Lesson 6 of 7
The same rate, another cause
The identical fall in the rate, produced by credit instead of saving. Producers respond the same way. The goods that would have paid for it are not there.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Give producers newly created money instead of savings and the proportion of spending moves the same way, to one to three, and the structure lengthens the same way, to six stages.
- The difference appears only with time. Consumers did not choose to consume less, so as their incomes rise they push the proportion back.
- Mises's statement of the endpoint: a moment must come when the means of subsistence are used up while the capital goods started are not yet finished.
Run the previous lesson again and change one thing. The extra 40 in the loan market is not lent by a saver. It is created by a bank.
The same proportion, reached two ways
Reached by saving
- Consumers' goods: 30.
- Intermediate products: 90.
- Proportion: one to three.
- Money in circulation: 120.
Reached by credit
- Consumers' goods: 40.
- Intermediate products: 120.
- Proportion: one to three.
- Money in circulation: 160.
Producers cannot tell these two columns apart when they borrow.
What producers see
Nothing different. A rate, a set of projects, and a calculation about which ones clear it. Hayek's own summary is that the changes in the structure of production necessary to employ the new funds correspond exactly to the changes brought about by saving, and that the output of each stage measured in physical units ends up exactly as great as in the saving case.
The only thing apparent at first is that the money values are a third higher.
What is missing
The abstention. In the saving case, the goods that pay the workers during the extra period were left unbought by the people who saved. Here nobody left anything unbought.
So the resources the longer processes need have to come from somewhere else, and Hayek says where. Consumers in general are outbid. They forego part of what they used to consume, not because they want to consume less but because they get fewer goods for the same money income.
That involuntary retrenchment is what the next course calls forced saving.
Why it does not hold
Because the people it was taken from did not agree to it. Hayek's argument is that if their money receipts rise again, they will immediately try to restore the old proportion of consumption, and that their receipts will rise, because the new money is being paid out as wages and rents.
At that point the proportion moves back towards one to two, and the structure of production has to follow it back. Hayek's footnote on the asymmetry is the sentence to remember: moving to longer processes need bring about none of these disturbances, and moving to shorter ones regularly comes with a crisis.
Where Mises puts the limit
The Theory of Money and Credit states the endpoint without diagrams. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods.
It arrives faster than it otherwise would, he adds, because the lower rate weakens the motive for saving.
The claim to carry forward
Not that credit expansion is wrong, and not that it is ruinous. Just this: two different causes produce the same rate, producers cannot tell them apart at the moment they decide, and only one of the two has the goods behind it.
Everything the next two courses say is an elaboration of that sentence.
Check yourself
What does Hayek say the physical output of each stage looks like in the credit case?
- Smaller than in the saving case
- Exactly as great as in the saving case, with only the money values a third higher at first
- Entirely different in composition
Show the answer
Answer: B.
The changes needed to employ the new funds correspond exactly to those brought about by saving, which is why the two cases look identical to a producer.Where do the resources for the longer processes come from in the credit case?
- From the bank's reserves
- From consumers in general, who are outbid and get fewer goods for the same money income
- From an increase in productivity
Show the answer
Answer: B.
Hayek is explicit that the retrenchment is not voluntary and is not made by the people who benefit from the new investment.What is Mises's statement of the limit?
- That banks eventually run out of paper
- That a time must come when the means of subsistence are used up while the capital goods started are not yet finished
- That the rate cannot fall below zero
Show the answer
Answer: B.
He adds that the moment arrives sooner because the lower rate weakens the motive for saving, slowing the accumulation of capital.Sources
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture II, section 10, for the credit case reaching the same proportion and the same physical output with money values a third higher, for the involuntary retrenchment of consumption, and for the footnote on the asymmetry between lengthening and shortening.
- Hayek, Prices and Production, lecture III, sections 7 and 8, for the sequence by which the prices of consumers' goods rise again and the longer processes become unprofitable.
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part three, chapter 5, section 4, for the exhaustion of the means of subsistence before the capital goods mature, and for the weakening of the motive to save.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The figures are Hayek's own illustrative numbers from diagrams, not measurements. The four-year plant is invented and describes no company.
- Whether producers really cannot distinguish the two cases is disputed. The obvious reply is that they could learn to, from experience or from published data, and that reply is taken seriously in the course on the case against this theory later in this track.
- No position is taken here on whether credit expansion should be permitted, restricted or encouraged.