Hayek And Business Cycle Essay, Research Paper
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,
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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-
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