Keynes versus Hayek: Past is Prologue

June 30, 2010

KEYNES HAYEK 1932 Cambridge vs.LSE

by Mario Rizzo  

My friend economist Richard Ebeling has discovered two extremely important letters. (Click the link above.)

In 1932 before John Maynard Keynes’s General Theory was written, these letters appeared in The Times of London regarding the appropriate economic policies for Britain to follow during the slump.  

There are a number of things that catch the eye. First, the letter signed by J.M. Keynes is also signed by A. C. Pigou whom Keynes was later to consider a prime representative of the out-dated “classical” economics. Second, Pigou and Keynes (as well as the other signatories) caution against both private sector and public sector austerity. This is essentially the same stimulus idea that Keynesians are promoting today.  

“Consequently, in present conditions, private economy does not transfer from consumption to investment part of an unchanged national real income. On the contrary, it cuts down the national income by nearly as much as it cuts down consumption. Instead of enabling labour-power, machine-power and shipping-power, to be turned to a different and more important use, it throws them into idleness.  

Moreover, what is true of individuals acting singly is equally true of groups of individuals acting through local authorities. If the citizens of a town wish, to build a swimming-bath or a library, or a museum, they will not, by refraining from doing this, promote a wider national interest. They will be “martyrs by mistake,” and, in their martyrdom, will be injuring others as well as themselves. Through their misdirected good will the mounting wave of unemployment will be lifted still higher.”  

The letter signed by F.A. Hayek and Lionel Robbins (and others) is noteworthy because, first, it makes clear that “everyone” is in agreement that deflation is not desirable and should be avoided.  

“It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation in itself is desirable.”  

Second, Hayek and Robbins stress that the Keynes-Pigou skepticism about private frugality is short-sighted:  

“The signatories of the [above] letter…, however, appear to deprecate the purchase of existing securities on the ground that there is no guarantee that the money will find its way into real investment. Under modern conditions the securities markets are an indispensable part of the mechanism of investment. A rise in the value of old securities is an indispensable preliminary to the flotation of new issues. The existence of a lag between the revival of old securities and the revival elsewhere is not questioned… [Thus] the sale of securities or the withdrawal of…deposits would [not] assist the coming of recovery. “  

Third, the letter goes on to reject Keynes-Pigou fiscal stimulus on the grounds that expansion of the public debt would increase the frictions that inhibit recovery.  

Finally, Hayek and Robbins conclude: 

“If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure, but to abolish those restrictions on trade and the free movement of capital…which are at present impeding even the beginning of recovery. “ 

It does not take much to see that the issues are basically the same today. The positions of the opposing sides are also the same. As I have said many times before, the great debate is still Keynes versus Hayek. All else is footnote.

UPDATE 07/10/10: See Richard Ebeling’s reply to Paul Krugman here.

77 Responses to “Keynes versus Hayek: Past is Prologue”

  1. Troy Camplin Says:

    Someone of the Austrian economists should write a similar letter with a list of signatories in regards to the current economic situation. I’m not an economist (just a humble Ph.D. in the humanities who uses Austrian economists in his scholarly work), but I would happily sign such a letter written by a current Austrian on what we should be doing.

  2. Greg Ransom Says:

    I’ve typed up the Hayek letter in html for easy reading here:

    http://hayekcenter.org/?p=3057

    Richard also sent me a copy of these earlier today.

  3. Daniel Kuehn Says:

    Mario –
    Hayek and Robbins only really sound like Reinhart and Rogoff in the sections you quoted – which is fair enough. Like the deflation point you highlight, this is something that I think all sides agree on, but some sides choose to emphasize more than others at various times.

    You don’t quote what I thought was the more interesting section that is more characteristic of modern Austrians, where they refute Keynes’s and Pigou’s unwillingness to make a call between consumption and investment and write “we regard a revival of investment as peculiarly desirable”.

    Very interesting – thanks!

  4. Mario Rizzo Says:

    An article by David Leonhardt in the New York Times on June 29th says:

    “The policy mistakes of the 1930s stemmed mostly from ignorance. John Maynard Keynes was still a practicing economist in those days, and his central insight about depressions — that governments need to spend when the private sector isn’t — was not widely understood.”

    http://www.nytimes.com/2010/06/30/business/economy/30leonhardt.html?scp=1&sq=Keynes%201932&st=cse

    In the view of the Keynes-Pigou quotations in letter above, how accurate is Leonhardt’s claim?

  5. Daniel Kuehn Says:

    :) You seem to be leading, Mario – but for good reason. I think the answer is obvious.

    The counter-cyclical/functional finance logic was nothing revolutionary at that point. What I think was perhaps revolutionary was Keynes’s justification for government spending not as a cyclical response, but as a persistent response to an economy that was, as he says, not in depression but not operating at full capacity either. It was the wedding of demand deficiency with liquidity preference that was new, not simple counter-cyclical spending.

    Do you know, Mario, when counter-cyclical spending did first appear as a macroeconomic response?

  6. Mario Rizzo Says:

    Daniel,

    You are right.

    Take a look at:

    http://www.cfeps.org/pubs/sp-pdf/sp7-perez.pdf

    “Chicago, Keynes and Fiscal Policy” by E.P. Caldentey.

  7. Greg Ransom Says:

    Foster & Catchings were all the rage in the 1920s and 1930s — everyone knew the story of the need for government spending and the systematic problem of lack of private demand — including Sen Wagner and Pres. Hoover who both endorsed the theory.

    The problem was that not an economist in the world knew how to refute the idea, although thousand tried with the aim of winning a huge cash prize for doing so.

    Keynes gave us a Marshal version of F & C mixing in some botched Wicksell & stuff he learned from Hayek & McCracken and the rest is history (if we pretend Keynes created “Keynesian economics” which is as much myth as truth.).

