Hayek on Deflation and the Great Depression

Steve Horwitz

Greg Ransom has found a new book with an interview done with Hayek in 1979.  In it, Hayek says the following:

“I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy.  I am not only against inflation but I am also against deflation.  So, once again, a badly programmed monetary policy prolonged the depression.”

Those Austrians who think deflation is always and everywhere a good phenomenon strongly overlap with those Austrians who wonder whether Hayek is really an Austrian (or a even a classical liberal) anyway, so I'm doubtful this will convince them of the claim that a concern with monetary deflation has been, and should be, a core part of Austrian monetary and macro theory.  However, it does, in fact, bolster the case for a monetary equilibrium reading of Hayek.

It is also useful to counter the claim that Hayek was a "liquidationist" in the sense often deployed by people like Brad DeLong, as well as the more general claim that Hayek thought we should do nothing during the depression.  By implication, if you think deflation is bad, you believe that the Fed (given its existence) should have behaved differently between 1930 and 33.  It could have done something to prevent the events that "prolonged the depression."

This also is some support for what I would call the Austrian-Monetarist-Interventionism explanation of why the Great Depression got started, got so deep so quickly, and lasted so long.  Each "school" (think Rothbard, F&S, and Higgs if you want authors) lines up with each element of the explanation in the order given.  Even Hayek agrees that traditional Austrian cycle theory alone can't explain the whole thing, even buttressed by Higgs or Cole & Ohanian.  If you want to explain why the Great Depression was both "great" and a "depression" not a recession, you need the Friedman and Schwartz story, and you'll have Hayek on your side.

Whether the same situation as we faced in 1930 was in place last fall remains a debatable question.  However, if velocity was falling in the way some folks believed, doing nothing would have invited a potential repeat of the early 30s, and now we can say with even more certainty that Hayek, at least, would have recommended that the Fed act to avoid it.  (Of course, nothing in this paragraph is an endorsement of the extreme to which the Fed went, nor the other really stupid things it did last fall and since.)

Comments

[Dave Prychitko]

It's interesting that Hayek didn't appear to make that argument before 1979.

My only concern, again, is how much quantitative easing today? The knowledge problem is unavoidable, and the public choice problem is over-inflation. Given these, I'm pessimistic that the Fed can adjust the money supply appropriately to meet money demand.

[Greg Ransom]

Hayek explicitly discusses the phenomena of a "secondary deflation" in his Feb. 1932 review of Keynes' _Treatise_, and in the same review Hayek had positive things to say about Keynes' ideas in the _Treatise_ for countering the "secondary deflation".

Note well that much of Hayek's debate with Keynes was all about the 1925 British return to gold at pre-war parity, and centered on the trade offs between political considerations (how to deal with extremely powerful unions with very high, above market clearing wages, i.e. the "sticky wages" problem) and the economics consequences of Keynes' politically motivated policy proposals.

Hayek's argument was simply to point out that if you do X, then Y will be part of the consequence -- part of a consequence that Keynes didn't understand and by Marshallian/'macro' assumption could not imagine or "model".

[Greg Ransom]

I see no evidence that Hayek spent any time looking at the facts on the ground in the United States.

His policy focus -- to the extent that he had any -- was on the British and international situation which dated to 1925.

Hayek was an EXTREMELY busy theoretical & editorial guy at this time -- he couldn't have had but minutes a day to look at the empirical numbers in the papers or as he over heard them at the L.S.E. And most economists wer much more focused on theory at that time, and much less focused on empirical research (Hayek's empirical research days were absolutely behind him.)

And when exactly DID we get good numbers on the monetary situation in the United States? Writers on Friedman suggest economists didn't "get" the empirical situation until the publication of Friedman & Schwartz in the 1960s ...

[Greg Ransom]

"It's interesting that Hayek didn't appear to make that argument before 1979."

Hayek identified the problem of "secondary deflation" as early as Feb. 1932. What seems to be new is what was new to most economists -- what he learned about the facts on the ground from Friedman & Schwartz.

[Greg Ransom]

"It's interesting that Hayek didn't appear to make that argument before 1979."

Hayek talks about the deflation situation in _Britain_ in many places at an earlier date (most all Hayek interviews were conducted in the 1970s -- a post Nobel prize phenomena.)

Americans seem to forget that the Great Depression isn't just about America and Americans.

So they can't conceive that Hayek was focused on Britain and the British situation (and to some degree on the Continent) and not on America in the 1930s.

[Dave Prychitko]

Fair enough, Greg.

[Pietro M.]

Very interesting.

I believe that nowadays the banking and financial sectors of the economy are (or were no more than a year ago) overstretched.

In order to get rid of the consequences of twenty years of monetary interventionism, the economy will need to reduce financial leverage, maturity mismatch, household debt, consumption, opacity and complexity of financial instruments, operating leverage, reliance on international credit, etc.

Many of these things amount to a reduction in the money multipliers, less reliance on the shadow banking system and less capacity to turn short-term liquidity into long term credit (maturity mismatch).

No doubt it is painful, and the credit channel literature has described the pains of these readjustements in detail, like in Blanchard, Kiyotaki, Bernanke, Gertler, Gilchrist, Stiglitz, Mishkin (I may got some of the names wrong, it seems that a credit-view economist must have a difficult surname to get published).

