There has been some debate over whether Hayek was a liquidationist. Paul Krugman fired the opening salvo by quoting Friedman and Hayek, and Larry White’s response has led to discussion. Daniel Kuehn writes that while Hayek did advocate stabilizing nominal income, some of his other arguments are indeed liquidationist, and the former doesn’t make the latter irrelevant. I think people are talking over each other, but it also seems to me that those who emphasize Hayek’s support for nominal income targeting are side stepping the fact that Hayek was a liquidationist.

Let’s call the business cycle a “trade cycle.” This term helps emphasize one empirical similarity between most cycles in economic activity: a fall in the volume of trade. What causes a reduction in the volume of trade is a shortage of money. To see why this is, assume that the money stock at time t 0 is equal to M. At time t 1 , the demand for money rises to M+N. Instead of buying non-monetary goods, those seeking to increase their cash balances hoard money. In a world of money neutrality, this wouldn’t matter, because all prices would fall simultaneously and proportionally, such that everybody’s real cash balances would be restored. But, we live in a world where money is not neutral, and this is bound to create price stickiness and a decline in output. Hayek advocated stabilizing nominal income to avoid this problem, since this issue is not related to the malinvestment problem predicted by his business cycle model.

Where Hayek was a liquidationist was in the pattern of trade. Hayek wanted the level of activity to remain the same; he just advocated a re-arrangement of the allocation of inputs. A highly stylized example would be the reallocation of inputs from the earliest stage of production to the last stage of production, sacrificing some amount of producers’ good output in favor of consumers’ good output. For these inputs to become available, those who own them must liquidate: they have to sell their assets to others.

This is another reason why I like to illustrate Hayek’s model with the traditional definition of the production possibilities frontier,

What the PPF shows are all possible output combinations given some supply of inputs. Suppose that the point on the curve closer to the y-axis represents a combination of output that reflects society’s preferences, and that the move towards the new point closer to the x-axis is caused by an excess supply of money. This represents a change in the allocation of inputs. Hayek’s business cycle theory, then, argues that the recession is a movement back to the original point. (The fluctuation in employment occurs because while the initial move was gradual, the later move is affected by a demand shock [capital consumption — re-allocations in the flow of income cause part of the capital stock to lose value].)

To summarize the two causes of liquidationism discussed here,

What Hayek advocated: a reallocation of inputs (a movement on the PPF); What Hayek did not advocate: a shift of the PPF to the left and within the bounds of the original frontier.

Of course, the first kind of liquidationism is still not something advocated by anybody other than Austrians, and maybe some other heterodox schools. Austrians should accept this, because it follows from their business cycle theory. Austrians see the bust as a natural product of the boom, and this belief is rare amongst economists (it’s true, though, that recent focus on the movement of credit and a late adoption of Minsky’s ideas has led people to revisit this premise). If the root of the bust is in the boom, then it’s clear that part of the bust must deal with reversing the damages of a misallocation of resources during the preceding years.

It should be mentioned, though, that nominal income stabilization was not the only “counter-cyclical policy” advocated by Hayek. He also advocated an increase in savings. This essentially means that peoples’ preferences will change such that the equilibrium point shifts down the PPF, towards (in the above graph) the x-axis. This would save the economy from a transition back towards an increase in the production of consumers’ goods, and would allow much of the capital structure that came about during the boom to remain intact. This recommendation is the exact opposite of the Keynesian policy, which is to stimulate consumption. Hayek argued that this latter policy would increase unemployment, because it would require some time for specialized labor in the early stages to retrain for employment in later stages.

In any case, Hayek was a liquidationist, but he advocated specific forms of liquidation and opposed other processes (i.e. those caused by shortages of money). This time, Krugman is right. But, Austrians shouldn’t be ashamed and they shouldn’t try to cover it up.

Update:

Blogger Lord Keynes has some doubts whether Hayek really advocated stabilizing MV. I more-or-less agree with him. In “Hayek’s Monetary Theory and Policy: A Critical Reconstruction,” Lawrence White writes that as late as 1928 Hayek was skeptical of changes in the money supply as responses to changes in demand. By 1933, as we know, Hayek’s views changed, and he recommended stabilizing nominal income. What is more ambiguous is what Hayek had in mind for counter-cyclical monetary policy. Late in his life, he argued that monetary deflation ought to be avoided, but he wasn’t as explicit during the 1930s. I’d argue that what Austrian theory tells us about this is still ambiguous. This is one more reason why we need to develop a formal model, so that we can think through these things with some consistency.