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July 13, 2021 Reading Time: 14 minutes

Over the last few months, fears over rising price inflation have, again, become the focus of political policy makers and media pundits. While generally rising prices have a variety of deleterious effects, attention is often not given to how inflationary processes work, their negative effects beneath the surface of measured movements in the “price level.” Ninety years ago, the importance of these aspects of an inflationary process were emphasized by Austrian economist, Friedrich A. Hayek (1899-1992).

Nine decades ago, in January of 1931, Hayek, then a little known 31-year-old economist, arrived in London, England from Vienna, Austria to deliver a series of lectures at the London School of Economics (LSE). The lectures were a surprising success, especially since Hayek’s thick Viennese accent made it difficult for some who attended to easily follow his arguments, according to those who were in the audience. 

In Austria, Hayek had been serving since 1927 as the first director of the Austrian Institute for Business Cycle Research, an organization founded with the support and assistance of his mentor, the well-known Austrian economist, Ludwig von Mises. In short order, Hayek had built up the reputation of the Institute, partly through collaboration with the economic research branch of the League of Nations in Geneva, Switzerland, and significantly due to the quality of the economic analysis Hayek offered in the Institute’s monthly bulletins interpreting economic and financial trends in Austria and Central Europe in general. 

But within a few months of delivering those lectures at the LSE in early 1931, Hayek’s life was to radically change. Later that spring he was offered a visiting position at the LSE for the 1931-1932 school term, a position that shortly afterwards became a permanent professorship, with Hayek remaining at the London School until the late 1940s.

Hayek Became a Leading Critic of Keynes’s Economics

Not long after his arrival in London in the autumn of 1931 to take up his teaching duties at the LSE, his January lectures were published under the title, Prices and Production. With the publication of this relatively slender volume (only 112 pages), Hayek was catapulted into international stature with the presentation in English of his version of the “Austrian” theory of the business cycle, and through this he was soon considered one of the leading rivals of Cambridge economist, John Maynard Keynes, for explaining the causes, consequences, and cures for the Great Depression through which the world was suffering. 

In late 1931 and early 1932, Hayek published a lengthy and detailed two-part review essay of Keynes’s recently published, A Treatise on Money (1930) in the pages of Economica. Keynes had hoped that with this book he would be established as a leading monetary theorist. Instead, many of the most notable economists of the time criticized various aspects of his theories. But the coup de grace that buried Keynes’s two-volume work, was Hayek’s devastating review. 

It forced Keynes to lick his wounds and rethink much of what he wrote, only reappearing in 1936 with his famous and most influential work, The General Theory of Employment, Interest and Money. But criticisms that Hayek made of A Treatise on Money, were just, if even not more, relevant against The General Theory

“Mr. Keynes’s aggregates conceal the most fundamental mechanisms of [economic] change . . . Mr. Keynes’s assertion that there is no automatic mechanism in the economic system to keep the rate of saving and the rate of investing equal might with equal justification be extended to the more general contention that there is no automatic mechanism in the economic system to adapt production to any shift in demand. I begin to wonder whether Mr. Keynes has ever reflected upon the function of the rate of interest in . . . society.” 

Hayek on the Fallacies of Price Level Stabilization

Hayek had started making a name for himself in the German-speaking world of economists with a book that was published in 1929, Monetary Theory and the Trade Cycle (an English translation of which appeared in 1933). In the 1920s, the U.S. Federal Reserve had set as one of its policy targets the “stabilization” of the general price level; that is, neither price inflation nor price deflation, under the presumption that such a policy goal would help prevent the booms and busts of the business cycle.

Hayek argued that the policy of price-level stabilization was creating imbalances in the market by preventing a fall in prices in the face of cost efficiencies and greater supplies of goods offered in the market. He said that if a proper balance between supplies and demands was to be maintained through time, then the price of each good had to reflect the actual supply and demand conditions in existence in the various markets during each time period. Any attempt to “stabilize” the price of a good or a set of goods at some given “level” across time, in spite of differing market conditions that might arise as time passed, would set in motion market responses that would be “destabilizing.” 

Instead of allowing a downward trend in prices to naturally occur, the Federal Reserve increased the supply of money in the American economy to counteract the normal process of benign price deflation in the face of lower production costs and greater output. In aggregate terms, the amount of money demand for goods and services was increased just enough to match the increase in the quantity of those goods and services offered on the market to maintain the general statistical average of prices at a fairly “stable” level throughout most of the 1920s, as measured by the wholesale price index. 

In an economy experiencing increases in productivity and capital formation, Hayek reasoned, the resulting cost efficiencies and increased productive capacities in various industries would tend over time to put downward pressure on prices because of the increased supplies of goods offered to consumers on the market. The price of each of these goods would decrease to the extent required to ensure that the market in which each good was sold was kept in balance. 

