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Monetary Theory and the Trade Cycle

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Hayek's "Monetary Theory and the Trade Cycle" is an interesting view into the need for monetary economics to be incorporated into business cycle theory. Barter, village-fair, economic models of pure economics cannot explain economic fluctuations due to Say's Law. Under real business cycle theories only external causes can create business cycles (ex: Governments). Written during the Great Depression Hayek was trying to create a monetary theory that could explain endogenous causes of disequilibrium in the price mechanism.

Hayek's work consists of primarily three parts. First, Hayek describes why real theories, which assume equilibrium, cannot explain business cycles. It is only with the introduction of money that business cycles can occur. While business cycles may not be initially caused by monetary factors it is essential that monetary factors are part of the chain of causality. Second, Hayek deducts that it is both the price level and the volume of money that is crucial to economic expansion and recession. He strongly disagrees with the quantity theory of money's assumption that a constant price level will lead to economic stability. Finally, Hayek concludes that business cycles are unavoidable. Due to the nature of the private banking sector monetary expansion and retraction are inevitable. Any attempt at "forced savings" would prevent a current recession but would cause a much greater depression in the near future. Deflation is inevitable and will eradicate malinvestment.

Hayek's economic theory is greatly lacking. At some times he hints on genius and on other times he completely misses the mark regarding monetary and business cycle theory. Hayek begins with a superb analysis of why barter economic models, created by marginalist economists, are flawed.

However, Hayek treatise is highly flawed from both a theoretical and empirical perspective. From a theoretical perspective his critique of the quantity theory of money is entirely incorrect. His focus on the volume of money is misguided. Hayek flatly refuses to believe changing the volume of money to stabilize output, even if the price level increases to correspond with such a change, will lead to a business cycle. According to mainstream economists money is neutral. A moderate increase in the volume of money will in the long-run result in an increase in the price level. By itself an increase in the volume of money has no impact on the economy. Both Keynesians and Monetarists would strongly disagree with Hayek's contention. No mention is made regarding the velocity of money (something Keynesians might agree with).

Additionally, Hayek's conception of "forced savings" is entirely incorrect. To create "forced savings" the government must continually print money at an accelerating rate to increase the level of savings over the long-run. This in turn will create malinvestment that will be unproductive and will, eventually, be destroyed due to deflation. However, "forced savings" cannot exist in the theoretical framework Hayek discusses (at least to be of any use). Under a potential output economy an increase in the money supply would only lead to inflation and therefore would not change the rate or composition of savings. "Forced savings" during an economy below potential would not increase investment or employment (See JMK's "General Theory of Employment, Interest, and Money" CH7 s.IV for a more detailed explanation). "Forced savings" is both theoretically inconsistent and empirically wrong.

On the issue of empirical evidence Hayek's theory is utterly useless. The volume of money, and gross production, has exploded over the last 80 years without a resulting Depression. Two severe recessions have occurred but to validate Hayek's theory these recessions would have needed to be exponentially greater depressions to support his argument. Macroeconomic stabilization in the post-war era has largely worked.

Maybe key to Hayek's misunderstanding of econometrics, and science, is his belief, "Statistics can never prove or disprove a theoretical explanation, they can only present problems or offer fields for theoretical research."