Lesson 6 of 8
What moves, and in what order
The theory predicts a sequence in relative prices, not a general rise. Producers' goods first, consumers' goods after, and then the order reverses.
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.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The prediction is about the order and the direction of relative price moves between stages, not about the general price level.
- Mises's sequence: producers' goods prices rise while consumers' goods rise only moderately, then a counter-movement sets in and the order reverses.
- Hayek's addition: in the reversal the spread between consumers' goods and the stage before them widens first, and the widening works its way back up the chain.
The previous lesson computed why firms move. This one sets out what the theory says the price record should look like while they do, which is the part a reader can in principle check.
The sequence the theory predicts
Four phases
-
Credit arrives. Borrowers bid for producers' goods. Prices of producers' goods and of the original factors rise.
-
Consumers' goods lag. They rise too, but only moderately, and on Mises's account mainly because wages have risen. Margins in the early stages look good.
-
Incomes catch up. The new money has been paid out as wages and rents. Spending on consumers' goods rises, and now it rises faster than producers' goods.
-
The order reverses. Prices of consumers' goods rise and prices of production goods fall, which is the same thing as the loan rate rising back towards the natural rate.
Where the sequence comes from
Mises states it compactly in The Theory of Money and Credit. The increased activity that begins when banks lend below the natural rate first raises the prices of production goods while consumers' goods rise only moderately, and then a counter-movement sets in: consumers' goods prices rise, production goods prices fall, and the loan rate rises again towards the natural rate.
Hayek puts that same passage at the head of his third lecture and says that Mises's compression is what made the argument hard to follow, in particular the claim that a rise in consumers' goods prices causes the crisis, which sounds backwards until the stage structure is in view.
Hayek's account of the reversal
He works it through stage by stage. The first effect of a rise in consumers' goods prices is that the spread between them and the prices of the stage before grows wider than the spreads further up the chain.
That widened spread makes the last stage more attractive, so non-specific producers' goods are transferred towards it. Their prices rise as they are bid for. And because the relative rise in the price of the original factors and the mobile intermediate goods makes the longer processes unprofitable, the specific goods of the early stages fall in price, their production stops, and the fall is cumulative back up the chain.
Why this is the useful half of the theory
Because it is a claim about relative movements with a stated order, which is harder to make unfalsifiable than a claim about a level.
A general rise in prices is consistent with almost any story. A claim that early-stage prices lead and late-stage prices follow, and that the lead then reverses, is a claim that a price record could contradict. Whether the record does contradict it is a question the course on the case against this theory takes up with the published tests.
The honest caveat
Two of them. The stages are not observable, so any test has to substitute some classification of industries for them, and the substitution is a judgement. And many things move relative prices between industries, so a matching pattern is consistent with the theory rather than evidence only for it.
Check yourself
What does Mises say happens first when banks lend below the natural rate?
- Consumers' goods prices rise sharply
- Prices of production goods rise while consumers' goods rise only moderately
- All prices rise together
Show the answer
Answer: B.
He then describes a counter-movement in which consumers' goods prices rise and production goods prices fall, which is the loan rate returning towards the natural rate.Where does Hayek say the reversal starts?
- In the earliest stage of production
- In the spread between consumers' goods and the stage immediately before them, which widens relative to spreads further up
- In the loan market only
Show the answer
Answer: B.
The widened spread pulls non-specific goods towards the later stages, and the specific goods left behind in the early stages fall in price cumulatively.Why is a claim about relative prices more useful than one about the price level?
- Because relative prices are easier to measure
- Because a stated order of movement is something a price record could contradict, while a general rise is consistent with almost any account
- Because the price level does not change in a boom
Show the answer
Answer: B.
The caveats still bite: stages are not observable, and many things move relative prices between industries.Sources
- Mises, The Theory of Money and Credit, German original 1912, English translation by Batson 1934, part three, chapter 5, section 4, for the sequence in which production goods prices rise first and consumers' goods only moderately, and for the counter-movement that reverses it and returns the loan rate towards the natural rate.
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture III, for the passage from Mises placed at its head, for Hayek's statement of what was left unexplained, and for sections 7 and 8 on the widening spread at the consumption end and the cumulative fall in the price of specific goods in the early stages.
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 8, 14 and 4 percent in the example are invented figures chosen to show a pattern. They are not measurements of any period and no episode is described.
- Stages of production are not observable, so any empirical test substitutes an industry classification for them, and that substitution is a judgement rather than a measurement.
- A price pattern matching the sequence is consistent with this account rather than evidence only for it. The published tests, and what they found, belong to the course on the case against the theory.