Turning Point: Hayek as Monetary Visionary

In 1949, Hayek reflected on the success of socialist ideology and the waning of classical liberalism:

In particular, socialist thought owes its appeal to the young largely to its visionary character; the very courage to indulge in Utopian thought is in this respect a source of strength to the socialists which traditional liberalism sadly lacks. He closes the article by arguing:

We must make the building of a free society once more an intellectual adventure, a deed of courage. What we lack is a liberal Utopia, a program which seems neither a mere defense of things as they are nor a diluted kind of socialism, but a truly liberal radicalism which does not spare the susceptibilities of the mighty (including the trade unions), which is not too severely practical, and which does not confine itself to what appears today as politically possible.

During the Great Depression Hayek had struggled to convince his colleagues of the merits of certain classical liberal tenants that he valued. He failed to sway their opinion concerning the gold standard. This was also true concerning the Austrian Business Cycle Theory. He only partly succeeded in disillusioning them of their socialist utopian dreams with his participation in the Socialist Calculation Debate. Where had Hayek gone wrong? Hayek’s remarks in “Intellectuals and Socialism” about utopianism appear to be confession. He had not been idealistic enough.

Written before “Intellectuals and Socialism” in 1943, Hayek’s “A Commodity Reserve Currency” represents a shift in his research program where he begins to stress future avenues to prosperity and political organization, rather than a propose solutions that might be interpreted as “a mere defense of things as they are.” It is a truly symbolic of this change in that he moves from criticizing price level stabilization to proposing not only how it might successfully operate, but how the rules of its operations my mitigate the extreme fluctuations of the business cycle. His proposal is not the same as his peers. He suggests that, rather than having the price level be stabilized by changes in the money stock that offset changes in velocity, the use of a commodity reserves can stabilize the general price of commodities directly by setting a fixed exchange rate for commodities which will increase demand for them when prices fall below the fixed rate and alleviate demand when prices rise above the fixed rate:

With this [commodity] system in operation an increase in the demand for liquid assets would lead to the accumulation of stocks of raw commodities of the most general usefulness. As the hoarded money was again returned to circulation, and demand for commodities increased these stock would be released to satisfy the new demand.

He explains how this will dampen the business cycle:

The revival of activity will not lead to an extra stimulus to the production of raw commodities which would continue on an even keel. There is reason to regard the temporary stimulus of excessive expansion of production to raw commodities, which used to be given by the sharp rise of their prices in boom periods, as one of the most serious causes of general instability. This would be entirely avoided under the proposed scheme – at least so long as the monetary authority had any stocks from which to sell.

 Instead of pointing to the problem associated with past policies and suggesting a return to the golden days – which is easily interpreted as a return to the status quo – Hayek projects a vision of a future that improves upon the past.

This represents an about face from the direction of much of his previous work. His critique of price level stabilization and promotion of the gold standard during the 1930s had apparently gained Hayek few followers. The western world had suffered tragedy twice within two decades – first with the Great War, then the Great Depression – and the zeitgeist of the era did not look to the past for future success. Intellectuals craved idealism, not recitation of former creeds. They wanted swift change and saw the state as the vehicle for that change. Hayek learned that if the liberal values that he promoted were to survive, he needed to propose policies that were a radical departure for the past. The new vision must present previously unrealized solutions that constrain, rather than empower, the state. This new program is well exemplified in a couple passages of his 1943 article where he stresses the importance of rules:

There would, in particular, be no need for the monetary authorities or the government in any way directly to handle the many commodities of which the commodity unit is composed. Both the bringing-together of the required assortment of warrants and the actual storing of the commodities could be safely left to private initiative. Specialist brokers would soon take care of the collecting and tendering of warrants as soon as their aggregate market price fell ever so little below the standard figure and of withdrawing and redistributing the warrants to their various markets if their aggregate prices rose above that figure. In this respect the business of the monetary authority would be as mechanical as the buying and selling of gold under the gold standard.

And:

Even apart from monetary consideration, 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 an arbitrary and unpredictable manner and to make the controls instead subject to a mechanical and predictable rule.

We can certainly see the roots of Hayek’s later work on spontaneous order as Hayek suggested rules that might procure stability that allows economic agents to make plans and coordinate them with others.

