Jack Birner and Rudy van Zijp, eds.
Hayek, Coordination and Evolution:
His Legacy in Philosophy, Politics, Economics, and the History of Ideas
London: Routledge, 1994, pp. 109-125

Roger W. Garrison
 

The lectures that F. A. Hayek delivered at the London School of Economics in the early 1930s were punctuated with triangles—triangles of a sort his audience had never before seen. Now, more than sixty years after those lectures were published as Prices and Production (1931), the triangles still hold the key to understanding Hayekian macroeconomics. What exactly did Hayek see in them? Why could most of his audience see nothing at all in them? Satisfying answers to these two questions can go a long way towards identifying the core differences between Austrian and Anglo-American macroeconomics.
        Considering a third question can add significance to our answer. What relevance do the ideas that Hayek hung on those triangles have today? The lectures were written at a time when Hayek and the rest of the profession were contemplating the dramatic economic boom of the 1920s and the subsequent depression that had yet to find its bottom. The early 1990s find the profession in similar circumstances—contemplating the dramatic bull market of the 1980s and wondering if and how the current recession is related. It would be a mistake to assume that Hayek's triangulation as applied to the earlier episode applies in some wholesale fashion to the current one, but it would be a greater mistake to assume that Hayek's insights have no current application of all.
        Hayek's theory of boom and bust can be generalized so as to increase its plausibility as an account of the 1920s and 1930s and give it new life in accounting for the 1980s and 1990s. After making the appropriate conceptual and institutional adjustments, the story in Prices and Production can be retold in a way that sheds light on contermporary macroeconomic problems. Also, reconsidering the triangles—as Hayek employed them then and as present-day Hayekians might employ them now—helps to put in perspective the macroeconomics of the intervening years which grew out of the Keynesian revolution. 

The Macroeconomic Significance of the Triangles
The Hayekian triangle, as described in Hayek's second lecture (Hayek, 1967, pp. 36-47), is a heuristic device that gives analytical legs to a theory of business cycles first offered by Ludwig von Mises (1953, pp. 339-366). A right triangle depicts the macroeconomy as having a value dimension and a time dimension. It represents at the highest level of abstraction the economy's production process and the consumer goods that flow from it. One leg of the triangle represents dollar-denominated spending on consumer goods; the other leg represents the time dimension that characterizes the production process (Figure 5.1). In a fundamental sense, the Hayekian triangles in their various configurations illustrate a trade-off recognized by Carl Menger and emplasized by Eugen von Böhm-Bawerk. At a given point in time and in the absence of resource idleness, investment is made at the expense of consumption. Investment, which entails the commitment of resources to a time-consuming production process, adds to the time dimension of the economy's structure of production. To allow for investment, consumption must fall initially in both nominal and real terms. Once the capital restructuring is complete, the corresponding level of consumption is higher in real terms than its initial level. The nominal level of consumption spending, however, is lower than its initial level because a greater proportion of total spending is devoted to the maintenance of a more time-consuming production structure.
        The relative length's of the triangle's two legs, then, represent the inverse relationship between nominal consumption spending and nominal non-consumption spending—the latter as reflected by the time dimension of the economy's capital structure. Hayek makes use of several heuristic assumptions that cause production time and non-consumption spending to be more tightly linked in his graphics than in reality. He assumes, for instance, that the production process consists of stages of production such that output of one stage sells as input for the next and that the number of stages varies directly with production time. For the purpose of defining the triangles, the quantity of money and the velocity of circulation—and hence the product MV—are assumed constant. (Episodes of monetary expansion, however, provide the most interesting and relevant circumstances for application of the graphics.)
        The Hayekian triangles can change in shape in circumstances of a constant MV—and hence a constant PQ, where Q is understood to include the sum of the outputs of each stage of production including the final stage whose output is consumption goods. The Hayekian Q, then, lies somewhere between the Fisherian T, which stands for total transactions and the Friedmanian Y, which stands for income or final output (consumption plus net investment); the corresponding V lies somewhere between the transactions velocity and the income velocity.
