In the following passage by Hayek we get a quite peculiar admission:
“When, however, the inflow of money through investment ceases, the spreading of its effects will continue and will tend to restore something similar to the initial position. It is at this point that the Ricardo Effect operates in a manner in which it is least understood. Prices of investment goods at this stage will fall; prices of consumer goods will, for some time, continue to rise. This will make some of the investment which has been taking place less profitable than it was before, at the same time that the flow of investable fund is reduced. The controlling factor will thus be that, after the inflow of new money has ceased and, in consequence, smaller funds are available for investment, the prices of consumer goods will continue to rise for some time. The result will be that some of the factors which during the boom will have become committed to producing very capital-intensive equipment will become unemployed.The crucial passage deserves to be repeated:
This is the mechanism by which I conceive that, unless credit expansion is continued progressively, an inflation-fed boom must sooner or later be reversed by a decline in investment. This theory never claimed to do more than account for the upper turning point of the typical nineteenth-century business cycle. The cumulative process of contraction likely to set in once unemployment appears in the capital-good industries is another matter which must be analyzed by conventional means. It has always been an open question to me as to how long a process of continued inflation, not checked by a built-in limit on the supply of money and credit, could effectively maintain investment above the volume justified by the voluntary rate of savings. It may well be that this inevitable check only comes when inflation becomes so rampant-as the progressively higher rate of inflation required to maintain a given volume of investment must make it sooner or later-that money ceases to be an adequate accounting basis.” (Hayek 1969: 281–282).
“This theory never claimed to do more than account for the upper turning point of the typical nineteenth-century business cycle. The cumulative process of contraction likely to set in once unemployment appears in the capital-good industries is another matter which must be analyzed by conventional means.”This is rather startling.
If Hayek’s ABCT never claimed to do anything but explain “the upper turning point of the typical nineteenth-century business cycle,” then why were he and his followers applying it to 20th century business cycles and the Great Depression?
Taken literally, Hayek’s statement makes a nonsense of his earlier work and behaviour. Possibly, it is (1) poorly phrased and not what Hayek really thought or (2) it must be taken to be what Hayek later came to believe.
Furthermore, Hayek’s statement that the “cumulative process of contraction likely to set in once unemployment appears in the capital-good industries is another matter which must be analyzed by conventional means” (my emphasis) appears concede that a conventional Keynesian or perhaps monetarist analysis is appropriate for the contractionary phase of the business cycle.
This is indeed consistent with what Hayek later came to believe about the harmful nature of secondary deflation and the need for monetary and (possibly even) fiscal stimulus in situations where deflation was a threat:
“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; ….Hayek therefore seems to have conceded the need for monetarist or Keynesian interventions to prevent deflationary depressions: he renounced his earlier liquidationism.
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. (Hayek 1975: 4–5).
“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 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 to return to the more interesting point: if Hayek’s ABCT never claimed to explain anything but “the upper turning point of the typical nineteenth-century business cycle,” then why did Hayek apply it to 20th century business cycles and the Great Depression?
Hayek, Friedrich A. von. 1939. Profits, Interest and Investment. Routledge and Kegan Paul, London.
Hayek, Friedrich A. von. 1969. “Three Elucidations of the Ricardo Effect,” Journal of Political Economy 77.2: 274–285.
Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A. Von Hayek. American Enterprise Institute, Washington.
Hayek, Friedrich A. von. 1978. New Studies in Philosophy, Politics, Economics and the History of Ideas. Routledge & Kegan Paul, London.
Hicks, J. R. 1967. “The Hayek Story,” in J. R. Hicks, Critical Essays in Monetary Theory, Clarendon Press, Oxford. 203–215.
Pizano, D. 2009. Conversations with Great Economists. Jorge Pinto Books Inc., New York.