Hayekian Triangles and Beyond
Jack Birner and Rudy van Zijp, eds.
Hayek, Coordination and Evolution:
His Legacy in Philosophy, Politics, Economics, and
the History of Ideas
London: Routledge, 1994, pp. 109-125
Roger W. Garrison
The lectures that F. A. Hayek delivered at the London School of Economics
in the early 1930s were punctuated with triangles—triangles of a sort his
audience had never before seen. Now, more than sixty years after those
lectures were published as Prices and Production (1931), the triangles
still hold the key to understanding Hayekian macroeconomics. What exactly
did Hayek see in them? Why could most of his audience see nothing at all
in them? Satisfying answers to these two questions can go a long way towards
identifying the core differences between Austrian and Anglo-American macroeconomics.
Considering a third question
can add significance to our answer. What relevance do the ideas that Hayek
hung on those triangles have today? The lectures were written at a time
when Hayek and the rest of the profession were contemplating the dramatic
economic boom of the 1920s and the subsequent depression that had yet to
find its bottom. The early 1990s find the profession in similar circumstances—contemplating
the dramatic bull market of the 1980s and wondering if and how the current
recession is related. It would be a mistake to assume that Hayek's triangulation
as applied to the earlier episode applies in some wholesale fashion to
the current one, but it would be a greater mistake to assume that Hayek's
insights have no current application of all.
Hayek's theory of boom and
bust can be generalized so as to increase its plausibility as an account
of the 1920s and 1930s and give it new life in accounting for the 1980s
and 1990s. After making the appropriate conceptual and institutional adjustments,
the story in Prices and Production can be retold in a way that sheds
light on contermporary macroeconomic problems. Also, reconsidering the
triangles—as Hayek employed them then and as present-day Hayekians might
employ them now—helps to put in perspective the macroeconomics of the intervening
years which grew out of the Keynesian revolution.
The Macroeconomic Significance of the Triangles
The Hayekian triangle, as described in Hayek's second lecture (Hayek,
1967, pp. 36-47), is a heuristic device that gives analytical legs to a
theory of business cycles first offered by Ludwig von Mises (1953, pp.
339-366). A right triangle depicts the macroeconomy as having a value dimension
and a time dimension. It represents at the highest level of abstraction
the economy's production process and the consumer goods that flow from
it. One leg of the triangle represents dollar-denominated spending on consumer
goods; the other leg represents the time dimension that characterizes the
production process (Figure 5.1). In a fundamental sense, the Hayekian triangles
in their various configurations illustrate a trade-off recognized by Carl
Menger and emplasized by Eugen von Böhm-Bawerk. At a given point in
time and in the absence of resource idleness, investment is made at the
expense of consumption. Investment,
which entails the commitment of resources to a time-consuming production
process, adds to the time dimension of the economy's structure of production.
To allow for investment, consumption must fall initially in both nominal
and real terms. Once the capital restructuring is complete, the corresponding
level of consumption is higher in real terms than its initial level. The
nominal level of consumption spending, however, is lower than its initial
level because a greater proportion of total spending is devoted to the
maintenance of a more time-consuming production structure.
The relative length's of
the triangle's two legs, then, represent the inverse relationship between
nominal consumption spending and nominal non-consumption spending—the latter
as reflected by the time dimension of the economy's capital structure.
Hayek makes use of several heuristic assumptions that cause production
time and non-consumption spending to be more tightly linked in his graphics
than in reality. He assumes, for instance, that the production process
consists of stages of production such that output of one stage sells as
input for the next and that the number of stages varies directly with production
time. For the purpose of defining the triangles, the quantity of money
and the velocity of circulation—and hence the product MV—are assumed
constant. (Episodes of monetary expansion, however, provide the most interesting
and relevant circumstances for application of the graphics.)
The Hayekian triangles can
change in shape in circumstances of a constant MV—and hence a constant
where Q is understood to include the sum of the outputs of each
stage of production including the final stage whose output is consumption
goods. The Hayekian Q, then, lies somewhere between the Fisherian
which stands for total transactions and the Friedmanian Y, which
stands for income or final output (consumption plus net investment); the
corresponding V lies somewhere between the transactions velocity
and the income velocity.
