Help me understand Hayek vs. the Paradox of Saving

Economics Economics Questions
1

I don’t get how exactly Hayek solved the paradox of saving - which was basically the argument that if people are going to save more than they consume, the amount of investment made in the production of final consumer goods would be higher than the amount spent on consumption of these final consumer goods that are produced. So what results is producers not being able to sell their goods to the consumers at remunerative prices.

To cite an example, if society saves and invests $200 but spends only $100 on the final consumer goods that are produced as a result of investing $200, since the cost of production would be higher than the price of the final consumer goods, producers would have to take up losses and there would be a depression.

I think Hayek argued this was wrong. He said that businessmen would lengthen the structure of production in such a way that the final products can actually be sold at remunerative prices to the final consumers. But I really don’t understand how it happens. I have read Hayek’s paper (check the chapter named “paradox of saving” here: http://mises.org/books/hayekcollection.pdf) multiple times, but I still don’t get it. Can you guys help me understand this?

I’ve spent quite some time reading this multiple times, butI seem to be missing something about it. Lengthening, widening, stages of production etc sound very abstract to me. Can any one of you guys explain this stuff with a simple real-life example?

Thanks for your time!

2

I will try and contribute and hope I don’t say anything incorrect.

Savings represent a person valuing the money/resources in the furture more than they do now. If a person saves money, resources/goods/services/commodity that would have been directed towards the person in the alternative scenario remain in the market for other people to use. There will be more of commodity X against commodity Y than what would have occurred if the person decided to consumer. What results is that the value in monetray terms of resources change against one another. If this process leads to consumer’s goods clearing on the market less than what the entreprenuers expect, this is a price signal which tells them that consumers don’t value what they’re producing as they initially thought. Their endeavors could make a loss or even fail. If they do fail, the resources that they used in their particular production process will be freed for other uses in the market. Primarily this will occurr with marginal firms. The market’s price determination mechanism will in turn allocate the resources.

Now savings is your supply curve. People desiring loanable funds is your demand curve. Your price is the interest rate. You increase the supply savings, ceteris paribus the interest rate will decrease. The lower interest rate factor into the entreprenuer’s economic calculation and long term production processes will seem more economically viable. If it is deemed to economically viable, they will take out the loan and bid resources away from other areas of the economy. Perhaps from production processes resulting in consumer’s good’s.

As you can see, this process diverts resources from one section to another section of the economy/market. This simple truth renders Keyne’s theory to the field of irrelevancy. There is no such thing as insufficient aggregate demand because the fact is that consumers don’t value the current strucutre of production. Even if you could artificially boost consumption there is nothing stating that consumers would want or value the produce produced by failing sectors or marginal firms.

3

Hi proxyamenra, thanks for your reply. But can you tell me how exactly “long-term production processes” would make sure that $200 worth of investments get recuperated even when the final consumption demand is only $100?

4

You don’t know your actual return on investment until you find the price at which your product clears on the market. If you invested $200, your revenue after your product clears on the market is $100 and assuming you have no equity in the capital goods, you have made a $100 loss. Ergo, you can’t make sure you’re going to make a return. You can make an educated guess.

In simple, the main idea is that when a person saves money they’re in fact saving resources. These resources than can be used for investment. In the long run the market’s price determination mechanism will allocate saved resources to be used in investments. In other words, in the long run savings=investment.

5

I am not sure what you’re saying. I think you say that producers will make losses when investment is more than consumption. But that’s exactly the Keynesian argument that Hayek refutes in the paper. Only that I am having a hard time understanding how Hayek does it.

6

I remember really struggling with the paradox of thrift when I tried to read it. I don’t know if I’d fair better now that I have a better understanding of the Austrian conception of the production structure.

We can view a fixed money supply as being simplistically utilized in one of three ways: consumption, investment, and plain savings, which forms the “consumption/investment ratio”. At any one short run period of time the higher consumption is the better off consumers are in that time period if we disregard market frictions. Over any “two” time periods, a theoretical measure meant to indicate an amount of time it takes to consume some amount of capital or produce another “batch” of capital.

