Archive for the 'Hayek' Category

Next Entries »

Kuehn, Keynes and Hawtrey

Published March 7, 2012 Cassel , Hawtrey , Hayek , Keynes 5 Comments

Following up on Brad DeLong’s recent comment on his blog about my post from a while back in which I expounded on the superiority of Hawtrey and Cassel to Keynes and Hayek as explainers of the Great Depression, Daniel Kuehn had a comment on his blog cautioning against reading the General Theory either as an explanation of the Great Depression, which it certainly was not, or as a manual for how to recover from the Great Depression. Although Daniel is correct in characterizing the General Theory as primarily an exercise in monetary theory, I don’t think that it is wrong to say that the General Theory was meant to provide the theoretical basis from which one could provide an explanation of the Great Depression, or wrong to say that the General Theory was meant to provide a theoretical rationale for using fiscal policy as the instrument by which to achieve recovery. Certainly, it is hard to imagine that the General Theory would have been written if there had been no Great Depression. Why else would Keynes have been so intent on proving that an economy in which there was involuntary unemployment could nevertheless be in equilibrium, and on proving that money-wage cuts could not eliminate involuntary unemployment?

Daniel also maintains that Keynes actually was in agreement with Hawtrey on the disastrous effects of the monetary policy of the Bank of France, citing two letters that Keynes wrote on the subject of the Bank of France reprinted in his Essays in Persuasion. I don’t disagree with that, though I suspect that Keynes may have had a more complicated story in mind than Hawtrey did.   But it seems clear  that Hawtrey and Keynes, even though they were on opposite sides of the debate about restoring sterling to its prewar parity against the dollar, were actually very close in their views on monetary theory before 1931, Keynes, years later, calling Hawtrey his “grandparent in the paths of errancy.” They parted company, I think, mainly because Keynes in the General Theory argued, or at least was understood to argue, that monetary policy was ineffective in a liquidity trap, a position that Hawtrey, acknowledging the existence of what he called a credit deadlock, had some sympathy for, but did not accept categorically.  Hawtrey is often associated with the “Treasury view” that holds that fiscal policy is always ineffective, because it crowds out private spending, but I think that his main point was that fiscal policy requires an accommodative monetary policy to be effective. But not having studied Hawtrey’s views on fiscal policy in depth, I must admit that that opinion is just conjecture on my part.

So my praise for Hawtrey and dismissal of Keynes-Hayek hype was not intended to suggest that Keynes had nothing worthwhile to say. My point is simply to that to understand what caused the Great Depression, the place to start from is the writings of Hawtrey and Cassel. That doesn’t mean that there is not a lot to learn about how economies work (or don’t work) from Keynes, or from Hayek for that matter. The broader lesson is that we should be open to contributions from a diverse and eclectic range of sources. So despite superficial appearances, there really is not that much that Daniel and I are disagreeing about.

PS (8:58 AM EST):  I pressed a button by mistake and annihilated the original post.  This is my best (quick) attempt to recover the gist of what I originally posted last night.

PPS (11:07 AM EST):  Thanks to Daniel Kuehn for reminding me that Google Reader had protected my original post against annihilation.  I have now restored fully whatever it was that I wanted to restore.

Am I Being Unfair to the Gold Standard?

Published February 12, 2012 Cassel , gold standard , Hawtrey , Hayek , monetary policy , monetary theory 38 Comments

Kurt Schuler takes me (among others) to task in a thoughtful post on the Free-Banking blog for being too harsh in my criticisms of the gold standard, in particular in blaming the gold standard for the Great Depression, when it was really the misguided policies of central banks that were at fault.

Well, I must say that Kurt is a persuasive guy, and he makes a strong case for the gold standard. And, you know, the gold standard really wasn’t fatally flawed, and if the central banks at the time had followed better policies, the gold standard might not have imploded in the way that it did in the early 1930s. So, I have to admit that Kurt is right; the Great Depression was not the inevitable result of the gold standard. If the world’s central banks had not acted so unwisely – in other words, if they had followed the advice of Hawtrey and Cassel about limiting the monetary demand for gold — if the Bank of France had not gone insane, if Benjamin Strong, Governor of the New York Federal Reserve Bank, then the de facto policy-making head of the entire Federal Reserve System, had not taken ill in 1928 and been replaced by the ineffectual George L. Harrison, the Great Depression might very well have been avoided.

So was I being unfair to the gold standard? OK, yes, I admit it, I was being unfair. Gold standard, you really weren’t as bad as I said you were. The Great Depression was really not all your fault. There, I’m sorry if I hurt your feelings. But, do I want to see you restored? No way! At least not while the people backing you are precisely those who, like Hayek, in his 1932 lament for the gold standard defending the insane Bank of France against accusations that it caused the Great Depression, hold Hawtrey and Cassel responsible for the policies that caused the Great Depression. If those are the ideas motivating your backers to want to restore you as a monetary standard, I find the prospect of your restoration pretty scary — as in terrifying.

Now, Kurt suggests that people Ron Paul are not so scary, because all Ron Paul means when he says he wants to restore the gold standard is that the Federal Reserve System be abolished. With no central bank, it will be left up to the market to determine what will serve as money. Here is how Kurt describes what would happen.

If people want the standard to be gold, that’s what free banks will offer to attract their business. But if people want the standard to be silver, copper, a commodity basket, seashells, or cellphone minutes, that’s what free banks will offer. Or if they want several standards side by side, the way that multiple computer operating systems exist side by side, appealing to different niches, that’s what free banks will offer. A pure free banking system would also give people the opportunity to change standards at any time. Historically, though, many free banking systems have used the gold standard, and it is quite possible that gold would re-emerge against other competitors as the generally preferred standard.

Now that’s pretty scary – as in terrifying – too. As I suggested in arecent post, the reason that people in some places, like London, for instance, seem to agree readily on what constitutes money, even without the operation of legal tender laws, is that there are huge advantages to standardization. Economists call these advantages network effects, or network externalities. The demand to use a certain currency increases as other people use it, just as the demand to use a computer operating system or a web browser increases as the number of people already using it increases. Abolishing the dollar as we know it, which is what Kurt’s scenario sounds like to me, would annihilate the huge network effects associated with using the dollar, thereby forcing us to go through an uncertain process of indefinite length to recapture those network effects without knowing how or where the process would end up.  If we did actually embark on such a process, there is indeed some chance, perhaps a good chance, that it would lead in the end to a gold standard.

Would a gold standard associated with a system of free banking — without the disruptive interference of central banks — work well? There are strong reasons to doubt that it would. For starters, we have no way of knowing what the demand of such banks to hold gold reserves would be. We also have no way of knowing what would happen to the gold holdings of the US government if the Federal Reserve were abolished. Would the US continue to hold gold reserves if it went out of the money creation business?  I have no idea.  Thus, the future value of gold in a free-banking system is thus completely unpredictable. What we do know is that under a fractional reserve system, the demand for reserves by the banking system tends to be countercyclical, going up in recessions and going down in expansions. But what tends to cause recessions is an increase in the demand of the public to hold money.  So the natural cyclical path of a free-banking system under a gold standard would be an increasing demand for money in recessions, associated with an increasing monetary demand for gold by banks as reserves, causing an increase in the value of gold and a fall in prices. Recessions are generally characterized by declining real interest rates produced by depressed profit expectations. Declining real interest rates increase the demand for an asset like gold under the gold standard with a fixed nominal value, so both the real and the monetary demand for gold would increase in recessions, causing recessions to be deflationary. Recessions with falling asset prices and rising unemployment and, very likely, an increasing number of non-performing loans would impair the profitability and liquidity of banks, perhaps threatening the solvency of at least some banks as well, thereby inducing holders of bank notes and bank deposits to try to shift from holding bank notes and bank deposits to holding gold.

