Last night, I caught up with Martin Wolf’s November programmes for Radio 4 Analysis, which you can find here. He offered a predictable blend of commentators calling for more money printing, world central banking and greater global governance. It prompted me to look out Monetary Theory and the Trade Cycle (1933).
Hayek wrote (emphasis mine):
It is a curious fact that the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organization exclusively responsible for our present plight. And the same stabilizers who believed that nothing was wrong with the boom and that it might last indefinitely because prices did not rise, now believe that everything could be set right again if only we would use the weapons of monetary policy to prevent prices from falling.The same superficial view,which sees no other harmful effect of a credit expansion but the rise of the price level, now believes that our only difficulty is a fall in the price level, caused by credit contraction.
All eerily familiar. And:
We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown.
The truths set out by Hayek in that crucial essay – and in Prices and Production in the same PDF – are ever more relevant today. Yet, despite the evidence of the intervening 80 years, the Keynesians, and indeed the Monetarists, continue to peddle their interventionist policies and monetary statism. Their intellectual bankruptcy is plain but still institutions are regarded as august which hawk their poor ideas about money and bank credit.
The economic truths which Hayek set out in the 1930s are much neglected. It is high time that they were widely read by economists and businessmen and that the impoverishing ideas of Keynes which are now doing so much damage are laid to rest.
I’m pleased to promote another Hayek vs Keynes event at the London School of Economics:
Date: Monday 13 February 2012 Time: 6.30-8pm Venue: Sheikh Zayed Theatre, New Academic Building Speaker: Nicholas Wapshott Chair: Professor Danny Quah
Eighty years ago at the LSE, Friedrich Hayek launched an assault upon the new economic thinking of John Maynard Keynes. The clash was so bitter and vituperative that it scandalized the cloistered world of academia. Eighty years on, the differences between the two men have still not been finally resolved and their conflicting approaches to the economy continue to define the profound chasm between politicians of left and right.
The (financial) world is currently long in questions but short in answers. We believe that gold is still one of the few right answers in times of chronic uncertainty.
In the preface to his classic work “The Theory of Money and Credit”, Ludwig von Mises says: “Nevertheless, the problem of money has remained one of the darkest chapters in economics to this day”. Unfortunately one has to admit the nothing much has changed. In my reports and in the following brief introduction I would therefore like to explain how and why money developed.
Carl Menger, the founder of the Austrian School of Economics, tried to find satisfying explanations for observable phenomena of human (inter)action. Menger assumed the subjective perspective (subjectivism) of the acting person in order to construct the economy in its entirety emanating from the human subject. For Carl Menger, human action is the source of insight. Friedrich Hayek is of the opinion that probably every meaningful insight into economic theory has just taken subjectivism a step further.
The Austrians owe the realisation that money is a good to subjectivism. For investors, this may well be the most important lesson the Austrian School has taught them. In our previous Gold Reports we already discussed at length how the most marketable good gradually turned into money in order for indirect barter trade to work. Ludwig von Mises pointed out that over the millennia gold had turned out to be the most suitable good to ensure the functioning of indirect barter trade. This also explains why central banks around the world still hold gold instead of copper or nickel. Gold is therefore unlike any other commodity. Investors who have realised this also understand why gold is gaining in importance on the free market in spite of attempts to the contrary.
The need for a stable means of exchange is as old as mankind. Cigarettes, seashells, salt, goats, dried fish, or paper all fulfilled that role at some point. Their scarceness in relation to annual production made them bad items of value storage; most commodities come with an annual flow that outweighs the stock by a long shot. Therefore in the long run only gold and silver prevailed.
The regression theorem that Ludwig von Mises postulated in “The Theory of Money and Credit” is a pivotal piece when it comes to our understanding of the monetary character of gold. It says that the expectation with regard the future purchasing power of money depends crucially on the knowledge about today’s purchasing power of money. Today’s evaluation of purchasing power in turn is derived from yesterday’s purchasing power. If we continue this regression, we find that at the beginning of the process there has to be a good that was generally needed and had an industrial use. This means that money has emerged from a tangible good. This also includes the demand for jewellery and thus gold. According to Mises only those goods that have a generally accepted utility value can turn into generally accepted, natural money. Gold and silver were already used as jewellery before they assumed their monetary functions. According to Mises, the past experience is the decisive factor for the future trust in monetary stability.
The trust in the stability and the future purchasing power is essential for the value measurement of money. According to the regression theorem people only trust in money as long as it offers a certain degree of safety with regard to the future money supply and thus to the future purchasing power. From our point of view, the high stock-to-flow ratio seems to play an important role in this context. In the following report we want to discuss this central and unique, and hitherto quite disregarded, feature of gold.
According to some media sources Douglas Carswell MP is today bringing a bill to the House of Commons that aims to demonopolise the UK’s legal tender laws. Very much a sign of the times, I believe you will hear a lot more about this idea in the days and weeks ahead. Already, the BBC has picked it up here.
A Conservative MP is to call for a basket of foreign currencies to be made legal tender in the UK.
Such a move would protect savers by allowing them to hold the currency least likely to be devalued, Douglas Carswell will argue in the Commons.
And it would allow consumers to shop around for the best currency deal – perhaps via a smart phone application – when buying goods in shops or online.
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.
