04/05/2001 Pertinent Analysis from Friedrich A. Hayek *

It was another week of historic stock market volatility in a financial environment that grows more unsettled/precarious by the week. On the back of yesterday’s huge advance, the Dow ended the week with a loss of only 1%. The S&P500 and the Transports dropped 3%, while the Utilities were hit for 4%. The Morgan Stanley Cyclical index declined 1% and the Morgan Stanley Consumer index dropped 2%. Selling was broad based, with the small cap Russell 2000 sinking 4% and the S&P400 Mid-Cap index declining 3%. The spectacular technology collapse – albeit with stunning volatility – runs unabated. For the week, the NASDAQ100 declined 8%, the Semiconductors 11%, The Street.com Internet index 14%, and the NASDAQ Telecommunications index 12%. With the tech bubble in tatters, PG&E’s bankruptcy filing, and heightened general financial stress, it is certainly not surprising that the financial stocks have come under some selling pressure. For the week, the S&P Bank and Securities Broker/Dealer indices dropped 5%. Gold stocks showed some life, with the HUI index adding 3%.

Instability is also a prominent characteristic of the U.S. credit market, with today’s developments leading to a strong rally in Treasuries and fixed-income generally. For the week, 2-year yields dropped 12 basis points to just over 4%. The yield curve steepened, with long-bond yields actually rising 1 basis point. The key 10-year Treasury note yield declined 4 basis points, while the 5-year saw yields drop 9 basis points. Spreads were relatively stable, especially considering the circumstances, with mortgage-back yields declining 5 basis points and agency yields 8 basis points. The dramatic dollar rally appeared to come to an abrupt halt this week, with the dollar index dropping about 2%. There were noteworthy rallies in the Canadian dollar, the Australian dollar and the Korean won.

This afternoon the Federal Reserve reported that total bank credit expanded by $27 billion last week. Commercial and Industrial loans were unchanged, while "Other Security Holdings" jumped $11 billion, and "Security Loans" jumped $11 billion as well. This is not indicative of a sound financial system. What’s more, broad money supply (M3) surged $66 billion last week, led by a $13 billion increase in retail money market funds and a $30 billion jump in institutional money fund assets. Not unrelated, the consumer borrowing boom runs unabated with this afternoon’s report of a stronger than expected $13.5 billion jump in consumer borrowings during February (10.5% growth rate). Revolving debt expanded by more than $11 billion, the largest increase since September 1995. Further evidence of the signficant surge in first-quarter consumer borrowing and security issuance came yesterday from DowJones: "It was an impressive quarter by any yardstick. The asset-securitization market has just completed a record-setting quarter for new issuance… According to market statistician Thomson Financial Services Data, Newark, ABS issuance aggregated a whopping $89.5 billion in the January-to-March quarter, up from $61.9 billion in the comparable year-ago quarter."

Yesterday from MarketNewsInternational: "After soaring to new records in the wake of the 1996 bankruptcy bill, credit card losses had retreated, despite remaining at still-high levels. Today, losses are beginning to rise again, hitting 5.8% in February 2001, based on Standard & Poor's data, up from a low of 5.1% in September 2000. In 2001, the economy is slowing, and the unemployment rate is edging higher. A new bankruptcy bill is likely to raise personal bankruptcies in the short run, as individuals try to file before the new act takes effect six months after it is signed. The result will be a sharp rise in credit card portfolio losses, to 6.1% from last year's average of 5.5%."

The acutely fragile U.S. financial system suffered a major blow this afternoon with the bankruptcy filing of Pacific Gas and Electric, the largest ever utility bankruptcy. PG&E has liabilities of $18 billion, with losses mounting at a rate of $300 million each month. Several leading banks, Wall Street firms and numerous power generators have significant exposure to PG&E (as well as Edison International and various energy generators). Even more troublesome, the company has borrowed aggressively from money market funds, and this bankruptcy will certainly reverberate throughout the industry. This is now very much a systemic financial crisis. The utilities and others involved in this quagmire have numerous and long tentacles, and there is certainly the possibility of considerable disruption in energy and credit derivatives, as well as within "structured finance" generally. Today’s filing follows the recent $12 billion bankruptcy of Asia Pulp and Paper, also with negative ramifications for the asset-backed and swaps marketplace where it had become a significant player. Numerous other international issues, including crisis in Turkey and Argentina, are also factors in this arena. Throw in the recognition of "off-balance sheet" losses by American Express and increasing liquidity concerns for the likes of industry heavyweights Lucent and Motorola, and it becomes clear that there has been a significant escalation in the unfolding U.S./global financial crisis.