No doubt it will take time to pay the debts, household and public (for instance that accumulated with the trade imbalance), and that disposable income will be henceforth reduced.

No doubt that real deflation, which so far has not occurred, is costly because it is a floor on the real interest rate. When prices fall by X% per year, no investment is possible with less than X% of real return, and thus capital goods prices shall fall much more than usual.

However, are there any alternatives? The Fed is not avoiding deflation, it's keeping malinvestment hidden with all possible means, and will be fostering inflation, moral hazard and additional malinvestment as soon as the economy really recovers. The Fed is doing what it has done for twenty years at least.

I believe that three years of a Volcker cure would solve almost all the problems. But financial and monetary* aggregates may still be in need of falling as the financial industry is as much overstretched as the US military.

* May be not money, as at least a few months ago there were enough reserves to pay deposits by cash.

PS I think I'll have to read Cole/Ohanian again, but if I remember well I won't find the answer to this question: Would have the Great Depression been so long and deep without cartels, protectionism, wage rigidity? May be the fear of a secondary depression is excessive (despite what I said earlier, as I'm surely not rothbardian on the point) because its negative effects were compounded with the ineptitude of Hoover and Roosevelt. Without the same problems on the "real" side, and nowadays we don't have any of them (unless Obama goes nuts), would a real monetary contraction be so deep and longlasting?

[Lee Kelly]

Can there be deflation when the money supply is expanding, the price level is rising, and nominal expenditure is increasing? If an economy is "expecting" a growth rate of 5% for nominal expenditure, then isn't a 3% growth rate going to be deflationary? In other words, plans are drawn up and contracts signed expecting some particular future increase in nominal expenditure. When the expanding money supply doesn't materialise or falls short, expected prices will then be too high *relative* to the actual money supply. In this analysis it is possible, for all intents and purposes, to have an expanding money supply, rising price level, and increasing nominal expenditure and *still* have deflation. Furthermore, I think the "money illusion" is tantamount to *expecting* an expanding money supply, or at least so far as macroeconomics and monetary equilibrium is concerned.

Does this make sense to anyone? I am just making this up as I go so it would be nice for some feedback.

[Ivo Sarjanovic]

With reference to the issue of the Austrian Economists' opinion about deflation in the 30's I found the following articles very interesting:
1. Hansjörg Klausinger, 2005. "'Misguided monetary messages: The Austrian case, 1931--34," European Journal of the History of Economic Thought, Taylor and Francis Journals, vol. 12(1), pages 25-45, March.
2. Hansjörg Klausinger, 2003. "The Austrians on Relative Inflation as a Cause of Crisis," Journal of the History of Economic Thought, Taylor and Francis Journals, vol. 25(2), pages 221-237, January.
3. Hansjorg Klausinger, 2008 “Policy advice by Austrian economists: The case of Austria in the 1930” in Advances in Austrian Economics 11.
(pp. 25-53)

[s]

Two points:

Firstly, I don’t quite see the point in looking at Hayek’s views of the post-crash situation. It’s a bit like asking a cancer researcher what you should do after 30 years of smoking give you lung cancer. “Well, you should not have smoked for thirty years” is all that the cancer researcher can tell you, because that’s his life’s work: smoking causes cancer.

Hayek’s life’s work is about how monetary expansion leads to a crash. His view is that governments should not inflate in the first place. And that inflation cannot possibly end well. Once initiated, it will either end in a painful recession, hyperinflation, or both. What should be done after the crash, in my humble opinion, is not the purview of economists, as there simply are no good choices: deflation leads to plenty of people losing wealth; inflation re-inflates the bubble, returns us to the unsustainable status quo ante and prepares a bigger crash. Continuous re-inflation causes a disastrous endless cycle of boom-and-bust that turns wealth and sectoral allocation into a political game where central planners decide society’s financial state—as is the case today. (Think of South Park’s bail-out-determining-headless-chicken scene.)

The right course of action—and the only advice an economist can give—is: don’t inflate in the first place. Any suggestion about what should be done is simply political and carries massive redistributionist implications.

Secondly, for those thinking of how Hayek’s comments apply to today’s crisis, it might be worth noting the views of (ironically enough) Anna Schwartz on the current reflation. The problem with banks’ balance sheet is not simply a liquidity problem; it is a very serious solvency problem caused by plummeting housing prices. This isn’t some pop-psychology “investor confidence” or “animal spirits” nonsense driving these plummeting prices and liquidity concerns; this is a real sectoral (Hayekian) shift away from an over-inflated housing sector that needs to shrink. By treating it like a liquidity problem, bailed out financial institutions have ended up suffering the least from the insolvency and unsoundness of their investments. Worse, all the people who made mistakes are rewarded while those who didn’t are punished. Even worse, the needed sectoral shifts away from these sectors are delayed and possibly reversed. (Doesn’t anyone else think it is a disaster that Caterpillar is announcing profits again? For the sake of the world economy, shouldn’t they be out of business!?)

The answer, again, is not to have inflated in the first place. Everything else is politics.