July 26th saw one of the most eagerly anticipated economic events of recent years. At the London School of Economics (former employer of Friedrich von Hayek), Professor George Selgin and Dr. Jamie Whyte for the Hayekians and Professor Lord Skidelsky and Duncan Weldon for the Keynesians gathered in front of a packed lecture hall to debate Keynes vs. Hayek. Two other lecture halls were required for the overspill. The debate will be broadcast on BBC Radio Four on August 3rd.
In front of a boisterous crowd, Hayek won fairly easily. Skidelsky’s haughty style contrasted with Selgin’s bullishness and the perennial Keynesian failure to look at the origins of the bust won over nobody in an admittedly partisan crowd. But even an hour of discussion left a few things hanging.
China
One questioner asked whether the Chinese stimulus package had been so much more successful than America’s because the totalitarianism of China allowed the government to direct the spending more effectively than in the US with its dispersed government.
To my great surprise this question was largely ignored by the Hayekians and waved through by the Keynesians, Skidelsky murmuring his approval for the proposition. I was surprised this question generated so little comment because it proves one of Hayek’s key propositions, namely that economic control goes hand in hand with political and social control.
To Hayek there was no such thing as ‘the economy’, as some separate area of human activity which can be tweaked and tinkered with. The economy is, instead, the whole arena of what Hayek’s mentor called Human Action. Or as Ronald Reagan put it, “a government can’t control the economy without controlling people”
We see this with Mussolini’s declaration that “Fascism entirely agrees with Mr. Maynard Keynes” or with the fascistic Blue Eagle which represented the National Industrial Recovery Act of Roosevelt’s New Deal. The effectiveness of China’s Keynesian stimulus came at the price of Tiananmen Square.
Keynesian diagnosis
One of Skidelsky’s repeated attacks on Hayek was that while he had plenty to say about how we got into the bust he had nothing to say about how we get out of it. Selgin dealt with this very well, but there is another point: if a doctor has no idea why your foot is hurting, would you blithely accept his prescription that it needs to be sawn off?
Whereas Austrian economics is famous for its theory of business cycles, with unsustainable booms leading to busts in which bad investments are liquidated, Keynesian theory is silent about the business cycle. All we get is the concept of “animal spirits”, which simply states that at some point for some reason business people suddenly decide en masse to stop investing, and boom turns to bust. As an explanation for why an economy hits the skids, animal spirits is up there with “in the long run we are all dead” — a typical Keynesian shrug of the shoulders.
And it doesn’t even fit the current slump. The economy hit the skids, as Austrian theory always suggested it would, when the Federal Reserve raised interest rates to stifle the inflation caused by the unsustainable credit expansion of the boom period. Many investments that were viable in an environment of easy credit were sustainable no longer. Animal spirits played no part in this. If Keynes was wrong about the diagnosis, why should we place any faith in his prescription?
Mellon and liquidation
This led inevitably to the introduction of a quote attributed to Andrew Mellon, Secretary of the Treasury under President Hoover when the Wall Street Crash hit:
liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate…it will purge the rottenness out of the system
There are two grounds on which to question this. First, this quote comes from Hoover’s memoirs and Hoover was the original executor of Keynesian stimulus.
Second, what actually is wrong with it? Look back at the recent boom. In Britain, the US, Ireland, Spain and elsewhere, we had rocketing house prices based on low interest rates. Lots of house building got under way to cash in, and lots of people were drawn into the construction industry.
Now, if we have too many houses as a result of the boom’s over-investment, we do not need new houses built. It follows that we also need fewer people building them. Elements of the construction industry, in other words, will be liquidated just as Mellon said.
They have to be. Consider the alternative: construction workers are laid off in large numbers and a movement begins to ‘do something’. All that can be done is either monetary or fiscal action directed to keeping these workers building houses we do not need. Anything else is Mellon’s liquidation.
Keynes famously said that unemployment could be solved
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again
His modern day disciples, it seems, think that we can build a prosperous economy around the building of houses no one will ever live in.
Larry Summers
I have to give Weldon some credit. For anyone even vaguely involved in the economic policy making of the last government to show his face in public takes real nerve. He was rewarded with a titter from the smattering of Keynesians when he quoted with approval the words of Larry Summers, who described the coalition’s belief that spending cuts are necessary for recovery as “oxymoronic”. Weldon suggested that Summers could have dispensed with the ‘oxy’.
This is, of course, the same Larry Summers who said of the recent Japanese tsunami
It may lead to some temporary increments, ironically, to GDP as a process of rebuilding takes place. In the wake of the earlier Kobe earthquake Japan actually gained some economic strength
Perhaps Weldon could find an adjective for this?
It is quite a bizarre argument that a man can destroy his house in year one, rebuild it in year two, and at the end of that second year pat himself on the back for increasing his GDP by the cost of his new house. But then you are through the looking glass with Keynesianism. The doctrine holds, after all, that the more you spend the richer you get. Predictably it wasn’t an argument which impressed the tough crowd at the LSE.
I follow Steve Baker’s speeches in Hansard with interest, and there have been many good ones, but his recent discourse on the IMF stands apart. It was made in the debate of the Draft International Monetary Fund (Increase in Subscription) Order 2011 by the “Second Delegated Legislation Committee”.
The unexcitingly-named proposal before this obscure-sounding committee would commit an additional £10 billion of British taxpayers’ money to the IMF.
