A Critical Review of Hayek's ‘Prices and Production’: Part I/V

- Compiled By Chinedu Okoye 

Lecture 1: Theories of the Influence of Money on Prices:

The Dependence of Production activity on Money:

Hayek begins by acknowledging the impact of money on both the volume and direction of production. He cited the war and post war inflation and the return to gold standard by countries like Britain which was achieved through a a monetary contraction.

At the present moment she said, “the best minds believe the cause of the existing world-wide depression to be a scarcity of gold” as they sought monetary means to overcome it.

Thus, though from different angles, it agrees with the Minskian perspective, that money affects production activity (investment and output).

Up until the point of this publication, Hayek asserts that little progress made in understanding the connection between money and prices (if money affects production or does affect prices as well), and of general doctrines in the preceding century.

The fundamental problems in the field he says, remain(ed) unsolved, and some doctrines “very doubtful in validity”.

On The Quantity Theory of the Value of Money:

He cited Irving Fischer as the resurrector of quantitative measures and the mechanistic approach to quantity theory of the value of money in his ‘Equation of Exchange’, as contributing “a great deal to influence the methodology of the present representatives of this [Fischer’s] school.”

He said: he neither proposed to quarrel with the positive content of the theory, and said he was “ready to concede that so far as it goes it is true, and that, from a practical point of view, it would be one of the worst things which would befall us of the general public should ever again cease to believe in the elementary positions of The Quantity Theory.” [Which is that money supply affects prices]

His complaints however, was that the quantity theory, in its form then, isolated the theory of money, from the main body of the general economic theory, “if we try to establish direct causal connections between the total quantity of money, the general price level, and the total amount of production [output]”.

His argument (which I partly agree with) is that Fischer's quantity theory is based on the assumption of the knowledge of the decision of individuals. Which is true, for if money is expected to have a mechanical influence on prices, leaving output unscathed, it is assumed that individual preferences and spending don't change, this is addressed however in Keynes's and Post-Keynesian literature, which emphasizes the role and significance of uncertainty, and liquidity preferences.

Hayek argued further that “it is to this individualistic method that we owe whatever understanding of the phenomena we posses”.

In Hayekian thoughts; neither aggregates nor averages actually depend upon each other and it will never be possible to establish necessary connections of cause and effects between them, he argued.

A position I understand but disagree with as data has overtime been able to show how money supply increases affect consumer spending. Though it may be difficult it near impossible to forecast, to deny a causal relationship would be to assume that changes in values of money and other economic goods do not affect human behaviour.

Yet he argues that “from the very nature of economic theory,, averages can never form a link in its reasoning”.

The central preoccupation of these prior theories he says, was that a change in price level, would be of no consequence if other prices were affected “equally and simultaneously”. The main concern with this theory he says was: “certain suppositions “tendencies which affect all prices equally, or at any rate impartially, at the same time, in the same direction”.

It is only after the alleged causal relationship between the quantity of money and prices has been established, that that the effects on relative prices are considered. The general assumption of prior economist and Fischer, was that the quantity of money affects only price levels, whilst explaining changes in relative prices (that is, changes in actual exchange-ratios) away as “due to “disturbing factors or “frictions””.

Hayek argued however that experience has taught us that these disturbances and frictions are “regularly connected with changes of the price level” that is that these disturbances and frictions are fundamental to how money works. Thus relative price changes are a feature of price level changes (perhaps from changes in money supply), and not due to disturbances or frictions.

This is similar to Minsky's position on instability being a feature of a capitalist economy a bug]

Changes in prices of goods do not occured in a definite sequence as Fischer's quantity theory would suggest.

On the influence of prices on production, the theory assumes that price level changes affect overall production, with no attempt to show why this must be so, he says.

Thus it is only the general or average price movements that affects production. [Not expectations, preferences, interest rates, production costs, none of these as they all are neutral and clear at all levels.

Erroneous Opinions:

The idea held the is that changes of relative prices and changes in production depend on changes in price level [i.e., if producers expect to sell at a higher price it will induce them to produce more]. And that money affects individual prices “by means of it's influence on the general price level.” This Hayek says, “seems to be a the root of at least three very erroneous opinions:

Firstly, that money acts upon prices and production only if the general price level changes [before prices settle at a new equilibrium], so prices and production are always unaffected by money. Second, that a rising price level seems to cause a rising production and a falling price level causes a decrease in production (or output), and thirdly, that monetary theory is described only as the theory of how the value of money is determined, [with no connection to real output absent a change in prices].

