Virtually no one in the central banks, government treasury departments, or independent analysts see the real inflationary danger. There is a lone exception perhaps in Dr Zhang Weiying, the top economist at Beijing University and formally in charge of China’s economic policy, who quoted Hayek’s business cycle theory to point out the dangers of excessive deficits.[i] Whether he is listened to by his colleagues, we shall doubtless find out in due course. Otherwise, a sudden acceleration of price inflation will come as a complete surprise to our financially sophisticated markets.
This article explains why the danger lies in the structure of production, which in the West at least is seriously out of whack. The follies of post-crisis central bank monetary reflation are likely to drive us rapidly into the next credit crisis as a consequence. To understand why this is so requires us to revisit the 1930s writings of an Austrian-born economist, who was tasked by the London School of Economics with explaining to advanced students the disruption to the production process from changes in consumer demand.
Friedrich von Hayek was famously reported as the economic guru of both Margaret Thatcher and Ronald Reagan. This distinction owes its origin to his market-based approach to economics, which was in stark contrast with the statist approach that was predominant in political circles at that time, and still is today. It was simple shorthand for the media writing for a mass audience.
The distinction is nonetheless correct. Instead of spending his professorial career bending with the socialist and Keynesian winds, he continued to develop and defend free-market economic theory. As a war for hearts and minds, apart from his occasional successes, it was one Hayek lost, and the consequences of the triumphs of Keynes and socialism are reflected today in systemic instability. But that is no reason to abandon the Hayekian tradition.
Hayek made a number of important contributions to economics, including an understanding of the business cycle, which he demonstrated was driven by credit expansion, and the subsequent consequences of that earlier expansion. The root of the problem, as it is today, is the way producers of goods and services adapt to changes in demand for final goods. It is a problem seemingly ignored by policy makers. Instead they believe that monetary expansion can replace savings without negative economic consequences. This is simply not true.
Hayek illustrated the mechanism of production and the effects of capital flows in a capitalistic economy in the form of a triangle, which showed the steps in production from its early stages towards the final product in time sequence. Using this simplistic illustration he explained the effects of fluctuations of consumer demand on production. The following illustration is of Hayek’s triangle.
The triangle’s sides represent an inverted vertical axis of time, and a horizontal axis of output, the output being consumer goods. The dotted lines represent the various stages of production, typically from the gathering of raw materials and the processing of products through intermediate stages of processing, until the final products are ready for sale to consumers. The assumptions are ones of equilibrium, that is to say there is no change from technology, the distribution of stages of production are even, the quantity of money in the economy is fixed, and lastly there are no alterations in consumer choice.
This highly artificial construction is intended to isolate the factors that determine the relationship between production and consumption, a vital subject otherwise concealed from us by the noise from all the other extraneous factors.
At this point, we must dismiss the common assumption behind GDP, that it is only output that matters. The error has a long history, and goes back even to Adam Smith, who wrote,
“The value of goods circulated between the different dealers never can exceed the value of those circulated between dealers and consumers; whatever is bought by the dealer being ultimately destined to be sold to the consumers."[ii]
In the sense of the sum of added values, this is obviously true. But what matters in our context is payments, payments in the production chain and payment for the final product. The payments between the various stages of production can be many multiples of the final payment, a fact which is hidden from us by the GDP statistic. Indeed, it is only partly revealed to us by the business-to-business activities that occur in production as captured by the US Bureau of Economic Analysis’s gross output statistic.[iii]
Hayek took his triangle to the next stage, and that was to consider the relationship of money flows between intermediate processes, compared with payment for the final consumption output. The intermediate steps are given payment values. The working assumption is that they increase at an even rate as they progress towards the final product, which is likely to be the case because if the returns on one intermediate process is out of line with the others, capital flows can be expected to correct the disparity.
- Source, James Turk's Goldmoney
