Friedrich Hayek’s intellectual course can in some way be thought of as a blueprint for success. His early works display astonishing attention to detail within the narrow confines of economic theory, yet never without maintaining a grasp of the whole picture. It is in his later works that he applies this same mastery of detail across a wider scope, going from critiques and postulates of economics to critiques and postulates of philosophy itself.
His 1933 work, Monetary Theory & The Trade Cycle, was originally published in German in 1928. It’s original intent was to refute the theory that a “stabilized” general price level could alleviate the “disturbing monetary causes” related to the trade cycle. He focuses on the “monetary causes that start the cyclical fluctuations [emphasis Hayek’s unless noted otherwise],” rather than the real changes in economic structure that result from these changes—this topic he will cover later.
That the work was published in 1928 and republished in English in 1933 will appear noteworthy given what happened in between: the economic crash of 1929 which impacted Europe along with the United States. Hayek’s overarching point: he seeks to prove that monetary causes are the fundamental drivers of economic cyclicality. As we’ll see, he does not offer data to support this conclusion, but logic.
The Trade Cycle Problem, Defined
Epistemological Humility
Hayek begins with frank admission of the empirical problems involved in such research: “Empirical studies…can at best afford merely a verification of existing theories; they cannot in themselves provide new insight into the causes or the necessity of the trade cycle.”
Such a preamble is what we will come to expect often from Hayek: he is not a master of understatement so much as precision—and he is never so precise as he is when discussing the limits of what one can know about a subject.
Questionable Value of Statistics
Statistics cannot serve as the basis for theory, says Hayek; they can only help with verifying theories. Even this leaves statistics with a “very limited value”, as “it is possible to verify theory by statistics…only in a negative sense…It [Statistics] cannot be expected to confirm the theory in a positive sense.” This reminds us of the duality of hypothesis testing, which produce two possible results: reject, or fail to reject. And a failure to reject is a far cry from confirmation of truth.
Because of this, statistics are a tool to serve logic, and should remain subservient to it: they should “give us accurate information about the events that fall within the province of theory.”
The Primacy and Error of Theory
“One can say without exaggeration that the practical value of statistical research depends primarily upon the soundness of the theoretical conceptions on which it is based.” Writing only a few years before Keynes’ General Theory was published, Hayek claims “not only do we now lack a theory that is generally accepted by economists, but we do not even possess one that could be formulated in such an unexceptionable way, and worked out in such detail, as eventually to command such acceptance [emphasis mine].” Keynes’ theory was subsequently accepted by a great many economists, but we can imagine it was not developed to a level of detail sufficient to meet Hayek’s criteria.
Despite the lack of a unified general theory of economics, research could continue to proceed on theoretical grounds, but “we must always remember that we are acting on certain theoretical assumptions whose correctness has not yet been satisfactorily established.” Indeed, “the ‘practical man’ habitually acts on theories that he does not consciously realize; and in most cases this means that his theories are fallacious.” Life is full of theories taken for granted, whether they are correct or not—even everyday decisions are based on a network of assumptions we make about the world.
Non-Monetary Theories Defined & Debunked
As Hayek claims monetary explanation of the trade cycle are most appropriate he deals point-by-point with trade cycle theories that support other explanations. His goal is to “show the fundamental objections to which all non-monetary theories of the trade cycle are open”. His “insuperable obstacle” in this effort is “the very multiplicity of such theories”, even to the point where it is difficult for him to judge which ones he should focus upon. Yet non-monetary theories have one common point: “They all regard the emergence of a disproportionality among the various productive grounds, and in particular the excessive production of capital goods, as the first and main thing to be explained.” Yet simply explaining non-constant capital goods production is not sufficient, as this is a symptom of non-constant economic growth. “The real problem is the growth of excessive fluctuations in the capital goods industries out of the inevitable and irregular fluctuations of the rest of the economic system.”
Another point he stresses is that the proper scope of such theories is not to map out the whole cycle, but to underline the causes of the actual crisis—failure to keep this focus “suffers inherently from the danger of paying less and less attention to the crucial problem.”
