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8. Inflation and the Business Trade Cycle
Thus far all explanation of the market system has been predicated on the assumption that there is no inflation problem and no erratic business pattern of intermittent general expansion followed by general recession or depression. The market system has been shown to operate through the price mechanism, which induces adaptive and complementary actions on the part of the market participants in the face of ever-changing market conditions. There is nothing inherent in this system to produce a general or widespread increase in prices or to lead to pervasive business expansion and then general business contraction. Changes in specific prices, i.e., relative price changes, abound, mirroring changes in valuations and available supplies. These price shifts include increases and decreases; absent is any factor to cause most prices to increase over time. Characteristic too are errors on the part of some entrepreneur-producers who suffer money losses from malinvestments. Yet there is no causal element that leads to widespread malinvestment and the attendant general recession or depression. That these occurrences of a general rise in prices and the ebb and flow of general business activity pertain to our world today hardly needs mentioning. What is of significance to us here is their cause.
Popular use of the term inflation to mean a general rise in prices misconstrues the fundamental problem by focusing on the effect and not the cause. It is the inflation of the money supply by the U. S. Treasury and the central banking system that engenders in the structure of market prices a general upward movement over time. The printing of additional Federal Reserve notes and the creation of new demand deposits in connection with the monetization of federal debt along with fractional-reserve banking and member-bank borrowing (discounting) from Federal Reserve banks constitute the basic mechanisms of inflation of the money supply. These are all forms of credit expansion, which means the injection of additional money into the system. A continuous rise in prices in general is the natural outcome of a continuous policy of credit expansion.
We have seen already that the interest rate reflects the ratio of present goods valuation to future goods valuation. If there is a shift toward a greater preference of present goods over future goods, then the interest rate increases correspondingly, reflecting the greater discount of future goods. Conversely, a change in favor of more future goods would lead to a lowering of the interest rate. The market interest rate tends toward a level at which the amount of funds that savers are willing to invest in production equals the amount that entrepreneur-producers are willing to obtain and use for productive purposes.
The saving-investment of funds means that purchasing power is used so that a certain amount of resources is directed toward the production of capital goods as opposed to consumer goods. As we have seen, capital goods production generally lengthens the production process, i.e., roundabout production is expanded. However, capital goods production might also require a lateral expansion of production in the form of additional plants and equipment similar to existing ones. It is important to stress that the market rate of interest provides a signal that indicates the extent to which capital goods production may be undertaken without frustrating the demand for consumer goods. The savings made available for business investment at the market interest rate are thereby intentionally withdrawn by the savers from the otherwise potential demand for consumer goods. Entrepreneur-producers are being allowed to use these funds to employ resources in the productive process in view of whatever profit opportunities they perceive and choose to pursue. And yet these production decisions are not without restraint:
The role which the rate of interest plays in these deliberations of the planning businessman is obvious. It shows him how far he can go in withholding factors of production from employment for want-satisfaction in nearer periods of the future and in dedicating them to want-satisfaction in remoter periods. It shows him what period of production conforms in every concrete case to the difference which the public makes in the ratio of valuation between present goods and future goods. It prevents him from embarking upon projects the execution of which would not agree with the limited amount of capital goods provided by the saving public.1
The expansion of credit, i.e., the increase in the money supply, through the joint action of the federal government and the banking system tends to lower the interest rate below a level that would otherwise prevail in a market devoid of such actions to increase the money supply. In the early stages of the credit expansion the interest rate actually drops. Subsequently, as the effect of such policies on prices throughout the market becomes apparent, a price premium is added to the interest rate in order to protect the savers from the harmful impact of expected price increases. Note, however, that this price premium starts after the price effects have occurred so that, in largely mirroring such effects, it must necessarily lag behind what would be adequate to cover further price increases under continuing inflation. Because of the price premium, the interest rate tends to rise over time despite continued additions to the money supply. Nevertheless, continued doses of additional money dampens this rise in the interest rate so that it "continues to lag behind the height at which it would cover both ordinary interest plus the positive price premium."2
The fact that interest rates reach levels uncharacteristic of years past does not invalidate the point that the rates are kept artificially lower than rates adequate to cover the discount, entrepreneurial, and inflation elements. The often heard complaint that interest rates are too high under these conditions is a misconception. We have just seen that there are two factors that tend to hold down the rate of interest below the level sufficient to allow for the related elements emerging on the market: (1) The implementation of the price premium lags behind the changes in purchasing power stemming from the inflation; and (2) the additional supply of money thrown onto the market has a dampening effect on the interest rate. Concerning the latter point, it must be realized that entrepreneur-producers are unable to differentiate between additional funds that have been artificially created and additional funds emanating from real savings.
