It’s fair to think of many of Hayek’s works as reactive—written in response to ideas that Hayek considered incorrect. Yet Prices and Production is different: it is a basic summary of Hayek’s ideas and the Austrian School of thought on which he drew.
Prices and Production was a summary of four lectures that Hayek delivered at the London School of Economics in 1931—while he was still in his early 30s. In these lectures, he explains the origin of many concepts developed on the Continent but less accepted in Britain. A key idea in his thesis is the “structure of production” model that he employed in his refutation of Foster & Catchings’ The Dilemma of Thrift.
1: How Money Influences Prices
The keys of Hayek’s series are twofold: “the real changes of the structure of production which accompany changes in the amount of capital and the monetary mechanism which brings this change about.”
The State of Monetary Theory
Hayek opens his lecture by contending that the early 20th century’s monetary theories were not original, but in fact were well-understood by economic writers a century earlier. Further, he claims “that some of the most fundamental problems in this field remain unsolved, that some of the accepted doctrines are of a very doubtful validity, and that we have even failed to develop the suggestions for improvement which can be found in the works of these early writers.”
He finds this lapse all the more ironic given the difficult economic period of the two prior decades: a World War, post-war inflation, and the contraction of currency that accompanied Britain’s return to the gold standard. After all: “In the past, periods of monetary disturbance have always been periods of great progress in this branch of economics. The Italy of the sixteenth century [Medici Florence, etc.] has been called the country of the worst money and the best monetary theory.”
The Aggregates Fallacy
Hayek’s claim that the “general” price level does not exercise “influence on the decisions of individuals” seems incongruous with our economic climate today, in which decisions and sentiments certainly appear influenced by a few key aggregated data points—like the Consumer Price Index. But Hayek’s contention appears to rely not on scant availability of such data at the time, but rather the fact that “neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc.”
This denigration of aggregation is starkly contrasted with Keynes’ thinking—and also with today’s consensus of economic analysis.
Economic theories which do rely on changes in the “general price level” fall prey to three mistaken ideas:
- That all prices and production always remain at their “natural” equilibrium whenever the general price level is stable.
- That periods of rising price levels cause increases in production, and vice versa.
- That monetary theory is merely the “theory of how the value of money is determined.”
An Enlightenment History of Monetary Theory
Hayek’s digression on the history of monetary theory was not simply done in passing—it was to familiarize his mostly British audience with the works of many Continental economists of the two prior centuries.
The British well knew John Locke, whose political philosophy works are peppered with comments on economics. But they did not know Richard Cantillon, whose 1755 Essai sur le Commerce chided Locke’s economic reasoning. Cantillon credited Locke will realizing that “abundance of money makes all things dear [expensive],” but claimed that Locke missed the boat on how “and in what proportion” such increases to money would occur. In Hayek’s explanation of Cantillon: “Starting from the assumption of the discovery of new gold or silver mines, he proceeds to show how this additional supply of the precious metals, first increases the incomes of all persons connected with their production, how the increase of the expenditure of these persons next increases the prices of things which they buy in increased quantities, how the rise in the prices of these goods increases the incomes of the sellers of these goods…and so on. He [Cantillon] concludes that only those persons are benefited by the increase of money whose incomes rise early while to persons whose incomes rise later the increase of the quantity of money is harmful [emphases mine].”
From such a line of reasoning it follows that regarding monetary influences on the economy, “everything depends on the point where the additional money is injected into circulation.” The “where” in any form of monetary stimulus matters a great deal.
Value of Money, Price of Money
Price and value are two different things—as any value investor will recognize. Yet this is equally the case when considering the “value” of a unit of money and the “price for a money loan.” Here, Hayek traces the origins of theory regarding “the influence of the quantity of money on the rate of interest.”
Henry Thornton’s 1802 Paper Credit of Great Britain held that there was no “natural tendency” that would serve to keep the Bank of England’s paper money circulation in check. Indeed, “circulation might expand beyond all assignable limits if the bank would only keep its rate of interest low enough.”
Per Thornton’s theory, the rate of interest should be compared with the current rate of “mercantile profit”. If businesses generally earned a return higher than the rate of interest, they would demand more credit funds, and vice versa if their returns fell below the rate of interest. This touches on the idea of employed capital having a cost and generating a return, and also speaks somewhat to the concepts of “positive” versus “negative” leverage.