11.39 am – Steve Baker
…
I begin by welcoming the Minister’s resolve and composure in what are clearly historic and contentious circumstances. We have seen today that there is broad agreement across the Committee that what matters is human prosperity, and we are all deeply worried about our constituents. I am going to make three points. First, I do not believe that we have this money and that we cannot afford the liability. I do not think that my constituents will understand why they should pick up the liability. It seems to me that one way or another, this country will end up borrowing in order to lend to fund present consumption, and funding present consumption through borrowing is simply not a route to prosperity. I wish I felt that it was not necessary to expand on that point, but it seems these days that we forget. If we consume on credit, we are in fact making ourselves poorer.
I find the notion of getting the money back quite worrying. It seems to me that we will borrow some of this money, at least, from commercial banks, inevitably monetising the debt and debasing the currency further after 40 years of continuous debasement. That will involve inflation and further distortions in the structure of the economy. In short, this measure would simply kick the can down the road. We might argue that that is the job of the IMF these days, but the Greek people are already rioting and we have to ask ourselves whether they would be any more sympathetic to such austerity measures simply because they were brought forward by the IMF. I question the action itself.
Secondly, the IMF was created as part of the Bretton Woods system of currencies. We tend to talk as though our current monetary arrangements were a fixed point and had always been the same, but the present monetary orthodoxy has evolved over the years and centuries. Bretton Woods was constructed after the catastrophe of the second world war; the dollar was redeemable in gold, and all other currencies were pegged to the dollar. The job of the IMF was to stabilise exchange rates by bridging temporary gaps in nations’ balance of payments, but the IMF now seems to serve the purpose of ensuring the repayment of reckless financial institutions.
Above all, at all stages of its history the IMF has existed to bring financial stability, which I believe it has singularly failed to do. Turning to the monetary system and stability, I encourage Members to google a chart that I can make available, which shows the price of oil-index factor 1945, the origin of Bretton Woods-brought forward to today. It prices oil in dollars and in gold. I do not like to use the G-word, but I feel that since my hon. Friend the Member for Wellingborough has mentioned it already, I can continue. The price of oil has been high and volatile since 1971, but only when priced in dollars. If we price oil in gold, the price has been low and stable ever since the end of the second world war.
I simply make the point that our monetary arrangements are not fixed, that the IMF has not brought stability and that in fact many of our most important commodities are far more susceptible to the effects of our present, inflationary monetary arrangements than is generally considered. I would like to finish my point about the IMF with Hayek’s words. He said:
“monetary policy all over the world has followed the advice of the stabilisers. It is high time that their influence, which has already done harm enough, should be overthrown.”
He wrote that in 1932 in the preface to “Monetary Theory and the Trade Cycle“, which hon. Members can find by googling “prices and production.”
Thirdly, I want to talk about the contemporary mainstream. With great respect to hon. and right hon. Friends, although my right hon. Friend the Member for Wokingham foresaw many aspects of the crisis, the majority of the mainstream did not see this coming. I have sat at lunch with eminent economists who said that nobody saw this coming, to which I simply replied that they should read Huerta de Soto’s “Money, Bank Credit and Economic Cycles“. That book, which was written in 1998, clearly set out that this would happen and why, following in the footsteps of Hayek, Mises and others. The Queen asked why no one saw this coming. If she had asked me, I would have said that it was because economists pay too little attention to time-the simple matter of the importance of time. Production takes time and, in a market, interest rates should arise from people’s time preferences for consumption. In the jargon, the contemporary mainstream lacks an adequate theory of the inter-temporal structure of capital-that is, capital goods, or the means of production.
We are at the end of an extremely long credit expansion. I depart from my right hon. Friend the Member for Wokingham, but that is because I follow that particular theory of capital. Hayek, it is not often known, was a socialist and confesses as much in the preface to Mises’ book, “Socialism“, but he and Mises together worked out the theory of the trade cycle. Mises wrote:
“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion.
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
That is from “Human Action“, page 572.
At this point came an intervention to delight Cobden Centre readers:
Mr Cash: My hon. Friend’s contribution is very thoughtful; he knows a great deal about such things, in the tradition of Cobden. However, is the real problem one of human nature as well as of economics? People are competing in an environment in which there is no real or comparative advantage because the new world-if I may use that expression-of the Brits has a huge advantage over the others. Good money is being thrown after bad unless the real problem is tackled: cheap credit that is not based on real, tangible economic advantage.
Steve Baker: I absolutely agree with my hon. Friend. He makes an excellent point with which I am in full agreement.
Mr Redwood: Before my hon. Friend sits down, I hope that he will give the Committee the benefit of his advice on the order, because we are not yet quite clear what he would do about the £9.5 billion sub.
Steve’s concluding remarks pull no punches (emphasis mine):
The Government should avoid committing that sum of money; my view is that it will not help. I made a second point about the IMF and our monetary arrangements. If this is not the time of all times to question the fundamental basis of our financial system, I do not know when we ever shall. My third point was that I am afraid that the contemporary mainstream of economics is missing some vital information, which leads it to justify the very measures that we are discussing today. As I explained, as Mises set out, as Hayek followed in his steps and as others have predicted, we risk a final and total catastrophe for our currency system.
To conclude, we are in danger of simply kicking a can down the road and, as my hon. Friend the Member for Clacton said, ladling water into the boat. We are looking at further credit expansion, further monetisation of debts and further socialisation of risk. Throughout the western world, we are in danger of appearing as King Canute, trying to use politics to hold back the realities of social co-operation, which we usually describe as economics. The IMF is an institutional legacy from a monetary system that failed 40 years ago, and the successor to which is even now failing as well.
