Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek

5

The Ricardo Effect

THE INTERLUDE

However much
Prices and Production furthered Hayek’s career, it led to confusion, debate, and even bewilderment. At the time, most would surely have said that Hayek’s reputation would be made as a monetary theorist. Few today think of him as a monetary theorist.
*1 Not only did the Keynesian revolution have an effect, but also Hayek’s 1931 exposition left much unexplained. In addition,
Prices and Production had a Continental flavor on which Hicks has remarked.
*2 Had Hayek’s audience been familiar with Austrian capital theory, communication would have been easier. But there was no way he could have reviewed Austrian capital theory in the time allotted to his original London lectures.
*3

During the 1930s Hayek became embroiled in the controversy over resource allocation under socialism.
*4 In the 1930s he was on the editorial board of
Economica. In 1939 he returned explicitly to the task that he had begun in
Prices and Production and wrote an essay he regarded “as a revised version of the central argument of [
Prices and Production], but treated from a different angle on somewhat different assumptions.”
*5

It should be a maxim of intellectual history that if an author changes the form of an argument—even with demonstrable improvement—he invites misinterpretation and the belief that he has “changed his mind.”
*6

The 1939 essay received two extended reviews in
Economica. In the first Nicholas Kaldor contended that Hayek’s essay offered “a new version of his theory that in many ways radically departed from, and contradicted, the first.”
*7 In the other, Ludwig M. Lachmann observed that Hayek had disposed of major criticisms of
Prices and Production and attributed some of the confusion over Hayek’s earlier work to his readers’ proclivity to frame the argument in static terms.
*8 Hayek believed that he had made no substantive changes in the 1939 essay.
*9 Thus, when his essay was published, Hayek’s contemporaries were uncertain whether the 1939 work extended the 1931 theory or replaced it altogether. It is to this latter question that we must next turn.

THE RICARDO EFFECT

In this essay an attempt will be made to restate two crucial points of the explanation of crises and depressions which the author has tried to develop on earlier occasions. In the first part I hope to show why under certain conditions, contrary to a widely held opinion, an increase in the demand for consumers’ goods will tend to decrease rather than to increase the demand for investment goods. In the second part it will be shown why these conditions will regularly arise as a consequence of the conditions prevailing at the beginning of a recovery from a depression.
*10

In developing his thesis, Hayek made one radical change from the argument in
Prices and Production. Instead of beginning with full employment and the economy in a “stationary state,” as he had in
Prices and Production, Hayek began by assuming the economy was in the depths of depression.
*11 He then traced out a sequential path by which full employment is reached. His new approach was calculated to dispel the criticism of his earlier “assumption” of full employment and at the same time extend the analysis of
Prices and Production. Furthermore, he was determined to abandon even the appearance of static analysis; his stated intention was to show how cyclical fluctuations “tend to become self-generating, so that the economic system may never reach a position which could be described as equilibrium.”
*12

His argument proceeded from four specific assumptions:

1. There is no mobility of labor between industries.

2. Money wages cannot be reduced.

3. Existing capital equipment is “fairly specific.”

4. The money rate of interest is kept constant by the banking system.
*13

It is the last assumption that defines the major difference between “Profits, Interest, and Investment” and
Prices and Production. In
Prices and Production, a rise in the loan rate of interest ended the boom and precipitated the crisis.
*14 The possibility of a rise in the interest rate is precluded by assumption in the 1939 essay, yet the crisis occurs anyway.

The thesis in
Prices and Production also allows for some specificity of capital, imperfect mobility of workers, and less than perfectly flexible wages.
*15 In fact, the first three assumptions of the 1939 essay are overly stringent. Employment responses will occur if prices are less than perfectly flexible and labor less than perfectly mobile.
*16 In a sense, Hayek caricatured
Prices and Production to demonstrate that his thesis in that work depended neither on resource or price flexibility nor on a rise in the interest rate.

According to Hayek, the crisis occurs when the rising factor incomes generated by the previous expansion lead to an increase
in consumer demand. In turn, prices of consumer goods are raised relative to prices of specific capital goods. This point is the same in both versions of Hayek’s theory.
*17 In
Prices and Production, increases in the money supply bring about a decrease in market rates. Capital deepening occurs as price margins narrow between stages of production. But factor incomes rise at the same time. Repeated injections of money (in the form of bank credit) may maintain the “lengthened” production structure (that is, prevent capital enshallowing), but once these injections cease or the rate of increase is slowed, market interest rates rise. At the same time a rise in consumer demand causes relative prices to return (approximately) to their pre-expansion values; consumption output increases and the structure of production is once again “shortened.”
*18

