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Business Cycles, Money and Economic Policy

Lutz and Equilibrium Theories of the Business Cycle

Lutz et les theories d’équilibre des cycles d’affaires
Muriel Dal-Pont Legrand et Harald Hagemann
p. 241-262


La question de l’incorporation des phénomènes cycliques dans un cadre analytique en termes d’équilibre a longtemps été considérée comme une question à la fois fondamentale et controversée jusqu’à ce que, au début des années 70, Lucas propose une solution à ce dilemme. Différents papiers ont depuis souligné la (dis-)continuité entre les programmes de recherche de l’entre-deux guerre et celui de Lucas. Dans ce débat, la contribution de Lutz a été totalement négligée. L’objectif de ce papier est d’analyser son ouvrage de 1932, Konjunkturproblem in der Nationalökonomie considéré comme une contribution majeure à a théorie des cycles d’équilibre.

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1Among Pascal Bridel’s many outstanding contributions probably the most important are the two books Cambridge Monetary Thought. The Development of Saving-Investment Analysis from Marshall to Keynes (Bridel, 1987) and Money and General Equilibrium Theory. From Walras to Pareto. In Money and General Equilibrium Theory, Bridel (1997) offers “a detailed analytical reconstruction of Walras’s and Pareto’s various attempts at coordinating money and general equilibrium theory from 1870 to 1923” and reaches the conclusion that “the purely static nature of Walras’s pure economics, and the simultaneous lack of a proper technology of exchange in which money as a means of exchange has an essential role to play, exclude ex definitione the integration of monetary and value theory” (Bridel, 1997, vii). Pascal Bridel regards Robert Lucas as the leading modern proponent of the “monetary equilibrium” approach initially aimed for by the founder of general equilibrium analysis (Ibid., 60, n. 34).

  • 1 For a critical discussion of this superficial interpretation see Laidler (1986), Hoover (1988, part (...)

2In “Understanding Business Cycles” one of his most widely read contributions, Lucas (1977, 7) quotes with full approval Hayek’s statement in Monetary Theory and the Trade Cycle “that the incorporation of cyclical phenomena into the system of economic equilibrium theory, with which they are in apparent contradiction, remains the crucial problem of Trade Cycle theory” (Hayek, 1933, 33n). In a footnote, which was not included in the German original Geldtheorie und Konjunkturtheorie (Hayek, 1929), Hayek specifies that: “By ‘equilibrium theory’ we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics.” (Hayek, 1933, 42n.t) This has been interpreted widely as the Walrasian influence on Hayek, and a line going from Walras via Hayek to Lucas.1

3In Das Konjunkturproblem in der Nationalökonomie (The Problem of Business Cycles in Economics) (1932), Friedrich A. Lutz reviewed the body of work on theories of economic fluctuations from the viewpoint of equilibrium economics. This work, which was submitted as his habilitation thesis to the University of Freiburg and is of great interest for a precise theoretical foundation of business-cycle theory, astonishingly had been neglected in the modern literature on equilibrium business cycles (EBC) and real business cycles (RBC) models for a long time. This was mainly due to the fact that it somehow concluded the debate on the (in)compatibility of business-cycle theory with the equilibrium system, initiated by Löwe, in the German language area, where none of the main protagonists was living anymore soon after publication, and for the very same political reasons the German language lost its role as a medium of international scientific discourse. The importance of Lutz’s work for modern debates was only rediscovered rather late when Rühl (1994, 188) even claimed to its being “one of the most splendid books on the history of business cycle theory ever written” and rightly emphasized that “Lutz’s discussion should be considered indispensable for any truly comprehensive account of the origins of contemporary equilibrium business-cycle theories” (Rühl, 1997, 416).

4In the following we focus first in section 1 on the debate on business-cycle theory in the German language area in the 1920s and early 1930s, which constitutes the contemporary background to Lutz’s contribution. In section 2 we briefly review the life and academic career of Friedrich A. Lutz (1901-1975). In section 3, which forms the core of this paper, we focus on The Problem of Business Cycles in Economics (Lutz, 1932). A condensed version of his marked position on the central question of the (in)compatibility of an explanation of business cycles with the dominant general equilibrium approach in economics is provided in Lutz’s (1933a) contribution to the famous Festschrift for Arthur Spiethoff Der Stand und die nächste Zukunft der Konjunkturforschung (The State and the Near Future of Business Cycle Research) (Clausing, 1933). Some conclusions are drawn in the final section 4.

1. The Debate on Business Cycles in the German Language Area During the Weimar Republic

5Business-cycle theory was a dominant theme for German and Austrian economists in the interwar period in a debate which attracted the most brilliant and innovative minds among a new generation of theoretically inclined economists. “Analysing business cycles means neither more nor less than analysing the economic process of the capitalist era” (Schumpeter (1939, V) is the opening statement in Schumpeter’s monumental study Business Cycles, which was published at the end of the interwar period. Schumpeter had started to reflect on the problem of the business cycle as far back as 1905 as he points out in the preface to the first German edition of The Theory of Economic Development (Schumpeter, 1911, VIII). He emphasized also that this book and his earlier Vienna habilitation thesis The Nature and the Main Content of Theoretical Economics (Schumpeter, 1908) formed an entity, although both books could be read independently. The “division of labor” between the two books can best be understood with reference to the two masters: Walras, Schumpeter’s great hero who had conceptualized a system of general economic equilibrium, and Marx whose vision of the long-run development of the capitalist economy and emphasis on capital accumulation and technical progress were a life-long challenge for Schumpeter.