        The basis for a change in the shape of the triangle is a hypothetical preference change within the output aggregate. Suppose that consumers become more future oriented. Their time preferences—to use the Austrian term—are lower than before. In the first instance, this preference change means a decrease in demand for current consumption and an increase in saving. In the Austrian formulation, saving means more than simply not consuming. Income earners do not just save; they save-up-for-something. Saving-up-for-something is another terminological in-betweener lying somewhere between the conventional polar concepts of saving as a flow and savings as a stock. Increased saving in the Austrian formulation gets translated through market mechanisms and entrepreneurial foresight into higher demands for inputs in the relative early stages of production. The demand for output as a whole, then, is neither higher nor lower than before the preference change. Rather, the pattern of demand has changed in a way that is conveniently depicted by a Hayekian triangle whose consumer-spending leg has become shorter and whose production-time lag has become longer (Figure 5.2).
        The height of the hypotenuse of the reconfigured triangle measured at each stage of production along the production-time leg shows (1) that the demand for input is reduced in the final and late stages of production, (2) that the extent of the reduction diminishes as stages further removed from consumption are considered, (3) that stages remote from consumption experience an increased demand for input and (4) that stages of production more remote than had existed before have been created anew. The slope of the hypotenuse, now less steep than before, reflects a lower rate on interest corresponding to the reduced time preference.
        Reduced time preferences mean a smaller time discount on future consumption. Consumers are more willing to sacrifice consumption goods available now and in the immediate future for consumption goods available in the relatively remote future. Tailoring production plans to consumption preferences requires that the structure of production be modified in precisely the way depicted by the change in the Hayekian triangle just described. Hayek went beyond determining what changes in the structure of production were required by the preference change to identifying, in his third lecture, the market mechanisms that could allocate resources among the stages of production in conformity with the time preferences of consumers. Lower time preferences means increased saving and hence a lower rate of interest. The lower interest rate drives down the competitive gross profit margin in each stage of production. That is, for each stage input prices are bid up in relationship to output prices. the cumulative effect of this relative-price adjustment increases with increased remoteness from the final stage. Accordingly, resources are shifted out of late stages and into early stages in response to the lower time preferences.
        It is easy to fault Hayek and his triangles for sins of omission. What about durable capital and consumer durables? What about changes in the degree of vertical integration? What about instances of input-output circularity such as coal as an input in the production of steel and steel as an input in the production of coal? The realization that there are many aspects of a modern decentralized capitalist economy not captured by a triangle should come as no surprise. What is surprising is how much these triangles do depict or imply. Implicit, for instance, is the notion that the structure of production is characterized by some—but not complete—specificity: If all capital goods were wholly non-specific, then no structure could be defined; if every capital good were completely specific, then no modification could be made. The notion of stage-specific capital implies a certain intertemporal complementarity that characterizes the structure of production. Complementarity through time gives special significance to the time element in the production process—which was so emphasized by Menger and Böhm-Bawerk.
        Treating the problem of intertemporal allocation of resources in terms of the economy's capital structure keeps the entrepreneurial element of the argument in perspective. In the alternative Anglo-American formulations, capital theory is suppressed. Hence, the concept of investment, which is defined as the rate of change in the capital stock, is not well anchored, and doubts that saving will get translated into investment dominate in discussions of both theory and policy. The Hayekian triangles are a constant reminder that a certain amount of entrepreneurial foresight governing the intertemporal allocation of resources is essential to the functioning of a capitalist economy whether or not there are any net additions to the economy's capital stock. If market mechanisms governing intertemporal allocation are working properly, saving and investment pose no special problems. Changes in saving propensities have a direct impact on the rate interest. Market mechanisms together with entrepreneurial foresight continue to operate as before—only now under different credit conditions—to allocate capital and other resources among the stages of production.
