Prices and Production, Lecture 3, The Working of the Price Mechanism in the Course of the Credit Cycle

Prices and Production and Other Works

by Friedrich A. Hayek (1931 [2008]).


The Working of the Price Mechanism in the Course of the Credit Cycle

The first effect of the increase of productive activity, initiated by the policy of the banks to lend below the natural rate of interest is . . . to raise the prices of producers’ goods while the prices of consumers’ goods rise only moderately. . . . But soon a reverse movement sets in: prices of consumers’ goods rise and prices of producers’ goods fall, i.e., the loan rate rises and approaches again the natural rate of interest.

L. v. Mises
Theorie des Geldes und der Umlaufsmittel (1912), p. 431


In the last lecture I dealt with the problems of changes in the structure of production consequent upon any transition to more or less capitalistic methods of production, in terms of the total sums of money available for the purchase of the product of each stage of production. It might seem, therefore, that now I come to the problem of explaining those changes in relative prices which bring it about that goods are directed to new uses — the central problem of these lectures [54] — the explanation should run in terms of sectional price levels, that is to say, in terms of changes in the price levels of the goods of the different stages of production. But to do this would mean that at this stage of the explanation I should fall back upon just that method of using price averages which I condemned at the outset.

At the same time, it should by now be clear that, at this stage of the explanation, a treatment in terms of price averages would not be adequate to our purposes. What we have to explain is why certain goods which have thus far been used in one stage of production can now be more profitably used in another stage of production. Now this will only be the case if there are changes in the proportions in which the different producers’ goods may be profitably used in any stage of production, and this in turn implies that there must be changes in the prices offered for them in different stages of production.

[54] As has already been mentioned in the first lecture, the effects of a divergence between the money rate and the equilibrium rate of interest on relative prices were originally briefly discussed by Professor Mises. On the actual working of the price mechanism which brings about the changes in the structure of production, his work contains, however, hardly more than the sentences quoted at the beginning of this lecture. It seems that most people have found them difficult to understand and that they have remained completely unintelligible all who were not very familiar with Böhm-Bawerk’s theory of interest, on which they are based. The main difficulty lies in Professor Mises’s short statement that the rise of the prices of consumers’ goods is the cause of the crisis, while it seems natural to assume that this would rather make production more profitable. This is the main point which I have here tried to clear up. So far, the most exhaustive previous exposition of these interrelationships, which anticipates in some points what is said in the following pages, is to be found in R. Strigl, “Die Produktion unter dem Einfluss einer Kreditexpansion,” Schriften des Vereins für Sozialpolitik 173, no. 2 (Munich, 1928), esp. p. 203 et seq. More recently, Professor Strigl has further developed his views on the subject in a book, Kapital und Produktion (Vienna: Springer, 1934). Some references to earlier anticipations of the ideas developed in this lecture will now be found in an additional note at the end of this lecture.


At this point, it is necessary to introduce the new [55] distinction between producers’ goods to which I alluded in the last to lecture: the distinction between producers’ goods which may be used in all, or at least many, stages of production, and producers’ goods which can be used only in one, or at the most, a few, stages of production. To the first class belong not only almost all original means of production, but also most raw materials and even a great many implements of a not very specialized kind — knives, hammers, tongs, and so on. [56] To the second class belong most highly specialized kinds of machinery or complete manufacturing establishments, and also all those kinds of semi-manufactured goods which can be turned into finished goods only by passing a definite number of further stages of production. By adapting a term of von Wieser’s, we may call the producers’ goods which can be used only in one or a few stages of production, producers’ goods of a specific character, or more shortly “specific” goods, to distinguish them from producers’ goods of a more general applicability, which we may call “nonspecific” goods.[57] Of course, this distinction is not absolute, in the sense that we are always in a position to say whether a certain good is specific or not. But we should be able to say whether any given good is more or less specific as compared with another good.

[55] Since the publication of the first edition of this book my attention has been drawn to the fact that this distinction is clearly implied in some of Böhm- Bawerk’s discussions of these problems. Cf. his Positive Theorie des Kapitalzinses, 3rd ed. (Jena: Gustav Fischer, 1921), pp. 195 and 199.

