Overconsumption and Forced Saving in Mises-Hayek Theory of the Business Cycle

The business cycle theory developed during the interwar period by Ludwig von Mises and Friedrich A. Hayek is a theory of the unsustainable boom. Responding to cheap-credit policies of the central bank, the economy can find itself on a growth path that is inconsistent with the underlying economic realities.¹ Internal tensions in the market forces that guide consumption and investment decisions eventually precipitate a bust.

This understanding of the market process that takes the economy through boom and bust has come piecemeal and in a leapfrog progression in the writings of Mises and Hayek. Mises first gave the theory its Austrian identity in his Theory of Money and Credit ([1912] 1953, 357–66). Clearly, the theory emerges as a combination of the interest-rate dynamics introduced by Swedish economist Knut Wicksell ([1898] 1962) and the Austrian capital theory outlined by Carl Menger ([1971] 1981) and developed by Eugen von Böhm-Bawerk ([1884] 1959). (The divergence of the market rate of interest from the natural rate causes a misallocation of resources among the temporally sequenced stages of production.) The "internal tensions," which become most pronounced at the upper turning point of the cycle, manifest themselves in Mises's original account as "counter-movements" in the prices of consumption goods relative to the prices of production goods. These relative prices fall during the boom but eventually rise, provoking corresponding counter-movements of resources and marking the economy's transition from boom to bust.

In the mid-1920s, Hayek applied Mises's theory to the policy-driven boom in the United States. But having been persuaded by Gottfried Haberler that Mises's initial casting of the theory was too sketchy to serve this purpose, Hayek (1984, 27–28) added a footnote of more than five hundred words to set out his own version of Mises's theory.² The counter-movements in Hayek's account take the form of movements in the demand for raw materials in the early stages of production. When the rate of interest is artificially low, this demand is strengthened, but because of ultimate resource constraints and pressing demands elsewhere, it must eventually decline.

A key analytical stepping stone in the development of the Austrian theory came with Hayek's 1931 lectures at the London School of Economics and his introduction of a graphical device for depicting the effects of a change in the rate of interest on the intertemporal allocation of resources. The Hayekian triangle depicted in figure 1 keeps track of the relationship between (1) the economy's consumable output and (2) the time dimension of the production process from which that output emerges. This relationship is not fixed by technological considerations but rather can vary with changes in intertemporal preferences. Variation can also be induced—although not to the benefit of the economy's long-run macroeconomic health—by the central bank.

In its simplest application, the two legs of this right triangle measure consumption and the corresponding production time (reckoned in the number of stages of production) for an economy that has achieved an intertemporal equilibrium. A primitive instance of this intertemporal equilibrium and of potential changes in it can be illustrated by a Robinson Crusoe who for some time is content to sustain himself by catching fish with the aid of little or no fishing equipment. A greater output of fish is possible but only if Crusoe is willing to take time away from fishing in order to fashion a net and possibly a boat. Consumable output would have to fall while the production process is being enhanced. Once the new, more capital-intensive (and more time-consuming) process is completed, however, the level of output would rise above its initial level. The new intertemporal equilibrium can be depicted by a Hayekian triangle with a longer consumption leg, representing more fish, and a longer production...