6This corresponds to the fundamental distinction between statics and dynamics on which Schumpeter’s theoretical system is based. Schumpeter’s economic dynamics deals with changing the data of the static system or destruction of the circular flow through the introduction of new combinations including the five cases of new methods of production, new products, opening of new markets, new sources of supply, and new forms of organization. In Schumpeter’s system, economic dynamics is linked strongly to the phenomenon of economic development which, in his view, is endogenous, spontaneous, and discontinuous. It is the task of dynamic theory to explain the causes and effects of the wave-like movement of economic development. Schumpeter’s theory consists of an original combination of three key elements: innovations implying ‘creative destruction’, pioneering entrepreneurs as the decisive actors that set the out-of-equilibrium process in motion, and bank credit as a prerequisite for financing innovative investment activities, leading to a reallocation of resources (Schumpeter’s ‘Triad’).

7In the mid-1920s Schumpeter’s theory had become a central point of reference for the more theoretically-minded economists in the German language area. Thus when Adolf Löwe (1893-1995) presented a critical survey of the theoretical and empirical literature in his contribution “The current state of research on business cycles in Germany” to the Festschrift for Lujo Brentano (Löwe 1925), he was clearly inspired by Schumpeter’s view that a Walrasian system of general economic equilibrium was inappropriate for business-cycle theory. Löwe (1925, 355n.1) stated that the static (or equilibrium) and the dynamic approaches refer to “two structurally distinct systems of motion.”

  • 2 Kuznets (1930b, 128). See Gehrke (1997, 238-242) for a survey of contemporary reactions to Löwe’s 1 (...)

8Löwe made his claim to the necessary abandonment of static equilibrium theory in the analysis of business cycles even more explicit in his subsequent Kiel habilitation thesis How is business-cycle theory possible at all? (Löwe, [1926] 1997), with which he qualified to become the founding Director of the new Department of Statistical International Economics and International Trade Cycles at the Kiel Institute of World Economics. In this “brilliant article”2 Löwe pointed out the fundamental conflict between the equilibrium approach as the dominant method of economic theory and the subject of inquiry: cyclical fluctuations of the economy which have a genuine out-of-equilibrium character. In his critical investigation of the existing body of business-cycle theories Löwe came to the result that all serious approaches have either introduced exogenous factors or fully or partly abandoned the interdependency requirements of a system of general economic equilibrium. He concluded therefore that:

The business cycle problem arises on the basis of the static system with such sharpness, because on this basis it is not analytically solvable from the axioms of the system. The business cycle problem is not a reproach for, but a reproach against the static system, because in it it is an antinomic problem. It is solvable only in a system in which the polarity of upswing and crisis arises analytically from the conditions of the system just as the undisturbed adjustment derives from the conditions of the static system. Those who wish to solve the business cycle problem must sacrifice the static system. Those who adhere to the static system must abandon the business cycle problem. (Löwe [1926] 1997, 267)

9Löwe diagnoses the necessary transformation of the existing static system into a new dynamic one in which “the polarity of upswing and crisis will acquire the same status as a data constellation which the equilibrium has in the static system” and which “by its internal logic promises to provide answers which the static system must necessarily have failed to supply.” (Löwe [1926] 1997, 269-270)

  • 3 For a more detailed analysis see Hagemann (1994).

10In the following year Friedrich A. Hayek became the founding Director of the Austrian Institute for Research on Business Cycles in Vienna. A closer look at chapter I on ‘The Problem of the Trade Cycle’ in Hayek’s ([1929] 1933) Vienna habilitation thesis Monetary Theory and The Trade Cycle shows clearly how much he was challenged by Löwe’s attack on the construction of a business-cycle theory on the basis of an equilibrium approach to economics. There are important points of agreement but also disagreement between these two economists.3

  • 4 Löwe ([1926] 1997, 246) and Hayek ([1929]1933, 28).

11Hayek agreed explicitly with Löwe’s statement that “it would of course mean to misunderstand the logical relationship between theory and empirical research to expect an immediate furtherance of the theoretical system from an increase in empirical insight”.4 There can be no doubt “that the practical value of statistical research depends primarily upon the soundness of the theoretical conceptions on which it is based. To decide upon the most important problems of the Trade Cycle remains the task of theory” (Hayek, [1929] 1933, 39). Thus Hayek and Löwe shared a view on the relation between empirical observation and theoretical explanation. Any adequate explanation of business cycles must employ a proper theory. Hayek and Löwe clearly repudiate the methodological position taken by Wesley Mitchell, the Harvard Committee, and Ernst Wagemann who had become the founding Director of the German Institute for Business Cycle Research in Berlin in 1925, and stood closer to the tradition of the German Historical School. The views of Löwe and Hayek on this issue is shared fully by Lutz who in his discussion of statistical business cycle research (Lutz, 1932, ch.4), although acknowledging its usefulness, criticizes the turning away from theory and instead emphasizes the primacy of theory over statistics.