In 1939 Hayek attempted to demonstrate that, even if increasing consumer demand is not accompanied by a rise in the market rate of interest, the crisis (that is, the sudden decrease in demand for certain types of investment goods) will nonetheless occur. Herein is the vital difference between the two formulations of Hayek’s theory. For at least two reasons, Hayek’s analysis in 1939 of the case where the rate of interest may not rise was not mentioned in 1931. First, by 1939 the gold standard had been abandoned. In this situation discrepancies in interest rates are possible for longer periods than when the domestic money stock is closely tied to the quantity of international reserves. Second, Hayek wanted to demonstrate that his theory was not a purely monetary theory of the business cycle. In his 1939 essay he stated that monetary changes are not necessary for a cyclical downturn, real factors alone being sufficient. He had not been successful in previous attempts to distinguish his theory from purely monetary theories, though he had much earlier noted the differences:

I have become less convinced that the difference between monetary and nonmonetary explanations is
the most important point of disagreement between the various Trade Cycle theories…. It seems to me that within the monetary group of explanations the difference between those theorists who regard the superficial phenomena of changes in the value of money as decisive factors in determining cyclical fluctuations, and those who lay emphasis on the real changes in the structure
of production brought about by monetary causes, is much greater than the difference between the latter group and such so-called non-monetary theorists as Professor Spiethoff and Professor Cassel.
*19

As Machlup stated: “The fundamental thesis of Hayek’s theory of the business cycle was that
monetary factors
cause the cycle but
real phenomena
constitute it.”
*20

Once full employment is attained, rising consumer demand will lead to a rise in the rates of return in industries producing consumer goods relative to rates of return in capital goods industries. In such situations, it is the (expected) rates of return in different stages that influence the form that investments take rather than the absolute level of the loan rate of interest or the difference between the loan rate and natural rate. To Hayek, an infinitely elastic supply of credit cannot in the long run determine the marginal rate of return on capital.
*21

The investment decision facing entrepreneurs is one of choosing an appropriate rate of turnover for investment. In what follows one must remember the Austrian conception of capital as ”
saved-up labour and saved-up land.”
*22 Thus, Hayek’s analysis assumes “that the labour used directly or indirectly (in the form of machinery, tools, and raw materials), in the manufacture of any commodity is applied at various dates so that Ricardo’s ‘time which must elapse before the commodity can be brought to the market’ is two years, one year, six months, three months, and one month respectively for the various amounts of labour used.”
*23 Labor can be employed directly or indirectly in the form of capital with a longer or shorter investment period. Only in equilibrium will the rates of return on investments of different periods be the same.

Hayek presented a table to illustrate the effects of a rise in consumer demand (relative to costs) on the rates of return for various investments. The equilibrium annual rate of return (ignoring compounding effects) on labor invested for different periods is 6 percent.
*24 It is then assumed that the price of the product increases by 2 percent (due to the rise in consumption demand, generated by the previous rise in factor incomes):

Hayek used this table as a pedagogic device to illustrate market tendencies that would be realized to the extent his assumptions adequately reflected reality.
*25 Certain adjustments are implied:

A rise in the price of the product (or a fall in real wages) will lead to the use of relatively less machinery and other capital and of relatively more direct labour in the production of any given quantity of output. In what follows we shall refer to this tendency as the “Ricardo Effect.”
*26

A change in the price of the product relative to the money wage rate is a change in the “real wage.” The analysis is a somewhat roundabout way of referring to the effects of an increase in the value of the marginal product relative to the wage rate in some areas of labor employment and a decrease in others.
*27 By “real wages” Hayek did
not mean the nominal wage rate divided by the cost of living. He was concerned with the ratio of the nominal wage rate to the price of the specific product being produced rather than consumed by the worker. The Ricardo effect is thus a basic microeconomic proposition.
*28

Real wages may fluctuate irrespective of their measurement in terms of a unit of general purchasing power. Statisticians have often been confused about what constitutes the relevant real wage in economic analysis of the business cycle. The wage as measured in units of industrial output is what is important for labor demand, whereas the wage as measured in units of consumables is relevant to labor supply.
*29

THE RICARDO EFFECT AND CYCLICAL FLUCTUATIONS

The Ricardo effect had the same importance in Hayek’s 1939 formulation as changes in price margins had in
Prices and Production.*30 A rise (decline) in real wages corresponded to a narrowing (widening) of the price margins. In the earlier work, a change in the interest rate altered the allocation of resources only by way of a change in price margins. Microeconomists often contend that the interest rate is a ratio of prices.
*31 But in practice macroeconomists often ignore this relationship.
*32 A change in the interest rate leads to systematic changes in the relation of consumer goods prices to capital goods prices and of the prices of various kinds of capital goods to one other. Changes in the relative prices of (heterogeneous) capital goods are at least as significant as the change in the price of “consumption” relative to “capital” enunciated in the so-called sophisticated macromodels. However, this former type of change is generally ignored. Nor do changes in the prices of capital goods depend entirely on durability. Other things being equal, the more durable an asset, the greater will be the sensitivity of its present value to changes in the interest rate. But, as Hayek emphasized, one must not overlook how that capital good is used in the structure of production.
*33

