By Robert Field
(Author’s preface: Even the wife complained that reading the below tended to put her to sleep. But the intention is to share with the reader the type of economic matters that were being debated prior to Keynes’ break through ideas which were the basis of The General Theory. Hayek remained rooted in highly theoretical classical economics and made his major achievements in political philosophy in fighting fascism and communism. He never comprehensively responded after the publication of Keynes’ breakthrough masterpiece as opponents to Keynesian concepts would have us believe. Almost all of the leading economists are Keynesians and called for more fiscal stimulus in 2011 and 2012. )
Author Nicholas Wapshott, in Keynes Hayek, The Clash That Defined Modern Economics, describes the early differing views of Friedrich Hayek and John Maynard Keynes in the late 1920s as follows:
“The nub of the issue, according to Hayek, was that by reducing interest rates, the central bank interfered in the relationship between savings and investment. He and the Austrian School believed that all markets over time, including the market in money, would reach a state of equilibrium where the supply of goods from manufacturers and demand came to be matched. Hayek suggested that the price mechanism reflected the tendency towards equilibrium and that any attempt to artificially alter prices would have dire consequences. In his view, to tamper with prices was merely to tinker with the symptoms of the shift toward equilibrium. To artificially reduce interest rates, or the price of borrowing money, merely led to price inflation, while raising interest rates artificially meant encouraging a contraction of business activity (a slump).”
“The battle lines between Keynes and Hayek were thus drawn. Keynes believed it was a government’s duty to do what it could to make life easier, particularly for the unemployed. Hayek believed it was futile for governments to interfere with forces that were, in their own way, as immutable as natural forces. Keynes rejected adherence to the free market as an inappropriate application of Darwinism to economic activities and argued that a better understanding of the workings of an economy would allow responsible governments to make decisions that could iron out the worst effects of the bottom of the business cycle. Hayek eventually came to the conclusion that knowledge about how exactly an economy worked was difficult if not impossible to discover, and that attempts to form economic policy based on such evidence were, like a barber practicing primitive surgery, likely to do more harm than good.”
Hayek went so far as to suggest: “In 1976, in a paper on The Denationalization of Money, Hayek advocated that rather than re-instituting a government-mandated gold standard, a free market in money be allowed to develop, with issuers of money competing with each other to produce the best, most stable and healthy currency.”
According to Wapshott, “In Paradox’of Savings [published in 1929] Hayek conceded that ‘if administered with extraordinary caution and superhuman ability,’ the plan to have a government infuse money into the system to provoke demand ‘could… perhaps, be made to prevent crises. But more likely, “in the long run” such manipulation of the economy ‘would bring about grave disturbances and the disorganization of the economic system as a whole.’ He concluded that ‘the whole expediency of such attempts to alleviate unemployment by relief works and so on is in the light of this analysis highly questionable.’”
Keynes view came to differ with Hayek’s and other classical economists concerning ‘liquidity preference’. According to Wapshott, “For classical economists, interest rates depended on the relationship between savings and investments: if too many people saved, interest rates fell, encouraging them to invest in businesses to maximize their yield; if too few saved, interest rates rose to attract more savers.
“Keynes explored the motivation of savers and came to a quite different conclusion. He believed that rather than lodge money in bank or invest in stocks and shares, savers often preferred to keep their savings in ‘liquid’ form (i. e. , cash), so that they could take advantage of rapidly changing circumstances.”
Note that this is Keynes very early in his break with classical economics. In fact during a recession or depression, people will keep their money in banks rather than spend it and corporationss will build up liquid assets but the banks and corporations will refrain from investing the funds on hand… a recent phenomenon following the 2008 crash and panic. (Keynes was a pragmatist who saw in the late 1920s what was needed to restore the economy but it took until the mid 1930s for him and his coterie of advisors to develop the theoretical framework to support his observations and recommendations.)
Wapshott: “Keynes had no intention of ushering in a grim gray future in which individual liberties were lost under a welter of state regulations. …Keynes further anticipated Hayek’s pessimistic assessment of the effects of departing from a free market when he offered an olive branch to the classical school by suggesting that classical theory still had an important part to play. ‘Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve economic problems in of the actual world,’ he wrote. The means to bring about full employment did not imply a socialist, or semi-socialist, or social democratic society. ‘If [government-inspired investments in public works succeed] in establishing an aggregate volume of output corresponding to full employment as nearly as practicable, the classical theory comes into its own again from this point onwards,’ he wrote.”