Bloomberg quoted an energy law attorney: "This is taking the crisis in California thermonuclear. This throws all the assets into a pot and everyone who is owed money has to scramble." This news also comes as the state of California prepares to issue up to $14 billion of energy bonds to finance this unfolding debacle. The California energy crisis is now a rapidly spreading and highly contagious cancer. Especially with this morning’s weaker than expected employment data, we will go into next week anticipating action by the Fed.

"Amid the current mixed bag of economic indicators, strong consumer spending continues to drive industry sales. Clearly, the economic slowdown has not impacted all segments and all manufacturers." Jim Press, Toyota USA (TMS) executive vice president and COO, April 4, 2001 as Toyota reported that March was their best month of U.S. sales ever. Considering the extraordinary financial and economic backdrop, I thought it appropriate to highlight some very cogent analysis from the great Austrian economist Friedrich A. Hayek regarding the 1920’s bubble and the depression that followed. The following quote is from Money, Capital, and Fluctuations: Early Essays, The Monetary Policy of the United States After the 1920 Crisis, 1925

"The excessive development of the industries producing raw materials and capital goods, whose regular recurrence is thus to be regarded as the main cause of the periodic economic crises, necessarily arises from and is chiefly due to the much praised elasticity of our modern credit system. The cumulative effect which any increase in the demand for finished products exerts upon the output of goods of higher order finds its expression in the accumulation of excessive stocks of commodities, a disproportionate expansion of the apparatus with which they are produced, and especially a greater rise in the prices of raw materials and capital goods and thereby the elimination of profits. This can take place only because the extension of credit by the banking system is not strictly linked to the growth of savings. The banks can make purchasing power available to the entrepreneur even if no one else has refrained from exercising to a corresponding extent the purchasing power which they possess. The banks are especially prone to behave in this way if a favorable economic situation appears to reduce the risks involved in doing so. Since the increased demand thereby making its appearance in the market is confronted by an unchanged supply, it must bring about a rise in prices which is particularly great in the case of goods of higher order. The reason is that the possibility of expanding the supply of money capital to a level in excess of that of real capital also puts the banks in a position to offer the former at a rate which is cheaper than that which corresponds to the proportion which the increased demand bears to the supply of real capital. It thereby makes capital investments continue to appear to be profitable though in fact they exceed the economically permissible level and hence must sooner or later be partly lost. The most significant phenomena of the upswing, over-investment and a general rise in prices, and at the same time the causes of the crises which always follow upon the upswing, are therefore largely a result of an extension of credit which is from time to time excessive. This extension of credit gives rise to a short-lived inflation and leads to the emergence of the disproportions between the individual sectors of the economy to which the accompanying stimulation of business always gives rise. The crisis then becomes the only way of eliminating these disproportions. The recurrent inflation therefore works like a drug giving rise not merely to a short-lived increase in well-being but also to an extended nightmare later."

The following paragraphs are excerpts from Review of Monetary Theory and the Trade Cycle, by C. Bresciani-Turroni, from Critical Assessments, F.A. Hayek

"It is, however, not necessary to assume, as current monetary theories of the Trade Cycle do, that the monetary causes act only in so far as the value of money – which is measured by the general prices level – changes. On the contrary, the leading idea of Professor Hayek’s book is that the mere fact of a variation in the volume of money, even if the level of general prices remains constant, is sufficient to "dissolve the closedness of the system" and "to open the way for tendencies leading away from the equilibrium position."