[56] This class will, in particular, comprise most of the goods which at one and the same time belong to different stages. “Of course,” says Marshall (Principles of Economics, 1st ed. [London: Macmillan, 1891], p. 109n.),

a good many belong to several orders at the same time. For instance, a railway train may be carrying people on a pleasure excursion, and so far it is a good of the first order; if it happens to be carrying at the same time some tins of biscuits, some milling machinery and some machinery that is used for making milling machinery, it is at the same time a good of the second, third and fourth order.

In cases like this a transfer of its services from a later to an earlier stage (or, to use Menger’s terminology, from a lower to a higher order) is, of course, particularly easy. A plant manufacturing equipment for the production of consumers’ goods as well as for the production of further machinery will sometimes be used mainly for the former and sometimes mainly for the latter purpose.

[57] Cf. Friedrich von Wieser, Social Economics, trans. A. Ford Hinrichs (New York: Adelphi, 1927), book 1, chap. 15.


It is clear that producers’ goods of the same kind which are used in different stages of production cannot, for any length of time, bring in different returns or obtain different prices in these different stages. On the other hand, it is no less clear that temporary differences between the prices offered in the different stages of production are the only means of bringing about a shift of producers’ goods from one stage to another. If such a temporary difference in the relative attractiveness of the different stages of production arises, the goods in question will be shifted from the less to the more attractive stages until, by the operation of the principle of diminishing returns, the differences have been wiped out.

Now, if we neglect the possibility of changes in technical knowledge, which may change the usefulness of any particular producers’ goods, it is obvious that the immediate cause of a change in the return obtained from producers’ goods of a certain kind used in different stages of production must be a change in the price of the product of the stage of production in question. But what is it which brings about variations of the relative price of such products? At first glance it might seem improbable that the prices of the successive stages of one and the same line of production should ever fluctuate relatively to one another because they are equally dependent upon the price of the final product. But, in regard to what was said in the last lecture concerning the possibility of shifts between the demand for consumers’ goods and the demand for producers’ goods, and the consequent changes in the relation between the amount of the original means of production expended and the output of consumers’ goods, and how an elongation of the process of production increases the return from a given quantity of original means of production — this point should present no difficulty.

Now, so far I have not expressly referred to the price margins which arise out of these relative fluctuations of the prices of the products of successive stages of production. This has been because I have intentionally neglected interest, or, what amounts to the same thing, I have treated interest as if it were a payment for a definitely given factor of production, like wages or rent. In a state of equilibrium these margins are entirely absorbed by interest. Hence my assumption concealed the fact that the total amount of money received for the product of any stage will regularly exceed the total paid out for all goods and services used in this stage of production. Yet that margins of this kind must exist is obvious from the consideration that, if it were not so, there would exist no inducement to risk money by investing it in production rather than let it remain idle. To investigate the relationship of these margins to the peculiar advantages of the roundabout methods of production would lead us too far into the problems of the general theory of interest. We must therefore be content to accept it as one of the definite conclusions of this theory that — other things remaining the same — these margins must grow smaller as the roundabout processes of production increase in length and vice versa. There is one point, however, which we cannot take for granted. The fact that in a state of equilibrium those price margins and the amounts paid as interest coincide does not prove that the same will also be true in a period of transition from one state of equilibrium to another. On the contrary, the relation between these two magnitudes must form one of the main objects of our further investigations.

The close interrelation between these two phenomena suggests two different modes of approach to our problem: either we may start from the changes in the relative magnitude of the demand for consumers’ goods and the demand for producers’ goods, and examine the effects on the prices of individual goods and the rate of interest; or we may start from the changes in the rate of interest as an immediate effect of the change in the demand for producers’ goods and work up to the changes in the price system which are necessary to establish a new equilibrium between price margins and the rate of interest. It will be found that whichever of these two alternatives we choose as a starting point, our investigation will, in the end, lead us to those aspects of the problem which are the starting point for the other. For the purposes of this lecture, I choose the first as being more in line with my previous argument.

