hayek vs. keynes
TRANSCRIPT
Brandon Harnish
HS 368: The Making of Modern America
Dr. Webb
Spring 2010
Friedrich A. Hayek’s Trouble with John Maynard Keynes and His Macroeconomics
By the 1940s, Friedrich A. Hayek’s influence in technical economics was on the decline.
Many of his students had moved into the Keynesian circle since the heralded publication of The
General Theory of Employment, Interest, and Money (1936). One student, Ludwig Lachmann,
remembers that in the early 1930s, nearly everyone at the London School of Economics was a
Hayekian; ten years later, there were only two, Hayek and himself.1 In 1946, Hayek’s good
friend and former ally in the socialist calculation debate, Lionel Robbins, joined the “Keynesian
Revolution” as well. After the war, his own government in England began putting into place
much of the democratic-socialist program that he had criticized in The Road to Serfdom (1944),
and in 1950, he would leave for the Committee on Social Thought at the University of Chicago,
never to live in his cultural home again.2
The previous decade had been one of wearisome conflict and criticism from numerous
corners for Hayek, on top of his struggles with a new language. His work Prices and Production
(1931) received a spiteful review from Keynes, being described as a collection of “frightful
muddles,” an example of how, “starting with a mistake, a remorseless logician can end up in
Bedlam.”3 His follow up, The Pure Theory of Capital (1941), which sought to provide a solid
capital theory foundation to his business cycle theory, was hardly noticed by the economics
1 Alan Ebenstein, Hayek’s Journey: The Mind of Friedrich Hayek (New York: Palgrave, 2003), p. 90.2 F. A. Hayek, Contra Keynes and Cambridge, Essays, Correspondence, vol. 9, The Collected Works of F. A. Hayek, Bruce Caldwell, ed., (Chicago: The University of Chicago Press, 1995), pp. 45-46. 3 J. M. Keynes, “The Pure Theory of Money. A Reply to Dr. Hayek,” in Hayek, Contra Keynes and Cambridge, p. 154.
profession with much of the attention on the war, and even Hayek himself was unsatisfied with
the finished product. At this juncture, Hayek had become tired of economics proper and moved
on to other projects having never written a review of Keynes’ General Theory, a decision he
would regret.4 In 1965, Time announced, “We are all Keynesians now.”5 The debate was over.
Keynes had won.
In 1946, Hayek saw his friend Keynes for the last time. They were, it appears, often able
to set aside professional differences. He asked him whether he was concerned of what some of
his students were making of his theories. Hayek had read a pamphlet by Keynes which suggested
that he and his old rival were not as far off as first seemed, and that Keynes was, without
question, no inflationist. Further, Keynes had given an agreeable review of The Road to
Serfdom.6 Keynes told Hayek not to worry, that should any of his followers become dangerous,
he would turn public opinion against them. Hayek recalled that Keynes quickly moved his hand
to demonstrate how rapidly that would be done. Three months later, Keynes was dead.7
In the 1970s, stagflation dealt the Keynesian paradigm a devastating blow. According to
Keynesian theory, recessions are caused by underspending and inflation is caused by
overspending. The key for governments is to find that happy balance between inflation and
unemployment, to “fine-tune” the economy. If the economy is getting too hot, the central bank 4 Bruce Caldwell, Hayek’s Challenge: An Intellectual Biography of F. A. Hayek (Chicago: University of Chicago Press, 2004), pp. 180-181; Bruce Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 40. Much has been written on why Hayek decided not to review Keynes’ General Theory. The answer is multifaceted, ranging from a previous review experience of Hayek’s where Keynes simply change his mind, to Hayek’s apparent belief that there were more pressing matters at hand, to Hayek being tired of controversy, and more. 5 “The Economy: We are All Keynesians Now,” December 31, 1965. http://www.time.com/time/magazine/article/0,9171,842353-1,00.html (accessed February 25, 2010)6 Keynes had read the book on a trip to America. He wrote, “The voyage has given me the chance to read your book properly. In my opinion it is a grand book. We all have the greatest reason to be grateful to you for saying so well what needs so much to be said. You will not expect me to accept quite all the economic dicta in it. But morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in a deeply moved agreement.” Letter, Keynes to Hayek, June 28, 1944, reprinted in Activities 1940-1956: Shaping the Post-War World: Employment and Commodities, ed. Donald Moggridge, vol. 27 (1980) of The Collected Writings of J. M. Keynes (London: Macmillan, 1971-1989), p. 385, found in Hayek, Contra Keynes and Cambridge, p. 46. 7 F. A. Hayek, “Review of Harrod’s Life of J. M. Keynes,” in Hayek, Contra Keynes and Cambridge, p. 232; pp. 44-45.
