by Mario Rizzo
[This was submitted to the Financial Times as a possible op-ed piece. Unfortunately, it was rejected. Nevertheless, it seems to me that most readers of the financial press are still unaware of just how fundamental a challenge F.A. Hayek made to the economics of J.M.Keynes. Hayek’s challenge often gets homogenized with other free-market approaches that are still macro-economic in nature. Hayek questions the macroeconomic way of thinking.]
Robert Skidelsky wrote in the Financial Times that recent debates among economists are a rerun of the disagreements between John Maynard Keynes and the U.K. Treasury in the early 1930s. To a certain extent this is true. But it might be more instructive to pay some attention to another debate in the 1930s. This is the debate between Keynes and Friedrich Hayek.
Today Hayek is best known for books in political economy such as The Road to Serfdom. It is sometimes said that a key question in Britain’s academic circles some seventy-five years ago was: Who is right – Keynes or Hayek? To most contemporary readers, economists included, it would seem that the debate was a general one over the role of the state in economic life. However, in the 1930s Hayek had not yet written his political tracts.
The dispute between Hayek and Keynes was over what we call today “macroeconomics.” At the time, this would have been considered monetary or trade cycle theory. Hayek was opposed to the macro-aggregation of Keynes’s approach to questions of employment, interest rates and cycles. He believed that the aggregates chosen by Keynes obscured the fundamental changes that constitute macroeconomic phenomena. As the economist Roger Garrison points out, for Hayek there were indeed macroeconomic phenomena but only microeconomic explanations.
Keynes focused on the labor market, insufficient aggregate demand and the associated idea of less-than-full-employment income. In effect, Keynes thought of aggregate output as if it were just one undifferentiated thing and investment as a volatile form of spending that brought this output into existence.
Hayek focused on structure of capital. By this he meant the array of complementary (and substitutable) capital goods at different distances from consumable output. These capital goods work with labor and other factors to produce what Keynes would call “aggregate output.” Thus for Hayek “investment” wasn’t a homogeneous aggregate but represented specific changes to a structure of interrelated capital goods. When the central bank lowered interest rates excessively (below the rate that would equate planned savings with planned investment), the structure of production would be distorted. It is not just that “output” increased but its composition was altered.
This typically meant a number of unsustainable changes. Low interest rates discourage savings and yet at the same time encourage certain types of investment. Housing, commodities, and other sectors with long time-horizons would expand. But at the same time consumers would try to consume more. So the Keynesian is misled to think that, “See, consumption and investment are not alternatives. We can have more of both. In fact, consumption stimulates investment!”
What really occurs in the boom, however, is too much consumption and too much investment in sectors far from consumption. Overconsumption and malinvestment. Isn’t this what we have just seen?
Hayek can indeed be faulted for not having taken on Keynes more directly after 1936. He vastly underestimated the significance of the growing Keynesian revolution. And he thought that Keynes would soon change his mind as he did with his earlier book The Treatise on Money (1930). Furthermore, Hayek probably should have emphasized more that his theory implied the need to avoid a “secondary deflation” during the bust period. Increases in the demand to hold money should be offset by the banking system.
Nevertheless, we really should not ignore Hayek’s side of the academic controversies of the 1930s. While the Treasury officials raised important points against Keynes they did not challenge him in the fundamental way that Hayek did.
Today the issue is still Keynes versus Hayek.
Update 07/07/2010: A more recent and related post is available here.