Sunday, June 17, 2012

Monetary Theories of the Trade Cycle - Friedrich A. Hayek

The argument of the foregoing chapters has demonstrated the main reason for the necessity of the monetary approach to trade cycle theory. It arises from the circumstance that the automatic adjustment of supply and demand can only be disturbed when money is introduced into the economic system. This adjustment must be considered, according to the reasoning that it most clearly expressed in Say’s Théorie des Débouchés, as being always present in a state of natural economy. Every explanation of the trade cycle that uses the methods of economic theory—which of course is only possible through systematic coordination of the former with the fundamental propositions of the latter—must, therefore, start by considering the influences that emanate from the use of money. By following up their results it should be possible to demonstrate the total effect on the economic system, and formulate the result into a coordinated whole. This must be the aim of all theories that set out to explain disturbances in equilibrium, which by their very nature cannot be regarded as immediate consequences of changes in data, but only as arising out of the development of the economic system itself. For that typical form of disturbance that experience shows to be regularly recurrent, and which can properly be called the trade cycle, the influence of money should be sought in the fact that when the volume of money is elastic, there may exist a lack of rigidity in the relationship between saving and the creation of real capital. This is a fact that nearly all the theories of the disproportional production of capital goods are agreed in emphasizing. It is, therefore, the first task of monetary trade cycle theory to show why and how monetary influences directly bring about regular disturbances in just this part of the economic system.

Naturally no attempt will be made at this stage to present such a theory systematically. This chapter is concerned with one particular task: it attempts to show how far existing monetary theories have already gone toward a satisfactory solution of the problem of the trade cycle, and what corrections are needed in order to invalidate certain objections that, up to the present, have appeared well founded.
It should already be clear that what we expect from a monetary trade cycle theory differs considerably from what most of the monetary trade cycle theories regard as the essential aim of their explanation. We are in no way concerned to explain the effect of the monetary factor on trade fluctuations through changes in the value of money and variations in the price level—subjects that form the main basis of current monetary theories. We expect such an explanation to emerge rather from a study of all the changes originating in the monetary field—more especially, variations in its quantity—changes that are bound to disturb the equilibrium interrelationships existing in the natural economy, whether the disturbance shows itself in a change in the so-called “general value of money” or not. Our plea for a monetary approach to all trade cycle theory does not, therefore, imply that henceforward such theories should be exclusively, or even principally, based on those arguments that usually predominate in writings on money, and that set out to explain the general level of prices and alterations in the “value of money.” On the contrary, monetary theory should not merely be concerned with money for its own sake, but should also study those phenomena that distinguish the money economy from the equilibrium interrelationships of barter economy that must always be assumed by “pure economies.”

It must of course be admitted that many trade cycle theorists regard the importance of monetary theory as residing precisely in its ability to explain the cause of fluctuations by reference to changes in the general price level. Hence, it is not difficult to understand why certain economists believe that, once they have rejected this view, they have settled once and for all with the monetary explanations of the trade cycle. It is not surprising that monetary theories of the trade cycle should be rejected by those who, like Professor A. Spiethoff in his well-known work on the quantity theory as “Haussetheorie,”identify them with the naïve quantity theory explanations that derive fluctuations from changes in the price level. Against such a conception it can rightly be urged that there are a number of phenomena tending to bring about fluctuations, which certainly do not depend on changes in the value of money, and which can, in fact, exert a disturbing effect on the economic equilibrium without these changes occurring at all. Again, in spite of many assertions to the contrary, fluctuations in the general price level need not always be ascribed to monetary causes.

But theories that explain the trade cycle in terms of fluctuations in the general price level must be rejected not only because they fail to show why the monetary factor disturbs the general equilibrium, but also because their fundamental hypothesis is, from a theoretical standpoint, every bit as naïve as that of those theories which entirely neglect the influence of money. They start off with a “normal position” which, however, has nothing to do with the normal position obtaining in the static state; and they are based on a postulate, the postulate of a constant price level, which, if fulfilled, suffices in itself to break down the interrelationships of equilibrium. All these theories, indeed, are based on the idea—quite groundless but hitherto virtually unchallenged—that if only the value of money does not change, it ceases to exert a direct and independent influence on the economic system. But this assumption (which is present, more or less, in the work of all monetary theorists), so far from being the necessary starting point for all trade cycle theory, is perhaps the greatest existing hindrance to a successful examination of the course of cyclical fluctuations. It forces us to assume variations in the effective quantity of money as given. Such variations, however, always dissolve the equilibrium interrelationships described by static theory; but they must necessarily be assumed if the value of money is to remain constant despite changes in data; and therefore they cannot be used to explain deviations from the course of events which static theory lays down. The only proper starting point for any explanation based on equilibrium theory must be the effect of a change in the volume of money; for this, in itself, constitutes a new state of affairs, entirely different from that generally treated within the framework of static theory.

