If the real world is always in disequilibrium, meaning most (or, all) prices are never their equilibrium values, how can we give meaning to concept of price distortions? Specifically, how does the “transmission mechanism,” so to speak, of the Mises–Hayek theory of intertemporal discoordination work, if prices are always, in a sense, distorted? Mises and Hayek placed emphasis on the concept of relative prices, to draw attention to differences in the movement of prices of goods belonging to different stages of production (on aggregate, we can talk about the relative price of producers’ goods to consumers’ goods). To give meaning to their theory in a world of disequilibrium, we should also emphasize the concept of profit and loss. Indeed, what we typically refer to as a price distortion may be better termed a distortion of profit.

In equilibrium, prices perfectly reflect the goods’ opportunity costs, and the market process is irrelevant, because all goods are already perfectly allocated — this world is changeless, since change would change the equilibrium value of the goods in question. It follows that in the real world, where the market process is, by virtue of experience, always in a state of change, prices do not perfectly reflect goods’ opportunity cost. Does this imply that these prices are “distorted,” whether it be as a result of government intervention or an outcome of the kaleidoscopic market process? In the very narrow sense of disequilibrium, sure, but I don’t think what most people have in mind when they talk of price distortions.

In a world of non-equilibrium prices, how do economic agents coordinate? To explain this, economists of the inter-war era, including Ludwig von Mises and Frank H. Knight, looked to profit and loss. If we assume, for the sake of simplicity, that all equilibria are perfectly competitive, profit and loss can only exist in a world of disequilibrium. Profits are earned by exploiting price differentials, and losses accrue by poorly estimating price differentials. These two related phenomena make up one of the market process’ most important feedback mechanisms. Profits are signals for other entrepreneurs to allocate their capital towards the production of output where profits are relatively high, while losses are a signal of overinvestment. Losses and profits also force the redistribution of capital from entrepreneurs who preform poorly to those who do well, and this process of redistribution continues perpetually, meaning it’s receptive to the fact that entrepreneurial success, probably, has as much to do with luck as it does with skill.

Within the context of profit and loss, the way I conceptualize non-distorted market prices is to look at possible prices as a range. This range is bounded by profit and loss, such that a highly inaccurate price will bring either extreme profit or extreme loss, pushing the price in the opposite direction as entrepreneurs react. In The Market as an Economic Process, Ludwig Lachmann urges us to look at both sides of the coin when emphasizing that all coordinating forces can also cause discoordination, and vice versa. For example, an entrepreneur who is seeking to exploit the profitability of a certain market will throw off other entrepreneurs who seek the same end, if the degree of future competition in that market is not well predicted. This is how I look at, what we can call, market bounded prices, where prices in disequilibrium implies some degree of discoordination, but at the same time the profits and losses which stem from disequilibrated prices help coordinate market agents.

When thinking of the distortion necessary to bring about sustained intertemporal discoordination, it may be easier to think about it in terms of profit and loss — or, in terms of constrained price ranges.

Suppose that some hypothetical, advanced market economy enjoys a banking system where there is a single currency. Individual banks are not allowed to issue their own banknotes, but must acquire them from official mints, controlled either by some government or by a central bank. The lack of competitive currencies eliminates an important disciplining mechanism, which is the constraint private banknotes place on the banks themselves (where excess notes are ultimately returned to the bank for redemption, either for some metallic money or for some other backing asset). This lack of a disciplining mechanism makes fiduciary over-issue (the supply of inside money beyond the demand for it) not only more likely, but it also lifts the constraints on the extent of the over-issue, such that the supply of money can exceed the demand for it for a significantly longer period of time and at a much greater volume.

According to Austrian capital theory, since money is non-neutral, new money will impact some prices more and sooner than others, implying that the social distribution of new money is unequal. Consumer credit complicates our analysis a little, so for the sake of simplicity we’ll assume it to be irrelevant. Banks typically issue new money through the loanable funds market, implying that people borrow it — new money is created during the process of the intermediation of savings. If the increase in the supply of money is met by an increase in the demand for money, we can assume that all new loaned money represents social savings. In the case of a fiduciary over-issue, there is some fraction of total new money that does not correspond to savings, causing intertemporal discoordination. This is because money lent through the loanable funds market, on average, is invested, meaning it targets a specific set of goods: capital goods.

