Thursday, February 6, 2014

Hayek the Evil Inflationist!

… or that is what I would call this post if I were a Misesian or Rothbardian Austrian economist.

I refer to the passage below from a talk that Hayek gave on April 9, 1975 to the American Enterprise Institute in Washington DC, in which he had been asked to speak on 1970s inflation.

Early in this talk Hayek said that he rejected the Keynesian view that employment is “a direct and simple function of what is called aggregate demand” (Hayek 1975: 4), even though he proceeded to concede two important instances where aggregate demand was the “dominating factor in determining the level of employment”:
“Let me say, first, that there are two circumstances in which changes in aggregate demand are indeed the dominating factor in determining the level of unemployment; and these two circumstances have governed the development of the theory.

The first one was an accidental historic situation—but an historic situation that determined the climate of opinion in the country which then dominated economic theory. In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.

This particular situation, however, while it largely explains the growth of Keynes’s own views, would not be sufficient to explain their wide acceptance.

The second situation in which it is true that an increase of employment requires an increase in aggregate demand is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction. The original substantial unemployment lends to a shrinkage of demand that causes more unemployment, and so on; it releases a deflation due to the ‘inherent instability of credit’ (to use the terminology of a once very influential but now undeservedly almost forgotten economist who died a few days ago, R. G. Hawtrey).

Once you have the kind of situation in which there already exists extensive unemployment, there is thus a tendency to induce a cumulative process of secondary deflation, which may go on for a very long time. I am the last to deny — or rather, I am today the last to deny—that in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was compatible with a functioning economy. Perhaps I should even then have understood that this possibility no longer existed. I think it disappeared in 1931 when the British government abandoned its attempt to bring wages down by deflation, just when it seemed about to succeed. After that attempt had been abandoned, there was no hope that it would ever again be possible to break the rigidity of wages in that way.

I still believe that we shall not get a functioning economy until wages again become flexible, but I think that we shall have to find different techniques for that purpose. I would no longer maintain, as I did in the early ’30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognisable function whatever, and that there is no justification for supporting or permitting a process of deflation.”
(Hayek 1975: 4–5).
This is Hayek’s mea culpa and a repudiation of his 1930s liquidationism.

But what policy does Hayek recommend to avoid deflation? He does not here specify how, but elsewhere makes it clear that he supported monetary intervention (like Milton Friedman) and (probably) a guarded and conservative use of fiscal policy involving public works expenditure. In one word: inflation.

Most interesting is Hayek’s implicit admission that inflation was the right course for the British economy in the 1920s after the disastrous return to the gold exchange standard at too high a parity:
“In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.”
So Hayek, after all his attacks on Keynes in the 1930s, essentially admitted Keynes was right, at least on these points at any rate.

Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A Von Hayek. American Enterprise Institute, Washington.


  1. Maybe this is why they hate Hayek so much over at Murphy's. Not just for changing his mind but even more for saying a certain someone else was right.

    Hayek seems to me very different from the praxers. Ihe doesn't seem the same as the Mises bunch. IDo you think I get my morning copy and sit down to figure out how to justify policies I like? Or do you think I get my morning copy and set down to do the best economic science I can? Is aaustrian a label for a connected set of ideas or just a historical accident.

    1. Ken B,

      There is no doubt that Hayek rejected Mises's apriorism and praxeology.

      Just look at this damning Hayek quote I cite here where he seems to class apriosrism with Marxism and Freudianism:

      He also endorses Popper's empiricist methodology.

  2. Ken,

    Oh they hate Hayek.

    Han Herman Hoppe on Hayek

    Walter Block on Hayek

    Murray Rothbard reviewing Hayek's Constitution of Liberty, see pages 61-71

    1. Hoppe lives up to mmy view of him by citing Hayek's book dedication the way he does.

    2. "The state, for Mises, is legalized force, and its only function is to defend life and property by beating antisocial elements into submission."

  3. BTW, I don't hate Hayek. He was a great man and I have respectful disagreements with him. LK's analysis, of course, is completely out of context as it concerns what might be done in the midst of a funny money-induced depression where no one has the slightest idea that the cure (painful as it might be) lies in restoring undistorted prices. Hayek was quite clear that the “solution” was to avoid the problem by abolishing the sources of funny money distortions:

    From "A Discussion With FRIEDRICH A. VON HAYEK"
    Held at the American Enterprise Institute on April 9, 1975. At that time, there was an inflationary recession.

    For forty years I have preached that the time to prevent a depression is during the preceding boom; and that, once a depression has started, there is little one can do about it. My advice was completely disregarded as long as the boom lasted. Now suddenly, when my prediction has come true and we have reached the stage where, in my opinion, little can be done about the inevitable reaction which has set in, people suddenly turn to me and ask for my opinion. I am very much tempted to answer, "Well, if you had listened to me before, you wouldn't be in that mess. Of course, I do not mean you—I mean the public in general.