"Are changes in the volume of money the consequence of arbitrary interferences of the monetary authorities – as current monetary theories of the Trade Cycle generally assume – or are they an "immanent" characteristic of the present credit organization? Professor Hayak accepts the latter view, thus stressing the "endogenous" character of his theory. According to him the Trade Cycle begins in most cases with an improvement in the expectations of profit, which results in an increase in the demand for credit. Professor Hayek then proceeds to prove that in the present credit organization it is plainly impossible for the banks to adjust quickly the rate of interest charged by them to the rise in the natural rate of interest. The result is that the "interest brake" fails to operate. Productive resources are devoted to the production of fixed capital in greater quantity than can be accounted for by the supply of real savings. Necessarily, however, a moment must come when the banks will cease to extend credits. Then the money rate of interest suddenly rises to its nature level, "and this will render unprofitable (temporarily at least) those investments which were created with the aid of additional credits." The crisis makes its appearance. Thus, the elasticity of the volume of money – that is to say, the readiness of banks to adjust the volume of money to the requirements of business, which is generally considered as one of the principle advantages of the present credit organization – is, in Professor Hayek’s opinion, "the element whose presence forms the necessary and sufficient condition for the emergence of the Trade Cycle."

"A basic criticism of Keynes’s system by Hayek (1931, p. 227) was the level of aggregation in Keynes’s model: ‘Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change’. Keynesian analysis has a highly aggregated capital goods sector whereas the Austrians have a disaggregated approach… Hayek believed that the general approach of the whole work (Keynes’s General Theory), the aggregate or ‘macro’ analysis, was fundamentally mistaken."

Clearly, the brilliance of the "Old Austrian" economists provides invaluable insight into the current extraordinary environment. Yet, I am left with the feeling that some of the more pertinent monetary analysis is unfortunately left unexplored. Actually, we have been quite frustrated with contemporary monetary thinking from the "Austrian" camp. They maintain a very insular focus on a quite narrow definition of money, while placing the Federal Reserve as the virtual exclusive master of the supply of money, as well as the world’s monetary and economic ills. The leading "neo-Austrian" monetary analysts go so far to specifically exclude money market funds as a component of the general supply of "money," hence ignoring more than $2 trillion of monetary assets and the single greatest source of monetary inflation for this cycle. This approach is questionable analytically, and is quite inconsistent and, as far as I’m concerned, an injustice to the brilliant work of Ludwig von Mises. Mises’ analyses looked specifically to lending as the source for the creation of a broad range of "money" and "money substitutes" – "fiduciary media" – and our focus on broad money and credit excess is very much in the spirit of Mises. He astutely recognized the necessity of recognizing a broad category of "fiduciary media" that demonstrated the economic functionality (with diverse and varying inflationary consequences) of the more traditional narrow definitions of "money." In this respect, he saw the traditional focus of the vast majority of economists to only the narrowest definitions of "money" as an analytical error.

Importantly, Mises and Hayek argued specifically against the "neutrality of money." From Mises (Ludwig von Mises, Notes and Recollections, 1975): "My theory of the inevitable non-neutrality of money…namely, that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money bring about simultaneous and proportional changes in the ‘level’ of prices." While many would argue that the collapse in semiconductor and electronic component prices is indicative of a deflationary environment, a more valuable analysis would recognize that the surge in real estate, health care, natural gas and California energy prices (picking just a few of the most obvious) is a manifestation of continuing monetary excess and unmistakable evidence of the "non-neutrality of money." This issue is a troubling, if unappreciated, predicament today facing U.S. central bankers in this acutely unstable financial and economic environment. Indeed, today’s bankruptcy filing by PG&E and the greater California electricity debacle could not provide a better example of the great financial and economic risk associated with current extraordinary price instability. When and where will the next even better example arise?

Importantly, moves by the Fed to secure what it perceives as broad price level stability – perhaps with a focus on a general price index, such as CPI, or more specifically deflating technology prices or equity values – would not only be unsuccessful, but would most certainly be counterproductive and potentially disastrous. As the California energy fiasco has demonstrated, the maladjusted U.S. economy is replete with inflationary "tinderboxes" waiting for sparks. Accordingly, those that have argued that a "price rule" allows the Fed the luxury to continue to look the other way to egregious credit excess and the heightened price distortions lying just below the friendly surface of seemingly benign aggregate price data (or those that look to the weak gold price as evidence of "tight" general monetary conditions), are following flawed and dangerous monetary theories. The "Old Austrians" demonstrated a profoundly superior grasp of monetary analysis as they spoke often of "processes," "changing relations," "dis-equilibrium" and "instability" in relation to the interaction of monetary and economic forces. Quoting again from Hayakian analysis: "Monetary theory had to be extended in scope in order to allow for the identification of the systematic relative price effects associated with any process of the expansion or contraction in money." Bingo!

