Friday, October 31, 2014

The “Depression” of 1920–1921: The Libertarian Myth that Won’t Die

Yes, there was a recession from 1920–1921, but its history and significance are badly misrepresented by libertarians and Austrian economists, and the following talk by James Grant is a case in point. Grant even has a forthcoming book on the recession called The Forgotten Depression: 1921: The Crash That Cured Itself (2014).

What are the problems here?

They are as follows:
(1) the downturn of 1920–1921 was not a depression, if “depression” is defined as a contraction in the business cycle where real output fell by 10% or more.

The two best estimates of the depth of the downturn of 1920–1921 are Romer (1989) and Balke and Gordon (1989: 84–85).

Romer (1989) provided a new estimate for GNP declines from 1920 to 1921, as follows:
Year | GNP* | Growth Rate
1914 | $414.599
1915 | $443.048 | 6.86%
1916 | $476.498 | 7.54%
1917 | $473.896 | -0.54%
1918 | $498.458 | 5.18%
1919 | $503.873 | 1.08%
1920 | $498.132 | -1.13%
1921 | $486.377 | -2.35%

1922 | $514.949 | 5.87%
1923 | $583.105 | 13.23%
* Billions of 1982 dollars
(Romer 1989: 23).
These estimates show a GNP contraction of only 3.47% from 1919 to 1921, a mild to moderate recession.

By contrast, Balke and Gordon (1989: 84–85) estimate a GNP decline of 5.58% from 1920–1921, a moderately bad recession.

On either of these estimates, however, the downturn of 1920 to 1921 was nothing like the Great Depression, and, as we will see below, was an anomaly in other ways.

(2) Even the idea that the recession of 1920 to 1921 was some remarkably short recession is untrue. The recession lasted from January 1920 to July 1921: a period of 18 months. But a recession lasting 18 months is in fact quite a long one by the standards of the post-1945 US business cycle. The average duration of US recessions in the post-1945 era of classic Keynesian demand management (1945–1980) and the neoliberal era (1980–2010) has been about 11 months (Carbaugh 2010: 248; Knoop 2010: 13). So far from being some remarkably quick recession that was shorter than post-1945 recessions, it was about 7 months longer than the post-1945 average.

(3) At 12.29–12.33, Grant says that the recession of 1920 to 1921 was “the last governmentally unmediated major business cycle downturn.” This is untrue. Why? Because the Federal Reserve existed, and engaged in both open market operations and interest rate reductions as a deliberate strategy to stimulate recovery. In particular, by April and May 1921, the Federal Reserve member banks dropped their rates to 6.5% or 6%. In November 1921, there were further falls in discount rates: rates fell to 4.5% in the Boston, Philadelphia, New York, and to 5% or 5.5% in other reserve banks (D’Arista 1994: 62).

From the perspective of libertarian ideologues, it was worse than this, because other government interventions occurred as follows:
(1) a proto-form of quantitative easing by the Federal Reserve in which there were open market operations in late 1921–1922 to aid recovery, and in which the Federal Reserve bought government bonds from November 1921 to June 1922 and tripled its holdings from $193 million in October 1921 to $603 million by May 1922 (a fact even noted by Rothbard 2000: 133).

(2) direct credit allocation by the government “War Finance Corporation” and the “Federal Land Bank system” from early 1921, in which loans were granted to distressed farm cooperatives and other agricultural businesses. In August 1921, the War Finance Corporation corporation even became a rediscount agency for agricultural and livestock producers.

(3) there was even some limited deficit-financed public works, in the form of municipal bonds.
What should be particularly embarrassing for libertarians and Austrians is that all these interventions were known to and described by Rothbard (see Rothbard 2000: 137–138, 191–193).

(4) Running through the talk is the bizarre background assumption that Keynesian economics says that economies can never recovery from recessions without government intervention. But that is not what Keynes or Keynesians think. What Keynes thought was that there is no universal, consistent, and reliable tendency for market economies to converge to full employment equilibrium. This does not mean that market economies can sometimes recover relatively rapidly from recessions, under the right circumstances.

(5) There were a number of reasons why the recession of 1920–1921 was unusual and indeed anomalous, and why it did not become very severe and protracted:
(1) the deflation was caused to some great extent, not by demand shocks, but a positive supply shocks in commodities due to the resumption of shipping and production after WWI (Romer 1988: 110; Vernon 1991).

(2) the recession of 1920–1921 also had no serious financial crisis, and no mass bank runs and collapses;

(3) the level of private debt was considerably lower in 1920 than in 1929, and the real value of debt had been reduced considerably by the large WWI and 1919 inflation, so that debt deflationary forces did not become severe.
In short, 1920 to 1921 was an anomalous recession, it was not especially short, it did have monetary interventions that aided recovery, and it is absurd to think that you can make sweeping generalisations from it about how government interventions are never needed to stabilise economies.

Further Reading
“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

“There was no US Recovery in 1921 under Austrian Trade Cycle Theory!,” June 25, 2011.

“The Depression of 1920–1921: An Austrian Myth,” December 9, 2011.

“A Video on the US Recession of 1920-1921: Debunking the Libertarian Narrative,” February 5, 2012.

“More Fake History of the Great Depression,” September 28, 2012.

“The Recovery from the US Recession of 1920–1921 and Open Market Operations,” October 4, 2012.

“Rothbard on the Recession of 1920–1921,” October 6, 2012.

“The Recession of 1920–1921 versus the Depression of 1929–1933,” February 2, 2014.

“Debt Deflation: 1920–1921 versus 1929–1933,” February 3, 2014.

“US Wages in 1920–1921,” February 10, 2014.

“The Causes of the Recession of 1920–1921,” February 11, 2014.

Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92.

Carbaugh, R. J. 2010. Contemporary Economics: An Application Approach. M.E. Sharpe, Armonk, New York.

D’Arista, J. W. 1994. The Evolution of U.S. Finance, Volume 1: Federal Reserve Monetary Policy: 1915–1935. M. E. Sharpe, Armonk, New York.

Grant, James. 2014. The Forgotten Depression: 1921: The Crash That Cured Itself. Simon & Schuster.

Knoop, T. A. 2010. Recessions and Depressions: Understanding Business Cycles (2nd edn). Praeger, Santa Barbara, Calif.

O’Brien, Anthony Patrick. 1997. “Depression of 1920–1921,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 151–154.

Rothbard, Murray N. 2000. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Alabama.

Romer, C. D. 1988. “World War I and the Postwar Depression: A Reinterpretation based on Alternative Estimates of GNP,” Journal of Monetary Economics 22.1: 91–115.

Romer, C. D. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869–1908,” Journal of Political Economy 97.1: 1–37.

Vernon, J. R. 1991. “The 1920–21 Deflation: The Role of Aggregate Supply,” Economic Inquiry 29: 572–580.

