Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek
By Gerald P. O'Driscoll
Axel Leijonhufvud first suggested to me that reexamining Hayek’s contributions might be worthwhile. From the start, I sensed that Hayek’s theories were misunderstood in important respects. One major reason was the tidal wave of the Keynesian revolution. Contributing to the eager acceptance of Keynes’s message was a desperate desire for a cure for the economic ills of the Great Depression…. [From the Introduction]
First Pub. Date
Kansas City: Sheed Andrews and McMeel, Inc.
Foreword by Friedrich A. Hayek.
The text of this edition is copyright © 1977, The Institute for Humane Studies.
Mr. Locke….has clearly seen that the abundance of money makes everything dear, but he has not considered how it does so. The great difficulty of this question consists in knowing in what way and in what proportion the increase of money raises prices (Richard Cantillon,
Essai sur la nature du commerce en général ).
Many of the lively monetary debates of the 1920s and 1930s concerned which issues come under the purview of monetary theory and what constitutes an adequate monetary explanation of cyclical fluctuations. To make sense of these debates, we must consider the differences between the conception of monetary theory then and now.
Many of the participants in the early debates had a wider conception of monetary theory than do contemporary monetary theorists. This narrowing of interests among monetary theorists is partly attributable to the Keynesian revolution. After Keynes there was a loss of interest in monetary theory as a separate field of inquiry. To some extent, the Keynesian interpretation of the liquidity trap and other passages in the
General Theory cast doubt on the effectiveness of monetary policy altogether.
*1 Similarly, research waned in related areas, such as business cycle theory, in which monetary theorists had always taken an active interest.
However, according to Harry Johnson, activity in monetary theory was again flourishing by 1962.
*2 Increasing attention was paid to the work of the new monetary theorists. These theorists restricted their inquiry to three broad but interrelated areas: analysis of the demand for money, determination of the money stock (or the money supply function), and determination of aggregate nominal income.
*3 Other important issues, such as
those raised by the Patinkin debate having to do with the long-run neutrality of money, were generally abandoned.
Milton Friedman’s 1956 paper on the restatement of the quantity theory was a milestone in the revival of interest in monetary theory.
*5 His formulation of the quantity theory is one that has greatly influenced the course of subsequent research. By in effect redefining the scope of monetary theory, he has successfully focused attention on a narrow range of issues in monetary theory and promoted the neglect of others.
Friedman expressed his conception of the quantity theory as follows: “The quantity theory is in the first instance a theory of the
demand for money. It is not a theory of output, or of money income, or of the price level.”
*7 As he noted: “In order to have a complete model for the determination of money income, it would be necessary to specify the determinants of the structure of interest rates, of real income, and of the path of adjustment in the price level.”
*8 But if interest rates and real income are determined by forces other than the demand and supply for money, then Friedman’s restatement yields a theory of the equilibrium level of money income despite his original disclaimer.
In successive restatements of his original thesis, Friedman consistently treated the determination of nominal income (in the short run) as the chief goal of monetary theory.
*10 Moreover, the analysis of fluctuations in nominal income is carried out in terms of the effects of an excess demand for money.
Critics of the neo-quantity theory often seem reluctant to call themselves “monetary theorists.” The tendency is to accept a neo-quantity theory explanation as
the monetary explanation. Contemporary opponents of monetarists find themselves in a quandary as to what to call themselves.
*12 Formal definitions of monetary theory also reflect this change.
Actually, monetarists are following Hicks’s famous “Suggestion for Simplifying the Theory of Money.”
*14 It could be argued that Hicks’s suggestions are responsible for the change in monetary theory. But, as is often true of novel ideas, implementation of Hicks’s approach was slow.
Is there more to monetary theory than demand-and-supply analysis of money, or the determination of nominal income? In
the post-World War I era monetary theory (specifically, the quantity theory) was criticized for overemphasizing the effects of an excess demand for money. According to Hayek and others, important phenomena were ignored if economists failed to significantly modify the analysis of the quantity theory, particularly in studying short-run economic fluctuations.
A historical background is essential for an understanding of the quantity theory as it appeared to monetary theorists in the early part of this century. Hayek’s criticism of the quantity theory becomes meaningful once the character of the older quantity theory is properly delineated. And to the degree that the neo-quantity theory has kept essential features of the older quantity theory, Hayek’s criticisms have more relevance today.
Hayek constructed his monetary theory upon the foundations laid by early British monetary theorists and Knut Wicksell and Ludwig von Mises. The specifically short-run character of Hayek’s monetary analysis is significant, as is his use of the concept of the “neutrality of money.” Let us now turn our attention to this development, and to monetary theory as it was at the beginning of the century.
At the end of the nineteenth century Wicksell concluded that the quantity theory was the only “specific” theory of money available. What was specific about it for Wicksell was the
proportionality theorem—the unique relationship between the stock of money and the purchasing power of a single unit of money—which held that price changes are ultimately in direct proportion to changes in the quantity of money:
Since, however, it is true of all commodities than [sic] an increase in supply in itself tends to lower their exchange value, there is nothing unusual in the quantity theory nor anything peculiar in money as such. The special peculiarity of the Quantity Theory consists in the proportionality required between the quantity of money and commodity prices.
Thus, Wicksell argued that “the whole dispute” over the quantity theory “turns ultimately on… whether the velocity of circulation of money is of autonomous or merely subordinate significance for the currency system.”
*16 But regardless of the outcome of this dispute, it was the quantity theorists alone who had something approximating a systematic theory. He believed the quantity theory to be basically correct for an inflow of specie, the case for which it was first developed. However, Wicksell thought it needed to be supplemented when dealing with the phenomena of an increase in the money supply in the form of bank credit.
Imprecision and lack of focus often characterize discussions of what the quantity theory is. Viewed as a
ceteris paribus proposition the proportionality theorem is but a verbal presentation of the information in the equation of exchange:
PQ. I doubt whether quantity theorists ever intend
only to assert this tautologous proposition.
