Let us make an in-depth study of Hayek’s monetary overinvestment theory of trade cycle.
Hayek based his theory of the trade cycle on Wicksell’s theory of the income determination.
Wicksell had analyzed the equilibrium of the economic system with the help of a distinction between the natural rate and money rate of interest.
Natural rate of interest is that at which the demand for loanable funds equals the supply of loanable funds.
Natural rate of interest shows the equilibrium state of the economy Money rate of interest, on the other hand, is that which actually prevails in the market at a particular time. While the natural rate is the result of operation of the long term factors, both monetary’ and real, the money rate of interest is the result of monetary forces over a short period.
Wicksell had proposed that when the money rate diverges from the real rate of interest, there is disequilibrium in the economic system.
The two rates must be brought into equality if equilibrium is to prevail. If the money rate is above the natural rate of interest, there is contraction. If the money rate happens to be less than the natural rate, there is expansion of the economic system.
Hayek’s theory is called ‘monetary’ overinvestment theory’ because it considers ‘overinvestment’ of the economy’s resources in the capital goods sector as the sole cause of the business cycle, and the overinvestment takes place when there is too much expansion of money; cheaper money encourages the producers to introduce more roundabout (capital-intensive) methods of production because these have lower cost of production and hence give a higher rate of profit to them.
If the productive structure of the economy is to be kept in balance, then there must be an equilibrating proportion of the resources devoted between consumer goods and capital goods production. Producers decide to invest resources in their individual capacity.
They have no regular plan at the economy level for maintaining the desired proportion. Thus unplanned changes in the structure of production of the economy brought about by the divergence between the money rate and the natural rate of interest are considered to be the main cause of instability of the system.
The boom in the economy is considered in this theory to be the result of money rate being brought substantially below the natural rate of interest through an increased supply of money. Easier availability of credit and the low interest rate encourage the producers to introduce more roundabout methods of production.
As a result, the process of production is considerably lengthened. This means a rise in the prices of producer goods relative to those of consumer goods.
The increased purchasing power in the hands of the producers enables them to attract productive resources away from the consumer goods sector to the production of capital goods. If full-employment of resources already prevailed in the economy, additional resources into the producer-goods industries can come only from reduced supplies of the resources to consumer-goods industries.
Thus, the output of producer goods would increase at the expense of the output of consumer goods. Reduced output of consumer goods would raise the prices of these goods and discourage consumption. A cut in consumption means forced saving.
This forced saving serves to expand the producer goods output. In addition to this, forced saving is the extra saving of the class of persons having contractual incomes like rents and salaries. These savings also go into the production-goods sector. Thus, the boom is fed by monetary overinvestment of resources in the production of capital goods.
How does the boom end into a collapse of the system? Hayek argues that as the capital-goods output expands, consumer goods become scarce and their prices start rising fast. Profit-margins in the production of consumer-goods go up.
Therefore, entrepreneurs in the consumer-goods sector also try to bid for resources in competition to the producer-goods sector. This raises costs of production and reduces profit-margin in the producer-goods sector.
The process of rise in costs and reduction of profit in this sector will continue all the normal and natural ratio of consumer goods to producer’s goods prevails in the economy. But the process of contraction in the producer-goods sector becomes cumulative because of the slump in the natural rate of interest.
At the same time, banking system may also clamp restriction on the flow of credit to the producer-goods industries. Falling profit margins and shortage of credit would compel the firms to switch back to the less roundabout processes of production which employ less capital and more labour. New projects would not be executed and old ones may be abandoned.
Since the demand for producer goods of a roundabout nature falls, their prices crash and the firms having such stocks suffer losses. This is the onset of recession. How does the recession lead to a depression? The answer is fall of the natural rate of interest below the money rate of interest as a result of the shortening of the processes of production both in the capital-goods sector and the consumer-goods sector.
Since consumers are able to revert to their level of consumption they had before the boom started, the prices of consumer goods do not fall as much as the prices of producer goods. Producers try to shift resources from producer-goods to consumer-goods production but the process of shifting is painfully slow.
This is because the rate of absorption of labour and materials by consumer-goods industries is much lower than the rate at which these are released by the producer-goods sector. The result is a rising number of the un-employers.
Under the pressure exerted by unemployment, low wages, reduced profit margins in the capital goods industries and restricted credit facilities, less roundabout methods of production are used in the production of consumer goods.
Since the producers become pessimistic in the process of restructuring production, the system contracts even beyond the level at which the natural rate of interest would be the same as the market or money rate. As a consequence, the depression becomes unnecessarily prolonged and recovery much more difficult.
How does the recovery ultimately come about? During depression, commodity prices typically fall faster than money wages. The rising level of real wages during the slump phase brings about a revival of investment. This revival occurs through what has been called ‘capital deepening’.
Since real wages tend to rise during the slump, producers have a tendency to adopt more durable machines which are supposed to replace labour by capital. The rising demand for capital goods for capital deepening begins to offset the decline in induced investment. Thus, recovery starts which eventually leads to an upswing and so on.
From the analysis of the upswing and the downswing of economic activity given by Hayek and described above, we can easily say that it was an effort at combining Hawtrey’s monetary theory with the Austrian theory of capital to explain more convincingly the phenomenon of the trade cycle.