(4) I begin, as I began in the last lecture, with the supposition that consumers decide to save and invest a larger proportion of their income. The immediate effect of the increase in the demand for producers’ goods and the decrease in demand for consumers’ goods will be that there will be a relative rise in the prices of the former and a relative fall in the prices of the latter. But the prices of producers’ goods will not rise equally, nor will they rise without exception. In the stage of production immediately preceding that in which the final touches are given to consumers’ goods, the effect of the fall in the prices of consumers’ goods will be felt more strongly than the effect of the increase of the funds available for the purchase of producers’ goods of all kinds. The price of the product of this stage will, therefore, fall, but it will fall less than the prices of consumers’ goods. This means a narrowing of the price margin between the last two stages. But this narrowing of the price margin will make the employment of funds in the last stage less profitable relatively to the earlier stages, and therefore some of the funds which had been used there will tend to be shifted to the earlier stages. This shift of funds will tend to narrow the price margins in the preceding stages, and the tendency thus set up toward a cumulative rise of the prices of the products of the earlier stages will very soon overcome the tendency toward a fall. In other words, the rise of the price of the product of any stage of production will give an extra advantage to the production of the preceding stage, the products of which will not only rise in price because the demand for producers’ goods in general has risen, but also because, by the rise of prices in the preceding stages, profits to be obtained in this stage have become comparatively higher than in the later stages. The final effect will be that, through the fall of prices in the later stages of production and the rise of prices in the earlier stages of production, price margins between the different stages of production will have decreased all around.

This change of relative prices in the different stages of production must inevitably tend to affect the prospects of profits in the different stages, and this, in turn, will tend to cause changes in the use made of the available producers’ goods. A greater proportion of those producers’ goods which can be used in different stages of production — the nonspecific goods — will now be attracted to the earlier stages, where, since the change in the rate of saving, relatively higher prices are to be obtained. And the shifting of goods and services of this type will go on until the diminution of returns in these stages has equalized the profits to be made in all stages. In the end, the returns and the prices obtained for these goods in the different stages of production will be generally higher and a larger proportion of them will be used in the earlier stages of production than before. The general narrowing of the price margins between the stages of production will even make it possible to start production in new and more distant stages which have not been profitable before, and in this way, not only the average time which elapses between the application of the first unit of original mean of production and the completion of the final product, but also the absolute length of the process of production — the number of its stages — will be increased. [58]

But while the effect on the prices of nonspecific producers’ goods has been a general rise, the effect on the prices of goods of a more specific character — those goods which can only be used in one or a very few stages of production — will be different. If a good of this sort is only adapted to a comparatively late stage of production, the relative deficiency of the nonspecific producers’ goods required in the same stage of production will lower its return, and if it is itself a product, its production will be curtailed. If, on the other hand, the good belongs to a relatively early stage of production, its price and the amount of it produced will increase. At the same time, the additional stages of production which have been started as a consequence of this transition to more capitalistic methods of production will probably require new goods of a specific character. Some of these will be new products, some natural resources which formerly it was not profitable to use.

Exactly the reverse of all these changes will take place if the demand for consumers’ goods increases relatively to the demand for producers’ goods. This will cause not only an increase of the difference between the prices of consumers’ goods or products of the last stage of production, and the prices of the products of the previous stage, but also an all round increase of the price margins between the products of the successive stages of production. Prices in the later stages will rise relatively to prices in the earlier stages, producers’ goods of a nonspecific character will move from the earlier stages to the later, and the goods of specific character in the earlier stages of production will lose part of their value or become entirely useless, while those in the later stages of production will increase in value. I shall discuss certain exceptions to this parallelism later on.

It will, perhaps, facilitate the understanding of these complications if we think of production in its successive stages as a fan, the sticks of which correspond to the prices of the different stages. If more demand is concentrated toward the one extreme — consumers’ goods — the fan opens, the differences between the stages become larger, and goods gravitate toward the stages where higher prices are obtained, that is, toward the stages nearer consumption. The most distant stages are abandoned, and within the remaining stages more goods are concentrated toward the one end. The opening of the price fan is thus accompanied by a reduction of the number of stages of production, i.e., of the number of sticks. [59] If, however, a shift of demand from consumers’ goods toward producers’ goods takes place, the price fan will close, i.e., the differences between the stages will become smaller and goods will tend to gravitate toward the higher stages where prices are now relatively higher, and new and hitherto unused possibilities of further extension of the process of production will be exploited. The closing of the price fan has brought a greater number of stages of production within the range of practical possibilities and thus initiated the transition to longer roundabout methods of production.

[58] This lengthening of the structure of production need, however, by no means takes exclusively or even mainly the form that the methods used in any individual line of production are changed. The increased prices in the earlier stages of production (the lowered rate of interest) will favor production in the lines using much capital and lead to their expansion at the expense of the lines using less capital. In this way the aggregate length of the investment structure of society might in the extreme case take place without a change of the method employed in any one line of production.

