The Bank for International Settlements Falls into a Hayekian Trap

On April 9, 1975, F. A. Hayek, having recently received the Nobel Prize in economics, was invited to give a talk to a group of distinguished economists at the American Enterprise Institute in Washington DC. He was introduced by his old friend and colleague from Vienna, Gottfried Haberler. During his talk, Hayek pointed out that although a downturn can be triggered by microeconomic factors causing a lack of correspondence between the distribution of demand across products and industries and the distribution of labor across products and industries.

These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due ot some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, somewhat misleadingly, we call an equilibrium structure, and second, that labor is reallocated according to these new prices.

Lacking such price readjustment and resource reallocation, the original unemployment may then spread by means of the mechanism I have discussed before, the “secondary contraction,” as I used to call it. In this way, unemployment may eventually become general.

In the subsequent discussion, Haberler asked Hayek to elaborate on the concept of a “secondary contraction,” and the appropriate policy response to such a phenomenon. Haberler asked:

I was very glad you said that you find some justification in the view that depressions are aggravated by a cumulative spiral and that there is such a thing as a secondary deflation. Don’t you think that it is possible to do something about that aggravation without recreating the fundamental maladjustments which, in your opinion, caused the depression.

Hayek replied:

I hope I implied this. The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose.

Later in the discussion, Haberler again pressed Hayek on his position regarding a downward deflationary spiral such as occurred in the 1930s. Hayek responded to Haberler as follows:

You ask whether I have changed my opinion about combatting secondary deflation. I do not have to change my theoretical views. As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market.

In a terrific commentary on the recent annual report of the Bank for International Settlements, Ryan Avent disposes of the arguments offered by the BIS for tightening current monetary policies.

I was especially struck by the following passage, quoted by Avent, from the report.

Although central banks in many advanced economies may have no choice but to keep monetary policy relatively accommodative for now, they should use every opportunity to raise the pressure for deleveraging, balance sheet repair and structural adjustment by other means.

Here, in another, slightly less ferocious, guise, is the deflationary argument that Hayek himself disavowed nearly 40 years ago: that secondary deflation could be used to “break the growing rigidity of wage rates,” or in updated BIS terminology could “raise the pressure for deleveraging, balance sheet repair and structural adjustment.”

Plus ca change, plus c’est la meme chose.