[Excerpt of R. Skidelsky] Hayek versus Keynes: The Road to Reconciliation

자료: Hayek versus Keynes: The Road to Reconciliation, by Robert Skidelsky, 

in The Cambridge Companion to Hayek, edited by Edward Feser, (Cambridge University Press, 2006)

※ This reader thanks to the author for his kindly offering an insightful writing on the Internet.

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i. Introduction

(... ...) Yet the brief encounter of 1944 discloses the common terrain on which they[Keynes and Hayek] might have fruitfully argued out their differences. This is the grounds on which, and the methods by which, liberalism could most successfully be defended. For both men were liberals in all important senses of the term. They both repudiated central planning Russian style. They disagreed about whether liberal values could best be protected by more or less state intervention in the economy, but neither gave a very clear indication of 'where to draw the line'.

The common ground was created by the run-up to the war, and by the war itself. The war clarified for both men the values they shared. 'Our object in this mad, unavoidable struggle', Keynes declared on 12 December 1939, 'is not to conquer Germany, but ... to bring her back within the historic fold of Western civilisation of which the institutional foundations are ... the Christian Ethic, the Scientific Spirit and the Rule of the Law. It is only on these foundations that the personal life can be lived'. The full employment which the war produced also whittled away their differences in economics. Hayek praised Keynes's anti-inflationary pamphlet How to Pay the War: 'It is reassuring to know', Hayek wrote to Keynes after reading his anti-inflationary pamphlet How to Pay for the War, 'that we agree o completely on the economics scarcity, even if we differ on when it applies'. In turn, Keynes cordially welcomed Hayek's Road to Serfdom: 'It is a grand book ... Morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement, but in deeply moved agreement'.

This essay charts the path to their reconcilation.

ii. Different Temperaments, Different Backgrounds

Hayekians argue that Keynes represented the impatient, Hayek the patient, version of liberalism. [Hayek thought that Archilocus's famous line 'the fox knows many things, but the hedgehog knows one big thing' summed up the difference between Keynes and himself.] One 'big' thing which Hayek 'knew' was that all state intererece in the market system is evil.. The Fox, Hayek implied, knew this too, but felt he was clever enough to evade the trap, conjuring up new theories, arguments, policie for each occasion. Hayek, it might be said, was all of a piece; Keynes a man of many pieces. It is a self-serving Hayekian image, for the hedgehog wins the race in the end. Hayek was infuriated by the rapidity with which Keynes changed his theories. This seemed to show he lacked scientific principles. Statesmanship without principle, Hayek would have said, is the slippery slope to totalitarianism. Statemanship without prudence, Keynes would have replied, is the royal road to disaster.

The contrast between the fox and hedgehog suggest another: that between the administrator/politician and the scholar/scientist. Keynes came from an activist tradition: the ancient universities saw themselves as part of the British ruling class, pushing their graduates into the highest civil service. Keynes himself had three spells in Whitehall. As an emigre, Haye had scholarly detachment forced on him. His thinking was never tested by the reality of prospect of action. However, Hayek was not quite so detached as he made out. His fear of inflation, linked to the destruction of his own family fortune and the Viennese middle class by post-war hyperinflation, coloured all his supposedly Olympian economics. He went on warning against the dangers of inflatin in the 1930s long after deflation had become the problem.

The essential difference between them as theorists was that Hayek's economics was reverential, Keynes's was revolutionary. Hayek added important clarifictions to the Austrian school of Boehm-Bawerk, Menger and Mises; Keynes saw himself as overturning 'classical' economics, including those of his 'master', Alfred Marshall. Hayek was much more learned than was Keynes in the history of economic thought: he is right to say that Keynes disliked the 19th century and lacked knowledge of its economics and economc history. Hayek thought about economic theory within the framework of a tradition; for Keynes the important thing was to get the argument right on the page (or on the day). Keynes was the more creative thinker. This was partly the result of an innate quality of mind; but it was also partly because his training in economics was so superficial. Keynes had no difficulty in seeing his ideas as original; to Hayek they were simply the latest installment of age-old fallacies.

A final difference was one of intellectual manners. By the early 1930, Keynes and his followers felt a sense of urgency, almost of desperation, to get the idea accepted. It became the hallmark of Keynes's coterie to regard every economist outside Cambridge as mad or stupid; argumentative good manners were sacrificed to world salvation. On the other hand, there i near unanimous testimony to Hayek's intellectual hospitality. For example, when Robert Bryce, one of Keynes's students, decided, in 1935, to do some missionary work at the LSE, 'Hayek very courteously gave me several sessions of his seminar to expose [the new Keynesian ideas] to his students'. Hayek was much impressed by Menger's remark that the final victory of a scientific idea could only be secured by letting every contrary proposition run a free and full course. (... ...) The optimism of Cambridge confronted the fatalism of Vienna.

