Theoretical Economics: My Time With Friedrich Hayek -- and Why Understanding Him and Keynes Is Central to This Election, Part 2

To read Part 1, click here.

A month later I arrived at the San Francisco airport and was picked up by IHS staff. I met the 19 other scholars in the group, which included some of the top young economists in America: Larry White, Mario Rizzo, Gerald O'Driscoll, Don Lavoie, Roger Garrison, Roger Arnold, Richard Ebeling and Joe Salerno. We were all focused in the area of economic theory that utilized methological individualism and "subjective costs" as the tools for methodology. We probably all felt we were the best young theoretical economists in the world.

At first, 10 of us were put up at a house in Palo Alto, where Don Lavoie and I, in particular, became good friends. Soon we were assigned our own offices. Every morning I would walk to my office in downtown Palo Alto and be at my desk by nine. The days were spent reading and discussing the classics in economics. My focus, as always, was on why the economy experiences recessions and booms. What causes these cycles of depression and expansions? And what should the government's role be in the economy?

I studied articles about Hayek's Prices and Production obsessively, and his interpretations of Knut Wicksell's work on the concept of two interest rates -- the natural and the artificial -- to try to understand the real impact of artificial increases in the supply of money by the government, achieved through lowering interest rates. Although this is common practice these days by the Federal Reserve to stimulate the economy, Hayek argued that it encourages entrepreneurs to borrow too much money and over-invest. Hayek's view was that when the natural, higher interest rate reasserts itself, entrepreneurs will not be able to pay the money back, and will be forced to liquidate their investments and lay off employees, causing unemployment. My own work sought to measure this over-investment using statistics.

I was also interested in how and why people voted, and had conducted a test of voting patterns on the first Michigan tax-and-expenditure-limitation amendment. The results were published in 1979 the prestigious journal, Public Choice. My hypotheses were that people who received government money were more likely to vote against a tax-limitation amendment and higher income people were more likely to vote in favor of the amendment.

This work on income and voting led me to think about how theory could be applied to issues of poverty. Recognizing that the key driver of economic activity was the entrepreneur, and being the only MBA in our group of scholars, I began to explore how we could create more entrepreneurs to capitalize on their unique knowledge. I became fascinated with the debate between Keynes and Hayek on the setting of the price of curriencies and the effect of those decisions on international trade. I was eager to share my ideas with Hayek, and get some feedback and guidance from him.

When Hayek arrived, he proved to be tall and elegant, an intellectual force of nature, somewhat reticent, but full of energy and old-world charm. His Austrian origins were pronounced in his Austrian accent.

Hayek's office was three doors down from mine in the back of the president of IHS' office. I was hesitant, but late that first day I got up my courage and walked in and introduced myself. After several weeks I couldn't find him and was told he had moved to another office near Hoover Institute. I soon figured out where and went to chat with him.

I was fascinated by Hayek's ideas on prices and their role in transferring information. "How is this connected to your trade cycle theory?" I asked. He carefully explained how prices communicate information that helped organize society. Then, making an excuse, he would politely lead me to the door and bring our conversation to an end.

To my dismay, I discovered that Hayek was not only indifferent to my statistical studies on the effect of lowering interest rates, but very much against them -- even though the latter was a test of his own theory. He argued that what I was trying to measure was too complex to be understood through statistics. He nevertheless promised to read my papers if I gave them to him.

On one occasion we were talking about how information was transferred instantaneously through prices, and I quoted verbatim the ninth paragraph from his legendary The Use of Knowledge in Society. Impressed, he gave me the highest compliment possible: Well, you certainly did your homework!" I asked him what his biggest insight was, and he said: "That knowledge is divisible."

Hayek's most recent book at the time was Law, Legislation, and Liberty. I did not understand it, but would nevertheless carry the book with me and was delighted when he would talk about it. I asked him to autograph it, but he declined, gently pointing out that he had already signed it for me. I would also carry around The Road to Serfdom, and made sure he noticed the many passages I had underlined, and margin notes I had made. This book had changed the debate on socialism/capitalism, becoming one of the all-time top selling books on political theory, and was instrumental in Hayek being awarded the Nobel Prize.

Finally, Hayek invited me to come talk with him about my papers. I had finally given him copies of all three: the statistical test of his trade cycle theory, the draft of the public choice/voting article, and a more controversial one on methodology -- an earlier version of which had impressed Milton Friedman two years before. I was up all night preparing, keeping my roommates awake with my constant questions. I was excited, but anxious, too. I asked my best friend and roommate, Don Lavoie, to go with me for support.

The next day, Hayek listened attentively as I again explained my view that trade cycles could not only be explained by the lengthening of the production structure, but could also be measured with mathematical regression analysis, thus proving his theory.

Hayek seemed to be impressed, saying, "Mr. Mariotti, yours is a first-rate paper. Very good." I tried to feign indifference, but turned my face away because I was tearing up. "Thank you, Professor Hayek, I knew you would like it. I have worked on it for years. Collecting the stats and running the regressions took years." My voice was on the verge of breaking.

"Oh no, not that one, Mr. Mariotti," Hayek responded, "It was your paper on voting that I enjoyed. You cannot measure changes in capital using statistics. A statistical test of trade cycles is not possible -- you will mislead the field by advocating that. And on methodology, I was surprised you did not mention Karl Popper."

I had never read Popper, although he was much discussed at IHS, and sadly I actually confused him with Wittgenstein, another Vienna-based philosopher. Don, realizing that I was getting into trouble, hustled me out of the office. Hayek, very much a gentleman, shook hands and encouraged us to continue our work. We made the walk back from Hayek's office to ours in abject silence.

I was completely deflated and humiliated. Not reading Popper in the methodology field of economics was like not being aware of Einstein in physics, as he was the top European philosopher who supported democracy. I felt that my career in economic theory had just come to an end. I no longer felt equal to the other top young economists in pure theory, nor did I have the patience for the many thousands of hours of reading I would need to do to catch up. My only comparative advantage was my joy in the use of statistics, to look for economic relationships, a skill not deemed valuable in the Austrian community. Not quite a "Hayekian," because I disagreed with the master that mathematics could not be used to illuminate theory, and distrustful of Keynesian theory, which advocated massive government spending and deficits -- I felt I had no intellectual home.

And so I packed my bags, and decided to focus on business, and put aside pure theoretical economics, which had been my first love. Perhaps that's what we should ask of our presidential candidates between now and the election -- just focus on business, make sure our entrepreneurs can survive and thrive. If we can achieve that, we're going to be all right.