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MAY 1975

Public Policy for a Free Economy
An Address by Darryl R. Francis............


Inflation, Unemployment, and H a y e k ........


International Trade and Finance Under
the Influence of Oil — 1974 and
Early 1975 ........................................ 11

Vol. 57, No. 5

Public Policy for a Free Economy
Remarks by DARRYL R. FRANCIS, President, Federal Reserve Bank of St. Louis,
Before the Students and Faculty of Washington University, for the
Dedication of the Center for the Study of American Business
Washington University, April 3, 1975
I t IS A distinct privilege to be the first speaker to
address the Center for the Study of American Busi­
ness. I view the inauguration of this center as a timely
event, and one that marks the beginning of a program
that could have a profound impact on the future of
economic freedom in America. While my discussion
will be limited to economic freedom, the ideas that I
will express have a bearing on all freedoms — eco­
nomic, social, and political. In my view the three are
interdependent, and no one of them can exist without
the others.
Let me begin by stating the basic premises upon
which the discussion will rest. I view economic free­
dom as the freedom to determine and to seek to sat­
isfy one’s own wants as he sees them. Aside from its
desirability as an end in itself, I subscribe to the
widely held doctrine that the promotion of economic
freedom is consistent with the attainment of the maxi­
mum possible standard of living for society. According
to this view, state regulation should be viewed with
suspicion as a potential enemy of society’s material
well-being. On the other hand, maximum freedom for
individuals to act in their own self interest should be
viewed as a source of the variety and diversification of
ideas, experiments, and innovations which lead to the
discovery of new products and more efficient means
of production. If one accepts these premises, then a
free economy should be viewed not only as precious
in itself, but also as the most promising means by
which the standards of living of all members of society
can be raised.

The Role of Government — In Theory
If we accept the foregoing proposition, as I am sure
most of us do, what then is the role of public policy
in assuring a free economy? I see the role as follows.
The maintenance of maximum economic freedom de­
mands the organization of our economic life largely
through individual participation in a game with defi­
nite rules. The necessity of rules arises because ab­
solute economic freedom is impossible. One man’s
Page 2

freedom can conflict with another’s security and prop­
erty rights. Hence, each person must give up some
freedom in order to resolve individual conflicts. The
major problem is determining those freedoms which
the individual should give up in order to resolve con­
flict with others.
Just as a good game requires player acceptance of
both the rules and an umpire to interpret and enforce
such rules, so a free society requires that its members
agree on the general rules that will govern relations
among themselves, and on some device for enforcing
compliance with them. Unfortunately, we cannot rely
on custom or consensus alone to interpret and to en­
force the rules; we need an umpire. These then are
the basic roles of government in a free economy — to
provide a means whereby we can establish some set
of general rules, and to enforce compliance with the
rules on the part of those few who would otherwise
not play the game.
The advocate of a laissez-faire policy today realizes
that there is a constructive role for government in the
economy; he is not an anarchist. He recognizes that a
system which promotes maximum economic freedom
may not be a god-send and that its existence depends,
in part, upon affirmative government action. However,
he also recognizes that each new governmentally en­
acted rule of the game involves a loss of some free­
dom. Herein lies the problem; where do we draw the
line? At what point does affirmative government ac­
tion begin to have a net negative impact on economic
I can offer you no hard and fast principles on how
far it is appropriate to use government to maximize
economic freedom. However, I would suggest to you
that in any particular case of proposed intervention,
we should make up a balance sheet, listing separately
the advantages and disadvantages of the proposed
policy. Most importantly, we must always enter on the
liability side of any proposed government intervention
its effect in threatening freedom, and give this effect
considerable weight. For it is an indisputable, yet


MAY 1975

frequently overlooked, reality that every new rule has
its costs in terms of a loss of some freedom.

irreconcilable conflict between democracy and free

The Role of Government — In Practice

Regulatory Reflex

We have witnessed abroad the culmination of move­
ments from constitutional government to dictatorships,
from freedom back to authority. This spectacle, for
most of us, is revolting, and something to be avoided
at all costs. Yet, faced with the same problems as these
other nations, we too have often adopted measures
which call for more government authority and less in­
dividual freedom. We have often been too eager to
justify and rationalize policies which propel us in a
direction in which we overwhelmingly disapprove. As
an indicator of how far and how fast we have moved
in this direction, consider for a moment just a few
facts and figures which are indicative of the tremen­
dous growth of the government’s influence on our

The regulatory reflex operates in the following man­
ner. Upon observation of what some individuals deem
an undesirable result produced by the free enterprise
system, government officials or the press suggest that
this is an area in which the government should “do
something.” This usually has meant the creation of a
powerful new government agency, or an increase in
the powers of an existing one. Such an agency is em­
powered to make decisions regarding the allocation of
resources according to its own interpretations of what
is best, rather than leaving the outcome to determina­
tion by the market process.

1) It took 186 years for the Federal budget to reach
the $100 billion mark, a line we crossed in 1962, but
in only nine more years we reached the $200 billion
mark, and in only four more years we broke the $300
billion barrier.
2) In 1930, prior to the New Deal, government
spending at all levels accounted for just 12 percent of
our gross national product. Today, government spend­
ing accounts for over 32 percent of our gross national
product, and if present trends continue, government
could account for as much as 60 percent of GNP by
the year 2000.
3) As the role of government has increased, the
bureaucracy has also grown so that today one out of
every six working men and women in this country
works directly for either Federal, state, or local
Why is it, in light of the record, that the burden of
proof still seems to rest on those of us who oppose
new government programs which curtail our freedoms?
Why is it that society seems so bent on curtailing the
very freedoms that have netted us the highest stand­
ards of living and economic freedom in the entire
I submit to you that the reason for this drift is that
there are natural biases in its favor. One of these
biases has to do with what I will call the regulatory
reflex that seems to have grown to almost epidemic
proportions in our country. The other has to do with
the same political realities which led Joseph Schumpe­
ter to argue thirty years ago that there was an