Over time, the average level of prices as measured by some statistical price index would record that there had occurred a “deflation” of prices. But such a price deflation was not only not harmful in its effects, but was essential if the market-determined structure of relative prices was to keep the supply and demand for each individual good in balance with each other through time. 

But in Hayek’s view, it was this attempt at price level stabilization by the Federal Reserve, and the “beneath the surface” imbalances being created among and between sectors of the American economy that finally led to a “break,” in the form of the economic downturn of 1929-1930, which snowballed into the severity of the Great Depression.

Time and the Periods and Stages of Production

In Prices and Production, Hayek explained in more detail the logic of this argument. In doing so, he built upon the earlier writings of Ludwig von Mises’s The Theory of Money and Credit (1912; 2nd ed. 1924) and Monetary Stabilization and Cyclical Policy (1928), who, in turn, had synthesized ideas developed by the Austrian economist, Eugen von Böhm-Bawerk and the Swedish economist, Knut Wicksell.  

Time is an element inseparable from the human condition. Everything we do involves time. Every one of our actions requires us to think about time and to act through time. Whether it is boiling an egg or traveling by train or car to another city or country, we are confronted with the necessity of waiting for the desired result to be forthcoming. We apply various means at our disposal that seem most appropriate to the tasks at hand and we try to bring about the desired ends we have in mind. 

But the cause (the application of the means) always precedes the effect (the resulting end or goal); and between the initiating of that cause and its resulting effect, there is always a period of time, whether that time period is merely a few minutes or many years. Each of our plans, therefore, contains within it a period of production

Rarely, however, can our production plans be completed in one step. Usually the resources at our disposal must go through various transformations in a number of stages of production before the consumer goods that we want are ready for use in their desired, finished form. A tree must be chopped down in the forest. The wood must be transported to and cut in the lumber mill. The cut wood must be taken to the pulp factory and manufactured into paper. The paper must be boxed and shipped to the printing shop. The paper must be cut to size and the print must be applied to the separate pages to produce a book that gets into our hands after purchasing it at a bookstore or ordering it online. What is expressed in this simple example has its analog in every line of production for the manufacturing of every conceivable good. 

Saving, Investment, and the Rate of Interest

To undertake these processes of production, however, requires a certain amount of savings. Resources and raw materials that might otherwise have been used to satisfy some of our wants in the more immediate present must be freed for more time-consuming production activities. First, some of these resources must be available for transformation into capital goods – tools, machinery, and equipment – with which workers who are not employed in the more direct manufacture of consumer goods can combine their efforts in more time-consuming or “round-about” production processes. 

Second, resources and consumer goods must be available for use by those employed in the production processes. The more savings there are, the more numerous the processes of production that can be undertaken in society – and the longer they can be. And as a result, the greater will be the quantities and the qualities of the goods that will be available for our consumption uses in the future. Why? Because other things being equal, the more time-consuming or “round-about” the production process, the more productive (usually) are the resulting methods of production. 

However, the longer the periods of production we utilize, the longer we have to wait for the desired goods we wish to use or consume. People, therefore, have to evaluate the sacrifice, in terms of waiting, they are willing to make to get a potentially greater and more desired effect that can only be attained by producing for a time further into the future. 

The sacrifices of time people are willing to make often differ among individuals. And these differing evaluations of time open up opportunities for potential gains from trade. Those who are willing to defer consumption and the uses of resources in the present may find individuals who desire access to a larger quantity of resources and goods than their own income and wealth provides them with in the present. And this second group of people may be willing to pay a price in the future for the use of those resources in the more immediate present. 

An intertemporal price emerges in the market as transactors evaluate and “haggle” over the value of time and the use of resources. The rate of interest is that intertemporal price. The rate of interest reflects the time preferences of the market actors concerning the value of resources and commodities in the present in comparison with their value in the future.

Interest Coordinates Saving, Investment, and the Periods of Production

As the price of time, the rate of interest brings into balance the willingness to save by some with the desire to borrow by others. But the rate of interest not only coordinates the plans of savers and investors. It also acts as a “brake” or “regulator” on the lengths of the periods of production undertaken with the available savings in the society. 

For example, suppose we were to ask, what are the respective present values of a $100 return on an investment either one year, two years, or three years from now, with a market rate of interest of, say, 10 percent? They would be, respectively, $90.91, $82.64, and $75.13. Now, suppose that people in the society had a change in their time preferences such that they now chose to save more, with the resulting greater supply of savings available for lending purposes decreasing the rate of interest to 7 percent. What, again, would be the present values of that $100 return on an investment one, two, and three years from now? The present values would be, respectively, $93.46, $87.34, and $81.63. 