Once full employment is reached in industries producing consumer goods, the Ricardo effect begins to operate. Any further increase in the demand for consumer goods leads to the kind of factor substitution described previously. Most important, with capital specificity the demand is always for particular capital goods rather than for “capital.”
*34

Hayek’s analysis does not depend on the assumption of full employment of all factors. In the model presented in “Profits, Interest, and Investment,” availability of additional factors of a given type in the capital goods industries does nothing to alleviate an excess demand for those factors in the consumer goods industries; the elimination of excess demand is excluded by the assumption of factor immobility in the short-run formulation of that model. But this stringent assumption, which has been criticized, obscures the operation of the Ricardo effect in the
more general case. If factors are generally mobile and used in combination (that is, are complementary), and if some factors are used in both capital and consumer goods industries, then a rise in demand for one or more of these general nonspecific factors in consumer goods industries will produce characteristic effects. In other words, once one nonspecific (complementary) factor becomes fully employed and is bid away from firms producing capital goods, the Ricardo effect will operate. Many other factors may be in excess supply, but if none is perfectly substitutable in the short run for the factor in question, the cyclical expansion of capital goods industries must be choked off.

In the process that Hayek described, increasing incomes of factor owners leads to an increasing demand for goods in relatively short supply, namely, consumer goods. Resources have been attracted into the production of capital goods at the expense of consumption output.
*35 These capital goods would have been profitable to produce,
ex post, only at higher rates of planned saving. Increasing consumption in the current period implies that the prices of consumer goods and of capital goods specific to the stages nearest to final output will rise relative to the current wage rate. The value of the marginal product of labor in these stages will rise relative to the current wage. Thus, real wage rates will fall. This basic story is not very different from that in
Prices and Production.*36

If labor were completely immobile in the short run, then, as the demand for consumer goods increased, the rates of return would rise in some industries and fall (even become negative) in others. As long as the factor immobility assumption is strictly adhered to, there will be unemployment in some industries, and the demand for labor will be high in others.
*37 But Hayek never envisioned this type of underemployment equilibrium. For Hayek the process does not end at this point.

A single firm, faced with different rates of return on different investments, would attempt to equalize them at the margin (net of risk differences). The firm would borrow at the going rate of interest and invest in capital goods until the marginal rate of return on all investments is equal to the rate of interest. Kaldor assumed that this model applied to the economy as a whole.
*38

Hayek responded that it is a
non sequitur to apply the model of a single firm to the model of the entire economy. In so doing, the resource constraint is violated. An interest rate below the equilibrium rate will lead to a progressive rise in incomes. The process will continue until the rise in the rates of return in the consumer goods industries dominates the effects of the low money rate of interest.
*39 As long as the market rate of interest is below the equilibrium level, the marginal propensity to spend (that is, the marginal propensity to consume plus the marginal propensity to invest) will be greater than one. And if relative prices continue to be “wrong,” there should be some mechanism (other than a change in the market rate of interest) that will lead to a correction.

Entrepreneurs will not be successful in attempts to drive the various rates of return down to the (below equilibrium) rate of interest. For what is being supplied is an infinite quantity of credit, not an infinite quantity of labor and other factor services. Entrepreneurs’ borrowing at the depressed rates of interest in order to maintain or extend the existing pattern of investments will promote a further rise in incomes and consumption demand. There will be no tendency for rates of return to become equalized. The reason is that factor scarcity necessitates the curtailment of some production (namely, consumer goods) to expand the production of other goods (namely, capital goods for capital deepening). The assumption is that planned saving out of increments to income will be less than planned investment. Consumption demand will be greater,
ex post, than was anticipated by entrepreneurs in general.

In
The Pure Theory of Capital Hayek put this more succinctly:

In long-run equilibrium, the rate of profit and interest will depend on how much of their resources people want to use to satisfy their current needs, and how much they are willing to save and invest. But in the comparatively short run, the quantities and kinds of consumers’ goods and capital goods in existence must be regarded as fixed, and the rate of profit will depend not so much on the absolute quantity of real capital (however measured) in existence, or on the absolute height of the rate of saving, as on the relation between the proportion of the
incomes spent on consumers’ goods and the proportion of the resources available in the form of consumers’ goods. For this reason it is quite possible that, after a period of great accumulation of capital and a high rate of saving, the rate of profit and the rate of interest may be higher than they were before—if the rate of saving is insufficient compared with the amount of capital which entrepreneurs have attempted to form, or if the demand for consumers’ goods is too high compared with the supply. And for the same reason the rate of interest and profit may be higher in a rich community with much capital and a high rate of saving than in an otherwise similar community with little capital and a low rate of saving.
*40

