Monetary Theory and the Trade Cycle

The American economics profession has been dominated, in the last three and one-half decades, by two strains of thought—one associated with the University of Chicago and the other with Harvard University. In the analysis of business cycles and depressions, the Chicago School has been known for its monetarist explanation while the Keynesians, centered at Harvard, have opted for a non-monetarist explanation.

Although much heat has been generated in debates between the two strains, the differences between them are more apparent than real. Both strains rely heavily on statistical rather than logical analysis; both concentrate on “macro” aggregates (total consumption, total spending, total production) which have nothing to do with individual choice nor the basic postulates of well grounded microeconomics; both completely ignore the effects of the business cycle on relative prices; both call upon government to “fine tune” the economy and “iron out” the business cycle. It is true that the “liberal” Keynesians emphasize government spending, or fiscal policy, while the “conservative” Chicagoites stress government monetary policy, but this is merely a matter of emphasis. In fact, there is little difference between the two “warring” factions.

Lost in all this furor between the tweedle dum and the tweedle dees is an exciting, radical and eminently sensible analysis of business cycles which lacks only one thing necessary for instant box-office success: it is hardly new. The Austrian, or praxeological theory of business cycles as expounded in F. A. von Hayek’s Monetary Theory and the Trade Cycle (hereafter MTTC) was first published in 1933, and then lost sight of in the rush to the “Keynesian Revolution” begun by the publication of Keynes’ General Theory of Employment, Interest and Money in 1936 and by the subsequent reaction to it on the part of the Chicagoans. Based on the pathbreaking work of Ludwig von Mises, the praxeological insights of MTTC offer just the antidote needed.

In MTTC, Hayek deals with the causes of the business cycle, considering three main types of explanations: (1) non-monetary explanations, (2) monetary explanations other than praxeological and (3) the monetary explanation of the Austrian, or praxeological, school of thought.

Hayek easily deals with the non-monetary explanations, disposing of the empirical and statistical studies of business cycles made by W. C. Mitchell as mere attempts to measure, but not to explain business cycles. Hayek then launches into an attack upon business cycle theories based upon the technical conditions of production of the Keynesian non-monetary explanations.

He then moves on to a consideration of the Chicagoite view. The Chicagoite explanation is a monetary one, and thus cannot be criticized in the same way as a non-monetary explanation. But a fatal flaw in this as well as in every other non-Austrian monetary explanations of the business cycle is the reliance on the price level as an explanatory tool, as opposed to relative prices. For example, it is possible for the government’s monetary policy to cause business cycles without raising the level of prices; merely warping the relative prices between the different orders of production—consumer goods and capital goods—will do this quite well enough.

Hayek then undertakes an explanation of the Austrian theory. At the heart of the Austrian theory is the process of credit expansion under fractional reserve banking. Hayek undertakes an explanation of this process, which is nowadays a standard piece of economic analysis available in all introductions to money and banking. Unlike the textbook treatment, however, Hayek concludes from this analysis that credit expansion, in lowering the money rate of interest below that of the natural, market or equilibrium rate, is responsible for diverting investment funds from consumption and the lower orders of production to the basic industries in higher orders of production—raw materials, capital goods production, mining and the like. In the attempt to raise the growth rate in a society higher than that desired by the people—as shown by their time preferences, which underlie their decisions concerning savings and investment—all the government succeeds in doing is misdirecting efforts into the higher orders. But sooner or later, the banking system must slow down or cease the monetary expansion or else cause a runaway inflation. When it does slow down the monetary expansion, these over-investments in the higher orders of production are then shown up for the misallocations and malinvestments that they were all along. The depression phase of the business cycle is then the cleansing process that wipes out the malinvestments of the previous inflationary period.

Although Monetary Theory and the Trade Cycle is an extremely valuable example of Austrian business cycle analysis, it is not without mistakes of its own. But these mistakes are not caused by a strict adherence to praxeological reasoning, but rather because they do not adhere to such an approach strictly enough.

For example, take Hayek’s views on interest. The usual Austrian analysis 'holds that interest is determined by time preference, and by time preference alone. Hayek holds that the reasons for an increase in the natural rate of interest can include new inventions or discoveries, new markets, bad harvests, entrepreneurs of genius, heavy immigration and natural catastrophies.

Hayek also seems a bit “weak” on gold. He fails to make a strong distinction between gold money and fractional reserve paper, holding that both are ways “to regulate the volume of circulating media within a country.” But as far as the cause of the business cycle is concerned, there is all the difference in the world between a Federal Reserve System and gold mining activity.

Hayek furthermore is seemingly in need of a good grounding in revisionist history as regards banks and their share of guilt in causing the business cycle.

But the worst mistake that Hayek makes in the book is his view that even if we could, it would not be desirable to “keep the total amount of bank deposits entirely stable,” because to do so “would be to obtain stability of the economic system (the elimination of the business cycle) at the price of eliminating economic progress.” For shame. And so ironic. Hayek complains that such a policy would keep the “rate of interest constantly above the level maintained under the existing system.” Of course it would! But Hayek has just spent much time and effort to show, quite correctly, I think, that it is this same artificial lowering of the rate of interest which is presently responsible for our cycles of boom and bust and that this attempt to artificially lower the rate of interest can only result in a misallocation of investment resources, and now in an increase in the growth rate. Nowhere does Hayek—nor could he—demonstrate that the rate of interest reflected by the time preferences of the people would be insufficient to maintain economic progress.

These criticisms aside, Hayek’s Monetary Theory and the Trade Cycle is a fascinating and pathbreaking work presenting the Austrian analysis of the causes of depressions.

Reviewed by Walter Block / Economics (244 pages, Indexed) / BFL Price $10