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,

Mark. Economic Theory in Retrospect. Cambridge: Cambridge University Press,

1978. 571-74. Butler, Eamonn. Hayek: His Contribution to the Political and

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Hagemann, H., and Hamouda, O. Economics of F.A. Hayek. (Vol.2, pp xii- xiii).

Edward Eglar Publishing Limited. England. 1994. Haney, Lewis H. History of

Economic Thought. New York: The Macmillan Company, 1949. 667-84. O’Driscoll,

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-

Century Social Thought. Oxford: Blackwell Publishers, 1993. 55-57. Palgrave,

Robert Harry Inglis. "Friedrich August von Hayek". The New Palgrave: A

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C 1987. Palgrave, Robert Harry Inglis. "Ricardo-Hayek effect". The New

Palgrave: A Dictionary of Economics. (Vol. 4, pp. 198-99). The Macmillan Press

Limited. USA. C 1987. Spiegel, Henry. The Growth of Economic Thought. New

Jersey: Prentice-Hall, Inc., 1971. 543-44. Tomlinson, Jim. Hayek and the Market.

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