Friedrich Hayek Credit Trade Cycle

Friedrich Hayek Credit and Trade Cycle

It is, of course, true that market systems, although they are in principle self-regulating, experience frequent crises and much of Hayek's early career as a pure economic theorist was concerned with the regular ups and downs of capitalist market economies known as the trade cycle. His work here was concerned primarily with the disequilibriating effect of money Because of the institution of money the signals put out by the market may systematically mislead transactors so that the automatically-adjusting properties of the market are impaired. Hayek (1941, p. 408) has described money as a kind of 'loose joint' in an otherwise automatically-adjusting system and the policy implications of his economic theory have been concerned with the various ways in which the discoordinating effects of money can be mitigated. What is remarkable is that it is only recently that Hayek (1976a) has made his most radical policy suggestion. This is the proposal that, because government control of money has lead to such economic dislocation, this monopoly should be removed and the supply of the "'money good left to the private rnarket. It is Important to trace the steps by which Hayek has reached this dramatic conclusion.

Although Hayek is known today mainly for his refutations of Keynesian macroeconomic policies his early economic theory (1931, 1933 and 1939) was directed at certain versions of the quantity theory of money. While Hayek has always stressed the truth of the basic propositions of the quantity theory, and has insisted that inflation invariably follows if governments forget these, his economics goes beyond 'monetarism'. While the simple quantity theory directs attention only to changes in the general price level Hayek's theory concentrates on short-run changes in the structure of relative prices brought about by monetary disturbance. Money is therefore not 'neutral' in the short-run arid policies which are aimed at merely stabilising the the general price level are deficient since changes in this macroeconomic magnitude conceal changes in the structure of relative prices (a microeconomic phenomenon).

Changes in relative prices depend upon the particular point in the system at which new money__enters. In his trade-cycle theories Hayek demonstrated'the disequilibriating effect of extra Money created by the banking system. Through their normal operations banks create credit which lowers the market rate of interest. below the 'natural' or 'equilibrium' rate the natural rate of interest is the rate at which the demand for loan capital by entrepreneurs and the supply of savings offered by the public excactly agree: The market rate is simply the price of money market.In long-term equilibrium, of course, the two rates must be identical since here money is neutral, but in the short-run, in a dynamic economy, increased credit from the banking system makes available funds for investment which are not justified by thelevel of voluntary saving.

Bank credit enables entrepreneurs to 'pre-empt' a dispropor­tionate share of economic resources and invest in longer produc­tion processes at the expense of consumption. In the Austrian theory of the trade cycle production is understood as a series of stages with immediate consumption goods at the near end and investment goods at the furthest stages. As an economy becomes more 'capitalistic' it employs more 'roundabout' methods of production: these will lengthen the time it takes to bring goods to the final consumption stage (although they will yield a greater supply of consumer goods in the long-run).

Now if the lengthening of the production occurs because of an increase in the supply of voluntary savings the resulting structure is fundamentally stable since capital will be available for the completion of all the stages necessary to bring goods to final consumption. But this is not the case if it comes about through 'forced saving', i.e. when monetary injection makes available credit for a capital expansion not warranted by the current consumption-savings ratio. When this happens the expansion is unstable because people's time-preferences have not changed, so that the higher incomes earned by factors at the longer stages will be spent on consumption goods. The higher prices for consump­tion goods makes inevitable a switch back to shorter, less capitalistic methods. The 'crisis' comes when the injection of credit ceases, so that the market rate approaches the natural rate, and capital is not available for the completion of the longer processes. The complementary capital goods which are required for the completion of these processes are used in the stages nearer consumption so that 'specific' capital goods, those at the furthest stages of production which cannot be easily adapted to other uses, lie idle. There must therefore be unemployment at the stages of production furthest from immediate consumption.

The crisis is not characterised by a surplus of capital but by its scarcity, since complementary capital goods are required to complete the longer processes. Furthermore, it is not a drop in demand that precipitates unemployment but, in effect, the opposite. The only way unemployment in the longer processes can be alleviated is for demand to fall so that extra savings become available to provide the capital required to bring longer processes back into use.

In fact, the problem of malinvestment can be solved only by the liquidation of those investments which cannot be sustained, given the current level of saving, through the market process. Reces­sions are therefore an inevitable part of the trade cycle and interventionist policy to end them is to be eschewed since, by keeping in operation businesses that should be liquidated, it must disrupt the tendency towards equilibrium.