"Joiners" and Strong Social Bonds

Robin Hanson at Overcoming Bias reflects on the relationship between extreme opinions and social bonds:

High commitment groups produce stronger community bonds, and people vary in their taste for such strong bonds. Some folks are “joiners,” with a taste for more strongly bonded groups. Joiners have an induced taste for groups with extreme opinions, and thus an induced taste to have their own more extreme opinions, in order to better fit with stronger groups. Thus joiners tend to let themselves have more opinions and more extreme opinions on many topics.

Well worth reading in its entirety.

Scott Sumner On Kahan Tea Party Intelligence Distribution

Insightful. Check it out.

I apologize for picking on Dan Kahan, because he seems like a good guy.  And he’s no worse than the typical Yale academic.  But he really should be embarrassed. How could an academic expect people who identify with the Tea Party to be below average in any sort of intelligence/education metric? It boggles the mind. 

Average people pay little attention to public affairs.  Following public policy is not normal behavior; it’s what smart people do.  People like to talk about how popular Fox News is, but compare its ratings to professional wrestling, or some other non-intellectual show.  You will be surprised by how few people watch Fox.  The only reason the Tea Party didn’t do better is that the group included those who merely sympathize–if you took actual members the score would have been far higher.

Blindsided: Hayek, Austrian Business Cycle Theory, and the Narrative Fallacy

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!

Hayek on Gold Sterilization: Wither Gold Demand?

I finally got my hands on Good Money, Part I which is a collection of essays from Hayek on international monetary conditions during the interwar period. It is an ideal set of essays for anyone who is interested in understanding Hayek’s disposition toward the gold standard.

Today I shall concern myself with two points of Hayek’s analysis from 1924: 1) Hayek stresses that Federal Reserve operations should take into account Europe’s imminent return to the gold standard and 2) he ignores the impact of an increase in demand for gold from the United States on the price of gold.

In the opening paragraph of his 1924 article, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” Hayek writes that “the outcome of American monetary policy is of considerable importance, given that many European currencies are dependent on it at present and probably for some time to come.” At the time of writing, the United States was one of few nations still on the gold standard, and of those, had the largest stock of gold – around 45% of the world’s monetary gold reserves. He also notes that, since gold was most often not directly involved in transactions, “the value of gold… is determined almost exclusively by the purchasing power of the dollar” and that “foreign exchange policy is geared to maintaining the parity of their currency with the dollar.” Countries that pegged their currency values to the dollar and, thus, indirectly maintained an exchange rate in terms of gold. Given this observation the similarity of this scheme with the gold exchange standard, his disagreement with supporters of price stabilization seem out of place. But more on that next time.

Hayek does not fully take into account the significance of the large drop in the price level that would likely follow the reestablishment of the gold standard. He does at least intuit that the drop in the price level was due to a shift in demand for gold by central banks after they delinked from the gold standard:

With its confinement to a single large country, the gold currency lost the stabilizing effect that it had produced in the prewar period, as demonstrated by the sharp rise in the general price level between the outbreak of war and 1920, in which the value of the dollar was cut in half, and by the ensuing drop in prices. In the years that followed, it became clear that the United States could not maintain even the degree of price stability attained by countries with an unconvertible paper currency.

Year-to-Year Percent Change 

He never explicitly notes the impact of demand for gold on its price. As I have shown, the majority of the rise in the price level in terms of gold and its later fall can be explained by the percent change in the world's total gold reserves held less the percent change in the world’s total gold stock. The more positive the difference, the greater was the marginal impact on the price level.

The above graph certainly was not available in 1924, but Gustav Cassel and Ralph Hawtrey were making a similar argument throughout the decade. In 1918, Cassel wrote that “the decrease in the monetary demand for gold… has brought the value of gold down to about half its pre-war level” and worried that “bringing prices down again to their old level would probably be still more disastrous.” In observing the Genoa resolution (1922), Hawtrey expressed concerned that “if an undue demand for gold is to be avoided, we must have some method of economising the use of gold as currency.” For some reason – which I hope to fully uncover – Hayek does not consider these arguments.