We can interpret Austrian capital theory as a theory of the optimal intertemporal distribution of capital goods (all goods which are not consumers’ goods; usually, original factors of production [land, labor, et cetera] are not included, but for simplicity’s sake I do). To help form of an idea of what Austrians have in mind, imagine production to take over a series of stages. The last stage, which provides the final consumers’ good, requires certain inputs, and the production of these inputs make up the second stage. To manufacture these inputs, in turn, these firms require other inputs, and the production of these makes up the third stage. This continues until the earliest stage, whose inputs are original factors of production. Reality is a bit more complicated, but this abstract model helps capture what Austrians have in mind. The length of the structure of production, that is the number of stages, is determined by social time preference, or the ratio between saving and consumption. The volume of production within a given structure, though, is determined by the capital stock (the greater the capital stock, the more you can produce).

Money is relevant to the intertemporal distribution of capital goods, because it’s money prices, and profit and loss, which guides the allocation of goods over time. Assume all new money is lent to entrepreneurs. A fall in consumption lowers the price of consumers’ goods, increasing the relative price of labor in those industries. As a result, these firms increase their demand for labor saving machinery, raising the prices of these capital goods. An increase in savings will allow entrepreneurs to borrow these and invest them in the production of this machinery, which in turn will increase the demand for the inputs required to produce this machinery, and this continues, theoretically, until the rate of profit in each stage is equalized. In a world of disequilibrium there will always be discoordination, but it should be randomly distributed, and profit signals will help constrain the degree of discoordination.

The problem of an excess supply of money, then, is that it will raise the profitability of manufacturing capital goods, and therefore alter the structure of production, without simultaneously increasing the stock of savings. A conflict between consumption and investment is created. Within the context of bounded market prices, what excess money creation does is change the range of possible market prices. As long as new credit increases at an accelerating rate (which fits with the data on credit creation preceding real world demand crises), these distortions of prices, and therefore profit and loss, will be sustained. In other words, the distribution of error is no longer non-random, but guided by distorted signals. This is why Austrians (borrowing from Murray Rothbard’s America’s Great Depression) call attention to the “cluster of errors,” rather than entrepreneurial error itself. The distinction between random and non-random error helps understand how Austrians interpret the phenomena of the demand-driven business cycle.

Illustrating this process with a Hayekian triangle and a production possibilities curve may help,

I ≡ investment; O C ≡ consumers’ goods; O P ≡ producers’ (capital) goods. In equilibrium, there is a specific point on the production possibilities curve (PPC) the economy will be in. Given how the axes are termed, the slope of the tangent of the equilibrium point will be equal to –P P /P C (the relative price of producers’ goods). We can see how an increase in savings and investment leads to a lengthening of the structure of production (represented by the triangle), as goods originally allocated in stages nearer the consumer are re-allocated towards earlier stages of production. This entails a movement down the PPC, as relative prices change. Therefore, an oversupply of money will cause this save movement, but without a change in social time preference, such that when relative prices re-adjust, a movement back to the original point must occur. This movement back to the original point is the depression (and recovery), and is aggravated because of the sudden collapse of demand — the distribution of profits and losses change, and those earning sustained profits during the boom are now subject to the losses that come with prices returning to the bounded range that better reflects the underlying opportunity costs of the goods in question.

Austrian business cycle theory — what I call the Mises–Hayek theory of intertemporal discoordination — is usually modeled with microeconomic tools which are built around the concept of equilibrium. This is done, because it’s easier. But, it’s fundamentally a disequilibrium process. It can only happen in a world where there exists profit and loss, and changes in prices. It entails a shift from a random distribution of losses to a non-random distribution of losses, caused by the distortion of prices that comes with an over-issue of money. Conceptualizing it in a world of disequilibrium only requires being creative with how we interpret the models used to illustrate the process.