    What I want to discuss is policy in the long run—by which I mean not only the very long run in the Marshallian sense, but policy over the next few years. What we should absolutely avoid is any attempt to recreate employment, or diminish unemployment by a further does of inflation.

    I will confess that I do not know whether, at this moment, even a strong additional dose of inflation would still be effective. I expect that it will be attempted, and I rather hope that it will not succeed and that we shall be forced to turn to the fundamental problem of the readjustment of the structure of production.
    But the main point is: what can we do to avoid the same sort of mistakes in the future?

    The public, having so long been taught false doctrines, is still convinced that the government has it in its power substantially to reduce or perhaps, in the short run, completely to abolish unemployment by such tricks as deficit spending, increasing the quantity of money, and so on. Is there any possibility of preventing the government, even if it should wish to act more sensibly, from being forced by public opinion into repeating its mistakes and being driven to more and more-inflation?

    This leads me to a point where I am afraid I have persistently disagreed with many of my closest friends and associates. I believe that if we want to prevent the government from giving in to public pressure for quick and rapidly effective measures, we must put fetters on what the government can do and restore several institutions which were designed to prevent the government from abusing its powers, and particularly its powers to inflate.

    In fact, the long period of accelerating inflation we have behind us has been very largely the effect of the removal, one-by-one, of those checks on undue credit expansion which the practical wisdom of the past had erected to prevent governments and monetary authorities from inflating. The abandonment of the gold standard was largely motivated by the wish to give governments greater powers of expansion. The Bretton Woods agreement, with its endeavor to put the burden of adjustment on the creditor countries and to relieve the debtor countries of the need to contract, was another step in that direction. The various decisions that provided for additional inter-national liquidity at a time when it was already dear that the process of inflation had started, were further milestones on that road. And finally, the abandonment of fixed rates of exchange, which were the last obstacle preventing the central banks from expanding without limits, has made it possible to continue inflation indefinitely.

  4. Hayek continued:

    In a way, I regard our experience of the last twenty-five years as a large-scale repetition of the periodically recurring credit expansions which we used to call the business cycle. We have made it possible for that process of credit expansion to go on for twenty-five years by removing those checks which in the past used to terminate these periods of expansion after a few years.

    The regularity of such early termination of the process of credit expansion during the hundred years preceding 1931 was of course largely due to the fact that the gold standard, in time, braked the expansion. The gold standard was the first obstacle we removed. Later on, we removed all the others. So that now we have a system under which the politician is powerless to resist the pressure of those who know—and, in most instances, know rightly—that the government has the means in the short run for a short period, to reduce unemployment or relieve them of their momentary difficulties. A politician can resist such pressure only if he can refer to some insurmountable obstacle which prevents him from giving in. As long as he has the power to satisfy those demands, he will be driven to using that power.

    I have always maintained this position against those of my friends who were converted to a system of flexible exchange rates on the ground that it gave more scope to a sensible policy. This reason would be perfectly valid if those who conducted the policy, once they were relieved of the institutional obstacles, were able to act according to rational considerations.

    The reason becomes invalid, however, when you realize that politicians are under constant pressure for inflation and are able to resist this pressure only by pointing out the obstacles which prevent them from doing what they are asked to do. All these obstacles have been removed, on the advice of economists, and we have been placed in a position where the politicians—or those responsible for monetary policy—have necessarily been driven into an accelerating inflation. There are no longer any institutional obstacles to which they could point and say, "I cannot do this," and no political group or party that wants immediate relief will listen to the consideration that any short-run gain will have to be paid for by even greater suffering in a year, or in two, or perhaps in five.


    I do not know whether we shall be able, in the foreseeable future, to restore a system, such as the gold standard, which, although not foolproof, is at least in some respect protected against the pressure of fools. But it certainly is necessary to make people understand that the now fashionable method of securing employment by monetary and credit management is fundamentally false, and that so long as we attempt to do so, we just repeat, on a greatly enlarged scale, the kind of fluctuations we used to call business cycles. These fluctuations were unpleasant enough when we allowed the misdirection of resources by excessive credit expansion to go on for two or three years. I am afraid they will prove to be even more unpleasant after we have allowed this misdirection of resources to go on for twenty-five years.

    Let me emphasize, in conclusion, that I am not arguing that another Great Depression of the type of the 1930s is inevitable. Even then, such a long-lasting and severe depression was not necessary, but was largely due to the foolishness of the policies pursued. We need not move into an equally serious and general depression if we avoid equally foolish policies—which included, in my opinion, the attempts made after 1929 to maintain demand and maintain wages, policies initiated by President Hoover and then expanded by President Roosevelt. But notice the proviso: if we do not make mistakes as bad as those we made in the early '30s. I shall leave it to you to judge what chances we have of avoiding such mistakes.

    Thank you.

  5. And

    (1) Hayek's ABCT was wrong.

    (2) his explanation of unemployment wrong.

    (3) his price theory either largely irrelevant to the real world, or grossly overrated.

    So that he wanted to avoid further inflationary policies in the 1970s, while true, does not refute the points of this post.