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Krugman on Friedman, Hayek, and Liquidationism

In a blog post yesterday, entitled “Friedman and the Austrians” , Paul Krugman quotes Milton Friedman’s charge that in the “London School (really Austrian) view,” i.e. the view held by F. A. Hayek and Lionel Robbins,

the depression was an inevitable result of the prior boom, that it was deepened by the attempts to prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by “easy money” policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate weak and unsound firms.

Krugman then remarks:

I have, incidentally, seen attempts to claim that nobody believed this, or at any rate that Hayek never believed this, and that characterizing Hayek as a liquidationist is some kind of liberal libel. This is really a case of who are you gonna believe, me or your lying eyes.

One of the "attemps" Krugman may be referring to is my June 2008 article in the Journal of Money, Credit, and Banking, “Did Hayek and Robbins Deepen the Great Depression?” (Ungated pre-publication version here). Or he may be referring to subsequent discussion of the question on Brad DeLong’s blog — if you follow this link, please scroll down to see my comments on DeLong’s post.

In either case Krugman’s remarks call for a reply.

In the 2008 article I point out that Hayek enunciated a monetary policy norm of stabilizing nominal income (aka nominal aggregate demand, or MV in the equation of exchange) in the face of a declining money multiplier or declining velocity of money. Under a gold standard, a high price level driven unsustainably high (by the boom-creating inflationary policies that Friedman references) needs to return to the sustainable level, but there is no virtue in “secondary” deflation going beyond that point. Thus, according to Hayek, the central bank should expand its liabilities H to offset an increased bank reserve ratio or public hoarding that reduces M/H or V. In yet other words, it is better to remedy an unsatisfied excess demand for money balances by supplying the called-for money balances than by putting a burden of downward price adjustment on the economy.

Overlooking Hayek’s stable-MV norm, Friedman and others have mischaracterized Hayek as prescribing only “to let the depression run its course.” Hayek did oppose cheap-money policies that distort the economy, and did counsel policy-makers not to obstruct the process of correcting the mistaken investments made during the boom. But quoting such statements doesn’t show that he said nothing else about depression policy.

It’s a question of who you gonna believe, a one-sided quoting of only some bits of Hayek by people unaware of the rest, or the full story of what Hayek wrote about depression policy?

I’m sorry that Krugman didn’t call me out by name. It prevents his readers from finding and reading the other side of the debate.

I might also mention that my article treats the question of what Hayek really said as a matter of getting the intellectual history right. I do not suggest that mischaracterization of Hayek’s position is limited to left-liberals. Indeed, as Krugman’s blog post does, my article prominently quotes Milton Friedman’s criticism of Hayek for supposed liquidationism. Friedman is no left-liberal. Thus I would never call it “some kind of liberal libel.”

  • George Machen

    Oh, drat; Scribd still wanted a $9.00 "day pass" to read the "ungated pre-publication version" beyond three pages, even if I signed-up for a Scribd account. And the JMBC article doesn't qualify under my free MyJSTOR account.

    • Larry White

      Pretty cheeky of Scribd to charge for what was never their property. Sorry about that.

  • MichaelM

    I'm trying to search out any un-gated copies of the paper but, in the meantime, do you have anything specific where Hayek explicitly says you should aim to stabilize nominal income?

    I understand some of the objections I've read from you in comments elsewhere (that quotes where he seems to be condoning 'liquidationism' are him warning against trying to boost nominal income ABOVE a healthy level, rather than saying it should be allowed to fall below a healthy level), I'm just looking for some kind of more exact confirmation of that point of view.

  • One of the troubling things for me is that this seems to be a common problem with Hayek. He makes both liquidationist and stable-MV statements. He makes both slippery slope and non-slippery slope arguments in RTS. He's all over the map in a lot of cases. You'd never get liquidationism jumbled together with anti-liquidationism in Keynes or Friedman, for example. Even if we allow for varying opinions over a long life and the occasional vague or confusing claims, this seems to be a major problem with Hayek. I think there's a point where we have to accept that DeLong and White are both brilliant intellectual historians, as are Farrant/McPhail and Caldwell/Boettke, and that the buck has to stop with Hayek for leaving such contradictory work. This doesn't mean Hayek isn't brilliant, it's just to say that this is one liability of reading him.

    • McKinney

      I have read a lot of Hayek and never found him to contradict himself. What I find is a lot of speed readers who understand Hayek superficially and see contradictions that don't exist. They don't have the intellect to understand what Hayek is saying.

