Hayek and the Austrian Theory of Business
Cycles
Wednesday, March 13th 2013
University of Kragujevac
Prof. Dr. Harald Hagemann, University of Hohenheim, Stuttgart
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Friedrich August Hayek (1899-1992)
1927 – 1931:
Founding Director of the Austrian
Institute for Business-Cycle Research in
Vienna (today‘s WIFO)
1928:
Habilitation in Vienna
1929:
Geldtheorie und Konjunkturtheorie
(Monetary Theory and the Trade Cycle,
1933)
1931:
Prices and Production
London School of Economics
(Tooke Professor of Political Economy)
1941:
The Pure Theory of Capital
1950:
Chicago
1961:
Freiburg
1974:
Nobel prize together with Gunnar Myrdal
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Hayek’s Business-cycle theory
•
Hayek’s Business-cycle theory is a combination of five
building blocks (Prices and Production, 1931)
(1)
Wicksell’s theory of the cumulative process where price
changes are caused by the discrepancy between the market rate
and the natural (equilibrium) rate of interest;
(2)
Mises’s theory of money and credit in which banks artificially
lowering the money (market) rate of interest are responsible for
overinvestment and a misallocation of resources which necessarily
has to be corrected.
(3)
Böhm-Bawerk’s theory of capital with its emphasis on the time
structure of the production process;
(4)
Cantillon effects of changes in the money supply on the price
structure and hence on the structure of production (non-neutrality
of money);
(5)
Ricardo effects of a shortage of consumption goods on the
production of investment goods (disproportionality of circulating and
fixed capital).
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Equilibrium and the Business Cycle (1)
• Lowe’s methodological challenge:
-
-
-
-
The abandonment of static equilibrium theory by Lowe and, among
others, endorsed by Kuznets.
the defence of the equilibrium method by dichotomizing the cycle
from the trend and by introducing money and credit as a propagation
mechanism for cyclical fluctuations in an existing equilibrium
configuration, as it was the case in Hayek's response to Lowe's
challenge.
a path-dependent approach without an a priori trend line, as it had
been developed by Schumpeter.
the defence of the prevailing equilibrium approach by denying the
need for the development of a general theory of the business cycle
since the business cycle does not exist and the real problem of
analysing concrete-historical cases of fluctuations with a variety of
different factors at work, could be completely dealt with within the
framework of a modern static equilibrium approach (Lutz 1932).
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Equilibrium and the Business Cycle (2)
• Lowe: how is business cycle theory possible at all?
“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 between upswing
and crisis arises analytically from the conditions of the system just
as 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.” (Lowe [1926] 1997:
267)
• Kuznets regarded “the equilibrium approach I to be a blind alley
from the point of view of business-cycle theory” (QJE, 1930: 399)
• “I the practice of treating change as a deviation from an imaginary
picture of a rigid equilibrium system must be abandoned” (ibid.:415)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Equilibrium and the Business Cycle (3)
•
•
•
Hayek: The logic of equilibrium theory “properly followed through, can do
no more than demonstrate that such disturbances of equilibrium can only
come 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 wellknown methods of adaptation, i.e. by the formation of a new equilibrium.”
(Hayek 1933: 42-43)
The incorporation of cyclical phenomena into equilibrium theory is the
crucial problem of business-cycle theory and that, accordingly, cycles
should be explained as endogenous outcomes of market processes.
Money and credit as a decisive endogenous propagation mechanism for
business cycles.
“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.” (Hayek [1928] 1984: 75; emphasis added)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Hayek – Lowe debate (1926 - 33)
•
Hayek agrees with Lowe
-
that the integration of business-cycle phenomena into the system of
the theory of economic equilibrium is the decisive problem of
business-cycle theory,
-
in the claim for an explanation of business cycles by an endogenous
theory,
-
in his emphasis on the importance of production structures.
•
Hayek differs from Lowe
-
in his adherence to general equilibrium theory also in the
explanation of business cycles ( Lucas and modern equilibrium
business-cycle theory, EBC),
-
in identifying money and credit instead of technical progress as the
decisive endogenous factor,
-
in using a vertical instead of a horizontal production structure.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
“Old” roots for the Lucas project?
• Lucas “Understanding Business Cycles” 1977: 7 “(…)
the incorporation of cyclical phenomenon 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.)
