When Economics Was Young.
Henderson, David R.
NICHOLAS WAPSHOTT. Keynes Hayek: The Clash that Defined Modern
Economics. W.W. Norton & Company. 355 PAGES. $28.95.
VIRTUALLY EVERY economist in the world has heard of John Maynard
Keynes. Many have heard of Friedrich Hayek. But few economists (and far
fewer non-economists) know that the major controversy in macroeconomics
in the 1930s was between Keynes and Hayek. Most economists under age 60
know little about the history of economic thought because, for the last
three decades, Ph.D. economics programs have put little or no emphasis
on it.
Thus, Keynes Hayek helps fill a big gap. Before reading Nicholas
Wapshott's book, I had known about the debate between Hayek and
Keynes but hadn't known many of the fascinating details, especially
about the personalities involved. Now I do. Wapshott, a journalist who
was senior editor at the Times of London, weaves an exciting tale in
which not only the economic arguments, but also the players'
personalities, come alive. We see how the various young economists at
the time--Joan Robinson and John Kenneth Galbraith, for instance--and
middle-aged economists such as Arthur Pigou and Lionel Robbins--lined
up. We also see a fair amount of cruelty towards Hayek among
Keynes's young acolytes. To be fair to Keynes himself, though, the
book highlights his generosity of spirit toward Hayek--a spirit Hayek
appreciated and reciprocated. The book's subtitle is misleading
(more on that later), but Wapshott rightly sees the Keynes/Hayek debate
as an important subject.
Wapshott points out that before Keynes's work in the 1930s,
culminating in his classic The General Theory of Employment, Interest,
and Money in 1936, there was no such field as macroeconomics. That is
not to say that economists didn't think about things like
unemployment, inflation, and economic growth. They did. But they thought
about those issues with the standard tools of economics that
Keynes's mentor, Alfred Marshall, and most other economists used.
Keynes changed all that by introducing the concept of
"aggregate demand," the demand for goods and services in
general. Aggregate demand is made up of the demand for consumption
goods, the demand for investment, government's demand for goods and
services, and exports minus imports. Keynes argued that there was
nothing in market processes to ensure. that aggregate demand would be
high enough to lead to full employment. He was particularly concerned
about investment demand because, he argued, the "animal
spirits" of businessmen were not stable. If businesses became
pessimistic, he thought, then investment demand would decline, causing
aggregate demand to decline and unemployment to increase. That's
where Keynes saw a role for government policy to increase aggregate
demand: either to cut taxes so that people, feeling wealthier, would
consume more, or to, without increasing taxes, increase government
spending on goods and services.
The neoclassical economists, whom Keynes in the General Theory
incorrectly, but cleverly, labeled as classical economists, had always
admitted that economies could go through recessions or even depressions.
They argued, though, that relatively free economies would work their way
out of depressions as long as prices and wages were flexible. If the
demand for goods and services declined, according to the neoclassical,
wages and prices would fall, thus increasing the amount of goods and
services and the amount of labor demanded.
But, Wapshott writes, Keynes thought that wages were
"sticky." That's my interpretation of Keynes also,
although there's a whole cottage industry directed to figuring out
what Keynes really believed about wages. With wages not falling, high
unemployment could last a long time.
The fact that British unemployment in the late 1920s and early
1930s stayed stubbornly high gave a boost to Keynes's way of
thinking. Maybe wages weren't so flexible as many neoclassical
economists had believed. But Wapshott notes that one factor making wages
"sticky" was high unemployment benefits, which made workers
more resistant to wage cuts. He even quotes Keynes making that
concession in a radio broadcast circa 1930. Wapshott could have
bolstered his case with evidence that U.S. economists Daniel Benjamin
and Levis Kochin presented in a path-breaking 1979 article about the
connection between British unemployment benefits and Britain's
unemployment rate. In their article, published in the prestigious
Journal of Political Economy, Benjamin and Kochin wrote:
By 1931 weekly benefits exceeded 50 percent of
average weekly wages, and an adult worker who
had made 3 o weekly contributions at any time
in his working career could draw full benefits
for an unlimited period.
It shouldn't have been surprising, then, that unemployment
stayed high.
WHERE DOES Friedrich Hayek fit in? Hayek grew up in Austria and
studied under the famous Austrian economist Friedrich von Wieser. In
1921, Hayek took a government job under Austrian economist Ludwig von
Mises. In that job, Hayek experienced the Austrian hyperinflation that
occurred at the same time as the horrible German hyperinflation.
Wapshott notes that in just eight months on the job, Hayek received 200
pay raises. This experience made Hayek fearful of inflation until his
dying day. Wapshott writes, "The Austro-Hungarian Bank printed
notes night and day to keep up with demand." That view of causation
is a major misconception, although officials in the German and,
presumably, Austro-Hungarian central banks at the time did hold it. The
demand for money did not drive the printing of notes. Rather the
printing of notes fed inflation, which, it is true, led people to want
more notes. Without the original printing of money, the inflation would
not have occurred and there would have been no issue of "keeping
up."