The basis for a change in
the shape of the triangle is a hypothetical preference change within
the output aggregate. Suppose that consumers become more future oriented.
Their time preferences—to use the Austrian term—are lower than before.
In the first instance, this preference change means a decrease in demand
for current consumption and an increase in saving. In the Austrian formulation,
saving means more than simply not consuming. Income earners do not just
save; they save-up-for-something. Saving-up-for-something is another terminological
in-betweener lying somewhere between the conventional polar concepts of
saving as a flow and savings as a stock. Increased saving in the Austrian
formulation gets translated through market mechanisms and entrepreneurial
foresight into higher demands for inputs in the relative early stages of
production. The demand for output as a whole, then, is neither higher nor
lower than before the preference change. Rather, the pattern of demand
has changed in a way that is conveniently depicted by a Hayekian triangle
whose consumer-spending leg has become shorter and whose production-time
lag has become longer (Figure 5.2).
The height of the hypotenuse
of the reconfigured triangle measured at each stage of production along
the production-time leg shows (1) that the demand for input is reduced
in the final and late stages of
production, (2) that the extent of the reduction diminishes as stages further
removed from consumption are considered, (3) that stages remote from consumption
experience an increased demand for input and (4) that stages of production
more remote than had existed before have been created anew. The slope of
the hypotenuse, now less steep than before, reflects a lower rate on interest
corresponding to the reduced time preference.
Reduced time preferences
mean a smaller time discount on future consumption. Consumers are more
willing to sacrifice consumption goods available now and in the immediate
future for consumption goods available in the relatively remote future.
Tailoring production plans to consumption preferences requires that the
structure of production be modified in precisely the way depicted by the
change in the Hayekian triangle just described. Hayek went beyond determining
what changes in the structure of production were required by the preference
change to identifying, in his third lecture, the market mechanisms that
could allocate resources among the stages of production in conformity with
the time preferences of consumers. Lower time preferences means increased
saving and hence a lower rate of interest. The lower interest rate drives
down the competitive gross profit margin in each stage of production. That
is, for each stage input prices are bid up in relationship to output prices.
the cumulative effect of this relative-price adjustment increases with
increased remoteness from the final stage. Accordingly, resources are shifted
out of late stages and into early stages in response to the lower time
It is easy to fault Hayek
and his triangles for sins of omission. What about durable capital and
consumer durables? What about changes in the degree of vertical integration?
What about instances of input-output circularity such as coal as an input
in the production of steel and steel as an input in the production of coal?
The realization that there are many aspects of a modern decentralized capitalist
economy not captured by a triangle should come as no surprise. What is
surprising is how much these triangles do depict or imply. Implicit, for
instance, is the notion that the structure of production is characterized
by some—but not complete—specificity: If all capital goods were wholly
non-specific, then no structure could be defined; if every capital good
were completely specific, then no modification could be made. The notion
of stage-specific capital implies a certain intertemporal complementarity
that characterizes the structure of production. Complementarity through
time gives special significance to the time element in the production process—which
was so emphasized by Menger and Böhm-Bawerk.
Treating the problem of
intertemporal allocation of resources in terms of the economy's capital
structure keeps the entrepreneurial element of the argument in perspective.
In the alternative Anglo-American formulations, capital theory is suppressed.
Hence, the concept of investment, which is defined as the rate of change
in the capital stock, is not well anchored, and doubts that saving will
get translated into investment dominate in discussions of both theory and
policy. The Hayekian triangles are a constant reminder that a certain amount
of entrepreneurial foresight governing the intertemporal allocation of
resources is essential to the functioning of a capitalist economy whether
or not there are any net additions to the economy's capital stock. If market
mechanisms governing intertemporal allocation are working properly, saving
and investment pose no special problems. Changes in saving propensities
have a direct impact on the rate interest. Market mechanisms together with
entrepreneurial foresight continue to operate as before—only now under
different credit conditions—to allocate capital and other resources among
the stages of production.