[59] At this point the simile becomes liable to mislead and it is important to keep in mind all the time that the “fan” refers to price relationships only, but that the length of the structure of production will move in the reverse direction compared with the width of the fan. When the price fan opens, the structure of production is shortened, and vice versa.


A more exact representation of this process can be given by means of a diagram. This has the special advantage of making quite clear a point which is of considerable importance but on which a merely verbal explanation is likely to mislead. It is necessary in such an exposition, if one wants to avoid too cumbersome expressions, to speak of actual changes in the relative prices of goods in the different stages, where it would be more correct to speak of tendencies toward such a change, or of changes in the demand function for the particular commodity. Whether and to what extent such changes in demand will lead to an actual change in price will of course depend on the elasticity of supply, which in the particular case depends in turn in every stage on the degree of specificity of the intermediate products and the factors from which they are made.

The way in which this shifting of the demand curves for any single factor in the different stages of production operates can be illustrated in the following way. In Fig. 7 below the successive curves represent the marginal productivity of different quantities of one factor in the successive stages of production, the earlier stages being shown on the left and the later stages toward the right. To make the main point come out clearer it has been assumed that the physical quantity of the product due to every additional unit of the factor decreases at the same rate in all stages and that in consequence the general shape of the curves is the same.

Prices and Production Fig. 7

The value of the marginal product attributable to every unit of factors will, however, be equal to the value of the physical product which is due to it only in the very last stage where no interval of time elapses between the investment of the factors and the completion of the product. If we assume, then, the curve on the right to represent not only the physical magnitude but also the value of the marginal product of successive units of factors applied in that stage, the other curves representing the physical marginal product of the factors invested in earlier stages will have to be somewhat adjusted if they are to represent the discounted value of the marginal product of successive units of factors applied in the respective stages. And if we assume the points to which these curves refer, to be equidistant stages as were those discussed before, the adjustment necessary at any given rate of interest can be shown by drawing a discount curve (or a family of discount curves) connecting every point on the curve on the right with the corresponding points of the curves further on the left, and lowering each of these curves by the amount indicated by the discount curves. (Since every point on these curves will have to be adjusted separately, i.e., will have to be lowered not by the same amount but by the same percentage, this will involve a change not only of the position but also of the shape of these curves.) The set of fully drawn curves in the above diagram shows the position at a given rate of interest indicated by the one discount curve which is also fully drawn. And since these curves show the discounted value of the marginal product of one kind of factor which must of course be the same in the different stages of production, they enable us to determine how much of this factor will be used in every stage if either its price or the total quantity of it to be used in this process is known. This distribution of the factor between the different stages at an arbitrarily assumed price is shown by the fully drawn horizontal lines.

Assume now that the rate of interest is reduced. The new position is indicated by the dotted discount curve and the correspondingly changed shape and position of the marginal productivity curves for the individual stages. Under these conditions the old distribution of factors between the stages would evidently not represent an equilibrium position but one at which the discounted value of the marginal product would be different in every stage. And if the total quantity of the factor which is available remains the same the new equilibrium distribution will apparently be one at which not only the price of the factor will be higher but at which also a considerably greater quantity of it is used in the earlier stages and correspondingly less in the later stages.

This accounts for the change in the price and the distribution of factors which can be used in different stages. To what extent and in what proportion the prices of different factors will be affected by a given change in the rate of interest will depend on the stages in which they can be used and on the shape of their marginal productivity curves in these stages. The price of a factor which can be used in most early stages and whose marginal productivity there falls very slowly will rise more in consequence of a fall in the rate of interest than the price of a factor which can only be used in relatively lower stages of reproduction or whose marginal productivity in the earlier stages falls very rapidly.

It is essentially this difference between the price changes of the different factors which accounts for the changes of the relative prices of the intermediate products at the successive stages. At first it might seem as if, since relative prices of the different intermediate products must correspond to their respective costs, they could change only to the relatively small extent to which the direct interest element in their cost changes. But to think of interest only as a direct cost factor is to overlook its main influence on production. What is much more important is its effect on prices through its effect on demand for the intermediate products and for the factors from which they are produced. It is in consequence of these changes in demand and the changes in cost which it brings about by raising the prices of those factors which are in strong demand in early stages compared to those which are less demanded there, that the prices of the intermediate products are adjusted.


