On the Austrian Theory of the Trade Cycle, Part I
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Filed Under: Thoughts on Freedom
Tags: boom and bust cycles • economic cycles • F. A. Hayek • inflation • interest rates • monetary expansion • money supply • relative prices • trade cycles
One of the most vivid memories of my undergraduate years is of sitting for hours in my carrel in the old Polk Library at Nicholls State University and reading F.A. Hayek’s Monetary Theory and the Trade Cycle and his Prices and Production. These books on the economic cycles of booms and busts are among the most challenging Hayek wrote.
Sitting in that same carrel, I then read Gerald O’Driscoll’s 1977 book Economics as a Coordination Problem—a work that explains in more up-to-date terms the logic of Hayek’s theory of such cycles.
Having done my best to digest these works, along with some related articles and helpful conversations with my professor Bill Field, I believed myself to have gotten a pretty firm grasp of Hayek’s macroeconomic thinking. And the logic of Hayek’s explanation for economic booms and busts made good sense to me.
Spending time with Roger Garrison during my doctoral-study days at Auburn University only raised my confidence in this explanation of so-called “trade cycles.”
The logic is straightforward. Investors and business people, like consumers, respond to relative prices in deciding how to act. And relative-price movements are crucial signals directing resources to uses that consumers value most.
So, for example, if the demand for apples rises relative to the demand for pears, the price of apples will rise relative to the price of pears. Producers—responding to this signal—will then switch some resources and effort from pear production into apple production. This response is appropriate.
But prices, of course, are expressed in money terms. If relative prices are caused to change not by any change in underlying economic reality but instead by changes in the supply of money, then producers and consumers will be misled by these changing relative prices to act as if some real economic fact has changed when actually nothing has happened. For example, if the central bank injects new money into the economy by giving it to people who have a special fondness for eating apples, this new money will enable its recipients to increase their demand for apples beyond what it would be without the new money. The price of apples will rise relative to that of pears, peaches, and other goods and services.
Eventually, though, this new money spreads throughout the economy, causing all prices to rise (resulting in what modern economists call inflation). Importantly, relative prices eventually adjust to reflect more accurately the underlying economic reality. When the underlying reality is clearly revealed by the now-correct relative prices, production plans based on the false price signals must be undone. Undoing these production plans takes time. One result of this process of undoing economically unsustainable production plans is temporary unemployment.
Interest Rates
The power of Hayek’s theory, though, lies in its focus on a particular price: the interest rate. This price coordinates production and consumption plans across time. If people are very impatient to consume and, in consequence, save very little, interest rates will be higher than they would be if people were more willing to defer consuming the fruits of their labors. A high rate of interest, therefore, signals to businesses that it is not worthwhile to use resources today to build highly complex and expensive machinery for producing greater output in the future. In these circumstances, resources satisfy more urgent needs when they are used to produce goods for consumption today rather than to produce producer goods that will increase the availability of consumer goods only tomorrow.
Only if people generally become more willing to save—that is, to allow a greater amount of resources to be used not to increase the flow of consumer goods today but to build production processes that increase outputs tomorrow—does the size of an economy’s stock of capital increase.
The price that signals this greater willingness to save is the interest rate. The higher the willingness to save, the greater the supply of savings available to be loaned to entrepreneurs—hence, the lower the rate of interest. But just as changes in the supply of money can cause the price of apples relative to pears to “lie” about the underlying demand for apples relative to pears, so too can changes in the supply of money cause the interest rate to “lie” about people’s willingness to save.
Building on works by Richard Cantillon, Carl Menger, Eugen von Bohm-Bawerk, and Ludwig von Mises, Hayek argued that increases in the supply of money (beyond any possible increases in people’s demand to hold money) are especially likely to cause the nominal rate of interest to fall. And as this price is pushed below its true (“natural”) level, entrepreneurs increase the size of their investments. They channel resources from producing consumer goods into producing capital goods.