Implicit in this reflex is the assumption that the free
market system produces undesirable results and that
government planning is the means of achieving a more
desirable end. Unfortunately, the desired end sought
by a group of regulators is frequently not the same as
that which the members of society would choose for
themselves. The process often results in some group
of zealots determining that others should not have
what they want, but rather should accept that which
the regulators consider “best” for them. This type of
thinking, combined with the power to implement it,
poses a tremendous threat to freedom, and yet it is
becoming increasingly common. For example, wit­
ness the proposed compulsory health insurance, social
security, seat belt interlock mechanisms, and the issu­
ance of food stamps instead of money to the poor, and
the not so poor, to name just a few.
Another aspect of this regulatory reflex is that there
are many people who still subscribe to the medieval
notion that all business is a zero-sum game. That is,
many people believe that one person’s profit is another
person’s loss. Such notions are behind the frequently
heard demands that the government should inter­
vene in the market to limit what some consider to be
the “obscene” profits of entrepreneurs and “protect”
the powerless consumer. This kind of thinking is based
on a notion that is absolutely false. Its acceptance re­
quires that we also accept the proposition that some
parties to all transactions are either irrational or vic­
tims of a fraud.
Free individuals will enter a transaction only if
they can benefit their own interests as a result. Busi­
ness transactions are never a zero-sum game as long
as the participants are free to choose for themselves
and as long as they have alternative choices. There is
Page 3


no question that there are shoddy practices in every
profession and that market economies produce goods
that are often undesirable to some individuals or poorly
made. However, the beauty of the free market system
is that if the consumer does not want to purchase such
products, he has alternatives, and the businesses that
produce them will either shift to accommodate con­
sumer desires or they will fail. The fact is that the
alternative to free markets, planning by government
bureaucracies, also results in the production of shoddy
and expensive products (the postal service and auto­
mobile modifications, for example). The crucial dif­
ference, however, is that the plans pursued by bu­
reaucracies are not subject to the forces of market
competition, and therefore there is no way to test
their relative efficiency or acceptability.
I believe that much of the blind faith in the efficacy
of government intervention stems from impatience
and shortsightedness on the part of many individuals,
aided, of course, by the lobbying of those who stand
to gain directly from a particular regulatory proposal.
Most policies are formulated with an eye to the short
run. In a familiar pattern we see a situation arise in
which the short-run outcome of the interaction of free
market forces is considered by many to be less than
socially optimal. The key question is what is the al­
ternative? For example, we have experienced several
years of inflation. Impatience leads many to clamor
for the quickest solution to the problem. Certainly, in
this case, many people believe that wage and price
controls fit the bill. A rigid system of wage and price
controls will in fact keep reported prices from rising
in the short run. Unfortunately, such controls will also
create shortages and distortions in the economy that
result in severe bottlenecks in the production process.
Reported prices are temporarily fixed, but the con­
sumer is robbed of the right to purchase those items
which are in short supply. However, everyone concen­
trates on the immediate impact of the controls on the
movement of reported price indices and says, “You
see how simple that was?”
So it is with most cases of state intervention. The
seemingly beneficial effects are direct, immediate, and
visible. On the other hand, the undesirable effects are
often gradual and indirect, and are frequently con­
sidered only when they actually occur, if even then.
However, the ignored long-run costs of such interven­
tion eventually show up. And, when they do, there is
a call for more short-run intervention to correct the
problems which arose as a result of the earlier poli­
cies. Over a long period of time there is a cumulative

Page 4

MAY 1975

and disastrous effect which erodes freedom and de­
tracts from the efficiency of the economy.
Unfortunately, it is a truism that regulation begets
further regulation and that regulations outlive their
rationale. Though most government regulation was en­
acted under the guise of protecting people from abuse,
much of today’s regulatory machinery only provides
jobs for the regulators, increases the cost of doing
business, and shelters those who are being regulated
from the normal consequences of free enterprise com­
petition. In some cases, the Interstate Commerce Com­
mission for example, the original threat of abuse no
longer exists. In other cases, the regulatory machinery
has simply become perverted. In still other cases, the
machinery was a mistake from the start. In any case,
the individual, from whatever presumed abuse he is
being spared, is paying for the regulation through
both a loss of freedom and a loss of material well­
While many regulatory programs seem to accom­
plish their goal (desirable or not) in the short run,
they are seldom successful in the long run. The central
problem with all of these measures is that they all in­
volve an abridgement of some freedoms. They seek
through government to force some individuals to act
against their own immediate interests in order to pro­
mote a supposedly general interest. They substitute
the values of outsiders for the values of participants.
Some people are telling others what is “good” for them,
or else the government is taking from some to benefit
others. These measures are therefore counter to the
attempt by millions of individuals to promote their
own interests and to live their lives by their own
values. This is the major reason why the measures
have so often had the opposite of the intended effects.

Possible Conflict Between Democracy
and Free Enterprise
Despite the fact that the regulatory reflex con­
taminates so much of our society, I do not believe that
it could be as pervasive as it has been were it not
provided with a political framework conducive to its
proliferation. Consider the situation in a community in
which the mass of the people are in favor of economic
freedom of choce in their daily lives and are against
government direction. As will normally happen, how­
ever, many groups are formed which perceive an op­
portunity for material gain through a particular form
of government intervention. Under the guise of such
slogans as “fair prices,” “equitable wages,” or “fair
trade” laws, they perceive an opportunity to be pro­


tected from the sources of competition. In such situa­
tions a political party hoping to achieve and maintain
power will have little choice but to use its power to
buy the support of these special interest groups by
catering to their legislative demands. The reason they
will do so is not necessarily because they think that
the majority of society is interventionist, but rather
because they cannot achieve and retain a majority if
they do not solicit support through the promise of
special advantages. This means, in practice, that even
a statesman wholly devoted to the maintenance of
freedom, and who realizes that every new regulation
is an abridgement of those freedoms, will be under
constant pressure to satisfy the interventionist de­
mands of organized groups.
Some special interest groups undoubtedly favor in­
tervention not for personal gain as much as for what
they determine to be for the “good of society.” These
groups labor under the illusion that they can draft a
law to prevent every outcome which they, and fre­
quently only they, deem undesirable. In this case,
the operation of the regulatory reflex merely feeds
an insatiable appetite for power on the part of those
who wish to impose their values on the rest of society.
When regulation fails to accomplish its goals, as it
almost inevitably does, these people do not call for
the repeal of the laws. Instead, they push to amend
them into infinite complexity until the purpose of the
original law is lost. As a result, the hand of regula­
tion ends up touching every aspect of human action.
It is not only wasteful, but serves to destroy incentive
and to discourage ingenuity.