  • alanmoran

    Friedman’s prescription for economic stability, a steady growth in the money supply of 3 per cent a year, was incubated on the basis of his assessment of the causes of the Great Depression.
    Friedman did not see extreme exuberance in the 1920s and did not regard that decade’s credit creation as being excessive. He considered the fall in the supply of money after 1929 was the prime cause of the on-going slump. According to Stockman, whose views are reflective of those of the Austrians in the 1930s,
    “Yet the historical evidence is unambiguous; there was no liquidity shortage and no failure by the Fed to do its job as a banker’s bank. Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves.
    “And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate. In fact, the Fed’s discount rate had been progressively lowered from 6 percent before the crash to 2.5 percent by early 1933.”
    “Wall Street crash wiped out margin players but banks had ample liquidity. Only the agricultural banks closed down hit by falling overseas demand and plummeting prices of commodities.
    “The sharp reduction after 1929 in the money supply was an inexorable consequence of the liquidation of bad debt, not an avoidable cause of the depression.” He also points out that experience shows holding money supply growth to a single level, 3 per cent, is impossible even if political overrides did not occur. The notion of money changes so markedly that the normal definition of M1 becomes useless.
    Stockman acidly opines, “The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.”
    Hayek and Lionel Robins at the time advocated doing very little other than the opposite of what FDR was implementing (i.e. free up trade, allow freedom of wages and prices, balance the budget, Great War debt forgiveness to England and France). They saw a market crash as an inevitable outcome of excessive money creation in the 1920s being used to finance Wall Street gambling and European agricultural imports from the US. They saw no alternative but to cease priming the pump and that a downturn would ensue but be no more serious than previous events without the aggravation resulting from government regulatory policies.
    Such views, which both later may have modified, are totally at varaince with those of Friedman

    • Lio

      I fully agree with you. 1/ Friedman's explanations about the great depression and the responsability of the Fed are not very convincing,  He confused cause and effect.  We see now that monetary inflation has not the effects on the  economy that many expected. After multiple QEs, LTROs, ZIRP and asset purchase programs, the economy remains very weak and future is compromised. Monetary inflation as a solution is an illusion: it relieves for a time  but creates more problems to be solved in the future. Keynesians and market monetarists fail to see it.  They are only focused on the very short term. Hayek, Mises and other austrians give a better insight of how an economy really works. In particular, the austrian theory of money is more relevant than its  competitors 2/Was or wasn't Hayek a liquidationist during the thirties? The thought of Hayek  is constantly distorted  by his intellectual ennemies. So, most of the time I pay little attention of what keynesians tell about non-keynesians. I prefer to focus on theoritical aspects.

  • JohnLott

    I was only able to read the first four pages because of what Machen noted above, but my recollection was that Hayek's Pure Theory of Capital argued that low interest rates caused longer term investments that didn't make much sense. Either the government keeps expanding the money supply or interest rates rise. If they rise, you have a liquidation of the longer term investments. Hayek wouldn't want to keep the interest rates down, so why is the liquidation argument wrong? Presumably I am missing something obvious?

  • Lord Keynes

    White is conflating two different views Hayek held at different points in his life. And it is obviously completely contradicted by the evidence:

    Moreover, by 1935 Hayek was advocating deficit-financed public works, but Hayek "the fiscalist" is also written out of history by most of the Austrians and free bankers!

  • Paul Marks

    The monetary expansion of the late 1920s (the Irving Fisher – Benjamin Strong "boom" where the credit-money was increased to keep the "price level stable") was indeed responsible for the "bust" of 1929 – and (yes) prices (and WAGES) should have been left to fall as "broad money" (bank credit) shrank back towards the "monetary base" (in this case – gold).

    HOWEVER, the above does NOT explain the Great Depression – the real reason for why the Great Depression was so different from (for example) the crash of 1921, was the government REACTION to the bust.

    In all previous economic busts (from 1819 to 1921) government had allowed markets (especially labour markets) to operate (to "clear") after the bust of 1929 Herbert "The Forgotten Progressive" Hoover did NOT allow this to happen (and neither did President Franklin Roosevelt).

    This is the reason the 1930s witnessed unprecedented levels of long term mass unemployment.

    World War II actually had markets clearing – but in a very weird way.

    War time price controls masked price rises (real prices were, of course, "Black Market" prices) – wages were not allowed to go up in the line with real (i.e. "Black Market") prices – because unions (which the government had so massively backed in the 1930s) suddenly had the ground swept out from under them (by the very government that had previously supported their contract breaking, obstruction and so on) – also the government introduced de facto wage controls (just as the National Socialists had in Germany after 1933),

    So the labour market did "clear" during World War II (which had not been ALLOWED to do in the 1930s) but in a very non free market way.