[Lee Kelly]

s,

I disagree that expanding the money supply after the bust inevitably reinflates bubbles, because it entirely depends on where the new money is injected into the economy. When decisions regarding monetary expansion are left to politicians, I expect them to try and stabilise *relative* prices, i.e. reinflate the bubble. However, when decisions regarding monetary expansion are handled by private institutions (as in a free banking scenario), I expect healthy banks to thrive and avoid propping up malinvestment, i.e. let relative prices adjust without requiring painful deflation.

[Campbell]

Isn't it a Hayekian and Austrian idea that money supply should not be inflated nor deflated artificially, that these things need to happen naturally in response to stimuli by the economic environment of the day?

[Lee Kelly]

Campbell,

I think everyone here agrees that price controls are bad and should be abolished. However, if abolshing a price control is not feasible, then the best price control is one that attempts to emulate whatever price would otherwise emerge in the marketplace.

It's basically the same logic with central banks; yes the money supply should not be expanded and contracted by artificial means, but that isn't a feasible option right now. In the "world of second best" (as Horwitz regularly states it), we do the best we can to emulate what would otherwise emerge in the marketplace.

This, of course, invites another question: the powers needed to achieve good monetary policy can also be used for bad, so can central banks be trusted with such powers? Would it be better to suffer deflation than grant central banks the means to achieve equilibrium? In my opinion, the answer to this question depends on the specific institutional arrangements.

[Mario Rizzo]

So now we have not only the logic of Hayekian economics (both micro and macro) and the words of the man himself that deflation (of the increase in the relative demand to hold variety) should be avoided. I claim infallibly that this is the Hayekian position. We can argue about whether he was right but we cannot profitably argue about whether this was his position. QED.

[Don Lloyd]

Let's try a simple example to see if any of this makes sense.

1. Assume the Fed is quiescent and suddenly Warren Buffet defaults on all of his outstanding loans.

2. This clearly results in a reduction in the supply of money/credit not due to any action of the Fed.

3. What is the Fed supposed to do now?

4. If the Fed injects new money or credit, this injection can be broken into two parts distinguished by their effects on prices.

5. The injections can be assigned as either changing the absolute price level or relative prices. Of course, any real action will do some of both.

6. But WTF would anyone want the Fed to do either of these things, let alone an unpredictable combination? If you want to change the profitability of manufacturing widgets by changing relative prices, you will have to say so and explicitly justify it. If you want to affect the absolute price level, you will likely have to admit to being a price stabilizationist, and line yourself up directly in opposition to Mises.

Regards, Don

[Lee Kelly]

There is a big difference between stabilising relative prices and stabilising the price level. Moreover, I would argue that, centaris paribus, relative prices can adapt more rapidly when the price level is constant. To paraphrase Horwitz: price level stability removes noise from the price signal, thus allowing for more efficient relative price adjustments.

In any case, it seems to me that proponents of monetary equilbrium seek to stabilise nominal expenditure; the price level (or at least its rate of increase in the case of Bill Woolsey) should rise and fall with ups and downs in the supply of goods and services.

[TGGP]

Your comment about Higgs & Rothbard supplementing other takes on the Great Depression reminded me of something Bryan Caplan wrote. He said that Friedman/Schwartz' account really makes the most sense when meshed with Rothbard's "America's Great Depression".

[Steve Horwitz]

Let me be clear: I'm not in favor of stabilizing the price level. I'm in favor of allowing the price level to change due to changes on the real side, such as changes in productivity. The Fed should NOT be offsetting changes in the price level. A properly functioning banking system should be adjusting the supply of money to meet changes in the demand to hold it, but that is not the same thing as price stabilization.

More on Don's post later.

[James H]

Lee wrote: "I disagree that expanding the money supply after the bust inevitably reinflates bubbles, because it entirely depends on where the new money is injected into the economy."

Lee, maybe it's implicit here, but where might new money be "injected" such that it would *not* reinflate a bubble -- if not in nominal terms, certainly in relative terms?

For instance: bonds issued by TARP banks (the chief beneficiaries of the bailouts as it happens); or, the debt market in general (we agree that there is a debt bubble, no?).

[Nikolaj]

Steve,
You don't need Friedman-Schwartz approach whatsoever in order to explain particular depth of Great Depression. Everything that you need is Hayek- liquidationist plus Ohanian. Depression was caused by inflationary polices prior to 1929, and prolonged by propping up wages, and trade restrictions. You don't need monetarist explanation for that at all.

If you disagree, then you have to explain how monetary contraction similar or even more dramatic than that during great Depression, the one during 1921-22 episode, resulted only in a sharp but short living recession? The same old problem with "forgotten Depression" all mainstream monetary historians are struggling to accommodate. If you (and other mainstream monetarist theoreticians) are right, and we need Friedman-Schwartz explanation for GD, how then 1921-22 came about? Speedy recovery with no monetary injection whatsoever, with equally passive stance of Fed as 1929-32? 1921-22 episode represents the controlled experiment-test for Friedman-Schartz thesis, and it fails miserably on that test. What happened then was exactly the opposite of what one would expect according to their theory.