It is ironic that groups which constantly look for
problems in our country insist on inhibiting the ability
of the economy to respond to these problems. For

MAY 1975

example, present technology does not permit us to
have surgically clean air and plentiful electricity at
less cost at the same time. However, there is no reason
to believe that future technology could not provide
those benefits. The essential ingredient is freedom to
react to incentives and an understanding that indi­
vidual liberty is not only precious, but efficient. Just
as thought control is the great enemy of the freedom
of inquiry in academia, economic controls are the great
enemy of economic freedom and the entrepreneurial
spirit which is needed to solve our problems.
Rediscovering the indivisibility and efficiency of
political and economic freedom will take time in a
society which has become so accustomed to overreliance on government intervention. The political and
intellectual bias against the free market is strongly
entrenched, and there are some who will always find
a platform to continue to feed this bias out of a com­
plete misunderstanding of both the political and the
market functions.
Those of us who firmly believe in the precious­
ness and efficiency of a system which maximizes eco­
nomic freedom more often than not find ourselves on
the defensive. Given the biases that seem to continu­
ously propel our society away from such a system,
being merely defensive is not nearly enough. We must
take the offensive and encourage others to restudy the
philosophy of free enterprise. It is in this regard that
I applaud the inauguration of the Institute for the
Study of American Business. We need to drive home
the point that every new rule of the game involves
the loss of some freedom and that one cannot erode
freedom in one sector of society without adversely
affecting all others. In other words, we must insist
that public policy be based on a recognition of the
desirability, efficiency, and interdependence of politi­
cal, social, and economic freedom.

Page 5

Inflation, Unemployment, and Hayek

I n TH ESE times of high unemployment and rising
price levels, one looks to the leaders of the economics
profession for analysis and solutions. One possible
candidate, who has investigated these problems in
detail, is Friedrich August von Hayek. Hayek was
awarded a share of the Nobel Prize for Economics
last autumn. Born in 1899 in Austria, Hayek is prob­
ably better known in Europe than in the United
States. After spending his formative years studying
economics and law in Austria, he moved to England
in 1931 and then on to the University of Chicago in
1950. Hayek accepted a chair at the University of
Freiburg in Germany in 1962. Several years later he
returned to Austria, where he now lives.
After teaching and publishing extensively in the
economics field during much of the first forty years of
his life, Hayek became more interested in political
and social developments. In fact, he is best known for
his The Road To Serfdom 1 which projected a dim
future for capitalistic societies, given the steady en­
croachment of government into all phases of private
life. That book, plus his participation in the founding
of the Mont Pelerin Society in 1946, placed Hayek in
the front ranks of laissez-faire advocates throughout
the world.
There was a time, specifically during the 1930s,
when Hayek and John Maynard Keynes were intense
rivals for the attention and leadership of the economics
profession.2 The obvious problem in those (perhaps
simpler) days was unemployment alone, and any anal­
ysis, such as Hayek’s, which also included the likeli­
hood of a rising price level, was doomed to rejection.
Keynes emerged the clear winner; his analysis of
“inadequate” aggregate demand and prescription of
stepped-up government spending were adopted by
all capitalistic nations by the 1940s. From that time
on, active governmental intervention to secure full
iFriedrich A. Hayek, The R oad to Serfdom (Chicago: Uni­
versity of Chicago Press, 1944).
. . it is hardly remembered that there was a time when the
new theories of Hayek were the principal rival of the new
theories of Keynes.” John Hicks, Critical Essays In Monetary
Theory (London: Oxford University Press, 1967), p. 203.
Digitized for Page 6

employment became the chief economic obligation of
the leaders of the western world.
Today, Keynesian economic principles are being
questioned more than at any time in the past
thirty years. Economists are seeking new explana­
tions and some have begun to look in the direction
of Professor Hayek. This article is devoted to pre­
senting and interpreting Hayek’s analysis of inflation
and unemployment.

We discuss the inflation issue first because Hayek
took the view that an extended period of rising prices
would likely lead to a serious recession or depression.
A concise explanation of this hypothesis was advanced
in Chapter 21 of Hayek’s book The Constitution of
Liberty ,3 This chapter, entitled “The Monetary Frame­
work”, summarized a good deal of Hayek’s economic
analysis developed during the preceding forty-year

The chief cause of inflation, Hayek wrote, is gov­
ernmental control of the money supply.4 As the gov­
ernment endeavors to provide more services, it tends
to run up more debt. The increase in its own debt
prompts government to take a more active interest in
national financial matters — the creation of money, in
particular. Hayek reasoned that as long as the gov­
ernment can avoid extensive debt financing, it is pos­
sible to maintain a completely free and independent
monetary system. Increases in the money supply,
which stimulate aggregate demand, constitute the un­
derlying source of inflationary pressures. It is not a
3F. A. Hayek, The Constitution o f L iberty (Chicago: The Uni­
versity of Chicago Press, 1960).
4In Hayek’s words, “with government in control of monetary
policy, the chief threat in this field has become inflation.
Governments everywhere and at all times have been the chief
cause of the depreciation of the currency. Though there have
been occasional prolonged falls in the value of a metallic
money, the major inflations of the past have been the result
of governments’ either diminishing the coin or issuing exces­
sive quantities of paper money.” Ibid., pp. 327-328.


conscious desire of the government to foster inflation.
However, short-run political expediency and guaran­
tees of full employment and assorted other amenities
of life for all citizens make a growing government,
expanding money supply, and inflationary pressures
virtually inevitable. The assorted amenities include
social security programs, rent and food subsidies, and
legislation designed to put floors under wages and
ceilings on consumer prices.
Elsewhere in The Constitution of Liberty, Hayek
specifically singled out labor unions for their part in
fostering inflation and unemployment. It is his con­
tention that by permitting unions to force up wages,
the government is put into the position of validating
the wage-price pressure through money supply in­
creases, or facing general unemployment by failing to
validate the union action.
Besides curbing government and union power,
Hayek’s solution to rising price levels involves stabiliz­
ing the rate of growth of the money supply. A rule of
some sort, which recognizes the inexact relation be­
tween monetary policy actions and changes in the
price level, is considered desirable because it lessens
inflationary pressures and removes monetary policy
actions as a source of uncertainty to private decision
makers. The lessening of uncertainty has long been of
interest to Hayek, especially with regard to the free
market economy.5