Hayek groups non-monetary cycle explanations into three categories:
- “Technique of production”
- “Savings and investment”
- “Psychological theories”
We will cover each group in turn.
“Technique of Production” Theories
The substance of the “technique of production” theories is that higher demand for consumption goods (or even just an expectation of such increased demand) causes “a relatively larger increase in the production of goods of a higher order [capital goods].” Put simply: imagine if, when the demand for Starbucks lattes rises 10%, the cultivation of coffee beans in Brazil rises 50%.
Part of such “excessive fluctuations in the production of capital goods” is due to “the long period of time that is necessary…for preparing the fixed capital goods which enable the expansion of the productive process to take place.” The newly cultivated coffee farms in Brazil will likely not serve this year’s Starbucks clientele, nor next year’s. It is this delay, the lead time between the origination and fruition of capital goods, that is the substance of the “technique of production” concept.
And again: “Every change in demand, from the moment of its appearance, propagates itself cumulatively through all the grades of production, from the lowest [closest to the consumer] to the highest [furthest from the consumer].” The implication of this is that the early-stage goods should be more volatile over a cycle than later-stage goods. Intuitively this makes sense: demand for housing tends to vary much less over a cycle than demand for excavators to build that housing. Demand for coffee tends to vary less over a cycle than demand for the machines employed on the coffee farms. The emergence of such fluctuations can therefore be blamed upon “the extensive use of durable capital equipment in the modern economy.”
Hayek does not deny the fundamental idea of lead times as an important interconnection in the production process, but takes issue with the idea that the response of early-stage demand to late-stage demand must necessarily be excessive: “why do the forces tending to restore equilibrium become temporarily ineffective and why do they only come into action again when it is too late?”
Singled out for examination here is the argument of another economist, C.O. Hardy, who claimed that the “price mechanism” is necessary to “adjust supply to demand,” although ‘this mechanism is imperfect, if a long period has to lapse between production and the arrival of the product at the market.”
He quotes Hardy on the following: “Prices and orders give information concerning the prospective state of demand compared with the known facts of the present and future supply, but they give no clue to the changes in supply which they themselves are likely to cause.” And again, Hardy: “No force intervenes to check the continual increase in production [of early-stage capital goods] until it reflects itself in declining orders and falling prices [of those same goods].”
Here, Hayek takes issue with this tacit assumption that entrepreneurs regulate their production based on the volume of demand. Producers don’t focus on meeting the level of demand they expect; they focus instead on maximizing their profitability. In their estimates of their prospective profits, entrepreneurs “will generally be in a position to estimate the price [for their goods] that will rule after the changes [in production volumes] have taken place, as distinct from the quantitative changes in the total volume of demand.” Further, the producer will also consider an estimate of any potential change in costs—which is likely if increased production raises demand for those goods which he himself must buy as inputs in his production. Because entrepreneurs optimize their businesses for profit and not for meeting the aggregate demand they expect to face, the price mechanism does not simply take a vacation. Or: “The mere existence of a lengthy production period cannot be held to impair the working of the price mechanism.”
A further effect which such theories overlook is the impact of increased capital goods investment on the demand for the capital such investment requires. A greater demand for such capital should correspond to “a rise in the rate of interest”, which is simply “the price paid for the use of capital”. This factor alone, according to static economic theory, should “always keep the supply of capital goods in equilibrium with that of consumption goods.”
Savings and Investment Theories
The second category of non-monetary trade cycle theories deals with the “periodical disturbances of equilibrium purely through the phenomena arising out of the accumulation and investment of savings.” Some such theories assume that “unused savings are accumulated for a time and then suddenly invested, thus causing the productive apparatus to be extended in jerks.” Hayek considers this assumption “groundless and inadmissible.”
