Misconstruing Hayek

Slogging through Prices and Production and other Works, though somewhat painful, was very rewarding, as I find most such undertakings to be once they are over and done with. I had avoided Hayek for a long time because I find him generally to be difficult to read, mostly because he is so exacting in his language that it gives me a headache, like watching a TV screen with the contrast set too high. It is tiring, with no wriggle room for the brain to relax a little.

However, as might be expected, if you have understood him you can be sure you know exactly what he meant, which I can't always say is the case for other authors, such as Mises, whose writing I find to be often rather fuzzy so that I'm not quite sure exactly what he means. But maybe that is not their fault, as most of what I have read are English translations from other languages. Further, my abilities at reading comprehension often leave something to be desired.

All that said, I think that of all the Austrians I have read so far, I find Hayek's arguments and point of view to be most convincing. His arguments confirmed my longheld view that the quantity of money was actually the key to understanding its behavior and effects on the economy -- and not its valuation, as is so often the focus. He even chides Mises a bit for focusing on the issue of value as opposed to quantity. As I have repeatedly argued, he also believes that money will function most effectively when its quantity is absolutely fixed. I'm glad to find him in my corner on these issues, about which I must confess Mises was raising doubts.

On a very important point, though, I found that my understanding of his views was somewhat lacking -- the Austrian conception of the production structure, to which he apparently contributed more or less the majority of ideas in terms of a triangular model of the stages of production. I had previously only encountered this model in summaries by other writers, and the idea that I had in my head made so much sense to me and worked so well and was so useful that I thought I had the thing pretty well understood. I was close, but I had taken the idea in a far more abstract sense, and even at that I was not quite there.  But now having read Hayek for myself, I understand where a certain idea came from that I have frequently encountered and thought rather strange.  First, a summary of the model, from which my readers will no doubt extract an overly abstract idea like the one I did and go on misconstruing Hayek to others until such time as they actually read the book for themselves.



Hayek models the production structure as a series of extending bars, which when stacked up make a triangle. (My apologies if the picture at that link does not resemble what I have just described.  I could not easily find a good picture. If you want to see a proper one, check p. 233 of my first link.) The extension of the bars represent the increasing value of materials as they are processed  towards consumer goods and receive additional inputs of the original means of production -- land (raw materials) and labor -- which cause this increase in value.  Basically, it is kind of like a production line, where goods start as raw materials and proceed through various manipulations until they become finished products, increasing in value along the way as more labor and materials are invested in them and they get closer and closer to being finished products.

Raw materials enter at the 'top' of the triangle and move towards the bottom as they are converted to products. The vertical axis is a sort of 'time' axis. This had confused me a bit -- I had thought that the 'top' of the triangle represented higher-order capital goods, but what it really represents is merely earlier stages of production. I think that my original misinformed interpretation is actually mostly correct in an accidental sort of way -- which I'll explain in a minute -- but clearly, that was not the way the triangle was meant to be interpreted by its creator.

Hayek modeled economic growth as an extension of the triangle upwards, adding more stages of production to the top of the triangle. This results from savings and investment, which allow capital investments that permit longer, more complex methods of production which are more efficient. Savings and investment -- or the fake variety produced by inflation -- create demand for these longer methods of production by inducing entrepreneurs to seek more efficient means of producing goods.

Hence an assertion by many economists of the Austrian school which I have run into many times in recent years, but which to this point in time made no sense to me -- that the spike in commodity prices we have witnessed recently were caused by inflationary forces acting at the highest stages of production. Raw materials are furthest from the stage of consumption, therefore they should be the first to respond to inflationary pressures.

This may sound all well and good taken in isolation, but actually it makes no sense at all looking at the bigger picture. If this take on things were true, commodities would always be at the 'top' of the production structure, and one would expect them to rise first, near the beginning of the business cycle. But looking at commodity prices in the 1980's, and even the 1990's, one finds them more or less flat. They haven't risen really substantially until the latter 2000's -- near the end of the business cycle! Meanwhile, stock prices, homes, and other capital goods were all off to the races through the 80's and 90's, suggesting that they somehow occupy an earlier stage in the production structure. But how can that make sense -- don't they have to be made out of something?

What is going on here? Time for that explanation.

It is my opinion that this method of looking at the production structure, however true it may be to Hayek's original description, may be somewhat outdated -- or at least in need of updating. Prices and Production was written in the 1930's, at a time of far less capital intensive production methods. It probably made a lot more sense to think of things this way back then, but today the situation is much more complicated.  Far more capital is employed in the production of goods, such that a great deal of capital must already be produced and in existence for pretty much any manipulation of materials to take place -- even for the extraction of natural resources from the environment!  Clearly, then, for such capital to be in place already, it must as a rule be produced at an earlier stage of production, else it will not be in existence to do its job.

Hayek addresses this more or less directly, suggesting that the steps for producing capital goods which are used for the production of later stage goods may simply be incorporated further up in the production structure from the point at which they are used. So, in effect, my original interpretation was correct, as higher-order goods really will be higher up in the production structure, though I had no concept of the details that would lead to this conclusion and completely lacked the fundamental understanding of why this was the case.  It is solely a sort of byproduct of the fact that earlier stages of production belong higher up the triangle. But getting back to the issue of commodities, if this is the case, then in order to describe the modern production structure, there is an awful lot more piling on to do in comparison to the early 1930's.