can raise interest rates. If it is slowing down, the bank can lower interest rates and the legislature
can sustain deficits. What, then, is the bank to do if both inflation and recession occur at once?
This run-in with the law of non-contradiction lead Austrian economist Murray Rothbard to write,
“Since 1973-74, Keynesianism has been intellectually finished, dead from the neck up.”8 Hayek,
writing in 1950, noted that such policy measures could very well result in an inflationary
recession and concluded that “[a] government which uses inflation as an instrument of policy but
wants to produce only the desired effects is soon driven to control ever increasing parts of the
economy;”9 thus came Nixon’s wage and price controls in August of 1971.
In 1974, Hayek was awarded the Nobel Memorial Prize in Economics for his work in
business cycle theory, referred to at the time by Rothbard as “a welcome and blockbuster
surprise to his free-market admirers in this country and throughout the world.”10 This was a
surprise on two counts: One, because Hayek was a leading free-market economist: Two, because
he was a dedicated opponent of those economists who postured themselves as scientific experts
of economic planning, the sort to whom Nobel Prizes were usually given.11 The award sparked a
renewed interest in his work and a broader revival in Austrian economics.12 In the spring of
1992, Hayek died at his home in Freiburg.
The debate between Friedrich A. Hayek and John Maynard Keynes stands as one of the
most important episodes in the development of economic theory, in the development of business
cycle theory, and in the development of economic policy. Bruce Caldwell, editor of The
Collected Works of F. A. Hayek, a massive project under construction since 1990, concluded that
8 Llewellyn H. Rockwell, ed., The Economics of Liberty (Auburn, Alabama: Ludwig von Mises Institute, 1990), p. 30.9 F. A. Hayek, Studies in Philosophy, Politics, and Economics (New York: Simon and Schuster, 1967), p. 176.10 Murray Rothbard, “Hayek and the Nobel Prize,” http://mises.org/daily/4082 (accessed February 4, 2010)11 Ibid.12 Joe Salerno, “The Second Austrian Revival,” March 18, 2010. http://mises.org/daily/4202 (accessed April 21, 2010).
“[Keynes] and [Hayek] differed profoundly in their responses to the interwar world that they
inhabited. Both observed a world gone mad. Keynes saw salvation in a thorough revision of the
liberal order. Hayek saw it in the rediscovery of one. Their debate over this question continues to
this day; it perhaps the most important issue that democratic regimes, old or new, must
address.”13 If only to confirm this contention, the monthly sales of The Road to Serfdom more
than quadrupled with the onset of the Panic of 2008.14 Indeed, Hayek and the Austrian tradition
of which he is part have never been more relevant than they are today. At the same time,
Keynesian economics has come back into view, and for similar reason. Those looking for a
theoretical underpinning for the Economic Stimulus Act of 2008 and the American Recovery and
Reinvestment Act of 2009 can find it in Keynes and his followers. To be sure, Keynesian
economics still rules the day in Washington D. C.
This paper looks to briefly unpack Hayek’s troubles with Keynes’s economic program. It
will do so by moving through three areas of disagreement. The third will feature a juxtaposition
of Hayek’s business cycle theory, illustrated by a “Hayekian triangle,” with Keynes’ circular
flow economy. Hayek’s problems with Keynesian economics run deep into methodology and
carry broad implications that affect government policy. A full picture requires an explanation of
all areas. Hayek’s first two problems may be considered methodological; his third, both
economic and political.