Lured by rising prices of consumer goods, entrepreneurs may anticipate and plan for a greater rise in the future. But, insofar as they do, they will discover that prices of current period consumption output have risen faster than anticipated: “The faster entrepreneurs expected prices to rise, the more they would necessarily speed up this price rise beyond their expectations.” The reason is that “any increase of money expenditure on the one kind of good [that is, labor services] is found to cause an increase of money expenditure on the other kind of good [that is, consumer goods].”
*41

In presenting a theory of the inflationary process, Hayek provided a model in which it was meaningful to speak of the self-perpetuating characteristics of an inflation, or of rising prices fueled by inflationary expectations, or even of a “wage-price spiral.” Though not developed as theories, these characterizations are descriptive of particular phases of a Hayekian inflationary process. For example, as entrepreneurs bid up factor costs, an observer within the system may believe that rising prices result from rising incomes, which in turn are being generated by rising wage rates. This phenomenon might even be described as “wage-push inflation.” The superficial observation is that in the later stages of an inflationary process wages push prices up, or that inflationary expectations are keeping the inflation going. The economist, however, would know that at the root of the price inflation is the inflation of the monetary and credit media. Changed expectations alter the
form of the inflationary process; they move the economy from one phase (say, an investment
boom) to another phase (say, a relative expansion of consumer goods industries) in the expansionary part of the business cycle. But all these changes presuppose an expansion of the means of payment.
*42 It is by no means necessary that this expansion continue to occur in the money stock, narrowly defined. Whether this in fact is the case is entirely a question of institutions and each unique historical manifestation of the business cycle.

PRICE CHANGES AND EXPECTATIONS

Hicks observed that price expectations were not treated explicitly in
Prices and Production because “their day had not yet come.”
*43 But even in the 1930s, Hayek was sensitive to the criticism that expectations played no role in his theory.
*44 Nonetheless he devoted less space in his work on cyclical fluctuations to an
explicit consideration of expectations than did Lindahl, Myrdal, Shackle, Lachmann, or, for that matter, Keynes himself. Yet Hayek’s theory is about the inconsistency of plans—about unfulfilled expectations. This point should have received wider recognition, especially after Hayek’s work on the role of prices in communicating information for the coordination of economic activity. In fact, it was in a lecture delivered in 1933 on cyclical fluctuations that Hayek first presented the thesis of his later “Economics and Knowledge.”
*45 In
Prices and Production and also in subsequent works, for example, “Profits, Interest, and Investment,” Hayek explained how entrepreneurs are induced to make investment decisions largely inconsistent with the saving decisions made by income recipients in general. But Hayek’s formal work on the coordination problem has been grouped with his work on economic calculation under socialism. It is instructive, however, to read his work on economic coordination in conjunction with that on cyclical fluctuations because the two subjects are interconnected.

Hayek was explicit about the nature of investors’ expectations: “Most investments are made in the expectation that the supply of capital will for some time continue at the present level.”
*46 The “supply of capital” is ambiguous and suggests that capital is a
homogeneous fund—a concept hardly consistent with Hayek’s own views on capital theory. The point is that entrepreneurs make investments not only on the expectation that funds will be available at the prevailing interest rate to complete
that investment project, but also on the expectation that funds will be available to complete
complementary investments in other stages, so that there will finally emerge a complete structure of production. “These further investments which are necessary if the present investments are going to be successful may be either investments by the same entrepreneurs who made the first investment, or—much more frequently—investments in the products produced by the first group by a second group of entrepreneurs.”
*47 As Hayek argued in “Economics and Knowledge,” an individual’s plans are necessarily mutually consistent.
*48 But different entrepreneurs may be led into making inconsistent production plans by faulty price signals. The coordinating mechanism for these decisions can fail to operate in an equilibrating fashion. According to Hayek,
the business crisis occurs when entrepreneurs can no longer attract the funds to complete or maintain a given structure of production.

Hayek acknowledged that entrepreneurs may react to a rise in the price of consumer goods and a fall in real wages in the consumer goods industries by anticipating an even larger price rise in the future. They may for a time have “elastic” expectations and react to a rise in the prices of consumer goods by increasing investment for the future production of consumer goods as opposed to increasing current output of consumer goods. Since when consumer prices rise, there is full employment in the industries producing consumer goods, these two increases cannot occur simultaneously. However, if entrepreneurs discover that they have continually underestimated the yield from increasing the output of consumer goods in the immediate future, they will revise their pattern of behavior, even if the loan rate of interest would otherwise prompt them to borrow and invest for the more distant future.
*49 Hayek’s capitalists are not wont to entrust their funds to entrepreneurs who consistently pass up the more lucrative investment opportunities.

