Hayek’s Contribution To The Business Cycle Essay, Research Paper

Hayek’s Contribution to the Business Cycle

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.

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