*17 While Wicksell suggested that the dispute over the validity of the quantity theory hinges on the question whether or not velocity is autonomous, Joseph Schumpeter, writing half a century later, suggested that the quantity theory should be defined in terms of four propositions: (1) that the quantity of money is autonomous with respect to prices and the physical volume of transactions; (2) that velocity is autonomous with respect to prices and the volume of transactions;
*18 (3) that real output is unrelated to the quantity of money; and (4) that,
ceteris paribus, variations in the quantity of money “act mechanically on prices,”irrespective of the manner in which the variations first occur.
According to Schumpeter, the only “major writers” to advance this extreme form of the quantity theory were John Wheatley, David Ricardo, James Mill, and John R. McCulloch.
*20 Schumpeter here offered a more precise statement of the assumptions behind what Wicksell termed the proportionality theorem.
Wicksell cited few writers in his study. He relied mostly on Ricardo and J. S. Mill for statements of the proportionality version of the quantity theory. In the chapter “Of the Value of Money, as Dependent on Demand and Supply” in the
Principles, Mill provided a straightforward account of the quantity
*21 Mill started with the case of “the arrival of a foreigner in a place, with a treasure of gold and silver.”
*22 Prices eventually rise uniformly: “Prices would have risen in a certain ratio, and the value of money would have fallen in the same ratio.” The reader is told that “this ratio would be precisely that in which the quantity of money had been increased.”
*23 The teachings of Ricardo and James Mill are evident in John Stuart Mill’s work a generation later. But too much had taken place in the intervening years for the younger Mill to let the subject rest there. When he considered the effects of credit, he amended his previous analysis:
The proposition which we have laid down respecting the dependence of general prices upon the quantity of money in circulation, must be understood as applying only to a state of things in which money, that is, gold or silver, is the exclusive instrument of exchange, and actually passes from hand to hand at every purchase, credit in any of its shapes being unknown. When credit comes into play as a means of purchasing, distinct from money in hand, we shall hereafter find that the connexion between prices and the amount of the circulating medium is much less distinct and intimate, and that such a connexion as does exist no longer admits of so simple a mode of expression.
He concluded that the “sequel of our investigation will point out many qualifications…qualifications which, under a complex system of credit like that existing in England, render the proposition an extremely incorrect expression of the fact.”
Mill stated, in effect, what he thought was a necessary condition for the proportionality theorem to be applicable: the absence of bank credit. Once he introduced bank credit, he deemphasized the mechanical linkage between a given change in the quantity of money and any subsequent change in prices.
*26 Thus, in order to attribute a proportionality theorem to J. S. Mill, his observations on the determination of the “value of money” must be taken out of context.
Let us grant, however, if not Mill then at least Ricardo was a genuine proponent of the quantity theory as defined by Wicksell and Schumpeter.
*28 J. S. Mill’s analysis of the “value of money,” as determined by demand and supply, gave exposure to the quantity
theory in the form of a proportionality theorem. But the result is curious: the strict quantity theory in the form of the proportionality theorem was severely criticized by J. S. Mill. Given Mill’s position in economics, this should have been sufficient to bury the theory for at least fifty years. A lot of energy has been spent on a theory that by the middle of the nineteenth century had been rendered untenable—at least when stated in an unqualified form.
There is, however, another way to approach the controversy over the quantity theory—an approach that makes some sense out of this seemingly senseless dispute. Ricardo and his intellectual disciples were chiefly concerned with establishing comparative static propositions. The legacy of Adam Smith’s treatment of the long run is evident in subsequent work. The long run, or
natural price, “is, as it were, the central price, to which all the prices of all commodities are continually gravitating.”
*29 But a country blessed by wise rulers, just laws, and fortuitous circumstances might resist for long periods this central tendency. This resistance is accomplished by growth, which in this context means population growth and the accumulation of capital. The accumulation of capital in turn keeps the labor market in permanent disequilibrium and maintains wage rates above their long-run level.
*30 But it was a “golden rule” of growth over time that occupied the later classical economists (especially the Ricardians), not the disturbing fluctuations around this trend.
In all situations Ricardians in particular focused on the
ultimate effects of a given change.
*32 It was just this emphasis in classical economics to which Wicksell objected. Wicksell initially characterized the debate over the quantity theory as essentially a question of feedback effects on velocity of changes in the money stock, or the volume of transactions. The debate has traditionally been treated in this way.
But for some critics of the quantity theory the important issue is the
focus of monetary theory—the ultimate effects of an increase of money on prices, or the process by which these changes occur. For Ricardo, the quantity theory was a tool to answer a specific question: what would be the results of a long period of increase in the quantity of banknotes? Ricardo treated the question
as one of value theory and hence employed equilibrium analysis.
*33 However, Henry Thornton, a contemporary of Ricardo’s, wished to examine the process of adjustment to disequilibrium specifically in the loan market. Those who adopted this approach often focused on the effects of an increase in the quantity of money on borrowing and lending because the initial effects of a monetary disturbance are felt here. Quantity theorists, having adopted Ricardian thinking in monetary matters, focused on the increased spending in all markets (including the loan market) that
eventually results. Thus quantity theorists asked whether prices will
eventually rise uniformly as the result of a permanent change in the stock of money. Critics of the quantity theory approach were critical of the comparative static approach used in analyzing what are essentially disequilibrium situations. Beginning with Thornton and Malthus the critics focused on the loan market, for it was in the loan market that the new money entered the system.
Malthus and Thornton made much the same point that the eighteenth-century critic Richard Cantillon made against John Locke’s early formulation of the quantity theory.
He [Locke ] realised well that the abundance of money makes everything dear, but he did not analyse how that takes place. The great difficulty of this analysis consists in discovering by what path and in what proportion the increase of money raises the prices of things.
Ricardo endorsed the cruder formulations of Locke and Hume as against the more refined analysis of Cantillon and Thornton. Successive generations reaffirmed the quantity theory, without perceiving how naked it was without a supporting theory of the short-run adjustment process.