The ultimate effect of a
change in the rate of interest on the capital structure is seen as a difference
in shape between the initial and subsequent Hayekian triangle. In Prices
and Production, Hayek did not treat in any detail the issues of the
traverse, as john Hicks (1965. pp. 183-197) was later to call it. The intertemporal
profile of output during the capital restructuring—the traverse—is dependent
on a myriad of details involving the specifics of technology and the intertemporal
complementarities and substitutabilities that characterized the existing
capital structure. Implicit in Hayek's application of the triangle, however,
is one critical distinction. Depending upon what caused the interest rate
to fall, the traverse may or may not be consistent with an actual completion
of the capital restructuring. In summary terms, we can say that if the
lower interest rate is attributable to new economic realities, particularly
if it reflects lower time preferences of consumers, then the traverse will
be consistent with completing the process of capital restructuring. If,
instead, the lower interest rate is attributable to new economic policies,
particularly if it reflects credit expansion by the central bank, then
the traverse will be inconsistent with completing the process of capital
restructuring. The preference-induced process is one of economic growth;
the policy-induced process is one of boom and bust (Hayek, 1967, pp. 50-60).
Hayekian Shapes and Keynesian Sizes
Capital theory in which value is played off against time should not
have been totally foreign to Hayek's English audience. A half-century before
Hayek molded his lectures around those triangles, an essentially equivalent
construction, not then known by Hayek (1967, p. 38), had been offered by
William Stanley Jevons. The Jevonian investment figures, which were the
core of Jevons's chapter on capital (Jevons, 1970, pp. 225-253), showed
capital value rising linearly with time as production proceeded from inception
to completion. What was foreign to the English audience was the use of
the triangular construction as the basis for macroeconomic theorizing and
for theorizing, in particular, about boom and bust.
Capital theory is complex
in its own right—as are most theories of cyclical variation. Hayek's attempt
to present a capital-based theory of cyclical variation in an early stage
of development involved the compounding of complexity with complexity.
It is not at all surprising, then, that these ideas would seem foreign
to most and bewildering to many. Reflecting years later on Prices and
Production, Hicks remarked that the book "was in English, but it was
not English economics (Hicks, 1967, p. 204). Joan Robinson, who had heard
Hayek lecture at Cambridge on his way to the London School, referred to
Hayek's theory as a "pitiful state of confusion," and believed that his
whole argument "consisted in confusing the current rate of investment with
the total stock of capital goods" (Robinson, 1972, p. 2).
John Maynard Keynes (1931)
reviewed Hayek's book in what was purportedly a reply to Hayek's critique
of Keynes's Treatise on Money. Piero Sraffa (1932) defended his
own views on production and distribution theory in what was purportedly
a review of Hayek's book. Both Keynes and Sraffa were unreceptive and even
hostile to the ideas in Prices and Production. After reporting his
own early fascination with Hayekian theory, Nicholas Kaldor (1942) reassessed
and Production in the light of subsequent application of the theory.
He concluded that the basic ideas in that book must be wrong and referred
jeeringly to Hayek's capital-based theory of boom and bust as the "Concertina
Some English economists,
notably Lionel Robbins (1934) and to a lesser extent John Hicks and Abba
Lerner, were persuaded, at least temporarily, of the merit of Hayek's theory.
But the general direction the economics profession was taking at the time
was not conducive to the acceptance of a capital-based macroeconomics.
The very complexity of a capital structure in macroeconomic disequilibrium
seemed to be grounds for sending value and capital theory in one direction
and macroeconomics in another. The breaking away of macroeconomics from
consideration of capital structure became complete with the publication
in 1936 of Keynes's General Theory of Employment, Interest, and Money.
If the assumptions Hayek
invoked to make his theory tractable seem severe, the ones Keynes invoked
in Chapter 4 of his General Theory should seem more so. Keynes's
assumption of a fixed structure of industry effectively took the triangles
out of play. So long as fixity characterizes the relationship among the
stages of production, questions about the intertemporal allocation of resources
are moot, and scope for intertemoral discoordination nil. With a given
ratio of the value leg and the time leg of the Hayekian triangle, the issue
of the triangle's shape, so emphasized by Hayek, gave way in Keynes's own
theorizing to the issue of the triangle's size. Scope for variation in
size is simply the mirror image of scope for variation in resource idleness.