I looked at IFRS and how it boosts bank capital, and we found that RBS is possibly overstating its capital by £25 billion. That must meant that RBS at least is far more susceptible to financial shocks than is generally thought. It is my view, because of the weaknesses of IFRS, that all banks are substantially more susceptible to financial shocks than is generally understood. I therefore offer three points. First, the Government should please look at cross-cancellation of debt held by sovereign nations-I refer the Government to work by ESCP Europe and Dr Anthony Evans. Secondly, let us face the reality-not optional-and look at how we restructure outstanding debt. Thirdly, at this time of all times, rather than merely increasing our liability to the IMF, let us seriously rethink the foundations of the international financial system and, in particular, start planning for how to protect the payments system.
Writing over 230 years ago, Adam Smith noted the ‘juggling trick’ whereby governments hide the extent of their public debt through ‘pretend payments’. As the fiscal crises around the world illustrate, this juggling trick has run its course. This article explores the relevance of Smith’s juggling trick in the context of dominant fiscal and monetary policies. It is argued that government spending intended to maintain stability, avoid deflation and stimulate the economy leads to significant increases in the public debt. This public debt is sustainable for a period of time and can be serviced through ‘pretend payments’ such as subsequent borrowing or the printing of money. However, at some point borrowing is no longer a feasible option as the state’s creditworthiness erodes. The only recourse is the monetarization of the debt which is also unsustainable due to the threat of hyperinflation.
Policy Implications
The fear of deflation on the part of policy makers has led to an inflationary bias which neglects or underestimates the costs of inflation.
The debt–inflation theory of economic crises must be considered as a viable alternative to the standard debt–deflation theory of economic crises.
In order to curtail the tendency of using the tools of monetary and fiscal policy to concentrate benefits and disperse costs, policy institutions must effectively tie the rulers’ hands.
After centuries of only fleeting success at curtailing the deficit, debt and debasement cycle of public policy, we may have to consider seriously the possibility that the only way successfully to constrain the state is to eliminate from its purview the task of monetary policy.
Writing in 1776, Adam Smith noted the following regarding public debt:
When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. … publick bankruptcy has been disguised under the appearance of a pretend payment. … When it becomes necessary for a state to declare itself bankrupt, in the same manner as when it becomes necessary for an individual to do so, a fair, open, and avowed bankruptcy is always the measure which is both least dishonorable to the debtor, and least hurtful to the creditor. The honour of a state is surely very poorly provided for, when in order to cover the disgrace of real bankruptcy, it has recourse to a juggling trick of this kind … Almost all states, however, ancient as well as modern, when reduced to this necessity, have upon some occasions, played this very juggling trick (Smith, 1776, pp. 929–930).
The implications of Smith’s logic regarding public debt have come to fruition as evidenced by the violent situation in the streets of Athens, the situation facing the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and the pending fiscal crisis facing US states such as California, Illinois and New Jersey. In each of these instances, the current predicament did not arise over the past year or two, but rather was the result of decades of public policy decisions resulting in fiscal imbalance. While pretend payments and the juggling of finances were able to hide the underlying realities for decades, the bill has now come due.
Over 230 years after Smith wrote The Wealth of Nations, the Great Recession has again brought debates about the public debt, and the role of government more broadly, to the forefront. The purpose of this article is to explore the relevance of Smith’s ‘juggling trick’ in the context of the dominant fiscal and monetary policies. Our central argument can be stated as follows: government spending intended to maintain stability, avoid deflation and stimulate the economy leads to significant increases in the public debt. This public debt is sustainable for a period of time and can be serviced through ‘pretend payments’ such as subsequent borrowing or the printing of money. However, at some point borrowing is no longer a feasible option as the state’s credit- worthiness erodes. This implies that the ultimate result of Smith’s juggling trick is the monetarization of the debt in order for the state to avoid bankruptcy. This too, however, is an unsustainable policy due to the threat of hyperinflation which has ravaging effects as evidenced by Russia and Germany in the early 20th century.
We proceed as follows. The next section shows how the current debates over public debt mirror the debate that took place during the 1930s between John Maynard Keynes and F. A. Hayek. We also highlight how concerns over the debt–deflation spiral emerged as part of this debate and continue to drive policy today. Section 2 discusses the mechanisms underpinning the debt–inflation cycle. We contend that the focus on deflation leads to an inflation-biased policy which neglects the cost of inflation and the logic of democratic politics that Smith highlighted in the opening quote. Section 3 lays out the dilemma we face. On the one hand we have theories indicating that active fiscal and monetary policies are necessary for recovery and growth. At the same time, we have public choice theories which indicate that increased public debt is ultimately unsustainable. Section 4 concludes with the lessons learned.
1. Back to the future
In the 1930s, the main macroeconomic debate in economic theory and policy centered around the question of who was right, Keynes or Hayek? In the wake of the Great Depression, Keynes argued that unless action was taken to stimulate aggregate demand the economy would sink further into an abyss of unemployment and lackluster economic growth. In contrast, Hayek argued that fiscal irresponsibility threatened the recovery and long-term economic health of the economy. The key to recovery and growth, according to Hayek, was private investment.
Keynes won the day in the 1930s, but in the 1970s that same debate resurfaced with a more ambiguous resolution, and since 2008 the debate has returned with a vengeance at a variety of levels. The current debate mimics the earlier one in that there is intense academic dispute about the causes of the Great Recession, as well as the best way forward. Further, as during the 1930s, the debate is also being played out in newspapers and magazines, as well as in vigorous political dialogue between conservative and liberal politicians on both sides of the Atlantic. Perhaps nothing illustrates more how the current debate mirrors that of the 1930s than the comparison of the writings in the pages of the major newspapers (see Boettke et al., 2010).
