Hayekian Credit Booms

by Andreas Hoffmann

Currently there is an interesting discussion in the blogosphere on how it is possible that in Hayek’s Prices and Production framework consumption and investment can increase at the same time.

In my opinion they cannot, or only very slightly, but this is not a problem! Because,

1) the explanation is not one of the boom, but of the upper turning point, for methodological reasons Hayek restricts himself to begin the analysis at full employment. But this is not necessary for the a Hayek-style story 2) the credit boom starts before the turn-around, and 3) a growing economy can grow faster in some sectors and less in others. But it might grow in all sectors during the credit boom.

I explain the credit boom as follows:

At the beginning of the upswing, investment demand, and with it the natural rate of interest, increases. However, the central bank stimulates spending during this period of less than full employment. Thus banks lend below natural rates. At these rates the production of capital goods is relatively more lucrative than it otherwise would be (they are capital intensive).

But ex-ante saving is low and therefore especially durable consumption good demand picks up as well. The rise in durable consumer goods production will lift prices for available capital goods (ppi) and reinforce the cycle. More resources are employed in capital goods and durable consumption goods sectors. These sectors expand relatively more than others during the upswing while the economy starts to grow. In this period of the cycle, we have a co-movement of growing investment and consumption because of unemployed resources and growth.

While the central bank slowly increases policy rates to balance the economy, some households buy assets to participate in the boom. Rising asset markets improve balance sheets of firms and banks. The expected returns on investment keep rising with the risen policy rate. Again, banks are inclined to lend below the ever rising natural rate. The credit boom gains new momentum, both consumption and investment are fuelled. During the credit boom the investment risk in the economy is high, because much production depends on too low capital market rates and asset price increases.

At some point, capacity limits are reached (e.g. labor is scarce). Temporary over-employment of resources may continue to satisfy the ever increasing demand. While this causes a more rapid depreciation of capital goods, the immediate profits may seem more attractive. Finally overconsumption emerges, when production growth cannot keep up with steadily rising wages and consumption.

As more money chases a stagnating amount of goods, the boom turns bust, when overconsumption leads to serious consumer price inflation and over-employment of resources (necessary because other resources are held in overinvested capital good industries) does not allow keeping up the production level. Then the central bank increases the policy rate to fight inflation and/or banks reassess the credit risk of investment, because first capital goods seem unprofitable.

With capital market rates rising towards the natural rate, investment projects that are not lucrative at higher rates are dismantled. Capital goods remain unfinished as expected returns fall. Also durable consumer goods production is unsustainable at higher rates. Asset prices burst and worsen balance sheets of firms and banks. This leads to further disinvestment. Wages fall, unemployment rises and less is produced. In this situation ex-ante saving is higher than investment. Thus, due to falling consumption preferences, produced goods (especially durable goods) and capacities lose value and prices deflate (so that ex-post savings and investment are equal again).

21 thoughts on “Hayekian Credit Booms

  1. This theory begins with unemployed resources, which means that it begins with the economy on a point below the PPF. So, I don’t think this story is really saying that consumption and investment can rise at once “only very slightly”.

    The problem with PPF based frameworks like Hayek’s in P&P is that they begin by assuming that something must be done with the available stock of input. They don’t adequately cope with the option of keeping it. This is Gene Callahan’s point when he talks about leisure and resources and the gaps in Say’s law.

  2. @Current

    I believe that in Hayek’s crisis resources are set free through in the restructuring process. So there must be unemployed resources at the beginning of a cycle.

    Also Note 3)

    There is no reason to believe that during an upswing there is no technological progress or growth.

    The problem of too low interest rates becomes obvious only in the late stages of my credit boom. Otherwise it would not start.

  3. To elaborate the methodological point in Hayek’s development of the cycle theory in Prices and Production:

    Hayek followed the traditional or orthodox comparative static analysis (later elaborated by Fritz Machlup). First, you postulate an equilibrium, not because you think it is a realistic picture of the world, but because it serves to isolate analytically the source of a disturbance.

    Second, in this disturbance-free world you analytically create a shock. Here that would be a lowering of the bank rate of interest below the natural rate.

    Third, you trace out the initial effects of that change on the production structure (eg, lengthening,etc). In that analysis you discover that these initial effects are not equilibrium or sustainable effects. To restore equilibrium certain other changes must happen. The production structure must reflect the accurate-communicated preferences of agents. Thus, the crisis ensues. But analytically you end the story in a new equilibrium.

    Notice what Hayek was trying to do. He was trying to do business cycle analysis with the equilibrium tools of comparative static analysis! As a result, certain problems or lack of correspondences with reality arose.

    Therefore, while beginning the analysis in a situation of unused resources (which Hayek later did) may not be not methodologically satisfying, it seems to add some realism to the model.

    Nevertheless, this is an important and not easy issue.

  4. He in significant measure pitched that over the side with his _The Pure Theory of Capital_, didn’t he?

    Mario writes,

    “what Hayek was trying to do. He was trying to do business cycle analysis with the equilibrium tools of comparative static analysis!”

    And he began doing it with his introduction of the intertemporal equilibrium construction in 1928 …

  5. Andreas,

    > I believe that in Hayek’s crisis resources
    > are set free through in the restructuring
    > process. So there must be unemployed
    > resources at the beginning of a cycle.
    > Also Note 3)
    > There is no reason to believe that during
    > an upswing there is no technological
    > progress or growth.

