique own rate of interest and,
therefore, no natural rate. But Sraffa ignored the arbitrage constraint on own rates. The arbitrage
constraint ensures that r*t = r*c, so that, given the forward prices of cucumbers and tomatoes,
borrowers and lenders are indifferent between contracting loans in terms of cucumbers or
tomatoes.
Let r*t = r*c = r*. Thus, a unique real own rate of interest does exist after the demand shift
posited by Sraffa, namely r*. And this real rate can also be thought of as the natural rate of
interest. Hayek’s conception of the natural rate therefore is entirely coherent, corresponding to
the real own rate whose existence is ensured by the arbitrage constraint. Sraffa provided no
reason why real, as opposed to nominal, own rates would differ even under conditions of
disequilibrium.
However, one point remains unresolved. Does the unique real rate that existed before the
demand shift equal the unique real rate, r*, that obtains after the demand shift. Our assumptions
do not allow us to say one way or the other. We will have more to say about this question below
in section 6.
5 Hayek’s Response
15
Hayek’s (1932b) response to Sraffa seemed ineffective, inasmuch as he accepted Sraffa’s
assertion of the possibility of multiple own rates of interest. , While conceding Sraffa’s assertion,
Hayek denied that the concession was problematic for his position, thereby appearing to ignore,
I think it would be truer to say that . . . there would be no single rate which, applied to all
commodities, would satisfy the conditions of equilibrium rates, but there might, at any
moment, be as many “natural” rates of interest as there are commodities, all of which
would be equilibrium rates; and which would all be the combined result of the factors
affecting the present and future supply of the individual commodities, and of the factors
usually regarded as determining the rate of interest. (Hayek 1932, emphasis in original)
Hayek did not elaborate on this argument, simply concluding with a statement (“The inter-
relation between these different rates of interest is far too complicated to allow of detailed
discussion within the compass of this reply”), suggesting that he was at a loss in how to frame a
From his terse commentary about multiple natural rates, Hayek shifted to a discussion of
the related, though possibly second-order, issue of whether the effects following from any one
natural (own) rate of interest in a barter economy being “out of equilibrium” would be
comparable to the effects arising in a monetary economy when the money rate diverged from the
natural rate.17 Silent on how to implement his policy rule in a monetary economy with multiple
natural rates, Hayek left unanswered Sraffa’s criticism that, in the ideal barter economy that
served as Hayek’s theoretical benchmark, there could be a multiplicity of natural rates of interest,
with none having a unique claim to serve as a criterion for a neutral monetary policy.
Sraffa’s (1932b, p. 251) rejoinder chided Hayek for conceding the existence of multiple
natural rates while failing to respond to the substantive criticism he had directed at Hayek:
17
Hayek (1932, p. 246) maintains that the latter, but (in general) not the former, will tend to lead
to disequilibrium outcomes (“I certainly believe that it is possible in this case to change
‘artificially’ the rate of interest in a sense in which this . . . cannot be said of any commodity.”).
16
Dr. Hayek now acknowledges the multiplicity of the “natural” rates, but he has nothing
more to say on this specific point than that they “all would be equilibrium rates.” The
only meaning (if it be a meaning) I can attach to this is that his maxim of policy now
requires that the money rate should be equal to all these divergent natural rates.
In other words, Hayek’s new position on the natural rate was unresponsive or nonsensical.
However, Hayek’s response may be interpreted more charitably than Sraffa did; it could
be interpreted in a way that is at least suggestive of our criticism of Sraffa’s own-rate analysis
and of Lachmann’s (1956) argument that, even under barter, arbitrage would force the separate
own rates to converge on a common equilibrium value, after allowing for differences in real
the previous section that the existence of a unique real own rate follows from the existence of
forward markets, as assumed by Sraffa, and an arbitrage constraint. The arbitrage constraint does
not imply the existence of an intertemporal equilibrium, so Lachmann’s argument for the
existence of a unique real own rate of interest is valid even without intertemporal equilibrium.
Because Hayek himself had argued in earlier publications that, in the context of
intertemporal equilibrium, anticipated price changes are not inconsistent with equilibrium, Hayek
did not dispute that own rates of interest could diverge. But divergent nominal own rates are not
inconsistent with equilibrium. The problem with Hayek’s response in failing to distinguish
between the unique real own rate embedded in the nominal own rates and the varying nominal
But such a defense would have required Hayek to enlarge his conception of what
constitutes a neutral monetary policy, which he was not prepared to do. He would have been
forced acknowledge that any rate of monetary expansion was consistent with a neutral monetary
17
policy provided that price expectations were correct. But Hayek’s conception of a neutral
monetary policy was limited to a situation in which total spending was kept constant.
Given Keynes’s stake in demolishing Hayek’s analysis in Prices and Production, his
selection of Sraffa to write a review of Prices and Production, and his adoption, with explicit
remarkable that the discussion in chapter 17 actually provides the analytical tools with which
Hayek could have responded to Sraffa’s criticism of his treatment of the natural rate of interest.