On 17 October 1932, D. H. Macgregor, A. C. Pigou, J. M. Keynes, Walter Layton, Arthur Salter and J. C. Stamp (Macgregor et al., 1932) published a letter in the Times of London noting that private spending was one of the primary causes for the continuation and severity of the Great Depression. They argued that immediate government action was necessary to counteract the fall in aggregate demand. Two days later, T. E. Gregory, F. A. von Hayek, Arnold Plant and Lionel Robbins (Gregory et al., 1932) responded in the same paper arguing that private investment was necessary to recovery and growth.
Eighty years later, a similar debate took place. On 14 February 2010, a group of economists led by Timothy Besley published a letter in the Sunday Times arguing for a credible fiscal plan to create confidence in the robustness of the UK system (Besley et al., 2010). Only by reducing the structural budget deficit, the authors argued, could the confidence of private investors be maintained. Four days later, a group of economists led by Lord Skidelsky, Keynes’ biographer, published a letter in the Financial Times arguing that the immediate concern should not be reducing the deficit, but instead ensuring robust growth through public spending (Skidelsky et al., 2010).
As the comparison of these two exchanges illustrates, the high stakes in the 1930s regarding government policy still exist decades later. However, the debate cannot be adequately understood in broad brush strokes of free market versus government intervention, or even in terms of the effectiveness of fiscal policy or monetary policy. It is much more subtle than that, even as it does turn ultimately on the question of the self-correcting capacity of the market economy. To understand the debate, one has to recognize the classic position carved out in the 1930s by Irving Fisher (1933). Fisher argued that a debt–deflationary spiral can sink an economy into a great depression unless the appropriate policies are performed to prevent the downward spiral of economic activity. Deflation, in other words, must be avoided by the monetary authorities, even at significant cost.
This preoccupation with avoiding deflation necessarily leads to an inflation-biased monetary policy. The ‘chief source of the existing inflationary bias’, Hayek wrote, ‘is the general belief that deflation … is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable’ (Hayek, 1960, p. 330). The practical problem in monetary policy under this set of assumptions results in a situation where because ‘we do not know how to keep price completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation’ (Hayek, 1960, p. 330).
There are at least two major policy issues with the preoccupation with deflation. First, a positive case for declining price levels can be made since deflation, if it reflects generalized productivity gains that result from technological innovation in an economy, is good, not bad (see Selgin, 1997). It is complicated, if not impossible, to sort out as a matter of public policy good deflation from bad deflation. As a result, we are back again to the situation of cumulative inflation stressed by Hayek. Second, the self-reversing of the economic errors caused by inflation can be interpreted as a collapse in spending and a corresponding decline in economic activity as resources are reallocated, and thus those who fear deflation will call for a re-inflation to forestall the debt–deflation downward spiral. Hayek argues that the problem politically is that moderate inflation will be viewed pleasantly and will be revealed to be costly only in the future, whereas deflation is immediately observable and painful. Expediency in politics will reinforce the push for inflation, whereas politics by principle would demand permitting market adjustment and the reallocation of resources however painful in the short run (see Hayek, 1973, pp. 55–71).
The concern of deflation, and the neglect of inflation, have continued to the present day as evidenced by a recent speech by Federal Reserve Chairman Ben Bernanke (2010) in which he noted:
the FOMC [Federal Open Market Committee] will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation.
Recognizing Fisher’s concern for the debt–deflationary spiral is crucial because while the debate between Keynes and Hayek focused largely on fiscal policy, the fear of deflation shifted focus to monetary policy. The combined result was, and continues to be, a policy characterized by a proactive Keynesian case for fiscal policy to stimulate growth, and a proactive monetarist (and proto-monetarist) policy to avoid deflation. This, however, puts us in the very situation raised by Smith in The Wealth of Nations. How do we avoid the natural tendency of politicians and policy makers to engage in the juggling trick that hides the true costs of these proactive fiscal and monetary policies through increased borrowing and the monetarization of debt which can ultimately destroy an economy?
2. The public debt–inflation cycle
Smith’s recognition of the juggling trick regarding public debt is especially prescient because it correctly recognized the incentives facing elected officials well before the public choice revolution of the 1960s. This focus on basic incentives was lost with the Keynesian revolution. As Zingales (2009a) notes, ‘Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economics base all their analysis on incentives’. This is a crucial point because fiscal and monetary policy is not designed in a vacuum. Instead, we must consider the incentives at two levels. First, we must understand the incentives facing policy makers when they design policy. Second, we must consider the incentives created by those policies. Let us consider each of these incentives in turn.
The logic of Smith’s ‘juggling trick’ insight was based on the basic incentives facing elected officials. Government can raise revenue in three ways: taxation, debt and inflation. To maintain popularity, governmental leaders prefer not to raise explicit taxes, so the preferred method of revenue generation is to borrow and then pay debts back with debased currency (an implicit tax). The democratic bias is to concentrate the benefits of public policy on well-organized and well-informed voters in the short run, and disperse the costs of public policy on the ill-organized and uninformed masses in the long run. The least informed and organized interest group at any point of time is future generations. Hence, the natural proclivity for the ruling regime is to run deficits that result in accumulated public debt, which is paid off with debasement. Throughout history this governmental habit of deficit, debt and debasement is what has brought down regimes and with that sometimes civilizations (see Groseclose, 1961, pp. 57–76; Rothbard, 1990 [1963], pp. 63–64).
