The Next Generation of Austrian Economics: Essays in Honor of Joseph T. Salerno

In* recent decades we have witnessed several debates on the legacy of Friedrich von Hayek in the realm of monetary policy. His writings have been both endorsed and attacked by economists from opposing branches of Austrian economics.1 Part of the problem is that Hayek partially changed his mind throughout his life and gave different policy prescriptions in the 1970s than he did in 1930s.2 But even the interpretation of his major works on money, banking and business cycle from 1920s and 1930s poses some problems.

We would like to shed some light on the Hayekian analysis of different monetary institutions. Specifically, we want to clarify what the economic consequences of such institutions: fractional and one-hundred percent reserve banking; and various monetary policy norms of central banks.3 Special attention will be given to the differences between constructs of pure money and business cycle theories as opposed to policy prescriptions. The first section discusses the relation between fractional-reserve banking and the business cycle. It also deals with Hayek’s opinions on one hundred percent reserve banking. In the second section we debate the claim of Hayek endorsing the monetary policy of stabilizing the level of nominal spending. Several concluding remarks are offered in the last section.

Fractional and One-Hundred Percent Reserve Banking

In Hayek’s view the contemporary organization of the banking sector was responsible for the cyclical fluctuations of the economy. He devoted the whole chapter of the Monetary Theory and the Trade Cycle to show that the expansion of credit by fractional-reserve banks must necessarily lead to unsustainable boom even if there is no central bank.4

According to Hayek the magnitude of the bank’s credit expansion depends on its cash reserves. The crucial point is “that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable.”5 If, for whatever reason, economic conditions improve and banks consider their cash reserve to be excessive, they will grant additional credit to their customers. “[F]or reasons of competition ... the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit.”6

This expansion of credit occurres without corresponding growth of savings. Other banks cannot distinguish between deposits created out of new savings and the ones created without it. They will join the credit expansion, as money from other banks will be deposited in their company, and lower their growing reserve ratio. The effect of the process is that the money rate of interest is for the time being lower than the natural rate.

Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must … rise again to its natural level and thus render unprofitable … those investments which were created with the aid of additional credit.7

Since fractional reserve banking is in Hayek’s view responsible for the business cycle, it’s hardly a surprise that he mentioned on several occasions the idea of one-hundred percent reserve banking. As early as 1925 he discussed the idea shortly in a review of Federal Reserve monetary policy after the crisis of 1920. Hayek wrote the following:

The older English theorists of the Currency School, who, as we already pointed out, understood the nature of cyclic fluctuations better than most of the economists who came after them, also hoped that cyclic swings could be prevented by their proposals for the regulation of note issues. … If the basic idea underlying the Peel’s Act were consistently implemented and a 100 per cent gold coverage were required for bank deposits as well as for bank notes, the problem of preventing depressions would be resolved in a drastic manner.8

A monetary system without business cycle seems like a desirable goal, but Hayek was not eager to advocate the idea of abolishment of fractional reserves. In Monetary Theory and the Trade Cycle Hayek stated clearly that in case of one hundred percent reserve banking:

[t]he stability of the economic system would be o9 btained at the price of curbing economic progress. The rate of interest would be constantly above the level maintained under the existing system. … The utilization of new inventions and the “realization of new combinations” would be made more difficult, and thus there would disappear a psychological incentive toward progress.

Hayek didn’t elaborate further on this point. It therefore seems unconvincing: why would capitalists earning a higher rate of interest on their capital be discouraged to innovate and invest? Shouldn’t a system where entrepreneurs make mistakes on a regular basis (malinvest during the business cycle) be more disruptive for innovators?10 Jesús Huerta de Soto thinks that “maybe it would be wiser to interpret the assertions Hayek made in 1929 (in Monetary Theory and the Trade Cycle) in the context of the lecture given before the Verein für Sozialpolitik. ... Hayek’s speech was subject to a rigorous examination by professors who were little inclined to accept conclusions they viewed as too original or revolutionary.”11