Hayek also claims, and he was not alone in doing so, that the Federal Reserve was correct to not fully employ the gold arriving from Europe. This, as with the rest of his argument, is a consequence of ignoring the price distorting effects of an increase in demand for gold from the Federal Reserve. Hayek  stresses that:

The proper policy to pursue [i.e., not fully employing gold from Europe] became problematic only when the revival of business activity gave rise to increased demands for credit. It was clear from the very start that under existing international conditions and with the enormous gold reserves of the Federal Reserve Banks in mind, the raising of discount rates should not be postponed until reserves were nearly exhausted, lest a dangerous inflation be encouraged and a severe downturn subsequently precipitated in its wake.

His analysis is certainly peppered with insights from the Austrian Business Cycle Theory, although this is a strange extrapolation of it where he justifies one intervention – sterilization – as a means to reestablishing the gold standard. He writes:

Whatever its actual magnitude, there is no question that this fraction of the credit basis will be withdrawn whenever European currencies have been so reliably stabilized that the dollar will no longer need to be used in international trade. To that extent, the sterilization of the increased gold stocks is a justifiable policy of the Federal Reserve Board.

 Hayek writes this despite his admission that “the very measures that were taken to sterilize the increase in gold supplies and to prevent prices from rising contribute to continued gold imports.” Had Hayek taken into account the international deflationary effect of gold sterilization that resulted from an increase in the value of gold, perhaps he might have thought differently. Without any record of Hayek on the significance of demand for gold it is impossible to know, but the omission of this from his writing suggests that he was either ignorant of the issue or thought it unimportant.

In any case, Hayek continues with a distinctly Austrian analysis where he decries the inflation associated with eventual expansion of credit by the Federal Reserve, credit that relied on incoming gold. I’ll have more to say about that next time.

***If anyone is familiar with any writings from Hayek in which he references demand for gold, I would appreciate that information.

Low Blow after Low Blow: Tom Watson at Salon

Read it here.

At one point he uses the word authoritarian as a descriptor. Never does he approach the theoretical foundations. Instead he whines that libertarians oppose the notion that government solutions are superior. This quotation sums his position well:

The Libertarian Party itself – inaccurately described by Stop Watching Us as a “public advocacy organization” – is a right-wing political party that opposes all gun control laws and public healthcare, supported the government shutdown, dismisses public education, opposes organized labor, favors the end of Social Security as we know it, and argues in its formal political manifesto that “we should eliminate the entire social welfare system” while supporting “unrestricted competition among banks and depository institutions of all types.”

Yet my progressive friends would take the stage with the representatives of this political movement? Why? The loss is much greater than the gain. Organizers trade their own good names and reputations to stand alongside – and convey legitimacy to – a party that opposes communitarian participation in liberal society, and rejects the very role of government itself. And their own argument for privacy is weakened by the pollution of an ideology that uses its few positive civil liberties positions as a predator uses candy with a child.

The loudest cry of libertarians (big and small "L") is that markets and voluntary societies provide the surest means of securing an enduring freedom and prosperity. Why? Because markets and voluntary societies allow the provision of needs to be internalized within communities, both small and broad. They provide solutions where gains are positive sum, rather than zero or negative sum. Solutions provided by government, at least thus far, tend to be of the latter type. Why? Because actors in markets and voluntary societies face the consequences of failure more immediately than bureaucrats in public agencies. If a business runs substantial deficits for an extended period, it will face bankruptcy. Government agencies, for example the post office, can consistently run deficits but never see an end.

The problems don't end there. Government provision of goods and services tend to bifricate society by class. Those who are poorer tend to have government services available for options like medical care, education, etc... Why? Because provision of these goods and services by government crowd out cheaper options, regardless of their effectiveness. The result is that in poorer communities where the provision of these goods and services have been internalized, or at least could be, lose the option of voluntary provision and with it, social cohesion. The relative cost of joining a local community for support increases as the provision of subsidized benefits increase. 

It's simple economics.

@ 1231 P.S. Steve Horwitz just pointed out a couple other responses here and here.

Gold: What was Hayek's Actual Position? Juxtapose Friedman

In 1961, Milton Friedman gave his speech, “Real and Pseudo Gold Standards” to an audience at the Mont Pelerin Society (I am unable to find the attendee list, but I assume that Hayek was there as it was his final year as president). At the time, much of what Friedman said was probably not met with great disagreement from Hayek, but I find it instructive to compare Friedman’s speech to Hayek’s original views.

