Keynes versus Hayek: A rerun of the 1930s

by Mario Rizzo  

[This was submitted to the Financial Times as a possible op-ed piece. Unfortunately, it was rejected. Nevertheless, it seems to me that most readers of the financial press are still unaware of just how fundamental a challenge F.A. Hayek made to the economics of J.M.Keynes. Hayek’s challenge often gets homogenized with other free-market approaches that are still macro-economic in nature. Hayek questions the macroeconomic way of thinking.]  

Robert Skidelsky wrote in the Financial Times that recent debates among economists are a rerun of the disagreements between John Maynard Keynes and the U.K. Treasury in the early 1930s. To a certain extent this is true. But it might be more instructive to pay some attention to another debate in the 1930s. This is the debate between Keynes and Friedrich Hayek.   

Today Hayek is best known for books in political economy such as The Road to Serfdom. It is sometimes said that a key question in Britain’s academic circles some seventy-five years ago was: Who is right – Keynes or Hayek? To most contemporary readers, economists included, it would seem that the debate was a general one over the role of the state in economic life. However, in the 1930s Hayek had not yet written his political tracts.  

The dispute between Hayek and Keynes was over what we call today “macroeconomics.” At the time, this would have been considered monetary or trade cycle theory. Hayek was opposed to the macro-aggregation of Keynes’s approach to questions of employment, interest rates and cycles. He believed that the aggregates chosen by Keynes obscured the fundamental changes that constitute macroeconomic phenomena. As the economist Roger Garrison points out, for Hayek there were indeed macroeconomic phenomena but only microeconomic explanations. 

Keynes focused on the labor market, insufficient aggregate demand and the associated idea of less-than-full-employment income. In effect, Keynes thought of aggregate output as if it were just one undifferentiated thing and investment as a volatile form of spending that brought this output into existence.  

Hayek focused on structure of capital. By this he meant the array of complementary (and substitutable) capital goods at different distances from consumable output. These capital goods work with labor and other factors to produce what Keynes would call “aggregate output.” Thus for Hayek “investment” wasn’t a homogeneous aggregate but represented specific changes to a structure of interrelated capital goods. When the central bank lowered interest rates excessively (below the rate that would equate planned savings with planned investment), the structure of production would be distorted. It is not just that “output” increased but its composition was altered.  

This typically meant a number of unsustainable changes. Low interest rates discourage savings and yet at the same time encourage certain types of investment. Housing, commodities, and other sectors with long time-horizons would expand. But at the same time consumers would try to consume more. So the Keynesian is misled to think that, “See, consumption and investment are not alternatives. We can have more of both. In fact, consumption stimulates investment!”  

What really occurs in the boom, however, is too much consumption and too much investment in sectors far from consumption. Overconsumption and malinvestment. Isn’t this what we have just seen?  

Hayek can indeed be faulted for not having taken on Keynes more directly after 1936. He vastly underestimated the significance of the growing Keynesian revolution. And he thought that Keynes would soon change his mind as he did with his earlier book The Treatise on Money (1930). Furthermore, Hayek probably should have emphasized more that his theory implied the need to avoid a “secondary deflation” during the bust period. Increases in the demand to hold money should be offset by the banking system.

Nevertheless, we really should not ignore Hayek’s side of the academic controversies of the 1930s. While the Treasury officials raised important points against Keynes they did not challenge him in the fundamental way that Hayek did.

Today the issue is still Keynes versus Hayek.

Update 07/07/2010: A more recent and related post is available here.

90 thoughts on “Keynes versus Hayek: A rerun of the 1930s

  1. Excellent point. However, I can see why this would not be accepted. Macroeconomics gives thousands of economists something to do all day. 🙂

  2. Maybe you could make some alterations to this and resubmit it to the Wall Street Journal. As I recall, they ran a piece on Keynes a while back, but didn’t mention Hayek. The article said that when JMK was in a Washington restaurant once, he swept some food on to the floor, claiming that by doing that he could stimulate the economy anc create new jobs. They didn’t run my Bastiat-inspired letter criticizing this idea.
    They need a dose of Austrian analysis, and this is just what the doctor ordered.

  3. Here is the letter to the WSJ.

    In sweeping a pile of towels on to a restaurant floor, and claiming this would boost employment in the restaurant industry (“The New Old Big Thing in Economics: J.M. Keynes”, Jan. 8), Keynes proved himself a better dramatist than economist. With similar logic, he might have thrown out the food being prepared for the restaurant’s patrons, or broken the dishware on which it would have been served. He overlooked what was not seen, namely that the workers were more productive serving the demands of restaurant patrons, which most assuredly did not include waiting for re-cooked meals to be served on paper plates.

    Keynes’s argument was a variation on the broken window fallacy, which claims that a window-breaking vandal stimulates employment in the window industry, spurring economic growth. This idea, which was refuted by Frederic Bastiat, is blind to the fact that the owner of the window is poorer by the cost of replacing the window. The money he would have spent on other goods, such as restaurant meals, would have helped provide employment for restaurant workers, or those in other industries. Maybe they hope that the vandal will become their patron, but they can’t count on it, unlike the business they would have received from the vandal’s victim.

    William J. Stepp

    New York, NY

  4. Excellent.

    Wolfe has been badmouthing Hayek on false grounds in the FT in the last few months — I’m guessing he didn’t want to be shown up.

  5. Absolutely beautiful. As I often quote to my (Keynesian) friends: “Mr Keynes’ aggregates conceal the most fundamental mechanisms of change”.

  6. […] In his recent Hayek vs Keynes article, when Mario Rizzo says, “Hayek probably should have emphasized more that his theory implied the need to avoid a “secondary deflation” during the bust period.  Increases in the demand to hold money should be offset by the banking system” lots of folks might ask, what is Rizzo talking about?  Steve Horwitz explains: … [when a credit induced misallocation boom has led to an unavoidable bust] “primary” adjustment of prices and reallocation of resources needs to take place, but what needs to be avoided is the velocity-induced *secondary* deflation that might or might not follow .. […]

  7. “what needs to be avoided is the velocity-induced *secondary* deflation that might or might not follow .. […]”

    I don’t get that at all. What are you saying, that there should credit expansion to avoid deflation?