Hayek returned to the idea of one hundred percent reserve banking in 1937 in the series of lectures published as Monetary Nationalism and International Stability. In the fifth lecture he reviewed briefly “The Chicago Plan of Banking Reform.”12 This time Hayek’s objections to the abolishment of fractional reserve banking were completely different:

The most serious question which it raises, however, is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. … [T]he question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. … The [Peel’s Banking] Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance?13

This analysis does not mention any economic deficiencies connected with the system of one hundred percent reserve banking. The obstacle is of a practical nature — whether we will be able to stop the creation of new money substitutes that will take the place of bank notes and deposits.14 We may conclude here that Hayek saw the merits of advocating for an end of fractional-reserve banking — a seed of the business cycle in the contemporary economy — but never fully endorsed the program of one hundred percent reserve banking, pointing to problems of both a theoretical and practical nature.

Central Bank’s Policy Prescriptions

The greatest controversies regarding Hayek’s stance on monetary theory arise from the central bank’s policy norms that Hayek allegedly proposed. Since we live (as Hayek did as well) in a world of central banks managing the fractional-reserve banking system, we may ask if there is something the monetary authorities can do to mitigate the business cycle.15 Recently Lawrence White stated:

Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms, the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.16

White’s bold statements led Marius Gustavson to propose a ‘Hayek Rule’ — understood as keeping MV constant — as a norm for Federal Reserve’s policy in the 21st century.17 Two questions arise:

(1) Did Hayek endorse such a policy?

(2) Does Hayek’s business cycle theory provide a justification for “Hayek Rule”?

To properly answer these questions it’s useful to consider the theoretical context of Hayek’s business cycle investigations. For Hayek the main puzzle was how to integrate the theory of business cycle into the general equilibrium theory.18 In other words: how it is possible that forces leading markets to clear fail to coordinate consumers’ preferences and producers’ decisions during the business cycle? Hayek’s view was that we should focus on the active role money plays in the economy. The introduction of money breaks the clear process of price formation in barter and makes it possible that “real” factors responsible for price formation will be for some time hindered by monetary factors.

Beginning in mid-1920s Hayek struggled to describe the active role money plays in price formation in a more detailed fashion.19 He came up with the idea of “neutral money” — a set of conditions needed for the money to be neutral toward prices. His first idea was that the supply of money must be constant in order to be neutral. In the 1930s he changed his mind and advocated the idea that money may be neutral when the effective money stream (MV) is constant.20 Does it follow that Hayek advocated the monetary policy of stabilizing MV? Not necessarily.

In the second edition of Hayek’s Prices and Production21 and in a paper from 1933 titled On ‘Neutral’ Money22 we find some clarifications as to the proper relation between the theoretical concept of neutral money and the prescribed monetary policy. In the latter Hayek wrote: “The concept of neutral money was designed to serve as an instrument for theoretical analysis, and should not in any way be set up as a norm for monetary policy, at least in the first instance.”23 Hayek stressed the monetary policy can have different goals than getting close to the state of neutral money. He also mentioned the stable MV is not the sufficient condition for money to be neutral.

It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.24

Lack of perfect foresight regarding the future value of money and any degree of price stickiness make neutral money an impossibility. One could argue that even though we cannot reach perfection, it is still a good idea to pursue the ideal. But Hayek saw other problems with stabilizing the level of nominal expenditures. In Prices and Production he briefly discussed the problems with changing money velocity due to hoarding, dishoarding, changes in business organization etc.

For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.25

For Hayek it was clear that pumping money in any place in the economy as a reaction for increased demand for money in another place would not suffice to get closer to money neutrality. The money would have to be given to exactly those persons whose demand has increased. Hayek understood well that giving more money to a single person will result in a series of small adjustments of incomes and spending habits of many individuals cooperating with the agent, who got the money in the first place.26 Increasing the quantity of money in places where the demand for money remained unchanged27 would entail another round of necessary adjustments of incomes and spending patterns without accommodating the original change in money velocity.