Friedman identifies three types of monetary standards. There is a real gold standard, where gold is used as the medium of exchange or as the base of money, but in which there is no fixed exchange rate. Then there is what Friedman calls a “pseudo gold standard” under which exchange rates are fixed by an external authority. Gold can, but often does not, circulate freely under the latter regime and monetary authorities are free to manipulate international gold flows. According to Friedman:

Though these have many surface features in common, they are at bottom fundamentally different -just as the near identity of prices charged by competitive sellers differs basically from the identity of prices charged by members of a price-ring or cartel.

The gold standard, as it historically operated in the modern, capitalist era, has operated as a “pseudo gold standard.” In this sense, it was only a nominal a gold standard whose benefits might be obscured if only some nations abandoned the gold standard or if policy supported gold hoarding by central banks, both of which occurred during and after World War I.

Friedman’s assessment dives to the heart of the debate as it occurred among free-market liberals at the time. Those who supported a return to the gold standard hoped for a real gold standard, but this is probably impossible in practice as long as government controls the money stock. Friedman rightly conjectured that any reversion to gold by national government would probably be half baked:

I believe that those of us who support it in the belief that it either is or will tend to be a real gold standard are mistakenly fostering trends the outcome of which they will be among the first to deplore.

The gold standard as it existed after 1934 was obviously of the pseudo-type, but the difference between that gold standard and the one that preceded it was much more of degree than of kind. Given the expectation that any government managed gold standard was a “pseudo gold standard,” Friedman and company called for: 

A separation of gold policy from exchange-rate policy. It favors the abandonment of rigid ex-change rates between national currencies and the substitution of a system of floating exchange rates determined from day to day by private transactions without government intervention. With respect to gold, there are some differences, but most of us would currently favor the abandonment of any commitment by governments to buy and sell gold at fixed prices and of any fixed gold reserve requirements for the issue of national currency as well as the repeal of any restrictions on private dealings in gold.

I first did not understand why this was not the consensus among academics at Mont Pelerin. Hayek’s Great Depression era work provides insight into the issue.

Throughout Monetary Nationalism and International Stability, Hayek praises the gold standard for its ability to serve as a truly “international currency system.” That is, prices in one country can be directly compared to prices in any other country on the gold standard. “Differences in denomination of national currencies,” writes Hayek, “would really be no more significant than the fact that the same quantity of cloth can be stated in yards and in meters.” Hayek also observes that with the breakdown of the gold standard, “homogeneity of the circulating medium of different countries has been destroyed by the growth of separate banking systems organized on national lines.” Hayek wanted a homogeneous international unit of account, but his policy suggestion was entirely unworkable. This adds not a small amount of trouble in attempting to decipher Hayek’s argument.

To clear up the problem, we must look at Hayek’s ideal policy suggestion:

It is far less obvious why all the banking institutions in a particular area or country should be made to rely on a single national reserve. This is certainly not a system which anybody would have deliberately devised on rational grounds, and it grew up as an accidental by-product of a policy concerned with different problems. The rational choice would seem to lie between either a system of ‘free banking,’ which not only gives all banks the right of note issue and at the same time makes it necessary for them to rely on their own reserves, but also leaves them free to choose their field of operations and their correspondents without regard to national boundaries, and on the other hand, an international central banks. I need not add that both of these ideals seem utterly impracticable in the world as we know it. But I am not certain whether the compromise we have chosen, that of national central banks which have no direct power over the bulk of the national circulation but which hold as the sole ultimate reserve a comparatively small amount of gold, is not one of the most unstable arrangements imaginable.

We see again that Hayek’s actual policy suggestion was backward looking, but his ideal arrangement is far ahead of his peers. He recognized the problems with the gold standard raised over 20 years later by Friedman at Mont Pelerin, yet failed to seize upon his greatest strength. Hayek did eventually alter his policy prescriptions, but the habit of some Austrians to give backward looking policy suggestions remains to this day as a simple google search for “Austrian Gold Standard” reveals an ongoing debate among Austrians. At one extreme, some like Walter Block support a return to the 100% gold standard and the generally opposing group, which includes Larry White and George Selgin, that support a free-banking solution. The latter group certainly carry on, at least in part, Hayek’s legacy and fit well with the position of Friedman in 1961. Unfortunately, those not entirely familiar with Austrian economics are probably better acquainted with the perspectives of the former group. 

