Saturday, October 5, 2013

Hayek, Monetary Theory and the Trade Cycle, and Price Level Stabilization

I have begun a study of Hayek where I am concentrating not as much on Hayek’s claims about his own work as his claims about his opponents. I am hoping that it will help clarify his position concerning the international monetary system during the 1920s and 1930s.

In the process of promoting his and Mises's theory of the business cycle, Hayek’s star rose as he eventually earned a position at the LSE. Not coincidentally, his influence as an economist reached a pinnacle in the early thirties. It is not without irony that Hayek later lost this influence precisely because his theory of the trade cycle could not explain the severity of the downturn, nor was its suggestion of government inaction relevant since central banks and governments were certainly not doing nothing during the downturn. These problems needed to be confronted.

Eventually, even Hayek left the original Hayekian position. I am by no means the first to notice this. At the end of his article, “Hayek’ Monetary Theory and Policy: A Critical Reconstruction,” Lawrence White makes a similar observation:

As he was logically compelled to do if he were to embrace consumer price-level stabilization, Hayek here essentially repudiated his earlier business cycle theory and all that rested on it, most importantly his explanation for the onset of the Great Depression (hardly ‘a problem of minor practical significance’) as the necessary consequence of central bank stabilization experiments in the 1920s. He did not indicate what cycle theory should be put in its place. In this key respect Denationalisation of Money breaks radically with Hayek’s earlier work. Hayek’s transformation into supporter of price-level stabilization presents a puzzle for future research.

In this post I am interested in considering the significance of Hayek’s early view that business cycles are caused by changes in M, but never in V. As noted above, this was not his final position. I do think, however it is not unreasonable to claim that Hayek’s loss of influence owed in large part to his original unwillingness to consider the importance of MV stabilization.

The difficulty that confronts this narrative is confusion between different types of price level stabilization. In the introduction of Monetary Theory and the Trade Cycle Hayek writes:

It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown.

These policies were supposed to stabilize demand for gold – total reserves held by central banks – so that the percent increase in holding would not outpace the percent increase in the gold stock itself. This is different than stabilizing MV. The policies were in a part a consequence of the activism of Ralph Hawtrey and Gustav Cassel. What was either a lack of understanding or outright disregard for Cassel’s actual position (for the most part Hawtrey’s work avoids this level of disdain) appears throughout this work as Hayek only concerns himself with arguments about stabilization of MV. He never confronts the more interesting and pertinent case of stabilization of gold demand. Cassel certainly wanted to stabilize the price level, but he was most concerned about changes in the value of gold. As he noted in “Further Observations on the World’s Monetary Problem”:

The decrease in the monetary demand for gold in comparison with the more and more abundant supply of paper money has brought the value of gold down to about half its prewar level, with the consequence that, as is seen in the United States, the prices of commodities in gold have risen to about double what they were before the war. Though this enhancement of prices has certainly been a most injurious process, the inverse process of bringing prices down again to their old level would probably be still more disastrous. The prospect of a long period of falling prices would kill all enterprise and impede that reconstruction of the world which is just now so very urgent.

The above argument was not an argument for stabilizing MV, and it was this argument that dominated policy. Unfortunately for Hayek, his concentration on changes in broader measures of M put him on the losing side of the intellectual battle – not to claim that his theory is invalid, only inadequate given the environment.

By the early 1930s, Hayek began to concede ground to the promoters of price stabilization, but this was too little too late. This is not to say that Hayek was an inferior economist, only that the slowness of his change in views cost him and the Austrian school much esteem. In coming posts, I will be looking for more comments by Hayek concerning the interwar gold standard and the issue of the price of gold. Of particular interest will be the lectures in Prices and Production Monetary Nationalism and International Stability. I hope to break down his position on gold – which is complicated! I close by noting that Hayek did have something to say concerning gold demand in Prices and Production Monetary Nationalism and International Stability. At one point in the final lecture he notes that:

The policy on the part of those countries which are already in a strong position … should have been … 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 has fallen sufficiently to enable those countries to acquire sufficient reserves should a general and simultaneous return to a free gold standard be attempted.

Here he sounds suspiciously like Hawtrey and Cassel. More to come as I dissect his arguments over the next week.


  1. Out of curiosity James Caton, have you seen this recently uploaded piece in The European Journal of the History of Economic Thought? I believe you might be interested in it.

  2. Looks promising. Thanks for the suggestion.