Daniel Kuehn: Keynes's Foreword to the German Edition of the General Theory
California Democratic Party Convention: "Too Big to Fail" Panel

In Which I Am Once Again Reminded of How Wrong Friedrich Hayek Was...

Niklas Blanchard sends us to Kaz, who gives us:

Hayek’s 1932 Letter on the Great Depression: TO THE EDITOR OF THE TIMES

Sir, the question whether to save or whether to spend which has been raised in your columns, is not unambiguous. It involves three separate issues:

  1. Whether to use money or whether to hoard it;
  2. whether to spend money or whether to invest it;
  3. whether Government investment is on all fours with investment by private individuals.

While we do not wish to over-stress the nature of our differences with those of our professional colleagues who have already written to you on these subjects, yet on certain points that difference is sufficiently great to make the expression of an alternative view desirable.

On the first issue — whether to use one’s money or whether to hoard it — there is no important difference between us. It is agreed that hording money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.

On the question whether to spend or whether to invest our position is different from that of the signatories [Pigou, Keynes et al.] of the letter which appeared in your columns on Monday. They appear to hold that it is a matter of indifference as regards the prospects of revival whether money is spent on consumption or on real investment. We, on the contrary, believe... [i]t is perilous in the extreme to say anything which may still further weaken the habit of private saving.

But it is perhaps on the third question — the question whether this is an appropriate time for State and municipal authorities to extend their expenditure — that our difference with the signatories of the letter is most acute.... [M]any of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities... [that] mortgage the Budgets of the future, and... drive up the rate of interest.... Hence we cannot agree with the signatories of the letter that this is a time for new municipal swimming baths, etc., merely because people “feel they want” such amenities.

If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure, but to abolish those restrictions on trade and the free movement of capital (including restrictions on new issues) which are at present impeding even the beginning of recovery.

We are, Sir, your obedient servants,

T. E. Gregory, F. A. von Hayek, Arnold Plant, Lionel Robbins

This is of some interest in light of Larry White's claim that:

The Hayek-Robbins (“Austrian”) theory of the business cycle did not in fact prescribe a monetary policy of “liquidationism” in the sense of doing nothing to prevent a sharp deflation. Hayek and Robbins did question the wisdom of re-inflating the price level after it had fallen from what they regarded as an unsustainable level (given a fixed gold parity) to a sustainable level. They did denounce, as counterproductive, attempts to bring prosperity through cheap credit. But such warnings against what they regarded as monetary over-expansion did not imply indifference to severe income contraction driven by a shrinking money stock and falling velocity. Hayek’s theory viewed the recession as an unavoidable period of allocative corrections, following an unsustainable boom period driven by credit expansion and characterized by distorted relative prices. General price and income deflation driven by monetary contraction was neither necessary nor desirable for those corrections. Hayek’s monetary policy norm in fact prescribed stabilization of nominal income rather than passivity in the face of its contraction...

The interesting thing in this letter is that nowhere in it does Hayek suggest the government adopt any policy to stabilize nominal income. Instead, his policy recommendations are that the government (i) raise taxes, (ii) cut spending, (iii) cut tariffs, and (iv) eliminate capital controls. If that isn't doing nothing macroeconomically relevant in the midst of a sharp deflation, what would be?

Let me see if I can make some progress by writing down an augmented quantity-theoretic model to discuss how we would stabilize nominal GDP in the context of a financial crisis that has greatly increased the demand for safe savings vehicles and so pushed the short-term safe nominal interest rate that is the opportunity cost of holding money to very low levels. We start with our quantity theory of money, which tells us what nominal income PY is:

PY = MV(i)

Normally one would stabilize nominal income by boosting M. The problem is that the normal way the central bank boosts M is via open-market operations by which it buys safe savings vehicles for cash. Reduce the supply of safe savings vehicles and you raise their price--and thus lower the safe nominal interest rate i some more. Lowering i further reduces the opportunity cost of holding money and further reduces V. The net effect on PY is:

d(PY) = [V(i) + M(dV/di)(di/dM)]dM

A policy of stabilizing nominal income via open-market operations is thus a policy of enormous monetary expansion, as you have to expand the money stock enough to offset the effect on velocity of the fall in interest rates that the central bank's buying-up of safe nominal savings vehicles triggers and expand it by enough more to restore nominal income to its desired path. A better policy would be to combine open-market operations that expand the money stock with other policy moves that present your open-market operations from further reducing the interest rate on safe savings vehicles and so reducing velocity.

What would this better policy for stabilizing nominal GDP be? Let's look at the demand and supply for safe nominal savings vehicles. We have a flow of desired increases in holdings of safe savings vehicles, call it S(i), and--because in a financial crisis virtually no private-sector borrower is regarded as safe--we have the net increase in government bonds, G-T. In equilibrium:

S(i) = G - T

Increase government spending G--build those swimming pools that provide genuine utility to the citizens that Hayek sneers at--and you raise the interest rate i as well--and so raise velocity and so nominal income. (3) is a path toward stabilizing nominal income.

Or you could do something else to affect the safe nominal interest rate. Convince households to save less and spend more at any given level of i, and you will raise i--and so raise velocity and so nominal income. (2) is a path toward stabilizing nominal income as well.

Will the end and you will the means.

If you want to claim that Hayek's desired end was to stabilize nominal GDP, then face up to the fact that expansionary fiscal policy, jawboning to reduce desired household savings, bank recapitalizations so that private-sector institutions can issue safe assets, the creation of expectations of less future deflation or higher future inflation via abandonment of the gold standard and raising inflation targets, are all means alongside and at times instead of expansionary open market operations are all means to stabilize nominal GDP.

And then explain to me why Hayek was in favor of none of them.