Tuesday, October 28, 2014

Hayek on Costs and Pricing

This comment that Hayek makes occurs in a discussion of Keynes’ General Theory, which I first quote merely for context:
“Now if there is a well-established fact which dominates economic life, it is the incessant, even hourly, variation in the prices of most of the important raw materials and of the wholesale prices of nearly all foodstuffs. But the reader of Mr. Keynes’ theory is left with the impression that these fluctuations of prices are entirely unmotivated and irrelevant, except towards the end of a boom, when the fact of scarcity is readmitted into the analysis, as an apparent exception, under the designation of ‘bottlenecks’. And not only are the factors which determine the relative prices of the various commodities systematically disregarded; it is even explicitly argued that, apart from the purely monetary factors which are supposed to be the sole determinants of the rate of interest, the prices of the majority of goods would be indeterminate. Although this is expressly stated only for capital assets in the special narrow sense in which Mr. Keynes uses this term, that is, for durable goods and securities, the same reasoning would apply to all factors of production. In so far as ‘assets’ in general are concerned the whole argument of the General Theory rests on the assumption that their yield only is determined by real factors (i.e. that it is determined by the given prices of their products), and that their price can be determined only by capitalising this yield at a given rate of interest determined solely by monetary factors. This argument, if it were correct, would clearly have to be extended to the prices of all factors of production the price of which is not arbitrarily fixed by monopolists, for their prices would have to be equal to the value of their contribution to the product less interest for the interval for which the factors remained invested. That is, the difference between costs and prices would not be a source of the demand for capital but would be unilaterally determined by a rate of interest which was entirely dependent on monetary influences. (Hayek 2009 [1941]: 374–375).
But the crucial passage is here:
“The reason why Mr. Keynes does not draw this conclusion, and the general explanation of his peculiar attitude towards the problem of the determination of relative prices, is presumably that under the influence of the ‘real cost’ doctrine which to the present day plays such a large role in the Cambridge tradition, he assumes that the prices of all goods except the more durable ones are even in the short run determined by costs. But whatever one may think about the usefulness of a cost explanation of relative prices in equilibrium analysis, it should be clear that it is altogether useless in any discussion of problems of the short period.” (Hayek 2009 [1941]: 375, n. 3).
Of course, the idea here seems to be that, in the long run, prices move towards marginal cost, so it is not modern mark-up pricing theory per se.

Nevertheless, Hayek is utterly wrong that many, even most prices, are not determined by costs of production in the short run. On the contrary, we now know, after many decades of empirical study, that most prices are cost-based or mark-up prices and are determined by total average unit costs plus a profit mark-up, not only in the long run but also in the short run. Therefore an economic theory that assumes this is how most prices are set is entirely realistic and correct, and it is marginalist pricing theory that is severely flawed and wrong.

Hayek, F. A. 2009 [1941]. The Pure Theory of Capital. Ludwig von Mises Institute, Auburn, Ala.

Monday, October 27, 2014

Marcello de Cecco on the International Monetary System under Bretton Woods and After

Marcello de Cecco, an economic historian, is interviewed here on the international monetary system during Bretton Woods and after.

Sunday, October 26, 2014

A Bibliography on Alfred Marshall

I have recently become more interested in Alfred Marshall (1842–1924), and the Marshallian tradition in economics, which included Keynes in his early career.

That being so, I list a quick, but far from complete, bibliography on Alfred Marshall below:
Biographies and Studies on Marshall’s Economics
Arena, Richard and Michel Quéré. 2003. The Economics of Alfred Marshall: Revisiting Marshall’s Legacy. Palgrave Macmillan, New York and Basingstoke, UK.

Cook, Simon J. 2009. The Intellectual Foundations of Alfred Marshall’s Economic Science: A Rounded Globe of Knowledge. Cambridge University Press, Cambridge and New York.

Groenewegen, Peter. 1995. A Soaring Eagle: Alfred Marshall, 1842–1924. Edward Elgar, Aldershot and Brookfield, VT.
The best and most detailed biography of Marshall.

Groenewegen, Peter. 2007. Alfred Marshall: Economist 1842–1924. Palgrave Macmillan Ltd., New York.
A shorter, introductory biography.

Groenewegen, Peter. 2012. The Minor Marshallians and Alfred Marshall: An Evaluation. Routledge, New York.
A good study of the minor Marshallian economists and students of Marshall and their contributions to economics.

Raffaelli, Tiziano, Becattini, Giacomo, and Marco Dardi (eds). 2006. The Elgar Companion to Alfred Marshall. Elgar, Cheltenham, UK and Northampton, Mass.

Wood, John Cunningham (ed.). 1982. Alfred Marshall: Critical Assessments. Croom Helm, London.

Marshall’s Writings and Collections of his Writings
Marshall, A. 1887. “Remedies for Fluctuations in General Prices,” Contemporary Review 51 (March): 357–375. (reprinted in Marshall 1925.)

Marshall, A. and Marshall, M. P. 1879. The Economics of Industry. Macmillan, London.

Marshall, Alfred. 1890. Principles of Economics (1st edn.). Macmillan, London.

Marshall, Alfred. 1891. Principles of Economics (2nd edn.). Macmillan, London.

Marshall, Alfred. 1895. Principles of Economics (3rd edn.). Macmillan, London.

Marshall, Alfred. 1898. Principles of Economics (4th edn.). Macmillan, London.

Marshall, Alfred. 1907. Principles of Economics (5th edn.). Macmillan, London.

Marshall, Alfred. 1916. Principles of Economics (7th edn.). Macmillan, London.

Marshall, Alfred. 1920. Principles of Economics: An Introductory Volume (8th edn.). Macmillan, London.

Marshall, A. 1923. Money, Credit and Commerce. Macmillan, London.

Marshall, Alfred. 1925. Memorials of Alfred Marshall (ed. by A. C. Pigou). Macmillan, London.

Marshall, Alfred. 1925 [1887]. “Remedies for Fluctuations in General Prices,” in A. C. Pigou (ed.), Memorials of Alfred Marshall. Macmillan, London. 188–212.

Marshall, A. 1926. Official Papers of Alfred Marshall (ed. by J. M. Keynes). Macmillan, London.

Marshall, Alfred. 1975. The Early Economic Writings of Alfred Marshall, 1867–1890 (ed. by J. K. Whitaker). Macmillan for the Royal Economic Society, London.

Whitaker, John K. (ed.). 1996. The Correspondence of Alfred Marshall, Economist. Volume One: Climbing, 1868–1890. Cambridge University Press, Cambridge.

Whitaker, John K. (ed.). 1996. The Correspondence of Alfred Marshall, Economist. Volume Two: At the Summit, 1891–1902. Cambridge University Press, Cambridge.

Whitaker, John K. (ed.). 1996 . The Correspondence of Alfred Marshall, Economist. Volume Three: Towards the Close, 1903-1924. Cambridge University Press, Cambridge.

Saturday, October 25, 2014

Marcello de Cecco on the Great Depression and the International Monetary System

Marcello de Cecco, an economic historian, is interviewed here on the international monetary system during the Great Depression.

Friday, October 24, 2014

Marcello de Cecco on the International Monetary System during and after the First World War

Marcello de Cecco, an economic historian, is interviewed here on the international monetary system, both during and after WWI.

Thursday, October 23, 2014

Engelbert Stockhammer on Post Keynesian Economics: An Introduction

Engelbert Stockhammer gives a talk below which is an introduction to Post Keynesian economics, given on the 29 June at the Rethinking Economics Conference in London (28–29 June, 2014).

Wednesday, October 22, 2014

Hayek’s Prices and Production (1935), Lecture IV: A Summary

I summarise below Lecture IV of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

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.

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).
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.

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.

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).
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.

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).
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.

Tuesday, October 21, 2014

Hayek’s Prices and Production (1935), Lecture III: A Summary

I summarise below Lecture III of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

Hayek has a long analysis of the prices of intermediate goods in different stages of production (Hayek 1935: 70–83).