        The ultimate effect of a change in the rate of interest on the capital structure is seen as a difference in shape between the initial and subsequent Hayekian triangle. In Prices and Production, Hayek did not treat in any detail the issues of the traverse, as john Hicks (1965. pp. 183-197) was later to call it. The intertemporal profile of output during the capital restructuring—the traverse—is dependent on a myriad of details involving the specifics of technology and the intertemporal complementarities and substitutabilities that characterized the existing capital structure. Implicit in Hayek's application of the triangle, however, is one critical distinction. Depending upon what caused the interest rate to fall, the traverse may or may not be consistent with an actual completion of the capital restructuring. In summary terms, we can say that if the lower interest rate is attributable to new economic realities, particularly if it reflects lower time preferences of consumers, then the traverse will be consistent with completing the process of capital restructuring. If, instead, the lower interest rate is attributable to new economic policies, particularly if it reflects credit expansion by the central bank, then the traverse will be inconsistent with completing the process of capital restructuring. The preference-induced process is one of economic growth; the policy-induced process is one of boom and bust (Hayek, 1967, pp. 50-60).

Hayekian Shapes and Keynesian Sizes
Capital theory in which value is played off against time should not have been totally foreign to Hayek's English audience. A half-century before Hayek molded his lectures around those triangles, an essentially equivalent construction, not then known by Hayek (1967, p. 38), had been offered by William Stanley Jevons. The Jevonian investment figures, which were the core of Jevons's chapter on capital (Jevons, 1970, pp. 225-253), showed capital value rising linearly with time as production proceeded from inception to completion. What was foreign to the English audience was the use of the triangular construction as the basis for macroeconomic theorizing and for theorizing, in particular, about boom and bust.
        Capital theory is complex in its own right—as are most theories of cyclical variation. Hayek's attempt to present a capital-based theory of cyclical variation in an early stage of development involved the compounding of complexity with complexity. It is not at all surprising, then, that these ideas would seem foreign to most and bewildering to many. Reflecting years later on Prices and Production, Hicks remarked that the book "was in English, but it was not English economics (Hicks, 1967, p. 204). Joan Robinson, who had heard Hayek lecture at Cambridge on his way to the London School, referred to Hayek's theory as a "pitiful state of confusion," and believed that his whole argument "consisted in confusing the current rate of investment with the total stock of capital goods" (Robinson, 1972, p. 2).
        John Maynard Keynes (1931) reviewed Hayek's book in what was purportedly a reply to Hayek's critique of Keynes's Treatise on Money. Piero Sraffa (1932) defended his own views on production and distribution theory in what was purportedly a review of Hayek's book. Both Keynes and Sraffa were unreceptive and even hostile to the ideas in Prices and Production. After reporting his own early fascination with Hayekian theory, Nicholas Kaldor (1942) reassessed Prices and Production in the light of subsequent application of the theory. He concluded that the basic ideas in that book must be wrong and referred jeeringly to Hayek's capital-based theory of boom and bust as the "Concertina Effect."
        Some English economists, notably Lionel Robbins (1934) and to a lesser extent John Hicks and Abba Lerner, were persuaded, at least temporarily, of the merit of Hayek's theory. But the general direction the economics profession was taking at the time was not conducive to the acceptance of a capital-based macroeconomics. The very complexity of a capital structure in macroeconomic disequilibrium seemed to be grounds for sending value and capital theory in one direction and macroeconomics in another. The breaking away of macroeconomics from consideration of capital structure became complete with the publication in 1936 of Keynes's General Theory of Employment, Interest, and Money.
        If the assumptions Hayek invoked to make his theory tractable seem severe, the ones Keynes invoked in Chapter 4 of his General Theory should seem more so. Keynes's assumption of a fixed structure of industry effectively took the triangles out of play. So long as fixity characterizes the relationship among the stages of production, questions about the intertemporal allocation of resources are moot, and scope for intertemoral discoordination nil. With a given ratio of the value leg and the time leg of the Hayekian triangle, the issue of the triangle's shape, so emphasized by Hayek, gave way in Keynes's own theorizing to the issue of the triangle's size. Scope for variation in size is simply the mirror image of scope for variation in resource idleness.
