article: Hayekian Macro & the Roaring 20s


“Hayek, in a series of works from the mid-1920s through The Pure Theory of Capital (1941), added to Mises’ theory a more detailed account of the malinvestment during the boom and how it distorts the economy’s structure of production away from equilibrium.   Hayek commented in 1932 that “what I tried to do in Prices and Production, and in certain earlier publications, was to show that monetary factors may bring about a kind of disequilibrium in the economic system.”

The problem caused by the distortion of the interest rate is a mismatching of the intertemporal plans of savers and investors or, as Hayek sometimes put it, the distorted rate fails to equalize the supply with the demand for real capital.  The artificially lowered interest rate no longer meshes the time-profile of output for which businesses are making their investment plans – to produce so much for the present and so much for various future periods – with the public’s planned time-profile of savings and consumption across the same periods.  Instead investment is skewed too much toward what Hayek called the “higher” stages of production, projects that will yield consumable output only in relatively distant future periods, and too little toward the “lower” stages or near-future consumable output.  As he summarized the problem:

[A]n expansion of credit via the Bank Rate mechanism [i.e. via the central bank lending more at a lower market interest rate and thereby expanding the supply of loanable funds] will not ‘apportion the additional money between consumers and producers so as not to disturb the initial proportions,’ but will certainly favour the “higher” stages at the expense of the “lower”.

The “misdirection of production” leads to “a consequent crisis.”  The mismatch between the entrepreneurs’ planned investment profile and the consumers’ planned savings and consumption profile is revealed in the bust, when non-viable investments – projects that cannot be profitably completed because the public does not want to provide enough savings to finance the completion at low interest rates – are finally recognized and terminated.  The crisis occurs because “it becomes obvious that it is not possible to wait as long as had at first seemed practicable for the product of the investment.”

doc:  Lawrence White, “The Roaring Twenties and Austrian Business Cycle Theory”.

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