Brandon Harnish

HS 368: The Making of Modern America

Dr. Webb

Spring 2010

Friedrich A. Hayek’s Trouble with John Maynard Keynes and His Macroeconomics

By the 1940s, Friedrich A. Hayek’s influence in technical economics was on the decline.

Many of his students had moved into the Keynesian circle since the heralded publication of The

General Theory of Employment, Interest, and Money (1936). One student, Ludwig Lachmann,

remembers that in the early 1930s, nearly everyone at the London School of Economics was a

Hayekian; ten years later, there were only two, Hayek and himself.1 In 1946, Hayek’s good

friend and former ally in the socialist calculation debate, Lionel Robbins, joined the “Keynesian

Revolution” as well. After the war, his own government in England began putting into place

much of the democratic-socialist program that he had criticized in The Road to Serfdom (1944),

and in 1950, he would leave for the Committee on Social Thought at the University of Chicago,

never to live in his cultural home again.2

The previous decade had been one of wearisome conflict and criticism from numerous

corners for Hayek, on top of his struggles with a new language. His work Prices and Production

(1931) received a spiteful review from Keynes, being described as a collection of “frightful

muddles,” an example of how, “starting with a mistake, a remorseless logician can end up in

Bedlam.”3 His follow up, The Pure Theory of Capital (1941), which sought to provide a solid

capital theory foundation to his business cycle theory, was hardly noticed by the economics

1
Alan Ebenstein, Hayek’s Journey: The Mind of Friedrich Hayek (New York: Palgrave, 2003), p. 90.
2
F. A. Hayek, Contra Keynes and Cambridge, Essays, Correspondence, vol. 9, The Collected Works of F. A. Hayek,
Bruce Caldwell, ed., (Chicago: The University of Chicago Press, 1995), pp. 45-46.
3
J. M. Keynes, “The Pure Theory of Money. A Reply to Dr. Hayek,” in Hayek, Contra Keynes and Cambridge, p.
154.
profession with much of the attention on the war, and even Hayek himself was unsatisfied with

the finished product. At this juncture, Hayek had become tired of economics proper and moved

on to other projects having never written a review of Keynes’ General Theory, a decision he

would regret.4 In 1965, Time announced, “We are all Keynesians now.”5 The debate was over.

Keynes had won.

In 1946, Hayek saw his friend Keynes for the last time. They were, it appears, often able

to set aside professional differences. He asked him whether he was concerned of what some of

his students were making of his theories. Hayek had read a pamphlet by Keynes which suggested

that he and his old rival were not as far off as first seemed, and that Keynes was, without

question, no inflationist. Further, Keynes had given an agreeable review of The Road to

Serfdom.6 Keynes told Hayek not to worry, that should any of his followers become dangerous,

he would turn public opinion against them. Hayek recalled that Keynes quickly moved his hand

to demonstrate how rapidly that would be done. Three months later, Keynes was dead.7

In the 1970s, stagflation dealt the Keynesian paradigm a devastating blow. According to

Keynesian theory, recessions are caused by underspending and inflation is caused by

overspending. The key for governments is to find that happy balance between inflation and

unemployment, to “fine-tune” the economy. If the economy is getting too hot, the central bank
4
Bruce Caldwell, Hayek’s Challenge: An Intellectual Biography of F. A. Hayek (Chicago: University of Chicago
Press, 2004), pp. 180-181; Bruce Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 40. Much
has been written on why Hayek decided not to review Keynes’ General Theory. The answer is multifaceted, ranging
from a previous review experience of Hayek’s where Keynes simply change his mind, to Hayek’s apparent belief
that there were more pressing matters at hand, to Hayek being tired of controversy, and more.
5
“The Economy: We are All Keynesians Now,” December 31, 1965.
http://www.time.com/time/magazine/article/0,9171,842353-1,00.html (accessed February 25, 2010)
6
Keynes had read the book on a trip to America. He wrote, “The voyage has given me the chance to read your book
properly. In my opinion it is a grand book. We all have the greatest reason to be grateful to you for saying so well
what needs so much to be said. You will not expect me to accept quite all the economic dicta in it. But morally and
philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but in a
deeply moved agreement.” Letter, Keynes to Hayek, June 28, 1944, reprinted in Activities 1940-1956: Shaping the
Post-War World: Employment and Commodities, ed. Donald Moggridge, vol. 27 (1980) of The Collected Writings
of J. M. Keynes (London: Macmillan, 1971-1989), p. 385, found in Hayek, Contra Keynes and Cambridge, p. 46.
7
F. A. Hayek, “Review of Harrod’s Life of J. M. Keynes,” in Hayek, Contra Keynes and Cambridge, p. 232; pp. 44-
45.
can raise interest rates. If it is slowing down, the bank can lower interest rates and the legislature