A free-banking system based on a gold standard is thus likely to be subject to a shift in demand from holding bank money to holding gold, when it is least able to accommodate such a shift, making a free-banking system based on a gold standard potentially vulnerable to a the sort of vicious deflationary cycle that characterized the Great Depression. The only way out of such a cycle would be to suspend convertibility. Such suspensions might or might not be tolerated, but it is not at all clear whether or how a mechanism to trigger such a suspension could be created. Insofar as such suspensions were expected, the mere anticipation of a liquidity problem might be sufficient to trigger a shift in demand away from holding bank money toward holding gold, thereby forcing a suspension of convertibility.  Chronic suspensions of convertibility would tend to undermine convertibility.

In short, there is a really serious problem inherent in any banking system in which the standard is itself a medium of exchange. The very fact that gold is money means that, in any fractional reserve system based on gold, there is an inherent tendency for the system to implode when there is a loss of confidence in bank money that causes a shift in demand from bank money to gold. In principle, what would be most desirable is a system in which the monetary standard is not itself money.  Alternatively, the monetary standard could be an asset whose supply may be increased without limit to meet an increase in demand, an asset like, you guessed it, Federal Reserve notes and reserves. But that very defect is precisely what makes the Ron Pauls of this world think that the gold standard is such a wonderful idea.  And that is a scary — as in terrifying — thought.

Ludwig von Mises and the Great Depression

Published February 10, 2012 Cassel , gold standard , Hawtrey , Hayek , monetary history , monetary theory 54 Comments

Many thanks to gliberty who just flagged for me a piece by Mark Spitznagel in today’s (where else?) Wall Street Journal about how Ludwig von Mises, alone among the economists of his day, foresaw the coming of the Great Depression, refusing the offer of a high executive position at the Kredit-Anstalt, Austria’s most important bank, in the summer of 1929, because, as he put it to his fiancée (whom he did not marry till 1938 just before escaping the Nazis), “a great crash is coming, and I don’t want my name in any way connected with it.”  Just how going to work for the Kredit Anstalt would have led to Mises’s name being associated with the crash (the result, in Mises’s view, of the inflationary policy of the US Federal Reserve) is left unclear.  But it’s such a nice story.

Ludwig von Mises was an extremely well-read and diligent economist, who had some extraordinary insights into economics and business and politics.  As a result he made some important contributions to economics, most important the discovery that idea of a fully centrally planned economy is not just an impossibility, it is incoherent.   He made other contributions to economics as well, but that insight, perhaps also perceived by Max Weber, was first spelled out and explained by Mises in his book Socialism. That contribution alone is enough to ensure Mises an honorable place in the history of economic thought.

Mises also perceived how the monetary theory of Knut Wicksell, based on a distinction between a market and a natural rate of interest, could be combined with the Austrian theory of capital, developed by his teacher Eugen von Bohm-Bawerk into a theory of business cycles.  Von Mises is therefore justly credited with being the father of Austrian business-cycle theory.  His own development of the theory was somewhat sketchy, and it was his student F. A. Hayek, who made the great intellectual effort of trying to work out the detailed steps in the argument by which monetary expansion would alter the structure of capital and production, leading to a crisis when the monetary expansion was halted or reversed.

Relying on their newly developed theory of business cycles, Mises and Hayek warned in the late 1920s that the decision of the Federal Reserve to reduce interest rates in 1927, when it appeared that the US economy could be heading into a recession, would distort the structure of production and lead eventually to an even worse downturn than the one the Fed avoided in 1927.  That was the basis for Mises’s “prediction” of a “crash” ahead of the Great Depression.

Of course, as I have pointed out previously, Mises and Hayek were not the only ones to have predicted that there could be a downturn.  R.G. Hawtrey and Gustav Cassel had been warning about that danger since 1919, should an international return to the gold standard not be managed properly, failing to prevent a rapid deflationary increase in the international monetary demand for gold.  When the insane Bank of France began accumulating gold at a breathtaking rate in 1928, and the US reversed its monetary stance in late 1928 and itself began accumulating gold, Hawtrey and Cassel recognized the potential for disaster and warned of the disastrous consequences of the change in Federal Reserve policy.

So Mises and Hayek were not alone in their prediction of a crash; Hawtrey and Cassel were also warning of a looming disaster, and were doing so on the basis of a theory that was both more obvious and more relevant to the situation than theory with which Mises and Hayek were working, a theory that, even giving it the benefit of every doubt, could not possibly have predicted a downturn even remotely approaching the severity of the 1929-31 downturn.  Indeed, as I have also pointed out, the irrelevance of the Mises and Hayek “explanation” of the Great Depression is perfectly illustrated by Hayek’s 1932 defense of the insane Bank of France, showing a complete misunderstanding of the international adjustment mechanism and the disastrous consequences of the gold accumulation policy of the insane Bank of France.

Mr. Spitznagel laments that the economics profession somehow ignored Ludwig von Mises.  Actually, they didn’t.  Some of the greatest economists of the twentieth century were lapsed believers in the Austrian business-cycle theory.  A partial list would include, Mises’s own students, Gottfried Haberler and Fritz Machlup; it would include  Hayek’s dear friend and colleague, Lionel Robbins who wrote a book on the Great Depression eloquently explaining it in terms of the Austrian theory in a way that even Mises might have approved, a book that Robbins later repudiated and refused to allow to be reprinted in his lifetime (but you can order a new edition here); it would include  Hayek’s students, Nobel Laureate J.R. Hicks, Nicholas Kaldor, Abba Lerner, G.L.S. Shackle, and Ludwig Lachmann (who sought a third way incorporating elements of Keynesian and Austrian theory).  Hayek himself modified his early views in important ways and admitted that he had given bad policy advice in the 1930s.  The only holdout was Mises himself, joined in later years after his arrival in America by a group of more doctrinaire (with at least one notable exception) disciples than Mises had found in Vienna in the 1920s and 1930s.  The notion that Austrian theory was ignored by the economics profession and has only lately been rediscovered is just the sort of revisionist history that one tends to find on a lot of wacko Austro-libertarian websites like Lewrockwell.org.  Apparently the Wall Street Journal editorial page is providing another, marginally more respectable, venue for such nonsense.  Rupert, you’re doing a heckuva job.

Some Fallacies in the Interpretation of Inflation

Published December 31, 2011 Hayek , monetary theory 24 Comments

In a post earlier this week I took reporter Jon Hilsenrath of the Wall Street Journal to task for asserting that the recent reduction in inflation was good news, because it meant that more money would be left in people’s pockets than if inflation hadn’t come down.

The real problem with that sentence is the unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is. I do not expect Mr. Hilsenrath to accept my theoretical position that, under current conditions, inflation would contribute to a speedup in the rate of growth in real income, but it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income.

Blogger Jonathan Catalan in turn took me to task in this post.