If money supply is increased by banks and the rate of interest falls below the natural rate (Hayek 1935: 86; and Hayek specifically states that in equilibrium the rate of return on capital is equal to the interest rate [Hayek 1935: 73]) and credit is obtained by producers, then Hayek’s Austrian business cycle is initiated:
“Now the borrowers can only use the borrowed sums for buying producers’ goods, and will only be able to obtain such goods (assuming a state of equilibrium in which there are no unused resources) by outbidding the entrepreneurs who used them before. At first sight it might seem improbable that these borrowers who were only put in a position to start longer processes by the lower rate of interest should be able to outbid those entrepreneurs who found the use of those means of production profitable when the rate of interest was still higher. But when it is remembered that the fall in the rate will also change the relative profitableness of the different factors of production for the existing concerns, it will be seen to be quite natural that it should give a relative advantage to those concerns which use proportionately more capital. Such old concerns will now find it profitable to spend a part of what they previously spent on original means of production, on intermediate products produced by earlier stages of production, and in this way they will release some of the original means of production they used before. The rise in the prices of the original means of production is an additional inducement. Of course it might well be that the entrepreneurs in question would be in a better position to buy such goods even at the higher prices, since they have done business when the rate of interest was higher, though it must not be forgotten that they too will have to do business on a smaller margin. But the fact that certain producers’ goods have become dearer will make it profitable for them to replace these goods by others. In particular, the changed proportion between the prices of the original means of production and the rate of interest will make it profitable for them to spend part of what they have till now spent on original means of production on intermediate products or capital. They will, e.g., buy parts of their products, which they used to manufacture themselves, from another firm, and can now employ the labour thus dismissed in order to produce these parts on a large scale with the help of new machinery. In other words, those original means of production and non-specific producers’ goods which are required in the new stages of production are set free by the transition of the old concerns to more capitalistic methods which is caused by the increase in the prices of these goods. In the old concerns (as we may conveniently, but not quite accurately, call the processes of production which were in operation before the new money was injected) a transition to more capitalistic methods will take place; but in all probability it will take place without any change in their total resources: they will invest less in original means of production and more in intermediate products.

Now, contrary to what we have found to be the case when similar processes are initiated by the investment of new savings, this application of the original means of production and non-specific intermediate products to longer processes of production will be effected without any preceding reduction of consumption. Indeed, for a time, consumption may even go on at an unchanged rate after the more roundabout processes have actually started, because the goods which have already advanced to the lower stages of production, being of a highly specific character, will continue to come forward for some little time. But this cannot go on. When the reduced output from the stages of production, from which producers’ goods have been withdrawn for use in higher stages, has matured into consumers’ goods, a scarcity of consumers’ goods will make itself felt, and the prices of those goods will rise. Had saving preceded the change to methods of production of longer duration, a reserve of consumers’ goods would have been accumulated in the form of increased stocks, which could now be sold at unreduced prices, and would thus serve to bridge the interval of time between the moment when the last products of the old shorter process come on to the market and the moment when the first products of the new longer processes are ready. But as things are, for some time, society as a whole will have to put up with an involuntary reduction of consumption.” (Hayek 1935: 86–88).
This is a curious aspect of Hayek’s theory: according to Hayekian ABCT, there will be, as investment in higher stages of production proceeds, a “scarcity of consumers’ goods” and “the prices of those goods will rise.” It is not clear whether this means an actual fall in real consumption, or merely excess demand in relation to supply and rising prices.

As an aside, in Mises’ version of the ABCT there does appear to be a contraction of consumer goods output in the later stages of the boom:
“The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.” (Mises 2009 [1953]: 362–363).
To return to Hayek’s version of ABCT, he continues:
“But this necessity will be resisted. It is highly improbable that individuals should put up with an unforeseen retrenchment of their real income without making an attempt to overcome it by spending more money on consumption. It comes at the very moment when a great many entrepreneurs know themselves to be in command—at least nominally—of greater resources and expect greater profits. At the same time incomes of wage earners will be rising in consequence of the increased amount of money available for investment by entrepreneurs. There can be little doubt that in the face of rising prices of consumers’ goods these increases will be spent on such goods and so contribute to drive up their prices even faster. These decisions will not change the amount of consumers’ goods immediately available, though it may change their distribution between individuals. But—and this is the fundamental point—it will mean a new and reversed change of the proportion between the demand for consumers’ goods and the demand for producers' goods in favour of the former. The prices of consumers’ goods will therefore rise relatively to the prices of producers’ goods. And this rise of the prices of consumers’ goods will be the more marked because it is the consequence not only of an increased demand for consumers’ goods but an increase in the demand as measured in money. All this must mean a return to shorter or less roundabout methods of production if the increase in the demand for consumers' goods is not compensated by a further proportional injection of money by new bank loans granted to producers. And at first this is probable. The rise of the prices of consumers’ goods will offer prospects of temporary extra profits to entrepreneurs. They will be the more ready to borrow at the prevailing rate of interest. And, so long as the banks go on progressively increasing their loans it will therefore, be possible to continue the prolonged methods of production or perhaps even to extend them still further. But for obvious reasons the banks cannot continue indefinitely to extend credits; and even if they could, the other effects of a rapid and continuous rise of prices would, after a while, make it necessary to stop this process of inflation.” (Hayek 1935: 88–90).
So as the wages of workers are bid up, the process by which consumer goods’ prices rise is accelerated. So it seems that a crisis of inflation marks the shift to the “bust” (Hayek 1934 is an earlier discussion of how the boom turns into a bust).

We can trace the steps by which the boom turns into the bust:
(1) when the banks cease to advance new loans and the money rate of interest rises, the demand for producers’ goods falls, but demand for consumers goods will continue to increase for some time, as they “lag somewhat behind the additional expenditure on investment which causes the increase of money incomes” (Hayek 1935: 90–91);

(2) producers will want to shift back to producing consumer goods at the lower stages of production, but that process causes the bust:
“Very soon the relative rise of the prices of the original factors and the more mobile intermediate products will make the longer processes unprofitable. The first effect on these processes will be that the producers’ goods of a more specific character, which have become relatively abundant by reason of the withdrawal of the complementary non-specific goods, will fall in price. The fall of the prices of these goods will make their production unprofitable; it will in consequence be discontinued. Although goods in later stages of production will generally be of a highly specific character, it may still pay to employ original factors to complete those that are nearly finished. But the fall in the price of intermediate products will be cumulative; and this will mean a fairly sudden stoppage of work in at least all the earlier stages of the longer processes.

But while the non-specific goods, in particular the services of workmen employed in those earlier stages, have thus been thrown out of use because their amount has proved insufficient and their prices too high for the profitable carrying through of the long processes of production, it is by no means certain that all those which can no longer be used in the old processes can immediately be absorbed in the short processes which are being expanded. Quite the contrary; the shorter processes will have to be started at the very beginning and will only gradually absorb all the available producers’ goods as the product progresses towards consumption and as the necessary intermediate products come forward. So that, while, in the longer processes, productive operations cease almost as soon as the change in relative prices of specific and non-specific goods in favour of the latter and the rise of the rate of interest make them unprofitable, the released goods will find new employment only as the new shorter processes are approaching completion. Moreover, the final adaptation will be further retarded by initial uncertainty as regards the methods of production which will ultimately prove profitable once the temporary scarcity of consumers’ goods has disappeared. Entrepreneurs, quite rightly, will hesitate to make investments suited to this overshortened process, i.e., investments which would enable them to produce with relatively little capital and a relatively great quantity of the original means of production.” (Hayek 1935: 92–93).
So now the process shifts to the bust.