This “lengthening” of the production process, however, is not done in one fell swoop. It takes time and requires a continuing flow of resources for its completion. For example, an entrepreneur lured by a low rate of interest to build a new factory needs resources not only today to build the factory’s basement, but tomorrow and the next day to complete his planned construction. If this entrepreneur discovers tomorrow that the resources that he thought would be available to complete the factory are not available, then he must abandon his plan. Workers hired in the expectation that the factory would be built and operated will be laid off.
Because newly created money usually enters the economy through the banking system, monetary expansion typically does indeed push the nominal rate of interest below the real rate. Entrepreneurs and businesses in general are thus misled into making production plans that require a continuing flow of capital larger than the flow of capital that will be forthcoming given people’s actual plans to save.
The new money, however, soon causes a rise in the general price level—including a rise in the nominal rate of interest. This general rise in prices reflects the lower value of money, and the higher nominal rate of interest reflects the spreading expectation that money will continue to lose value.
To keep the inflation-adjusted rate of interest artificially low enough so that it continues to deceive investors about the public’s willingness to save, the monetary authority must increase the speed with which it injects new money into the economy. Inflation rises faster and faster. The economy either eventually grinds to a halt because money prices have become so unreliable or the monetary authority stops printing new money.
In either case, adjustments to the true, underlying reality of people’s preferences and resource constraints must be made. These adjustments take time and involve unemployment.
As I said, this theory made sense to me. But the economic growth of the past 30 years caused me to doubt its veracity. And today’s economic turmoil is causing me to revisit both this theory and my doubts about it. In my next column I explore my doubts about the theory and my new doubts about my doubts.
Comment by Roger McKinney on 24 January 2009:
Nice intro to Hayek’s work! I would also like to promote his “Profits, Interest and Investment” which I think explains more clearly, and from a different perspective, what he intended in “Prices and Production.” Also, in PII Hayek demonstrates the impotence of the interest rate in regulating economic activity and the way in which profits do the heavy lifting.
Comment by Joe D. on 24 January 2009:
Understanding Austrian Business Cycle Theory
———————————————
Here is my take on what is wrong with Austrian economic theory, their theory is based on gold based currency system. Economy works on food/fuel/energy, energy is essence of all living beings including humans. Gold does not have any usable energy content, hence it is just a token, when tokens are used to represent energy transfers (economic transactions) they need redemption obligation in terms or energy, otherwise it is very easy to manipulate the system and free markets cannot exist.
For eg. Ancient wisdom of getting rich while using gold currency is to understand the \"secret that gold is worthless substance\" and hold on to it for minimum amount of time. As soon as one gets gold, exchange it for something valuable like food grains and store it, food grains like rice, wheat can be stored for 20 years. When food scarcity hits the market negotiate favorable terms while exchanging food grains against gold repeat the cycle couple of time and you get rich. People who are made to believe gold is more valuable then food grains become poor losers, people who understand food grains are more valuable than gold become rich.
Using gold as currency without redemption obligation by issuer was the longest running scam in the world. Gold does not have a inherent value/energy so exchange value has to be negotiated during each transaction, hence it cannot act as store of value. During times of resource crunch / famine the last person holding gold cannot make one more exchange and he/she ends up as the looser in the series of transactions. Essentially it ends up as a ponzi scheme.
A currency needs to satisfy 3 functions to become a true representation of transactions between living beings.
1. Medium of exchange
2. Store of value
3. Delivery of value (energy)
For gold/paper tokens to be valid the issuer should be able to deliver \"value / energy\" on redemption of currency, otherwise gold/paper currency has no mechanism to satisfy the \"3. Delivery of value\" function to be real currency and ends up as a ponzi scheme which repeats itself, this is called the \"theory of business cycle\".
Comment by Gene Callahan on 26 January 2009:
“Here is my take on what is wrong with Austrian economic theory, their theory is based on gold based currency system.”
No, it isn’t.
“Economy works on food/fuel/energy,”
No, it doesn’t. This equation of ‘value’ with ‘energy’ is a long discredited idea.
Comment by Philip Bitar on 2 February 2009:
Though I\’m not conversant in the Hayek school of economics, I do have a modest familiarity with the Bitar school, and that goes something like this. (Ron Paul, sit up and pay attention!)
