Tuesday, 28 September 2010

Hayek vs. Keynes: On policies of economic stimulus

Keynes and Hayek main divergence was on whether governments could and should play a role in smoothing the business cycle. Their opposite views were expressed in the pages of The Times of London, on the 17th and 19th October 1932, barely three months after the bottom of the biggest ever stock market crash. The current heated debate on the desirability and efficiency of stimulus packages takes place in circumstances similar to those prevailing at the time..

Both economists agreed that savings used for hoarding damaged economic growth. However, Hayek opposed public spending on the grounds that the already high level of public debt in the UK would tend to drive up interest rates and undermine the supply of capital to where it was justifiable – the private industry – while encouraging the old habits of lavish government expenditure. Hayek’s alternative to public spending was to abolish trade restrictions and to liberalize international capital movements. For Keynes piling up bank balances or purchasing existing securities (to bid asset prices to its previous level) would release real resources while failing to find new opportunities to invest them due to a lack of confidence (animal spirits). The stimulus could only be brought by increased (local) government spending.

Now, with the benefit of hindsight, we know that both points of view had some validity but were necessarily partial. Hayek was vindicated in forecasting the rise of the role of government in the economy. However, Keynes was also correct in predicting that recessions would be fewer and less pronounced.

Let us compare first the past and current circumstances in relation to three major economies - the UK, USA and Japan. In 1932 the UK government spending was equal to 27% of GDP, with a large portion devoted to servicing a net national debt equivalent to 175% of GDP at a time when 3–month interest yields were at 2.75%. Currently, in August 2010, the UK government expenditure stands at 46%, the net national debt at over 55% and the 3-month yields are at 0.55%. In the US the corresponding figures were then 22%, 33% and 0.18%, but are now at 44%, 94% and 0.15%, respectively. The position of the two countries is now a bit reversed, but in the interim period the country (USA) with slimmer government and lower indebtedness has overtaken the other as the major economic player.

Turning now to the aftermarket of the Japanese market crash in 1992, the figures show for that year a government expenditure equivalent to 33% of the GDP, the central government debt at 49% and the call rates at 4.12%. The equivalent figures for 2010 are respectively 37%, 178% and 0.10%. This shows that the Japanese attempts to recover from the market crash by keeping low interest rates and increasing government spending failed to revive either the asset markets or the growth of the real economy. Similarly, the efficiency of the New Deal policies in the US is still an unsettled debate among economists.

In what concerns the frequency, duration and amplitude of post World War II recessions the US evidence for the two 65-year-periods from 1854-1919 and 1945-2010 clearly shows a reduction in its number from 16 to 11, a reduction on its average duration from 22 to 11 months and a fall in the average change in unemployment rates from 15 to less than 5 percentage points.

Yet, notwithstanding the productivity losses caused by an ever growing role of the state in the economy, the fact that the last recession (December 2007-to June 2009) lasted 7 months more than usual, caused unemployment to grow at twice the rate of previous recessions and left a legacy of fiscal deficits much bigger than even those experienced during the great depression raise serious doubts on whether the growth of the state sector has reached its limit as a stabilizer of future economic cycles.

So what have Keynes and Hayek missed? First, some degree of saving and hoarding will need to take place for precautionary motives and to bring back leverage to its optimal level. Second, investors should write-off some of their capital losses rather than beg governments for bail-outs. Third, governments must manage to cut current spending (like everyone else) while simultaneously running increased deficits to support the consumption of the poorer and the financing of public (local) investments with a positive return and a short payback period.

Last but not least, they did not realize that the marginal efficiency of capital is not just the result of animal spirits but it is also significantly shifted by expectations about leverage and changes in interest rates (not their level). Therefore, central banks should not encourage prolonged bond bull markets, as they are currently doing, but rather resume a smooth return to the type of bond bear market required for faster economic growth (on this see our blog on Keynes and the rentier classes: http://marques-mendes.blogspot.com/2010/07/is-keynes-wrong-or-outdated-on.html).

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