It is this logic that has historically underpinned calls for an independent central bank, and various constraints on the policy discretion of both the treasury and the central bank. Ideally, rules must be designed to prevent policy cooperation ⁄ collusion between the fiscal and monetary policy makers precisely because we know the history of the political temptations to be seduced by the opportunity to engage in the juggling trick that Smith so long ago identified.
However, the problem goes beyond the incentives facing policy makers. The process of engaging in Smith’s juggling trick also creates perverse incentives in the private arena as proactive fiscal and monetary policies have led to increased efforts on the part of private actors to influence these policies for their personal gain. This raises the return to lobbying and rent-seeking activities relative to productive entrepreneurial activities, which are necessary not only for immediate recovery, but for long-term growth.
This interplay between the incentives facing policy makers and private businesspeople has resulted in a ‘vicious circle’ of favouritism and a lack of trust in financial and political institutions by citizens (see Zingales, 2009b). Politicians are intertwined with private markets as the logic of special interests discussed above (see Smith et al., forthcoming). At the same time, politicians seek to signal to citizens that they are independent of private interests. They do so by adopting strong policies against those private interests in the wake of crisis – increased regulation, threatened and actual taxes and fines, etc. This attempt to send a strong signal, however, has the unintended effect of creating an uncertain environment for subsequent investment which further exacerbates the fundamental problem of encouraging private investment for recovery and growth.
3. Misdiagnosing the sickness and cure
We are faced with a dilemma. On the one hand, the dominant theories of economic crises indicate that government must play a proactive role in getting the economy out of the depressed state of affairs. Active fiscal policy must be used to stimulate aggregate demand while active monetary policy must be used to avoid a deflationary spiral. However, we also have public choice theories dating back to Adam Smith which indicate that these very government actions are unsustainable and economically destructive.
The trends seem to support the Smith ⁄ public choice line of reasoning. In Capitalism and Freedom, Milton Friedman (1962, p. 75) pointed out that the primary justification of the expansion of public expenditure since the Second World War has been the ‘supposed necessity for government spending to eliminate unemployment’; an idea, Friedman goes on to argue, that has been thoroughly discredited by theory and practice. But, as he points out, ‘The idea may be accepted by none, but the government programs undertaken in its name, like some of those intended to prime the pump, are still with us and indeed account for ever-growing government expenditures’ (Friedman, 1962, p. 76). Close to 20 years later, Friedman noted that little had changed from when he first made those observations. ‘The repeated failure of well-intentioned programs is not an accident. It is not simply the result of mistakes of execution. The failure is deeply rooted in the use of bad means to achieve good objectives.’ But in spite of the overwhelming record of failure, these programs continue to expand. ‘Failures are attributed to the miserliness of Congress in appropriating funds, and so are met with a cry for still bigger programs’ (Friedman and Friedman, 1980, pp. 87–88).
Further, in the 25-plus years since those words were written little has changed in the day-to-day operation of politics, though Friedman was successful in transforming the rhetoric in the direction of market-economics language. At best, the growth of government was slowed, but it is important to stress that neither the Reagan nor Thatcher administrations reversed the trend line, and in the subsequent years even that slowing of the growth of government was reversed, especially after the 11 September 2001 terrorist attacks and the ensuing military conflicts and enhanced domestic security measures.
It is important to stress this because one of the great mythologies is that the Great Recession is evidence of the failure of unregulated capitalism. A similar mythology arose concerning the Great Depression. As Friedman and Friedman summed it up:
The depression convinced the public that capitalism was defective; the war, that centralized government was efficient. Both conclusions were false. The depression was produced by a failure of government, not of private enterprise. As to the war, it is one thing for government to exercise great control temporarily for a single overriding purpose shared by almost all citizens and for which almost all citizens are willing to make heavy sacrifices; it is a very different thing for government to control the economy permanently to promote a vaguely defined ‘public interest’ shaped by the enormously varied and diverse objectives of its citizens (Friedman and Friedman, 1980, pp. 85–86).
Failing to distinguish between unregulated capitalism and state-led capitalism, or mercantilism, has two negative consequences. The first is that it runs the risk of misdiagnosing the problem. If failures are attributed to capitalism when they are in fact the result of distortions caused by fiscal and monetary policies, this will lead to an incorrect diagnosis of the actual problem. The second, and related, consequence is that it runs the risk of misdiagnosing the solution. If, in fact, the cause of downturns is distortions caused by past fiscal and monetary solutions, then it is incorrect to assume that these same policies are the solution to the very problem they caused.
There is reason to believe that both types of misdiagnosis are at work in the current crisis. Zingales (2009a) notes that Keynesian policies have not only failed to avoid the current crisis but instead were a contributing factor to its onset. He writes that ‘The Keynesian desire to manage aggregate demand, ignoring the long-run costs, pushed Alan Greenspan and Ben Bernanke to keep interest rates extremely low in 2002, fuelling excessive consumption by the household sector and excessive risk-taking by the financial sector’ (Zingales, 2009a). Similarly, Taylor (2009) has documented how easy monetary policy combined with government programs that unintentionally shifted the incentives for risk taking caused and prolonged the current crisis. Finally, Rajan (2010) highlights how the role of loose monetary policy and the political push for easy housing credit contributed to the current crisis.