As the initial changes in relative prices which are caused by a change of the relative demand for consumers’ goods and producers’ goods give rise to a considerable shifting of goods to other stages of production, definite price relationships will only establish themselves after the movements of goods have been completed. For reasons which I shall consider in a moment, this process may take some time and involve temporary discrepancies between supply and demand. But there is one medium through which the expected ultimate effect on relative prices should make itself felt immediately, and which, accordingly, should serve as a guide for the decisions of the individual entrepreneur: the rate of interest on the loan market. Only in comparatively few cases will the people who have saved money and the people who want to use it in production be identical. In the majority of cases, therefore, the money which is directed to new uses will first have to pass into other hands. The question of who is going to use the additional funds available for investment in producers’ goods will be decided on the loan market. Only at a lower rate of interest than that formerly prevailing will it be possible to lend these funds, and how far the rate of interest will fall will depend upon the amount of the additional funds and the expectation of profits on the part of the entrepreneurs willing to expand their production. If these entrepreneurs entertain correct views about the price changes which are to be expected as a result of the changes in the method of production, the new rate of interest should correspond to the system of price margins which will ultimately be established. In this way, from the outset, the use of the additional funds which have become available will be confined to those entrepreneurs who hope to obtain the highest profits out of their use, and all extensions of production, for which the additional funds would not be sufficient, will be excluded.


The significance of these adjustments of the price mechanism comes out still more clearly when we turn to investigate what happens if the “natural”movement of prices is disturbed by movements in the supply of money, whether by the injection of new money into circulation or by withdrawal of part of the money circulating. We may again take as our two typical cases (a) the case of additional money used first to buy producers’ goods and (b) the case of additional money used first to buy consumers’ goods. The corresponding cases of a diminution of the amount of money we may neglect because a diminution of the demand for consumers’ goods would have essentially the same effects as a proportional increase of the demand for producers’ goods, and vice versa. [60] I have already outlined in the last lecture the general tendencies involved in such cases. My present task is to fill in the details of that rough sketch and to show what happens in the interval before a new equilibrium is attained.

As before, I commence with the supposition that the additional money is injected by way of credits to producers. To secure borrowers for this additional amount of money, the rate of interest must be kept sufficiently below the equilibrium rate to make profitable the employment of just this sum and no more. Now the borrowers can only use the borrowed sums for buying producers’ goods, and will only be able to obtain such goods (assuming a state of equilibrium in which there are no unused resources) by outbidding the entrepreneurs who used them before. At first sight it might seem improbable that these borrowers who were only put in a position to start longer processes by the lower rate of interest should be able to outbid those entrepreneurs who found the use of those means of production profitable when the rate of interest was still higher. But when it is remembered that the fall in the rate will also change the relative profitableness of the different factors of production for the existing concerns, it will be seen to be quite natural that it should give a relative advantage to those concerns which use proportionately more capital. Such old concerns will now find it profitable to spend a part of what they previously spent on original means of production, on intermediate products produced by earlier stages of production, and in this way they will release some of the original means of production they used before. The rise in the prices of the original means of production is an additional inducement. Of course it might well be that the entrepreneurs in question would be in a better position to buy such goods even at the higher prices, since they have done business when the rate of interest was higher, though it must not be forgotten that they too will have to do business on a smaller margin. But the fact that certain producers’ goods have become dearer will make it profitable for them to replace these goods by others. In particular, the changed proportion between the prices of the original means of production and the rate of interest will make it profitable for them to spend part of what they have till now spent on original means of production on intermediate products or capital. They will, e.g., buy parts of their products, which they used to manufacture themselves, from another firm, and can now employ the labor thus dismissed in order to produce these parts on a large scale with the help of new machinery. In other words, those original means of production and nonspecific producers’ goods which are required in the new stages of production are set free by the transition of the old concerns to more capitalistic methods which is caused by the increase in the prices of these goods. In the old concerns (as we may conveniently, but not quite accurately, call the processes of production which were in operation before the new money was injected), a transition to more capitalistic methods will take place; but in all probability it will take place without any change in their total resources: they will invest less in original means of production and more in intermediate products.