So much, in fact, that it seems perfectly reasonable to me to expect that the stages of production of capital goods for application to the production of most consumer goods would extend far longer than the stages of production to produce the consumer good itself from raw materials. That was a really long sentence. Let me give an example.

Imagine wood being processed to produce something like a baseball bat. The tree must be felled, stripped, processed to lumber, shaped, and finished to produce the baseball bat. However, imagine all the stages of production which must be applied to generate the heavy equipment just to cut down and transport the trees! I can't imagine describing a similar process for producing just a tractor trailer, and even that is not the most complex, high-tech equipment used in the process. If this is the case, it is a relative hop, skip and jump to produce the bat in comparison with the long, hard, slogging and complicated marathon to produce the truck, so that the wood will necessarily enter the production structure at a relatively low point overall.

It may be objected that the truck is made of steel and other commodities, which must necessarily enter at the top of the production structure, or at least higher than the truck. But, just to illustrate a point for a moment, I shall retort that it takes capital equipment to produce the steel, which must necessarily stretch in steps up above the entry of the steel for the truck. Of course, the steel working equipment must itself be made of commodities, and on and on, chicken and egg and chicken and egg, on into infinity.

This was basically the argument of Thorstein Veblen, who asserted that, contrary to the position of the Austrians, the production structure is flat. Sheet metal and screws are produced by factories, which are themselves made of sheet metal and screws, therefore no such analysis is possible. To this I say that the entry of commodities for production of these types of higher-order goods is irrelevant. The volume of commodities required for these types of production is relatively insignificant in comparison to the volume used for lower order products, such that the price of these higher-order goods and changes in their production volume will not influence the overall price of the commodity because it will not influence supply or demand significantly. The volume of wood being processed for factory tool manufacturing will be insignificant in comparison to the volume for paper production, plywood, furniture and the like, such that the volume of the latter will set the price of wood overall. Inflation will have no impact until it begins to influence the price of these types of goods, which are near the bottom of the structure.

Therefore, one should expect that with few exceptions, commodity prices will not rise until late in the business cycle -- as I have asserted before, and contrary to what many Austrians are arguing. Hayek's own model even explicitly and openly acknowledges that raw materials are used over the entire course of the process of production, such that there are actually many entry points for commodities into the production structure after the initial stage.  Why so many Austrians have seized on only the initial entry point as describing price behavior eludes me, and even so, if one is to consider the modern production structure as it stands today, then latter entry points must surely be more important.  The inflation we are seeing today is influencing commodity prices so strongly because the wave of price increases has moved down near the bottom of the production structure. If it were really as the 'traditional' interpretation would have it, stock markets and large-business valuations would be rallying to high-heaven, and unemployment would probably be much lower in response to the flood of money that the banking system has generated lately. Instead, it is moving into commodity and consumer price inflation. 

Was that all clear? I have one more topic, along similar lines.

If Hayek's triangles are to represent the flow of intermediate goods towards consumer goods, then the question naturally arises as to where management and corporate hierarchy fits into the picture. Certainly, these people represent an employment of part of the original means of production (labor), and certainly they are engaged in 'production' of some sort, if they are said to be employed. But how does their rather abstract 'product' fit in?

I say it belongs atop whatever order of production they as individuals oversee, and extends upwards in proportion to the depth of the hierarchy in question.  I say this because it is their 'output' that couples with the industrial equipment under their oversight which produces the intermediate, capital, or consumer good in question, and that higher levels of the hierarchy are employed in the management of the workings/'output' of the subordinate levels.  At the top are people rearranging the production structure at the very highest levels, buying and selling whole companies.

This model fits neatly into what one actually observes with respect to wages -- higher-ups and the financial community see their incomes escalating early in the cycle, till at the end, when unemployment falls, lower-order wages start increasing and consumer price inflation is looming.  At this point, those higher-up and the financial community tend to get hammered, relatively speaking, especially if their is some degree of monetary tightening.  Of course, they may still be making a great deal of money, particularly when they successfully lobby Washington to give them some courtesy of taxpayers.

Conclusion

Don't count your chickens before they hatch, and don't think you know something 'till you've read the original reference.

The production structure is best understood in terms of the flow of materials -- circulating capital, moving from raw materials to intermediate goods to consumer goods -- vs. the ordering of a capital structure in terms of higher- and lower-order fixed capital, though as a sort of accident, they happen to roughly coincide if taken in a very abstract manner.  Because supply and demand ultimately determine prices, price changes should operate at the 'center of mass' of a good's employment in the production structure, so that commodities which are principally employed for the production of lower stage goods -- which is most commodities -- will see their prices rise late in the cycle, rather than early as a more direct interpretation of Hayek's model would suggest.

But then again, I'm hardly a master, only an amateur, and I'm making all of this up as I go.  As always, don't take my word for the gospel.