12Hayek also accepted Löwe’s seminal argument that all existing business cycle theories suffered from the fundamental weakness that they relied on exogenous shocks or disturbances and adjustments to such shocks in an equilibrium framework. This could hardly result in a satisfactory theory to explain economic fluctuations which occur in a somewhat regular pattern. The logic of equilibrium theory “properly followed through, can do no more than demonstrate that such disturbances of equilibrium can come only from outside – i.e. that they represent a change in the economic data – and that the economic system always reacts to such changes by its well-known methods of adaptation, i.e. by the formation of a new equilibrium” (Ibid., 42-43). Trade cycle theory like any other economic theory, must fulfill two criteria of correctness to avoid the pitfalls of creating cyclical fluctuations via the introduction of exogenous shocks into a static system:

Firstly, it must be deduced with unexceptionable logic from the fundamental notions of the theoretical system; and secondly, it must explain by a purely deductive method those phenomena with all their peculiarities which we observe in the actual cycles. Such a theory could only be ‘false’ either through an inadequacy in its logic or because the phenomena which it explains do not correspond with the observed facts. (Ibid., 32-33)

13Hayek points explicitly to the parallels to his argument in the views expressed by Löwe (1928) in his contribution “On the influence of Monetary Factors on the Business Cycle” to the 1928 Zurich meeting of the Verein für Sozialpolitik where Hayek had presented his essay “Some Remarks on the Relation of Monetary Theory to Business Cycle Theory” (Hayek, 1928a), the core of which text he later presented as his Vienna habilitation thesis Monetary Theory and the Trade Cycle.

14Hayek shared Löwe’s view that the integration of cyclical phenomena into general equilibrium theory is the crucial problem of business-cycle theory, and that correspondingly, business cycles should be explained as endogenous outcomes of market processes. However, the two economists differed fundamentally in their conclusions. Whereas Löwe wanted to abandon the use of the traditional equilibrium concept, Hayek adhered also to general equilibrium theory for explaining business cycles (which animated Lucas to his Hayek reference). Hansjörg Klausinger (2012) in his excellent introductions to the two volumes on Business Cycles in the Chicago edition of Hayek’s works documents very thoroughly how Hayek’s writings in the interwar period on monetary theory and business cycles were firmly based on an equilibrium approach, and included an ambitious attempt to integrate time and money into the equilibrium framework. Hayek ([1928a] 1984, 75) argues in his famous article on “Intertemporal Price Equilibrium and Movements in the Value of Money”:

Yet the concept of equilibrium is just as indispensable a tool for the analysis of temporal differences in prices as it is for any other investigation in economic theory. Strictly speaking, its field of application is identical with that of economic theory, since only with its assistance is it possible to give a summary depiction of the very great number of different tendencies of movement which are operative in every economic system at every point in time. (emphasis added)

  • 5 For a detailed discussion of the role of Cantillon and Ricardo effects in Hayek’s business cycle th (...)

15Hayek’s business cycle theory integrates monetary theory and capital theory, and rests on the idea that prices determine the direction of production. The function of prices as an intertemporal coordination mechanism is to give entrepreneurs the information required for their investment and allocation decisions. However, while monetary factors cause the business cycle, it is constituted by real factors. Cantillon effects of changes in the money supply on the price structure and hence on the structure of production (non-neutrality of money) and Ricardo effects of a shortage of consumption goods on the production of investment goods which function to explain the upper turning point of the cycle and the tendency to restore the original equilibrium position, play a decisive role in Hayek’s theory.5 While in Monetary Theory and the Trade Cycle Hayek’s focus is on the monetary causes promoting the cycle, the emphasis in his subsequent Prices and Production lectures is on changes in the real structure of production.

16An essential assumption in Hayek’s explanation of business cycles is that they start from an equilibrium position with efficient utilization of resources. Prices and Production (Hayek, 1935, 34) is characterized by Hayek’s “conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of tendency towards an equilibrium.” To analyze dynamic questions requires integrating the time dimension into the notion of equilibrium and accounting for differences in the prices of the same goods at different points in time.

17In contrast to Löwe who was convinced of disorderly tendencies in uncontrolled industrial economies, Hayek considered the free market economy as inherently stable so that all movements could essentially be regarded as equilibrating adjustment processes. While for Löwe technical progress was the decisive endogenous factor causing cyclical fluctuations, for Hayek it was monetary disturbances and their impact on the real structure of production that were decisive. In his business-cycle theory Hayek combines Wicksell’s theory of the cumulative process—where price changes are caused by the discrepancy between the market (money) rate of interest charged by the banks and the natural (equilibrium) rate of Iinterest—with Mises’s theory of money and credit—in which banks artificially reduce the money rate of interest and are responsible for overinvestment and misallocation of resources which necessarily have to be corrected sooner or later. The excesses of the boom contain the seeds of later crisis. Austrian business cycle theory along the lines of Mises and Hayek, therefore, consists of a monetary overinvestment theory in which the emphasis is not on changes to the absolute price level but on distortions to the system of relative prices and their impacts on the real structure of production. To elaborate the latter factors, Hayek added core elements of Böhm-Bawerk’s theory of capital with its emphasis on the time structure of the production process, particularly the famous triangles in chapter II of Prices and Production. While agreeing with Löwe’s emphasis on the importance of production structures, Hayek deviated by employing a vertical (‘Austrian’) rather than a horizontal (sectoral) disaggregation of production structures.