(3) Hayek sees the explanation of unused resources as the great achievement of his ABCT:
Here then we have at last reached an explanation of how it comes about at certain times that some of the existing resources cannot be used, and how, in such circumstances, it is impossible to sell them at all—or, in the case of durable goods, only to sell them at very great loss. To provide an answer to this problem has always seemed to me to be the central task of any theory of industrial fluctuations; and, though at the outset I refused to base my investigation on the assumption that unused resources exist, now that I have presented a tentative explanation of this phenomenon, it seems worth while, rather than spending time filling up the picture of the cycle by elaborating the process of recovery, to devote the rest of this lecture to further discussion of certain important aspects of this problem. Now that we have accounted for the existence of unused resources, we may even go so far as to assume that their existence to a greater or lesser extent is the regular state of affairs save during a boom. And, if we do this, it is imperative to supplement our earlier investigation of the effects of a change in the amount of money in circulation on production, by applying our theory to such a situation. And this extension of our analysis is the more necessary since the existence of unused resources has very often been considered as the only fact which at all justifies an expansion of bank credit.” (Hayek 1935: 97–98).
At this point Hayek now considers situations where unused resources exist “to a greater or lesser extent” as a “regular state of affairs save during a boom”:
“If the foregoing analysis is correct, it should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect; a relative increase of the demand for consumers’ goods could only make matters worse. Matters are not quite so simple so far as the effects of credits granted for productive purposes are concerned. In theory it is at least possible that, during the acute stage of the crisis when the capitalistic structure of production tends to shrink more than will ultimately prove necessary, an expansion of producers’ credits might have a wholesome effect. But this could only be the case if the quantity were so regulated as exactly to compensate for the initial, excessive rise of the relative prices of consumers’ goods, and if arrangements could be made to withdraw the additional credits as these prices fall and the proportion between the supply of consumers’ goods and the supply of intermediate products adapts itself to the proportion between the demand for these goods. And even these credits would do more harm than good if they made roundabout processes seem profitable which, even after the acute crisis had subsided, could not be kept up without the help of additional credits. Frankly, I do not see how the banks can ever be in a position to keep credit within these limits.

And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit-expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production to the proportion between the demand for Consumers’ goods and the demand for producers’ goods as determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to ‘mobilise’ all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes.

(10) And so, at the end of our analysis, we arrive at results which only confirm the old truth that we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come.” (Hayek 1935: 97–99).
It is here that Hayek earned his reputation as a liquidationist: for he says clearly that “we can do nothing to get out of it before its natural end.”

Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.

Hayek, F. A. von. 1934. “Capital and Industrial Fluctuations,” Econometrica 2.2: 152–167.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Mises, L. von. 2009 [1953]. The Theory of Money and Credit (enlarged, new edn). Ludwig von Mises Institute, Auburn, Ala.

Monday, October 20, 2014

Hayek’s Prices and Production (1935), Lecture II: A Summary

I summarise below Lecture II of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

Hayek commits himself to a static Walrasian general equilibrium model early in his Lecture II:
“…it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency towards an equilibrium. For it is this concept alone which permits us to explain fundamental phenomena like the determination of prices or incomes, an understanding of which is essential to any explanation of fluctuation of production. If we are to proceed systematically, therefore, we must start with a situation which is already sufficiently explained by the general body of economic theory. And the only situation which satisfies this criterion is the situation in which all available resources are employed. The existence of unused resources must be one of the main objects of our explanation.

(4) To start from the assumption of equilibrium has a further advantage. For in this way we are compelled to pay more attention to causes of changes in the industrial output whose importance might otherwise be underestimated. I refer to changes in the methods of using the existing resources. Changes in the direction given to the existing productive forces are not only the main cause of fluctuations of the output of individual industries; the output of industry as a whole may also be increased or decreased to an enormous extent by changes in the use made of existing resources. Here we have the third of the contemporary explanations of fluctuations which I referred to at the beginning of the lecture. What I have here in mind are not changes in the methods of production made possible by the progress of technical knowledge, but the increase of output made possible by a transition to more capitalistic methods of production, or, what is the same thing, by organising production so that, at any given, moment, the available resources are employed for the satisfaction of the needs of a future more distant than before. It is to this effect of a transition to more or less ‘roundabout’ methods of production that I wish particularly to direct your attention. For, in my opinion, it is only by an analysis of this phenomenon that in the end we can show how a situation can be created in which it is temporarily impossible to employ all available resources.” (Hayek 1935: 34–36).
Hayek is also concerned with the structure of production: that is, changes which involve a longer as opposed to a shorter period of production and a hence a longer period of time before final consumer goods output is produced (Hayek 1935: 38).

Hayek has the following famous diagram illustrating the structure of production, as below.

Hayek explains this diagram as follows:
… “I find it convenient to represent the successive applications of the original means of production which are needed to bring forth the output of consumers’ goods accruing at any moment of time, by the hypotenuse of a right-angled triangle, such as the triangle in Fig. I. The value of these original means of production is expressed by the horizontal projection of the hypotenuse, while the vertical dimension, measured in arbitrary periods from the top to the bottom, expresses the progress of time, so that the inclination of the line representing the amount of original means of production used means that these original means of production are expended continuously during the whole process of production. The bottom of the triangle represents the value of the current output of consumers’ goods. The area of the triangle thus shows the totality of the successive stages through which the several units of original means of production pass before they become ripe for consumption. It also shows the total amount of intermediate products which must exist at any moment of time in order to secure a continuous output of consumers’ goods. For this reason we may conceive of this diagram not only as representing the successive stages of the production of the output of any given moment of time, but also as representing the processes of production going on simultaneously in a stationary society.” (Hayek 1935: 38–40).
As time increases between the use of the original means of production and the actual production of final consumer goods output, production becomes “more capitalistic” (Hayek 1935: 42).

The crucial problem for Hayek is: how does an economy transition from lower to much higher “capitalistic” methods of production? (Hayek 1935: 49).

The answer:
“… a transition to more (or less) capitalistic methods of production will take place if the total demand for producers’ goods (expressed in money) increases (or decreases) relatively to the demand for consumers’ goods. This may come about in one of two ways: either as a result of changes in the volume of voluntary saving (or its opposite), or as a result of a change in the quantity of money which alters the funds at the disposal of the entrepreneurs for the purchase of producers’ goods.” (Hayek 1935: 50).
What underlies this reasoning are the following assumptions:
(1) A Wicksellian loanable funds theory, where money interest rates are determined by time preference and are a reliable and effective indicator of inter-temporal consumption plans;

(2) the assumption that investment is a straightforward function of money interest rates, and

(3) a situation of general equilibrium in which no unused resources are available.
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.

Sunday, October 19, 2014

Hayek’s Prices and Production (1935), Lecture I: A Summary

In what follows, I summarise Lecture I of Hayek’s Prices and Production (2nd edn.; 1935), the classic work where Hayek developed his version of the Austrian business cycle theory (ABCT). I use the second, revised edition of 1935 (the first edition was published in 1931).

Hayek notes that by the 1930s it was widely accepted that monetary influences can play a great role in the “volume and direction of production” (Hayek 1935: 1).

Hayek devotes much of Lecture I to a review of the history of monetary theory. The first major stage of monetary theory was the development of the quantity theory.

However, Hayek criticised the quantity theory for neglecting the way in which money supply changes can cause changes in relative prices (Hayek 1935: 3–6). Hayek concludes that money is not neutral in its effects (Hayek 1935: 7).

The “second stage” in the history of monetary theory was the realisation that the quantity theory is wrong to assume that money supply changes merely affect the general price level in a uniform and proportional manner (Hayek 1935: 8). Locke, Montanari and, above all, Richard Cantillon realised this (Hayek 1935: 8). Hayek sketches the mechanism we now call Cantillon effects (Hayek 1935: 9–10):
“… [sc. Cantillon] attempts to show ‘by what path and in what proportion the increase of money raises the price of things’. Starting from the assumption of the discovery of new gold or silver mines, he proceeds to show how this additional supply of the precious metals first increases the incomes of all persons connected with their production, how the increase of the expenditure of these persons next increases the prices of things which they buy in increased quantities, how the rise in the prices of these goods increases the incomes of the sellers of these goods, how they, in their turn, increase their expenditure, and so on. He concludes that only those persons are benefited by the increase of money whose incomes rise early, while to persons whose incomes rise later the increase of the quantity of money is harmful.” (Hayek 1935: 8–9).
The “third stage” in the development of monetary theory was when economists examined how money supply increases affect the rate of interest, and through this the demand for capital goods and consumer goods (Hayek 1935: 11–12).