  8. Daniel Kuehn Says:

    “if we pretend Keynes created “Keynesian economics” which is as much myth as truth”

    I always think it’s funny how the fact that we are all inspired by others and standing on the shoulders of giants can, in the hands of critics, be turned into some sort of case for inauthenticity :)

  9. Greg Ransom Says:

    The fact that Keynes is not the same as Keynesian economics is substantive. Many books are written on the top.

    Once again, you spin and twist the words of others to detract from understanding, raher than to advance it.

  10. Greg Ransom Says:

    The post Keynesians see things otherwise — “Keynesian economics” just isn’t Keynes in their considered judgment.


  11. Keynes was a latecomer to fiscal stimulus. The Old Chicago School advocated that before him. He and Irving Fisher made common cause at one point over a purely or mainly monetary response.

    Meanwhile both the Chicago School and Fisher had banking reform planes that involved narrow banking (100% reserves). Friedman later revived the Chicago Plan. Now Laurence Kotlikoff has an even more comprehensive narrow banking plan.

  12. Daniel Kuehn Says:

    “The fact that Keynes is not the same as Keynesian economics is substantive.”

    I don’t think I responded to this point, did I? I think it’s quite clear that there have been changes and developments and differences of opinion since 1936, and I don’t know of anyone that is concerned about concealing this.

    My concern was your reference to and interpretation of the extent to which Keynes synthesized or reinterpreted previous positions. That’s a different issue entirely, Greg.

    “Once again, you spin and twist the words of others to detract from understanding, raher than to advance it.”

    How? I think you’re misunderstanding me. I wasn’t commenting on what you mentioned at all.

  13. Daniel Kuehn Says:

    “The post Keynesians see things otherwise — “Keynesian economics” just isn’t Keynes in their considered judgment.”

    Ya, I don’t see the value of this kind of territorialism. Other “Keynesianism” aside from post Keynesianism is clearly derivative. But what non-post Keynesian “Keynesian” would ever deny this? The lineage back to Keynes is still clear despite the differences. What’s the point of denying it?

  14. Greg Ransom Says:

    Well, you weren’t clear at all, and seem to load your reply with snark, which doesn’t help communication.

    Think about it.

    Daniel wrote:

    “My concern was your reference to and interpretation of the extent to which Keynes synthesized or reinterpreted previous positions.”

  15. Efinancial Says:

    WOW…this is depressing! Almost 100 years of debate and our economic and political leaders continue with the same old arguments, the same old disagreements. Even this discussion is getting mired in the nuances of old Keynes and new Keynes.

    I guess if a century of empirical evidence showing that the use of force in human affairs results in the destruction of human well-being can’t persude that voluntary trade is the best approach,no amount of intellectualizing about economic theories can make a dent in the Human desire to use force to live at other peoples expense.

    Or am I expecting too much for people to realize that all forms of Keynesianism and monetarism are based on force?

  16. Greg Ransom Says:

    Actually, in many ways it’s not.

    “The lineage back to Keynes is still clear despite the differences.”

    David Hull has a great book on how ideas are evolving historical individuals, and are not natural kinds. I get the idea and mostly agree with it.

    But here we have inter weaving ideas and interweaving personalities, and massive confusion and ignorance on the part of moderns with little or no historical training.

    All of this had made thinks less clear and the history more obscured.

    It ain’t helping.

    Work like David Laidler’s _Fabricating the Keynesian Revolution_ is helpful in clarifying concepts and the origins — this conceptual clarification and untwisting helps the advance of science and understanding.

    Calling everything “Keynes” does not.

  17. Greg Ransom Says:

    At this point, I don’t think there is much room for serious debate, for those who have read Keen, Laidler and others — both on the issue of where Keynes got his ideas and how the ideas and models and understandings of others, many pre-dating Keynes, were given the “Keynesian” label.

    The history of ideas is hard. Calling everything under the sun “Keynes” is easy.

    “My concern was your reference to and interpretation of the extent to which Keynes synthesized or reinterpreted previous positions.”

  18. Daniel Kuehn Says:

    “Well, you weren’t clear at all, and seem to load your reply with snark, which doesn’t help communication.”

    I think you try to see snark in it. I certainly didn’t mean any. I think you were unfair to Keynes, and in an obvious way – is simply thinking and saying that “snark”? Anyway – sorry you read it that way but I certainly didn’t intend it.

  19. Daniel Kuehn Says:

    “WOW…this is depressing! Almost 100 years of debate and our economic and political leaders continue with the same old arguments, the same old disagreements.”

    Part of this is inevitable. Empirical verification is extremely hard anyway, and it’s that much harder because policy makers never do what either side wants them to do (what “Keynesian” episode is there to test? What “Austrian” episode is there to test? There are none really that perfectly fit). That’s a recipe for an inability to arbitrate between two theories.

    This may be self-serving because I’m essentially saying “let’s not be too hard on ourselves”, but I really think it’s true. We have very convincing arguments at our disposal, but not definitive way of settling the question.

  20. Daniel Kuehn Says:

    “At this point, I don’t think there is much room for serious debate, for those who have read Keen, Laidler and others — both on the issue of where Keynes got his ideas and how the ideas and models and understandings of others, many pre-dating Keynes, were given the “Keynesian” label.

    To repeat – I don’t think anyone has challenged these facts, Greg. Nobody. Certainly not me. My point is that you’re wrong to dismiss the creativity of an important synthesis.

    And who calls “everything under the sun” Keynesian? Are you saying it’s wrong to recognize the common lineage of New Keynesianism and Post Keynesianism despite the different ways that the school of thought has branched out and developed and changed? That seems silly.

  21. Joe Salerno Says:

    I have two comments on these very interesting letters, one doctrinal and one substantive. First, I know Mario was speaking loosely, but it is important to emphasize that these letters were not just now “discovered.” Their existence has been long known to economists. The letter from the LSE economists, in particular, has been extensively used as the “smoking gun” to implicate Hayek and Robbins as “deflationists” and “liquidationists” in the 1930s.