This curiosum went unnoticed for over twenty years until Ludwig Lachmann (1956), Hayek’s
loyal student at LSE, but also an admirer of Keynes, applied Keynes’s analysis in chapter 17 to
explain that, even in a barter system, the expected return (including the pecuniary and non-
pecuniary yields plus price appreciation, net of storage costs) must be equalized for all those
assets that are held from period to period. Three decades later, following up on his earlier
If there is a multiple of commodity rates, it is evidently possible for the money rate of
interest to be lower than some but higher than others. What, then, becomes of monetary
equilibrium? . . . It is not difficult, however, to close this particular breach in the Austrian
rampart. In a barter economy with free competition commodity arbitrage would tend to
establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the
highest and the barley rate the lowest of interest rates, it would become profitable to
borrow in barely and lend in wheat. Inter-market arbitrage will tend to establish an
overall equilibrium in the loan market such that, in terms of a third commodity serving as
numéraire, say, steel, it is no more profitable to lend in wheat than in barley.
Lachmann (id.) went on to conjecture what arbitrage activity implies for the expected own rates
This does not mean that actual own-rates must all be equal, but that the disparities are
exactly offset by disparities between forward prices. The case is exactly parallel to the
way in which international arbitrage produces equilibrium in the international money
market, where differences in local interest rates are offset by disparities in forward rates.
18
In overall equilibrium, it must be impossible to make gains by “switching” commodities
as in currencies.
Thus, while own rates in intertemporal equilibrium may differ, the differences are subject to the
condition that the expected return from holding each asset must be equal, any divergence
between expected returns triggering a readjustment of asset valuations. Lachmann argued that
the weakness of the natural-rate concept is not that it pertains to a barter, rather than a monetary,
economy, but that it can be defined uniquely only in the context of full intertemporal
In our view, Lachmann conceded too much, because the arbitrage constraint equalizing
own rates, in the presence of forward markets, can be effective in the absence of intertemporal
equilibrium, as we showed above in our discussion of Sraffa’s critique of Hayek, Sraffa, himself,
having based his argument for the divergence of own rates on the existence of forward markets
for commodities, thereby allowing own rates of interest to be precisely determined by the ratios
of forward to spot prices. The equality of real own rates of interest, net of the price changes
reflected in forward markets, is the result of arbitrage, and does not require full intertemporal
equilibrium.18
While Keynes adopted Sraffa’s analysis of the own rate and rejected the notion of a
unique natural rate of interest, his reasons for rejecting the natural-rate concept, which he
introduced and expounded upon in the Treatise, were very different from Sraffa’s:
This quotation shows that, for Keynes, “non-uniqueness” of the natural rate refers not to a
multiplicity of own rates, but to the possibility that different natural rates of interest could hold in
different equilibrium states corresponding to differing levels of employment. That is to say, while
there is a particular natural rate corresponding to the full-employment equilibrium, there may be
different natural rates corresponding to equilibria at less than full employment. Thus, for any
level of employment, the real own rates of interest would all converge to the same “unique” level
critique of Sraffa’s argument that there is no unique own rate of interest, the possibility that the
unique real own rate of interest might change after a shift in demand cannot be ruled out.
This view of multiple natural rates is not at all similar to Sraffa’s criticism of Hayek’s
conception of the natural rate, which concerned differing own rates of interest across
commodities, a possibility explicitly ruled out by Keynes in chapter 17. As Keynes made clear,
in asset values.19 In other words, even if (nominal) gross own rates of return differ across
storable commodities in equilibrium, the net real rates of return across these assets must be
equalized; otherwise opportunities to earn profits are being willingly foregone. Taking money as
the standard measure of value, Keynes (1936, p. 227; emphasis added) made this very same
point:
And if there are reasons to believe that the adjustment of “disequilibrium” natural (own) rates
19
would be sticky, one will not find them laid out in the General Theory.
20
To determine the relationships between the expected returns on different assets which are
consistent with equilibrium . . . let the expected percentage appreciation (or depreciation)
of houses be a 1 and of wheata 2. q 1, −c 2, and l 3 we have called the own-rates of interest
of houses, wheat and money in terms of themselves as the standard of value . . . with this
notation it is easy to see that the demand of wealth owners will be directed at houses, to
wheat or to money according as a 1+ q1, a 2−c 2, or l 3 is greatest.
This realization in turn leads Keynes (pp. 227-28; first emphasis added) to the following
unambiguous conclusion:
Thus in equilibrium the demand-prices of houses and wheat in terms of money will be
such that there is nothing to choose in the way of advantage between the alternative
natives, i.e., a 1+ q1, a 2−c 2, and l 3 will be equal.
This point was noted by Lachmann (1956): there is a dynamic process that eliminates differences
in own rates, net of differences in service flows, expected appreciation, and storage costs. Of
course, economists have proposed theories of why the efficient market hypothesis may not hold
(e.g., due to information costs as in Grossman and Stiglitz (1980)), but it does not appear that
Sraffa was implicitly appealing to any such notions in his review of Hayek.
reinterpret Hayek’s seemingly weak response to Sraffa in a somewhat more favorable light than
has been customary. His apparent concession that own rates might indeed be different may have
been no more than an acknowledgement that differences in service flows or storage costs or
expected appreciation could account for differences in nominal own rates. However, for
equilibrium to obtain, such differences would be possible only insofar as the net expected returns
from holding assets were equal. If the distinction had been clear in Hayek’s mind, one would
have expected him to articulate the difference more clearly than he expressed it. So although we
are not confident that Hayek perceived the point as clearly as Keynes did in chapter 17, there
may some basis for revising the received view that Hayek’s response to Sraffa was ineffectual.
