The other day I had a conversation with Garett Jones about the sources of dysfunction in the medical sector. After I rattled off an explanation in which I cited barriers to entry, the revolving regulatory door, and systematic control of journals by departments whose interests are aligned with big-pharma, etc… he asked, “What do you think the R-squared is for that?” In other words, on a scale of 0 to 100 percent, how much does your story explain? I felt pretty confident about the causation presented by my narrative, but this brought to my attention the problem of the narrative fallacy within the field of economics.
Of special concern to me, of course, is appearance of the narrative fallacy within Austrian economics, especially as expressed by Hayek in his early work. His analysis of central bank policy usually centered on the possibility of discoordination as a result of relative price changes that occur with the expansion of the money stock. Hayek believed that this was the primary source of the economic disturbances for greater than a decade after the war. His concern with relative price movements in Prices and Production is well encapsulated in his critique of Ralph Hawtrey:
But the main concern of this type of theory [price level targeting] is avowed, with certain suppositions ‘tendencies, which affect all prices equally, or at any rate, impartially, at the same time in the same direction.’ And it is only after the alleged causal relation between changes in the quantity of money and average prices has thus been established that effects on relative prices are considered…He though that Hawtrey was incorrect to claim:
...that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money – that they are at their ‘natural’ level – if the price level remains stable.
Hayek believed that Hawtrey’s concerns were misplaced, or to put it more accurately, poorly ordered. Price level changes only mattered so much as they affect relative prices. Hayek had the theory to prove it, and a nice story to tell about it. When confronting Cassel’s support of price stabilization, which was akin to that of Hawtrey, Hayek states clearly his narrative and the theory on which it relies:
But general price changes are no essential feature of a monetary theory of the trade cycle; they are not only unessential, but they would be completely irrelevant if only they were completely ‘general’ – that is, if they affected all prices at the same time and in the same proportion. The point of real interest to trade cycle theory is the existence of certain deviations in individual price relations occurring because changes in the volume of money appear at certain individual points; deviations, that is, away from the position that is necessary to maintain the whole system in equilibrium. Every disturbance of the equilibrium of prices leads necessarily to shifts in the structure of production, which must therefore be regarded as consequences of monetary change, never as additional separate assumptions. The nature of the changes in the composition of the existing stock of goods, which are effected through such monetary changes, depends of course on the point at which the money is injected into the economic system.
As usual, Hayek tells a story of how changes in relative prices affect the structure of production and breed economic discoordination. This claim is by no means incorrect. But the question I must ask is, “What is the R-squared for that?” And I might add, “What variables are omitted?”
As I showed last post, both Cassel and Hawtrey were concerned about the short-run price level destabilization that might occur with the reestablishment of the gold standard. These men were not only concerned with shifts in velocity of the broader measures of the money stock, but of change in demand for gold itself, particularly by central banks. To the best of my knowledge, they did not emphasize the danger of shifts in relative prices, but of a sharp deflation or inflation associated with changes in demand for gold. It is curious that Hayek, who was concerned about destabilization of relative prices due to central bank policy, did not simply modify the concerns of Hawtrey and Cassel by attributing these dangers to relative prices. The reason, I believe, is that it threatened his narrative.
The prosperity that the western world experienced after 1870 came alongside mass adoption of the gold standard. Until World War I, the “rules of the game” of the game had procured relative monetary and price stability. If a central bank expanded the monetary base by too great a degree, investors would remove their gold from the central bank and place it elsewhere. This would discipline central banks that practiced easy money policies. Also, if excess gold in one nation led to a rise in prices, gold would flow to countries where prices were lower. Thus the gold standard was an international standard that allowed information about scarcity to be transmitted globally.
In light of this, Hayek stresses the significance of a return to the gold standard. In Monetary Nationalism and International Stability, he wrote:
Since people will always feel that against these emergencies they will have to hold some reserve of the one thing which by age-old custom civilized as well as uncivilized people are ready to accept – that is, since gold alone will serve one of the purposes for which stock of money are held – and since to some extent gold will always be held for this purpose, there can be little doubt that it is the only sort of international standard which in the present world has any chance of surviving. But, to repeat, while an international standard is desirable on purely economic grounds, the choice of gold with all its undeniable defects is made necessary entirely by political considerations.
But governments had found a way to not only subvert the discipline of gold, but make the standard entirely dysfunctional even for those who followed the “rules of the game.” By substantially increasing gold reserves at different times in the years following the war, countries like France and the United States depressed the price level, and in doing so, distorted relative prices. This is very similar to distortions that might occur due to changes in velocity of the broader money stock. Since gold holdings had been largely centralized by central banks, one can view this entirely as shifts in the price level that occurred due to central bank intervention. The emphasis of Austrian Business Cycle Theory on domestic inflation likely promoted this bias.
Hayek did not begin to integrate this element into his framework until late. After the war, the return to the gold standard required cooperation among central banks. Their policies were decided often on political grounds. This was the case in France when the franc was devalued and France’s share of the world increased from 7% in 1927 to 27% in 1932. In his 1932 article, “The Fate of the Gold Standard,” Hayek denied that this was a problem:
Hence it was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the ‘rules of the game’ by the breakdown of their gold standard.
It was not until 1937 that he revised this view and admitted that central banks with large gold stocks need to relax their demand for gold:
The policy on the part of those countries which are already in a strong gold position, if it aims at the restoration of an international gold standard, should have been, while maintaining constant rates of exchange with all countries in a similar position, to reduce the price of gold in order to direct the stream of gold to those countries which are not yet in a position to resume gold payments. Only when the price of gold had fallen sufficiently to enable those countries to acquire sufficient reserves should a general simultaneous return to a free gold standard be attempted.
This can be viewed appropriately as an extension of his theoretical admission in Prices and Production that:
A change in the ‘velocity of circulation’ has rightly always been considered as equivalent to a change in the amount of money in circulation, and though, for reasons which it would go too far to explain here, I am not particularly enamored of the concept of an average velocity of circulation, it will serve as sufficient justification of the general statement that any change in the velocity of circulation would have to be compensated by a reciprocal change in the amount of money in circulation if money is to remain neutral toward prices.
Not until his 1943 article, "A Commodity Reserve Currency," that Hayek apparently ceased supporting a gold standard that depended on central bank cooperation. By then he was ignored by the policy debate.
In review, Austrian Business Cycle Theory did not take into account the need for cooperation between central banks. Each bank must maintain stable exchange rates which do not under or overvalue the domestic currency. This made Hayek unable to adequately address the arguments of proponents of price level stabilization. He overestimated the explanatory power of the Austrian Business Cycle Theory in regard to economic instability during the interwar period and underestimated explanatory power of arguments from price level stabilization proponents. Hayek was slow to update his theory. For nearly two decades after the war, Hayek’s theory and his narrative were still in want of fuller consideration of the open economy and political economy!