II. The Misuse of Aggregates 1. INFLATIONISM

In 1931 Professor Hayek believed that the naïve inflationist view—that every expansion of monetary expenditure produces expansion in output—had been superseded; but this view was revived in 1936 by the General Theory which strengthened the ‘subtler inflationism’ against which he directed his attack.

While the more naïve forms of inflationism are sufficiently discredited today not to do much harm in the near future, contemporary economic thought is so much permeated by an inflationism of a subtler kind that it is to be feared that for some time we shall still have to endure the consequences of a good deal of dangerous tampering with currency and credit. It is my belief that some even of those doctrines which are generally accepted in this field have no other basis than an uncritical application to the problems of society in general of the experience of the individual, that what he needs is more money.¹

(Preface to first edition of Prices and Production)

2. NO CAUSAL CONNECTION BETWEEN MACRO TOTALS AND MICRO DECISIONS

Professor Hayek emphasises the operational significance of individual specific price changes in the real world; he also emphasises the ex post nature of such statistical constructs as averages and aggregates.

. . . What I complain of is not only that [the quantity] theory in its various forms has unduly usurped the central place in monetary theory, but that the point of view from which it springs is a positive hindrance to further progress. Not the least harmful effect of this particular theory is the present isolation of the theory of money from the main body of general economic theory. For so long as we use different methods for the explanation of values as they are supposed to exist irrespective of any influence of money, and for the explanation of that influence of money on prices, it can never be otherwise. Yet we are doing nothing less than this if we try to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production. For none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of non-monetary economic theory are based. It is to this ‘individualistic’ method that we owe whatever understanding of economic phenomena we possess; that the modern ‘subjective’ theory has advanced beyond the classical school in its consistent use is probably its main advantage over their teaching.

If, therefore, monetary theory still attempts to establish causal relations between aggregates or general averages, this means that monetary theory lags behind the development of economics in general. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning.

(Prices and Production, pp. 3–5)

3. FALLACY OF ‘THE’ PRICE LEVEL

Professor Hayek points out that the ex post statistical construct of a price index, which we call ‘the’ price level, is not a representation of reality—in the sense in which, say, the ‘observations’ of the physical sciences are such a representation. (He also refers—in 1937—to the serious monetary consequences of an attempt to offset by monetary policy downward inflexibility of prices and/or wage-rates.)

It is clear that in this case the argument for a national monetary system cannot rest on any peculiarities of the national money. It must rest, and indeed it does rest, on the assumption that there is a particularly close connection between the prices—and particularly the wages—within the country which causes them to move to a considerable degree up and down together compared with prices outside the country. This is frequently regarded as sufficient reason why, in order to avoid the necessity that the ‘country as a whole’ should have to raise or lower its prices, the quantity of money in the country should be so adjusted as to keep the ‘general price level’ within the country stable. I do not want to consider this argument yet. I shall later argue that it rests largely on an illusion, based on the accident that the statistical measures of price movements are usually constructed for countries as such; and that in so far as there are genuine difficulties connected with general downward adjustments of many prices, and particularly wages, the proposed remedy would be worse than the disease.

(Monetary Nationalism and International Stability, p. 7)

4. ECONOMIC SYSTEMS OVERLEAP NATIONAL BOUNDARIES

In tracing through the effects of a change in demand that crosses an international political boundary Professor Hayek shows the series of interconnected price and income changes it produces, emphasising the basic point that it is these interlinked changes in relative prices that constitute reality, rather than ‘movements’ in some statistical price-‘level’.

The important point in all this is that what wages and what prices will have to be altered in consequence of the initial change will depend on whether and to what extent the value of a particular factor or service, directly or indirectly, depends on the particular change in demand which has occurred, and not on whether it is inside or outside the same ‘currency area’. We can see this more clearly if we picture the series of successive changes of money incomes, which will follow on the initial shift of demand, as single chains, neglecting for the moment the successive ramifications which will occur at every link. Such a chain may either very soon lead to the other country or first run through a great many links at home. But whether any particular individual in the country will be affected will depend whether he is a link in that particular chain, that is whether he has more or less immediately been serving the individuals whose income has first been affected, and not simply on whether he is in the same country or not. In fact this picture of the chain makes it clear that it is not impossible that most of the people who ultimately suffer a decrease of income in consequence of the initial transfer of demand from A to B may be in B and not in A. This is often overlooked because the whole process is presented as if the chain of effects came to an end as soon as payments between the two countries balance. In fact however each of the two chains—that started by the decrease of somebody’s income in A, and that started by the increase of another person’s income in B—may continue to run on for a long time after they have passed into the other country, and may have even a greater number of links in that country than in the one where they started. They will come to an end only when they meet, not only in the same country but in the same individual, so finally offsetting each other. This means that the number of reductions of individual incomes and prices (not their aggregate amount) which becomes necessary in consequence of a transfer of money from A to B may actually be greater in B than in A.

