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.

Central Banks and the Interwar Gold Standard

I just uploaded my paper to SSRN:

In the last several decades David Glasner, Douglas Irwin, Ronald Batchelder, and Scott Sumner have revived Hawtrey and Cassel’s explanation of the Great Depression. According to them, the intensity of the Great Depression can be explained by a dramatic increase in demand for gold by central banks, principally in the United States and France, which forced down prices internationally. This paper expands their analysis with a model to test the impact of changes in aggregate gold reserves on the gold price level throughout much of the interwar era.

Upcoming Seminar

I finally have almost everything in order for the graduate IHS seminar I'll be presenting at in July. I'll be analyzing the significance of shifts in gold demand on the world price level during World War I and the interwar period. I plan to post snippets over the next month.

The Next Four Years

Last week I received funding offers from both UC Santa Cruz and George Mason University. I weighed my options for several days, but really only needed one. As of this afternoon, I have accepted the offer from George Mason.  My choice reflects a passion for understanding that began to stir within me not long after high school. George Mason's economics program emphasizes methodology and political economy and is a nice fit for my interests. I plan to concentrate in monetary theory and new institutions.

Chris Coyne got back to me with a reading list. In the spirit of Armen Alchian's recent passing, my first book of the summer will be Armen Alchian and William R. Allen's Exchange and Production, Competition, Coordination and Control.

Krugman, Gold, and 1 Trillion Dollars (Lift Pinky to Corner of Lip)

Paul Krugman posted on the trillion dollar coin and used the opportunity to talk about the "barbarous relic" and the benefits of state-managed money:

For people like me, on the other hand, the economy is a social system, created by and for people. Money is a social contrivance and convenience that makes this social system work better — and should be adjusted, both in quantity and in characteristics, whenever there is compelling evidence that this would lead to better outcomes. It often makes sense to put constraints on our actions, e.g. by pegging to another currency or granting the central bank a high degree of independence, but these are things done for operational convenience or to improve policy credibility, not moral commitments — and they are always up for reconsideration when circumstances change.

Now, the money morality types try to have it both ways; they want us to believe that monetary blasphemy will produce disastrous results in practical terms too. But events have proved them wrong.

There are better arguments for Krugman to confront than that of the "money morality types." Most free market economists don't wish for a state-managed gold standard. Even Hayek was weary of a wholesale return to gold by central banks because of the potential of discoordination (see Prices and Production). The danger of a return of state managed gold standards would inherently bring volatility in the purchasing power of gold unless central banks could coordinate their monetary policies, which is unlikely. Serious economists do not suggest a return to this gold standard. They do not propose that gold has intrinsic value. Krugman is confronting a political argument, not a legitimate argument from economists.

Krugman reveals the crux of the argument concerning money when he refers to changes in the money stock. But the question to confront is not whether the "quantity and characteristics" of money "should be adjusted" to suit economic circumstances, but by what mechanism this should be done. Free banking theorists suggest that the market can handle these adjustments either in whole or in part. Some like Scott Sumner, Nick Rowe, and David Glasner stress income targeting by central banks and argue that this has a stabilizing effect. Glasner especially stresses the endogeneity of the broader money stock and draws the conclusion that central banks simply need to adjust the monetary base to target nominal wages (similar to NGDPLT - to understand the nuance read this). Others like White and Selgin theorize about competitive banking systems where the unit of account is determined by the market and outside money is commodity money (for a nice theory of the evolution money, whether managed by markets or the state, read this). The latter free banking theorists consider gold, and sometimes silver, as money in their analysis because these commodities have historically been chosen by the market as outside money and the unit of account. It is not inconceivable that the market would once again adopt gold as the unit of account. It could serve this purpose as other commodities and assets serve as a store of wealth (probably via ETFs and other instruments), and thereby alleviate upward pressure on the purchasing power of gold. It is also possible that the market uses something other than gold as the unit of account.The point is that the market process can work out the details.

Krugman's argument assumes that the unit of account is managed by the state. This assumption is not untenable under current circumstances, but if he is going to consider an alternative like a gold standard, he ought to confront a robust theory, not a political talking point.  Markets, by trial and error, can determine the unit of account and the quantity of outside and inside money endogenously. While some unsophisticated commentators might suggest that nations return to the gold standard, this is not the proposition of serious theorists.

*Late thought*

I would like to see Krugman discuss the interrelatedness of fiscal and monetary policy and consider the impact of this on central bank policy and macroeconomic phenomena. I'll have to save these thoughts for a later post.