18Hayek was not the only leading young economist who was challenged by Schumpeter’s distinction between statics and dynamics and by Löwe’s emphasis on the incompatibility of the equilibrium approach to the business-cycle problem and its foundation for claims to a new dynamic theory. The last major contribution before the Nazis’ rise to power came from Friedrich A. Lutz (1932). In his core chapter 3 ‘Return to, and Extension of, the Pure Theory’ in his The Problem of Business Cycles in Economics, Schumpeter and Löwe are the most intensively discussed authors.

2. The Life and Academic Career of Friedrich A. Lutz

  • 6 For the biography and academic career of Lutz see also Rühl (1999) and particularly Veit-Bachmann ( (...)

19Friedrich A. Lutz was born on 29 December 1901 in Saarburg, Lothringia, then part of Germany, now Sarrebourg, Lorraine, in France.6 After WWI he finished high school in Stuttgart in 1920 and went on to study economics at the Universities of Heidelberg (1920-21) and Berlin (1921-25). In Berlin he encountered the young Privatdocent Walter Eucken (1891-1950). He became Eucken’s first dissertation student and was awarded his Ph.D. from the University of Tübingen for his work The Battle on the Notion of Capital in Recent Times (Lutz, 1925). Thereafter he worked for three years in close association with Alexander Rüstow (1885-1963)—the then main organizer of the theoretically-minded so-called German ‘Ricardians’ against the epigones of the younger Historical School, and later one of the leading liberal thinkers—at the German Machine Builders’ Association in Berlin. In April 1929, Lutz began an academic career as research assistant to Eucken, who in 1927 had moved to Freiburg. There Lutz successfully submitted his habilitation thesis on The Problem of Business Cycles in Economics (Lutz, 1932), and was employed as a Privatdocent from 1932 to 1938.

20Lutz was the intellectually most outstanding, and internationally most renowned of Eucken’s students, and made key theoretical contributions on the monetary and currency order to the “Ordnungsökonomik” of the Freiburg School. Against the historical background of the hyperinflation in Germany in the early 1920s, which was ended by the late 1923 currency reform, the primacy of monetary and currency stability later became a key constituent principle of German Ordoliberalism alongside the fundamental principle of a functioning price system of full competition. It was Lutz (1936) who contributed the important essay on The Basic Problem of the Monetary Constitution to the four-volume set on Die Ordnung der Wirtschaft (The Economic Order) which established the ideas of the Freiburg School.

21Lutz later contributed to monetary and currency theory as well as interest and investment theory. Much of the stimulus for these works came from his long stays at leading Anglo-Saxon universities in a period when German economics was generally dissociated from international developments. Lutz had been a Rockefeller Foundation Fellow in the United Kingdom during the academic year 1934-35. There he studied the British monetary system and got to know Vera C. Smith (1912-1976), who was awarded her PhD from the London School of Economics and Political Science in 1935 after submission of a thesis, supervised by Friedrich A. Hayek, on Free Banking (Smith, 1936). Lutz married Vera Smith in March 1937.

22As a liberal opponent to the Hitler regime, Lutz emigrated from Nazi Germany exploiting the opportunity of a second year as a Rockefeller Foundation Fellow, in 1937-38, in the United States. He began an academic career at Princeton University, finally being appointed Full Professor in July 1947. From summer 1948 Lutz taught regularly at the University of Freiburg, and was one of the co-founders of ORDO, the new Freiburg School journal which became the flagship of German Ordoliberalism. Lutz (1949) published his basic article “Monetary Policy and Economic Order” where he elucidated their mutual interdependencies. Lutz pointed not only to the role of money in enabling freedom of consumer choice which would dissipate in the centrally planned economies but also to the gold standard as the proper monetary system for a competitive order since it was based on the principle of an ingeniously constructed mechanism: “As the price mechanism dictates the actions of individuals, so does the gold mechanism dictate the chiefs of central banks their actions and makes ‘their’ monetary policy a more or less automatic reaction to the influx or drain of gold” (Lutz, 1949, 207; our translation). Such as the competitive order is incompatible with central economic planning, the gold standard had to be abolished at the very moment when an autonomous national monetary policy began to pursue a goal of full employment, and the decision centre of monetary policy shifted from the central bank to the ministry of finance. The great distance between Lutz and contemporary Keynesian doctrine is obvious. The earlier experience with the German hyperinflation had engraved on the thinking of Eucken and Lutz who gave price stability highest priority for the monetary and currency order and were opposing any monetary policy they considered to imply inflationary dangers.

23In 1951 Lutz published The Theory of Investment of the Firm, coauthored with his wife, in which the microeconomic theory of the firm is extended to include the issues of time and capital. Money, capital, and interest were a persistent major concern for Lutz, as is evident in his early and important paper on “The structure of interest rates” (Lutz, 1940) and in his The Theory of Interest (Lutz, [1956] 1967) and “The essentials of capital theory” (Lutz, 1961), his contribution to the famous Corfu conference volume on capital controversies which Lutz co-edited for the International Economic Association.

