Keynes vs Hayek debate

Jamie Whyte is the Head of Research and Publications at Oliver Wyman, a strategy consulting firm specialising in the financial services industry. This is his opening statement from the Keynes vs Hayek debate at the LSE on 26 July 2011.

(1) The power of prayer is something people are normally inclined to doubt. But in moments of peril, credulity increases and the idea of a magical benefactor becomes irresistible. As the saying goes, there are no atheists in trenches.

Or, to adapt it to economics, there are no Hayekians in recessions. No one wants to suffer the pain of liquidating bad investments, including the bad investment of working for the wrong company. During a recession, the Keynesian idea that government spending can save us becomes irresistible.

(2) Hence “The return of the Master”, as Lord Skidelsky puts it in the title of his recent book. Since Keynesian policies were last popular and unsuccessful, in the 1970s, the growing consensus had been that paying people to dig holes in the ground and dropping freshly printed dollar bills from helicopters are not paths to prosperity.

But it does not take long for the desperate to forget a thousand unanswered prayers. When the Federal Reserve’s interest rate price-fixing finally led to a financial crisis in 2008, politicians around the Western world recommitted their lives to Keynes.

(3) Sorry, that is not quite right. Politicians around the Western world committed the lives of citizens to government officials. The central Keynesian idea is that, because ordinary people are subject to irrational mood swings, politicians and their appointed bureaucrats, who are cleverer and less animal in their spirits, should force us to make the correct investment decisions.

In your irrational fear, you might be unwilling to invest in a recently failed bank or in a company that builds green cars or that makes tunnels allowing turtles in Florida to cross roads safely. You may be unwilling to invest in a firm that buys cars for thousands of dollars and then destroys them.

Well then, the government will force you to, by borrowing money, investing in these enterprises and, on threat of imprisonment, making you service the loan with your taxes. Submit to these superior beings and you will be saved.

(4) You may think my talk of prayer, submission and salvation is unfair. Keynesian economics is not a religion but a science. When Christina Romer, President Obama’s economic advisor, designed his stimulus programme, she did so with mathematical precision. Borrowing hundreds of billions to spend on turtle tunnels and such like, she told us, would have a multiplier effect of 1.57. For every dollar of such government spending, GDP would increase by $1.57. Not $1.56 or $1.58: $1.57. This is science!

Unfortunately, in the same report, we learned that Ms Romer’s Keynesian model predicted US unemployment peaking at 9% without her stimulus and at 8% with it. Well, they got the stimulus and unemployment peaked at 10%. The Keynesian model didn’t just get the magnitude of the effect wrong; it got the direction wrong. As it also did in the great depression. The Keynesian policies of deficit spending adopted by both the Hoover and Roosevelt administrations, which were supposed to reduce the length of the downturn, made it the longest in modern history.

The problem with Keynesian economics is not that it is unscientific – like any good scientific theory, it issues testable predictions. The problem is that it is false.

(5) Macro-economics is a difficult and relatively new subject. Even theories that have not yet suffered repeated empirical refutation should inspire scepticism. To discard voluntary exchange and the normal consequences of business failure in return for the promised benefits of some miraculous macro-economic theory is intellectually adolescent. Someone who does it is like a teenager who, having read a new-age self-help book, tells his parents that all their inherited wisdom is bunkum.

Alas, unlike teenagers, the wishful politicians who adopt Keynesian economic policy are not just hormones and big talk. They are hormones and big government. Keynesian economics encourages politicians to wield the power of the state in ways that do enormous harm.

You can listen to the debate here.

"The Keynesian policies of deficit spending adopted by both the Hoover and Roosevelt administrations, which were supposed to reduce the length of the downturn, made it the longest in modern history."

Except that the General Theory of Employment, Interest and Money wasn't published until 1936, the Great Depression started in 1930, Hoover left office in 1933 and few Keynesian policies were even attempted let alone fully implemented until the 1940s or 50s. In fact even as late as 1933 both Hoover and Roosevelt were still advocating balanced budgets, sound currency (i.e. low inflation), higher taxes and lower government spending.

So unless Keynes was related to Dr Who in some way, it is a bit difficult to see how he can be blamed for a depression that was already well established before he had even formulated his ideas, or had disseminated them to the wider economics and political communities, let alone achieved any measure of widespread acceptance for them.

The General Theory was written to explain why the economic policies of the 1930s were a failure. So it is hardly credible for anyone to instead claim that The General Theory was the blueprint for those policies.

