Hayek’s breakthrough year of 1936 was also the year of Frank Knight.  Avi Cohen’s article on the Hayek-Knight dust up includes previously unpublished correspondence between Hayek and Knight during this period.  Hayek’s take away lesson from his encounter with Knight was that logical constructs involving homogenized capital provided a barrier to understanding both the logic of valuation and the coordinating process of the market.  It was a lesson Hayek brought back to equilibrium theory and to the explanatory problems of macroeconomics.

Avi Cohen’s paper is “The Hayek/Knight Capital Controversy: The Irrelevance of Roundaboutness, or Purging Processes in Time?” History of Political Economy, Fall 2003, 35(3), 469-90.  More papers on capital theory by Avi Cohen can be found here.

Here is the final paragraph of Cohen’s paper on Hayek and Knight:

The differences between Hayek and Knight over what determines the interest rate are so vast that a resolution is impossible. For Hayek, the interest rate is the outcome of dynamic processes of intertemporal optimization by both consumers and firms. Knight understands the interest rate as determined in steady state equilibrium by the technical productivity of homogeneous capital alone. A final factor in the unresolved controversy between Knight and Hayek is the shared awareness of the limitations of equilibrium for analyzing capital theory or business cycles.  The controversy occurs as they are moving in opposite directions on the role and applicability of economic theory. Knight is ruling more and more phenomena out of economic bounds, while Hayek is moving to expand the boundaries of economics to include more coordination of- knowledge phenomena (Emmett 1998; Boettke and Vaughn 2002).  Despite their reservations, both continue using equilibrium methodology during their controversy. When Hayek calls Knight on this contradiction, Knight does not respond, perhaps because he agreed. But Knight never develops the “special methodology” that he says is necessary to deal with the long-run, historical changes that characterize the capital market.  Instead, he disengages and stands behind his simplifying assumptions that eliminate change, adhering to the insights and results of his capital conception in the one-commodity Crusonia plant model. Hayek, on the other hand, turns away from equilibrium analysis altogether , and moves outside the boundaries of traditional economic theory to tackle the problems of the coordination of knowledge. No debate on equilibrium is ever joined.