        The capital-based Hayekian vision and the capital-free Keynesian vision can be put into perspective with the aid of a simple production-possibilities frontier in which investment is traded off against consumption. So long as investment is positive, the frontier itself moves outwards from one period to the next enabling higher levels of both investment and consumption. The two visions differ fundamentally in terms of the assumed initial conditions, or starting point, underlying the theory and in terms of acknowledged market forces that propel or constrain movement from those initial conditions.
        Hayek took some point on the frontier as his starting point and concerned himself with market processes and central bank policies that move the economy along the frontier in the direction of more investment. he argued, in effect, that if lower time preferences—and hence a reduction in the natural rate of interest—underlie the shift of resources away from consumption and towards investment, the intertemporal market process governed largely by the interest rate would move the economy along the frontier facilitating a more rapid expansion of the frontier itself. If, however, credit expansion—and hence a suppression of the interest rate below its natural level—underlies the shift of resources in the direction of more investment, then the market process, forced in the direction of more investment, would create internal tensions within the capital structure which ultimately would throw the economy off the production possibilities curve in the direction of resource idleness.
        Keynes took some point interior to the frontier as his starting point and concerned himself with fiscal and monetary policies as well as institutional and social reforms that may facilitate movement back to the frontier. Prospects for a market-driven mobilization of idle resources were ruled out in his preliminary chapters. With capital theory suppressed, concerns about which particular point on the frontier to aim at were secondary—if that—to the basic concern of eliminating resource idleness. The idea of a natural rate of interest and implied mix of investment and consumption spending held no significance for Keynes (1964, p. 373). He held, in effect, that there are as many natural rates as there are combinations of demands that put the economy on its production possibilities frontier. Market forces within the capital structure that may favor one point on the frontier over another on the basis of intertemporal consumption preferences were no part of his theory. In sum, Hayek offered a capital-based explanation of how the economy got into a depression; Keynes offered a capital-free prescription for getting out.

The Economics of Credit Controls and Credit Expansion
Abstract as the Hayekian triangles are, their application has strong counterparts in basic microeconomic theory. The macroeconomic flavor can be retained by virtue of the explicit accounting of the time element in the production process which may involve scope for economywide intertemporal discoordination. Alternative credit-market interventions can be considered in the context of basic supply-and-demand analysis. The particular intervention, conceived in microeconomic terms, may or may not have significant macroeconomic consequences depending upon whether or not there is scope for a systematic discoordiantion within the structure of production.
        First, consider the economics of credit control in the form of an interest-rate ceiling. So long as the legal maximum is below the market-clearing rate of interest, the credit market will be cut short. The supply of credit becomes the binding constraint. Savers who would have been willing to supply funds at interest rates between the legal-maximum rate and the market-clearing rate will now find additional consumption more attractive. The credit shortage reflects the many would-be borrowers eager to take advantage of investment opportunities made attractive by the low interest rate—which is to say, opportunities in the relative early stages of production. The incentives created by credit control, then push in opposite directions: erstwhile savers prefer to increase their current rate of consumption while investors become—or at least would like to become—more future oriented.
        By the very nature of the price ceilings, however, the constrained preferences do not get translated into realities. There is no scope even for the beginnings of a process of capital restructuring as would be guided by a low market-clearing rate of interest. In fact, to the extent that black markets or grey markets, which flout or skirt the legal restriction, come into being, the corresponding rate of interest will be demand-determined. Some demanders of credit who would have been shut out by the legislated ceiling are accommodated but at an interest rate above the old market-clearing rate. This high rate of interest puts a premium on time an channels resources into the relative late stages of production. The ultimate result is that both the time pattern of production and the time pattern of consumption are less future oriented than before the imposition of the interest-rate ceiling.
        Second, consider the imposition of an interest-rate ceiling accompanied with a further intervention to prevent the credit shortage from materializing immediately. Suppose that the difference between credit supplied and credit demanded at the legal maximum is made up for by credit creation. The creating and lending of money to fill the gap between supply and demand has the effect of papering over the shortage. It keeps the discrepancy in incentives between the two sides of the market from showing itself immediately.
