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Kirk Houghton

Author of The Dividing Lines and Bad Things to Good People

Kirk's Book Reviews

Kirk's Book Reviews

Review of Keynes Hayek:The Clash that Defined Modern Economics by Nicholas Wapshott

Posted on September 30, 2015 at 8:40 AM

Keynes Hayek: The Clash that Defined Modern EconomicsKeynes Hayek: The Clash that Defined Modern Economics by Nicholas Wapshott

My rating: 4 of 5 stars

John Maynard Keynes was the heavyweight economist of the twentieth century – a Cambridge professor, Paris Peace Conference negotiator, architect of the post-war Bretton Woods system of fixed currencies, one of the brains behind the World Bank, best-selling author, and the inventor of Macro-Economics. As a member of the Bloomsbury group of ‘progressive’ intellectuals, he also made a fortune speculating on the commodity markets, and in 1936 produced the most influential economic study of the last 150 years. It is no exaggeration to say Keynes was Britain’s seminal intellectual, perhaps the last great thinker to emerge from these shores with a truly global reach.
Friedrich Von Hayek, an Austrian who secured a Professorship at the London School of Economics (LSE) in the 1930s, is better known as the most articulate critic of socialism and its inability to plan an economy, not to mention its unwitting tendencies to erode individual freedoms as the state takes over most aspects of our lives. Hayek remained an outsider throughout his life and Prices and Production (1931) and The Pure Theory of Capital (1941), his two main contributions to pure economics, remain unread by most. Even those who admire his philosophical works, such as Milton Friedman, remain unconvinced by his writings on the dismal science, yet eulogise about his influence on Neo-Liberalism (especially his epic study, The Constitution of Liberty, said to be Margaret Thatcher’s secular Bible).
Nicholas Wapshott presents us here with an impressive study of how a Micro-Economic debate between Cambridge University and the LSE in the late 1920s concerning the equilibrium between savings and investment eventually cascaded into the wider world until, by 1976, the future of capitalism seemed dependent on which side of the Keynes-Hayek camp you belonged to. And if it wasn’t for the stagflation of the 1970s, we would still be voting for parties that support aggregate demand policies and promote state investment in the economy in times of impending deflation. Keynes would be King and Hayek unread.
Summarising the difference of opinion between these two great intellectual behemoths is no easy task, and Wapshott does a marvellous job of framing both sides of the debate in a concise, intelligible language that often eludes economists. Having read this book in one go and then revisited selected chapters, the core message is that Keynes had one lifelong obsession: how do you counter high unemployment at the bottom end of the business cycle? Hayek’s message was even more succinct: government investment in public works would eventually lead to inflation and distortion of the economy if you tried to avoid recession by boosting demand through taxation, borrowing or tax cuts (or a combination of any two from three).
There is no doubt that some of Keynes innovations in thinking have now been discredited, yet plenty of his theories are still correct. Outside the socialist and Fabian camps, nobody did more to challenge Classical Economics than Keynes, and some of his most iconoclastic theories are still intriguing. An economy will never reach full employment when savings and investment are in balance; self-interest does not promote the general interest; governments should lower interest rates at the bottom end of the business cycle and raise them to cool the boom times – these were radical ideas at the time when Alfred Marshall, Adam Smith and David Ricardo dominated economic thinking. But his most influential policy recommendations are to be seen in The General Theory of Employment, Interest and Money (1936), including his most innovative interpretation of interest rates. According to Keynes, the notion that the natural rate of interest is produced by an equilibrium between savings and investment is absurd. Why? Because banks base their lending criteria on the ratio of their cash reserves against their money liabilities and have no consideration for the classical equilibrium. Furthermore, people often keep their savings as a ‘liquidity preference’ e.g. Banks have to offer them unnaturally high rates of interest to get them to part with their money. This divergence makes the equilibrium theory even more unattainable.
The most famous term associated with Keynes is ‘deficit financing,’ again an innovation that sent shockwaves around the world. For the first time Governments re-building after the Second World War, with the prolonged depression and high unemployment of the 1930s still haunting them, knew one thing – they could not go back to Laissez Faire. No wonder the idea you can lower taxes without a corresponding public expenditure cut had wide appeal in the late 1940s. As Keynes pointed out, offsetting tax cuts with reductions in expenditure would simply redistribute rather than produce a net increase in national spending power. And every industrialised nation lapped it up from 1950 to 1975, while Hayek looked like a hopeless relic preaching a nineteenth-century creed.
Perhaps the one criticism of this excellent book, is that not enough time is devoted to conveying how the stagflation of the 1970s shattered the Keynesian consensus. All Governments had assumed that unemployment would go down when interest rates rise; instead they got the worst of all worlds in 1974 – more joblessness, higher inflation, and a slump in demand. Economists had no explanation, and politicians had nothing else to fall back on in Macro-Economic theory.
