Special: Keynes vs Hayek The clash that defined economics

The greatest debate in the history of economics began with a simple request for a book. In the early weeks of 1927, Friedrich Hayek, a young Viennese economist, wrote to John Maynard Keynes at King’s College, Cambridge, in England, asking for an economic textbook written 50 years before: Francis Ysidro Edgeworth’s exotically titled Mathematical Psychics.

Keynes replied with a single line on a plain postcard: “I am sorry to say that my stock of Mathematical Psychics is exhausted.”
Why did Hayek, an unknown economist with little experience, approach, of all people, Keynes, perhaps the best-known economist in the world?

For Keynes, Hayek’s request was just another item in his bulging postbag. Cambridge’s economics prodigy retained no record of Hayek’s request, even though he was so conscious of the contribution he was making to posterity through his daring approach to the study of political economy that he had taken to hoarding each scribbled note and every last letter. His posthumously published papers, even when edited, fill dozens of volumes.

Hayek, meanwhile, seemed fully aware of the significance of his request. He treasured Keynes’s bald reply and preserved it for the next 65 years as a personal memento and professional trophy. The postcard sits today in the Hayek archive at the Hoover Institution on the Stanford University campus in California — tangible evidence that Hayek had instigated the first contact
in what would become an intense duel over the role of government in society and the fate of the world economy.

Scarce resources
Edgeworth interested Hayek because one of the subjects he explored at length was a topic that would come to engage both Keynes and Hayek: how scarce resources can best maximise the “capacity for pleasure.” The forbiddingly titled Mathematical Psychics: An Essay on the Application of Mathematics to the Moral Sciences, published in 1881, was Edgeworth’s best-known work.

It anticipated a great number of the debates that would entangle economists over the next century, including notions of “perfect competition,” “game theory” and, most important for the impending battle between Keynes and Hayek, the belief that an economy will reach a state of “equilibrium” with every able-bodied adult fully employed.

Edgeworth was also an early expounder of theories about money and the monetary system, which by 1927 both Keynes and Hayek had already addressed at length.

Slender pretext
There was a pretext, albeit slender, that might have prompted Hayek to reach out to Keynes: Keynes had succeeded Edgeworth as editor of the Economic Journal in 1911. But why Hayek should expect Keynes to possess what Keynes jokingly refers to as “my stock of ‘Mathematical Psychics,’” as if he maintained a secret hoard of Edgeworth’s forbidden works, is hard to fathom.

Though Edgeworth was little remembered even among UK economists, Mathematical Psychics was commonly available. While a profound division existed between the British school of economics, centred around the teachings of Keynes’s mentor, Alfred Marshall at Cambridge and the continental variety, which focused on the theories of capital investment (the money invested in a business) expounded in Vienna by Hayek’s mentor, Ludwig von Mises, there was a good deal of contact, and a fair degree of misunderstanding, between the two camps.

Mercantilist tradition
Marshall’s economics was based on a common-sense understanding of the subject and how business worked in practice, emanating from the mercantilist tradition that had made Britain the most successful commercial nation in history. The notions of the “Austrian School” were more theoretical and mechanistic, deriving from an intellectual, rather than a practical, understanding of how business might work.

The Austrians mostly read English and were conversant with the English tradition; the English couldn’t read German and ignored the works of Austrian and German theorists. But such was the bond between academics that national borders meant little. The trading of books and journals continued throughout the horrors of World War I, even when scholars found themselves on opposite sides of trench-dug borders. The philosopher Ludwig Wittgenstein, a friend of Keynes’s at Cambridge and a distant cousin of Hayek’s, wrote to Keynes while serving in the Austrian army on the Italian front, asking for a new volume by the Cambridge philosopher Bertrand Russell: “Could you possibly send it to me and let me pay for it after the war?” Keynes duly obliged.