  8. Supply and demand: additional money to provide for an increase in the demand to hold in order to avoid deflation. This would occur under competitive banking which we do not have. So the central bank must mimic this as far as possible. This controversy has been raging at The Austrian Economists blog. If that makes me a “Keynesian” to some degree, then fine. Hayek was, too, in that case.

  9. I totally agree with Mario. During crisis periods, central banks need to expand money supply to satisfy demand of the banking system.
    This is also logical, if we think about the natural rate which has to be equal to the market rate. During the boom the rates are too low as the banking sector expands credit too far. But when market rates rise at the turning-point and a crisis sets in, the natural rate falls below the market rate. Thus the Fed has to provide more liquidity to the banking sector to lower market rates. But during the panic this may not be enough as the banking sector that determines the market rates keeps rates up. Thus the central bank has to further increase money supply, even replace the interbanking market, until the panic is over and the banking system lowers rates. Otherwise the money market rate stays above the natural rate and induces a downward spiral.


  10. Mario,

    Well, I would disagree that Keynes focused on labor markets more than investment, other than to note what Hayek never did, that it is possible to have involuntary unemployment. The Hayek analysis of malinvestment does not quite explain that rather signal fact that was very prominent during the 1930s in quite a few countries.

    You are right that Hayek focused more on malinvestment than on aggregate investment as did Keynes. Of course, another difference is that Keynes emphasized psychological factors, including the outcome of speculative bubbles in stock markets, in leading to overinvestment, with the collapse of bubbles helping to trigger the collapse of “animal spirits” that pushed total investment down and thus employment and output. Hayek does briefly mention speculative bubbles (as Greg Ransom has pointed out to me), but it is a sideshow.

    For the current situation, clearly the collapse of a giant speculative bubble in housing has played a very major role in what has happened. Now, is this more Keynesian or Hayekian? The Hayekian argument would be to say that it was low interest rates, and most of us would agree that they were “too low” in 2003-04, which certainly helped goose up the housing bubble. But Shiller argues the bubble began in 1998. This is not such a simple matter.

  11. Prof Rizzo,

    I haven’t seen that debate raging at the Austrian Economists blog. Wish I had.

    You said that Hayek too was a “Keynesian” in that sense. How about Mises and Rothbard? I’ll bet the house that they weren’t.

  12. The question was asked about differences between Mises and Hayek on the theory of money and the business cycle.

    Hayek always said that he was building upon Mises’ formulation of what became known as the “Austrian” theory of the business cycle when he (Hayek) was developing his own version of the theory in the late 1920s and the 1930s.

    Hayek considered the most essential element in money’s effect on the economy was not whether or to what degree changes in the quantity of money resulted in a change in the general purchasing power (or value) of money, say, as measured by some statistical price index.

    The non-neutrality of money concerned the manner in which changes in the quantity of money worked its way through the economy and modified the structure of relative prices and the allocation of resources among various sectors of the economy.

    He, of course, always reminded his readers that this was an essential element in Mises’ analysis, too. But especially in “Monetary Theory of the Trade Cycle” and “Prices and Production,” he sometimes stated that the next stage of monetary theory would be to set aside an special focus on money’s impact on the price level, and would be more strictly focused on its microeconomic consequences.

    Mises was not an advocate of monetary deflation or contraction. Indeed, more than once in the 1920s and early 1930s, he emphasized in some of his writings that it was an error for the British government to decide to return to the pre-World War I gold parity because it required a monetary contraction. Such a monetary contraction was as harmful as a monetary expansion, precisely because of its relative price and relative income effects, that were inseparable from an attempt to raise (or lower) the general value of the monetary unit.

    Both Mises and Hayek believed that any attempt to prevent the necessary post-boom relative price and wage, and resource allocational adjustments through a “reflation” would only prolong the adjustment period, and possibly generate a new set of misdirections of resources that would have to be corrected for as well. (In the early 1930s this argument was strongly made by Lionel Robbins, also.)

    Only the other hand, both were not in support of a monetary contraction. How, then, could you prevent a monetary contraction during the downturn due to bad investment loans that could not be paid back into the banking sector, and withdrawals of deposits from the banks by panic-stricken depositors?

    Neither of them provided any developed answer to this dilemma in the institutional setting of the 1930s (i.e., a regime of central banking).

    Mises resigned himself to the fact that it was better to let the process just work itself out, since any interventions (including a monetary reflation) would only make the adjustment process worse.

    Hayek never really resolved this problem, either, under central banking.

    The modern free banking school has attempted to explain part of the mechanism by which there may be a resolution of this dilemma. Other Austrian “100 percenters” have challenged this on a variety of grounds.

    This is remains one of the active areas of the Austrian research program.

    Richard Ebeling

    Richard Ebeling

  13. Prof Ebeling,

    There were two components of the action of the British government that you referred to, the political and the “deflationary.”

    How do you know that it was the “deflationary” rather than simply the political that created a problem?

    The question remains: would a purely market driven “deflation” be harmful?

  14. Barkley, you evidently haven’t read Hayek’s “Profits, Interest and Investment”

    “I would disagree that Keynes focused on labor markets more than investment, other than to note what Hayek never did, that it is possible to have involuntary unemployment.”

    And of course, the whole language of “involuntary unemployment” is question begging cross-paradigm bullying, isn’t it?

