Something Had Gone Wrong with the Steering Mechanism of Federal Reserve Policy and It Behooves Us to Know Why

The reason why all this deserves attention is that we now know that the Titanic of the US financial system in 1923 was even then on course for the iceberg of 1929. Something had gone wrong with the steering mechanism of Federal Reserve policy and it behooves us to know why. At several points in his review of US monetary policy in the early 1920s (chapter 2, this volume), Hayek raised warning flags, particularly in section six, which points to the lack of a coherent theoretical foundation. 

What went wrong? The Reserve Board was no longer able to use changes in the reserve ratio as the steering mechanism. “Under the present conditions, with gold embargoes in force in most foreign countries and the United States practically the only free gold market of the world, the movement of gold to this country does not reflect the relative position of the money markets nor does the movement give rise to corrective influences, working through exchanges, money rates, and price levels, which tend to reverse the flow. The significance which movements in the reserve ratios formerly possessed rested upon the fact that they were the visible indicators of the operation of the nicely adjusted mechanism of international finance. With this mechanism now inoperative, the ratios have lost much of their value as administrative guides. It has therefore been necessary for banking administration even in those countries that have been most successful in maintaining a connection with the gold standard to develop or devise other working bases.”

—Stephen Kresge, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 5, Good Money, Part I: The New World, by F. A. Hayek (Indianapolis: Liberty Fund, 1999), 22.

Surprisingly, Hayek in 1937 Expressed a Preference for an International Central Bank over International Free Banking

In the choice between the two routes to a truly international monetary system, Hayek in 1937 expressed a preference for an international central bank over international free banking. This is surprising given the outlook on economic policy for which he was well known, a classical liberal appreciation for the profound limitations of government activism. 

The language Hayek used is even more surprising in light of his more recent (1973, 1988) critiques of “constructivist rationalism” in social thought. In the 1937 lectures, he spoke of “the ideal” of “a rationally regulated world monetary system,” and commented that “a really rational monetary policy could be carried out only by an international monetary authority, or at any rate by the closest cooperation of the national authorities and with the common aim of making the circulation of each country behave as nearly as possible as if it were part of an intelligently regulated international system.”

—Lawrence H. White, “Monetary Nationalism Reconsidered,” in Money and the Nation State: The Financial Revolution, Government and the World Monetary System, ed. Kevin Dowd and Richard H. Timberlake Jr. (New Brunswick, NJ: Transaction Publishers, 1998), 379.

Hayek’s Constancy of Nominal Spending Rule (Keep MV Constant) Made Him Doubt the Merits of the Gold Standard and Free Banking

Hayek noted that a hypothetical gold monetary system in which the money stock consisted exclusively of gold coins (without bank-issued money) would poorly approximate his norm because the stock of monetary gold would not adjust promptly to offset changes in velocity. Gold accumulated slowly from additional mining following a rise in the relative price of gold. Nor would a system with bank-issued money approximate it well, he thought, unless a central bank existed to promptly offset any changes in the volume of bank-issued money not warranted by velocity changes. Thus Hayek was more ambivalent than Mises regarding the merits of the gold standard and free banking. 

—Lawrence H. White, “The Roaring Twenties and Austrian Business Cycle Theory,” in The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (New York: Cambridge University Press, 2012), 83-84.

Hayek Wants NOT a Constant Money Supply BUT a Neutral Money Supply Insuring that There Will Be NO Monetary Causes of Price Changes

The Mises-Hayek business cycle theory led Hayek to the conclusion that intertemporal coordination is best maintained by constancy of nominal spending or “the total money stream.” In terms of the variables of Irving Fisher’s equation of exchange (MV=PQ), nominal spending is the money stock times its velocity of circulation, MV. In Prices and Production Hayek recommended that to keep MV constant 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. The price level P should be allowed to fall with growth in real income Q. As Hansen summarized the prescription:

The supply of money should, therefore, be kept constant, except for such increases or decreases as may be necessary to offset . . . changes in the velocity of circulation . . . Hayek wants, therefore, not a constant money supply, but a neutral money supply — one which will insure that there will be no monetary causes of price changes.

—Lawrence H. White, “The Roaring Twenties and Austrian Business Cycle Theory,” in The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (New York: Cambridge University Press, 2012), 83.