To some critics, the crux of the quantity theory debate is the matter of velocity. However, few theorists subscribed to the view that velocity is constant, or that changes in the quantity of money automatically effect changes in prices. The differences among monetary theorists must lie elsewhere.
“Quantity theorists” such as Hume, Ricardo, and J. S. Mill analyzed the impact of a change in the quantity of money on
actual and desired cash balances. Even when the impact of credit was considered, as in J. S. Mill’s analysis, it was treated only insofar as it affected spending in general.
*36 Thus, later quantity theorists analyzed monetary disturbances in terms of
aggregate purchasing power and
Any impact of changes in the supply of money or credit on the economy were regarded by quantity theorists as affecting spending directly. Henry Thornton is an example of someone who should
not be classified as a “quantity theorist” because he did
not conduct his monetary analysis in terms of the demand and supply of a subset of assets called “money.” In fact, Thornton’s specific contribution to monetary economics, aside from his criticism of the “real bills” doctrine, was his analysis of the indirect mechanism by which a monetary disturbance affects real economic activity. J. S. Mill started his monetary analysis by supposing “that to every pound, or shilling, or penny, in the possession of any one, another pound, shilling, or penny, were suddenly added.”
*37 Thornton, however, focused on monetary disturbance in capital markets and emphasized the gradual effects on spending by way of changes in the interest rates on marketable securities. “In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances.”
The chief difference between Thornton and the “quantity theorists” is that the latter adopted the Ricardian approach of analyzing the long-run effects of a disturbance.
*39 Thornton, on the other hand, was interested in the initial impact of a disturbance and the mechanisms effecting the ultimate outcome.
Schumpeter’s comparative evaluation of Ricardo and Thornton in monetary economics is appropriate:
In matters of monetary as of general theory, Ricardian teaching is a detour and…slowed up the advance of analysis, which could have been much quicker and smoother had Thornton’s lead been followed—had Ricardo’s force not prevailed over Thornton’s insight.
In Wicksell’s initial analysis of the quantity theory the important question was the autonomy of velocity. But, as we shall emphasize in the next section, his emphasis in fact was, like Thornton’s, on the transmission mechanism by which newly created money makes its way through the economy. Schumpeter, as already noted, presented four propositions to define the quantity theory.
*42 His second proposition was the velocity is autonomous with respect to prices and the volume of transactions. However, Schumpeter, in his fourth proposition, pointed out that the manner in which money is introduced into the system is not important. The quantity theorist insofar as he is a Ricardian is concerned only with the long-run effects of a monetary disturbance. Thus
the quantity theory approach is an analysis in which the long-run effects of a monetary disturbance are the main concern, to which short-run effects are incidental.
The business cycle was not the major policy problem to nineteenth-century classical economists. Economic growth and development was the prime policy concern.
*44 In classical analysis the quantity of money was unrelated to economic growth. The quantity of money in particular did not enter into the determination of the rate of interest and, hence, did not alter the rate of capital accumulation. Short-run effects of changes in the quantity of money were unimportant in the long run.
It was against the quantity theory approach as described here that Wicksell and Hayek reacted. Their attitudes reflected the shift in emphasis from the study of economic growth to the study of cyclical fluctuations.
The theory Wicksell presented was not original though apparently he did develop it independently of other influences. There was a British tradition in monetary theory that sometimes
paralleled and sometimes diverged from, but was quite independent of, Richardo’s quantity theory. In this respect, Wicksell’s failure to mention Henry Thornton is perhaps the most striking
lacuna in the
Lectures.*48 Yet much of Wicksell’s analysis of the interaction of money, credit, the interest rate, and prices duplicated Thornton’s.
In his Introduction to Wicksell’s
Lectures, Lionel Robbins pointed out Wicksell’s ignorance of this earlier tradition in British monetary theory. Wicksell apparently did not know of this tradition, save as it was embodied in a passage in Ricardo’s
High Price of Bullion, with which he became acquainted only after publication of his own work:
I do not dispute, that if the Bank were to bring a large additional sum of notes into the market, and offer them on loan, but that they would for a time affect the rate of interest. The same effects would follow from the discovery of a hidden treasure of gold or silver coin…. It is only during the interval of the issues of the Banks, and their effect on prices, that we should be sensible of an abundance of money; interest would, during the interval, be under its natural level; but as soon as the additional sum of notes or of money became absorbed in the general circulation, the rate of interest would be as high.
Ricardo’s thesis is most uncanny in light of later developments. Yet he did not develop this short-run analysis any further.
Wicksell would not have learned about Henry Thornton’s work through J. S. Mill’s
Principles. Though J. S. Mill cited Thornton extensively he did so only regarding the real-bills doctrine, and Mill completely ignored Thornton’s analysis of the effects of changes in the money stock (“paper credit”) on interest rates.
To find “the right solution in this chaos of vague conceptions,” Wicksell started his analysis-much as had Henry Thornton-by examining the effects of a monetary disturbance on market rates of interest.
*51 The important question now is
how more money enters the system. A lowering of market interest rates by an injection of money in the form of bank credit leads to increased investment. Changes in the demand-and-supply condition in commodity markets must then follow and thus changes in
compositionof output. A larger fraction of national income is devoted to investment expenditures, and as a result the marginal productivity of investment declines.
Wicksell did not completely separate this theory from the quantity theory in the
Lectures. Even though his real contribution was to analyze the effects of monetary disturbances on relative prices, he did not carry it through to a final conclusion.
The history of twentieth-century monetary theory cannot be told without consideration of the Ludwig von Mises’s
Theorie des Geldes und der Umlaufsmittel, a major yet neglected work of this century.