can sustain deficits. What, then, is the bank to do if both inflation and recession occur at once?

This run-in with the law of non-contradiction lead Austrian economist Murray Rothbard to write,

“Since 1973-74, Keynesianism has been intellectually finished, dead from the neck up.”8 Hayek,

writing in 1950, noted that such policy measures could very well result in an inflationary

recession and concluded that “[a] government which uses inflation as an instrument of policy but

wants to produce only the desired effects is soon driven to control ever increasing parts of the

economy;”9 thus came Nixon’s wage and price controls in August of 1971.

In 1974, Hayek was awarded the Nobel Memorial Prize in Economics for his work in

business cycle theory, referred to at the time by Rothbard as “a welcome and blockbuster

surprise to his free-market admirers in this country and throughout the world.”10 This was a

surprise on two counts: One, because Hayek was a leading free-market economist: Two, because

he was a dedicated opponent of those economists who postured themselves as scientific experts

of economic planning, the sort to whom Nobel Prizes were usually given.11 The award sparked a

renewed interest in his work and a broader revival in Austrian economics.12 In the spring of

1992, Hayek died at his home in Freiburg.

The debate between Friedrich A. Hayek and John Maynard Keynes stands as one of the

most important episodes in the development of economic theory, in the development of business

cycle theory, and in the development of economic policy. Bruce Caldwell, editor of The

Collected Works of F. A. Hayek, a massive project under construction since 1990, concluded that

8
Llewellyn H. Rockwell, ed., The Economics of Liberty (Auburn, Alabama: Ludwig von Mises Institute, 1990), p.
30.
9
F. A. Hayek, Studies in Philosophy, Politics, and Economics (New York: Simon and Schuster, 1967), p. 176.
10
Murray Rothbard, “Hayek and the Nobel Prize,” http://mises.org/daily/4082 (accessed February 4, 2010)
11
Ibid.
12
Joe Salerno, “The Second Austrian Revival,” March 18, 2010. http://mises.org/daily/4202 (accessed April 21,
2010).
“[Keynes] and [Hayek] differed profoundly in their responses to the interwar world that they

inhabited. Both observed a world gone mad. Keynes saw salvation in a thorough revision of the

liberal order. Hayek saw it in the rediscovery of one. Their debate over this question continues to

this day; it perhaps the most important issue that democratic regimes, old or new, must

address.”13 If only to confirm this contention, the monthly sales of The Road to Serfdom more

than quadrupled with the onset of the Panic of 2008.14 Indeed, Hayek and the Austrian tradition

of which he is part have never been more relevant than they are today. At the same time,

Keynesian economics has come back into view, and for similar reason. Those looking for a

theoretical underpinning for the Economic Stimulus Act of 2008 and the American Recovery and

Reinvestment Act of 2009 can find it in Keynes and his followers. To be sure, Keynesian

economics still rules the day in Washington D. C.

This paper looks to briefly unpack Hayek’s troubles with Keynes’s economic program. It

will do so by moving through three areas of disagreement. The third will feature a juxtaposition

of Hayek’s business cycle theory, illustrated by a “Hayekian triangle,” with Keynes’ circular

flow economy. Hayek’s problems with Keynesian economics run deep into methodology and

carry broad implications that affect government policy. A full picture requires an explanation of

all areas. Hayek’s first two problems may be considered methodological; his third, both

economic and political.