Not until 1823 did Thomas Joplin articulate the “currency doctrine”: a theory which Hayek describes as “interwoven with some quite erroneous opinions, which probably prevented his contemporaries from recognizing the real contributions contained in his writings.” Yet Joplin still gave “the clearest explanation of the relations between the rate of interest and the fluctuations of the note circulation which had been given up to that time.”
Joplin’s key contention on this point was that Thornton and his adherents had overlooked the fact that excess supply of capital often “has the effect of compressing the country circulation [of money],” and vice versa.
Says Joplin in An Analysis and History of the Currency Question (1832): “The interest of money, when it is abundant, is not reduced, but the circulation…is diminished; and on the contrary, when money is scarce, an enlargement of issues takes place, instead of a rise in the rate of interest. The Country Bankers never vary the interest they charge…He must, of necessity, have one fixed charge, whatever it may be: for he never can know what the true rate is.”
It’s easy to see how such an argument could be disputed: for instance, the lack of available market information which plagued banking in 19th-century Britain has to a great extent been alleviated since. But that notwithstanding, we can see the parallels between Joplin’s explanation of circulation taking the place of the interest rate in responding to credit supply/demand dynamics and Hayek’s analysis of the trade cycle in his earlier works.
“You Will Save and You Will Like It”
By extension of the development of such theories relating the quantity of money to rates of interest, a second line of theory related the money supply to the production of capital more broadly. The essence of such theories is that “an increase of money brings about an increase of capital”, which is often referred to as “forced saving”.
J. Bentham was the first to recognize this concept clearly. Bentham’s “Forced Frugality” entailed an incremental “addition to the mass of future wealth” which can be brought about by government spending or increased money supply—as long as the new funds are destined to production of capital goods.
Bentham’s work went unpublished for new four decades after he wrote it, which gave Thomas Malthus (he of drastic population analysis fame) a chance to beat him to the punch. On this subject Malthus’ key point was that a “change of the proportion between capital and revenue to the advantage of capital [Hayek’s paraphrase]” would increase the entire productivity and wealth of the nation—even if such a change was the result of “a fresh issue of notes…into the hands of those who mean to employ them…in profitable business [Malthus’ own words].”
This again recurs to Hayek’s conclusion in Monetary Theory and the Trade Cycle, in which he reinforces the idea that the expansion of money available to producers can create growth in the economy as a whole, although Malthus points out it also serves to redistribute wealth toward the “productive” class.
A Natural Rate of Interest
The “forced saving” idea lay dormant for decades, until being lit upon by the Swedish economist Knut Wicksell in his 1898 Geldzins und Guterpreise. Wicksell, whose works were primarily published in German, earns Hayek’s praise for “definitely welding the two…separate strands of thoughts into one,” unifying the theories of the quantity of money’s impact on (1) interest rates and (2) capital production.
The key idea of Wicksell’s theory was the idea of a “natural rate of interest”, which, as we have seen, is the rate which equilibrates supply of savings funds and demand for these funds to be available for investment. As long as the actual “money rate” of interest equals the natural rate, interest rates will have no effect on prices for goods. When the money rate falls below the natural rate, prices will rise—a higher money rate causes prices to fall. Think of such a theory as a basic summary of the U.S. Federal Reserve’s approach to central bank actions: when prices rise too much, the Fed will raise interest rates—the “money rate”.
Yet Wicksell’s theory held a fundamental error, which Hayek saw as the Swede’s greatest claim to fame. Wicksell sought “to establish a rigid connection between the rate of interest and the changes in the general price level.” One reason this failed was illuminated by the Austrian Ludwig von Mises in his 1912 Theorie des Geldes und der Umlaufsmittel. (Mises was Hayek’s mentor.) The improvement Mises offered to Wicksell’s ideas was “an analysis of the different influences which a money rate of interest different from the equilibrium rate exercises on the prices of consumers’ goods on the one hand, and the prices of producers’ goods on the other. [emphasis mine].”