*54 Building on Menger, Mises was the first to integrate monetary theory into general economic theory using marginal utility analysis. His work was a textbook on the Continent, though it was unknown in Great Britain before the translation under the title
The Theory of Money and Credit.*55
In an odd way the success of Mises’s work hurt it. As Robbins noted, the ideas worked their way slowly into Anglo-Saxon monetary theory, despite the wide currency of his ideas on the Continent. By the 1930s English-speaking economists could no longer recognize the revolutionary character of
The Theory of Money and Credit.*56
Mises extended the Wicksellian theory by explicitly examining the differential impact on demand for consumption and capital goods brought about by a divergence between loan and natural interest rates. Most important, he distinguished between the effects on general and relative prices. But his business cycle theory is marred by the manner of presentation. Much of
The Theory of Money and Credit deals with changes in the “inner value of money” (
innere objektive Tauschwert), which, as Hayek noted, is a somewhat confusing way of dealing with the neutrality of money. The terminology was bound to engender confusion among English readers. The “building block” quality of German undoubtedly makes clear the distinction Mises intended, for those
fluent in German.
Mises’s theory is literally buried in a conventional treatment of monetary inflation. The forced-savings theory follows a cycle theory based on changes in the value of money, in which certain contractual costs are “rigid” in the fact of rising prices. What
appeared as an appendage at the time was a radically new theory of cyclical fluctuations.
Mises himself commented obliquely on the disjointedness of his presentation in the Preface to the second German edition:
I have come to the conclusion that the theory which I put forward as an elaboration and continuation of the doctrines of the Currency School is in itself a sufficient explanation of crisis and not merely a supplement to an explanation in terms of the theory of direct exchange, as I supposed in the first edition.
Hayek referred to Mises’s theory as the Wicksell-Mises’s theory and stated that progress in monetary theory would depend “partly upon the foundations laid by Wicksell and partly upon criticism of his doctrine.”
Hayek broke completely with the quantity-theory approach. The defect in the quantity theory lay in its comparative static approach, lack of attention to adjustment problems, and consequent focus on movements in the price level to the detriment of any analysis of real disturbances. Hayek’s criticism thus paralleled Wicksell’s.
*60 Instead of viewing the proportionality theorem as essential to the quantity theory, he characterized the whole approach of the quantity theorists as “a positive hindrance to further progress.”
*61 “Hardly any idea in contemporary monetary theory” was not known to writers in the early nineteenth century.
*62 In forsaking the approach of microeconomics—”the ‘individualistic’ method” to which “we owe whatever understanding of economic phenomena we possess”-the quantity theorists were led astray.
*63 The quantity-theory approach tended to lead to “three very erroneous opinions”:
Firstly, that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money,-that they are at their “natural” level,-if the price level remains stable.
Secondly, that a rising price level tends always to cause an increase of production, and a falling price level always a decrease of production; and
thirdly, that “monetary theory might even be described as nothing more than the theory of how the value of money is determined.”
Here Hayek attacked the very idea to which J. S. Mill had subscribed: that changes in the quantity of money (or the velocity of its circulation) affect only general prices and not relative prices.
*65 Hayek saw the proposition that monetary disturbances affect real activity through price level changes to be the logical extension of Mill’s analysis. The next step would be to view the business cycle as largely a movement in price levels, with real economic activity being affected only insofar as adjustment to a changing price level is costly.
One must be careful not to read more into the criticism than was there. Hayek regarded the quantity theory as unassailable as a comparative static proposition:
I do not propose to quarrel with the positive content of this theory: I am even ready to concede that so far as it goes it is true, and that, from a practical point of view, it would be one of the worst things which would befall us if the general public should ever again cease to believe in the elementary propositions of the quantity theory.
But like Wicksell, Thornton,
*69 and many others before him, Hayek believed the quantity theory overlooked
essential details. The quantity theory had “usurped the central place in monetary theory…. Not the least harmful effect of this particular theory is the present isolation of the theory of money from the main body of general economic theory.”
Hayek deplored the lack of attention paid by quantity theorists to relative price changes. The title
Prices and Production was surely chosen to emphasize this argument. Relative prices are what guide production, but, in the divorce of monetary theory from value theory, money is assumed to have no effect on relative prices. Thus by hypothesis money is viewed as having no influence on production. Such was the blind alley into which, Hayek argued, the quantity theory had led economists. Vestiges of the long-run, comparative static approach of classical value theory remained embedded in the quantity theory. It was to this barter model that ignored financial markets that Hayek objected.
The introduction of money does not interfere with the operation of any of the Laws of Value…. The relation of commodities to one another remains unaltered by money: the only new relation introduced is their relation to money itself; how much or how little money they will exchange for; in other words, how the Exchange Value of Money itself is determined.
Keynes also reacted against the division between monetary theory and value theory:
So long as economists are concerned with what is called the Theory of Value, they have been accustomed to teach that prices are governed by the conditions of supply and demand; and, in particular, changes in marginal cost and the elasticity of short-period supply have played a prominent part. But when they pass in volume II, or more often in a separate treatise, to the Theory of Money and Prices, we hear no more of these homely but intelligible concepts and move into a world where prices are governed by the quantity of money, by its income-velocity, by the velocity of circulation relatively to the volume of transactions, by hoarding, by forced saving, by inflation and deflation
et hoc genus omne, and little or no attempt is made to relate these vaguer phrases to our former notions of the elasticities of supply and demand.
Indeed, Hayek had applauded Keynes’s first faltering departure from the quantity-theory approach:
That the new approach, which Mr. Keynes has adopted, which makes the rate of interest and its relation to saving and investment the central problem of monetary theory, is an enormous advance on this earlier position [the Cambridge cash-balance theory ], and that it directs the attention to what is really essential, seems to me to be beyond doubt.
Again, Hayek’s objection to the quantity-theory approach was not a criticism of its positive content, but was, to paraphrase Keynes, an objection to the failure to cast works in this tradition in terms of ordinary economic categories. The quantity theory was an “obstacle” for two reasons: First, from a theoretical view-point, couching a monetary theory of the business cycle in terms of changes in the price level would prejudice readers against other monetary explanations.
