The mainstream remains clueless about Hayek
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Among the prominent thinkers of the 20th century, Friedrich A. Hayek, the joint-winner of the Nobel Prize in economics 1974 and a member of the Austrian school of economics, remains perhaps the most under-appreciated and misunderstood. Hayek’s clash with British economist John Maynard Keynes is well-known, and is one of the most important policy debates of all time. But in a recent paper titled Reconciling Hayek’s and Keynes’ views of recessions, Paul Beaudry, Dana Galizia, and Franck Portier argue that the prescriptions of Hayek and Keynes to deal with economic downturns “may simply reflect two sides of the same coin”.
Hayek, they say, contended that recessions are the result of excess supply (mainly of capital goods like housing, durables and physical capital); while Keynes believed downturns were caused by insufficient aggregate demand. The Keynesian way out of the downturn lies in boosting aggregate demand to absorb excess supply, while the Hayekian way out is in allowing the market to liquidate excess supply to come to terms with demand. The authors consider the Keynesian option to be the better one as Hayek’s solution would take time, cause high unemployment and lead savers to further accumulate savings, thus lowering demand for goods.
However, neither Hayek nor any other Austrian economist viewed recessions as the result of excess capital accumulation or over-investment. It was, in fact, the over-investment—or under-consumption—theory of W.T. Foster and W. Catchings that Hayek set about to refute in his essay The ‘Paradox’ of Savings. (Keynes would later go on to reclaim the same fallacy preached by Foster and Catchings through the fallacious idea of paradox of thrift.) In fact, Ludwig von Mises, one of the stalwarts of the Austrian school, quite clearly mentioned in his magnum opus Human Action that “the essence of the credit-expansion boom is not over-investment, but investment in wrong lines, i.e., mal-investment”.
The idea of mal-investment, however, has eluded mainstream economists for long now. This is largely owing to the distinct tradition of economic thinking in continental Europe that Hayek introduced to the Anglo-Saxon world during his tenure at the London School of Economics. In his most prominent 1931 work Prices and Production, Hayek explained the real effects of monetary disturbances in the form of new credit injected into the economy by banks. These real effects of monetary disturbances are largely owing to the effect of credit expansion on the relative prices of consumer and producer goods.
Excess savings above that which can be profitably invested in satisfying consumer demand in the near future are invested in lines of production satisfying demand in the farther future. In real terms, this means a movement of resources from shorter production processes to longer ones. To cite an example, this is no different from savings being invested in hoarding commodities to satisfy demand in the farther future. Land and labour that would have otherwise been invested in satisfying needs in the nearer future are bid towards more time-consuming processes.
Notably, Hayek referred to the reallocation of factors towards satisfying needs in the farther future as lengthening of the structure of production, while Eugen von Bohm-Bawerk called it an increase in the roundaboutness of the production process.
Apart from higher savings by individuals owing to lower time preference, it is also possible that excess savings can be made available to entrepreneurs in the form of credit created by banks. Like in the case of an increase in genuine savings, this would allow additional capital to be allocated towards lines of production satisfying demand in the farther future. Hayek, however, termed such capital accumulation owing to credit creation by the banking system as forced saving. This is since credit in this case is not sourced from genuine savings made available to entrepreneurs through a lowering of savers’ time preference, but instead through artificial credit expansion. This is also the reason why the process will eventually reverse itself.
During the credit expansion process, resources earlier allocated towards less roundabout production processes are reallocated towards more roundabout lines of production. But once the additional credit is spent on factors—thus percolating through the system—the actual preference of individuals is re-established. Provided that the banking system does not expand credit further to sustain longer production processes, this will lead to much lesser savings being made available to entrepreneurs in the next cycle. A rearrangement of the production structure then ensues, with available savings—and thus resources—being allocated towards less roundabout lines of production.
For instance, it may no longer be profitable—or much less profitable—to spend capital on hoarding commodities to satisfy demand in the farther future as the demand for goods in the nearer future is higher. In other words, given consumer demand for goods in the nearer future, using available savings to satisfy demand in the farther future may not be economically warranted.
What results is the liquidation of longer production processes and higher unemployment as resources are reallocated according to actual consumer preference, that is, from longer production processes to shorter ones. This is also the reason why any counter-cyclical policy measure to artificially boost demand for goods towards longer production processes will be futile, as these will be reversed once consumer preference is re-established. As Murray Rothbard noted in America’s Great Depression, “The ‘depression’ is actually the process by which the economy adjusts to the wastes and errors of the boom, and re-establishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments.”
The painful liquidation process, in other words, is absolutely necessary for sustainable growth to return and mis-allocated resources to be re-allocated according to consumer preference. Also, note that further credit expansion to sustain the longer production process cannot continue for long except at the risk of a currency crisis, as the pace of credit expansion will have to progressively increase with increasing volume of money in circulation.
A particular feature of the bust is the presence of unused capacity, which results from intermediate goods specific to longer production processes going without use as these processes are abandoned. Longer the credit expansion process continues, more the resources that are allocated towards processes that will eventually be abandoned, and cause intermediate goods without alternate uses to go waste. Rothbard noted the same: “Some of these [wasteful investments] will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816–1818 and deserted during the Panic of 1819); others will be shifted to other uses.”
Mainstream economists, who have little idea about the structure of production, mistake such unused capacity as a symptom of over-investment and lack of aggregate demand, while in fact it is glaring evidence of scarce resources going waste due to mis-allocation. Not surprisingly, then, they see demand deficit as the problem rather than inappropriate resource allocation. In this sense, Beaudry, Galizia and Portier are no different from their clueless fellow economists.
Natural Order runs every Monday, with a libertarian take on the world of economics and finance.