The capital-based Hayekian
vision and the capital-free Keynesian vision can be put into perspective
with the aid of a simple production-possibilities frontier in which investment
is traded off against consumption. So long as investment is positive, the
frontier itself moves outwards from one period to the next enabling higher
levels of both investment and consumption. The two visions differ fundamentally
in terms of the assumed initial conditions, or starting point, underlying
the theory and in terms of acknowledged market forces that propel or constrain
movement from those initial conditions.
Hayek took some point on
the frontier as his starting point and concerned himself with market processes
and central bank policies that move the economy along the frontier in the
direction of more investment. he argued, in effect, that if lower time
preferences—and hence a reduction in the natural rate of interest—underlie
the shift of resources away from consumption and towards investment, the
intertemporal market process governed largely by the interest rate would
move the economy along the frontier facilitating a more rapid expansion
of the frontier itself. If, however, credit expansion—and hence a suppression
of the interest rate below its natural level—underlies the shift of resources
in the direction of more investment, then the market process, forced in
the direction of more investment, would create internal tensions within
the capital structure which ultimately would throw the economy off the
production possibilities curve in the direction of resource idleness.
Keynes took some point interior
to the frontier as his starting point and concerned himself with fiscal
and monetary policies as well as institutional and social reforms that
may facilitate movement back to the frontier. Prospects for a market-driven
mobilization of idle resources were ruled out in his preliminary chapters.
With capital theory suppressed, concerns about which particular point on
the frontier to aim at were secondary—if that—to the basic concern of eliminating
resource idleness. The idea of a natural rate of interest and implied mix
of investment and consumption spending held no significance for Keynes
(1964, p. 373). He held, in effect, that there are as many natural rates
as there are combinations of demands that put the economy on its production
possibilities frontier. Market forces within the capital structure that
may favor one point on the frontier over another on the basis of intertemporal
consumption preferences were no part of his theory. In sum, Hayek offered
a capital-based explanation of how the economy got into a depression; Keynes
offered a capital-free prescription for getting out.
The Economics of Credit Controls and Credit Expansion
Abstract as the Hayekian triangles are, their application has strong
counterparts in basic microeconomic theory. The macroeconomic flavor can
be retained by virtue of the explicit accounting of the time element in
the production process which may involve scope for economywide intertemporal
discoordination. Alternative credit-market interventions can be considered
in the context of basic supply-and-demand analysis. The particular intervention,
conceived in microeconomic terms, may or may not have significant macroeconomic
consequences depending upon whether or not there is scope for a systematic
discoordiantion within the structure of production.
First, consider the economics
of credit control in the form of an interest-rate ceiling. So long as the
legal maximum is below the market-clearing rate of interest, the credit
market will be cut short. The supply of credit becomes the binding constraint.
Savers who would have been willing to supply funds at interest rates between
the legal-maximum rate and the market-clearing rate will now find additional
consumption more attractive. The credit shortage reflects the many would-be
borrowers eager to take advantage of investment opportunities made attractive
by the low interest rate—which is to say, opportunities in the relative
early stages of production. The incentives created by credit control, then
push in opposite directions: erstwhile savers prefer to increase their
current rate of consumption while investors become—or at least would like
to become—more future oriented.
By the very nature of the
price ceilings, however, the constrained preferences do not get translated
into realities. There is no scope even for the beginnings of a process
of capital restructuring as would be guided by a low market-clearing rate
of interest. In fact, to the extent that black markets or grey markets,
which flout or skirt the legal restriction, come into being, the corresponding
rate of interest will be demand-determined. Some demanders of credit who
would have been shut out by the legislated ceiling are accommodated but
at an interest rate above the old market-clearing rate. This high rate
of interest puts a premium on time an channels resources into the relative
late stages of production. The ultimate result is that both the time pattern
of production and the time pattern of consumption are less future oriented
than before the imposition of the interest-rate ceiling.
Second, consider the imposition
of an interest-rate ceiling accompanied with a further intervention to
prevent the credit shortage from materializing immediately. Suppose that
the difference between credit supplied and credit demanded at the legal
maximum is made up for by credit creation. The creating and lending of
money to fill the gap between supply and demand has the effect of papering
over the shortage. It keeps the discrepancy in incentives between the two
sides of the market from showing itself immediately.