The Cantillon Effect:

Hayek's theory builds on Richard Cantillon's ‘Essai sur le Commerce’ published in 1755, where he attempted to show the path and proportion to which the increase in money raises the price of things”

Cantillon's theory starts from the assumption, he says, of new gold and silver mines. And then he “proceeds to show how the additional supply of precious metals [money then] first increase the incomes of all persons connected with their production”, and how increases in theit individual expenditures increases the prices of goods they consume, and now buy in larger quantity.

The increased demand raises prices and by extension the income of the sellers or producers of these goods, who in turn increase their own expenditure, and so on.

This assumption implies, correctly that prices do not increase at the silmultaneously and impartially, but at different rates, different degrees and sometimes in different directions.

So incomes of some rise earlier than others. And to those whose incomes rise later rather than earlier, the increase in quantity of money is harmful.

Everything he said, depends on the point of monetary injection or monetary extraction.amd that effects could be different depending on if it comes to the hands of manufacturers and producers first and if it comes into the hands of salaried people employed by the state.

Earlier Doctrines of The Theory of Money:

Here he states that there had been a number of close related doctrines whose importance where not appreciated at the time. But in the end they were combined to fill the gap. By this he was referring to ‘the quantity theory of money on the rate of interest and it's dependence on ‘the relative demand for consumers' goods on the one hand and producers' or capital goods on the other goods on the other.’

The doctrines struggled because “economists had struggled for so long a time struggled to distinguish the value of money proper and the price of money loan [interest rates] that in the end the become incapable of seeing that there was any relation at all between the rate of interest and the value of money”

This means, a Classical Economists separated these spheres of the value of money and interest rates. To them, the value of money is determined by supply and demand for it, and interest rates determined separately in markets for loanable funds.

Hayek is saying that both are connected; i.e., the same market dynamics affect both the value d money and interest rates. Lower rates increases Money supply and reduced its value, higher rates contract money supply and and reduces or contains prices. So interest rates and moneys purchasing power (the value of money) are linked, and not independent.Keynes has a view but from a different angle.

For Hayek, money supply shocks distort interest rates away from their natural level, misguiding investments and creating cycles.For Keynes Money demand and liquidity preferences tie money supply to interest rates which influence output and unemployment.So for both schools money supply affects output through interest rates.

It is the treatment of that money supply increases that they differ. Austrians see it as a bad thing and Keynesians see it as a positive.

Hayek mentions that Henry Thornton was the first author known to him to “enunciate a doctrine on this point” in his work:“Paper Credit of Great Britain” in 1802.

He “inquired into the question on whether there existed a natural tendency to keep the circulation of the Bank of England within limits which would prevent a dangerous depreciation.”

He rejected that such tendency existed, and held that on the contrary, “the circulation might expand beyond all assignable limit if the Bank would only keep its rate of interest low enough.”

By this, Thornton added a new and different theory on the relations between price and interest: “the theory of influence of the expectations of a rise in price on the money rate of interest”. This was generally accepted by bullionist.

The effect of Money on Production Prices:

Having identified the relationship between the rate of interest, the amount of money in circulation, and prices, Hayek moves on to a second line of thought —“the influence which an increase in the amount of money exercises upon the production of capital resources” this can be directly or through interest rates.

From this emerges a theory that “an increase in money brings about an increase of capital”. Bentham was the first to clearly state this doctor . He called it forced frugality in which the government can add to future wealthy “applying funds raised by taxation or the creation of paper money to production of capital goods”. Hayek gives the honor of the first author to recognize this tendency for increased money supply to increase national capital, to J.R. Malthus.

But the recognition of this tendency, Hayek says, didn't blind Malthus to the “dangers and manifest injustice! connected with it”, but “simply offers a rational explanation of the fact that a rise in prices is generally found conjoined with public prosperity”. This would represent my thinking and that of Keynes and Post-Keynesians, that Inflation is an associate of positive real growth and the latter almost impose without the former.

Walras' Re-Discovery and Wicksellian Theory:

Contributions of other economists like: Sidwick, Giffen, Nicholson and even Marshall, he says, “hardly adds anything to what had been evolved from Thornton to Tooke.

Through Leon Walras in 1879, the rediscovery of the forced savings doctrine was rediscovered independently. The doctrine of Walras then reached Knut Wicksell who merged the strands of the separate strands of thoughts into one.

Thornton and Tooke, the classical writes who made an early recognition of how money/credit expansion can stimulate both output and prices (temporarily).

Walras made an independent discovery on the idea of “forced savings” —credit expansion creating unplanned shifts in consumption and investment patterns.]

Hayek attributed Wicksell's success to “the fact that his his attempt was based on a modern and highly developed theory of interest by Böhm-Bawerk.”

