Money by Its Very Nature Constitutes a Kind of Loose Joint in the Self-Equilibrating Apparatus of the Price Mechanism

But even without further continuing the discussion of the rôle money plays in this connection, we are certainly entitled to conclude from what we have already shown that the extent to which we can hope to shape events at will by controlling money are much more limited, that the scope of monetary policy is much more restricted, than is today widely believed. We cannot, as some writers seem to think, do more or less what we please with the economic system by playing on the monetary instrument. In every situation there will in fact always be only one monetary policy which will not have a disequilibrating effect and therefore eventually reverse its short-term influence. That it will always be exceedingly difficult, if not impossible, to know exactly what this policy is does not alter the fact that we cannot hope even to approach this ideal policy unless we understand not only the monetary but also, what are even more important, the real factors that are at work. There is little ground for believing that a system with the modern complex credit structure will ever work smoothly without some deliberate control of the monetary mechanism, since money by its very nature constitutes a kind of loose joint in the self-equilibrating apparatus of the price mechanism which is bound to impede its working—the more so the greater is the play in the loose joint. But the existence of such a loose joint is no justification for concentrating attention on that loose joint and disregarding the rest of the mechanism, and still less for making the greatest possible use of the short-lived freedom from economic necessity which the existence of this loose joint permits. On the contrary, the aim of any successful monetary policy must be to reduce as far as possible this slack in the self-correcting forces of the price mechanism, and to make adaptation more prompt so as to reduce the necessity for a later, more violent, reaction.

—F. A. Hayek, The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, ed. Lawrence H. White (Indianapolis: Liberty Fund, 2007), 367.

The Type of Economy Determines the “Propagation Mechanism,” How the Economy Reacts to Monetary or Real “Impulses”

The crucial property of a money economy is that, absent neutral money, a divergence of investment from voluntary saving becomes possible. In particular, Hayek considers an excess of investment over saving, financed by credit creation (inflation), as the root cause of maladjustments in the structure of production and thus ultimately of the crisis. These maladjustments will arise irrespective of whether the exogenous change that generates excessive investment originates from the monetary or the real side. Or put in terms of the interest rate criterion: It does not matter if a discrepancy comes about by a fall in the money rate or a rise in the natural rate—the former resulting from a policy of monetary expansion, the latter from an increase in the (expected) rate of profit, possibly due to technical progress. Indeed, Hayek in Monetary Theory and the Trade Cycle stressed fluctuations in the natural rate (relative to an unchanged money rate) as the typical impulse, while later on in Prices and Production he started the analysis of maladjustments from assuming a fall in the money rate. Framing the problem—anachronistically—in terms of Ragnar Frisch’s famous distinction, the type of economy—money or barter—determines the propagation mechanism, that is, how the economy reacts to impulses, be they monetary or real. According to Hayek it is the distinguishing property of a (non-neutral) money economy that it will not react to such impulses by an immediate tendency towards equilibrium.

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 7, Business Cycles, Part I, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 19-20.

This Is the ONLY Sense in Which It is Proper to Speak of a MONETARY Explanation of the Business Cycle

Introducing Prices and Production in 1935, Hayek contrasted the two main pillars of his theory of the cycle,  “the monetary factors which cause the trade cycle” and “the real phenomena which constitute it.” In the following we will keep to this distinction and first concentrate on money as the prime cause of the cycle before turning to the changes in the structure of production as the crucial cyclical mechanism. 

As already noted, Hayek maintains that cycles and crises are possible only in a money economy. The analytical force of this argument draws on the distinction between neutral and non-neutral money, epitomised in the interest rate criterion, and in the identification of violations of this criterion as the ultimate cause of the business cycle. This is the only sense in which it is proper to speak, in Hayek’s view, of a monetary explanation of the business cycle. With the introduction of money the tendency towards equilibrium prevalent in the static economy is replaced by the more complicated adjustment patterns of dynamic theory. Yet, among the various peculiarities that make the money economy differ from its static counterpart, the most systematic, and that most pertinent to the existence of the business cycle, is the effect of credit creation (or destruction) in causing an incongruity between investment and voluntary saving.

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 7, Business Cycles, Part I, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 19.

Alvin Hansen’s “Stagnation Thesis” Has Characteristics Similar to Joseph Schumpeter’s Business Cycle Theory

Schumpeter’s second explanation is that innovations cluster in only one or a few industries and that these innovation opportunities are therefore limited. After a while they become exhausted, and the cluster of innovations ceases. This is obviously related to the Hansen stagnation thesis, in the sense that there are alleged to be a certain limited number of “investment opportunities” — here innovation opportunities — at any time, and that once these are exhausted there is temporarily no further room for investments or innovations. The whole concept of “opportunity” in this connection, however, is meaningless. There is no limit on “opportunity” as long as wants remain unfulfilled. The only other limit on investment or innovation is saved capital available to embark on the projects. But this has nothing to do with vaguely available opportunities which become “exhausted”; the existence of saved capital is a continuing factor. As for innovations, there is no reason why innovations cannot be continuous or take place in many industries, or why the innovatory pace has to slacken. 

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 856.

Keynesian Theory ‘Demoted’ the Interest Rate from the Rôle of Guiding Intertemporal Allocation to that of Rewarding the Sacrifice of Liquidity

Keynesian theory depicted current income as proximately determined by current expenditure (Y = C + I + G) rather than by prior production. The ‘circular flow’ supplanted capital theory in macroeconomics. Current-period analysis displaced intertemporal analysis. The interest rate no longer played an equilibrating rôle. Left to its own devices, the economy could readily get stuck at a level of expenditure too small to achieve full employment. Smithies found it remarkable (note his apparently sneering use of quotation marks) that “Professor Hayek’s point of view is that a ‘real’ economy, if left to itself, will automatically achieve ‘equilibrium’ and that the disturbances that occur in real life are due to the subversive influence of money.” Keynesian theory, as Uhr put it, ‘demoted’ the interest rate from the rôle of guiding intertemporal allocation to that of rewarding the sacrifice of liquidity. Though it never became mainstream doctrine, some Keynesians nearly overthrew the idea that capital is scarce, and needs to be carefully allocated, in favour of the ‘secular stagnation’ thesis that remunerative uses of capital are or soon will be hard to come by.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, by F. A. Hayek (Indianapolis: Liberty Fund, 2007), xxxi.