L of G M University talks with EconTalk host . about Hayek’s ideas on the business cycle and money. W lays out Hayek’s view of business cycles and the role of monetary policy in creating a boom and bust cycle. The conversation also explores the historical context of Hayek’s work on business cycle theory–the onset of the Great Depression and the intellectual battle with Keynes and his work. In the second half of the podcast, White turns to alternative ways to provide money, in particular, the possibility of private currency and free banking explored by Hayek late in his career. White then describes his own research on free banking and in particular, the more than a century-long experience Scotland had with free banking. The podcast concludes with the economics rap “Fear the Boom and Bust,” recently created by John Papola and Russ Roberts. The song itself can be downloaded at EconStories.tv where viewers can also watch the video, read the lyrics, and find related resources on the web for Keynes and Hayek.DL of the University of WO talks about money and monetary policy with EconTalk host. L sketches the monetarist approach to the Great Depression and the Great Recession. He defends the Federal Reserve’s performance in the recent crisis against the critics. He argues that the Fed’s monetary policies have not been unconventional nor impotent as some critics have suggested. The conversation closes with a discussion of the state of macroeconomics and monetary economics.
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ntro. [Recording date: January 27, 2010.] Friedrich A. Hayek’s view of the business cycle
and money. Rap song, John Papola and Russ Roberts, at end of interview; video at
EconStories.tv. Business cycle: What did Hayek see as the cause of the business, the booms
and busts? Two scenarios. One: Central Bank independently decided to cheapen credit,
expand the supply of loanable funds–Wicksellian phrase–ignite and investment boom.
Second scenario more subtle: investors become more optimistic, new technology they want
to invest in; come to banks and want to borrow more; instead of banks letting that drive the
interest rate up, the Central Bank becomes involved by injecting enough credit to keep the
interest rate from rising. So, first theory is the supply of loanable funds shifts first; second
is that demand shifts first, but then the Central Bank shifts the supply to accommodate the
demand. As the “real bills doctrine” used to put it: to supply the needs of trade. In either
case, bad idea; drives the market interest rate below the equilibrium or natural rate and
creates a disequilibrium between the plans of savers and investors. Investors are trying to
invest more resources than are really available in the economy; consumers don’t want to
delay that much consumption. First scenario: Fed mistakenly or because of political
pressure artificially lowers interest rates. That does what in the real economy that causes a
problem? Think of investors having lots of investment plans on their shelf with different
rates of return; interest rate serves as a rationing device, benchmark that an investment plan
has to clear to make it worth it. As the interest rate goes down, more and more investment
plans begin to look like they’ll pay back enough to cover the cost. Plans come off the shelf,
which increases the quantity of money. In particular, Hayek emphasizes: it’s the most
interest-sensitive plans that are going to take off in a low-interest environment; and those
are the ones that involve a lot of time between the investment and the rewards being reaped-basic principle of finance. You discount your cash flows back to the present. If you can
borrow just a little more cheaply, long term investment projects become more attractive.
4:42 Continue the story: Some projects get undertaken. Sounds good! More investment!
What’s wrong with that? There are only so many resources in the economy–only so many
workers, equipment, raw materials; they get drawn away from more sustainable investment
projects into these other projects that aren’t appropriate for the state of demand in the
economy, the time-preferences of consumers. Economy invests in roundabout production,
early stages of long-term projects; other parts start to languish; shorter projects become
starved for resources. Misallocation; which would mean that the pie is not as big as it could
get. But that’s not the end of the story. Projects that need a long time to come to fruition
need continual investments; you don’t usually investments at once and wait; you have to
keep tending the tree. That’s where the problem comes. As resources are expended to keep
these projects going, they start to bid up the prices of labor, materials, and machines; other
businesses find their costs of production going up. Input prices going up; not enough to go
around. At some point it becomes clear that there aren’t enough savings to bring all these
projects to fruition and some have to be terminated–they aren’t going to make a profit. Will
lead to unemployment in those industries that made the wrong investment. In the last boom
and bust, it was the housing industry that took off. Characteristic of the Hayekian process
is where you see half-finished investment projects being abandoned because they will not
be profitable. Half-built condominium projects on the outskirts of Las Vegas. But those
were stopped because the interest rate changed; the funding changed. In the current
situation–John Taylor’s story–the artificially lower interest rates of the 2002-2004 period
encouraged lots of borrowing and construction; but when raised by Greenspan in 20042005 they became unprofitable. In the Hayekian story, does it require the rise in interest
rates? That’s the usual symptom of their being more investment than savings. In the short
run or intermediate run if the Federal Reserve is controlling interest rates, it comes through
the news as the Central Bank decided that it needs to raise interest rates. They are bowing
to the inevitable; scarcity of resources is pushing interest rates back up to equilibrium.