  15. Barkley,

    People who are voluntarily “unemployed” are retired, not unemployed; and the unemployment stats rightly don’t count them as part of the labor force.
    So what exactly is this “involuntary” unemployment you allege Hayek didn’t know about? Are you claiming that Hayek was unaware of unemployed workers? Or that he thought that they were “voluntarily” not working, i.e., retired?
    Regarding the housing bubble, it did begin in 1998. But sometimes bubbles take a very long time to inflate, or inflate in bits and starts. Shiller’s observation that it began in 1998 is consistent with the Austrian theory. Remember that there was a stock bubble going on in the late ’90s, which was fueled by low interest rates. Rates were cut after the demise of LTCM in 1998.
    Also, we might take a page from George Selgin’s “Less Than Zero,” and, recalling that productivity gains were greater than average after 1995 (for about 8 years), realize that monetary policy should have been tightened a bit in accordance with his productivity norm.

  16. Prof Rizzo,

    Yes, I see that discussion at the Austrian Economists blog. Peter Boettke just added to it this morning.

    He offers the analogy, to the Fed’s trying to undo its mistakes, of the driver, who had just run over someone, backing up over them to undo the damage.

    It seems to me that there is nothing necessarily optimal about a particular “price level.”

    Regardless of what brought it about, the optimum would be no further political interference with it, that, if prices went up, because of the losses, say, of a hurricane, so be it, and, if down, because of technological advancement, so be it.

  17. Any monetary deflation requires that some of the quantity of the money in the economy is taken out of circulation.

    For example, in the early 19th century after the wars with France, the British government ran budget surpluses. It returned to the Bank of England its notes received as taxes, to pay off the government’s accumulated debt from borrowing from the Bank of England during the war. This continued until the early 1820s, when the enough notes had been withdrawn from circulation that the Bank of England could restore formal redemption of notes for gold starting in 1823.

    Institutionally, in the current U.S. system, the Federal Reserve would sell government (and other) securities that it held on the open market. This would drain reserves from the banking system, limiting the amount of lending banks could make.

    Regardless of the particular avenue through which the monetary contraction occurs, specific individuals in a specific time sequence experience a decrease in the amount of money they receive as sales revenues, money incomes, etc.

    Just as there is no helicopter that proportionally and simultaneously drops additional money in each and every individual’s cash balance, there is no giant vacuum cleaner that would proportionally and simultaneously suck out money from each and every individuals’ cash balances.

    Just as a monetary inflation generates its own injection effects, a monetary contraction brings about its own withdrawal effects.

    Thus, in the British case of the early 19th century, people would have paid their taxes and that money was then kept out of circulation. Those who paid those taxes had less money to spend; they would have decreased their demands for good and services in distinct ways guided by their marginal evaluations of which quantities of goods they preferred to do without, given the smaller remaining amount of money income at their disposal.

    The sellers of those particular goods and services would have seen a decline in the demand for their marketed goods. Their money revenues and incomes would have declined, reducing their ability to spend on other goods. They, in turn, would have (at the margin) decreased their demands for various goods in non-proportional ways. Etc. etc.

    Thus, in a particular time-sequence prices in general in that economy would have decreased. But the particular individual steps in that time-sequence would be the specific non-neutral manner in which a monetary deflation will have brought about a general rise in the purchasing power (or value) of the monetary unit.

    During this process, and for as long as it went on, the structure of relative prices and wages, profit margins, and the allocational uses of resources, capital and labor, would be impacted upon as an inescapable component, the end result of which is the increase in the monetary units value.

    There cannot occur a change in the general value or purchasing power of the monetary unit in either direction other than through the specific exchange sequential steps through which individuals increase or decrease their money demands for goods and services, in the face of finding themselves with greater or smaller cash balances out of which to make purchases.

    Thus, the British government’s decision to raise the value of the British pound to pre-World War I parity in the early 1920s carried with it these non-neutral effects.

    The dilemma (besides any others) was the fact that wage rates had risen during the wartime inflation, trade union power had grown, and money wage adjustments downwards in the face of the monetary contraction resulted in increased unemployment in Great Britain.

    Mises already in the 1920s (as Hayek did later) pointed out David Ricardo’s policy proposal from the early 19th century that when the value of the monetary unit had depreciated beyond a certain percentage, it is pragmatically better to stabilize the value of the currency at his inflated level than to put the economy through the process of a monetary deflation.

    Mises sometimes used the example that if a car going forward runs a man over, the driver of that car does not reverse the damage done by going backwards and running over him again. That merely makes matters worse with its own particular type of damage.

    Whatever degree of non-neutral and distorting effects a monetary deflation may bring in its wake, those effects are intensified to the extent to which wages or prices are resistant to reflecting the changing value in the monetary unit.

    Richard Ebeling

  18. Prof Ebeling,

    You wrote,

    “money wage adjustments downwards in the face of the monetary contraction resulted in increased unemployment in Great Britain.”

    Why would wage adjustments downward result in increased unemployment? Wouldn’t it be just the opposite?

    Understanding inflation and deflation not as a rise or fall in prices but an increase or decrease in the money supply, and putting the question in its simplest terms, imagine either an increase or decrease of it, either through the discovery of more gold in the ground or the loss of it in shipwrecks.

    Assuming nothing but 100% reserve banks, the problem is simple.

    Those who have discovered the gold gain the most from its discovery, and, those most directly serving them, the next most, and so on. Anything wrong with that?

    Conversely, those who have lost their gold in shipwrecks suffer the consequences. Anything wrong with that?

    Fractional reserve banking makes it look more complicated, but it still comes down to the same thing? Those who better conserve credit, a vital social asset, profit from it, and, those who don’t, suffer. Anything wrong with that?

    If not, all that your bail-out of the financial system comes down to is the bail-out of imprudence at the expense of prudence.

    And what is right with that?

  19. Dear Lesvic:

    My apology, I meant “resistance” to downward money wage adjustment.

    I did not anywhere in my comment imply support for or endorsement of a “bailout of the financial system.” Nor did I suggest in anyway that a reflation of any sort was desirable or economically necessary from a policy point-of-view.

    It is important not to read into words things that may not be there.