Hayek’s criticism of Keynes was, in principle, a sweeping condemnation of
macroeconomics, a phrase around which Hayek derisively placed quotation marks. To Hayek,
macroeconomics tended to obscure the understanding of economics as a science of human
13 Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 48.14 Bruce Caldwell, “The Secret Behind the Hot Sales of ‘The Road to Serfdom’ by Free-Market Economist F. A. Hayek,” February 17, 2010. http://voices.washingtonpost.com/shortstack/2010/02/the_secret_behind_the_hot_sale.html (accessed February 25, 2010)
action, what he sometimes called, “catallactics,”15 meaning, the study of "the order brought about
by the mutual adjustment of many individual economies in a market."16 Hayek was unsatisfied
with even the term “economics,” which in Greek means “household management,” and therefore
gives the impression that economies are meant to be managed or consist of groups of actors with
shared plans and goals.17 The phrase “catallactics” provides a linguistic example of the
theoretical clash between Hayek’s understanding of economics and the Keynesian view, which
sees economies in large aggregates and in need of government management. Hayek, then, was
careful to emphasize methodological individualism and subjective marginal utility theory, which,
in the Austrian tradition, by focusing on the subjective nature of economic value, never lost sight
of the human actor in economic affairs and never believed that the central planning of large scale
economies could bring about prosperity or the sustained creation of wealth.18
Keynesian macroeconomics troubled Hayek on three major counts: First, there was the
problem of its using mathematics to explain economic phenomena.19 If one understands
economic value as subjective, as coming from the individual human mind and changing at
different points in time with no necessary correspondence to the physical order, then efforts to
make economics into a “hard” science like physics or engineering is sure to present a
methodological issue. Indeed, it did for Hayek, who directed several attacks against this
approach, which he called “scientism.” Rather than letting the subject matter guide the method,
15 F. A. Hayek, The Fatal Conceit: The Errors of Socialism (Chicago: The University of Chicago Press, 1988), p. 98.16 F. A. Hayek, Law, Legislation, and Liberty, Vol. 2: The Mirage of Social Justice (Chicago: The University of Chicago Press, 1978), pp. 108-109.17 Ibid.18 In their explanation of economic phenomena, the classical economists focused on the value of objects and searched for an explanation of prices in the history of the object itself, either labor or cost of production. The Austrian school moved the focus away from goods and towards actors, away from the things being valued and on the actors doing the valuing. This is known as the principle of subjectivism, which Hayek considered one of the great advancements in the history of economic science. See, F. A. Hayek, The Counter-Revolution of Science: Studies on the Abuse of Reason (Chicago: The University of Chicago Press, 1979), p. 31. 19 Hayek, The Fatal Conceit, p. 99.
scientism brought over the method of natural science and applied it uncritically to human
action.20 It was, however, precisely this feature of the Keynesian model that carried sway among
economists, as Bruce Caldwell observed, “Keynes presented his ideas within what economists
call a ‘comparative static’ framework, one that conveys a sense of both determinateness and
rigorous simplicity.”…Keynes’ model was easily translatable mathematically; those who tried to
develop Hayek’s framework met with failure.”21 In the years immediately following the Second
World War - an event which appeared to vindicate the Keynesian antidote for depressions:
government demand management - neo-Keynesian economists John Hicks and Paul Samuelson
formalized Keynesian comparative statistics in economics, most notably with the C+I+G=Y
formula.22 Some tried to translate Hayek’s model into a mathematical expression but little came
of it, as Hicks reflected, “Several of us made attempts at that translation; the journals of the
1930s are full of them. But what emerged when we tried to put the Hayek theory into our own
words was not Hayek. It was some inner mystery to which we failed to penetrate.”23
Further, Hayek saw economic phenomena as consisting in large part of an entrepreneurial