    Second, Hayek et al. stated i their letter, “No one thinks that deflation IN ITSELF is desirable.” This is by no means logically equivalent to Mario’s interpretive statement, “The letter . . . makes clear that “everyone” is in agreement that deflation is not desirable and should be avoided.” The first proposition does not logically contradict, for example, the following: “We think deflation is desirable as a means for breaking the rigidity of wage rates caused by unions.” (In other words, I do not think having a needle stuck into the soft tissue in my spine and withdrawing spinal fluid is desirable in itself, but I do think it is a desirable means for diagnosing spinal meningitis.)

    In fact, the second proposition represents Hayek’s position in the early 1930s. Thus in 1975 Hayek wrote: “[A]t the beginning of the Great Depression . . . I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should even then have understood that this possibility no longer existed.” Hayek then went on to say that he no longer believed that deflation was the appropriate means for overcoming wage rigidity and thought that “we shall have to find different techniques for that purpose.”

    In 1980, Hayek was less repentant and went a little further to reveal that he still believed that the deflationary remedy had almost achieved its goal. Hayek was referring to the deflation that was initiated in 1925 in Great Britain to restore prices and wages to a level consistent with the prewar parity of the British pound: “[A] slow and highly painful process of deflation was initiated, bringing lasting and extensive unemployment, to be abandoned only when it became intolerable when intensified by the world crisis of 1931–but I am still inclined to believe, just at a time when the aim of that painful struggle had been nearly achieved.”

    The evidence, as provided by Hayek himself, strongly suggests that he indeed was a “deflationist” in the early 1930s, a fact that he later regretted, more or less.

  22. Greg Ransom Says:

    Note well.

    Hayek was concerned in the first instance with internationally overpriced British union labor — overprice in large part because of the deflation of _1925_.

    He was NOT thinking of America AT ALL.

    Every interview with Hayek about his “debate” with Keynes focuses on this exact issue.

    And note also that what Hayek remembers he thought at the time is _not_ what he actually publicly wrote at the time.

    Joe writes:

    “[A]t the beginning of the Great Depression . . . I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy.”

  23. Greg Ransom Says:

    Hayek position is more complex.

    He stongly opposed the creation of deflation via the return to par in 1925.

    The question then becomes, now what?

    Hayek saw a case both for and against using inflation to solve the 1925 caused deflation problem — BUT what interested Hayek was the fact the Keynes and the British economist did NOT see the economic consequences of their inflation proposal (e.g. an unsustainable malinvestment structure.)

    The timing here is important — we’re not talking immediate re-regrowth of the money supply immediatedly after Churchill’s mistake, we are talking about re-inflation years after the deflation has already taken place.

    Joe writes:

    “The evidence, as provided by Hayek himself, strongly suggests that he indeed was a “deflationist” in the early 1930s, a fact that he later regretted, more or less.”

  24. Greg Ransom Says:

    I think it is more accurate to say that Hayek was against a “re-inflation” half a decade after the damage of deflation had already done most of its work in Britain (outside of the overpriced labor problem).

    Joe writes:

    “The evidence, as provided by Hayek himself, strongly suggests that he indeed was a “deflationist” in the early 1930s, a fact that he later regretted, more or less.”

  25. Greg Ransom Says:

    Note that getting the history right is important, and it helps to have Hayek’s theory right to get the history right.

    The easy thing most Hayek haters do is botch the history — and use botched history to attack a scientific research program they don’t understand the first thing about.

    That is what Samuelson did in some very nasty and brain dead attacks on Hayek.

    And it’s not too far from what Friedman did.

    And we see it all the time still today.

    (Don’t be confused, I’m not talking about Joe or anyone else in the discussion here.)


  26. The discussion between Joe Salerno and Greg Ransom is important. Economists may have been aware of the letters. But Hayek’s statement about deflation in no way supports the view that he favors it as policy. In Prices and Production, he correctly pointed out that goods deflation was a natural outcome of progress. He eschewed deflation of wages, however.

    I believe Greg is correct that Hayek, along with virtually every other economist opposed Chruchill’s policy of going back to pre-war parity. Economists opposed it precisely because it would force a painful and unnecessary deflation of prices and wages.

    And Greg is surely correct when he reminds us that what Hayek wrote in the 1930s is different from what Hayek remembered he thought in the 1970s and 1980s.

    Finally, the letter once-and-for-all puts to rest the claim that Hayek believed in doing nothing. His call for free trade (and free movement of capital) is precisely what Allan Meltzer recommended yesterday for the current recession.

  27. Joe Salerno Says:

    I agree with Greg that Hayek did not have conditions in the U.S. in mind when he co-wrote his letter to the London Times and that even in later reflections on his 1930s “deflationism” he was referring specifically to British conditions. But I never implied anything else in my comment. Greg also says that Hayek never actually publically wrote what he says he remembers his views were at the time. To the extent that this is true it is not evidence of a faulty memory but rather testament to Hayek’s political savvy. His views would never have gotten a hearing had he couched them in anti-union terms. Finally, in my comment I put deflationist in parentheses because I agree with Greg that there was a tension in Hayek’s thought. Although Hayek believed that the original decision to go back to the gold standard at an overvalued par was “questionable”, once the decision had been made he supported the deflationary measures necessary for the decision to succeed. In fact, in 1932, he criticized Keynes and other opponents of a return at an overvalued parity for not abandoning their opposition after the decision had been made and continuing to fight against the measures that would have permitted the gold standard to work. Too, Hayek probably also saw the necessary deflation as an opportunity to dissolve union power and restore flexibility to the price system, which to him was the sine qua non of a functioning economy. So I would say that Hayek was not just against re-inflation, but approved of the continuing fall in money and prices which were still above equilibrium in the context of an open economy with an overvalued currency.

  28. Greg Ransom Says:

    It looks like Joe and I are pretty much on the same page, it was an error on my part to seem to suggest otherwise.