        If borrowers were to respond to the combination of a ceiling rate and abundant credit in the same way they would respond to a low market rate, resources would be allocated away from late stages of production and into the early stages. As this capital restructuring is underway, income earners would be turning from saving to consumption in the face of the interest-rate ceiling. The market linkages through which the production process is tailored to consumption preferences, however, are not so tight as to curtail the capital restructuring in its incipiency. The time element inherent in the production process translates directly into scope for capital restructuring even in the absence of any change in consumption preferences. But the discrepancy in incentives means that the capital restructuring in necessarily ill-fated. Unavoidably, there will be a clash between producers and consumers as the restructuring process goes forward. Misallocations revealed in the clash will require liquidation and reallocations more consistent with consumer preferences and the interest-rate ceiling.
        It is doubtful that investors would actually respond to a ceiling rate—even with the would-be credit shortage papered over with credit creation—in the same way that would respond to a low market rate. The very enactment of the interest-rate ceiling would have a certain announcement effect that would warn borrowers away from business-as-usual investment strategies. The credit creation, however, initially described as "further intervention" aimed at concealing temporarily the effects of the interest-rate ceiling, actually makes the interest-rate ceiling largely redundant. That is, the expansion of credit by itself has the effect of reducing the interest rate as it adds to the supply of loanable funds. The allocational consequences, somewhat implausible in the face of a legislated interest-rate ceiling, gain in plausibility—and in historical relevance—when attributed to credit expansion alone.
        Finally, then, consider the economics of credit expansion. The differences to be highlighted by considering this particular sequence of interventions are differences in announcement effects and in expectations about future credit-market conditions. Unlike an interest-rate ceiling as might be imposed by the legislature, credit expansion orchestrated by the central bank can be initiated without public debate and without any strong announcement effect. Borrowers are likely to respond to favorable credit conditions attributable to central-bank policy in about the same way they would have responded to favorable credit conditions attributable to increased saving. In fact, many borrowers would not bother to find answers or even to ask questions about the basis for the lower interest rate. Yet, the policy-induced lower rate creates the same discrepancy of incentives as does an interest-rate ceiling. Savers save less, and borrowers borrow more, with the difference between saving an borrowing being made up by credit expansion.
        Business-as-usual investment decisions under favorable credit conditions are the makings of an economic boom. Increased funds in the hands of investors and the increased profit prospects in long-term projects allow for increased employment opportunities as resources are drawn away from late stages of production and into earlier stages. The multi-stage production process as depicted by the Hayekian triangles provides scope for extensive capital restructuring in the direction of a more time-consuming production process despite the actual reduction in saving. The tug-of-war between producers and consumers implicit in the policy-induced economic expansion does not produce a victor in a timely manner. It is a tug-of-war with and expandable rope.
        If the business community continues to respond to the credit expansion as if favorable credit conditions will last indefinitely, then the duration of the boom will be limited by the time element in the production process itself. Outputs of earlier stages feed successively into subsequent stages. At some stage in this process, the viability of the policy-induced capital restructuring comes into question. Capital and labor resources complementary to those already committed to earlier stages are in short supply (Hayek, 1967, pp. 85-91). The bidding up of input prices in the late stages of production impinges on credit markets as well. So-called distress borrowing puts an upward pressure on interest rates wholly separate from any inflation premium attributable to credit expansion.
        In the final throes of a policy-induced boom, the role of the central bank becomes more evident and more visible. Will the central bank supply additional credit, which will more fully satisfy each demand in nominal terms but will translate generally into higher resource prices rather than more successful bidding? Or, will the central bank curtail credit to avoid still further misallocation of resources and a general price inflation? The tug-of-war between producers and consumers becomes, from the perspective of the central bank, a tiger by the tail. Both bulls and bears engage in speculative transactions on the basis of their guesses about how long the central bank will hang on and just when it will let go.