Hayek's Confusing Perspectives on the Gold Standard

My review of Hayek’s work, which with today’s post now thoroughly, though not completely, spans from late 1920s to 1930s, has revealed to me a consistent weakness throughout his writing. Aside from short inklings into his future work on spontaneous social orders, his work from this period is backward looking and his attempts to bridge theory and policy produce awkward, and probably unworkable, suggestions. It is this tension between Hayek the theorist and Hayek the policy wonk that I hope relay in reviewing his analysis of the international gold standard. I must first present the monetary difficulties that the world faced due to a managed gold standard and the distaste for gold that his bred.

A great strength of Hayek’s analysis of the gold standard is that he differentiates the gold standard in practice from the gold standard in the abstract. The Great Depression was a consequence of the former, a managed gold standard. He writes at the end of Price and Production:

I am not even convinced that a good deal of the harm which is just now generally ascribed to the gold standard will not by a future and better informed generation of economists be recognized as a result of the different attempts of recent years to make the mechanism of the gold standard inoperative. 

To some extent, he was correct in this prediction, though it seems that few economists have actually spelled this out specifically so as to place the failure of the gold standard entirely on the shoulders of bad management. (I am unsure if the phrase good management is not a paradox within this context.) Richard Timberlake states this most clearly:

They [presumably Barry Eichengreen and Peter Temin] seem unaware that if central bankers are managing a ‘gold standard’ in order to control monetary policy, whatever it is they are managing is not really a gold standard. 

The problem is not due to gold. If central banks managed any other commodity standard with fixed exchange rates, the same problem would likely occur. The problem was management. Historical observation and counter-historical modeling from Christina Romer and Chang-Tai Hsieh support a similar conclusion:

 Our evidence from the one time that the Federal Reserve undertook monetary expansion in the early 1930s is that the Federal Reserve actually had substantial room to maneuver. For this reason, we are inclined to agree with Friedman and Schwartz that the Federal Reserve’s failure to act was a policy mistake of monumental proportions, not the inevitable result of the U.S. adherence to the gold standard.

 Despite evidence that ought to rectify an excessively harsh view toward the gold standard qua gold standard (see also here and here), the general sentiment toward it remains closer to the “golden fetters” perspective than to any other. In short, the dominant sentiment has not changed considerably since the Great Depression, this is likely due to the difficulty of separating policy from theory, especially among intellectuals (in the Hayekian sense).

Hayek sums the monetary problem clearly at the start of Monetary Nationalism and International Stability.

It [monetary nationalism] will certainly continue to gain influence for some time to come, and it will probably indefinitely postpone the restoration of a truly international currency system. Even if it does not prevent the restoration of an international gold standard, it will almost inevitably bring about its renewed breakdown soon after it has been re-established.

 The gold standard, as it historically operated under a system of independent central banks, is, in the long run, not a functional solution. The policies of central banks will likely not promote the health of the system as they are not constrained by market incentives. This system was especially fragile. As I argue in my recent paper, “the resumption of gold redemption by European central banks [after WWI] would lead to financial disaster even if only several attempted to maintain prewar exchange rates or attract gold by other means.” In particular, the Federal Reserve had to arbitrarily inhibit demand for gold as Great Britain returned to the gold standard at an overvalued parity. They and other central banks unsuccessfully engaged the prisoner’s dilemma. Hayek certainly takes this into account in Monetary Nationalism and International Stability:

It seems to me impossible to doubt that there is indeed a very considerable difference between the case where a country, whose inhabitants are induced to decrease their share in the world’s stock of money by ten percent, does so by actually giving up this ten percent in gold, and the case where, in order to preserve the accustomed reserve proportions, it pays out only one percent in gold and contracts the credit superstructure in proportion to the reduction of reserves. It is as if all balances of international payments had to be squeezed through a narrow bottleneck as special pressure to be brought on people who would otherwise not have been affected by the change to give up money which they would have invested productively. 

Hayek must have in mind the deflation that followed tight central bank policies in 1928 and 1929.

It is not unsurprising that some readers might be confused by such a view from Hayek. Throughout the 1920s, Hayek was concerned about inflationary central bank policy. Even in Prices and Production, a lecture that were given in the midst of a deflationary crisis, Hayek busied himself by explaining the policies that might lead to depression and only touches on policies necessary to avert the deepening of a depression:

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. 

