Hayek on Saving and Interest

Some time ago, someone recommended that I read "Price Expectations, Monetary Disturbances, and Malinvestments," by F.A. Hayek. It was from a lecture he gave in Copenhagen in 1933. It is included in Profits, Interest, and Investment. I finally got to it Wednesday. I read yesterday that it was the 20th anniversary of Hayek's death. Over at Coordination Problem, Steve Horwitz suggested that everyone provide their favorite quotes from Hayek as a remembrance.

I recently reread Hayek's Denationalization of Money, and there were plenty of good quotes consistent with what I see central to the market monetarist approach--adjust the nominal quantity of money according to changes in the demand to hold money. Still, rather than hunt those up, I am instead going to pick some quotes that I dislike from the 1933 essay.

"The success of almost any investment made for a considerable period of time will depend on the future development of the capital market and of the rate of interest. If at any moment people begin to add to the productive equipment this will as a rule represent only a part of a new process which will be completed only by further investments spread over a period of time; and the first investments will only prove to have been successful if only the supply of capital makes the expected further developments at later dates possible. In general, it is probably true that most investments are made in the expectation that the supply of capital will for some time continue at the present level. Or, in other words, entrepreneurs regard the present supply of capital and the present rate of interest as a symptom that approximately the same situation will continue to exist for some time. And it is only some such assumption that will justify the use of any additional capital to begin new round-about methods of production which, if they are to be completed, will require continued investment over a further period of time. (These further investments which are necessary if the present investments are going to be successful may be either investment by the same entrepreneurs who made the first investment, or--much more frequently--investments in the products produced by the first group by a second group of entrepreneurs"

Here we have the early Hayek suggesting that entrepreneurs myopically project the current interest rate into the future. The interest rate is identified with the "supply of capital," which is also supposed to remain constant into the future. In my view, assuming that any current interest rate will remain unchanged in the future would be an entrepreneurial error--an egregious and foolish one.

Hayek ties this "supply of capital" to saving, and he claims the entrepreneurs can act on the basis that the saving rate is more or less constant.

"Very large and unforeseen fluctuations of saving would therefore be sufficient to cause extensive losses on investment made during the period preceding then and therefore to create the characteristic situation of an economic crisis. The cause of such a crisis would be that entrepreneurs had mistakenly regarded a temporary increase in the supply of capital as permanent and acted in this expectation. The only reason why we cannot regard this as a sufficient explanation of economic crises as we know them is that experience provides no ground for assuming that such violent fluctuation in the rate of saving will occur otherwise than in consequence of crises. If it were not for the crises, which therefore we shall have to explain in a different way, the assumption of the entrepreneurs that the supply of saving will continue at about the present level for some time would probably prove to be justified."

Since Hayek wrote these words, there has been a good bit of analysis that suggests that the saving rate is not so stable. Friedman's permanent income hypothesis explains that saving adjusts to smooth consumption in the face of changes in income. When we add "real business cycle theory," or just an even more traditional understanding of creative destruction, a constant growth path for real income and output looks to be unrealistic. More generally, I can conceive of many possible future events, worry about which would result in increased saving. In other words, assuming that the current level of saving will persist and generate a continuing "supply of capital" and unchanged interest rates would be an entrepreneurial error.

At the end of this paragraph, Hayek makes it clear that this supposedly stable path of saving has to do with the allocation of consumption over time:

"The decisions of the entrepreneurs as to the dates and quantities of consumers' goods for which they provide by their present investments would coincide with the intention of the consumers as to the parts of their incomes which they want to consume at the various dates."

What is so striking is Hayek's apparent view that the current interest rate is sufficient to signal entrepreneurs as to how many consumer goods will be demanded at each particular future date. Read again the complicated story of an entrepreneur making investments--producing capital goods or having them produced--that will be used by other entrepreneurs, which will be used by still other entrepreneurs, all of which must have a "supply of capital" available to complete their plans. The first entrepreneur does this with some notion as to what will be the demand for the consumer goods produced by that other entrepreneur some years into the future?

In a world of creative destruction, where new products and new production techniques are constantly being introduced, such planning is unrealistic. A sufficient supply of capital, (which really means, sufficient saving, which really means, productive capacity beyond current consumption,) may be necessary for these plans to be completed. But there are so many other conditions that must be met as well. These other entrepreneurs don't come up with a different production process that uses other capital goods. Some other entrepreneur does not come up with a new way of satisfying consumer wants.

Further, from the perspective of any one entrepreneur, what is relevant isn't the future "supply of capital," in aggregate, but what will be available to those entrepreneurs that will be purchasing his products. This suggest that the "demand for capital," and the opportunity cost of the funds is important. In particular, if entrepreneurs discover some new opportunity that will produce large amounts of some product, this will raise interest rates. Any entrepreneur set up to supply capital goods or other inputs used for "old," less productive processes, would find that his customers, the entrepreneurs involved in those processes, would not have a "supply of capital." The funds will have been bid away by those entrepreneurs involved in the newly-discovered, more profitable projects. One obvious signal of this would be a higher interest rate, even though the total "supply" of capital has not changed, with the rate of saving and the demand for consumer goods in aggregate over various dates unchanged.

