Yes, Virginia, Hayek was a Liquidationist in 1932

But you won’t know it from the weird Hayek apologists and Free Bankers who have essentially rewritten history to make it seem as if Hayek was in favour of MV stability by monetary stimulus and central bank intervention during the early years of the Great Depression (see here for a full discussion).

Not too long ago I had a run in with some of the Hayekian True Believers on Twitter.

One of them cited the second part of Hayek’s review of Keynes’ Pure Theory of Money (see Hayek 1932; the first part of the review is Hayek 1931), in order to prove that Hayek was definitely in favour of monetary stimulus and was not a nasty liquidationist.

Well, I checked this out and – lo and behold! – Hayek gives us his opinion:

“I do not deny that, during this process [viz., the slump], a tendency towards deflation will regularly arise; this will particularly be the case when the crisis leads to frequent failures and so increases the risks of lending. It may become very serious if attempts artificially to ‘maintain purchasing power’ delay the process of readjustment – as has probably been the case during the present crisis. This deflation is, however, a secondary phenomenon in the sense that it is caused by the instability in the real situation; the tendency will persist so long as the real causes are not removed. Any attempt to combat the crisis by credit expansion will, therefore, not only be merely the treatment of symptoms as causes, but may also prolong the depression by delaying the inevitable real adjustments. It is not difficult to understand, in the light of these considerations, why the easy-money policy which was adopted immediately after the crash of 1929 was of no effect.

It is, unfortunately, to these secondary complications that Mr. Keynes, in common with many other contemporary economists, directs most attention. This is not to say that he has not made
valuable suggestions for treating these secondary complications. But, as I suggested at the beginning of these Reflections, his neglect of the more fundamental ‘real’ phenomena has prevented him from reaching a satisfactory explanation of the more deep-seated causes of depression.” (Hayek 1932: 44).

Ouch!!

That is very explicit: “Any attempt to combat the crisis by credit expansion will, therefore, not only be merely the treatment of symptoms as causes, but may also prolong the depression by delaying the inevitable real adjustments.” Crystal clear. As late as the second edition of Prices and Production (1935), Hayek was still saying that “we can do nothing to get out of ... [sc. a depression] before its natural end” (Hayek 2008 [1935]: 274–275).

Hayek is defending the Austrian Business Cycle Theory (ABCT) here, and its liquidationist solution to depressions.

In the same year (1932), Hayek signed a letter opposing British government intervention in the economy, as explained by Ludwig Lachmann:

“AEN: In the early 30’s there had been great interest among the profession in the ‘Austrian’ or Hayekian theory of the trade cycle. Yet as the 1930’s progressed even those who had been adherents seemed to have given up their belief in its correctness. What reasons do you think were behind this?

Lachmann: Well, you presumably know about the two different letters to the London Times that appeared in October, 1932. This, of course, was before I came to London. In one of them, Keynes and some Cambridge economists who were not, in general, his friends, like Pigou and Dennis Robertson, demanded that the government should take steps against unemployment. And three days later, Hayek, Robbins and Arnold Plant sent another letter saying that anything the government did by way of public works or similar methods would only make things worse and would not have the affect that Keynes claimed it would have.

That is to say, the ‘Austrians’ seemed to be committed to a policy of continuous deflation whatever happened. Yes, I’m quite sure that the apparent insistence of the ‘Austrians’ that the depression must run its course in the sense that both prices and wages in general must fall seemed to make it increasingly difficult for most other economists to support it, because it was by then obvious that wages didn’t fall, not in the Britain of the 1930’s anyway. That is to say, there was an obvious difference between the point of view expressed by Hayek, Robbins and their letter of October, 1932, and their willingness to admit the following year that a secondary depression was possible.”
Ludwig Lachmann, “An Interview with Ludwig Lachmann,” The Austrian Economics Newsletter, Volume 1, Number 3 (Fall 1978)
https://mises.org/library/interview-ludwig-lachmann

So Hayek changed his mind after he started to believe in the existence of “secondary depressions,” and then came to advocate monetary and eventually even fiscal interventions as a correct response to “secondary depressions” or “secondary deflations,” particularly when he came to accept the severity of downwards nominal wage rigidity in modern capitalist nations.

We know this because Hayek explicitly said so later in life:

“Although I do not regard deflation as the original cause of a decline in business activity, such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

And by the time of Hayek’s 1937 essay “The Gold Problem” (“Das Goldproblem” in German; see Hayek 1999: 169–185, and 184), Hayek is found actually endorsing, not just MV stability, but deficit-financed public works as a response to depression (see here).

I don’t think people appreciate the full extent of Hayek’s humiliation, volte face and capitulation to Keynes on these issues today (even if this was only a strategic move by Hayek at the time).

But Hayek clearly wasn’t saying these things in 1930, or 1931 or 1932. At that time, Hayek was indeed a liquidationist in any meaningful sense of the term.

Further Reading
“Hayek was originally a Liquidationist: Free Bankers are Wrong!,” August 13, 2013.

