Hayek And Business Cycle
Friedirch August von Hayek was born in Vienna
on May 8, 1899 and died on March
23, 1992, in the city of Freiburg in
Breisgan in Germany. Hayek was a central
figure in 20th-century economics and
he represented the Austrian tradition.
After Hayek served military
service, he became a student at the University of
Vienna where he got his
doctorate in law and political science. In 1923-4, Hayek
visited New York and
then returned to Vienna where he continued his work. Hayek
became the first
director of the Austrian Institute for Business Cycle Research
in 1927. He
also gave some lectures in England at the London School of Economics
in 1931.
In England, he participated in such debates as monetary, capital,
and
business-cycle theories during the 1930s. Hayeks' contributions were
very
important. To describe, business cycles, one has to examine the
historical
record of a nation's overall economic performance. "It is a
pattern of
long-term growth marked by alternations of expansion and
contradiction. These
recurrent alternations above and below the long-term
trend are business
cycles" (Outhwaite, 55). The term "economic fluctuations"
is used
to describe the same phenomena. Economists have distinguished many
cause of the
business cycle. There are some factors outside the economic
system and those
within it. Outside causes such as war and major inventions
are referred to
exogenous factors. Whereas "endogenous factors belong to the
internal
working of the economy itself and its tendency to fluctuate over
extended
periods" (Outhwaite, 56). Before World War II, the emphasis was put
on
endogenous factors, and thus theories such as monetary;
overinvestment;
underconsumption; psychological were more important than
others. In general, all
cycle theories involve some kind of cost
maladjustment. F. A. Hayek was one of
the many economists who, indeed,
explained overinvestment theory in a monetary
sense. Overinvestment theory is
related to the overproduction-type theories.
Those theories include
consumer goods, capital goods, or investment of money or
credit. "They may
stress fixed capital against circulating or liquid
capital" (Haney, 667).
However, the overinvestment theory assigned a
crucial role to the
acceleration principle, according to which "a mere
decline in the rate of
increase in business sales could give rise to an absolute
decline in the
production of investment goods" (Outwaite, 56). Hayek
examined the role of
money and the banks in causing economic fluctuations. He
showed how sudden
injection of credit into economy could cause changes in the
relative prices
between goods and lead to overinvestment that cannot be
maintained. "When
money and credit vary, it sets up a train of events which
draws resources
into places where they would not normally go. In particular, an
increase in
credit stimulates investment" (Butler, 8). Thus, Hayek shows
that it is a
response to the false signal of new credit being created, and
therefore this
investment cannot be maintained. Hayek concentrates on the
initial
disturbance that starts a cycle. It is used to create new bank credit in
the
shape of unwarranted advances to enterprises. He considers money (credit)
as
a factor to explain the cycle theory. The elasticity of the money supply
(MV) is
what allows and facilitates the disequilibria of business cycles. By
expanding
the currency, malinvestments in capital are generated, which are
not productive
enough to be maintained (Haney, 681). Having said this, Hayek
makes two points
here. He talks about "voluntary saving" and enterprisers'
anticipation
of rising prices. The former is concerned with the changes in
capital structure
brought about by changes in the volume of money. It is the
difference between
"voluntary saving" and the creation of new credit currency
by banks.
In particular, Hayek describes the self-reversing real effects
of credit
expansion. He states that "all new capital goods which are created
with the
help of a credit expansion ("voluntary" savings being constant)
will
be destroyed during the crisis which necessarily follows the upward
phase of the
cycle" (Colonna, xi). The new credit currency is considered to
be inflation
and cannot be maintained whereas voluntary savings are
production and can be
maintained. In Hayek's words In a free market society
newly created money can
never take the place of true voluntary savings: money
expansions do not have
temporary distorting effects on the price system and
on the directions of
production, but these effects are not in harmony with
the free choices of the
consumers, money will never be able to change
permanently the relative scarcity
of capital (Colonna, xi). By saying this,
Hayek showed the integration of
monetary and capital theory. In his second
point, Hayek discusses how important
the enterprisers's anticipation of
rising prices is. "The entrepriser,
anticipating rising prices, and aided by
money rates below the equilibrium rate,
plunges into overinvestment" (Haney,
682). Now, Hayek developes a third
point. He calls it "the vertical structure
of production, and the different
effects of price rises on the various
stages" (Haney, 682). Here, Hayek
talks about different goods and their total
demand. He mentions production
goods, intermediate goods, and consumption
goods. Hayek introduces the term
"forced savings" which means inability to
buy the usual quantity of
consumers' goods. As banks having excess reserves
encourage businessmen to
borrow at below-normal interest rates, an
overexpansion of investment develops.
The roundabout process of producing
by means of capital goods begins, and the
spending of the new credit raises
expenses and prices before the incomes of
consumers can rise (Haney, 682).
From this explanation, forced saving results.
Hayek states that "this
phase will continue as long as the investment feeds
on new bank credit, and
thus exceeds voluntary savings" (Haney, 682). Hayek
puts an emphasis on the
highly technical area of trade-cycle theory after 1931.