    Nonetheless, if there were a contraction of the monetary supply, such as an intentional decrease in the amount of money in circulation by the government, there would be consequences and effects in the market.

    If unanticipated, it most certainly would impact on creditor/debtor relationships.

    But even if the planned aggregate contraction of the money supply were known, and even if it was known that, on average and in general, this would tend to bring about, say, an “x” percent increase in the general value or purchasing power of the monetary unit, as measured by some price index, there would still be non-neutral effects on the structure of relative prices and wages, profit margins, and incentives to employ factors of production in particular ways.

    This is, of course, no different than what is likely to be expected from an increase in the supply of money, as the Austrians have made famous in their micro-based analysis of money and inflation.

    There are differences, though. In principle the money supply could be expanded unendingly until the value of money becomes virtually worthlesss. The money supply can only be contracted until the quantity of that type of money in circulation is zero.

    Another difference, for example, is that sluggishness in money wage adjustment in an upward direction during a monetary inflation may generate additional artificial profit margins that can create the illusion of “prosperity.”

    Rigidities in money wage adjustment downwards during a monetary contraction will additionally reduce some profit margins or even generate losses for some businesses or sectors of the economy, creating the impression that the situation is “gloomier” than may be the case.

    Understanding and analyzing the consequences that may follow from either a monetary increase or decrease does not imply any specific policy prescription.

    For example, I tend to be out of line with some of my Austrian friends and colleagues because I don’t support any policy prescription that endorses monetary reflation under a system of central banking.

    I have my own “positive” and “normative” reasons for holding this position.

    But it does not change the fact money is non-neutral in its effects on the market process, and this is both when the money supply increases and decreases. Understanding the impacts of such monetary expansions or contractions is a “value-free” aspect of the economist’s work.

    Richard Ebeling

  20. dg lesvic,

    Here is my explanation of Hayek’s secondary recession, and why a prescription of inflation may be appropriate:

    Upon the onset of a recession, in addition to necessary restructuring, the demand to hold money may increase. Because the bust shatters so many expectations, even those who did not malinvest may be spooked, and their perception of risk increases. Money is then often seen as a safe alternative to ordinary spending, and the market is flooded with sellers. This “flight to liquidity” disrupts the flow of money which old prices had been predicated upon, and sets in motion a series of adjustments. Unfortunately, the adjustment process takes time, and some prices, particularly wages, might be “sticky”. In consequence, an economy may be burdened with a glut of unemployed resources, and thrown into political turmoil as large numbers lose their jobs.

    A sensible response by a central bank, when faced with a “flight to liquidity”, might be to increase the money supply. Although this prescription is superficially similar to a Keynesian monetary stimulus, it differs in that its purpose is to synchronise saving and investment, because otherwise interest rates would not fall sufficiently in response the increased demand for money, i.e. savings, i.e. the unemployed resources and unemployed people.

    In a free market banking system, without a central bank, these adjustments would take place automatically. In other words, the secondary recession is not the product of the market, but of a central bank’s control of the money supply.

    Of course, whether a central bank should tackle a secondary recession ought to be considered case by case, because a central bank’s ability to respond quickly and free of political pressure is of prime concern. In some circumstances, a secondary recession might be a lesser evil than an empowered central bank closely allied to government.

  21. Clarification:

    When I wrote that, “in a free market banking system, without a central bank, these adjustments would take place automatically”, the “adjustment” I mean is an increase in the money supply.

    When the demand for money (i.e. bank liabilities) increases, it gives the bank greater control over resources, which it can then use to increase its lending.

    In other words, credit expansion would occur in reaction to a secondary recession in a free banking system. But since we are stuck with a central bank, we might hope that it can at least replicate what the free market would have done anyway.

    None of this would affect the unwinding of bubbles and price adjustments necessary to set the economy on a sustainable growth path.

  22. In other words, there are unforeseen changes in the supply of and demand for money as for anything else, and, as with everything else, those who best anticipate or merely through luck better position themselves for change gain what the Austrian School defines as profit, as distinct from wages and interest.

    And it follows that any political interference, even with the consequences of prior political interference, merely redistribute income from more to less socially useful allocations.

  23. Kelly,

    I wrote the above before seeing your two insertions. They don’t change my thinking.

    The stickiness you refer to is a consequence of political interference. And, as I believe you imply, the best thing is to let things hit bottom as quickly as possible, so they may start up again as quickly as possible.

  24. dg lesvic,

    I am saying that a free banking system would create a great big cushion, so that “hitting bottom” would not be so painful. The high unemployment that follows a bust is, in part, due to a temporary shortage of money at the prevailing prices. A free banking system would respond to an increase in demand for money, i.e. its liabilities, with lower interest rates. Therefore, in principle, there does not need to be any fall in prices, and the high unemployment would be dealt with automatically.

  25. Lee Kelly

    You wrote,

    “The high unemployment that follows a bust is, in part, due to a temporary shortage of money at the prevailing prices.”

    There was no “shortage” of money, just a failure of prices to fall into line with changes in the money supply. Once they did so, there would be no more problem, and no more apparent “shortage” of money.

    There would no such failure of prices to adjust to the supply of money in the free market. They must adjust, immediately. Assuming you want to remain employed, you have no choice. You must accept a lower wage. The only thing that could keep you from doing so was political interference with prices and wages.

  26. It is perhaps worth recalling the causes of unemployed resources, including labor.

    The textbooks talk about “frictional,” or “structural” or “cyclical” unemployment. But a better classificatory formulation was offered by W.H. Hutt in his “The Theory of Idles Resources” (1939).

    Hutt asked, why would a resource or a worker be unemployed? He responded that workers might be unemployed when:

    (a) no one has any use for their services;

    (b) employment opportunities are seasonal and it pays for workers to be idle part of the year;

    (c) workers won’t move to where jobs are, or won’t accept the prevailing wages for their skills, or prefer leisure, or have their idleness subsidized;

    (d) a union pushes wages above market levels and a barrier or incentive prevents the unemployed workers from moving to other jobs;

    or (e) workers withhold their labor because they are unwilling to accept pay cuts when the demand for their services has fallen.