Famous worldwide
Even if Hayek couldn’t find a copy of  Mathematical Psychics in the University of Vienna’s extensive library, it was a stretch to imagine that his next port of call should be the world-renowned Keynes. Keynes was not merely a fellow of King’s College, Cambridge, teaching economics to undergraduates. At age 42, he was famous worldwide because of his role as a British Treasury negotiator at the Paris Peace Conference, the precursor to the Treaty of Versailles, which brought the cataclysm of World War I to an end. By revealing to the wider public the intense xenophobia and nationalistic spite that had guided the Paris deliberations, Keynes had become a celebrated figure not only in Britain but also in Europe generally, particularly in the defeated nations of Austria and Germany.

Precocious understanding
Keynes’s precocious understanding of economics and public finance was so considerable that when Britain declared war on Germany in 1914, he was recruited to negotiate an enormous loan from American creditors. The borrowing was vast not only because it funded Britain’s worldwide war effort, in defence of an empire that covered half the globe, but also because American bankers didn’t trust the French and Italians to meet their repayments, leaving Britain to indemnify its allies. Keynes’s efforts were so ingenious, and his charm so effective in cutting through bureaucracy, that when the war ended, Keynes joined the team to advise on how to make Germans pay for causing death and devastation.

The war was the most destructive in history up to that time. At its root, the struggle between the Central Powers of Germany, Austria-Hungary, Turkey and Bulgaria versus the Allies, made up of the UK, France, Russia and, eventually, the US, was over territory and world trade. The conflict marked the end of a chivalrous age and the dawn of the modern era. Cavalry and bayonet charges slowly gave way to tank battles, chemical- weapons attacks and aerial bombardment.

Four terrible years
After four years, the Germans were starved into submission, and by the armistice in 1918 almost 10 million in uniform on both sides lay dead, a further 8 million were “missing,” more than 21 million had been wounded, and about 7 million civilians had perished. A generation of young Europeans had been slaughtered or maimed.

As Hayek recalled, Keynes was “something of a hero to us Central Europeans” owing to his courageous condemnation of British, French and American leaders for levying crippling reparations on those in the remnants of the defeated alliance. His damning account of the Paris talks, The Economic Consequences of the Peace, was published just months after the Versailles treaty was signed. Keynes’s predictions that the burdensome reparations would lead to political instability and extremist politics, and that they might spark another world war, would turn out to be chillingly prescient.

Arrival in London
Friedrich Hayek arrived in London in January 1931 to take up an invitation to participate in the most telling duel in the history of economics. His aim, in four lectures at the London School of Economics: Overturn the theories of John Maynard Keynes, and prove that recessions were not caused by a lack of desire from customers to buy goods.

In his second lecture, Hayek addressed an important and, in light of the world slump, a highly topical subject: Under what conditions do resources come to be left unused? He declared that to explain any economic phenomenon it was convenient to assume that over time an economy would reach a state of equilibrium in which all resources would be fully employed. But there would be times in the interim when all available resources were not used.

Of all the ways that production could be increased, Hayek suggested, the most effective was by employing capital to satisfy later demand in what he called “roundabout” methods of production. Hayek drew a diagram on the blackboard in the shape of a triangle. He argued that to meet future demand, entrepreneurs over time invest in a succession of intermediate capital goods — such as tools and machinery — that are, in the main, sold to other producers of capital goods. In due course, the employment of these roundabout methods of production led to the provision of more consumer goods in the future. Entrepreneurs were prepared to delay making a profit by investing in such intermediate production methods because it would allow them to produce more consumer goods in the future, thereby fulfilling the desires of consumers, who save today to have more tomorrow.

Core question
This brought Hayek to the core question of his lecture: How did methods of production needing less capital progress to methods needing more capital? The answer was simple: When people spent less on consumer goods and saved more, their savings were invested in capital goods. But there was another way: More capital goods might be produced when money was made available to producers by bank loans. This second method, he said, was not real saving but “forced saving” because the new investment had come about not because of an increase in savings but simply because it suited banks to lend. When the money lent to producers was reduced to its former level, the capital invested in equipment was lost.