What could we expect from growing inflationary
pressures? Writing during the period of relative price
stability in the late 1950s, Hayek described a number
of events (although he did not list them) which ac­
company the onset of inflation. The following is an in­
terpretation (and only an interpretation) of his view
of these events, many of which were later realized:

MAY 1975

(2 ) Inflation encourages debt — private as well as
public. With growing incomes, people seem to be less
reluctant to take on debt than at other times. What­
ever one’s view of the desirability of private debt,
there can be little doubt that it has escalated rapidly
in recent times. Private debt increased 300 percent
over the past fifteen years. Public debt about doubled
over this period, while that part of the public debt
held by the Federal Reserve — which directly in­
flates commercial bank reserves and the money sup­
ply — approximately tripled.
(3 ) Real costs, profits, and income becom e difficult
to ascertain. Price movements act as a veil concealing
the true course of important economic variables. Re­
cent efforts to uncover the values of “real” interest
rates, “real” money supply, “real” profits and the “real”
inventory situation suggest the accuracy of this
(4 ) Progressive taxation, coupled with rising
prices, affects investment adversely. It is difficult to
show that investment growth has slowed over the past
fifteen years, or that progressive taxation might have
contributed to any such slowing. There is evidence,
however, that profits have slipped in recent years and
it is possible that taxes were partially responsible.
Quite likely, the stimulative effects of unanticipated
inflation on profits in the early 1960s were later re­
versed as price anticipations began to catch up with
(5 ) Sliding scale contracts emerge. These are
both a cause and a consequence of continuing infla­
tion. Besides the growth in the number of union
workers whose wages are altered monthly by changes
in the consumer price index, social security payments
have added over 30 million people to the list of in­
dividuals whose income is directly adjusted to chang­
ing price levels.

At first, virtually all firms enjoy increased
(6 ) Over an extended period, the unemployment
profits because the jump in prices is not anticipated.
rate accompanying sustained inflation is no lower than
Since most of their liabilities are contractually fixed in
in the absence of sustained inflation. In Hayek’s words,
price (for a time) and their assets are not, the rise
in asset prices enhances firms’ net worth. Thus, in a
rising market, as evidenced during the long expansion
of the 1960s, profits expand and relatively few firms
5F. A. Hayek, “The Use of Knowledge in Society,” T he Ameri­
can Econom ic R eview (September 1945). In this article,
Hayek wrote about the capacity of a free market economy to
lessen uncertainty via the transmission of information which
occurs as individual transactors make demand and supply de­
cisions. Hayek is credited with being one of the early con­
tributors to the current cost-of-information approach to micro
and macroeconomic analysis.

“The reasonable goal of a high and stable level of em­
ployment can probably be secured as well as we know
how while aiming at the stability of some comprehen­
sive price level.”6 Inflation may initially contribute to
a lowering of the unemployment rate below what it
would otherwise be, but after inflationary expectations
catch up with reality, this is no longer the case. In
other words, this means that the Phillips curve does
not exist in the usually hypothesized “rounded - L”
’Hayek, The Constitution o f Liberty, p. 337.
Page 7


shape. Events of the past few years give credence to
this hypothesis.7
(7 ) Inflation leads to more governmental control.
Control is difficult to quantify, but the steady rise in
all government employment relative to total employ­
ment, in government spending relative to total spend­
ing, and the recent price-wage control experience are
all suggestive of increased control.
(8 ) I f prices do not continue to rise at an accelerat­

ing rate, a serious recession or depression is inevita­
ble. “Once it [inflation] has continued for some time,
even the prevention of further acceleration will create
a situation in which it will be very difficult to avoid a
spontaneous deflation.”8 In 1973-74, a serious reces­
sion occurred despite continued acceleration of price
increases. Just what is the relation of the recent in­
crease in unemployment to Hayek’s conjectures is not
clear. For one thing, Hayek was vague in his later
writings concerning the specific mechanism which
would produce unemployment. For that reason, it may
be profitable to turn to earlier analysis in which he
spelled out in more detail his beliefs regarding the
emergence of unemployment.

Hayek advanced a prices-unemployment argument
in the 1930s which was derived largely from his ver­
sion of the concept of “forced savings”.8 A brief sum­
mary of the argument follows.
Starting from full employment, let us suppose there
occurs a rise in bank credit to firms. The rise in such
credit is accompanied by a fall in the market rate of
interest below the “natural” rate.10 The additional
7See the Prices and Unemployment chart of Darryl R. Francis,
“Inflation, Recession— What’s a Policymaker To Do?” this
Review (November 1974), p. 6 for an indication of the failure
of this relation to assume the rounded-L shape.
8Hayek, T he Constitution o f Liberty, p. 332.
■'Hayek’s most specific “forced saving” ideas can be found in
Prices and Production (London: George Routledge & Sons,
Ltd., 1946). See also F. A. Hayek, Monetary Theory and The
T rade Cycle, trans. N. Kaldor and H. M. Croome (London:
Jonathan Cape, 1933), and Profits, Interest and Investment
and Other Essays on the Theory o f Industrial Fluctuations
(London: George Routledge & Sons, Ltd., 1939) for elabora­
tion. The concept of forced saving, popular with numerous
classical and neoclassical economists, can be traced at least
as far back as Richard Cantillion, a Physiocrat, writing be­
tween 1730 and 1734. See Roger W. Spencer and William
P. Yohe, “A Historical Analysis of the ‘Crowding Out’ of Pri­
vate Expenditures by Fiscal Policy Actions,” Federal Reserve
Bank of St. Louis Working Paper No. 13 (January 31, 1971).
Wicksell explained the natural interest rate as the rate “at
which the dem and fo r loan capital and the supply o f sav­
ings exactly agree.” Knut Wicksell, Lectures on Political
Econom y, Vol. II, Money, ed. Lionel Robbins (London:
Routledge & Kegan Paul Ltd., 1935), p. 193.