What Glasner seems to be arguing, though, is that because inflation amongst consumers’ goods necessarily requires rising nominal expenditure (by consumers) real wages remain the same.  That is, prices rise proportionally to the increase in consumer spending.  In order for Glasner’s proposition to be true all consumers’ nominal wages would have to increase proportionally, and the change in prices of individual goods would have to occur in such a way that the value of money in relation to all consumer goods remains the same.  We can deduce right away that such a set of prerequisites is impossible to fulfill.

Actually Catalan is reading more into that quotation than I put into it. All I meant to say was that the existence of inflation is predicated on an increase in total spending compared to an alternative world in which there was no inflation. I am not saying that inflation raises all prices proportionally, I am just saying that if prices in general have risen, total spending, and therefore total income, must also have risen. This not a matter of diagnosing the cause or effects of inflation, it is just simple bookkeeping. Thus, Catalan is aiming at a strawman in his next paragraph, not at me.

Right away, we know that not all consumers’ have had their nominal incomes grow proportionally.  A little over eight percent of the United States’ labor force is unemployed; to that, we can add a large quantity of discouraged workers.  These are consumers who are not earning an income, besides any unemployment or welfare benefits they are receiving (benefits that follow inflation trends, if even that).  The employed labor force are all working for wages set by their employers (based on the demand for specific/unspecific labor and supply of adequate laborers) — I do not think that anybody is assuming that all wages are rising proportionally and simultaneously. [DG:  Just wondering, does Catalan think that wages rise only when employers feel like raising them?]

I didn’t say that all wages were rising proportionally. What I said was that with nominal income rising along with prices, the gains in nominal income as a result of those price increases had to accrue to someone. Thus, insofar as some people were made worse off by inflation, others were made better off. There are of course theories asserting that inflation has either good effects – and others asserting that inflation has bad effects — on the economy, but, for purposes of this discussion, I am not taking sides for or against those theories. In his next paragraph, Catalan repeats the same point, suggesting erroneously that I argued that no one can be made worse off by inflation. But at the most naïve level, i.e., not trying to figure out the indirect and long-term effects of inflation, the losses of some are offset by the gains of others.

Catalan continues, and here he gets himself into trouble.

But, if wages are not rising simultaneously and proportionally for all consumers, then some must suffer from a reduction of the real purchasing power of the dollar.  Abstracting sufficiently, we can pool individuals into those who receive newly created dollars and those who do not.  Those who receive money first will be able to bid new currency towards consumers’ goods at their prices of the immediate past, causing prices to increase.  Those who do not receive this money will have to suffer from an increase in the prices of consumers’ goods.

What is wrong with this statement? Well, first, it’s not clear if new currency is injected into the economy in just one dose, or if injections are ongoing. If the injection is a one-time dose, then Catalan is correct that the sequence in which the new money reaches individuals has some transitory significance on the distribution of gains and losses from transitory inflation. People who get the money first may have some fleeting advantage over people who receive the money only after it has already gone through many hands before reaching them (although even this proposition is subject to any number of potential qualifications). However, if money is being injected continuously or periodically, Catalan’s statement is erroneous, because once the cycle of injection and dispersal is repeated, it is no longer meaningful to identify a particular point of entry as prior to any other point in a continuing cycle. What matters is not the temporal sequence in which the new funds are spent, but whether the injection of new money alters the overall distribution of spending.

Catalan concludes:

Glasner’s mistake — unless I terribly misinterpreted his point — is an over-reliance on the mechanical quantity theory of money and prices.  Yes, inflation is a monetary phenomenon.  That does not mean that inflation actually takes place simultaneously and proportionally amongst the prices of all economic goods and wages.  Instead, prices change relative to each other; some lose and some win.  It was this lack of focus on relative prices that Friedrich Hayek warned about in Prices and Production (although, he was referring to relative prices amongst goods of different stages in the structure of production and this would lead him to his elucidation of intertemporal discoordination).

In a sense, Catalan and I are not that far apart. We agree that monetary expansion can raise prices, and that as it raises prices, newly injected money may also affect relative prices. However, I don’t think that it’s possible to say much about how injections of money affect relative prices unless the monetary authorities are deliberately aiming to put money into the pockets of specific groups of people. But that’s not really how new money is injected into the economy, so I don’t think that trying to find the relative-price effects associated with inflation is very useful way of analyzing the effects of inflation. And that is why Hayek was unable to make a positive contribution to the analysis of business cycles beyond articulating some very general (but nonetheless important) principles about the conditions necessary for intertemporal equilibrium, the importance of stabilizing nominal income over the business cycle, and the ineffectiveness (in most circumstances) of anticipated inflation in increasing employment.

So to come back to the specific point that Catalan took me to task for, although I did not argue that inflation does not affect real wages, I do think that it is far from obvious that inflation has reduced real wages, i.e., that inflation has caused prices to rise faster than wages. Surely some wages have risen less rapidly than prices, but some wages have gone up more rapidly than prices. And as a general proposition, we have little way of determining whether recent changes in relative prices (and wages) were caused by real forces affecting relative prices and wages or by the forces affecting inflation. Given our ignorance of what is causing individual prices to change, there is no obvious basis for suggesting that anyone’s real income has been affected by inflation. If you want to make that claim, be my guest. But there is no inherent property of inflation that justifies it. If you want to make the claim, it’s your burden to come up with an argument to make the claim credible. Good luck.

PS  It looks like this will be my last post for 2011.  Best wishes for 2012.  May it be an improvement on 2011!

Hayek’s 1932 Defense of the Insane Bank of France

Published December 17, 2011 Hawtrey , Hayek , monetary history , monetary policy , monetary theory 27 Comments

In my post last Monday, I suggseted that Hayek’s attachment to the gold standard led him to recommend a policy of deflation during the Great Depression even though his own neutral-money policy criterion of stabilizing aggregate monetary expenditure would have implied aggressive monetary expansion during the Great Depression. Forced to choose between two conflicting principles, Hayek made the wrong choice, opting for defense of the gold standard rather than for stabilizing nominal GDP. He later changed his views, disavowing support for the gold standard as early as 1943 in a paper (“A Commodity Reserve Currency”) in the Economic Journal (reprinted as chapter 10 of Individualism and Economic Order) and reaffirming his opposition to the gold standard in The Constitution of Liberty (p. 335). I cited his 1932 paper “the Fate of the Gold Standard” translated from the original German and republished in his collected works and quoted his opening paragraph lamenting that Britain had abandoned the gold standard because (in September 1931 as the Great Depression was rapidly spiraling downward) Britain found the discipline of the gold standard “irksome.”

I also referred to Hayek’s defense of what I called “the insane French policy of gold accumulation.” I did not want to burden readers of an already long post with further quotations from Hayek’s article, so I just left it there without giving another quotation. But I think it may be worth analyzing what Hayek wrote, not because I want to make Hayek look bad, but because his defense of the Bank of France betrays a basic misunderstanding of the theory of international monetary adjustment and how the gold standard worked that is characteristic of many discussions of the gold standard.

Here is what Hayek wrote (F. A. Hayek, The Collected Works of F. A. Hayek, Good Money, Part 1, p. 160).

The accusation that France systematically hoarded gold seems at first sight to be more likely to be correct [than the charge that the US Federal Reserve had been hoarding gold, an accusation dismissed in the previous paragraph]. France did pursue an extremely cautious foreign policy after the franc stabilized at a level which considerably undervalued it with respect to its domestic purchasing power, and prevented an expansion of credit proportional to the amount of gold coming in. Nevertheless, France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow – and this alone is necessary for the gold standard to function.