    Only in the late 1940s (under the so called "do nothing Congress") was something like a free market restored in the United States – a free market that had been undermined by HERBERT HOOVER (even before Franklin Roosevelt became President).

  • Justin Merrill

    Unrelated to Hayek's views, I noticed a huge error made by Krugman in his summary of Rand Paul's interview. Krugman claimed that Rand isn't an Austrian and prefers Milton Friedman to Hayek. If you actually read the interview both those claims by Krugman are clearly false.

    This just shows that the critics are being intellectually dishonest or they don't read at a third grade level. Just like when Brad DeLong makes public statements like quoting from Hoover's memoirs that Andrew Melon's recommended a liquidationist policy, without citing the very next page where Hoover states he rejected Melon's advice; or the time that DeLong criticized Mises for believing in labor and cost of production theories of price. There is no excuse for their mistakes.

  • Paul Marks

    Justin Merrill – you mean that Krugman was lying about Rand Paul? You shock me Sir!

    Sarcasm ends.

    As for Brad DeLong – his statements about the policies of Herbert "The Forgotten Progressive" Hoover, and the opinions of Ludwig Von Mises, are blatantly false.

    No "reasonable man" (to use a legal term) would believe that Brad DeLong is honestly in error – it is clear "beyond reasonable doubt" that he says things he knows to be false.

    As for Hayek and Rand Paul – there are NON ECONOMICS aspects of Hayek that Rand Paul certainly would reject (but there is no time to get into the agency versus determinism debate).

  • McKinney

    I lost a lot of respect for Friedman after reading this from Roger Garrison.

    "Friedman’s account of his differences with Hayek puts the “fine points of abstruse theory” into perspective: 'I am an enormous admirer of Hayek, but not for his economics. I think Prices and Production (1935) is a flawed book. I think his capital theory book [The Pure Theory of Capital (1941)] is unreadable. On the other hand, The Road to Serfdom (1944) is one of the great books of our time; (Ebenstein, 2001, p. 81)" Hayek and Friedman: Head to Head" by Roger W. Garrison.

    Pure Theory is difficult for people who understand only mainstream econ, but it is "readable" at worst, and brilliant at best.

  • Paul Marks

    Hayek has his faults on monetary policy (especially in old age, where he SOMETIMES loses sight of things he understood when younger, there is the same problem in Adam Smith although not in relation to monetary theory – in his middle years Adam Smith understood there is no "paradox of value" as we never value all "water" in relation to all "diamonds" we value a specific diamond in relation to a specific amount of water in a particular time and place).

    However. Hayek is vastly better at monetary theory than Milton Friedman is. Milton Friedman regarded Irving Fisher as the "greatest American economist of the 20th century" – in reality Irving Fisher was refuted by Frank Fetter (a person who wrote in the same tradition of thought as Hayek). Yet Milton Friedman falls for the Irving Fisher "keep the price level stable" fallacy – accepting that the money supply should be increased to keep this "general price level" "stable" – there are many fallacies locked into this sort of thinking (forgetting the importance of relative prices being only one of them).

    However, I must qualify the above.

    Eventually Milton Friedman agreed that the "monetary base" should be "frozen" because he came to the conclusion that POLITICALLY government could not be trusted with the power to increase the money supply.

    In theory Milton Friedman might remain a follower of Irving Fisher – but DECADES of experience had taught him that governments (around the world) could not be trusted with the power to increase the money supply.

    As for bank credit (so called "broad money").

    Sadly I believe that Milton Friedman lost sight of the original insights of the (original) Chicago School (and the "Currency School" of the early 19th century) that "broad money" (bank credit – the CREDIT BUBBLE) is not a good thing.

    This may be because of Milton Friedman's rejection of REASON and his insistence that a theory does not have to make sense as long as it "predicts".

    Milton Friedman's essays on "Positive" economics (in the early 1950s) are like a suicide note for economic theory (reasoning).

    In his popular work (such as the essays in Newsweek magazine – Milton Friedman took over from Henry Hazlitt, an Austrian School man) Milton Friedman still made arguments (based on reasoning), but in his theoretical work he (sadly) rejected reason – formally rejected it in the early 1950s essays on "Positive" economics.

    This is why when someone made the LOGICAL point that total lending (of all types) should not be greater than REAL savings of PHYSICAL money the eyes of such an "empirical" person as Milton Friedman would just glaze over.

    To them economics was not about basic reason (common sense), it was about mathematical models (or whatever).

    Again, I repeat, NOT all the time – but in certain key theoretical works.