    The political element usually enters when the government subsidizes unemployment through unemployment insurance, which lowers the cost of more quickly taking a pay cut, or looking for a new job in a different location, or immediately retraining oneself with a new marketable specialization.

    It also enters into the process when, with political backing, trade unions can resist wage adjustments downwards through preventing any others (both union and non-union) from offering their labor services at more attractive terms to prospective employers.

    The crux of the unemployment problem during the Great Depression, Hutt argued, were labor unions’ often aggressive resistance to pay cuts in the face of declining demand for various goods and services.

    The massive unemployment of the 1930s, therefore, was the result of what Hutt called “contrived” scarcities created by government and special-interest groups with political clout.

    Richard Ebeling

  27. dg lesvic,

    There can be a shortage of money. Although we usually price goods in terms of money, we can also price money in terms of goods. Because prices do not adjust immediately, a general increase in demand for money can produce a temporary shortage.

    When faced with a shortage, prices and supply typically increase, with the former providing the signal for the latter. But with money, (i.e. bank liabilities), you seem to make an exception, and assert only price increases are appropriate, but why? Why shouldn’t banks, or anyone else for that matter, increase the supply of their liabilities in response to increasing demand? What good would such a piece of financial regulation achieve? Why not let the market work?

  28. “Why would a resource or a worker be unemployed?”

    Because “no one has any use for their services.” ?????????

    Prof Hutt gets a B minus at best.

    Before explaining chronic, massive unemployment you should make it clear that there is no such thing in the free market.

    The market, always tending toward equilibrium per se, always tends toward full employment, equilibrium between the supply of and demand for manpower.

    Only one thing in the market itself could keep it from equilibrium and full employment, an oversupply of labor relative to land. But, with equilibrium between land and labor, or undersupply of land, the owners of land must employ all of the available labor in order to maximize the profitable use of their land; and, any of them not capable of doing so will be displaced by those who are.

  29. The reason that there can’t be a shortage of money, in a free market, is that any amount of it is infinitely divisible. A given supply of gold will perform its monetary service just as well with one as with any other amount of goods, and whether a loaf of bread is priced at one tenth or one hundredth of an ounce of gold.

    You wrote,

    “Although we usually price goods in terms of money, we can also price money in terms of goods.”

    What’s the difference?

    You wrote,

    “Because prices do not adjust immediately, a general increase in demand for money can produce a temporary shortage.”

    At the moment, I have a very definite shortage of money. But that doesn’t mean that the economy as a whole has a shortage of money, and that a super monetary authority should create more of it.

    A “general increase in demand for money” doesn’t create a shortage of it but a higher price of it. If a political authority suppresses the price, it will create a shortage of money, as it creates a shortage of anything, when it suppresses the price.

    Again, the solution is not the printing press but a pink slip for the political authority.

    You wrote,

    “Why shouldn’t banks, or anyone else for that matter, increase the supply of their liabilities in response to increasing demand? What good would such a piece of financial regulation achieve? Why not let the market work?”

    Why not, indeed!

  30. Lesvic:

    The context in which Hutt is discussing these issues in “The Theory of Idle Resources” is when any factor of production might be unused, or idle, or unemployed.

    In general, we might think of labor as the most versatile factor of production. But when dehomogenizing labor, this need not always be the case.

    A man, say, wounded in war or in an accident may be so disabled that while he might desire to work, and might work at any wage (so to speak), he lacks the capacity to perform any useful activity for which an employer might wish to hire him.

    Certainly this would be the case in which the specific worker is “useless” from the market’s point-of-view.

    And there are certainly specific forms of capital that may be unemployable any longer and not worth even incurring the cost to sell it for scrap; hence, it is left to simply rust.

    So, in my humble opinion, Professor Hutt would earn something significantly above a B minus.

    Richard Ebeling

  31. Prof Ebeling,

    Does the case of a man in a coma invalidate the proposition that the unhampered market tends toward full employment?

    Your example of men who are unemployed because they have no services to offer has nothing to do with the case of men who are unemployed because “no one has any use for their services.”

  32. Lesvic:

    You seem to be afraid that there is lurking a hidden Keynesian around every corner.

    Did anyone among the Austrians who have commented in this exchange of views suggest once that a free market fails to tend toward full employment?

    But this is not really the point. The questions concern how and to what degree markets adjust to changing circumstances — both market based and intervention-influenced.

    I fear that you are allowing your libertarian defense mechanisms to blind you to the fact that there are legitimate questions in economic theory that need to be analyzed.

    You may (or may not) recall that Hayek pointed out many times that due to the nature of imperfect, decentralized knowledge in a constantly changing environment the question is not why markets may be out of equilibrium, but rather how they would ever be tending to such a hypothetical equilibrium?

    It is the task of Austrian-type process analysis precisely to explain the nature of how markets work to bring about situations in which there is successful plan coordination in a complex arena of trade with tens of millions of participants.

    To assert that “markets assure full employment” is not a substitute for the clear and logical analysis of how this may or may not come about in different institutional situations.

    Richard Ebeling

  33. Prof Ebeling,

    I’m afraid you’re going to have to give me a failing grade, because I don’t see how you can agree that markets tend toward equilibrium and then question how they do so. If you don’t know how they do so, how do you know that they do so?

    You may observe phenomena of the physical world without knowing how they came about, but you can’t observe the Invisible Hand.

    Knowledge of it could only be knowledge of how it works.

  34. Well, that may not have been exactly right either. You could observe the effects of the invisible hand, induce its existence from the effects, without knowing exactly how it worked. But, for the benefit of those Austrians who don’t know, here is how it works.

    Imagine an isolated community with one store, and that when the housewives came in to buy meat and potatoes for the evening dinner, they found more meat but not as many potatoes as they wanted.

