Thursday, April 17, 2014
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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.

Read more from our "In Keynes's Footsteps" Focal Point.

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  1. CommentedKevin Remillard

    The Skidelsky statement: “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” is false. When you concentrate risk with liquidity instruments and a reduction in exposure to capital markets with syndication you get collapse. Ludwig von Mises is unread by Mr. Skidelsky?

  2. CommentedJonathan Lam

    Gamesmith94134: Dr. Doom Warns Wall Street and Washington---- Heed Karl Marx's Warning!

    Mr. Gert van Vugt,
    You make the best description on the theory on the economical growth Paradigm that the economic change seems like Malthusian’s diminishing return, and I agree. However, Mr. Roubini makes his point on the social disruption reverse itself through the diminishing demand. If we can put away the elements like the Ponzi scheme and benefactors in social caused deficiency or defects to growth. Corruption by capitalism and the dependency by socialism among societies both caused failure in the economical and societal development.
    Perhaps, we focus on the circuitry on the accumulation of wealth and consumable wealth that runs the economy. It seems both the capitalism and socialism ran short and proven wrong in the economical model or social model that became self-destructive; eventually, the economy runs from diminishing demand to diminishing return, or vice versa. So, if we use the living standard as the equilibrium position to the supply line of the circuitry of wealth balanced by both of the diminishing return and diminishing demand.
    How about I call my paradigm on the wealth circuitry in economical and social growth that supports and balances both accumulated wealth and consumable wealth; and it created a “Z” shaped development running both on the diminishing demand and diminishing return; which is based on the assumption, the route above the standard of living equal in length with the one below the standard of living is in agreement of its living standard to sustain a viable growth, which contains;
    • The base line as the diminishing return where the societies kept peace with its populace that consumable wealth that cause economical displacement like with its negative growth or no growth; it provides entitlement or social programs with non-productive individual citizens for example, 27% of its population on welfare with add-on with subsidies to sustain a standard of living.
    • The top line as the diminishing demand that ended with accumulated wealth favors of concentrated wealth owned by individuals that ended with profitless, 1% holds 27% of the global or national wealth, plus those with extra wealth is not in production yields to no growth.
    • And the diagonal line that connected to both ends is the support of the price and value in the middle is the standard of living which contains the most of the productive individuals who is moving up and down the ladder of growth.
    If more of the wealth accumulated than the wealth consumed, then it causes saturation of the wealth. The diminishing demand under the standard of living agreement made the demand idle because of the shortage of consumption. In the process, the standard of living will go down to meet its demand after the deflationary measure to make it consumable. In reverse, the wealth consumed is over the wealth accumulated, as it is less profitable. Then, it triggers the inflationary measures to aggregate demand to accumulate more wealth in its diminishing return mode; eventually it will balance itself again with the agreement of the standard living with a viable growth.
    It is not the supply and demand. It is rather the circuitry of wealth under the spells of the lower living standard that diminishing demand is being part of the deflationary measure. If the accumulated wealth became saturated, then it means the lower living standard that made the demand finite like lesser demand in loan of dollars in ECB.
    I am certain I am not being introspective; I may twist the theory a little; but the proof of the lower living standard in Europe made it plausible.
    May the Buddha bless you?

    I bet not many know of Keynes or Hayek, economist may find theories on the principles; however, the burden now lean on the majority who strive under the margin of affordability. The coming disaster with not be defaults of banks; it will be strike and riots within that supply and demand which became irrelevant to them. Social uprising demonstrates the defiance of the price and valuation that Central Bank and governments. This is because they erased the deflation for the convenience of easier balance in the budget or stability as Ms. Thatcher demanded, and not within the pockets of the labor, and they do not get relief. Further stimulation could become the rift as interest rate or CPI rises. And, I said the chaos begin in October when CDS and CoCos and shareholders of the bank having conflict in reviving the debt or the banking. Goldman Sachs is the first sign, another Buffet?

    Sorry, I have never read "The Road to Serfdom", and I hands shake when I took out my credit card.

    May the Buddha bless you?

    May the Buddha bless you?

