Hayek’s economic perspectives certainly varied over the course of the Great Depression. The beginning of this change saw him distinguish between theory of his opponents and their policy recommendations. In Monetary Theory and the Trade Cycle, Hayek claims that relative prices only move due to a change in the quantity of money:
Apart from individual saving activity (which includes, of course the savings of corporations, of the state, and of other bodies entitled to raise compulsory contributions) the proportions between consumptions and capital creation can only change as a result of alterations in the effective quantity of money.
I noted before that this is strange because, unless the income elasticity for all goods is the same across the economy, a change in income due to a fall or rise in velocity will result in the adjustment of relative prices. By the time Prices and Production reached print, these views had changed.
Throughout the Prices and Production, Hayek is careful never to support a policy of price level stabilization, but the nature of his criticism against it had changed. He begins, first, with a partial admission concerning and partial defense against velocity stabilization in Monetary Theory and the Trade Cycle:
The second effect of this assumption of separate ‘stages' of production of equal length was that it imposed upon me a somewhat one-sided treatment of the problem of the velocity of circulation of money. It implied more or less that money passed through the successive stages at a constant rate which corresponded to the rate at which the goods advanced through the process of production, and in any case excluded considerations of changes in the velocity of circulation or the cash balances held in the different stages. The impossibility of dealing expressly with changes in the velocity of circulation so long as this assumption was maintained served to strengthen the misleading impression that the phenomena I was discussing would be caused only by actual changes in the quality of money and not by every change in the money stream, which in the real world are probably caused at least as frequently, if not more frequently, by changes in the velocity of circulation than by changes in the actual quantity. It has been put to me that any treatment of monetary problems which neglected in this way the phenomenon of changes in the desire to hold money balances could not possibly say anything worthwhile. While in my opinion this is a somewhat exaggerated view, I should like to emphasize in this connection how small a section of the whole field of monetary theory is actually treated in this book. All that I claim for it is that it deals with an aspect which has been more neglected and misunderstood than perhaps any other and the insufficient understanding of which has led to particularly serious mistake.
The final line that I have bolded is a valid apology, except that Hayek’s view on velocity in Monetary Theory and the Trade Cycle remains, at best, ambiguous. He denies the significance of a price level whose inverse is consider the purchasing power of money throughout the book, yet uses the phrase, which I quoted at the beginning of this entry, “effective quantity of money,” a phrase that I assume refers to changes in the quantity and purchasing power of money. This appears to have been a veiled confession whose clarification had to wait until the completion of Prices of Production.
After Hayek moves on from apologetics, Hayek considers the quantity theory shortly. Hayek’s opinion at the time was that the theory was not realistic, citing it as a deviation away from methodological individualism:
For none of these magnitudes [M,V,P,Y] as such ever exerts an influence on the decisionsa of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of monetary economic theory are based.
Hayek’s distaste for aggregates certainly shows here. His claim, however, really has no bearing on the usefulness of the accounting identity proposed by the quantity theory. Hayek’s disagreement throughout this section is more with policy than the quantity theory of money. It just so happens that the quantity theory is the cornerstone of the theory upon which price level stabilization is based.
During this critique, however, Hayek does uncover a weakness in the theory as proposed by Ralph Hawtrey:
But the main concern of this type of theory 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.
Concerning this point, Hayek’s attack on the theory behind price stabilization is keen. He appears to be suggesting an improvement [I will have to read Hawtrey’s “Money and Index Numbers” to be sure] on the theory concerning the impact of velocity on prices. The problem with a change in velocity is not that it simply shifts the price level, but that it distorts relative prices. Assuming that individual income elasticities for goods vary and are biased in aggregate, a shift in the price level will certainly lead to shifts in relative prices. Perhaps the most important relative price relationship is that between a security and the value of its asset. When the nominal value of assets fall, the nominal value of the securities are not affected and the owner of the asset is still expected to repay the loan in full. This increases the risk of default and also discoordination within credit markets. The aforementioned theoretical disagreement between Hayek and Hawtrey is not, I believe, in regard to the correctness of Hawtrey’s proposition, but its accuracy. Hawtrey's work could have been improved from writing about shifts in the price level in terms of the impact on relative prices.
I close by clarifying the problem associated with shifts in relative prices. Hayek does not immediately elaborate on the issue within the context of changes in velocity, but we can better understand his point by reflecting on his primary concern about monetary inflation. An increase in the money stock shifts relative prices of goods at each stage of production, positively impacting earlier stages first:
The final effect will be that, through the fall of prices in the later stages of production and the rise of prices in the earlier stages of production, price margins between the different stages of production will have decreased all around.
Eventually, the increased profitability of the earlier stages of production push up wages which ultimately increase the price of consumer goods. Soon, the earlier stages of production become less profitable and therefore must shrink. Entrepreneurs realize that they have been misled by these changes in relative prices and become conservatively inclined as the economy enters recession. This theory of discoordination given an increase in the money stock is simple to understand. The complexities of discoordination due to a change in velocity, on the other hand, are not as simple to model. One might benefit by considering first the impact on the relative price of securities given a change in the value of money.
Expect more over the next few days as I continue to unpack Prices and Production and consider both its theoretical implications and its significance within the history of economic thought. Next I plan to discuss Hayek's theoretical analysis of the impact of velocity on production.