The importance, and sometimes even the existence of capital is an essential aspect of the modern economy which is wholly lost to most people. Societies can always be more productive than they currently are with the production of capital goods, which are those goods that allow us to produce more of a good, or usually produce any amount of a good at all. It is impossible to build an ipod without a large amount of capital. However, in order to produce capital now, productive inputs have to be used to do that instead of producing things today. To make a machine I have to take time and resources away from producing something like cakes. It is the time component of producing capital that is most important to understanding its accumulation. Another key factor is that capital wears out. Factories and machines wear down over time, inputs like wooden boards are used immediately within the productive process and must be directly replaced in order for the uses the wood was initially put to to continue in further time periods.

Producing capital isn’t as simple as just engaging in a higher-productivity endeavor. If this were the case then production would be instantaneous. No, goods must be used over time to produce for concerns in the future rather than in the present. How productive something must be to justify its production is indicated by the interest rate, which communicates time preference. Society will always produce goods now as opposed to the future, therefore the rate will always be greater than zero. This means that what is produced over time must be more productive than things produced today or the entrepreneur who produced it will run at a loss. Therefore the lower the interest rate the less productive over time a project would have to be to justify its production. This makes way for two types of capital accumulation: capital accumulation that increases the “size” of existing stages, and capital accumulation that directly widens the production structure and increases the number of stages of production.

For instance if we take project X, which only takes a year to produce and which already exists in a large capacity, but the marginal project X will only give a return of 4 percent, then it will not occur at an interest rate of 4.1 percent. As the interest rate falls this can be justified and resources are taken away from more instantaneous productive endeavors that are closer to consumption. Similarly a new productive endeavor that hasn’t been engaged in yet because it takes so long may also become possible as the interest rate falls. a project that is incredibly productive over time, say 25 percent more productive, still isn’t worthwhile if it takes a mere 4 years to complete. However if the interest rate falls by two percent then this project could certainly be completed in that time period.

This is where the consumption/investment ratio comes into play: interest rate determination. As we know, increasing demand causes prices to rise. Let’s say that we have an economy that is in equilibrium, but which has a large amount of savings. If a large number of consumers suddenly pull out money from their plain savings (mind you that this is just stuck under their pillows or in some other way that means the money is outside of the system. Here we will also overlook any monetary disequilibrium over time this might cause). This causes general inflation and increases prices in general, however because the amount of money investment has not increased. This means that the real value of the money supplied in the loan market decreases and the interest rate rises while demand for more instantaneous production has increased. This makes long term production more expensive as the interest rate rises, and current consumption more valuable. The opposite happens if the money comes out of plain savings into investment. This increases prices in general, but because the money available for consumption has not increased the real value of that goes down, therefore resources “farther away” from consumption into longer processes either old or new. Removing money from the system causes deflation and alters the proportion in one way or the other depending on where the money comes out of. If money is taken equally out of consumption and investment and is saved then there is merely pure deflation in the economy. If savings come entirely out of consumption then the interest rate falls and capital is accumulated.

Remember that the key element in what we’ve been talking about is price flexibility at different stages of production. Because prices are flexible the market, if it is frictionless (something which Austrians and every other sane human being expressly deny), cannot run into difficulties caused by monetary changes or changes in spending patterns.

Now we finally have the theoretical basis to understand Hayek’s paradox of thrift, and the answer is really quite simple. If people spend less in consumption and plain save then prices in general fall but those further away from production rise in relative terms regardless of whether they fall in nominal terms. This leads to a decrease in the interest rate and higher investment and standards of living in the long term as more goods and services move towards the higher stages of production and increase capital accumulation. Remember that higher demand means a higher price and a higher quantity supplied. In this case the demand is coming from producers who can now afford to produce longer-term projects. They demand the land and labor that was previously employed in more current production.

Meanwhile if we assume that the money goes from consumption into investment then the prices of consumers goods fall while producers goods increase relatively. There may still be a decrease in the price level, but the interest rate will fall to the point where the amount spent on production plus the interest rate will justify production.

There is no paradox, just a fact of human existence of current vs. future consumption.

