Hayek's Contribution to Monetary Theory

By Marius Gustavson
“Those who wish to preserve freedom should recognize, however, that inflation is probably the most important single factor in that vicious circle wherein one kind of government action makes more and more government control necessary. For this reason, all those who wish to stop the drift toward increasing government control should concentrate their efforts on monetary policy.”

--F.A. Hayek, The Constitution of Liberty (1960)

Today, May 8th, 2010, the Austrian economist and social philosopher Friedrich Hayek would have turned 111 years old. Born in 1899, he became one of the leading intellectual figures of the 20th century--a champion for freedom as well as sound economic thinking and policy.

Hayek wrote on many important subjects, including economics, jurisprudence, the history of ideas, social evolution and psychology. He published highly influential articles, such as "The Use of Knowledge in Society" (1945), "Individualism: True and False" (1945), and "Competition as a Discovery Procedure" (German original, 1968)--and equally influential books, most notably The Road to Serfdom (1944), The Constitution of Liberty (1960), and the three volume Law, Legislation and Liberty (1973-1979).

Less known, however, are his monetary writings. Starting in the 1920s--when he was still in his own 20s--Hayek took a keen interest in one of the major economic problems of his own times, namely how to secure a stable and sound monetary system.

At the outbreak of war in 1914, the belligerent countries (as well as several neutral ones) suspended gold redemption, thus ending the "classical" gold standard. After the war, Great Britain--the leading financial and economic power of the preceding 100 years--attempted to erect a pseudo gold standard in which other currencies were tied to the pound and the pound (as well as the dollar) was tied to gold. This "gold-exchange" standard proved elusive, and broke down almost immediately after it had been established in 1925-28.

One commonly shared assumption among the warring parties of Europe was that the military conflict that erupted in the late summer of 1914 would be short. As the war dragged out, however, the fiscal burden led governments to turn to the printing presses of their central banks in order to finance the war efforts. When the war ended, monetary chaos ensued, and some countries experienced rapidly accelerating inflation--most notably the hyper-inflationary episode of Germany which reached its peak in late 1923.

Hayek's native Austria experienced a similar monetary break-down. In November 1918, at the war's end, the money supply had expanded by close to a factor of 10 (from 3.4 billion crowns to around 34 billion crowns). In the aftermath of the war, the Austrian-Hungarian emperor abdicated, the empire dissolved into various nation states with destructive protectionist tariffs directed against each other, and the Social Democrats formed the first government in the newly established Austrian republic.

As in Germany, the fiscal needs of the government were attempted solved in the same manner as during the war--through the printing press of the central bank (in addition to highly confiscatory taxes, that nonetheless were not able to finance the rapidly growing deficits). Between 1919 and 1923, Austria’s money supply increased by 14,250 percent. The cost-of-living index (analogous to today's CPI) which stood at 100 before the outbreak of World War I (July, 1914) and 1640 when the war ended (November, 1918) reached the astounding level of 1,183,600 at the beginning of 1923, before the runaway inflation was stopped.

During the period of the classical gold standard (c. 1870-1914), international trade and capital flows expanded rapidly, as did the global economy. From 1914-1950, however, a process of deglobalization took place as major economic powers followed a policy of what Hayek described as "monetary nationalism." This was part of a larger drive towards economic nationalism, seen in its most extreme manifestation in Nazi Germany and Stalin Russia.

The instabilities of the interwar years also led to a heightened interest among economists in the phenomenon of the "trade cycle." In 1923-24, Hayek went on a study trip to the United States, visiting among others the famous American economist and business cycle researcher Wesley Clair Mitchell (1874-1948). Hayek also made himself aquainted with the monetary writings of Irving Fisher--the leading U.S. monetary theorist in the first part of the 20th century--and the monetary policies of the Federal Reserve.

When he returned to Austria, to work for the Austrian institute for business cycle research, established by Hayek's informal mentor Ludwig von Mises, he wrote on the state of American thinking on the business cycles. Hayek acknowledged the vast empirical work and data collection by Mitchell and his colleagues, but was somewhat skeptical of their theoretical understandings of the business cycle. Hayek also reviewed the monetary policies conducted by the recently created American central bank, the Federal Reserve (which was established by Congress in 1913). Hayek's monetary essays from the 1920s can be found in the anthology Good Money, Pt. 1.

Hayek expressed concerns about the ideas of price stabilization, a recurrent theme in his writings. As he wrote in 1932:

"In order to save the sound elements in the monetary theories of the trade cycle, I had to attempt, in particular, to refute certain theories that have led to the belief that, by stabilizing the general price level, all the disturbing monetary causes would be eliminated. [...] The critique of the program of the 'stabilizers' [...] has now occupied me for many years [...]"

Later on, Hayek developed his own comprehensive theory of the trade cycle, drawing upon the monetary theory of Mises.

Hayek's main contributions to monetary issues in the Interwar years are two set of lectures which were published as Monetary Theory and the Trade Cycle (1933) and Monetary Nationalism and International Stability (1937).

Hayek's understanding of the business cycle--emphasising how interest rates below the "natural" rate and credit expansion leads to economy-wide distortions--led him to warn that stable prices would not secure a stable economy, as prices should fall when there are productivity gains and growth in the economy:

"The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price level stable, is always lower than the rate that would keep the amount of available loan capital equal to the amont simultaneously saved by the public."

Thus, despite a stable price level, economic distortions can take place, pushing the economy away from equilibrium. As can be seen, Hayek early on criticized the idea of "price stabilization" which plays such an important role in current monetary thinking and policymaking.

Hayek predicted the coming Crash of 1929 and was instantly able to explain the origins of the economic downturn that followed. However, Hayek was slow in developing a clearly formulated policy response to the ongoing depression and deflationary pressures that continued in the 1930s.

Some economists have argued that Hayek adhered to an economic doctrine dubbed "liquidationism" and that this had disatrous consequences for the U.S. economy because leading policy-makers were influenced by this mode of thinking. As commented upon in a previous article, this is hardly historically accurate. U.S. policymakers were not influenced by Hayek or any other "Austrian" economist during the presidency of Herbert Hoover, nor was Hayek a liquidationist, as suggested by economist J. Bradford DeLong. In fact, Hayek proscribed a monetary rule of stabilizing the annual flow of money, something which would have cushioned off the worst of the1930s deflation. However, Hayek did not express such a monetary rule or guiding principle untill 1937 in his lectures on Monetary Nationalism.

George Mason University economist Lawrence H. White has written a paper on this important subject, and describes Hayek's monetary policy prescription of the 1930s as follows:

"Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of 'the total money stream,' or in Fisherian terms the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V."

Thus the central bank's main task should be, in Hayek's own words, “offsetting as far as possible the effects of changes in the demand for liquid assets on the total quantity of the circulating medium.”

In the 1970s, Hayek returned to the important subject of monetary policy in two essays--"Choice in Currency" (1976) and “Denationalisation of Money” (1976).


In the 1970s, Hayek returned to monetary issues, writing two important essays on currency competition.

F.A. Hayek (1933)Monetary Theory and the Trade Cycle

F.A. Hayek (1937)Monetary Nationalism and International Stability

F.A. Hayek (1976)"Choice in Currency"

F.A. Hayek (1976)Denationalisation of Money

F.A. Hayek (1999)Good Money, Pt. 1

F.A. Hayek (1999)Good Money, Pt. 2

Lawrence H. White (2008)"Did Hayek and Robbins Deepen the Great Depression?"

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