Notes on Hayek vs.
Keynes: The Business Cycle Revisited
As the great debate continues - let's look at the intellectual debate between Hayek and Keynes and provide an alternative to the Keynesian business cycle theory.
The
Economic Calculation Debate between F. A. Hayek and J. M. Keynes:
Can the economy be planned and manipulated with any degree of success?
This was NOT an ideological debate -- it was a technical debate. The question was "can" not "should" the economy be planned and still meet the basic necessities of life? Or more specifically, can economic (government) planners "calculate" where resources should be allocated without market prices and profits and loss.
F. A. Hayek built upon his teacher - Ludwig von Mises, who wrote about the impossibility of economic calculation (determining where resources should go) in his 1920 article "Economic Calculation in the Socialist Commonwealth." Hayek then later added to this work in his "debate" with J. M. Keynes.
F. A. Hayek: His answer was NO - it is impossible to allocate resources through government planning such that the economic order can meet the basic necessities of life (and go beyond that) – Why not?
Two kinds of knowledge in society:
In order to produce what is necessary for people to live - we need knowledge regarding where and how scarce resources should be utilized (we do not need scientific knowledge)!!
If there are property rights in capital goods - then there are markets in capital goods (people can trade them) - then market prices for these goods emerge - and from those prices, business owners can find out if they have made profits or losses. They can then utilize that knowledge to determine where and how to utilize resources. This is economic calculation - determining profits and losses to determine resource allocation.
So without property rights in the means of production (capital) and the knowledge (individual knowledge of what people want, value, etc. as well as knowledge of how to do specific things, etc.) resources will be wasted and people will starve!! Life is pretty dismal under socialism!
But what about capitalism with some planning -- there is still the problem:
Government planners are unable to even meet the basic necessities of life -- this knowledge problem (coordination problem), along with a lack of incentives to be productive -- lead Hayek to predict that the planned economies around the world would eventually fail. He was right - they have.
Hayek believed in a general theory of Say's Law. Productivity drives an economy - one must first produce something in order to have the means to consume. Government spending will create misallocations (booms and busts - more on this later).
How do members of congress or the board of governors of the FED know where to use taxpayer money so that it will be "efficient" and "productive"? -- they don't !!
J. M. Keynes: His answer was YES – not only can government planners be successful at directing resources, they are necessary for maintaining stability within markets. Why?
Planners have the knowledge necessary to plan (via "experts" and economic data):
Keynes convinced many policy makers and economists that planning was both possible and necessary (but not all).
Demand drives an economy. Government spending (in one form or another) is often necessary to manipulate markets out of a slump.
So politically Keynesian ideas became very popular. They give politicians short term means of gaining votes, etc. The New Deal under President F. D. Roosevelt was Keynesian economics.
But after Keynes was long gone (1946) -- the Soviet Union and other planned economies collapsed. Hayek is awarded the Nobel prize in economics in 1974 (although I don't know how respectful a Nobel prize is anymore) and died in 1992 after the fall of the Berlin wall, etc. in the late 1980s -- and many economists decided that "in the long run" Hayek has won the debate intellectually. Others still disagree and think that Keynesian economics (government planners are better than markets or entrepreneurs when it comes to resource allocation). So the debate still continues.................
TO SUM UP THE DIFFERENCES:
Hayek:
1. Say's Law is correct (in its basic form) - productivity drives an economy and creates jobs.
2. Saving is important to this economic growth. Savings leads to capital investment and productivity.
3. Property rights in capital goods, market prices and individual knowledge are the keys -- markets provide knowledge to direct resources such that people's values/wants are met. Without this knowledge, coordination will not happen.
4. Government distorts market signals - creates booms and busts - more on this!
Keynes:
1. Say's Law is wrong - spending or aggregate demand drives an economy.
2. Saving is "bad" when the economy needs a stimulus -- when people save, they are not spending.
3. Planners have enough knowledge to plan an economy -- we need "experts" and statistics, and the government can stabilize the economy.
4. Markets are chaotic - they create booms and busts.
An Alternative Theory of the Business Cycle - the Austrian* Theory
*Austrian Economics is a school of thought (the founders were from Austria in the late 1800s) - it has nothing to do with the country of Austria today.
Most credit for this theory can be given to Ludwig von Mises and F. A. Hayek.
Assumptions of the Theory:
First: Say's Law is correct.
Second: Markets are not perfect (because people are acting under change and uncertainty) - but that are also not chaotic either (as Keynesian economists often model them).
Third: Knowledge is the key here. Markets are amazing information generating processes. When this knowledge is distorted by government, the outcomes are not market outcomes, they are government created outcomes.
The Austrian Theory of the trade or business cycle is one explanation of a boom and bust in an economy. It explains what happens during a boom (most especially brought on by increases in the money supply by the FED but also more generally -- could happen with fiscal policy as well but in a slightly different way).
Pay special attention to "malinvestment" and the knowledge issues that are explained. We have talked about some of this before.
Remember Economic Calculation: Prices, interest rates, profits, losses -- they are all market information signals to entrepreneurs about what to do with resources. The signals ultimately reflect the preferences of individuals in an economy if they are not distorted in some way. But they are distorted on a regular basis by government (most especially the FED in the case of the business cycle - but also through fiscal policy as well).
Watch for these distortions: These distortions will lead to changes in resource allocation - not just regarding consumer goods, but also capital goods. This is "malinvestment" in that profitability is "false" and short-lived.
Let's first look at capital because this theory views capital in a very different way than mainstream economists do.
Capital Goods - capital in an economy is a structure of physical capital and labor - as well as financial capital vs. (mainstream view) capital as a dollar amount and homogeneous physical amount. So usually the theory goes - Output = f (k, l), where k is capital and l is labor.
To explain capital as a structure - let's go back to Hayek:
The Hayekian triangle and it's meaning as a capital structure (higher order capital goods and lower order consumer goods) - complementary, inter-connected heterogeneous capital:
Note that production takes place through time. The time element is important to both interest rate theory (and actually wage theory as well).
Entrepreneurs take on the uncertainty of income. Wage earners, on the other hand, earn a present and agreed upon wage (with much less uncertainty). Because of positive time preferences -- most people prefer the given wage to the uncertain wage (even if it could end up being much lower than those who go out on a limb).
What if there were no entrepreneurs (those who take on the uncertainty)? Interesting to think about.
Review Positive Time Preferences and interest rates:
Relatively high (what does that mean about savings, future consumption and interest rates)?
Relatively low (what does that mean about savings, future consumption and interest rates)?
Shifting of the triangle and the "signal" to entrepreneurs (time preferences) and the interest rate:
So why would a "cluster of errors" take place?
Signal extraction problem:
As Ludwig von Mises mentions, this is when prices increase due to the credit expansion. But not uniformly - some increase more than others. Again - directing resources in different directions.
Mal-investment (on two levels):
Retooling in individual markets - injection effects and relative price changes -- resources allocated to unproductive markets....
Retooling in the capital structure -- returning investment to where it should have been.
The recession or downturn is when the market returns resources to where they should have been. If the government (including the FED) continues to distort signals (prices, profits, interest rates) -- the market is unable to work effectively at creating jobs and bringing unemployment back down. The recession (or depression) continues much longer than necessary.
This is due to not only the signal distortions continuing - but also the increase in uncertainty created by all of the "false" signals of the past (and present).
How do the relatively recent "quantitative easing" schemes by the government fit into this theory?
How does the housing boom and bust fit into this theory?
(Now you should be able to understand this Rap Video).