Hayek’s criticism of Keynes was, in principle, a sweeping condemnation of

macroeconomics, a phrase around which Hayek derisively placed quotation marks. To Hayek,

macroeconomics tended to obscure the understanding of economics as a science of human

13
Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 48.
14
Bruce Caldwell, “The Secret Behind the Hot Sales of ‘The Road to Serfdom’ by Free-Market Economist F. A.
Hayek,” February 17, 2010.
http://voices.washingtonpost.com/shortstack/2010/02/the_secret_behind_the_hot_sale.html (accessed February 25,
2010)
action, what he sometimes called, “catallactics,”15 meaning, the study of "the order brought about

by the mutual adjustment of many individual economies in a market."16 Hayek was unsatisfied

with even the term “economics,” which in Greek means “household management,” and therefore

gives the impression that economies are meant to be managed or consist of groups of actors with

shared plans and goals.17 The phrase “catallactics” provides a linguistic example of the

theoretical clash between Hayek’s understanding of economics and the Keynesian view, which

sees economies in large aggregates and in need of government management. Hayek, then, was

careful to emphasize methodological individualism and subjective marginal utility theory, which,

in the Austrian tradition, by focusing on the subjective nature of economic value, never lost sight

of the human actor in economic affairs and never believed that the central planning of large scale

economies could bring about prosperity or the sustained creation of wealth.18

Keynesian macroeconomics troubled Hayek on three major counts: First, there was the

problem of its using mathematics to explain economic phenomena.19 If one understands

economic value as subjective, as coming from the individual human mind and changing at

different points in time with no necessary correspondence to the physical order, then efforts to

make economics into a “hard” science like physics or engineering is sure to present a

methodological issue. Indeed, it did for Hayek, who directed several attacks against this

approach, which he called “scientism.” Rather than letting the subject matter guide the method,

15
F. A. Hayek, The Fatal Conceit: The Errors of Socialism (Chicago: The University of Chicago Press, 1988), p. 98.
16
F. A. Hayek, Law, Legislation, and Liberty, Vol. 2: The Mirage of Social Justice (Chicago: The University of
Chicago Press, 1978), pp. 108-109.
17
Ibid.
18
In their explanation of economic phenomena, the classical economists focused on the value of objects and
searched for an explanation of prices in the history of the object itself, either labor or cost of production. The
Austrian school moved the focus away from goods and towards actors, away from the things being valued and on
the actors doing the valuing. This is known as the principle of subjectivism, which Hayek considered one of the
great advancements in the history of economic science. See, F. A. Hayek, The Counter-Revolution of Science:
Studies on the Abuse of Reason (Chicago: The University of Chicago Press, 1979), p. 31.
19
Hayek, The Fatal Conceit, p. 99.
scientism brought over the method of natural science and applied it uncritically to human

action.20 It was, however, precisely this feature of the Keynesian model that carried sway among

economists, as Bruce Caldwell observed, “Keynes presented his ideas within what economists

call a ‘comparative static’ framework, one that conveys a sense of both determinateness and

rigorous simplicity.”…Keynes’ model was easily translatable mathematically; those who tried to

develop Hayek’s framework met with failure.”21 In the years immediately following the Second

World War - an event which appeared to vindicate the Keynesian antidote for depressions:

government demand management - neo-Keynesian economists John Hicks and Paul Samuelson

formalized Keynesian comparative statistics in economics, most notably with the C+I+G=Y

formula.22 Some tried to translate Hayek’s model into a mathematical expression but little came

of it, as Hicks reflected, “Several of us made attempts at that translation; the journals of the

1930s are full of them. But what emerged when we tried to put the Hayek theory into our own

words was not Hayek. It was some inner mystery to which we failed to penetrate.”23

Further, Hayek saw economic phenomena as consisting in large part of an entrepreneurial

discovery process. The economist, as he regularly restated, is never allowed access to an existing

