Mises Daily Articles
Introducing A Tiger by the Tail
The small book you are holding in your hands is unique. It is perhaps the finest introduction to the thought of a major thinker ever published in the discipline of economics. What makes it unique is the fact that it comprises selections and short excerpts from a broad range of Hayek's works written over a span of forty years. Despite its broad coverage, the book is amazingly compact and coherent, seamlessly integrating the main themes from Hayek's writings on money, capital, business cycles, and international monetary systems. Furthermore, although it mainly uses Hayek's own words, some from his more technical works, it has been compiled and arranged by the late Sudha Shenoy in a way that makes it comprehensible to the layperson and student but can also be read with profit by the professional economist and teacher. Because of Shenoy's brilliant choice and arrangement of the 23 separate excerpts and her own illuminating, but never intrusive, introductions to each separate selection, the book stands as a work in its own right and gives new insight into Hayek's thought. In a real sense, it is as much Shenoy's book as it is Hayek's.
The publication of the new edition of this classic could not have come at a better time, moreover. For it is not merely an outstanding contribution to intellectual history, but also a tract for our times. The United States has been mired in an officially recognized recession for more than a year now with no end in sight. Our current downturn is fast becoming the lengthiest and most severe of the post–World War II era. Entering its fourteenth month, it has already surpassed the average length of the last six recessions and is rapidly approaching the postwar record of sixteen months. The net decline in employment of 2.6 million recorded for 2008 represents the greatest absolute decline in the number of jobs since 1945. With over a half-million workers losing their jobs in December 2008 alone, the unemployment rate unexpectedly spiked from 6.8 percent in November 2008 to 7.2 percent, the highest level in sixteen years. The 4.78 million Americans now claiming unemployment insurance is the highest since 1967, when this statistic began to be recorded and represents the highest proportion of the work force since 1983. Adding to the dismal employment picture, the average work week for the month plummeted to 33.3 hours, the lowest level since 1964, while part-time jobs shot up by 700,000, or nearly 10 percent, from the previous month, indicating that many part-time workers counted as officially employed were either previously terminated from full-time jobs or reduced from full-time to part-time employment by their current employers. Other indicators of the severity of recession besides employment reveal that the current recession has been deeper than the average recession, including industrial production, real income, and retail sales. As one Fed economist concluded, "Main recession indicators tend to support the claim that this recession could be the most severe in the past 40 years."1
Indeed the dread word "depression" is now being used by some economists and media pundits to portray our current difficulties, conjuring up the specter of the prolonged mass unemployment amidst idle industrial capacity and unsold piles of raw materials that marked the 1930s. For most recognized experts and opinion leaders, how we got into our current difficulties is now a moot question. Everyone is clamoring for a way out. A massive government bailout involving $700 billion to purchase risky assets and to subsidize troubled financial service and domestic automobile firms has proven spectacularly ineffective in reversing or even slowing the contraction of the economy, although it has led to a staggering projected federal budget deficit of $1.2 trillion for the current fiscal year. Accompanying this deluge of red ink is highly inflationary growth in the official Fed monetary aggregates, with MZM shooting up by 10.1 percent and M2 by 7.6 percent year-over-year as of November 2008. Driving this monetary inflation has been the Fed's expansion of the adjusted monetary base by 76 percent over the same period, which has reduced the target federal-funds rate from 5.25 percent in mid-2007 to less than .25 percent by the end of 2008.2
In response to the deepening economic crisis, politicians and their economic advisers are offering more of the same deficit-spending and money-creation snake oil. President Obama is promoting a massive $800-billion program of increased government spending and tax cuts over two years that includes the largest public-works program since World War II. But this "stimulus program" is nothing but a continuation of the failed financial bailout under a new name. The federal government will continue to spend and spend like a drunken sailor on shore leave. And, as Chairman Bernanke has indicated, the Fed will happily accommodate this orgy of wasteful and destructive spending by creating money to buy assets of every kind imaginable.
Crude, old-style Keynesianism has thus returned with a vengeance. In truth, it never really left. Despite all the talk by government policy makers and central bankers and their macroeconomic advisers that they have painstakingly developed and learned to deploy sophisticated new tools of "stabilization policy" in the last 25 years, their tool shed is, in actual practice, completely bare of all but the blunt and well-worn instruments of deficit spending and cheap money. For their part, the mandarins of academic macroeconomics have revealed the total intellectual bankruptcy of their discipline and the laughable irrelevance of their formal models by abandoning all scholarly reserve and decorum and stridently promoting and endorsing the long discredited policies of old-fashioned Keynesianism. The amazing, knee-jerk resort to simplistic Keynesian remedies by the macroeconomics establishment in the current crisis is tantamount to the admission that there has been absolutely no progress in the postwar era in understanding the causes and cures of business cycles. This reveals a deeper and more chilling truth: contemporary stabilization policy is implicitly based on one of the oldest and most naïve of all economic fallacies, one that has been repeatedly demolished by sound economic thinkers since the mid-18th century. This fallacy is that there exists a direct causal link between the total volume of money spending and the levels of total employment and real income.
In this book, Hayek provides an incisive critique of this fallacy in its Keynesian form and demonstrates the dire consequences of pursuing policies based on it. But the book contains much more than a critique of fallacious theories and policies: it holds the recipe for a solid and steady recovery from our current depression (and yes, always the straight talker, Hayek uses this forbidden word).