Hayek traces these ideas through the 19th century British economists and writers, and lists the following:
(1) Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), p. 287.

(2) Lord King’s Thoughts on the Effects of the Bank Restriction (London, 1803), p. 20.

(3) John Leslie Foster’s An Essay on the Principles of Commercial Exchanges (London, 1804), p. 113.

(4) David Ricardo’s The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.; London, 1810), p. 47, and On the Principles of Political Economy and Taxation (3rd edn.; London, 1821), p. 349–350.

(5) the “Report of the Committee on Gold Bullion” (London, 1810), p. 56.

(6) Thomas Joplin’s Outlines of a System of Political Economy (London, 1823), pp. 37–38, and An Analysis and History of the Currency Question (London, 1832).

(7) Thomas Tooke’s An Inquiry into the Currency Principle (London, 1844), p. 77, and Considerations of the State of the Currency (London, 1826), p. 22.

(8) Nassau William Senior’s Biographical Sketches (London, 1863).

(9) John Stuart Mill’s Principles of Political Economy: With Some of their Applications to Social Philosophy (6th edn.; London, 1865).
These authors presented monetary theories that were precursors to Knut Wicksell’s monetary equilibrium theory, with a natural rate of interest set by the profits on real capital and a money rate of interest that can diverge from the natural rate.

The “fourth stage” of monetary theory seen by Hayek as the antecedent to the ABCT was that linking money supply and interest rate changes to the production of capital goods (Hayek 1935: 18). The authors cited by Hayek who developed the idea of “forced saving” in relation to capital goods investment are as follows:
(1) Jeremy Bentham’s Manual of Political Economy (written in 1804 but only published in 1843).

(2) Thomas Robert Malthus’ “Depreciation of Paper Currency,” Edinburgh Review 17.34 (1811): 339–372, at p. 363.

(3) John Stuart Mill’s “On Profits and Interest” and Principles of Political Economy (6th edn.; London, 1865).
Leon Walras probably rediscovered the “forced saving” doctrine in 1879, and from him it passed to Wicksell (Hayek 1935: 22).

But it was Wicksell who combined the different strands of monetary theory into one synthesis (Hayek 1935: 23).

Hayek then summarised Wicksell’s monetary equilibrium theory as follows:
“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.

Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; if they raise the money rate above the equilibrium rate—a case of less practical importance—they exert a depressing influence on prices. From this correct statement, however, which does not imply that the price level would remain unchanged if the money rate corresponds to the equilibrium rate, but only that, in such conditions, there are no monetary causes tending to produce a change in the price level, Wicksell jumps to the conclusion that, so long as the two rates agree, the price level must always remain steady. There will be more to say about this later. For the moment, it is worth observing a further development of the theory. The rise of the price level which is supposed to be the necessary effect of the money rate remaining below the equilibrium rate, is in the first instance brought about by the entrepreneurs spending on production the increased amount of money loaned by the banks. This process, as Malthus had already shown, involves what Wicksell now called enforced or compulsory saving. That is all I need to say here in explanation of the Wicksellian theory.” (Hayek 1935: 23–25).
Mises had already adopted Wicksell’s monetary theory and developed the first form of the ABCT (Hayek 1935: 25), and Hayek’s own version in Prices and Production was a development of Mises’.

Hayek departs from Wicksell’s monetary theory on a number of points:
(1) Hayek thinks that the banks need to keep the amount of money in circulation unchanged to secure a stable price level, and

(2) the amount of money in circulation has to be changed as the volume of production increases or decreases (Hayek 1935: 27).
But Hayek thinks that the banks cannot keep the demand for real capital in line with the supply of savings and the price level stable at the same time, except in a stationary equilibrium state (Hayek 1935: 27). In times of expansion of production, even when the money rate of interest is equal to the natural rate, there would be a falling price level (Hayek 1935: 27):
“The banks could either keep the demand for real capital within the limits set by the supply of savings, or keep the price level steady; but they cannot perform both functions at once. Save in a society in which there were no additions to the supply of savings, i.e., a stationary society, to keep the money rate of interest at the level of the equilibrium rate would mean that in times of expansion of production the price level would fall. To keep the general price level steady would mean, in similar circumstances, that the loan rate of interest would have to be lowered below the equilibrium rate. The consequences would be what they always are when the rate of investment exceeds the rate of saving.” (Hayek 1935: 27–28).
Hayek also repudiates the idea of a general price level as a useful economic concept (Hayek 1935: 29–30).

In place of the general value of money, Hayek substitutes the crucial concept of how money influences the relative values of goods (Hayek 1935: 31). If money leaves relative values of goods’ prices unchanged, then money is “neutral” (Hayek 1935: 31).

Foster, John Leslie. 1804. An Essay on the Principles of Commercial Exchanges, and more particularly of the Exchange between Great Britain and Ireland: With an Inquiry into the Practical Effects of the Bank Restrictions. J. Hatchard, London.

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.

Joplin, Thomas. 1823. Outlines of a System of Political Economy: written with a View to Prove to Government and the Country, that the Cause of the Present Agricultural Distress is Entirely Artificial: and to suggest a Plan for the Management of the Currency. Baldwin, Cradock, and Joy, London.

Joplin, Thomas. 1832. An Analysis and History of the Currency Question: Together with an Account of the Origin and Growth of Joint Stock Banking in England: Comprised in a Brief Memoir of the Writer’s Connexion with these Subjects. James Ridgway, London.

Malthus, Thomas Robert. 1811. “Depreciation of Paper Currency,” Edinburgh Review 17.34: 339–372.

Mill, John Stuart. 1865. Principles of Political Economy: With Some of their Applications to Social Philosophy (6th edn.). Longmans Green, London.

Report from the Committee of Secrecy on the Bank of England Charter: With the Minutes of Evidence, Appendix and Index, J. & L. G. Hansard & sons, London, 1832.

Report, Together with Minutes of Evidence, and Accounts from the Select Committee on the High Price of Gold Bullion: Ordered, by the House of Commons, to be Printed, 8 June 1810 (Report of the Committee on Gold Bullion, 1810), J. Johnson and J. Ridgway, London, 1810.

Ricardo, David. 1810. The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.). John Murray, London.

Ricardo, David. 1821. On the Principles of Political Economy and Taxation (3rd edn.). John Murray, London.

Senior, Nassau William. 1863. Biographical Sketches. Longman, Green, Longman, Roberts, & Green, London.

Thornton, Henry. 1802. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. J. Hatchard, London.

Tooke, Thomas. 1826. Considerations of the State of the Currency. John Murray, London.

Tooke, Thomas. 1844. An Inquiry into the Currency Principle: The Connection of the Currency with Prices, and the Expediency of a Separation of Issue from Banking. Longman, Brown, Green, and Longmans, London.

Saturday, October 18, 2014

David Ricardo on the Natural Rate of Interest

Both Blaug (1992: 126) and King (2013: 123) point out that a market rate of interest and some kind of “natural” rate of interest can be found in David Ricardo’s On the Principles of Political Economy and Taxation.

I quote from the 3rd edition of 1821:
“The rate of interest, though ultimately and permanently governed by the rate of profit, is however subject to temporary variations from other causes. With every fluctuation in the quantity and value of money, the prices of commodities naturally vary. They vary also, as we have already shewn, from the alteration in the proportion of supply to demand, although there should not be either greater facility or difficulty of production. When the market prices of goods fall from an abundant supply, from a diminished demand, or from a rise in the value of money, a manufacturer naturally accumulates an unusual quantity of finished goods, being unwilling to sell them at very depressed prices. To meet his ordinary payments, for which he used to depend on the sale of his goods, he now endeavours to borrow on credit, and is often obliged to give an increased rate of interest. This, however, is but of temporary duration; for either the manufacturer's expectations were well grounded, and the market price of his commodities rises, or he discovers that there is a permanently diminished demand, and he no longer resists the course of affairs: prices fall, and money and interest regain their real value. If by the discovery of a new mine, by the abuses of banking, or by any other cause, the quantity of money be greatly increased, its ultimate effect is to raise the prices of commodities in proportion to the increased quantity of money; but there is probably always an interval, during which some effect is produced on the rate of interest.” (Ricardo 1821: 349–350).
So though affected by other factors, the money rate of interest is ultimately determined “by the rate of profit.”