20
See, Hayek, The Counter-Revolution of Science and F. A. Hayek, The Sensory Order (Chicago: The University of
Chicago Press, 1952. Hayek’s assessment of scientism and his work in psychology provide a thoroughgoing critique
of behaviorism. Bruce Caldwell lists three points of emphasis: First, behaviorists deny the existence of the two
factual orders, the objective and the subjective, and speak as though they are one and the same. To Hayek, however,
the subjective order is of great importance in understanding economic phenomena, which are always the result of
human action, not of physical properties within resources. Second, behaviorists, in denying that the phenomenal
order is separate and different than the physical order, violate their own principles by making reference to observed
events which themselves are a part of the phenomenal order. Third, behaviorists believe that in removing the
phenomenal order and focusing only on the physical order they are eliminating interpretation from science.
However, for Hayek, the process of classification within the phenomenal order is itself an act of interpretation.
Therefore, science, or any human endeavor, is never free from interpretation. Hayek believed that his work in
psychology was among his most important contributions to knowledge. As a young man Hayek pursued interests in
genetics, psychology, and psychiatry. After the publication of The Road to Serfdom, he spent his time reigniting that
old interest and writing The Sensory Order. See Caldwell, Hayek’s Challenge, pp. 270-272; G. R. Steele, The
Economics of Friedrich Hayek (New York: St. Martin’s Press, Inc., 1993), p. 3; Alan Ebenstein, Friedrich Hayek: A
Biography (New York: Palgrave, 2001), pp. 147-148.
21
Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 33.
22
Ibid. (C) consumption spending + (I) investment spending + (G) government spending = (Y) national income
23
Hayek, Contra Keynes and Cambridge, p. 33n
stock of data or knowledge collectable into a single planning body. It is never his task to

maximize efficiency in the economy in same way an engineer tries to maximize efficiency in an

engine or computer or light bulb. “The economic problem of society,” Hayek explained, “is thus

not merely a problem of how to allocate “given” resources – if ‘given’ is taken to mean given to

a single mind which deliberately solves the problem set by these ‘data.’ It is rather a problem of

how to secure the best use of resources known to any of the members of society for ends whose

relative importance only these individuals know. Or, to put it briefly, it is a problem of the

utilization of knowledge which is not given to anyone in its totality.”24 There were those, such as

Oscar Lange in the 1930s, who suggested that the entrepreneurial discovery process could be

replaced by a scientific planning board. This suggestion, of course, ignored the fact that prices

are themselves information which only the market is in a position to provide.

Second, there was the problem of Keynes’ aggregation. Opposition to statistical

aggregation that masks the movement of relative prices in particular lines of industry has always

been a methodological principle of the Austrian school. Their business cycle theory is in part the

story of how market prices coordinate supply and demand over time and move resources to areas

of more relative importance as determined by consumer time-preference and choice, thus

producing a pattern of sustainable growth without sudden shocks of mass unemployment, the

type seen during the 1930s. This process, Hayek observed “is wholly concealed by the analysis

Keynes chose to adopt and which has since come to be known as ‘macroeconomics’: an analysis

in terms of the relations between various aggregates or averages, such as aggregate demand or

supply, average prices etc.”25 Elsewhere he noted, “The General Theory…took the whole

24
F. A. Hayek, “The Use of Knowledge in Society,” American Economic Review, XXXV, No. 4 (September, 1945),
pp. 519-30, in F. A. Hayek, Individualism and Economic Order (Chicago: The University of Chicago Press, 1948),
p. 77-78.
25
F. A Hayek, “The Keynes Centenary: The Austrian Critique,” The Economist, June 11, 1983, pp. 45-48, in Hayek,
Contra Keynes and Cambridge, p. 251.
structure of relative prices for granted and provided no tools to explain the changes in relative

prices or their effects.”26 In the Keynesian model, profits and the earnings of capital are separated

in such a way as to create aggregates of “total profits” and “demand for factors of production,”

with no analysis whatever of the various lines of production and of the relative price fluctuations

that make for profit and loss. “Mr. Keynes’s aggregates,” thus wrote Hayek, “conceal the most

fundamental mechanisms of change.”27

The combination of an uncritical bias in favor of mathematical expressions and aggregate

statistical magnitudes, Hayek recalled, was the root problem of the Keynesian revolution: “To

me it seems as if this whole effort were due to a mistaken effort to make the statistically