9:35 Wouldn’t this also happen in any industry where there is innovation? Take the Fed
out of it for the moment and talk about creative destruction–Schumpeter’s term–the idea
that innovation and new ideas come along, new business comes along; draws resources
away from other areas. Price system tries to soften the transition; can’t do it perfectly,
imperfect information. As a new sector springs up–automotive industry at end of 19th
century, internet industry at the end of the 20th century–people are drawn to these new
opportunities; some will turn out to be failures. Not artificially induced by an artificially
low interest rate. Amazon was unprofitable for a long time; profitable now. Took all kinds
of resources that made it hard for other businesses to thrive. That’s a healthy kind of growth;
test is whether projects do become profitable. If because of new technology, economy has
a new set of investment projects that promise higher payoffs in the future, people will be
willing to save to provide investment for those projects. New demand for investable
resources bids up the interest rate if the Central Bank allows it to happen. Hayek referred
to this as the interest rate brake, preventing the economy from overinvesting. To bid the
resources away from the current users, businesses have to pay a little more. Healthy, brings
about economic growth. Problem comes in second scenario; if Central Bank decides
interest rate ought not to rise and pumps in enough credit so that you get the new
investments and the old investments, then you get the danger. Some will be profitable like
amazon, but pet-dot-com didn’t make it. Very often, an overinvestment or malinvestment
boom piggybacks on an overinvestment boom. It’s just allowed to go too far because the
Central Bank is over-accommodating. What influence did the Austrian and Hayek theories
have on real business cycle theory, the time-to-build work, Prescott, and others? Empirical
puzzle for monetary malinvestment theories: Thought experiment: Central Bank changes
policy, makes the interest rate low. We should see a burst of new investment starts. Hard
thing to explain is why the change in investment persists even after the change becomes
evident to everybody. That’s what the time-to-build model attempts to explain: you don’t
just invest all at once; you have to make continuous investments. Mike Montgomery, U. of
Maine, has written papers trying to apply the modeling technique of Kydland and Prescott
to show that there’s more mileage in the Austrian approach. Some have disrespected–not
sure of verb looking for. Sometimes hear references to distress borrowing.
16:31 Role of expectations. When the Federal Reserve plays with the current interest rate,
it goes down if we are talking about the current crisis, 2002-2004; low for an unusually
long time, negative in real terms for a couple of years; most people expect those rates to go
back up at some point. If I’m planning a long-term investment, say, with this time-to-build,
delayed, ongoing investment–not so much building a house, but an amazon–will have to
build warehouses, will have to advertise–will be pumping money in continually over a
fairly long period of time. Why would I respond to low interest rates if I know they are only
temporarily low–forget rational expectations–if I just reasonably expect that that’s not
going to persist? Wouldn’t it be surprising if short-run changes in interest rates generate
these long-term projects? Good question; has to be answered to make sense of Hayek’s
theory. If everybody had perfect expectations, perfect foresight about the path of interest
rates, you wouldn’t see this cycle. It doesn’t require that everybody guess wrong. It just
requires that too many people guess wrong about the path of interest rates, in order to get
enough malinvestment to cause a problem. Piggybacked on sustainable investments.
People are convinced now that it’s a new era–This Time is Different, by Rogoff and
Reinhart. Reinhart podcast. Sometimes Fed has encouraged this: Greenspan talked about
the “new economy” in the midst of the dotcom boom. Supposed to be permanent, everhigher productivity growth. Can get the problem. There’s no doubt there’s a wide
distribution of savviness; uncertainty. Differences of opinion about how soon and how
much; people want to make their money now and get out at the right time; uncertainty about
how long the money is going to stay cheap. Political pressure to keep it cheap. Very, very
low interest rates now; but artificially low; Fed trying to keep rates low for home-buying.
Big spread now between short-term and long-term interest rates. Would avoid getting
caught if you locked in for the long-term, but tempting to borrow at the low short-term rate
and roll it over–and that’s when people get caught out. U.S. Government doing that now.