  3. CommentedMarinus Huizer

    Why is there so much emphasis on "austerity" in Europe, and so much criticism from the US and UK about that position? Is tray reduceable to Hayek vs Keynes? I guess not

  4. CommentedG. A. Pakela

    When indiduals need to save more, as in the aftermath of the most recent crisis, it is because they are over-leveraged. They have borrowed too much relative to their income and assets. Since the accumulation of excess debt on the part of households was widespread, it is better to allow them to get their fiscal houses in order so they can return to a more reasonable or equilibrium level of consumption. Keynesian economics would suggest that in the interim, government purchases take up the slack. This already takes place with deficit spending and automatic stabilizers in the federal budget. However, a permanent increase in government spending will create problems down the road as households will have to be taxed more in order to pay for the increase.

    The effort on the part of central banks to cheapen money by taking real interests to zero and below is counter productive because those that can afford to borrow are made better off with cheaper debt, while those that depend on savings for retirement are made worse off. The question is whether this has become a zero sum game or worse.

    Finally, a case can be made that the increased "stimulus" spending is crowding out private investment. While this might seem to be a counterintuitive outcome during a recession, the massive government deficits are causing lending to flow to the government at the expense of smaller firms. This has led to less private investment, and government is unable to pick up the slack through direct hiring.

  5. CommentedStamatis Kavvadias

    The debate of Hayek-Keynes is outdated, and return to these views is a clear sign that economics, at least those popular to policy makers, are *not a science*. I am not an economist, but it is easy to see that in western economies, where the crisis hit, the ultra rich that amount to the largest part of the economy (those with the greatest savings, and least need to spend), have been those with the largest ability to save during the crisis. They have increased their wealth. The only issue is that they are placing their investments in developing countries instead of western ones.
    Is that less or more investment economists?

    From such ideological ...heights, the solution to the crisis could be, and all normal people (non-economists) can already see it, Hayekian to the ultra rich and Keynesian to the rest! They will leave with their firms? Make it very heavy economically to leave, for a sort interval, and "liquidate misallocations" fast.

    There is an even bigger issue hidden by such ideological conversations of "economics scientists", which are not based on data and facts for today's economies, and still ask if cause of the crisis is "more investment or less", "more savings or less". The issue of 95% debt-created money, on which the western economies owe interest, no matter the choice between "liquidating the misallocations" or state borrowing to spend in the economy! States have tied their own hands, giving away the privilege to create money to the private banks (keeping only the central banks which play neutral). Now serious mismanagement of the most crucial part of the private sector, the banks, still does not raise political discussion to take away the privilege. There is no need for private banks to be the only suppliers of money, and for all money to be credit. Print real money (same as US zero interest rates), as long as banks do not lend, but do not give it to the banks. Put it directly to help, education, and infrastructure. Stiglitz is the only one making any sense.

    Maybe the US can borrow at zero interest and spend around the world (possibly that is what the author insinuates). But if the above issue I mention is not addressed, only the ultra rich will benefit. A scam to monopolize an immense amount of money, far larger than nations can create (unless central banks really interfere bypassing private banks), will have worked.

    1. CommentedStamatis Kavvadias

      Well, I made a mistake. Really "printed" money are not like the US borrowing at zero interest, because they stay in the economy until removed purposely (with intervention). This is problematic when money is lent twice and owed to two simultaneous lenders... When virtually all money is debt, there is no way to repay the amount of twice lent money.
      ...And the question is if you would print real "everlasting" money, would it be wise to repay such lenders?

  6. CommentedCarol Maczinsky

    Mr. Skidelsky overlooked the real Austrian school: Ordoliberalism. This view is the winner of all debates we had in the last 50 years, including the USSR transition. The sort of US softy regulation inflicts too high costs. Of course ordoliberal policies require a defense of the governance against corporate capture.

    It is not important wheter the "the coordinated global stimulus of 2009 stopped the slide into another Great Depression.", simply because it is the response to previous regulatory failure, and the regulatory side still isn't fixed.. When the house burns you may argue whether it is useful to pour water in or do sth else to keep the fire under control. That is no argument for living in wet rooms.