observable magnitude the main object of theoretical explanation.” But, he warned, “The fact that

we can statistically ascertain certain magnitudes does not make them causally significant, and

there seems to me no justification whatever in the widely held conviction that there must be

discoverable regularities in the relation between those magnitudes on which we have statistical

information.”28

Notably, The General Theory was written during the Great Depression and during a

paradigm shift in economic thought from microeconomics to macroeconomics. The combination

of the fact that political leaders tend towards action in times of crisis and the emergence of an

economic program that gave intellectual backing to such action, and fit nicely with Keynes’

model, account for The General Theory’s success, but also for Hayek’s third trouble: It’s integral

call for government economic intervention.

26
F. A. Hayek, “The Economics of the 1930s as Seen from London,” in Hayek, Contra Keynes and Cambridge, p.
60.
27
F. A. Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica, vol. 11, no. 33, August
1931, pp. 270-295, in Hayek, Contra Keynes and Cambridge, p. 128.
28
F. A. Hayek, “The Economics of the 1930s as Seen from London,” p. 61.
 On the matter of the significance of the historical context of The General Theory, Alan

Ebenstein makes the interesting point that the title “General Theory” was intended to bring to

mind Einstein’s general theory of relativity, published in 1915. As Einstein had revolutionized

physics, so too was Keynes trying to change the face of economics, and in much the same way.

Einstein showed Newtonian physics to be relative and appropriate only as far as it goes. Keynes

was attempting the same with economics, namely, with Say’s Law, or the ability of markets to

adjust to changing conditions.29 The pivotal question in the debate between Hayek and Keyes is

this: Are markets in need of government macromanagement or are they self sustaining and able

to go on without cyclical depressions? If so, then what accounts for the cycle of boom and bust?

The Austrian theory of the trade cycle provides Hayek’s answer and likewise a major source of

his disagreement Keynes.

The Austrian theory of the trade cycle, set forth by Ludwig von Mises in Theory of

Money and Credit (1912) and further developed by Hayek in Monetary Theory and the Trade

Cycle (1933) and Prices and Production, attempts to explain the process by which markets

absent government management coordinate production and allocate resources intertemporally.

Moreover, and vital for the formulation of policy, it attempts to explain how monetary expansion

by governments, the sort which Keynes considered necessary to prevent recession, end in

distortions of the structure of production, unemployment, inflation, and a disequilibrium of

supply and demand. The 1920s observed a tremendous rise in capital goods prices, as reflected in

the booming stock market, and this is precisely what Austrian theory would expect to see prior to

a depression such as that which occurred during the 1930s and 1940s.30 Also, in areas of
29
Ebenstein, Hayek’s Journey, p. 86.
30
The length of its duration is a somewhat separate issue, focusing in part on how long the inflationary boom was
sustained in the first place – a longer boom means a sharper depression – but moreso on how the government
responds to the crisis: does it intervene as it did in the 1930s or does it let the depression run its course, which as
Austrian theory shows is the market’s corrective liquidation of the malinvestments brought about by inflation? The
Mises-Hayek theory of the trade cycle does not comment on this particular point other than to say continued
consumer goods, the price level remained stable, which, in the face of increased productivity,

would have fallen in a non-inflationary environment, thus improving general living standards.31

But what of the anatomy of Hayek’s theory? What were his troubles with Keynesian political-

economy?

In the early 1930s, Hayek was chosen to review a new work by Keynes, A Treatise on

Money (1930). He was in a particularly good position for such a project. He had already

published and had in the works books on monetary economics. Further, he and Keynes’ theories

were both developed from Knut Wicksell, a 19th century Swedish economist whose first book

sought to integrate Austrian school economist Eugen von Böhm-Bawerk’s theory of capital with

marginal productivity theory. Wicksell’s book Interest and Prices made a distinction between

the “market” rate of interest and the “natural” rate of interest, which proves vital in Hayek’s

effort square business cycle theory with equilibrium theory.