With the publication of Keynes The General Theory in 1936, “Hayek, who had set himself the formidable task of contradicting the steady stream of arguments emanating from Keynes’s prodigious pen, now seemed honor bound to respond… But answer came there none. Hayek remained hushed. Faced with confronting Keynes at full flow, Hayek blinked… Keynes’s great work was met with neither a bang nor a whimper. Hayek’s response, so keenly awaited by classical economists throughout Britain and the continent, was a yawning silence.” It lasted for a decade and, when it came, was laden with caveats that implied his acceptance in large part of Keynes’s macro-economics.
In fairness to Hayek, The General Theory was to economics what Nicolaus Copernicus and Galileo Galilei observations that the earth circled the sun was to astronomy.
That economic forces react differently during times of high unemployment had not been seriously considered prior to Keynes. It wasn’t that classical economists were wrong. It simply was that Marshallian micro-economic theories did not necessarily apply during hard times.
Wapshott notes:“[Galbraith] also recalled the generational divide that Keynes’s work revealed. ‘The old economics was still taught by day [at Harvard],’ he wrote. ‘But in the evening and almost every evening from 1936 on, almost everyone discussed Keynes.’”
A common misunderstanding concerning Keynes is that he only advocated deficit spending. He called for that during times of recession and depression. He called for raising taxes and cutting costs during strong economic times to reduce national debt, to avoid inflation, and to minimize competition with private enterprise. An example from our own history is how, during the prosperity of the latter Clinton administration in the late 1990s, federal surpluses were rapidly reducing the national debt to the point where economists were concerned that it might be paid off and thus destabilize the basis of our federal banking system. (Huge tax cuts, increased spending on health care benefits and defense, and two wars during the “W” administration and finally the need to prevent a the economy falling into depression generated, apart for World War II spending, unprecedented annual federal deficits in proportion to Gross Domestic Product.)
Wapshott: “In May [1936], Hayek offered Harbeler his verdict on The General Theory. He said he was ‘of course awfully annoyed’ by the work, not least because ‘through his formulation [Keynes] discredits many important ideas, which now lie in the air, among many people, and it will make it hard to try to persuade them without tackling all the other nonsense.’ But that brief aside proved be the sum of Hayek’s contemporaneous critical assessment of The General Theory. Rather than expand on his ‘annoyance’ and confront Keynes’s ‘nonsense,’ Hayek concentrated his efforts on completing the first part of the Pure Theory of Capital, a two-volume work he hoped would directly compete with The General Theory.”
“From this line of reasoning he came to two important conclusions, neither of which he made explicit in the lecture but both of which were to pave the way for a new direction in his thought: that it is through prices that the communal wisdom of what was going on in a market is reflected, and that when outside forces such as governments interfere in the setting of prices, it is tantamount to trying to regulate the speed of a car by holding the needle of the speedometer in place; and that no single person, not even ‘an omniscient dictator,’ as he put it, can know the minds, desires, and hopes of all the individuals that make up an economy. If a totalitarian ruler, or even apparently benign apolitical ‘planners,’ were to interfere in the economy on the assumption that they knew best or thought they knew the minds of others, they would inevitably frustrate the wishes and curtail the happiness and liberties of the individuals in whose interest they calmed to act. It was Hayek’s eureka moment. He was to describe this pivotal notion as ‘the one enlightening idea which made me see the whole character of economy theory in what to me was an entirely new light.’ ”
In the The Road to Serfdom, Hayek bravely spoke out against the fascism of German and Italy and the communism of the Soviet Union during the Great Depression when many were losing confidence in the largely free enterprise capitalistic system.
From Wikipedia: “Hayek was concerned about the general view in Britain’s academia that fascism was a capitalist reaction to socialism and The Road to Serfdom arose from those concerns. It was written between 1940 and 1943. The title was inspired by the French classical liberal thinker Alexis de Tocqueville’s writings on the “road to servitude”. It was first published in Britain by Routledge in March 1944 and was quite popular, leading Hayek to call it “that unobtainable book,” also due in part to wartime paper rationing.[31] When it was published in the United States by the University of Chicago in September of that year, it achieved greater popularity than in Britain. At the arrangement of editor Max Eastman, the American magazine Reader’s Digest also published an abridged version in April 1945, enabling The Road to Serfdom to reach a far wider audience than academics.”