“Hayek the Stable MV Theorist?,” August 13, 2013.

“The Evidence for Hayek the Stable MV Theorist is still Feeble,” August 21, 2013.

BIBLIOGRAPHY
Hayek, F. A. von. 1931. “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica 33: 270–295.

Hayek, F. A. von. 1932. “Reflections on the Pure Theory of Money of Mr. J. M. Keynes (continued),” Economica 35: 22–44.

Hayek, F. A. von. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas. Routledge & Kegan Paul, London.

Hayek, F. A. von. 1999. “The Gold Problem” (trans. G. Heinz), in S. Kresge (ed.), The Collected Works of F. A. Hayek. Volume 5. Good Money, Part 1. The New World. Routledge, London. 169–185.

Hayek, F. A. von, 2008 [1935]. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala.

I’m on Twitter:
Lord Keynes @Lord_Keynes2
https://twitter.com/Lord_Keynes2

The Filthy Anti-Capitalist Mentality – of Austrian Economics

And I mean the anti-capitalist mentality of the Austrian libertarian cult and certainly in its Rothbardian form, because – make no mistake – these people are anti-capitalist in their core ideological beliefs, no matter how much we have to hear of their blustering nonsense.

Let us take the crucial points which make Austrian libertarianism anti-capitalist:

(1) Opposition to fractional reserve banking
Rothbardians and many other Austrian libertarians oppose even private capitalist fractional reserve banking, but their arguments for doing so are utterly flawed, wrong or just plain ignorant. In truth, fractional reserve banking is neither inherently immoral nor fraudulent, but is a fundamental and indispensable basis of capitalism. You cannot have modern capitalism without it.

In its ignorant opposition to fractional reserve banking, Rothbardianism and other Austrian economics following the Rothbardian view are actually profoundly anti-capitalist and (on their own principles!) would require coercive violations of private property rights and free contract to ban fractional reserve banking, if they were to implement their utopian anarcho-“capitalist” system.

(2) The Austrian business cycle theory (ABCT) when we understand Point (1)
Because of their mistaken view in (1), Austrians and Rothbardians – whether they want to admit it or not – are logically committed to the view that business cycles are a core and inevitable element of capitalism. In essence, Rothbardians assert that, in order to avoid business cycles, not only central banking but also private-sector fractional reserve banking must be abolished.

However, as we have seen, fractional reserve banking is a fundamental basis of capitalism and is not fraudulent. It cannot be abolished without rejecting capitalism. Capitalism is stuck with fractional reserve banking. It follows that Austrians and Rothbardians (if they were honest) must admit that capitalism – since fractional reserve banking is at its heart – is inherently and badly flawed and naturally tends to produce business cycles in its laissez faire state. Laissez faire capitalism is therefore obviously not the best system we could have. And Austrians must therefore hold the view that capitalism is inherently bad. They are just filthy anti-capitalists like their opponents.

Now let’s expand on these points.

What is the major argument Austrians have against fractional reserve banking? The Rothbardians argue that fractional reserve banking is fraudulent because it supposedly involves two incompatible property claims to the same money “deposited” in a bank whenever one opens a demand deposit.

However, this is simply a blatant falsehood, because when you open a demand deposit, you utterly forfeit your property rights to the money and transfer the ownership rights in the money to the bank. The money becomes the bank’s property. All you get in return is an IOU or debt instrument, promising to repay the debt owed to you on demand. Therefore there are not two property claims to the same money: there is only one.

I cannot be bothered repeating all my refutations of every ignorant and absurd Austrian argument against fractional reserve banking, but you can read them here:

“Hayek’s Original View of Fractional Reserve Banking,” February 29, 2012.

“Fractional Reserve Banking, Option Clauses, and Government,” January 31, 2012.

“Are the Public Ignorant of the Nature of Fractional Reserve Banking?,” December 17, 2011.

“Why is the Fractional Reserve Account a Mutuum, not a Bailment?,” December 17, 2011.

“Callable Option Loans and Fractional Reserve Accounts,” December 16, 2011.

“Future Goods and Fractional Reserve Banking,” December 15, 2011.

“Rothbard on the Bill of Exchange,” December 11, 2011.

“Hoppe on Fractional Reserve Banking: A Critique,” December 11, 2011.

“Schumpeter on Fractional Reserve Banking,” June 12, 2011.

“If Fractional Reserve Banking is Fraudulent, Why isn’t the Insurance Industry Fraud?,” September 29, 2011.

“The Mutuum Contract in Anglo-American Law,” September 30, 2011.

“Rothbard Mangles the Legal History of Fractional Reserve Banking,” October 1, 2011.

“More Historical Evidence on the Mutuum Contract,” October 1, 2011.

“If Fractional Reserve Banking is Voluntary, Where is the Fraud?,” October 3, 2011.

“Huerta de Soto on the Mutuum Contract: A Critique,” August 11, 2012.

“A Simple Question for Opponents of Fractional Reserve Banking,” August 17, 2012.