Page 8

MAY 1975

credit permits firms to pay higher prices for factors of
production, and they are able to bid resources away
from consumers. The assumed shift in resources to­
ward the production of more producer goods and
fewer consumer goods leads to higher prices and a
reduced supply of consumer goods. Many consumers,
rather than pay the higher prices, choose to add to
their savings — thus the term “forced” savings.
Sooner or later the banking system, taking note of
inflationary pressures, cuts back its credit advances.
Unless “new” saving is forthcoming, the market rate
rises to the natural rate of interest, making investment
projects, which appeared lucrative at the old, lower
rate of interest, no longer profitable. The prices of
consumer products continue to advance due to the
earlier supply reduction as well as to the fact that
the uncompleted investment projects add nothing to
the existing stock of consumer goods. Workers in the
declining investment goods industries cannot be easily
shifted to consumer goods industries; thus unemploy­
ment emerges in the face of rising price levels.
If one gets the impression that this argument is
something other than iron-clad, then one is probably
on the right track. Economists were intrigued and
baffled by Hayek’s logic throughout the decade of the
1930s. But since Hayek’s price effect went the wrong
way (up), contrary to the experience of the 1930s, the
Hayekian view was set aside.
Sir John Hicks, also a Nobel Prize winner in Eco­
nomics, recently made another attempt at interpret­
ing Hayek’s theory. Recognizing the irrelevance of
Hayek’s diagnosis to the conditions of the 1930s, Hicks
stated that, “because it was wrong then, it does not
follow that it must always be wrong. It is possible that
there may be conditions to which it is appropriate;
and in these days ( in 1967) one may not have to look
very far before one finds them.
“It can happen that there is unemployment even
while there is inflation.”11 Hicks envisioned conditions
in which unemployment would occur due to a decline
in the marginal productivity of labor. If labor fails to
accept a decline in real wages, which could occur for
any number of reasons, unemployment could arise in
conjunction with rising price levels. The reason for
the decline in real wages accompanying a fall in
labor’s marginal productivity might be disadvanta­
geous shifts in foreign trade, the destruction of capital
through war or political upheaval, or more rapid pop­
ulation growth.
n Hicks, Critical Essays, p. 214. Italics supplied.


But it is by no means excluded that it should happen
for H ayek’s reason: in the afterm ath of an attempted
expansion, greater than the economy was able, or
willing, to afford — so that it has been abortive. If
shortages develop from such a cause, prices will rise;
. . . there may be no rate of price-rise w hich will not
be altogether explosive, unless so severe a hand is kept
upon the monetary circulation that unemployment re­
sults. There may b e rapid inflation; but if it is to be
kept down to a finite rate of inflation, there must be
unemployment. This is the Hayek ‘slump’. T o such
conditions the Keynesian prescription is irrelevant, as
irrelevant as H ayek’s was in 1931.12

How might we interpret the Hicksian view of
Hayek, with an eye toward explaining price-unemployment developments in the 1970s? First, it is clear
that the economy was overstimulated for a number of
years, beginning in the 1960s. Second, “shortages” of
all sorts emerged in the 1970s. Third, there has been
a sharp decline in real wages. Fourth, although mone­
tary expansion and inflation continued through much
of the 1970s, a firm enough hand was kept on the
monetary controls that money supply growth dropped
sharply in 1974. Fifth, unemployment has risen

Obvious modifications must be made in Hayek’s
basic theory to explain current economic develop­
ments. Hayek’s increases in bank credit, or money
supply as some might say today, have not benefited
private investment, but rather government, at the ex­
pense of consumers. If one takes the long view, it is
striking that consumer spending as a percentage of
GNP declined from 75 percent in 1929 to 63 percent
in 1974 while government spending increased over
that period from 8 percent to 22 percent. Investment,
which was at 16 percent of GNP in 1929, stood about
unchanged at 15 percent in 1974. If Hayek had fore­
seen in the 1930s this rapid growth of the government
sector, he would undoubtedly not have waited so long
to shift the emphasis of his theory of “slumps” from
one which accentuated excessive business expansion
to one which highlighted excessive government
Another obvious change in Hayek’s theory required
to accommodate actual events is the necessity of
introducing exogenous supply shifts. The “shortages”
envisioned by Hayek occur entirely because of prior
excessive demand. There is no doubt that rapid in­
creases in demand on a worldwide scale the past
12Ibid., p. 215.

MAY 1975

decade contributed strongly to the recent shortages of
such items as food, oil, paper, and chemicals. How­
ever, it is necessary to note, especially in the case of
fuels, that an important decrease in supply also oc­
curred. One might attribute this to government wage
and price controls, effective oligopolies, or to a dis­
advantageous shift in the terms of trade, as suggested
by Hicks.
The above are probably the two most important
changes required to update Hayek’s views on unem­
ployment and inflation. Given that we are still ex­
periencing economic discomfort in both these areas,
what policies would Hayek prescribe to alleviate the
situation? First, he would probably remind us that we
would never have gotten into our current difficulties
if we had maintained a fairly steady, moderate growth
rate of the money supply. In particular, we would
have been better off not allocating increased credit to
expand governmental operations.
Second, now that we have both considerable infla­
tion and unemployment, we should not rely on driving
the money supply in one direction or another in order
to get out of this predicament; steady money growth
to stabilize prices should be initiated. In addition,
Hayek would undoubtedly advocate a reversal of the
progressive growth of the government sector as a sig­
nificant step toward the achievement of monetary
Third, one might conjecture the remedies Hayek
would endorse to include: 1) getting labor to accept
a smaller real wage temporarily; and 2) increasing
(over the longer run) the marginal productivity of
labor. With regard to the former remedy, Hayek
would likely suggest action to curb possible monopo­
listic practices of labor (he was also concerned about
monopolistic business practices). In addition, we should
cut job information costs and reduce uncertainty by
way of relying more strongly on the price signals
emitted by a free market economy. With regard to
the second remedy, Hayek would probably endorse
policies directed toward maximizing labor efficiency
through quantitative and qualitative improvements in
the private capital stock.
What would Hayek’s old rival Keynes suggest to
alleviate our current economic discomfort? One might
think that Keynes would turn toward vigorous gov­
ernment intervention in order to control unemploy­
ment and prices more closely. Keynes, however, was
quite pragmatic in his approach to economic policy­
making, as suggested by his change from a fairly or­
Page 9


MAY 1975

thodox, neoclassical economist in the years preceding
the 1930s to an advocate of government action in the
Great Depression. In his last conversation with Hayek,
Keynes indicated that he adapted his economic ideas
to fit the times. Hayek related the incident in the
following passage:

ment issues, showed impeccable timing in his endorse­
ment of the desirability of government intervention
to escape from the throes of the Great Depression.
Hayek, whose analysis incorporated both inflation and
unemployment issues, was pushed into relative ob­
scurity by the developments of the 1930s.

