Friedrich August von Hayek, “A Testing Time for Monetarism”

“A Testing Time for Monetarism” is a letter to the editor of The Times, published on June 13, 1980, and reproduced in the supplied 2022 version with explanatory editorial notes. Responding to Ivor Pearce’s challenge concerning wages and monetary expansion, Hayek defends a monetary explanation of inflation while arguing that monetary restraint cannot succeed without prior institutional reform. The letter moves from economic causation to political feasibility, then to a concrete financing proposal. Its central contention is that ending inflation requires removing both the pressures that induce governments to expand the money supply and their fiscal dependence on doing so.

Hayek begins by separating the economic determination of money’s value from the political circumstances governing its supply:

I am still convinced that, as far as economic causation is concerned, the value of money is wholly determined by the magnitude of the supply of money in relation to the demand for holding it.

This formulation includes the demand to hold money, rather than treating its quantity alone as sufficient explanation. Hayek explicitly agrees with Milton Friedman’s rejection of cost-push inflation. Yet this agreement does not eliminate the importance of trade unions: wage pressure can create circumstances in which a government believes monetary expansion is politically unavoidable. The editorial note on Pearce clarifies the dispute. Pearce had argued that wage increases prompted firms to obtain newly created bank money; Hayek’s reply preserves monetary causation while acknowledging that political pressure can determine the authorities’ response. The distinction allows him to assign unions a decisive role in sustaining inflation without treating wage increases as an independent monetary mechanism.

The consequence is an argument about the necessary order of reform:

For this reason I am even convinced that trade union reform must precede monetary reform.

Hayek’s emphasis falls on the institutional conditions under which restraint can be maintained. As long as unions retain their existing power and government controls the money supply, he believes governments cannot politically withstand demands for additional money. Gradualism therefore fails in both fields: it leaves the source of pressure intact while postponing the stabilization that might demonstrate reform’s benefits. This is a conditional political judgment, not merely a restatement of monetarist theory. The feasibility of controlling money depends on changing the legal and political environment within which control is exercised.

Hayek acknowledges that a theoretician, especially one living abroad, should hesitate to prescribe political decisions. Nevertheless, he proposes a referendum authorizing the immediate removal of all legally granted special privileges of trade unions, followed immediately by the termination of inflation. The electoral calendar supplies his urgency. Reform must happen early enough for its beneficial effects to become visible before the government’s term ends. The accompanying editorial note places this proposal alongside his correspondence with Margaret Thatcher and Norman Tebbit, recording both Thatcher’s guarded response and Tebbit’s concern that so radical a measure would encounter disabling controversy. Those notes illuminate the proposal’s political reception without changing the letter’s own uncompromising timetable.

The next movement distinguishes the technical capacity to stop inflation from the government’s capacity to finance itself afterward. Hayek invokes Arthur Burns’s acknowledgment that monetary authorities can stop inflation quickly, but identifies public finance as the practical obstacle:

Ending inflation demands that government is deprived of the recourse to the printing press for financing its expenditure.

Stopping inflation consequently requires a balanced budget. Hayek nevertheless concedes that a government cannot achieve this overnight. His rejection of gradual monetary stabilization therefore coexists with acceptance of a fiscal transition lasting perhaps two years. The distinction matters: expenditure reduction may take time, but that interval must be financed without continuing inflation. In his assessment, ordinary sterling borrowing would threaten further inflation and impose an intolerable burden. The letter does not elaborate that assessment, but uses it to motivate an alternative form of public debt.

Hayek proposes a chiefly domestic loan denominated in an indexed unit provisionally called “solids.” He expects savers lacking satisfactory outlets for their funds to accept relatively low interest rates in exchange for protection of value. The proposal also depends on the British government’s surviving reputation for honesty, which he treats as a potentially valuable asset rather than an assured entitlement. “Solids” would be defined and redeemable through quantities of other currencies sufficient, at the time of redemption, to purchase a precisely specified basket of internationally traded raw materials. This is a proposal for commodity-indexed borrowing mediated through currencies, not a promise to redeem the loan directly in physical commodities.

The immediate purpose is to give the government time to bring expenditure within revenue without relying on monetary finance. Hayek also suggests that the indexed unit might eventually become the basis of a new British currency, though the letter does not develop that possibility. Its concluding warning returns to the political timing of the entire program:

If the present rightly directed efforts fail because of delay, it may be the loss of the last chance of a British recovery for generations.

The letter’s relevance lies in its insistence that monetary stabilization is inseparable from institutional power, fiscal arrangements, and electoral constraints. Hayek endorses the direction of government policy while questioning whether its pace and supporting institutions can make it effective. His distinctive conceptual move is to preserve a monetary account of inflation while relocating the decisive obstacles to the political production of money. The indexed loan completes that argument by offering a bridge between immediate monetary restraint and slower fiscal adjustment.