This concept of the "non-neutrality of money" is today most critical. By now, we should all recognize clearly that the U.S. economy has experienced an unprecedented period of credit-induced malinvestment and endemic economic distortions. It’s time to move the analysis forward. With stock prices sinking, a spectacular collapse in technology shares, a faltering U.S. manufacturing sector, and heightened financial stress, policymakers and the economic community almost universally believe the cure can be found through the Federal Reserve’s creation of additional money supply and liquidity (to maintain/raise general prices levels). I have even read criticism of my analysis (as I highlight continued credit excess) for "completely disregarding deflationary forces." I am certainly not ignoring what is an unavoidable technology collapse after years of truly unprecedented credit, speculative and spending excess. I do, however, see this dilemma (consistent with Hayek) as more the consequence of previous monetary inflation and maladjustments, and clearly not due to any semblance of monetary deflation. Further, the current explosion in mortgage debt and GSE balance sheets is consistent with the failed policy of the Greenspan Fed in accommodating excessive monetary expansion, especially in the context of its present policy goal of lessening the fallout from the technology/NASDAQ bust. Tacit Fed support for continued reckless mortgage lending and financial sector leveraging is simply one more in a string of blatant financial excesses accommodated in this (painful to watch) historic episode of unrelenting monetary mismanagement. No doubt about it, this is but one more example of the Fed "Putting a Coin In The Fuse Box" that is today only creating the clear and present danger of fostering a process that could end in financial collapse ("Burning Down The House"). This is where the current debate should be focused, on the very lines espoused by Mises and Hayek. Where are the "Austrians"?

As such, I’m unequivocally with Hayek on two key points: First, "aggregates conceal the most fundamental mechanisms of change." Some may argue that total credit growth is not today "out of line." I would respond by encouraging forward analysis to focus on individual sector borrowings, while today noting that unprecedented mortgage credit excess in the face of a deteriorating financial and economic backdrop is one massive financial and economic distortion that follows a recurring string of ever-greater bubble distortions. Auto sales data is another excellent case in point. Total ("aggregate") sales for March came in at a stronger than expected 17 million units, just 4% below last year’s record sales rate. The "Big 3," however, saw sales drop almost 9%, with Ford sales sinking 13%, Chrysler 10%, and GM 5%. It was a much different story for the foreign nameplates. Toyota had its best month of sales ever, jumping more than 11% over last year’s strong sales. This performance helped Asian manufactures pick up more than 3 points of market share, to 29%. Toyota’s Lexus unit had a record March, with sales up 24% y-o-y. If this is "recession," it sure is a strange one. BMW enjoyed a record first quarter (+9%), with March sales up 5%. Mercedes-Benz sales were 3% above last year, and Acura had its best month ever, with sales surging 32% above last year. It was a record March for Honda, a record first quarter for Mitsubishi, the best March since 1986 for Subaru, and the best first-quarter since 1995 for Mazda (March sales up 20%). Volkswagen enjoyed its second-best March in 20 years. Korean manufacturers are doing exceptionally well, with Kia experiencing its best month ever (+51% y-o-y) and a record March for Hyundai (+26% y-o-y). Clearly, the key issue today is not faltering consumer demand, but the dramatic drop in market share for the American companies. It’s difficult to see this situation easily rectified by Federal Reserve policy.

Second, "In so far as deflation is brought about – as it may well be – by this change in the prospects of investment, it is a secondary or induced phenomenon caused by the more fundamental, real, dis-equilibrium which cannot be removed by new inflation, but only by the slow and painful process of readjustment of the structure of production." The unprecedented distortions to the real economy and financial system – specifically in relation to the massive technology/communications spending boom - have been the significantly fostered by inflationary forces (especially the 1998 and Y2K monetary fiascos), and additional monetary inflation will only exacerbate general monetary and economic dis-equilibrium. Throwing more credit/inflation on this acutely maladjusted and dysfunctional system is anything but the answer. Here I passionately part company with what would seemingly be the consensus prescription from the "Keynesians", but I just see no way to inflate out of this particular predicament. Moreover, such policies clearly risk financial collapse for a credit system with endemic over-leveraging and unprecedented speculative excess (not to mention the injustice further inflation will bare on those who have worked hard, "played by the rules," been prudent, and saved).