Upon examining the work of one Professor Spiethoff, whom Hayek calls “the most distinguished exponent of these theories”, Hayek quotes this as his key defense of such theories: “’If capitalists and producers of immediate consumption goods want to keep their production in step with the supply of acquisitive loan capital, these processes should be consciously adjusted to one another.’” Yet similar to the first group of theories, savings and investment theories of the trade cycle also assume that it is expected demand, not prices, that drive the production decisions of entrepreneurs. Further, these theories make another critical assumption that does not hold—an assumption which Hayek passes over for the moment.
Psychological Theories
Hayek’s criticism here is focused on endogenous factors: those “which explain the origin of general under- and overestimation from the economic situation itself, and not from some external circumstance.” These theories might be more commonly thought as assuming some “errors of forecast” which distort the production decisions in the economy. The central tenet is that by a general overestimation of demand, producers as a whole will invest in excessive production capacity which should correct automatically without a preceding psychological shift.
Again, such theories, says Hayek, put the “demand” cart before the “price” horse. “Production is governed by prices, independently of any knowledge of the whole process on the part of individual producers.” Only when the prices are disturbed will production decisions be affected.
Credit: Where Monetary Theory Sneaks In
Having dealt with each theory in turn, Hayek at last gets to a crucial point.
For the non-monetary theories to be valid as such, they should each equate to be a “purely ‘real’ explanation.” Yet this does not hold, as “all non-monetary trade cycle theories tacitly assume that the production of capital goods has been made possible by the creation of new credit.” Even worse, non-monetary theories assume such credit is available “at an unchanged price.”
The granting of credit by banks and other institutions is a key lever in determining the total supply of money. Under fractional reserve banking, a bank can lend out more money than it strictly holds in deposits, up to a point (usually a limit set by government regulators). This money multiplier is essentially the bank’s contribution to creating new money: taking a $100 deposit and turning it into a $1000 personal loan, for instance.
And here’s the rub: if non-monetary theories assume that such a process can occur, they are baking in a factor that is monetary by definition: the expansion of the money supply through banking. Thus Hayek reiterates his argument: “only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations.”
Monetary Theories
In the preceding section, we’ve outlined Hayek’s reasoning as to why the equilibrating forces of supply and demand “can only be disturbed when money is introduced into the economic system.” He moves on to explain the fundamentals of why monetary theory is more appropriate.
Inflation, Debunked?
It’s worth noting that Hayek’s works are shot through with footnotes and references from dozens of other economists: of the four writers we’ve covered so far (Smith, Marx, Keynes, and Hayek), he is easily the most well-read when it comes to economic theory. Here again he cites Professor Spiethoff’s theory linking fluctuations in the money supply to fluctuations of the general price level. Yet Hayek insists that the “fluctuations in the general price level need not always be ascribed to monetary causes.”
This could be read as an open assault on modern central banking: Hayek goes on to claim that assuming general price levels are only influenced by monetary factors is dependent on circular reasoning. Yet like so many of his hottest takes, this line of argument is simply made in passing. Hayek’s crucial focus is on “the possibility of alternations in the quantity of money occurring automatically and in the normal course of events,” i.e. credit granted by banks.
Natural and Real Rates of Interest
Here Hayek brings in the theory of the “natural rate” of interest, borrowed from Knut Wicksell. This natural rate is defined as “that rate which exactly balances the demand for loan capital and the supply of savings.” The “money rate” of interest is entirely separate: it is the cost to borrow money, the rate one would pay if borrowing or receive if lending. As the natural rate is the equilibrium between supply of capital (savings) and demand for capital (investment), a money rate equal to the natural rate will ensure monetary factors bear “a completely neutral relationship to the price of goods.”
If the money rate is lower than the natural rate, the general price of goods will rise; if the money rate is above the natural rate, general prices of goods will fall. This suggests that when the rates are equal, the general price level and the production of capital goods are both in equilibrium: prices are stable, and production is within the limits of current savings.
But in an expanding economy, “stability of the price level presupposes changes in the volume of money,” and therefore “the rate of interest at which…the amount of new money entering circulation is just sufficient to keep the price level stable, is always lower than the rate that would keep the amount of available loan capital equal to the amount simultaneously saved by the public,” that is, the money rate will be lower than the natural rate, even at stable prices.