Writing all that was a bit awkward. What I would say is that the supply of saving and demand for investment determined one interest rate now. And then, later, due to the discovery of new, more productive investment projects, the demand for investment would rise, as would the interest rate.

In other words, the investment demand "curve" shifts to the right. The higher interest rate reduces the quantity of investment demanded. This is a crowding out of particular investment projects that have lower returns. Those entrepreneurs with specific capital goods that were committed to those projects will suffer losses.

My point is that any one entrepreneur cannot simply identify the current interest rate with the current and future supply of saving. Interest rates can change due to investment demand, and any one entrepreneur must make a judgement about how those changes will impact the demand for his particular product.

Further, if the supply of saving is less than perfectly interest inelastic, then the rate of saving, the current demand for consumer goods and the amount demanded at various future dates, will change due to the discovery of new, more-productive projects.

Hayek continues on to discuss how monetary changes can impact what he calls the "current supply of money-capital."

"If the supply of money-capital is increased, by monetary changes, beyond this amount, the result will be that the rate of interest will be lowered below the equilibrium rate and entrepreneurs will be induced to devote a larger part of the existing resources to production for the more distant future than corresponds to the way in which consumers divide their income between saving and current consumption."

If we imagined that the "supply of money-capital" is given to entrepreneurs as a gift and that they just happen to fund their favorite project with it, then the result might be a bit different than when these funds are lent, so that entrepreneurs must choose to borrow and plan on repaying the funds. This makes the "lower interest rate" important to the supposed distortion. To me, the assumption is that an excess supply of money results in a lower market interest rate--below the interest rate where saving equals investment. In Hayek's words, this would be below the rate where the "the supply of money-capital was of exactly the same amount as current savings." But for this to cause a problem, the entrepreneurs borrowing these funds must be taking the current interest rates, suddenly lowered, as a signal of some new rate of saving, something that supposedly doesn't change much. They borrow money short term to fund projects that will require that they, or perhaps someone else, be able to borrow money at low interest rates in the future. Regardless, they assume that the new, low interest rates will persist.

However, in reality, the new, low interest rate could be a symptom of increased saving, that while "real," is only temporary. And further, it is quite possible that in the future, interest rates will be higher even if the increase in saving was permanent, because new investment projects will be discovered that will result in a higher interest rate.

Taking a lower interest rate today to mean that interest rates in the future will also remain low, is a foolish entrepreneurial error. It is not simply an error because this lower interest rate might be due to an excess supply of money. It is an error even if there were never any excess supply of money. Any analysis that assumes constant investment demand and supply, and so an unchanging natural (or equilibrium, in Hayek's words,) interest rate is mistaken.

Why does Hayek go so wrong? The Austrian version of long run equilibrium was the ERE (Evenly Rotating Economy.) If we think about how a shift in the market interest rate below the natural interest rate would effect the pattern of demand in such an economy, then growing shortages of consumer goods might well develop. (Most economists, including me, would expect these shortages of consumer goods to show up too quickly for there to be much in the way of malinvestment.)

General equilibrium theory (and not the abbreviated macro versions,) describes actual markets where the demands for particular goods at particular future dates meet supplies. That is absurd enough, but they go further where there are markets for all possible future states of the world. About the only value of all of that is to help us keep in mind that it is a bit much to expect "the" interest rate to keep that coordinated. Shumpeter's creative destruction, and Lachmann and Shackel's kaleidoscopic future is a much more plausible way to frame the real world. The notion that there can be a level of short term interest rates such that each entrepreneur can look at it and then make judgments as to the amount of consumer goods that will be demanded at each future date is a chimera.

It is these sorts of considerations that have led me to see the key role for a monetary regime is to adjust the nominal quantity of money to the demand to hold it, and so avoid any shifts in nominal expenditure on output due to shortages or surpluses of money. In my view, the least bad environment for entrepreneurs to face the kaleidoscopic future that is a consequence of creative destruction is one where current nominal expenditure, and more importantly, expected future nominal expenditure, remains on a slow, steady growth path. At least roughly, such expectations both require and are consistent with a quantity of money that adjusts to the demand to hold it, and market interest rates that keep saving and investment equal over the near term. However, it provides no guarantee that current short term market interest rates will persist into the future, much less that an investment made based on that short term interest rate will find consumers ready to buy at the particular future dates when the project matures.

Taking current current short term rates to be the proper gauge of future interest rates is foolish. It is about as foolish as projecting the past trend in the price of an asset into the future. (Housing prices have always gone up, so they will continue to go up. Housing prices have been rising very rapidly for the last few years, so I should buy a house now and make a lot of money too.) To the degree people make these sorts of foolish decisions, perhaps economists should provide some warning. But I don't think having a monetary regime that promises to keep interest rates at a level where such mistakes are avoided is feasible, or even desirable.