Mises had already developed his conception of the entrepreneur as a moving force in the market economy in the 1940 German edition of
Human Action: A Treatise on Economics. The Misesian entrepreneur is not a refurbished version of Schumpeter’s innovator-entrepreneur, but has the day-to-day responsibility of discovering discrepancies between prices and costs and of constantly reevaluating past methods of production. He is a
discoverer of existing opportunities.
*50 The presence of the Misesian entrepreneur is needed to make Hayek’s concept of the
business cycle more plausible; for Hayek relied on the market system to produce the “right” expectations in the face of monetary disturbances that systematically distort expectations.

The effect of this rise in the rate of profit in the consumers’ goods industries will be twofold. On the one hand it will cause a tendency to use more labour with the existing machinery, by working overtime and double shifts,…etc., etc. On the other hand, insofar as new machinery is being installed, either by way of replacement or in order to increase capacity, this, so long as real wages remain low compared with the marginal productivity of labour, will be of a less expensive, less labour-saving or less durable type.
*51

Changed profitability of different investments also increases uncertainty and makes entrepreneurs heavily discount future
returns. This factor reinforces the tendency for entrepreneurs to capture short-run returns and pursue current opportunities that appear most profitable.
*52

One type of expectation formation does not affect Hayek’s basic analysis, though a great deal of attention has been devoted to it in recent years. This is the effect of anticipated inflation of nominal interest rates. In Hayek’s theory, where changes in the price level play no causal role, anticipations of such changes, whether correct or incorrect, also play no causal role.

Let us assume that
n is the natural, or equilibrium, rate of interest;
i is the nominal, or market, rate of interest;
^e is the expected rate of change in the price level per period

Also assume that an expansionary monetary policy has depressed
i below
n, and a cumulative rise in incomes brings about a cumulative rise in prices.

Yet another rate of interest is needed—Fisher’s
realized, or real rate of interest,
p, where
p = i-
. If the per period rate of change in the price level is correctly extrapolated into the future, then i =
p +
P^e; and
=
^e. But the real rate will nonetheless be lower than it was prior to the inflationary disturbance. The so-called inflation premium is “added on” to a market rate that is lower than the equilibrium (natural) rate of interest, that is, (i +
^e) < (n +
^e). The fact that market participants may succeed in protecting themselves against the effects of a generally depreciating currency provides no basis for concluding either that inflation will be neutral in its effects on the allocation of resources or that capital malinvestment can be avoided.
*53

The entire Fisherian analysis is irrelevant to the present problem and is of little relevance in an ongoing inflation of any magnitude. The reasons are several, though interrelated and reenforcing. Each market participant is concerned with the market prices facing him and the expected costs he will incur. In each contract the creditor and debtor are concerned with different subsets of relative prices and weigh the importance of individual price changes differently. They form expectations about different prices, and they attach different degrees of importance to each particular price change. Moreover, the data each individual
(creditor or debtor) considers are subjective, and each will interpret them differently.

Not only do market-day equilibria represent the temporary balancing of bullish and bearish expectations—the divergent views of those who expect higher and those who expect lower rates of inflation—but also these temporary equilibria are resultants of expectations about different events. What inflation premium could protect both parties to a debt contract? What indexation scheme could protect all or even most market participants? The questions are of course purely rhetorical.
*54

The whole notion of a balanced, anticipated inflation is a pure fiction resulting from a question-begging assumption and a methodological error. The question-begging assumption is that inflation is even-handed in its effects and is superimposed on a situation of long-run equilibrium. The existence of equilibrium in the form of anticipated inflation is deduced from the assumption of equilibrium. “The statement that, if people know everything, they are in equilibrium is true simply because that is how we define equilibrium. The assumption of a perfect market in this sense is just another way of saying that equilibrium exists but does not get us any nearer an explanation of when and how such a state will come about.”
*55

The methodological error involves the use of the Marshallian representative individual who buys the typical market basket and is confronted by prices increasing at the average rate. This construct leaves in doubt whether there are any atypical individuals, any gainers or losers in the process. The fact is that there are no representative individuals in an inflationary process.

In Hayek’s theory, rising prices (particularly of consumer goods) result from a maladjustment in
relative prices; the result is a planned output that is not synchronized with the planned demand for those goods. Even if transactors correctly anticipate the average rate of price increases—that is, if higgling and haggling in the securities market produce a consensus—then the stipulated rate of return for nominally dominated assets will increase once and for all. Assuming that in general transactors
lower desired real money balances in an anticipated inflation, prices will increase on a once and for all basis.
*56 But relative prices remain out of line with desired saving, and it is the maladjustment of relative prices that constitutes the inflationary problem.