Finally, the fact that Hayek was inconsistent is hardly a discovery. You cited his reconsiliatory sentences with Friedman. There are probably many more. But, they are inconsistent with general tenets of Austrian theory, as well as with HAyek's own explicit theoretical concepts and statements. For example, in "Prices and Production" he explicitly acknowledges that monetary intervention to preclude secondary recession is practically impossible. Reason is that central bank must adjust money supply both quantitatively and qualitatively, i.e. both to match exactly increased demand for money, and to direct the money towards projects that have been "overcorrected", which Hayek directly and unequivocally describes as impossible. In that regard, he certainly would not have advised central bank today to avoid 1930s by monetary expansion (I don't think they needed such advise, because they have applied it "successfully" on almost unimaginable scale), because he would regard that enterprise impossible in principle. Furthermore, he ridicules in Prices and Production the "idle resources" argument for monetary intervention during recession, so critical to you, monetary equilibrium theorists. He rejects it completely.

So, it seems to me that you are using Hayek's inconsistencies and compromising of his own basic theoretical assumptions to justify your own inconsistencies and your own compromising of the general Austrian theory, and even to "prove" that that abandoning of Austrian theory is actually its essence.

[Don Lloyd]

Nikolaj,

"...Depression was caused by inflationary polices prior to 1929, and prolonged by propping up wages, and trade restrictions. You don't need monetarist explanation for that at all."

This is not only correct, but an understatement. I challenge anyone to read the appropriate portion of Garrett's The American Story (from Mises in either printed book or pdf) and not come away believing that the 30's economy was so deliberately and completely FUBAR'd that monetary policy was all but irrelevant. Obama described before he was born.

Regards, Don

[Bob Murphy]

I have no problem with Pope Mario's pronouncement, but I do disagree that Hayek was correct. I suppose if you are going to say that Hoover's wage and price supports are a given, then maybe printing money is better than not.

But generally I don't like to make these kinds of arguments. "Given that we have a welfare state, it's best to have soldiers police the borders. Given that we have Medicare and Medicaid, it's best if we tax the heck out of cigarettes and pass helmet laws..."

[Nikolaj]

Mario Rizzo says: "So now we have not only the logic of Hayekian economics (both micro and macro) and the words of the man himself that deflation (of the increase in the relative demand to hold variety) should be avoided. I claim infallibly that this is the Hayekian position."

And you are flat out wrong. Hayek's position in Prices and Production is exactly the opposite, as I explained in my previous comment.

"We can argue about whether he was right but we cannot profitably argue about whether this was his position. QED."

Again, you are completely wrong. He had two mutually inconsistent positions, one Misesian Austrian, and the other, quasi/monetarist, Friedmanite. The only thing we can argue about is whether Hayek-Misesian (liquidationist) of Hayek-monetarist (inflationist) was right. You would like to reject former and accept later, but to avoid in the same time admitting that, by muddying the water with false claim that there wasn't Hayek Misesian whatsoever, Hayek from "Prices and Production" and "Monetary theory of the trade cycle"!

[s]

I agree with Dr. Rizzo that we should stop the "What would Brian Boitano do" debate and stick to the merits of each position.

Professor Horwitz says: "A properly functioning banking system should be adjusting the supply of money to meet changes in the demand to hold it, but that is not the same thing as price stabilization."

It may not be the same thing, but it is every bit as bad. The most important fact in monetary economics is that pointed out by Mises in 1912: any quantity of money is always enough. There is never a need to change or "adjust" the supply of money. Ever.

If people decide to "hoard" money, that constitutes no reason whatsoever to print more money.

A properly functioning banking system would have a hard and basically stable money supply. People's decisions about hoarding, spending and investing are coordinated spontaneously in the very same way that their decisions about producing, consuming and eating potatoes are. There never is a need for a central planner to coordinate this. And money being a medium, there never is a need to adjust its quantity.

[Pietro M.]

I may need to check F&S, but it seems, from here:

http://research.stlouisfed.org/wp/2003/2003-006.pdf

that a 30% reduction in note circulation in 1920 didn't produce a depression, so at first sight it seems that Nicolaj is right.

Without govenrment sponsored real rigidities there would have been no depression, and to postpone a readjustment for fear of a liquidation is not a policy option as sooner or later an adjustment will need occur, especially because the more the boom goes on the less the banks are sound and the more the needed fall in the money supply will be considerable.

If the right money multiplier is for instance 5, nothing can avert a deflation if the central bank has pushed banks to a multiplier of 10 by insuring them and promising interventions. As I said previously, the financial and banking sector badly need deleveraging (and thus demonetization) and I don't see how there can be recovery without deflation.

This is painful, but the comparison between 1921 and 1929 may show that without government caused rigidities depressions can't occur or at least can't last (and this seems to answer to my previous question). Although I agree that it would be good to be able to avoid deflation, coeteris paribus, and that deflation is costly, I just don't see how it can be done.

[Bill Woolsey]

The deflation of 1920-21 returned the price level to where it was just a short few years before.

And, of course, there was a sharp drop in production and a huge spike in unemployment. Sure, there was not a decade long disaster.

Proving that there is a market process that returns the economy to equilibrium (as opposed to permanent depression of vulgar Keynesian myth) should be nothing but challenging a strawman.