Hayek made a fundamental error here, assuming that a small open economy (which France could be considered to have been in the late 1920s) had control over its money supply and its price level under the gold standard. The French price level, once France pegged the franc to the dollar in 1926 at $0.0392/franc, was no longer under the control of French monetary authorities, commodity arbitrage requiring commodity prices quoted in francs to equal commodity prices quoted in dollars adjusted for the fixed dollar/franc parity. The equalization was not perfect, because not all commodities enter into international trade and because there are differences between similar products sold in different countries that preclude full price equalization. But there are strict limits on how much national price levels could diverge under a gold standard. Similarly, the money supply in a country on the gold standard could not be controlled by the monetary authority of that country, because if people in that country wanted to hold more money than the monetary authority made available, they could increase their holdings of money by increasing exports or decreasing imports, thereby generating an inflow of gold, which could be converted into banknotes or deposits.

So Hayek’s observation that France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow means only that the Bank of France refused to increase the French money supply at all (or even attempted to decrease it), forcing the French to increase their holdings of cash by acquiring gold through an export surplus. Hayek’s statement thus betrays a total misunderstanding of what “is necessary for the gold standard to function.” All that was necessary was that France maintain a fixed parity between the dollar and the franc, not that the Bank of France achieve a particular change in the money supply governed by the amount that its holdings of gold had changed. Hayek wrongly assumed that the French monetary authorities had control over the French money supply and that the inflow of gold was somehow determined by real forces independent of French monetary conditions. But it was just the opposite. The French money supply increased because the French wanted to increase the amount of cash balances they were holding. The only question was whether the French banking system would be allowed by the Bank of France to accommodate the French demand for money by increasing the French money supply, or whether the desired increase in the money supply would be permitted only through gold imports generated by an export surplus. Refusing to allow the French money supply to increase except through the importation of gold meant that the increase in the French demand for money was transformed into an equivalent increase in French (and, hence, the world) demand for gold, thereby driving up the value of gold, the proximate source of the deflation that produced the Great Depression.

As I said, this misconception of money supply adjustment under the gold standard was not unique to Hayek.  In some ways it is characteristic of many orthodox treatments of the gold standard and it can be traced back at least to the British Currency School of the 1830 and 1840s, if not even further back to David Hume in the 18th century.  Milton Friedman was similarly misguided in many of his discussions of the gold standard and international adjustment, especially in his discussion of the Great Depression in his Monetary History of the United States.  Ralph Hawtrey, as usual, got it right.  But the analysis was much later articulated in more conventional model by Harry Johnson and his associates in their development of the monetary approach to the balance of payments.

Keynes v. Hayek: Enough Already

Published December 12, 2011 Cassel , Hawtrey , Hayek , Keynes , monetary history , monetary policy , monetary theory 78 Comments

First, it was the Keynes v. Hayek rap video, and then came the even more vulgar and tasteless Keynes v. Hayek sequel video reducing the two hyperintellectuals to prize fighters. (The accuracy of the representations signaled in its portrayal of Hayek as bald and Keynes with a full head of hair when in real life it was the other way around.) Then came a debate broadcast by the BBC at the London School of Economics, and then another sponsored by Reuters with a Nobel Prize winning economist on the program arguing for the Hayek side. Now comes a new book by Nicholas Wapshott Keynes Hayek, offering an extended account of the fraught relationship between two giants of twentieth century economics who eventually came to a sort of intellectual détente toward the end of Keynes’s life, a decade or more after a few years of really intense, even brutal, but very high level, polemical exchanges between them (and some of their surrogates) in the pages of England’s leading economics journals. Tyler Cowen has just reviewed Wapshott’s book in the National Review (see Marcus Nunes’s blog).

As I observed in September after watching the first Keynes-Hayek debate, we can still learn a lot by going back to Keynes’s and Hayek’s own writings, but all this Keynes versus Hayek hype creates the terribly misleading impression that the truth must lie with only one side or the other, that one side represents truth and enlightenment and the other represents falsehood and darkness, one side represents pure disinterested motives and the other is shilling for sinister forces lurking in the wings seeking to advance their own illegitimate interests, in short that one side can be trusted and the other cannot. All this attention on Keynes and Hayek, two charismatic personalities who have become figureheads or totems for ideological movements that they might not have endorsed at all — and certainly not endorsed unconditionally — encourages an increasingly polarized discussion in which people choose sides based on pre-existing ideological commitments rather than on a reasoned assessment of the arguments and the evidence.

In part, this framing of arguments in ideological terms simply reflects existing trends that have been encouraging an increasingly ideological approach to politics, law, and public policy. For an example of this approach, see Naomi Klein’s recent musings about global warming and the necessity for acknowledging that combating global warming requires the very social transformation that makes right-wingers oppose, on ideological principle, any measure to counter global warming.  Those are just the terms of debate that Naomi Klein wants.  Thus, both sides have come to see global warming not as a problem to be addressed or mitigated, but as a weapon to be used in the context of a comprehensive ideological struggle. Those who want to address the problem in a pragmatic, non-ideological, way are losing control of the conversation.

The amazing thing about the original Keynes-Hayek debate is not only that both misunderstood the sources of the Great Depression for which they were confidently offering policy advice, but that Ralph Hawtrey and Gustav Cassel had explained what was happening ten years before the downturn started in the summer of 1929. Both Hawtrey and Cassel understood that restoring the gold standard after the demonetization of gold that took place during World War I would have hugely deflationary implications if, when the gold standard was reinstated, the world’s monetary demand for gold would increase back to the pre-World War I level (as a result of restoring gold coinage and the replenishment of the gold reserves held in central bank coffers). That is why both Hawtrey and Cassel called for measures to limit the world’s monetary demand for gold (measures agreed upon in the international monetary conference in Genoa in 1922 of which Hawtrey was the guiding spirit). The measures agreed upon at the Genoa Conference prevented the monetary demand for gold from increasing faster than the stock of gold was increasing so that the world price level in terms of gold was roughly stable from about 1922 through 1928. But in 1928, French demand for gold started to increase rapidly just as the Federal Reserve began tightening monetary policy in a tragically misguided effort to squelch a supposed stock-price bubble on Wall Street, causing an inflow of gold into the US while the French embarked on a frenzied drive to add to their gold holdings, and other countries rejoining the gold standard were increasing their gold holdings as well, though with a less fanatical determination than the French. The Great Depression was therefore entirely the product of monetary causes, a world-wide increase in gold demand causing its value to increase, an increase manifesting itself, under the gold standard, in deflation.

Hayek, along with his mentor Ludwig von Mises, could also claim to have predicted the 1929 downturn, having criticized the Fed in 1927, when the US was in danger of falling into a recession, for reducing interest rates to 3.5%, by historical standards far from a dangerously expansionary rate, as Hawtrey demonstrated in his exhaustive book on the subject A Century of Bank Rate. But it has never been even remotely plausible that a 3.5% discount rate at the Fed for a little over a year was the trigger for the worst economic catastrophe since the Black Death of the 14th century. Nor could Keynes offer a persuasive explanation for why the world suddenly went into a catastrophic downward spiral in late 1929. References to animal spirits and the inherent instability of entrepreneurial expectations are all well and good, but they provide not so much an explanation of the downturn as a way of talking about it or describing it. Beyond that, the Hawtrey-Cassel account of the Great Depression also accounts for the relative severity of the Depression and for the sequence of recovery in different counties, there being an almost exact correlation between the severity of the Depression in a country and the existence and duration of the gold standard in the country. In no country did recovery start until after the gold standard was abandoned, and in no country was there a substantial lag between leaving the gold standard and the start of the recovery.