In complete contrast to those economic changes conditioned by “real” forces, influencing simultaneously total supply and total demand, changes in the volume of money have, so to speak, a one-sided influence that elicits no reciprocal adjustment in the economic activity of different individuals. By deflecting a single factor, without simultaneously eliciting corresponding changes in other parts of the system, it dissolves its “closedness,” makes a breach in the rigid reaction mechanism of the system (which rests on the ultimate identity of supply and demand) and opens a way for tendencies leading away from the equilibrium position. As a theory of these one-sided influences, the theory of monetary economy should, therefore, be able to explain the occurrence of phenomena that would be inconceivable in the barter economy, and notably the disproportional developments that give rise to crises. A starting point for such explanations should be found in the possibility of alterations in the quantity of money occurring automatically and in the normal course of events, under the present organization of money and credit, without the need for violent or artificial action by any external agency.

Even if a systematic treatment of the trade cycle problem has not yet been forthcoming, it should be noted that, throughout the different attempts at monetary explanation, there runs a secondary idea that is closely allied to that of the direct dependence of fluctuations on changes in the value of money. It is true that this idea is used merely as a subordinate device or technique to assist in the explanation of fluctuations in the value of money. But its development included the analysis of the most important elements in the monetary factors chiefly connected with the trade cycle. This was done in the teaching that began with H. Thornton48 and D. Ricardo and was taken up again by H.D. Macleod, H. Sidgwick, R. Giffen, and J.S. Nicholson, and finally developed by A. Marshall, K. Wicksell, and L. v. Mises, whose works trace the development of the effects on the structure of production of a rate of interest that alters relatively to the equilibrium rate, as a result of monetary influences. For the purpose of this review it is unnecessary to go back to the earlier representatives of this group; it is enough to consider the conceptions of Wicksell and Mises, since both the recent improvements that have been effected and the errors that still subsist can be best examined on the basis of these studies.

It must be taken for granted that the reader is acquainted with the works of both Wicksell and Mises. Wicksell, from the outset, regards the problem as concerning explicitly the average change in the price of goods, which from the theoretical standpoint is quite irrelevant. He starts from the hypothesis that, in the absence of disturbing monetary influences, the average price level must remain unchanged. This assumption is based on another, only incidentally expressed, which is not worked out and which, from the point of view of most of the problems dealt with, is not even permissible; the assumption of a stationary state of the economy. His fundamental thesis is that when the money rate of interest coincides with the natural rate (i.e., that rate which exactly balances the demand for loan capital and the supply of savings) then money bears a completely neutral relationship to the price of goods, and tends neither to raise nor to lower it. But, owing to the nature of his basic assumptions, this thesis enables him to show deductively only that every lag of the money rate behind the natural rate must lead to a rise in the general price level, and every increase of the money rate above the natural rate to a fall in general price level. It is only incidentally, in the course of his analysis of the effects on the price level of a money rate of interest differing from the natural rate, that Wicksell touches on the consequences of such a distortion of the natural price formation (made possible by elasticity in the volume of currency) on the development of particular branches of production; and it is this question that is of the most decisive importance to trade cycle theory. If one were to make a systematic attempt to coordinate these ideas into an explanation of the trade cycle (dropping, as is essential, the assumption of the stationary state), a curious contradiction would arise. On the one hand, we are told that the price level remains unaltered when the money rate of interest is the same as the natural rate; and, on the other, that the production of capital goods is, at the same time, kept within the limits imposed by the supply of real savings. One need say no more in order to show that there are cases—certainly all cases of an expanding economy, which are those most relevant to trade cycle theory—in which the rate of interest that equilibrates the supply of real savings and the demand for capital cannot be the rate of interest that also prevents changes in the price level. In this case, stability of the price level presupposes changes in the volume of money; but these changes must always lead to a discrepancy between the amount of real savings and the volume of investment. The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price level stable, is always lower than the rate that would keep the amount of available loan capital equal to the amount simultaneously saved by the public; and thus, despite the stability of the price level, it makes possible a development leading away from the equilibrium position. But Wicksell does not recognize here a monetary influence tending, independently of changes in the price level, to break down the equilibrium system of barter economics; so long as the stability of the price level is undisturbed, everything appears to him to be in order. Obsessed by the notion that the only aim of monetary theory is to explain those phenomena that cause the value of money to alter, he thinks himself justified in neglecting all deviations of the processes of money economy from those of barter economy, so long as they throw no direct light on the determination of the value of money; and thus he shuts the door on the possibility of a general theory covering all the consequences of the phenomena he indicates. But although his thesis of a direct relationship between  movements in the price level and deviations of the money rate of interest from its natural level, holds good only in a stationary state, and is therefore inadequate for an explanation of cyclical fluctuations, his account of the effects of this deviation on the price structure and the development of the various branches of production constitutes the most important basis for any future monetary trade cycle theory. But this future theory, unlike that of Wicksell, will have to examine not movements in the general price level but rather those deviations of particular prices from their equilibrium position that were caused by the monetary factor.