What is the least bad macroeconomic environment? Is it one where the nominal prices and wages adjust the real quantity of money to the demand? Or is it better to have the nominal quantity of money adjust to the demand without requiring price and wage adjustments to fix monetary disequilibrium?

However, I do think that the 1920 experience is instructive.

The inflation that had occured during that previous period was due to inflationary finance of the war, especially in Europe.

Under the monetary regimes of the period, the usual situation was to suspend the gold standard during the war, inflate, and then reverse after the war. This should be expected by everyone.

And, that is more or less what happened.

Suppose someone had sold and someone else bought a 30 year corporate bond in 1905. During the war inflation, the bond holder is receiving interest payments that buy relatively little. And the bond issuer is making payments worth a little.

When the price level partially returns to its previous value, the situation returns to closer to the "normal expecation."

Of course, during that regime, there were also temporary deflations. But they would be reversed. By that, I mean the price level would fall below its long run, more or less stable, trend. But then it would recover.

Now, suppose it is 1929. Prices fall. People wait for them to rise. But they don't, year, after year, after year. (3 years.)

I really think that these sorts of concerns, about the regime and how it is expected to work, are really important.

Oh.. one other thing. Moving from war production to consumer production in the post war era should result in structual unemployment and a temporary loss in production. And the adjustment should have been expected too. There is nothing mysterious about it.

[Bill Woolsey]

If there is a depression going on, and the economy is in the process of adjusting price and nominal incomes so that the real quantity of money will match the demand, the relative prices in the adjustment period are unlikely to be much like some kind of long term sustainable values. If entrepreneurs use relative prices to make long term investments, they will surely make errors.

If the increase in money demand is temporary, then this is even more true. In that case, the changes in relative prices will have close to nothing to do with the long run relative prices.

Entrepreneurs will have to look beyond the current disturbed conditions. And it is likely that this will be more difficult, and any long term investments made will be more likely to involve errors. But any entrepreneur who myopically looks at relative prices (including interest rates) during a crisis, and projects those into the future--well, they deserve to suffer losses.

[Bill Woolsey]

Don Lloyd:

Why does Warren Buffet's default impact the supply of money or the demand for money?

Perhaps it would, but this example suggests to me a confusion of of money and credit.

The demand for money is the amount of monetary assets people want to hold. The supply of money is the amount of such assets that currently exist.

The demand for credit is the amount of money people want to borrow, usually to fund spending. The supply of credit is how much money people want to lend.

[Don Lloyd]

Bill,

Confusing money and credit would be keeping them separate. When credit is extended it is money that is actually made available in a loan, often in the form of a checking account. When a loan goes into default, the supply of credit must fall as there are no longer any repayments to loan out again. The lack of a new loan and the resulting checking account means that less money is also a result.

Regards, Don

[Bob Layson]

One can agree that, given price flexibility, some money is enough money for full production and exchange to take place, without thinking or implying that a sudden collapse in the money stock can be adjusted to immeditately and painlessly.

[Bill Woolsey]

Don:

You need to think about this just a bit more.

"Often" in the form of a checking account?

The supply of credit "must" fall because there are no repayments to lend out?

Both of these things are highly contingent.

About 60% of credit comes from outside the banking system.

About 80% of bank credit is funded by deposits other than checkable deposits. (Though we do have the sweep account mess to worry about.)

Sure, borrowers generally receive _money_ and spend it. But workers generally receive money and spend it too.

There is a relationship between money and credit. Telling stories about Warren Buffet, that have nothing to do with money leads to confusion.

If you see, "the banks (or Fed) should increase the quantity of money to match an increase in demand" and read, the banks (or Fed) should lend out more money to meet an increase in the demand for loans," then you are misreading the entire discussion.

The demand for money is how much money people want to hold. The demand for credit is how much money people want to borrow, generally in order to spend.

The supply of credt includes bank loans funded by monetary liabilities, but that is just a small part. The demand for credit might include a demand to borrow money just to hold on to it. I think most people would keep a line of credit and just borrow when they need to spend.

The quantity of money includes monetary assets issued by banks to fund loans. This is a big portion of the quantity of money. It also includes Fed liabilities, which I think are best undestood as funding some kind of loans as well.

But to treat all changes in the supply of credit as involving changes in quantity of money is a mistake. And confusing the demand for credit with the demand for money is perhaps the _worst_ confusion possible. (Well, confusing nominal income and the quantity of money is pretty bad too.)

I also think it is important to recognize that lenders do not necessarily relend repaid funds. They may do any number of things with those funds.

For what it is worth, I think that the discovery that assets are worth less should generally result in an increase in saving as people attempt to rebuild net worth. That increase in saving should normally imply an increase in the supply of credit. So, your story of Buffet's default requires all sorts of further analysis. Why did he default? What happens to the flow of funds that would have been used to pay Buffet and then his creditors? There were real entrepreneural mistakes? How does that impact what people do? Usually, poorer people consume less. When there is a default, what is the comparison? To what would have happened if payments had been continued? To what would have happened if the real investments really paid off?

Anyway, your story seemed to be that Buffet's creditors no longer receive a flow of monies that they can lend out. Should the Fed expand its lending to make up that shortfall in the loan market? Well, if that is how you see the situation, you are probably confused. But then, maybe no more than about half of the FOMC.