It is only natural that the attention of academics is swayed by present circumstances. If one is interested in providing policy suggestions to officials, he or she must pay attention to the crisis at hand, not the problems of yesterday. Given the circumstances of the Great Depression, Hayek made himself irrelevant.

Hayek continued this trend throughout the decade. As noted by David Glasner, Hayek defended France’s policy of an undervalued Franc. In 1932 he wrote:

The accusation that France systematically hoarded gold seems at first sight to be more likely to be correct [than the charge that the US Federal Reserve had been hoarding gold, an accusation dismissed in the previous paragraph]. France did pursue an extremely cautious foreign policy after the franc stabilized at a level which considerably undervalued it with respect to its domestic purchasing power, and prevented an expansion of credit proportional to the amount of gold coming in. Nevertheless, France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow – and this alone is necessary for the gold standard to function.

Glasner comments:

So Hayek’s observation that France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow means only that the Bank of France refused to increase the French money supply at all (or even attempted to decrease it), forcing the French to increase their holdings of cash by acquiring gold through an export surplus. 

It is bad enough that Hayek suggests backward looking solutions in arguing against the price level stabilizers. He surely discredited himself among contemporaries in 1932 as he sanctioned the policy that was steering the world economy off course and destroying the gold standard. To his opponents were it was very clear that the interwar gold standard and its effect on the price of gold was the source of the trouble. In 1928, Cassel noted the problem and suggested a solution: 

But if the gold-economizing policy does not succeed, or if it at a future time is found no longer possible to carry through, the unavoidable consequence must be that the gold standard will have to be abolished, and that the world's economy will have to be based on paper standards regulated with the single purpose of keeping the general level of prices constant.

In retrospect it is not difficult to see why Hayek lost this battle. For about a decade he fought against price stabilization without fully acknowledging the danger of gold price volatility and without offering a realistic alternative. The earliest concession from Hayek concerning the gold standard and central bank driven price distortion from Hayek that I can find is in Monetary Nationalism and International Stability, and which I have mentioned in a previous post:

Now the present abundance of gold offers an exceptional opportunity for such a reform. But to achieve the desired result not only the absolute supply of gold but also its distribution is of importance. In this respect it must appear unfortunate that those countries which command already abundant gold reserves and would therefore be in a position to work the gold standard on these lines, should use that position to keep the price artificially high. 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 appears to be the moment that Hayek’s analysis in some ways catches up with the profession. But it would be about another about another decade before his research into spontaneous order merged with his monetary interest (see last post) and still more time before this would allow him to create work that was far ahead of his field.

There is still much more to appreciate from Monetary Nationalism and International Instability. Next time I plan to compare Hayek’s analysis with Friedman’s article “Real and Pseudo Gold Standards.”

(Still) Uncovering Hayek's view of MV: A Note

Fingering through Denationalisation of Money tonight, I found a quote that clearly reflects, I think, Hayek's view regarding MV stabilization. As you might expect, if you have read my last few posts, it is complicated!:

I have long since come to the conclusion that no real money can ever be neutral in this sense, and that we must be content with a system that rapidly corrects inevitable errors. The nearest approach to such a condition which we can hope to achieve would appear to me to be one in which the average prices of the 'original factors of production' were kept constant. But as the average price of land and labour is hardly something for which we can find a statistical measure, the nearest practicable approximation would seem to be precisely that stability of raw material and perhaps other wholesale prices which we could hope competitively issued currencies would secure. 

I will readily admit that such a provisional solution (on which the experimentation of competition might gradually improve), though giving us an infinitely better money and much more general economic stability than we have ever had, leaves open various questions to which I have no ready answer. But it seems to meet the most urgent needs much better than any prospects that seemed to exist while one did not contemplate the abolition of monopoly of the issue of money and free admission of competition into the business of providing currency.

