Wednesday, October 22, 2014

Hayek’s Prices and Production (1935), Lecture IV: A Summary

I summarise below Lecture IV of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

In Lecture IV, Hayek considers the arguments for and against an elastic money supply. We must remember that Hayek’s main concern was to make money “neutral” with respect to the structure of production.

Hayek comes out very strongly against money supply expansion as production increases, and advocates deflation as a natural state of affairs:
“If the considerations brought forward in the last lecture are at all correct, it would appear that the reasons commonly advanced as a proof that the quantity of the circulating medium should vary as production increases or decreases are entirely unfounded. It would appear rather that the fall of prices proportionate to the increase in productivity, which necessarily follows when, the amount of money remaining the same, production increases, is not only entirely harmless, but is in fact the only means of avoiding misdirections of production.” (Hayek 1935: 105).
Hayek rejects the idea that money supply should change in relation to the volume of production (Hayek 1935: 105–108), though seems to suggest that meeting the demand for high-powered money in times of crisis, as long as it does not increase the total quantity of money, might be acceptable (Hayek 1935: 112–113):
“The second source of the prevalent belief that, in order to prevent dislocation, the quantity of the circulating medium must adapt itself to the changing needs of trade arises from a confusion between the demand for particular kinds of currency and the demand for money in general. This occurs especially in connection with the so-called seasonal variations of the demand for currency which in fact arises because, at certain times of the year, a larger proportion of the total quantity of the circulating medium is required in cash than at other times. The regularly recurring increase of the ‘demand for money’ at quarter days, for instance, which has played so great a role in discussions of central bank policy since attention was first drawn to it by the evidence of J. Horsley Palmer and J. W. Gilbart before the parliamentary committees of 1832 and 1841, is mainly a demand to exchange money held in the form of bank deposits into bank notes or coin. The same thing is true in regard to the ‘increased demand for money’ in the last stages of a boom and during a crisis. When, towards the end of a boom period, wages and retail prices rise, notes and coin will be used in proportionately greater amounts, and entrepreneurs will be compelled to draw a larger proportion of their bank deposits in cash than they used to do before. And when, in a serious crisis, confidence is shaken, and people resort to hoarding, this again only means that they will want to keep a part of their liquid resources in cash which they used to hold in bank money, etc. All this does not necessarily imply a change in the total quantity of the circulating medium, if only we make this concept comprehensive enough to comprise everything which serves as money, even if it does so only temporarily.” (Hayek 1935: 112–113).
It is interesting to see that Hayek also recognises that the private sector often creates credit money itself and that this will be convertible into high-powered money too:
“(5) But at this point we must take account of a new difficulty which makes this concept of the total quantity of the circulating medium somewhat vague, and which makes the possibility of ever actually fixing its magnitude highly questionable. There can be no doubt that besides the regular types of the circulating medium, such as coin, bank notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, ceteris paribus, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required. The criterion by which we may distinguish these circulating credits from other forms of credit which do not act as substitutes for money is that they give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else. This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods. It applies also to a number of other forms of commercial credit, as, for example, when book credit is simultaneously introduced in a number of successive stages of production in the place of cash payments, and so on. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided. But it is important not to overlook the fact that these forms of credits owe their existence largely to the expectation that it will be possible to exchange them at the banks against other forms of money when necessary, and that, accordingly, they might never come into existence if people did not expect that the banks would in the future extend credit against them. The existence of this kind of demand for more money, too, is therefore no proof that the quantity of the circulating medium must fluctuate with the variations in the volume of production. It is only a proof that once additional money has come into existence in some form or other, convertibility into other forms must be possible.” (Hayek 1935: 113–115).
It is undoubtedly true that negotiable bills of exchange, negotiable promissory notes, negotiable cheques, and other private sector, monetised IOUs can expand the money supply, but Hayek never even considers that this might be sufficient to drive one of his Austrian business cycles – a serious flaw in his analysis. For the simple reason is that these forms of credit money need not be backed by prior “saving” and their expansion, if the “discount” on such bills falls below the “natural rate,” would increase the demand for factor inputs and perhaps even higher order capital investments.

Some few instances where an increase in the money supply are warranted are discussed by Hayek too (Hayek 1935: 120–124). If one firm splits into two firms and the need for money to purchase factor inputs thereby increases, then an increase in money supply may be warranted (Hayek 1935: 120–121).