Ricardo is adamant that the rate of profit is what fundamentally determines the money interest rate:
“M. Say allows, that the rate of interest depends on the rate of profits; but it does not therefore follow, that the rate of profits depends on the rate of interest. One is the cause, the other the effect, and it is impossible for any circumstances to make them change places.” (Ricardo 1821: 353, n.).
In Ricardo’s The High Price of Bullion (1810), an earlier work, he had already given a similar statement of what determines the money rate of interest:
“It is contended, that the rate of interest, and not the price of gold or silver bullion, is the criterion by which, we may always judge of the abundance of paper-money; that if it were too abundant, interest would fall, and if not sufficiently so, interest would rise. It can, I think, be made manifest, that the rate of interest is not regulated by the abundance or scarcity of money, but by the abundance or scarcity of that part of capital, not consisting of money.” (Ricardo 1810: 43).
So Ricardo though that the money rate of interest was determined by a real factor: the rate of profit on capital (King 2013: 123).

Ricardo even speaks of the money interest rate being driven below its “natural” level by excessive money supply increases:
“I do not dispute, that if the Bank were to bring a large additional sum of notes into the market, and offer them on loan, but that they would for a time affect the rate of interest. The same effects would follow from the discovery of a hidden treasure of gold or silver coin. If the amount were large, the Bank, or the owner of the treasure, might not be able to lend the notes or the money at four, nor perhaps, above three per cent.; but having done so, neither the notes, nor the money, would be retained unemployed by the borrowers; they would be sent into every market, and would every where raise the prices of commodities, till they were absorbed in the general circulation. It is only during the interval of the issues of the Bank, and their effect on prices, that we should be sensible of an abundance of money; interest would, during that interval, be under its natural level; but as soon as the additional sum of notes or of money became absorbed in the general circulation, the rate of interest would be as high, and new loans would be demanded with as much eagerness as before the additional issues.” (Ricardo 1810: 46–47).
There also appear to be two letters where Ricardo discusses the “natural” rate of interest in relation to the money rate, but I have not yet been able to read them:
(1) a letter to Pascoe Grenfell on the 27 August 1817, and

(2) a letter to Thomas Malthus on the 21 October, 1817.
Blaug, Mark. 1992. The Methodology of Economics, or, How Economists Explain (2nd edn.). Cambridge University Press, Cambridge, UK.

King, John Edward. 2013. David Ricardo. Palgrave Macmillan, Basingstoke, UK.

Ricardo, David. 1810. The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.). John Murray, London.

Ricardo, David. 1821. On the Principles of Political Economy and Taxation (3rd edn.). John Murray, London.

Smithin, John N. 2003. Controversies in Monetary Economics (rev. edn.). Edward Elgar, Cheltenham, UK and Northhampton, MA.

Marcello de Cecco on the Gold Standard Before World War I

Marcello de Cecco, an economic historian, is interviewed here on the pre-World War I gold standard, and the way it was already breaking down before 1914 (h/t to Jan).

One of his important books is The International Gold Standard: Money and Empire (2nd edn.; 1984).

de Cecco, Marcello. 1984. The International Gold Standard: Money and Empire (2nd edn.). F. Pinter, London.

Friday, October 17, 2014

The Proto-Natural Rate of Interest and Henry Thornton

Smithin (2003: 92, citing Laidler 1989 and Humphrey 1993) points out that the germ of Wicksell’s monetary equilibrium approach, with a proto-natural rate and bank rate, appears already in Henry Thornton’s book An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802):
“It only remains to enquire, lastly, whether any principle of moderation and forbearance on the part of the borrowers at the bank may be likely to exempt the directors of that institution from the necessity of imposing their own limit.

It may possibly be thought, that a liberal extension of loans would soon satisfy all demands, and that the true point at which the encrease of the paper of the bank ought to stop, would be discovered by the unwillingness of the merchants to continue borrowing.

In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first, of interest to be paid on the sum borrowed; and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital. The gain which can be acquired by the means of commerce is commonly the highest which can be had; and it also regulates, in a great measure, the rate in all other cases. We may, therefore, consider this question as turning principally on a comparison of the rate of interest taken at the bank with the current rate of mercantile profit.

The bank is prohibited, by the state of the law, from demanding, even in time of war, an interest of more than five per cent., which is the same rate at which it discounts in a period of profound peace. It might, undoubtedly, at all seasons, sufficiently limit its paper by means of the price at which it lends, if the legislature did not interpose an obstacle to the constant adoption of this principle of restriction.” (Thornton 1802: 286–287).
So here the “current rate of mercantile profit” is the non-monetary, real “natural” rate which is the anchor for the bank rate. That corresponds to Wicksell’s natural rate:
“The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital, will then be the normal or natural real rate. It is essentially variable.” (Wicksell 1935: 192–193).

“According to the general opinion among economists, the interest on money is regulated in the long run by the profit on capital, which in its turn is determined by the productivity and relative abundance of real capital, or, in the terms of modern political economy, by its marginal productivity. (Wicksell 1907: 214).

Humphrey, Thomas M. 1993. Money, Banking, and Inflation: Essays in the History of Monetary Thought. Edward Elgar, Aldershot, UK and Brookfield, VT.

Laidler, David. 1989. “The Bullionist Controversy,” in J. Eatwell. M. Milgate. and P. Newman (eds), The New Palgrave. Money. Macmillan, London. 60–71.

Smithin, John N. 2003. Controversies in Monetary Economics (rev. edn.). Edward Elgar, Cheltenham, UK and Northhampton, MA.

Thornton, Henry. 1802. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. J. Hatchard, London.

Wicksell, K. 1907. “The Influence of the Rate of Interest on Prices,” The Economic Journal 17.66: 213–220.

Wicksell, K. 1935. Lectures on Political Economy. Volume 2: Money (trans. E. Classen). Routledge & Kegan Paul, London.

Thursday, October 16, 2014

Thomas Joplin on the Natural Rate of Interest

The “Economicreflections” blog has a fascinating post on the early-19th-century maverick economist Thomas Joplin (c. 1790–1847) and his version of the natural rate of interest:
“Early 19th century origins of the Natural Rate of Interest,” Economicreflections, 15 October, 2014.
This discussion of the “natural rate” comes in one of Joplin’s letters (which was later noted by Jacob Viner 1955: 191 over a hundred years later):
“The circulation of each district must bear a certain proportion with that of the rest of the kingdom, in order that its internal trade may balance, and if the general circulation be ever so deficient, the Banks of no district can increase their issues, unless the others do so; nor yet, in the regular course of banking reduce them, be it ever so redundant, unless the reduction be general. If the prices of any district were either above or below their due proportion with the rest, an exportation or importation of corn and cattle, as we explained in our last letter, would bring them in, probably, a few weeks to their level. Any internal cause, therefore, by which a general extension or contraction of the currency is produced must be common to all.

We also pointed out, in our former letters, that money had two values,—its value as currency, and its value as income, or capital; and that the issues of our banks are founded upon a demand for the latter, governed evidently by principles that ought to have no connexion whatever with the currency. There was no want of currency when the banks first issued notes; but by forcing the original metallic money out of circulation, they have created a want, and this want, is a sum of paper, precisely equal to the amount of metallic money, which would have been in circulation if there had not been any paper money at all.