However Hayek would point out one major area Wicksell erred; his attempt to establish rigid connection betweem the rate of interest and general prices. For his theory argues that “if it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings.”

Wicksell argues that “in a money economy the actual or money rate of interest could differ from the equilibrium or natural rate”. This is because the demand and supply of capital do not meet in their “natural form” but in the form of money, whose quantity can be “arbitrarily changed”.

He explains further saying that; when banks lower interest rates by lending more than has been entrusted to them, thereby adding to the circulation, this must tend to raise prices.

But if they raise the money rate above the neutral rate, they cause a situation of depressed prices.

From this "correct" statement, –in Hayek's words– Wicksell jumps to the conclusion that so long as the two rates (money and equilibrium rates) agree there would be no change in the price level. This is where Hayek differs, or what he opposes — the neutrality of money on price level changes, at some equilibrium — and his position is that prices in that scenario, doesn't remains steady though monetary causes that tend to produce changes in the price level, are eliminated.

Mises, he said improved Wicksellian theory, by an analysis of different influences which a money rate of interest is different from the equilibrium rate exercised on prices” of both consumer goods and production goods.

From this he transformed the Wicksellian theory into an explanation of the credit cycle which is “logically satisfactory”.

Hayek now moved to the what he thought monetary theory ought to be, beginning with pointing out the deficiencies of Wicksell's doctrine, which catalysed the breakaway from some fundamental concepts in his theory. He begins by restating that, Wicksell's equilibrium rate of interest is one that restricts demand for real capital to available savings (or loanable funds), whilst securing the price stability.

This idea was widely accepted at the time, that “an equilibrium rate of interest, money would remain neutral towards prices”. In such circumstances, Wicksell implies that there would be no reason whatsoever for price levels to change. Hayek pointed that for supply and demand for real capital to be equalized (per Wicksellian assumptions), banks must not lend more or less than available deposits (savings).

Also, he says for the price level to remain unchanged, the amount of money in circulation must change in the same direction as production (output). [So, since the attempt to keep money demand and money supply equal, banks have to restrcit demand to available savings, and money supply has to move with production changes for price level to be stable—two assumptions and implications of Wicksell's theory, banks can either choose to keep demand and supply [of money] equal , by restricting lending to available savings, or keep the price level steady, by channeling the inceeased Money supply to production.

This is cause the price level changes with fluctuations in output, so restricting money supply when output is rising, would lead to a decrease in price levels. Similarly, an attempt to keep general prices steady, as production increases means money supply has to increase (or interest rates has to fall, below the equilibrium rate).

Therefore, production increases, even without a change in interest rates affects prices, and by extension interest rates. Relative prices he say, can be change by monetary influenced even under a stable price level. And may remain disturbed only when general price level changes. 

That is exchange-ratios of goods and services, which is determined by changes in the level of demand.for each, can be disturbed by money supply changes, as money is deployed to different sectors and to different degrees, and is neutral only when the general price level changes.

Hayek urged that “we have to give up the generally received opinion that if the if the general price level remains the same, the tendencies towards economic equilibrium are undisturbed by monetary influences”. And also that changes from the monetary side can only be felt if the imvolves or cause a general price level changes.

This doctrine he says, lies at the heart of at the root of my oat shortcomings of the monetary theory at the time. He stood on the opinion that: “in the near future, monetary theory will not only reject the explanation in terms of a direct relation between money and the price level”.

He said instead the focus will be on the causes of changes in relative prices and their effects on production – a theory of the influence of money of the different exchange-ratios between goods of all kinds.The following lectures focuses on “how it is possible to solve problems of monetary theory without recourse to the concept of a value of money in general”.

This general price level treatment and rejection is understandable, but also makes for a less concise monetary thinking.

Cause relative prices woud be important only if we were in a barter system. As long as the current monetary system is concerned, there'd always be a need for a gauge in general prices. How one relates this to other variables like money supply and production (output) is where the issue lies, and where I differ with economists like Wicksell, Fischer etc.

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Lecture II: The Conditions of Equilibrium Between the Production of Consumer Goods and The Production of Producer Goods:

Here Hayek begins with a quote from TR Malthus, staying; that it isn't the quantity of the circulating medium that determines which produces the effects here described, but the different distributions of it” Malthus stated further that on every fresh note issued a larger proportion falls into the hands of those who consume and produce, and a smaller proportion goes to the consumer.

This is as the producers who are also consumers are able to create value and hence profits to offset any associated price change it accomodate increased consumption as a result of the money supply increase.