CPI, Debunked
Hayek’s first key criticism of Wicksell’s formulation is that does not distinguish the processes of a money-based economy from a barter-based one. His second criticism is the focus on general price levels. Writing of general price levels: “they are not only unessential, but they would be completely irrelevant if only they were completely “general”—that is, if they affected all prices at the same time and in the same proportion. The point of real interest to trade cycle theory is the existence of certain deviations in individual price relations…Every disturbance of the equilibrium of prices leads necessarily to shifts in the structure of production, which must therefore be regarded as consequences of monetary change.”
General price level changes are insufficient therefore to get a sense of the trade cycle—Hayek suggests considering the relative prices of different types of goods. It is this structure of relative prices that will change in response to a disturbed equilibrium interest rate, and “deviations of this kind necessarily lead to such changes in the relative position of the various branches of production as are bound later to precipitate the crisis.”
Monetary Factors are Part of the Economy Too
Hayek moves on to address another key question: are monetary trade cycle theories truly “endogenous”? Do they truly constitute explanations based on factors intrinsic to the economy, as opposed to exogenous factors which influence the economy from outside (such as natural disasters, resource depletion, etc.)? His answer is that they are endogenous “in the fullest sense of the word”, because the monetary factors he describes do not occur as a result of disinterested and meddlesome top-down policy; the relevant process “must always recur under the existing credit organization, and…it thus represents a tendency inherent in the economic system.”
Based on his writing style, you’d be forgiven for thinking that there aren’t exactly too many cliffhangers in Hayek. But here’s one. After great length he’s finally getting around to what exactly this “inherent tendency” of the “existing credit organization” is, and how it affects the trade cycle.
Defining the Question
Hayek describes the circulation of money as occurring in three ways:
- Changes in the volume of circulating cash vs. gold (exchanging paper bills for gold & vice versa).
- Changes in circulation of central bank notes.
- The “often-disputed ‘creation’ of deposits by other banks.”
Hayek saw the potential for monetary disturbances in the trade cycle arising from the third of these means. In order to support his theory, he must show that “the rate of interest charged by the banks to their borrowers is not promptly adjusted to all changes in the economic data”. If such a statement holds, it is equivalent to saying that the interest rate fails to calibrate itself to equilibrium, and the ripple effects will impact the rest of the economy. As Hayek puts it, “we shall have proved that, under the existing credit organization, monetary fluctuations must inevitably occur and must represent an immanent feature of our economic system—a feature deserving of the closest examination.”
In 21st century terms our key question is: is the money rate of interest “sticky” in respect to changes in economic data?
A Brief Description of Banking
English and American banking practice of the 1930s involved banks generally crediting a borrower’s account with the full amount of the loan, before any of this money was “actually utilized” by the borrower. Further, American banks required significant margins to be held as collateral against these loans. These two practices both facilitate the “credit creation” that increases the size of the money supply, but such conditions are absent from mainland Europe.
To Hayek this is immaterial, as any credit created from such automatic crediting of borrower accounts is not tenable: “there is no reason why the borrower…should borrow money at a higher rate of interest merely to leave that money on deposit at a lower rate.” Therefore Hayek chooses to evaluate the true impact of banks on money supply under the assumption of Continental conditions, in which “the sums granted will be credited to the account of the borrower only at the time when, and to the extent that, he makes use of them.”
Hayek goes on to illustrate the effects of bank credit, assuming (for illustration alone) a 10% reserve ratio, meaning that banks will lend $900 for every $100 they have in hard deposits. Consider the following:
- Person A deposits $100 in Bank A.
- Bank A lends $90 to Person B, who deposits the money in Bank B.
- Bank B lends $81 to Person C, who deposits the money in Bank C.