The present value will have increased for all three of these potential investments, with their different time horizons. But the percentage increases in the present values of these three possible investment horizons would not be the same. On the one-year investment project, its present value will have increased by 2.8 percent. On the two-year investment project, its present value will have increased by 5.7 percent. And on the three-year investment, its present value will have increased by 8.6 percent. Clearly, the tendency from a fall in the rate of interest would be an increase in investments with longer periods of production. 

If, instead, time preferences were to move in the opposite direction, with people choosing to save less, with a resulting increase in the rate of interest, longer-term investments would become relatively less attractive. If the rate of interest were to rise from 7 percent to 10 percent, the present values on a $100 return for either one, two, or three years from now would decrease, respectively, by 2.7 percent, 5.4 percent, and 8 percent. This would make investments with shorter periods of production appear relatively more attractive. 

In an economy experiencing increases in real income, decisions by income-earners to save a larger proportion of their income need not require an absolute decrease in consumption. Suppose income-earners’ time preferences were such that they normally saved 25 percent of their income. Out of an income of, say, $1,000, they would be saving $250. If their preference for saving were to rise to, say, 30 percent, with a given income of $1,000, their consumption would have to decrease from $750 to $700 to increase their savings from $250 to $300. 

However, if income-earners were to have an increase in their real income to, suppose, $1,100 and their savings preference were to increase to that 30 percent, then they would now save $330 out of their higher income. But consumption would also rise to $770. This is the reason why savings can increase for new capital formation and investments in even longer periods of production without any absolute sacrifice of consumption in a growing economy. Consumption increases with the higher real income, albeit less than it could have if income-earners had not chosen to save a greater percent of their income.

Price Level Stabilization Distorted Investment Decision-Making

But what happened in the 1920s, leading to the economic downturn of the early 1930s, Hayek argued, was that by trying to maintain that relatively stable price level, the Federal Reserve had to increase the supply of money and credit sufficiently to induce enough investment borrowing and spending into the economy to counteract what would have been that greater goods-induced decline in prices. 

The problem, Hayek explained, was the rate of interest which equilibrates the supply of real savings and the demand for capital would not be a rate of interest which also prevents changes in the price level. Said Hayek: 

“In this case, stability of the price level presupposes change in the supply of money . . . The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price-level stable, is always lower than the rate which would keep the amount of available loan-capital equal to the amount simultaneously saved by the public: and thus, despite the stability of the price level, it makes possible a development away from the equilibrium position.”

Institutionally, increases in the money supply are introduced in the form of increased reserves supplied to the banking system by the Federal Reserve, on the basis of which additional loans may be extended. But the only way banks can induce potential borrowers to take up the increased sums of lendable funds is to lower the rate of interest at which the banks offer to lend them. 

The lower rate of interest decreases the cost of borrowing relative to the expected rate of return from various investment projects. But the rate of interest is not only a measure of the cost of loans; it is also the factor by which the prospective value of an investment is capitalized in terms of its present value. The lower rate of interest also acts, therefore, as a stimulus for the undertaking of longer-term investment projects involving time horizons further into the future than would have been the case at the higher rate of interest that would have prevailed on the loan market if not for the increase in the money supply. 

Thus, in the 1920s, beneath the apparent calm of a stable price level, Federal Reserve policy was creating a structure of relative price and profit relationships that induced a number of longer-term investments that was in excess of actual savings to sustain them in the long run. Why were they unsustainable in the long run? Because, as the new money was spent on new and expanded investment projects, the additional money eventually passed into the hands of factors of production drawn into those employments as higher money incomes. 

As the higher money incomes were then spent in the market, the demands for consumer goods increased as well, acting as a counterpull to attract production and resources back to consumer goods production and investment projects with shorter time horizons. Only with further injections of additional quantities of money into the banking system was the Federal Reserve able to keep market rates of interest below their proper equilibrium levels and thus able to temporarily maintain the profitability of the longer-term investment projects set into motion by the attempt to keep the price level stable.  

Finally, in 1928, under the pressure of this monetary expansion, the price level began to rise. The Federal Reserve, fearful of creating an absolute inflationary rise in prices, reined in the money supply. But with the end to the monetary expansion, interest rates began to rise to their real market-clearing levels. Some of the longer-term investment projects that either had been brought to completion or were still in progress were shown to be unprofitable at the higher rates of interest. The investment “boom” collapsed, with its first major indication being the “break” in the stock market in October 1929. 