Misleading Concepts of Prices and Incomes

This picture is of course highly unrealistic because it leaves out of account the infinite ramifications to which each of these chains of effects will develop. But even so it should, I think, make it clear how superficial and misleading the kind of argument is which runs in terms of the prices and the incomes of the country, as if they would necessarily move in unison or even in the same direction. It will be prices and incomes of particular individuals and particular industries which will be affected and the effects will not be essentially different from those which will follow any shifts of demand between different industries or localities.

This whole question is of course the same as that which I discussed in my first lecture in connection with the problem of what constitutes one monetary system, namely the question of whether there exists a particularly close coherence between prices and incomes, and particularly wages, in any one country which tends to make them move as a whole relatively to the price structure outside. As I indicated then, I shall not be able to deal with it more completely until later on. But there are two points which, I think, will have become clear now and which are important for the understanding of the contrast between the working of the homogeneous international currency we are considering, and the mixed system to which I shall presently proceed.

In the first place it already appears very doubtful whether there is any sense in which the terms inflation and deflation can be appropriately applied to these interregional or international transfers of money. If, of course, we define inflation and deflation as changes in the quantity of money, or the price level, within a particular territory, then the term naturally applies. But it is by no means clear that the consequences which we can show will follow if the quantity of money in a closed system changes will also apply to such redistributions of money between areas. In particular there is no reason why the changes in the quantity of money within an area should bring about those merely temporary changes in relative prices which, in the case of a real inflation, lead to misdirections of production—misdirections because eventually the inherent mechanism of these inflations tends to reverse these changes in relative prices.

(Monetary Nationalism and International Stability, pp. 21–24)

5. DANGERS OF ‘NATIONAL’ STABILISATION

This extract indicates the extent to which policies of national price-‘level’ ‘stabilisation’ may cumulatively produce international inflation. If prices in general are not permitted to fall in regions where a fall is necessitated by changes in circumstances, the only other method of securing such a relative decline is by a general rise in prices in all other regions.

Indeed, if we take a somewhat more realistic point of view, there can be little doubt what will happen. While, in the country where in consequence of the changes in international demand some prices will tend to fall the price level will be kept stable, it will certainly be allowed to rise in the country which has been benefited by the same shift in demand. It is not difficult to see what this implies if all countries in the world act on this principle. It means that prices would be stabilised only in that area where they tend to fall lowest relatively to the rest of the world, and that all further adjustments are brought about by proportionate increases of prices in all other countries. The possibilities of inflation which this offers if the world is split up into a sufficient number of very small separate currency areas seem indeed very considerable. And why, if this principle is once adopted, should it remain confined to average prices in particular national areas? Would it not be equally justified to argue that no price of any single commodity should ever be allowed to fall and that the quantity of money in the world should be so regulated that the price of that commodity which tends to fall lowest relatively to all others should be kept stable, and that the prices of all other commodities would be adjusted upwards in proportion? We only need to remember what happened, for instance, a few years ago to the price of rubber to see how such a policy would surpass the wishes of even the wildest inflationist. Perhaps this may be thought an extreme case. But, once the principle has been adopted, it is difficult to see how it could be confined to ‘reasonable’ limits, or indeed to say what ‘reasonable’ limits are.

But let us disregard the practical improbability that a policy of stabilisation will be followed in the countries where, with stable exchanges, the price level would rise, as well as in the countries where in this case it would have to fall. Let us assume that, in the countries which benefit from the increase of the demand, the prices of other goods are actually lowered to preserve stability of the national price level and that the opposite action will be taken in the countries from which demand has turned away. What is the justification and significance of such a policy of national stabilisation?

Theoretical Case Not Argued

Now it is difficult to find the theoretical case for national stabilisation anywhere explicitly argued. It is usually just taken for granted that any sort of policy which appears desirable in a closed system must be equally beneficial if applied to a national area. It may therefore be desirable, before we go on to examine its analytical justification, to trace the historical causes which have brought this view to prominence. There can be little doubt that its ascendancy is closely connected with the peculiar difficulties of English monetary policy between 1925 and 1931. In the comparatively short space of the six years during which Great Britain was on a gold standard in the post-war period, it suffered from what is known as overvaluation of the pound. Against all the teaching of ‘orthodox’ economics—already a hundred years before Ricardo had expressly stated that he ‘should never advise a government to restore a currency, which was depreciated 30 p.c., to par’²—in 1925 the British currency had been brought back to its former gold value. In consequence, to restore equilibrium, it was necessary to reduce all prices and costs in proportion as the value of the pound had been raised. This process, particularly because of the notorious difficulty of reducing money wages, proved to be very painful and prolonged. It deprived England of real participation in the boom which led up to the crisis of 1929, and, in the end, its results proved insufficient to secure the maintenance of the restored parity. But all this was not due to an initial shift in the conditions of demand or to any of the causes which may affect the condition of a particular country under stable exchanges. It was an effect of the change in the external value of the pound. It was not a case where with given exchange rates the national price or cost structure of a country as a whole had got out of equilibrium with the rest of the world, but rather that the change in the parities had suddenly upset the relations between all prices inside and outside the country.