If borrowers were to respond
to the combination of a ceiling rate and abundant credit in the same way
they would respond to a low market rate, resources would be allocated away
from late stages of production and into the early stages. As this capital
restructuring is underway, income earners would be turning from saving
to consumption in the face of the interest-rate ceiling. The market linkages
through which the production process is tailored to consumption preferences,
however, are not so tight as to curtail the capital restructuring in its
incipiency. The time element inherent in the production process translates
directly into scope for capital restructuring even in the absence of any
change in consumption preferences. But the discrepancy in incentives means
that the capital restructuring in necessarily ill-fated. Unavoidably, there
will be a clash between producers and consumers as the restructuring process
goes forward. Misallocations revealed in the clash will require liquidation
and reallocations more consistent with consumer preferences and the interest-rate
It is doubtful that investors
would actually respond to a ceiling rate—even with the would-be credit
shortage papered over with credit creation—in the same way that would respond
to a low market rate. The very enactment of the interest-rate ceiling would
have a certain announcement effect that would warn borrowers away from
business-as-usual investment strategies. The credit creation, however,
initially described as "further intervention" aimed at concealing temporarily
the effects of the interest-rate ceiling, actually makes the interest-rate
ceiling largely redundant. That is, the expansion of credit by itself has
the effect of reducing the interest rate as it adds to the supply of loanable
funds. The allocational consequences, somewhat implausible in the face
of a legislated interest-rate ceiling, gain in plausibility—and in historical
relevance—when attributed to credit expansion alone.
Finally, then, consider
the economics of credit expansion. The differences to be highlighted by
considering this particular sequence of interventions are differences in
announcement effects and in expectations about future credit-market conditions.
Unlike an interest-rate ceiling as might be imposed by the legislature,
credit expansion orchestrated by the central bank can be initiated without
public debate and without any strong announcement effect. Borrowers are
likely to respond to favorable credit conditions attributable to central-bank
policy in about the same way they would have responded to favorable credit
conditions attributable to increased saving. In fact, many borrowers would
not bother to find answers or even to ask questions about the basis for
the lower interest rate. Yet, the policy-induced lower rate creates the
same discrepancy of incentives as does an interest-rate ceiling. Savers
save less, and borrowers borrow more, with the difference between saving
an borrowing being made up by credit expansion.
decisions under favorable credit conditions are the makings of an economic
boom. Increased funds in the hands of investors and the increased profit
prospects in long-term projects allow for increased employment opportunities
as resources are drawn away from late stages of production and into earlier
stages. The multi-stage production process as depicted by the Hayekian
triangles provides scope for extensive capital restructuring in the direction
of a more time-consuming production process despite the actual reduction
in saving. The tug-of-war between producers and consumers implicit in the
policy-induced economic expansion does not produce a victor in a timely
manner. It is a tug-of-war with and expandable rope.
If the business community
continues to respond to the credit expansion as if favorable credit conditions
will last indefinitely, then the duration of the boom will be limited by
the time element in the production process itself. Outputs of earlier stages
feed successively into subsequent stages. At some stage in this process,
the viability of the policy-induced capital restructuring comes into question.
Capital and labor resources complementary to those already committed to
earlier stages are in short supply (Hayek, 1967, pp. 85-91). The bidding
up of input prices in the late stages of production impinges on credit
markets as well. So-called distress borrowing puts an upward pressure on
interest rates wholly separate from any inflation premium attributable
to credit expansion.
In the final throes of a
policy-induced boom, the role of the central bank becomes more evident
and more visible. Will the central bank supply additional credit, which
will more fully satisfy each demand in nominal terms but will translate
generally into higher resource prices rather than more successful bidding?
Or, will the central bank curtail credit to avoid still further misallocation
of resources and a general price inflation? The tug-of-war between producers
and consumers becomes, from the perspective of the central bank, a tiger
by the tail. Both bulls and bears engage in speculative transactions on
the basis of their guesses about how long the central bank will hang on
and just when it will let go.