Equilibrium theory states that in a market system, changes in supply and demand bring

about adjustments in relative prices which coordinate the actions of buyers and sellers. In other

words, prices operate as a coordination mechanism. In the loanable funds market, changes in

supply and demand are reflected in interest rates. The natural rate of interest is a reflection of

consumer time-preference, the decision to consume now or later. If time-preference is low and

consumers prefer later consumption to present consumption, the interest rate will fall as

reflection of the greater savings. Investors respond to this price signal by taking out loans and

beginning new projects which suddenly become profitable. These loans tend to be spent on more

“roundabout” methods of production, or “goods of a higher order,” that is, those methods of

production which are farthest removed in time from the consumer. Hayek illustrated the capital

inflation to prevent depressions will only result in hyperinflation and a fate far worse than any downturn.
31
Murray Rothbard, America’s Great Depression, fifth edition (Auburn, Alabama: Ludwig von Mises Institute,
2000), p. 171.
structure with a triangle.32 In the situation described, the capital structure was lengthened as

producers responded to the low interest rates and begun investment in higher order goods, which

are the most interest rate sensitive. “Investment,” then, is not simply an aggregate process of

adding more machines, but a change in the structure of production to and from different methods

depending on relative price changes. The price mechanism, as Hayek described it, is a “kind of

machinery for registering change.”33 It is a “system of telecommunications” which enables

entrepreneurs to adjust their activities to changes which they know nothing of, thus bringing

about economic harmony without economic planning in the form of centralized decision making.

On the contrary, as Hayek’s theory makes clear, it is government meddling which creates

economic discoordination and cyclical booms and busts.34

This brings us to Wicksell and the “market” rate of interest. The important point to

understand is that the market rate can differ from the natural rate. Within the context of a

discussion on trade cycle theory, a market rate lower than the natural rate carries explanatory

power. When market rates are lowered by credit expansion, they cease to reflect the natural rate

and in turn the valuations of consumers. Hayek and other Austrians point to this as the cause of

the cycle. Lowering the market rate below the level of the natural rate via credit expansion sends

a signal to investors to begin lengthening the structure of production. Firms use the credit to

make their necessary purchases and the prices of capital goods are bid up. However, this line of

economic activity fails to reflect consumer time-preference and the economy is pulled in two

directions – towards both consumption and investment. The growth cannot be sustained and, in

time, scarcity reasserts itself. Firms discover their projects to be unprofitable and a period of

readjustment follows – the bust. As the structure of production adjusts to match the buying habits
32
F. A. Hayek, Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold
Standard (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 228.
33
Hayek, “The Use of Knowledge in Society,” p. 87.
34
Ibid.
of consumers and the real pool of available savings, the malinvestments are liquidated and

unemployed resources, including labor, become visible. “In this connection, as in so many

others,” Hayek concluded, “we are forced to recognize the fundamental truth, so frequently

neglected nowadays, that the machinery of capitalistic production will function smoothly only so

long as we are satisfied to consume no more than that part of our total wealth which under the

existing organization of production is destined for current consumption.”35

Keynes also put Wicksell’s distinction between market and natural rates of interest to use

but, significantly, ignored the capital theory foundation.36 Hayek pointed out this problem in the

review: “Mr. Keynes ignores completely the general theoretical basis of Wicksell’s theory.”37

The failure to incorporate this foundation prevented Keynes from seeing the changes within the

capital structure. Indeed, Hayek believed that this was the fatal error of the entire Keynesian

system.38 He laid out the whole mistake: Businessmen must make decisions on what proportion

of their funds will be used for current production and future production. Their choice is

influenced by technical knowledge and the relative demand for future or present consumption.

The ability to see this process requires the capital theory which Keynes ignores. It is,

consequently, at this point that Keynes obscures the “mechanisms of change” and aggregates the

production of consumption goods from the production of investment goods, thus C + I. Hayek

disagreed sharply and concluded: “The alternative is not between producing consumption goods

or producing investment goods, but between producing investment goods which will yield

consumption goods at a more or less distant date in the future.”39

35
Hayek, Prices and Production, pp. 272-273.
36
Caldwell, Hayek’s Challenge, p. 177; Caldwell, “Introduction,” in Hayek, Contra Keynes and Cambridge, p. 14.
37
Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” p. 130.
38
Hayek, “The Keynes Centenary,” p. 251.
39
Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” p. 137.
 What does Keynes’ theory mean for the theory of the trade cycle? It means that the

policies which Hayek’s theory points to as causal are pointed to by Keynesianism as preventative

and as positive means for growth. Where Hayek saw a tradeoff between consumption and

investment, and thus emphasized the intertemporal coordination function of market prices,