It strikes me that some of the key aspects of the brilliance of "Old Austrian" analyses have been lost throughout the years, as the emphasis seems to have drifted to a fixation on the ills of government intervention and central banking. Simplistically, I think the Old Economic Masters were really saying that money does matter. It matters how much money is created; it matters even more how money is spent. Furthermore, if money is borrowed and created in excess, the resulting monetary processes unleashed matter tremendously. If a credit-induced boom stokes business spending/"investment" and consumption to unsustainable levels, with consequential maladjustments, there is simply no way around a difficult workout period. Moreover, if these processes stimulate over-consumption at the expense of sound investment, there will be "capital consumption," with corresponding long-term detrimental effects to the standard of living of its citizens. In my view, only massive (unsustainable) imports and concomitant speculative "Hot Money" inflows mask the fact that as a country we have been consuming capital/"burning the furniture to warm the house." And while many discuss concepts of over-investment in describing the U.S. technology boom, I would argue that what most describe as "investment" could be more accurately recognized as massive monetary flows into the tech sector that all too often made their way directly to incredible income and capital gains for a relatively limited number of individuals. It was much more about over-spending and wealth transfer than true business investment. I think if an inventory was made of what actually remains of the many hundreds of billions that flowed into the tech bubble the findings would be frightening.

Going forward, there will be no free lunch through the creation of additional debt obligations. Importantly, as understood clearly by the "Old Austrians," excessive money creation and resulting bubble economies destroy, not create wealth. The severity of the unfolding workout depends specifically on the scope of the preceding boom – the degree of credit excess, how far spending diverged from a level of stability/equilibrium, the impairment of the financial sector and the quality and future profitability of boom-time "investment." This requires not only quantitative analysis, but perhaps more importantly, sound qualitative analysis as well. In my own humble opinion, this is where the "Old Austrians" provide economic insights of significantly greater depth than the present American economic consensus.

Right here I think we can isolate the greatest weakness of the U.S. economic thinking: Apparently, the nature of spending or the quality of new debt is largely irrelevant – all that is important is the expansion of aggregate demand/GDP and the continued liquidity of financial markets. Success today is measured by the willingness of American households to continue their borrowing and spending binge, as well as declining U.S. market interest rates to sustain systemic liquidity. The fact that the U.S. bubble economy is being preserved in part by an unsustainable extraction of equity from an historic real estate bubble is viewed, incredibly, as good news – "it’s keeping the economy out of recession" (it is worth noting the causation of the boom as recognized in 1925 by Hayek - "chiefly due to the much praised elasticity of our modern credit system"). The fact that American consumers are borrowing aggressively to fund the consumption of imported products is apparently not worrisome. And since the ballooning current account deficit has not yet turned problematic, there persists this dangerous notion that foreign sources will finance our boom in perpetuity. Such irrational analysis holds (with the dollar maintaining for now global purchasing power) and the massive accumulation of foreign liabilities remain, amazingly, a non-issue. Likewise, the fact that the State of California is now borrowing more than $1 billion monthly to fund electricity losses is apparently viewed as a convenient offset to telecommunications companies that have lost access to borrowings. What is the true quality of the assets backing the recent explosion of broad money supply? Yet, as long as the credit system continues to create new debt in the aggregate sufficient to sustain aggregate spending, all is apparently well and "analysis" need go no further.

Today, the intricacies of the credit mechanism – the debt structures, vehicles, derivatives and vulnerabilities of the sources of underlying credit availability – are a complete non-issue. This is a momentous shortcoming of current analysis. Again, all eyes are fixated on aggregate demand. Not only does it not matter if spending is for consumption or sound profitable investment, it similarly doesn’t matter if the sources accommodating lending excess are household savings or hedge funds borrowing in Japan to take speculative positions in higher-yielding U.S. securities. In reality, however, it matters greatly with respect to financial fragility. And as the complacent consensus thinking goes, if somehow financial system liquidity falters, Federal Reserve liquidity injections will quickly resolve (1998-style) the problem. Similarly, if the financial sector does find itself again impaired with credit losses, no worries. The Federal Reserve is certainly prepared to orchestrate another early 1990’s-style "recapitalization"; financial sector impairment is only a Fed-provided "spread" away from rectification. So it really doesn’t matter how money is lent, and major bankruptcies like PGE are not a major issue. After all, the U.S. economic consensus has great confidence that the Fed will always make more money. Moreover, money doesn’t matter because the distorting effects to the real economy so brilliantly recognized by the likes of Mises and Hayek somehow don’t even enter into contemporary economic discourse.