Not much about Hayek here, though plenty of criticism of Keynes. One of the main distinctions between their approaches is that Keynes was, famously, a short-termist, because he was always looking for the politically-acceptable fix. Hayek, on the other hand, like most free market supporters, took the long view, recognising that most people could learn from their experiences. Another important difference was that Keynes, like most of his supporters, tended to think in aggregates, whereas Hayek and the Austrians were 'methodological individualists'. (This was also something that often separated Chicago from Vienna.)
I really enjoyed the debate. I believe Hayek/Mises models have much more explanatory power than Keynesian analysis by a long, long way. Unfortunately the prescription Hayek would have recommended seems only possible amid chaos as it seems on the fringe of our current political discourse. I also worry that the prescription is too hard on people that did nothing to create the malinvestment in the first place and did not benefit from it. The reason for this is, in my opinion, corrupt politicians and corrupt business people (I reserve this description for business people that have excessive influence over the political process, not the average market entrepreneur). And unfortunately this corruption leads to a further transfer of wealth from the poor to the relatively rich, which is ridiculous. That is why, once in the crisis I think taxes should be cut dramatically at lower levels of income and profits (say a flat 15% below £1,000,000) which will create jobs, the filthy rich should be soaked with temporary wealth (50%) and income taxes (70%) to help pay income support and lower deficits and bankrupt companies including banks should be allowed to fail. If credit dries up the government should auction bank licenses to get some new, safe banks going. The rich won't be happy but they benefited from a false boom and, quite frankly, they'll be fine. And at least the poor are somewhat protected in this scenario.
Robert Skedelsky is unlikely to have understood the anecdote in his opening remarks in the LSE Hayek/Keynes debate. He related that, in addressing an audience of Cambridge economists, Hayek was asked, ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ and that Hayek had replied, ‘Yes, but it would take a very long mathematical argument to explain why’. Indeed, the argument would take a very long time to explain to economists who lack the basic understanding. Hayek criticised Keynes for not taking time to understand capital theory, and the same criticism applies to Keynesians today. A credit-led investment boom diverts capital toward long-term projects. Many of these falter in the ensuing bust. ‘Housing’ is the most recent illustration and ‘green’ energy is a likely candidate for the future. As the boom diverts resources to capital projects, fewer goods are produced for more immediate consumption. Yet, expenditures are raised all round. As (in the most recent case) rising property values stoked higher levels of consumption, too little saving again showed as the primary characteristic of a credit-led boom. As the boom goes bust, there is a temptation to support non-viable projects with state interventions. For an economy to thrive, however, mistakes must be remedied. Where there has been too little saving, it makes no sense to encourage consumers into the High Street to purchase new overcoats.
People seem to love talking about the Great Depression, and how Hoover and Roosevelt tried Keynesian-like government intervention to deal with it. But they only succeeded in extending its duration to more than ten years, from 1929 to at least 1939. In contrast, Harding's 'Small Depression' of 1920-21 was over in about one year, thanks to his 'orthodox' approach of cutting government spending and taxes, allowing wage-rates to fall and liquidating bad investments. This seems to be an aspect of Keynes versus Hayek that could have been mentioned in the recent debate.

It is a bit difficult for me to believe that Harding’s 'Small Depression' was cured by tax cuts when those tax cuts weren’t implemented until 1922 and the economy had begun to recover during the previous summer. Moreover those tax cuts were economically insignificant for the vast majority of the population. It is also worth pointing out that it was probably government spending cuts that partially caused the Depression in the first place. There was certainly precious little fall in government spending after 1922.

The big fall was between 1919 and 1921 where federal spending fell by almost 80%. That coupled with an abrupt change in monetary policy probably explains the Depression. Such large and abrupt changes to the balance of supply and demand across the economy are almost certain to cause a recession as a basic analysis of Say’s law of Markets would demonstrate. Thus it wasn't the case of the government alleviating the recession. It probably caused it in the first place.

Moreover, those tax cuts rather than helping the economy probably contributed to the growing financial instability over the following decade: the contractions in GDP in 1924 and 1927, the Florida housing bubble of 1925, and of course The Great Crash of 1929. All in all, hardly a glowing reference for tax cuts for the rich, or for the ideal of a small state.

As for 1929 and the Great Depression, I would just love to know where this Keynesian stimulus was before 1934. In fact as far as I can see there wasn’t that much after 1934 either when compared to the magnitude of the problem.

For almost all of the 1920s public sector spending in the USA was barely above 10% of GDP and Federal spending barely exceeded 5% of GDP. That means that 90% of the US economy was in the private sector. Yet from the start of the Depression in 1929 until 1933 US GDP fell by over 45%. In response total government (public sector) spending rose only modestly from about $12bn to only about $14bn over the same period.

So, I would suggest that the BIG questions for the Hayekians or the anti-Keynesians are these.