In 1928, Hayek was invited to a joint meeting of economists at
Cambridge University and the London School of Economics. There, he
quickly got into an argument with Keynes and, in doing so, impressed
Lionel Robbins, one of the leading economists at LSE. Robbins,
uncomfortable with the interventionist direction in which he could see
Keynes heading, had been looking around for someone to refute Keynes.
Robbins saw a lot of promise in Hayek. So in 1931, he invited Hayek to
give four lectures on the business cycle at LSE. Hayek did so, but not
before first giving a lecture at Keynes's Cambridge, a talk that
Keynes and his young entourage did not receive warmly. Hayek was a hit,
though, with LSE's economics faculty, which responded by voting
unanimously to offer him the Tooke Chair in Economic Science and
Statistics. Hayek accepted.
As soon as Hayek joined the LSE faculty, Robbins, also editor of
the prestigious journal Economica, asked Hayek to review Keynes's
latest book, A Treatise on Money. In it, Keynes advanced some of the
themes he would later develop in the 1936 General Theory. Hayek wrote
his lengthy review in two parts. Wapshott quotes at length from the
first part. Hayek stated that Keynes's book was "so highly
technical and complicated that it must forever remain entirely
unintelligible to those who are not experts." "One can never
be sure," wrote Hayek, "whether one has understood Mr. Keynes
right."
Keynes was furious and, well before Hayek published part two,
responded in Economica. Keynes wrote, "Any denial of his
[Hayek's] own doctrine has seemed to him so unthinkable that even
thousands of words of mine directed to its refutation have been water
off a duck's back." A back and forth debate by mail ensued. In
those days, mail moved faster than now. Hayek even wrote Keynes on
Christmas morning in 1931 and that afternoon (the Royal Mail, explains
Wapshott, delivered twice daily, even on Christmas) Keynes replied.
In February 1932, Economica ran the second installment of
Hayek's review. Hayek kept up the insults and Wapshott quotes them,
but Wapshott also quotes Hayek's substantive argument. Hayek argued
that government-funded public works would cause "inflation, forced
saving, misdirection of production and, finally, a crisis." Rather
than replying, though, Keynes encouraged the young Italian economist
Piero Sraffa to attack Hayek. Sraffa did, Keynes had Sraffa respond in
kind by reviewing Hayek's Prices and Production in the Economic
Journal of March 1932. Sraffa found the book unintelligible.
Interestingly, even some economists who leaned in Hayek's direction
did not find the book understandable. John Hicks, for example, an LSE
lecturer sympathetic to the Austrian School (later to become a Keynesian
and much later to win the Nobel prize), stated, "Prices and
Production was in English, but it was not English economics. It needed
further translation before it could be properly assessed." And
Frank Knight of the University of Chicago stated his wish that Hayek
"or someone would try to tell me in a plain grammatical sentence
what the controversy between Sraffa and Hayek is all about." Even
today, economists still debate the issues that Sraffa and Hayek debated
almost 80 years ago.
Meanwhile, Keynes turned his attention to completing the General
Theory. Interestingly, even though Hayek, Keynes, and Sraffa had all
leveled the charge of unintelligibility--Hayek on Keynes and Keynes and
Sraffa on Hayek--with the publication of the General Theory, obscurity
became a virtue. Wapshott quotes Paul Samuelson, who, in his famous
textbook. Economics, popularized Keynesian economics for millions of
American economics students. Here's what Samuelson wrote on the
General Theory:
It is a badly written book, poorly organized ... It abounds
with mares' nests and confusions ... An awkward definition
suddenly gives way to an unforgettable cadenza. When finally
mastered, its analysis is found to be obvious and at the
same time news. In short, it is a work of genius.
Much later, Keynesian economist John Kenneth Galbraith wrote,
"Unlike nearly all of Keynes's other writing, this volume is
deeply obscure."
Wapshott writes that Keynes "went out of his wav to invite
Hayek's criticism," even sending Hayek advance copies so that
Hayek could publish his critique by the time the book was released. Why?
Writes Wapshott: "Keynes was a master publicist and knew the value
of courting controversy."
And how did Hayek respond? He didn't. As Wapshott puts it,
"Hayek declined to enter the ring." Much later, Havek would
sav that this was a "failure for which I have reproached myself
ever since." Part of Hayek's reason, though, was that he was
trying to finish a competing book, The Pure Theory of Capital, and had
become "hopelessly stuck in chapter 6." Hayek was still trying
to work out, as young Austrian economists still do today, the effects of
monetary policy, via interest rates, on the structure of production.
Possibly because Hayek didn't directly respond to the General
Theory, some of the younger Hayek acolytes, such as John Hicks, Abba
Lerner, and Nicholas Kaldor, went over to the Keynesian side. Wapshott
quotes Galbraith's observation about the various young Keynesian
economists, especially Kaldor, attending lse seminars to poke cruel fun
at Hayek.