In 1932, in an article on, “The Fate of the Gold Standard,” Hayek summarized what he considered to be the lessons of the 1920s: 

“Instead of prices being allowed to fall slowly, to the full extent that would have been possible without inflicting damage on production, such volumes of additional credit were pumped into circulation that the level of prices was roughly stabilized…. Whether such inflation merely serves to keep prices stable, or whether it leads to an increase in prices, makes little difference. Experience has now confirmed what theory was already aware of; that such inflation can also lead to production being misdirected to such an extent that, in the end, a breakdown in the form of a crisis becomes inevitable. This, however, also proves the impossibility of achieving in practice an absolute maintenance of the level of prices in a dynamic economy.” 

Corrective forces in the market were set in motion, once the monetary expansion had come to an end. But the depth and duration of the Great Depression turned out to be far greater and longer than would have normally seemed to be required for economy-wide balance to be restored. The reasons for the Great Depression’s severity were not, however, to be found in any inherent failure of the market economy, but rather in the political ideologies and government policies of the 1930s.

Severity of the Great Depression Due to Government Intervention

Shortly after Hayek had delivered those lectures at the LSE that became Prices and Production, his mentor, Ludwig von Mises, delivered a lecture to a group of German industrialists in February of 1931, on The Causes of the Economic Crisis, in which he summarized the policy dilemma arising from the government interventions that were interfering with the market’s own rebalancing and correcting processes to restore economy-wide coordination and full employment. Said Mises:

“If everything possible is done to prevent the market from fulfilling its function of bringing supply and demand into balance, it should come as no surprise that a serious disproportionality between supply and demand persists, that commodities remain unsold, factories stand idle, many millions are unemployed, destitution and misery are growing and that finally, in the wake of all these, destructive radicalism is rampant in politics . . . With the economic crisis, the breakdown of interventionist policy – the policy being followed today by all governments, irrespective of whether they are responsible to parliaments or rule openly as dictatorships – becomes apparent . . . Hampering the functions of the market and the formation of prices does not create order. Instead it leads to chaos, to economic crisis.” 

Throughout the 1930s, Hayek was one of the most quoted and referenced monetary and business cycle economists of that time in the English-speaking world. Indeed, a survey of economics journals from that decade showed that Hayek was the third most cited economist, after Keynes and Dennis Robertson, a highly regarded monetary theorist who also taught at Cambridge University. 

Hayek’s policy prescriptions for recovering from the Depression were, like Mises’s, for free, competitive markets; less government interference with prices and wages; reduced government taxing and spending; and an end to central bank manipulations of money and interest rates to forestall any new boom and bust.

Hayek’s Intellectual Eclipse Until the Nobel Prize

But these policy proposals led Hayek to go against the tide of the time with its growing calls for government deficit spending, increased regulatory and restrictive intervention, and proposals for more radical socialist planning “answers” to the problems of the Great Depression. By the second half of the 1940s, in the aftermath of the Second World War, Keynes and the Keynesian Revolution had conquered the monetary and fiscal policy debates. As a consequence, Hayek’s analysis of the business cycle was not only rejected by the large majority of professional economists, but his ideas in general went into a near full eclipse for almost a quarter of a century. 

Only following Hayek being awarded the Nobel Prize in 1974 for his work on money and the business cycle and his analysis of the coordinating role of competitive prices in a world of decentralized knowledge, did his important place on matters of economic theory and policy, and the political economy of a free society, once again receive the recognition he rightly deserved.

We are presently witnessing a vigorous revival of many of the same social engineering and central planning ideas that Hayek confronted in the 1930s and 1940s. The statist interpretations of the financial crisis of 2008-2009, the paternalist legacy of last year’s government lockdowns and shutdowns in the face of the coronavirus, and the fanaticism of the global warming gloom and doomers, as well as the tribal identity politics warriors, are all threatening a dangerous turn into an even more collectivist direction than we have already been traveling down. 

Central banks have been hellbent on tidal waves of monetary expansion. Market-interest rates have been manipulated down to zero through Federal Reserve policy. Governments have embarked on fiscal madness with tens of trillions of dollars of accumulated debt, and still rising. And the political paternalists are pushing to straightjacket the economy within forms of fascist-like central planning in the name of “saving the planet.”

At some point, a new recession or even depression will emerge, and the hand wringing of the “politically correct” will all point at new accusations of another “failure of capitalism.” It is essential that they be responded to with sound, reasonable, and persuasive ideas that the culprits for any economic disaster are to be found in the halls of government and not in the marketplace of free enterprise. 

Hayek’s monetary and business cycle writings from 90 years ago, and his many contributions to the general understanding of the dynamic market process and the limits to government omniscience, are and will be crucial to that task of fighting for the free and prosperous society.  

Richard M. Ebeling

Richard M. Ebeling

Richard M. Ebeling, an AIER Senior Fellow, is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel, in Charleston, South Carolina.

Ebeling lived on AIER’s campus from 2008 to 2009.

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