When U.S. Government borrows short-term, they have an incentive to promote inflation;
can refinance their debt.
20:54 Economic history. Hayek’s most important book on this subject–Prices and
Production, 1931. Did he have a story to tell for what started the Great Depression? That
was his story. His story was that the Federal Reserve and the Bank of England had injected
credit during the 1920s and built up a credit bubble. Done it during a genuine period of high
growth in the economy in order to keep the price level from falling–they were
stabilizationists, inspired by keeping price level stable. Hayek argued said in 1933 that for
several years he had been arguing against the stabilizationists. In an environment of
growing output, it requires a continual injection of money to keep the price level from
falling; and that injection of credit distorts the interest, and that causes the problem. Hayek
criticized earlier economists who said that if the price level is flat, everything must be fine-that’s not the indicator you want to look at. Argued that you want to look at relative prices,
early vs. late stage investment, structure of production. Explanation for why the boom of
1920s couldn’t last. Attracted a lot of followers. Something went wrong; by the 1940s, he
was out of favor as a macroeconomist. Austrian business cycle theory neglected, almost
forgotten by the economics profession. Why? Another guy came along–Keynes. Hayek
was not the only guy troubled by Keynes’s ascent–Schumpeter also was very resentful.
Both are remembered fondly by other economists; but their work on microeconomics is
well-respected, but it’s their macro stuff that got put on the shelf. What happened? Events
kept moving forward. Hayek had, arguably, a good explanation for the downturn. He didn’t
have such a good explanation for why the economy continued to deteriorate after 1931-continued to go down and stayed down for so long. He actually had a prescription for what
to do about it. In Prices and Production–which we did at the time–he said that the Central
Bank should try to stabilize the money stream–nominal GDP, or MV, money times the
number of times it’s turning over, V, velocity of money. If people are hoarding, inject more
money. Also Milton Friedman’s advice. But Hayek didn’t say that based on his own advice,
and later apologized for it: had fond wish that a little deflation would help break the rigidity
of prices and wages and restore a more flexibly functioning economy–pipe dream. Did not
call for Central Banks to do what his own theory called for–keep spending to continue from
encouraging downward spiral. Other Austrians offered what advice for what they called a
“secondary deflation.” Kind of overkill, having economy going through this deflationary
cycle. Hayek should have spoken out more against it; didn’t do so. Viewed as having
nothing useful to say about how to stop the cycle, even if he had been right about how it
started. In that kind of environment, as Friedman has said, Hayek’s picture of events was
regarded as very gloomy–nothing we can do, had to let the economy purge the problems
out of the system in the most painful way possible. When Keynes came along, it was
regarded as a message of hope. Here’s something we can do. We don’t have to just sit by
and linger in the depression; something active we can do. Same hopeful message a year
ago with the stimulus package; hopeful message keeps selling. Idea that fiscal policy-playing around with government spending and taxes–has enjoyed a comeback. Thought it
was dead; thought evidence showed it was too little too late or doesn’t have any effect
because offset by private spending. Reason may be view that the Fed is out of bullets-interest rates can’t go any lower so they can’t do anything. Think that’s wrong. Some
economists have rediscovered idea that monetary policy still is the thing that’s ruling the
behavior of the economy–if we’d prevented the shrinkage in nominal GDP, the recession
would have been milder. Scott Sumner argument; podcast. Difficult to know whether that’s
right. Can’t eliminate recessions that way. There were real malinvestments. When those are
written down, real income has to decline. Resources are unemployed temporarily till they
can find more sustainable uses. But you don’t want to exacerbate it by making it hard for
people to repay their debts because, say, nominal income is shrinking.