    They would bid up the price of the potatoes, and downward that of the meat, and, thereby, send a signal to the farmers: less meat and more potatoes. To maximize their sales and profit, the farmers, and all of the other producers, would have to respond to the signals and wishes of the consumers, and until there were no more relative oversupplies and undersupplies but equilibrium between the supply of and demand for meat and potatoes, and everything else.

    It was the spontaneous tendency toward equilibrium, driven by the profit motive, and guided by the signals of price, that Smith called the Invisible Hand.

    Note the two things that make it work, the profit motive and market prices. The market is a profit and price system.

    You wouldn’t need it in the small-scale economy of a self-sufficient farm household, tribe, or commune. For, you could observe all of the factors of supply and demand, and judge their input and output. But, in the maze of a vast, intricate, modern economy, you could only observe their prices, not the factors themselves, and calculate, not judge, the countless intermediate steps to profit or loss, success or failure, and only by means of the cardinal numbers ($1, $2, $3) of the price system.

    And if we understand that, we understand capitalism, for it is the price system, the large-scale, modern, progressive economic system.

  35. Lesvic:

    Yes, prices are signals.

    But how do you know what the price signal is telling you? Or what is the right response? Or what others in the market might be planning to do in competition with you that you must take into consideration in planning your own course of action?

    And a wide variety of other crucial questions that actors in the market place all must answer in correct ways over time to assure that markets “do their job.”

    I would suggest that you might find it of interest to read “The Economics of Time and Ignorance” by Gerald P. O’Driscoll and Mario Rizzo (the host of this blog).

    And I can assure you that Hayek understood these things, and much more. I would suggest that you read through some of Hayek’s essays in “Individualism and the Economic Order,” especially, ‘Individualism: True and False,’ “The Use of Knowledge in Society,’ ‘Economics and Knowledge,’ and ‘The Meaning of Competition.’

    Richard Ebeling

  36. Prof Ebeling,

    George Soros shares your concerns, but I don’t. For no uncertainties in the market can change the fact that it tends toward a final state of rest, and that, since it cannot rest at disequilibrium, it must tend toward equilibrium.

    Entrepreneurial error doesn’t change the fact that the market tends to correct it, and that interference with the market is interference with the correction.

    The possibility of market failure is immaterial. Economics is not a science of possibilities, for anything is possible, nor of certainties, for nothing is certain. It is a science of practical and reasonable assumptions, and the futility of human action is not one of them. The possibility of getting hit by a truck if we get out of bed in the morning doesn’t mean we shouldn’t get out of bed. To live we must act, to act presume success, and, to analyze our action, a universe conducive to it, tending not toward disequilibrium and chaos but equilibrium and order.

  37. dg lesvic,

    My point earlier is not that the market fails because prices do not adjust immediately. My point is the the secondary recession which Hayek describes is a product of a centrally planned monetary policy. In other words, the deflation is not the market’s natural response, but the only one available given the presence of a central bank.

    If there was a free market in banking and money, if there was no central bank, if the government did not have a monopoly on the supply of money, (i.e. if we had a free banking system), then an increase in the money supply would happen automatically when demand for money increases. That would be a natural market mechanism, that would be the free market at work, and not some Keynesian style intervention by a central bank.

    But since we are stuck with a central bank, it is not unreasonable to suggest that it emulate what the market would have done if it were allowed to function. Whether you trust a central bank to do this is another matter.

  38. Lee Kelly,

    In other words, if I want more money, in a free market, some bank would create it for me, and, if a bank wouldn’t, some other counterfeiter would.

    And since we’re stuck with a central bank and counterfeiter, it would be reasonable to suggest that it do what free market banks and counterfeiters would do.

    Reallocate credit from the more to the less useful dispositions of it.

  39. But there wouldn’t be anything counterfeit about the credit expansion, because it would be backed up by real savings. Otherwise the market rate of interest would rise above the natural rate, and distortions similar to what the ATBC describes would occur.

    Ordinarily, central banks keep the market rate of interest below the natural rate (i.e. the real saving rate), and therefore create the distortions of the kind described by Hayek, Mises, etc., but what if the market rate of interest rises about the natural rate, wouldn’t that also cause similar distortions? Wouldn’t companies that should get credit be denied?

    Central banks are quite capable of mismanaging interest rates in either direction, and Hayek recognised this in the case of a secondary recession.

    A free banking system would automatically step in and expand the money supply in response to increased savings, and it would simultaneously not stop the a bubble from deflating. Hayek suggest that since we are stuck with a central bank, it should at least try and emulate this function of the free market.

  40. Lee Kelly,

    You wrote,

    “But there wouldn’t be anything counterfeit about the credit expansion, because it would be backed up by real savings.”

    But what the credit expansion does is rob the savers of the benefits of their savings.

    However you complicate the analysis, it will always come down to this simple conclusion: “credit expansion” simply takes real credit from those who’ve earned it and gives it to those who haven’t.

  41. “But what the credit expansion does is rob the savers of the benefits of their savings.” – dg lesvic

    Not at all. Please try and consider what I am trying to say, rather than reflexively responding as you are accustomed.

    If the market rate of interest falls below the natural rate, then increasing the supply of money does no rob savers of the benefit of their savings, but actually preserves the value of their savings, because otherwise resources are left to depreciate.

    It’s as though you held your savings in fruit. It quickly begin to spoil, and soon your savings would be worth nothing at all. But, if you invested your fruit in someone else, so that in the future they could pay you back with fresh fruit, then your savings are preserved.

    This is exactly what increasing the money supply can achieve under some circumstances, and it is why a free market banking system would automatically achieve what we only hope a central bank might competently mimic.

  42. Correction:

    “If the market rate of interest falls below the natural rate”

    This is supposed to read:

    “If the market rate of interest rises above the natural rate”

  43. Lee Kelly,

    I’m an apple grower. I have harvested 100 bushels of apples. But I don’t take them to market. I store them for future use. And, whaddyaknow, they spoil. There is nothing to show for my efforts. Nobdy got to eat my apples, and I lost all my investment in them.

