Keynes and Hayek are both dead, and wrong

Despite the fact that both John Maynard Keynes and Friedrich August Hayek are dead, their ideas are very much alive today and form the basis of whether governments chose austerity or stimulus as a way out of our current economic crisis.

Both men were brilliant and arguably had people listened to their opinions before the Great Depression that started in 1929, the Depression and the Second World War would not have happened.  Modern politicians are listening to their opinions now in the hope of preventing our Great Recession from turning into a second Great Depression.  This is a mistake.

Before History Future Now explains why it is a mistake, it would be useful to provide a very quick primer on who these men were and an elevator pitch on their policies.

Friedrich August Hayek

Hayek was born in Vienna in 1899, while is was part of the Austro-Hungarian empire.  He died in Freiburg Germany aged 92, in 1992, having seen the First World War, the rise of communism in Russia, the boom of the 1920s, the Great Depression, the rise of Hitler and the Second World War, the Cold War and the end of the Soviet Union.

After a stint as an artillery spotter on the Italian front in WW1 he ended up in the late 1920s as the founder and director of the Austrian Institute for Business Cycle Research, where he wrote pretty dry papers on economics.  One thing that he did write of note was a prediction of the great Wall Street Crash in late 1929 by arguing that low interest rates fixed by the Federal Reserve Bank (then a relatively new institution) encouraged speculative borrowing on property and on the stock market.  He later joined the LSE in London, became a British citizen, and wrote his classic book “The Road to Serfdom”, which was published in 1944.

Contrary to the belief of many conservatives today, Hayek did think that government had a role to play in the monetary system, how labour laws were governed, freedom of information and that it should provide some form of social safety net – including mandatory universal health care and unemployment insurance.  But that was about it.

He particularly disliked government intervention in anything that would promote one industry over anything else and really disliked the use of interest rates to manipulate a currency. He believed that artificially low interest rates were likely to cause bubbles.  The best way to stop economic crashes was to stop the bubble from emerging in the first place.

Since governments like boom periods, as it makes them more likely to be reelected,  it was always going to be tempting for a government to keep interest rates low to encourage borrowing and thus growth.  It is for this reason that so many conservatives are attracted to his theories today: our boom since the 1990s has been based on generally low interest levels which have fuelled a huge bubble in property and stocks.  Has we listened to Hayek we might not have been in this mess.

John Maynard Keynes

Keynes was older than Hayek and was born in Cambridge in 1883, at the height of the British Empire.  He died young, 62 years later in 1946.  Wildly considered a genius and intimidating to talk with, he generally an optimist, perhaps linked to a happy childhood and thought that all problems could be solved if you worked hard enough at them, something that he picked up from Eton and Cambridge.

At the start of the First World War he joined the British Treasury.  It was his work at the Versailles Conference, however, which really set him apart as a visionary.  He tried, unsuccessfully, to persuade the French and British governments not to impose huge war reparations on Germany and Austria as a punishment for the war.  He argued that this would destabilise the country and would eventually result in a new war.  He wrote in The Economic Consequences of the Peace in 1919 that:

The policy of reducing Germany to servitude for a generation, of degrading the lives of millions of human beings, and of depriving a whole nation of happiness should be abhorrent and detestable,–abhorrent and detestable, even if it were possible, even if it enriched ourselves, even if it did not sow the decay of the whole civilised life of Europe.

And that:

If we aim deliberately at the impoverishment of Central Europe, vengeance, I dare predict, will not limp. Nothing can then delay for very long that final war between the forces of Reaction and the despairing convulsions of Revolution, before which the horrors of the late German war will fade into nothing.

Whilst it was his views about reparations that showed him to be a visionary during his lifetime, it was his views about the role of government intervention in an economy that make him so influential today, 66 years after his death.