The short answer is that they shouldn't worry about what happens to the total supply of credit because buffet's lenders aren't adding as much to it out of repayments of loans than before. They should only consider what happens to the amount of money people want to hold and supply that.

[Steve Horwitz]

As I have many times in the last few months, I can only say "What Bill said."

Nicolaj: I'm not about to waste more of my valuable time going over issues we've debate ad nauseum here before. Interested third parties can search for previous discussions.

As for 20-21, Bill here too has it about right. I will expand in a separate post.

[Don Lloyd]

Bill,

"About 80% of bank credit is funded by deposits other than checkable deposits. (Though we do have the sweep account mess to worry about.)"

My use of checking accounts is as the form in which money is created by banks, not the source of loanable funds.

Until somebody sells me something else, I am not inclined to believe that the Fed or any other banking arrangement should try to match any kind of demand for money. The main problem is that money (the medium of exchange) and the demand for it must be distinguished from the demand for liquid financial assets. All money is a liquid financial asset, but the reverse is not true. A good deal of the money actually held could equally well (or better) be a liquid financial asset easily, but not necessarily instaneously, convertible to money.

Regards, Don

[liberty]

This is a brilliant thread--some outstanding comments I think (as someone with very little knowledge in this area, at least).

I appreciate also that it has stayed on topic, people have responded thoughtfully and brought up interesting counter-points (there were several comments I was going to make but someone else already made them), and no trolling so far!

I have one question for Bill or Steve or anyone who wants to tackle it:

Why was there "year after year after year (3 years)" without a rise again in prices following 1929, when the rebound occurred so much faster in 20-21? Was this due to the form of the inflationary period? Was it due to some other policy enacted in 1929-30 or thereabouts, e.g. Smoot-Hawley? Could that have reduced the economy's ability to make necessary adjustments and allow the price level to rise again?

[Lee Kelly]

James H,

Losses on malinvestment would not disappear, and some banks may go bankrupt. Lending would shift away from goods overinvested in during the boom, because *relatively* those assets would be worth less than before. Prudent banks would be in the best position to capitalise on the newly emerging market order, and thus the "moral hazard" problems would not arise.

Of course, as Bill Woolsey points out, during a panic, before money velocity rises, entreprenuers would be in a more difficult position than usual. But the spike in saving the original fall in money velocity represents should lower interest rates; it should spur the economy to put to use saved resources creating goods and services to be consumed in the future.

[Don the libertarian Democrat]

Here's a good read:

http://economics.sbs.ohio-state.edu/jmcb/jmcb/07056/07056.pdf

[James H]

Lee, thanks. I see your point, now. By your use of the term "injected" I was assuming you meant the central bank (though you later referred to a "free banking scenario").

To clarify, then, would you argue that central bank injections of money would *necessarily* inflate or reinflate some asset bubble? In any case, it seems it's more a question of "who" injects the money rather than where.

[Pietro M.]

Woolsey:

Although it is true that credit and money are two different things, it doesn't mean it is practical to disentangle the two: the Fed only has one steering wheel, i.e., setting the interest rate, and when it uses it affects both money and credit. How can the Fed control the money supply without affecting credit conditions? It would need to bypass the banking system, for instance by giving banknotes directly to public employees. Can it?

I don't disagree that it is preferrable to have a recession without price deflation. Just don't see how this can be achieved: banks are overstretched and whatever they do on the way toward soundness will impact the money supply. Also the shadow banking system has been creating credit pyramiding on the Fed promises of intervention, and thus also wide sense money will be affected (M2, MZM). Thus, return to normalcy will negatively affect everything also through a price deflation channel (which Rothbard said, wrongly, didn't exist).

If there are alternatives which enable to decouple money and credit conditions, I don't know them, but I'm quite sure they have nothing to do with standard monetary policy tools.

Besides, it is an interesting point that about the difference between 1921 and 1929, and you basically repeat the Mises point that prices first need to stabilize to make long term plans possible*. However, why did prices didn't stabilize? As I know no convincing story which does without real rigidities in labor and consumption goods markets+, I'm not that worried about that historical unicum called the Great Depression.

To summarize, I believe that after long booms the financial and banking sectors become overstretched and in need of downsizing. This also implies a reduction in the money supply, latu and strictu sensu, and this has additional negative effects on the economy. However, there's nothing long lasting in it and there are no policy options (at least in central banking) which enable the decoupling of monetary and credit disequilibria, so that keeping money up keeps malinvestment alive.

* Bernanke said something similar in 1983, in "irreversibility uncertainty and cyclical investment"... it is about the option value of not committing to fixed investments, which increases with uncertainty. Nice paper. We would all be better off if he remained closed in the ivory tower. :-)

+ The crisis hit firms and banks; banks cut back lending and money supply as a result; prices needed to fall and don't; more firms and more banks got into trouble; the equilibrium of underproduction and underemployment became stable.

[Pietro M.]

I, like Liberty, really appreciate the thread. Sorry for the length.