Most of us know Hayek’s remedies through his supply side economic recommendations of later years (when he was no longer writing as an economist). In other words, the market could produce a recovery if most levers of government control were dismantled and competition was restored to the system. Today, Conservatives in all developed liberal democracies base their entire economic policy on ensuring Hayek and Milton Friedman’s small-government, market-orientated solutions remain undisturbed – in effect they remain gatekeepers against the Keynesian social democrats that want a return to aggregate demand.
However, it is pure Schadenfreude to say Hayek has won the duel with Keynes in the aftermath of the 2008/09 world recession. When confronted with deflation and a deep recession, western governments everywhere opted for ultra-low interest rates, quantitative easing, and government spending cuts – they had no time for Hayek’s recommendation to ride out the recession until the natural rate of interest is restored and savings and investment are in equilibrium. Barak Obama even returned to a Keynesian policy with a bungled attempt to restore aggregate demand via public works programmes. One look at the new economic language emanating from Jeremy Corbyn’s hard-left Labour Party in 2015 shows how his epithets on growing the economy are pure Keynesian in their attempt to boost demand using the great man’s ‘multiplier effect’ theory.
Ironically, some of the most interesting (and obscure) arguments between the two camps are to be found in Micro-Economics, although these will not be settled or understood in the public arena of politics. Will anyone outside academia really care if Hayek believes there is no correlation between consumer demand and the level of employment? Or if Keynes’ attack on the idea that saving is better than spending is a dagger at the heart of Classical Economics?
But this isn’t just a rehearsal of both sides of a debate by an introverted economics scholar. Wapshott’s research is meticulous and revealing – just as important it delves into the personalities between the two antagonists. Lionel Robbins, the LSE Professor who brought Hayek to England, would later desert him over the way he treated his Austrian wife; even worse, like Nicholas Kaldor (Hayek’s English translator and former pupil) he defected to the Keynes camp in 1960. This was one of the reason why Hayek fell into a deep depression in the early 60s, especially after the commercial disappointment of his 1959 masterpiece, The Constitution of Liberty (now, of course, a bestseller).
Keynes meanwhile was Britain’s foremost intellectual celebrity. Which other economist could get a personal invite from Roosevelt to see him at the White House or have just about every one of his articles from The Daily Mail and The Times published in serial form and later collected into best-selling works? Yet for a man who often didn’t rise until noon (spending most of the morning in bed placing trades with his broker), Keynes output and work schedule was impressive. Indeed, Wapshott believes one of the reason Keynes ended the duel with Hayek in the academic journals was because he had bigger fish to fry and was dealing with the burden of saving the world from mass unemployment – a task he assigned to himself and truly believed in accomplishing. And as the superstar economist responsible for more inferiority complexes than anyone from his generation, Keynes looks like somebody straight from centre stage. Wapshott notes how he would bludgeon his opponent with a mixture of playful sarcasm and theoretical onslaught, sometimes even changing his beliefs along the way when the facts changed; Hayek was more rigid and stuck to his core beliefs, leading the charge with a systemic attack on the smaller details of his opponent’s theories. Arthur Pigou (the distinguished Cambridge Professor) was not alone in calling for a more gentlemanly argument between the two, with Keynes, especially, venturing into more personal territory in his first response to Hayek’s harsh review of A Treatise on Money (1930).
The greatest tragedy is that the Keynes vs Hayek battle presented the western world with a terrible dilemma in the 1970s and early 80s – more inflation or unemployment. In Britain, the Conservatives took control under Margaret Thatcher and opted to defeat the first by allowing the latter to rise above 3 million. For this reason Hayek is a figure of loathing in leftish circles, whereas Keynes still retains admirers from all sides of the political spectrum, excluding the neo-Liberals (remember the Right in the Anglo-Saxon world is far different to the Centre-Right in France, where Keynes still has headway). As Hayek, himself acknowledged, his policy prescriptions are not exactly appealing compared with Keynes ambitious and monumental attempts to provide intellectual justification for government intervention in the economy. This may be why he would later become disillusioned with his 1944 classic anti-Socialist polemic, The Road to Serfdom, still a big-seller in America to this day.
But perhaps the best referee in the Keynes-Hayek clash is Milton Friedman, the Nobel Laurette who is most associated with the free-market resurgence of the 1980s. A committed follower of Hayek’s philosophical works on the need for small government and free market competition, he had no time for Hayek’s economics and lauded Keynes as the greatest economist of the twentieth century. As Friedman admits, most of Keynes’ insights into Macro-Economics remain valid today, even if his ‘multiplier effect’ and ‘aggregate demand’ policies have proven to be a failure in sustaining growth and smoothing out the business cycle.
We might well call the contest a draw, although I suspect the author is more sympathetic to Hayek than the great Keynes. And who knows what the next big debate will be in the world of economics. With climate change, ageing populations and finance sectors too big to fail (but prone to future meltdowns), the question of state intervention and bigger or smaller government might be superseded by something even more important in the future.

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