In Lecture IV, Hayek considers the arguments for and against an elastic money supply. We must remember that Hayek’s main concern was to make money “neutral” with respect to the structure of production.
Hayek comes out very strongly against money supply expansion as production increases, and advocates deflation as a natural state of affairs:
“If the considerations brought forward in the last lecture are at all correct, it would appear that the reasons commonly advanced as a proof that the quantity of the circulating medium should vary as production increases or decreases are entirely unfounded. It would appear rather that the fall of prices proportionate to the increase in productivity, which necessarily follows when, the amount of money remaining the same, production increases, is not only entirely harmless, but is in fact the only means of avoiding misdirections of production.” (Hayek 1935: 105).Hayek rejects the idea that money supply should change in relation to the volume of production (Hayek 1935: 105–108), though seems to suggest that meeting the demand for high-powered money in times of crisis, as long as it does not increase the total quantity of money, might be acceptable (Hayek 1935: 112–113):
“The second source of the prevalent belief that, in order to prevent dislocation, the quantity of the circulating medium must adapt itself to the changing needs of trade arises from a confusion between the demand for particular kinds of currency and the demand for money in general. This occurs especially in connection with the so-called seasonal variations of the demand for currency which in fact arises because, at certain times of the year, a larger proportion of the total quantity of the circulating medium is required in cash than at other times. The regularly recurring increase of the ‘demand for money’ at quarter days, for instance, which has played so great a role in discussions of central bank policy since attention was first drawn to it by the evidence of J. Horsley Palmer and J. W. Gilbart before the parliamentary committees of 1832 and 1841, is mainly a demand to exchange money held in the form of bank deposits into bank notes or coin. The same thing is true in regard to the ‘increased demand for money’ in the last stages of a boom and during a crisis. When, towards the end of a boom period, wages and retail prices rise, notes and coin will be used in proportionately greater amounts, and entrepreneurs will be compelled to draw a larger proportion of their bank deposits in cash than they used to do before. And when, in a serious crisis, confidence is shaken, and people resort to hoarding, this again only means that they will want to keep a part of their liquid resources in cash which they used to hold in bank money, etc. All this does not necessarily imply a change in the total quantity of the circulating medium, if only we make this concept comprehensive enough to comprise everything which serves as money, even if it does so only temporarily.” (Hayek 1935: 112–113).It is interesting to see that Hayek also recognises that the private sector often creates credit money itself and that this will be convertible into high-powered money too:
“(5) But at this point we must take account of a new difficulty which makes this concept of the total quantity of the circulating medium somewhat vague, and which makes the possibility of ever actually fixing its magnitude highly questionable. There can be no doubt that besides the regular types of the circulating medium, such as coin, bank notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, ceteris paribus, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.It is undoubtedly true that negotiable bills of exchange, negotiable promissory notes, negotiable cheques, and other private sector, monetised IOUs can expand the money supply, but Hayek never even considers that this might be sufficient to drive one of his Austrian business cycles – a serious flaw in his analysis. For the simple reason is that these forms of credit money need not be backed by prior “saving” and their expansion, if the “discount” on such bills falls below the “natural rate,” would increase the demand for factor inputs and perhaps even higher order capital investments.
In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required. The criterion by which we may distinguish these circulating credits from other forms of credit which do not act as substitutes for money is that they give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else. This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods. It applies also to a number of other forms of commercial credit, as, for example, when book credit is simultaneously introduced in a number of successive stages of production in the place of cash payments, and so on. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided. But it is important not to overlook the fact that these forms of credits owe their existence largely to the expectation that it will be possible to exchange them at the banks against other forms of money when necessary, and that, accordingly, they might never come into existence if people did not expect that the banks would in the future extend credit against them. The existence of this kind of demand for more money, too, is therefore no proof that the quantity of the circulating medium must fluctuate with the variations in the volume of production. It is only a proof that once additional money has come into existence in some form or other, convertibility into other forms must be possible.” (Hayek 1935: 113–115).
Some few instances where an increase in the money supply are warranted are discussed by Hayek too (Hayek 1935: 120–124). If one firm splits into two firms and the need for money to purchase factor inputs thereby increases, then an increase in money supply may be warranted (Hayek 1935: 120–121).
Also, if there is a change in velocity of circulation, then the amount of money in circulation may need to be changed (Hayek 1935: 123–124).
However, Hayek immediately qualifies these concessions:
“(10) Even now our difficulties are not at an end. 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, i.e., to that part of the system where that change in business organisation or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. 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. No doubt the statement as it stands only provides another, and probably clearer, formulation of the old distinction between the demand for additional money as money which is justifiable, and the demand for additional money as capital which is not justifiable. But the difficulty of translating it into the language of practice still remains. The ‘natural’ or equilibrium rate of interest which would exclude all demands for capital which exceed the real supply capital, is incapable of ascertainment, and, even if it were not, it would not be possible, in times of optimism, to prevent the growth of circulatory credit outside the banks.In other words, even the few exceptions where changes in the money supply are theoretically warranted are practically difficult or impossible to actually address by central banks.
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. Under existing conditions, to go beyond this is out of the question. In any case, it could be attempted only by a central monetary authority for the whole world: action on the part of a single country would be doomed to disaster. It is probably an illusion to suppose that we shall ever be able entirely to eliminate industrial fluctuations by means of monetary policy. The most we may hope for is that the growing information of the public may make it easier for central banks both to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by ‘a little inflation.’” (Hayek 1935: 124–125).
Finally, Hayek thought the prolonged economic problems of the 1930s were being caused by government interventions, in addition to the monetary disturbances that form part of his ABCT:
“Though I believe that recurring business depressions can only be explained by the operation of our monetary institutions, I do not believe that it is possible to explain in this way every stagnation of business. This applies in particular to the kind of prolonged depression through which some European countries are passing today. It would be easy to demonstrate by the same type of analysis which I have used in the last two lectures that certain kinds of State action, by causing a shift in demand from producers’ goods to consumers' goods, may cause a continued shrinking of the capitalist structure of production, and therefore prolonged stagnation. This may be true of increased public expenditure in general or of particular forms of taxation or particular forms of public expenditure. In such cases, of course, no tampering with the monetary system can help. Only a radical revision of public policy can provide the remedy.” (Hayek 1935: 128).BIBLIOGRAPHY
Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.
Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.