24In the academic year 1951/52 Lutz took a temporary chair at Freiburg following the untimely death of his former teacher and life-long friend, Eucken, during a lecture series at the London School of Economics. Subsequently Lutz rejected the University of Freiburg’s offer of a permanent professorship and moved from Princeton to Switzerland where he was appointed Full Professor at the University of Zurich in April 1953. Lutz, who had become an American citizen in September 1944, re-acquired German citizenship in March 1955.

25Lutz had analyzed the consequences of the banking crises in Germany, Britain and the United States, and deplored the economically and politically destabilizing results of the devaluation race and currency war in the 1930s. He drew a link between monetary policy and the international financial order and pointed out that neither the gold standard nor flexible exchange rates are compatible with a centrally planned economy. He accentuated the compromising character of the Bretton Woods System and became an early adherent of full convertibility of currencies and flexible exchange rates, in a period that was still marked by many controls on international capital movements. Lutz (1954) expressed his view in a characteristic way in his paper “The Case for Flexible Exchange Rates.” Lutz engaged in the construction and stabilization of a functioning international currency order as an adviser to the Bank for International Settlements and an activist in the Bellagio Group and the Mont Pèlerin Society which he presided over between 1964 and 1967.

26It is astonishing that despite his international prominence and reputation Lutz’s (1932) contribution, to which we now turn, has been mostly overlooked in modern debate on the (in)compatibility of business-cycle theory with general economic equilibrium theory.

3. Equilibrium and the Business Cycle: Lutz’s View

27Lutz’s habilitation thesis The Problem of Business Cycles in Economics aimed at analyzing explanations of the business-cycle problem since the classical political economists in relation to the robustness of the methodology for the problems and their solution. It was not intended to be a history of economic thought but his discussion of earlier theories was aimed at “a systematic clarification of the questions which, in principle, the business-cycle problem raises to economic research, whereby at the same time a positive contribution to business-cycle research should be given” (Lutz, 1932, Foreword). Lutz’s treatise is comprised of six chapters. In Chapter 1 Lutz deals with the treatment of the business-cycle problem by classical economists and comes to the conclusion that their treatment of the general glut problem failed, because they could not solve it within the framework of their system which presumed the idea of a general equilibrium in the economy.

28Chapter 2 deals with the putting together of theoretical analysis and unanalyzed facts in various “mixed theories.” Among the economists more intensively discussed by Lutz are Clément Juglar, Gustav Cassel and Arthur Spiethoff. Lutz considers as the unifying element of the members of this group that they regard the various cycles as resembling phenomena concerning their nature and that the identification of this uniform nature is defined as the decisive solvable problem. However, since every business cycle is unique, a scientific solution of this problem is impossible. Therefore empirical facts are brought in to make the theory more realistic and to explain the individual cycles. It is this realistic investigation of the empirical facts to solve the business cycle problem which has ended the uniformity of the formulation of the problem and led to great subjectivity in business cycle research. These attempts by the proponents of the mixed theories could be regarded as the result of the fight between two souls in the breast of these business-cycle researchers of which the one is longing for the seizing of reality whereas the other aims for a theory at the expense of pressing different historical cycles into the strait-jacket of a general scheme (see Lutz, 1932, 80-81).

29Lutz’s critique of the mixed theories immediately caused a reply by Gustav Clausing (1933b), the editor of the Spiethoff Festschrift. In his response to Clausing’s plea for a “historical-realistic” theory, Lutz (1933b) made his position clear. After initially pointing out an agreement with Clausing in their rejection of a pure theory to solve the business cycle problem, Lutz distances himself. Time and again he emphasizes that, on principle, business cycles are unique historical episodes. It is therefore no surprise that in particular those researchers who know best the empirical facts have perceived the uniqueness of the individual cycles and the difficulties to distil a common type of the cycle. Lutz (1933b, 734) explicitly refers to Wesley Mitchell before he considers that “it therefore has been proved that the historical cycles cannot be understood as an invariable object concerning their nature.” A working out of a business cycle scheme, which the theory has to explain would imply a violation of the facts and therefore has to be rejected. According to Lutz it is impossible to formulate a theory which once and for all would explain the causes of the cycle. It is therefore a basic defect of the mixed historical-realistic theory that their representatives are making a bad compromise, in, on the one side joining the pure theorists in looking for a general solution, but, on the other side, dispensing the theory and falling back upon empirical facts in the explanation of individual cycles. “To elevate a problem into a general one, only then makes sense and has an internal justification, when the character of the problem allows a purely theoretical solution, i.e. if one succeeds to demonstrate necessary conditional connections in this general sphere.” (Ibid., 736)

30Lutz’s analysis also includes an elaborate critique of Schumpeter’s work which he rightly regards as being founded on the distinction made by John Bates Clark between statics and dynamics. In Schumpeter Wesen und Hauptinhalt der Nationalökonomie constitutes the static part, and Theory of Economic Development the dynamic one. Lutz regards Schumpeter’s conception of statics theory as superior to Clark’s in being motivated by Böhm-Bawerk’s emphasis on the processes of economic change caused by data changes, which lead to a new state of equilibrium. According to Lutz,

