I hope not to have misrepresented Hayek in my review of his opinion of velocity in the last several posts. I have made clear that Hayek did not accept the idea of MV stabilization as a legitimate policy prescription at the time of his writing Prices and Production. This certainly does not mean he had nothing deep to say in this theoretical matter. In lecture 4 of Prices and Production, he presents the problem that a change in velocity might present. His presentation of the matter is both lucid and accurate. "The question to which we must now address or attention is this,” he writes:
Will not such changes in the proportions of money transactions to the total flow of goods make a corresponding change in the quantity of the circulating medium necessary?
The answer to that question depends upon whether, without such a corresponding change in the quantity of money, the change in business organization, would cause shifts in the directions of demand and consequential shifts in the direction of production not justified by changes in the ‘real’ factors. That the simple fact that a money payment is inserted at a point in the movement of goods from the original means of production to the final stage where none has been necessary before (or the reverse) is no ‘real’ cause in the sense that it would justify a change in the structure of productions, is a proposition which probably needs no further explanation. If, therefore, we can show that, without a corresponding change in the amount of circulation, it has such an effect, this would provide sufficient reason, in these circumstances, to consider a change in the amount of money to be necessary.
Though he asks whether “a change in the amount of money” is needed, Hayek is not speaking in terms of policy, but rather, theory. Throughout Prices and Production, he concerns himself with shifts in relative prices. As I have mentioned before, it would be disingenuous to suggest that a change in relative prices due to a change in velocity has no bearing on the structure of production. Hayek, whose work throughout his career was both thorough and honest, does not shy away from this issue. He not only acknowledges the problem, but provides a theoretical solution:
The effects [of an increase in the value of money and a drop in the volume of currency] would be the same as if, other things remaining the same, the total amount of money in circulation had been reduced by a corresponding sum used before for productive purposes. The two cases are so far alike that the change in the proportion between the demand for consumers’ goods and the demand for producers’ goods, which in the second case as in the first is not determined by ‘Real’ causes, will not be permanent: the old proportion will tend to re-establish itself. But if, from the outset, the demand of the new entrepreneur for the additional cash balances had been satisfied by the creation of new money, this change in the total quantity of circulation would not have caused a change in the direction of demand, and would only have helped preserve the existing equilibrium.
There you have it. Hayek arguing that this problem might be corrected by injection of new money into the system! Of course, this is not quite the same thing as stabilizing the price level. Hayek suggests that the only way to prevent the distortion of relative prices is to give money to precisely those whose consumption and investment patterns are affected by the change in velocity. To simply inject money into the financial sector does not accomplish this. Hayek elaborates with further admission of the problem and follows with a critique of policy:
But the situation become different as soon as we take into account the possibility of changes in methods of payment which make it possible for a given amount of money to effect a larger or smaller number of payments during a period of time than before. Such 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.
For in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it… But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy…
Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that – save in an acute crisis – bankers need not be afraid to harm production by overcaution.”
Hayek’s position is both clear and well thought out. Theoretically, the promoters of price stabilization are correct that a change in the value of money can lead to economic fluctuations. The problem does not lie in a change in the price level, but a shift in relative prices just as occurs when the quantity of money in circulation increases or decreases. To think that a central bank can correct this problem requires two assumptions: first, discoordination brought about by a change in general prices that occurs due to a change in velocity can be corrected by a proportional adjustment of the volume of money – that is, that a change in the volume of money won’t compound the problem – and second, that central bankers have the knowledge and incentives to accomplish this. Even if the first claim is true, the latter, while it certainly can be true, has not been empirically satisfied given the history of central banking. Given the issues presented, one might see reason to sympathize with Hayek’s arguments about price stabilization.
I hope I have not made the reader to comfortable with the argument against price stabilization. These arguments are not easy to understand and perhaps their implications still harder to comprehend. Hayek's later work reflects this. His willingness to consider theoretical arguments clearly guided his thinking in later years as he continued to recognize the problem of shifts in velocity and actually reversed his position. In “A Commodity Reserve Currency” (reprinted in Individualism and Economic Order), Hayek actually embraces the policy of price stabilization with a caveat:
…the great need is for a system under which these controls are taken from the separate bodies which can but act in what is essentially and arbitrary and unpredictable manner and to make the controls instead subject to a mechanical and predictable rule.
In a manner that would later be more fully embodied in his work, Denationalisation of Money, Hayek argued for a mechanism that would automatically stabilize prices by a relatively predicable procedure. Some might jump to critique Hayek for changing this position, but I suggest that any who do consider his desire to be careful and correct in his presentation as such an attitude permeates his work.
Next post expect more on Hayek and the gold standard.