Economists who do not theorize
in terms of a capital structure and who question the meaning or significance
of the natural rate on interest, tend to see little harm—and may see great
benefit—in credit expansion. Most of those same economists would see as
foolish, wasteful, and counterproductive any attempt to impose a price
ceiling on any market and especially an attempt to impose an interest-rate
ceiling on credit markets. Yet, the key difference emphasized above between
an interest-rate ceiling and credit expansion in the context of a multi-stage
capital structure is that the perversities of the interest-rate ceiling
manifest themselves more directly and more quickly and, although disruptive,
are less so than the alternative policy of credit expansion. The perversities
of a credit-induced boom are obscured by the initial positive effects of
credit expansion, the time element that separates credit expansion from
its negative effects, and the complexity of the capital theory needed to
make the theoretical connection between expansion and crisis.
Three Components of the Interest Rate
Attention to the time element in the capital structure allows the message
in Hayek's Prices and Production to be generalized and then adapted
so as to apply in contexts other than the one that inspired his London
lectures. Production time inherent in the multi-stage production process
can put a lag between intervention in credit markets and the ultimate consequences
on that intervention. The particular intervention of concern to Hayek,
credit expansion, affected the capital structure's intertemporal orientation.
The cheap credit favored a reallocation of resources among the stages of
production that was inconsistent with intertemporal consumer preferences.
More specifically, the artificially low rate on interest caused production
plans to become more future oriented and consumption plans to be come less
Other sorts of intervention
that might have lagged consequences on an economywide scale can be identified
by taking the interest rate to be the key market signal that translates
cause into lagged effect and considering the individual components of the
market rate on interest. To this end, it is convenient to conceive of the
market rate as consisting of three components: an underlying time discount,
an inflation premium, and a risk premium. Hayek's triangulation in the
early 1930s was based squarely on the first component.
By the 1960s the focus of
macroeconomists had shifted from the first component to the second. Practiced
use of monetary tools as economic stimulants—however temporary the actual
effects—gave increasing importance to the role of expectations. Scope for
a significant discrepancy between expected and actual inflation rates resulted
in macroeconomic constructions that featured the inflation premium. Arguably,
the most interesting consequences of imperfectly anticipated inflation
are those that manifest themselves as the misallocation of capital and
labor among the stages of production as might be depicted by Hayekian triangles.
But by the time the problem of inflation had captured the attention of
modern macroeconomists, capital theory had been in eclipse for more than
The Keynesian revolution
had so weakened the perceived link between capital and interest that it
became commonplace to theorize in terms of the level on employment in the
context of a given capital structure. Monetary expansion, which has its
most direct effects in credit markets and on interest rates, came to be
analyzed in terms of labor markets and wage rates. This shift in focus
was seen as a glaring incongruity to economists who learned their macroeconomics
from Hayek but was second nature to economists who had long since left
capital theory behind.
The nature and significance
of the inverse relationship between the inflation rate and the level of
employment as depicted by the Phillips curve was derived from differences
in the abilities of employers and employees in forming relevant expectations
and on differences in the way market participants, broadly conceived, adjust
their expectations about inflation (Friedman, 1976). The first difference
governed the strength of the short-run trade-off between inflation and
unemployment; the second difference governed the length of the short run.
What came to be the conventional account of the consequences of monetary
expansion traces the movement along a short-run Phillips curve, which reflects
given expectations, then allows for a shifting of the curve to reflect
a change in expectations. The adjustment process involves a temporary decrease
in the unemployment rate as wage adjustments lag behind price adjustments
followed by a permanent increase in the inflation rate as the general level
of prices catches up to the expanding money supply. Except for occasional
reference to temporary and wholly incidental disturbances affecting stock-flow
relationships in markets for financial and real assets, business-cycle
theory based upon short-run/long-run Phillips curve dynamics takes no account
of capital misallocation. The critical time element, which was a fundamental
aspect of the capital-based theory of Hayek's theory, was retained in the
tenuous form of time-consuming adjustments—accomplished differentially
by employers and employees—of perceptions to realities.