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iii. Starting Positions 

Hayek believed hat the market economy was a smoothly-adjusting machine in the absence of credit creation by the banking system. Keynes saw monetary 'management' by the central bank, which could include credit creation, as the only way to keep it stable. This was the pith of their debate. Keynes won it, because he made the more relevant statements.

Hayek came to their debate in 1931 equipped with an 'Austrian' inter-temporal theory of value which Keynes lacked. This sought to demonstrate that an unimpeded market systemㅡone in which relative prices were free to adjust demand and supply simultaneously in all marketsㅡsecured the full employment of resources not jut at any moment of time but over time. The theory of capital and interest, which showed how this came about, rounded off neo-classical value theory, substituting the notion of dynamic for static equilibrium. The Austrian thus told a much more complete, and confident 'market' story than any available in Anglo-American economics.

In the Hayek story, the rate of interest was the price which adjusted decisions to save to decision to invest, in line with individual time-preferences. A high rate of saving was key to a progressive economy, ensuring that increasing quantities of machinery, and decreasing quantities of labour, were applied to the production of consumer goods.

The only problem was that the situation in the 1930 did not fit Hayek's story. There was massive unemployment of resources. So Hayek had to introduce money as the 'loose joint' in his theory in order to explain the phenomenon of the trade cycle. Monetary theory should concern itself with the question of 'how and when money influences he relative values of goods and under what conditions it leaves these relative values undisturbed'. The main conclusion he drew from this analysis was that a credit-money economy will only behave like a barter-exchange economy if banking policy can keep money 'neutral'ㅡthat is, provide a constant supply of money per unit of output, and above all prevent inflation. This wa difficult and almost impossible. So the trade cycle was inevitable. The best way of mitigating itㅡof limiting credit expansionㅡwas by rigid adherence to a full gold standard. In Hayek' view, the grea depression was the direct result of failing to follow this precept. Credit creation in the 1920s had distorted the system of relative prices, producing depression. There was no alternative to liquidating the inflation even though this might well deepen the depression for a time.

Keynes approached the same phenomena from the standpoint of the quantity theory of money. This states that the price level changes proportionately to the quantity of money. As such it si purely a theory of the value of money, when the level of output is taken as given. As such it could not explain fluctuations in output. However, there was a tradition, going back to Hume, and latterly reinforced by Irving Fisher, which held that it took time for a change in the money supply to have its full impact on the price level, and that during the interval when prices were rising or falling the economy could either expand or contract. This was the approach Keynes used in his Tract on Monetary Reform(1923).To get his 'transitional' results he introduced uncertain expectations. When the price level was changing, uncertainty about future prices prevented the instant adjustment of nominal interest rates and wages necessary to validate the quantity theory of money. Businessmen made 'windfall' profits in the inflationary upswing and windfall losses in the deflationary downswing. 'The fact of falling prices injures entrepreneurs; consequently the fear of falling prices causes them to protect themselves by curtailing their operations'. From the Tract comes his best-known phrases. Having agreed that QTM was 'probably ture' in 'the long run', he went on: 'But in the long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again'. This expresses, in typically striking language, his main requirement for a serviceable economic theory: it must be able to account for 'tempestuous' as well as 'flat' seasons, and prescribe prevention and cure for the former.

The institutional culprit in the Tract was the international gold standard, with sacrificed domestic price stability to exchange-rate stability. The policy conclusion was obvious: active monetary policy was needed to stabilise the domestic price level. This required abandonment, or at least severe modification, of the gold standard.

Both economists suffered from the handicap of using models to explain phenomenoa which could not occur if the models were correct. The models could be adjusted to reality only by means of ad hoc additions: Hayek's 'loose joint' theory of money, Keynes's 'stickness' of key prices. Keynes's approach was more politically attractive because it pointed to policies of prevention and cure, whereas Hayek's enjoined stoicism. He rejected Keynes's policy of stabilising the price level: a stable price level could disguise inflationary tendencies when prices ought to be falling. 'The bank could either keep the demand for real capital within the limits set by the supply of saving; or keep the price level steady; but they cannot perform both functions at once'. Questions to do with the role of the state in the economy, of rules versus discretion in monetary policy, of knowledge and ignorance in economics, of prescribing for the long term or the short term, all of which were to become the battleground between the Hayekians and the Keynesians, had been posed, though not yet sharply.


iv. Different Domains?

