In his recent Hayek vs Keynes article, when Mario Rizzo says, “Hayek probably should have emphasized more that his theory implied the need to avoid a “secondary deflation” during the bust period. Increases in the demand to hold money should be offset by the banking system” lots of folks might ask, what is Rizzo talking about? Steve Horwitz explains:
… [when a credit induced misallocation boom has led to an unavoidable bust] “primary” adjustment of prices and reallocation of resources needs to take place, but what needs to be avoided is the velocity-induced *secondary* deflation that might or might not follow ..
By the time [Prices & Production] rolls around, Hayek is pretty clear that the rule to guide monetary policy is to stabilize MV. This means that IF the demand for money is rising (V is falling), the monetary system should react by increasing M to maintain the flow of expenditures and nominal GDP.
One can be in an Austrian “bust” in which V is not falling notably, in which case all kinds of prices adjustments need to and are taking place. In such a situation, Hayek’s rule would say the monetary authority should do nothing. It should allow all of those adjustments, including firms going out of business etc, to take place.
However, if the bust includes a notable decline in velocity (as was the case in 29-33), then Hayek’s rule says the money supply should be increased accordingly. This does not cause all of the distortions Nikolaj claims because those additions prevent the bust from turning catastrophic through a total collapse of the expenditure flow. Those additions supply the desired money holdings the public wishes to have, leaving them free to spend as they would have during the bust under the first scenario above.
The goal is not to get back to the inflated world of the boom, but rather to enable the corrections of the bust to take place without the deflationary death spiral kicking in.
The reason why Hayek, looking back, said he messed up during the Depression is because he didn’t recognize how severe the decline in V was. Had he realized it at the time, he would have not made his criticisms of expanding the money supply. That is clear by his own admission and by the implications of the MV rule that he adopts in the 30s.
If you want to criticize modern monetary equilibrium Austrians, you’ll have to forget everything Hayek wrote after the early/mid-30s when he clearly articulated that standard. He didn’t apply it to the Great Depression at the time only because he didn’t think, empirically, the historical reality was that V was falling so hard.
He was right on the theory but wrong on the data at the time. He also had the integrity to admit it later. ME Austrians are just trying to make sure that error isn’t repeated …
Here’s Hayek in P&P (108-109):
“It does not seem open to doubt that the amount of money necessary to carry on the trade of a country fluctuates regularly with the seasons, and that central banks should respond to these changes in the ” demand for money “, that not only can they do this without doing harm, but that they must do so if they are not to cause serious disturbances. It is also a fact which has been established by long experience, that in times of crisis central banks should give increased accommodation and extend thereby their circulation in order to prevent panics, and that they can do it to a great extent without effects which are injurious.”
and better yet on 121:
“But I think that what I have already said on this point will be sufficient to justify the conclusion that changes in the demand for money caused by changes in the proportion between the total flow of goods to that part of it which is effected by money, or, as we may tentatively call that proportion, of the co-efficient of money transactions, should be justified by changes in the volume of money if money is to remain neutral towards the price system and the structure of production.”