    Yes, I agree with that.

    I think I may have misunderstood your point. Are you saying that:
    * Hayek’s P&P model leaves little scope for consumption and investment rising at once.
    * But, in a real world with disequilibrium and unemployment they will, and that doesn’t necessarily contradict ABCT.

    Or are you saying that *you think* there is little scope for consumption and investment rising at once in real economies? If you mean the latter then I disagree with you.

  6. Mario’s elaboration underlines the fact that we have not recast ABCT with an eye to testing. We have not done the equivalent of Friedman’s theory of the consumption function. It’s hard to see how we can make any real progress (internally or with others) until we do.

  7. Roger — this has to be a task for someone with tenure.

    You can’t ask an untenured guy to sacrifice his life, give the current guild set up of economic.

  8. Greg: I’m not tracking. How does your comment affect the veracity of my remark? Anyway, I don’t think you’re right on this point.

  9. Roger, I agree with your observation.

    As I see the profession, doing such work is a risky career move — such work is likely to be politically and scientifically radioactive and suspect for any newbe attempting to make there way on the job market.

    If I’m wrong, that’s good.

    I take a dim view of the scientific health of your profession — given its extremely narrow guild structure and bogus pretentions to “science” –especially in the domains of macroeconomic and econometrics.

    It would be great if I was completely mistaken about this, and a GMU grad student could do such work and get hired at a top 30 dept. — or top 50 or 60 dept.

    I’d genuinely like to seem it. The profession wouldnbe in better health and would encourage greater scientific creativity & diversity than I have reason to believe is the case.

  10. If I may be permitted to add some doctrinal history. Already, admittedly in passing, in Mises’ 1928 monograph on “Monetary Stabilization and Cyclical Policy,” he mentions the possibility of unemployed resources at the beginning of the cycle, and then has a subsection on this in “Human Action.”

    In “Profits, Interest, and Investment,” (1939) Hayek starts the analysis with unemployment, to show (in his new Ricardo Effect version) how this does not fundamentally change the outcome of the story.

    Also, in Erik Lindhahl’s 1930 monograph, “Methods of Monetary Policy” (partly included in the “Studies in the Theory of Money and Credit,” which appeared in English in 1939), he follows rather closely a Wicksell-Mises type story of the phases of the business cycle.

    But . . . he develops it under four scenarios. At the beginning of the cycle: (1) both consumers goods and investment goods sectors are fully employed; (2) the consumer goods sector is fully employed, but there is unemployment in the investment goods sector; (3) there is unemployment in the consumers goods sector, but full employment in the investment goods sector; and (4) there is initially unemployment in both the consumer goods and investment goods sectors.

    And he shows that the outcome of unsustainable mis-allocations of resources among the sectors still ends up resulting in an “boom” that must lead to a correcting downturn.

    As I recently explained in some detail in a comment to a posting on “Coordination Problem,” both Hayek in “Monetary Theory and the Trade Cycle” and Mises in “Human Action” presume that the cycle is superimposed on an economy that is growing. And Mises, in particular, uses this to explain why during the upturn there can be both what he refers to as “over-consumption” spending and “mal-investment” in the capital goods sectors.

    Thus, the mis-directions of resources as the cycle occurs is “superimposed” in a setting in which the production possibility frontier is moving out to the right.

    Richard Ebeling

  11. “At the beginning of the upswing, investment demand, and with it the natural rate of interest increases”

    Is this correct or a typo? investment demand =? loanable funds, more = lower interest rate ?

    Thanks, Don

  12. @ Richard Ebeling

    I also thank you for this comment.

    @ Don Lloyd,

    This is not a typo.

    I think the “Monetary theory of the trade cycle” start of the upswing is more realistic:

    Innovations or/and higher expected returns on investment start the cycle.

    Thus the investment curve shifts to the right. The natural rate of interest increases. Now banks would have to increase capital market rates to keep the economy in equilibrium. But they hold rates low and stimulate investment (as central banks allow them to do so).

  13. “…the cycle is superimposed on an economy that is growing.”

    It took me a while to get the importance of that statement. The fact that the economy is growing makes it possible to increase consumption and investment at the same time.

    There are so many explanations of why this happens by Austrian economists that I’m totally amazed that some people think it contradicts the same theory. And yet those critics claim to be experts on Austrian econ. Go figure!

  14. Maybe we shouldn’t say that credit expansion causes the economy to produce beyond the PPF. Conceptually that’s difficult. Capital consumption and using previously ignored resources can work for only a very short period of time. Maybe what we should say is that when we hit the new PPF after years of using up idle resources, the PPF if the brick wall that the economy runs into. Hitting the new PPF is what causes the malinvestment made during the expansion (the trip from a point inside the old PPF to the new PPF) to be revealed. That malinvestment is revealed, becomes worthless and sends the economy spinning backwards to a point inside the new PPF. What do you think?

  15. Non-economic goods become inputs to production when the time and complexity structure of production deepens — allowing temporarilly greater output and contributing to larger GDP.

  16. Greg, couldn’t one say that all unused resources are non-economic goods during the recovery from a depression?

  17. Roger — goods become non-economic for different reasons.

    Modern macroeconomists don’t allow most of this into their small mental universe.

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