discovery process. The economist, as he regularly restated, is never allowed access to an existing
20 See, Hayek, The Counter-Revolution of Science and F. A. Hayek, The Sensory Order (Chicago: The University of Chicago Press, 1952. Hayek’s assessment of scientism and his work in psychology provide a thoroughgoing critique of behaviorism. Bruce Caldwell lists three points of emphasis: First, behaviorists deny the existence of the two factual orders, the objective and the subjective, and speak as though they are one and the same. To Hayek, however, the subjective order is of great importance in understanding economic phenomena, which are always the result of human action, not of physical properties within resources. Second, behaviorists, in denying that the phenomenal order is separate and different than the physical order, violate their own principles by making reference to observed events which themselves are a part of the phenomenal order. Third, behaviorists believe that in removing the phenomenal order and focusing only on the physical order they are eliminating interpretation from science. However, for Hayek, the process of classification within the phenomenal order is itself an act of interpretation. Therefore, science, or any human endeavor, is never free from interpretation. Hayek believed that his work in psychology was among his most important contributions to knowledge. As a young man Hayek pursued interests in genetics, psychology, and psychiatry. After the publication of The Road to Serfdom, he spent his time reigniting that old interest and writing The Sensory Order. See Caldwell, Hayek’s Challenge, pp. 270-272; G. R. Steele, The Economics of Friedrich Hayek (New York: St. Martin’s Press, Inc., 1993), p. 3; Alan Ebenstein, Friedrich Hayek: A Biography (New York: Palgrave, 2001), pp. 147-148.21 Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 33.22 Ibid. (C) consumption spending + (I) investment spending + (G) government spending = (Y) national income23 Hayek, Contra Keynes and Cambridge, p. 33n
stock of data or knowledge collectable into a single planning body. It is never his task to
maximize efficiency in the economy in same way an engineer tries to maximize efficiency in an
engine or computer or light bulb. “The economic problem of society,” Hayek explained, “is thus
not merely a problem of how to allocate “given” resources – if ‘given’ is taken to mean given to
a single mind which deliberately solves the problem set by these ‘data.’ It is rather a problem of
how to secure the best use of resources known to any of the members of society for ends whose
relative importance only these individuals know. Or, to put it briefly, it is a problem of the
utilization of knowledge which is not given to anyone in its totality.”24 There were those, such as
Oscar Lange in the 1930s, who suggested that the entrepreneurial discovery process could be
replaced by a scientific planning board. This suggestion, of course, ignored the fact that prices
are themselves information which only the market is in a position to provide.
Second, there was the problem of Keynes’ aggregation. Opposition to statistical
aggregation that masks the movement of relative prices in particular lines of industry has always
been a methodological principle of the Austrian school. Their business cycle theory is in part the
story of how market prices coordinate supply and demand over time and move resources to areas
of more relative importance as determined by consumer time-preference and choice, thus
producing a pattern of sustainable growth without sudden shocks of mass unemployment, the
type seen during the 1930s. This process, Hayek observed “is wholly concealed by the analysis
Keynes chose to adopt and which has since come to be known as ‘macroeconomics’: an analysis
in terms of the relations between various aggregates or averages, such as aggregate demand or
supply, average prices etc.”25 Elsewhere he noted, “The General Theory…took the whole
24 F. A. Hayek, “The Use of Knowledge in Society,” American Economic Review, XXXV, No. 4 (September, 1945), pp. 519-30, in F. A. Hayek, Individualism and Economic Order (Chicago: The University of Chicago Press, 1948), p. 77-78.25 F. A Hayek, “The Keynes Centenary: The Austrian Critique,” The Economist, June 11, 1983, pp. 45-48, in Hayek, Contra Keynes and Cambridge, p. 251.
