July 05, 2010
I am rereading Hayek’s “The Road to Serfdom”, and doing a little outside research on Hayek’s views.
Today I was looking up a quote on deflation, that I had seen previously, in response to a post I saw by R. S. McCain. McCain seems to like the idea of deflation, whereas my understanding is that most economists consider deflation to be much more damaging to an economy than mild to moderate inflation. During the course of digging up the quote I was looking for I came across the April 1945 Reader’s Digest condensed version of “The Road to Serfdom”. I have never seen this version before and I think it is probably safe to assume that most people currently jumping on the Hayek bandwagon haven’t either so I am linking it here for the curious.
BTW – the quote I was looking for was:
The silly deflationary policy that Hayek is referring to was a failure of the Federal Reserve to inflate the monetary supply to combat deflation.The deflationary cycle is described in Wikipedia:
“I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.”
During the Crash of 1929 preceding the Great Depression, margin requirements were only 10%. Brokerage firms, in other words, would lend $9 for every $1 an investor had deposited. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors attempted to withdraw their deposits en masse, triggering multiple bank runs. Government guarantees and Federal Reserve banking regulations to prevent such panics were ineffective or not used. Bank failures led to the loss of billions of dollars in assets. Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday.I don't know if this view is correct or not, but it appears that Hayek agreed with it, at least in part. I am not going to claim that he wholeheartedly endorsed all of the Monetarist's conclusions, just that he would have attempted to prevent the deflationary cycle.
Bank failures snowballed as desperate bankers called in loans, which the borrowers did not have time or money to repay. With future profits looking poor, capital investment and construction slowed or completely ceased. In the face of bad loans and worsening future prospects, the surviving banks became even more conservative in their lending. Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A vicious cycle developed and the downward spiral accelerated.
The liquidation of debt could not keep up with the fall of prices it caused. The mass effect of the stampede to liquidate increased the value of each dollar owed, relative to the value of declining asset holdings. The very effort of individuals to lessen their burden of debt effectively increased it. Paradoxically, the more the debtors paid, the more they owed. This self-aggravating process turned a 1930 recession into a 1933 great depression.
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