Keynes vs. Hayek by Brian Doherty

British journalist Nicholas Wapshott’s new book, Keynes Hayek: The Clash That Defined Modern Economics is about a heated debate, eight decades past, between two of the most influential economists in modern history. That debate, which took place in the midst of the Great Depression, concerned the causes and cures of business cycle downturns.

The book comes out at a propitious time. The ongoing economic crisis raises many of the same questions that fueled the intellectual duel between the British-born liberal lion John Maynard Keynes and F.A. Hayek, his free market Austrian friend and opponent. The confluence between subject matter and current events surely helped Wapshott sell his book to a publisher and likely will sell many copies to readers. But potential buyers should be aware that the book says nothing about how the economic dispute between Keynes and Hayek might apply to today’s economic situation. This omission proves fatal.

Wapshott does not ignore the present in favor of the distant past, although the bulk of the book’s narrative is set in the 1930s. But he seems to think his subjects’ contemporary relevance is best reduced to the big-picture conflict between government intervention (Keynes) and free markets (Hayek). Wapshott focuses on the disagreements the two had over political philosophy and practice rather than the technical specifics of their economics. Those political disagreements are important, but they arose from crucial differences in economic theory.

At its root the Keynes/Hayek clash concerned alternate theories about how business cycles work. Wapshott does a workmanlike job walking readers through the lectures, books, articles, reviews, rebuttals, and counter-rebuttals that made up the bulk of their dispute. That is the book’s greatest value, and it’s the most thorough and lengthy such discussion available in the lay literature.

This book is about nothing if not economic theory and history; the personalities simply aren’t that gripping, despite slightly interesting scattered details about Hayek’s marital troubles and the torrid affairs between Keynes’ disciples. Yet Wapshott somehow never spends more than a sentence or two at a time on complicated economic ideas. He devotes far more space to discussing the feuding economists’ intemperate tone than he does to explaining what they meant. Readers who don’t already have a basic understanding of Hayekian and Keynesian economics will get little help here.

But the Keynes/Hayek argument was more complex than just the political question of government vs. markets. It was about complicated notions of price adjustment, especially the vital question of price adjustments for labor. In a 1930s context of very powerful unions, Keynes thought it was politically impossible to achieve the nominal wage reductions necessary to clear the market for labor—that is, to let wages fall so that hiring would be cheaper and unemployment thereby reduced. He instead promoted inflation as a means to trick labor into taking lower real wages.

Keynes’ most famous quip applied to Hayek’s worries about the long-run effects of inflationary attempts to put the consumption cart before the production horse. “In the long run,” Keynes said, “we are all dead.”

Hayek thought the long run might come quicker than Keynesians believed. In his 1941 book Pure Theory of Capital, the Austrian quoted Keynes’ famous line, adding, “I fear that these believers in [that principle] may get what they have bargained for sooner than they wish.” Hayekians would argue that our current economic crisis is an example of living in Keynes’ “long run”—that inflationary credit expansion and high levels of government spending have led to a bust and a debt crisis that we can’t handle. While Keynes himself thought government should spend borrowed money only during recessions, his disciples in government observe no such restriction.

Partly because he shifted from economics to political philosophy in the second half of his career, Hayek is often treated merely as a small-government polemicist. (Wapshott, trying to complicate this view, erroneously reports that Hayek believed in universal government-provided health care.) It’s a shame that a book centered on the years of Hayek’s greatest and most influential work as an economist only cements this incomplete reputation.

From Hayek’s perspective, booms and busts were caused by unnatural credit creation, setting in motion productive processes (say, home building) that end up not paying off in the end, given people’s real desire for future goods vs. present ones. Under normal circumstances, those desires would tend toward equilibrium via adjustments in interest rates. But interest rates are skewed by artificial credit creation. While the additional credit has short-term stimulative effects (booms), in the long run a structure of production that does not match actual saved capital will collapse, leading to damaging busts.

These are precisely the aspects of Hayek’s thought that make him relevant to the current crisis, and these are precisely the aspects that Wapshott avoids when discussing it. That lacuna makes his book a maddening missed opportunity for readers trying to understand how the hoary economic-journal arguments of the 1930s might shed light on today’s problems.

The years leading up to our current crisis saw exactly the sort of artificially low interest rates and monetary expansion that Hayek warned would cause unsustainable booms and busts, in this case manifest in the housing market. In reaction to the 2001 recession, Federal Reserve policy became highly expansionist.

That growth was artificial, and for various reasons having to do with federal housing policy and the practices of the financial industry it led to an economy unhealthily dependent on continually rising housing prices. As Hayek would have predicted, the bust was inevitable. And here we are.