Now, contrary to what we have found to be the case when similar processes are initiated by the investment of new savings, this application of the original means of production and nonspecific intermediate products to longer processes of production will be effected without any preceding reduction of consumption. Indeed, for a time, consumption may even go on at an unchanged rate after the more roundabout processes have actually started, because the goods which have already advanced to the lower stages of production, being of a highly specific character, will continue to come forward for some little time. But this cannot go on. When the reduced output from the stages of production, from which producers’ goods have been withdrawn for use in higher stages, has matured into consumers’ goods, a scarcity of consumers’ goods will make itself felt, and the prices of those goods will rise. Had saving preceded the change to methods of production of longer duration, a reserve of consumers’ goods would have been accumulated in the form of increased stocks, which could now be sold at unreduced prices, and would thus serve to bridge the interval of time between the moment when the last products of the old shorter process come onto the market and the moment when the first products of the new longer processes are ready. But as things are, for some time, society as a whole will have to put up with an involuntary reduction of consumption.

But this necessity will be resisted. It is highly improbable that individuals should put up with an unforeseen retrenchment of their real income without making an attempt to overcome it by spending more money on consumption. It comes at the very moment when a great many entrepreneurs know themselves to be in command — at least nominally — of greater resources and expect greater profits. At the same time incomes of wage earners will be rising in consequence of the increased amount of money available for investment by entrepreneurs. There can be little doubt that in the face of rising prices of consumers’ goods these increases will be spent on such goods and so contribute to drive up their prices even faster. These decisions will not change the amount of consumers’ goods immediately available, though it may change their distribution between individuals. But — and this is the fundamental point — it will mean a new and reversed change of the proportion between the demand for consumers’ goods and the demand for producers’ goods in favor of the former. The prices of consumers’ goods will therefore rise relatively to the prices of producers’ goods. And this rise of the prices of consumers’ goods will be the more marked because it is the consequence not only of an increased demand for consumers’ goods but an increase in the demand as measured in money. All this must mean a return to shorter or less roundabout methods of production if the increase in the demand for consumers’ goods is not compensated by a further proportional injection of money by new bank loans granted to producers. And at first this is probable. The rise of the prices of consumers’ goods will offer prospects of temporary extra profits to entrepreneurs. They will be all the more ready to borrow at the prevailing rate of interest. And, so long as the banks go on progressively increasing their loans it will, therefore, be possible to continue the prolonged methods of production or perhaps even to extend them still further. But for obvious reasons the banks cannot continue indefinitely to extend credit; and even if they could, the other effects of a rapid and continuous rise of prices would, after a while, make it necessary to stop this process of inflation. [61]

Let us assume that for some time, perhaps a year or two, the banks, by keeping their rate of interest below the equilibrium rate, have expanded credit, and now find themselves compelled to stop further expansion. What will happen? (Perhaps it should be mentioned at this point that the processes I shall now describe are processes which would also take place if existing capital is encroached upon, or if, in a progressive society, after a temporary increase in saving, the rate should suddenly fall to its former level. Such cases, however, are probably quantitatively less important.)

Now we know from what has been said already that the immediate effect of the banks’ ceasing to add to their loans is that the absolute increase of the amount of money spent on consumers’ goods is no longer compensated by a proportional increase in the demand for producers’ goods. The demand for consumers’ goods will for some time continue to increase because it will necessarily always lag somewhat behind the additional expenditure on investment which causes the increase of money incomes. The effects of such a change will, therefore, be similar to what would happen in the second case we have to consider, the case of an increase of money by consumers’ credits. At this point, accordingly, the two cases can be covered by one discussion.

[60] As I have tried to show in another place (“Capital and Industrial Fluctuations,” p. 164) it is even conceivable, although highly unlikely to occur in practice, that hoarding of money income before spent on consumers’ goods, might give rise to some additional investment.

[61] For a fuller discussion of the reasons why this process of expansion must ultimately come to an end, whether the banks are restricted by reserve regulations, etc., or not, and of some of the points alluded to in the next paragraphs, see my article on “Capital and Industrial Fluctuations,” p. 161.


Speaking generally, it might be said that the effects of a relative increase in the demand for consumers’ goods are the reverse of the effects of an increase in the relative demand for producers’ goods. There are, however, two important differences which make a detailed account necessary.

The first effect of the rise of the prices of consumers’ goods is that the spread between them and the prices of the goods of the preceding stage becomes greater than the price margins in the higher stages of production. The greater profits to be obtained in this stage will cause producers’ goods in use elsewhere which may be used in this stage to be transferred to it, and the all-around increase of price margins between the stages of production which will follow will cause a widespread transfer of nonspecific producers’ goods to lower stages. The new demand for these goods will cause a relative rise of their prices, and this rise will tend to be considerable because, as we have seen, there will be a temporary rise in the price of consumers’ goods, due to the transient discrepancy between demand and supply, greater than will be the case after the supply of consumers’ goods has caught up with demand. These temporary scarcity prices of consumers’ goods will, furthermore, have the effect that at first production will tend to shrink to fewer stages than will be necessary after equilibrium prices of consumers’ goods have established themselves.

