Hayek on Secondary Deflation

Austrians frequently assert that deflation is not to be feared, and even that deflation has no undesirable consequences. One of the more absurd statements from their literature is by Murray Rothbard. This can be found in Man, Economy, and State (p. 766):

“Goods are useful and scarce, and any increment in goods is a social benefit. But money is useful not directly, but only in exchanges. And we have just seen that as the stock of money in society changes, the objective exchange-value of money changes inversely (though not necessarily proportionally) until the money relation is again in equilibrium. When there is less money, the exchange-value of the monetary unit rises; when there is more money, the exchange-value of the monetary unit falls. We conclude that there is no such thing as ‘too little’ or ‘too much’ money, that, whatever the social money stock, the benefits of money are always utilized to the maximum extent. An increase in the supply of money confers no social benefit whatever; it simply benefits some at the expense of others, as will be detailed further below. Similarly, a decrease in the money stock involves no social loss. For money is used only for its purchasing power in exchange, and an increase in the money stock simply dilutes the purchasing power of each monetary unit. Conversely, a fall in the money stock increases the purchasing power of each unit” (Rothbard 2004 [1962]: 766).

Rothbard clearly never heard of debt deflation or Irving Fisher’s debt deflation theory of depressions, or if he did never properly understood the process, and one cannot take seriously his view that “a decrease in the money stock involves no social loss.”

Hayek, to his credit, had a different view of the role of deflation in 1929–1933, at least later in life:

“There is no doubt, and in this I agree with Milton Friedman, that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation! So, once again, a badly programmed monetary policy prolonged the depression” (Pizano 2009: 13).

Hayek, then, argued that a secondary deflation had negative effects on the US economy after 1929 and admitted that his earlier views had been wrong:

“Although I do not regard deflation as the original cause of a decline in business activity, such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

In saying that he agreed with Milton Friedman, however, Hayek presumably would have accepted a monetarist solution of stabilizing the money supply by open market operations and other interventions, but not a Keynesian solution of fiscal policy.

Despite the acknowledgement that some monetary intervention was necessary in situations like 1929–1933, Hayek still failed to see that mere monetary stabilization will not stop debt deflationary collapse.

Merely preventing a contraction of the money supply by itself will not prevent price deflation when it is caused by a severe contraction of aggregate demand, through deleveraging, shocks to business confidence, net negative changes in debt, and a slump in consumption and investment. To prevent such crashes, fiscal policy and more radical interventions to fix broken financial systems are necessary.

If monetary policy were really all that is needed to prevent price deflation, then why did Japan’s ZIRP in the 1990s not prevent the descent into price deflation in 1999? And why did price deflation persist in Japan for years after the beginning of quantitative easing in 2001?

UPDATE

I have a new post here related to this one on Rothbard’s view of deflation:

http://socialdemocracy21stcentury.blogspot.com/2011/01/rothbard-refutes-rothbard-on-effects-of.html


BIBLIOGRAPHY

Hayek, F. A. 1975. A Discussion with Friedrich A Von Hayek, American Enterprise Inst., Washington.

Hayek, F. A. 1978. New Studies in Philosophy, Politics, Economics and the History of Ideas, Routledge & Kegan Paul, London.

Pizano, D. 2009. Conversations with Great Economists, Jorge Pinto Books Inc., New York.

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.