The interest demand for money, or capital is also subject to great fluctuations. During war, when Government borrows largely, it is infinitely greater than during peace, when it does not borrow any. In the former period, the natural market-rate of interest has often been seven or eight per cent, and is generally above five; in the latter it has often been at two per cent, and is generally under four.

The natural rate of interest, however, can never be properly known with our system of currency. It depends, as we have stated, upon the quantity of income saved, proportioned to the demand for capital. But, with the power possessed by our banks of cancelling money which has been saved, or manufacturing it when it has not, this supply and demand can never be ascertained. Consequently, the banks have an arbitrary charge, some of four, but most of five per cent., from which they do not vary; but which, being neither the natural war-rate nor the peace-rate, is as little likely to be the true rate as any other between these two extremes they could have pitched upon.

The natural rate of interest is pretty uniform throughout the kingdom; and when money is scarce or plentiful it operates upon all the banks at the same time.
When, therefore, during the war, it was above five per cent, there was a constant tendency in the banks to increase their issues; since the war, except for a short interval, it has been considerably under that rate, and a great reduction of their issues has taken place.” (Letter IX. To the Editor of the Courier, in Joplin 1825: 37–38).
This appears to be a monetary “natural rate” that clears the market for loanable funds, when the money supply is limited strictly to a given supply of commodity money (for Joplin’s other works, see Joplin 1823 and 1832).

According to Glasner (1997: 56), Thomas Joplin had the clearest expression of the idea of a “natural rate” before Wicksell, although Henry Thornton (1760–1815) was also another early theorist with a proto-natural rate concept.

I am not quite sure what relationship Joplin had to the Currency School, but their ideas seem similar, and Hayek even considered Joplin the “inventor of the currency [sc. school] doctrine” (Hayek 1935: 15). The Currency School’s ideas were seen by the early Austrians like Mises and Hayek as the precursor to their Austrian business cycle theory (Mises 2006 [1978]: 101–103; Garrison 1997: 23).

Another point that strikes me (as brought out in the Economicreflections blog post) is that there was a great deal of intense discussion of economic issues in the early 19th century, but now largely forgotten.

In addition to the development of writings in Classical Political Economy following Adam Smith, there was the following:
(1) the last phase of the bullionist controversies from 1800 to 1819 (Glasner 1997);

(2) the debates after 1819 between the Banking School, the Currency School, and Free Banking School over what caused the business cycle and other monetary issues (White 1997).

(3) the emerging anti-laissez faire, protectionist writings of Friedrich List (1789–1846), Henry Clay (1777–1852), and the early German Historical School.

(4) the writings of the proto-Keynesian “Birmingham School” of economists (Checkland 1948), including the following economists:
Birmingham School
Thomas Attwood
George Frederick Muntz
Matthias Attwood
Arthur Young
Patrick Colquhoun
Sir John Sinclair
Robert Montgomery Martin.
Checkland, S. G. 1948. “The Birmingham Economists, 1815–1850,” The Economic History Review n.s. 1.1: 1–19.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds.), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 23–27.

Glasner. D. 1997. “Bullionist Controversies,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 56–58.

Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.

Joplin, Thomas. 1823. Outlines of a System of Political Economy: written with a View to Prove to Government and the Country, that the Cause of the Present Agricultural Distress is Entirely Artificial: and to suggest a Plan for the Management of the Currency. Baldwin, Cradock, and Joy, London.

Joplin, T. 1825. An Illustration of Mr. Joplin’s Views on Currency, and Plan for Its Improvement; together with Observations applicable to the Present State of the Money; in a series of Letters. Baldwin, Cradock, and Joy, London.

Joplin, Thomas. 1832. An Analysis and History of the Currency Question: Together with an Account of the Origin and Growth of Joint Stock Banking in England: Comprised in a Brief Memoir of the Writer’s Connexion with these Subjects. James Ridgway, London.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala.

O’Brien, D. P. 1997. “Joplin, Thomas (c. 1790–1847),” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 344–345.

Viner, Jacob. 1955. Studies in the Theory of International Trade. Allen & Unwin, London.

White, Lawrence H. 1997. “Banking School, Currency School, and Free Banking School,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York. 47–49.

Tuesday, October 14, 2014

Alfred Marshall on the Deflation of 1873–1896

On 16th January, 1888, Alfred Marshall appeared before the British “Royal Commission on the Value of Gold and Silver” (instituted in 1887), and was questioned about the economic conditions of the 1870s and 1880s in Britain during the first part of the great deflation of 1873 to 1896.

For clarity, I have edited the original text to make the questions and Marshall’s answers clearer:
“[Question:] 9823. Do you share the general opinion that during the last few years we have been passing through a period of severe depression?

[Marshall:] Yes, of severe depression of profits.

[Question:] 9824. And that has been during a period of abnormally low prices?

[Marshall:] A severe depression of profits and of prices. I have read nearly all the evidence that was given before the Depression of Trade and Industry Commission, and I really could not see that there was any very serious attempt to prove anything else than a depression of prices, a depression of interest, and a depression of profits; there is that undoubtedly. I cannot see any reason for believing that there is any considerable depression in any other respect. There is of course great misery among the poor; but I do not believe it is greater than it used to be. I do not mean that we should idly acquiesce in the existence of this misery, and regard it as inevitable. I hold rather extreme opinions in the opposite direction.

[Question:] 9825. (Chairman.) Then I understand you to think that the depression in those three respects is consistent with a condition of prosperity?

[Marshall:] Certainly.

[Question:] 9826. (Mr. Chaplin.) The depression of profits, does not that more or less affect all classes?

[Marshall:] No, I believe that a chief cause of the depression of profits is that the employer gets less and the employé more.

[Question:] 9827. You think that during a period of depression the employed working classes have been getting more than they did before?

[Marshall:] More than they did before, on the average. I do not deny that during the years of spasmodic inflation everybody was working very hard; everybody got exceptionally high returns, employers and employed together. But, as I have already said, I think that history shows that those times have always sown the seeds of coming disasters.

[Question:] 9828. Can you speak as to the fact whether there has been a larger number of the working classes than usual unemployed altogether during this period of depression?

[Marshall:] My belief is that there have not been a larger number of people unemployed during the last 10 years than during any other consecutive 10 years. Of course there are many more unemployed now than there were in 1872–73.

[Question:] 9829. Do you speak with knowledge of the thing and of the working classes?

[Marshall:] I speak from personal observation ranging over many years, and a study of almost everything of importance that has been written on the subject.

[Question:] 9830. Are you aware that we have had evidence given by gentlemen speaking with definite knowledge of a directly opposite nature to what you are stating now?

[Marshall:] I am aware that some persons actively engaged in business have given evidence that they believe there is an increasing unsteadiness of employment. But the facts which they bring forward are, in my opinion, outweighed by the statistical and other evidence in the opposite direction. I have given reasons for believing that the statistics showing unsteadiness of employment require to be carefully interpreted; because the more people are employed in factories the more every interruption of employment shows itself in statistics. I have, however, omitted one thing of very great importance. I think that whatever had been the condition of prices there would have been a special reason causing irregularity of employment now; that is the transitional stage in which a great number of industries are. When an improvement is brought into an industry it benefits the public at once, and in the long run it is pretty sure to benefit even the trade into which it is introduced; but in many cases an improvement in the methods of the industry injures that industry, and throws people temporarily out of employment. Now, I do not think there has been any period in which there have been so many great changes. That has been put before you by Mr. Fowler, and it has been argued at great length in Mr. Wells’ articles that this has been a period of great changes in the methods of industry, changes of such a kind as to tend to throw people out of employment. But in spite of that, I do not believe that the want of employment is, on the average, greater than it has been.

[Question:] 9831. But you mean to say that these changes, as you have described them on the methods of industry, have not been continuing now for a great number of years?

