[This was originally published in Jesús Huerta de Soto's book, Money, Bank Credit and Economic Cycles. A free version, as a PDF, can be found on this website.]
Monetarists not only overlook the role time and stages play in the economy’s productive structure. They also accept a mechanistic version of the quantity theory of money, a version they base on an equation which supposedly demonstrates the existence of a direct causal link between the total quantity of money in circulation, the “general level” of prices and total production. The equation is as follows:
MV = PT
where M is the stock of money, V the “velocity of circulation” (the number of times the monetary unit changes hands on average in a certain period), P the general price level, and T the “aggregate” of all quantities of goods and services exchanged in a year.
Supposing the “velocity of circulation” of money remains relatively constant over time, and the gross national product approximates that of “full employment”, monetarists believe money is neutral in the long run, and that therefore an expansion of the money supply (M) tends to proportionally raise the corresponding general price level. In other words, though in nominal terms the different factor incomes and production and consumption prices may increase by the same percentage as the money supply, in real terms they remain the same over time. Hence monetarists believe inflation is a monetary phenomenon that affects all economic sectors uniformly and proportionally, and that therefore it does not disrupt or discoordinate the structure of productive stages. It is clear that the monetarist viewpoint is purely “macroeconomic” and ignores the microeconomic effects of monetary growth on the productive structure. As we saw in the last section, this approach stems from the lack of a capital theory which takes the time factor into account.
The English economist R.G. Hawtrey, a main exponent of the Monetarist School in the early twentieth century, is one whose position illustrates the theoretical difficulties of monetarism. In his review of Hayek’s book, Prices and Production, which appeared in 1931, Hawtrey expressed his inability to understand the book. To comprehend this assertion, one must take into account that Hayek’s approach presupposes a capital theory; but monetarists lack such a theory and therefore fail to grasp how credit expansion affects the productive structure. Furthermore against all empirical evidence, Hawtrey declares that the first symptom of all depressions is a decline in sales in the sector of final consumer goods, thus overlooking the fact that a much sharper drop in the price of capital goods always comes first. Thus the prices of consumer goods fluctuate relatively little throughout the cycle when compared to those of capital goods produced in the stages furthest from consumption. Moreover, in keeping with his monetarist position, Hawtrey believes credit expansion gives rise to excess monetary demand which is uniformly distributed among all goods and services in society.
More recently other monetarists have also revealed their lack of an adequate capital theory and have thus expressed the same bewilderment as Hawtrey with respect to studies on the effects of monetary expansion on the productive structure. Milton Friedman and Anna J. Schwartz, in reference to the possible effects of money on the productive structure, state:
We have little confidence in our knowledge of the transmission mechanism, except in such broad and vague terms as to constitute little more than an impressionistic representation rather than an engineering blueprint. (Friedman, The Optimum Quantity of Money and Other Essays)
Furthermore, surprisingly, these authors maintain that no empirical evidence exists to support the thesis that credit
expansion exerts an irregular effect on the productive structure. Therefore they disregard not only the theoretical analysis presented in detail here, but also the different empirical studies reviewed in the last chapter. Such studies identify typical, empirical features which largely coincide with those observed in all cycles from the time they began.
Friedrich A. Hayek stated that his
chief objection against [monetarist] theory is that, as what is called a “macrotheory,” it pays attention only to the effects of changes in the quantity of money on the general price level and not to the effects on the structure of relative prices. In consequence, it tends to disregard what seems to me the most harmful effects of inflation: the misdirection of resources it causes and the unemployment which ultimately results from it. (Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas)
It is easy to understand why a theory such as the one monetarists hold, which is constructed in strictly macroeconomic terms with no analysis of underlying microeconomic factors, must ignore not only the effects of credit expansion on the productive structure, but also, in general, the ways in which “general price level” fluctuations influence the structure of relative prices. Rather than simply raise or lower the general price level, fluctuations in credit constitute a “revolution” which affects all relative prices and eventually provokes a crisis of malinvestment and an economic recession. The inability to perceive this fact led the American economist Benjamin M. Anderson to assert that the fundamental flaw in the quantity theory of money is merely that it conceals from the researcher the underlying microeconomic phenomena influenced by variations in the general price level. Indeed monetarists content
themselves with the quantity theory’s equation of exchange, deeming all important issues to be adequately addressed by it and subsequent microeconomic analyses to be unnecessary.
The above sheds light on monetarists’ lack of a satisfactory theory of economic cycles and on their belief that crises and depressions are caused merely by a “monetary contraction.” This is a naive and superficial diagnosis which confuses the cause with the effect. As we know, economic crises arise because credit expansion and inflation first distort the productive structure through a complex process which later manifests itself in a crisis, monetary squeeze, and recession. Attributing crises to a monetary contraction is like attributing measles to the fever and rash which accompany it. This explanation of cycles can only be upheld by the scientistic, ultraempirical methodology of monetarist macroeconomics, an approach which lacks a temporal theory of capital.