[T]he idea of equilibrium is the result of thinking through processes of economic change, it is the product of the recognition that the economy tends towards equilibrium… the static theory is well able to deal with the tasks which Clark assigns to the dynamic theory. Its domain necessarily includes problems of change. The same forces operate in dynamics as in statics, but in the latter case they are in balance. Statics is really but a branch of dynamics, as Marshall puts it. ... [T]he mere fact that business cycle theory deals with processes of change does not mean that it is part of a dynamic theory rather than the static one. (Lutz, [1932] 2002, 185-186 n.2)

31Lutz shows convincingly that this is carefully considered by Schumpeter who assigns to dynamic theory the task of explaining the origin and effects of discontinuous changes within the economy. The carriers of this endogenous development are the pioneering entrepreneurs who implement new combinations of the factors of production. They are responsible for economic development, and thus for the difference between dynamics and statics. Since these entrepreneurs appear in swarms, development takes on the form of a wave-like movement. However, Lutz criticizes Schumpeter for relying on irrational behavior among the group of entrepreneurs, since his great group of mere managers relying on past experience only miss profitable opportunities in the equilibrium state. If these opportunities arose only as the result of technical progress they would come from without and not from within the economy. In this case Schumpeter’s dynamic theory would have to rely on exogenous forces, i.e. on changes in the data, which do not necessarily imply periodicity. Lutz also rightly notices that Schumpeter’s famous and controversial statement of the non-existence of interest in statics is the consequence of his premise that the introduction of new methods of production is excluded. Schumpeter has to rely also on the assumption of rational behavior of the entrepreneurs in his analysis of the re-equilibrating process: “In any case, since a theory is only possible on the basis of economic agents who behave rationally, Schumpeter’s division between static and dynamic theory must be abandoned.” (Lutz, [1932] 2002, 193)

  • 7 See Lutz (1932, 114-122 ; 2002, 202-209).

32Lutz also deals intensively with Löwe’s analysis of the (in)compatibility of the business cycle problem and the equilibrium method and Löwe’s claim for a new dynamic theory.7 He confirms that Löwe had clearly seen and precisely identified the problems which cyclical fluctuations cause for static theory, but that he had proposed a solution, i.e. his demand for a new dynamic theory, which is impossible. Lutz maintains that Löwe had confused ‘data’ with ‘variables’, when he regards the data of the theory also subject to the general interdependence, which is definitely not the case. The introduction of technical progress, as favoured by Löwe, is nothing else than a change in the data which would lead to a new equilibrium. However, the analysis of changes in the data, which is the task of business-cycle theory, could be done completely within the existing framework of equilibrium theory by the use of the variation method. For that reason there would be no need for a ‘new dynamic theory’: “In any case, what must be stressed is that since ‘independent variables’ only represent changes in data, introducing them can neither help show a way out of the static system nor resolve the difficulties posed by the problem of business cycles.” (Ibid., 205)

33In the same line of reasoning Lutz criticizes Kuznets (1930a) for his accusation that static theory had overlooked different reaction speeds. For Lutz, who only concedes that equilibrium theory, particularly in its Lausanne school blend which does not include the time element, had not put enough emphasis on adjustment processes, static theory also includes the “investigation of how equilibrium comes about, i.e. the movement towards equilibrium following a change in data” (Lutz, [1932] 2002, 208). However, the introduction of the time element does not put an end to general interdependence.

  • 8 See, for example, Lutz (1933a, 163).

34For Lutz’s own solution to the methodological dilemma posed by Löwe it is decisive to deny the regularity postulate because it is this periodicity which is emphasized by many contemporary economists as the main task of business-cycle theory. In that context Lutz also refers to Pigou’s psychological approach or Jevons’s earlier harvest theory of the business cycle. Time and again, including his concise summary contribution to the Spiethoff Festschrift (Lutz, 1933a) and in his response to Clausing (Lutz, 1933b), he states that there is no general paradigm or ‘nature’ of business cycles, which therefore cannot be squeezed into a unifying scheme. An endogenous inevitability of business cycles is incompatible with modern economic theory which is based on the central idea that the economy tends towards equilibrium. To ascribe the periodicity of the business cycle to internal economic forces therefore would imply to give up the equilibrium concept.8

  • 9 Ibid., 165.