• “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.)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Wicksell’s theory of the cumulative process (1)
It was Wicksell's main achievement to have elaborated an
analysis in which time and money are subjected to the
marginal principle. The market rate of interest serves the
double function of coordinating the supply and demand for all
loanable funds and at the same time the supply and demand
for real capital in terms of saving and investment. An increase
(decrease) in savings due to a change in individuals’
intertemporal preferences would lead to a lower (higher) rate
of interest and a lengthening (shortening) or more (less)
roundabout method of production. The natural rate of interest
acts as the centre of gravitation for the market rate of interest
which in monetary equilibrium also equals the marginal
physical productivity of real capital.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Wicksell’s theory of the cumulative process (2)
Wicksell’s ideas on the dis- and reequilibrating mechanism of
divergences between the money and the natural rate of
interest provided an important building block for Austrian
business-cycle theory as it was developed by Mises and
particularly Hayek, who combined Wicksell's analysis of the
cumulative processes with the doctrine of “forced saving” (see
“A Note on the development of the doctrine of ‘forced saving’”
(1932); reprinted as chapter VII in Hayek 1939) to generate a
monetary theory of the business cycle in which injections of
money or bank credit lead to overinvestment and thereby to a
distortion in the time structure of production which is
unsustainable. In principle two major impulses which can
cause a divergence between the two rates of interest have to
be distinguished:
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Wicksell’s theory of the cumulative process (3)
1. an improvement in profit expectations due to technical progress
which causes an increase in the natural rate of interest and
investment demand;
2. a generous granting of credit by the banking system which
leads to a fall of the money rate of interest below the natural
rate.
Whereas the first impulse is real and a “natural” one, the second
impulse is a monetary one and, in the view of Mises and Hayek,
“artificial”. Although Wicksell mainly elaborated his cumulative
process analysis for a better understanding of changes in the
general level of prices and his business-cycle theory remained a
fragment or an “enigma” (Wicksell [1907] 1951), we have to note
that “Wicksell was, in short, so impressed by the real elements in
cyclical fluctuations, and in particular those involving investments
activity that he treated monetary aspects of the cycle as peripheral.”
Laidler (1991: 146)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Wicksell’s theory of the cumulative process (4)
Thus Wicksell emphasizes technology shocks and perceives
in real factors which lead to an increase in the natural rate of
interest the essential reason for business cycles.
With the emphasis on technical progress Wicksell stood in
the German tradition of such diverse authors as Marx and
Schumpeter. In the contemporary debate with Hayek and
Mises this argument was made by Löwe and Burchardt who,
with explicit reference to Wicksell, pointed out that, although
changes in the market rate of interest are important for
movements of the price level, the real impulse for the
disturbance of equilibrium is given by technical progress
which increases the natural rate.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Mises’s theory of money and credit (1)
Ludwig von Mises had established himself as the
first leading representative of a monetary theory or
credit view of the business cycle in the German
language area with the publication of his The
Theory of Money and Credit (1912). Mises can be
recognized as the pioneer of a typically “Austrian”
theory of the business cycle. It is a central element
of his “circulation credit theory” that the banking
system grants a volume of credit which transcends
the level of voluntary savings, thereby causing a
misallocation of resources. The boom thus contains
the seed of its later correction.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Mises’s theory of money and credit (2)
Mises took over the theorem of the two interest rates from
Wicksell. However, he criticised the latter for concentrating
too narrowly on the effects of this divergence on the absolute
level of prices, thereby overlooking the impact of additional
credit for the structure of production. The expansion of credit
and the lowering of the money rate of interest below the
natural rate creates an artificial or “unhealthy boom” (Mises
[1936] 1983: 4) in which entrepreneurs are forced to enter
upon longer processes of production. However, despite the
initial increase in productive activities the consequences
finally are negative ones because the gratuitous nature of
credit contains the seeds of its own destruction.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Mises’s theory of money and credit (3)
“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.” (Mises
[1924] 1981: 401)
Thus the excess investment generated by credit creation and the
artificial lowering of the money rate of interest below the natural rate
is stopped by a shortage of savings before the lengthening of the
production processes are coming to fruition. A further injection of
credit could prolong the process but would make things even worse
since inflation would accelerate and the corrective crisis aggravate.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Mises’s theory of money and credit (4)
Hayek from the beginning followed Mises’s view that
discrepancies between the money and the natural rates of
interest cause discrepancies in the structure of production,
i.e. a deviation of the allocation of productive resources to
capital goods and consumptions goods which differs from the
allocation in equilibrium. He criticizes Wicksell for focussing
on changes in the purchasing power of money in his
cumulative process analysis, as well as Löwe and Burchardt
for only identifying general price changes as monetary
effects. According to Hayek “monetary theory has by no
means finished its work when it has explained the absolute
level of prices.”
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Mises’s theory of money and credit (5)
Furthermore, “general price changes are no essential feature
of a monetary theory of the Trade Cycle; they are not only
unessential, but they would be completely irrelevant if only
they were completely 'general' – that is, if they affected all
prices at the same time and in the same proportion” (Hayek
[1929] 1933: 117 n. and 123). Consequentially, a stabilization
of the price level would not eliminate cyclical fluctuations.