        Economists who do not theorize in terms of a capital structure and who question the meaning or significance of the natural rate on interest, tend to see little harm—and may see great benefit—in credit expansion. Most of those same economists would see as foolish, wasteful, and counterproductive any attempt to impose a price ceiling on any market and especially an attempt to impose an interest-rate ceiling on credit markets. Yet, the key difference emphasized above between an interest-rate ceiling and credit expansion in the context of a multi-stage capital structure is that the perversities of the interest-rate ceiling manifest themselves more directly and more quickly and, although disruptive, are less so than the alternative policy of credit expansion. The perversities of a credit-induced boom are obscured by the initial positive effects of credit expansion, the time element that separates credit expansion from its negative effects, and the complexity of the capital theory needed to make the theoretical connection between expansion and crisis.

Three Components of the Interest Rate
Attention to the time element in the capital structure allows the message in Hayek's Prices and Production to be generalized and then adapted so as to apply in contexts other than the one that inspired his London lectures. Production time inherent in the multi-stage production process can put a lag between intervention in credit markets and the ultimate consequences on that intervention. The particular intervention of concern to Hayek, credit expansion, affected the capital structure's intertemporal orientation. The cheap credit favored a reallocation of resources among the stages of production that was inconsistent with intertemporal consumer preferences. More specifically, the artificially low rate on interest caused production plans to become more future oriented and consumption plans to be come less so.
        Other sorts of intervention that might have lagged consequences on an economywide scale can be identified by taking the interest rate to be the key market signal that translates cause into lagged effect and considering the individual components of the market rate on interest. To this end, it is convenient to conceive of the market rate as consisting of three components: an underlying time discount, an inflation premium, and a risk premium. Hayek's triangulation in the early 1930s was based squarely on the first component.
        By the 1960s the focus of macroeconomists had shifted from the first component to the second. Practiced use of monetary tools as economic stimulants—however temporary the actual effects—gave increasing importance to the role of expectations. Scope for a significant discrepancy between expected and actual inflation rates resulted in macroeconomic constructions that featured the inflation premium. Arguably, the most interesting consequences of imperfectly anticipated inflation are those that manifest themselves as the misallocation of capital and labor among the stages of production as might be depicted by Hayekian triangles. But by the time the problem of inflation had captured the attention of modern macroeconomists, capital theory had been in eclipse for more than two decades.
        The Keynesian revolution had so weakened the perceived link between capital and interest that it became commonplace to theorize in terms of the level on employment in the context of a given capital structure. Monetary expansion, which has its most direct effects in credit markets and on interest rates, came to be analyzed in terms of labor markets and wage rates. This shift in focus was seen as a glaring incongruity to economists who learned their macroeconomics from Hayek but was second nature to economists who had long since left capital theory behind.
        The nature and significance of the inverse relationship between the inflation rate and the level of employment as depicted by the Phillips curve was derived from differences in the abilities of employers and employees in forming relevant expectations and on differences in the way market participants, broadly conceived, adjust their expectations about inflation (Friedman, 1976). The first difference governed the strength of the short-run trade-off between inflation and unemployment; the second difference governed the length of the short run. What came to be the conventional account of the consequences of monetary expansion traces the movement along a short-run Phillips curve, which reflects given expectations, then allows for a shifting of the curve to reflect a change in expectations. The adjustment process involves a temporary decrease in the unemployment rate as wage adjustments lag behind price adjustments followed by a permanent increase in the inflation rate as the general level of prices catches up to the expanding money supply. Except for occasional reference to temporary and wholly incidental disturbances affecting stock-flow relationships in markets for financial and real assets, business-cycle theory based upon short-run/long-run Phillips curve dynamics takes no account of capital misallocation. The critical time element, which was a fundamental aspect of the capital-based theory of Hayek's theory, was retained in the tenuous form of time-consuming adjustments—accomplished differentially by employers and employees—of perceptions to realities.
