An application of Hayekian law and economics: the comparative analysis of alternative monetary and banking regimes

It is Hayek’s emphasis on the theme of the interrelation between the system of rules and its systematic outcome at the level of the order of actions that qualifies him as a law and economics theorist (see also Hayek, 1967, pp.

6681). Hayek views the economic problem of society as essentially a coordination problem:

The essential problem remains that of whether the plans of different individuals will tally and will accordingly all stand a chance of being successful, or whether the present situation carries the seed of inevitable disappointment to some, which will make it necessary for them to change their plans. (Hayek, 1941, p. 22)

Thus in a sense the theme of the interplay between institutional structure and economic order was, at least implicitly, already touched upon in Hayek’s early economic work on business cycle theory. Business cycles are instances of how an economy can suffer coordination failures on economy-wide scale. In the so-called ‘Austrian’ theory of the trade cycle (Hayek, 1935 [1967]), the boom is a self-reversing process set into motion by monetary expansion brought about by the central bank, which is essentially a governmental bank. If the banks were truly competitive, the business cycle would never get under way.

It had long been recognized that the Austrian theory of the business cycle embraces a constitutional perspective with respect to monetary problems: the search is not so much for a proper policy but for an appropriate monetary framework. The cycle depends on the elasticity of bank credit, that is, the characteristic of a developed financial system that allows the supply of money credit to differ from the supply of credit based on real saving.² Economists may study different institutional arrangements in order to determine which type of institution is most likely to minimize the tendency for the market rate of interest to be reduced below the natural rate.

Monetary and banking arrangements will acquire particular significance in this respect.

As Vera C. Smith reminds us:

Any attempt to make a final evaluation of the relative merits of alternative systems of banking must look primarily to the tendencies they manifest towards instability, or more particularly to the amount of causal influence they exert in cyclical fluctuations. Most modern theories of the trade cycle seek the originating force of booms and depressions in credit expansions and contractions with the banks as the engineering agencies. (Smith, 1936 [1990], pp. 192-3)

Hayek, however, never endorsed free banking in his early economic writings, despite his general emphasis on the coordinating properties of market competition. Hayek believed that the impulse initiating unsustainable cyclical booms was often the failure of the market rate of interest to rise with the equilibrium or natural rate when the demand for loanable funds increased. To explain why the market rate failed to rise, Hayek elaborated Thomas Joplin’s argument as to how commercial banks responded to an increase in loan demand by varying only the quantity of loans and not the price (Hayek, 1935 [1967], pp. 15-17); in other words, the argument is built on the assumption that the short-run supply of bank loans is perfectly elastic at the prevailing rate of interest (Hayek, 1933 [1966], pp. 171-3; White, 1999b).

Therefore a useful central bank, Hayek advised, ‘will have to act persistently against the trend of the movement of credit in the country, to contract the credit basis when the superstructure tends to expand and to expand the former when the latter tends to contract’ (Hayek, 1937 [1989], pp. 89-90).

Hayek’s later ‘The denationalisation of money’ (Hayek, 1978 [1991]) constituted a radical policy departure from his earlier support for central banking. Hayek, following up on an earlier suggestion by Benjamin Klein (1974), now envisaged a market in which all issuers, public and private, would offer non- redeemable currencies, each currency constituting its own monetary standard.

Each private issuer would pledge to maintain purchasing-power stability in terms of a particular basket of goods, but this pledge would not take the form of an enforceable redemption contract. Thus, and consistent with his early scepticism toward free banking, Hayek did not suggest free competition among banks offering wholly or fractionally backed liabilities redeemable for a commodity money.

Although Hayek’s proposal with regard to the denationalisation of money has not been exempt from serious criticism,³ it has led to a variety of proposals for fundamental financial and monetary reform. The development of a contemporaneous free banking school in economics has thus been stimulated (White, 1984 [1995]; Selgin, 1988; Salin, 1998). The advocates of fractional reserve free banking believe that one of the desirable macroeconomic characteristics this system would exhibit is the avoidance, or at least the limitation of Hayekian cycles. Monetary economists Greenfield and Yeager (1983) on the other hand have proposed a multi-commodity standard involving a separation of the medium of account from the medium of redemption, a system which, as these authors believe, would foster price level stability and the avoidance of monetary disequilibrium. More recently the search for institutional alternatives in the domain of money and banking has also led to the development of law-based macroeconomics, a project which culminates in a consistent argument for a return to a 100 per cent reserve requirement in banking (Jesus Huerta de Soto, 1998).⁴

Notes

1. For a more complete intellectual biography of F.A. Hayek, see Hennecke (2000).

2. Several excellent accounts of the theory of the business cycle are available; reference is here made to Garrison (2001) and Skousen (1990). The theory was originally conceived in Mises (1912 [1981], pp. 377-404). Mises’s achievement resulted from the integration of different strands of thought: he essentially combined Bohm-Bawerk’s capital theory and Wicksell’s interest rate mechanism with his own sequence analysis of monetary forces.

The theory highlights how changes in the market for loanable funds lead to capital restructuring, and how changes emanating from some sources can lead to unsustainable capital structures that will inevitably require a later correction. An artificial boom is an instance in which the change in the interest rate signal as a result of credit expansion and the change in resource availabilities are at odds with one another. With seemingly favourable credit conditions, long-term investment projects are being initiated at the same time that the resources needed to see them through to completion are being consumed. As the market guides these projects into their intermediate and late stages, the underlying economic realities become increasingly clear. The sequence of malinvestment and overconsumption, followed by crisis, liquidation and unemployment characterizes the intertemporal disequilibrium that is summarily described as a business cycle.

3. More particularly, and in light of the general problem of time-inconsistency identified by macroeconomists the question can be raised of whether the keeping of such a nonenforceable pledge would be consistent with profit maximization. A profit-maximizing fiat-type issuer could choose to hyperinflate its own brand of money, and would do so if staying in business promised less than the one-shot profit available from an unanticipated hyperinflation (White 1999c, 227 ff.). Moreover, the feasibility of private fiat-type money may be doubtful in view of the money regression theorem; on the latter, see Mises (1912 [1981], pp. 129-46) and Selgin (1994, pp. 809-11).

4. Jesus Huerta de Soto (1998) basically demonstrates that Hayek’s business cycle theory can be integrated with his legal theory, his constitutional economics and his spontaneous order paradigm. This accomplishment raises doubts as to the merits of the thesis of an author like Witt (1997) who argues that the distinction between Hayek’s early investigations into price theory, capital theory, and theory of the business cycle prior to and during his time at the London School of Economics (Hayek I) and, thereafter, his work on social philosophy, spontaneous economic order, and societal evolution (Hayek II) is one between two different and basically incompatible research programmes pursued consecutively by Hayek.

It is nevertheless correct that Hayek himself never reconsidered the theory of business cycles from the perspective of his later work. The comparative institutional approach to the study of business cycles is also embraced in Van den Hauwe (2005).

An application of Hayekian law and economics: the comparative analysis of alternative monetary and banking regimes

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