  29. Bogdan Enache Says:

    This is a much better, facsimile version, of the letters than the transcription I once read. I’m not familiar with the British 1930s press, but was the courtesy expression at the end, “We are, Sir, your obedient servants”, quite customary back then? From the literature of the time, one could not have guessed that journalists/newspapers managers or the readers? were addressed with almost the same rhetorical embellishments as the French ministers treated Louis XIV :)

  30. Joe Salerno Says:

    Jerry is s correct, of course, on the general attitude of economists to Churchill’s return to gold at the prewar parity. Hayek questioned it, Mises adamantly expressed his opposition to it in a number of places, and Jacques Rueff also opposed it. Later Rothbard wrote that it was an error.

    Regarding Hayek’s views in Prices and Production, the book assumed a closed economy. In Monetary Nationalism and International Stability, Hayek explained that in the case of open economies sharing a common money, the redistribution of money from one country to another could not meaningfully be described in terms of “deflation” and “inflation,” which applied to changes in the money supply in a closed economy and were disequilibrating. The contractions and expansions of money supplies in different parts of a gold currency area were the very means by which the fixed supply of the common money was adjusted to the ever changing pattern of demands for products, incomes, and demands for cash balances. Great Britain after 1925 was a country with a disproportionately large share of the world’s money supply because of its overvalued exchange rate and relative decline in productivity and, therefore, a restoration of international equilibruium required a loss of part of the money stock to other nations. Hayek recognized this situation in his 1932 aticle on “The Fate of the Gold Standard” and argued that the price stabilizationist policies of the Bank of England inhibited this needed adjustment and led to the abandonment of the gold standard.

  31. Richard Ebeling Says:

    My dear Mr. Enache,

    We ARE talking about the London “Times.” Why if the “Times” is not shown this degree of respect, then, well, it is the death knell of the “Empire.”

    And where will the world be, then, my dear boy?

    Not sound; not sound at all.

    Clearly, you’re not British. Foreigner, not doubt. What?

    Your obedient servant,
    Richard Ebeling


  32. I think that Joe, Greg and I are all on the same page that, once having gone back on the gold standard at pre-war parity, price deflation was inevitable. That is not to advocate a policy, however, but a piece of positive analysis. It doesn’t imply deflation is good policy, but inevitable. Hence, in my opinion, the statement: “No one thinks that deflation is in itself desirable.”

    Let us also not overlook the rigidities in both the US and UK economies. Throughout the 1920s, trade unions in the UK resisted wage cuts or pushed up wages even as there were overall deflationary pressures (above).

    (Many years ago, Daniel Benjamin wrote an empirical article on that epsiode and attributed far more of the unemployment to the actions of unions than the return to the gold standard at pre-war parity.)

    In the LSE letter, the authors cite both government debt and protectionism as impeding recovery. Thanks to the work of Rothbard, Higgs, Ohanian and others, we know how government interventions in the US worsened and prolonged the Great Depression.

    Today we have had similar interventions preventing adjustments: programs to prop up housing prices, to prop up public sector wages, and, of course, bailouts of zombie banks.

    Bottom line is that Mario is correct when he said these letters frame the debate even today on what to do in a Great recession.

  33. REG CROWDER Says:

    Save yourselves a lot of time and just read what Dr. Joseph Stiglitz has to say about the economy. He does this funny thing. He starts out by looking at how the world really works.

  34. Greg Ransom Says:

    How much of Keynes’ “flexibility of mind” can’t be explained as a merchantilists’ effort to imagine crank solutions controlled by the elite which favor Britain and its people again others?

    Occam’s razor argues that we go for the simplest explanation available.

    It’s at least half of a theory.

    Joe writes,

    “Regarding Hayek’s views in Prices and Production, the book assumed a closed economy. In Monetary Nationalism and International Stability, Hayek explained that in the case of open economies sharing a common money, the redistribution of money from one country to another could not meaningfully be described in terms of “deflation” and “inflation,” which applied to changes in the money supply in a closed economy and were disequilibrating. The contractions and expansions of money supplies in different parts of a gold currency area were the very means by which the fixed supply of the common money was adjusted to the ever changing pattern of demands for products, incomes, and demands for cash balances. Great Britain after 1925 was a country with a disproportionately large share of the world’s money supply because of its overvalued exchange rate and relative decline in productivity and, therefore, a restoration of international equilibruium required a loss of part of the money stock to other nations. Hayek recognized this situation in his 1932 aticle on “The Fate of the Gold Standard” and argued that the price stabilizationist policies of the Bank of England inhibited this needed adjustment and led to the abandonment of the gold standard.”

  35. Greg Ransom Says:

    If you look at his theoretical work, it’s clear this is not true.

    Stigilitz doesn’t even look at the real world when he’s talking about the scientific work of others.

    Reg wrote,

    “Save yourselves a lot of time and just read what Dr. Joseph Stiglitz has to say about the economy. He does this funny thing. He starts out by looking at how the world really works.”

  36. Ivan Says:

    “I think that Joe, Greg and I are all on the same page that, once having gone back on the gold standard at pre-war parity, price deflation was inevitable. That is not to advocate a policy, however, but a piece of positive analysis. It doesn’t imply deflation is good policy, but inevitable. Hence, in my opinion, the statement: “No one thinks that deflation is in itself desirable.””

    I don’t know whether named gentlemen agree with you on this, but I think that

  37. Ivan Says:

    Jerry O Driscoll:“I think that Joe, Greg and I are all on the same page that, once having gone back on the gold standard at pre-war parity, price deflation was inevitable. That is not to advocate a policy, however, but a piece of positive analysis. It doesn’t imply deflation is good policy, but inevitable. Hence, in my opinion, the statement: “No one thinks that deflation is in itself desirable.””