Keynes swept the tradeoff aside, and saw consumption and investment as moving side by side in

a circular pattern. More investment means more income and more income means more

consumption which means more profits and therefore more investment. If the “animal spirits” of

entrepreneurs wane, then government policy must pick up the slack through fiscal and monetary

measures which have a “multiplier effect,” i.e., one person’s spending is another person’s

spending and so on and so forth. Savings, in this analysis, are inimical to economic growth

because they restrain spending – the very opposite of Hayek’s view, which describes savings as

the only means to sustainable growth. Prices too fail to perform the responsibility Hayek

ascribed to them, which is Keynes’ more fundamental swipe at Say’s Law and the position that

there can never be a “general glut” where supply exceeds demand if prices are permitted to

fluctuate freely. It would stand to reason that if Keynes disagreed with Hayek on capital theory,

the relationship between investment and consumption, the role of savings, and the function of

prices, then he would disagree with him on the manner of handling the boom and bust cycle.

Indeed, he did; as he wrote, “Thus the remedy for the boom is not a higher rate of interest but a

lower rate of interest! For that may enable the so-called boom to last. The right remedy for the

trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-

slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”40 This, of

course, is the worst possible suggestion in Hayek’s view, because not only does it aggravate the

40
J. M. Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace and
Company, 1936), p. 322.
problem, increasing the totality of malinvestments and delaying the painful but necessary

adjustment process, it is the problem, encumbering the coordination function of interest rates

thus creating the malinvestments in the first place. During the Great Depression, Hayek chastised

the cry for perpetually low interest rates:

What we need is a readjustment of those elements in the structure of production and of

prices.…But, instead of furthering the inevitable liquidation of the maladjustments

brought about by the boom during the last three years, all conceivable means have been

used to prevent that readjustment from taking place; and one of these means, which has

been repeatedly tried though without success, from the earliest to the most recent stages

of depression, has been this deliberate policy of credit expansion.…To combat the

depression by a forced credit expansion is to attempt to cure the evil by the very means

which brought it about; because we are suffering from a misdirection of production, we

want to create further misdirection—a procedure that can only lead to a much more

severe crisis as soon as the credit expansion comes to an end.41

The political-economic implications of Keynesianism were anathema to Hayek, and each

gave support to the other. Keynesian economic doctrine dresses the government for a continuous

stabilization role which the Hayekian system sees as (1) unnecessary, because market prices

coordinate economic activity and plot the course for a sustainable pattern of growth; (2) unwise,

because inflation creates economic discoordination as seen in the trade cycle and is to blame for

the dispiriting and painful adjustment process; and (3) dangerous, because Keynesian economic

policy tends towards more government control and is, as Keynes himself admitted in the preface

to the German edition of The General Theory, more easily applied in a totalitarian system:

“[T]he theory of output as a whole, which is what the following book purports to provide, is
41
Hayek, Prices and Production, pp. 6-7.
much more easily adapted to the conditions of a totalitarian state, than is the theory of production

and distribution of a given output produced under the conditions of free competition and a large

measure of laissez-faire.”42

Hayek was intellectually generous to his old friend, perhaps overly so. In 1983, he looked

back on the inflationary recession of the 1970s and more or less exempted Keynes from blame.