L ater a turn in the conversation m ade m e [Hayek]
ask him [Keynes] whether he was not concerned
about what some of his disciples were making of his
theories. After a not very complimentary remark about
the persons concerned he proceeded to reassure me:
those ideas had been badly needed at the time he had
launched them. But I need not be alarmed: if they
should ever becom e dangerous I could rely upon him
that he would again quickly swing round public opin­
ion — indicating by a quick movement of his hand
how rapidly that would b e done. B ut three months
later he was dead.13

It is not yet clear exactly who has the best explana­
tion for the economic events observed in the first half
of the 1970s. There has been inflation at times, un­
employment at times, and there have been times at
which the two have occurred simultaneously. The
Keynesian analytical framework, erected to explain
unemployment deficiencies alone, would appear lack­
ing. However, it is not obvious that the “forced saving”
argument advanced by Hayek would be necessary or
sufficient to explain our current problems. Possibly,
Hayek’s later theories, which interwove a concern for
growing governmental control of resources and the
money supply with a guarantee of full employment,
are closer to the mark. His concern was that the infla­
tionary tendencies inherent in these developments
would eventually result in a pronounced change in
the structure of capitalistic societies. In any event,
the fact that Hayek foresaw many of the actual eco­
nomic developments of the 1960s and early 1970s
provides strong incentive for further study of his
voluminous works.

F. A. von Hayek was a man ahead of his time. Now
living in_ Austria, he wrote extensively of price and
unemployment problems before switching later in life
to political and social concerns. His earlier writings
competed for attention with those of John Maynard
Keynes. Keynes, whose analysis focused on unemploy­
13F. A. Hayek, Studies in Philosophy, Politics and Economics,
(Chicago: The University of Chicago Press, 1967), p. 348.

Page 10

International Trade and Finance
Under the Influence of Oil - 1 9 7 4 and Early 1975

I n ANY given period, a country’s economic per­
formance in the international arena is determined by
both domestic and foreign forces. In 1974, however,
external forces (the operation of a foreign oil cartel)
exerted an overwhelming influence on virtually all
U.S. international transactions — both imports and
In addition to the impact of higher oil prices, U.S.
international transactions were affected by the depre­
ciation of the U.S. dollar against most major curren­
cies, high, though differing, rates of inflation here and
abroad, cyclical downturns in many countries, and the
removal of capital controls. Some of these factors are
likely to continue to influence our international eco­
nomic performance in 1975.
At the beginning of 1974, rates of economic growth
in most of the world were declining in response to
both supply constraints and earlier measures which
had been designed to slow the unsustainable eco­
nomic expansion which prevailed in 1972 and early
1973. Not the least of these supply constraints was
the October 1973 - March 1974 oil embargo and the
quadrupling in oil prices. This latter development
also caused significant changes in relative prices
within oil importing countries and thus influenced
their reported rates of inflation.

Petroleum-Related Problems . . .
With the announcement of higher oil prices, oil
importing countries became concerned about ensuing
oil payments and how to finance them. The fear was
that oil exporting countries would accumulate claims
on the output of all oil importers but would invest
their oil revenues in only a few industrial countries.
Furthermore, there was concern that the financing
burden of some countries would be so large as to
severely retard their future economic growth. Coin­
ciding with the development of these fears was the
implementation of an earlier U.S. decision to eliminate
existing controls on capital exports. Thus, if U.S.
financial markets would experience the anticipated
surplus inflow of funds from OPEC ( Organization of

Petroleum Exporting Countries), U.S. banks would
not be restricted in the intermediation of such funds
to other oil importers.
A further oil-related fear was that as a result of
projected trade deficits, countries might pursue poli­
cies aimed at coping with their own problems while
disregarding the possibly adverse effects on other
countries — generally referred to as beggar-thy-neighbor policies. Thus, while one country might benefit in
the short run, in the long run all countries would
eventually lose if every country pursued such policies.
In response to such fears, the countries belonging to
the Organization for Economic Cooperation and De­
velopment (O ECD ) reached an agreement in May
1974 to refrain from implementing beggar-thy-neighbor policies.

. . . Proved Somewhat Less Burdensome
The impact of the oil embargo, however, was not
as severe as initially anticipated and there was a
change in the pattern of demand for the world’s cur­
rencies. Some commercial banks, which had incor­
rectly anticipated exchange rate developments and
based their trading of individual currencies on earlier
projections, incurred unusually large financial losses
once their anticipations were not realized. This led to
the insolvency of some banks and increased the un­
certainty over how oil payments would be financed.
However, toward the end of the year, financial mar­
kets calmed, partly because the international banking
community began to understand the true impact and
proportions of the oil transfer problem.
Large merchandise trade deficits did emerge in most
oil importing countries, as expected, but the burden
of oil financing was handled almost entirely by the
private financial markets of the world. As a supple­
ment, members of OPEC provided loans to some less
developed countries as well as to Britain, France, and
Japan. Other intergovernmental financing arrange­
ments, such as the gold-guaranteed loan by Germany
to Italy, and the establishment of a special account
at the International Monetary Fund (IM F ), were
Page 11


MAY 1975

Com parative Rates of C h an ge of Industrial Production
A n n ual R a te s of C h a n g e fro m

P e rc e n t



Selected Short-Term M o n e y M a rk e t R a t e s 1

P r e v io u s Four O u a rte rs

P e rc e n t

1 96 9







ources: C a n a d ia n Sta tistico l R eview , Th< M in iste r o f In d u stry , Trade, a n d C o m m ei
In te rn a tio n a l F in a n c ia l Statistic

