Monetary Theories of the Cycle



(A) Money and Cycle Traditions

In business cycle theory, the Continental tradition has tended to be to emphasize that it is "real" phenomena -- technological change in particular -- that pushes the economy out of equilibrium and that it is the consequent unbalanced structure of the real economy that drives the cycle. It is important to note that, for the Continental tradition, it is a horizontal unbalancedness, i.e. disproportionalities across sectors of the economy at a point in time, that drive the cycle In contrast, the Anglo-American tradition is to focus on how "external" things like psychology or credit, can "unbalance" the economy and drive the cycle. But for Anglo-Americans the unabalancedness is vertical, i.e. difficulties in coordinating across time.

In both these theories, credit plays a role -- in particular, the starting point for all of them is Knut Wicksell's insight on the relationship between the "natural" rate of interest and the "money" rate of interest. But Wicksell's theory of the cumulative process was talking about money and prices, consequently, it was natural to turn explicit attention to the interrelationship between money, prices and the cycle. This was the main endeavour of Ralph G. Hawtrey and Friedrich A. von Hayek in the 1920s.

When grafting a monetary theory into a cycle theory, one must already have some sort of idea of how the cycle process works itself through. This is where the division between the Continental and Anglo-Ameican traditions in cycle theory is useful way of dividing the monetary cycle theories as well. Hawtrey, a Cambridge economist, naturally adopted the Anglo-American approach for his underlying cycle, while Hayek, an Austrian economist at the L.S.E., took adopted the Continental approach. Consequently, for Hawtrey, the economy is a "single-sector" entity and the cycle is driven by vertical unbalancedness -- miscoordination across time (caused by money, of course). For Hayek, the economy is a "multi-sectoral" complex, and thus the cycle is driven by horizontal unbalancedness -- miscoordination across sectors (caused by money as well). Thus, Hawtrey is unconcerned with relative prices; money influences his "single-sector" economy by affecting the absolute price level. In contrast, for Hayek's multi-sector economy, it is how money affects relative prices that is the key to the cycle. Absolute prices, in Hayek's view, are irrelevant.

(B) Hawtrey's Pure Money Cycles

R.G. Hawtrey has perhaps the most famous "pure money" theory which he outlined in a barrage of articles and books (1913, 1926, 1928, 1933, 1937). His theory, as noted, is Wicksellian in many respects. But his chief characters are wholesalers and middlemen who rely unduly on bank credit and are thus highly sensitive to interest rates. Any slight injection of money which lowers the money rate of interest induces these middlemen to increase inventories. They do so by borrowing from banks increases and demanding increases in production from firms. But because increasing production takes time, the money supply of the economy is momentarily too large for the given amount of income (think of a Cambridge cash-balance theory). This "unspent margin" leads to higher demand for goods by consumers - but that extra demand will itself lower the inventories of these middlemen. Realizing their falling inventories, they will then call again upon firms to step up production and borrow money to do so. But again that leads to an excess supply of money, etc.

The turning points in the Hawtrey cycle arise when production (and thus income) finally catches up with the higher money supplies. They will catch up, Hawtrey tells us, because banks will begin to close off credit when they see their reserves being stretched too far. Then we jump into the recession: when banks stop lending to middlemen, these will reduce their demands on firms. Production will slow down and so will incomes - but with a lag again. The fall in money supply comes first and so consumers now have excess demand for money and will thus lower their demand for goods. That leads to inventory build up and a further demand by middlemen that production reduce further. The downturn continues until the banks are flushed with money once again and need to lend out.

(C) Hayek's Monetary Theory

Hawtrey's theory is interesting, but, as noted, is very "vertical". The cycle theory of Friedrich Hayek (1929, 1931) is concentrated on "horizontal" aspects and thus closer in spirit to the Continental tradition of Spiethoff and Cassel. Hayek's theory combins Wicksellian themes with the concept of changing factor proportions - namely, what he calls "lengthening" and "shortening" of the "period of production", Austrian concepts we may interpret loosely as "increasing" and "decreasing" the production of capital goods relative to consumer goods.