So not only did Hawtrey and Cassel predict the Great Depression, specifying in advance the conditions that would, and did, bring it about, they identified the unerring prescription – something provided by no other explanation — for a country to start recovering from the Great Depression. Hayek, on the other hand, along with von Mises, not only advocated precisely the wrong policy, namely, tightening money, in effect increasing the monetary demand for gold, he accepted, if not welcomed, deflation as the necessary price for maintaining the gold standard. (This by the way is what explains the puzzle (raised by Larry White in his paper “Did Hayek and Robbins Deepen the Great Depression?”) of Hayek’s failure to follow his own criterion for a neutral monetary policy, stated explicitly in chapter 4 of Prices and Production: stabilization of nominal expenditure (NGDP). However, a policy of stabilizing nominal expenditure was inconsistent with staying on the gold standard when the value of gold was rising by 5 to 10% a year. Faced with a conflict between maintaining the gold standard and following his own criterion for neutral money, Hayek, along with his friend and colleague Lionel Robbins in his patently Austrian book The Great Depression, both opted for maintaining the gold standard.)

Not only did Hayek make the wrong call about the gold standard, he actually defended the insane French policy of gold accumulation in his lament for the gold standard after Britain wisely disregarded his advice and left the gold standard in 1931. In his paper “The Fate of the Gold Standard” (originally Das Schicksal der Goldwahrung) reprinted in The Collected Works of F. A. Hayek: Good Money, Part 1, Hayek mourned the impending demise of the gold standard after Britain tardily did the right thing. The tone of Hayek’s lament is struck in his opening paragraph (p. 153).

There has been much talk about the breakdown of the gold standard, particularly in Britain where, to the astonishment of every foreign observer, the abandonment of the gold standard was very widely welcomed as a release from an irksome constraint. However, it can scarcely be doubted that the renewed monetary problems of almost the whole world have nothing to do with the tendencies inherent in the gold standard, but on the contrary stem from the persistent and continuous attempts from many sides over a number of years to prevent the gold standard from functioning whenever it began to reveal tendencies which were not desired by the country in question. Hence it was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the “rules of the game” by the breakdown of their gold standard.

So what do we learn from this depressing tale? Hawtrey and Cassel did everything right. They identified the danger to the world economy a decade in advance. They specified exactly the correct policy for avoiding the danger. Their policy was a huge success for about nine years until the Americans and the French between them drove the world economy into the Great Depression, just as Hawtrey and Cassel warned would happen if the monetary demand for gold was not held in check. Within a year and a half, both Hawtrey and Cassel concluded that recovery was no longer possible under the gold standard. And as countries, one by one, abandoned the gold standard, they began to recover just as Hawtrey and Cassel predicted. So one would have thought that Hawtrey and Cassel would have been acclaimed and celebrated far and wide as the most insightful, the most farsighted, the wisest, economists in the world. Yep, that’s what one would have thought. Did it happen? Not a chance. Instead, it was Keynes who was credited with figuring out how to end the Great Depression, even though there was almost nothing in the General Theory about the gold standard and a 30% deflation as the cause of the Great Depression, despite his having vilified Churchill in 1925 for rejoining the gold standard at the prewar parity when that decision was expected to cause a mere 10% deflation.

But amazingly enough, even when economists began looking for alternative ways to Keynesianism of thinking about macroeconomics, Austrian economics still being considered too toxic to handle, almost no one bothered to go back to revisit what Hawtrey and Cassel had said about the Great Depression. So Milton Friedman was considered to have been daring and original for suggesting a monetary explanation for the Great Depression and finding historical and statistical support for that explanation. Yet, on the key elements of the historical explanation, Hawtrey and Cassel either anticipated Friedman, or on the numerous issues on which Friedman did not follow Hawtrey and Cassel — in particular the international gold market as the transmitter of deflation and depression across all countries on the gold standard, the key role of the Bank of France (which Friedman denied in the Monetary History and for years afterwards only to concede the point in the mid to late 1990s), the absence of an explanation for the 1929 downturn, the misplaced emphasis on the contraction of the US money stock and the role of U.S. bank failures as a critical factor in explaining the severity of the Great Depression — Hawtrey and Cassel got it right and Friedman got it wrong.

So what matters in the success in the marketplace of ideas seems to be not just the quality or the truth of a theory, but also (or instead) the publicity machine that can be deployed in support of a theory to generate interest in it and to attract followers who can expect to advance their own careers in the process of developing, testing, or otherwise propagating, the theory. Keynes, Friedman, and eventually Hayek, all had powerful ideologically driven publicity machines working on their behalf. And guess what? It’s the theories that attract the support of a hard core of ideologically motivated followers that tend to outperform those without a cadre of ideological followers.

That’s why it was very interesting, important, and encouraging that Tyler Cowen, in his discussion of the Keynes-Hayek story, felt the need to mention how Scott Sumner has shifted the debate over the past two years away from the tired old Keynes vs. Hayek routine. Of course Tyler, about as well read an economist as there is, slipped up when he said that Scott is reviving the Friedman Monetarist tradition. No, Scott is reviving the Hawtrey-Cassel pre-Monetarist tradition, of which Friedman’s is a decidedly inferior, and obsolete, version. It just goes to show that one person sometimes really can make a difference, even without an ideologically driven publicity machine working on his behalf. Just imagine what Hawtrey and Cassel could have accomplished if they had been bloggers.

Policy Rules Are Not Rules, They Are Policies

Published December 6, 2011 Hayek , monetary policy 38 Comments

I have been giving John Taylor a lot of attention lately (see here, here, here, and here). I should probably lay off, but I think there is an important point to be made, and I am going to try one more time to get to the bottom of what I find disturbing about Taylor’s advocacy of rule-like behavior by central bankers. Some of what I want to say has already been said by Nick Rowe in his excellent post responding to Taylor’s criticism of NGDP targeting, but I want to address more directly Taylor’s actual statements than Nick did.

Taylor argues that targeting objectives, like NGDP, is not a policy rule at all, but rather a way of giving the central bank the discretion to do what it wants under the guise of what purports to be a policy rule that isn’t a rule at all. Here is how Taylor put it.

NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

As I pointed out in my previous post, Friedman’s proposed rule for money supply growth is an exceedingly inapt example of an instrument rule, because the Fed has no more control over the money supply than it does over NGDP, as Friedman himself belatedly had to acknowledge. Now it is true that the Fed can control the short-term interest rate, so it is an instrument. The Taylor rule, a recipe for the short-term interest rate, specified in terms of the difference between the actual and the target rates of inflation and the difference between actual and potential GDP, does qualify as an instrument rule (on Taylor’s understanding of the term). But, as Nick Rowe points out, potential GDP being unobservable, it must be estimated. The higher potential GDP, the lower the implied short-term interest rate. So even the Taylor rule does not preclude an exercise of discretion by the Fed.