IM F ; E co n o m ic Trends, U.K. C en tra l

Statistical O ffice ; F e d e ra l R e se rve B o a rd

Exchange Rate Developments During
1974 and Early 1975
Unusually large capital movements occurred as a
result of the oil price increases and the subsequent
financing operations. Initially, many analysts both here
and abroad believed that the U.S. economy was less
vulnerable than other countries to a cutback in im­
ported oil, making dollar denominated assets attrac­
tive to foreign buyers. In addition, there was expec­
tation that the increasing receipts of oil exporting
countries would be invested mainly in dollar denomi­
nated assets. As a consequence, there was a rise in the
international price of the dollar early in 1974.
During the second quarter of 1974, after oil ship­
ments had resumed, the U.S. trade deficit increased
faster than initially expected, U.S. output declined
more sharply than expected, and inflation accelerated.

Page 12

Source: World Financial Markets. Morgan Guaranty Trust Company
U_The following rates were used:
Belgium— 4-month Fondes des Rentes certificates
C an ada— 3-month prime finance com pany paper
France— 3-month interbank money again st private paper
Germ any— 3-month interbank deposits
Italy— interbank deposits of up to one-month maturity
Japan— call money rate
United Kingdom — 3-month local authority deposits;
*3-month interbank deposits
United States— 3-month prime industrial paper
Eurodollar— prime b ank's bid rate for 3-month deposits in London

These factors all contributed to a decline in the inter­
national price of the dollar after the first quarter rise.
In mid-May 1974, the dollar depreciation halted
and began to reverse. Reduced rates of monetary
growth, rising interest rates in the United States rela­
tive to other countries, and the continuing large
accumulation of dollar denominated assets by OPEC
in Euro-dollar and U.S. financial markets contributed
to the renewed strength of the dollar. Beginning in
September, however, the international price of the
dollar declined again, probably in response to the
marked slowdown in U.S. economic activity, declining
U.S. interest rates, and reports that OPEC might shift
from dollars and sterling into continental European


MAY 1975

E x c h a n g e R a te M o v e m e n t s 1

Percent C hange A g a in st U .S. Dollar from M a y 1 970 Rates
--------- ----------------------


-------------------------------- 7 0

--------- -----------------------60

--------- -----------------------50

------------------------ -------


-------------------------------- 30

---------- --- 2

---------- ---


ill 11 11 11 11 11 I ill 11 11 .10
Source: Federal Reserve Bank of New York
LLExchonge rates expressed as U.S. cents per unit of foreign currency.

International Trade and Finance in 1974
The 1974 merchandise trade performance was
greatly affected by the sharply increased oil import
prices, despite the fact that oil import volume has
declined slightly since 1973. In fact, if oil imports are
excluded from these measurements, exports exceeded
imports by $19.2 billion in 1974.
A breakdown of U.S. international trade by coun­
tries reveals that while the volume of U.S. imports
from oil exporting countries increased, so did exports
to those countries. For example, U.S. merchandise
imports from OPEC increased from $5 billion in 1973
to $17 billion in 1974. U.S. merchandise exports to
OPEC, on the other hand, increased from $3 billion
in 1973 to $6 billion in 1974.
The dollar value of exports exceeded the dollar
value of imports for agricultural products, capital
goods, and chemicals in 1974, but the quantity of
agricultural exports declined by 9 percent. On the
other hand, the dollar value of imports of consumer
goods exceeded exports somewhat more than in 1973.
On balance, in 1974, merchandise imports exceeded
merchandise exports by $5.8 billion.

Net Investment Income and Special Transactions —
Net investment income increased to $9.7 billion in
1974 from $5.3 billion in 1973. A large portion of the
1974 increase resulted from inventory profits following
oil price increases and receipts from a large volume
of U.S. bank loans to customers abroad. There were
also special bookkeeping transactions such as the $2
billion U.S. Government grant to India which was
used to repay previous loans.

Long-Term C apital — Long-term capital outflows
increased significantly in 1974. U.S. direct investment
abroad amounted to $6.8 billion in 1974, as compared
to the 1973 investment of $4.9 billion. At the same
time a reduction of foreign purchases of U.S. stocks
and bonds significantly reduced inflows of long-term
capital. Inflows of foreign capital for direct invest­
ment in the United States fell slightly to $2.3 billion
in 1974, compared to $2.5 billion in 1973.
Short-Term Capital — Net outflows of nonliquid
short-term capital, mainly U.S. bank loans to foreign­
ers, increased rapidly during the first half of 1974. A
number of factors contributed to this development:
increased loan demand to meet oil import payments,
the removal of U.S. controls on capital outflows early
in the year, and higher interest rates in many foreign
countries relative to those in the United States. Dur­
ing the second half of 1974, however, U.S. bank loans
to foreigners were considerably smaller than in the
first half. This may have been related to a narrowing
of the differential between U.S. and foreign interest
rates and a leveling-off in foreign loan demand as the
volume of oil shipments returned to more normal
magnitudes following the post-embargo rebuilding of
It is apparent from this discussion that virtually all
major international transactions were influenced by
the greatly increased oil import prices. For this rea­
son, a more detailed analysis of the oil situation is pre­
sented in the next section.
Page 13


The Oil Situation
In spite of all the rhetoric about reducing our de­
pendence on foreign sources of oil, during 1974 the
United States actually increased the proportion of oil
acquired from foreign producers. During 1974 U.S.
oil consumption averaged 16.8 million barrels per day
(M B D ) while domestic production was 11 MBD. Im­
ports amounted to 6.1 MBD, or 36 percent of total
domestic consumption.1 In 1973, for comparison, oil
imports amounted to 35 percent of domestic consump­
tion. In order to put this development into perspec­
tive, U.S. oil consumption, production, and imports
are examined for the period 1950-1974.
United States Petroleum Su p p ly a n d D em a nd
R a tio S e a l*

R a tio Scale

Sources: Bureau of Mines, 1946-1955; Americon Petroleum Institute, 1956-1971;