structure of relative prices for granted and provided no tools to explain the changes in relative
prices or their effects.”26 In the Keynesian model, profits and the earnings of capital are separated
in such a way as to create aggregates of “total profits” and “demand for factors of production,”
with no analysis whatever of the various lines of production and of the relative price fluctuations
that make for profit and loss. “Mr. Keynes’s aggregates,” thus wrote Hayek, “conceal the most
fundamental mechanisms of change.”27
The combination of an uncritical bias in favor of mathematical expressions and aggregate
statistical magnitudes, Hayek recalled, was the root problem of the Keynesian revolution: “To
me it seems as if this whole effort were due to a mistaken effort to make the statistically
observable magnitude the main object of theoretical explanation.” But, he warned, “The fact that
we can statistically ascertain certain magnitudes does not make them causally significant, and
there seems to me no justification whatever in the widely held conviction that there must be
discoverable regularities in the relation between those magnitudes on which we have statistical
information.”28
Notably, The General Theory was written during the Great Depression and during a
paradigm shift in economic thought from microeconomics to macroeconomics. The combination
of the fact that political leaders tend towards action in times of crisis and the emergence of an
economic program that gave intellectual backing to such action, and fit nicely with Keynes’
model, account for The General Theory’s success, but also for Hayek’s third trouble: It’s integral
call for government economic intervention.
26 F. A. Hayek, “The Economics of the 1930s as Seen from London,” in Hayek, Contra Keynes and Cambridge, p. 60.27 F. A. Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica, vol. 11, no. 33, August 1931, pp. 270-295, in Hayek, Contra Keynes and Cambridge, p. 128.28 F. A. Hayek, “The Economics of the 1930s as Seen from London,” p. 61.
On the matter of the significance of the historical context of The General Theory, Alan
Ebenstein makes the interesting point that the title “General Theory” was intended to bring to
mind Einstein’s general theory of relativity, published in 1915. As Einstein had revolutionized
physics, so too was Keynes trying to change the face of economics, and in much the same way.
Einstein showed Newtonian physics to be relative and appropriate only as far as it goes. Keynes
was attempting the same with economics, namely, with Say’s Law, or the ability of markets to
adjust to changing conditions.29 The pivotal question in the debate between Hayek and Keyes is
this: Are markets in need of government macromanagement or are they self sustaining and able
to go on without cyclical depressions? If so, then what accounts for the cycle of boom and bust?
The Austrian theory of the trade cycle provides Hayek’s answer and likewise a major source of
his disagreement Keynes.
The Austrian theory of the trade cycle, set forth by Ludwig von Mises in Theory of
Money and Credit (1912) and further developed by Hayek in Monetary Theory and the Trade
Cycle (1933) and Prices and Production, attempts to explain the process by which markets
absent government management coordinate production and allocate resources intertemporally.
Moreover, and vital for the formulation of policy, it attempts to explain how monetary expansion
by governments, the sort which Keynes considered necessary to prevent recession, end in
distortions of the structure of production, unemployment, inflation, and a disequilibrium of
supply and demand. The 1920s observed a tremendous rise in capital goods prices, as reflected in
the booming stock market, and this is precisely what Austrian theory would expect to see prior to
a depression such as that which occurred during the 1930s and 1940s.30 Also, in areas of
29 Ebenstein, Hayek’s Journey, p. 86.30 The length of its duration is a somewhat separate issue, focusing in part on how long the inflationary boom was sustained in the first place – a longer boom means a sharper depression – but moreso on how the government responds to the crisis: does it intervene as it did in the 1930s or does it let the depression run its course, which as Austrian theory shows is the market’s corrective liquidation of the malinvestments brought about by inflation? The Mises-Hayek theory of the trade cycle does not comment on this particular point other than to say continued
consumer goods, the price level remained stable, which, in the face of increased productivity,
would have fallen in a non-inflationary environment, thus improving general living standards.31
But what of the anatomy of Hayek’s theory? What were his troubles with Keynesian political-
economy?
In the early 1930s, Hayek was chosen to review a new work by Keynes, A Treatise on
Money (1930). He was in a particularly good position for such a project. He had already
published and had in the works books on monetary economics. Further, he and Keynes’ theories
were both developed from Knut Wicksell, a 19th century Swedish economist whose first book
sought to integrate Austrian school economist Eugen von Böhm-Bawerk’s theory of capital with
marginal productivity theory. Wicksell’s book Interest and Prices made a distinction between
the “market” rate of interest and the “natural” rate of interest, which proves vital in Hayek’s
effort square business cycle theory with equilibrium theory.