It’s Relative Prices, Not General Ones
Wicksell’s theory was that the natural rate of interest would keep demand for capital within the limits of savings and also keep price levels stable. Yet Mises and Hayek contend that the banks can only do one of these functions at a time, and never both.
Suppose that additional savings are made available for investment at a time when interest rates equal the natural rate of interest—therefore there is no “new money” facilitating this investment. Yet the funds are invested in a project which increases the productive capacity in the economy. All else equal, such a development would cause a fall in prices. To keep the price level stable in this case, the money rate of interest would have to fall below the natural rate.
Hayek admits that some cases would exist where such new investment does not act at all on general price levels. But he also takes it as obvious that “almost any change in the amount of money, whether it does influence the [general] price level or not, must always influence relative prices. And, as there can be no doubt that it is relative prices which determine the amount and the direction of production, almost any change in the amount of money must necessarily also influence production.”
Here we have what might seem like a counterintuitive welding together a micro- and macro-economic ideas—yet it’s consistent with Hayek’s contentions in other works: that entrepreneurs make decisions based on the relative price of the inputs and their outputs—that is, their expectations of profit.
Further, Hayek takes a hard line against the validity of general prices as a concept: “when we investigate into all the influences of money on individual prices…it is not long before we begin to realize the superfluity of the concept of a general value of money, conceived as the reserve of some price level.” He even goes so far as to predict the imminent abandonment of “general price level” as a concept, to be replaced by “investigations into the causes of the changes of relative prices and their effects on production.” Alas, such a blow to economic consensus has not yet been struck.
Yet that didn’t stop Hayek from basing much of his own economic theory on the importance of relative prices. This same line of inquiry is the focus of the rest of Prices and Production. “What we are interested in is only how the relative values of goods as sources of income or as means of satisfaction of wants are affected by money.”
2: Balancing Production and Consumption
In the second lecture, Hayek focuses in on the relative prices and supplies of producers’ goods versus consumers’ goods. He starts with a simple question: why does industrial output vary at all? For this, he cites three explanations from contemporary theory:
- “Changes in the willingness of individuals to expand effort,” or rather, how hard people feel like working. Hayek suggests that this explanation is the most accepted at the time, but it depends heavily on theories of value which are, to him, unjustified.
- “Changes of the amount of factors of production [land, labor, etc.] used. In my opinion this is no explanation at all. It depends essentially upon a specious appeal to facts.” Such an idea assumes that any increase in production is due to the utilization of previously idle resources. But the existence of such resources cannot be considered a “necessary condition of an increase of output,” and Hayek therefore sees this explanation as at odds with the equilibrium theory upon which economics should be founded.
- Unsurprisingly given what we’ve learned about Hayek so far, the third explanation is both the most complex and the one that Hayek endorses: It is the “effect of a transition to more or less ‘roundabout’ methods of production”—that is, more or less “capitalistic” or capital-intensive production.
Defining Terms
Hayek gives a brief listing of a few key terms before going on. We’ll cover the most important of them here.
- Production: “all processes necessary to bring goods into the hands of the consumer”
- Original means of production: land and labor
- Factors of production: “all factors from which we derive income in the form of wages, rent, and interest.
- Producers’ goods: All goods “which are directly or indirectly used in the production of consumers’ goods,” but are not consumers’ goods.
- Intermediate products: goods which are not original means of production, but are also not consumers’ goods. This is a subset of producers’ goods.
The essence of more capitalistic production is that production is more devoted to producers’ goods, and less devoted to consumers’ goods. This will mean that a more capitalistic production system will produce more consumer goods in the future at the cost of lower consumer goods output in the present—the greater production of future consumer goods is made possible by the increase in producers’ goods in the present.
Stages of Production & Smith’s Faulty Claim
The model of stages of production is much as Hayek described it in The “Paradox” of Saving—recall our example based on hamburger buns. As he describes there, each stage occurs simultaneously at the same time, although the process are ultimately “successive stages” for the ultimate production of consumer goods.
An increase in number of stages of production is effectively the same as an increased “time interval between the application of the original means of production and the completion of the consumers’ goods.” This is what Hayek refers to as “more capitalistic” production.