“Chapter 1 of Huerta de Soto’s Money, Bank Credit and Economic Cycles: A Critique,” August 31, 2012.

“Huerta de Soto on Justinian’s Digest 16.3.25.1,” September 1, 2012.

“Huerta de Soto on Banking in Ancient Rome: A Critique,” September 2, 2012.

“A Critique of Rothbard on the History of English Bailment Law,” August 11, 2014.

“Fractional Reserve Banking is a Fundamental Part of Capitalism,” August 8, 2014.

“The Mutuum Contract in Henry de Bracton and English Law,” August 1, 2014.

“Coggs v. Bernard and the History of English Bailment Law,” July 31, 2014.

“A Critique of Murray Rothbard on the Origins and Legal Basis of Fractional Reserve Banking,” July 30, 2014.

“Foley versus Hill and the History of Fractional Reserve Banking,” July 29, 2014

“Mutuum versus Bailment in Banking,” July 24, 2014.

“Carr versus Carr (1811) and the History of Fractional Reserve Banking,” July 23, 2014.

“Rothbard on ‘Deposit’ Banking: A Critique,” July 22, 2014.

Every stupid and ignorant Austrian argument is dealt with above, from Huerta de Soto’s unbelievable errors on banking and the mutuum contract in ancient Rome to Rothbard’s gross misunderstanding of the court case Carr versus Carr (1811).

When we get to the essence of the matter it is this: Rothbardians and their ignorant cult leader Rothbard tried to paint fractional reserve banking as an alien, unnatural and fraudulent addition to pure capitalism in its “garden of Eden” state, which was the reason for business cycles.

We can see this in Rothbard’s attempt to do just this in his book Economic Depressions: Their Cause and Cure, in the passage as follows:

“What, then, are the causes of periodic depressions? Must we always remain agnostic about the causes of booms and busts? Is it really true that business cycles are rooted deep within the free-market economy, and that therefore some form of government planning is needed if we wish to keep the economy within some kind of stable bounds? Do booms and then busts just simply happen, or does one phase of the cycle flow logically from the other?

The currently fashionable attitude toward the business cycle stems, actually, from Karl Marx. Marx saw that, before the Industrial Revolution in approximately the late 18th century, there were no regularly recurring booms and depressions. There would be a sudden economic crisis whenever some king made war or confiscated the property of his subject; but there was no sign of the peculiarly modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions. Since these cycles also appeared on the scene at about the same time as modern industry, Marx concluded that business cycles were an inherent feature of the capitalist market economy. All the various current schools of economic thought, regardless of their other differences and the different causes that they attribute to the cycle, agree on this vital point: that these business cycles originate somewhere deep within the free-market economy. The market economy is to blame. Karl Marx believed that the periodic depressions would get worse and worse, until the masses would be moved to revolt and destroy the system, while the modern economists believe that the government can successfully stabilize depressions and the cycle. But all parties agree that the fault lies deep within the market economy and that if anything can save the day, it must be some form of massive government intervention.” (Rothbard 2009 [1969]: 12–14).

Rothbard, of course, blamed “fraudulent” and “immoral” fractional reserve banking as well as central banks for the business cycle. As we have seen, he thought fractional reserve banking was some alien and anti-market addition to a pristine, wonderful and pure form of capitalism.

Rothbard was laughably wrong here. It is particularly absurd because it never seems to have occurred to Rothbard that the idea that the cause of business cycles lies within capitalism was actually a view of Hayek!

Hayek – to his credit – admitted that if one were to take his absurd business cycle theory seriously, we are stuck with the view that capitalism is inherently flawed and doomed to produce endless endogenous business cycles:

“we can … see how nonsensical it is to formulate the question of the causation of cyclical fluctuations in terms of ‘guilt,’ and to single out, e.g., the banks as those ‘guilty’ of causing fluctuations in economic development. Nobody has ever asked them to pursue a policy other than that which, as we have seen, gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the modern organization of credit. So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them.” (Hayek 2008: 102).

According to the logic of the ABCT, since capitalism naturally has an endogenous/elastic money supply, not only from fractional reserve banking, but also from things as simple as bills of exchange and promissory notes, it will be hit by perpetual business cycles. Capitalism has an inherent and natural tendency to produce such destabilising cycles.

It is no surprise that, when Hayek was propounding his business cycle theory at the LSE in the 1930s, his theory was even attractive to socialists, as Skidelsky notes:

“Hayek, like Keynes, hoped to prevent a slump from developing by preventing the credit cycle from starting. But his method was very different. It was to forbid the banks to create credit, something which could be best achieved by adherence to a full gold standard. He was quite pessimistic, though, about this being practical politics, so his conclusion, like Keynes’s, was that a credit-money capitalist system is violently unstable – only with this difference, that nothing could be done about it. One can understand why Hayek’s doctrines attracted a certain kind of socialist: they seemed to reach Marx’s conclusions by a different route. Because of the Austrian school’s close attention to the institutional and political setting of a credit-money economy, Hayek’s picture of the capitalist system in action was altogether more sombre than that of conventional Anglo-Saxon economics, with its story of easy adjustments to ‘shocks.’” (Skidelsky 1992: 457).