    My neighbor, on the other hand, also an apple grower, harvested 100 bushels of apples too. But he sold them for gold. People got to eat his apples, and he still had something to show for his investment.

    In order to salvage my malinvestment in apples, you are going to have to take somebody else’s gold away from him.

    Why on Earth would you want to do that?

  44. And let’s not quibble over semantics.

    It doesn’t make any difference whether we’re talking about salvaging a malinvestment in perishable fruit or in “depreciating” assets.

    You cannot salvage malinvestment without taking away from investment.

    Nor does it make any difference whether you’re counterfeiting in a good or bad cause.

    It’s still counterfeiting.

  45. It’s not actually counterfeiting for a bank, or anyone else, to issue liabilities (i.e. money). It’s only counterfeiting if someone tries to issue someone else’s liabilities.

    So, no, what I am describing is not counterfieting.

  46. What’s the difference between a banker issuing claims against property he doesn’t have and my doing so, except that I go to jail and he goes to Las Vegas?

  47. No, you’re right and I’m wrong. What the banker is doing is what anyone does who issues stock in a company, and a claim not just upon current but future revenues.

    Score one for the Kellys.

  48. But whether it’s legally counterfeiting or not, it has the same effect, it dilutes the value of the currency, and robs the savers for the benefit of the squanderers, misallocates resources, and creates the bubbles that must burst.

    So, call it what you will, it’s still a prescription for disaster.

  49. Some thoughts on this excellent discussion. I don’t think there are substantive differences between Mises and Hayek on the cycle. Both went back to common roots, i.e., classical political economy. Until 1929-33, governments more or less let downturns run their course. The first counter-example was 1920-21, in which the Harding Administration acted agressively to cut taxes, spending ,regulations, etc. There are good, free-market responses to depression. But “do no harm” is the second best. Mises defined inflation as an increase in the money supply not matched by an increase in demand. Theoretically, then, some monetary expansion in a depression would be in order. A fiat system has no signalling mechanism to tell you how much.

  50. As one of my earlier posts suggested, Mises and Hayek’s conception of the phases of the business cycle are very similar.

    I would just add to Jerry O’Driscoll’s comment that while it is true that Mises does define inflation as an increase in the money supply not matched by an increase in the demand for money, this does not mean that the purchasing power of the monetary unit would be stable or unchanged if the supply of money was only matching any increase in the demand for money.

    This is due to the fact that the usual statistically derived average level of prices — the “price level” — has no unambigious way of being measured, as Mises repeatedly emphasized in great detail many times.

    For Mises, the purchasing power of the monetary unit is the array, or network, of individual exchange ratios between money and all the other goods against which it exchanges.

    In principle, every change in the relative prices amongst goods can also generate a change in the general purchasing power of money, and every change in the general purchasing power of money invariably also generates a change in the structure of relative prices.

    Richard Ebeling

  51. Prof O’Driscoll,

    You wrote,

    “Mises defined inflation as an increase in the money supply not matched by an increase in demand.”

    That surprises me. I would sure like to know just where Mises said that, and, especially, in Human Action, 3rd Edition, which I have right before me.

    I’m scanning it now, looking for that.

  52. Perhaps I’m confusing Mises with Rothbard, though I would have thought they agreed on this, but I seem recall at least one of them saying that any increase in the supply of money, matched by an increase in production, or not, was inflationary. The fact that it didn’t result in higher prices didn’t change the fact that it still distorted production.

    The more I think about it, the more I think that was from Rothbard, but, again, I would be surprised if they differed on that.

  53. Prof O’Driscoll,

    Once again, you wrote,

    “Mises defined inflation as an increase in the money supply not matched by an increase in demand. Theoretically, then, some monetary expansion in a depression would be in order.”

    But, Prof Ebeling, above, wrote:

    “Both Mises and Hayek believed that any attempt to prevent the necessary post-boom relative price and wage, and resource allocational adjustments through a “reflation” would only prolong the adjustment period, and possibly generate a new set of misdirections of resources that would have to be corrected for as well. (In the early 1930s this argument was strongly made by Lionel Robbins, also.)”

    “Mises sometimes used the example that if a car going forward runs a man over, the driver of that car does not reverse the damage done by going backwards and running over him again. That merely makes matters worse with its own particular type of damage.”

    So, while it appears that you are drawing the conclusion that, theoretically, some monetary expansion in a depression would be in order, from what you say was Mises’ premise, that inflation was an increase in the money supply not matched by an increase in demand, it appears, from what Prof Ebeling told us, that Mises did not draw that conclusion at all, from any premise.

  54. Prof O’Driscoll,

    Again, your statement: “Mises defined inflation as an increase in the money supply not matched by an increase in demand.”

    Are you sure you didn’t mean Friedman, rather than Mises? I have been looking and looking through Human Action (3rd Ed), and found nothing of the sort. To the contrary:

    “The services which money renders can be neither improved nor repaired by changing the supply of money…The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.” P 421

    “It is possible by means of an increase in the quantity of money to delay or to interrupt this process of adjustment. It is impossible either to make it superfluous or less painful for those concerned.” P 431

  55. I would suggest you go to the Theory of Money and Credit for the Mises definition. With a gold standard and free banking, changes in the demand for money tend to bring forth new supply. It is self-regulating. Rothbard is a different story, and Friedman yet another. I agree with Richard Ebeling on all points.

  56. From Mises, The Theory of Money and Credit, p. 240. Available at

    “In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term)…”

  57. Prof Rizzo,

    Thank you for providing us with Mises’ exact words and exactly where they could be found. That was most helpful.

    I was very surprised by them. They certainly seem inconsistent with the other statements of his that I quoted above, particularly,

    “The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.” Human Action, 3rd Ed, P 421

    I can understand a changing demand for money, but not a changing “need,” if any given quantity of it is “always sufficient.”