Such an economic framework will clearly show that “the amount of money spent on producers’ goods during any period of time may be far greater than the amount spent for consumers’ goods during the same period.” Yet this directly contradicts Adam Smith’s assertion that the value of trade between “dealers” can never exceed the value of trade between dealers and consumers.
The missing concept in Smith is, as Hayek identifies, the fact that “most goods are exchanged several times against money before they are sold to the consumer”—a concept that we could call the “velocity of goods”, akin to the velocity of money. The average number of times goods change hands between producers is exactly equal to the proportion which producers’ goods hold over consumers’ goods in the economy.
How the Structure of Production Shifts
The central problem of the second lecture is to understand “how a transition from less to more capitalistic methods of production…is actually brought about.” The answer starts with Hayek’s confidence in the price mechanism, as the structure of production will shift based on where entrepreneurs find the readiest markets for their products.
An increase in demand for producers’ goods relative to consumers’ goods will lengthen the structure of production, making it more capitalistic, and at the same time will reduce the volume of consumption goods directly available.
Consider an economy where the total output of consumer goods is valued at 40 units of money, and the total value of producer goods over the same period is 80. The ratio here is 1:2, implying an average of 2 stages of production.
But in this example, if the consumers chose to save 10, this amount would be transferred from the purchase of consumer goods and would instead be spent on producer goods. Because of this, the consumers’ output is now 30, and the value of intermediate producers’ products is 90—the ratio has increased to 1:3. Not only has the total producers’ goods output increased, but this increase is concentrated among the earlier stages of production.
Introducing Monetary Factors
Now Hayek takes this framework and investigates changes to the circulation of money—the goal is to see how the structure of production is impacted by a non-constant money supply.
First, Hayek assumes that instead of organic savings by consumers, funds for production and investment are expanded through “credits granted to producers”—that is, by creating new money and giving it to producers.
Above, we saw how consumers’ savings would effect a change in the structure of production. Using the same start point as above, a grant of credit to producers of 40 units of money would have the same impact on the total structure of production. The ratio would go from 40:80 to 40:120, or 1:2 to 1:3.
Why Forced Saving is Forced
The consequence of this shift, however, is very different from one engendered through investment of organic savings.
How does saving happen? It is what happens when people decide “to spend a smaller share of their total money receipts on consumption and a larger share on production [that is, saving].” Because of this, the impacts of organic saving on the structure of production can well be sustainable.
But with a structure of production modified by producers’ credits, it cannot be so. After all, such an action induces the economy to a ratio of consumption to production that is more production-heavy than the consumers were willing to accept; “this sacrifice [of consumption] is not voluntary, and it not made by those who will reap the benefit from the new investments. It is made by consumers in general, who…are forced to forgo part of what they used to consume. It comes about not because they want to consume less, but because they get fewer goods for their money income.”
At a certain point in this process, the wages of consumers will rise in this process—and assuming this, “then at once the money stream will be redistributed between consumptive and productive uses according to the wishes of the individual concerned, and the artificial distribution, due to the injection of the new money, will, partly at any rate, be reversed.”
The result of this in our numerical example is that the structure of production will revert to the 1:2 ratio it was before the credits—that is, a shift from 40:120 to 53.3:106.7 (the terms must add up to the same 160). The structure of production here has become less capitalistic, which Hayek intends to illustrate will be equivalent to economic crisis.
In terms of early stages, at least, his reasoning feels intuitive. The early-stage goods which appeared to be made profitable by the availability of credit now no longer appear so, and any costs incurred in developing capacity there will fail to yield the returns expected.
What About Stimulus Checks?
Hayek applies the same line of reasoning in regards to money payments directly given to consumers—essentially applying the idea of Foster & Catchings’ work. The idea behind such payments at the time was to “make possible the sale of an increased amount of consumers’ goods”—that is, a subsidy for consumption of a volume of goods which had increased through result of consumers saving.
Yet the effect of such policies can only be a crystallization of the existing structure of production. Let’s return to our example in which consumers who used to spend 40 now choose to save 10, resulting in a shift from 40:80 to 30:90 regarding the proportion of consumer versus producer goods.
The recommendation of Foster & Catchings would be, says Hayek, to give to consumers “an additional amount of money sufficient to compensate for the relative increase of the demand for intermediate products cause by the savings”—therefore, the subsidy to consumers would be 15.