Very soon the relative rise of the prices of the original factors and the more mobile intermediate products will make the longer processes unprofitable. The first effect on these processes will be that the producers’ goods of a more specific character, which have become relatively abundant by reason of the withdrawal of the complementary nonspecific goods, will fall in price. The fall of the prices of these goods will make their production unprofitable; it will in consequence be discontinued. Although goods in later stages of production will generally be of a highly specific character, it may still pay to employ original factors to complete those that are nearly finished. But the fall in the price of intermediate products will be cumulative; and this will mean a fairly sudden stoppage of work in at least all the earlier stages of the longer processes.

But while the nonspecific goods, in particular the services of workmen employed in those earlier stages, have thus been thrown out of use because their amount has proved insufficient and their prices too high for the profitable carrying through of the long processes of production, it is by no means certain that all those which can no longer be used in the old processes can immediately be absorbed in the short processes which are being expanded. Quite the contrary; the shorter processes will have to be started at the very beginning and will only gradually absorb all the available producers’ goods as the product progresses toward consumption and as the necessary intermediate products come forward. So that, while in the longer processes productive operations cease almost as soon as the change in relative prices of specific and nonspecific goods in favor of the latter and the rise of the rate of interest make them unprofitable, the released goods will find new employment only as the new shorter processes are approaching completion. [62]Moreover, the final adaptation will be further retarded by initial uncertainty as regards the methods of production which will ultimately prove profitable once the temporary scarcity of consumers’ goods has disappeared. Entrepreneurs, quite rightly, will hesitate to make investments suited to this over-shortened process, i.e., investments which would enable them to produce with relatively little capital and a relatively great quantity of the original means of production.

It seems something of a paradox that the self-same goods whose scarcity has been the cause of the crisis would become unsaleable as a consequence of the same crisis. But the fact is that when the growing demand for finished consumers’ goods has taken away part of the nonspecific producers’ goods required, those remaining are no longer sufficient for the long processes, and the particular kinds of specific goods required for the processes which would just be long enough to employ the total quantity of those nonspecific producers’ goods do not yet exist. The situation would be similar to that of a people of an isolated island, if, after having partially constructed an enormous machine which was to provide them with all necessities, they found out that they had exhausted all their savings and available free capital before the new machine could turn out its product. They would then have no choice but to abandon temporarily the work on the new process and to devote all their labor to producing their daily food without any capital. Only after they had put themselves in a position in which new supplies of food were available could they proceed to attempt to get the new machinery into operation. [63] In the actual world, however, where the accumulation of capital has permitted a growth of population far beyond the number which could find employment without capital, as a general rule the single workman will not be able to produce enough for a living without the help of capital and he may, therefore, temporarily become unemployable. And the same will apply to all goods and services whose use requires the cooperation of other goods and services which, after a change in the structure of production of this kind, may not be available in the necessary quantity. In this connection, as in so many others, we are forced to recognize the fundamental truth, so frequently neglected nowadays, that the machinery of capitalistic production will function smoothly only so long as we are satisfied to consume no more than that part of our total wealth which under the existing organization of production is destined for current consumption. Every increase of consumption, if it is not to disturb production, requires previous new saving, even if the existing equipment with durable instruments of production should be sufficient for such an increase in output. If the increase of production is to be maintained continuously, it is necessary that the amounts of intermediate products in all stages is proportionately increased; and these additional quantities of goods in process are of course no less capital than the durable instruments. The impression that the already existing capital structure would enable us to increase production almost indefinitely is a deception. Whatever engineers may tell us about the supposed immense unused capacity of the existing productive machinery, there is in fact no possibility of increasing production to such an extent. These engineers and also those economists who believe that we have more capital than we need, are deceived by the fact that many of the existing plant and machinery are adapted to a much greater output than is actually produced. What they overlook is that durable means of production do not represent all the capital that is needed for an increase of output and that in order that the existing durable plants could be used to their full capacity it would be necessary to invest a great amount of other means of production in lengthy processes which would bear fruit only in a comparatively distant future. The existence of unused capacity is, therefore, by no means a proof that there exists an excess of capital and that consumption is insufficient: on the contrary, it is a symptom that we are unable to use the fixed plant to the full extent because the current demand for consumers’ goods is too urgent to permit us to invest current productive services in the long processes for which (in consequence of “misdirections of capital”) the necessary durable equipment is available.