Also, if there is a change in velocity of circulation, then the amount of money in circulation may need to be changed (Hayek 1935: 123–124).

However, Hayek immediately qualifies these concessions:
“(10) Even now our difficulties are not at an end. For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organisation or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy. No doubt the statement as it stands only provides another, and probably clearer, formulation of the old distinction between the demand for additional money as money which is justifiable, and the demand for additional money as capital which is not justifiable. But the difficulty of translating it into the language of practice still remains. The ‘natural’ or equilibrium rate of interest which would exclude all demands for capital which exceed the real supply capital, is incapable of ascertainment, and, even if it were not, it would not be possible, in times of optimism, to prevent the growth of circulatory credit outside the banks.

Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by overcaution. Under existing conditions, to go beyond this is out of the question. In any case, it could be attempted only by a central monetary authority for the whole world: action on the part of a single country would be doomed to disaster. It is probably an illusion to suppose that we shall ever be able entirely to eliminate industrial fluctuations by means of monetary policy. The most we may hope for is that the growing information of the public may make it easier for central banks both to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by ‘a little inflation.’” (Hayek 1935: 124–125).
In other words, even the few exceptions where changes in the money supply are theoretically warranted are practically difficult or impossible to actually address by central banks.

Finally, Hayek thought the prolonged economic problems of the 1930s were being caused by government interventions, in addition to the monetary disturbances that form part of his ABCT:
“Though I believe that recurring business depressions can only be explained by the operation of our monetary institutions, I do not believe that it is possible to explain in this way every stagnation of business. This applies in particular to the kind of prolonged depression through which some European countries are passing today. It would be easy to demonstrate by the same type of analysis which I have used in the last two lectures that certain kinds of State action, by causing a shift in demand from producers’ goods to consumers' goods, may cause a continued shrinking of the capitalist structure of production, and therefore prolonged stagnation. This may be true of increased public expenditure in general or of particular forms of taxation or particular forms of public expenditure. In such cases, of course, no tampering with the monetary system can help. Only a radical revision of public policy can provide the remedy.” (Hayek 1935: 128).
Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Tuesday, October 21, 2014

Hayek’s Prices and Production (1935), Lecture III: A Summary

I summarise below Lecture III of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

Hayek has a long analysis of the prices of intermediate goods in different stages of production (Hayek 1935: 70–83).

If money supply is increased by banks and the rate of interest falls below the natural rate (Hayek 1935: 86; and Hayek specifically states that in equilibrium the rate of return on capital is equal to the interest rate [Hayek 1935: 73]) and credit is obtained by producers, then Hayek’s Austrian business cycle is initiated:
“Now the borrowers can only use the borrowed sums for buying producers’ goods, and will only be able to obtain such goods (assuming a state of equilibrium in which there are no unused resources) by outbidding the entrepreneurs who used them before. At first sight it might seem improbable that these borrowers who were only put in a position to start longer processes by the lower rate of interest should be able to outbid those entrepreneurs who found the use of those means of production profitable when the rate of interest was still higher. But when it is remembered that the fall in the rate will also change the relative profitableness of the different factors of production for the existing concerns, it will be seen to be quite natural that it should give a relative advantage to those concerns which use proportionately more capital. Such old concerns will now find it profitable to spend a part of what they previously spent on original means of production, on intermediate products produced by earlier stages of production, and in this way they will release some of the original means of production they used before. The rise in the prices of the original means of production is an additional inducement. Of course it might well be that the entrepreneurs in question would be in a better position to buy such goods even at the higher prices, since they have done business when the rate of interest was higher, though it must not be forgotten that they too will have to do business on a smaller margin. But the fact that certain producers’ goods have become dearer will make it profitable for them to replace these goods by others. In particular, the changed proportion between the prices of the original means of production and the rate of interest will make it profitable for them to spend part of what they have till now spent on original means of production on intermediate products or capital. They will, e.g., buy parts of their products, which they used to manufacture themselves, from another firm, and can now employ the labour thus dismissed in order to produce these parts on a large scale with the help of new machinery. In other words, those original means of production and non-specific producers’ goods which are required in the new stages of production are set free by the transition of the old concerns to more capitalistic methods which is caused by the increase in the prices of these goods. In the old concerns (as we may conveniently, but not quite accurately, call the processes of production which were in operation before the new money was injected) a transition to more capitalistic methods will take place; but in all probability it will take place without any change in their total resources: they will invest less in original means of production and more in intermediate products.