He argued that to stop the unemployment crisis of the 1920s in Britain the UK should depreciate the pound stirling and go off the gold standard to make British exports more competitive.  He also argued that the government could stimulate the economy by borrowing now to pay for public works today.  He was not particularly bothered where the money was spent – it was the act of spending that would stimulate the economy and get people working again, through the concept of the multiplier effect.

In 1933, as the Great Depression was at its peak, he wrote a book called The Means to Prosperity which detailed his thoughts.  Sweden and Germany picked up on his ideas and Hitler’s use of public spending to get Germans back to work was ultimately very successful and embarrassing at the same time.

The US also underwent stimulus measures, but it was arguably the Second World War which proved that huge government spending could pull an economy out of a recession.  Big government was now popular and many in the UK took on Keynes’ idea of government spending to an extreme that he had not envisaged: spending not to get out of a recession but just spending all the time.

Keynes early death in 1946 meant that his ideas could not be refreshed by the man himself and by the late 1970s he was widely discredited.  Thatcher and Reagan were great lovers of Hayek.  They saw government as the problem, not the solution, and called for the rapid retreat of government from the economy.  Deregulation and privatisation were their calls to arms.

Since the 2008 crisis, however, governments have jumped back onto the Keynes bandwagon with great enthusiasm: the combination of currency devaluation (quantative easing or printing money) and huge public spending are policies that Keynes had advocated in order to get ourselves out of the Great Depression in the 1930s.

Summing up their positions

So, to sum up their two positions:

Hayek thought that government meddling, such as in the form of low interest rates, was the cause of bubbles and that bubbles ultimately resulted in crashes once people, companies and governments realised that they had become unsustainably large.  It is hard to argue with that.

Keynes thought that once you had a recession workers would not willingly reduce their cost of labour (they had fixed costs of their own – like housing and food)  and so the only way you could rapidly pull your country out of a recession was to borrow money to pay for public works that would stimulate demand.  The general feeling of well being that resulted from that would then encourage workers to spend money on other activities (the multiplier effect) which would then generate more demand, and more feelings of well being.  Once demand had been sufficiently primed, the government’s need to stimulate the economy would recede and increased tax revenues from the primed economy would then pay off the debt that had just been accumulated for the stimulus.  It is hard to argue with that either.

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So why are they both wrong?

The policies that both Hayek and Keynes proscribed do not work in our historical period and context.  As such, they are wrong and political leaders are wrong to rely on solutions that might have worked when they were thought up over 80 years ago.

Hayek’s problem is that his solution does nothing to get us out of our current predicament.  When the  US investment banking sector imploded in 2008 Hayek’s position would have been to do absolutely nothing.

It is galling to see investment bankers make so much money in good times, and the fact that their losses were taken over by the general public through bailouts makes the system doubly unjust.  Private sector profit and public sector losses.  That seems a prescription for gambling and Hayek would have criticised this and rightly so.

But doing nothing had the real possibility of creating a financial domino effect where even well run, conservatively managed companies would have been forced into bankruptcy as people who owed them money were unable to pay and as banks called in their loans.  The possibility of the entire economy being wrecked was real.

Hayek’s usefulness is in providing us guidance about how to reduce the likelihood of future booms, and thus eventual busts.  But even here he is in a weak position.  Voters like to see their politicians “do something” and solve problems. Politicians like “doing something” as well as it justifies their existence.  In the US, electoral campaign funding by the private sector requires politicians to “do something.”  The chances of a political system allowing little government intervention is thus low.

Keynes’ policies do try to provide a solution to the problem of the Great Recession.  He is offering more than Hayek in that regard.  But while Hayek’s policies might have stopped us from getting into the situation we are now in, Keynes’ solution does not work for the West today.  The main reasons for this is due to demographic, environmental and balance of power changes.

Keynes grew up in a world in which there were just over 1.5 billion people.  By 1930 there were 2 billion people.  Today there are over 7 billion people.  In 38 years there will be 10 billion people.  The good thing about an increase in population normally is that people stimulate the economy, and more people are able to pay of debts faster than fewer people.