Taking it from the article, according to the Hayek school, the propensity to save is an independent variable that determines the supply of money and, hence, the interest rate. By contrast, according to the Bitar school, the interest rate is merely the price of money in the interest-paying niche; hence, the interest rate reflects the ratio of demand to supply in that niche. But neither demand nor supply is an independent variable. Rather, together they define a dynamic equilibrium over time that is characterized by fluctuation or variance. The greater the variance, the greater the short-term instability in the demand:supply ratio. Thus, the interest rate is not independently determined by the propensity to save but, instead, interacts with the propensity to save by influencing it.
As for the money supply, money is a good just like any other good, in the most abstract sense of the word. The fact that the government prints money on its printing presses is as uninteresting as the fact that Hallmark prints greeting cards on its printing presses. Since money is a good, the price of money will reflect the demand:supply ratio. The price of commodity-based money will, accordingly, be subject to the instability of the respective commodity market — the market in gold or silver or rabbit feet. For the price of money to remain stable over time, the demand:supply ratio must remain stable over time.
Fiat money solves the problem of monetary instability if it is properly managed. The goal is quite simple to state: the supply should match the demand because, of course, this will maintain a stable value for the money. But what we mean by supply, here, is supply by the government to the market, and what we mean by demand, here, is demand for government products, which is reflected in all payments made to the government. Translating demand and supply to values averaged over time, we obtain this simple goal: the issue rate by the government should equal the use rate in payments to the government. That is, averaged over time, the government should issue money at the rate that it takes it in, with the qualification that the rate will increase slowly over time in proportion to the growth of the economy.
So what happens if the government issue-rate exceeds the use rate? Well, what happens if Hallmark\’s greeting card issue-rate exceeds the use rate? The supply exceeds the demand and, accordingly, drives prices down. Of course, the issue rate and the use rate are averaged over time and are subject to variance due to short-term fluctuations. But keeping this in mind, a long-run excessive supply of money will cause the price of money to decrease and, hence, interest rates to decline.
As interest rates decline, the demand for purchasing money from local banks will increase, and businesses and people will borrow accordingly. Liberals in the federal government may compound the effect by encouraging lending to marginal borrowers because that is, after all, just an all-around nice thing to do for people, and it\’s about time for banks to be nice to people.
As for a business that borrowed enough money at a low interest rate to complete half of a new factory, the business may be up a creek to finish the factory if interest rates rise sharply before money is borrowed to finish the factory. Accordingly, as the author conveys, it’s crucial for the government to maintain a stable value for money so that businesses can make long-range plans.
In the Bitar school, there is no such thing as the true, underlying reality of an unadulterated market. Rather, there is just the market with all of its complexity, one facet of which is the management of fiat money by the government. The reason for minimal government is not that government adulterates the market. The problem with government is not that government is unnatural. The problem with government is that it can readily harm the market, and the reason for this harm is often so clear that the harm can easily be predicted.
In reply to Joe D, what money ultimately delivers is what it can buy from the issuing government. If nothing else, it keeps you out of jail by paying your taxes. But presumably the government is doing some useful things, such as lawmaking, law enforcement, and road building, even if those things are not done as wisely and as skillfully as we wish.
The theory of money presented above is developed in a book that I recently finished and that I introduce at http://www.philipbitar.com.
Since the book is huge, thus far I\’ve published only an abridged version, in which I summarize the theory of money. However, the abridged version does present a theory of commerce which establishes the following: democracy is an economic necessity, but American government lacks the most fundamental feature that a democracy must have, and the result is the ever burgeoning size and cost of government. The silver bullet for solving this problem is a constitutional amendment that establishes a ceiling on the price of the federal monopoly and that places control of the ceiling in the hands of the people. The ceiling is expressed as a fraction of GDP.
I\’ve written an article on the silver bullet, and I\’ve tried to bribe Sheldon Richman into publishing the article in The Freeman. But I discovered that bribes don\’t work with an editor having a family name like his, so I\’ve just got to bide my time and wait for him to read the article. With any luck, you\’ll get a chance to read it, too.