The very term
anticipated inflation is misleading. What is anticipated in an anticipated inflation? For an inflation to have no effect on real activity (to be neutral), the precise sequence of price changes must be anticipated. If transactors could predict the exact sequence of price changes, they could predict every future price. To do so they must have direct access to future demand and supply conditions in each market. If such knowledge were possible, why would we use prices at all? Prices reflect the balancing of opinions as to future events. All the inefficiencies of a market system are tolerated because it is the
least inefficient way of transmitting decentralized information. If the market could adapt perfectly to an inflation, then the power to choose the “correct” prices is being attributed to the market. In other words, in a fully anticipated inflation this power is attributed to every (representative) individual. If, however, the representative individual is privy to the information required to correctly anticipate prices in every period, society would be well served to pick out a representative individual at random and make him an economic dictator. Markets could be dispensed with and resources allocated by fiat. No one would have to worry about the future rate of inflation, since there would not be any prices, just allocation orders.

The conception is fanciful, as is the model of a perfectly anticipated inflation. But the conception does illustrate how seemingly unrelated arguments converge. The argument over economic allocation without prices is relevant to the theory of inflation. It is relevant because inflation threatens to destroy the mechanism for economic calculation upon which a complex economy depends for its continued existence. Inflation is not merely a technical issue, nor are its effects frictional (“imperfect adjustment”). Rather, the inflation problem threatens the very fabric of a developed society.

THE CRISIS

A typical Hayekian crisis is characterized by “a scarcity of capital.” The paradox that a decline in the production of capital goods occurs because capital is in short supply seemingly delighted Hayek. By this way of expressing his ideas he focused attention on the insights of some of the “common sense” observations of the British monetary tradition of which he was so fond.
*57

In
Prices and Production, Hayek emphasized the responsiveness of wage rates to an excess demand for labor at relevant stages of production, and labor mobility between stages.
*58 In 1939, however, the emphasis was on the role of raw materials. Increasing consumption demand results in increasing demand for nonspecific (circulating) capital, particularly raw materials. Raw materials constitute the typical component of capital that is “turned over” rapidly. Users of highly labor-saving or durable machinery find themselves unable to compete for complementary factors, such as raw materials. The producers of such machinery find themselves in a similar situation as the demand for their products decreases. In short, the Ricardo effect induces businessmen to make more intensive use of labor and less durable machinery. Even where uses can be found for the relatively labor-saving machinery and durable capital goods in question, producers of these capital goods suffer. For while the stocks of capital goods can be used, they will not be maintained or replaced. Furthermore, this process occurs in the face of a changing pattern of demand for capital goods.

The capital goods in short supply consist mostly of raw materials. An excess demand for raw materials emerges because in the previous cyclical upswing capital was malinvested in fixed machinery as a consequence of forced saving.

It is not so much a matter of too much investment in money terms (or real terms, if this could be meaningfully measured), as of investment applied in the wrong areas. Without the availability of complementary circulating capital (for example, raw materials) at prices that permit a profit, the durable equipment (machinery) is eventually regarded as malinvested capital. In
terms of Hayek’s investment diagram, it is impossible to complete all stages on the way to a finished production structure. An unfinished production structure is incapable of producing consumption output. To the degree that investments have been made in incorrect anticipation of a finished production structure, capitalists incur losses. As capital goods are rearranged to fit a structure that can be finished, the value of the existing goods will
generally be less than their earlier selling price; in some cases, the prices may fall to zero. In the language of classical analysis, too much revenue has been converted to fixed capital. The existing capital goods (machinery) is not all usable—at least not for the original purpose—because the raw materials (and, in the case of a mobile labor force, the labor services) are not available. In real terms, there is an undersupply of nonspecific capital relative to the amount of machinery and current consumption demand.

The crisis consists of a rise in the prices of raw materials, and labor services relative to the prices of fixed capital.
*59 Moreover, the same factor—rising consumption demand—that causes these price movements results in declining demand for capital goods specific to the earlier stages of production. A price “squeeze” in the capital goods industries results. Adjustment to these changes takes time, and in the process affects employment and output.

Hayek’s emphasis on circulating capital and not on fixed machinery in
Prices and Production is less of a
lacuna than it might seem. In Hayek’s later formulation, where fixed capital is worked into the model, circulating capital turns out to be the important link in the causal process.