Prior to the onset of the crisis, economists too quickly identified the lack of macroeconomic volatility with the perfection of central banking, rather than seeing policies in terms of Smith’s juggling trick whereby fiscal and monetary policies paper over (literally) the efforts by market forces to correct for the misleading signals of the previous period of manipulation of money and credit in the economy. The Fed ‘getting off track’, to borrow Taylor’s (2009) apt phrase, was due to efforts to keep the previous misguided set of economic activities afloat rather than permitting the necessary adjustment to economic reality by market participants.
To the extent that Zingales, Taylor and Rajan are correct that past fiscal and monetary policies were a factor in causing the current situation, what confidence do we have that those same policies can now solve the existing predicament they helped to create? Further, to the extent that these policies are successful, they will only be so in the short run as they are just a continuation of the juggling trick. As the debt crises around the world illustrate, while payment can be delayed, eventually the bill becomes due.
4. Lessons learned
What have we learned from the Great Recession? We would like to highlight three lessons which we hope will be the subject of subsequent debate and discussion.
First, the debt–inflation theory of economic crises must be considered as a viable alternative to replace the debt–deflation theory of economic crises. Under the debt–deflation theory policy makers interpret every downturn in economic activity as a potential deflation, and therefore counteract it with easy monetary policy. When this happens market corrections will be cut short, and the previous boom is recreated through the manipulation of money and credit.
Ludwig von Mises (1966 [1949]) and F. A. Hayek (1979) were early expositors of an expectation-based macro-economics arguing that efforts to offset economic downturns through monetary policy enter a dangerous game of expectations and anticipated inflation. As Hayek argued, ‘We now have a tiger by the tail: How long can this inflation continue? If the tiger [of inflation] is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished!’(Hayek, 1979, p. 110, emphasis added) It is this theory of the ‘crack-up boom’ (see Mises, 1966 [1949], pp. 426–428) that very well may be what we have seen manifesting itself in reality with the onset of the Great Recession in 2008. If this is accurate then the policy steps taken to date have merely reinforced, rather than ameliorated, the problem as a market correction to previous malinvestments has been turned into a global crisis by the very steps taken to prevent the market correction from occurring.
Second, to curtail the tendency of using the tools of monetary and fiscal policy to concentrate benefits and disperse costs, policy institutions must effectively tie rulers’ hands to eliminate the possibility of engaging in the juggling trick that Smith warned against. The importance of establishing credible and binding constraints on monetary authorities and government spending is by no means a new idea. However, modern history has demonstrated the elusiveness of the quest to establish binding and credible constraints on monetary and fiscal authorities.
This has important implications because the relevant question is not if constraints should be established, but instead whether binding constraints can be established within the existing institutional framework. If that institutional framework is vulnerable to the inevitable errors committed by policy makers – either innocent or malevolent – then the problem is not in the framework, it is the framework. Milton Friedman (1962, pp. 50–51) recognized this possibility when he wrote:
Any system which gives so much power and so much discretion to a few men that mistakes – excusable or not – can have such far reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic – that is the key political argument against an ‘independent’ central bank. But it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an ‘independent’ bank. To paraphrase Clemenceau, money is much too serious a matter to be left to the Central Bankers.
Similarly, Buchanan and Wagner are pessimistic of the ability to restrain the state from engaging in juggling tricks leading them to conclude that, ‘politically, Keynesianism may represent a substantial disease, one that can, over the long run, prove fatal for a functioning democracy’ (Buchanan and Wagner, 1977, p. 56, emphasis added).
This leads to our third and final lesson. After centuries of only fleeting success at curtailing the deficit, debt and debasement cycle of public policy, we may have to consider seriously the possibility that the only way successfully to constrain the state is to eliminate from its purview the task of monetary policy. Rather than a centralized and government monopoly control of the money supply, perhaps more decentralized and competitive institutional arrangements might have to be relied upon. Of course, what is required is the attention of economists to examine such institutional arrangements in depth and with all their critical attention. What cannot continue is the standard practice of looking at central banking theory and practice as if they were to be done by fully informed agents who act only in the public interest. Instead, a robust theory of the institutions of the monetary framework must be developed.
References
Bernanke, B. S. (2010) ‘The Economic Outlook and Monetary Policy’. Speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, 27 August. Available from: http://federalreserve.gov/newsevents/speech/bernanke20100827a.htm [Accessed 22 February 2011].
Besley, T., Davies, H., Goodhart, C., Marcet, A., Pissarides, C., Quah, D. et al. (2010) ‘UK Economy Cries Out for Credible Rescue Plan’, Sunday Times, 14 February, p. 26.
Boettke, P. J., Smith, D. and Snow, N. (2010) ‘Been There Done That: Political Economy of Déjà vu’, mimeo.
Buchanan, J. M. and Wagner, R. E. (1977) Democracy in Deficit: The Political Legacy of Lord Keynes. New York: Academic Press.
Fisher, I. (1933) ‘The Debt–Deflation Theory of Great Depressions’, Econometrica, 1 (4), pp. 337–357.
Friedman, M. (1962) Capitalism and Freedom. Chicago, IL: University of Chicago Press.
Friedman, M. and Friedman, R. (1980) Free to Choose. New York: Harcourt Brace.
Gregory, T. E., Hayek, F. A., Plant, A. and Robbins, L. (1932) ‘Spending and Saving: Public Works from Rates’, Times of London, 19 October, p. 10.
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Hayek, F. A. (1960) The Constitution of Liberty. Chicago, IL: University
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Hayek, F. A. (1979) A Tiger by the Tail: The Keynesian Legacy of Inflation. San Francisco, CA: The CATO Institute.