29:06 Money; what the Fed has done wrong. What should the Fed to get it right to avoid
these booms and busts? What did Hayek say about what the Fed should be doing? Hayek
had talked about the issue on various levels. When he took for granted that you should have
a Central Bank issuing fiat money and asked what’s the most neutral monetary policy they
can pursue, what will do the least damage to the economy, he was always a strong opponent
of inflation, against the idea that you could stimulate the economy in any useful way by
cheap money. But he suggested early on trying to stabilize the spending flow in the
economy–nominal GDP. In The Constitution of Liberty he later said that maybe a
shorthand way of doing that would be to stabilize an index of wholesale prices. Still didn’t
want to stabilize consumer prices because of the problem he pointed to in the 1920s–you
are injecting more credit when productivity is high, and that can cause a credit bubble. But
instead focus on input prices. As the 1970s went on, and inflation got out of hand, he started
thinking more fundamentally about the institutional arrangement: not what the Fed should
do, but is there some institutional arrangement, some regime change, that would give us
better performance than we are getting from Central Banks. Famously published a
pamphlet in 1976 called Choice and Currency, where he said to protect ourselves against
inflation, people ought to be free to use whatever currency in the world they find more
stable. That would put a damper on the inflationary proclivities of any one Central Bank.
Then he pushed it a little further and said why don’t we let private firms into this
competition; published a monograph: The Denationalization of Money–available on the
web at IEA at no charge. Argues against the presumption that government has to provide
money and imagines what would happen if private firms were providing money, and fiattype money: money that is not based on gold or silver but based on the promises of these
private banks that they would keep the value stable; might be more reliable than central
banks have been. Easier to hold private firms to their promises than to hold central banks
to their promises. Historical context: for those of us in our fifties living in the United States,
the worst inflation of our lifetimes was in the 1970s, when inflation reached 13.3% in 1979.
Scared a lot of people. In the last year or two, some question as to whether we’ve had
deflation, if it was mild; but for somebody like Hayek, they had seen hyperinflation, not
just in Zimbabwe, which we read about in the paper, but in many of the nations of Europe.
In Germany, in the aftermath of WWI, hyperinflation led to political consequences, partly
leading to the rise of Hitler. Fear of inflation must have been very different for that
generation. Hayek in his correspondence with Keynes was very uneasy about the threat of
inflation in the 1940s. Vigilant; this creature had to be contained. Under the institution of
the gold standard, which prevailed for the early part of Hayek’s life, there is no tendency
toward a rising price level; some periods of mild deflation, even periods when output tends
to grow a little faster than the price of gold. Anything about 0 in the price level is cause for
concern. Hayek: need to look behind the scenes. Concerned about the consumer price index
but also what was behind it, excess growth in Central Bank credit. In the 1970s, these
inflation and consumer price index inflation in Great Britain was in the 20% range–much
higher than the United States, very alarming.
35:37 Turn to The Denationalization of Money. If Hayek was proposing a private money
supply, what would be the implications for his story of the interest rate as coordinating the
plans of savers and investors? What would be the interest rate path, path of inflation, under
a denationalized money in Hayek’s view? Written about this: in The Denationalization of
Money Hayek seems to switch toward favoring stability in the consumer price index,
contrary to what he believed his entire career. It was his explanation for the crash of 1929.
But in The Denationalization of Money he says private money issuers would most appeal
to the public if they promised stable prices. Has a little footnote: Yes, yes, I’m among those
who pointed out this could be a problem, but I no longer think it’s a problem of much
practical relevance. Trouble making sense of that. Think what he’s saying is that when you
are talking about Central Banks creating problems of 25% inflation, that’s a much bigger
practical problem than the malinvestment caused by trying to create a stable price level. Go
back to 1931-1932 for a minute: talking about why Hayek’s ideas fell out of favor. Gloomy
story; waiting it out takes a long time. Others have argued that that long time wasn’t Hayek’s
fault: there was regime uncertainty. Bob Higgs has argued that–Roosevelt frantically
intervening in a lot of ways in the price system and the rules of the game, so private
investment takes horrible tumble in the 1930s; could be for other reasons as well. Add in
all these stories: Higgs: regime uncertainty; Friedman: money supply collapsing. Not just
uncertainty about Roosevelt was going to do, but what Roosevelt actually did in the
National Recovery Act and the Agricultural Adjustment Act. Organized agriculture to
restrict output in the name of raising prices, in the name of restoring profits, and thereby
prosperity. Non sequitur there: you can make one industry more profitable by cartelizing it
and increasing its profits, but you can’t do that for everybody because it only works by
restricting output. If everybody restricts output, it’s even worse. Industries restricting output
are not going to be hiring more workers–they will be cutting back on all those things.
Strange idea that still has some life of its own.
40:09 Piece of Keynes that is fruitfully tied into the story of Hayek: The role of animal
spirits, psychology, fear of the future, uncertainty–reference in rap video we are about to
hear …
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