The investigations of Professor Mises represent a big step forward in this direction, although he still regards the fluctuations in the value of money as the main object of his explanation, and deals with the phenomena of disproportionality only insofar as they can be regarded as consequences—in the widest sense of the term—of these fluctuations. But Professor Mises’s conception of the intrinsic value of money extends the notion of “fluctuations in money value” far beyond the limits of what this term is commonly understood to mean; and so he is in a position to describe within the framework, or rather under the name, of a theory of fluctuations in the value of money, all monetary influences on price formation. His exposition already contains an account of practically all those effects of a rate of interest altered through monetary influences, which are important for an explanation of the course of the trade cycle. Thus he describes the disproportionate development of various branches of production and the resulting changes in the income structure. And yet this presentation of his theory under the guise of a theory of fluctuation in the value of money remains dangerous, partly because it always gives rise to misunderstandings, but mainly because it seems to bring into the foreground a secondary effect of cyclical fluctuations, an effect that generally accompanies the latter but need not necessarily do so.
This is no place to examine the extent to which Professor Mises escapes from this difficulty by using the concept of the inner objective value of money. For us, the only point of importance is that the effects of an artificially lowered rate of interest, pointed out by Wicksell and Mises, exist whether this same circumstance does or does not eventually react on the general value of money, in the sense of its purchasing power. Therefore they must be dealt with independently if they are to be properly understood. Increases in the volume of circulation, which in an expanding economy serve to prevent a drop in the price level, present a typical instance of a change in the monetary factor calculated to cause a discrepancy between the money and natural rate of interest without affecting the price level. These changes are consequently neglected, as a rule, in dealing with phenomena of disproportionality; but they are bound to lead to a distribution of productive resources between capital goods and consumption goods that differs from the equilibrium distribution, just as those changes in the monetary factor that do manifest themselves in changes in the price level. This case is particularly important, because under contemporary currency systems, the automatic adjustment of the value of money in the form of a flow of precious metals will regularly make available new supplies of purchasing power that will depress the money rate of interest below its natural level.

Since a stable price level has been regarded as normal hitherto, far too little investigation has been made into the effects of these changes in the volume of money, which necessarily cause a development different from that which would be expected on the basis of static theory and which lead to the establishment of a structure of production incapable of perpetuating itself once the change in the monetary factor has ceased to operate. Economists have overlooked the fact that the changes in the volume of money, which, in an expanding economy, are necessary to maintain price stability, lead to a new state of affairs foreign to static analysis, so that the development that occurs under a stable price level cannot be regarded as consonant with static laws. Thus the disturbances described as resulting from changes in the value of money form only a small part of the much wider category of deviations from the static course of events brought about by changes in the volume of money—which may often exist without changes in the value of money, while they may also fail to accompany changes in value of money when the latter occur.

As has been briefly indicated above, most of the objections raised against monetary theories of cyclical fluctuations rest on the mistaken idea that their significant contribution consists in deducing changes in the volume of production from the movement of prices en bloc. In particular, the very extensive criticism recently leveled by Dr. Burchardt and Professor Lowe against monetary trade cycle theory is based throughout on the idea that this theory must start from the wave-like fluctuations of the price level, which are conditioned mainly by monetary causes; the rise, as well as the fall, of the price level being brought about by particular new forces originating on the side of money. It is only through this special assumption, which is also stated explicitly, that Professor Lowe’s systematic presentation of his objections in his latest work becomes comprehensible; he is completely misleading when he asserts that, if it is to raise the monetary factor to the rank of a conditio sine qua non of the trade cycle, monetary theory ought to prove that the effectiveness of all non-monetary factors depends on a previous price boom.66 We have already shown that it is not even necessary, in order to ascribe the cause of cyclical fluctuations to monetary changes, to assume that these monetary causes act through changes in the general price level. It is therefore impossible to maintain that the importance of monetary theories lies solely in an explanation of price cycles.