Fortunately, Hayek didn't quit. He wrote The Road to Serfdom,
a volume that made him famous in the United States and one that Keynes
called "a grand book." Hayek seemed to have regrets about the
work, though, because of some of the nastiness that American
intellectuals heaped on him in response to it. In the 1980s, Hayek
wrote, "I discredited myself by publishing" the book. (I think
he used the word "discredited" differently from the way I
would. The Road to Serfdom, though somewhat overstated, is a fine work.
In context, Hayek seems to have meant that the book cost him some of his
reputation.)
Hayek then turned to some of his path-breaking works on economics
and knowledge. One of these was his 1945 article, "The Use of
Knowledge in Society," published in one of the most prestigious
American economics journals at the time, the American Economic Review.
This is probably one of the ten most important economics articles of the
20th century. With this and some earlier articles on the economics of
knowledge, Hayek drove the final intellectual nail through the coffin of
socialism.
Nevertheless, from the late 1930s on, Hayek felt as if he was in
the wilderness. He became increasingly depressed, but his depression
ended after he won the Nobel Prize in 1974. I saw him the next year at a
weeklong conference and offered to carry his bag up some stairs so that
I could get a chance to talk to him. There was a definite bounce in his
step and a twinkle in his eye.
BUT is wapshott's subtitle justified? Certainly, the clash
between Hayek and Keynes was important. One might even argue that it
should have defined modern economics. But did it? No. Keynesianism did
lose ground from the mid-1960s on, but that was due mainly to Milton
Friedman, not Friedrich Hayek. From the late 1950s to the late 1960s,
Friedman delivered three body blows to the Keynesian corpus. The first
was his 1957 book, A Theory of the Consumption Function, in which
Friedman showed that consumption is not a function of current income, as
Keynes had posited, but, rather, a function of what Friedman called
"permanent income." This meant that a government that tried to
increase consumption with spending or with a temporary tax cut would not
succeed because people would rightly regard both as temporary. The Bush
II tax rebates of 2008 are a textbook illustration of the impotence of
temporary tax cuts: They caused not even a blip in consumption spending.
Friedman's second big hit on the Keynesian model was his
now-classic book, co-authored with Anna J. Schwartz, A Monetary History
of the United States, 1867-1960. In it, they showed that every major
recession in the United States was preceded by a fall in the money
supply or in the growth rate of the money supply. And the biggest drop
in the money supply in the almost 100 years they studied occurred in the
first four years of the Great Depression. That finding undercut one of
the main tenets of Keynesian economics: the idea that monetary policy
has little effect and that fiscal policy (the use of taxation and
government spending to shift aggregate demand and thereby affect the
unemployment rate) is more potent.
Third and finally, in his 1967 presidential address to the American
Economic Association, Friedman laid out how one could have a stagnating
economy and inflation at the same time. This, he pointed out, was
inconsistent with the dominant Keynesianism of the time. Lo and behold,
in the early 1970s, the United States got "stagflation": a
recession combined with high inflation. Incidentally, Jimmy Carter,
running for president in 1976, crystallized the concept with his
"misery index"--the sum of the unemployment rate and the
inflation rate--which he used effectively against his opponent,
President Gerald Ford. Friedman himself said that the stagflation of the
early 1970s was more important than any of his theoretical arguments in
getting across the problems with the Keynesian model.
Wapshott mentions some of this, although he gets one key fact
wrong. Friedman, he writes (Wapshott gives no credit to his co-author
Schwartz except in a footnote), "studied every peak and trough in
America from the mid-nineteenth century on and discovered that each
downturn was preceded by an explosion in the supply of money." In
fact, Friedman and Schwartz found not an explosion in the money supply
but the opposite: a reduction in the money supply or in its rate of
growth. More important, Wapshott doesn't inform the reader that
Friedman's accomplishments had little to do with Hayek.
To say, as I do, that the debate between Keynes and Hayek did not
define modern economics is not to say that it couldn't do so in the
future. Many economists still have not fully contended with Hayek's
point that the information that matters most is held in decentralized
form in the minds of each of us. But we aren't there yet.
I shouldn't leave this review without noting one major mistake
Wapshott makes in discussing the recent financial crisis. Wapshott
writes, "The mayhem suggested that the decades-long experiment in
allowing barely restrained markets to generate growth and prosperity had
failed." In fact, markets, in Britain and in the United States,
have been heavily restrained for almost a century. It's true that
free-market economists until recently were winning the intellectual
battle. But they haven't come close to winning the policy battle.
Indeed, many of us think that if we had, the financial crisis would have
been much less severe.
David R. Henderson is a research fellow with the Hoover Institution
and an associate professor of economics at the Graduate School of
Business and Public Policy at the Naval Postgraduate School. He blogs at
www.econlog.econlib.org.