Thursday, January 30, 2014


2. Hayek - Sraffa debate and the fallacy of the “natural rate of interest”

The debate between Friedrich von Hayek, perhaps the most prominent representative of the Austrian School in the twentieth century, and Piero Sraffa, Italian economist who founded the Neo-Ricardian school, on the problem of uniqueness and consistency of the notion of “natural price” was curiously result (and somehow the continuation) of an earlier discussion between another two great economists: John Maynard Keynes and Lionel Robbins.

In the early thirties the intellectual environment of the University of Cambridge (England) was largely dominated by Lord Keynes who, by then, had already published his Treatise on Money and was working in The General Theory of Employment, Interest and Money. The professor Robbins, renowned liberal economist of the time, disagreed with the ideas of Keynes. However, he had failed to build until that moment a conclusive rebuttal of them.

It is precisely in this context that Hayek was invited to Cambridge. Joan Robinson, considered as the most important disciple of Keynes, describes the event as follows: “While the controversy about public works was developing, Professor Robbins sent to Vienna for a member of the Austrian school to provide a counter attraction to Keynes. I very well remember Hayek’s visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time”. (2)

Thereby Hayek’s involvement in the Keynes-Robbins debate began to tip the balance to the side of Robbins. Keynes would had to overcome such criticism to continue successfully the project of the General Theory, but had little success in response: like other English economists, he had difficulty understanding and replying to Hayek given the little knowledge we had about the conceptual structure of the Austrian approach. And that's where Sraffa, with more knowledge of the Austrian tradition and invited by Keynes in 1927, enters in the debate.

The controversy between Hayek and Sraffa focuses, as has been said, on the issue of “natural price” which, of course, is central and relevant to the Austrian Business Cycle Theory since this theory postulates that crises are caused by Central Banks that artificially determine an interest rate below the level of the “natural rate of interest”. In 1932, Sraffa published in the Economic Journal the article “Dr. Hayek on Money and Capital” (3) and the same year Hayek responds with “Money and Capital: A reply” (4). Subsequently Sraffa replies with “Money and Capital: A rejoinder”. (5)

Sraffa’s critique is basically an internal critique, i.e., he analyzes the logical consistency and coherence of the Hayek’s argument. By doing this analysis Sraffa realize that there are serious logical gaps in Hayek’s theory and therefore is canceled all the explanatory value of the notion of "natural price" and also of the notion of “natural rate of interest”.

Specifically, the strongest Sraffa’s attack is to the uniqueness of the “natural price”. Starting from Hayek’s assumption about that money is merely a medium of exchange and by introducing the notion of “own rate of interest” for each good, Sraffa demonstrates the non-uniqueness of the alleged “natural price”. He writes: “If money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium, but there might be at any one moment as many ‘natural’ rates of interest as there are commodities, though they would not be ‘equilibrium’ rates. The ‘arbitrary’ action of the banks is by no means a necessary condition for the divergence; if loans were made in wheat and farmers (or for that matter the weather) ‘arbitrarily changed’ the quantity of wheat produced, the actual rate of interest on loans in terms of wheat would diverge from the rate on other commodities and there would be no single equilibrium rate”. (6)

Thereby, considering the dynamics of the market, if there is only one disequilibrium between supply and demand of goods, the natural rate of interest on such goods will diverge with respect to the natural rate of other goods. Therefore, there is no uniqueness of the “natural price”.

In his reply Hayek, having had to admit the existence of multiple “natural rate of interest”, however says that they all are “equilibrium rates” (7). Sraffa is conclusive in showing the theoretical and practical difficulties of such a response: “Dr. Hayek now acknowledges the multiplicity of the ‘natural’ rates, but he has nothing more to say on this specific point than 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”. (8)

Hayek’s attempts to revive the debate were sterile. Sraffa’s critique was too strong and the Austrian economists had to bear it for decades. In fact, it was not until 1994 that the prominent Austrian economist Ludwig Lachmann, defender of radical subjectivism, gave a relevant answer to the Sraffa's critique pointing out the ability of “entrepreneurial action” to eliminate the disequilibrium (9).

However, in an important paper in 2010 entitled “Multiple Interest Rates and Austrian Business Cycle Theory”, the Austrian economist Robert Murphy recognizes the inadequacy of the Lachmann’s solution: “Lachmann’s demonstration -that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest- does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to “the” real rate of interest”.  (10)

It is clear that there is no such thing as a “natural rate of interest” and therefore actually Austrian economists lack an objective parameter on which to base their argument that the crisis is caused because the Central Bank establishes a rate of interest “below” of “the” natural rate of interest. In fact, that leads us to the epistemological issue of falsifiability: given a lack of objective parameters, there is no way to determine if the theory corresponds to reality or not. One can understand the Austrians’ critique of the mathematization of Economics because this is not the ideal way to understand “complex phenomena” (11) but their rejection of the Statistic itself in the study of specific cases turns the theory in unfalsifiable and, therefore, puts into question its scientific character. (12)

To be continued


2) Joan Robinson, “The Second Crisis of Economic Theory”, The American Economic Review, vol. 62, Issue ½, 1972, p. 2
3) Piero Sraffa, “Dr. Hayek on Money and Capital”, Economic Journal, vol. 42, 1932, pp. 42-53.
4) Friedrich von Hayek, “Money and Capital: A reply”, Economic journal, vol. 42, 1932, pp. 237-249.
5) Piero Sraffa, “Money and Capital: A rejoinder”, Economic Journal, vol. 42, 1932, pp. 249-251.
6) Piero Sraffa, “Dr. Hayek on Money and Capital”, Economic Journal, vol. 42, 1932, p. 52.
7) Friedrich von Hayek, “Money and Capital: A reply”, Economic journal, vol. 42, 1932, p. 245
8) Piero Sraffa, “Money and Capital: A rejoinder”, Economic Journal, vol. 42, 1932, p. 251.
9) Cf. Ludwig Lachmann, Expectations and the Meaning of Institutions: Essays in Economics, Routledge Press, London, 1994, p. 154.
10) Robert Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory”,, 2010, p. 14.
11) Cf. Friedrich von Hayek, “Theory of Complex Phenomena”, Studies in Philosophy, Politics and Economics, University of Chicago Press, Chicago, 1967, p. 22-42.
12) See: Karl R. Popper, La Lógica de la Investigación Científica, Tecnos Press, Madrid, 1980.

You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and (email)