F.A.Hayek's theory of business cycles starts on a Wicksellian footing: a credit expansion at the trough because the accumulation of loanable funds has led the "natural" rate of interest to fall below the "real" rate of interest. An investment expansion ensues and thus capital goods are demanded.

However, the initial raise in the demand for capital goods, by itself, essentially means that the aggregate demand in an economy is greater than aggregate supply. Assuming the economy to be resource constrained, this implies that firms must decide whether to simply not respond to the higher capital demand and keep on producing the same consumer goods as before or else to respond and thus produce more capital goods and reduce the production of consumer goods. Hayek argued the latter would happen - and thus the proportion of capital to consumer goods would rise.

But when we keep aggregate supply fixed, that means consumer income is kept fixed - thus consumer demand for consumer goods has not dropped. But the supply of consumer goods has dropped. Thus, there will be what Hayek called "forced savings": consumers are forced to save simply because there are no more consumer goods to buy. This increase in savings, we must note, will fund the initial expansion in credit.

But then our story would end without fluctuations in output. Let us then follow Hayek and argue that aggregate supply is not completely fixed and that new resources are brought into use. Then capital goods and consumer goods production will both rise. This is a general expansion of output. But expansion of output in general means higher income and higher income in general and thus higher consumer demand. As a result, consumers demand more consumer goods and place pressure on the consumer goods industry to produce more.

This can continue until the full employment level is reached. Then the aggregate supply constraint we spoke of comes in force. Assuming proportions are not changing, the rising demand for consumer goods leads to rising prices in the consumer goods industry relative to capital goods. This is merely the expression of forced savings again. But what effect will this have? The rising prices of consumer goods make the consumer goods industry more profitable relative to the capital goods industry. They can thus begin to outcompete the capital goods industry on the (now very tight) factor markets: i.e. consumer goods industries will start getting the labor and capital that the capital goods industry used to command. This bidding war leads to a rise in factor costs overall - rises in wages and rises in the money loan rate. This is the peak of the cycle.

What happens then? Hayek suggested the rising costs in the economy and the relatively poorer position of the capital goods industry will lead make them less profitable to begin with; furthermore, the rising loan rate will only lead to a decrease in investment and thus a decrease in demand for their products. In short, faced with lower profit and lower demand, the capital goods industry will shrink in size relative to the consumer goods industry. The downswing is on.

During the downsing, as the capital-goods industry shrinks, people who were employed by that sector will be laid off. That will lead to a decline in the demand for consumer goods, which now will lead to a shrinkage in the consumer goods industry. But the shrinkage in the consumer goods indutry means that now investment demand will drop even further (as consumer goods firms also demand capital). That will lead to a further shrinkage of capital goods production and so on. As a result of the general collapse in output and collapse in investment demand, loanable funds will again start piling up unused at the banks and there thus money (loan) rate will start falling. A point will come, argued Hayek, when the loan rate will collapse below the natural rate and investment picks up again. This way, the trough is reached and the capital goods industry begins producing again - and thus expansion arises.

The main points to note about Hayek's theory are these: if there was no banking system providing credit, there would be no cycle because everything would have to be in equilibrium. It is money (or, more precisely, the supply of credit by banks at a rate below the real rate of interest) which is disequilibrating demand and supply for capital goods and consumer goods. During the expansion there is a "lengthening of the period of production", i.e. an rise in capital goods production relative to consumer goods, but both sectors are increasing output. During the contraction, there is a "shortening of the period of production", i.e. fall in the amount of capital goods produced relative to consumer goods, but both sectors are decreasing output. This "lengthening"/"shortening" during the expansion/contraction is what earned it the name of "Concertina Effect".

Most importantly, the turning point of the cycle is caused by consumers demand too much. Thus excess consumer demand is the direct cause of recessions (the indirect cause is the earlier overinvestment or, more precisely, the banking sector's cheap lending policies which started the whole thing.)