This is a very long and extensive post, but it contains what I believe to be the real foundations of understanding the issue at hand. If there’s anything specifically you want me to clarify or elaborate on (lol) then feel free to say so

7

No. Producers will make a loss if the market clearing price is less than the marginal cost of production ie. negative net revenue. It has little to do with investment being greater or less than consumption.

8

Hey Neodoxy, thanks. But I still don’t understand how that explains the fact that, say, a saving/investment amount of $200 into making producer goods can be sustained when the final consumer demand is only $100. Or does your reply actually answer this problem? In that case, what am I missing?

9

But, proxyamera, I am only interested in the case where investment in the economy turns out to be greater than consumption. That’s what the whole controversy of paradox of saving is all about.

10

The total amount being invested in that case would be disseminated over many different projects and time periods. Using your numbers the fact is that at the end of each year 100 dollars is paid back, but there is 200 dollars in the whole of investment which is paid back over several years. For instance if we imagine a production structure that is uniform throughout time, so that the same amount of time was spent on each project and that each “cycle” ended after the, then when time came to pay the debt would be paid in full but the total amount of money in investment, within “all” the cycles going on at any one time would be different.

Take a productive process of two years. The interest rate is ten percent and the plain cost (no interest) of each stage is 50 dollars. Therefore the total markup of the first stage is 55 (501.1) dollars. Then the markup for the second stage is 115.5 (551.1+50*1.1). Therefore what is needed in consumption to justify this is 115.5 dollars each year. However, because each year the same amount is being invested in the first AND the second stage, the total amount in investment is 165.5 (55+(115.5-5) (we subtract 5 from the markup in the second period because this is passed on to consumers. It is interest that is accumulated from forwarding the money, not money that is needed within investment). Investment/consumption ratio is 165.5/115.5. The only time we would need more money in Because there is a whole production structure that needs to be maintained which requires payment over time, a much larger amount will likely be needed in investment than in consumption to maintain the structure.

The only case where consumption is likely to be greater than investment in equilibrium is in a single stage production economy. for instance, if there were only the first stage of production in the above example 50 dollars in investment would yield a product worth 55 dollars. This amount would have to be provided in consumption with investment/consumption ratio looking like 50/55. As soon as another decently important stage is added. If we assume the same interest rate and number of stages above with the first stage costing 5 dollars and the second costing 50: 2(5(1.1))+50=61 (5(1.1))+50(1.1)=60.5

Investment/consumption ratio= 61/60.5. The amount needed to keep the cycle going is 61 dollars, but fifty cents fewer are required in consumption to maintain it. We multiply the amount racked up in the second stage by two because that amount is passed on to the next stage and is being repeated again in a new cycle.

Does this make sense?

11

Hi Neodoxy, lemme state my understanding of your point and you can tell me if I’ve got you right.

Suppose each year an economy saves and invests $300 (including interest discount), and spend $100 on final consumption goods. What you’re saying is that production would be rearranged in such a way that only $100 worth of goods reaches the market for final consumption goods at the end of the year? The remaining $200 worth of investment would in turn produce $100 worth of final consumer goods in years 2 and 3 (in each of these years final consumption demand is $100)?

Do I understand you right?

12

The paradox of savings relies on the assumption that consumption is the engine of value creation in the economy. Along with Keynesian analysis in general holds an over reliances on simply looking aggreagate balance sheets which do not inform the inquirer of what is occurring within the economy. The assumption is incorrect and the analysis methodology is flawed. What is actually the engine of wealth creation is investment in captial goods vis a vis production processes which statisfies the demands of consumers. This may be explained better by taking the scenario to the extreme. If there were no investment and only consumption, you will never have an expansion in the amount of goods yielding value to consumers. Ergo, no wealth creation.

When consumers save money it entails that they value the money more in the future than what consumers goods are being produced by the current structure of production. If there were a sudden large increase in savings and reduction in consumption for some strange reason, some marginal producers will suffer a loss or possible fail. In the event of failure, the resources they commanded (factors of production ie. natural given resources, capital goods, labor, etc.) will be freed and used else where in the economy. Is this process a machination? No. Investment in what consumers don’t value will cease and will allow for entreprenuers to produce other goods with the freed resources that consumers may see value in.