This leaves the economy example where it was before. The extra 15 in the hands of consumers shifts the economy from 30:90 to 45:90. The ending ratio is 1:2, which is what it would have been had no savings occurred at all. Therefore, “the only effect of such an increase of consumers’ money incomes would be to frustrate the effect of saving.”
3: How Prices Act Through the Credit Cycle
Lecture 2 dealt with the relative changes to production of producers’ and consumers’ goods. In Lecture 3, the focus is now on relative changes to prices of these goods. The section begins with a quote from Ludwig von Mises: “The first effect of the increase of productive activity, initiated by the policy of the banks to lend below the natural rate of interest is…to raise the prices of producers’ goods while the prices of consumers’ goods rise only moderately….But soon a reverse movement sets in: prices of consumers’ goods rise and prices of producers’ goods fall, i.e., the loan rate rises and approaches again the natural rate of interest.”
Recall the fundamental assertion that entrepreneurs make their decisions based on expectations of profit. This profit expectation is largely a function of prices: the price the producer expects to receive for the product, and the prices of the inputs required for production.
Two Types of Producers’ Goods
Hayek identifies producers’ goods as being either “specific” or “nonspecific”:
- A specific good is one which can only be used in a specific stage of the productive process. These would include highly specialized machines (combines, tunnel boring equipment), semi-manufactured goods (aircraft or automobile engines, etc.), or raw materials with only one possible use.
- A nonspecific good is one that can be used in multiple different stages of production. Petroleum is a nonspecific good, as it could be used to make rubber or plastic or fuel. General tools, such as knives, hammers, rivets, etc. are also nonspecific goods.
You may be able to see where Hayek is going here: changes in prices at each stage will have an influence on which employments of nonspecific goods are most productive.
Let’s take a very simple example: a nation where all transport is done either by train or by car, and both trains and cars require welding machines in the manufacturing process. At any given moment in time, there is a finite supply of welding equipment in the country. If we suppose that train travel becomes very popular, and there is a great demand for new locomotives, the price of locomotives will increase, the locomotive manufacturers will demand more manufacturing inputs, and therefore the profit from employing a welding machine to build a locomotive will be higher than the machine’s profit if it were employed to build a Ford Focus.
What will be the result of this? Welders and their machines will flock to the railyards. And why shouldn’t they? The locomotive builder is willing to pay a higher price for their contribution to the manufacturing process. Yet this imbalance is self-correcting. Eventually the train market’s need for welders will be saturated, and the automakers may be compelled to pay more for welding machines themselves, in order to ensure some supply. Eventually, the profits of a single welding machine will be equal between trains and cars—even if the proportion in which they are employed in each sector has changed.
This is the price mechanism at work: “producers’ goods of the same kind which are used in different stages of production cannot, for any length of time, bring in different returns or obtain different prices in these different stages.” Any temporary discrepancy that does exist will be corrected by the price mechanism Hayek describes.
How This Works in the Structure of Production
The example above does not, however, do the problem justice. To truly understand where Hayek is going here, we would need to consider the welding machines as capable of working on multiple stages of production related to the same end consumer good—for instance, welding work being done on the body of the locomotive versus work being done on the boiler that is itself a component of the locomotive.
We return, then, to the example in which consumers decide to save and invest some of their income. The resulting shift in the structure of production begins with consumers’ goods falling in price relative to producers’ goods. This makes sense, as the money saved by consumers will chase the producers’ goods, cause their prices to rise.
But—this is key—the prices of producers’ goods will not all rise by the same proportion. Put simply, the most significant increase will occur in prices for the earliest-stage goods. At each successive stage when moving toward the consumer, the increase in price will be diminished, to the point that the price of the latest-stage intermediate producers’ goods may in fact fall, although in lower proportion to the fall in prices of consumers’ goods. The ultimate impact of all this: “through the fall of prices in the later stages of production and the rise of prices in the earlier stages of production, price margins between the different stages of production will have decreased all around.”