35On the other hand, equilibrium theory delivers all the necessary tools to explain individual business cycles as unique historical events, so that also for this reason the idea to deduce the business cycle from certain premises in a purely theoretical way must be given up. The business cycle problem is a concrete one, and it is the task of theory to explain specific business-cycle trajectories by applying all the findings of static theory, particularly those of the effects of various data changes by use of the variation method. The set of instruments of static theory put together for that purpose therefore has to be elaborated by systematically investigating the effects of changes in the data. Lutz perceives technical progress, capital formation and changes in the quantity of money as the most important data changes for cyclical fluctuations.9

36According to Lutz, there cannot exist a general theory of the business cycle that transcends what equilibrium theory has accomplished. Therefore he diagnoses the failure of the attempts to develop a “new dynamic theory.” In his response to Clausing, Lutz (1933b, 93-94) concludes with a detailed statement that his view—that every business cycle is a unique historical episode whose explanation requires recourse to the application of general economic theory—meanwhile has gained increasing support from modern business cycle researchers. Lutz not only refers to Cassel and Emil Lederer, who completely dispense with their business cycle theory in the interpretation of the Great Depression, but particularly also to several other contributions to the Spiethoff Festschrift. This is less surprising with regard to his teacher Eucken, who had already polemized against a general business cycle theory before, although in a less elaborated and convincing way than Lutz. More interesting is Lutz’s explicit reference to the leading economists from the Kiel Institute: Hans Neisser, Gerhard Colm and Adolph Löwe. It is understandable that Lutz first refers to Neisser, since he points out in his essay that the variation method and its refinement must form the indispensable basis of a sound business-cycle theory, and that a typology is required to cover the pluralism of data changes. Furthermore, Neisser (1933) stresses that a reasonable selected collection of theoretical fragments is necessary to explain different historical cycles in a satisfying way, and it is this point where he differs from the otherwise instructive work of Lutz (Neisser, 1933, 209-210).

37Mutual esteem characterizes also the extensive review of Lutz’s book by Fritz Burchardt (1934) who had been the closest research associate at the Kiel Institute of Löwe with whom he moved to the Goethe University in Frankfurt in fall 1931. While agreeing with Lutz that every historical cycle has its own specific characteristics which require explanation, and pointing out that the structure and process of business cycles has substantially changed in modern economies which made the isolation of the data influencing cycles from the other elements of capitalist dynamics more difficult, as Löwe (1933) did, Burchardt nevertheless stresses some important differences from Lutz. In contrast to upswings and downswings, the equilibrium position constitutes hardly a real phenomenon over the business cycle. Upswings and downswings therefore should be made the subject of theoretical inquiry despite the fact that their nature has changed historically. It also would be a major fault to infer the non-existence of cyclicity from the absence of an exact periodic recurrence. While basically agreeing with Lutz that individual business cycles should be explained by the application of the theory (see Lutz, 1933, ch.5), the difference remains whether this could be done on the basis of the existing static general equilibrium theory or would require a “new dynamic theory”.

38Lutz’s approach also contains some weaknesses. For instance, it can be questioned whether processes of capital accumulation could be grasped simply as data changes, as Lutz did in his attempt to deny a need for a special business-cycle theory and to demonstrate the superiority of the static equilibrium approach. This view would also exclude the possibility of an endogenous technical process. A comprehensive explanation of cyclical fluctuations can be neither purely exogenous nor purely endogenous. Data changes always influence the economy, but they cannot by themselves produce recurrent and pervasive fluctuations. It is also doubtful to consider changes in technology, preferences, or politics, and even climate, as completely exogenous. Interdependence, however, should be a key issue of a theory of business cycles which explains dynamic processes in a modern economy. In contrast to the interwar period it is nowadays characterized by a growing importance of services and knowledge. No doubt that the historical character of business cycles, as emphasized by Lutz, has changed again.

4. Concluding Remarks on Equilibrium and Business Cycles Theory: From One Research Agenda to the Other

39Lucas presented his paper “Understanding Business Cycles” with the initial Hayek quotation on the (in)compatibility of equilibrium theory with the business cycle problem originally at the Kiel Conference on Growth without Inflation in June 1976. Seemingly Lucas was completely unaware of the fact that in April 1926 Löwe had become the founding director of the new research department on business cycles at exactly that Institute of World Economics where Lucas presented his paper half-a-century later. Furthermore, Löwe qualified for his job with his habilitation thesis How is business-cycle theory possible at all? (Löwe, 1926), which became the main challenge for Hayek two years later.

  • 10 Cf. for instance Hoover (1988) or Arena (1994).
  • 11 Lucas (1996).

40As we know, Lucas’s own references to Hayek in 1977 stimulated various reactions among academics. First of all, they carefully investigated the possible filiation which could be identified between Lucas and Hayek, and one can consider that nowadays, this question has been solved;10 Lucas himself acknowledged that his reference to Hayek was a mistake.11 He nevertheless argued that, in his view, economists “resort to disequilibrium dynamics only because the analytical equipment available to them offers no alternative” (Lucas, 1996, 669). He then specifies:

The intelligence of these attempts to deal theoretically with the real effects of changes in money is still impressive for the modern reader, but serves only to underscore the futility of attempting to talk through hard dynamic problems without any of the equipment of modern mathematical economics. (Ibid., 669)

41This is a strong statement which means that, for Lucas, there is a clear homogeneity among what can be considered as equilibrium approaches. The investigation of Lutz’s contribution to equilibrium and business cycles theory mainly leads to two conclusions:

  • 12 Lundberg’s 1930 contribution is included and, together with other important interwar contributions, (...)
  • 13 The reference to Lutz is also absent from the otherwise very interesting book by Kim (1988) who nev (...)