In other words, Hayek’s theory in the 1930s was seen as a pessimistic criticism of capitalism as inherently flawed that naturally attracted people sympathetic to socialism – a point which splendidly confirms everything I have been arguing here.

Austrian economics has a profoundly anti-capitalist mentality, and they should admit this instead of denying the heart and soul of their theory, like the delusional idiot Rothbard.

So, to all Austrians everywhere, it seems to me you need to come out of the closet and embrace your inner and suppressed hatred of capitalism. I’m sure you’ll feel a lot better when you admit to being the filthy anti-capitalist you really are.

BIBLIOGRAPHY
Hayek, F. A. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure. Ludwig von Mises Institute, Auburn, Ala.

Skidelsky, R. J. A. 1992. John Maynard Keynes: The Economist as Saviour, 1920–1937 (vol. 2), Macmillan, London.

Further Reading
“Rothbard Shoots Himself in the Foot: Why the ABCT is Anti-Capitalist,” June 25, 2012.

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.

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

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).

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

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

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.”

BIBLIOGRAPHY
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.

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.

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

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

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

BIBLIOGRAPHY
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.

How did Wicksell, the early Austrians and Keynes define the Natural Rate of Interest?

There appears to be two ways in which Wicksell defined the natural rate of interest, as pointed out by Klausinger (2003: 73). In what follows, I will look at the following points:

(1) how Wicksell defined the “natural rate of interest”;

(2) how it was defined by Mises and Hayek in their early trade cycle theory, and

(3) how Keynes defined it in his pre-General Theory work.

First, how did Wicksell define the “natural rate of interest”? The first definition is given in Geldzins und Güterpreise (Wicksell 1898). We can quote from the English translation of this called Interest and Prices (trans. R. F. Kahn; 1936).

In the context of a discussion about excessive money supply and inflation, Wicksell has this to say about the interest rate:

“The rate of interest charged for loans can clearly never be either high or low in itself, but only in relation to the return which can, or is expected to, be obtained by the man who has possession of money. It is not a high or low rate of interest in the absolute sense which must be regarded as influencing the demand for raw materials, labour, and land or other productive resources, and so indirectly as determining the movement of prices. The causative factor is the current rate of interest on loans as compared with what I shall be calling the natural rate of interest on capital. This natural rate is roughly the same thing as the real interest of actual business. A more accurate, though rather abstract, criterion is obtained by thinking of it as the rate which would be determined by supply and demand if real capital were lent in kind without the intervention of money.” (Wicksell 1936: xxiv–xxv).

Later in the book Wicksell elaborates on this:

“There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital. (Wicksell 1936: 102).

In Wicksell’s later work Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922) there is another definition. In the English translation of this work called Lectures on Political Economy. Volume 2: Money (trans. E. Classen; 1935) we have this:

“But of what does this capital consist? In this connection it is usual to think of the stocks of goods in the warehouses of merchants and manufacturers’ stocks of articles ready for consumption, or of raw materials, or semi-manufactured goods. But this is not correct. The magnitude of stocks of goods is of little importance to the real phenomenon of capital, although in certain circumstances it may become so (cf. p. 251). On the contrary, on a first approximation we may completely ignore the existence of stocks and assume that all products, consumption goods, raw materials, and machinery find a market as soon as they are ready either for consumption or for further processes of production. Under such circumstances free capital will not really have any material form at all—quite naturally, as it only exists for the moment. The accumulation of capital consists in the resolve of those who save to abstain from the consumption of a part of their income in the immediate future. Owing to their diminished demand, or cessation of demand, for consumption goods, the labour and land which would otherwise have been required in their production is set free for the creation of fixed capital for future production and consumption and is employed by entrepreneurs for that purpose with the help of the money placed at their disposal by savings. Of course, this process presupposes an adaptability and a degree of foresight in the reorganization of production which is far from existing in reality, though this is as a rule of secondary importance in comparison with the main phenomenon.

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. If the prospects of the employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise and stimulate further saving at the same time as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. And at the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices will remain unchanged. The sum of money incomes will then usually exceed the money value of the consumption goods annually produced, but the excess of income—i.e. what is annually saved and invested in production—will not produce any demand for present goods but only for labour and land for future production.” (Wicksell 1935: 192–193).

So what is the difference here? Erturk (2006: 454–455) defines the natural rate (apparently in the sense as given by Wicksell here) as the rate that is equal to the “return on new capital.” So Wicksell in Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922) seems to abandon the definition of the “natural rate” in terms of the barter rate on real capital goods that clears those real markets. By 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” does Wicksell mean the monetary rate on loanable funds (or the exogenous money supply “saved” and loaned out by banks)? But if this in turn causes clearing of real markets for capital goods, it seems to come to same thing as the earlier definition.

The early Austrians Mises and Hayek took over the natural rate and the Wicksellian loanable funds theory in their Austrian business cycle theory (ABCT).