Equilibrium theory states that in a market system, changes in supply and demand bring
about adjustments in relative prices which coordinate the actions of buyers and sellers. In other
words, prices operate as a coordination mechanism. In the loanable funds market, changes in
supply and demand are reflected in interest rates. The natural rate of interest is a reflection of
consumer time-preference, the decision to consume now or later. If time-preference is low and
consumers prefer later consumption to present consumption, the interest rate will fall as
reflection of the greater savings. Investors respond to this price signal by taking out loans and
beginning new projects which suddenly become profitable. These loans tend to be spent on more
“roundabout” methods of production, or “goods of a higher order,” that is, those methods of
production which are farthest removed in time from the consumer. Hayek illustrated the capital
inflation to prevent depressions will only result in hyperinflation and a fate far worse than any downturn.31 Murray Rothbard, America’s Great Depression, fifth edition (Auburn, Alabama: Ludwig von Mises Institute, 2000), p. 171.
structure with a triangle.32 In the situation described, the capital structure was lengthened as
producers responded to the low interest rates and begun investment in higher order goods, which
are the most interest rate sensitive. “Investment,” then, is not simply an aggregate process of
adding more machines, but a change in the structure of production to and from different methods
depending on relative price changes. The price mechanism, as Hayek described it, is a “kind of
machinery for registering change.”33 It is a “system of telecommunications” which enables
entrepreneurs to adjust their activities to changes which they know nothing of, thus bringing
about economic harmony without economic planning in the form of centralized decision making.
On the contrary, as Hayek’s theory makes clear, it is government meddling which creates
economic discoordination and cyclical booms and busts.34
This brings us to Wicksell and the “market” rate of interest. The important point to
understand is that the market rate can differ from the natural rate. Within the context of a
discussion on trade cycle theory, a market rate lower than the natural rate carries explanatory
power. When market rates are lowered by credit expansion, they cease to reflect the natural rate
and in turn the valuations of consumers. Hayek and other Austrians point to this as the cause of
the cycle. Lowering the market rate below the level of the natural rate via credit expansion sends
a signal to investors to begin lengthening the structure of production. Firms use the credit to
make their necessary purchases and the prices of capital goods are bid up. However, this line of
economic activity fails to reflect consumer time-preference and the economy is pulled in two
directions – towards both consumption and investment. The growth cannot be sustained and, in
time, scarcity reasserts itself. Firms discover their projects to be unprofitable and a period of
readjustment follows – the bust. As the structure of production adjusts to match the buying habits 32 F. A. Hayek, Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 228.33 Hayek, “The Use of Knowledge in Society,” p. 87.34 Ibid.
of consumers and the real pool of available savings, the malinvestments are liquidated and
unemployed resources, including labor, become visible. “In this connection, as in so many
others,” Hayek concluded, “we are forced to recognize the fundamental truth, so frequently
neglected nowadays, that the machinery of capitalistic production will function smoothly only so
long as we are satisfied to consume no more than that part of our total wealth which under the
existing organization of production is destined for current consumption.”35
Keynes also put Wicksell’s distinction between market and natural rates of interest to use
but, significantly, ignored the capital theory foundation.36 Hayek pointed out this problem in the
review: “Mr. Keynes ignores completely the general theoretical basis of Wicksell’s theory.”37
The failure to incorporate this foundation prevented Keynes from seeing the changes within the
capital structure. Indeed, Hayek believed that this was the fatal error of the entire Keynesian
system.38 He laid out the whole mistake: Businessmen must make decisions on what proportion
of their funds will be used for current production and future production. Their choice is
influenced by technical knowledge and the relative demand for future or present consumption.
The ability to see this process requires the capital theory which Keynes ignores. It is,
consequently, at this point that Keynes obscures the “mechanisms of change” and aggregates the
production of consumption goods from the production of investment goods, thus C + I. Hayek
disagreed sharply and concluded: “The alternative is not between producing consumption goods
or producing investment goods, but between producing investment goods which will yield
consumption goods at a more or less distant date in the future.”39
35 Hayek, Prices and Production, pp. 272-273.36 Caldwell, Hayek’s Challenge, p. 177; Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 14.37 Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” p. 130.38 Hayek, “The Keynes Centenary,” p. 251.39 Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” p. 137.
