My colleague Larry White – a great economic historian, historian of economic thought, and monetary theorist – sets straight the mischaracterization of Hayek’s macroeconomics as consisting of nothing more than ‘liquidationism.‘ Paul Krugman is not the only person to get Hayek wrong on this front. As Larry points out, so, too, did Milton Friedman fail to read Hayek in full. Here’s a slice of Larry’s post:
Thus, according to Hayek, the central bank should expand its liabilities H to offset an increased bank reserve ratio or public hoarding that reduces M/H or V. In yet other words, it is better to remedy an unsatisfied excess demand for money balances by supplying the called-for money balances than by putting a burden of downward price adjustment on the economy.
Overlooking Hayek’s stable-MV norm, Friedman and others have mischaracterized Hayek as prescribing only “to let the depression run its course.” Hayek did oppose cheap-money policies that distort the economy, and did counsel policy-makers not to obstruct the process of correcting the mistaken investments made during the boom. But quoting such statements doesn’t show that he said nothing else about depression policy.
Hayek’s views on this matter did indeed change over time. In the early 1930s Hayek was more willing than he was by the mid- to late-1930s to rely chiefly upon a general decline in prices – rather than upon an increase by central banks in the supply of money – to satisfy an increased demand for money. Yet until he died in 1992 Hayek remained a master expositor of, and defender of, the Austrian theory of the trade cycle. So it’s wrong and misleading to overlook the aspect of Hayek’s monetary theory (and policy espousal) that Larry highlights in his post. (No one would think it appropriate to assess J.M. Keynes’s money-macro thinking by ignoring all that Keynes wrote and said after, say, 1923.)
Let me also here riff on what is disparagingly called ‘liquidationism.’
While Hayek quite clearly (as Larry points out), by the mid- to late-1930s, endorsed a policy of stabilizing MV, he continued for the rest of his life to insist that easy money distorts relative prices (most importantly, interest rates) and that such distortions, in turn, lead people to make investments and plans that are unsustainable given underlying consumer demands, time preferences, technology, and resource constraints. For an economy to be as productive and as free of disruption as possible such malinvestments must be undone and replaced by more-appropriate investments – investments the patterns of which are formed chiefly by the direction of undistorted relative prices. Bad investments, in other words, must be liquidated (although if you don’t like this word, choose another). Such liquidation is perfectly consistent with a policy of stabilizing MV; recognizing the merits of one doesn’t imply rejection of the other.
Why is this observation by Hayek so controversial? When a particular business firm in the U.S. goes into Chapter 7 bankruptcy its assets are liquidated. Perhaps consumer demands have changed in such a way as to make a once-profitable use of resources no longer profitable. Perhaps technology has rendered a once-profitable production technique unprofitable. Perhaps the business was an unprofitable idea from the start. Doesn’t matter. If the particular pattern of resource use in that firm no longer yields revenues at least as great as the cost of this matrix of resources, then the firm should be liquidated.
But suppose that one day a Dr. Canes strolls into a bankruptcy hearing and points out that this liquidationist notion is oh so old-fashioned, crude, and cruel. ”My friends,” explains the good Dr., “if we increase demand for the output of this now-suffering firm, all will be well. It will not need to be liquidated.”
And, yes indeed, Dr. Canes is indisputably correct in the most narrow and myopic of ways: if demand for the output of this firm were sufficiently high, the firm would not need to be liquidated in Chapter 7 bankruptcy. Duh! But Dr. Canes is mistaken in the large. In fact, this firm is a collection of mis-used resources. Its pattern of production is wasteful. It should be liquidated.
Most people understand that a proper and useful Chapter 7 bankruptcy proceeding involves the liquidation of the firm’s assets. And they understand that, for the larger economy (if not for the owners, creditors, and workers and other suppliers of the firm) such liquidation is good. Delaying it is harmful.
So why do so many people fail to extend this understanding to the larger economy? If a particular firm can be a collection of mal-invested assets – a production plan that must be abandoned – capital goods, inventories, contracts, workers’ skills that are wasteful as currently fitted together – why cannot the same be true for many firms? At what point do we conclude that inadequate aggregate demand necessarily is the cause of too many businesses operating at full capacity to be unprofitable? Why is it so contemptible to point out at least the possibility that the economy currently has an unusually large amount of assets devoted to production plans that are not all sustainable over time? Why is it, therefore, so unacceptable to suggest at least the possibility that an unusually large number of existing incarnations of production plans (firms, parts of firms, perhaps whole industries) be liquidated?