He concentrates
on the "Ricardo effect" in that period. In a boom the
rising demand for
consumer goods drives up their prices, leading to a fall in
real wages. This,
in turn, leads to an increase in investment demand, but this
is coupled with
and eventually offset by a fall in capital: output ratios as
real wages fall
(Tomlinson, 5). However, Hayek argues that "investment will
tail-off in a
slump even though profits are rising" (Tomlinson, 5). He
relates the Austrian
theory of capital to the business cycle in order to show
that a rising level
of consumption must reduce rather than increase the rate of
investment. Hayek
shows that A rise in the demand for consumer goods, with money
wages and
interest rates remaining unchanged, by causing an increase in prices
of
consumer goods and a decrement of real wages, will lead to a fall in
the
demand for capital goods thereby causing unemployment (Palgrave, 198).
The
Ricardo-Hayek effect comes from Ricardo's argument: "a general rise
in
money wages leads to a substitution of machinery for labor" (Blaug,
571).
Hayek thinks that Ricardo's statement is misleading. Hayek,
himself, tries to
prove that if the relative prices of labor and machines
change, a rise in wages
will induce substitution of capital for labor, and
vice versa. A rise in the
ratio of output to input prices increases the
annual rate of profit on working
capital more than on fixed capital. This
induces the firm to invest its liquid
capital funds in processes with a high
rate of turnover. When the fall in real
wages is general, the result is that
the average period of turnover of gross
investment expenditures in the
economy as a whole declines; in other words, the
average period of production
is shortened (Blaug, 573). According to Hayek,
commodity prices rise faster
than money wages in the upswing of the business
cycle. Labor will be replaced
with machinery, if this higher price-wage ratio
persists. Therefore, Hayek
draws a conclusion that The fall in real wages leads
to changes in the
relative profitability of different methods of production in
favor of shorter
or less roundabout methods. At some point, investment demand
for "capital
widening" in response to expanding consumer demand for
current output - the
demand for more machines of exactly the same type as before
- is more than
offset by this type "capital shallowing", and total
investment demand in the
economy falls off (Blaug, 571). Controversy, when there
is a depression "the
rising level of real wages brings about a revival of
investment as "capital
deepening" - the tendency to adopt more durable
machines - begins to offset
the decline in induced investment" (Blaug,
571). The Ricardo-Hayek effect
is dynamic because it deals with transient phase.
It includes fixed and
circulating capital assets. The essence of this effect is
that Profits will
be higher on the method with the higher rate of turnover, not
because they
would accrue at a higher rate after the new equilibrium but because
the
profits on the less capitalistic method will begin to accrue earlier
than
those on the more capitalistic method (Palgrave, 199). In other words,
the new
position, which will be achieved, depends on time because during the
transition
the behavior of the firms is affected by the profits accruing to
them as the
adjustment process progresses. There is no doubt about Hayek's
theory. It
provides an adequate basis for understanding modern cycles. In his
statement,
Hayek points out various psychological and technological
factors such as
entrepreneur anticipations, consumption habits, and
industrial structure. Hayek
saw the business cycle " as resulting from the
noncorespondance of plans of
savers and investors when important market
signals - relative prices - are
falsified by previous monetary disturbance"
(O'Driscoll, 10). Hayek
contributed to the business cycle by providing the
overinvestment theory. A
depression ensues when investment funds cease to be
readily available and
thereby leave incomplete investment projects that have
already been constructed
but require complementary projects, the construction
of which has come to a halt
(Spiegel, 543). In sum, any change takes time and
needs adjustment costs. In
particular, changes to the structure of production
are inevitable in an
investment boom. The rate of interest rises once the
boom in underway and thus,
a higher rate of interest tells against more about
roundabout methods. To
conclude, one may say that Hayek's contribution to the
business cycle provides a
basis for interpreting economy in the 19 and 20
century. Bibliography Blaug,
Mark. Economic Theory in Retrospect.
Cambridge: Cambridge University Press,
1978. 571-74. Butler, Eamonn.
Hayek: His Contribution to the Political and
Economic Thought of Our
Time. USA: Universe Books, 1985. 8-10. Colonna, M.,
Hagemann, H., and
Hamouda, O. Economics of F.A. Hayek. (Vol.2, pp xii- xiii).
Edward Eglar
Publishing Limited. England. 1994. Haney, Lewis H. History of
Economic
Thought. New York: The Macmillan Company, 1949. 667-84.
O'Driscoll,
Gerald P., Jr. Economics as a Coordination Problem: The
Contributions of
Friedrich A. Hayek. Kansas City: Sheed Andrews and
Mcmeel, Inc. 1977. 9-11.
Outhwaite, William and Tom Bottomore. The
Blackwell Dictionary of Twentieth-
Century Social Thought. Oxford:
Blackwell Publishers, 1993. 55-57. Palgrave,
Robert Harry Inglis.
"Friedrich August von Hayek". The New Palgrave: A
Dictionary of
Economics. (Vol. 2, pp. 609-10). The Macmillan Press Limited. USA.
C
1987. Palgrave, Robert Harry Inglis. "Ricardo-Hayek effect". The
New
Palgrave: A Dictionary of Economics. (Vol. 4, pp. 198-99). The
Macmillan Press
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Tomlinson, Jim. Hayek and the Market.
London: Pluto Press. 1990. 5-6.