Relative Price and Cost Structures

Nevertheless this experience has created among many British economists a curious prepossession with the relations between national price- and cost- and particularly wage-levels, as if there were any reason to expect that as a rule there would arise a necessity that the price and cost structure of one country as a whole should change relatively to that of other countries. And this tendency has received considerable support from the fashionable pseudo-quantitative economics of averages with its argument running in terms of national ‘price levels’, ‘purchasing power parities’, ‘terms of trade’, the ‘Multiplier’, and what not.

The purely accidental fact that these averages are generally computed for prices in a national area is regarded as evidence that in some sense all prices of a country could be said to move together relatively to prices in other countries.³ This has strengthened the belief that there is some peculiar difficulty about the case where ‘the’ price level of a country had to be changed relatively to its given cost level and that such adjustment had better be avoided by manipulations of the rate of exchange.

Now let me add immediately that of course I do not want to deny that there may be cases where some change in conditions might make fairly extensive reductions of money wages necessary in a particular area if exchange rates are to be maintained, and that under present conditions such wage reductions are at best a very painful and long drawn out process. At any rate in the case of countries whose exports consist largely of one or a few raw materials a severe fall in the prices of these products might create such a situation. What I want to suggest, however, is that many of my English colleagues, because of the special experience of their country in recent times, have got the practical significance of this particular case altogether out of perspective: that they are mistaken in believing that by altering parities they can overcome many of the chief difficulties created by the rigidity of wages and, in particular, that by their fascination with the relation between ‘the’ price level and ‘the’ cost level in a particular area they are apt to overlook the much more important consequences of inflation and deflation.⁴

(Monetary Nationalism and International Stability, pp. 42–46)

6. MONETARY DANGER OF COLLECTIVE BARGAINING

This extract is noteworthy for its prediction, in 1937, of the process of wage-inflation of the 1950s and 1960s.

While the whole idea of a monetary policy directed to adjust everything to a ‘given’ wage level appears to me misconceived on purely theoretical grounds, its consequences seem to me to be fantastic if we imagine it applied to the present world where this supposedly given wage level is at the same time the subject of political strife. It would mean that the whole mechanism of collective wage bargaining would in the future be used exclusively to raise wages, while any reduction—even if it were necessary only in one particular industry—would have to be brought about by monetary means. I doubt whether such a proposal could ever have been seriously entertained except in a country and in a period where labour has been for long on the defensive.⁵ It is difficult to imagine how wage negotiations would be carried on if it became the recognised duty of the monetary authority to offset any unfavourable effect of a rise in wages on the competitive position of national industries on the world market. But of one thing we can probably be pretty certain: that the working class would not be slow to learn that an engineered rise of prices is no less a reduction of wages than a deliberate cut of money wages, and that in consequence the belief that it is easier to reduce by the roundabout method of depreciation the wages of all workers in a country than directly to reduce the money wages of those who are affected by a given change, will soon prove illusory.

(Monetary Nationalism and International Stability, pp. 52–53)

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¹This theme is elaborated in item 18 below.

²In a letter to John Wheatley, dated 18 September, 1821, reprinted in Letters of David Ricardo to Hutches Trower and Others, edited by J. Bonar and J. Hollander (Oxford, 1899), p. 160.

³The fact that the averages of (more or less arbitrarily selected) groups of prices move differently in different countries does of course in no way prove that there is any tendency of the price structure of a country to move as a whole relatively to prices in other countries. It would however be a highly interesting subject for statistical investigation, if a suitable technique could be devised, to see whether, and to what extent, such a tendency existed. Such an investigation would of course involve a comparison not only of some mean value of the price changes in different countries, but of the whole frequency distribution of relative price changes in terms of some common standard. And it should be supplemented by similar investigations of the relative movements of the price structure of different parts of the same country.

⁴The propensity of economists in the Anglo-Saxon countries to argue exclusively in terms of national price and wage levels is probably mainly due to the great influence which the writings of Professor Irving Fisher have exercised in these countries. Another typical instance of the dangers of this approach is the well-known controversy about the reparations problem, where it was left to Professor Ohlin to point out against his English opponents that what mainly mattered was not so much effects on total price levels but rather the effects on the position of particular industries.

⁵It is interesting to note that those countries in Europe where up to 1929 wages had been rising relatively most rapidly were on the whole those most reluctant to experiment with exchange depreciation. The recent experience of France seems also to suggest that a working class government may never be able to use exchange depreciation as an instrument to lower real wages.