Monday, March 16, 2009

What Hayek really meant. Really! (amv)

I have become involved into a little discussion between Brad DeLong, Steven Horwitz, and Lawrence White on the F.A. Hayek's preferred monetary policy rule. Brad DeLong takes the (wrong) position that Hayek (and Lionel Robbins) suggested a kind of automatic rule for money supply, something like: hold the money supply constant, no matter if money demand and thus velocity changes or not. What is true - pointed out by White - is that Hayek believed that monetary contraction would break nominal price rigidities (union power) would free the market mechanism from government privileges. He was wrong, prices did not fall appropriately, and output contracted as well. In theory, Hayek already in 1931 (but also in 1941 and 1960) proposed to stabilize aggregate expenditures, or, what is the same thing in a monetary economy, the level of circulating broad money (E=Mv). This is his criterion for money's neutrality.

Here, some excerpts from the debate:

Brad DeLong:

I think that White's painting of Hayek and Robbins as people who wanted to stabilize MV is completely wrong--it is Ben Bernanke and the inflation targeters who want to stabilize MV, not Hayek and Robbins. If you had asked Hayek back at the time, he would have said that increasing the monetary base from 1929-1933 in order to offset the decline in monetary velocity was the very last thing that he wanted to see done. Stabilizing MV at its 1929 level was not on his or Robbins's agenda by any means. This, of course, is nonsense. Bernanke and the inflation targeters stabilize the growth rate of Mv for a somehow predetermined trend rate of output growth. Otherwise, they would not target inflation, but a constant level of nominal income.

Steven Horwitz responds (the brackets include DeLong’s odd habit to comment into the written text of others):

DeLong confuses "stabilizing MV" with "stabilizing P," allowing him to use Hayek's correct arguments against stabilizing P as if they were Hayek denying his belief that stabilizing MV is the correct policy norm. This is a very naked bait-and-switch on DeLong's part. In fact, stabilizing MV is in contradiction with stabilizing P. If one tries to stabilize MV, one has to allow P to fluctuate inversely to changes in Q. [But one wants to stop fluctuations in Q. The point of the exercise is to stop fluctuations in Q. The fluctuation in Q is called the "Great Depression." It is not a good thing...] This was Hayek's argument against price stabilization from as far back as at least 1928. More important, here's Hayek writing in *Prices and Production* (1935, p. 121): "But I think that what I have already said on this point will be sufficient to justify the conclusion that changes in the demand for money caused by changes in the proportion between the total flow of goods to that part of it which is effected by money, or, as we may tentatively call that proportion, of the co-efficient of money transactions, should be justified by changes in the volume of money if money is to remain neutral towards the price system and the structure of production." That sure reads like someone who wants to offset changes in V with changes in M so as to stabilize the product MV. And notice that the goal is NOT "stabilize P" but "remain neutral towards...the structure of production." For Hayek, that's a reference to his 1928 work on intertemporal price coordination. Remaining neutral in Hayek's sense allows for changes in P to emerge from changes in Q. [???????????????????? What does "allow[ing] changes in [the price level] P to emerge from changes in [aggregate output] Q possibly mean? Does it mean that when Q goes down P should then go up--but if Q falls, V falls to, and so M has to go up enormously? You seem to be saying that the real Hayek was agreeing with Friedman and Viner on what the right policy was in 1932--but kept it a deep, dark secret, and only you today 77 years later have figured out what he really meant...]

I support Horwitz:

DeLong is again making uninformed claims. In support of Horwitz, I quote Hayek from The Constitution of Liberty (1960/2008): This means that when at any time people change their minds how much cash they want to hold in proportion to the payments they make (or, as the economists calls it, they decide to be more or less liquid), the quantity of money should be changed correspondingly. However we define 'cash,' people's propensity to hold part of their resources in this form is subject to considerable fluctuation both over the short and over long periods, and various spontaneous developments (such as, for instance, the credit card and the traverlers' check) are likely to affect it profoundly. No automatic regulation of the supply of money is likely to bring about the desirable adjustments before such changes in the demand for money or in the supply of substitute for it have had a strong and harmful effect on prices and employment. (p. 284) the automatic regulation is, for instance, Friedman's k-rule.