All the same, the momentous dilemma to be appreciated today is that monetary inflation has created intractable economic and financial distortions and that continued monetary inflation depends specifically on the capacity of the U.S. financial sector to continue leveraging, as well as the uninterrupted continuation of massive foreign (investment and enormous speculative "hot money") inflows. Unfortunately, this brings us right back to the issue of acute financial fragility. To keep this bubble economy levitated requires massive continued monetary inflation (as we have been witnessing) in an unmistakable historic Credit Bubble. Though continued mortgage and consumer credit excess only assures greater consumer sector distress and financial sector impairment come the inevitable piercing of this unsustainable bubble. And come the faltering of the consumer bubble, it is quite likely that a sinking dollar will not provide the Fed the luxury of an easy "reliquefication"/recapitalization for the U.S. financial sector. This will prove a disappointment for U.S. financial institutions, as well as the leveraged speculating community.

I can’t help but to believe that with the current service-sector structure of the U.S. economy, labor costs have developed into the overwhelming dominant "factor" involved in "driving up the prices of the factors of production." Not only is U.S. wage inflation quietly stimulating demand, it is a key factor in general faltering U.S. corporate profitability and increasingly bearing on the ability of U.S. companies to compete effectively. Continued U.S. inflation will not only augment the loss of global competitiveness and hurt the bottom line, this process will also exacerbate another major economic distortion: the massive U.S. trade imbalance. We just can’t shake the notion that inflationary forces have set in motion a confluence of processes that will manifest into a major adjustment in the valuation of the dollar. What’s more, the longer monetary inflation and the resulting maladjustments are allowed to run unabated, the more dramatic and destabilizing the inevitable market correction. However, perhaps, "it is only by such a decline (in the dollar) that equilibrium can be restored," or at least the necessary adjustment process can commence. One thing is for sure, it’s long overdue.

For now, we are left to wait and see the fallout from the PG&E’s bankruptcy filing and a myriad of other festering financial problems. We have often warned of the danger from financing the U.S. Credit Bubble through mechanisms perceived as safe by the investing/saving public – the "poisoning" of money. The sanctity of money should be respected and coveted, not abused. In particular, we have always looked with considerable askance at the proliferation of sophisticated off-balance sheet "funding corps" that have issued more than $650 billion of asset-backed commercial paper. The lack of transparency in these vehicles and structures works well during bull markets; it will however prove a significant disadvantage going forward. Such undertakings have always risked breaking the perception of the near absolute safety of money market funds. Confidence can be a very fragile and fleeting thing. It is now certainly not outrageous to consider the possibility and momentous ramifications of a systemic loss of liquidity in the $2 trillion money market fund complex. The potential for a run on fund assets should certainly not be discounted out of hand, and it is definitely time to carefully scrutinize money fund holdings. And while we would presume considerable anxiety "behind the scenes," confidence has held together remarkably well for what we would see as very vulnerable areas encompassing "structured finance," including the massive derivatives marketplace, credit insurance, and asset-backed securities generally. We don’t think it is a stretch to say "as goes confidence in U.S. ‘structured finance’, so goes the dollar." This has a very ominous "look and feel," and we strongly encourage everyone to consider taking aggressive measures to reduce risk and protect assets.