Wicksell had introduced the important distinction between the
stability of the equilibrium of relative prices and the
(in)stability of monetary (general price level) equilibrium. In
contrast to Wicksell’s monetary equilibrium and old and new
monetarist views of the “neutrality” of money Hayek's
monetary equilibrium was not associated with the price level
but with the system of relative prices.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Böhm-Bawerk’s theory of capital (1)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Böhm-Bawerk’s theory of capital (2)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Böhm-Bawerk’s theory of capital (3)
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Cantillon effect (1)
Initially, the economy is in equilibrium. This implies full
employment and a market rate of interest that equates
investment demand with voluntary saving, as determined by
intertemporal consumer preferences. Money is neutral in the
sense that it leaves ‘the relative values of goods . . .
undisturbed’ (Hayek 1935: 31). The disturbance which causes
cyclical fluctuations is a difference between the market rate of
interest and the equilibrium rate, to the extent that the lending
rates of the banks are lower than the equilibrium rate. This is
perceived as a signal for a profitable lengthening of
production processes. Credit demand will rise and additional
money will be injected into the economy by a lengthening of
the banks’ balance sheets.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Cantillon effect (2)
Under the assumption that all resources are fully utilized in
equilibrium, a credit expansion implies that producers of
capital goods in the ‘new’ processes of production bid away
resources from ‘older’ processes. This is where the Cantillon
effect begins to work. The injection of additional money
increases the purchasing power in those parts of the economy
where the money arrives first. The bidding changes the price
structure, reallocates resources and redistributes incomes
(Hayek 1935: 8f and 85ff). Inflation in the Hayekian sense is
thus strictly defined as a rise in the quantity of money, not in
the price level. Inflation is not uniquely reflected in movements
of the price level, and the monetary cause of changes in the
price structure will hardly be perceived as such.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Forced saving
Meanwhile, the redirection of capital towards ‘new’, longer
processes of industrial production reinforces itself since the
prices of capital goods rise faster than the prices of consumer
goods. This leads to a squeeze of the price margins between
the stages of production and a corresponding fall in the rates
of return on capital in the ‘older’, shorter processes. The
output of consumption goods declines, even though consumer
preferences remain unchanged and money incomes have
risen with labour demand in the production of capital goods.
Shortages of consumption goods make their prices rise faster
than incomes. This process constitutes the mechanism of
‘forced saving’ which, in Hayek's view, will eventually make
the redirection of resources into less roundabout production
profitable. Yet the boom prevails as long as the credit
expansion favours investment in more roundabout processes.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Ricardo effect
At some point, the credit expansion must stop. Normally the downturn
is brought about by a rise in the lending rates which makes the
completion of the ‘new’, more roundabout projects unprofitable.
However, according to Hayek it is sufficient that inflation stops to
accelerate. Firms in the capital goods sector will then lose their lead in
purchasing power, whereas the given demand continues to raise the
prices of consumption goods. This increases the price margins and
reinforces a fall in real wages whereby shorter, more labour-intensive
processes of production regain their profitability. The Cantillon effect
ceases to be effective, whereas the Ricardo effect now makes itself
felt in a cumulative decrease of the roundaboutness of production. The
structure of production that is produced by inflation turns out to be
unsustainable because of a disproportionality of fixed and circulating
capital, respectively capital and consumption goods (1935: 9lff). The
specific resources employed in the 'unduly elongated' processes of
production (both capital and qualified labour) become redundant. Even
unspecific resources may not be integrated into the remaining profitable
processes without frictions.
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UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Summary: the crisis as a cure
The credit boom is thus inevitably followed by unemployment and
capital destruction. The changes to more productive methods of
production turn out to be futile, unless the credit expansion is
accidentally succeeded by an increase in voluntary saving (Hayek
1939: 180). Even though Hayek did not write much about the crisis
(not to mention the lower turning point), he essentially regarded the
crisis as a cure that has to be waited out (1935: 99). Credit-induced
booms induce activities which tend to restore the initial equilibrium
position of the economy - even if that position is never attained
(1939: 6). The equilibrium rate of interest will not be changed by any
‘purely monetary’ credit expansion, because the corresponding
shifts in the structure of production fail to coincide with the given
intertemporal preferences of the consumers (1933: 221ff, 1941:
406f). Even though money is bound to be non-neutral in the short
run, it tends to be neutral in the long run. In Hayek's words, money
may be a loose joint in the price mechanism, but it does not break
the mechanism.
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