We can see this in Mises’ statements in The Theory of Money and Credit (2009 [1953], original German edition 1912) and his “Monetary Stabilization and Cyclical Policy” (1928):

“Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about. Up to this point Wicksell commands assent; … .” (Mises 2009 [1953]: 355).

“In conformity with Wicksell’s terminology, we shall use ‘natural interest rate’ to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. ‘Money rate of interest’ will be used for that interest rate asked on loans made in money or money substitute. Through continued expansion of fiduciary media, it is possible for the banks to force the money rate down to the actual cost of the banking operations, practically speaking that is almost to zero. As a result, several authors have concluded that interest could be completely abolished in this way. Whole schools of reformers have wanted to use banking policy to make credit gratuitous and thus to solve the ‘social question.’ No reasoning person today, however, believes that interest can ever be abolished, nor doubts but what, if the ‘money interest rate’ is depressed by the expansion of fiduciary media, it must sooner or later revert once again to the ‘natural interest rate.’ The question is only how this inevitable adjustment takes place. The answer to this will explain at the same time the fluctuations of the business cycle.” (Mises 2006 [1978]: 107–108).

This is the “natural rate” as in Wicksell’s Geldzins und Güterpreise (Wicksell 1898).

We can see too that in Hayek’s Prices and Production (2nd edn.; 1935; the 1st edition was published in 1931), Hayek takes over the “natural rate” from Wicksell as defined in the latter’s Geldzins und Güterpreise (1898):

“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; …” (Hayek 2008 [1935]: 215).

It very strange indeed, then, to see that in Hayek’s earlier work Geldtheorie und Konjunkturtheorie (1929) – translated into English in 1933 as Monetary Theory and the Trade Cycle – he endorses the alternative definition of the natural rate in Wicksell’s Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922), and as in the later English translation Lectures on Political Economy. Volume 2: Money (1935):

“As regards the relationship of the natural or equilibrium rate of interest to the actual rate, it should be noted, in the first place, that even the existence of this distinction is questioned. The objections, however, mainly arise from a misunderstanding which occurred because K. Wicksell, who originated the distinction, made use in his later works of the term ‘real rate’ (which to my mind is less suitable than ‘natural rate’) and this expression became more widespread than that which we have used. The expression ‘real rate of interest’ is also unsuitable, since it coincides with Professor Fisher’s ‘real interest’, which, as is well known, denotes the actual rate plus the rate of appreciation or minus the rate of depreciation of money, and is thus in accordance with common usage, which employs the term ‘real wages’ or ‘real income’ in the same sense. Unfortunately Wicksell’s change in terminology is also linked up with a certain ambiguity in his definition of the ‘natural rate’. Having correctly defined it once as ‘that rate at which the demand for loan capital just equals the supply of savings’ he redefines it, on another occasion, as that rate which would rule ‘if there were no money transactions and real capital were lent in natura’. If this last definition were correct, Dr. G. Halm would be right in raising, against the conception of a ‘natural rate’, the objection that a uniform rate of interest could develop only in a money economy, so that the whole analysis is irrelevant. If Dr. Halm, instead of clinging to this unfortunate formula, had based his reasoning on the correct definition which is also to be found in Wicksell, he would have reached the same conclusion as Professor Adolf Weber—the distinguished head of the school of which he is a member; that is, that the natural rate is a conception ‘which is evolved automatically from any clear study of economic interconnections’. In accordance with this view, Wicksell’s conception must be credited with fundamental significance in the study of monetary influences on the economic system; especially if one realizes the practical importance of a money rate of interest depressed below the natural rate by a constantly increasing volume of circulating media. Unfortunately, although Wicksell’s solution cannot be regarded as adequate at all points, the attention which it has received since he propounded it has borne no relation to its importance. Apart from the works of Professor Mises, mentioned above, the theory has made no progress at all, although many questions concerning it still await solution. This may be due to the fact (on which we have touched already) that the problem had become entangled with that of fluctuations in the general price level. We have already stated our views on this point, (p. 196) and indicated what is necessary for the further development of the theory. Here, we shall try to restate the problem in its correct form, freed from any reference to movements in the price level.” (Hayek 1933: 209–212).

Again, is Hayek trying to define the natural rate merely as a monetary rate that clears that market for loanable funds, and that is equal to the return on capital? But at the same time that rate must cause equilibrium in the markets for real capital goods, so it is unclear why Wicksell’s earlier definition is problematic.

Now we come to Keynes. I am unsure whether Keynes’ uses the natural rate in A Tract on Monetary Reform (1923), but in Keynes’ A Treatise on Money (1930), he also uses a concept called the natural rate, which he connects with Wicksell:

“It is now evident in what manner changes in the Bank-rate, or—more strictly—changes in the rate of interest, are capable of influencing the purchasing power of money.

