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 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.”

BIBLIOGRAPHY
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.

Monday, October 20, 2014

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

I summarise below Lecture II 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 commits himself to a static Walrasian general equilibrium model early in his Lecture II:
“…it is my 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 a tendency towards an equilibrium. For it is this concept alone which permits us to explain fundamental phenomena like the determination of prices or incomes, an understanding of which is essential to any explanation of fluctuation of production. If we are to proceed systematically, therefore, we must start with a situation which is already sufficiently explained by the general body of economic theory. And the only situation which satisfies this criterion is the situation in which all available resources are employed. The existence of unused resources must be one of the main objects of our explanation.

(4) To start from the assumption of equilibrium has a further advantage. For in this way we are compelled to pay more attention to causes of changes in the industrial output whose importance might otherwise be underestimated. I refer to changes in the methods of using the existing resources. Changes in the direction given to the existing productive forces are not only the main cause of fluctuations of the output of individual industries; the output of industry as a whole may also be increased or decreased to an enormous extent by changes in the use made of existing resources. Here we have the third of the contemporary explanations of fluctuations which I referred to at the beginning of the lecture. What I have here in mind are not changes in the methods of production made possible by the progress of technical knowledge, but the increase of output made possible by a transition to more capitalistic methods of production, or, what is the same thing, by organising production so that, at any given, moment, the available resources are employed for the satisfaction of the needs of a future more distant than before. It is to this effect of a transition to more or less ‘roundabout’ methods of production that I wish particularly to direct your attention. For, in my opinion, it is only by an analysis of this phenomenon that in the end we can show how a situation can be created in which it is temporarily impossible to employ all available resources.” (Hayek 1935: 34–36).
Hayek is also concerned with the structure of production: that is, changes which involve a longer as opposed to a shorter period of production and a hence a longer period of time before final consumer goods output is produced (Hayek 1935: 38).

Hayek has the following famous diagram illustrating the structure of production, as below.


Hayek explains this diagram as follows:
… “I find it convenient to represent the successive applications of the original means of production which are needed to bring forth the output of consumers’ goods accruing at any moment of time, by the hypotenuse of a right-angled triangle, such as the triangle in Fig. I. The value of these original means of production is expressed by the horizontal projection of the hypotenuse, while the vertical dimension, measured in arbitrary periods from the top to the bottom, expresses the progress of time, so that the inclination of the line representing the amount of original means of production used means that these original means of production are expended continuously during the whole process of production. The bottom of the triangle represents the value of the current output of consumers’ goods. The area of the triangle thus shows the totality of the successive stages through which the several units of original means of production pass before they become ripe for consumption. It also shows the total amount of intermediate products which must exist at any moment of time in order to secure a continuous output of consumers’ goods. For this reason we may conceive of this diagram not only as representing the successive stages of the production of the output of any given moment of time, but also as representing the processes of production going on simultaneously in a stationary society.” (Hayek 1935: 38–40).
As time increases between the use of the original means of production and the actual production of final consumer goods output, production becomes “more capitalistic” (Hayek 1935: 42).

The crucial problem for Hayek is: how does an economy transition from lower to much higher “capitalistic” methods of production? (Hayek 1935: 49).

The answer:
“… a transition to more (or less) capitalistic methods of production will take place if the total demand for producers’ goods (expressed in money) increases (or decreases) relatively to the demand for consumers’ goods. This may come about in one of two ways: either as a result of changes in the volume of voluntary saving (or its opposite), or as a result of a change in the quantity of money which alters the funds at the disposal of the entrepreneurs for the purchase of producers’ goods.” (Hayek 1935: 50).
What underlies this reasoning are the following assumptions:
(1) A Wicksellian loanable funds theory, where money interest rates are determined by time preference and are a reliable and effective indicator of inter-temporal consumption plans;

(2) the assumption that investment is a straightforward function of money interest rates, and

(3) a situation of general equilibrium in which no unused resources are available.
BIBLIOGRAPHY
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.