A tradition in British political economy was concerned with the proportion between fixed and circulating capital. In
Principles of Political Economy (especially the chapter “Of Circulating and Fixed Capital”), J. S. Mill examined the impact of a change in the proportion between fixed and circulating capital, the total quantity (in real terms) remaining constant.
*60 “All increase of fixed capital, when taking place at the expense of circulating, must be, at least temporarily, prejudicial to the interests of the labourers.”
*61 What interests us about Mill’s analysis is his description
of fixed capital created at the expense of circulating capital as a social loss, defined in terms of the workers displaced by this process. This misallocation of resources is not related to a discussion of prices and interest rates. The exposition is quintessentially macro in approach, indeed, a retrogression to mercantilist modes of thinking because processes are described without any consideration of what price incentives may have brought them about. Capitalists switch investments from circulating to fixed capital without specified changes in parameters. And the implications, except for labor employment, are not pursued. Nor does he make a connection with the role interest rates play in preventing the conversion of circulating into fixed capital. Furthermore, he fails to make the connection between the problem being discussed and the discussions of forced saving, which are common in British monetary theory and with which this problem is linked.
*62

The interrelation of the notion of forced saving and the capital structure was not perceived until certain aspects of classical capital theory were made coherent by Böhm-Bawerk, Wicksell, Mises, and finally Hayek.
*63 Nonetheless, the effects of an increase in fixed relative to circulating capital existed for all to see; it remained only for Hayek to give clearer expression to the problem that Mill had dimly seen.

THE DEPRESSION PROCESS AND REVIVAL

The assumption of labor immobility that Hayek employed in 1939 was a way of assuring that shifts in demand would have an impact on output and employment; for he wished to emphasize that employment in capital goods industries depends “at least as much on
how the current output of consumers’ goods is produced as on
how much is produced.”
*64 At full employment, rising demand for consumer goods causes the demand for certain types of capital equipment to decline, especially that specific to methods of production that are only profitable at low rates of interest. Demand for labor increases at some stages of production (and in some industries) and declines in others. Wage rates
rise in some stages (industries) because of increasing demand for labor there, while unemployment occurs elsewhere.
*65

In his later work, Hayek undertook a more extensive explanation of general unemployment in a depression. Generalized unemployment begins with unemployment in capital goods industries. As the incomes of factors previously employed fall, the demand for current output also decreases. Where many economists today would part company with Hayek is in his insistence that strong forces in the market process reverse a cyclical decline already under way.

As unemployment emerges in the capital goods industries, the rate of increase in consumer demand, and hence in the prices of consumer goods, slows. National income may even decline. In terms of the Ricardo effect, if consumption demand actually declines, prices of consumer goods fall relative to nominal wage rates, and real wage rates rise. At some point in this process, it would pay to substitute machinery for labor. Operating in reverse, the Ricardo effect restores full employment by making the production of capital goods once more profitable. Presumably, the stringent assumptions concerning structural rigidities could be relaxed, though Hayek did not pursue this possibility.

In this analysis, consumption demand need not decline in absolute terms. Whether a slowing down in consumption demand will lead to a rise in real wage rates depends on the level nominal wage rates have reached. This in turn depends on whether entrepreneurs anticipate a higher rate of growth in consumption demand than actually obtains.

It must be emphasized that Hayek did not envision a significant money wage deflation in the course of the depression; he accepted the proposition that money wage rates are “sticky.” In fact, he feared that real wage rates could rise so much that the cyclical revival would recur with malinvestment.
*66

There is more to a business cycle of course than changes in the allocation of resources between stages of production. Markets always produce changes in such aggregates as labor employment. Hayek insisted that changes in these aggregates cannot be analyzed in terms of the aggregates themselves. He admitted that there are macro variables but denied the possibility of macro-analysis;
for Hayek and the Austrian school in general there is only microanalysis. To him, there are no fixed relationships between macro variables.
*67 Nonetheless, he considered the explanation of unemployment to be of an important goal of business cycle analysis.
*68

Is Hayek’s analysis applicable to a deep depression, such as that of 1929-33? It was certainly a period in which deflation and unemployment were fairly general. Yet in an earlier work Hayek remarked: “There is no reason to assume…that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom.”
*69 Nonetheless, this “secondary phenomenon” became of utmost importance in the 1930s. While Hayek ranked it as of secondary importance, he did not fail to recognize the phonomenon.
*70

Robertson explicitly attempted to link Keynes’s analysis with Hayek’s.
*71 Others treated Keynes’s
Treatise on Money and Hayek’s
Prices and Production as similar in approach.
*72 According to Robertson, Hayek explained why a turning point occurs, that is, why a cyclical expansion, once begun, cannot continue. Keynes concentrated on the secondary deflation process, the existence of which depends on a crisis (as explained by Hayek’s analysis). Robertson did not treat the analyses of
Prices and Production and
The General Theory as mutually exclusive. Rather, the two analyses refer to different aspects of one and the same process.
*73 The failure of either side in the Keynes-Hayek debates to make use of Robertson’s attempted reconciliation is to be regretted.