What does Keynes’ theory mean for the theory of the trade cycle? It means that the
policies which Hayek’s theory points to as causal are pointed to by Keynesianism as preventative
and as positive means for growth. Where Hayek saw a tradeoff between consumption and
investment, and thus emphasized the intertemporal coordination function of market prices,
Keynes swept the tradeoff aside, and saw consumption and investment as moving side by side in
a circular pattern. More investment means more income and more income means more
consumption which means more profits and therefore more investment. If the “animal spirits” of
entrepreneurs wane, then government policy must pick up the slack through fiscal and monetary
measures which have a “multiplier effect,” i.e., one person’s spending is another person’s
spending and so on and so forth. Savings, in this analysis, are inimical to economic growth
because they restrain spending – the very opposite of Hayek’s view, which describes savings as
the only means to sustainable growth. Prices too fail to perform the responsibility Hayek
ascribed to them, which is Keynes’ more fundamental swipe at Say’s Law and the position that
there can never be a “general glut” where supply exceeds demand if prices are permitted to
fluctuate freely. It would stand to reason that if Keynes disagreed with Hayek on capital theory,
the relationship between investment and consumption, the role of savings, and the function of
prices, then he would disagree with him on the manner of handling the boom and bust cycle.
Indeed, he did; as he wrote, “Thus the remedy for the boom is not a higher rate of interest but a
lower rate of interest! For that may enable the so-called boom to last. The right remedy for the
trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-
slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”40 This, of
course, is the worst possible suggestion in Hayek’s view, because not only does it aggravate the
40 J. M. Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace and Company, 1936), p. 322.
problem, increasing the totality of malinvestments and delaying the painful but necessary
adjustment process, it is the problem, encumbering the coordination function of interest rates
thus creating the malinvestments in the first place. During the Great Depression, Hayek chastised
the cry for perpetually low interest rates:
What we need is a readjustment of those elements in the structure of production and of
prices.…But, instead of furthering the inevitable liquidation of the maladjustments
brought about by the boom during the last three years, all conceivable means have been
used to prevent that readjustment from taking place; and one of these means, which has
been repeatedly tried though without success, from the earliest to the most recent stages
of depression, has been this deliberate policy of credit expansion.…To combat the
depression by a forced credit expansion is to attempt to cure the evil by the very means
which brought it about; because we are suffering from a misdirection of production, we
want to create further misdirection—a procedure that can only lead to a much more
severe crisis as soon as the credit expansion comes to an end.41
The political-economic implications of Keynesianism were anathema to Hayek, and each
gave support to the other. Keynesian economic doctrine dresses the government for a continuous
stabilization role which the Hayekian system sees as (1) unnecessary, because market prices
coordinate economic activity and plot the course for a sustainable pattern of growth; (2) unwise,
because inflation creates economic discoordination as seen in the trade cycle and is to blame for
the dispiriting and painful adjustment process; and (3) dangerous, because Keynesian economic
policy tends towards more government control and is, as Keynes himself admitted in the preface
to the German edition of The General Theory, more easily applied in a totalitarian system:
“[T]he theory of output as a whole, which is what the following book purports to provide, is
41 Hayek, Prices and Production, pp. 6-7.
much more easily adapted to the conditions of a totalitarian state, than is the theory of production
and distribution of a given output produced under the conditions of free competition and a large
measure of laissez-faire.”42
Hayek was intellectually generous to his old friend, perhaps overly so. In 1983, he looked
back on the inflationary recession of the 1970s and more or less exempted Keynes from blame.