Decreased interest rates in the early stages of the credit expansion emerge as faulty signals to entrepreneur-producers about the real savings available for business investment purposes. Business decisions are made as if the ratio of present (consumer) goods to future (capital) goods had dropped, when in actuality no such change has occurred. Additional investments in capital goods, broadening and lengthening the structure of production, are spurred as a business boom gets underway. Resources are diverted into the production of capital goods, and the prices of such resources are concomitantly bid up in the process. Yet the cue that the entrepreneur-producers have followed, the interest rate, has been falsified by the effects of the credit expansion. From the viewpoint of the general public it would be better that such resources not be misdirected in this fashion. Real savings appropriately available for additional capital goods formation has not increased.
Under the conditions of a short-lived credit expansion, the boom can be only temporary. The demand for consumer goods has not dropped, and the impropriety of enlarging and lengthening the production process as if it had is revealed once the credit expansion is terminated. The costs invested are seen as unjustified because the longer waiting time to complete and implement the additional capacity to produce is inappropriate in view of the unaffected demand for consumer goods. Production expansions cannot be finished, and the structure of production, which involves the coordination of numerous links in the lengthened production chain, is thrown out of smooth running order. Liquidations and rearrangements of production are necessary in order to correct the undesirable and unforeseen effects of the malinvestments. The actual consumption-saving ratio is once again able to dictate the balance between shorter and longer or more roundabout approaches to production. The correction or adjustment process is what is commonly referred to as a recession or depression.
If the duration of the credit expansion is not short, then the extent of malinvestments is compounded and the inevitable and eventual correction process is intensified. The continuous flow of additional credit enables the illusion to persist of greater savings as indicated by dampened interest rates in the midst of booming business. The additional purchasing power entering the market through the capital goods industries leads to increases in the demand for and prices of consumer goods. It appears to the entrepreneur-producers that the higher costs involved in continuing the capital goods expansion will be justified. The error in their expectations is hidden by the effects of the steady stream of additional credit. The additional credit accommodates their need for more funds to carry out the completion of their ventures in the face of rising costs. The boom must stop once the credit expansion is terminated. At that time, the correction process, i.e., a recession or depression, is ushered in.
The decision not to halt the credit expansion eventually must lead to what Mises has called the "crack-up boom," characterized by a general flight into real values and the collapse of the monetary system. In the later stages of the expansion the additions to the money supply must be increasingly accelerated as market participants have come to expect ever-increasing prices. At some point, the system of monetary exchange must break down. Consequently, to continue the easy-money policy in order to avoid the otherwise inevitable depression must bring about an even harsher fate: the collapse of the monetary system and the market economy, with its great advantages of specialization and division of labor.
The evidence of recent years indicates that it is unlikely that the credit expansion will be so protracted and uninterrupted that a crack-up boom will occur. It appears that, as dictated by political exigencies, intermittent expansion and contraction of the money supply generating a cyclical process that "becomes self-perpetuating and proceeds to the `stop-go cycle'"3 is the pattern likely to prevail. This means that with shorter-lived expansions the corrections or adjustments are less severe, and thus emerges the familiar and softer term "recession" in lieu of "depression."
It is important to see that the intervening in the market by increasing the money supply sidetracks the market process from its natural tendency to coordinate the actions of various market participants. The problem of inflation, then, is not merely a problem of a deteriorating monetary unit. The problem with inflation is that it cuts at the heart of the market process, producing at best intermittent and disruptive cyclical swings and at worst the disastrous cessation of market exchange as it is known in highly industrialized societies.
Hayek, Friedrich A. Monetary Theory and the Trade Cycle. Clifton, N.J.: Kelley, 1975.
Mises, Ludwig von. Human Action: A Treatise on Economics, pp. 538-586.
O'Driscoll, Gerald P., Jr. Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek. Kansas City: Sheed Andrews and McMeel, Inc., 1977.