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World Economy. Princeton, NJ: Princeton University Press.
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of Nations, Volume II. Indianapolis, IN: Liberty Fund.
Smith, A., Wagner, R. E. and Yandle, B. (forthcoming) ‘A Theory of Entangled Political Economy, with Application to TARP and NRA’, Public Choice.
Taylor, J. (2009) Getting Off Track: How Government Actions and
Interventions Caused, Prolonged, and Worsened the Financial
Crisis. Stanford, CA: Hoover Institution Press.
Jamie Whyte‘s superb BBC Radio 4 documentary, focusing on F.A. Hayek, is now available as a BBC podcast.
You can download it from here:
Yo, Hayek! (Broadcast on BBC Radio 4, 8:30pm, 31st Jan, 2011)
(iTunes users can also find the podcast on the iTunes store, for free subscription, if they search for ‘bbc radio 4 analysis’, though it may take a little time to appear.)
I would prefer to let you listen to the documentary yourselves, rather than try to annotate my own personal highlights (such as the mention of ‘factors of production’, the linking of ‘quantitative easing’ with ‘money printing’, or anything stated by Professor Robert Higgs and Steve Baker MP).
Basically, it’s all good.
However, I must just say that I was mightily impressed when the opening section began with the theme of the following video. I would therefore like to thank Jamie for giving me yet another opportunity to embed this video within a Cobden Centre article.
Having recently sold my food business, life is moving at a much slower pace, which gives time for thought and reflection before I undertake my next venture or ventures. One thought was: what did I learn from academia that I applied to my business dealings?
I concluded that my behaviour was moved by my instinct and alertness to opportunity, and my ability to provide strategic leadership to people and give them vision. With my actions over the years I was always Hayekian in outlook.
I could not say for sure if my reading of Hayek made me behave and structure my business as I did, or if I just did it because common sense always told me that local management, with profit and loss responsibility handed down to the smallest units possible, and as little reliance on the central head office function as possible, was the only way forward. In fact, to the day I sold, I never did have a head office. This perplexed bankers, accounts etc, but no one else.
I also used to say to my people, “if the man from Mars (read: management consultant, banker, accountant, anyone who’s good at spreadsheets and sits at a desk) came down and looked at our business, he would say we are mad”. We would sometimes send three vehicles to deliver fish down the same road to different people at different times of the day — we should surely consolidate these deliveries, and send one vehicle only. Also, we would buy some of the same species of fish from all the ports of the land, indeed from all over the world, and but not consolidate our buying power. “You are mad”, the Martian would say, “you are running an inefficient business”. To this I’d respond that the proof is in the bottom line of the P&L. We made more money than any of our competitors, by far. So do not worry, I told my people, with reason and conviction I knew our approach was right.
The Keynesian approach would be the opposite of the Hayekian, and would be just what my hypothetical man from Mars would advocate. The aggregation for efficiencies by central agents would have destroyed my business, as I saw happen with my major competitors once the spreadsheet whallas got involved.
Dispersed knowledge, collected locally and applied intelligently, told us that our customers were prepared to pay more for very convenient just-in-time deliveries. Some of our customers opened up their business for a lunch service that required delivery early in the morning; others were evening service only. Some were open 24 hours; others were night only. So we catered to all, as opposed to saying “we are only in this area from time X to time Y, on such and such a day”. This meant vans going out 1/4 full and “inefficient”, but up to three times a day with a higher margin payload delivering up more profit.
Dispersed knowledge, collected locally and dealt with intelligently, told us that buying wild-hunted local fish from various ports and harbours, and selling it locally having bought at different cost prices (rather than using our buying power to leverage the best deal with the cheapest central seller) actually meant we could sell fish to the local restaurant and hotel marketplace for more margin and hence more profit was delivered to the P&L.
The aggregating and centralising “Keynesian” approach would have been the end for us.
One influence that I must also add to this little reflective piece is Michael Oakeshott. His On Human Conduct has probably had more influence on me than Human Action by Mises. This being an economics-orientated web site, I think this is the first time I’ve mentioned the great political philosopher.
Tradition, intimation, and latent knowledge and talent are often hard to observe. Cooking a recipe is following a simple set of instructions, just like cutting fish. Some of us can perform only moderately well (even with lots of training), and others, like Gordon Ramsey, outstandingly. This talent is latent and cannot be written down and copied. It can’t be rationalised. It is the aim of most of the world’s all-encompassing philosophies to be rationalistic in outlook. Applied to business, there were many skills I could not objectify that key members of my staff displayed. If they produced a profit, I left alone. This is not to say you should not always attempt to fully understand what is going on, and why people do things in certain ways; you always should. My Oakeshottian contribution was to exhaust this process of understanding, only gently change if it was deemed wrong by me, and love and cherish it if it was a little bit off piste and entrepreneurial. This is why my bottom line was always bigger than my competitors.
Oakeshott famously criticised his LSE contemporary Hayek by saying that his political philosophy, as expounded in The Road to Serfdom, of less planning was just as much a rationalist ideology as the central planners he cautioned against, even if it may be a better approach. Irrationality, “quirkiness”, hidden skill, and entrepreneurial talent are all things that do not fit in the box. These I always sought to preserve and encourage in the business. So my rational leadership and vision was always tempered by respect for this insight of Oakeshott. This is also why I am a liberal philosophically, tempered with good doses of conservative wisdom and leanings.
