Thinking Things Over              November 6, 2011

Volume I, Number 16: 2012 is Another Repassage of Keynes versus Hayek  

By John L. Chapman, Ph.D.                                                                                                                         Washington, D.C.

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.  Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.                                                                                                                                                    — John Maynard Keynes

The recently concluded meetings of G20 heads of state in Cannes, France provided another exercise for a group of bloviating self-promoters to get together on the international stage for photo ops, good food, le beaux vins français, and, one must add, a grand opportunity for thorough waste of the scarce wealth of their respective taxpayers.  For while the partying never stops along the golden Mediterranean coast of the Côte d’Azur, it surely has just 950 miles to the east, in Athens, Greece.  And the meeting only brought further discredit to the glaringly incompetent American delegation, led by a hapless President who announced that the meeting was a success in terms of  making progress to put “economic recoveries on a firmer footing” in the world’s advanced economies.  What recovery?  And what firmer footing, Mr. President?

For indeed, at a time when the world needs American economic leadership as it has so often in the past, it is instead sadly true that retrograde policies are all that emerge from the Beltway maelstrom these days.  U.S. GDP growth will end up in 2011 at roughly +1.8% in real terms, which is not quite enough to maintain per capita income levels in the U.S., and is barely half the U.S. long term average growth rate going back to 1900.  But this anemic growth rate looks positively boom-like when compared with the Eurozone’s 0.3%, and Japan’s zero growth.  Indeed, Europe is certainly headed for recession in 2012, and a potentially bad one at that, while the world’s second and third largest economies, China and Japan, are troubled as well, the latter just emerging from a nearly year-long slump.

As for the United States, troubles in so much else of the world economy explain part of the reason for anemic growth here — but only part.  The U.S. faces structural issues (too much debt & deficit spending, not enough investment, very harmful monetary policy in which the central bank has ratified fiscal profligacy and weakened the dollar) that, in fairness, pre-date Mr. Obama, and these have now arisen to take their toll.  But for any fan of economic growth, the present Administration has pursued a series of antediluvian policies already tried and found wanting in Europe and Japan (as well as here, previously) for several decades now, and sadly these have left the United States only deeper challenged.  The class of job-creators in this country, found in both small and large businesses alike, is a truly heroic one, having fostered 2 million or so new private sector jobs in the last two years.   But a series of retrogressive spending actions along with significant new legislative burdens threatens the sustainability of modest growth in U.S. GDP.  To say this differently, there is nothing endogenous to the current U.S. policy mix that suggests economic growth will accelerate here – and, even if there were, as PIMCO’s Mohammed El-Erian is fond of saying, one cannot be the best house in a bad neighborhood for long and expect to hold one’s value.

Given present challenges, therefore, the election precisely a year away in the United States is an inflection point in U.S. history, because either the current policy track will be ratified and embedded in baseline fiscal programming, or a return to a more market-based approach will be forthcoming.  For the economics profession the analog to this choice has been a long-running debate about the role of government in an economy, represented by two poles exemplified in the writings of Adam Smith and Karl Marx, but famously actuated in the 1930s in a running debate between Cambridge University’s Lord Keynes and F.A. Hayek, then newly-installed at the London School of Economics.

This debate, famous in the history of economic thought, was brought to mind this week with the release of a new book on the topic by Nicholas Wapshott, the well-known British journalist.   Mr. Wapshott adequately captures the essence of the controversies taken up by the two giants after 1930 and ending only with Keynes’ untimely death in 1946.  For those interested, a 90-minute Oxford-style debate connected with Mr. Wapshott’s book tour will be held in New York on Tuesday, November 8, at 5:30PM Eastern, and will be broadcast over the Internet.  Participants defending Hayek include Ned Phelps, the 2006 Nobel Laureate in Economics, Lawrence H.White, the George Mason economist who is one of the world’s foremost monetary theorists, and Steve Moore of the Wall Street Journal editorial board.

The reason this long-forgotten running debate from the 1930s matters today is because it was then pursued in the midst of the Great Depression, and the diametrically-opposed policy solutions proffered by Keynes and Hayek back then are mirrored in the argumentation that will (more or less) play out in 2012 in the United States.  For Keynes, the business cycle was an inherent feature of a capitalistic market economy, thanks to the whims of capricious investors.  If their “animal spirits” inclined them toward a positive outlook, they would risk capital in new ventures, new factories, and new hiring, all of which impelled consumer spending and a concomitant boom in the economy.  But just as easily, their outlook could turn dour, leading to a slump that would involve plant closings, layoffs, idled capital, and less spending.  These labor and capital resources in the economy were idled, according to Keynes, because of a failure of classical economic doctrine, which held that involuntary unemployment was not possible in a market economy thanks to automatic price adjustment between supply and demand.  Rather, Keynes said, changing goods prices was costly, and wages especially were “sticky” downward; rather than cut workers’ pay, firms would just lay off part of their workforce.  This downward spiral could continue indefinitely because the more workers were laid off, the less output was produced and the lower were aggregate incomes.  As Keynes called it, “aggregate demand” could settle in an equilibrium state that may well not be the one needed for full employment, thus implying permanently unemployed resources and workers.