Now, contrary to what we have found to be the case when similar processes are initiated by the investment of new savings, this application of the original means of production and non-specific intermediate products to longer processes of production will be effected without any preceding reduction of consumption. Indeed, for a time, consumption may even go on at an unchanged rate after the more roundabout processes have actually started, because the goods which have already advanced to the lower stages of production, being of a highly specific character, will continue to come forward for some little time. But this cannot go on. When the reduced output from the stages of production, from which producers’ goods have been withdrawn for use in higher stages, has matured into consumers’ goods, a scarcity of consumers’ goods will make itself felt, and the prices of those goods will rise. Had saving preceded the change to methods of production of longer duration, a reserve of consumers’ goods would have been accumulated in the form of increased stocks, which could now be sold at unreduced prices, and would thus serve to bridge the interval of time between the moment when the last products of the old shorter process come on to the market and the moment when the first products of the new longer processes are ready. But as things are, for some time, society as a whole will have to put up with an involuntary reduction of consumption.” (Hayek 1935: 86–88).
This is a curious aspect of Hayek’s theory: according to Hayekian ABCT, there will be, as investment in higher stages of production proceeds, a “scarcity of consumers’ goods” and “the prices of those goods will rise.” It is not clear whether this means an actual fall in real consumption, or merely excess demand in relation to supply and rising prices.

As an aside, in Mises’ version of the ABCT there does appear to be a contraction of consumer goods output in the later stages of the boom:
“The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.” (Mises 2009 [1953]: 362–363).
To return to Hayek’s version of ABCT, he continues:
“But this necessity will be resisted. It is highly improbable that individuals should put up with an unforeseen retrenchment of their real income without making an attempt to overcome it by spending more money on consumption. It comes at the very moment when a great many entrepreneurs know themselves to be in command—at least nominally—of greater resources and expect greater profits. At the same time incomes of wage earners will be rising in consequence of the increased amount of money available for investment by entrepreneurs. There can be little doubt that in the face of rising prices of consumers’ goods these increases will be spent on such goods and so contribute to drive up their prices even faster. These decisions will not change the amount of consumers’ goods immediately available, though it may change their distribution between individuals. But—and this is the fundamental point—it will mean a new and reversed change of the proportion between the demand for consumers’ goods and the demand for producers' goods in favour of the former. The prices of consumers’ goods will therefore rise relatively to the prices of producers’ goods. And this rise of the prices of consumers’ goods will be the more marked because it is the consequence not only of an increased demand for consumers’ goods but an increase in the demand as measured in money. All this must mean a return to shorter or less roundabout methods of production if the increase in the demand for consumers' goods is not compensated by a further proportional injection of money by new bank loans granted to producers. And at first this is probable. The rise of the prices of consumers’ goods will offer prospects of temporary extra profits to entrepreneurs. They will be the more ready to borrow at the prevailing rate of interest. And, so long as the banks go on progressively increasing their loans it will therefore, be possible to continue the prolonged methods of production or perhaps even to extend them still further. But for obvious reasons the banks cannot continue indefinitely to extend credits; and even if they could, the other effects of a rapid and continuous rise of prices would, after a while, make it necessary to stop this process of inflation.” (Hayek 1935: 88–90).
So as the wages of workers are bid up, the process by which consumer goods’ prices rise is accelerated. So it seems that a crisis of inflation marks the shift to the “bust” (Hayek 1934 is an earlier discussion of how the boom turns into a bust).

We can trace the steps by which the boom turns into the bust:
(1) when the banks cease to advance new loans and the money rate of interest rises, the demand for producers’ goods falls, but demand for consumers goods will continue to increase for some time, as they “lag somewhat behind the additional expenditure on investment which causes the increase of money incomes” (Hayek 1935: 90–91);

(2) producers will want to shift back to producing consumer goods at the lower stages of production, but that process causes the bust:
“Very soon the relative rise of the prices of the original factors and the more mobile intermediate products will make the longer processes unprofitable. The first effect on these processes will be that the producers’ goods of a more specific character, which have become relatively abundant by reason of the withdrawal of the complementary non-specific goods, will fall in price. The fall of the prices of these goods will make their production unprofitable; it will in consequence be discontinued. Although goods in later stages of production will generally be of a highly specific character, it may still pay to employ original factors to complete those that are nearly finished. But the fall in the price of intermediate products will be cumulative; and this will mean a fairly sudden stoppage of work in at least all the earlier stages of the longer processes.