        The general focus of macroeconomic discussion changed dramatically between the 1930s and the 1960s as the focus changed from the time-discount component of the interest rate to the inflation premium and from capital markets to labor markets. In summary terms, Hayek's Prices and Production provided a capital-based account of policy induced distortions in time discounts, while the macroeconomics of the 1960s provided a labor-based account of policy-induced changes in the inflation premium. The purpose here in making the contrast in this way is not to pit one macroeconomic framework against the other (as in done in Bellante and Garrison, 1988) but rather to point in the direction of a third framework that may prove more applicable to the 1990s.
        The third component of the market rate of interest, the risk premium, has played a significant role neither in Hayekian constructions nor in more modern ones. Typically, risk premiums get mentioned only in introductory throat-clearing paragraphs in which considerations of risks along with administrative charges and other workaday matters are assumed away. At most, the perceived riskiness of holding non-monetary assets helps in some formulations to explain the demand for money. But there has been no macroeconomic theory attempting to explain any episode of boom and bust in terms of the market's allocation of risk-bearing or policy-induced distortions of risk-related market mechanisms. Until recently, such a theoretical formulation would have little if any application. But the macroeconomic experience of the 1980s and 1990s might best be accounted for by just such a formulation.
        The risk-based formulation parallels Hayek's original triangulation and, to a lesser extent, the more modern theorizing about short-run and long-run Phillips curves. In summary terms, we can say that the market allocates risk-bearing among market participants in accordance with the willingness of each to bear risk. Policies can create a discrepancy between risk willingly born and risk actually born. Because of a critical time element embedded in risk-bearing, such policies can have cause-and-effect relationships that manifest themselves macroeconomically as boom and bust. 

The Economics of Risk Control and Risk Externalization
Not all conceivable policies that would interfere with the market's allocation of risk-bearing would have significant macroeconomic effects. Suppose, for example, that the legislature, which might take all market rates of interest more than, say, five percent above the Treasury-bill rate to reflect excessive riskiness, were to declare all payment for such risk-bearing politically incorrect. A legislated Treasury-plus-five cap on interest rates would have a direct and immediate effect on credit markets. Entrepreneurs interested in relatively risky undertakings would face a credit shortage. The effects of this partial prohibition against risk-taking would differ little from the effects of a simple interest-rate cap. Black and grey credit markets would emerge to partially offset the effects of legislation, and the trade-off between debt and equity financing would be biased in favor of equity. Apart from these effects, which are wholly predictable on the basis of conventional microeconomics, there is no basis for predicting that any macroeconomically significant consequences would follow from such risk-control legislation.
        The effects of this hypothetical risk-control legislation are set out here in order to provide a basis for contrasting those distortions of market mechanisms for allocating risk-bearing that do have macroeconomically significant effects and those that do not. The exposition also allows us to identify links between the economics of risk allocation and the economics of credit allocation. We can anticipate the argument by saying that, in terms of the macroeconomic significance of the effects of intervention, credit control is to risk control what credit expansion is to risk externalization. Legislative actions and policy innovations may allow borrowers to take risks that are systematically out of line with the risks perceived or actually born by lenders. So long as risk is effectively concealed from lenders or actually shifted to others, risk-taking will be excessive. The initial phase of excessive risk-taking will manifest itself as an economic boom, but eventually, when actual losses begin to change the perception of lenders and begin to impinge upon unsuspecting others, the boom will give way to a bust.
        Adding substance to this summary account of boom and bust attributable to distortions of the risk premium requires the identification of legislative action and policy innovation that create a discrepancy between risk-taking and (perceived) risk-bearing. The market process set into motion by the discrepancy can then be shown to play itself out in the context of actual markets that embody risk-taking. In this way, a capital-based account of legislative and policy-based distortions in risk premiums can point to specific interventions that underlay the boom of the 1980s and sowed the seeds for the bust—the Bush recession—in the early 1990s
        The single piece of legislation most relevant to risk allocation in the 1980s' boom was the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which dramatically changed the banking industry's ability and willingness to finance risky undertakings. Increased competition within the banking industry and from non-bank financial institutions drove commercial banks to alter their lending policy so as to accept greater risks in order to achieve higher yields. The deregulation gave new significance to the Federal Deposit Insurance Corporation (FDIC), which continued to absolve the banks' depositors of all worries about illiquidity and even about bankruptcy, while the Federal Reserve in its long-established capacity of lender of last resort diminished the banks' own concerns about such problems. The risks in the private sector, then, were only partially reflected in higher borrowing costs and lower share prices. In substantial measure, private-sector risks were transformed into risks of inflation in the event of excessive last-resort lending by the Federal Reserve and risks of a large and unbudgeted liability in the event of excessive last-resort closings by the FDIC. But these risks were born unknowingly and hence unwillingly by market participants and taxpayers throughout the economy. During the 1980s, then, the increased riskiness in the private sector was effectively externalized and diffused so that the private-sector activity, spurred on by correspondingly increased yields, was largely unattenuated by considerations of risk.
