9. The Policy of General-Price-Level Stabilization and its Destabilizing Effects on the Economy

Theorists are particularly interested in the following question, which has carried practical significance in the past and appears to be acquiring it again: If the banking system brings about credit expansion unbacked by real saving, and as a result the money supply increases, but just enough to maintain the purchasing power of money (or the “general price level”), then does the recession we are analyzing in this chapter follow? This question applies to those economic periods in which productivity jumps due to the introduction of new technologies and entrepreneurial innovations, and to the accumulation of capital wisely invested by diligent, insightful entrepreneurs.²⁴ As we have seen, when bank credit is not artificially expanded and the quantity of money in circulation remains more or less constant, growth in voluntary saving gives rise to a widening (lateral) and lengthening (longitudinal) of the capital goods stages in the productive structure. These stages can be completed with no problem, and once concluded, they yield a new rise in the quantity and quality of final consumer goods and services. This increased production of consumer goods and services must be sold to a decreased monetary demand (which has fallen by precisely the amount saving has risen), and consequently the unit prices of consumer goods and services tend to decline. This reduction is always more rapid than the possible drop in the nominal income of the owners of the original means of production, whose income therefore increases very significantly in real terms.

The issue we now raise is whether or not a policy aimed at increasing the money supply by credit expansion or another procedure, and at maintaining the price level of consumer goods and services constant, triggers the processes which lead to intertemporal discoordination among the different economic agents, and ultimately, to economic crisis and recession. The American economy faced such a situation throughout the 1920s, when dramatic growth in productivity was nevertheless not accompanied by the natural decline in the prices of consumer goods and services. These prices did not fall, due to the expansionary policy of the American banking system, a policy orchestrated by the Federal Reserve to stabilize the purchasing power of money (i.e., to prevent it from rising).²⁵

At this point it should be evident that a policy of credit expansion unbacked by real saving must inevitably set in motion all of the processes leading to the eruption of the economic crisis and recession, even when expansion coincides with an increase in the system's productivity and nominal prices of consumer goods and services do not rise. Indeed the issue is not the absolute changes in the general price level of consumer goods, but how these changes evolve in relative terms with respect to the prices of the intermediate products from the stages furthest from consumption and of the original means of production. In fact in the 1929 crisis, the relative prices of consumer goods (which in nominal terms did not rise and even fell slightly) escalated in comparison with the prices of capital goods (which plummeted in nominal terms). In addition the overall income (and hence, profits) of the companies close to consumption soared throughout the final years of the expansion, as a result of the substantial increase in their productivity. Their goods were sold at constant nominal prices in an environment of great inflationary expansion. Therefore the factors which typically trigger the recession (relative growth in profits in consumption and a mounting interest rate), including the “Ricardo Effect,” are equally present in an environment of rising productivity, insofar as increased profits and sales in the consumer sector (more than the jump in nominal prices, which at that point did not take place) reveal the decline in the relative cost of labor in that sector.

The theoretical articles Hayek wrote on the occasion of his first scholarly trip to the United States in the 1920s were aimed at analyzing the effects of the policy of stabilizing the monetary unit. Fisher and other monetarists sponsored the policy, and at that time its effects were considered harmless and very beneficial to the economic system. Upon analyzing the situation in the United States, Hayek arrives at the opposite conclusion and presents it in his well-known article, “Intertemporal Price Equilibrium and Movements in the Value of Money,” published in 1928.²⁶ There Hayek demonstrates that a policy of stabilizing the purchasing power of the monetary unit is incompatible with the necessary function of money with respect to coordinating the decisions and behaviors of economic agents at different points in time. Hayek explains that if the quantity of money in circulation remains constant, then in order to maintain intertemporal equilibrium among the actions of the different economic agents, widespread growth in the productivity of the economic system must give rise to a drop in the price of consumer goods and services, i.e., in the general price level. Thus a policy which prevents an upsurge in productivity from reducing the price of consumer goods and services inevitably generates expectations on the maintenance of the price level in the future. These expectations invariably lead to an artificial lengthening of the productive structure, a modification bound to reverse in the form of a recession. Although in 1928 Hayek had yet to make his polished contributions of the 1930s, writings which we have used in our analysis and which make this phenomenon much easier to understand, it is especially commendable that at that point he arrived at the following conclusion (in his own words):

[I]t must be assumed, in sharpest contradiction to the prevailing view, that it is not a deficiency in the stability of the purchasing power of money that constitutes one of the most important sources of disturbances of the economy from the side of money. On the contrary, it is the tendency peculiar to all commodity currencies to stabilize the purchasing power of money even when the general state of supply is changing, a tendency alien to all the fundamental determinants of economic activity.²⁷

Hence it is not surprising that F.A. Hayek and the other theorists of his school during the latter half of the 1920s, upon examining the expansionary monetary policy of the United States (which, nonetheless, given the increase in productivity, did not manifest itself as a rise in prices), were the only ones capable not only of correctly interpreting the largely artificial nature of the expansionary American boom and its accompanying impact in the form of what appeared to be unlimited growth in the New York stock market indexes, but also of predicting, against the tide and to the surprise of all, the arrival of the Great Depression of 1929.²⁸ Therefore we can conclude with Fritz Machlup that

[t]he creation of new circulating media so as to keep constant a price level which would otherwise have fallen in response to technical progress, may have the same unstabilizing effect on the supply of money capital that has been described before, and thus be liable to lead to a crisis. In spite of their stabilizing effect on the price level, the emergence of the new circulating media in the form of money capital may cause roundabout processes of production to be undertaken which cannot in the long run be maintained.²⁹

Though in the past these considerations could be thought of little practical importance, given the chronic increase in the general price level in western economies, today they are again significant and demonstrate that even with a policy of monetary “stability” guaranteed by central banks, in an environment of soaring productivity economic crises will inevitably hit if all credit expansion is not prevented. Thus in the near future these considerations may very well regain their very important practical significance. At any rate, they are of great use in understanding many economic cycles of the past (the most consequential of which was the Great Depression of 1929), and as an application of the theoretical conclusions of our analysis.³⁰