On a different topic:

As Neodoxy stated, the loan is paid off over time. To figure out the component of the product’s marginal cost which accounts for the loan one need only to use the following basic formula:

A=[Pi(1+i)^n]/[(1+i)^n-1]

A - annual payments
P - loan principle
i - interest rate
n - time increment

Q - units produced per time increment

Marginal cost = A/Q

Assuming no other costs, you would need to sell the products greater than the marginal cost in order to yield profit per time incremenet. Providing that you can sell the product to consumers greater than the marginal cost. If you make a loss, it means the way in which you have allocated resources in producing the good could have been better allocated to fulfilling other ends that consumers hold.

13

A reply to the original question. I only give a very genral outline, because that’s all I have so far.

As stated, the question is easily answered. When producers see that people are buying less, they will make less. They may take a hit for a while until they adjust, but that’s life.

But Foster and Catchings argued that they will never adjust. Because if consumption goes down, there is more money available to increase production, and people being what they are, instead of producing less, they are going to go ahead and invest that money and increase production. They will make more, shooting themselves in the foot as the market gets more and more flooded. The producers are constantly making more and more for a public that wants to buy less, a disastrous situation.

Hayek’s basic answer is that the money will be invested in such a way as to decrease costs of production. Thus the producers can keep making money by selling at a lower price [charging $100 a year for all they produce]. Since, using their new method, their production cost are now only $75 a year, they are still making money.

They had to spend a lot of money to build up the machinery etc. that makes costs of production so low, but that’s what the $200 was for. They will recoup that $200 over time, as is always the way capital investment makes money. If you buy a house to rent it, it will take years before you get back your original investment, but it’s worth it.

Everyone is happer, because there is more to go round, and at a lower price, and yet producers are still making profits.

Of course, it sounds incredibly optimistic to say that the $200 will be used exactly that way, and that all the numbers will fall into place that make Hayek’s rosy scenario possible. So Hayek “gets his hands dirty” and proves that it is feasible. He makes the assumption that producers know what they are doing, and will not invest in the first place unless they see Hayek’s outcome as the result of their efforts.

That’s all I’ve got.

14

"To cite an example, if society saves and invests $200 but spends only $100 on the final consumer goods that are produced as a result of investing $200, since the cost of production would be higher than the price of the final consumer goods, producers would have to take up losses and there would be a depression. "

Before we get to Hayek let me try and explain in laymans terms my opinion.

The assumption itself is an utterly improbable if not impossible scenario.

It assumes “society” is a closed system

It assumes that your choices are only consume or take money out of consumption to save for improvements,why? Why is buying improved workers, equipment or facilities not considered consumption?

It assumes that one or many companies taking losses leads to a depression, rather than assuming they go bankrupt and sell their assets to a more efficient producer

It assumes that the $200 “investment” savings is used inefficiently in a process that raises production costs. It assumes that the buying public remains constant and that the sellers are not allowed to find new markets elsewhere. It assumes that the manufacturer will produce twice as much product without doing market research to see if there is demand (like the Ford motor company already sells a Ford to every citizen, but now decides to reinvest in capital improvements to where it now makes two or three Fords per American citizen, tries to sell it to them at the same or even higher price and suddenly it is caught by surprise that they end up with a surplus)

You don’t need Hayek to tell you that is not how the real economy works.

But to take just one of Hayeks refutations: He said the capital improvement will be used to IMPROVE production, likely lowering the cost. Nobody saves or “invests” in a process that will lose money, only in ventures that are likely to increase the return on their savings

For instance: The Suez Canal Digging Co. employs 100 diggers with teaspoons and pays them $300 to produce their product- little canals that they can sell for a modest profit - this is the ideal Keynesian scene- perfect cycle no savings..

Everybody is happy until The Suez Canal Company decides to invest in capital improvements. The Authors (and Keynesians) posit that the only way to do that is by hiring another 100 diggers with teaspoons.- Leading to increased costs and according to them fewer customer dollar available- right on the surface it looks to me like you are actually increasing customers, but that is not my point.