But in the West, this demographic bonanza does not exist. Most European countries have birth rates that are well below replacement levels.  The financial crisis is likely to exasperate this as women hold off having children.  In addition, the population of the West is much older than when Keynes was alive.  He died aged 62.  This was not unusual for his time, but is very young today.  What this means is that societies in the West have increasingly large numbers of adults that are retired and of pensionable age.  They contribute little in terms of taxes but take out significant sums from the economy in the form of pensions and medical care.

Simultaneous to this, the number of young people in employment has dropped significantly.  Due to educational aspirations set in the 1980s and onwards, more young people are in higher education.  This means that they contribute little in terms of taxes but take out a significant amount in terms of education and maintenance support.  Theoretically, once they have graduated they should be able to get higher wages, resulting in higher tax receipts.  However, youth unemployment is over 25% across the European Union on average, with rates of over 50% in Greece and Spain and over 30% in 1o EU countries.  Unemployment rates for university graduates are also very high.

So unlike for Keynes, who could count on a growing young population and a small old population, the West today has a shrinking overall population, a growing older population and an economically crippled younger population.  This is a problem for Keynesian macro economic theory.  As the West borrows more money for one stimulus package after another the overall debt level and interest levels rise.  This debt burden then falls onto a population that is demographically unable to pay the debt down.

The second issue is environmental.  Born in 1883, Keynes lived in a world of expanding material wealth with resources that were being unlocked from the earth after being hidden away since creation: coal, oil, gas, minerals, forests and new agricultural land were being opened up.  New technologies expanded productivity of farming on land and new fishing vessels brought in catches from the deep blue oceans.  Had he lived a few more years he would have been able to see a world of passenger jets that could bring cargoes of fresh fruit and flowers from the southern hemisphere to the northern hemisphere.

Today the opposite is true in nearly every respect.  We are living in an environmentally constricting world.  Oil and gas have either peaked or are about to peak, before they enter their long downwards slide.  Farming productivity has shrunk, despite ever increasing amounts of oil and fertiliser inputs.  Grand irrigation programmes that unlocked the great plains of the Mid West in the US are facing extinction as the underground aquifer water runs out over the next 25 years.  Our forests have been cut and ploughed over.  Global fish stocks have dropped over 80%.  Global warming will exasperate and accelerate these environmental problems.

The reason why this is an issue is that it is much harder to grow when your resources are declining.  The adage that “a rising tide lifts all boats” is also true of the economy.  With a resource boom, it is easier to pay off your debts at a later stage.  But as the tide goes down, as our resources decline, the opposite is also true.

Finally, the balance of power of the world is radically different.  When Keynes and Hayek were growing up Western powers utterly dominated the world.  There were struggles, but all the struggles were between Western powers.  The West not only dominated in manufacturing – forcing the non western world to buy their goods – but also dominated in resources – its imperial colonies providing the raw materials for the West’s consumption.  This dominance created great wealth and jobs.

The end of the Cold War opened up the non aligned world to trade.  In the same way that the US had blossomed economically out of the rubble of post Second World War Europe, dominating in a way that it had been unable to before the War, the West blossomed after the end of the Cold War, rushing into markets in Eastern Europe, India and China.  But this opening up also awakened economic spirits that had lain dormant for hundreds of years.

Trillions of dollars of investment flowed into new emerging markets.  New roads, bridges, ports, power stations and factories were built.  New schools and universities churned out thousands of well educated and keen workers.  Western media showed these people of the lives that they could aspire to once they grew economically.

And so they did.  And in doing so they started to pull in the jobs that once had been done by Western workers by the millions.  First they peeled away low end manufacturing jobs.  The West was happy to lose them – they were dirty and undesirable.  Then they peeled away mid level jobs.  The West was still ambivalent, but getting concerned.  Then they peeled away high technology jobs, from aircraft manufacturing and high speed rail to solar photovoltaics and wind turbines.