*74 Thus, the explanation of cyclical fluctuations in terms of changes in the price level was a “naive
*75 and economists of the stature of Spiethoff rejected all monetary explanations because they identified them with the “naive” quantity theory.
*76 Second, the quantity approach led its adherents to erroneously conclude that stabilizing the price level would automatically stabilize economic activity.
*77 But, as will be seen,
the major policy conclusion of the Austrian theory of the business cycle is that stabilizing the price level will not, in general, stabilize economic activity.
Hayek saw Wicksell’s and Mises’s approach as one that permitted the intergration of monetary and value theory. The effect of money on pricing could be taken into account; moreover, money could be shown to have (short-run) effects because changes in the demand for or supply of money alter interest rates, intertemporal prices, and hence the allocation of resources. In current terminology, Hayek’s was a theory in which “money mattered.”
Hayek systematically criticized theories of cyclical fluctuations in which relative prices—particularly intertemporal prices—played no causal role. While at first he regarded the quantity theory as the chief impediment to progress, he subsequently shifted his attack to the Keynesian economics, or the income-expenditure approach. In Hayek’s analysis, both the “naive quantity theory” and Keynesian macroeconomics are cut from the same cloth—the barter conception embodied in Mill’s
Principles. Both analyze economic disequilibrium with the tools of comparative static analysis. And both theories are inherently “macro”—they abstract from changes in relative prices.
To Hayek, Keynes erred in attempting to establish macroeconomic relationships without regard to “the microeconomic structure.”
*78 “The artifical simplification necessary for macrotheory…tends to conceal nearly all that really matters.”
*79 Keynes’s Marshallian and quantity-theory backgrounds lived on in the work that Keynes thought was a “clean break.”
Because of Hayek’s acceptance of the long-run connection between money and prices, he constructed his business cycle
theory as he did. Given his insistence that increases in the money supply (initially) alter relative prices, he was encouraged to seek a mechanism that would restore the original set of relative prices once altered.
*80 The theorems of equilibrium states are tools to aid the monetary theorist in analyzing market
tendencies. Analysis of market adjustment processes indicates when those tendencies may be realized and when thwarted.
Hayek initiated one of the great debates in monetary theory—the debate on the neutrality of money. Today, the concept of the neutrality of money is a bulwark of monetary theory. But the concept is taken to be about long-run effects. However, Hayek, like Keynes, Robertson, and others, wished to analyze the effects of monetary disturbances on economic activity
before equilibrium is restored. Hayek, like Wicksell was concerned with “what occurs,
in the first place, with the middle link in the final exchange of one good against another, which is formed by the demand of money for goods and the supply of goods against money.”
Keynes might contend that ”
the importance of money essentially flows from its being a link between the present and the future.”
*83 Myrdal might complain that “most theorists have their early gymnastics in stationary theory and have transferred loose habits of thought to their monetary analysis.”
*84 And Shackle could describe money as “the refuge from specialized commitment, the postponer of the need to take far-reaching decisions.”
*85 But all echoed Wicksell in his insistence that monetary analysis is concerned mainly with short-run adjustment; all were concerned with the economics of disequilibrium.
Over the years, English economists, especially at Cambridge, demonstrated little sympathy with Wicksellian or Austrian analysis. Hayek’s concept of the “neutrality of money” was also received with some hostility. Sraffa declared:
If Dr. Hayek had adhered to his original intention, he would have seen at once that the differences between a monetary and a non-monetary economy can only be found in those characteristics which are set forth at the beginning of every text-book on money.
To which Hayek responded: “I am, however, not quite sure whether Mr. Sraffa has perceived that the refutation of this idea is one of the central theses of my book.”
Nevertheless, the concept of neutral money quickly attracted interest, undoubtedly because of possible applications to monetary policy for mitigating cyclical fluctuations. After the publication of
The General Theory, interest in the neutrality of money waned.
*88 Since Patinkin, economists have employed the concept to show that under stated conditions changes in the quantity of money do not, in the long run, affect either relative prices or real output.
And yet, Hayek employed the very same concept to demonstrate how changes in the quantity of money ordinarily affect interest rates, relative prices, and real economic activity. Indeed, Hayek attracted attention because he demonstrated how monetary disturbances could be nonneutral in their effects.
Hayek’s analysis differs from that of contemporary monetary theorists because he focused attention on the short-run effects usually excluded, by assumption, from current theories. He maintained that monetary policy ordinarily has distributional effects that alter relative prices in a predictable way. In fact, an increased quantity of money will cause
ex ante investment to be larger than
ex ante saving.
Ex post saving will equal
ex ante investment. The difference between
ex ante and
ex post saving he termed “forced saving,” which leads to an excess accumulation of capital that cannot be maintained.
Hayek’s theory of economic fluctuations depends on the soundness of his argument about the nonneutrality of monetary policy; and his treatment of monetary disturbances is intelligible only in terms of his views on forced saving.
Hayek, as an expert on the history of the concept of forced savings, noted that it was first offered in criticism of early quantity-theory
analysis. Thus, in commenting on Ricardo’s analysis, Malthus stated:
Whenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former. The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of some others. This diminution is affected by the rise of prices, occasioned by the competition of the new notes, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrious classes,—all those who sell as well as buy,—are, during the progressive rise of prices, making unusual profits; and even when this progression stops, are left with the command of a greater portion of the annual produce than they possessed previous to the new issues.
Malthus’s analysis contained insights that anticipated theoretical developments by Mises, Wicksell, Hayek, and others. An increased quantity of money represents an increased command over real resources. The new money units represent “so much additional capital” to entrepreneurs (“those who mean to employ them in the prosecution and extension of profitable business”). But at full employment, there is a resource constraint, and increased expenditures on capital goods must come at the expense of consumption. Consumers (“those who are only buyers”) cannot purchase as many consumer goods as they could before. The mechanism is “the competition of the new notes,” which leads to a rise in prices.