But while the non-specific goods, in particular the services of workmen employed in those earlier stages, have thus been thrown out of use because their amount has proved insufficient and their prices too high for the profitable carrying through of the long processes of production, it is by no means certain that all those which can no longer be used in the old processes can immediately be absorbed in the short processes which are being expanded. Quite the contrary; the shorter processes will have to be started at the very beginning and will only gradually absorb all the available producers’ goods as the product progresses towards consumption and as the necessary intermediate products come forward. So that, while, in the longer processes, productive operations cease almost as soon as the change in relative prices of specific and non-specific goods in favour of the latter and the rise of the rate of interest make them unprofitable, the released goods will find new employment only as the new shorter processes are approaching completion. Moreover, the final adaptation will be further retarded by initial uncertainty as regards the methods of production which will ultimately prove profitable once the temporary scarcity of consumers’ goods has disappeared. Entrepreneurs, quite rightly, will hesitate to make investments suited to this overshortened process, i.e., investments which would enable them to produce with relatively little capital and a relatively great quantity of the original means of production.” (Hayek 1935: 92–93).
So now the process shifts to the bust.

(3) Hayek sees the explanation of unused resources as the great achievement of his ABCT:
Here then we have at last reached an explanation of how it comes about at certain times that some of the existing resources cannot be used, and how, in such circumstances, it is impossible to sell them at all—or, in the case of durable goods, only to sell them at very great loss. To provide an answer to this problem has always seemed to me to be the central task of any theory of industrial fluctuations; and, though at the outset I refused to base my investigation on the assumption that unused resources exist, now that I have presented a tentative explanation of this phenomenon, it seems worth while, rather than spending time filling up the picture of the cycle by elaborating the process of recovery, to devote the rest of this lecture to further discussion of certain important aspects of this problem. Now that we have accounted for the existence of unused resources, we may even go so far as to assume that their existence to a greater or lesser extent is the regular state of affairs save during a boom. And, if we do this, it is imperative to supplement our earlier investigation of the effects of a change in the amount of money in circulation on production, by applying our theory to such a situation. And this extension of our analysis is the more necessary since the existence of unused resources has very often been considered as the only fact which at all justifies an expansion of bank credit.” (Hayek 1935: 97–98).
At this point Hayek now considers situations where unused resources exist “to a greater or lesser extent” as a “regular state of affairs save during a boom”:
“If the foregoing analysis is correct, it should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect; a relative increase of the demand for consumers’ goods could only make matters worse. Matters are not quite so simple so far as the effects of credits granted for productive purposes are concerned. In theory it is at least possible that, during the acute stage of the crisis when the capitalistic structure of production tends to shrink more than will ultimately prove necessary, an expansion of producers’ credits might have a wholesome effect. But this could only be the case if the quantity were so regulated as exactly to compensate for the initial, excessive rise of the relative prices of consumers’ goods, and if arrangements could be made to withdraw the additional credits as these prices fall and the proportion between the supply of consumers’ goods and the supply of intermediate products adapts itself to the proportion between the demand for these goods. And even these credits would do more harm than good if they made roundabout processes seem profitable which, even after the acute crisis had subsided, could not be kept up without the help of additional credits. Frankly, I do not see how the banks can ever be in a position to keep credit within these limits.

And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit-expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production to the proportion between the demand for Consumers’ goods and the demand for producers’ goods as determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to ‘mobilise’ all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes.

(10) And so, at the end of our analysis, we arrive at results which only confirm the old truth that we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come.” (Hayek 1935: 97–99).
It is here that Hayek earned his reputation as a liquidationist: for he says clearly that “we can do nothing to get out of it before its natural end.”

Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1934. “Capital and Industrial Fluctuations,” Econometrica 2.2: 152–167.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Mises, L. von. 2009 [1953]. The Theory of Money and Credit (enlarged, new edn). Ludwig von Mises Institute, Auburn, Ala.