The Inaugural Conference of the Institute for New Economic Thinking, established with a $50 million grant by George Soros, took place at King’s College, University of Cambridge in Cambridge, UK on April 8-11, 2010. The landmark event was intended to reflect the organization's commitment to invigorate the conversation surrounding economic theory, method, and policy. More than 150 academic, business, and government policy thought leaders from around the world convened to explore the reasons prevailing economic theory failed to predict the financial and economic crisis that erupted in 2007-2008. Conversations were structured to examine the implications for reform, provoke creative energy, and foster the development of original contributions to economic thinking.
 
Through the good office of INET Director, Dr. Rob Johnson, I was one of the invited attendees but regrettably was unable to attend.

One of the Session Topics was: 1930 and the Challenge of the Depression for Economic Thinking: Friedrich Hayek versus John Maynard Keynes. Marshall Auerback was in attendance and posted his comments on the topic on the website of New Deal 2.0, a project of the Franklin and Eleanor Roosevelt Institute.

Keynes and Hayek is also a subject I had written on in 1999 and posted on the Post-Keynesian Thought on line discussion list.  Readers may find the article of interest.  It was published on April 15, 2010 in Asia Times on Line.

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Keynes and Hayek
 
By
Henry C.K. Liu
 
 
Keynes at Cambridge University, who advocated government intervention to protect the economy from the effects of the business cycle, and Hayek at the London School of Economics, who advocated the merits of free markets, had been theoretical opponents in economic theory since the 1930s.
 
Events in the 1930s had showed the socio-economic damage caused by free markets. Subsequently, the macroeconomics of Keynes's 1936 General Theory dominated academic circles as well as government policy establishments.
 
By the time Keynes died in 1945, Hayek and the classical, trade cycle theory had very few serious followers. Economic policy at that time emphasized demand management in which the business cycle was believed to be an undesirable defect to be managed with fiscal policies of deficit financing.
 
Discouraged, Hayek left economic theory work, eventually chaired the Committee on Social Thought at the University of Chicago in 1950, and later at the University of Freiberg (1962-68) and Salzburg (1968-77). He worked on psychology (The Sensory Order, 1952), political theory (The Constitution of Liberty, 1960), and legal studies (Law, Legislation & Liberty, Volumes l-lll, 1973-79) along generally conservative lines.
 
The so-called Socialist Calculation Controversy was prompted by the Austrian School's critique of central planning. From the 1920s until the 1940s, Hayek and his fellow Austrian and teacher, Ludwig von Mises, argued that socialism was bound to fail naturally as an economic system, although they seemed to allow for socialism's political imperative, albeit only as a fallacy.
 
Hayek maintains that only free markets, with individuals making disaggregated decisions in their narrow self-interest, can generate the information necessary to intelligently coordinate social behavior. Freedom of individual choice without “distortive” regard for social impacts is considered as necessary input for an efficient economy that would lead to prosperity. Hayek argues that free market prices are the true expression of a rational economy.

For three decades after WWII, reality ran counter to Hayek’s theories. Even conceptually, macro-economists began to suggest that with the aid of computerized macro input/output models, central planning can accommodate the very information problem that Hayek had raised. After all, if the boundless complexities of fluid mechanics in producing a silent-running submarine propeller can be simulated by mathematical models, why not the dynamics of a planned economy. Mathematics was challenging ideology in the evaluation of theories in economics.

Paradoxically, Hayek, who implies scientific determinism in his ideological argument for free market, is unsympathetic to the efficacy of applying the sophisticated tools of the physical sciences to the social sciences.
 
The shift from the “gun or butter” trade-off of the pre-war era to the “gun and butter” fantasy of 1960s and '70s pushed post-war prosperity into spiraling inflationary bubbles in countries that had benefited from Keynesianism, led by the United States and the U.K.
 
As more and more surplus value was siphoned off to non-productive military expenses, wages could only rise by permitting inflation to stay ahead of them. Employment thus became hostage to the militarization of peace. Even then, full employment could not be maintained by Keynesian measures in peace time because surplus value, having been stored in military inventory, was not being re-circulated in the economy through higher wages to sustained needed demand.
 
The traditional counter-cyclical therapy, such as stimulating consumption and postponing savings through government deficit spending, strained the elasticity of wage/price convergence, pushing the economy into stagflation.

The macro models, imperfect as they were, showed that the principle of “guns or butter” was not immune to macro-economic management. Too many guns would produce inflation that wages simply could not catch up.
 
Under Cold War mentality, cutting butter became the only option. Capital understood that managed inflation is pro-labor and anti-capital. Keynesian economics was essentially pro-labor in its macro approach by treating unemployment as a social virus that healthy doses of managed inflation should be tolerated as its cure. Government fiscal policy was deemed the natural venue to administer the medicine.
 
Capital, to combat this serious threat to its very existence, adopted a strategy with three legs.