But even the essential point in the criticism of Lowe and Burchardt—the assertion that all monetary theories explain the transition from boom to depression not in terms of monetary causes but in terms of other causes super-added to the monetary explanation—rests exclusively on the idea that only general price changes can be recognized as monetary effects. But general price changes are no essential feature of a monetary theory of the trade cycle; they are not only unessential, but they would be completely irrelevant if only they were completely “general”—that is, if they affected all prices at the same time and in the same proportion. The point of real interest to trade cycle theory is the existence of certain deviations in individual price relations occurring because changes in the volume of money appear at certain individual points; deviations, that is, away from the position that is necessary to maintain the whole system in equilibrium. Every disturbance of the equilibrium of prices leads necessarily to shifts in the structure of production, which must therefore be regarded as consequences of monetary change, never as additional separate assumptions. The nature of the changes in the composition of the existing stock of goods, which are effected through such monetary changes, depends of course on the point at which the money is injected into the economic system.

There is no doubt that the emphasis placed on this phenomenon marks the most important advance made by monetary science beyond the elementary truths of the quantity theory. Monetary theory no longer rests content with determining the final reaction of a given monetary cause on the purchasing power of money, but attempts instead to trace the successive alterations in particular prices, which eventually bring about a change in the whole price system.68 The assumption of a “time lag” between the successive changes in various prices has not been spun out of thin air solely for the purposes of trade cycle theory; it is a correction, based on systematic reasoning, of the mistaken conceptions of older monetary theories. Of course, the expression “time lag,” borrowed from Anglo-American writers and denoting a temporary lagging behind of the changes in the price of some goods relatively to the changes in the price of other goods, is a very unsuitable expression when the shifts in relative prices are due to changes in demand that are themselves conditioned by monetary changes. For such shifts are bound to continue so long as the change in demand persists. They disappear only with the disappearance of the disturbing monetary factor. They cease when money ceases to increase or diminish further; not, however, when the increase or diminution has itself been wiped out. But, whatever expression we may use to denote these changes in relative prices and the changes in the structure of production conditioned by them, there can be no doubt that they are, in turn, conditioned by monetary causes, which alone make them possible.

The only plausible objection to this argument would be that the shifts in price relationships occurring at any point in the economic system could not possibly cause those typical, regularly recurring, shifts in the structure of production that we observe in cyclical fluctuations. In opposition to this view, as we shall show in more detail later, it can be urged that those changes that are constantly taking place in our money and credit organization cause a certain price—the rate of interest—to deviate from the equilibrium position, and that deviations of this kind necessarily lead to such changes in the relative position of the various branches of production as are bound later to precipitate the crisis. There is one important point, however, that must be emphasized against the above-named critics; namely, that it is not only when the crisis is directly occasioned by a new monetary factor, separate from that which originally brought about the boom, that it is to be regarded as conditioned by monetary causes. Once the monetary causes have brought about that development in the whole economic system, which is known as a boom, sufficient forces have already been set in motion to ensure that, sooner or later, when the monetary influence has ceased to operate, a crisis must occur. The “cause” of the crisis is, then, the disequilibrium of the whole economy occasioned by monetary changes and maintained through a longer period, possibly, by a succession of further monetary changes—a disequilibrium the origin of which can only be explained by monetary disturbances.
Professor Lowe’s most important argument against the monetary theory of the trade cycle—an argument that, so far as most existing monetary theories are concerned, is unquestionably valid—will be discussed in more detail later. The sole purpose of the next chapter of this book is to show that the cycle is not only due to “mistaken measures by monopolistic bodies” (as Professor Lowe assumes), but that the reason for its continuous recurrence lies in an “immanent necessity of the monetary and credit mechanism.”

Among the phenomena that are fundamentally independent of changes in the value of money, we must include, first of all, the effects of a rate of interest lowered by monetary influences, which must necessarily lead to the excessive production of capital goods. Wicksell and Mises both rightly emphasize the decisive importance of this factor in the explanation of cyclical phenomena, as its effect will occur even when the increase in circulation is only just sufficient to prevent a fall in the price level. Besides this, there exist a number of other phenomena, by virtue of which a money economy (in the sense of an economy with a variable money supply) differs from a static economy, which for this reason are important for a true understanding of the course of the trade cycle. They have been partly described already by Mises, but they can only be clearly observed by taking as the central subject of investigation not changes in general prices but the divergences of the relation of particular prices as compared with the price system of static equilibrium. Phenomena of this sort include the changes in the relation of costs and selling prices and the consequent fluctuations in profits, which Professors Mitchell and Lescure in particular have made the starting point of their exposition; and the shifts in the distribution of incomes that Professor Lederer investigates—both of these phenomena depending for their explanation on monetary factors, while neither of them can be immediately connected with changes in the general value of money. It is, perhaps, for this very reason that their authors, although perfectly realizing the monetary origin of the phenomena they described, did not present their views as monetary theories. While we cannot attempt here to show the position these phenomena would occupy in a systematically developed trade cycle theory (a task that really involves the development of a new theory, and is unnecessary for the purposes of our present argument) it is not difficult to see that all of them can be logically deduced from an initiating monetary disturbance, which, in any case, we are compelled to assume in studying them. The special advantages of the monetary approach consist precisely in the fact that, by starting from a monetary disturbance, we are able to explain deductively all the different peculiarities observed in the course of the trade cycle, and so to protect ourselves against objections such as were raised in an earlier chapter against non-monetary theories. It makes it possible to look upon empirically recognized interconnections, which would otherwise rival one another as independent clues to an explanation, as necessary consequences of one common cause.

