Opposing Keynesianism: Hayek’s 1970s Volte Face—From Opposing to Supporting “Free Banking”

Abstract

Hayek was not a well-known figure within the conventional mainstream economics profession during the 1960s, nor was he publishing on economic theories as he did prior to 1941. However, a sudden and somewhat surprising change in Hayek’s intellectual life came when he was awarded the Nobel Prize in economics in 1974. His main economic writings after the mid-1970s were dedicated to advancing a novel argument in favor of free banking. Hayek’s objections to central banking came late in his life and his mature support for free banking, his late volte face, is in some senses puzzling. As outlined in The Denationalization of Money, the main argument concerned the feasibility of having competing monies. In the years following, Hayek promoted the new ideas he formulated between 1976 and 1978, arguing for many competing private issuers of money. The idea was in line with the doubts concerning the ability of gaining knowledge in economics that were shown already in his celebrated 1937 paper “Economics and Knowledge.”

Appendices

Appendix 1: A Note on Hayek’s Position on Free Banking in The Constitution of Liberty

As we have seen above, Hayek had tried after the mid-1970s to establish an earlier date for his newly adopted conceptualization of free banking. He mentioned his early thoughts about the free banking approach in 1960 and even earlier, a claim that is often echoed in the secondary literature. However, in The Constitution of Liberty (1960), a book that is not focused on economic analysis, Hayek’s approach was not yet the significant departure of his mature, mid-1970s thinking. In Chap. 21, dedicated to “The Monetary Framework,” Hayek wrote:

Governments have assumed a much more active part in controlling money, and this has been as much a cause as a consequence of instability. It is only natural, therefore, that some people should feel it would be better if governments were deprived of their control over monetary policy. Why, it is sometimes asked, should we not rely on the spontaneous forces of the market to supply whatever is needed for a satisfactory medium of exchange as we do in most other respects?

It is important to be clear at the outset that this is not only politically impracticable today but would probably be undesirable if it were possible. Perhaps, if governments had never interfered, a kind of monetary arrangement might have evolved which would not have required deliberate control; in particular, if men had not come extensively to use credit instruments as money or close substitutes for money, we might have been able to rely on some self- regulating mechanism.¹⁵ This choice, however, is now closed to us. We know of no substantially different alternatives to the credit institutions on which the organization of modern business has come largely to rely; and historical developments have created conditions in which the existence of these institutions makes necessary some deliberate control of the interacting money and credit systems. Moreover, other circumstances which we certainly could not hope to change by merely altering our monetary arrangements make it, for the time being, inevitable that this control should be largely exercised by governments. (1960/2011, pp. 451–452)

A footnote that appears here is the basis for the claim that sixteen years earlier than 1976 Hayek already was thinking on “free banking”; it is worth quoting in full:

Though I am convinced that modern credit banking as it has developed, requires some public institutions such as the central banks, I am doubtful whether it is necessary or desirable that they (or the government) should have the monopoly of the issue of all kinds of money. The state has, of course, the right to protect the name of the unit of money which it (or anybody else) issues and, if it issues “dollars,” to prevent anybody else from issuing tokens with the same name. And as it is its function to enforce contracts, it must be able to determine what is “legal tender” for the discharge of any obligation contracted. But there seems to be no reason whatever why the state should ever prohibit the use of other kinds of media of exchange, be it some commodity or money issued by another agency, domestic or foreign. One of the most effective measures for protecting the freedom of the individual might indeed be to have constitutions prohibiting all peacetime restrictions on transactions in any kind of money or the precious metals.[emphasis added]

In my reading, this note contains the strongest proof of Hayek’s early support for free banking. However, readers of the chapter will agree, I think, that there are many more paragraphs where Hayek is still committed to central banking, preferring rules rather than discretion, but not yet free banking.

Appendix 2: A Note on Hayek and Monetarism

In a short section which Hayek introduced to the second edition of Denationalisation he outlined his disagreements and agreements with Monetarism. Again, the subject is analyzed within the debate with Keynesianism. The short section is entitled:

A Note on ‘Monetarism’.

It has become usual, since the reaction against the dominance of the ‘Keynesian’ dogma set in, to lump together as ‘monetarists’ all who regard as mistaken Keynes's denial 'that an inflationary or deflationary movement was normally caused or necessarily accompanied' by ‘changes in the quantity of money and velocity of its circulation.’¹⁶ This ‘Monetarism’ is, of course, a view held before Keynes by almost all economists except a very few dissenters and cranks, including in particular those Continental economists who by their advice on policy became responsible for the great inflations of the 1920s. I agree with these 'monetarists' in particular on what is now probably regarded as their defining characteristic, namely that they believe that all inflation is what is now called ‘demand-pull’ inflation, and that there is, so far as the economic mechanism is concerned, no such thing as a ‘cost-push’ inflation-unless one treats as part of the economic causation the political decision to increase the quantity of money in response to a rise of wages which otherwise would cause unemployment.¹⁷

Where I differ from the majority of other ‘monetarists’ and in particular from the leading representative of the school, Professor Milton Friedman, is that I regard the simple quantity theory of money, even for situations where in a given territory only one kind of money is employed, as no more than’ a useful rough approximation to a really adequate explanation, which, however, becomes wholly useless where several concurrent distinct kinds of money are simultaneously in use in the same territory. Though this defect becomes serious only with the multiplicity of concurrent currencies which we are considering here, the phenomenon of substitution of things not counted as money by the theory for ‘what is counted as money by it always impairs the strict validity of its conclusions.’ (1999b, pp. 182–183)