“We shall see in the next lecture,” he said ominously, “that such a transition to less capitalistic methods of production necessarily takes the form of an economic crisis.”

Dislocation and collapse
In the third lecture, with his usual impeccably meticulous, if forbiddingly desiccated, approach, Hayek described how an unwarranted increase in borrowing led over time to a dislocation in the production process of capital goods, which, in turn, caused a collapse at the bottom of the business cycle. To help those without a remorselessly analytical bent, Hayek offered an example.

“The situation would be similar to that of a people of an isolated island, if, after having partially constructed an enormous machine which was to provide them with all necessities, they found out that they had exhausted all their savings and available free capital before the new machine could turn out its product,” he said. “They would then have no choice but to abandon temporarily the work on the new process and to devote all their labor to producing their daily food without any capital.”

Persistent unemployment
In the real world, Hayek suggested, the result was persistent unemployment. He offered a simple, if unpalatable, truth to those, like Keynes, who advocated increasing the demand for consumer goods to increase employment: “The machinery of capitalistic production will function smoothly only so long as we are satisfied to consume no more than that part of our total wealth which under the existing organisation of production is destined for current consumption. Every increase of consumption, if it is not to disturb production, requires previous new saving.”

Hayek also confronted another Keynesian remedy, that if an idle plant was brought into use, it would spur a depressed economy back to life and increase employment. “What [economists like Keynes] overlook is that … in order that the existing durable plants could be used to their full capacity it would be necessary to invest a great amount of other means of production in lengthy processes which would bear fruit only in a comparatively distant future.”

Artificial demand
He went on, “It should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would have quite the contrary effect.” Such “artificial demand,” he suggested, would merely postpone the day of reckoning. “The only way permanently to ‘mobilise’ all available resources is, therefore, not to use artificial stimulants — whether during a crisis or thereafter - - but to leave it to time to effect a permanent cure.” In brief, there was no easy way out of a slump. In the long run, the free market would restore an economy to an equilibrium that allowed everyone to be employed.

Hayek scored a bull’s-eye with his audience. Here at last was a cogent, convincing repudiation of Keynesian interventionist notions. Hayek showed that the remedies coming from Cambridge, which appeared so plausible, were riddled with logical flaws. Having the best of intentions wasn’t enough. Addressing the symptoms of a depressed economy by investing with borrowed money only made matters worse. Instead, Hayek offered a sober remedy of his own: Forget about quick fixes, the uncomfortable truth is that only time will cure an imbalanced economy. Beware smooth-talking doctors, such as Keynes, who offered a quick cure, for they are charlatans, snake-oil salesmen, and quacks. The market has its own logic and contains its own natural remedy.

Keynesian revolution
By the early 1940s, the Keynesian Revolution in America was in full swing. Fast-moving events in Germany obliged Franklin D Roosevelt to spend on the vast scale that John Maynard Keynes prescribed. Despite the president’s assurances during the 1940 presidential campaign — “I have said this before, but I shall say it again and again and again: Your boys are not going to be sent into foreign wars” — he ordered a gargantuan re-armament program. In 1940, the annual defence expenditure was $2.2 billion; the following year it reached a sizzling $13.7 billion.

“If expenditure on armaments really does cure unemployment, a grand experiment has begun,” Keynes declared in 1939. “We may learn a trick or two which will come in useful when the day of peace comes.”

The multiplier effect of so much public money being pumped into the American economy caused gross domestic product to jump by about $25 billion, with arms and other defence spending accounting for 46% of the increase. Even so, employment wasn’t restored to the pre-Roosevelt recession level until 1941, the year America was attacked by the Japanese at Pearl Harbour. “We saw the war as a justification of the Keynesian theory, the Keynesian doctrine, and the Keynesian recommendation,” John Kenneth Galbraith recalled.