The attractiveness of investment depends on the prospective income which the entrepreneur anticipates from current investment relatively to the rate of interest which he has to pay in order to be able to finance its production;—or, putting it the other way round, the value of capital-goods depends on the rate of interest at which the prospective income from them is capitalised. That is to say, the higher (e.g.) the rate of interest, the lower, other things being equal, will be the value of capital-goods. Therefore, if the rate of interest rises, P´ will tend to fall, which will lower the rate of profit on the production of capital-goods, which will be deterrent to new investment. Thus a high rate of interest will tend to diminish both P´ and C, which stand respectively for the price-level and the volume of output of capital-goods. The rate of saving, on the other hand, is stimulated by a high rate of interest and discouraged by a low rate. It follows that an increase in the rate of interest tends— other things being equal—to make the rate of investment (whether measured by its value or by its cost) to decline relatively to the rate of saving, i.e. to move the second term of both Fundamental Equations in the negative direction, so that the price-levels tend to fall.

Following Wicksell, it will be convenient to call the rate of interest which would cause the second term of our second Fundamental Equation to be zero the natural-rate of interest, and the rate which actually prevails the market-rate of interest. Thus the natural-rate of interest is the rate at which saving and the value of investment are exactly balanced, so that the price-level of output as a whole (Π) exactly corresponds to the money-rate of the efficiency-earnings of the Factors of Production. Every departure of the market-rate from the natural-rate tends, on the other hand, to set up a disturbance of the price-level by causing the second term of the second Fundamental Equation to depart from zero.” (Keynes 1930a: 154–155).

Later in A Treatise on Money Keynes has an extended discussion of the natural rate:

“Whilst Marshall, unless I have misunderstood him, regarded the influence of Bank-rate on investment as the means by which an increase of purchasing power got out into the world, and Mr. Hawtrey has limited its influence to one particular kind of investment, namely investment by dealers in stocks of liquid goods, Wicksell—though here also there are obscurities to overcome—was closer to the fundamental conception of Bank-rate as affecting the relationship between investment and saving. I say that there are obscurities to overcome, because Wicksell’s theory in the form in which it has been taken over from him by Professor Cassel seems to me to be reduced to practically the same thing as the first strand of thought mentioned above, namely that the level of Bank-rate determines the volume of bank-money and hence the price-level. But I think that there was more than this in Wicksell’s own thought, though obscurely presented in his book.

Wicksell conceives of the existence of a ‘natural rate of interest’ which he defines as being the rate which is ‘neutral’ in its effect on the prices of goods, tending neither to raise nor to lower them, and adds that this must be the same rate as would obtain if in a non-monetary economy all lending was in the form of actual materials. It follows that if the actual rate of interest is lower than this prices will have a rising tendency, and conversely if the actual rate is higher. It follows, further, that so long as the money-rate of interest is kept below the natural-rate of interest, prices will continue to rise—and without limit. It is not necessary for this result, namely the cumulative rise of prices, that the money-rate should fall short of the natural-rate by an ever-increasing difference; it is enough that it should be, and remain, below it.

Whilst Wicksell’s expressions cannot be justified as they stand and must seem unconvincing (as they have to Professor Cassel) without further development, they can be interpreted in close accordance with the Fundamental Equation of this Treatise. For if we define Wicksell’s natural-rate of interest as the rate at which Saving and the value of Investment are in equilibrium (measured in accordance with the definitions of Chapter 10 above), then it is true that, so long as the money-rate of interest is held at such a level that the value of Investment exceeds Saving, there will be a rise in the price-level of output as a whole above its cost of production, which in turn will stimulate entrepreneurs to bid up the rates of earnings above their previous level, and this upward tendency will continue indefinitely so long as the supply of money continues to be such as to enable the money-rate to be held below the natural-rate as thus defined. This means, in general, that the market-rate of interest cannot be continually held even a little below the natural-rate unless the volume of bank-money is being continually increased; but this does not affect the formal correctness of Wicksell’s argument. Professor Cassel’s belief, that Wicksell was making a very odd mistake in arguing in this way, may be justified by the incompleteness of Wicksell’s expression, but it probably indicates that, whilst Wicksell was thinking along the same lines as those followed in this Treatise, Cassel is not,—in spite of the fact that Cassel expresses himself elsewhere in practically the same terms as Wicksell, namely that the true rate of interest is that at which the value of money is unchanged.

At any rate, whether or not I have exaggerated the depth to which Wicksell’s thought penetrated, he was the first writer to make it clear that the influence of the rate of interest on the price-level operates by its effect on the rate of Investment, and that Investment in this context means Investment and not speculation. On this point Wicksell was very explicit, pointing out that the rate of investment is capable of being affected by small changes in the rate of interest, e.g. … [one and a quarter] per cent., which could not be supposed to affect the mind of the speculator; that this increased investment causes an increased demand for actual goods for use and not for ‘speculative’ purposes, and that it is this increased actual demand which sends up prices.

More recently a school of thought has been developing in Germany and Austria under the influence of these ideas, which one might call the neo-Wicksell school, whose theory of bank-rate in relation to the equilibrium of Savings and Investment, and the importance of the latter to the Credit Cycle, is fairly close to the theory of this Treatise. I would mention particularly Ludwig Mises’s Geldwertstabilisierung und Konjunkturpolitik (1928), Hans Neisser, Der Tauschwert des Geldes (1928), and Friedrich Hayek, Geldtheorie und Konjunkturtheorie (1929). (Keynes 1930a: 196–199).