Most of the responsibility fell on those, he thought, who carried on under the Keynesian banner

but supported policies which Keynes himself would not have approved.43 Earlier, in 1974, he was

somewhat more candid, writing, “The responsibility of the current world-wide inflation, I am

sorry to say, rests wholly and squarely with the economists, or at least with that great majority of

my fellow economists who have embraced the teachings of Lord Keynes.”44 In the final analysis,

Hayek’s contest with Keynesian macroeconomics leaves this fundamental insight: There is no

benefit to inflation. Its purported ability to bring about full employment at the small cost of a

slight redistribution of income disregards its most systemic and sardonic harm – the distortion of

the capital structure and the eventual mass unemployment of labor evermore extensive than that

which it was initiated to prevent. Government fiscal policy as a means to economic recovery

from recession suffers under the same delusion – that a “general glut” comes about due to

42
Hayek, “The Keynes Centenary,” p. 254n. Notably, Hayek was a critic of government planning in part for the
economic reasons here described, but also for matters pertaining to historically rival traditions of government. On
the one hand, there was the French tradition with its rationalism and inflated view of the powers of human reason.
This “abuse of reason” would carry important consequences with regards to the conceit of 20th century economic
planning. On the other hand, there was the British tradition, rooted in an understanding of traditional contrivances
which were the result of human action but not of human design. Hayek stretched this distinction all the way back to
Athens and set it against Sparta. He drew up two broad categories (constructivist rationalism and critical
rationalism) and named names. On the side of his own view of freedom were, in part, Aristotle, Thomas Aquinas,
Adam Smith, Alexis de Tocqueville, Lord Acton and William Gladstone. On the opposite side, the side of
totalitarianism, were, in part, Plato, Descartes, Thomas Hobbes, G. W. F. Hegel, Auguste Comte, Karl Marx, and B.
F. Skinner. See F. A. Hayek, The Constitution of Liberty (Chicago: The University of Chicago Press, 1960), pp. 54-
58; F. A. Hayek, “The Errors of Constructivism,” in New Studies in Philosophy, Politics, Economics and the History
of Ideas (Chicago: The University of Chicago Press, 1978), pp. 3-22; Arthur Diamond Jr., “F. A. Hayek on
Constructivism and Ethics,” http://mises.org/journals/jls/4_4/4_4_2.pdf (accessed April 26, 2010)
43
Hayek, “The Keynes Centenary,” p. 247.
44
F. A. Hayek, “The Campaign Against Keynesian Inflation,” in New Studies, p. 192.
underspending and some manner of state action is needed to “prime the pump” and employ idle

resources.

Gerald O’Driscoll Jr.’s recent comments on the importance of truth telling in markets

provide an interesting framework for some concluding remarks on Hayek and Keynes.45 It may

be polemical to say so, but in a very real sense Hayek put forward an economy of truth telling

where Keynes put forth an economy of lies. O’Driscoll, in this regard, specifically notes the need

for interest rates to be reliable guides in the allocation of capital across time. If the price system

is a mechanism for the communication of knowledge, as Hayek believed, then a necessary

condition for its success must be the communication of correct knowledge. After all, if the

capital structure has been adjusted based on faulty information, then we should expect nothing

less than a faulty system of production. Indeed, that is precisely what Hayek warned we would

get.

Is economics set for a counter-revolution in the tradition of Hayek? In some ways, it has

already occurred. The scientism and positivism of the early and middle 20th century no longer

hold much clout and the collapse of the Soviet Union in 1989 provided the final proof in the

Socialist Calculation debate.46 In other ways, Hayek remains hidden. The present financial crisis,

brought about, in part, by credit expansion, and the American government’s response under both

George W. Bush and Barack Obama leave room for doubt that the Keynesian paradigm will ever

be shaken.

In 1927, a young Friedrich Hayek received a postcard in reply from the famous

economist, John Maynard Keynes. Keynes had struck gold with The Economic Consequences of

45
Gerald P. O’Driscoll Jr., “An Economy of Liars,” April 20, 2010,
http://online.wsj.com/article/SB10001424052748704508904575192430373566758.html?
KEYWORDS=an+economy+of+liars (accessed, April 25, 2010)
46
F. A. Hayek, “Socialist Calculation I: The Nature and History of the Problem,” in Individualism and Economic
Order (Chicago: The University of Chicago Press, 1935), pp. 119-147.
the Peace just eight years prior. It read, “I am sorry to say that my stock of Mathematical

Psychics is exhausted.” This was the moment that began their relationship and, in turn, a battle

that remains unfinished to this day.

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