The policy of stabilising the price level by monetary methods was consistently opposed by Hayek in the 1930s because a stable price level may conceal an underlying disequilibrium. It is noticeable that the orthodox quantity of money theorists thought that the boom in the late 1920s was harmless precisely because it was accompanied by a stable price level but Hayek (1931, pp. 160-2) argued that prolonging the boom led to a distortion of relative prices which turned a mild recession into a depression. In fact, Hayek has always said that the time to start worrying about the cycle is during the boom itself, yet action is not normally taken until the recession.

Hayek continued to develop his trade-cycle theory throughout the 1930s but a theory that predicted a rising price level could have little appeal at that time (see Hicks, 1967). Hayek resolutely opposed attempts to stimulate consumer demand, provide public works and prop up the price level because he maintained that the market was self-correcting and that changes in relative prices would tend to harmonise saving and investment intentions which had been discoordinated by monetary disturbance. He did distinguish between an ordinary recession and a genuine deflation (a contraction in the supply of money which leads to such a fall in demand that there is substantial unemployment of all factors) and implied that different policies apply to these different phenomena. But even in really deep depressions Hayek believed that any corrective measures by government were essentially the actions of a 'desperado' (1939, pp. 63—4). Since money is not neutral in the short-run, stabilisation measures would be self-defeating and a policy of benign neglect, which is of course dependent on something like the Gold Standard or fixed rates of exchange, is likely to be the least harmful.

In the circumstances of the 1930s it is perhaps not surprising that Keynes's new macroeconomic theory should come to dominate the economics profession and that its associated policy prescriptions were seized upon by activist governments. Without going into the details of Keynes's ideas it is easy to see how they differ from Hayek's. The Keynes of the General Theory had no faith in the self-adjusting properties of the market and thought that once a depression had set in there was no necessity for a self-reversing process to correct it. Unemployment was not a con­sequence of microeconomic factors but of a deficiency in aggregate demand, therefore, in a depression, government should boost spending by running a deficit in order to create full employment in the short run.

Hayek has always denied that macroeconomic aggregates are significant in the determination of economic events and insisted that theories of unemployment must be micro in origin and must stress the role of relative prices in bringing a tendency towards equilibrium. His theory of unemployment is that there are 'discrepancies between the distribution of demand among the different goods and services and the allocation of labour and other resources among the production of these outputs' (Hayek, 1978, p. 25). The structure of production becomes distorted over time and there has to be a reallocation of resources, via price changes, to bring about a move to a new equilibrium. Spon­taneous readjustment is of course slowed down by rigidities in the labour market caused by trade union power. Since an efficient allocation depends upon wage flexibility it is natural that Hayek (1960, pp. 361-2) should be an unrelenting opponent of prices and incomes policies.

Post-war Keynesian economic policy worked longer than Hayek expected but in the last ten years the attempt to sustain virtually full employment by monetary and fiscal methods has produced just what Hayek predicted-inflation and unemployment. The great increase in government activity has meant that the effects of monetary expansion are different from those Hayek described in the 1930s; instead of expansion encouraging longer production processes it now directly stimu­lates consumer-goods industries. Nevertheless, the long-term discoordination is similar because constant stimulus to spending means that businesses that should be liquidated by the market process are allowed to continue, so making the necessary readjustment, if a free economy is to be preserved, all the more painful. In Great Britain the rise of the welfare state, and the power of the trade unions, has made the market more rigid than elsewhere in the west. The attempt, therefore, to mop-up unemployment, caused by these rigidities, by inflation can only lead to economic breakdown and the abandonment of money as an accounting device. In Hayek's grim prognosis, Keynesianism, with its implicit rejection of the signal­ling functions of the market, must lead to the direction of labour and a command economy.

The problem is that governments are no longer restrained by rules in economic matters. The end of the Gold Standard and the abandonment of the system of fixed exchange rates between currencies (which Hayek always preferred to 'floating' precisely because it imposed strict limits on government) has meant that governments have great discretion in economic matters. In fact the whole Keynesian system depends on a fully-informed econ­omic manager operating macroeconomic variables ('fine-tuning'). Hayek assumes that not only will the market be better-informed in a technical sense but also that it is a necessary, but not a sufficient, condition for individual liberty. It is therefore not really surprising that he should now recommend (Hayek, 1976a) that government must cease to have a monopoly over money and that the banks' own money, and foreign currencies, should be allowed to circulate in the market. Thus natural self-interest will dictate that only sound currencies will survive so that the distortion and discoordination produced by that 'loose joint' will be reduced to a minimum.