In brief, Hayek argues that all depressions involve a pattern of resource allocation, including and especially labor, that does not correspond to the pattern of demand, particularly among higher-order industries (roughly, capital goods) and lower-order industries (roughly, consumer goods). This mismatch of labor and demand occurs during the prior inflationary boom and is the result of entrepreneurial errors induced by a distortion of the interest rate caused by monetary and bank credit expansion. More importantly, any attempt to cure the depression via deficit spending and cheap money, while it may work temporarily, intensifies the misallocation of resources relative to the demands for them and only postpones and prolongs the inevitable adjustment.
The reason why this is not perceived by Keynesians is because of an implicit assumption that Hayek identified in Keynes's writings. Keynes wrongly assumed that unemployment typically involves the idleness of resources of all kinds in all stages of production. In this sense, Keynesian economics left out the vital element of the scarcity of real resources, the pons asinorum of undergraduate economic-principles courses. In Keynes's illusory world of superabundance, an increase in total money expenditure will indeed increase employment and real income, because all the resources needed for any production process will be available in the correct proportions at current prices. However, in the real world of scarcity, as Hayek shows, unemployed resources will be of specific kinds and in specific industries, for example unionized labor in mining or steel fabrication.
Under these circumstances, an increase in expenditure will increase employment, but only by raising overall prices and making it temporarily profitable to reemploy these idle resources by combining them with resources misdirected away from other industries where they were already employed. When costs of production have once again caught up with the rise in output prices, unemployment will once again appear, but this time in a more severe form because of the misallocation of additional resources. The government and central bank will then once again face the dilemma of allowing unemployment or expanding the stream of money spending. This sets up the conditions for an ever-accelerating monetary and price inflation, punctuated by periods of worsening unemployment, as was the case during the Great Inflation of the 1970s and early 1980s.
The alternative to this, Hayek argues, is to eschew monetary inflation and permit the prices of the unemployed resources to naturally readjust downward to levels that are sustainable at the current level of money income. In this case, unemployed labor and other resources will be guided by the price system into production processes that are sustainable at the current level of monetary expenditure. Permitting the market adjustment of relative prices and wage rates thus ensures a structure of resource employment that is coordinated with the structure of resource demands. In contrast, inflating aggregate money expenditure leads to a short-run increase in employment that causes an inappropriate distribution of resources whose inevitable correction ensures another depression. Such a correction can be postponed, but never obviated, only by repeatedly neutralizing relative price changes through accelerating inflation.
Those who deny Hayek's analysis — as all contemporary mainstream macroeconomists and policymakers do — and promote ever-increasing spending as the panacea for our present crisis live in the simplistic Keynesian fantasy land from which scarcity of real resources has been banished and in which the scarcity of money and credit is the only constraint on economic activity. As Hayek pointed out, such people do not merit the name "economist":
I cannot help regarding the increasing concentration on short-run effects — which in this context amounts to the same thing as a concentration on purely monetary factors — not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilization. To the understanding of the forces which determine the day-to-day changes of business, the economist has probably little to contribute that the man of affairs does not know better. It used, however, to be regarded as the duty and the privilege of the economist to study and to stress the long-run effects which are apt to be hidden to the untrained eye, and to leave the concern about the more immediate effects to the practical man, who in any event would see only the latter and nothing else.3
The recent bailouts and prospective stimulus package are aimed at reflating financial-asset and real-estate values back to levels inconsistent with the optimal distribution of labor and other resources as determined by the free interplay of market prices. And if enough money and spending are pumped into the economy, it is just possible that such a policy may, for a short while, freeze some resources in and return others to suboptimal employments, thus arresting or reversing our present downturn. But the advocates of these short-run spending palliatives are blind to what lies beyond: the long-run aftereffects of progressive inflation which, when eventually reined in, will result in an even more severe crisis and precipitous plunge into depression.
- 1.  Charles Gascom, "The Current Recession: How Bad Is It?" Federal Reserve Bank of St. Louis Economic Synopses 4 (January 8, 2009): 2.
- 2. It should be briefly noted that this was the same cheap-money policy that ignited and stoked the unsustainable real-estate boom in the first place. Thus from December 1999 through December 2005, the Fed increased the money supply as measured by MZM by about $2.5 trillion, or 57 percent, which works out to an uncompounded annual rate of 9.5 percent. During the same time period, another Fed monetary aggregate, M2, registered an increase of $2 trillion, or about 44 percent, which yields an uncompounded annual rate of 7.3 percent. This massive monetary inflation was naturally accompanied by a precipitous decline in interest rates, with the target federal-funds rate plunging from 6.5 percent in late 2000 to 1.0 percent in mid-2003 and being pegged at that level for nearly a year and then remaining below 3.0 percent for almost another year. Mortgage rates followed this sharp downward movement, with the rate on 30-year conventional fixed mortgages dropping 3 percentage points, from 8.52 percent in mid-2000 to 5.58 percent in mid-2005. But this understates the looseness in the home-loan markets generated by the monetary inflation, which also induced the development of a remarkable laxity in credit standards. The statistics in this footnote and in the associated paragraph in the text are based on data from The Federal Reserve Bank of St. Louis Economic Research.
- 3. The Pure Theory of Capital (London: Routledge and Kegan Paul, 1953), p. 409; p. 29 in this volume.