QuestionĂ¡rio

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).

Hayek vs. Keynes: The role of government and the dangers of totalitarianism and economic decadence

There is currently a generalized view of Keynes as the paragon of state intervention and of Hayek as the quintessential laissez-faire economist. Both views are wrong.

Keynes basic philosophy, as stated in his General Theory, is that governments should be entrusted with “the task of adjusting to one another the propensity to consume and the inducement to invest” to prevent effective demand deficiency. For him, the state should decide how much to produce (to achieve full-employment) while individuals should decide what to produce, with which resources (labor and capital) and to whom it should accrue.

For Hayek popular terms like “full employment”, “planning”, “social security”, and “freedom from want” were the fool’s-gold words, often invoked with catastrophic consequences, as in Germany where the full-employment between 1935 and 1939 was achieved at the expense of expropriating, deporting or killing 600 thousand Jews. For him monetary policy cannot provide a real cure except by a general and considerable inflation. Moreover, for him the rising monopolization of the economy was not inherent to capitalism (economies of scale) or justified by technological necessities but was instead the result of collusive agreements promoted by public policies.

Given the circumstances when they were writing, we can understand Keynes’ fear of recurrent massive unemployment destroying capitalism as well as Hayek’s alarm about the danger that rising government control would inevitably lead to a totalitarian state. However, after more than 70 years, and with the benefit of hindsight, we may now question if such fears were warranted.

After all, some of the totalitarian regimes were military defeated (e.g. the German Nazis and Italian Fascists), some imploded through inefficiency (e.g. communism in the Soviet Union and Eastern Europe) or have postponed their demise by embracing authoritarian mercantilist capitalism (e.g. the Chinese communists).

Equally, the subsequent recessions and accompanying massive unemployment were overcome without major social unrest, partly due to the generalization of unemployment insurance.

Nevertheless, we should not forget the tremendous losses caused by such collectivist experiments. The more than 60 million of casualties during the World War II started by Hitler, the 15 million victims of Stalin's reign of terror in the 1930s and Mao’s more than 20 million victims in the 1950s and 1960s during the so-called Great Leap Forward and the Cultural Revolution. Also pointless has been the waste of manpower as result of involuntary unemployment experienced in many countries ruled by collectivist (mostly socialist) regimes in 2009, namely: Zimbabwe (95%), Turkmenistan (60%), South Africa (24%), Spain (19%) or Tunisia (16%).

Given this grim past, the question is: could it have been avoided if the policy advice of Keynes and Hayek were more widespread and better understood? If not avoided it could at least be minimized. In particular this would be so, if the “prophets’ followers” shared their common care for capitalism.

Instead, most followers continued to ignore them on this, as well as the failure of all past predictions by both friends and foes of capitalism that it was doomed to fail. All such theories, from Karl Marx surplus value theory of capital accumulation, to Schumpeter’s claim that that the success of capitalism would lead to a form of corporatism and a fostering of values hostile to capitalism, especially among intellectuals, Milton Friedman’s theory on the suicidal nature of capitalists to Solzhenitsyn's attack on the commercialized nature of Western culture have been proved wrong.

Even more importantly, all attempts to create a pragmatic so-called “third-way”, from the recent British experience by Tony Blair’s New Labor, the Czech and Hungarian attempts to create a democratic socialism in 1968 and 1956, to the more distant Fascist “third way” of the 1930s, aimed at keeping the best of socialism and capitalism ended up dramatically retaining the worst of both systems, creating more collectivism, corruption and inequality.

For Keynes or Hayek there was no alternative to capitalism or “third-way”, simply a choice about the degree of government intervention in the economy. While assessing the supply of goods and services not provided by the private sector or the regulation aimed at promoting a level playing field, Keynes, the politician, was obviously more compromising about accepting a substantial role for the government while Hayek, the theorist, was more puritan.

Some types of state capitalism (notably the Scandinavian type) have now shown that fears about the rise of authoritarianism as a result of greater state involvement in the economy, as feared by Hayek, do not materialize until a high level of public spending as a percentage of GDP is reached (about 50%). Equally, the rising share of government in the economy has some smoothing effect on the business cycle as advocated by Keynes, but after a certain level (again, about 50%) it triggers a slowdown in productivity and consequent economic decadence. Thus, Keynes and Hayek’s views are correct within a given range of state intervention, but its limits are imprecise and poorly understood.

Hayek vs. Keynes: On individualism and collectivism

With the demise of anarchism in the 1930s and communism in the 1990s, we may say that the boundaries in the political spectrum on the role of the state in capitalism are defined by the extremes of the liberal (socialist in the European sense) and the libertarian movements. Currently, the bibles for both left/right-wing libertarians and liberals are still Hayek’s Road to Serfdom (1944) and Keynes’s General Theory (1936).

The two “prophets” were contemporaries, but Hayek outlived Keynes by almost fifty years. Indeed, as Hayek admitted later on his autobiographical interview, they engaged frequently on controversy but “remained personally on the best of terms, and I [Hayek] had in many respects the greatest admiration and liking for him as a man”. Keynes himself said of The Road to Serfdom: "In my opinion it is a grand book...Morally and philosophically I find myself in agreement with virtually the whole of it: and not only in agreement with it, but in deeply moved agreement".

However, today’s supporters of Keynesian and Hayekian theories behave as fanatical or newly-converted followers. Often their behavior resembles that of the fanatics in the Abrahamic religions and sects who believe that their particular faith is the only truth and all other believers are infidels and enemies. Both religious and economic followers fail to recognize that their “prophets” followed the same god and ideals (liberalism) and that their differences were mostly about how to achieve them. Keynes and Hayek embraced the same theory of political economy based on market capitalism and economic liberalism.

Both believed that they should be based on nineteenth-century individualism and not in its misleading meaning of selfishness and egoism used today. The advantages of individualism as recognized by Keynes were: 1) the best safeguard of personal liberty; 2) greater efficiency (through decentralization of decisions and the play of self-interest); and 3) best safeguard of the variety of life and peace. Similarly, for Hayek the merit of individualism rests on recognizing the super individual forces which guide the growth of reason. Individualism is thus an attitude of humility before this social process and of tolerance to other opinions.

If they differ only by degree and not on fundamentals, where are then their key differences? The key differences are the result of how they see the trade-cycle and the trade-off between individualism and collectivism. Although both favor individualism over collectivism, Keynes is willing to sacrifice the first to achieve full-employment. Hayek refutes such compromise and doubts that collective (government) action can achieve such objective without running the greater risk of creating a totalitarian society (greater concentration of decision-making power).

So, their “followers” would do better by focusing on the limits of their theories and on studying the circumstances under which they can be applied.