42First of all, the neglect of Lutz’s contribution clearly reflects the loss of international consciousness of the German language literature, despite the fact that Schumpeter (1954, 739n. and 1123), who appreciated the high analytical qualities, in his History of Economic Analysis twice refers to Lutz (1932). This modern neglect of the German literature contrasts remarkably from leading contemporary authors. So it was not only Simon Kuznets (1930a and 1930b) but, for example, also the young Erik Lundberg (1930) who in his licentiate thesis On the Concept of Economic Equilibrium took up Löwe’s methodological challenge and gave an elaborated assessment of the suitability of the equilibrium method for a theoretical analysis of economic change.12 Indeed, it is surprising that Lutz (1932) and his fundamental methodological position, which is summarized in the concluding chapter 6 “The nature of the problem of business cycles,” has not been quoted by modern proponents of equilibrium business-cycle theory.13

43Second, a careful investigation of Lutz’s research program, instead of identifying another forerunner for Lucas’s contribution, finally reveals elements of fundamental divergence between the interwar debates and Lucas’s program of research. Christof Rühl, who probably has been the first who recognized the importance of Lutz’s work for the modern debates, has concluded “that Lutz’s criticism ‘won’ the day” (Rühl, 1994, 200, n.27). However, despite the a priori deep connection between Lutz and Lucas’s approaches and the high quality of Lutz’s argumentation, it is doubtful whether this statement could be held without making some nuances. Indeed, Lutz and Lucas share the deep conviction that we need a “pure theory” in order to explain business cycles, i.e. a theory which emphasizes the main driving forces of business cycles, a theory which in order to be useful, does not try to be realistic but which aims at providing precision about the mechanisms at work. They both analyze business cycles within an equilibrium framework because they are convinced that there is a natural tendency for the system towards equilibrium, a belief which logically leads them to reject the necessity for an endogenous explanation of business cycles and also to consider that periodicity is not anymore a key feature of business cycles.

  • 14 See De Vroey (2009) for a discussion on the status of both equilibrium and tâtonnement in Walras’s (...)

44Nevertheless, the exclusive focus on the apparent convergence between the two programs of research underestimates the importance of their theoretical foundations. There is indeed a first important difference in the definition Lutz and Lucas give of dynamics but even more when it comes to the notion of equilibrium. Lutz has a Walrasian concept of equilibrium14 which naturally leads him to analyze adjustment processes and frictions, elements which are absent from Lucas’s concept of equilibrium analysis. Indeed, as Laidler (2010) emphasizes it, “The aggregate demand and supply curves of the typical macro-economic model of around 1970s, that is to say, were not behavior relationships, but equilibrium loci, and to be on either, the economy had to be on both, that is in full equilibrium.” (Laidler, 2010, 45). Lutz’s program of research is incompatible with this view. To some extent, it seems even closer to the Applied General Equilibrium or Computational General Equilibrium models which were developed since the 1960s. There was indeed a large variety of models which came up within the General Equilibrium paradigm: some were based on comparative-static analysis, others on dynamics or Recursive-dynamics but they were all concerned with the existence and the convergence towards equilibrium, a question which disappeared from the scope of macroeconomic analysis after New Classical Economics became dominant. One can nevertheless expect reasonably that a closer investigation of these models would also reveal important differences with Lutz’s own conception of what an equilibrium business cycles analysis should be. Certainly, the most interesting outcome historical perspectives can provide for modern economics is a clear assessment of what competing theories could finally achieve and how they affected the way economists addressed questions on important and recurrent issues.

The authors are grateful for the financial support provided by the Procope PHC (Programme Hubert Curien). The authors thank two anonymous referees. The usual disclaimer applies.

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1 For a critical discussion of this superficial interpretation see Laidler (1986), Hoover (1988, part V) and Arena (1994).

2 Kuznets (1930b, 128). See Gehrke (1997, 238-242) for a survey of contemporary reactions to Löwe’s 1926 article.

3 For a more detailed analysis see Hagemann (1994).

4 Löwe ([1926] 1997, 246) and Hayek ([1929]1933, 28).

5 For a detailed discussion of the role of Cantillon and Ricardo effects in Hayek’s business cycle theory see Hagemann and Trautwein (1998).

6 For the biography and academic career of Lutz see also Rühl (1999) and particularly Veit-Bachmann (2003).

7 See Lutz (1932, 114-122 ; 2002, 202-209).

8 See, for example, Lutz (1933a, 163).

9 Ibid., 165.

10 Cf. for instance Hoover (1988) or Arena (1994).

11 Lucas (1996).

12 Lundberg’s 1930 contribution is included and, together with other important interwar contributions, more intensively discussed in Hagemann (2002). Dal-Pont Legrand and Hagemann (2010) make a more detailed comparison of real versus monetary equilibrium business-cycle theories in the interwar period with modern approaches.

13 The reference to Lutz is also absent from the otherwise very interesting book by Kim (1988) who nevertheless provides a valuable historical perspective on equilibrium business cycles theories.

14 See De Vroey (2009) for a discussion on the status of both equilibrium and tâtonnement in Walras’s analysis.

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Muriel Dal-Pont Legrand

Université de Lille 1 and Clersé (CNRS, France),

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Harald Hagemann

University of Hohenheim, Institute of Economics, 70593 Stuttgart, Germany,

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