The shifts in relative prices will therefore most benefit the earliest stages of production. “A greater proportion of…nonspecific goods…will now be attracted to the earlier stages, where…relatively higher prices are to be obtained.” Such a shift will continue “until the diminution of returns in these stages has equalized the profits to be made in all stages.” Once this new equilibrium is reached, the earlier stages will employ a greater share of nonspecific goods than they did before the saving took effect.
For specific goods, the effect of the saving is simple: those goods used in early stages will rise in price, and the ones used in later stages will fall in price. Bear in mind here that as the price of the good rises, the expectations of profit accompanying possession of that good will rise, and therefore the production of the good will also increase.
In scenarios where, due to a decrease in saving or some other factor, the demand for consumers’ goods increases relative to demand for producers’ goods, then “exactly the reverse of all these [aforementioned] changes will take place.” Prices for consumer goods will rise, prices for producer goods will fall—especially for the earliest-stage goods. Nonspecific goods will seek out employment in later stages of production, and specific goods related to the earlier stages will fall in price, while those related to later stages will rise in price.
One complication remains to be mentioned: the rate of interest. Early-stage investments that may not bear return for several years will be particularly sensitive to interest rates relative to their later-stage peers. A reduction in the rate of interest therefore leads to an equilibrium “at which a considerably greater quantity of [a given productive factor] is used in the earlier stages and correspondingly less in the later stages.” A higher interest rate has the opposite effect.
The Impact of Producer Credits
As we should now understand, producer credits as Hayek describes them will have the following effects:
- The new money in the hands of producers will cause them to bid up the prices of producers’ goods.
- Because such a credit amounts to “forced saving”, “society as a whole will have to put up with an involuntary reduction of consumption”.
- This reduction, though necessary, “will be resisted”, and people will respond by seeking to spend more on consumption, increasing the prices of consumers’ goods relative to producers’ goods.
- Such a reaction will put pressure on producers, especially in the earliest stages, and will ultimately “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 [emphasis mine].”
- Even further, the eventual reaction by consumers will render the earliest stages of production unprofitable, and will entail “a fairly sudden stoppage of work in at least all the earlier stages of the longer process.” Hence the economic crisis.
Capital Sufficiency: Some Inconvenient Truths
The axiom Hayek urges us to remember is that “the machinery of capitalistic production will function smoothly only so long as we are satisfied to consume no more than that part of our total wealth which under the existing organization of production if destined for current consumption.”
During the economic crash, many economists (including Keynes) pointed to the vast unutilized industrial plant in the developed economies as evidence that consumption demand was insufficient. Yet Hayek claims this misses the point: “durable means of production do not represent all the capital that is needed for an increase of output…The existence of unused capacity is, therefore, by no means a proof that there exists an excess of capital and that consumption is insufficient: on the contrary, it is a symptom that we are unable to use the fixed plant to the full extent because the current demand for consumers’ goods is too urgent to permit us to invest current productive services in the long processes for which the necessary durable equipment is available.”
Another example Hayek uses: imagine a group of people on an island who have “partially constructed an enormous machine which was to provide them with all necessities”—but they run out of saved capital (food, money, etc.) before the machine is ready to operate. They would have to stop work on the machine and “devote all their labor to producing their daily food without any capital.”
In short: economic crises do not occur because of excess capital investment—they occur because capital has been misdirected to the point of insufficiency for the productive process to work smoothly.
Who Moved My Capital?
We need not be surprised that Hayek’s culprit for such misdirection of capital will be any entity that disturbs the natural workings of the price mechanism. The worst possible solution, he says, is a policy that grants credit to consumers. Here he openly contradicts the ideas of Foster & Catchings, which he has addressed separately.
The granting of producers’ credits, however, could work in theory—but only if the increase was exactly enough to offset increased prices of consumers’ goods, and arranged to taper off when no longer needed. Even such credits as these are harmful if they create mirages of profitability that can only exist without the credits.
Therefore, the economy is similar to the common cold—there is no cure. “The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants…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.”
Hayek ends this lecture almost apologetically, saying that his investigation offers no means to stop a crisis from occurring. But his analysis does offer three conclusions:
- The relative behaviors of specific and nonspecific goods is a helpful classification for intermediate goods.
- “Average movements of general prices show us nothing of the really relevant facts.”