Horwitz hints at my Hayek-quote, but DeLong has deleted his comment:

It's no secret if you actually read Hayek Brad. Seriously. See the comment below my original [that is my comment; amv]. It would also help if you actually read what modern Austrian economists have to say about these issues in the last 30 years, much of which builds on their reading of Hayek. If there's confusion here, it's on the part of those who are so convinced that they know what Hayek (or Hoover, or Mellon...) have said that they refuse to believe they could be wrong, even when the textual evidence is in front of them. And yes, the point IS to stop Q from falling. Hayek's whole point is that if V falls without a response in M, the right side (P*Q) has to fall, and that's the outcome he wishes to avoid - just as he believes that preventing increases in M not justified by changes in V will also prevent inflation and the boom of the cycle and the bust that leads to the danger of secondary deflation. Why is it so hard for you to believe YOUR understanding of Hayek might be inferior to those (of us) who have studied these issues for decades and written about them extensively? Why is it so important for you to be right here? What's the horrible tragedy if you're wrong? (Those are not rhetorical questions.)

DeLong reacts to my comment:

amv is both right and wrong. He is right in that while writing The Constitution of Liberty Friedrich Hayek wrote like an orthodox Chicago monetarist--a Friedmanite. He is wrong in claiming that this is an accurate summary of Hayek's position either while he was a leader of the LSE-based Austrian School contra Keynes during the Great Depression or indeed of Hayek's long term thinking. The phase during which Hayek was (or perhaps thought it impolitic not to pretend to be) a Friedmanite came after his monetary-overinvestment phase and before his private-money phase. More representative of his enduring thought, I would argue, is the Hayek of a later period Hayek who would flat-out deny even the possibility of the government's altering M in order to offset changes in V: [W]e never know what the quantity of money in this sense is. I think the rule ought to be that whoever issues the money must adapt the quantity so that the price level will remain stable. But to believe that there is a measurable magnitude which you can keep constant, with beneficial effects, I regard as completely wrong. I don’t like criticizing Milton Friedman not only because he is an old friend but because, outside of monetary theory, we are in complete agreement. Our general views on what is desired and what is not are almost identical until we get on to money. But if I told him what I said before, that I very much doubt whether monetary policy has ever done anything good, he would disagree. He personally is convinced that a good monetary policy is a foundation for everything... Horwitz, by contrast, in comments is simply incoherent: if you stabilize Q by stabilizing MV then you automatically must be stabilizing P, for PQ = MV. As long as you are trying to stabilize Q, saying "Hayek's correct arguments against stabilizing P... [are not] denying his belief that stabilizing MV is the correct policy norm..." makes no sense at all.

I defend Horwitz:

Perhaps, I can clarify some misunderstandings between DeLong and Horwitz. DeLong writes: "Horwitz, by contrast, in comments is simply incoherent: if you stabilize Q by stabilizing MV then you automatically must be stabilizing P, for PQ = MV. As long as you are trying to stabilize Q, saying "Hayek's correct arguments against stabilizing P... [are not] denying his belief that stabilizing MV is the correct policy norm..." makes no sense at all." This is true for a given Phillips-curve, for a given capacity. Here, the general price level is a function of output and thus of bottlenecked demand. A stable price level is ensured by a constant level of output. This, however, is not the framework Horwitz is talking about. Very much like the Pre-Keynesian way of thought, the quantity equation serves as a demand-supply framework that determines the price level. Read his equations like this: P=Mv/Y, where money in circulation (MV) is a measure of aggregate expenditure (E). P=E/Y. Ceteris paribus, a higher supply reduces the price level. It is therefore coherent to claim that in stabilizing Mv (or E) any increase in output reduces prices so as to keep nominal income (PY) stable. You only have to allow for output to increase independent of aggregate demand.

DeLong indeed seems to think in stationary states, whereas Hayek and Horwitz think in terms of a progressive economy.