The general focus of macroeconomic
discussion changed dramatically between the 1930s and the 1960s as the
focus changed from the time-discount component of the interest rate to
the inflation premium and from capital markets to labor markets. In summary
terms, Hayek's Prices and Production provided a capital-based account
of policy induced distortions in time discounts, while the macroeconomics
of the 1960s provided a labor-based account of policy-induced changes in
the inflation premium. The purpose here in making the contrast in this
way is not to pit one macroeconomic framework against the other (as in
done in Bellante and Garrison, 1988) but rather to point in the direction
of a third framework that may prove more applicable to the 1990s.
The third component of the
market rate of interest, the risk premium, has played a significant role
neither in Hayekian constructions nor in more modern ones. Typically, risk
premiums get mentioned only in introductory throat-clearing paragraphs
in which considerations of risks along with administrative charges and
other workaday matters are assumed away. At most, the perceived riskiness
of holding non-monetary assets helps in some formulations to explain the
demand for money. But there has been no macroeconomic theory attempting
to explain any episode of boom and bust in terms of the market's allocation
of risk-bearing or policy-induced distortions of risk-related market mechanisms.
Until recently, such a theoretical formulation would have little if any
application. But the macroeconomic experience of the 1980s and 1990s might
best be accounted for by just such a formulation.
The risk-based formulation
parallels Hayek's original triangulation and, to a lesser extent, the more
modern theorizing about short-run and long-run Phillips curves. In summary
terms, we can say that the market allocates risk-bearing among market participants
in accordance with the willingness of each to bear risk. Policies can create
a discrepancy between risk willingly born and risk actually born. Because
of a critical time element embedded in risk-bearing, such policies can
have cause-and-effect relationships that manifest themselves macroeconomically
as boom and bust.
The Economics of Risk Control and Risk Externalization
Not all conceivable policies that would interfere with the market's
allocation of risk-bearing would have significant macroeconomic effects.
Suppose, for example, that the legislature, which might take all market
rates of interest more than, say, five percent above the Treasury-bill
rate to reflect excessive riskiness, were to declare all payment for such
risk-bearing politically incorrect. A legislated Treasury-plus-five cap
on interest rates would have a direct and immediate effect on credit markets.
Entrepreneurs interested in relatively risky undertakings would face a
credit shortage. The effects of this partial prohibition against risk-taking
would differ little from the effects of a simple interest-rate cap. Black
and grey credit markets would emerge to partially offset the effects of
legislation, and the trade-off between debt and equity financing would
be biased in favor of equity. Apart from these effects, which are wholly
predictable on the basis of conventional microeconomics, there is no basis
for predicting that any macroeconomically significant consequences would
follow from such risk-control legislation.
The effects of this hypothetical
risk-control legislation are set out here in order to provide a basis for
contrasting those distortions of market mechanisms for allocating risk-bearing
that do have macroeconomically significant effects and those that do not.
The exposition also allows us to identify links between the economics of
risk allocation and the economics of credit allocation. We can anticipate
the argument by saying that, in terms of the macroeconomic significance
of the effects of intervention, credit control is to risk control what
credit expansion is to risk externalization. Legislative actions and policy
innovations may allow borrowers to take risks that are systematically out
of line with the risks perceived or actually born by lenders. So long as
risk is effectively concealed from lenders or actually shifted to others,
risk-taking will be excessive. The initial phase of excessive risk-taking
will manifest itself as an economic boom, but eventually, when actual losses
begin to change the perception of lenders and begin to impinge upon unsuspecting
others, the boom will give way to a bust.
Adding substance to this
summary account of boom and bust attributable to distortions of the risk
premium requires the identification of legislative action and policy innovation
that create a discrepancy between risk-taking and (perceived) risk-bearing.
The market process set into motion by the discrepancy can then be shown
to play itself out in the context of actual markets that embody risk-taking.