21
7 Conclusion
Although the burden of our argument has been that Sraffa’s supposedly devastating
criticism of Hayek’s business-cycle theory and his criterion for neutral monetary policy was less
devastating than subsequent commentators have supposed, we do not claim to have rehabilitated
Hayekian cycle theory or his criterion for neutral monetary policy. Our defense of Hayek is that
his conception of the natural rate of interest is not, as Sraffa charged, incoherent, because it is
possible to view the natural rate of interest as a unique real rate of interest in the Fisherian sense.
It is worth mentioning, if only in passing, that the Fisherian origin of Keynes’s own-rate
analysis in chapter 17, on which Keynes (1923) had also relied in his famous exposition of the
theory of covered interest-rate arbitrage, makes Keynes’s strident criticism in chapter 13 (p. 142)
of Fisher’s equation relating the nominal rate of interest to the real rate of interest and expected
inflation even more puzzling than it does taken in isolation. Presumably, Keynes’s criticism was
directed at the implicit assumption that the real rate of interest can be taken as being independent
of the rate of inflation. However, the reasoning behind Keynes’s attack on the Fisher equation
remains difficult to grasp and is clearly at odds with his treatment of own rates in chapter 17.
analysis in discussing how the same real rate could be expressed equivalently as different
nominal rates, depending on the choice of numeraire or unit of account. Keynes’s analysis in
similar conclusion, that a given real rate can be expressed equivalently in terms of many different
nominal rates, each one depending on a different choice of numeraire or unit of account. So even
if it is possible to identify a unique real natural rate of interest, a unique nominal natural rate of
interest cannot be identified, because the choice of a numeraire rising in value over time would
22
imply a lower nominal interest rate than would the choice of a numeraire stable or falling in
value over time. Hayek may have thought that a unique real natural interest rate implied a unique
nominal natural interest rate. If so, his conclusion was mistaken, but not incoherent.
In fact, the source of intertemporal disequilibrium that Hayek believed he had discovered
-- a divergence between the market rate of interest and the natural rate of interest -- could not
serve as a criterion for the absence of neutral money, because neutral money could be achieved
at any nominal rate of interest if price expectations were aligned with the nominal rate of interest
chosen by the monetary authority. Hayek, the originator of the concept of intertemporal
equilibrium, was equipped to grasp that point, but could not make the conceptual leap required to
overcome his attachment to the notion of a unique nominal natural rate of interest.
But even within his own limitations, Hayek was groping for an alternative to equality
between the nominal market interest rate and a nominal natural rate as the criterion for a neutral
monetary policy. In chapter IV of Prices and Production, Hayek introduced the notion of a
constant stream of spending (MV ¿as a criterion of neutral money. If the quantity of money were
adjusted to keep total spending constant, changes in the stock of money (M ) would just offset
changes in the demand to hold money ( V1 ) .Under such circumstances, Hayek felt that money
would have no disturbing effect on economic activity. Excess cash would not bid up prices and a
deficiency of cash would not drive down prices. Prices would adjust only in response to
increases (decreases) in productivity implying decreases (increases) in cost. Unlike the equality
between the nominal market interest rate and the indeterminate nominal natural interest rate,
Hayek’s alternative criterion of a neutral monetary policy was at least defined in terms of
potentially observable magnitudes, and, within some margin of error, was therefore operational.
23
To Hayek’s discredit, and his later regret, and despite the reasons he himself advanced on
policies to counter the Great Depression.20 Had he followed the implications of his analysis to
their logical conclusion, Hayek would have advocated a reflationary policy during the Great
Depression aimed at restoring MV to its pre-crash level, and would have been closer to being an
ally, rather than an opponent of Keynes, and of other supporters of monetary stimulus, such as
Hawtrey, Cassel, and Fisher, to promote recovery from the Great Depression. Exactly what
caused Hayek to advocate policies inconsistent with his own theoretical position is a question
that ought to keep Hayek scholars busy for some time to come.
criterion aimed at stabilizing MV , Hayek also has a strong claim to be considered a precursor of
current proposals to target nominal gross domestic product as the objective of monetary policy.
The arguments advanced by current advocates of targeting nominal GDP are in many ways
similar to those advanced by Hayek for stabilizing MV . While Hayek’s formal analysis was
couched in terms of stabilizing MV, in subsequent writings his position probably could have been
restated in terms of a rule for some steady rate of growth of nominal GDP. Most current
proposals for targeting nominal GDP recommend a target rate of growth of about 5 percent,
which Hayek would likely have considered excessive. However, that opposition would have
been least partially due to his mistaken belief that there is a unique nominal natural rate of
interest.
20
On Hayek’s conflicting policy positions during the Great Depression, see the interesting recent
discussion by Lawrence White (2008).
24
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