Most of the responsibility fell on those, he thought, who carried on under the Keynesian banner
but supported policies which Keynes himself would not have approved.43 Earlier, in 1974, he was
somewhat more candid, writing, “The responsibility of the current world-wide inflation, I am
sorry to say, rests wholly and squarely with the economists, or at least with that great majority of
my fellow economists who have embraced the teachings of Lord Keynes.”44 In the final analysis,
Hayek’s contest with Keynesian macroeconomics leaves this fundamental insight: There is no
benefit to inflation. Its purported ability to bring about full employment at the small cost of a
slight redistribution of income disregards its most systemic and sardonic harm – the distortion of
the capital structure and the eventual mass unemployment of labor evermore extensive than that
which it was initiated to prevent. Government fiscal policy as a means to economic recovery
from recession suffers under the same delusion – that a “general glut” comes about due to
42 Hayek, “The Keynes Centenary,” p. 254n. Notably, Hayek was a critic of government planning in part for the economic reasons here described, but also for matters pertaining to historically rival traditions of government. On the one hand, there was the French tradition with its rationalism and inflated view of the powers of human reason. This “abuse of reason” would carry important consequences with regards to the conceit of 20th century economic planning. On the other hand, there was the British tradition, rooted in an understanding of traditional contrivances which were the result of human action but not of human design. Hayek stretched this distinction all the way back to Athens and set it against Sparta. He drew up two broad categories (constructivist rationalism and critical rationalism) and named names. On the side of his own view of freedom were, in part, Aristotle, Thomas Aquinas, Adam Smith, Alexis de Tocqueville, Lord Acton and William Gladstone. On the opposite side, the side of totalitarianism, were, in part, Plato, Descartes, Thomas Hobbes, G. W. F. Hegel, Auguste Comte, Karl Marx, and B. F. Skinner. See F. A. Hayek, The Constitution of Liberty (Chicago: The University of Chicago Press, 1960), pp. 54-58; F. A. Hayek, “The Errors of Constructivism,” in New Studies in Philosophy, Politics, Economics and the History of Ideas (Chicago: The University of Chicago Press, 1978), pp. 3-22; Arthur Diamond Jr., “F. A. Hayek on Constructivism and Ethics,” http://mises.org/journals/jls/4_4/4_4_2.pdf (accessed April 26, 2010)43 Hayek, “The Keynes Centenary,” p. 247.44 F. A. Hayek, “The Campaign Against Keynesian Inflation,” in New Studies, p. 192.
underspending and some manner of state action is needed to “prime the pump” and employ idle
resources.
Gerald O’Driscoll Jr.’s recent comments on the importance of truth telling in markets
provide an interesting framework for some concluding remarks on Hayek and Keynes.45 It may
be polemical to say so, but in a very real sense Hayek put forward an economy of truth telling
where Keynes put forth an economy of lies. O’Driscoll, in this regard, specifically notes the need
for interest rates to be reliable guides in the allocation of capital across time. If the price system
is a mechanism for the communication of knowledge, as Hayek believed, then a necessary
condition for its success must be the communication of correct knowledge. After all, if the
capital structure has been adjusted based on faulty information, then we should expect nothing
less than a faulty system of production. Indeed, that is precisely what Hayek warned we would
get.
Is economics set for a counter-revolution in the tradition of Hayek? In some ways, it has
already occurred. The scientism and positivism of the early and middle 20th century no longer
hold much clout and the collapse of the Soviet Union in 1989 provided the final proof in the
Socialist Calculation debate.46 In other ways, Hayek remains hidden. The present financial crisis,
brought about, in part, by credit expansion, and the American government’s response under both
George W. Bush and Barack Obama leave room for doubt that the Keynesian paradigm will ever
be shaken.
In 1927, a young Friedrich Hayek received a postcard in reply from the famous
economist, John Maynard Keynes. Keynes had struck gold with The Economic Consequences of
45 Gerald P. O’Driscoll Jr., “An Economy of Liars,” April 20, 2010, http://online.wsj.com/article/SB10001424052748704508904575192430373566758.html?KEYWORDS=an+economy+of+liars (accessed, April 25, 2010)46 F. A. Hayek, “Socialist Calculation I: The Nature and History of the Problem,” in Individualism and Economic Order (Chicago: The University of Chicago Press, 1935), pp. 119-147.
the Peace just eight years prior. It read, “I am sorry to say that my stock of Mathematical
Psychics is exhausted.” This was the moment that began their relationship and, in turn, a battle
that remains unfinished to this day.
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