    I don’t know whether the named gentlemen agree with you on this or not, but I think that your description of Hayek’s attitude toward deflation during the early 1930s is somewhat misleading, or let’s say, incomplete. Namely, not only that Hayek believed that the British returning to the gold standard at the pre-war parity was a mistake, but even more importantly; he believed that any kind of monetary policy aimed at “quantitative easing” or credit expansion during the correction period was fatal. He believed that the malinvestment created by the boom must be liquidated without any fiscal or credit “stimulants”. He is absolutely crystal clear about that in Prices and Production.

    I think that Mario Rizzo, in spite of this fact, tried to portray Hayek’s sentence “deflation is not a good thing per se” as implying that Hayek thought the credit expansion and quantitative easing were the right responses to the deflationary recession, in other words that the credit “stimulants” were appropriate cure for the recession. But that is clearly wrong since Hayek in Prices and Production and in the early 1930 in general rejected this policy completely.

    Therefore, not only that deflation stemming from the overvalued pound sterling was “unavoidable”, but also the secondary deflationary spiral which has been experienced also by the USA (which did not overvalue its currency) was equally “unavoidable”, at least according to Hayek in 1932 or 1933.


  38. Ivan,

    You seem to be someone who enjoys arguing for its own sake. And I’m not sure whether your beef is with me or Mario. But I’ll proceed.

    When someone says something is inevitable, that is not normative economics but positive economics. For Hayek, the adjustments in the aftermath of a boom can be deferred, but only at the cost of even greater adjustments later.

    You have followed Joe Salerno by invoking Prices and Production. Until that point, however, we were all discussing the Times correspondence, not what Hayek said in P&P. P&P is neithe Hayek’s first nor certainly his last word on money and cycles.

    As I pointed out in Economics as a Coordination Problem, Hayek had already written the monetary theory undergirding P&P in Monetary Theory and the Trade Cycle. Written in German in 1928, it was not published in English until 1933. So the underlying monetary theory was not available to English readers of P&P. P&P is not a theory of money, but of what goes on in the real economy over a cycle.

    In the 4th chap. of P&P (“The Case for and Against an ‘Elastic’ Currency”), Hayek begins a complex a discussion of what he means by a “quantity of money in circulation.” He then begins a discussion of closed versus open economics. (Pace Joe Saleno, P&P is not simply theory of the closed economy.) Plus he makes clear that by the “quantity of money,” he means the “total of all kinds of media of exchange.”

    Thus Hayek subsumes under supply what others would call changes in the demand for money. In conventional terminology, his stricture to keep the supply of money constant translates into keeping MV constant. (Hence, in the 1932 letter, he could decry hoarding; hoarding is offset by supply changes.) It would have been better if Hayek had been more conventional in his terminology in P&P. But, again he was building on an earlier work.


  39. Keynes’ conflation of hoarding and savings has had a permanent effect on economic theory. The “paradox of thrift” is the best example.

    Keynes was a prisoner of 19th century debates w/o understanding them. The general glut controversy was precisely over this question. Sowell’s Classical Economics Reconsidered has a good, concise discussion of the issues.

    Henry Thornton wrote the Paper Credit of Great Britain in 1802 and observed that “it is well known that guineas are hoarded in times of alarm….” It was a commonplace and certainly some extraordinary theoretical insight.

    Hayek was, of course, the editor of a modern edition of Paper Credit. Hayek was a scholar of the history of economic thought, especially British, and well acquanited with the debates over hoarding and what central banks should do in such situations. Bagehot picked up where Thornton left off. His comment on hoarding must be read in that context.


  40. Sorry: NOT some extraordinary theoretical insight.

  41. Ivan Says:

    Jerry,

    You are wrong concerning Hayek and PP. He explicitly rejects the notion that MV stabilization “could ever be a maxim of a good monetary policy”. He even adds that no chain of reasoning could ever be valid if it contains those macroeconomic aggregates.

    It seemed to me (and your last reply confirmed that) that there was no difference between you and Mario at this point. Neverthless, you suggested you were on the same page with Salerno who pointed out that HAyek really was a liquidationist in the early 1930s. Both Rizzo and you you think that the credit expansion is an appropriate response in a deflationary recession. Hayek’s rejection of that idea is unequivocal:

    “In theory it is at least possible that, during the acute stage of the crisis when the capitalistic structure of production tends to shrink more than will ultimately prove necessary, an expansion of producers’ credits might have a wholesome effect. But this could only be the case if the quantity were so regulated as exactly to compensate for the initial, excessive rise of the relative prices of consumers’ goods, and if arrangements could be made to withdraw the additional credits as these prices fall and the proportion between the supply of consumers’goods and the supply of intermediate products adapts itself to the proportion between the demand for these goods. And even these credits would do more harm than good if they made roundabout processes seem profitable which, even after the acute crisis had subsided, could not be kept up without the help of additional credits. Frankly, I do not see how the banks can ever be in a position to keep credit within these limits” (PP 274-275)

  42. Mario Rizzo Says:

    The points are well taken. But the issue is this: Are the errors likely to be introduced by an attempt *simply* to avoid outright and prolonged deflation worse than the effects of letting deflation proceed unmitigated?

    To answer this question, one first has to distinguish (as George Selgin et at have)between secular price declines that have accompanied increases in productivity and the cyclical phenomenon arising from panic-induced increases in the demand for money. The former are not what is at issue; the latter is.

    My own view, consistent with the letters linked above, is that Hayek did not favor deflation. But it doesn’t really matter. The best modern Austrian analysis, building on Hayek, shows that this would not be a wise policy.

    While some distortion may be introduced by anti-deflationary monetary policy, this pales in comparison with the catastrophe of outright, significant and prolonged deflation.


  43. No time for trolls.

  44. Ivan Says:

    “While some distortion may be introduced by anti-deflationary monetary policy, this pales in comparison with the catastrophe of outright, significant and prolonged deflation.”

    That’s your opinion. But that is not what Hayek says in P&P. You are actually criticizing P&P when you say things like this. That was my whole point. I did not want to make any final judgement about whether Selgin and other free bankers are right when advocating a credit expansion as a cure for the so called “bad” deflation, or maybe Mises in Human Action, Hayek in P&P and De Soto in Money, Bank Credit and Economic Cycles where they reject this proposition. I just wanted to emphasize that those are entirely different approaches.