(i) In the light of these statistics, where is the evidence that Keynesian economics could possibly have caused or even exacerbated the Great Depression?

(ii) More specifically, how can a rise in government spending of barely 4%pa (or less than 0.5%pa of 1929 GDP) over a four year period be responsible for a 45% fall in GDP?

(iii) Or to put it another way, how could such a paltry level of government spending cause such an economic catastrophe when it represented such a miniscule portion of national economic activity in the first place?

(iv) And how can such a paltry level of government spending ever be construed as a Keynesian stimulus anyway?

Perhaps another issue that the debate should have considered was not merely the effect of Keynesian policies in getting economies out of recession, but the positive role that Big Government can play in reducing the severity and frequency of recessions in the first place.

If you look at the period 1929-1933 the most striking feature is of course the massive fall in US GDP of over 45% (or 27% in real terms). Yet government spending in 1929 was only about 10% of GDP. Clearly it is much more likely for the private sector to contract by 27% or 45% of GDP when it accounts for 90% of output than it would be if it only accounted for 60% of output. Not only that but a public sector of 40% or more is also more likely to be able to find the resources to plug the gap in aggregate demand in the private sector than would a public sector of only 10%.

It therefore follows that countries with larger public sectors should experience less severe recessions and the US GDP data for the last 150 years certainly appears to support this hypothesis. But it also highlights an even bigger and more surprising (to some at least) truth: that GDP growth is actually greater when public spending is higher. So much for Rahn curve analysis?!

When one looks at the economic data for the 25 years immediately prior to the 1929 crash one sees that US government spending averaged only about 10% of GDP. For the 25 years before that the average was even lower at barely 3% of GDP. In contrast, over the period 1950 to 2000 the average was closer to 35% of GDP. Now it appears to be a central tenet of neo-liberal free-market ideology that all economies will grow faster when government spending is reduced as a proportion of GDP. Yet the economic history of none other than that bastion of free-market capitalism, the USA, suggests otherwise. Instead of growth being higher in the period 1879-1929 when public spending was low, it was actually higher for the period 1950-2000 when public spending was much higher.

For the period 1879-1929 real GDP was 5.5 times larger in 1929 than it was fifty years earlier. That equates to an average annualised growth of 3.47%. Yet for the fifty years after 1950 the factor was 5.6 and so the growth was actually slightly higher at 3.50%pa. However this neglects the effects of population growth. Between 1880 and 1930 the US population grew by 150% whereas from 1950 to 2000 it only grew by 86%. So the annualised growth rates in real GDP per capita for the two periods are actually 1.6% and 2.2% respectively. That is a big difference, particularly when continued over fifty years. However the benefits of public spending don’t end there. They are also seen in the volatility of the growth rate and the frequency and severity of the ensuing recessions.

The striking thing about the GDP growth rate over the period 1879-1929 is its extreme volatility. One year growth could be over 10% and a couple of years later GDP is contracting by just as much. This happened repeatedly over that period. As a result the average growth rate was 3.6% but the standard deviation in this value was even greater at 5.2%. Contrast that with the second half of the twentieth century where the average growth rate was 3.5% but the standard deviation was actually much smaller at 2.3%. Not only that but this period also experienced recessions that were mild by historical standards with contractions in GDP of typically only 1%-2% each time. The period 1879-1929 on the other hand was blighted by repeated recessions where GDP contracted by 5%-10% or more. So what is that if not a clear demonstration of the stabilising effect of high government spending and Keynesian economic policy? (Plus of course the added benefits of a Federal Reserve Bank and deposit insurance instead of a system of free banking).

So for those still hankering after small government I suppose the BIG question is this. Which type of economy do you really want to live in?

(i) The economy with more government that offers better public services, higher growth, fewer recessions, greater economic stability and security, less inequality and few if any depressions?

Or:

(ii) The economy with inadequate small government that can only offer poor public services, low growth, more recessions, greater economic instability with little long-term security, more inequality and regular massive depressions?

Wow! What a tough choice.

Toxicity of free market investment was an effect of free markets decision making without outside control and outside regulations, leading to bubbles just to keep it afloat and to ultimately deceive the whole of society. Windowdressing, like advertisement in general, too became the rule in financial institution without rules and regulations. Without the controler controling the controler. Now it is important to fix this chronic system bug by paying back the bonussen in the first place, and introducing the malusses in the second. First we have to rome off those legalised thieves, and the spoilers of riches, and stimulate our fearing low risking economies by printing extra currency, to fill deficits of goverments, by giving out assured government bonds. So that hardworking clever people are not suffering for the failure of arrogant show people, charlatans, who ran our affaires way too long.

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