Pessimistic masterwork
Friedrich Hayek, meanwhile, set out on his pessimistic masterwork, The Road to Serfdom. As his biographer Alan Ebenstein observed, the book revolutionised Hayek’s life. Before its publication, he was an unknown professor of economics. A year after it was published, he was famous around the world. Not bad for a book that Hayek, with rare modesty, believed only a few hundred would read.

The principal targets of The Road to Serfdom are what Hayek deemed the twin evils of socialism and fascism, though he felt obliged to soften his criticisms of communism and allude more to the dangers of Nazism because at the time of writing Josef Stalin’s Soviet Union was allied to Britain and America. He said the common perception that the extremes of Left and Right were polar opposites was a misapprehension because both — by replacing market forces with state planning — assaulted individual liberties. He reiterated his belief that as economic planners can’t know the will of others, they end up acting like despots.

Hayek feared that when World War II was won, the Allied victors might conclude that wartime economic management would speed a more prosperous, more just post-war society. Such policies, he warned, invited the preconditions for totalitarianism and might cause history to repeat itself.

“We have progressively abandoned that freedom in economic affairs without which personal and political freedom has never existed in the past,” he wrote. “It is Germany whose fate we are in some danger of repeating.”

Classical economists and conservatives don’t fare much better than socialists and communists in Hayek’s analysis. He condemns the “wooden” advocates of free-market solutions, while rejecting conservatism, a devotion to existing institutions. “Though a necessary element in any stable society, [conservatism] is not a social program,” he wrote. “In its paternalistic, nationalistic and power-adoring tendencies, it is often closer to socialism than true liberalism; and with its traditionalistic, anti-intellectual, and often mystical propensities it will never . . . appeal to the young and all those others who believe that some changes are desirable if this world is to become a better place.”

Coincidence
By coincidence, Keynes read The Road to Serfdom in June 1944, while he was sailing across the Atlantic en route to Bretton Woods in New Hampshire to preside over the negotiations for the international currency mechanism that took the hotel’s name.

Plainly relaxed after his sea crossing, Keynes dropped a line to his old rival from the Claridge Hotel in Atlantic City, New Jersey.
“The voyage has given me the chance to read your book properly,” he wrote. “In my opinion it is a grand book. We all have the greatest reason to be grateful to you for saying so well what needs so much to be said. You will not expect me to accept quite all the economic dicta in it. But morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in a deeply moved agreement.”

Role for planning
Hayek conceded in The Road to Serfdom that in the case of tackling chronic unemployment, planning might play its part and that the right form of planning might not lead to oppression. As he later expressed it, “So far as government plans for competition or steps in where competition cannot possibly do the job, there is no objection.” He also believed that the state may have a moral duty to step in and that was admissible so long as the spirit of free enterprise was not compromised.

“There can be no doubt that some minimum of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody,” he wrote. “Where, as in the case of sickness and accident, neither the desire to avoid such calamities nor the efforts to overcome their consequences are as a rule weakened by the provision of assistance — where, in short, we deal with genuinely insurable risks — the case for the state’s helping to organise a comprehensive system of social insurance is very strong.”

So, more than 80 years after Hayek and Keynes first crossed swords, who won the most famous duel in the history of economics?

Although Keynesianism has been declared dead a number of times since the mid-1970s, Milton Friedman’s acknowledgment in 1966 that “in one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian” is a more accurate, if teasingly ambiguous, assessment of the state of economics in the early 21st century.

Key difference
One key difference between the two men, whether an economy is best understood from the top down or the bottom up, through macroeconomics or microeconomics, left Keynes in the ascendant. His big-picture approach is universally used today, as are such concepts as gross domestic product, key tools by which economists measure an economy.

Friedman, in his monetarist prescriptions, refined Keynes, but he didn’t replace him. Monetarism “has benefited much from Keynes’s work,” he wrote in 1970. “If Keynes were alive today, he would no doubt be at the forefront of the [monetarist] counter-revolution.” Keynes was looking for a cure for mass unemployment. His remedy was to increase total aggregate demand.

He suggested a number of routes: through monetary means, by lowering interest rates and funnelling new money into the economy; by tax breaks; and through public works.