So Keynes here defines the natural rate as:

(1) “… the rate at which saving and the value of investment are exactly balanced, so that the price-level of output as a whole (Π) exactly corresponds to the money-rate of the efficiency-earnings of the Factors of Production.”

(2) “… the rate at which Saving and the value of Investment are in equilibrium … .”

This seems to be developed from Wicksell’s definition in Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit (1922).

The final point (astonishing as it may seem) is that Keynes’ period as a quasi- or proto-monetarist before his work on the General Theory saw him developing a theory of inflation, the natural rate and investment which he saw as “fairly close to” the Austrian theory of Mises and Hayek. Though Keynes did not accept Austrian capital theory or the notion of the unsustainable lengthening of the structure of production, there seems to be some truth in this. Later of course when Hayek came to England and published Prices and Production on the basis of the lectures he had given at the LSE and Keynes knew the theory in greater detail, Keynes was not supportive.

BIBLIOGRAPHY
Erturk, K.A. 2006. “Speculation, Liquidity Preference and Monetary Circulation,” in P. Arestis and M. Sawyer (eds), A Handbook of Alternative Monetary Economics. Edward Elgar, Cheltenham, UK and Northampton, MA. 454–470.

Hayek, F. A. von. 1929. Geldtheorie und Konjunkturtheorie. Hölder-Pichler-Tempsky, Vienna.

Hayek, F. A. von. 1933. Monetary Theory and the Trade Cycle (trans. N. Kaldor and H. M. Croome). J. Cape, London.

Hayek, F. A. von. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala.

Hayek, F. A. von. 2008a [1933] “Monetary Theory and the Trade Cycle,” in F. A. von Hayek, Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard. Ludwig von Mises Institute, Auburn, Ala. 1–130.

Keynes, John Maynard. 1923. A Tract on Monetary Reform. Macmillan, London.

Keynes, John Maynard. 1930. A Treatise on Money. Volume 1. The Pure Theory of Money. Macmillan, London.

Keynes, John Maynard. 1930a. A Treatise on Money. Volume 2. The Applied Theory of Money. Macmillan, London.

Klausinger, Hansjoerg. 2003. “Hayek Translated: Some Words of Caution,” History of Economics Review 37: 71–83.

Mises, L. von. 1912. Theorie des Geldes und der Umlaufsmittel. Duncker & Humblot, Munich and Leipzig.

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.

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

Wicksell, K. 1898. Geldzins und Güterpreise. Fischer, Jena.

Wicksell, K. 1922. Vorlesungen über Nationalökonomie. Band 2: Geld und Kredit. Fischer, Jena.

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

Wicksell, K. 1936. Interest and Prices (trans. R. F. Kahn). Macmillan, London.

Liquidationism and early 1930s Germany: Not a Good Mix!

A rather candid admission from none other than Hayek himself:

“It may perhaps be pointed out here that it has, of course, never been denied that employment can be rapidly increased, and a position of ‘full employment’ achieved in the shortest possible time by means of monetary expansion–least of all by those economists whose outlook has been influenced by the experience of a major inflation. All that has been contended is that the kind of full employment which can be created in this way is inherently unstable, and that to create employment by these means is to perpetuate fluctuations.

There may be desperate situations in which it may indeed be necessary to increase employment at all costs, even if it be only for a short period–perhaps the situation in which Dr. Brüning found himself in Germany in 1932 was such a situation in which desperate means would have been justified. But the economist should not conceal the fact that to aim at the maximum of employment which can be achieved in the short run by means of monetary policy is essentially the policy of the desperado who has nothing to lose and everything to gain from a short breathing space.” (Hayek 1975 [1939]: 64, n. 1).

Of course, monetary and fiscal interventions are not “desperate means,” despite Hayek’s nonsense derived from his equally nonsensical trade cycle theory.

But this is at least a frank statement of what many Rothbardian Austrians these days cannot even bring themselves to admit: that the lack of government monetary and fiscal stability in early 1930s Germany was the primary cause of the surge in the popularity and electoral success of the Nazi party. It was deflationary depression, not hyperinflation, that destroyed democracy in Germany.

This can be seen in the Nazi party share of the vote in federal elections in the Weimar Republic from 1924 to 1933:

Date | % of Vote | Reichstag Seats
May 1924 | 6.5% | 32
Dec. 1924 | 3.0% | 14
May 1928 | 2.6% | 12
Sep. 1930 | 18.3% | 107
July 1932 | 37.3% | 230
Nov. 1932 | 33.1% | 196
March 1933 | 43.9% | 288
http://en.wikipedia.org/wiki/Nazi_Party#Federal_election_results

By 1928, during the economic boom in Germany, the Nazi party vote looked like it was almost dead and was only 2.6%. Remarkably, even in the aftermath of the Weimar hyperinflation in 1924 it was only 3%.