        The policy innovation most relevant to risk allocation in the 1980s' boom was the federal government's dramatically increased reliance on deficit finance. The Federal Reserve in its capacity to monetize government debt keeps the default-risk premium off Treasury bills. This is not to say that the risk that would otherwise attach itself to government securities is actually eliminated. The burden of bearing risk is simply shifted from the holders of Treasury securities to others. Borrowing and investing in the private sector is more risky than it otherwise would be. Holders of private debt and equity shares must concern themselves with all the usual risks and uncertainties of the market place plus the risks and uncertainties attributable to potential changes in the way the federal deficit is accommodated. The massive selling of debt by the Treasury in foreign credit markets, in domestic credit markets, or to the Federal Reserve can have major effects on the strength of export markets, on domestic interest rates, and on the inflation rate. Inability of market participants to anticipate the Treasury's borrowing strategy translates into unanticipated changes in the value of private securities and the real assets they represent. Speculative lending in the private sector, such as for commercial real-estate development or for highly leveraged financial reorganizations are risky in large part because of possible changes in such things as the inflation rate, interest rate, trade flows, and tax rates—the very things that can undergo substantial and unpredictable change when the federal budget is dramatically out of balance (Garrison, 1993).
        In circumstances where considerations of risk figure importantly in accounting for the performance of the economy, capital markets become the natural focus of attention. The focus on capital is what makes the macroeconomics of the 1980s and 1990s more closely related to Hayekian triangulation than to the labor-based short-run/long-run Phillips curve analysis of the 1960s. Long-term, or capital-intensive, undertakings are inherently more risky than short-term undertakings precisely because more time must elapse before such undertakings can prove their profitability—more time that increases the likelihood of some major change in deficit accommodation or some attempt at deficit reduction that can turn expected profits into losses.
        The temporal segregation of stages of production that make up the economy's capital structure puts a dimension in the analysis that is absent in labor-based theorizing. There is scope for profit-taking in early stages of production in cases where ultimately the entire project—all stages considered—yields a substantial loss. The possibility for short-term commitments in the early stages of long-term projects coupled with the many imperfections in contingency markets that allow for some hedging against changes in the federal government's fiscal and monetary strategy warn against too literal an application of the so-called efficient-market hypothesis. Ordinarily, markets allocate both capital and labor efficiently—or at least more efficiently that any alternative allocation mechanism. But a market system whose credit markets involve risks that are partially concealed from the lender and partially shifted to others will be biased in the direction of excessive risk-taking. And excessive risks are converted in time into excessive losses.

Hayekian Triangles for the 1990s
Frequent but vague references in the financial and popular press to the "excesses of the 1980s" can be taken to mean excess riskiness in comparison to wealth holders' willingness to bear risk. The 1980s may best be understood, then, as a decade in which risk externalization attributable to legislative action and policy innovation gave rise to a substantial but ultimately unsustainable economic boom.
        This diagnosis of the macroeconomic ills of the 1990s is more suggestive than conclusive. The purpose here is to demonstrate the versatility of Hayekian theory rather than render a final verdict on the most recent episode of boom and bust. Hayek gave us a good start on capital-based macroeconomics. The insights wrapped up in those triangles and the prospects for extension and application are yet to be fully developed or fully appreciated. 

References

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