Lord Lauderdale spoke of “bank increases [of ] the circulating medium of a country” leading to the creation of “a mass of fictitious capital.” Dugald Stewart, agreeing with Lord Lauderdale, argued that “the radical evil, in short, seems to be, not the mere over-issue of notes, considered as an addition to our currency, but the anomalous and unchecked extension of
credit and its inevitable effect in producing a sudden augmentation of prices by a sudden augmentation of demand.”
A single concept dominates virtually all discussions of forced saving. Entrepreneurs have an increased command over the scarce resources as the result of an increase in the quantity of money, which enters the system as an increase in credit. The prices of capital goods are bid up, and the production of capital goods is stimulated. Factor incomes are bid up; eventually, the demand for consumption goods increases. But only by this process and in this sequence, do changes in the quantity of money affect prices. That these changes
eventually affect all prices was not in dispute; the issue was the mechanism by which money affects prices.
Forced saving obviously refers to an
ex post situation. Consumers find that they must consume less than they had planned at each level of income.
*93 Consumer goods are not being produced at the rate at which consumers intend to consume them.
The schedules in figure 3.1 refer to planned magnitudes.
Ex post, investment (
I1 and saving (
S) is equal in value to investment,
I1. Thus the forced saving is equal to the discrepancy between actual and planned saving (
*95 Forced saving occurs during
each period (in which the quantity of money increases) because of the nonneutral effects of the monetary disturbance. The assumption is that monetary expansion is primarily an increase in the amount of credit available to business.
*96 As a consequence, the demand and supply functions that would exist in a barter situation are altered. As Hayek noted in an early work:
The difference between the course of events described by static theory (which only permits movements toward an equilibrium, and which is deduced by directly contrasting the supply of and demand for goods) and the actual course of events [is explained ] by the fact that, with the introduction of money (or strictly speaking with the introduction of indirect exchange), a new determining cause is introduced. Money…does away with the rigid interdependence and self-sufficiency of the “closed” system of equilibrium, and makes possible movements which would be excluded from the latter.
The concept of the neutrality of money (and thus, indirectly, the concept of forced saving) has frequently been criticized. Piero Sraffa’s review of
Prices and Production was hostile, as I have noted. Others, such as Koopmans and Classen grappled with the theoretical problems raised by the analysis.
*98 Again, in the work of recent years dominated by
The General Theory, that part of the Wicksellian tradition concerned with
relative prices and so-called distributional effects of monetary policy has been virtually ignored. Of the efforts to save the concept of neutrality of money, Patinkin’s is perhaps the most valiant among contemporary writers. But he was hoisted on his own petard. In any comparison between a barter and a money economy, the excess demand functions will
necessarily differ. Patinkin considered a barter economy as the limiting case of a money economy, that is, one in which the money supply is progressively reduced to zero.
As the nominal quantity of money approaches zero, so does the price level—and at the same rate. Hence the real quantity of money remains
unaffected. Thus the limiting position that we have defined as a barter economy is one in which there exists the same
real quantity of money as in a money economy.
neutrality was defined in terms of a congruence between the demand and the supply functions in a barter and a money economy. This comparison is obviously untenable: there is at least one commodity in a money world that is absent from a barter world.
Friedrich Lutz correctly concluded that an important issue was raised by the early neutrality theorists, an issue that becomes obvious in analyzing the conditions under which a
change in the supply of or demand for money will affect
relative prices and quantities of nonmoney goods.
As Lutz noted, key differences exist between the work of Wicksell and Hayek, and that of modern monetary economists. Today, neutrality of money follows from standard assumptions of macro models. For Hayek, neutrality of money was a policy goal in a world in which these assumptions did not and could not apply. An important difference exists between monetary theorists concerned with perfecting models (often merely exercises in logic) and earlier monetary theorists trying to explain the world as they perceived it.
The logic of the argument of these more recent writers is unassailable. They have from the start excluded any possible effect of the reduced money rate of interest on the production process by their assumption of the “absence of distribution effects.” This assumption allows them to disregard the phenomenon of “forced saving” (which presupposes a shift in income distribution in favour of entrepreneurs or of profit-receivers), and hence to disregard also the related increase in real capital formation. It means that the problem to which earlier writers had attached paramount importance is simply dropped out of the picture. Once we assume that there
are “distribution effects,” the question of what is the right monetary policy if it is desired to aim at the “neutrality” of money inevitably re-emerges.
Keynes’s occasional references to Hayek and the Austrians may seem curious, if not quaint—anachronistic discussions of work with no contemporary significance: grist for the mills of historians of thought.
According to Keynes, “‘Forced saving’ has no meaning until we have specified some standard rate of saving.” The reasonable thing to do would be to select “the rate of saving which corresponds to an established state of full employment….’Forced saving is the excess of actual saving over what would be saved if there were full employment in a position of long-period equilibrium’.”
*104 Keynes noted that to Hayek this definition was, in fact, the original meaning of the term.
As Keynes pointed out, the analysis of forced saving needed “some explanation or qualification” to extend it to conditions of less than full employment. However, Keynes accused these theorists
both of failing to extend the analysis to conditions of less than full employment
and of doing so without regard to the needed qualifications.
*106 Keynes seemed unable to distinguish between the methodological assumption of full employment and the assumption that in fact resources are always fully employed. This is an elementary distinction, concerning which Keynes was neither the first nor the last to be confused.
Obviously, forced saving occurs only in disequilibrium. Hayek used the concept to analyze the impact of a monetary disturbance.
*107 Forced saving is empirically important when the quantity of money is increased continually over a prolonged period of time, and the increases occur in the form of increases in the quantity of credit. Hayek investigated this kind of disturbance in
Prices and Production, and it is to this analysis that we must now turn our attention.
Monetary Theory and Policy, ed. Richard S. Thorn (New York: Random House, 1969), p. 5 (hereafter, “Monetary Theory”).
On Keynesian Economics and the Economics of Keynes (New York: Oxford University Press, 1968), pp. 294-95.