This cuts between Minsky's idea in his financial instability hypothesis texts on how the degree to which money supply affects the real economic depends on the sophistication of the financial sector of that economy.

Before we can attempt to understand the influence of prices (per the previous lecture), on the amount of goods produced, Hayek argued that “we must knows the nature of the immediate causes of a variation of industrial output”. [That is why the price and output changes aren't uniform and impartial as the classical theory implied].

Three Contemporary Explanations of Output Fluctuations:

He went on to point that though this question [of explaining output fluctuations] seems simple on the surface, “contemporary theory offers at least three explanations.”

First, we may view the main causes of variations in industrial output as an indication of the “willingness of individuals to expand effort”. This he says is the theory with the most adherents at the time in England. This he argued was “due to the fact that a comparatively great number of economists here are still under the influence of “real cost” theories of value. A a theory that makes the explanation natural.

Hayek saw no justification for the above assumption, and termed it “a highly artificial assumption I [he] would only be willing to resort to when all other explanations have failed”. However he didn't refute it directly as that wasn't the aim. The aim rather was to “show that there are other ways of accounting for changes in industrial output which seems less artificial”.

The second type of explanation he said was one that explained the variations in production as a result of changes in the amount of factors of production used. This he said was no explanation, and depended “essentially upon a spacious appeal to the facts”.

This is a point I agree with even as. Minskian-Keynsian, seen as prices and interest rates or liquidity could lead to output fluctuations even when the factors of production are not scarce.

However this, explanation regards an increase in output as simply the employment of unused resources, and any dimunision as resources becoming increasingly idle.

A false theoretical stance. Fluctuations in output or production, Hayek adds, requires a complete explanation. If we are to go by the existence of unused resources angle he says, that still is a “fact that needs explanation”. Why are there unsused resources in a contacting economy? 

The third contemporary explanation of fluctuations on production is built on the assumption of equilibrium, which he says has an advantage in that it compels one to pay attention to the causal factors of the changes in industrial output whose importance might be underestimated otherwise. By this he referred to changes in the methods of using existing resources.

Not as a result of changes in technical knowledge but as a result of “a transition to more capitalistic methods of production”. For the purposes of this lecture he confines himself to the “conditions under which an equilibrium between the production of producers' goods and the production of consumer goods are established” in a capitalist economy.

This is to say, fluctuations depends on the extent to which changes in the production (or supply) of producers' (or capital) goods, affect the production of consumers' goods.

Within practical limits, it is possible to increase the consumer goods output from a given level of production. So as a result, he asserts that at any point in time, “a far greater proportion of the available original means of production is employed to provide consumers' goods for some more or less distant future”. Now if technical knowledge wasn't what he considered per the section on the commentary explaining fluctuations in prices and output, it would be near impossible to expand production beyond a very narrow limit.

But he would sideline the productivity factor stating that it was “not necessary for [the] my present purpose to enter at any length into an explanation of this increase of productivity by roundabout methods of production.”

The reason being that any such change in productivity and efficiency “implies quite definite changes in the organization of production which he refers to as “the structure of organization”. So, he employed a schematic representation. From that approach, he asserts that “it should be clear that the production between.

The amount of intermediate products which is necessary at any moment in time to secure a continuous output of a given quantity of consumers' goods, and the amount of that output must grow with the length of the roundabout process of production”.

This is to say hat the amount of intermediate or component goods must grow with the length of time of overall production, because at each stage of the production chain, something has to be “in use” or “in process” to eventually yield a continuous output of consumers' goods.

Though the schematic illustration of production processes, was used to describe or represent the movement of goods, Hayek says: “it is just as legitimate to use it as an illustration of the movement of money.” He explains that whilst goods move from top to bottom, money moves in the opposite direction.

This means that in the process of production, goods flow from the producer who turns them to finished goods, which them makes it's way down to the consumer. Whereas, money flows from the consumer, when he gets the product, to the sellers and/or through to the producers. The reverse movement is cyclical, as each stage is financed by the latter.

So, to trace “trace the relation between actual money payments, or the proportion of quantities of money used in different stages of production, and the movement of goods, we need a definite assumption in regard to the division of the total.process among different forms which alone makes an exchange of goods necessary”

This means that we must assume that the whole production process is split up into different stages or firms.

Why?

Because if one person or one firm owned the entire process — from raw cotton to finished clothes — then no exchange (no buying and selling between stages) would take place. The same owner would just pass goods along internally, and we couldn’t observe money changing hands.

Production Goods Expenditure v Consumer Goods Expenditure:

With Hayek's approach, certain fundamental facts appear. First of which is that “the amount of money spent on producers' goods during any period of time may be far greater than the amount spent for consumers' goods during the same period.

