In writing my previous post on Hayek’s classically neoclassical 1969 elucidation of the Ricardo Effect, I came across a passage, which is just too marvelous not to share. To provide just a bit of context for this brief passage, the point that Hayek was trying to establish was that even a continuous and fully anticipated injection of money would alter the real equilibrium of an economy. On this point, Hayek was taking issue with J. R. Hicks who had argued that a fully anticipated increase in the money supply would have no real effects. I think that Hicks was basically right and Hayek wrong on this issue, but that is not the point that I want readers to take away from this post. The point to pay attention to is what Hayek says about the alleged unsustainability of inflationary booms. In the paragraph just before the passage I am going to quote, Hayek explains what happens when the monetary expansion that had been feeding an investment boom is terminated. According to Hayek, that readjustment in the relative prices of investment goods and consumption goods is the Ricardo Effect, causing “some of the factors which during the boom will have become committed producing very capital-intensive equipment [to] become unemployed.”
This is the mechanism by which I conceive that, unless credit expansion is continued progressively, an inflation-fed boom must sooner or later be reversed by a decline in investment. This theory never claimed to do more than account for the upper turning point of the typical nineteenth–century business cycle. The cumulative process of contraction likely to set in once unemployment appears in the capital-goods industries is another matter which must be analyzed by conventional means. It has always been an open question to me as to how long a process of continued inflation, not checked by a built-in limit on the supply of money and credit, could effectively maintain investment above the volume justified by the voluntary rate of savings. It may well be that this inevitable check only comes when inflation becomes so rampant – as the progressively higher rate of inflation required to maintain a given volume of investment must make it sooner or later – that money ceases to be an adequate accounting basis.
The built-in limit on the supply of money to which Hayek referred was the gold standard, manifesting itself in a tendency for monetary expansion to cause both an external and an internal drain on the gold reserves of the monetary authority. In a fiat-money system with a flexible exchange rate, no such limit on the supply of money exists. So according to Hayek, at some point, the monetary authority is faced with a choice of either increasing the rate of inflation to keep investment at its artificially high level or allowing investment to decline, triggering a recession. That is the upper turning point of the cycle. But he also says “the cumulative process of contraction like to set in once unemployment appear in the capital-goods industries is another matter which must be analyzed by conventional means.” I take this to mean that, according to Hayek, the monetary authority can limit the cumulative process of contraction that results when the current rate of inflation is fully anticipated and monetary expansion is not increased to accelerate inflation to a higher, as yet unanticipated, level. There is thus a recession associated with the stabilization of inflation, but monetary policy can prevent it from becoming cumulative. After the real adjustment takes place and the capital goods industry Is downsized, a steady rate of inflation can be maintained, with no further real misallocations. There is inflation, but no boom and recession. In other words, it’s the Great Moderation. Hayek called it in 1969.