"When the definitive history of economic analysis during the 1930s comes to be written, a leading character in the drama (it was quite a drama) will be Professor Hayek. . . . It is hardly remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes" (Sir John Hicks, 1967).
F. A. Hayek: Hayek was born into a family of intellectuals in Vienna. He earned doctorates from the University of Vienna (1921 and 1923). Influenced by Menger's Principles of Economics (1871), his ideas were also gradually refined by Eugen Boehm-Bawerk, Friedrich Wieser, and Ludwig von Mises.
Ludwig von Mises (1881-1973)
Note on Mises: Although this debate is famous in terms of Hayek and Keynes, Mises was central to understanding the concept of economic calculation and why, under a planned economy, it would be impossible to know where resources should be allocated without the knowledge generated from market prices. See Ludwig von Mises’s seminal essay, Economic Calculation in the Socialist Commonwealth, originally published in 1920 under the title “Die Wirtschaftsrechnung im sozialistischen Gemeinwesen” in the Archiv für Sozialwissenschaften, vol. 47 (1920). I agree with economist Joseph Salerno that
“Economic Calculation in the Socialist Commonwealth” surely ranks among the most important economic articles written this [20th] century."
J. M. Keynes: Born in Cambridge, England - son of an economics lecturer at Cambridge University (father) and successful author and social reformist (mother). Studies under Marshall and he is believed to have prompted Keynes's shift in interest from mathematics and classics to economics.
"The Hayek-Keynes debate was perhaps the most fundamental debate in monetary economics in the 20th century. Beginning with his essay, 'The End of Laissez Faire' (1926), Keynes presented his interventionist pleas in the language of pragmatic classical liberalism. As a result, Keynes was heralded as the 'savior of capitalism,' rather than being recognized as the advocate of inflation and government intervention that he was." (P. Boettke). Remember, "classical liberalism" is not the "liberalism" of today.
The First Debate
Point: Hayek - the fundamental problem with Keynes's economics was his failure to understand the role that interest rates and capital structure play in a market economy. Because of Keynes's use of aggregate (collective) concepts, he failed to address these issues adequately in A Treatise on Money (1930). Hayek pointed out that Keynes's aggregation tended to redirect the analytical focus of the economist away from examining how the industrial structure of the economy emerged from the economic choices of individuals.
Counter Point: Keynes did not take kindly to Hayek's criticism. He responded at first by attacking Hayek's book Prices and Production (1931). Then Keynes claimed that he no longer believed what he had written in A Treatise on Money, and turned his attention to writing another book, The General Theory of Employment, Interest, and Money (1936), which in time became the most influential book on economic policy in the 20th century.
No Counter Point from Hayek: Rather than attempting to criticize directly what Keynes presented in his General Theory, Hayek turned his talents to refining capital theory. Hayek said that part of the reason he didn't respond to Keyne's General Theory was because Keynes was always changing his mind -- so why take the time to write a response when Keynes will probably change his mind later anyway.
Some historians of thought think that if Hayek had responded to the General Theory -- history would have been very different?
By the end of the 1930s, Keynes's brand of economics was on the rise. In the eyes of the public Keynes had defeated Hayek. Hayek lost standing in the profession and with students.
During this time, Hayek was also involved in another grand debate in economic policy-the socialist calculation debate, triggered by a 1920 article by Mises which stated that socialism was technically impossible because it would lack market prices (cited above).
The Economic Calculation Debate - Main Question: To what extent can the economy be successfully planned and manipulated by government planners?
Hayek: In a way, this was a continuation of Hayek's arguments against Keynes for his "aggregates" -- but also against his call for economic planning.
Again, the economics profession and the intellectual community in general did not appreciate Hayek's criticism.
"What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic." F. A. Hayek - The Use of Knowledge in Society.
Focus is on coordination - how do coordination and economic order emerge from the unintended consequences of millions of economic actors?
Emphasis on knowledge - Dispersed economic agents have knowledge of time and circumstances which cannot be fully aggregated or understood by central planners. Government planners have a knowledge problem.
". . . the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation." (The Use of Knowledge in Society)
Two Kinds of Knowledge in Society:
Scientific:
Individual knowledge of time and circumstances (dispersed throughout society):
Can planners possess the knowledge necessary to move resources to where they are useful to people? Even move resources such that the basic necessities of life are met? Is economic calculation possible without market prices, profits and losses?
Emphasis on prices: Informational role of prices - prices serve as a learning mechanism which allows economic agents to economize on the quantity of information they must process in making choices.
Emphasis on change: "If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them." (The Use of Knowledge in Society)
Incentive Issues: Hayek pointed out that political agents will often face perverse incentives -- in the absence of private ownership, political agents will lack the incentive to allocate resources in an economically efficient manner (where people can use them). This is true even if they had the knowledge to do so - which they do not.
Keynes: Main work was The General Theory of Employment, Interest and Money (1936) - Response to the Great Depression and the "failure" of Classical economics.
Emphasis on demand - and the psychological reasons to consume or to invest:
"When employment increases, D1 [consumption] will increase, but not by so much as D [change in income]; since when our income increases our consumption increases also, but not by so much. The key to our practical problem is to be found in this psychological law." (The General Theory)
Emphasis on aggregates:
Looking at aggregate demand - and how this demand can be manipulated by government.
Was emphasis on uncertainty: But the uncertainty was one of the decision makers. Should they invest or not? Depends upon the expected rate of profit -- which is uncertain, for example. There was not an emphasis on the uncertainty of economic planners!
Really an entirely different way of looking at the economy and what was important to our understanding of it.
Summing Up: Keynes vs. Hayek
The original question: To what extent can the economy be successfully planned and manipulated by government planners?
Keynes: Government planners can effectively manipulate the economy as desired in order to overcome the "failures of the market" due to inadequate demand - "psychological law". Planners should be able to use discretionary policy (at their discretion).
Hayek: Due to the knowledge problem and incentive issues, government planners will be ineffective when attempting to plan an economy. Interventions will generate unintended (bad) consequences.