Hayek's ex-student (but now turned Keynesian), Nicholas Kaldor (1939) disagreed with his old master at L.S.E.. He proposed that the proportion of capital goods to consumer goods should actually fall rather than rise during the expansion. According to Kaldor, at the trough, firms as a whole are operating with excess capacity. In other words, there is a fixed stock of capital, part of which is not being used (by which we mean, labor is not being applied). Consequently, as the upswing begins, it would be madness if the first thing entrepreneurs did was go build more machines and raise capacity even more. Rather, Kaldor argued, during the initial stages of the upswing, more labor will get hired, but no new capital will be demanded. Thus consumer demand rises first, and thus consumer industries' profitability rises - and thus loanable funds are allocated to these. Thus, consumer goods industries should rise in proportion to the capital goods industry during the expansion. When firms reach their existing capacity, Kaldor went on, then they will begin to demand capital. Only then will demand for capital goods rise.

In the downswing, Kaldor (1939) argued, the reverse happens: as the peak begins to disappear, entrepreneurs cannot "fire" machines in the short run in order to cut back output - rather, they will lay off workers. But that precipitates a collapse in consumer demand and thus that related industry. Thus, the relative size of the capital goods industry rises even though output as a whole falls.

Hayek absorbed these lessons from his old student and in subsequent work (Hayek, 1939, 1941), he reversed his earlier argument completely around. In essence, Hayek proposed that the expansion of credit (at the trough), will expand the demand for consumer goods. This, in turn, would raise profits in the consumer goods industries and their prices. As consumer goods prices rise, real wages fall - thereby increasing profits. As profits increase, it may seem reasonable for entrepreneurs to invest for greater production. However, this new investment will be directed towards methods of production which are labor-intensive given that real wages have collapsed. This latter part is what Hayek referred to as the "Ricardo Effect".

In essence, the first investment effect would raise demand for capital goods whereas the second "Ricardo effect" should decrease it. Since Hayek assumes that the Ricardo effect eventually outweighs the investment effect, investment demand falls and the capital goods industries collapse in relative size.

The argument for why the collapse in real wages outweighs the profit-driven investment is understandable. As consumer demand expands and profits keep on rising, investment demand for capital- widening (i.e. applying machinery in order to keep up with greater employment of labor) will increase. However, as the real wages keep falling, capital-widening investment will become less tenable so that capital-"shallowing" (i.e. more labor-intensive techniques) is called for. Note that if investment rises, profits rise further and, the greater the rise in profits, the greater the fall in wages. In time then, the falling wages will outweigh the extra profits from capital-widening and actually result in capital- lessening which, in turn, prompt a collapse in investment demand and hence, a recession.

Hayek's new theory, however, depended too much on changes of technique as the dampener of business cycles. In addition, note that, unlike Keynes, Hayek proposed that overconsumption (thus higher prices and falling real wages) cause the upswing to slow down and eventually reverse itself. Excess demand causes recessions not excess supply.

Characteristically, Kaldor (1942) could not leave this alone. Why, he asked, did high profits imply lower investment? After all, in most theories, if the productivity of capital (read profits) rises above interest, investment should increase, "under no circumstances can total investment demand become smaller in consequence of a rise in the rate of profit" (Kaldor, 1942). Investment could ostensibly fall if, and only if, the rate of interest rises. If such happened, then we should not be surprised to see investment collapse. The Concertina effect, he noted: "as a phenomenon of the trade cycle is non-existent or insignificant while the supposition that a scarcity of savings causes booms to collapse is fallacious." (Kaldor, 1942)

Despite Hayek's (1942) attempted restatement of the Ricardo effect, the verdict of the age was clear. In both his 1931 attempt and in his 1939 rectification, he attempted to demonstrate that overconsumption was the chief cause of depressions. However, Kaldor succesfully picked away at his first theory and then showed that his Ricardo Effect was only possible under some very special circumstances and hence, highly unlikely. Kaldor, in effect, sustained the flag of underconsumption and overproduction as the chief evildoers.



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