Lesson 5 of 7
A lower rate, honestly earned
What a fall in the rate means when it came from people saving more. Hayek's own arithmetic, and the resources that are there to answer it.
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
- When saving rises, less is spent on consumption and more on producers' goods. The proportion between the two changes, and it stays changed.
- Hayek's own figures: a proportion of one to two becomes one to three, and four stages of production become six, with the quantity of money untouched.
- The goods that pay for the longer process are the goods the savers declined to buy. They exist, they are unclaimed, and nobody has to be disappointed.
This lesson and the next are one exercise. The same fall in the rate happens twice. Here it comes from saving. In the next lesson it comes from credit. The arithmetic is identical and the outcome is not.
Hayek's own two cases, before and after saving
Before: four stages
- Spent on consumers' goods: 40.
- Spent on intermediate products: 80.
- Proportion: one to two.
- Money in circulation: 120.
After saving: six stages
- Spent on consumers' goods: 30.
- Spent on intermediate products: 90.
- Proportion: one to three.
- Money in circulation: 120.
Total money is the same in both columns. What it is spent on is not.
What the saver actually did
Somebody with an income of 40 decided to spend 30 on consumption and lend 10. That is not a financial event with a real event attached. It is a real event with a financial record.
The goods worth 10 that the saver would have bought were not bought. The labour, materials and machine time that would have gone into replacing them next period are not required for that, and are free to be bid for by somebody else.
What producers do about it
The rate falls, because the supply of funds in the loan market rose. At the lower rate, projects that take longer to pay are worth starting, and the resources they need are exactly the ones the saver released.
Hayek's arithmetic in the second lecture of Prices and Production is the one in the figure. The change in the proportion from one to two to one to three requires the average length of the roundabout process to rise in the same proportion, from an average of two stages to an average of three, or from four actual stages to six.
He is explicit that the amounts in the diagram are money values, that the quantity of money and its velocity are held constant, and that the quantity of original means of production is unchanged. Nothing is created. The same resources are arranged differently.
Why it holds
Because nobody is going to want it reversed. The saver chose the new proportion. After the change, the saver receives a larger share of a larger real income, so there is no reason to push consumption back where it was.
Hayek states the point plainly: since the change was the effect of voluntary decisions, there exists no inherent cause for a return to the old proportions.
That sentence is the whole difference between this lesson and the next.
The two things this shows
First, that a fall in the rate is not by itself a distortion. This is the case in which the rate is doing its job, and a longer structure is the correct answer to a real change in what people want.
Second, that the test is never the rate. It is whether the resources needed to finish the longer processes were released by somebody, or not.
Check yourself
In Hayek's case, what happens to the quantity of money when saving rises?
- It rises by a third
- Nothing. The diagram holds the quantity of money and its velocity constant at 120
- It falls with consumption
Show the answer
Answer: B.
The figures move from 40 and 80 to 30 and 90. The total is the same and only the split changes.What pays the wages during the extra period of production?
- Newly created deposits
- The goods the savers declined to buy, which are unsold and unclaimed
- Future output, borrowed against
Show the answer
Answer: B.
Abstention releases real goods in the same act that supplies the funds. That is what makes this case different from the next lesson.Why does Hayek say this change is permanent?
- Because the machines cannot be dismantled
- Because it came from voluntary decisions, and those who made them get a larger share of a larger real income, so nothing pushes consumption back
- Because the rate cannot rise again
Show the answer
Answer: B.
He writes that there exists no inherent cause for a return to the old proportions, and that sentence is precisely what fails in the credit case.Sources
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture II, sections 9 and 10, for the shift in proportional demand from 40 to 80 to 30 to 90, the increase from four stages to six, the constancy of the quantity and velocity of money in the diagrams, and the statement that a change brought about by voluntary saving gives no inherent cause for a return to the old proportions.
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part three, chapter 5, section 4, for the requirement that a lengthening of the period of production is practicable only where the means of subsistence have increased or wants have decreased.
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 40, 80, 30 and 90 are Hayek's own illustrative numbers from a diagram, not measurements of any economy. The stage count is a device for making a continuous process countable, and he says so in the same lecture.
- The claim that the structure of production has a measurable length is contested, and Hayek himself later called the average period of production an inappropriate simplification. That argument is the last lesson of the next course.