Money, Wealth, and Economic Theory, which may be viewed as a continuation of the Patinkin debate (New York: The Macmillan Co., 1967 [hereafter,
Studies in the Quantity Theory of Money, ed. idem (Chicago: University of Chicago Press, 1956), pp. 3-21 (hereafter, “Quantity Theory”). On the importance of this paper, see Johnson, “Monetary Theory,” pp. 18-19.
Journal of Political Economy 78 (March/April 1970): 193-238 (hereafter, “Theoretical Framework”); and idem, “A Monetary Theory of Nominal Income,”
Journal of Political Economy 79 (March/April 1971): 323-37.
The assumption that monetary theory is coextensive with the quantity theory is implicit, for the adjustment to an excess demand for money is the crux of the
non-monetary explanation of cyclical fluctuations. Tobin characterized himself as “neo-Keynesian” or “Hicksian,” apparently because he believes “that
both monetary and fiscal policies affect nominal income.” He pleaded: “One thing the non-monetarists should
not be called is
‘fiscalists'” (James Tobin, “Friedman’s Theoretical Framework,”
Journal of Political Economy 80 (September/October 1972): p. 852).
Monetary theory turns out to be simply value theory applied to a good that has the special technical characteristic of yielding real income the level of which is directly proportional to the price per unit” (Pesek and Saving,
Money, pp. 135-36).
Critical Essays in Monetary Theory (New York: Oxford University Press, The Clarendon Press, 1967), pp. 61-82.
Lectures on Political Economy, ed. Lionel Robbins, 2 vols. (London: George Routledge & Sons, 1935), 2:141 (hereafter,
Principles of Political Economy, ed. William Ashley [Clifton, N. J.: Augustus M. Kelley, 1973], pp. 494, 495). This is J. S. Mill’s statement of the proportionality theorem, “other things being the same.” Mill then went on to analyze what occurs when these “other things” are not the same.
institutional datum is potentially misleading and associates the theory too much with the version propounded by one man, Irving Fisher.
History of Economic Analysis (New York: Oxford University Press, 1954), p. 703.
David Hume: Writings on Economics, ed. Eugene Rotwein [Madison: University of Wisconsin Press, 1970], p. 33). Hume’s version might be considered the
locus classicus (in English) for the quantity theory, as defined above. But the modernity of Hume’s essay is also striking; we still apparently labor under his first formulation of the effects of money on prices and output. An incipient monetarism might be inferred in his prescription against increasing the paper credit of a nation “beyond its natural proportion to labour and commodities” (Hume, p. 36).
Principles, pp. 490-93.
rigidly linked to the quantity of money by a velocity of circulation which remains constant through all transitional adjustment processes cannot be found in any classical, neoclassical or modern proponent of the quantity theory of money” (Thomas Sowell,
Classical Economics Reconsidered [Princeton: Princeton University Press, 1974], pp. 59-60).
History, p. 705). The reason is that Mill did not subscribe to the quantity theory as defined by Schumpeter.
The High Price of Bullion, reprinted in Piero Sraffa, ed.,
Works of David Ricardo, vol. 3 (Cambridge: Cambridge University Press, 1951) along with a chronology of Ricardo’s contributions on this question. Schumpeter remarked that “Ricardo…introduced qualifications occasionally and that, here and there, he made statements that were logically incompatible with his strict quantity theory, exactly as he did in the matters of his labour-quantity law of value. In both cases, however, he mentioned them only in order to minimize their importance…. We are…justified in attributing to him the strict quantity theory, as an approximation” (
History, pp. 703-4).
The Wealth of Nations, ed. Edwin Cannan (New York: Modern Library, 1965), p. 58.
and cannot possibly increase without it… It is not the actual greatness of national wealth, but its continual increase, which occasions a rise in the wages of labour” (Smith,
Wealth of Nations, pp. 68-69 [emphasis added]).
Classical Economics Reconsidered, pp. 33-34; see also Frank W. Fetter, “The Relation of Economic Thought to Economic History,”
American Economic Review 55 (May 1965) :138-39.
Principles—though his polemical pamphlets and correspondence dealt with such problems, even if sometimes somewhat grudgingly” (Sowell,
Classical Economics Reconsidered, p. 53). For a cost-of-production theorist, the
ultimate effects of a change in the demand for a commodity money can only be analyzed by taking into account the effects on the cost of production (Mill,
Principles, pp. 499-506.) But this was too long a run even for Mill and Ricardo. Both analyzed money in terms of demand and supply. Senior remained consistent, however, and insisted on analysis in terms of the cost of production of the metal (Schumpeter,
History, p. 702).
not follow from demand-and-supply analysis without further explanation (Schumpeter,
History, p. 703; Wicksell,
Lectures, 2: 141-44). On the nature of Ricardo’s question, see Wicksell,
Lectures, 2: 175-76.
An Inquiry into the Nature and Effects of the Paper Credit of Great Britain, ed. F. A. Hayek (London: George Allen & Unwin, 1939), p. 241 (hereafter,
Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), p. 1.
Principles, pp. 491-93). He treated credit as a substitute for money with similar effects. These effects alter the demand for “goods” (ibid., p. 514). See the text below on forced saving.
Paper Credit, p. 253.
Principles, pp. 532-41).
History, p. 704n. According to Sowell, “Thornton’s careful separation of short-run transitional effects from long-run equilibrium contrasts sharply with Ricardo’s repeated interpretation of
others’ doctrines in his own comparative statics terms” (
Classical Economics Reconsidered, p. 58).
Principles, p. 492).
Classical Economics Reconsidered, pp. 52-66.
Journal of Political Economy 80 [September/October 1972]: 945). I agree with Friedman on Henry Thornton, just as I disagree with him on Ricardo. Thornton and Ricardo were engaged in entirely different endeavors.
Works, vol. II I, p. 91; Robbins, in Wicksell’s
Lectures, 1: xvi-xvii.
Lectures, 2: 190.