Perhaps the failure of the Taylor rule to preclude any exercise of discretion is why Taylor in the article by Amity Shlaes to which he refers seems to be offering a pared down version of the Taylor rule. Shlaes writes:

In response to my query about NGDP, Taylor sent a description of the reform he seeks — not widening the Fed’s growth mandate, but rather removing it [my emphasis]. Taylor says he would like to see reform happen in this order: 1) Congress enacts a single mandate for price stability; 2) Congress enacts reporting requirements for the Fed on what its strategy or policy rule is; and 3) the Fed picks a strategy relating to money and interest rates and tells the public what that strategy is.

One can’t really be sure what this means, but wouldn’t enacting “a single mandate for price stability” require the Fed to base its choice of the short-term interest rate solely on the difference between the actual and the target rates of inflation regardless of the difference between actual and potential GDP? After all, allowing the Fed to take into consideration whether actual GDP is less than potential increases the scope for the Fed to exercise discretion.

But there is something else disturbing about Taylor’s fixation on rules. I have been writing about the long-running debate about rules versus discretion in monetary policy on this blog for a while, especially the past couple of weeks, but failing to identify the critical semantic confusion that infects much of the rules versus discretion debate, and especially Taylor’s pronouncements. It was not until I read the following comment by W. Peden on my post Rules v. Discretion that the point suddenly became clear to me.

It’s a shame that there isn’t a widely used term in economics that means something like “precise orders” to distinguish from our usual use of “rule”, which means something like a restriction on possible action. A rule does not give exact and invariable instructions.

So, for example, the Taylor rule is really a kind of varying imperative, since it gives precise instructions on the short-term interest rate. In contrast, targeting NGDP along a trend is a rule because it allows for a huge variety of actions within that period; in a once-in-a-lifetime financial crisis like the early 1930s or 2008-2009, it would require quite radical discretionary actions so that the trend could be maintained.

Peden is completely right to say that the Taylor rule is not a rule at all, it is a command to a policy maker to adopt a policy of a certain kind. But policies are not rules. Rules do not prescribe specific actions they impose certain constraints on the manner in which agents can take actions in the pursuit of goals that they, not the author of the rules, have chosen. Introducing the language of rules into a discussion of policy reflects an effort (either conscious or unconscious) to borrow the authority of the political ideal of the rule of law as a support for the particular policy being advocated. The point was obliquely recognized by F. A. Hayek in a passage from the Constitution of Liberty that I quoted in my previous post. And it bears repeating.

It should perhaps be explicitly stated that the case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals.

The political ideal of the rule of law does bear on the use of coercive powers of government, because the political ideal of the rule of law (sometimes called substantive due process by Constitutional lawyers) is meant to constrain the government in exercising coercive powers. But that political ideal has nothing to do with the formulation of policy when (e.g., in the case of setting monetary policy) it involves no exercise of coercion.

So, notwithstanding Friedman’s assertion in Capitalism and Freedom, endorsed by Taylor, there is no principled presumption in favor of formulating policies in terms of specific commands requiring the monetary authorities to set instruments under their direct control according to a recipe or formula defined in terms of an arithmetic formula. The notion that there is any political principle requiring a policy supposed to achieve some desired objective to be so formulated is based on a semantic confusion between rules and policies and on a complete misunderstanding of the political principle requiring governments to follow rules in exercising their coercive powers.

It is still conceivable that monetary policy in terms of a recipe for an instrument of monetary policy might lead to the best possible outcome. It is also conceivable that flying an airplane on automatic pilot would lead to a better outcome than having a trained pilot fly the plane. Indeed, that could be true under some circumstances, but it verges on the preposterous to suppose that it would never be desirable (or indeed imperative) for a live pilot to override the automatic pilot. But that suggests that ultimately policy ought to be formulated in terms of the objectives sought rather than in terms of what is no more than a recipe for an instrument by which the policy objective is to be pursued.

John Taylor’s Obsession with Rules

Published December 3, 2011 Hayek , monetary policy 18 Comments

In my previous post about George Selgin’s comment on John Taylor’s critique of NGDP targeting, I observed that Selgin had correctly focused on Taylor’s ambiguous use of the concept of an “inflation shock” without identifying the nature of the shock (violating Scott Sumner’s dictum “never reason from a price change). As Selgin pointed out, if the inflation shock were caused by a shock to aggregate supply, NGDP targeting would do better than a price-level or inflation rule. If the source of the inflation shock were excessive aggregate demand, well, that just means that NGDP had not been targeted. But there was another part of Taylor’s post, not addressed by Selgin, deserving of attention.  Taylor writes:

NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

Taylor goes on to elaborate, invoking the authority of Milton Friedman, on the properties that a rule governing the conduct of a central bank ought to have.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, [coincidentally mentioning Taylor six times and quoting him twice!] NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

The first point to make about this remark is that the money supply rule Friedman advocated, and Taylor endorses — despite its unworkability in theory (Goodhart’s Law) and its demonstrated unworkability in practice when adopted by the Fed under Paul Volcker in the early 1980s — did not – obviously did not! — satisfy Friedman’s own criterion of being stated in terms of “objectives that the monetary authorities . . . have the clear and direct power to achieve by their own actions.” The monetary aggregate that Friedman wanted to grow at a fixed rate was, for the most part, produced by private banks, not by the Fed, so there was obviously no way that the Fed could achieve its objectives for the growth of M1, M2, or Mwhatever by its own actions.

So what should one conclude from this? That Friedman was a hypocrite? I don’t think so. But he did have a propensity for getting carried away by his enthusiasms, and he took his enthusiasm for rules to an extreme, supposing that all problems of monetary policy could be solved by prescribing a rule for a fixed rate of growth in the money supply. Even in 1960, that was a remarkably simplistic, actually simple-minded, position to have taken, but in his obsession for simple rules, he thought he had found the Holy Grail of monetary policy. That John Taylor, half a century later, could approvingly cite Friedman’s rule for the rate of growth in the money supply as a benchmark by which to judge other monetary policy rules speaks volumes about Taylor’s grasp of what constitutes good monetary policy.

Actually to gain some obviously needed insight into monetary policy rules, Professor Taylor could do a lot worse than to start with Chapter 21 of Hayek’s Constitution of Liberty. Friedman could have profited from reading it as well, but Friedman, obviously disdaining Hayek’s abilities as an economist, probably did not take it seriously. Let’s have a look at some of what Hayek had to say on the subject of rules and monetary policy.

The case for “rules versus authorities in monetary policy” has been persuasively argued by the late Henry Simons [one of Friedman’s teachers at Chicago] in a well-known essay. The arguments advanced there in favor of strict rules are so strong that the issue is now largely one of how far it is practically possible to tie down monetary authority by appropriate rules. It may still be true that if there were full agreement as to what monetary policy ought to aim for, an independent monetary authority, fully protected against political pressure and free to achieve the ends it has been assigned, might be the best arrangement. . . . But the fact that the responsibility for monetary policy today inevitably rests in part with agencies whose main concern is with government finance probably strengthens the case against allowing much discretion and for making decisions on monetary policy as predictable as possible.