So instead of hiring 100 more teaspoondiggers how abou you give your $200 to Caterpillar to hire a machine that mechanically digs ditches Now 20 workers can dig 100 times deeper and faster than before - the other 80 laid off employees can now be employed by the Caterpillar company making Caterpillars for the Suez canal company, or be a salesforce to sell canals or expand into digging swimmingpools. The suez canal company will absolutely find new markets for their product or sell fewer products for cheaper, (but higher margins than before) or be replaced by more efficient competition… no dillemna no depression

15

I think it’s important to note here that what Keynesian economists mean by “saving” is not what Austrian-school economists typically mean by it. The former take it to mean “not spending money at all” while the latter take it to mean “not spending money on consumption goods”. Hence investment is a kind of saving for Austrian-school economists, but not for Keynesian economists.

As long as money is not being exchanged, it’s essentially removed from circulation. What this means is that we all save (in the Keynesian sense) to some extent. If I have $5 that I don’t spend for a day, then I’ve saved that $5 over that day. Now the more people save (again in the Keynesian sense), the higher their demand for money vis-a-vis other commodities can be said to be. Essentially what Keynesian economists have a problem with is when people’s demand for money is “too high” (i.e. higher than they’d like).

Why don’t Keynesian economists like that? Because the higher people’s demand for money, the lower their demand for other commodities. All other things being equal, this leads to lower revenues (and thus profits) for businesses. Naturally, the owners and operators of businesses don’t like that either. Neither do workers, who face a higher risk of being unemployed when that happens. Neither does the government, which faces the prospect of lower tax revenues when that happens. All of these people look at the money being saved (by others) and think, “That could be mine!”

Hopefully you’ll notice that none of this explains just how a dramatic upward shift in the demand for money occurs. Keynes handwaved that away with the notion of “animal spirits”. That’s code for the notion that people who suddenly have much higher demand for money (and thus much lower demand for all other commodities) are idiots. It should come as no surprise that Keynes was a consummate elitist.

Compare the theory of the business cycle put forth by Austrian-school economics (a systematic illusion of lower scarcity brought on by fractional-reserve banking, especially if centrally controlled, which leads to malinvestments) to that put forth by Keynesian economics (most people are idiots). Which one do you think has more explanatory power?

16

PP,

More or less perfect. Just make sure that you understand that, as you do indicate, it’s the money saved plus the discount rate at the various stages and the length of time. The 100 dollars in consumption contains the final intererest payment on all previous stages of producton, Therefore if you just look at a single project, consumption will be greater than production by some amount racked up in interest, which will vary wildley depending on how much was spent at higher or lower stages. Even a relatively inexpensive initial stage of production will take up a larger and larger portion of total cost if it was several years before the completion of the project.

17

Autolykos is right about the Keynesian point of view. They use this argument (the paradox of thrift) to justify their interference with the markets, to force people to “spend” rather than “save” because they believe “not spending or consuming” is evil and somehow investing falls in the same category.

Neither Keynes nor the authors that Hayek was refuting explain why “Saving” is not consuming. It is as if everybody that Saves keeps gold bars under their mattress for their scenario to be true.

If saving is the same as investing in capital goods it does not detract from the “society” spending

If saving means leaving money in savings accounts, it puts more money back in circulation through bank loans

Even if saving means you hoard your paper dollars under the mattress, it takes money out of circulation therefore making the remaining money more valuable, so consumers can buy more products with the same dollar.

There is not a scenario where society can hoard too much money (much less if it is invested in more products) -none of this leads to the paradox scenario

18

Just for the record, there is a point that has to be cleared up here.

The OP’s question, the situation Hayek talks about, is not the one Keynes is talking about.

The OP, Foster and Catchings, and Hayek are talking about when people take the money that they used to spend on consumption [=eating things up] and instead “invest” it. “Invest” is a technical term meaning using the money to increase production. Gold bars under the mattress are not what they are talking about.

Keynes is talking about gold bars under the mattress.

Foster and Catchings claimed that in their situation, more and more will be made with no one to buy it, until bad things start happening. Keynes claimed that in his situation, less and less will be made, and bad things will happen because of that.

Hayek’s discussion in the essay the OP linked to does not discuss, and does not solve, Keynes’s problem. He only solves Foster and Catching’s problem.