    I have read once again the paragraph from the letter in Times you quoted. It now seems to me that you could have a point. They really say that they agree with Keynes and co. that deflation and hoarding are bad, and possibly therefore imply the credit inflation or “quantitative easing”, as a good response. That would only mean Hayek once again was inconsistent for the sake of making allies and “broadening the support” for his ideas.

    But, if this interpretation is correct, it is not clear whence than the Hayek’s reputation as a liquidationist? If prof Salerno is right than the very Hayek’s reputation as a liquidationist stemmed from this letter.

  45. Richard Ebeling Says:

    If I may, I’d like to draw attention to two passages in one of Hayek’s later works in the 1930s, “Profits, Interest and Investment,” (1939).

    First, in a footnote (pp. 63-64) Hayek says:

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

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

    In another footnote in “Profits, Interest, and Investment” (p. 45), Hayek gives his definitions of inflation and deflation:

    “The criterion for ‘inflationary’ and ‘deflationary’ seems to me to be as follows. There is neither inflation nor deflation if (1) there occurs no change in prices unless it is necessary for the restoration of equilibrium either that the production of the commodities affected should be increased or reduced, or that the recipient of the income affected should permanently (i.e., till the next real change) get a larger or smaller income; and (2) if no price change necessary for this purpose is prevented. All monetary changes which do not fall in this category have the characteristic attribute that their effects are self-reversing, that is that they will cause further price changes by the impact of the effect of the monetary change.”

    I am not sure if this clarifies or confuses, but I thought it, still, would be worthwhile to draw attention to them.

    Richard Ebeling

  46. Greg Ransom Says:

    Ivan, the principle of anti-charity when approaching am set of ideas is no way to achieve a non-bogus understanding of things.

    So what is your purpose?

  47. Greg Ransom Says:

    Ivan, it seems to me you are going out of your way to botch Hayek (your intention?) or you simply know is work less well than you pretend.

    This is one problem with folks who hide who hide their identity– they are also hiding their intentions and their background understanding.

    In a post artificial boom malinvestmevt crash there are no good answers — but there additional errors which can be avoided.Hayek is talking about money supply AFTER the acute phase of the crisis.

    Do you understand the difference — or is you intent to willfully conflatebthing on purpose.

  48. Ivan Says:

    Greg,

    I am not sure what is exactly that you don’t like in my post. If you are protesting against my portrayal of Hayek as being “once again inconsistent for the sake of making allies and “broadening the support” for his ideas.”, here is my answer:

    Hayek in many occasions openly admitted this kind of behavior I ascribed to him. For example, he said in an interview from 1970s that he “refrained from criticizing” Keynes further during the 1930s and early 1940s because the “alternative to Keynes was even worse”.

    He similarly explained that he refrained from criticizing Friedman’s monetary theory during the 1950s and 1960s because “Friedman was a good friend” and Hayek also did not want to alienate the powerful figure of the American libertarianism.

    He also explained another reason why he refrained from criticizing Keynes during the early 1940s. He did no want to “prejudice the public about the much more important contribution I had to make in political theory” (i.e.Road to Serfdom). In other words, he wanted to avoid being labeled once again as “liquidationist” (although he was a liquidationist at the time) in order to secure the credentials of a “moderate” or “reasonable” or “respectable” guy and better reception for his new book.

    So, he very often has some broader political or “political” aims in mind in deciding whom to criticize and how to do that, besides the truth (unlike some other people like Mises, who were very intollerant toward the intellectual inconsistency, and hence were predestined to be rejected by the establishment as an “extremist” and the “fringe element”).

  49. Greg Ransom Says:

    “Ivan”

    In the first instant you haven’t shown that Hayek was inconsistent on this matter — and you haven’t shown you understand the matter.

    Forty and 50 years after the fact Hayek came up with multiple self-rationalizations for his life — the psychological literature tells us that memory and self-narrative isn’t fully reliable even within a shorter time.

    If one was a Hayek hater, you would even say that the fact that Hayek had multiple alternative stories of what happened makes those stories “inconsisten”.

    The story of Hayek’s interaction with Keynes is best explained by Keynes letter to Hayek where Keynes said it was best to attend to the development of his own ideas — and drop the dialogue with Hayek. Hayek clearly agreed.

    But actually his memory 40 and 50 and 60 years later was faulty. Hayek did return to his assault on Keynes, using megatonnage and not pea shooters (if you read between the lines) in his _The Pure Theory of Capital. So his membery is simply false on this.

    What Hayek remembers is what happened during the war — when he was plenty busy with his wartimee project, and no one cared about “Keynesian macroeconomics”.

    It helps to know the history.


  50. Greg,

    You offer a sound methodology of interpretation.

    As Hayek noted in Foreword to Economics as a Coordination Problem, he was “surprised when I found in Professor O’Driscoll’s account side by side statements I made at he interval of many years and on quite different problems, which still implied the same general approach.” Hayek was more consistent than he remembered.

    In my my Preface to Coordination Problem, I explained why I had written my dissertation without consulting Hayek or even informing him of the project. “I wanted to assess Hayek’s contributions, not what Hayek himself recalled contributing, or intended to contribute.”

    You are correct, of course, that Hayek criticized Keynes at the end of the Pure Theory of Capital. I discussed this on pp. 135-42 of Coordination problem. Hayek never wrote the second volume of the Pure Theory. That, not a nonexistent failure to criticize Keynes, is the shame.


  51. Greg,

    A reminder that you have available on your website a link to Roger Garrison’s article, “Hayek and Friedman: Head to Head.” Garrison quotes Hayek: “Milton and I agree on evrything except monetary policy.”

    Garrison also confirms my interpretation that, going back to 1928, Hayek advocated keeping MV constant.