It should perhaps be explicitly stated that the case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals. The argument against discretion in monetary policy rests on the view that monetary policy and its effects should be as predictable as possible. The validity of the argument depends, therefore, on whether we can devise an automatic mechanism which will make the effective supply of money change in a more predictable and less disturbing manner than will any discretionary measures likely to be adopted. The answer is not certain. No automatic mechanism is known which will make the total supply of money adapt itself exactly as we would wish, and the most we can say in favor of any mechanism (or action determined by rigid rules) is that it is doubtful whether in practice any deliberate control would be better. The reason for this doubt is partly that the conditions in which monetary authorities have to make their decisions are usually not favorable to the prevailing of long views, partly that we are not too certain what they should do in particular circumstances and that, therefore, uncertainty about what they will do is necessarily greater when they do not act according to fixed rules. (p. 334)

And a bit later:

There is one basic dilemma, which all central banks face, which makes it inevitable that their policy must involve much discretion. A central bank can exercise only an indirect and therefore limited control over all the circulating media. Its power is based chiefly on the threat of not supplying cash when it is needed. Yet at the same time it is considered to be its duty never to refuse to supply this case at a price when needed. It is this problem, rather than the general effects of policy on prices or the value of money, that necessarily preoccupies the central banker in his day-to-day actions. It is a task which makes it necessary for the central bank constantly to forestall or counteract development in the realm of credit, for which no simple rules can provide sufficient guidance.

The same is nearly as true of the measure intended to affect prices and employment. They must be directed more at forestalling changes before they occur than at correcting them after they have occurred. If a central bank always waited until rule or mechanism forced it to take action, the resulting fluctuations would be much greater than they need be. . . .

[U]nder present conditions we have little choice but to limit monetary policy by prescribing its goals rather than its specific actions. The concrete issue today is whether it ought to kepp stable some level of employment or some level of prices. Reasonably interpreted and with due allowance made for the inevitability of minor fluctuations around a given level, these two aims are not necessarily in conflict, provided that the requirements for monetary stability are given first place and the rest of economic policy is adapted to them. A conflict arises, however, if “full employment” is made the chief objective and this is interpreted, as it sometimes is, as that maximum of employment which can be produced by monetary means in the short run. That way lies progressive inflation. (pp. 336-37)

Professor Taylor, forget Friedman, and study Hayek.

The Tender-Hearted Prof. Sumner Gives Mises and Hayek a Pass

Published November 29, 2011 Hayek , monetary history , monetary policy , monetary theory 50 Comments

Scott Sumner is such a kindly soul. You can count on him to give everyone the benefit of the doubt, bending over backwards to find a way to make sense out of the most ridiculous statement that you can imagine. Even when he disagrees, he expresses his disagreement in the mildest possible terms. And if you don’t believe me, just ask Paul Krugman, about whom Scott, despite their occasional disagreements, always finds a way to say something nice and complimentary. I have no doubt that if you were fortunate enough to take one of Scott’s courses at Bentley, you could certainly count on getting at least a B+ if you showed up for class and handed in your homework, because Scott is the kind of guy who just would not want to hurt anyone’s feelings, not even a not very interested student. In other words, Scott is the very model of a modern major general – er, I mean, of a modern sensitive male.

But I am afraid that Scott has finally let his niceness get totally out of hand. In his latest post “The myth at the heart of internet Austrianism,” Scott ever so gently points out a number of really serious (as in fatal) flaws in Austrian Business Cycle Theory, especially as an explanation of the Great Depression, which it totally misdiagnosed, wrongly attributing the downturn to a crisis caused by inflationary monetary policy, and for which it prescribed a disastrously mistaken remedy, namely, allowing deflation to run its course as a purgatory of the malinvestments undertaken in the preceding boom. Scott certainly deserves a pat on the back for trying to shed some light on a subject as fraught with fallacy and folly as Austrian Business Cycle Theory, but unfortunately Scott’s niceness got the better of him when he made the following introductory disclaimer:

This post is not about Austrian economics, a field I know relatively little about. [Scott is not just nice, he is also modest and self-effacing to a fault, DG] Rather it is a response to dozens of comments I have received by people who claim to represent the Austrian viewpoint.

And then after his partial listing of the problems with Austrian Business Cycle Theory, Scott just couldn’t help softening the blow with the following comment.

Austrian monetary economics has some great ideas – most notably NGDP targeting. I wish internet Austrians would pay more attention to Hayek, and less attention to whoever is telling them that the Depression was triggered by the collapse of an inflationary bubble during the 1920s. There was no inflationary bubble, by any reasonable definition of the world “inflation.”

Scott greatly admires Hayek (as do I), so he sincerely wants to believe that the mistakes of Austrian Business Cycle Theory are not Hayek’s fault, but are the invention of some nasty inauthentic Internet Austrians. In fact, because in a few places Hayek seemed to understand that an increased demand for money (aka a reduction in the velocity of circulation) would cause a reduction in total spending (aggregate demand or nominal income) unless matched by an increased quantity of money, acknowledging that, at least in principle, the neutral monetary policy he favored should not hold the stock of money constant, but should aim at a constant level of total spending (aggregate demand or nominal income), Scott wants to absolve Hayek from responsibility for the really bad (as in horrendous) policy advice he offered in the 1930s, opposing reflation and any efforts to increase spending by deliberately increasing the stock of money. During the Great Depression, Hayek’s recognition that in principle the objective of monetary policy ought to be to stabilize total spending was more in the way of a theoretical nuance than a bedrock principle of monetary policy. The recognition is buried in chapter four of Prices and Production. The tenor of his remarks and the uselessness of his recognition in principle that total spending should be stabilized are well illustrated by the following remark at the beginning of the final section of the chapter

Anybody who is sceptical of the value of theoretical analysis if it does not result in practical suggestions for economic policy will probably be deeply disappointed by the small return of so prolonged an argument.

Then in the 1932 preface to the English translation of his Monetary Theory and the Trade Cycle, Hayek wrote the following nugget:

Far from following a deflationary policy, Central Banks, particularly in the United States, have been making earlier and more far reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion – with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices which existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. (pp. 19-20)

And then Hayek came to this staggering conclusion (which is the constant refrain of all Internet Austrians):

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind which has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve system in 1927, an experiment which Mr. A. C. Miller, the only economist on the Federal Reserve Board [the Charles Plosser of his time, DG] and, at the same time, its oldest member, has rightly characterized as “the greatest and boldest operation ever undertaken by the Federal reserve system”, an operation which “resulted in one of the most costly errors committed by it or any other banking system in the last 75 years”. It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world [like, say, France for instance? DG] has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown. [OMG, DG] (pp. 21-22)

That the orthodox Austrian (espoused by Mises, Hayek, Haberler, and Machlup) view at the time was that the Great Depression was caused by an inflationary monetary policy administered by the Federal Reserve in concert with other central banks at the time is clearly shown by the following quotation from Lionel Robbins’s book The Great Depression. Robbins, one of the great English economists of the twentieth century, became a long-distance disciple of Mises and Hayek in the 1920s and was personally responsible for Hayek’s invitation to deliver his lectures (eventually published as Prices and Production) on Austrian Business Cycle Theory at the London School of Economics in 1931, and after their huge success, arranged for Hayek to be offered a chair in economic theory at LSE. Robbins published his book on the Great Depression in 1934 while still very much under the influence of Mises and Hayek. He subsequently changed his views, publicly disavowing the book, refusing to allow it to be reprinted in his lifetime.

