Saturday, August 6, 2011

Hayek on Monetary Stabilisation in a Secondary Deflation

My post on the Selgin versus Skidelsky debate has brought up many issues. Professor Selgin points out errors I have made, which I feel bound to correct.

In particular, I previously claimed that it was only late in life that Hayek changed his mind and admitted he had been wrong in supporting the effects of a “secondary deflation” in the initial years of the Great Depression. For my assertion, I relied on an interview with Hayek published in 1978, where he made this statement:
“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).
There is also this statement of Hayek in an interview conducted in July, 1979 at Hayek’s home in Freiburg, Germany:
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).
But Selgin points out:
[sc. Hayek] … changed in in 1931--that is, 5 years before the appearance of the GT and while the spending collapse was still in progress! You can hear me quoting a passage from his 1933 essay ‘Saving’ to prove this point during the debate; and you may examine the Preface of the 2nd (1935) edition of Prices and Production (which I also referred to, but which was edited out), for more evidence.
Selgin also emphasises that he is “a stable MV person, as was Hayek from ’31 onwards.”

The relevant passage in the second edition of Prices and Production (1935) is here:
“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* [sic] of money and not 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 emphasise 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 mistakes. To incorporate this argument into the body of monetary theory is a task which has yet to be undertaken and which I could not and did not try to undertake here. But I may perhaps add that so far as the general theory of money (as distinguished from the pure theory of capital) is concerned, it is this work of Professor Mises much more than that of Knut Wicksell which provides the framework inside which I have tried to elaborate a special point.” (Hayek 1975 [1939]: xii–xiii).

* This appears to be a typo for “quantity”.
But this passage does not show Hayek urging monetary stabilisation during times of severely fluctuating velocity of circulation of money or falls in the quantity of money during depressions. He is talking about the implications of the fluctuation in the velocity of circulation of money for capital goods investment in his trade cycle theory.

I have also read Hayek’s essay Savings (1933; reprinted in Hayek 1975 [1939]: 157–170), but cannot see any statements there either on monetary stabilisation in a depression. That essay seems mostly concerned with definitions of saving, and questions like voluntary and forced saving.

Perhaps I have missed something. If Hayek did indeed urge monetary stabilisation as early as 1931 where is the evidence of this? Does anyone have a citation?

Let us say for the sake of argument that Hayek did indeed urge monetary stabilisation as early as 1931. That would show good sense by Hayek, of course. But then the question becomes: what was the best method of doing this?

If he thought the central bank should have done it, we already have an obvious problem, and one that monetarists also face: it is highly unlikely that radical open market operations (what we call quantitative easing) will in fact stabilise the broad money stock. At most, this would have prevented the collapse of large parts of the financial sector (of course, a good thing), but a contraction of the broad money supply would no doubt still have happened as a heavily indebted private sector engaged in distress selling of assets and deleveraging, which would have spilled over into shocks to business confidence, net negative changes in debt, and a slump in consumption, investment and employment. The banks would have hoarded their excess reserves, just as they mostly do now, and a public saturated with private debt would have been unwilling to take on new debts for investment or consumption. I do not see how a free banking system on a gold standard would overcome such a problem either.

If monetary policy were really all that is needed to prevent secondary price deflation, then why did Japan’s zero interest rate policy (ZIRP) in the 1990s and quantitative easing in the 2000s 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?

If we take the income quantity theory of money equation, as follows:
Equation 2: MV = PY

M = quantity of money;
V = velocity of circulation of money;
P = average price of the transactions, and
Y = the volume of all transactions that enter into the value of national income (goods and services),
then the only really effective way to stabilise M (conceived as the broad money stock) and V is fiscal policy, not merely monetary policy. Since the broad money stock is endogenous, its expansion and contraction is largely driven by the dynamics of private debt issued by banks. If it is contracted by deleveraging, and the private sector is overloaded with debt already (as in the 1930s, Japan in the 1990s, or America and other nations in the 2010s), businesses will not take on significantly new levels of debt, and consumers are unlikely to either. If one increases the excess reserves of banks to a great extent, these reserves will not get injected into the economy in significant flows to increase investment or spending. It is government spending that will be the only reliable way of doing it.


Hayek, F. A. von. 1967 [1935]. Prices and Production (2nd edn.), Augustus M. Kelley Publishers, New York.

Hayek, F. A. von. 1975 [1939]. Profits, Interest and Investment, Augustus M. Kelley Publishers, Clifton, NJ.

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.

1 comment:

  1. Lord K: Allow me to refer you on this to my HOPE article, "Hayek Versuis Keynes on How the Price Level Ought to Behave" ( For my own reasons for siding with Hayek in that debate see my pamphlet Less Than Zero (