  52. Ivan Says:

    Jerry,

    Hayek explicitly rejected MV constant in PP.

    “in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.” (pp. 297).

    So, he obviously rejected the idea of stabilizing MV as a mere theoretical possibility without any practical significance. To add salt on injury, he says:

    “In fact, 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. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning;:

    How can you state that he advocated a stable MV when he explicitly said that using aggregates cannot for a link in valid reasoning?

  53. Ivan Says:

    Greg,

    1.) I am not interested in your amateurish psychologizing.

    2.) I am not a “hater” of Hayek economist. On the contrary, as you see, I use his economics to refute the notions such as the usefulness of credit inflation as anti-recessionary tool.

    3) I don’t know what you mean by saying that I “did not prove that Hayek was inconsistent”. He obviously was inconsistent in theory (eg PP vs Times letter, nothing to say about PP vs latter works), but that was not my point. I only wanted to point out that one must be careful when one draws a far-reaching conclusions about the Hayek’s policy positions, especially when those policy positions are expressed in the statements for the public, like the letter for the newspapers. The fact that Hayek in such a letter subscribed to the notion that deflation was not good, is far from the proof that Hayek really believed that deflation was not good. If he believed the fiscal stimulus is the most harmful policy right now, and insisting that hoarding and deflation are not bad could lessen your credibility as a critic of the fiscal stimulus, he would pretend he was against deflation even if he wasn’t. Just like he pretended he was in agreement with Keyenes in economics during the preWar and wartime period in order to gain the “credibility” (“not prejudice the public”) for what he had to say about (what he considered to be) the most pressing problem of the time – a political and philosophical issue of the planning as a road to serfdom.

  54. Greg Ransom Says:

    Jerry, part 4 of TPTofP is an abbreviated version of his planned “part 2″ of that book, as Hayek makes clear.

    This is another small Hayek created myth.

  55. Troy Camplin Says:

    What kind of deflation was Hayek talking about? Natural deflation or monetary inflation? Those are two completely different things, from two completely different sources, with two completely different outcomes. Might it be that Ivan is talking about one kind, and everyone else here is making a finer distinction in deflations?

  56. Greg Ransom Says:

    This is bogus history.

    The issue never came up in this period — and in fact Hayek did blast Keynes with both barrels in this period, as I’ve pointed out.

    “Just like he pretended he was in agreement with Keyenes in economics during the preWar and wartime period in order to gain the “credibility””

  57. Greg Ransom Says:

    Again, this isn’t obvious.

    You are begging the question, and not well supporting your position, for those who know this stuff well.

    “He obviously was inconsistent in theory”

  58. Greg Ransom Says:

    This is sort of true. Hayek also disagree with Friedman about how to do economic science, and how to produced economic explanations.

    Hayek says that the two most important things that to his surprised needed refuting were Friedman’s bogus picture of economic science and Keynes bogus picture of macroeconomic explanation.

    Hayek never believed anyone would take either seriously.

    Hayek wasn’t always good at predicting the future of intellectual fashion.

    He also falsely believed that hot socialism was dead.

    Jerry wrote,

    “Garrison quotes Hayek: “Milton and I agree on evrything except monetary policy.””

  59. Pietro M. Says:

    Prof. Rizzo:

    “While some distortion may be introduced by anti-deflationary monetary policy, this pales in comparison with the catastrophe of outright, significant and prolonged deflation.”

    I’m worried of entering a heated and verbose discussion, given the risk of appearing a troll, but I disagree. I’m also worried because my contribution is verbose, too.

    1. I consider the extension of the financial system (monetary multipliers included) to be a mainly endogenous phenomenon, given external constraints like the supply of gold or the monetary policy function of the Fed. If the boom causes the financial and banking system to overshoot, the recession needs to check and counteract this overexpansion. This has been called deleveraging: from a monetary point of view, however, it is deflation. It is endogenous to the business cycle, thus it is a normal market response, although painful.

    2. The fear of deflation appears to be mainly based on a single event: the Great Depression. The 1873 depression hardly existed in real terms (I downloaded some paper on the subject on JSTOR, but I haven’t read them thoroughly yet), or the 1920 recession, which was severe but short-lived (I don’t know much about XIX recessions). I base my analysis on Cole and Ohanian’s papers: a historical unicum calls for a specific explanation, i.e., an exception to general models.

    Given (1), I’d consider impossible for an economic system whose “normal” monetary multiplier is ten, which however during the boom overshooted to twenty, to do without deflation. I generalize this: the same is true for financial leverage and many others risk indicators, it is true for both banks and shadow-banks, because it is a credit problem and not a money problem. This secondary depression is likely to have a greater real effect than the mere liquidation of malinvestment, as said by Strigl in “Capital and production”, and by Hayek. But it is a short-lived phenomenon, the Great Depression excluded.

    So, what can be done to avoid deflation? Monetary equilibrium analysis assumes that the problem is an excess demand for money, but the problem at the peak of a long boom is an excess of almost everything: risks, leverage, mismatches, malinvestment, malintermediation… M1 is too high with respect to M0, M2 is too high with respect to M1: the recession brings normalcy to these aggregates.

    Friedman and Schwartz had a similar opinion: in “Monetary history of the US” they argued that the Fed, by guaranteeing liquidity to the national banks, succeeded in increasing the efficiency of gold use, albeit at the cost of increasing the fragility of the whole financial edifice. If something has risen too much, it needs to fall.

    So, I reach point (2). I’m convinced that the Great Depression has been a historical unicum: Cole and Ohanian convincingly argued that it was caused by Hoover’s and Roosevelt’s policies of cartelization, sindacalization, nominal wage preservation, etc. This was also Phillips, McManus and Nelson’s thesis (one of them, better) in “Banking the the business cycle” and the beef of the argument against Hoover in Rothbard’s “America’s Great Depression”.