[Lee Kelly]

James H,

Like I said in the previous post. Although an ideal central bank would not exist, the next best thing is a central bank that emulates what free banking would do in its absence. However, I admit that is somewhat of a pipe dream, since central banks are creatures of political creation and sway. But will central banks use their powers to stabiliste relative prices, i.e. prop up malinvestment or "reinflate the bubble," to satisfy political pressures? Will they kick the can down the road by creating, whether by intent or accident, another bubble? Do they have the knowledge and ability to achieve good monetayr policy even in the absence of public choice issues?

These are all very good questions. I suppose the trade-off would be different case by case.

[Bill Woolsey]

Pietro:

I favor free banking, but even central banks don't have to use interest rate targeting. So I stongly disagree with the claim that the central bank has only one steering wheel, "setting the interest rate." In fact, I would insist that its one steering wheel in controlling the quantity of the monetary base. (Well, it can an interest rate to pays on reserves.) But I don't at all deny that this will impact credit markets. Nor do I deny that credit markets, impact the demand for money. I exactly agree that the collapse of shadow banking system resulted in an increase in the demand for FDIC insured checkable deposits and reserve balances at the Fed both.

Still, it is the quantity of money and the demand for money that is important.

Keep in mind that it is possible for the quantity of money to rise, and the supply of credit to fall. This just involves a bigger proportion of credit be funded by monetary liabilites. Only when the corner solution is reached, and all credit is funded by monetary liabilities, must the quantity of money march one-to-one with the quantity of credit.

It is also possible for the supply of credit to rise and the quantity of money to fall. It just required that loans be funded by nonmonetary assets. Certificiates of deposits issued by banks, commercial paper, notes or bonds.

The notion that the must move together is false. As for too big to fail, the Treasury could sell 30 treasury bonds and use the proceeds to buy stock in any insolvent firm it wants. This has no necessary connection with the quantity of money. (Of course, in reality, the Fed started doing this and dragooned the Treasury into the process a bit later.)

[Bill Woolsey]

Sorry about all the typos. One reason I started my own blog is that I can go back and fix all my typos!

[Pietro M.]

Bill Woolsey:

I agree with much of what you say (the possibility of nonmonetary credit interventions like the TSLF, the partial doubling of the steering wheel after the introduction of interests on deposit and the possibility of noncredit monetary interventions) but I have a couple of kinks to sort out and will think about it in the future.

I think I'll try for instance to imagine how the monetary policy can implement the constant MV rule. The Fed has done nonmonetary credit operations with the TSLF (or like in your 30y treasuries example), but so far I've seen nothing like a noncredit monetary operation, and this biases my intuition toward a negative answer. Probably working on the lending interest and the deposit interest can ease the decoupling, but, as I said, I have to think.

Silly question: the W. W. Woolsey at the end of the bibliography on Horwitz's book and you are the same persons?

[Dan]

I think Prof. Horwitz may be jumping the gun on this, because in the next page Hayek says: “I do not agree with Friedman on the causes” (Deflation per se – since we know what Friedman was blaming) and right before that he says “The authorities made things worse by a process of deliberate contraction” (emphasis on deliberate, as opposed to a natural contraction).

It is clear that Hayek is referring to deliberate policy of tampering with the money supply. Deliberate Inflation or Deflation will both distort interest rates in opposite directions. I don’t believe that that there is anything in that quote that supports the idea that Hayek was against a natural contraction of the money supply after the boom. I don’t know, especially in context of all of Hayek’s work on the Business Cycle, it seems that Prof. Horwitz is too quick to try to recruit authority to support “Equilibrium Theory”

[Bill Woolsey]

Pietro:

My name is Warren William Woolsey. Generally, I go by W. William Woolsey. W.W.Woolsey is probably me, yes.

Bill

[Free Oregon]

The ultimate result of both hyperinflation and deflation is the same - a shift of wealth, and a breakdown of economic activity. The beneficiaries differ, but the results are the same. Both result in liquidation. It's just different people who are liquidated.

Once you reach the point at which you no longer can put Humpty Dumpty together, the objective needs to be to prevent further shifts of wealth. In our case that means preventing a liquidation of the middle class.

The best way to do this, in my view, is wholesale debt forgiveness - a Jubilee of Biblical proportions. You make the creditors whole by printing money, as we are doing anyway. You may, or may not get destruction of the currency, but again, we seem on that path anyway.

The goal needs to be a new, level playing field with players able to play. By preserving the middle class you have a chance to have able players, ready to begin this sad credit spectacle all over again.

Oh, and I would suggest that the Government, which has demonstrated its incompetence, just get out of the way. No subsidies. No regulation. Let the people figure this out for themselves. 300 million plus minds at work are going to be much more effective than a few Harvard educated egoists.

[John P. Cochran]

Re:
It's interesting that Hayek didn't appear to make that argument before 1979.

Hayek in Unemployment and Monetary Policy (Cato 1979 but IEA paper #45 1975) made simailar arguments. The arguments can also be found in his 1975 lecture at UC-Boulder available by Fred Glahe at mises.org.