Much theoretical work will have to be done before such a theoretical system can be worked out in such detail that all the empirically observed characteristics of the trade cycle can find their explanation within its framework. Up to now, the monetary theories have unduly narrowed the field of phenomena to be explained, by limiting research to those monetary changes that find their expression in changes in the general value of money. Thus they are prevented from showing the deviations of a money economy from a static economy in all their multiplicity. The problem of cyclical fluctuations can only be solved satisfactorily when a theory of the money economy itself—still almost entirely lacking at present—has been evolved, comprising a detailed discussion of all those points in which it differs from the equilibrium analysis worked out on the assumption of a pure barter economy. The full elaboration of this intermediate step of theoretical exposition is indispensable before we can achieve a trade cycle theory, which—as Böhm-Bawerk has expressed it in a phrase, often quoted but hardly ever taken to heart—must constitute the last chapter of the complete theory of social economy. In my opinion, the most important step toward such a theory, which would embrace all new phenomena arising from the addition of money to the conditions assumed in elementary equilibrium theory, would be the emancipation of the theory of money from the restrictions that limit its scope to a discussion of the value of money.

Once, however, we have accomplished this urgently necessary displacement of the problem of monetary value from its present central position in monetary theory, we find ourselves in a position to come to an understanding with the most important non-monetary theorists of the trade cycle; for the effect of money on the “real” economic processes will automatically be brought more to the surface, while monetary theory will no longer appear to be insisting on the immediate dependence of trade cycle phenomena on changes in the value of money—a claim which is certainly unjustified. On the other hand, a number of non-monetary theories do not question in the least the dependence of the processes they describe on certain monetary assumptions; and in their case, the only conflict now arising concerns the systematic presentation of these. It should be the task of our analysis to show that the placing of the monetary factor in the center of the exposition is necessary in the interest of the unity of the system, and that the various “real” interconnections, which, in certain theories, form the main basis of the explanation, can only find a place in a closed system as consequences of the original monetary influences. There can hardly be any question, in the present state of research, as to what should be the basic idea of a completely developed theory of money. One can abandon those parts of the Wicksell-Mises theory that aim at explaining the movements in the general value of money, and develop to the full the effects of all discrepancies between the natural and money rates of interest on the relative development of the production of capital goods and consumption goods—a theory that has already been largely elaborated by Professor Mises. In this way, one can achieve, by purely deductive methods, the same picture of the process of cyclical fluctuations that the more realistic theories of Spiethoff and Cassel have already deduced from experience. Wicksell himself  drew attention to the way in which the processes deduced from his own theory harmonize with the exposition of Spiethoff; and conversely, Spiethoff, in a statement already quoted, has emphasized the fact that the phenomena he describes are all conditioned by a change in monetary factors. But it is only by placing monetary factors first that such expositions as those of Spiethoff and Cassel can be incorporated into the general system of theoretical economics. A final point of decisive importance is that the choice of the monetary starting point enables us to deduce simultaneously all the other phenomena—such as shifts in relative prices and incomes—that are more empirically determined and utilized as independent factors, and thus the relations existing between them can be classified and their relative position and importance determined within the framework of the theory.

Even when these phenomena are, as yet, much further from a satisfactory explanation than are the disproportionalities in the development of production, which are cleared up in a greater degree, there can be no doubt that it will become possible to incorporate them also into a self-sufficient theory of the effects of monetary disturbances. These effects, however, although ultimately caused by monetary factors, do not fall within the narrower field of monetary theory. A well-developed theory of the trade cycle ought to deal thoroughly with them; but as this book is exclusively concerned with the monetary theories themselves, we shall, in the following chapters, only study the reasons why these monetary causes of the trade cycle inevitably recur under the existing system of money and credit organization, and what are the main problems with which future research is faced by reason of the realization of the determining role played by money.

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