Monday, October 20, 2014

Hayek’s Prices and Production (1935), Lecture II: A Summary

I summarise below Lecture II of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

Hayek commits himself to a static Walrasian general equilibrium model early in his Lecture II:
“…it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency towards an equilibrium. For it is this concept alone which permits us to explain fundamental phenomena like the determination of prices or incomes, an understanding of which is essential to any explanation of fluctuation of production. If we are to proceed systematically, therefore, we must start with a situation which is already sufficiently explained by the general body of economic theory. And the only situation which satisfies this criterion is the situation in which all available resources are employed. The existence of unused resources must be one of the main objects of our explanation.

(4) To start from the assumption of equilibrium has a further advantage. For in this way we are compelled to pay more attention to causes of changes in the industrial output whose importance might otherwise be underestimated. I refer to changes in the methods of using the existing resources. Changes in the direction given to the existing productive forces are not only the main cause of fluctuations of the output of individual industries; the output of industry as a whole may also be increased or decreased to an enormous extent by changes in the use made of existing resources. Here we have the third of the contemporary explanations of fluctuations which I referred to at the beginning of the lecture. What I have here in mind are not changes in the methods of production made possible by the progress of technical knowledge, but the increase of output made possible by a transition to more capitalistic methods of production, or, what is the same thing, by organising production so that, at any given, moment, the available resources are employed for the satisfaction of the needs of a future more distant than before. It is to this effect of a transition to more or less ‘roundabout’ methods of production that I wish particularly to direct your attention. For, in my opinion, it is only by an analysis of this phenomenon that in the end we can show how a situation can be created in which it is temporarily impossible to employ all available resources.” (Hayek 1935: 34–36).
Hayek is also concerned with the structure of production: that is, changes which involve a longer as opposed to a shorter period of production and a hence a longer period of time before final consumer goods output is produced (Hayek 1935: 38).

Hayek has the following famous diagram illustrating the structure of production, as below.


Hayek explains this diagram as follows:
… “I find it convenient to represent the successive applications of the original means of production which are needed to bring forth the output of consumers’ goods accruing at any moment of time, by the hypotenuse of a right-angled triangle, such as the triangle in Fig. I. The value of these original means of production is expressed by the horizontal projection of the hypotenuse, while the vertical dimension, measured in arbitrary periods from the top to the bottom, expresses the progress of time, so that the inclination of the line representing the amount of original means of production used means that these original means of production are expended continuously during the whole process of production. The bottom of the triangle represents the value of the current output of consumers’ goods. The area of the triangle thus shows the totality of the successive stages through which the several units of original means of production pass before they become ripe for consumption. It also shows the total amount of intermediate products which must exist at any moment of time in order to secure a continuous output of consumers’ goods. For this reason we may conceive of this diagram not only as representing the successive stages of the production of the output of any given moment of time, but also as representing the processes of production going on simultaneously in a stationary society.” (Hayek 1935: 38–40).
As time increases between the use of the original means of production and the actual production of final consumer goods output, production becomes “more capitalistic” (Hayek 1935: 42).

The crucial problem for Hayek is: how does an economy transition from lower to much higher “capitalistic” methods of production? (Hayek 1935: 49).

The answer:
“… a transition to more (or less) capitalistic methods of production will take place if the total demand for producers’ goods (expressed in money) increases (or decreases) relatively to the demand for consumers’ goods. This may come about in one of two ways: either as a result of changes in the volume of voluntary saving (or its opposite), or as a result of a change in the quantity of money which alters the funds at the disposal of the entrepreneurs for the purchase of producers’ goods.” (Hayek 1935: 50).
What underlies this reasoning are the following assumptions:
(1) A Wicksellian loanable funds theory, where money interest rates are determined by time preference and are a reliable and effective indicator of inter-temporal consumption plans;

(2) the assumption that investment is a straightforward function of money interest rates, and

(3) a situation of general equilibrium in which no unused resources are available.
BIBLIOGRAPHY
Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Sunday, October 19, 2014

Hayek’s Prices and Production (1935), Lecture I: A Summary

In what follows, I summarise Lecture I of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

Hayek notes that by the 1930s it was widely accepted that monetary influences can play a great role in the “volume and direction of production” (Hayek 1935: 1).