From a draft paper I am working on for SDAE/SEA meetings:

Hayek: Then and Now
Hayek’s two major early English language contributions to business cycle theory were Prices and Production, which introduced ABCT to the English speaking world, and the 1933 release of Monetary Theory and the Trade Cycle, an English translation Hayek’s earlier foundational work in German, (1929). His other English language cycle related writings during 1930s, many collected in Profits, Interest, and Investment (1939), were often, rather than systematic development, piecemeal attempts to respond to critics. While these works provided some key insights and clarifications, for many it muddled the water and made the theory incomprehensible, even to the extent that Keynes (1936, 183) wrote, in the General Theory, in comments aimed at, but not directly mentioning Hayek, “But at this point we are in deep water. ‘The wild duck has dived deep down to the bottom—as deep as she can get—and bitten fast hold of the weed and the tangle and all the rubbish that is down there, and it would need an extraordinary clever dog to dive after and fish her up again.’”
Hayek in the 1930s emphasized the ABCT as a credit cycle which was a combination of monetary and capital theory outlined above with detailed emphasis on the impacts of monetary changes on the structure of production. Hayek’s last formal attempts to deal with the more technical aspects of ABCT were Part IV of the Pure Theory of Capital (1941) and “The Ricardo Effect” (1942). He was a staunch advocate that money expansion, even with stable prices (inflation in the absence of price inflation) could be significantly destabilizing. During the 1930s he argued for a monetary framework/policy that would maintain a constant money spending stream or a policy consistent with a ‘productivity norm’ (Selgin 1997and White 2006) and reliance on market prices and liquidation to correct and recover following a crisis.
By the 1970s, several of these views had been moderated or modified (Hayek 1979 and Pizano 2009). Hayek (1979, 41) placed more emphasis on misdirections of production from general Cantillon effects, and less reliance on the more specific capital structure, credit induced distortions. But he (p. 25) continued and made clearer his emphasis on the microeconomic nature of the causes of unemployment and on why such unemployment cannot be cured by … inflationary policies, “(t)he correct explanation appears to me be the existence of discrepancies between the distribution of the demand among the different goods and services and the allocation of labor and other resources among the production of those outputs.” Such an understanding also provides a guide to a solution, if “unemployment indicates that the structure of relative prices and wages have been distorted”, then “to restore equality between the demand for and supply of labor in all sectors” requires “changes of relative prices and wages and some transfers of labor” and of capital goods.
On monetary policy, at least if tied to a fiat currency under the auspices of a central bank, Hayek (17-18) retreated, perhaps for practical reasons, as he argued, “Though monetary policy must prevent wide fluctuations in the quantity of money or the volume of the income stream … (t)he primary aim must again become stability of the value of money.” To paraphrase, while in normal times there is a need to get back to, a la Friedman, a more or less automatic system, to “avoid serve liquidity crisis or panics, the monetary authorities must be given some discretion.”
What are the lessons from Hayek’s and the Austrian approach to monetary and capital theory in the current environment? Recovery must be driven by a revival of investment. But to return to stability and sustained growth, the new pattern of investment must be in line with resource availability and time preferences. Per Hayek (1979, p. 42), this is not likely to be achieved by “subsidization of investment” or “artificially low interest rates” which as described by Hayek (1939) and illustrated by the attempt at such a policy in the U.S. initiated to end the first recession in this century where the feds funds rate was set at one per cent for nearly a year. As predicted, policy contributed to a distorted structure of production and a subsequent bust. The policy, while temporally increasing production and employment, set the stage for future bottlenecks, imbalances and distortions in the economy. Even less desirable for long run stability, per Hayek’s (1939, 73-82) “Investment that Raises the Demand for Capital,” and Hayek (1979, 42) is a stimulus to consumer demand and any ‘investment’ driven by a response to such a stimulus.
While investment must lead a recovery, history has shown that preventing a recession from turning into a depression, a long period of stagnation, stagflation, or a hyperinflation driven collapse, requires that significant policies errors must be avoided. The depth and range of policy mistakes that contributed to past periods of delayed recovery are excellently covered by Rothbard (2000), Murphy (2009), Ohanian (2009 forthcoming), Vedder and Gallaway, (1993), Higgs (1997), and Powell (2002 and 2009).
Hayek points to a complicating factor in determining the correct course for monetary policy which is relevant for critiquing the current response by the monetary authorities. Taylor (2009) argues the monetary policy response to the emerging financial crisis was the wrong action based on a wrong diagnosis of the problem. According to Taylor’s analysis, central bankers responded as if there was a liquidity crisis when in fact the crisis was a counter party risk crisis. While Taylor’s analysis is important in understanding how and why the Fed allowed its balance sheet to balloon, Hayek raises other issues. Hayek argued the first necessary monetary policy step following a boom created by monetary excesses is to stop the inflation, stop the expansion of the nominal monetary spending stream or at least hold it to the growth rate of real output, but contra his arguments in the 1930s, policy should also endeavor to stop a deflation, what he terms a “secondary deflation” or “secondary depression” which provides no steering function. Such phenomena should be prevented “by appropriate monetary measures.” Has the Fed done enough to stop or slow the growth of nominal spending to prevent future distortion while preventing a calamitous, secondary depression? Many, including Hayek (Pizano, 2009, 13), in retrospect, attribute the depth and length of the Great Depression to such a financial collapse and secondary deflation.