Lectures, 1: 147-57; Ralph G. Hawtrey,
Capital and Employment, 2d ed. [London: Longmans, Green & Co., 1952], p. 29; and Hayek,
Pure Theory of Capital, p. 189). The term
marginal product with reference to capital is a misnomer; what is usually meant is the rate of increase in output attributable to an increment to capital.
Lectures, 2: 192-93. According to Myrdal, Wicksell incorrectly stated the condition of monetary equilibrium as a result (Myrdal,
Monetary Equilibrium, pp..126-31).
Autobiography of an Economist (London: Macmillan & Co., 1971), pp. 143-44.
Theory of Money for the
Economic Journal (just as A. C. Pigou had a little earlier reviewed Wicksell) without in any way profiting from it” (Hayek, “Personal Recollections of Keynes and the ‘Keynesian Revolution,'” in
A Tiger by the Tail, ed. Shenoy, p. 101). Keynes reviewed the Mises work in
Economic Journal 24 (September 1914).
Theory of Money and Credit (Irvington-on-Hudson, N. Y.: Foundation for Economic Education, 1971). This edition is a reprint of the revised English edition (1952); the first English edition (1934) was based on the second German edition (1924).
Theory of Money and Credit, pp. 339-66. The truly Misesian contribution commences on p. 349. If
Prices and Production, a series of four lectures running over one hundred pages, was overly concise, pity the poor reader confronted with this theory explained in fewer than twenty (albeit lengthier) pages! On the “inner value of money,” see Friedrich A. Hayek,
Monetary Theory and the Trade Cycle, trans. N. Kaldor and H. M. Croome (1933; reprint ed. New York: Augustus M. Kelley, 1966), p. 117 (hereafter,
Monetary Theory); see also translator’s note in
Theory of Money and Credit, p. 124.
Theory of Money and Credit, p. 24.
Monetary Theory and the Trade Cycle, p. 47; and
Prices and Production, 2d ed. (London: Routledge & Kegan Paul, 1935), p. 26.
The General Theory, and Keynes’s own criticism of the quantity-theory tradition.
Prices and Production, p. 4.
Quarterly Publication of the American Statistical Association, December, 1923; cited in Hayek,
Monetary Theory and the Trade Cycle, p. 236n.
Prices and Production, p. 3. The “elementary propositions” would be the
ceteris paribus, long-run connection between money and prices.
High Price of Bullion.
Prices and Production, p. 4.
Principles, p. 488. “In considering Value, we were only concerned with causes which acted upon particular commodities apart from the rest. Causes which affect all commodities alike do not act upon values. But in considering the relation between goods and money, it is with causes that operate upon all goods whatever that we are specially concerned. We are comparing goods of all sorts on one side, with money on the other side, as things to be exchanged against each other” (ibid., p. 491).
General Theory, p. 292.
Economica 11 (August 1931): 270. Hayek was here reviewing
Monetary Theory, p. 105.
Prices and Production, pp. 28-29.
Journal of Political Economy 77 (March/April 1969): 279-81.
Individualism and Economic Order (Chicago: University of Chicago Press, 1948), p. 45.
Lectures, 2: 159 (emphasis in original).
General Theory, p. 293 (emphasis in original).
Monetary Equilibrium, p. 45.
Years of High Theory (Cambridge: Cambridge University Press, 1967), p. 6.
Economic Journal 42 (March 1932): 43.
Economic Journal 42 (June 1932): 238.
Roads to Freedom, eds. Erich Streissler,
et al. [New York: Augustus M. Kelley, 1969], p. 112).
Money, Interest, and Prices, 2d ed. (New York: Harper & Row, 1965), pp. 175-76.
Prices and Production, pp. 19-20.
Profits, Interest, and Investment (New York: Augustus M. Kelley, 1970), p. 190.
Prices and Production, pp. 87-88. Thus, forced saving is not a sum of money that consumers are forced to save. On this, see W. E. Kuhn,
The Evolution of Economic Thought, 2d ed. (Cincinnati: South-Western Publishing Co., 1970), p. 386.
Prices and Production, p. 57.) But in keeping with contemporary analysis, which focuses on planned magnitudes at current prices, I have defined forced saving somewhat differently in the text. The
S function represents the supply of
voluntary (i.e., planned) saving; it is not the standard “supply of loanable funds” curve. A chief purpose of this analysis is to distinguish between loanable funds composed of voluntary savings and those that are not.
Prices and Production, p. 54).
Monetary Theory, pp. 44-45.
Money, Interest, and Prices, p. 75.
numéraire of Walras’s system: “Money in this latter sense is introduced, after the relative prices have been determined, in the shape of a money equation which sets the general price level while leaving relative prices unaffected” (Lutz, “On Neutral Money,” p. 107). But this concept of money would do violence to the work of Wicksell, Hayek, and others.
General Theory, pp. 39, 59-60, 76, 79-80, 176, 183, 192-93, 214, 328-29.
deficiency of saving the usual state of affairs” (
General Theory, p. 80). It is the first two propositions (that is, that forced saving is “rare” and that it is “unstable”) that are at issue. The third proposition is one of which I can make no sense, unless Keynes wished to maintain that we suffer chronic unemployment. Such cryptic remarks led Hayek to conclude that Keynes believed that unemployment was chronic and to criticize Keynes’s “economics of abundance” (
Pure Theory of Capital, pp. 373-75).
Profits, Interest, and Investment, pp. 183-97.
General Theory, pp. 80-81. See the caveat in note 95 above. Keynes’s treatment of forced saving is an instance of how his solecistic use of “classical” led him into error. He argued that “the usual classical assumption [is] that there is always full employment” (
General Theory, p. 191). What is true is that Ricardians were virtually always concerned with the long run, in which
ex hypothesi there is full employment. In Keynes’s terminology, forced saving theorists were “classical.” Hence, the reasoning goes, they thought there was always full employment, etc. Keynes cited no reference on forced saving, except Hayek’s note on the history of the concept. It is doubtful whether Keynes could have found any support for his argument.
Chapter 4. Money and Prices