In this way, a capital-based account of legislative and policy-based distortions
in risk premiums can point to specific interventions that underlay the
boom of the 1980s and sowed the seeds for the bust—the Bush recession—in
the early 1990s
The single piece of legislation
most relevant to risk allocation in the 1980s' boom was the Depository
Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which
dramatically changed the banking industry's ability and willingness to
finance risky undertakings. Increased competition within the banking industry
and from non-bank financial institutions drove commercial banks to alter
their lending policy so as to accept greater risks in order to achieve
higher yields. The deregulation gave new significance to the Federal Deposit
Insurance Corporation (FDIC), which continued to absolve the banks' depositors
of all worries about illiquidity and even about bankruptcy, while the Federal
Reserve in its long-established capacity of lender of last resort diminished
the banks' own concerns about such problems. The risks in the private sector,
then, were only partially reflected in higher borrowing costs and lower
share prices. In substantial measure, private-sector risks were transformed
into risks of inflation in the event of excessive last-resort lending by
the Federal Reserve and risks of a large and unbudgeted liability in the
event of excessive last-resort closings by the FDIC. But these risks were
born unknowingly and hence unwillingly by market participants and taxpayers
throughout the economy. During the 1980s, then, the increased riskiness
in the private sector was effectively externalized and diffused so that
the private-sector activity, spurred on by correspondingly increased yields,
was largely unattenuated by considerations of risk.
The policy innovation most
relevant to risk allocation in the 1980s' boom was the federal government's
dramatically increased reliance on deficit finance. The Federal Reserve
in its capacity to monetize government debt keeps the default-risk premium
off Treasury bills. This is not to say that the risk that would otherwise
attach itself to government securities is actually eliminated. The burden
of bearing risk is simply shifted from the holders of Treasury securities
to others. Borrowing and investing in the private sector is more risky
than it otherwise would be. Holders of private debt and equity shares must
concern themselves with all the usual risks and uncertainties of the market
place plus the risks and uncertainties attributable to potential changes
in the way the federal deficit is accommodated. The massive selling of
debt by the Treasury in foreign credit markets, in domestic credit markets,
or to the Federal Reserve can have major effects on the strength of export
markets, on domestic interest rates, and on the inflation rate. Inability
of market participants to anticipate the Treasury's borrowing strategy
translates into unanticipated changes in the value of private securities
and the real assets they represent. Speculative lending in the private
sector, such as for commercial real-estate development or for highly leveraged
financial reorganizations are risky in large part because of possible changes
in such things as the inflation rate, interest rate, trade flows, and tax
rates—the very things that can undergo substantial and unpredictable change
when the federal budget is dramatically out of balance (Garrison, 1993).
In circumstances where considerations
of risk figure importantly in accounting for the performance of the economy,
capital markets become the natural focus of attention. The focus on capital
is what makes the macroeconomics of the 1980s and 1990s more closely related
to Hayekian triangulation than to the labor-based short-run/long-run Phillips
curve analysis of the 1960s. Long-term, or capital-intensive, undertakings
are inherently more risky than short-term undertakings precisely because
more time must elapse before such undertakings can prove their profitability—more
time that increases the likelihood of some major change in deficit accommodation
or some attempt at deficit reduction that can turn expected profits into
The temporal segregation
of stages of production that make up the economy's capital structure puts
a dimension in the analysis that is absent in labor-based theorizing. There
is scope for profit-taking in early stages of production in cases where
ultimately the entire project—all stages considered—yields a substantial
loss. The possibility for short-term commitments in the early stages of
long-term projects coupled with the many imperfections in contingency markets
that allow for some hedging against changes in the federal government's
fiscal and monetary strategy warn against too literal an application of
the so-called efficient-market hypothesis. Ordinarily, markets allocate
both capital and labor efficiently—or at least more efficiently that any
alternative allocation mechanism. But a market system whose credit markets
involve risks that are partially concealed from the lender and partially
shifted to others will be biased in the direction of excessive risk-taking.
And excessive risks are converted in time into excessive losses.
Hayekian Triangles for the 1990s
Frequent but vague references in the financial and popular press to
the "excesses of the 1980s" can be taken to mean excess riskiness in comparison
to wealth holders' willingness to bear risk. The 1980s may best be understood,
then, as a decade in which risk externalization attributable to legislative
action and policy innovation gave rise to a substantial but ultimately
unsustainable economic boom.
This diagnosis of the macroeconomic
ills of the 1990s is more suggestive than conclusive. The purpose here
is to demonstrate the versatility of Hayekian theory rather than render
a final verdict on the most recent episode of boom and bust. Hayek gave
us a good start on capital-based macroeconomics. The insights wrapped up
in those triangles and the prospects for extension and application are
yet to be fully developed or fully appreciated.
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