Apart from abstract arguments about problems with implementation of stable MV policy Hayek specifically argued against monetary policy measures to combat deflation during the Great Depression as late as 1932. In a preface to English translation of Monetary Theory and the Trade Cycle Hayek wrote:

[The existence of deflationary process] does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. … To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.28

Not only did Hayek differentiate between theoretical concepts and policy norms, find practical problems in stabilizing MV and explicitly rejected fighting the recession with money creation, but he actually proposed another policy norm in the writings on money neutrality and constant flow of spending. In Prices and Production he mentions only that “Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by over-caution.”29 In On ‘Neutral’ Money Hayek dared to propose a more specific solution:

[I]t seems to me that the stabilization of some average of the prices of the original factors of production would probably provide the most practicable norm for a conscious regulation of the quantity of money.30

In light of these passages31 it seems that White’s statement about Hayek’s clear policy recommendation of stabilizing the level of nominal spending is unfounded — Hayek explicitly endorsed another rule and found problems with implementing targeted nominal spending rule.

There are big differences between stabilizing MV and stabilizing the prices of factors of production. Proponents of stabilizing MV claim that a shrinking nominal GDP is an indication that the central bank should increase the money supply (we need to remember that NGDP is only an approximation of the level of spending, since GDP excludes transactions of goods that are not final. If we want to measure the level of spending properly we should include all money transactions). A proponent of stabilizing MV could argue that even if money expenditures rose during the boom phase, it would be unwise to let it shrink to the pre-boom level. Therefore Quantitative Easing I in the USA would be justified since NGDP was falling between Q3 2008 and Q2 2009.32

A proponent of stabilizing the prices of the factors of production could argue that it’s unwise to maintain prices at the inflated boom level. Lower input prices would actually stimulate the demand by entrepreneurs to start investing again. Hence, if we look at the level of factors of production prices we see a different story. Let’s take for example Producer Price Index. At the end of the previous recession — in 2002 the index (1982=100) stood at around 100 points. At the bottom of recession in February 2009 it stood at around 160 points, so it would indicate that monetary policy was extremely accommodative.33

There is also another “Hayekian” problem connected with advocating QE: can the central bank actually gather and process all the information needed to fight the shrinking money expenditures in the same manner as private banks would do.34

Conclusions

Friedrich von Hayek rarely stated clearly his monetary policy proposals. He was mostly interested in the field of pure monetary theory (at least in the 1930s). It seems to us that his theories of money and business cycle can give good arguments for people advocating one hundred percent reserve banking. When it comes to monetary policy of the central bank Hayek briefly proposed the idea of stabilizing the prices of factors of production, but did not elaborate on why this should be the best policy.

Perhaps it is unfortunate Hayek used the framework of general equilibrium theory to investigate the problem of the business cycle.35 This might lead many to confuse the highly abstract and unrealistic conditions of general equilibrium with the desired state of monetary affairs, whereas occurrence of these conditions would actually mean that money is not needed in the economy at all.36 Only late in his life Hayek managed to incorporate his more dynamic view on economy regarding competition and entrepreneurial discoveries into the money and the area of business cycles. In Denationalization of Money37 he finally proposed the idea of opening the sphere of money and banking to the competition instead of leaving it to the plans of bureaucrats.

In a lecture from October 1977 Hayek stated:

The interesting fact is that what I have called the monopoly of government of issuing money has not only deprived us of good money but has also deprived us of the only process by which we can find out what would be good money. We do not even quite know what exact qualities we want because in the two thousand years in which we have used coins and other money, we have never been allowed to experiment with it, we have never been given a chance to find out what the best kind of money would be.38

This call for a competition in the field of money seems to me the best example of a truly Hayekian monetary policy.

References

Block Walter, Kenneth M. Garschina. 1996. “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process.” Review of Austrian Economics 9(1): 77–94.

Butos William N. 2012. “Monetary Orders and Institutions: A Hayekian Perspective.” Quarterly Journal of Austrian Economics 15(3): 259–76.