Friedman convinced economists that when on an even keel, the economy would be served better by a gradual, moderate, predictable rise in the supply of money. It was Friedman, not Keynes, whom most economists and politicians from the mid-1970s on adopted as their guide, after the application of all three of Keynes’s remedies simultaneously for three decades resulted in stagflation.

Volcker’s action
From the moment in 1979 when Paul Volcker, then the Federal Reserve chairman, rebooted the economy by deliberately inducing a recession, Friedman’s principles were widely applied. Friedman adopted Keynes’s idea of running an economy through macroeconomics, and politicians have gone along with it, whatever Hayekian rhetoric they may sometimes employ.

Hayek took an absolutist position, that because no one could know what was in the minds of every member of society, and that the best indicator of their conflicting needs was market prices, all attempts to direct an economy were misplaced. Over time, his failure to attract support during the Keynesian hegemony appeared to drive him into arguing his case ad absurdum.

Eventually Hayek wanted state power to withdraw to a minimal citadel, and he wished to see every last element of the economy, even the issuance of money, in private hands because he challenged the state’s monopoly of money-creating powers. This put him in direct opposition to Friedman, who, while wishing for the government to be minimised, believed that an economy should be managed to provide steady growth.

While Hayek may have risen in influence in the last 30 years, Keynes has never been far from economists’ thoughts. The federal government’s urgent response to the financial crisis of 2007-8, initiated by George W Bush and continued by Barack Obama, was thoroughly Keynesian, with both administrations intervening in the marketplace to head off the economy’s collapse. America faced an existential threat, and as in the 1930s, a failure to act was considered so foolhardy it was barely contemplated.
Keynesianism no panacea

At the height of the crisis, there were few in the short run who countered this resurgence of Keynesianism, even fewer who with a straight face promoted the Hayekian solution, to let the market find its own level.

The view of Austrian-American political philosopher Joseph Schumpeter that the free market must from time to time endure a period of “creative destruction” wasn’t allowed to be put to the test. Having so markedly been proved wrong, the widely held assumption that the free market always righted itself over time wasn’t given a second chance.

Few have tried to plot the dire consequences that would accompany the collapse of the economy: How many people made unemployed; how many deprived of their homes; how many declared bankrupt; and how many businesses shuttered.
Yet Bush and Obama received little credit for taking precipitate action to avoid an economic Armageddon. And Keynesianism proved to be no panacea. As the stimulus failed to quickly reduce the numbers f unemployed, and the tales of “wasted” money for contentious public programs began to spread, many Americans became alarmed at the extent of government borrowing.

For some, such as Harvard economics professor Robert Barro, Keynes became a figure of derision, a pied piper who lured the children of future generations into a dark cave of intolerable indebtedness. Others accused Obama and his economic advisers of being closet socialists. Hayek’s Austrian School argument — that public money put into investments would be wasted — was dusted off.

Galbraith’s view
Like Keynes and Hayek, John Kenneth Galbraith didn’t live to see the Great Recession, but he had an explanation for why conservatives couldn’t applaud Keynes’s efforts to save capitalism from itself. “Keynes was exceedingly comfortable with the economic system he so brilliantly explored,” observed Galbraith. “So the broad thrust of his efforts, like that of Roosevelt, was conservative; it was to help ensure that the system would survive. But such conservatism in the English-speaking countries does not appeal to the truly committed conservative … Better to accept the unemployment, idled plants, and mass despair of the Great Depression, with all the resulting damage to the reputation of the capitalist system, than to retreat on true principle … When capitalism finally succumbs, it will be to the thunderous cheers of those who are celebrating their final victory over people like Keynes.”

Nicholas Wapshott, a former senior editor at the Times of
London and the New York Sun, is the author of Ronald Reagan and Margaret Thatcher: A Political Marriage. This is  excerpted from his new book, Keynes Hayek: The Clash that Defined
Modern Economics, to be published October 11 by WW Norton.