This article was first published at the Adam Smith Institute on Saturday, 30 July 2011
At the Hayek v Keynes debate at the LSE on Tuesday, George Selgin probably raised a few eyebrows when he pointed out that Hayek would, in theory, have been in favour of quantitative easing to prevent a deflation. That doesn’t really chime with the extreme do-nothing image many people have of the Austrian school of economics.
Yet as Lawrence White pointed out in this paper, Hayek’s position on the correct monetary response to a downturn is more nuanced than is commonly imagined:
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.
Essentially, Hayek wanted money to be ‘neutral’ and that meant that it had to be constant. For it to be constant, changes in velocity had to be offset by changes in the money supply. The central bank should not, therefore, permit the kind of monetary deflation that occurred after the crash of 1929 to take place. On this basic point, there is actually little difference between the Hayekian view and the approach taken by Milton Friedman.
Does that make Hayek an apologist for central planning? Well, not exactly. Those in the modern free banking school (like Lawrence White and George Selgin) would argue that in a wholly denationalized banking system, private banks would react to a fall in velocity by issuing more base money (if people were hoarding cash) or by reducing their reserve ratios and lending more (if people were sitting on large deposit balances). That would achieve the constancy of the ‘total money stream’ that Hayek favoured, but would do so spontaneously rather than according to some central plan.
The argument goes, therefore, that central banks should try to mimic this process if faced with the same set of circumstances. Hence Selgin’s comment that Hayek would have favoured quantitative easing. But note that he only said ‘in principle’. In practice, there are a whole host of other considerations.
Firstly, central banks have limited information. As with all central planners, their chances of replicating the outcomes that would prevail in a free market are slim. Secondly, modern central banks tend to have a strong bias towards inflation. The upshot of these two points is that a policy like QE should only be pursued when the downside of doing nothing outweighs the potential cost of getting it wrong. Outside of severe crises, that’s unlikely to be the case. Thirdly, QE as practised today (using ‘new’ money to buy government bonds from a bust banking sector) might not be the best way of achieving the objective of monetary stabilisation. The old-fashioned Bagehot rule – providing liquidity support to solvent banks at a penalty rate – might well be preferable.
Finally, it’s worth stressing that the Hayekian / Free Banking approach is not about stimulating the economy, or bailing out failed institutions. It does not aim to re-inflate old bubbles, or create new ones. Nor is the idea to support wages or prices. The goal is simply to create a stable monetary environment so that economic adjustment and recalculation can take place.