    Shall we fear deflation on the basis of the experience of the Great Depression? It depends on which interpretation of its severity and length is correct. I don’t consider it a relevant proof of the dangers of deflation: its persistence had other causes.

    Hayek was thus doubly right: in saying that the deflation is painful and in saying that resource mobility is key for a quick recovery: if the latter holds, however, the fear of the former can be greatly relaxed.

  60. Claire Fay Says:

    Hey there all,

    Hope you don’t mind to my chiming in with this opportunistic note but I am selling (reluctantly) my signed copy of The Road to Serfdom on eBay – it’s a 1945 5th impression of the U.S. first (univ of Chicago, 1944 – as I’m sure you all well know.)

    It’s on eBay now. 10-day auction started July 1. Search: Serfdom and Signed – and that should pull it up for you.

    Best wishes to all Hayek fans here and everywhere and happy 4th of July!

  61. Greg Ransom Says:

    Pietro — your comments are a million miles from a troll posting, besides that, it’s become clear who you are, you aren’t hiding behind a phoney alias.

    On deflation, what has been under-appreciated is the massive effect of regime uncertainty on the expanded demand for money and gun-backed claims on taxpayer incomes (i.e. Treasury bills).

    When the rule of law collapses you spike the demand for non-productive asset stores of wealth like gold, gun-backed claims on taxpayers, and fiat money.

  62. diz Says:

    Just a quick point in regard to the purchase of existing securities:

    If one person is buying them, someone else is selling them in equal amount.

    It does not seem to me that this activity could ever result in a net use of liquidity in a society.


  63. If increased savings first go to purchase existings securities — a fixed stock — then their prices increases and yields fall. That stimulates the issuance of new securities.


  64. [...] spectacular find: dueling letters from Keynes and associates, on one side, and Hayek and associates, on the other. [...]

  65. mike Says:

    Wonderful find.

    But what we have now that Keynes and Hayek didn’t have then is more history and more evidence.

    That evidence shows Keynes was right.

  66. Greg Ransom Says:

    Actually, history shows no such thing.

    What the evidence shows is that people like Krugman, Samuelson, Friedman & Keynes rejected Hayek’s science on the basis of little more than a deep ignorance of the substance of that science.

    “But what we have now that Keynes and Hayek didn’t have then is more history and more evidence.

    That evidence shows Keynes was right.”


  67. [...] Keynes versus Hayek: Past is Prologue « ThinkMarkets [...]


  68. [...] Keynes and F. A. Hayek in the London Times in October 1932, which have been posted and discussed on ThinkMarkets. Krugman insists that Hayek is worse than he thought and that Keynes was better than he imagined. [...]

  69. Troy Camplin Says:

    That’s hillarious. History shows literally the complete opposite. You’re quite funny, posting jokes like that.

  70. mike Says:

    Well, I suppose we didn’t need history since the Great Depression, as the evidence before then already favored of Keynesian ideas.

    Nevermind the evidence; there is no Hayekian/Austrian/Libertarian theory that can explain 9.5 percent unemployment. The possible exception would be Friedman, who felt government stimulus of aggregate demand was not necessary if monetary policy was appropriately vigorous. But then Hayek even rejected Friedman’s monetarist views, much like today’s freshwater followers of Lucas and Prescott.

    I get it: you guys hate government. But don’t mistake your personal philosophy for theory and evidence. Don’t mistake deeply held belief and conviction for science. It’s like comparing Christianity to Darwinism.

  71. Mario Rizzo Says:

    Mike,

    You don’t really understand what ideology is. It is not a religion. It is a general perspective based on evidence as well as ethics.
    http://www.thefreemanonline.org/featured/in-defense-of-ideology/
    However, the points being discussed here are economic theory and history. There is plenty of evidence to suggest: (1) Hoover did not follow a laissez-faire policy; (2) international trade was hobbled by world-wide trade and capital flow restrictions; (3) the Fed followed a policy of inducing deflation by allowing the stock of money to fall drastically in a short-time; (4) both Roosevelt and Hoover worked hard to prevent the adjustment of prices and wages by various policies with the rationale that this would keep up purchasing power (“aggregate demand”?), and so forth. These were not causes of the depression but they worked against recovery.

  72. mike Says:

    Mario,

    I’ve read a LOT of this stuff. For many years.

    It is a religion.

    Check that–it’s an INSANE religion.

    You guys are living on a freakin flat earth.

    There is so much we still don’t know and still don’t understand and lots of interesting stuff we all should be talking about. But the crazies keep us all still talking about stuff that theory and evidence reconciled so, so long ago. It’s like arguing today, 2010, about whether smoking causes lung cancer. (No, even that’s too generous.)

    With regard to your trade story there is a tiny smidgen of truth. But the far larger reality in the Great Depression was causation going the other way: Depression reduced tade, just like our current downturn (which was worse) You can read to cliff notes version by Krugman on his blog or the gory details by Eichengreen. In any case, never mind the evidence: less than fully free trade doesn’t make for 20% unemployment–you have no theory for that.

    This has been beat to death. You’ve either (a) ignorant or (b) have undying faith.

    Please, do the world a favor and get over it, so we can argue about some of the real uncertainties about the world.

  73. Troy Camplin Says:

    These are the words of someone who has had his faith questioned. Everything is settled: that is the language of the fundamentalist. Only your religion is the One True religion. Except that those who believe in the economy as an evolving complex adaptive system rather than as an organization believe in evolutionary science, while you are clearly an economics Intelligent Designer at the very least. Creationism was settled long ago, too. And in some people’s minds, it is still settled. Doesn’t make it true, though. And it doesn’t make Darwinists religious believers, either.


  74. [...] Mario. 2010. “Keynes versus Hayek: Past is Prologue.” At ThinkMarkets.com (June [...]


  75. If anyone is still watching this thread I will write a comment which may be of interest, on Robbins’ later statement tht this view was “the greatest mistake” he ever made, and also to correct the view that it was “Cambridge vs LSE” entirely


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