Thus in the last analysis, it was deliberate co-operation between Central bankers, deliberate “reflation” on the part of the Federal Reserve authorities, which produced the worst phase of this stupendous fluctuation. Far from showing the indifference to prevalent trends of opinion, of which they have so often been accused, it seems that they had learnt the lesson only too well. It was not old-fashioned practice but new-fashioned theory which was responsible for the excesses of the American disaster. (p. 54)

Like Robbins, Haberler and Machlup, who went on to stellar academic careers in the USA, also disavowed their early espousal of ABCT. Mises, unable to tolerate apostasy on the part of traitorous erstwhile disciples, stopped speaking to them. Hayek, though never disavowing his earlier views as Robbins, Haberler, and Machlup had, acknowledged that he had been mistaken in not forthrightly supporting a policy of stabilizing total spending. Mises was probably unhappy with Hayek for his partial u-turn, but continued speaking to him nevertheless. Of course, Internet Austrians like Thomas Woods, whose book Meltdown was a best-seller and helped fuel the revival of Austrianism after the 2008 crisis, feel no shame in citing the works of Hayek, Haberler, Machlup, and Robbins about the Great Depression that they later disavowed in whole or in part, without disclosing that the authors of the works being cited changed or even rejected the views for which they were being cited.

So I am sorry to have to tell Scott: “I know it’s hard for you, but stop trying to be nice to Mises and Hayek. They were great economists, but they got the Great Depression all wrong. Don’t try to sugarcoat it. It can’t be done.”

Keynes v. Hayek: Advantage Hawtrey

Published September 6, 2011 Hawtrey , Hayek , Keynes , monetary policy , monetary theory 21 Comments

On Labor Day, I finally got around to watching the Keynes v. Hayek debate at  the London School of Economics on August 3 between Robert Skidelsky and Duncan Weldon on behalf of Keynes and George Selgin and Jamie Whyte on behalf of Hayek.  Inspired by the Hayek-Keynes rap videos, the debate, it seems to me, did not rise very far above the intellectual level of the rap videos, with both sides preferring to caricature the other side rather than engage in a debate on the merits.  The format of the debate, emphasizing short declaratory statements and sound bites, invites such tactics.

Thus, Robert Skidelsky began the proceedings by lambasting Hayek for being a liquidationist in the manner of Andrew Mellon (as rather invidiously described by his boss, Herbert Hoover, in the latter’s quest in his memoirs for self-exculpation), even though Skidelsky surely is aware that Hayek later disavowed his early policy recommendations in favor of allowing deflation to continue with no countermeasures.  Skidelsky credited FDR’s adoption of moderate Keynesian fiscal stimulus as the key to a gradual recovery from the Great Depression until massive spending on World War II brought about the Depression to a decisive conclusion.

Jamie Whyte responded with a notably extreme attack on Keynesian policies, denying that Keynesian policies, or apparently any policy other than pure laissez-faire, could lead to a “sustainable” recovery rather than just sow the seeds of the next downturn, embracing, in other words, the very caricature that Skidelsky had just unfairly used in his portrayal of Hayek as an out-of-touch ideologue.  George Selgin was therefore left with the awkward task of defending Hayek against both Skidelsky and his own colleague.

Selgin contended that it was only in the 1929-31 period that Hayek argued for deflation as a way out of depression, but later came to recognize that a contraction of total spending, associated with an increasing demand by the public to hold cash, ought, in principle, to be offset by a corresponding increase in the money supply to stabilize the aggregate flow of expenditure.   Larry White has documented the shift in Hayek’s views in a recent paper, but the argument is a tad disingenuous, because, despite having conceded this point in principle in some papers in the early to mid-1930s, Hayek remained skeptical that it could be implemented in practice, as Selgin has shown himself to be here.  It was not until years later that Hayek expressed regret for his earlier stance and took an outspoken and unequivocal stand against deflation and a contraction in aggregate expenditure.

I happen to think that one can learn a lot form both Hayek and Keynes.  Both were profound thinkers who had deep insights into economics and the workings of market economies.  Emotionally, I have always been drawn more to Hayek, whom I knew personally and under whom I studied when he visited UCLA in my junior year, than to Keynes.  But Hayek’s best work verged on the philosophical, and his philosophical and scholarly bent did not suit him for providing practical advice on policy.  Hayek, himself, admitted to having been dazzled by Keynes’s intellect, but Keynes could be too clever by a half, and was inclined to be nasty and unprincipled when engaged in scholarly or policy disputes, the list of his victims including not only Hayek, but A. C. Pigou and D. H. Robertson, among others.

So if we are looking for a guide from the past to help us understand the nature of our present difficulties, someone who had a grasp of what went wrong in the Great Depression, why it happened and why it took so long to recover from, our go-to guy should not be Keynes or Hayek, but the eminent British economist, to whose memory this blog is dedicated, Ralph Hawtrey.  (For further elaboration see my paper “Where Keynes Went Wrong.”)  It was Hawtrey who, before anyone else, except possibly Gustav Cassel, recognized the deflationary danger inherent in restoring a gold standard after it had been disrupted and largely abandoned during World War I.  It was Hawtrey, more emphatically than Keynes, who warned of the potential for a deflationary debacle as a result of a scramble for gold by countries seeking to restore the gold standard, a scramble that began in earnest in 1928 when the Bank of France began cashing in its foreign exchange reserves for gold bullion, a  move coinciding with the attempt of the Federal Reserve System to check what it regarded as a stock-market bubble by raising interest rates, attracting an inflow of gold into the United States just when the Bank of France and other central banks were increasing their own demands for gold.  It was the confluence of those policies in 1928-29, not a supposed inflationary boom that existed only in the imagination of Mises and Hayek and their followers that triggered the start of a downturn in the summer of 1929 and the stock-market crash of October 1929.   Once the downturn and the deflation took hold, the dynamics of the gold standard transmitted a rapid appreciation in the real value of gold across the entire world from which the only escape was to abandon the gold standard.

Leaving the gold standard, thereby escaping the deflation associated with a rising value of gold, was the one sure method of bringing about recovery.  Fiscal policy may have helped — certainly a slavish devotion to balancing the budget and reducing public debt – could do only harm, but monetary policy was the key.  FDR, influenced by George Warren and Frank Pearson, two Cornell economists, grasped both the importance of stopping deflation and the role of the gold standard in producing and propagating deflation.  So, despite the opposition of some of his closest advisers and the conventional wisdom of the international financial establishment, he followed the advice of Warren and Pearson and suspended the gold standard shortly after taking office, raising the gold price in stages from $20.67 an ounce to $35 an ounce.  Almost at once, a recovery started, the fastest recovery over any 4-month period (from April through July 1933) in American history.

Had Roosevelt left well enough alone, the Great Depression might have been over within another year, or two at the most, but FDR could not keep himself from trying another hare-brained scheme, and forced the National Industrial Recovery Act through Congress in July 1933.  Real and money wages jumped by 20% overnight; government sponsored cartels perversely cut back output to raise prices.  As a result, the recovery slowed to a crawl, not picking up speed again till 1935 when the NRA was ruled unconstitutional by the Supreme Court.  Thus, whatever recovery there was under FDR owed at least as much to monetary policy as to fiscal policy.  Remember also that World War II was a period of rapid inflation and monetary expansion along with an increase in government spending for the war.  In addition, the relapse into depression in 1937-38 was at least as much the result of monetary as of fiscal tightening.

I would never say forget about Keynes or Hayek, but really the true master– the man whom Keynes called his “grandparent in the paths of errancy” — was Ralph G. Hawtrey.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 665 other subscribers
Follow Uneasy Money on WordPress.com