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For those interested in more from Hayek, I found his critiques of the work of Keynes particularly insightful and intriguingly pertinent to today’s extraordinary environment. The following quotes were extracted from the introduction to Friedrich A. Hayek’s Critical Assessments:

"The details of how the debate evolved is a fascinating aside that is worthy of some attention. Hayek first met Keynes in 1928 and although they instantly had the first of many such disagreements on theory they thereafter became lifelong friends. Hayek reviewed Keynes’s Treatise on Money for Economica in two detailed articles. Keynes responded to the first by way of a counter-attack on Hayek’s Prices and Production. Hayek believed that he had largely refuted Keynes’s theoretical scheme. Yet he was greatly disappointed when all his efforts ‘seemed wasted because after the appearance of the second part of my [Hayek’s] article he [Keynes] told me that he had in the meantime changed his mind and no longer believed what he had said in that work.’ xv

"Monetary theory had to be extended in scope in order to allow for the identification of the systematic relative price effects associated with any process of the expansion or contraction in money. By using the Wicksellian notion of the natural rate of interest Mises had outlined how monetary policy could disrupt the market mechanism that would achieve intertemporal co-ordination – Hayek extended this to show how the market mechanism works to co-ordinate resources intertemporally." xvii

"A policy-induced change in the interest rate will lead to the same change in the structure of production as the market-induced change. However, when entrepreneurs eventually discover that real savings is insufficient to complete restructuring, a crisis results." xvii

"The fundamental thesis of Hayek’s business cycle theory is, as Machlup puts it ‘that monetary factors cause the cycle but real phenomena constitute it.’ Money, credit, capital and business cycles are all integrated in the Hayekian vision." Xvii

The following quotes are extracted from Hayek’s article originally published in Economica: Reflections on the Pure Theory of Money of Mr. J.M. Keynes.

"The appearance of any work by Mr. J.M. Keynes must always be a matter of importance and the publication of the Treatise on Money has long been awaited with intense interest by all economists."

"I shall not attempt even to outline here the reasons which have led me always to suppose that in such a society the technical obstacles to the maintenance of anything which can be called ‘stability’ must always be extremely formidable, nor those which lead me to think that if, in face of this ‘normal’ increase in capital equipment per head, ‘stability’ is to be interpreted to mean ‘stability of commodity prices,’ the difficulties become more formidable still. I will content myself with one illustration. Looking back on the American expansion of 1925-29, Mr. Keynes finds that up to 1927 the prodigious volume of ‘investment’ was accompanied by an equally prodigious volume of ‘saving,’ but in the subsequent years he is able now to detect signs of that ‘commodity inflation’ – that ‘excess of investment over savings’ – the existence of which he was at the time disposed to deny. But would it make much difference if he could detect no such thing? Even if ‘savings’ had continued to keep pace, could ‘investment’ have continued forever in America at the rate which it attained in those years? And what is the effect of an indiscriminate stimulation of ‘investment’ by low money rates and a general policy of boost at a time when all the known channels of investment are in a state of super-saturation? At such times, is the "put them through it’ policy of the parrots and penguins a mere relic of sadistic barbarism, or is it in truth an essential phase of the clinical treatment of the trade cycle, whose omission is as perilous as its over-prolongation? These are some of the broader questions over which Mr. Keynes’ rich volumes leave me, having sated the passions of pedantry, still puzzled and pondering." 35

"Within the limits of this article, it is impossible to deal, in the same detail with which the fundamental concepts have been discussed, with the last major subject upon which I wish to touch: viz. the explanation of the credit cycle… The first point which must strike any reader, conversant with the writings of Wicksell and of what Mr. Keynes calls the Neo-Wicksell school, is how little use he finally makes of the effects of a monetary dis-equilibrium on real investment – which he has been at such pains to develop. What he is really interested in is merely the shifts in the money streams and the consequent changes in price levels. It seems never to have occurred to him that the artificial stimulus to investment, which makes it exceed current saving, may cause a dis-equilibrium in the real structure of production which, sooner or later, must lead to reaction. Like so many others who hold a purely monetary theory of the trade cycle, he seems to believe that, if the existing monetary organization did not make is impossible, the boom could be perpetuated by indefinite inflation. Though the term ‘over-investment’ occurs again and again, its implications are never explored beyond the first conclusion that, so long as total incomes less the amount saved exceed the cost of the available output of consumers’ goods (because investment is in excess of saving), the price level will have a tendency to rise. In Mr. Keynes’ explanation of the cycle, the main characteristic of the boom is taken to be, not the increase in investment, but this consequent increase in the prices of consumer’s goods and the profit which is there for obtained. Direct inflation for consumption purposes would, therefore, create a boom quite as effectively as would an excess of investment over saving. Hence, he was quite consistent when, despairing of a revival of investment brought about by cheap money, he advocated, in his well-known broadcast address, the direct stimulation of the expenditure of consumers on the lines suggested by the purchasing-power theorists…for, on his theory, the effects of cheap money and increased buying of consumers are equivalent.