Throughout the 1930s, Hayek opposed both monetary and fiscal measures designed to hasten a return to full employment. Reflation treats a symptom as a cause and ignores the maladjustments that are at the root of the depression. Indeed, if monetary policy succeeds in depressing the market rate below the equilibrium rate, it perpetuates the maladjustments.
*74 Hayek viewed fiscal policy as stimulating consumption, whereas maladjustments are caused by planned saving’s falling short of planned investment. He had little faith in either monetary or fiscal remedies as a permanent solution to widespread unemployment.
*75

It may perhaps be pointed out here that it has, of course, never been denied that employment can be rapidly increased, and a position of “full employment” achieved in the shortest possible time by means of monetary expansion—least of all by those economists whose outlook has been influenced by the experience of a major inflation. All that has been contended is that the kind of full employment which can be created in this way is inherently unstable, and that to create employment by these means is to perpetuate fluctuations. There may be desperate situations in which it may indeed be necessary to increase employment at all costs, even if it be only for a short period…. But the economist should not conceal the fact that to aim at the maximum of employment which can be achieved in the short run by means of monetary policy is essentially the policy of the desperado who has nothing to lose and everything to gain from a short breathing space.
*76

By 1933 most Western countries were ruled by what Hayek termed “desperados.” If Hayek was accurate in his assessment of the consequences, it would be difficult to argue that the unemployment Western countries experienced after World War II justified “buying” a little employment. A rapid increase in employment, fueled by a monetary expansion, with market rates of interest depressed below the natural rate, leads to maladjustments. These maladjustments, in turn, lead to successive cyclical downturns. The cyclical process becomes self-perpetuating and proceeds to the “stop-go cycle,” a familiar phenomenon in Great Britain and one becoming familiar in the United States.

Hayek’s business cycle corresponds more to a Juglar cycle than, say, to a National Bureau of Economic Research reference cycle. Though two minor recessions occurred in the 1920s, Hayek treated the period as one long expansion, particularly of capital accumulation; had the expansion ceased in 1927, he believed the depression would have been mild. For the Great
Depression to be viewed correctly, the actions of the Federal Reserve System in 1927 would have to be treated as “unprecedented” in their attempts to halt a contraction process with an otherwise limited effect.
*77

The monetary shocks that occurred later were virtually unprecedented in their severity and could not have been foreseen. Hayek’s purpose was to demonstrate how cyclical fluctuations may occur even in the absence of changes in the “general” price level. In his analysis of neutral money, Hayek concluded that the only way to prevent cyclical disturbances was to prevent investment booms. His policy conclusion was consistent with his earlier views and has a modern ring to it:

If we have to steer a car along a narrow road between two walls, we can either keep it in the middle of the road by fairly frequent but small movements of the steering wheel; or we can wait longer when the car deviates to one side and then bring it back by more or less violent jerks, probably overshooting the mark and risking collision with the other wall; or we can try to keep the steering wheel stiff and let the car bang alternately into either wall with a good chance of leading the car and ourselves to ultimate destruction.
*78

>

Hayek subsequently returned to this theme:

I find myself in an unpleasant situation. I had preached for forty years that the time to prevent the coming of a depression is the boom. During the boom nobody listened to me. Now people again turn to me and ask how the consequences of a policy of which I had constantly warned can be avoided.
*79

THE LENGTH OF THE LONG RUN

In
Prices and Production Hayek did not take up the question of how long a cyclical expansion might last. He assumed that reserve losses or price inflation would eventually compel banks to raise the loan rate.
*80 He subsequently argued that even if banks maintained interest rates below the equilibrium level, the operation of the Ricardo effect would bring the expansion to an end. In his discussion of expectations, he was somewhat vague on
timing matters, as is characteristic of most macroeconomic theories. In 1969 Hayek appeared less sanguine about whether the Ricardo effect would check an expansion in the absence of a rise in market interest rates. To him, it was “an open question” how long investment expenditures could be maintained in excess of planned saving. The actual check might only come when price inflation was so great that “money ceases to be an adequate accounting device.” “But this cannot be further discussed without raising the problem of the effect of such changes on expectations—a problem which I do not wish to discuss here.”
*81 The thorny problem remained.

Determining the importance of the Ricardo effect would have one tangible benefit that I have not seen discussed. The Ricardo effect offers an explanation of the Phillips curve phenomenon. The observed relationship between the rate of change of wages and unemployment occurs if workers suffer a short-run money illusion but in the long run react only to changes in real magnitudes. This approach to the Phillips curve has become quite popular. If the rate of increase in nominal wage offers is higher than expected, the worker will assume he is being offered a greater command over society’s output; unemployment will decrease
as more workers accept employment at the going wage rate. When workers realize that the prices of consumer goods are increasing as fast as wage rates, unemployment will once again increase. There will then be “high” unemployment and “high” inflation. The Phillips curve will shift, as it were, from
A to
B.*82