Gustavson Marius. 2010. “The Hayek Rule: A New Monetary Policy Framework for the 21st Century.” Reason Foundation Policy Study 389.

Hayek F. A. 2012. Business Cycles. Part II. In The Collected Works of F.A. Hayek, vol. 8, Hansjoerg Klausinger, ed. Chicago: University of Chicago.

——. Good Money. Part I: The New World, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008.

——. Good Money. Part II: The Standard, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008.

——. Intertemporal Price Equilibrium and Movements in the Value of Money. In idem, Good Money. Part I, pp. 186–27.

——. Monetary Policy in the United States after the Recovery from the Crisis of 1920. In idem, Good Money. Part I, pp. 71–152.

——. Monetary Nationalism and International Stability. In idem, Prices and Production and Other Works, pp. 331–422.

——. Monetary Theory and the Trade Cycle. In idem, Prices and Production and Other Works, pp. 1–130.

——. On ‘Neutral’ Money. In idem, Good Money. Part I, pp. 228–31.

——. Prices and Production. In idem, Prices and Production and Other Works, pp. 189–329.

——. 2008. Prices and Production and Other Works: F.A. Hayek on Money, the Business Cycle, and the Gold Standard, Joseph Salerno, ed. Auburn, Ala.: Mises Institute.

——. “The Paradox of Saving.” In idem, Prices and Production and Other Works, pp. 131–87.

——. The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies. In idem, Good Money. Part II, pp. 128–229.

——. “Toward a Free Market Monetary System.” In Good Money. Part II, pp. 230–37.

Huerta de Soto, Jesús. 2006. Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup. Auburn, Ala.: Mises Institute.

Salerno Joseph T. “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 3–44.

——. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6, no. 2 (1993), pp. 113–46.

Steele G. R., “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14.

White Lawrence H. 2008. “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40(4): 751–68.

White Lawrence H. 1999. “Hayek’s Monetary Theory and Policy: A Critical Reconstruction.” Journal of Money, Credit and Banking 31(1): 109–20.

White Lawrence H. 1999. “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31(4): 753–69.