[Marshall:] I think there have been exceptionally great changes within the last few years. Many of them are to be traced to America, and before about 1868 or so, the Americans had other things to do; they had not settled down after the great war sufficiently to exert their full influence in changing the methods of industry. The changes are, I think, chiefly due to the great fall, the unparalleled fall, in the cost of transport, which renders it worth while to do a great many things that it was not worth while to do before; but besides this there are an immense number of changes in all industries, chemical and mechanical. I think Mr. Wells’ evidence points very strongly in that direction.”
Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. Appendix, Minutes of Evidence taken before the Royal Commission on Gold and Silver, pp. 21–22.
According to Marshall, then, there had been a “severe depression of profits and of prices,” but this condition was still compatible with “prosperity.”

An interesting research question is: if real wages were rising in this period, was this because of sticky nominal wages in the face of price deflation, which in turn would have squeezed profits? Or was there some other reason?

On unemployment, Marshall did not think that during the 10 year period from 1878–1888 high unemployment was higher as compared with other periods.

For what they are worth, we have the following recent estimates of UK unemployment from 1873 to 1896 in Boyer and Hatton (2002):
Year | Unemployment Rate
1873 | 2.8%
1874 | 3.3%
1875 | 4.0%
1876 | 4.8%
1877 | 6.6%
1878 | 7.9%
1879 | 9.1%
1880 | 6.6%

1881 | 5.7%
1882 | 5.0%
1883 | 4.9%
1884 | 6.3%
1885 | 8.0%
1886 | 7.9%
1887 | 7.1%
1888 | 5.8%

1889 | 4.3%
1890 | 4.0%
1891 | 4.9%
1892 | 6.1%
1893 | 7.3%
1894 | 7.0%
1895 | 7.3%
1896 | 6.1%

1897 | 5.9%
1898 | 4.9%
1899 | 4.3%
1900 | 4.3%
(Boyer and Hatton 2002: 667).
Some particularly bad periods of unemployment were 1876–1880, 1884–1888 and 1892–1896. The 1876–1880 unemployment figures are very strange, because the real GDP estimates for this period (in Maddison 2003) show real output growth in all years but 1879:
Year | GDP* | Growth Rate
Millions of international Geary-Khamis dollars

1873 | 108266 | 2.33%
1874 | 110063 | 1.66%
1875 | 112758 | 2.45%
1876 | 113881 | 0.99%
1877 | 115004 | 0.99%
1878 | 115454 | 0.39%
1879 | 115004 | -0.39%
1880 | 120395 | 4.69%
1881 | 124663 | 3.54%
1882 | 128257 | 2.88%
1883 | 129155 | 0.70%
1884 | 129380 | 0.17%
1885 | 128706 | -0.52
1886 | 130728 | 1.57%
1887 | 135894 | 3.95%
1888 | 141959 | 4.46%
1889 | 149596 | 5.38%
1890 | 150269 | 0.45%
1891 | 150269 | 0%
1892 | 146676 | -2.39%
1893 | 146676 | 0%

1894 | 156559 | 6.74%
1895 | 161500 | 3.15%
1896 | 168239 | 4.17%
1897 | 170485 | 1.33%
1898 | 178796 | 4.87%
1899 | 186208 | 4.14%
(Maddison 2003: 47).
What is fascinating is that the period of high unemployment from 1884–1887 comes at just the right time when the Royal Commission on the Value of Gold and Silver was set up.

But caused the high unemployment? That there was insufficient private investment seems a reasonable answer. But why insufficient private investment?

If profits were depressed and this caused business expectations to become pessimistic, then the underlying cause was deflation. Moreover, it is likely that debt deflationary dynamics were at work, though hardly as severe as that which hit the Western world from 1929 to 1933. This seems to be the reasonable explanation for the unusual data for this period.

Boyer, George R. and Timothy J. Hatton. 2002. “New Estimates of British Unemployment, 1870–1913,” The Journal of Economic History 62.3: 643–667.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

Maddison, Angus. 2003. The World Economy: Historical Statistics. OECD Publishing, Paris.

Monday, October 13, 2014

Alfred Marshall on the Natural Rate of Interest

Joan Robinson (1969: 397) noted that Alfred Marshall had developed something analogous to the concept of a “natural rate of interest,” though this appears to have been independently of Wicksell.

On 19 December 1887, Alfred Marshall gave evidence before a British “Royal Commission on the Value of Gold and Silver,” which was instituted in 1887 to investigate the question of changes in the value of gold and silver and the effects of this on trade and production.

The relevant quotation is as follows:
“9651. The evidence that has been put by some witnesses before us has been intended to show that so far from any connexion being traceable between plentiful money and a low rate of discount and a plentiful supply of the precious metals, the evidence was just the other way?—[sc. Marshall’s answer:] Oh yes, that is certainly true as regards permanent results; the supply of gold exercises no permanent influence over the rate of discount. The average rate of discount permanently is determined by the profitableness of business. All that the influx of gold does is to make a sort of ripple on the surface of the water. The average rate of discount is determined by the average level of interest in my opinion, and that is determined exclusively by the profitableness of business, gold and silver merely acting as counters with regard to it.”
(Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 4).
The notion that the level of interest is determined “exclusively by the profitableness of business” appears quite similar to the way in which Wicksell defined the natural rate in “The Influence of the Rate of Interest on Prices” (1907):
“According to the general opinion among economists, the interest on money is regulated in the long run by the profit on capital, which in its turn is determined by the productivity and relative abundance of real capital, or, in the terms of modern political economy, by its marginal productivity. This remaining the same, as, indeed, by our supposition it is meant to do, would it be at all possible for the banks to keep the rate of interest either higher or lower than its normal level, prescribed by the simultaneous state of the average profit on capital?” (Wicksell 1907: 214).
Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

Robinson, Joan. 1969. The Accumulation of Capital (3rd edn.). Macmillan, London.

Wicksell, K. 1907. “The Influence of the Rate of Interest on Prices,” The Economic Journal 17.66: 213–220.

Sunday, October 12, 2014

A Fundamental point about Hayek’s Early Career

It is made here by David Laidler:
“In the 1920s and early 1930s, for example, as judged by the standards of the time, Hayek showed no aversion to mathematics. More substantively important, he was an exponent of and contributor to Walrasian general-equilibrium analysis, which he referred to as ‘the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics’ (1929, tr. 1933, footnote on p. 42). The idea of competitive markets as being in a constant state of evolving disequilibrium as they process and disseminate information and incentives among agents, which we nowadays associate so strongly with Hayek, did not become central to his thought until after the appearance of his 1937 paper ‘Economics and Knowledge.’” (Laidler 1999: 31).
That is a very important point: the early Hayek was just as much a Walrasian general-equilibrium theorist as an Austrian, even though he did of course draw on Austrian capital theory and Mises’ trade cycle theory, and developed this uniquely “Austrian” theory which itself drew on Wicksell’s monetary equilibrium tradition.

I discuss the problems with Hayek’s trade cycle theory which stem from its use of Walrasian general-equilibrium here. Foremost amongst these problems is the role of expectations, a criticism which Myrdal (1933) made against Hayek a few years after Prices and Production (1931) was published.

Further Reading
“Hayek’s Trade Cycle Theory, Equilibrium, Knowledge and Expectations,” January 4, 2012

Laidler, David E. W. 1999. Fabricating the Keynesian Revolution: Studies of the Inter-War Literature on Money, the Cycle, and Unemployment. Cambridge University Press, Cambridge.

Myrdal, G. 1933. “Der Gleichgewichtsbegriff als Instrument der geld-theoretischen Analyse,” in F. A. Hayek (ed.), Beiträge zur Geldtheorie. Springer, Vienna. 361–487.