Since, according to this theory, it is the excess of the demand for consumer’s goods over the costs of the available supply which constitutes the boom, this boom will last only so long as demand keeps ahead of supply and will end either when the demand ceases to increase or when the supply, stimulated by the abnormal profits, catches up with demand. Then the prices of consumers’ goods will fall back to cost and the boom will be at an end, though it need not, necessarily, be followed by a depression; yet, in practice, deflationary tendencies are usually set up which will reverse the process. This seems to me to be, in broad outline, Mr. Keynes’ explanation of the cycle…

The main objections to these theories – I cannot go into details here…- seem to me to be three in number. Firstly, that the original increase in investment can be maintained only so long as it is more profitable to increase the output of capital goods than to bid up the prices of the factors of production in the effort to satisfy the increased demand for consumers’ goods. Secondly, that the increase in the demand for consumers’ goods, if not offset by a new increase in the amount of money available for investment purposes, so far from giving a new stimulus to investment, will, on the contrary, lead to a decrease in investment because of its effect on the prices of the factors of production. Thirdly, that the very fact that processes of investment have begun but have become unprofitable as a result of the rise in the price of factors and must, therefore, be discontinued, is, of itself, a sufficient cause to produce a decrease of general activity and employment (in short, a depression) without any new monetary cause (deflation). In so far as deflation is brought about – as it may well be – by this change in the prospects of investment, it is a secondary or induced phenomenon caused by the more fundamental, real, dis-equilibrium which cannot be removed by new inflation, but only by the slow and painful process of readjustment of the structure of production. While Mr. Keynes has occasional glimpses of the alternative character of an increase in the output of consumers’ goods and investment goods, he does not follow up this idea; and, in my view, it is this alone which could lead him to the true explanation of this crisis. But it is not surprising that he fails to do so, for it is precisely in the elucidation of these inter-relations that the tools he has created become an altogether inadequate and unsuitable equipment. The achievement of this object, is indeed, impossible with his present concepts of capital and ‘investment’ and without a clear notion of the change in the structure of production involved in any transition to more or less capitalistic methods." 80

"But if the increase of investment is not the consequence of a voluntary decision to reduce the possible level of consumption for this purpose, there is no reason why it should be permanent and the very increase in the demand for consumers’ goods which Mr. Keynes has described will put an end to it as soon as the banking system ceased to provide additional cheap means for investment." 81

"Indeed, it is the experience of all depressions and especially of the present one, that the sales of consumption goods are maintained until long after the crisis; industries making consumption goods are the only ones which are prosperous and even able to absorb, and return profits on, new capital during the depression. The decrease in consumption comes only as a result of unemployment in the heavy industries, and since it was the increased demand for the products of the industries making goods for consumption which made the production of investment goods unprofitable, by driving up the prices of the factors of production, it is only by such a decline that equilibrium can be restored." 82

"I do not deny that, during the process, a tendency towards deflation will regularly arise; this will particularly be the case when the crisis leads to frequent failures and so increases the risks of lending. It may become very serious if attempts artificially to ‘maintain purchasing power’ delay the process of readjustment – as has probably been the case during the present crisis. This deflation is, however, a secondary phenomenon in the sense that it is caused by the instability in the real situation; the tendency will persist so long as the real causes are not removed. Any attempt to combat the crisis by credit expansion will, therefore, not only be merely the treatment of symptoms as causes, but may also prolong the depression by delaying the inevitable real adjustments. It is not difficult to understand, in light of these considerations, why the easy-money policy which was adopted immediately after the crash of 1929 was of no effect.

It is, unfortunately, to these secondary complications that Mr. Keynes, in common with many other contemporary economists, directs most attention. This is not to say that he has not made valuable suggestions for treating these secondary complications. But, as I suggested at the beginning of these Reflections, his neglect of the more fundamental "real" phenomena has prevented him from reaching a satisfactory explanation of the more deep-seated causes of depression."