- Bank C lends $72.90 to Person D, who deposits the money in Bank D…
The ultimate sum of all these actions is the following: a “converging infinite series” resulting in $900, all from a fractionally smaller initial deposit. This is highly dependent on a few factors:
- The reserve ratio. Hayek admits his 10% assumption is “for simplicity’s sake” and “undoubtedly incorrect”. In many countries, there is a minimum reserve ratio by law, but it stands to reason that banks may sometimes choose to hold more than the legal minimum of reserves depending on credit market conditions.
- “The proportion in which the credit granted is transferred to other accounts—and not paid out in cash.” Hayek admits this is “subject to very wide fluctuations as between different individuals at a given moment, as well as between various periods of time for the economic system as a whole.” For instance, if Person B took the $90 in cash instead of redepositing the money in Bank B, the full course of the credit creation process would be interrupted.
This successive re-lending of deposits is “at the root of the banks’ ability to create purchasing power.” The next key question is “whether the causes [that induce banks to] increase their deposits through additional credit in periods of boom and thus postpone, at any rate temporarily, the rise in the rate of interest that would otherwise necessarily take place…are inherent in the nature of the system or not.”
Natural and Money Rates Diverge
Recall that the “natural” rate of interest is the equilibrium between an economy’s supply of available savings and that economy’s demand for investment funds. In periods of economic expansion, there will be higher demand for credit, meaning the natural rate of interest will rise. But what about the money rate of interest—the rate that banks charge?
Consider an economy where the minimum legal bank reserve ratio is 10% (as in the U.S.), and the current reserve ratio in the banking system is 14%. Let’s say the economy is in a period of expansion, where demand for credit is high and therefore the natural rate of interest has risen. Equilibrium theories would suggest that banks would need to raise the rates they charge on loans to bring the money rate back into equilibrium with the natural rate of interest.
And there’s the rub: the banks don’t have to do so. Instead, they could simply reduce their reserve ratio from 14% to 10%, satisfying demand for credit at the existing money rate of interest, which is lower than the natural rate of interest.
Why would banks make such a choice? For pure reasons of competition: “the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks.”
The effect of all this is that the demand for credit which raises the natural rate has no effect on the money rate, and this creates an untenable situation. Yet no single bank can check the credit freight train once it is underway: “Concerted action…which for competitive reasons is the only action possible, will ensue only when the increased cash requirements of business compel the banks to protect their cash balances by checking further credit expansion, or when the central bank has preceded them by raising its discount rate.” Sooner or later, the banks must “cease to extend the volume of credit”, at which point the music has stopped, and the credit bubble has burst.
It’s fundamental to Hayek’s thinking that even a single inconsistency in the web of prices and equilibria that make up the economy will ultimately lead to an unstable and recurring cycle. By Hayek’s reasoning, the monetary influence from the price of credit is the glitch in our economic matrix.
But Maybe It’s Worth It?
Hayek admits the “unpleasant consequences of the state of affairs” engendered by such credit cycles and their impact on the economy. But he stops short of saying this is a systemic problem in how economics and finance is structured. Indeed, “by creating additional credit in response to an increased demand…the banks ensure that impulse toward expansion of the productive apparatus shall not be so immediately and insuperably balked by a rise of interest rates as they would be if progress were limited by the slow increase in the flow of savings.”
The banks should not be seen as villains: “Nobody has ever asked them [the banks] to pursue a policy other than that which, as we have seen, gives rise to cyclical fluctuations.”
Furthermore, the excessive credit creation during periods of expansion cause much of that expansion—and the resulting periods of crisis are the price we pay for growth in excess of saving. Indeed, the ultimate question Hayek compels us to consider here is whether we are willing to give up economic growth in favor of economic stability.
Hayek remains on the growth side of this debate: “So long as we make use of bank credit as a means of furthering economic development, we shall have to put up with the resulting trade cycles…And even if it is a mistake—as the recurrence of crises would demonstrate—to suppose that we can, in this way, overcome all obstacles standing in the way of progress, it is at least conceivable that the non-economic factors of progress, such as technical and commercial knowledge are thereby benefited in a way we should be reluctant to forgo.”
In our next post, we’ll cover one of Hayek’s most famous early works, which he wrote as a critical review of another economic paper of the time.