Why do smart people still choose Keynes over Hayek?

The ridiculous and the sublime

On October 17th a group of concerned economists wrote to the Times. The current economic woes, they wrote, were down to insufficient spending/increased saving. “[W]hen a man economizes in consumption”, they argued, “and lets the fruit of his economy pile up in bank balances or even in the purchase of existing securities, the released real resources do not find a new home waiting for them.” Crucially, “In present conditions their entry into investment is blocked by lack of confidence.” The government should step in and spend to make up the shortfall they said.

On October 19th another group of economists replied with their own letter to the Times. They believed that the cause of the economic problems was monetary mismanagement which had created “a deficiency of investment-a depression of the industries making for capital extension, &c., rather than of the industries making directly for consumption.” They argued for the necessity of increased saving to readjust this and explicitly rejected any role for government spending, writing that “many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities.”

But this was October 1932 and the letters were written by John Maynard Keynes and Friedrich von Hayek. It says much about the essentially static nature of economic knowledge that an 80 year old debate remains so compelling today that it continues to inspire radio shows, debates, books, and even rap-offs.

Keynes’s economics, in a nutshell, argues that of the two components of ‘effective demand’, consumption and investment, investment is prone to volatile swings. As Keynes put it, investment spending was reduced when their expected payoff, the Marginal Productivity of Capital, dipped below the cost of financing them, the interest rate.

Why might this happen? “Animal spirits” was Keynes’ answer; “Don’t ask me guv” in other words. Whatever it was that tipped investors from optimism into effective demand-sapping pessimism is exogenous to the model; it cannot be accounted for by it.

Either way, the policy prescriptions of the Keynesian model are obvious. Financing costs must be held down with low interest rates and the Marginal Productivity of Capital must be underwritten by a government guarantee to purchase, with deficit spending if need be, whatever output industry might produce. Low interest rates and deficit spending. That is the Keynesian prescription for prosperity.

Hayek’s theory is very different. For Hayek, when low interest rates cause an expansion of credit, this credit flows into some parts of the economy before others. This blows up bubbles in the affected part of the economy, be it in housing, internet stocks, or tulips.

At some point, Hayek argues, the inflationary effect of this credit expansion overwhelms any wealth effect and interest rates begin to rise. With no further credit available to purchase the bubble assets the prices of these assets and their attendant industries collapse. This is the bust.

A major difference between Hayek’s theory and Keynes’s is that for Hayek the bust as well as the boom is endogenous to the model, it is explained by it. The bust isn’t caused by “animal spirits” switching inexplicably out of the clear blue sky, but by the predictable outcome of actions undertaken in the boom.

As Hayek’s model is radically different from Keynes’s, radically different prescriptions follow from it. Viewing the cycle as a whole Hayek believed that preventing a future bust was as important as fighting the current one and he proposed measures to limit the ability of banks to swell credit, his favoured solution being competing currency issue by banks.

More immediately, Hayek argued that as the bubble assets and attendant industries had been pumped up by unsustainable injections of inflationary credit, they could only be liquidated; any attempt to preserve their value would only prolong the bust or, as bad, set another cycle in motion. Sound money and non-intervention was the prescription of Hayek and his fellow Austrian Schoolers.

Looking back over the last few years you have to ask how intelligent people, examining the evidence, can still choose Keynes over Hayek. In both Britain and America we had monetary policy makers working to keep financing costs down with low interest rates. We had governments running budget deficits and applying fiscal stimulus to economies which were already growing. We followed the Keynesian prescription for prosperity and we still ended up with a bust – a bust which Hayekians, with their superior model, saw coming.

The answer lies in the prescriptions. Keynes, with his cheap credit and shower of borrowed money, is a pleasant prospect. Indeed, Paul Krugman, one of the most uncompromising modern Keynesians, believes that “Ending the depression should be incredibly easy”, all we need is cheaper credit and more borrowing. Just, in fact, what we had going into the crisis.

Hayek, on the other hand, offers a more painful prospect. As his mentor Ludwig von Mises put it:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved”

Which of these vistas would you prefer to gaze upon?

