Lesson 4 of 7
The contraction after
A fall in the quantity of money following a crisis is a different thing from the correction of the structure. The school disagrees sharply about it.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Two different things happen in a contraction: the structure of production is rearranged, and the quantity of money may fall. The theory's core claim is about the first.
- Hayek, writing in 1935, said the deflationary tendencies are not a necessary consequence of a crisis but are probably due to resistance to the required readjustment, and that he was far from underrating them.
- Rothbard argued the opposite in 1963: that the deflation and the price fall have positively beneficial effects. The disagreement is real and neither side is settled here.
Separating these two processes is the single most useful thing a reader can do with this literature, because almost every argument about it turns on people conflating them.
Two processes in one contraction
The primary adjustment
- Capital committed to the wrong stages is written down or redeployed.
- Prices of higher-order goods fall relative to lower-order ones.
- Factors move between stages.
- This is what the boom course's mechanism was about.
The secondary contraction
- Lending stops, deposits are not renewed, the quantity of money falls.
- Prices fall generally, not just relatively.
- Debts fixed in money become heavier.
- Whether this helps, hurts or does nothing is disputed.
Conflating these two is how most of the argument about this theory goes wrong.
Hayek in the 1930s
His reply to Hansen and Tout, published in Econometrica in April 1934 and reprinted as the appendix to the second edition of Prices and Production, makes the separation explicitly. He distinguishes the tendencies set up directly by a monetary change from the effects of further monetary changes that may, and probably will, but need not, be induced by the first.
His statement about the deflationary tendencies is careful. They are not a necessary consequence of any crisis and depression, but are probably due to resistances to the necessary readjustments caused by the rigidity of prices and the existence of long-term contracts. He adds that he is far from underrating the importance of these phenomena, and that what he is asking for is that they be kept analytically separate rather than confused with one another.
So even in the 1930s the position is not that the contraction in money is harmless. It is that it is a different question.
Rothbard in 1963
He takes the other side, and does not hedge. In the first chapter of America's Great Depression he writes that almost all economists take a gloomy view of the secondary deflation and the price fall and assert that these unnecessarily aggravate the severity of depressions, and that this view is incorrect: the processes not only do not aggravate the depression but have positively beneficial effects.
His reasons are that a general price fall is how an increased demand for money gets satisfied, that the demand for money falls again once liquidation is complete, and that the primary adjustment turns on relative prices and is unaffected if all prices fall to some degree.
Why the disagreement matters
Because the two positions imply different readings of the same historical episode. If the secondary contraction is a separate harm, then an account of a depression has to explain the monetary collapse as well as the misallocation, and the monetarist account in the next course becomes a complement rather than a rival. If it is benign, it does not.
Neither position is adopted here. The next lesson is one of the two authors above changing his mind in public.
Check yourself
What did Hayek say in the 1930s about deflationary tendencies?
- That they are a necessary part of every crisis
- That they are not a necessary consequence of a crisis but probably follow from resistance to the required readjustment, and that he was far from underrating them
- That they do not exist
Show the answer
Answer: B.
His stated aim in that appendix is that the direct effects and the induced monetary changes be kept analytically separate rather than confused.What position did Rothbard take in 1963?
- That the secondary deflation should be offset by the central bank
- That the deflation and the general price fall have positively beneficial effects rather than aggravating the depression
- That deflation has no effect either way
Show the answer
Answer: B.
His reasons are that a price fall satisfies an increased demand for money, that the demand falls again once liquidation ends, and that the primary adjustment is about relative prices.Why does the disagreement change how an episode is read?
- Because it changes the dates of the contraction
- Because if the secondary contraction is a separate harm, an account must explain the monetary collapse as well as the misallocation
- Because it determines the interest rate
Show the answer
Answer: B.
On that reading the monetarist account of a depression becomes a complement rather than a rival, which is exactly what the next course tests.Sources
- Hayek, 'Capital and Industrial Fluctuations: A Reply to a Criticism', published in Econometrica in April 1934 and reprinted as the appendix to the second edition of Prices and Production, 1935, for the distinction between tendencies set up directly by a monetary change and induced further monetary changes, for the statement that deflationary tendencies are not a necessary consequence of any crisis and depression but are probably due to resistances caused by price rigidity and long-term contracts, and for his saying he is far from underrating their importance.
- Rothbard, America's Great Depression, 1963, part one, chapter 1, section on secondary features of depression, for the claim that the secondary deflation and price fall do not aggravate a depression but have positively beneficial effects, and for the three reasons he gives.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The two firms and the 200m of debt are invented and describe no company.
- This lesson reports a disagreement between two named authors and adopts neither position. No view is taken here on what a central bank or a government should do in a contraction.