    Could it be that Mises changed his mind? Am I right in the recollection that The Theory of Money and Credit preceded Human Action?

  58. The passage you quote from “Human Action” is merely a restatement of an argument that many proponents of the quantity theory of money have made since David Hume in the mid-18th century in his famous essay, “Of Money.”

    All it is saying that if prices (meaning all prices for both finished goods and the factors of production) adjust appropriately to whatever the changed quantity of money may be, it is sufficient to facilitate all transactions that market participants wish to undertake.

    In a subsection of “The Theory of Money and Credit,” Mises refers to the ambiguity of precisely defining inflation or deflation and even suggests that for some “scientific” economic discussions it might be better to avoid the terms if possible.

    But if the terms are to be utilized, he adapts the meaning or definition that Dr. Rizzo quotes from “The Theory of Money and Credit.”

    Richard Ebeling

  59. Yes, The Theory of Money and Credit was much earlier than Human Action. While it is possible that Mises changed his mind, I have always reconciled the apparent difference in this way. Inflation (and deflation) refers to a process. The statements about any quantity of money being enough refer to comparative static analysis. In other words, the latter abstracts from any process of adjustment. The business cycle, in its recovery phase, is *essentially* a process of adjustment. So what happens to, say, expectations of prices, etc. is very important.

  60. Prof Ebeling,

    You wrote,

    “But if the terms are to be utilized, he adapts the meaning or definition that Dr. Rizzo quotes from “The Theory of Money and Credit.”

    I’m afraid you’re going to have to give me a failing grade on that, for I see nothing of it in the passage we’re referring to, Inflation and Deflation; Inflationism and Deflationism, in Human Action, 3rd Ed, Pp 422-424.

    Prof Rizzo,

    If Mises meant what you said, why didn’t he say it?

  61. The bottom line is this. Could we infer from anything Mises said that there was ever any good reason for increasing the quantity of money? And, if we could, how could we reconcile it with everything to the contrary he had said?

  62. Mises was not afraid to speak his mind.

    Where do you see him ever clearly saying that there were occasions for increasing the supply of money?

  63. What I care most about is where the analysis leads logically. I think Mises was making the distinction to which I referred above. But, if not, he was wrong.

  64. But, by not repeating the premise within his earlier work in his later work, he effectually repudiated it. So, whatever follows from his earlier work on the subject does not follow from his later, more mature, and considered work on it.

  65. You may still say that he was wrong in his later work. But what was his mistake?

    You refer to the distintion he made. But in his earlier work, he missed the distinction between an increase in the money supply matched by an increase in the demand for money and an increase in the one not matched by an increase in the other.

    What was wrong with making that distinction?

  66. It’s late at night, I’m a bit fuzzy, ahd got things backward.

    In Mises’ earlier work, as you relate it, there was the distinction you referred to, between an increase of the money supply and an increase of prices. They were both increases, but only the one was inflation.

    In his later work, Mises repudiated that distinction. They were both inflation. An increase of the money supply was an inflation of it, with or without an increase and inflation of prices.

    without the inflation of prices, the inflation of the money supply was masked. But it was still there, and still detrimental.

    An increase in prices per se is not detrimental. If it’s market driven, it’s essential.

    The only thing that was detrimental was interference with the market, and with the money supply as with any other part of it, and whether it resulted in higher prices or not.

  67. Market driven rises or falls in prices drive the market in the directions it needs to go.

    If prices are rising, it means that the market wants more of what is currently being produced.

    If they are falling, it means the market wants less of what is currently being produced, and more more saving and investment in new things.

    Tampering with the money supply masks these signals, and misdirects the market.

  68. Actually, there was an inflation of prices, even without an increase in prices, if the increase in the money supply kept prices from falling. Prices, though stable, were still higher than they would otherwise have been.

  69. Prof Rizzo said that banks must increase the supply of money to keep pace with increasing demand for it.

    Not at all.

    The increasing demand for money is for a greater proportion of the existing stock of it to be set aside, saved, and invested, and not for a greater overall amount of it.

  70. dg lesvic,

    I don’t think you understand. Just keep thinking about it, though, because regardless of what Mises thought, I think the proponents of free banking are right on this one.

  71. I just printed out this whole discussion, and see things on paper I didn’t see on a computer screen.

    I feel sorry for anyone reading this, for so much of it was so poorly written, vague, ambiguous, and confusing, and with myself as guilty as anyone.

    One passage of mine even puzzled me.

    “Without the inflation of prices, the inflation of the money supply was masked. But it was still there, and still detrimental.”

    It would make everything a lot clearer to realize that this discussion was all about something that was never explicitly mentioned, an increase in production.

    It was the increase in production that was “the greater demand for money,” and increase in production that kept prices stable even while the money supply was being inflated.

    And it was the increase in production, while the money supply was stable, in a completely free market, that drove prices downward, in an apparent “deflation.”

    Should the money supply be increased to counteract it?

    No, for that would mask the signal of the market, that it wanted less of the same things, and keep producers cranking out those same things in the same quantities that the market no longer wanted. The result, a glut, and wasted resources.

    It makes no difference whether the falling prices were the result of free market technological progress or the downward phase of an interventionist business cycle. They were still signaling the market’s needs, for less of what was currently being produced, and for more saving and investment in other things. And it would be as detrimental to mask that signal and misdirect the market in the one circumstance as in the other.

  72. Good day! I know this is kind of off topic but I was wondering which blog platform are you using for this site? I’m getting fed up of WordPress because I’ve had issues with hackers and I’m looking at alternatives for another platform. I would be great if you could point me in the direction of a good platform.

  73. There are some fascinating points in time in this article however I don’t know if I see all of them heart to heart. There may be some validity but I’ll take maintain opinion until I look into it further. Good article , thanks and we wish extra! Added to FeedBurner as effectively

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