Hayek, the Business Cycle and the Financial System

Hayek is difficult to read.  Monetary Theory and the Trade Cycle, published originally in 1929, is convoluted, torturous, complicated, et cetera.  Synonyms of these words would fittingly describe Friedrich Hayek’s writing style.  But, his insights are timeless and any economist interested in knowing and explaining truth is required to read this book.  Monetary Theory and the Trade Cycle is one of two books, and several long essays, included in the Ludwig von Mises Institute’s Prices & Production and Other Works.  Monetary Theory serves as a primer into Hayek’s monetary and capital theories.  In it, he takes the time to dismember opposing monetary theories of the trade cycle, discarding faulty analysis and maintaining sound foundations, as to lead to his own monetary theory of the trade cycle.  His trade cycle theory, largely based on the headway made in capital theory by Wicksell and Böhm-Bawerk, and Ludwig von Mises’ spectacular insights on monetary theory (The Theory of Money and Credit), is later further developed in Prices & Production, published in 1931.

While reading, you often find yourself stopping and asking yourself what you had just read.  The sentence structure is poorly constructed, and the text is very unclear.  Unless you really take the time to go back, re-read and make sure you understand, it is extremely easy to take what Hayek wrote out of context.  Alternatively, it also rather easy to misinterpret what Hayek wrote.  The topic covered by Friedrich Hayek was controversial (it was, and it still is), and so the temptation to misinterpret him increases by that much more.

In Chapter 4, “The Fundamental Cause of Cyclical Fluctuations”, he re-interprets Ludwig von Mises’ conclusions that it was central banking which caused the business cycle.  He does this to correct the error in many critics’ writing that what was to be called the “Austrian theory of the business cycle” was not exogenous, but endogenous.  That is, cyclical fluctuations are not a product of outside influence (i.e. central banking), but of factors inherent in the “existing credit organization”.[1] In other words, he specifies that business cycle are not the product of central banking per sé, but of fractional-reserve banking; he, of course, concedes that central banks usually make credit expansion much more widespread than it would have otherwise been.[2] The point of controversy is in whether or not the business cycle is intrinsic in the capitalist system.

Many “Austrians” before and after Friedrich Hayek maintain that fractional-reserve banking is not of natural ilk of the market.  Economists such as Ludwig von Mises[3], Murray Rothbard and Jesús Huerta de Soto operate under the strong belief that in a free market in banking fractional-reserve banking would be eradicated.  Monetary Theory was published in 1929, and it is very possible that Hayek’s opinions on banking changed in the years after, but at least at the time Hayek disagreed with these economists.

He wrote:

The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.

What he is saying is that the interest credit is lent at is not always the “equilibrium rate” (natural rate of interest), but an interest rate dictated by the expansion of fiduciary media as determined by the requirement of liquidity for each individual bank.  Unlike Mises, Hayek does not provide for natural limitations in credit expansion.  So, Hayek concludes later on:

If it were possible, as has been repeatedly asserted in recent English literature, to keep the total amount of bank deposits entirely stable, that would constitute the only means of getting rid of cyclical fluctuations.  This seems to us purely utopian.  It would necessitate the complete abolition of all bank money—i.e., notes and checks—and the reduction of the banks to the role of brokers, trading in savings.

He continues:

The stability of the economic system would be obtained at the price of curbing economic progress.

Certainly, Hayek provides much food for thought.  Previously, he asserted (not quoted above) that the existing “credit organization” was formed out of demand, and naturally.  This is a position held today by members of the so-called Free Banking school, which although defenders of a free market in the financial sector, maintain that fractional-reserve banking would be practiced. Now, there are several free bankers who disagree with the premise that credit expansion leads to business cycles; at least Hayek establishes that the business cycle is a product of fractional-reserve banking.  Nevertheless, Hayek’s beliefs as espoused in Monetary Theory and the Trade Cycle pose a dilemma.  Is the business cycle avoidable?

Given Hayek’s writing style—seemingly designed to confuse—it is not difficult to mistake his intentions.  However, it is possible that Friedrich Hayek wrote these words under the explicit intent to provide credibility to his argument by accepting the existing banking system.  So, rather than argue that the banking system could be reformed in such a way in which the business cycle would largely cease to exist, he conceded the point and simply focused on the topic of the monetary origins of such economic cycles.  Or, Hayek could have simply believed that fractional-reserve banking was a natural process of the market, and as such cyclic fluctuations were also natural processes of the market.

Certainly, Hayek makes some good points.  It is clear that by simply reading older generation of Austrian economists one cannot come to a suitable conclusion on whether or not fractional-reserve is “healthy”.  They provide good foundations to make one’s own deductions.  Hayek’s conclusions in Monetary Theory and the Trade Cycle make for good debate.  For example, Hayek believed that fractional-reserve banking sped up the process of economic progress.  If Hayek is right in his assertion that credit expansion makes capital-goods seem more profitable in relation to consumer-goods, and that this is the cause of malinvestment, he suggests that the majority of investment which takes place during a boom does not actually lead to economic progress.  Is he contradicting himself?  But, empirically, one can derive that during past booms there was plenty of economic progress.  Surely, after the necessary credit contraction stabilized, the economy was usually more advance than it was prior to the boom.  Does it follow that credit expansion leads to faster progress?  Or did the progress occur as a simultaneous phenomenon to the malinvestment created during the credit expansion?  These are examples of questions which must be debated if there is there ever to be consensus on whether or not fractional-reserve banking is healthy and is natural.

With the onslaught of Austrian literature on 100-percent reserve banking, mainly spearheaded by Hulsmann, Block and Huerta de Soto (all three influenced by Murray Rothbard), Hayek’s insights are surely important.  He brings to attention, to both the 100-percent reservists and the free bankers, several points which must be ironed out before an accurate theory on banking is completely laid out.

[1] Hayek (2008), pp. 75–78.

[2] For an explanation of credit expansion under different banking systems (single bank versus multiple banks versus a banking monopoly) see:  Huerta de Soto, Jesús, Money, Bank Credit and

[3] In Marxism Unmasked, Mises maintains that credit expansion would be kept to a minimum by natural means (fiduciary media would quickly be turned in to redeem their value in commodity money and the money supply restored to a stable volume).