• *Mateusz Benedyk is a PhD Candidate at the Faculty of Social Sciences, University of Wrocław and the President of Ludwig von Mises Institute Poland. The author would like to thank Mateusz Machaj and David Howden for their helpful comments. I was a summer research fellow in 2012. This chapter was inspired by Professor Salerno’s many contributions in the field of history of the Austrian school of economics and his investigations regarding the monetary theory.
• 1For example Hayek was attacked for not seeing the merits of fractional reserve banking by Lawrence H. White, “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31, no. 4 (1999): 753–69; and for not blaming fractional reserve bankers for business cycles by Walter Block, Kenneth M.Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 77–94.
• 2For the discussion of Hayek’s writings in 1970s and 1980s see G. R. Steele, “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14. Here we will deal primarily with the earlier works of Hayek.
• 3This list does not pretend to exhaust all of the Hayek’s insights in the field of money. It includes only the problems that created numerous controversies and rivalrous interpretations in the literature. More comprehensive study should include e.g., effects of various international monetary systems and the differences between central and free banking or between token and commodity money.
• 4Friedrich A. Hayek, “Monetary Theory and the Trade Cycle,” In: idem, Prices and Production and Other Works, ed. Joseph Salerno, Auburn 2008, pp. 73–103.
• 5Ibid., p. 91.
• 6Ibid., p. 93.
• 7Ibid., p. 94.
• 8Friedrich A. Hayek, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” In: Idem, Good Money. Part I, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008, p. 111, n. 37.
• 9Friedrich A. Hayek, Monetary Theory…, p. 103.
• 10On this point see: Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 22–23, 37–38.
• 11Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup, Auburn 2006, pp. 470–71, n. 74.
• 12Friedrich A. Hayek, “Monetary Nationalism and International Stability,” In: Idem, Prices and Production and Other Works, pp. 410–13.
• 13Ibid., pp. 411–12.
• 14A description of these obstacles is a major part of Hayek’s discussion of the Chicago Plan. It’s therefore an overstatement to say that “in Monetary Nationalism and International Stability, [Hayek] changed his mind, proposed a constant money supply and advocated the demand for a 100-percent reserve requirement in banking” — Jesús Huerta de Soto, Money…, p. 470, n. 74.
• 15We have already discussed the possibility of central banks requiring banks to hold one hundred percent reserves on deposits, so we won’t mention the subject in this section.
• 16Lawrence H. White, “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40, no. 4 (2008): 754–55, emphasis added.
• 17Marius Gustavson, The Hayek Rule: A New Monetary Policy Framework for the 21st Century, Reason Foundation Policy Study 389 (2010). Gustavson’s study includes references to White’s 2008 paper.
• 18In Hayek’s words: “By ‘equilibrium theory’ we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics.” — Friedrich A. Hayek, Monetary Theory…, p. 19, n. 15.
• 19Between 1925–1929 Hayek was preparing a book on the subject titled Geldtheoretische Untersuchungen, which he never completed. Two articles Hayek published at the time were excerpts from the book: Intertemporal Price Equilibrium and Movements in the Value of Money (originally appeared in German in 1928) published in Good Money. Part I; The Paradox of Saving (published in German in 1929) published inter alia in Prices and Production and Other Works. The English translation of the unfinished manuscript of the Geldtheoretische Untersuchungen has been recently published as Investigations into Monetary Theory, first chapter of: Friedrich A. Hayek, Business Cycles. Part II, ed. Hansjoerg Klausinger, The Collected Works of F.A. Hayek, vol. 8, Chicago 2012.
• 20This evolution of Hayek’s thought is well documented in another paper of Lawrence H. White, “Hayek’s Monetary Theory and Policy: A Critical Reconstruction,” Journal of Money, Credit and Banking 31, no. 1 (1999): 109–20.
• 21Friedrich A. Hayek, Prices and Production, [In:] Idem, Prices and Production and Other Works, pp. 301–04.
• 22Friedrich A. Hayek, On ‘Neutral’ Money, [In:] Idem, Good Money. Part I, pp. 228–31.
• 23Ibid., p. 228.
• 24Friedrich A. Hayek, Prices and Production, p. 304. Almost identical statement in: Friedrich A. Hayek, On ‘Neutral’ Money, p. 230.
• 25Friedrich A. Hayek, Prices and Production, p. 297.
• 26Example of such an analysis can be found in: Friedrich A. Hayek, Monetary Nationalism…, pp. 353–59.
• 27For example when central bank buys large quantities of securities in a Quantitative Easing program.
• 28Friedrich A. Hayek, Monetary Theory…, pp. 5, 6–7.
• 29Friedrich A. Hayek, Prices and Production, p. 298.
• 30Friedrich A. Hayek, On ‘Neutral’ Money, p. 231.
• 31Interestingly White quoted the same passage from “On ‘Neutral Money’” in Lawrence H. White, Hayek’s Monetary Theory…, p. 117.
• 32According to “The Economist”: “Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr [Lawrence] White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.”
• 33All the data is taken from Federal Reserve Bank of St. Louis.
• 34For the discussion see: William N. Butos, “Monetary Orders and Institutions: A Hayekian Perspective,” Quarterly Journal of Austrian Economics 15, no. 3 (2012): 259–76.
• 35For other problems associated with Hayek’s methodological choices see: Joseph Salerno, “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6, No. 2 (1993), pp. 113–46.
• 36Ludwig von Mises, Human Action. A Treatise on Economics, Auburn 1998, pp. 250–51.
• 37Friedrich A. Hayek, The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies, [In:] Idem, Good Money. Part II, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008, pp. 128–229.
• 38Friedrich A. Hayek, Toward a Free Market Monetary System, [In:] Idem, Good Money. Part II, p. 234.