The Keynes-Hayek Rematch
LONDON – The Austrian economist Friedrich von Hayek, who died in 1992 at the age of 93, once remarked that to have the last word requires only outliving your opponents. His great good fortune was to outlive Keynes by almost 50 years, and thus to claim a posthumous victory over a rival who had savaged him intellectually while he was alive.
Hayek’s apotheosis came in the 1980’s, when British Prime Minister Margaret Thatcher took to quoting from The Road to Serfdom (1944), his classic attack on central planning. But in economics there are never any final verdicts. While Hayek’s defense of the market system against the gross inefficiency of central planning won increasing assent, Keynes’s view that market systems require continuous stabilization lingered on in finance ministries and central banks.
Both traditions, though, were eclipsed by the Chicago school of “rational expectations,” which has dominated mainstream economics for the last twenty-five years. With economic agents supposedly possessing perfect information about all possible contingencies, systemic crises could never happen except as a result of accidents and surprises beyond the reach of economic theory.
The global economic collapse of 2007-2008 discredited “rational expectations” economics (though its high priests have yet to recognize this) and brought both Keynes and Hayek back into posthumous contention. The issues have not changed much since their argument began in the Great Depression of the 1930’s. What causes market economies to collapse? What is the right response to a collapse? What is the best way to prevent future collapses?
For Hayek in the early 1930’s, and for Hayek’s followers today, the “crisis” results from over-investment relative to the supply of savings, made possible by excessive credit expansion. Banks lend at lower interest rates than genuine savers would have demanded, making all kinds of investment projects temporarily profitable.
But, because these investments do not reflect the real preferences of agents for future over current consumption, the savings necessary to complete them are not available. They can be kept going for a time by monetary injections from the central bank. But market participants eventually realize that there are not enough savings to complete all the investment projects. At that point, boom turns to bust.
Every artificial boom thus carries the seeds of its own destruction. Recovery consists of liquidating the misallocations, reducing consumption, and increasing saving.
Keynes (and Keynesians today) would think of the crisis as resulting from the opposite cause: under-investment relative to the supply of saving – that is, too little consumption or aggregate demand to maintain a full-employment level of investment – which is bound to lead to a collapse of profit expectations.
Again, the situation can be kept going for a time by resorting to consumer-debt finance, but eventually consumers become over-leveraged and curtail their purchases. Indeed, the Keynesian and Hayekian explanations of the origins of the crisis are actually not very different, with over-indebtedness playing the key role in both accounts. But the conclusions to which the two theories point are very different.
Whereas for Hayek recovery requires the liquidation of excessive investments and an increase in consumer saving, for Keynes it consists in reducing the propensity to save and increasing consumption in order to sustain companies’ profit expectations. Hayek demands more austerity, Keynes more spending.
We have here a clue as to why Hayek lost his great battle with Keynes in the 1930’s. It was not just that the policy of liquidating excesses was politically catastrophic: in Germany, it brought Hitler to power. As Keynes pointed out, if everyone – households, firms, and governments – all started trying to increase their saving simultaneously, there would be no way to stop the economy from running down until people became too poor to save.
It was this flaw in Hayek’s reasoning that caused most economists to desert the Hayekian camp and embrace Keynesian “stimulus” policies. As the economist Lionel Robbins recalled: “Confronted with the freezing deflation of those days, the idea that the prime essential was the writing down of mistaken investments and…fostering the disposition to save was…as unsuitable as denying blankets and stimulus to a drunk who has fallen into an icy pond, on the ground that his original trouble was overheating.”
Except to Hayekian fanatics, it seems obvious that the coordinated global stimulus of 2009 stopped the slide into another Great Depression. To be sure, the cost to many governments of rescuing their banks and keeping their economies afloat in the face of business collapse damaged or destroyed their creditworthiness. But it is increasingly recognized that public-sector austerity at a time of weak private-sector spending guarantees years of stagnation, if not further collapse.
So policy will have to change. Little can be hoped for in Europe; the real question is whether President Barack Obama has it in him to don the mantle of President Franklin Roosevelt.
To prevent further crises of equal severity in the future, Keynesians would argue for strengthening the tools of macroeconomic management. Hayekians have nothing sensible to contribute. It is far too late for one of their favorite remedies – abolition of central banks, supposedly the source of excessive credit creation. Even an economy without central banks will be subject to errors of optimism and pessimism. And an attitude of indifference to the fallout of these mistakes is bad politics and bad morals.
So, for all his distinction as a philosopher of freedom, Hayek deserved to lose his battle with Keynes in the 1930’s. He deserves to lose today’s rematch as well.
Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.