U.S. Oil Consumption — In terms of the pattern
of U.S. oil consumption, there are four distinct periods
between 1950 and 1974. Between 1950 and 1964, U.S.
consumption of oil grew at an annual rate of 3.8 per­
cent. From 1964 to 1971, consumption increased at an
annual rate of 4.7 percent and from 1971 to 1973 ac­
celerated to a 7.2 percent annual rate. In response to
the oil embargo, sharply higher oil prices, and the
economic contraction experienced by the U.S. econ­
omy, oil consumption in 1974 decreased at a 3.9 per­
cent annual rate.
U.S. Oil Production — Again, the period 1950-1974
can be divided into four subperiods in terms of oil
production. Total production of crude and refined
oil in the United States between 1950 and 1964 in­
creased at an average annual rate of 3 percent. From
1964 to 1966 the rate of production briefly accelerated
lrThe difference between domestic production plus imports
and domestic consumption is due to the rebuilding of oil

Page 14

MAY 1975

to a 4.6 percent annual rate of increase. Beginning in
1966 and continuing through 1972, however, the rate
of production increased at only a 2.8 percent annual
rate. Finally, since 1972 domestic production has de­
clined at a 2.8 percent rate. Thus, from 1966 through
1973, the difference between domestic oil consump­
tion and domestic oil production widened. In 1974,
the differential narrowed as consumption declined
more than production.
This state of affairs is partially attributable to the
fact that the expansion of oil production facilities was
hindered by a number of factors. Among these factors
were environmental and safety regulations which
hampered attempts to construct new, and expand
existing, drilling and refining facilities. General price
controls, which affected the oil industry both directly
and indirectly, created bottlenecks in the production
of materials utilized in the construction of new facili­
ties. In addition, the existing dual price system for
oil — different prices for “new” and “old” oil — cer­
tainly was not conducive to providing the necessary
incentives for increasing production in 1974.

U.S. Oil Imports — During the period 1950-1964,
U.S. imports of oil increased at a fairly steady 7.2 per­
cent annual rate. From 1964 to 1967, reflecting the
increase in domestic crude oil production, U.S. oil
imports slowed to an annual rate of increase of 4 per­
cent. Beginning in 1967, however, U.S. oil imports in­
creased at a very sharp rate. For example, from 1967
to 1970 imports rose at a 10 percent annual rate and
between 1970 and 1973, as a result of absolute de­
clines in domestic oil production, and cyclical in­
creases in economic activity, accelerated to a 22 per­
cent annual rate of increase. Finally, in 1974, oil
imports declined 1.7 percent from 1973.

Oil Developments in 1974 and Beyond
As was expected at the beginning of 1974, gross
receipts by OPEC for oil exports amounted to $90
billion last year (receipts for other exports amounted
to an additional $5 billion). However, OPEC expendi­
tures on imports amounted to $35 billion, or about
one-third of total receipts.
Net OPEC receipts (total receipts minus expendi­
tures for imports), amounting to $60 billion, were
disposed of somewhat differently than initially ex­
pected. For example, direct placement of OPEC funds
in the United States amounted to only $11 billion.
Placements in the (more anonymous) Eurocurrency
market, on the other hand, amounted to $21 billion.
It is probable, however, that some OPEC Eurocur-

MAY 1975


even when economic growth resumes. The accruals of
oil revenues by OPEC may therefore not rise, and
may even decline over the next few years. Consider­
ing that OPEC imports from the oil importing coun­
tries will grow, the previously predicted accumulation
of OPEC reserves is not likely to materialize. In fact,
some studies taking the above factors into considera­
tion now project OPEC balance-of-trade deficits as
early as 1978. It should be pointed out that such
projections do not consider the possibility of a
break-up of the OPEC cartel which would result in
further reduction of oil revenues.

Summary and Outlook

rency placements were eventually channeled to U.S.
financial markets also.2 The remainder was composed
of loans and investments to other countries and to
international institutions.
With respect to the absorptive capacity of OPEC
countries, it is now apparent that far more oil reve­
nues than had been initially expected will be
expended in the near future for the purpose of es­
tablishing or improving industries in oil exporting
countries. OPEC imports from the United States in­
creased by 90 percent during 1974 and, while such a
rate of increase is not sustainable, the level of OPEC
imports will surely exceed that of years prior to 1974.
With respect to the consumption of oil in both the
United States and abroad, it seems reasonable at this
time to expect little or no growth in the next few
years. For one thing, high oil prices and temporary
reductions in the growth of aggregate demand, both
in the United States and other countries, have re­
duced oil consumption in general, and imports from
OPEC in particular. Moreover, new sources of oil
have been discovered in many non-OPEC countries
and prevailing world prices are conducive to con­
tinued intensive exploration. The upshot of this ar­
gument is that the quantity of oil demanded from
OPEC may not increase as fast as previously expected
2For a discussion of this development, see the December 1974
issue of this R eview, p. 14.

Sharply increased oil prices have significantly influ­
enced the 1974 trade performance. Excluding petro­
leum imports from and general merchandise exports
to OPEC, U.S. exports exceeded imports by $5 billion.
Even though U.S. merchandise exports to oil exporting
countries can be expected to increase in 1975, both
the value and the volume of total agricultural exports
can be expected to decline. In fact, some export or­
ders for agricultural commodities have already been
With respect to the emerging international eco­
nomic climate, the following observations may be
made. For some countries rates of inflation have al­
ready moderated, and for other countries the rates of
inflation can be expected to moderate at least in the
near term. For example, world commodity prices, ex­
cept for food and oil, have declined since May 1973,
the world food price index has declined since late
November 1974, and U.S. wholesale prices have de­
clined since December 1974. It is also likely that in
the second half of 1975 real economic growth in the
major industrial countries will resume.
A review of past and present economic policies
lends support to the prospective developments out­
lined above. For example, the response of an economy
to reduced monetary growth is first a slowdown in real
output and subsequently a reduction in prices. At the
same time, increased rates of monetary growth, which
are presently being experienced in the major indus­
trial countries, can be expected to lead to an expan­
sion in real economic growth. If the present monetary
stimulus is not too great, it is possible that the expec­
tations of both increased real economic growth and
reduced inflation may be realized.

Page 15

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102