This is true as it is possible to have a period were investment activity (that is expenditure on production goods) outpaces consumption expenditure. But this scene would either lead to a fall in prices, if the increase in capital goods is associated to productivity gains, or a contraction or decline in output and employment. This is in a real-world Post-Keynesian View.

Hayek highlights that not only was this fact overlooked by previous classical theories, it was “expressly denied by no less authority than Adam Smith” himself. For according to Smith, “the value of goods circulated within dealers never can exceed the value of those circulated between dealers and consumers”.

This means the amount of goods produced and sold from producer to retailer (total output), will always be equal to the amount (and monetary value) of those sold or moved from the sellers to the consumers (total consumption). Thus, overcapacity cannot exist and productivity is constant with prices only changing with changes in money supply or market conditions, the latter is neutral to the classicals since it occurs in an equal and indiscriminate manner.

Hayek however says that “this proposition clearly rests upon the mistaken inference from the fact that total expenditure made in production must be covered by the return from the sale of the ultimate products”. But this is not the case with every good, as “the continuance of the existing degree of capitalistic organization”, he says, depends on the prices paid for the product at every stage till it gets to the final consumer.

This makes prices (an expression of market demand relative to supply) the determining factor of the overall direction of production (where capital is allocated to the most) in man economy.

Prices and the Direction of Production:

He further elucidates by explaining that, the money stream received by an entrepreneur at any stage of production, is composed of his net income which he may use for consumption without dipping into working capital (money meant for production processes), and parts of that which he must continually reinvest.

However the proportion to which he distribute or allocates these returns is entirely up to him, but would depend on “the magnitude of the profits he hopes to derive from the production”[This falls in line with Keynes's “expectations” and “liquidity preference” theory.]

The Problem a Transition from Less to More Capitalistic Methods of Production:

Hayek is analyzing how economies transition between more capitalistic (capital-intensive, long-term) methods of production and less capitalistic (shorter, more immediate consumption-focused) methods.

On the transition to and from capitalistic methods he says is dependent on the demand of producers' goods relative to consumer goods. A transition to more capitalistic methods of production will occur, if the demand for producers' goods outweighs the demand for consumers' goods. And a transition from a more to less capitalistic method of production will occur if the demand for producers' goods decreased relative to the demand for consumers' goods.

(It should be noted that the demand here is expressed in money terms)

This, he says, may be as a result of changes in voluntary savings or “changes in voluntary spending, or as a result of changes in the quantity of money which alters the funds at the disposal of the entrepreneurs for the purchase of producers' goods”.

Savings: When savings rise, people reduce consumption and redirect resources toward investment. This allows entrepreneurs to buy more producers’ goods (machines, raw materials, intermediate goods), which in turn extends and deepens the structure of production.

Conversely, if savings fall (or if credit/monetary expansion makes consumption rise), the demand for consumers’ goods outpaces producers’ goods, leading firms to shorten production processes, disinvest, or reallocate away from long-term projects.

This is because increased savings = reduced consumption and vice versa. But this will be the case only if the roundabout processes of production increases in the same proportion as the demand for intermediate goods.

This means for equilibrium between demand for production goods (financed by savings), and demand for consumption goods (financed by income excluding savings) to hold, firms must redirect those freed-up resources into capital projects (producers’ goods, intermediate goods, longer production chains).

Those projects don’t yield immediate consumption but eventually increase the future supply of consumption goods, essentially compensating for the current shortfall.

Assumptions:

- That individuals save regularly without recourse to withdrawal needs.

- the original means of production used remains the same, and,

- the amount of money in circulation and it's velocity of circulation are supposed to remain unchanged.

Money Supply Increases:

Now Hayek moves from a change in the amount of money supply from an increase in savings, to investigating the effects of a change in the amount of money in circulation. Here, the change in the proportion between the demand for consumers' good and the demand for intermediate products is now caused not by savings but by “the granting of additional credits to producers”.

He said changes in structure of production which will be necessary to accommodate the increased available means, will exactly correspond to the changes brought about by savings.

Intermediate good produced during the same period will outpace the value of consumer goods produced. But the money value of these goods he says would have increased as well. [More than in the case of savings.]

Hayek finds justification in assuming the change in the distribution of demand between consumers' and producers' goods, will remain permanent, as it was an effect of “a voluntary decisions on the part of individuals. The Increased production powered by the decision for individuals to consume less.

The issue I find wrong with this analogy is that, reduced consumption, where real wages doesn't increase reduces sales/revenues as well, this could present liquidity challenges as it means businesses are selling and earning less whilst borrowing more.