To Combat the Depression by a Forced Credit Expansion Is to Attempt to Cure the Evil by the Very Means Which Brought It About

It seems certain, however, that we shall merely make matters worse if we aim at curing the deflationary symptoms and, at the same time (by the erection of trade barriers and other forms of state intervention), do our best to increase rather than to decrease the fundamental maladjustments. More than that: while the advantages of such a course are, to say the least, uncertain, the new dangers it creates are great. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection—a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind that has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve System in 1927, an experiment that Mr. A.C. Miller, the only economist on the Federal Reserve Board and at the same time its oldest member, has rightly characterized as “the greatest and boldest operation ever undertaken by the Federal Reserve System,” an operation that “resulted in one of the most costly errors committed by it or any other banking system in the last 75 years.” It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown.

—F. A. Hayek, “Monetary Theory and the Trade Cycle,” in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2008), 6-7.

Monetary Theories of the Trade Cycle Are Generally Regarded as “Exogenous” (Instead of “Endogenous”) Theories

If we are to understand the present status of monetary theories of the trade cycle, we must pay special attention to the assumptions upon which they are based. At the present day, monetary theories are generally regarded as falling within the class of so-called “exogenous” theories, i.e., theories that look for the cause of the cycle not in the interconnections of economic phenomena themselves but in external interferences. Now it is, no doubt, often a waste of time to discuss the merits of classifying a theory in a given category. But the question of classification becomes important when the inclusion of a theory in one class or another implies, at the same time, a judgment as to the sphere of validity of the theory in question. This is undoubtedly the case with the distinction, very general today, between endogenous and exogenous theories—a distinction introduced into economic literature some twenty years ago by Bouniatian. Endogenous theories, in the course of their proof, avoid making use of assumptions that cannot either be decided by purely economic considerations, or regarded as general characteristics of our economic system—and hence capable of general proof. Exogenous theories, on the other hand, are based on concrete assertions whose correctness has to be proved separately in each individual case. As compared with an endogenous theory, which, if logically sound, can in a sense lay claim to general validity, an exogenous theory is at some disadvantage, inasmuch as it has, in each case, to justify the assumptions on which its conclusions are based.

Now as far as most contemporary monetary theories of the cycle are concerned, their opponents are undoubtedly right in classifying them, as does Professor Lowe in his discussion of the theories of Professors Mises and Hahn, among the exogenous theories; for they begin with arbitrary interferences on the part of the banks. This is, perhaps, one of the main reasons for the prevailing skepticism concerning the value of such theories. A theory that has to call upon the deus ex machina of a false step by bankers, in order to reach its conclusions is, perhaps, inevitably suspect. Yet Professor Mises himself—who is certainly to be regarded as the most respected and consistent exponent of the monetary theory of the trade cycle in Germany—has, in his latest work, afforded ample justification for this view of his theory by attributing the periodic recurrence of the trade cycle to the general tendency of central banks to depress the money rate of interest below the natural rate.

—F. A. Hayek, “The Fundamental Cause of Cyclical Fluctuations,” in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2008), 75-76.