The first leg required that guns remained an untouchable priority. The rationale was that guns were needed geopolitically in a world that had become fatally dangerous to capitalism.

The second leg required that government be blamed for high inflation and unemployment. Voters had to be convinced that inflation was bad for them and that the pain workers with low wages were suffering was caused by big government and inefficient central planning that distorted the natural self-adjustments of a free market.

The third leg required the introduction of the threat of hyperinflation in the economy to scare the gullible masses into accepting an anti-government and anti-inflation frame of mind. This leg of the strategy encouraged the economy to run into prolonged runaway inflation and recurring government deficits that hurt both labor and capital, setting a stage for a anti-labor onslaught through anti-inflation and anti-government rationalization in the name of protecting the welfare of the nation.
 
The general public bought into the propaganda readily, but the intellectuals had to be won over with a new school of economic thought that would seize policy initiative from the Keynesians in government. Hayek’s discredited free market theories appeared tailor-made for this purpose.
 
To provide theoretical underpin for this three legged pro-capital strategy, the old classical economics prescriptions: savings, investment, balanced budgets, competition, productivity determined wage levels and supply-side growth, were dug up from of the intellectual graveyard and dusted off with new bells and whistles to be paraded as the
sound economic policy goals of good government.
 
Conservative politicians began to demonize Keynesianism domestically and rational socialist economic planning internationally. Third World socialism, burdened with endemic poverty from imperialism, was never given a chance economically by the new financial imperialism and politically by Cold War containment.

The Soviet Union, as the only socialist super power, fresh from a war-torn economy, was pushed gradually but systemically into bankruptcy by the ruinous arms race stage managed by the "guns and butter" policy of the US, the only capitalistic super power which had become rich in WWII which could violate the Bretton Woods gold standard fixed exchange rate with immunity.
 
To anoint respectability on the worn theories of free market voodoo economics, as propaganda against Keynesianism in the West and socialist planning in the Third World, Hayek was plucked from three decades of homelessness in the economics fraternity, to be awarded a surprised Nobel Prize in Economics in 1974.

For ideological balance, Gunnar Myrdal was named co-winner for the Nobel Prize in the same year. Myrdal would later published an article advocating the abolition of the Nobel Prize for Economics, as a reaction to the awarding of the prize to Milton Friedman and Hayek who would be attacked for “certainly never been much troubled by epistemological worries,” not withstanding Hayek's Nobel speech, delivered in Myrdal’s presence, dealt with the subject of the methodology of economics. Myrdal’s disdain for Hayek was shared by many in academic circles, particularly in Europe.
 
Nevertheless, overnight, the extremist right transformed a joker in the person of Friedrich August von Hayek, born in 1899, died March 23, 1992 in Freiberg, Germany, to guru status, as the greatest philosopher of capitalism since Adam Smith.
 
Actually, Hayek and Keynes were both fundamentally classical liberals, the former rooted Austrian idealism, the latter in English pragmatism. The basic ideas for both are based on individual freedom. Keynes was seduced by political necessity. His famous phrase: “in the long run we will all be dead,” implies his recognition of the importance of
immediate socio-political constraint over timeless doctrinal purity.

The difference between them was that to keep the economy going, Keynes would fight unemployment with inflation and Hayek would fight inflation with unemployment.
 
They also differed with regard to technical measures, as relating to interest rates, money supply, liquidity, etc., deemed appropriate for achieving the desired effects.
 
For politicians, inflation and unemployment are the two score-keeping measurements in economic policy.

Keynes' thesis is that government spending is needed to bolster aggregate demand in times of unemployment.

Hayek believed that if it were not for government interference with the monetary system, the economy would have no industrial fluctuations and no periods of depression. To him, trade cycles are caused by government monetary authorities creating a semi-monopoly where the basic money is controlled by government. Since banks issue secondary money, which is redeemable in basic money, a system of indeterminate control is created. So government monopoly over the issue of money is ultimately responsible the economy’s structural problems, because nobody in charge of such a monopoly could remain true to the logic, independent of political pressure.
 
Hayek allowed that the Keynesian period from about 1950 to 1975 would go down in history as the Great Prosperity, as opposed to the Great Depression of the 1930s. To Hayek, the hyperinflation of Germany in 1922 was not to maintaining prosperity but was forced upon Germany due to financial difficulties caused by a war debt strategy. If the purpose of inflation was to maintain prosperity, a much more moderate rate would have achieved the aim.

Hayek blamed the collapses of the inflationary booms during past trade cycles on the gold standard, which put a brake on those expansions after a few years. History has never had a time where a policy of deliberate expansion was unlimited by any framework of monetary order. So Milton Freidman’s monetary theory cannot solve any basic problems.
 
Hayek admitted that cuts in inflation have been accomplished through extensive unemployment. He acknowledged that ending inflation need not lead to long-lasting periods of unemployment like the 1930s, because then the monetary policy was wrong during the boom as well as during the Depression, by first prolonging the boom and intensified the depression, and then by allowing deflation to go on and prolonged the Depression. But after an extended period of inflation, an economy cannot get out of it without substantial unemployment.
 
