I refer to the passage below from a talk that Hayek gave on April 9, 1975 to the American Enterprise Institute in Washington DC, in which he had been asked to speak on 1970s inflation.
Early in this talk Hayek said that he rejected the Keynesian view that employment is “a direct and simple function of what is called aggregate demand” (Hayek 1975: 4), even though he proceeded to concede two important instances where aggregate demand was the “dominating factor in determining the level of employment”:
“Let me say, first, that there are two circumstances in which changes in aggregate demand are indeed the dominating factor in determining the level of unemployment; and these two circumstances have governed the development of the theory.This is Hayek’s mea culpa and a repudiation of his 1930s liquidationism.
The first one was an accidental historic situation—but an historic situation that determined the climate of opinion in the country which then dominated economic theory. In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.
This particular situation, however, while it largely explains the growth of Keynes’s own views, would not be sufficient to explain their wide acceptance.
The second situation in which it is true that an increase of employment requires an increase in aggregate demand is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction. The original substantial unemployment lends to a shrinkage of demand that causes more unemployment, and so on; it releases a deflation due to the ‘inherent instability of credit’ (to use the terminology of a once very influential but now undeservedly almost forgotten economist who died a few days ago, R. G. Hawtrey).
Once you have the kind of situation in which there already exists extensive unemployment, there is thus a tendency to induce a cumulative process of secondary deflation, which may go on for a very long time. I am the last to deny — or rather, I am today the last to deny—that in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.
I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was compatible with a functioning economy. Perhaps I should even then have understood that this possibility no longer existed. I think it disappeared in 1931 when the British government abandoned its attempt to bring wages down by deflation, just when it seemed about to succeed. After that attempt had been abandoned, there was no hope that it would ever again be possible to break the rigidity of wages in that way.
I still believe that we shall not get a functioning economy until wages again become flexible, but I think that we shall have to find different techniques for that purpose. I would no longer maintain, as I did in the early ’30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognisable function whatever, and that there is no justification for supporting or permitting a process of deflation.” (Hayek 1975: 4–5).
But what policy does Hayek recommend to avoid deflation? He does not here specify how, but elsewhere makes it clear that he supported monetary intervention (like Milton Friedman) and (probably) a guarded and conservative use of fiscal policy involving public works expenditure. In one word: inflation.
Most interesting is Hayek’s implicit admission that inflation was the right course for the British economy in the 1920s after the disastrous return to the gold exchange standard at too high a parity:
“In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.”So Hayek, after all his attacks on Keynes in the 1930s, essentially admitted Keynes was right, at least on these points at any rate.
Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A Von Hayek. American Enterprise Institute, Washington.