- “For similar reasons, every attempt to find a statistical measure in the form of a general average of the total volume of production, or the total volume of trade, or general business activity, or whatever one may call it, will only result in veiling the really significant phenomena, the changes in the structure of production [emphasis mine].”
4: The Debate Around “Elastic” Currency
The Limits of Monetary Policy
In the final lecture of the series, Hayek takes the framework he’s established and addresses a new question: should the volume of money be “elastic” in the sense that it varies automatically with the quantity of productive output?
He begins by noting 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.” The productivity-induced deflation in the prices of goods is not the bogeyman other economists fear, but rather “the only means of avoiding misdirections [sic] of production.”
And as he mentioned in the previous lecture, even specifically targeted monetary interventions in the economy must be calibrated with great accuracy—something Hayek claims “cannot be solved in practice.”
The doctrine that there could exist a “paper currency so regulated as to keep the general level of prices constant [Hayek cites this from an Economic Journal article by a Professor Cassel]” misses the boat, says Hayek. This doctrine would suggest that “changes in the quantity of the circulating medium which are only just sufficient to keep the general price level steady exert no active influence on the formation of prices.”
In sum: monetary policy will not succeed in regulating relative prices—and it is the relative prices of different goods that determine the production decisions and outcomes for the economy.
The Popularity of Monetary Policy
Despite this, Hayek admits that the idea of an elastic currency was seen as highly desirable by most economists of the day, and that the American Federal Reserve was often lauded as a key achievement of such thinking. How does this square with Hayek’s arguments?
To start, Hayek clarifies that his analysis has assumed a “closed” economic system: one with no communication with anyone outside the system. From this standpoint, the monetary policy of a particular country is simply “a change in the relative local distribution of the money of all nations.” Because virtually every country is an open system, the monetary policies of each will be rendered less effective. “While for any single country among others an increase of its possession of money is only a means of obtaining more goods, for the world as a whole the increase of the amount of money only means that somebody has to give up part of his additional product to the producers of the new money.”
There is another relevant distinction: between “demand for particular kinds of currency and the demand for money in general”. Demand for banknotes, central bank notes, cash in gold, etc. will vary based on conditions of trade. Even further, demand for different national currencies will vary based on market conditions.
The Credit Pyramid
Hayek further introduces a model of a country’s credit system as an inverted pyramid, with the narrowest section on the bottom. This base of the pyramid represents the “cash basis” of the credit structure. Upon this, levels of credit expansion can be erected in turn: central bank credit; commercial bank credit; private credit for businesses and individuals.
Monetary policy’s direct reach can in practice only extend to the two lowest levels: cash and central bank credit. Hayek admits as “conceivable” the possibility of similar control over commercial bank credit. Yet the amount of private credit cannot be directly controlled by any monetary authority: the central authority’s only recourse here is to affect the size of the base on which private credit rests—that is, attempt to change the amount of credit available to commercial banks.
Because of this, it is not sufficient for a central bank to curtail expansions simply by holding their own credits constant. They must “contract credit” to compensate for the changed proportion between their credit basis and that of the commercial banks. To Hayek at the time, such a notion of central banking felt “entirely utopian”.
What Does it All Mean?
The fact that Hayek’s key ideas generally result in negative rather than positive recommendations likely does his popularity no favors at all. As he concludes: “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.” Instead, bankers should exercise immense caution.
In a fit a self-awareness, he at least admits that “anybody who is skeptical 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.” But Hayek’s intent is to display that the theory of monetary policy is not yet proven out—“we are also not yet in a position drastically to reconstruct our monetary system, in particular to replace the semi-automatic gold standard by a more or less arbitrarily managed currency.” This is quintessential Hayek: demanding that any theory must pass a high bar before it is implemented in policy.
As an aside: Hayek wrote an entire piece on the dangers of such “managed” currencies, arguing that capital flows would reflect themselves by changes in the value of different currencies rather than shifts in quantities of money. Independent currency management by different countries would fall short of monetary goals because any action that a “closed” system might support would be rendered impotent by the international currency market. He covered these topics in his 1937 lectures, Monetary Nationalism and International Stability—but we will leave this aside for now.
In our next post, we’ll cover Hayek’s turn away from economics and into political philosophy.