To Hayek, inflation causes unemployment by drawing people into jobs which exist only because relative demand is temporarily increased, and these temporary employments must disappear as soon as the increase in
the quantity of money ceases.
 
Yet, in the United States, a long period of high unemployment would automatically strain income-maintenance programs, such as unemployment insurance, welfare, etc., and run up enormous deficits as to threaten monetary stability and inflation.
 
Hayek acknowledged that there would be intense political struggles on the question of whether social-security benefits ought to be indexed to inflation. He advocated using inflation to reduce the real cost of the social security system. He hoped that the horror of financing this colossal welfare bureaucracy would shock the country into a more
rational government framework.

To avoid inflation, Hayek's prescription has been to advocate that monetary policy be pursued with the goal of maintaining stability in the value of money. Since politicians cannot be trusted in a democracy to regulate the money supply, market forces should be allowed to adjust towards a gradual deflation.
 
Hayek wanted a free market of money. He viewed the gold standard as an unconstructive regulation. The gold standard, he argued, even if it were nominally readopted, would never work because people are not willing to play by the rules of the game, which for the gold standard require that an unfavorable balance of trade leads directly to a contraction of currency. But no government can do that; they would opt for going off the gold standard.
 
Hayek attacked monetarism as represented by Friedman, by pointing out the gold standard as based on an irrational superstition. Hayek toyed with the idea of a commodity-reserve system, but the idea of accumulating actual stocks of commodities as reserves is so complex and impractical that he shifted to place the issue of money in the hands of firms whose businesses depend upon their success in keeping the money they issue stable. In that case, there is no necessity of depending upon their obligation to redeem in commodities: it depends on the fact that they must so regulate the supply of their money that the public will accept the money for its stability. This is better than anything else.
 
The Keynesian economic formula seeks a symbiotic relationship with the political forces of the modem welfare state. Keynes accepts the need to adjust monetary policy to a rising wage structure. He opposes restriction on monetary policy so that it can be adjusted to deliver a politically acceptable level of economic performance.
 
Hayek considers the Keynesian formula to be an unsustainable spiral. As unions push up wages, government has to provide enough money to keep employment at these wages, and this leads into an inflationary spiral.

Keynes does not dispute this conclusion for the long run, but practical application of Keynesian measure seems to work at least in the short run. Hayek’s The Road to Serfdom warns of the invasion of the welfare state in people’s private lives, the fundamental conflict between liberty and bureaucracy.

The Austrian economists who view the economics system as the calculus of independent individual decisions differ with Milton Friedman and the Chicago School, which think macro-economically in analyzing total quantity of money, total price level, total employment, etc., in aggregates and averages terms. Friedman is an arch-positivist who believes nothing must enter scientific arguments except what is empirically proven, while Hayek theoretically rejects the usefulness of statistical studies.
 
Hayek observes that the Keynesian explanation of unemployment is more acceptable by economists over the classical explanation because the former can be statistically tested while the latter cannot. From that point of view, Friedman's monetarism and Keynesianism have more in common with each other than Hayekian theory has with either.
 
Hayek’s rejection of socialists thinking is based on his view that prices are an instrument of communication and guidance, which embodies more information than each market participant individually processes. To him, it is impossible to bring about the same price-based order based on the division of labor by any other means. Similarly, the distribution of incomes based on a vague concept of merit or need is impossible. Prices, including the prices of labor, are needed to direct people to go where they can do the most good. The only effective distribution is one derived from market principles. On that basis, Hayek
intellectually rejects socialism.
 
In Hayek's social philosophy, value and merit are and ought to be two distinctly separate issues. Individuals should be remunerated purely on the basis of value and not in accordance with any concept of justice, whether it be the Puritan ethic or egalitarianism.

Hayek went a far as to deny that the concept of social justice has any meaning whatever, on the basis that justice refers to rules of individual conduct. Since no rules of the conduct of individuals can determine how the good things of life should be distributed, the question of justice is mute. Since a free market is the natural outcome of a multitude of individual decisions, how the market decides is amoral.
 
Accordingly, a spontaneously working market, where prices act as guides to action, cannot take account of what people need or deserve, because it operates according to a neutral distribution system which nobody has designed. Such a distribution system cannot be just or unjust.

And the idea that things ought to be designed in a ‘just’ manner means, in effect, that one must abandon the market and turn to a planned economy in which somebody decides how much each ought to have. And the price for that justice is the complete abolition of personal liberty.
 
Hayek’s free market ideas have been applied to much of unregulated globalization, the socio-economic damage is now very visible. Not withstanding Hayek’s repugnant social philosophy, even his “scientific” claims on the effectiveness of free markets has not been substantiated by events.
 
Written on Jan 21, 1999 – first posted on Post-Keynesian Thought on line discussion list on the same date.
This article has not been updated since.