Furthermore not only are monetarists incapable of explaining economic recessions except by resorting to the effects of the monetary contraction; they have also been unable to present any valid theoretical argument against the Austrian theory of economic cycles: they have simply ignored it or, as Friedman has done, have only mentioned it in passing, falsely indicating that it lacks an “empirical” basis. Thus David Laidler, in a recent critique of the Austrian theory of the cycle, had no choice but to turn to the old, worn-out Keynesian arguments which center on the supposedly healthy influence of effective demand on real income. The basic idea is this: that an increase in effective demand could ultimately give rise to an increase in income, and hence, supposedly, in savings, and that therefore the artificial lengthening based on credit expansion could be maintained indefinitely, and the process of poor allocation of resources would not necessarily reverse in the form of a recession. The essential error in Laidler’s argument was clearly exposed by Hayek in 1941, when he explained that the only possible way for production processes financed by credit expansion to be maintained without a recession would be for economic agents to voluntarily save all new monetary income created by banks and used to finance such processes. The Austrian theory of the cycle suggests that cycles occur when any portion of the new monetary income (which banks create in the form of loans and which reaches the productive structure) is spent on consumer goods and services by the owners of capital goods and the original means of production. Thus the spending of a share on consumption, which is surely always the case, is sufficient to trigger the familiar microeconomic processes which irrevocably lead to a crisis and recession. In the words of Hayek himself:
All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumers’ goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumers’ goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income, and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved. (Hayek, Pure Theory of Capital)
It is interesting to note that one of today’s most prominent monetarists, David Laidler, is forced to resort to Keynesian arguments in a fruitless attempt to criticize the Austrian theory of economic cycles. Nevertheless the author himself correctly recognizes that from the standpoint of the Austrian theory, the differences between monetarists and Keynesians are merely trivial and mostly apparent, since both groups apply very similar “macroeconomic” methodologies in their analyses.
The above reflections on monetarism (its lack of a capital theory and the adoption of a macroeconomic outlook which masks the issues of true importance) would not be complete without a criticism of the equation of exchange, MV=PT, on which monetarists have relied since Irving Fisher proposed it in his book, The Purchasing Power of Money. Clearly this “equation of exchange” is simply an ideogram which rather awkwardly represents the relationship between growth in the money supply and a decline in the purchasing power of money. The origin of this “formula” is a simple tautology which expresses that the total amount of money spent on transactions conducted in the economic system during a certain time period must be identical to the quantity of money received on the same transactions during the same period (MV=?pt). However monetarists then take a leap in the dark when they assume the other side of the equation can be represented as PT, where T is an absurd “aggregate” which calls for adding up heterogeneous quantities of goods and services exchanged over a period of time. The lack of homogeneity makes this an impossible sum. Mises also points out the absurdity of the concept of “velocity of money,” which is defined simply as the variable which, dependent on the others, is necessary to maintain the balance of the equation of exchange. The concept makes no economic sense because individual economic agents cannot possibly act as the formula indicates.
Therefore the fact that monetarists’ equation of exchange makes no mathematical or economic sense reduces it to a mere ideogram at most, or, as the Shorter Oxford English Dictionary puts it, “a character or figure symbolizing the idea of a thing without expressing the name of it, as the Chinese characters, etc.” This ideogram contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure. The harmful, false notion that money is neutral results. However, as early as 1912, Ludwig von Mises demonstrated that all increases in the money supply invariably modify the structure of relative prices of goods and services. Aside from the purely imaginary case in which the new money is evenly distributed among all economic agents, it is always injected into the economy in a sequential manner and at various specific points (via public expenditure, credit expansion, or the discovery of new gold reserves in particular places). To the extent this occurs, only certain people will be the first to receive the new monetary units and have the chance to purchase new goods and services at prices not yet affected by monetary growth. Thus begins a process of income redistribution in which the first to receive the monetary units benefit from the situation at the expense of all other economic agents, who find themselves purchasing goods and services at rising prices before any of the newly-created monetary units reach their pockets. This process of income redistribution not only inevitably alters the “structure” of economic agents’ value scales but also their weights in the market, which can only lead to changes in society’s entire structure of relative prices. The specific characteristics of these changes in cases where monetary growth derives from credit expansion have been covered in detail in previous chapters.
What policy do monetarists advocate to prevent and counter crises and economic recessions? They generally confine themselves to recommending policies that merely treat the symptoms, not the ultimate causes, of crises. In other words they suggest increasing the quantity of money in circulation, and thus reinflating the economy to fight the monetary contraction which, to a greater or lesser degree, always takes place following the crisis. They fail to realize that this macroeconomic policy hinders the liquidation of projects launched in error, prolongs the recession and may eventually lead to stagflation, a phase we have already analyzed. In the long run, as we know, the expansion of new loans during a crisis can, at most, only postpone the inevitable arrival of the recession, making the subsequent readjustment even more severe. As Hayek quite clearly states:
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. (Hayek, “A Rejoinder to Mr. Keynes”, Economica 11, no. 4)
Finally, some monetarists propose the establishment of a constitutional rule which would predetermine the growth of
the money supply and “guarantee” monetary stability and economic growth. However this plan would also be ineffective in averting economic crises if new doses of money continued, to any degree, to be injected into the system through credit expansion. In addition whenever a rise in general productivity “required” increased credit expansion to stabilize the purchasing power of money, this action would trigger and intensify all of the processes which inexorably lead to investment errors and crisis, and which monetarists are incapable of understanding, due to the obvious deficiencies in the macroeconomic analytical tools they use.