Which causes an additional problem for Keynesian economics.  Countries borrow today in order to stimulate an economy so that domestic workers feel more confident.  They then spend more money, which makes other domestic workers feel more confident.  Eventually the economy is sufficiently confident that the stimulus can be removed and increased taxes can pay the debt that was incurred in stimulating the economy.

And this is the problem.  The stimulus money may provide more cash.  But will the cash be spent on Western products, or will it be used to buy cheaper products from abroad?  In a recession companies are likely to want to keep costs down, prompting them to buy cheaper products from abroad. That means that the stimulus cash is not making western workers feel more confident.  They then spend less, not more, either because they have no job – it has been outsourced – or they save, wondering if they will lose their job to outsourcing next.  Thus the stimulus package can get bigger and bigger, without any impact on the domestic economy – this is why we are getting a jobless recovery.

At some point, the borrowing has to stop.  The US Congressional Budget Office (CBO) expects that by 2025 US interest payments on debt combined with Medicare, Medicaid and Social Security will be so large that they will theoretically consume 100% of all federal tax income receipts. That is only 13 years from now.

So if Keynes and Hayek are wrong, what should we do?

Future History Now has started to offer solutions and has written about many of them.  Here are three:

To get our debt levels down, we need to go through a period of inflation. That makes the absolute amount of debt relatively easier to pay.  Inflation can be managed by printing money.  Unlike the Germans and Austrians after the First World War who did not really understand the consequences of uncontrolled printing of money and its likelihood of causing destabilising hyperinflation, we do.  We should be able to inflate just enough to speed up the reduction of debts to manageable levels without going into a hyperinflation nightmare.  The advantage of inflation over debt defaults is that the accounts add up and you dont need to take write downs which can have destabilising impacts on the economy. See here for more detail.  

Global free trade should be abandoned, replaced by regional free trade within regions of similar economies.  If you want to sell products into those regions you would need to create factories and jobs in those regions.  Trade between regions should be allowed, encouraged, but controlled.  This achieves two objectives.  First, any stimulus money that is paid for by the government, and thus taxpayers, gets spent in country (or  at least in region).  This means that the jobs that the stimulus funds generate get created in country, contributing to a sense of well being, making citizens spend more, in country, creating more jobs in country and thus increasing the tax base required to pay off any debt.  Second, it forces companies outside the region to relocate their factories and service jobs within your region if they want to be able to sell to you.  This creates jobs in region directly and also jobs indirectly as service jobs are created to support the activities of the factories. China actively pursues this policy already, to the benefit of its citizens.  We should follow their lead.  See here for more detail. 

We should stop exporting cash overseas unnecessarily.  The US has a trade deficit of over $400 billion per year with China, India, Taiwan, Japan and South Korea alone.  It spends an additional $137 billion per year on its Pacific fleet, which is mainly used for ensuring freedom of the seas between the same countries with whom it has a $400 billion trade deficit.  In the Middle East, the US spends $235 billion per year on average on its Persian Gulf fleet and has spent an additional $2.6 trillion between 2001 and 2010 on military involvement in Iraq and Afghanistan. It has done this to support the oil that it imports from the region, which only adds up to 19% of its imports but costs more than 2.5 times the remaining 81% of its imports.  If the US were to spend its budget on the Persian Gulf fleet on solar photovoltaics at home, it could provide free electricity equivalent to the entire electricity consumption of the United States every year.  This would support hundreds of thousands of jobs at in the US.  See here information on the US military budget and here for how the exact calculations were made.

Keynes and Hayek were brilliant men and gifted thinkers.  Their policies, had they been listened to, might have prevented the rise of Hitler (Keynes) and stopped boom and busts (Hayek).  But they are dead.  And the era in which they lived and that they thought about is over as well.  Had they been alive today they would have adapted their thoughts to fit with the new reality.

Our politicians must stop thinking of them as Gods, enlightened beings that they should listen to blindly.  Politicians should understand that the world has changed and that they need to adapt their policies accordingly.

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