In the January 2009 Freeman appears the first of two columns of mine on the Austrian theory of the trade cycle . My column is below the fold.
One of the most vivid memories of my undergraduate years is of sitting for hours in my carrel in the old Polk Library at Nicholls State University and reading F.A. Hayek’s Monetary Theory and the Trade Cycle and his Prices and Production. These books on the economic cycles of booms and busts are among the most challenging that Hayek wrote.
Sitting in that same carrel, I then read Gerald O’Driscoll’s 1977 book Economics as a Coordination Problem —a work that explains in more up-to-date terms the logic of Hayek’s theory of such cycles.
Having done my best to digest these works, along with some related articles and helpful conversations with my professor Bill Field, I believed myself to have gotten a pretty firm grasp of Hayek’s macroeconomic thinking. And the logic of Hayek’s explanation for economic booms and busts made good sense to me.
Spending time with Roger Garrison  during my doctoral-study days at Auburn University only raised my confidence in this explanation of so-called “trade cycles.”
The logic is straightforward. Investors and business people, like consumers, respond to relative prices in deciding how to act. And relative-price movements are crucial signals directing resources to uses that consumers value most.
So, for example, if the demand for apples rises relative to the demand for pears, the price of apples will rise relative to the price of pears. Producers—responding to this signal—will then switch some resources and effort from pear production into apple production. This response is appropriate.
But prices, of course, are expressed in money terms. If relative prices are caused to change not by any change in underlying economic reality but instead by changes in the supply of money, then producers and consumers will be misled by these changing relative prices to act as if some real economic fact has changed when actually nothing has happened. For example, if the central bank injects new money into the economy by giving it to people who have a special fondness for eating apples, this new money will enable its recipients to increase their demand for apples beyond what it would be without the new money. The price of apples will rise relative to that of pears, peaches, and other goods and services.
Eventually, though, this new money spreads throughout the economy, causing all prices to rise (resulting in what modern economists call inflation). Importantly, relative prices eventually adjust to reflect more accurately the underlying economic reality. When the underlying reality is clearly revealed by the now-correct relative prices, production plans based on the false price signals must be undone. Undoing these production plans takes time. One result of this process of undoing economically unsustainable production plans is temporary unemployment.
The power of Hayek’s theory, though, lies in its focus on a particular price: the interest rate. This price coordinates production and consumption plans across time. If people are very impatient to consume and, in consequence, save very little, interest rates will be higher than they would be if people were more willing to defer consuming the fruits of their labors. A high rate of interest, therefore, signals to businesses that it is not worthwhile to use resources today to build highly complex and expensive machinery for producing greater output in the future. In these circumstances, resources satisfy more urgent needs when they are used to produce goods for consumption today rather than to produce producer goods that will increase the availability of consumer goods only tomorrow.
Only if people generally become more willing to save—that is, to allow a greater amount of resources to be used not to increase the flow of consumer goods today but to build production processes that increase outputs tomorrow—does the size of an economy’s stock of capital increase.
The price that signals this greater willingness to save is the interest rate. The higher the willingness to save, the greater the supply of savings available to be loaned to entrepreneurs—hence, the lower the rate of interest. But just as changes in the supply of money can cause the price of apples relative to pears to “lie” about the underlying demand for apples relative to pears, so too can changes in the supply of money cause the interest rate to “lie” about people’s willingness to save.
Building on works by Richard Cantillon, Carl Menger, Eugen von Bohm-Bawerk, Knut Wicksell, and Ludwig von Mises, Hayek argued that increases in the supply of money (beyond any possible increases in people’s demand to hold money) are especially likely to cause the nominal rate of interest to fall. And as this price is pushed below its true (“natural”) level, entrepreneurs increase the size of their investments. They channel resources from producing consumer goods into producing capital goods.
This “lengthening” of the production process, however, is not done in one fell swoop. It takes time and requires a continuing flow of resources for its completion. For example, an entrepreneur lured by a low rate of interest to build a new factory needs resources not only today to build the factory’s basement, but tomorrow and the next day to complete his planned construction. If this entrepreneur discovers tomorrow that the resources that he thought would be available to complete the factory are not available, then he must abandon his plan. Workers hired in the expectation that the factory would be built and operated will be laid off.
Because newly created money usually enters the economy through the banking system, monetary expansion typically does indeed push the nominal rate of interest below the real rate. Entrepreneurs and businesses in general are thus misled into making production plans that require a continuing flow of capital larger than the flow of capital that will be forthcoming given people’s actual plans to save.
The new money, however, soon causes a rise in the general price level—including a rise in the nominal rate of interest. This general rise in prices reflects the lower value of money, and the higher nominal rate of interest reflects the spreading expectation that money will continue to lose value.
To keep the inflation-adjusted rate of interest artificially low enough so that it continues to deceive investors about the public’s willingness to save, the monetary authority must increase the speed with which it injects new money into the economy. Inflation rises faster and faster. The economy either eventually grinds to a halt because money prices have become so unreliable or the monetary authority stops printing new money.
In either case, adjustments to the true, underlying reality of people’s preferences and resource constraints must be made. These adjustments take time and involve unemployment.
As I said, this theory made sense to me. But the economic growth of the past 30 years caused me to doubt its veracity. And today’s economic turmoil is causing me to revisit both this theory and my doubts about it. In my next column I explore my doubts about the theory and my new doubts about my doubts.