The bad news did not end there, for Keynes: unfortunately, he held, there was no motive force inherent in a market economy that could lead to a turn-around and re-employment of unemployed workers.  Since the ”animal spirits” of investors could not be counted upon to do this, it must fall to government to exogenously provide for the market-generated shortfall in aggregate demand.  Why, Keynes asked, should workers be forced to suffer during slumps, when government could be used to ensure booms?  Hence, Keynes offered the political class a justification for government spending and the debt-and-deficit cycle that the Western world has followed ever since.  Right or wrong, Keynesian economics came to dominate policy for decades after his 1936 book, and to this day we argue in his terms, using his framework, and debate the efficacies of his policy recommendations.

Professor Hayek won the Nobel Prize in Economics in 1974 for work on business cycles and capital theory that largely refuted the Keynesian paradigm.  Hayek argued that Keynes made spectacular errors in logic that in turn fueled incorrect analysis and policy prescriptions.  First of all, Hayek asserted that there was nothing inherent in a market economy that would lead to boom-and-bust business cycles; rather, the inherent tendency of market economies is toward stability and prosperity, because peoples’ wants and needs are insatiable.  Keynes misapprehended the very nature of capitalism because he did not understand what caused the sudden shift in “animal spirits.”  What, Hayek asked, would lead entrepreneurs and decision-makers in business to make systematic, or economy-wide errors in judgment, leading to the “malinvestment” (or, waste) of scarce capital resources that in turn led to downturn in investors’ animal spirits?  Hayek asserts that this is only possible thanks to government intervention that is misguided, in the form of errant monetary policy ratifying spending and borrowing in the public sector.  That is to say, the government borrows funds to pursue spending, and the central bank, figuratively speaking, “prints” the money to pay for this spending via a supportive monetary policy’s open market operations.  But this literal creation of government credit out of thin air leads to a falsification of the structure of interest rates: they are made lower in “nominal” terms than they would be in “real” terms — that is to say, without the government’s intervention.

This has two effects, both of them deleterious: it pulls resources out of the productive private sector, including, importantly, capital that would be used to promote growth in jobs and output.  And at the same time it induces activity on the part of entrepreneurs and managers who respond to the now falsely-lowered interest rates by pursuing projects that, from a “real” perspective, have no basis in real demand.  Many such projects (e.g., an over-built housing sector, too much investment in dot-coms) are bound to end in failure, and the systematic nature of the cluster of errors can incite a recession.

For Hayek, then, stable-valued money, ideally market-generated and thus not politically-managed, was a necessary condition for a prosperous economy.  He therefore violently disagreed with Keynes’ description of capital as not only not being scarce, but as creatable following government-led spending; that is to say, Hayek defended the classical doctrine of saving being crucial and a priori to capital accumulation, and asserted Keynes made a seminal error in denying any importance to the role of saving.  Keynes in fact looked forward to the “euthanasia of the rentier”, in a world where government was largely the dominant player in the direction of “social investment”; Hayek could only admit to disbelief at such logic.

Hayek attacked this thesis from another vantage point: he held that the central problem to be solved in any economy is the coordination of scarce resources among competing plans and beliefs of what today are billions of economic agents.  This is accomplished through the “marvel” of the price system, that coordinates supply and demand in rapidly eliminating unmet market demand, and ensuring resources are utilized where they are most valued “at the margin.”  But for the price system to work effectively, government needed to stay out of the marketplace; any falsification of prices, including interest rates which set the terms of trade between resources available today and those in the future, would set in motion erroneous decision-making and possibly recession.  Hayek complained that Keynes’ description of “aggregate demand” was useful only in textbooks, and obscured as much as it might clarify.  For what matters in ending recessions is a correction of a relative price structure badly out of sort due to prior government intervention; further government interventions, via bail-outs, stimulus spending, and monetary manipulation can only lead to a further cluster of entrepreneurial error that wastes scarce capital — and generates more pain for “real” (and not nominal!) human beings.

In today’s terms, Keynes would likely endorse much of  the government spending and stimulus programs as well as inflationism in recent years, and decry Hayek’s “cold-heartedness” at a laissez faire approach that “did nothing” to alleviate the very real problems of unemployed and underemployed workers.  Hayek would reply that it was, in effect, quasi-permanent Keynesian stimulus that caused the catastrophe and present torpor of our age in the first place, and it is the continuing stimulus and government interference that is not only preventing a solid and sustainable recovery around the globe, but indeed threatens us with a further downward spiral in the global economy.  Hayek would plead for an end to fiscal insanity and a return to monetary stability as sine qua nons of a return to prosperity – which would ensue quickly if the political class would but permit it.  “Keynes”, Hayek would intone, “it is you and your supporters who are causing the massive pain across the globe today, via seminal errors in logic and misapprehension of the workings — and blessings — of a capitalistic market economy.  Far from being cold-hearted, I want to end this economic perversity immediately.”

Arguments made by politicians next year will not be as theoretical in nature nor as eloquently versed as the original Keynes and Hayek correspondence and debates across the 1930s, but it is their echo we will hear next year, however crudely.  It is regrettable more people do not seem to understand how crucial the outcome, delivered precisely a year from now, will be — for the stock market, the economy, and our collective future.

Post-script to readers who like graphics:  In order to highlight a big difference between Keynes and Hayek, we offer the following chart depicting growth in the monetary base in the U.S.  It is one of the more remarkable ever seen in the entire history of monetary economics, and it is one of which Keynes would approve, while causing Hayek a degree of fear.  We’ll save detailed commentary for another essay in the near future in terms of what it might portend, but, res ipsa loquitur: stagflation ahead, or brilliantly-timed intervention that is easily reversible?

Chart I. Growth in the Monetary Base

 

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. 

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