“The economist Walter Block observed critically that while The Road to Serfdom is ‘a war cry against central planning,’ it does show some reservations with a free market system and laissez-faire capitalism,[33] with Hayek even going so far as to say that ‘probably nothing has done so much harm to the liberal* [classical economics] cause as the wooden insistence of some liberals* [classical economists] on certain rules of thumb, above all the principle of laissez-faire.[34] In the book, Hayek writes that the government has a role to play in the economy through the monetary system, work-hours regulation, institutions for the flow of proper information, and other principles on which most members of a free society will tend to agree. These are contentions associated with the point of view of ordoliberalism. However, when central planning reaches into areas on which people will probably not agree, the tendency is created for dictatorship and totalitarianism (i.e. “serfdom”), as a means of coercing implementation of one’s plan.”
*The term “liberal” as used by Hayek above would now commonly be referred to as “classical economics” and “conservative.”
Here we have conflating Keynesian Economics with the central planning of fascist and communist regimes. Hayek was a very good classical economist (he later shared a Nobel award for micro-economic insights concerning the pricing mechanism) and made valuable contributions as a political philosopher. But neither Keynes nor Hayek favored German fascism or Russian communism; nor does Keynes advocate the state acquiring businesses during recessions or depressions.
As this writer remembers from his university days in the late 1950s, admiration for the central planning of socialism by the Soviet Union, China and, to a lesser extent, India continued well into the 1950s and 1960s. Some of us remember the crisis of confidence in the capitalistic system as late as the Soviet launching of Sputnik, the first earth satellite.
Hayek disciple author Ayn Rand took Hayek’s political science views to an extreme in her novel Atlas Shrugged.
And testimony to the wisdom of Hayek’s observation was the 1989 collapse of the Soviet Union in large part due to its central planning.
In Hayek’s The Pure Theory of Capital “he writes that his main objection to Keynes’s suggestion, that during a recession there are unused resources that could be productively brought into use to create jobs, is that ‘it is certainly not a normal position on which a theory claiming general applicability could be based.’”
But that is the point! Where Keynes saw two different set of circumstances, Hayek wanted to treat the working of economic forces as the same under all conditions.
Hayek concludes “ ‘It used… to be regarded as the duty and the privilege of the economist to study and to stress the long effects which are apt to be hidden to the untrained eye, and to leave the concern about the more immediate effects to the practical man,’ he wrote. ‘It is alarming to see that after we have once gone through the process of developing a systematic account of those forces which in the long run determine prices and production, we are now called up to scrip it, in order to replace it by the short-sighted philosophy of the business man raised to the dignity of a science.’”
In other words, we should not compromise pure, all embracing theories of classical economics by following a contradictory theory that would end the Great Depression!
Much of the latter part of the book deals with evolution of the concept that recessions can be offset monetary policy. Recent events have demonstrated this is not the case. Both fiscal and monetary approaches are essential.
Wapshott concludes his book as follows:
“Like Keynes and Hayek, John Kenneth Galbraith did not live to see the Great Recession, but he had an explanation for why conservatives could not applaud Keynes for saving capitalism a second time. ‘Keynes was exceedingly comfortable with the economic system he so brilliantly explored,’ observed Galbraith. ‘So the broad thrust of his efforts, like that of Roosevelt, was conservative; it was to help ensure that the system would survive. But such conservatism in the English-speaking countries does not appeal to the truly committed conservative… Better to accept the unemployment, idled plants, and mass despair of the Great Depression, with all the resulting damage to the reputation of the capitalist system, than to retreat on true principle…. when capitalism finally succumbs, it will be to the thunderous cheers of those who are celebrating their final victory over people like Keynes.’”
Hayek has been misrepresented and abused by those who present him as having co-equal status as an economist with Keynes and as having rebutted The General Theory. They have fabricated Hayek as their champion in an attempt to justify their rejection of fiscal stimulus through deficit spending as an important remedy for the Great Recession.
Hayek was a very good classical economist and a worthy political philosopher. That is sufficient unto itself.