As I read through Hayek I notice that he forms his opinions methodically. Early in his career, Hayek might convey a theory and its implications, but then deny its application to policy. I am gathering that, as his research carried into the "socialist calculation debate" and "spontaneous order," Hayek began to understand more clearly that although theory cannot be applied perfectly, corrective mechanisms, such as those that express themselves in the market, might compensate. I argue that in the above statement, Hayek presents a robust view that contains many, if not all, of the opinions that he previously expressed.  His position is something along the lines of "MV targetting does not work. Use MV targetting (at least for now)." This is followed by the suggestion that a more efficient policy will allow markets for money be freed from legal tender monopoly. It is not unreasonable to see Hayek as inconsistent, but such a reading is incorrect. If one does not study Hayek's views one layer at a time, then the interpretation that follows will be misleading.

So let's think of Hayek's view of MV stabilization as having 3 different layers (for simplicity):

1. Immediate Policy Suggestion
2. Ideal Policy Suggestion
3. Theoretical Analysis

The last of these is the source of the other two. Perhaps by such a perspective we can gain greater insight into both his view concerning MV stabilization and other economic phenomena.

Stay tuned for a more complete analysis Hayek, the gold standard, and central bank policies during the interwar period.

Hayek and Velocity sans Policy (and more)

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.

Glasner Reviews my Paper on the Interwar Gold Standard and Central Bank Gold Demand

See it here. And if you haven't already, check out the paper here.

I was pleasantly surprised to receive an email a couple of weeks ago from someone I don’t know, a graduate student in economics at George Mason University, James Caton. He sent me a link to a paper (“Good as Gold?: A Quantitative Analysis of Hawtrey and Cassel’s Theory of Gold Demand and the Gold Price Level During the Interwar Period”) that he recently posted on SSRN. Caton was kind enough to credit me and my co-author Ron Batchelder, as well as Doug Irwin (here and here) and Scott Sumner, for reviving interest in the seminal work of Ralph Hawtrey and Gustav Cassel on the interwar gold standard and the key role in causing the Great Depression played by the process of restoring the gold standard after it had been effectively suspended after World War I began.

Considering Velocity and Price Level Stabilization in Prices and Production

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.

More Thoughts on Hayek, the Monetary Theory of the Trade Cycle, and Price Level Stabilization

In looking over Monetary Theory and the Trade Cycle I also noticed a rather strange argument that Hayek makes in regard to changes in demand for money. He argues against a policy of stabilization outright. Even if we grant him this claim about policy, I find his desire to disregard the significance of changes in the value of money incongruous with his general concern about “all the changes originating in the monetary field.” Especially toward the end of his book, Hayek leaves little room for confusion of interpretation:

With the disappearance of the idea that money can only exert an active influence on economic movement when the value of money (as measured by one kind of price level) is changing, the theory that the general value of money is the sole object of explanation for monetary theory must fall to the ground. Its place must, henceforth, be taken by an analysis of all the effects of money in the course of economic development. All changes in the volume of effective monetary circulation, and only such changes, will therefore rank for consideration as changes in economic data capable of originating ‘monetary influences.’

In a different part of this book, the reason that Hayek presents for concentrating only on changes in the volume of currency should also apply to changes in the value of money. I refer to his claim that changes in the volume of currency impact relative prices:

“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.”

Again he writes elsewhere:

But this future theory, unlike that of Wicksell, will have to examine not movement in the general price level but rather those deviations of particular prices from their equilibrium position that were caused by the monetary factor.

The confusion appears to arise from the concentration of economists like Fisher and Cassel on stabilization of the general price level in general. Hayek expresses two doubts about their theory that can easily be confronted. One concerns the viability of the policy implication. The other makes an implicit assumption about income elasticity. The first is captured in the first citation above. In a flash of parenthetical sarcasm, Hayek expresses doubt about price level stabilization because it depends on the use of “one kind of price level.” Price level in theory and price level in practice are not the same, and they should be treated as such. According to the equation of exchange, MV = PY. Even if we take Hayek’s statement about price stabilization at face value, this does not mean that changes in the value of money do not impact the production structure. In fact, a change in V can affect P! This leads naturally to the second problem. A change in V can and does impact relative prices. Simple micro theory can elucidate this point. A change in V that affects P does not affect all prices symmetrically. The impact on price depends on the income elasticity of each good or service. Unless the income elasticity for all goods and services all equal one, the change in V does affect relative prices, and therefore, it may alter the production structure. As I mentioned yesterday, Hayek eventually changed his views. For the sake of the history of monetary thought, however, this incite is valuable in evaluating movement in academic sentiment at the time.

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.