Keynes Vs. Hayek: Old Ideas for a New Era

Marshall Auerback here with some further thoughts from the Institute for New Economic Thinking’s recent kick-off conference at Cambridge University.

It might appear ironic to commence a conference ostensibly centered on new economic thinking with a discussion of two economists who did their greatest work more than 70 years ago. But it speaks both to the rich and varied ideas of both J.M. Keynes and F.A. Hayek, and the concomitant paucity of thought embodied in modern day economic theories, such as the “efficient market hypothesis” and “rational expectations theory”, both of which took a real beating in the course of the INET panel discussions.

The discussion of these two giants of economic thought were led by, on the one hand, Lord Robert Skidelsky, (the pre-eminent biographer of J.M. Keynes) and, on the other, Duke University’s Bruce Caldwell, a leading historian of economic thought and chronicler of F.A. Hayek. Both speakers readily acknowledged that Keynes and Hayek could lay reasonable claim to predicting likely impending economic calamity, given their recognition of the fault-lines in the pre-Depression economy which made a collapse likely sooner or later.

But the respective diagnoses of these two rivals were quite distinct and in many respects laid the groundwork for today’s great debate between the Keynesians and so-called “Austrian School” of economics. That they both recognized problems, however, despite somewhat divergent perspectives, speaks to the importance of integrating credit and credit analysis into any serious macroeconomic analysis, an extraordinary omission in the post-war period, where simplistic mathematical formulae have predominated for so long.

As Skidelsky argued, Hayek signaled in the spring of 1929 that a serious setback to trade was inevitable, since the ‘easy money’ policy initiated by the US Federal Reserve Board in July 1927 had prolonged the boom for two years after it should have ended. The collapse would be due to overinvestment in securities and real estate, financed by credit creation. Keynes, in the autumn of 1928, criticized the aggressive interest rate policy of the NY Fed (which was making a concerted effort to choke off the asset boom). Savings, Keynes argued, were plentiful; there was no evidence of inflation. The danger was the opposite of the one diagnosed by Hayek. ‘If too prolonged an attempt is made to check the speculative position by dear money, it may well be that the dear money, by checking new investment, will bring about a general business depression’. (CW,xiii, 4 October 1928). For Hayek the depression was threatened by ‘investment running ahead of saving’; for Keynes by ‘saving running ahead of investment’.

Of course, once the slump started and intensified, and predictions evolved into explanations and corresponding policy recommendations, it was clear that Keynes would win this debate, largely on the grounds that his proposals were far more politically palatable than those of Hayek. The Keynesian analysis was ultimately vindicated: It was Keynes who demonstrated that effective demand determined employment and output and if that was deficient supply would contract. Classical economists had hitherto believed unemployment occurred because real wages were too high relative to productivity and argued that cutting wages was the solution.

Keynes noted this would further reduce aggregate demand because wages were both a cost (supply-side) and an income (demand-side). The classics assumed independence between the demand and supply sides of the economy so cutting wages would not impair the demand side. Their other line of response was that even if cutting wages caused demand to fall, it was likely that prices would also fall.

By contrast, Hayek focused his analysis on the nature of the slump, which he saw as the inevitable consequence of the previous disease of over-expansion of credit. In Hayek’s theory, recessions were the painful but necessary adjustment that returned the system back to equilibrium. His great fear was that attempts to combat the recession with expansionary policy would lead to “malinvestment” — too many investment projects getting started that could not ultimately be sustained, in the process delaying the necessary and painful process of adjustment (as well as setting up prospects for future inflation).

Unfortunately for him, Hayek’s solution, notes Lord Skidelsky, was a political non-starter. Letting “nature take its course” was, in the words of erstwhile Hayekian ally, Lionel Robbins, ‘as unsuitable as denying blankets and stimulants to a drunk who has fallen into an icy pond, on the ground that his original trouble was overheating’. In that regard, Hayek echoed the sentiments of many modern day neo-classical economists, who fundamentally believe in the self-correcting nature of markets (notably former Federal Reserve Chairman, Alan Greenspan).

In fairness to Hayek, however, he did not fall prey to the misguided ideas of most of the neo-classical economists of his day, who paraded models that essentially always assumed full employment. The break with neoclassical thinking came with the failure of markets to resolve the persistently high unemployment during the 1930s. And Hayek himself reformulated his views in the 1940s although, as Skidelsky argued, “what kept him out of the Keynesian camp was what he saw as the inflationary consequences of a Keynesian ‘cure’ for a slump, and a hatred of central planning.”

Keynesian thought has thoroughly dominated the policy front in the last couple of years. But Caldwell noted the many important lessons that Hayek’s ideas gave us in regard to regulation, another major preoccupation of the INET conference. Hayek, according to Caldwell, worried about “whether regulators would have the requisite knowledge to keep up with the ever-changing ebb and flow of the market process. Entrepreneurs, including those who recognize that there is money to be made from devising ways of getting around regulations, are always forward-looking, while regulators are almost of necessity backward-looking. He also asked Juvenal’s question, who is to regulate, or watch over, the regulators?”

Which is not to say that Hayek opposed all forms of regulation. Contrary to popular caricature, he felt that such regulation had to be embedded in a complementary set of social institutions, among them a democratic polity, with strong constitutional protections of private personal activity, operating under the rule of law, according to Caldwell. Hayek viewed the economy as a complex adaptive system, and thought that when we confronted such a phenomenon, our ability to control it was, by virtue of the market’s sheer complexity, severely limited.

Which should give any of us with a policy bent some reason to pause.

Caldwell concludes: “Hayek’s words explain why progress has been so slow in economics, why very bright people can still continue to disagree about the best way forward for our economy, and why it will ever be so. The hoped for effect of this is to make us all a bit more humble about our proposals, like Keynes’ dentists.”

This post was originally published at New Deal 2.0.