But these theories should be judged not on how warm and fuzzy they make us feel but on how accurate they are. On that score Hayek wins hands down yet some still cling doggedly to Keynes. It’s for the same reason the aunt who gives you chocolates is preferred to the aunt who makes you do your homework.

This article first appeared at The Commentator


5 thoughts on “Why do smart people still choose Keynes over Hayek?

  1. A refreshingly sober presentation. To judge by this essay alone, it seems you must be the best sort of conservative. Perhaps you can help me out of my confusion. I confess I find the disputes among experts in these matters to be mystifying.

    Don’t Keynes’s animal spirits help explain how the bubble arises in the first place? I mean, doesn’t the notion help us understand where to look for the mechanism by which “credit flows into some parts of the economy before others” during Hayek’s credit expansion? How does Hayek himself fill this lacuna? Isn’t there something at play here besides rational expectation and money supply? It sounds like the mechanism that allocates to the bubble, whatever it is, might not be endogenous to Hayek’s model as you have thus far described it.

    Would you agree, further, that the Keynesian prescription for managing the bursting bubble is more concerned than the Austrian’s with limiting the financial damage to working families with small or negative assets at the time of the bust? Even granting that Hayek’s cure is in an important sense more efficient, doesn’t tight money and nonintervention mean a big hit for working families with limited assets, forcing these families to pay the price every time businessmen, investors, and bankers succumb to temptation and irrational exuberance? Price mechanisms seem to guarantee that many working families earn hardly enough to save and invest during good times. Cyclical busts and unemployment will eat their assets and throw them into debt, putting them a year, or a decade, or a generation behind. Which is to say nothing of the negative pressure on growth and employment caused by decreased consumption during the same unhampered bust.

    • “Don’t Keynes’s animal spirits help explain how the bubble arises in the first place?

      They do but it still begs the question of what causes these ‘animal spirits’ to switch back and forth. Keynes’ explanation doesn’t actually explain anything.

      “Would you agree, further, that the Keynesian prescription for managing the bursting bubble is more concerned than the Austrian’s with limiting the financial damage to working families with small or negative assets at the time of the bust?”

      I wouldn’t agree with that at all. A cure which actually cures (Hayek) is better for working families than a ‘cure’ which actually makes things worse (Keynes).

  2. So we’re agreed that neither Keynes nor Hayek explains the mechanism by which credit is allocated to the bubble, though each theorist labels the spot in his theory where an explanation would go?

    If Hayek’s cure is really a cure, then it seems you’re right. But if bubbles will remain part of our long-term economic predicament, distributed over time through cycles of boom and bust, then Hayek hasn’t offered a cure. In that case, let’s not hide behind ideology, but strive to make the decisions we’re faced with as plain as possible: How do we prefer to balance our concern for economic efficiency and long-term GDP growth against our concern for working class families whose income and assets are demolished when the bubble bursts, while the most egregiously mis-allocating agents fly away on golden parachutes?

    In the developed economies, at least, many of us might prefer more stability and slightly slower growth in the long term, to a few months or years of negative growth in household assets every now and then.

    • It SOUNDS less painful, as you state it, but I’m not sure history bears out your theory. Take the Great Depression as an example. The Depression of 1929 hit Europe and Canada as well as the United States. According to “New Deal or Raw Deal” (and I’ve read a few others books and articles that support this), Europe and Canada did almost nothing to “treat” the depression and the worst of the economic downturn passed within a year and a half (about the time of these letters, actually). Google it. It was the Depression of 1929 in Europe. In the United States, first Hoover and then Roosevelt spent a lot of money trying to address the Great Depression (only called that here) and 12 years later, the economy still hadn’t recovered. It was World War II that got us out of the Great Depression and Congress had to do some fancy footwork in the late-40s to prevent us going back into it after the War. They didn’t throw tax dollars at it. They cut spending drastically and paid down the debt.

      Were the months of the Depression of 1929 hard on working families? To be sure. Was the 12-year Great Depression harder on working families? My grandparents would say “YES!” In fact, Grandpa had dual citizenship with Canada and considered moving his family north because people like my educated Grandmother knew it was better there.

      So short and painful followed by recovery or dull the pain and take most of a generation to recover? I’d prefer the first option. I think most people would if it was explained correctly.

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