[62] The reason for this asymmetry between a transition to longer processes of production, which need not bring about any of these peculiar disturbances, and a transition to shorter processes, which will regularly be accompanied by a crisis, will perhaps become more evident if it is considered that in the former case there will necessarily be time to amortize the capital invested in the existing structure before the new process is completed, while in the latter case this will evidently be impossible and therefore a loss of capital and a reduction of income inevitable. (In all these discussions it is assumed that technical knowledge remains the same; a shortening of the structure of production which is due to technical progress has an altogether different significance from that due to an increase of consumption.)

[63] Cf. the very similar example now given by C. Landauer, Planwirtschaft und Verkehrswirtschaft (Leipzig: Duncker & Humblot, 1931), p. 47.


Here then we have at last reached an explanation of how it comes about at certain times that some of the existing resources cannot be used, and how, in such circumstances, it is impossible to sell them at all — or, in the case of durable goods, only to sell them at very great loss. To provide an answer to this problem has always seemed to me to be the central task of any theory of industrial fluctuations; and, though at the outset I refused to base my investigation on the assumption that unused resources exist, now that I have presented a tentative explanation of this phenomenon, it seems worthwhile, rather than spending time filling up the picture of the cycle by elaborating the process of recovery, to devote the rest of this lecture to further discussion of certain important aspects of this problem. Now that we have accounted for the existence of unused resources, we may even go so far as to assume that their existence to a greater or lesser extent is the regular state of affairs save during a boom. And, if we do this, it is imperative to supplement our earlier investigation of the effects of a change in the amount of money in circulation on production, by applying our theory to such a situation. And this extension of our analysis is the more necessary since the existence of unused resources has very often been considered as the only fact which at all justifies an expansion of bank credit.

If the foregoing analysis is correct, it should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect; a relative increase of the demand for consumers’ goods could only make matters worse. Matters are not quite so simple so far as the effects of credits granted for productive purposes are concerned. In theory it is at least possible that, during the acute stage of the crisis when the capitalistic structure of production tends to shrink more than will ultimately prove necessary, an expansion of producers’ credits might have a wholesome effect. But this could only be the case if the quantity were so regulated as exactly to compensate for the initial, excessive rise of the relative prices of consumers’ goods, and if arrangements could be made to withdraw the additional credits as these prices fall and the proportion between the supply of consumers’ goods and the supply of intermediate products adapts itself to the proportion between the demand for these goods. And even these credits would do more harm than good if they made roundabout processes seem profitable which, even after the acute crisis had subsided, could not be kept up without the help of additional credits. Frankly, I do not see how the banks can ever be in a position to keep credit within these limits.

And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production to the proportion between the demand for consumers’ goods and the demand for producers’ goods as determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants — whether during a crisis or thereafter — but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes.


And so, at the end of our analysis, we arrive at results which only confirm the old truth that we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come. In the next lecture I shall be dealing with some of the problems connected with a monetary policy suitable for the prevention of crises. Meanwhile, although so far our investigation has not produced a preventive for the recurrence of crises, it has, I hope, at least provided a guide to the maze of conflicting movements during the credit cycle which may prove useful for the diagnosis of the situation existing at any moment. If this is so, certain conclusions with regard to the methods commonly used in current statistical analysis of business fluctuations seem to follow immediately. The first is that our explanation of the different behavior of the prices of specific and nonspecific goods should help to substitute for the rough empirical classification of prices according to their sensitiveness, a classification based on more rational considerations. The second, that the average movements of general prices show us nothing of the really relevant facts; indeed, the index numbers generally used will, as a general rule, fail even to attain their immediate object because, being for practical reasons almost exclusively based on prices of goods of a nonspecific character, the data used are never random samples in the sense required by statistical method, but always a biased selection which can only give a picture of the peculiar movements of prices of goods of this class. And the third is that for similar reasons every attempt to find a statistical measure in the form of a general average of the total volume of production, or the total volume of trade, or general business activity, or whatever one may call it, will only result in veiling the really significant phenomena, the changes in the structure of production to which I have been drawing your attention in the last two lectures.


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