Hayek devotes much of Lecture I to a review of the history of monetary theory. The first major stage of monetary theory was the development of the quantity theory.

However, Hayek criticised the quantity theory for neglecting the way in which money supply changes can cause changes in relative prices (Hayek 1935: 3–6). Hayek concludes that money is not neutral in its effects (Hayek 1935: 7).

The “second stage” in the history of monetary theory was the realisation that the quantity theory is wrong to assume that money supply changes merely affect the general price level in a uniform and proportional manner (Hayek 1935: 8). Locke, Montanari and, above all, Richard Cantillon realised this (Hayek 1935: 8). Hayek sketches the mechanism we now call Cantillon effects (Hayek 1935: 9–10):
“… [sc. Cantillon] attempts to show ‘by what path and in what proportion the increase of money raises the price of things’. Starting from the assumption of the discovery of new gold or silver mines, he proceeds to show how this additional supply of the precious metals first increases the incomes of all persons connected with their production, how the increase of the expenditure of these persons next increases the prices of things which they buy in increased quantities, how the rise in the prices of these goods increases the incomes of the sellers of these goods, how they, in their turn, increase their expenditure, and so on. He concludes that only those persons are benefited by the increase of money whose incomes rise early, while to persons whose incomes rise later the increase of the quantity of money is harmful.” (Hayek 1935: 8–9).
The “third stage” in the development of monetary theory was when economists examined how money supply increases affect the rate of interest, and through this the demand for capital goods and consumer goods (Hayek 1935: 11–12).

Hayek traces these ideas through the 19th century British economists and writers, and lists the following:
(1) Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), p. 287.

(2) Lord King’s Thoughts on the Effects of the Bank Restriction (London, 1803), p. 20.

(3) John Leslie Foster’s An Essay on the Principles of Commercial Exchanges (London, 1804), p. 113.

(4) David Ricardo’s The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.; London, 1810), p. 47, and On the Principles of Political Economy and Taxation (3rd edn.; London, 1821), p. 349–350.

(5) the “Report of the Committee on Gold Bullion” (London, 1810), p. 56.

(6) Thomas Joplin’s Outlines of a System of Political Economy (London, 1823), pp. 37–38, and An Analysis and History of the Currency Question (London, 1832).

(7) Thomas Tooke’s An Inquiry into the Currency Principle (London, 1844), p. 77, and Considerations of the State of the Currency (London, 1826), p. 22.

(8) Nassau William Senior’s Biographical Sketches (London, 1863).

(9) John Stuart Mill’s Principles of Political Economy: With Some of their Applications to Social Philosophy (6th edn.; London, 1865).
These authors presented monetary theories that were precursors to Knut Wicksell’s monetary equilibrium theory, with a natural rate of interest set by the profits on real capital and a money rate of interest that can diverge from the natural rate.

The “fourth stage” of monetary theory seen by Hayek as the antecedent to the ABCT was that linking money supply and interest rate changes to the production of capital goods (Hayek 1935: 18). The authors cited by Hayek who developed the idea of “forced saving” in relation to capital goods investment are as follows:
(1) Jeremy Bentham’s Manual of Political Economy (written in 1804 but only published in 1843).

(2) Thomas Robert Malthus’ “Depreciation of Paper Currency,” Edinburgh Review 17.34 (1811): 339–372, at p. 363.

(3) John Stuart Mill’s “On Profits and Interest” and Principles of Political Economy (6th edn.; London, 1865).
Leon Walras probably rediscovered the “forced saving” doctrine in 1879, and from him it passed to Wicksell (Hayek 1935: 22).

But it was Wicksell who combined the different strands of monetary theory into one synthesis (Hayek 1935: 23).

Hayek then summarised Wicksell’s monetary equilibrium theory as follows:
“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.

Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; if they raise the money rate above the equilibrium rate—a case of less practical importance—they exert a depressing influence on prices. From this correct statement, however, which does not imply that the price level would remain unchanged if the money rate corresponds to the equilibrium rate, but only that, in such conditions, there are no monetary causes tending to produce a change in the price level, Wicksell jumps to the conclusion that, so long as the two rates agree, the price level must always remain steady. There will be more to say about this later. For the moment, it is worth observing a further development of the theory. The rise of the price level which is supposed to be the necessary effect of the money rate remaining below the equilibrium rate, is in the first instance brought about by the entrepreneurs spending on production the increased amount of money loaned by the banks. This process, as Malthus had already shown, involves what Wicksell now called enforced or compulsory saving. That is all I need to say here in explanation of the Wicksellian theory.” (Hayek 1935: 23–25).
Mises had already adopted Wicksell’s monetary theory and developed the first form of the ABCT (Hayek 1935: 25), and Hayek’s own version in Prices and Production was a development of Mises’.

Hayek departs from Wicksell’s monetary theory on a number of points:
(1) Hayek thinks that the banks need to keep the amount of money in circulation unchanged to secure a stable price level, and

(2) the amount of money in circulation has to be changed as the volume of production increases or decreases (Hayek 1935: 27).
But Hayek thinks that the banks cannot keep the demand for real capital in line with the supply of savings and the price level stable at the same time, except in a stationary equilibrium state (Hayek 1935: 27). In times of expansion of production, even when the money rate of interest is equal to the natural rate, there would be a falling price level (Hayek 1935: 27):
“The banks could either keep the demand for real capital within the limits set by the supply of savings, or keep the price level steady; but they cannot perform both functions at once. Save in a society in which there were no additions to the supply of savings, i.e., a stationary society, to keep the money rate of interest at the level of the equilibrium rate would mean that in times of expansion of production the price level would fall. To keep the general price level steady would mean, in similar circumstances, that the loan rate of interest would have to be lowered below the equilibrium rate. The consequences would be what they always are when the rate of investment exceeds the rate of saving.” (Hayek 1935: 27–28).
Hayek also repudiates the idea of a general price level as a useful economic concept (Hayek 1935: 29–30).

In place of the general value of money, Hayek substitutes the crucial concept of how money influences the relative values of goods (Hayek 1935: 31). If money leaves relative values of goods’ prices unchanged, then money is “neutral” (Hayek 1935: 31).

BIBLIOGRAPHY
Foster, John Leslie. 1804. An Essay on the Principles of Commercial Exchanges, and more particularly of the Exchange between Great Britain and Ireland: With an Inquiry into the Practical Effects of the Bank Restrictions. J. Hatchard, London.

Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Joplin, Thomas. 1823. Outlines of a System of Political Economy: written with a View to Prove to Government and the Country, that the Cause of the Present Agricultural Distress is Entirely Artificial: and to suggest a Plan for the Management of the Currency. Baldwin, Cradock, and Joy, London.

Joplin, Thomas. 1832. An Analysis and History of the Currency Question: Together with an Account of the Origin and Growth of Joint Stock Banking in England: Comprised in a Brief Memoir of the Writer’s Connexion with these Subjects. James Ridgway, London.

Malthus, Thomas Robert. 1811. “Depreciation of Paper Currency,” Edinburgh Review 17.34: 339–372.

Mill, John Stuart. 1865. Principles of Political Economy: With Some of their Applications to Social Philosophy (6th edn.). Longmans Green, London.

Report from the Committee of Secrecy on the Bank of England Charter: With the Minutes of Evidence, Appendix and Index, J. & L. G. Hansard & sons, London, 1832.

Report, Together with Minutes of Evidence, and Accounts from the Select Committee on the High Price of Gold Bullion: Ordered, by the House of Commons, to be Printed, 8 June 1810 (Report of the Committee on Gold Bullion, 1810), J. Johnson and J. Ridgway, London, 1810.

Ricardo, David. 1810. The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.). John Murray, London.

Ricardo, David. 1821. On the Principles of Political Economy and Taxation (3rd edn.). John Murray, London.

Senior, Nassau William. 1863. Biographical Sketches. Longman, Green, Longman, Roberts, & Green, London.

Thornton, Henry. 1802. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. J. Hatchard, London.

Tooke, Thomas. 1826. Considerations of the State of the Currency. John Murray, London.

Tooke, Thomas. 1844. An Inquiry into the Currency Principle: The Connection of the Currency with Prices, and the Expediency of a Separation of Issue from Banking. Longman, Brown, Green, and Longmans, London.