When the deflationary depression struck Germany from 1929–1932, it soared to 18.3% (September 1930), then 37.3% (July 1932), and finally to 43.9% in March 1933 in the aftermath of the Great Depression.

BIBLIOGRAPHY
Hayek, F.A. 1975 [1939]. Profits, Interest and Employment. Augustus M. Kelley, Clifton.

Hayek on Prediction in the Social Sciences

Updated

From Hayek’s Nobel Memorial Lecture given at Stockholm (11 December, 1974):

“We cannot be grateful enough to such modern philosophers of science as Sir Karl Popper for giving us a test by which we can distinguish between what we may accept as scientific and what not – a test which I am sure some doctrines now widely accepted as scientific would not pass. There are some special problems, however, in connection with those essentially complex phenomena of which social structures are so important an instance, which make me wish to restate in conclusion in more general terms the reasons why in these fields not only are there only absolute obstacles to the prediction of specific events, but why to act as if we possessed scientific knowledge enabling us to transcend them may itself become a serious obstacle to the advance of the human intellect.

The chief point we must remember is that the great and rapid advance of the physical sciences took place in fields where it proved that explanation and prediction could be based on laws which accounted for the observed phenomena as functions of comparatively few variables – either particular facts or relative frequencies of events. This may even be the ultimate reason why we single out these realms as ‘physical’ in contrast to those more highly organized structures which I have here called essentially complex phenomena. There is no reason why the position must be the same in the latter as in the former fields. The difficulties which we encounter in the latter are not, as one might at first suspect, difficulties about formulating theories for the explanation of the observed events – although they cause also special difficulties about testing proposed explanations and therefore about eliminating bad theories. ….

A simple example will show the nature of this difficulty. Consider some ball game played by a few people of approximately equal skill. If we knew a few particular facts in addition to our general knowledge of the ability of the individual players, such as their state of attention, their perceptions and the state of their hearts, lungs, muscles etc. at each moment of the game, we could probably predict the outcome. Indeed, if we were familiar both with the game and the teams we should probably have a fairly shrewd idea on what the outcome will depend. But we shall of course not be able to ascertain those facts and in consequence the result of the game will be outside the range of the scientifically predictable, however well we may know what effects particular events would have on the result of the game. This does not mean that we can make no predictions at all about the course of such a game. If we know the rules of the different games we shall, in watching one, very soon know which game is being played and what kinds of actions we can expect and what kind not. But our capacity to predict will be confined to such general characteristics of the events to be expected and not include the capacity of predicting particular individual events.

This corresponds to what I have called earlier the mere pattern predictions to which we are increasingly confined as we penetrate from the realm in which relatively simple laws prevail into the range of phenomena where organized complexity rules. As we advance we find more and more frequently that we can in fact ascertain only some but not all the particular circumstances which determine the outcome of a given process; and in consequence we are able to predict only some but not all the properties of the result we have to expect. Often all that we shall be able to predict will be some abstract characteristic of the pattern that will appear—relations between kinds of elements about which individually we know very little. Yet, as I am anxious to repeat, we will still achieve predictions which can be falsified and which therefore are of empirical significance.

Of course, compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the over-confident because their experiments may after all produce some new insights. But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted.”
F. von Hayek, Nobel Memorial Lecture, Stockholm,11 December 1974
http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1974/hayek-lecture.html

There is a curious mix of good ideas and bad ones here.

First, the good ideas which Post Keynesians share: in the social sciences and economics, it is often not possible to make quantitative predictions of the type made in the natural sciences.

Nevertheless, it is still possible to make predictions in economics which are qualitative (or, as Hayek says, “pattern predictions”) and empirical, which can be verified or falsified.

But this passage seems to show that Hayek’s ultimate view of uncertainty is an epistemological, not an ontological, one:

“A simple example will show the nature of this difficulty. Consider some ball game played by a few people of approximately equal skill. If we knew a few particular facts in addition to our general knowledge of the ability of the individual players, such as their state of attention, their perceptions and the state of their hearts, lungs, muscles etc. at each moment of the game, we could probably predict the outcome.”

If Hayek is saying here that the natural sciences could exactly predict everything about the game given enough information (including presumably the brain states of human players), then he is committed to the view that the world is completely deterministic, and that our uncertainty about it is merely epistemic and caused by the insuperable difficulties of gathering enough information for calculations.

In contrast to this, Post Keynesians emphasise the ontological nature of uncertainty, and this commits them to a philosophical position quite different from that of Hayek.

The notion of “spontaneous ordering forces” that bring order to markets (like Smith’s “invisible hand” metaphor) seems overrated too.

“Spontaneous ordering forces” must be understood as emergent properties. That complex social and economic systems can display emergent properties that result in greater stability is not in doubt, but other emergent properties (e.g., the outcome of the paradox of thrift or distress selling in a market crash) can also be highly deleterious and destabilising. Hayek badly neglected such destabilising forces in his rhetoric about markets.