Why do booms, historically, continue for several years? What
delays the reversion process? The answer is that as the boom
begins to peter out from an injection of credit expansion, the
banks inject a further dose. In short, the only way to avert the onset of the depression-adjustment process is to continue
inflating money and credit. For only continual doses of new
money on the credit market will keep the boom going and the
new stages profitable. Furthermore, only ever increasing doses
can step up the boom, can lower interest rates further, and
expand the production structure, for as the prices rise, more
and more money will be needed to perform the same amount
of work. . . . But it is clear that prolonging the boom by ever
larger doses of credit expansion will have only one result: to
make the inevitably ensuing depression longer and more grueling. (Rothbard, Man, Economy, and State, pp. 861–62)
The success of this strategy of postponing the crisis through additional loans hinges on a continuously-growing rate of credit expansion. Hayek already revealed this principle
in 1934 when he stated: “[I]n order to bring about constant additions to capital, [credit] would have to . . . increase at a constantly increasing rate.”4 The need for this ever-escalating increase in the rate of credit expansion rests on the fact that in each time period the rate must exceed the rise in the price of consumer goods, a rise which results from the greater monetary demand for these goods following the jump in the nominal income of the original factors of production. Therefore given that a large portion of the new income received by owners of the original means of production originates directly from credit expansion, this expansion must progressively intensify so that the price of the factors of production is always ahead of the price of consumer goods. The moment this ceases to be true, the six microeconomic processes which reverse the changes made to the productive structure, shortening and flattening it, are spontaneously set in motion and the crisis and economic recession irrevocably hit. In any case credit expansion must accelerate at a rate which does not permit economic agents to adequately predict it, since if these agents begin to correctly anticipate rate increases, the six phenomena we are familiar with will be triggered.
Indeed if expectations of inflation spread, the prices of consumer goods will soon begin to rise even faster than the prices of the factors of production. Moreover market interest
irates will soar, even while credit expansion continues to ntensify (given that the expectations of inflation and of growth in the interest rate will immediately be reflected in its market value).
Hence the strategy of increasing credit expansion in order to postpone the crisis cannot be indefinitely pursued, and sooner or later the crisis will be provoked by any of the following three factors, which will also give rise to the recession:
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4Hayek, Prices and Production, p. 150.
(a) The rate at which credit expansion accelerates either
slows down or stops, due to the fear, experienced by bankers and economic authorities, that a crisis will erupt and that the subsequent depression may be even more acute if inflation continues to mount. The moment credit expansion ceases to increase at a growing rate, begins to increase at a steady rate, or is completely halted, the six microeconomic processes which lead to the crisis and the readjustment of the productive
structure are set in motion.
(b) Credit expansion is maintained at a rate of growth
which, nevertheless, does not accelerate fast enough to prevent the effects of reversion in each time period.
In this case, despite continual increases in the money supply in the shape of loans, the six effects described will inevitably develop. Thus the crisis and economic recession will hit. There will be a sharp rise in the prices of consumer goods; simultaneous inflation and crisis; depression; and hence, high rates of unemployment.
To the great surprise of Keynesian theorists, the western world has already experienced such circumstances and did so both in the inflationary depression of the late 1970s and, to a lesser extent, in the economic recession of the early 1990s. The descriptive term used to refer to them is stagflation.5
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5Mark Skousen correctly indicates that, in relative terms, stagflation is a universal phenomenon, considering that in all recessions the price of consumer goods climbs more (or falls less) in relative terms than the price of the factors of production. Widespread growth in the nominal prices of consumer goods during a phase of recession first took place in the depression of the 1970s, and later in the recession of the 1990s. It sprang from the fact that the credit expansion which fed both processes was great enough in the different stages of the cycle to create and maintain expectations of inflation in the market of consumer goods and services even during the deepest stages of the depression (apart from the typical recent phenomena of relentless growth in public spending and in the deficit, and of massive social transfer payments which foster direct growth in the demand for, and therefore, in the prices of consumer goods and services). See Skousen, The Structure of Production, pp. 313–15.
Hayek revealed that the increasing speed at which the rise in the monetary income of the factors of production pushes up the demand for consumer goods and services ultimately limits the chances that the inevitable eruption of the crisis can be deferred via the subsequent acceleration of credit expansion. Indeed sooner or later a point will be reached at which growth in the prices of consumer goods will actually start to outstrip the increase in the monetary income of the original factors, even though this may only be due to the emergence of a slowdown in the arrival of consumer goods and services to the market, as a result of the “bottlenecks” caused by the attempt to make society’s productive structure more capitalintensive.
Beginning at that point, the income generated by the factors of production, specifically wages, will begin to decline in relative terms, and therefore entrepreneurs will find it advantageous to substitute labor (now relatively cheaper) for machinery, and the “Ricardo Effect” will enter into action, hindering the projects of investment in capital-intensive goods, and thus ensuring the outbreak of the recession.6
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Hayek draws the following analogy to explain this phenomenon:
The question is rather similar to that whether, by pouring a
liquid fast enough into one side of a vessel, we can raise the
level at that side above that of the rest to any extent we desire.
How far we shall be able to raise the level of one part above
that of the rest will clearly depend on how fluid or viscid the
liquid is; we shall be able to raise it more if the liquid is syrup or glue than if it is water. But in no case shall we be at liberty to raise the surface in one part of the vessel above the rest to any extent we like. Just as the viscosity of the liquid determines the extent to which any part of its surface can be raised above the rest, so the speed at which an increase of incomes leads to an increase in the demand for consumers’ goods limits the extent to which, by spending more money on the factors of production, we can raise their prices relative to those of the products. (Hayek, “The Ricardo Effect,” pp. 127–52;
Individualism and Economic Order, p. 241)
(c) Finally let us suppose that the banking system at no
time reduces the rate at which it accelerates credit
expansion, and instead does just the opposite: it constantly
and progressively intensifies it, with the purpose
of quashing any symptom of an emerging depression. In this case, the moment economic agents begin to realize that the rate of inflation is certain to continue growing, a widespread flight toward real values will commence, along with an astronomical jump in the prices of goods and services, and finally, the collapse of the monetary system, an event which
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In 1969 Hayek again used this analogy in his article, “Three Elucidations of the Ricardo Effect,” in which he reiterates that the distorting effect of credit expansion on the productive structure must continue as long as banks create new money and this money enters the economic system at certain points at a progressively increasing rate. Hayek criticizes Hicks for assuming the inflationary shock will “uniformly” affect the entire productive structure, and he demonstrates that if credit expansion escalates at a rate exceeding the rise in prices, this process “can evidently go on indefinitely, at least as long as we neglect changes in the manner in which expectations concerning future prices are formed.” He concludes:
I find it useful to illustrate the general relationship by an analogy which seems worth stating here, though Sir John [Hicks]
(in correspondence) did not find it helpful. The effect we are
discussing is rather similar to that which appears when we
pour a viscous liquid, such as honey, into a vessel. There will, of course, be a tendency for it to spread to an even surface. But if the stream hits the surface at one point, a little mound will form there from which the additional matter will slowly spread outward. Even after we have stopped pouring in more, it will take some time until the even surface will be fully restored. It will, of course, not reach the height which the top of the mound had reached when the inflow stopped. But as long as we pour at a constant rate, the mound will preserve its height relative to the surrounding pool—providing a very literal illustration of what I called before a fluid equilibrium. (Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas, pp. |