The main issue between Hayek and Keynes comes out in their explanations of the Great Depression. Both could claim to have predicted it. Hayek argued in the sping of 1929 that a serious setback to trade was inevitable, since the 'easy money' policy initiated by the US Federal Resere Board in July 1927 had prolonged the boom for two years after it should have ended. The collapse would be due to overinvestment in securities and real estate, financed by credit creation. For Keynes, looking at the situation in the autumn of 1928, the danger lay in the 'dear money' policy initiated by the Fed in 1928 in an effort to choke off the stock market boom. Savings, Keynes argued, were plentiful; there was no evidence of inflation. The danger was the opposite to the one diagnosed by Hayek. It was that of under-investment. 'If too prolonged an attempt is made to check the speculative position by dear money, it may well be that the dear money, by checking new investment, will bring about a general business depression'. For Hayek the depression was threatened by 'investment running ahead of saving'; For Keynes by 'saving running ahead of investment'.

Hayek's attempt to integrate 'monetary' and 'real' theories of the business cycle, as expounded in his book, Prices and Production(1931), has six main elements:

1. Volutary savings by individuals are decisions to give up a certain amount of consumption now in order to secure a greater quantity of consumption in the future.

2. New acts of saving cause the rate of interest to fall, thus reducing the cost of producer(or investment) goods relative to consumer goods. They thus send a signal to producers to switch from making consumer goods to making producer or investment goods. Capital and labour flow out of the consumer good to making goods into the producer goods sectors, leading to capital deepening. (Hayek variously calls this process lengthening the 'period of production', increasing the 'roundaboutness of production', or switching to 'more capitalistic methods of production'.) When completed, the elongated structure of production will make possible a greater amount of consumer goods per unit of capital and labour, ie., the price of consumer goods will be lower than before and the savers' real capital income will have gone up.

3. Following the Swedish economist Wicksell, Hayek called the price which secures a balance between saving and investment the 'natural' rate of interest. The economy will be in equilibrium when the market, or actual, rate of interet equals the 'natural' rate.

4. The equilibrium condition is continually secured in a barter economy. It may be satisfied in a money economy in which money is kept 'neutral'. Only a change in the 'effective' quantity of money could generate a disequilibrium process. When the banks create credit, a source of funds additional to voluntaty savings becomes available to finance new investment. The market rate of interest falls, the money value of investment rises, and resource are attracted to the producer goods industries as before. But now the market rate is below the 'natural' rate. The signals producers get to invest in new productive facilite do not correspond to the willingness of consumers to forego consumption. Instead, these consumers are 'forced to save' by the rise in the prices of consumer goods.

5. The result is an unsustainable structure of production. As the incomes of wage earners 'catch up' with the reise in prices, they will seek to restore their previous standards of consumption, thus liquidating the 'saving' needed to complete the roundabout processes. The turning point comes when the banks have to restrict credit (or raise interest rates) to protect their cash reserves. The crisis has to run its courses, as the structure of production returns to its old proportions. Hayek describes this retrorgressive movements as 'capital consumption'. It necessarily produces an economic crisis, with unemployment appearing quickly in the investment goods sector and only gradually being re-absorbed in the 'shorter' processes. Pumping more money into the economy may help temporarily but will make matters worse in the end.

The situation [Hayek writes] would be similar to that of a people in an isolated isalnd, if, after, having partially constructed an enormous machine which was to provide them with all necessities, they found they exhausted all their savings and available free capital before the new machine could turn out its product. They would then have no choice but to abandon temporarily the work on the new process and to devote all their labour to producing their daily food without any capital'.

6. In an elastic money supply banking system, the business cycle can never be entirely avoided. 'Money', wrote Hayek, 'will always exercise a determining influence on the course of economic events...'. There are both technical and political difficulties in keeping money 'neutral'. The 'natural' rate is unknowable; price stability is no proxy, since it can conceal inflationary tendencies. The only practical maxim is that the banks should be overcautious in supplying credit in the upswing. However the risks of mismanagement can be mitigated by rigid adherence to the gold standard. Hayek rejected fractional reserve banking. All banks should hold 100% gold reserve against deposits. This would rapidly reverse credit creation, limit 'malivestment', and ensure that the crisis is shallow and short-lived.

It is a very peculir story.[:]

(1) Hayek was never able to explain why the new structure of production made possible by credit creation was any less permanent than one which reflected voluntary decisions to save. As Keynes's colleague Priero Sraffa pointed out,[:]

• 'One class has, for a time, robbed another class of part of their incomes; and has saved the plunder'. The 'forced' savings of the losers become the voluntary savings of the gainers; 
• and if wage earners benefit in due course from the increased flow of consumption goods made possible by the more roundabout processes, the gainers do not thereby lose the additional real capital they have created. 

Few rejoinders show up more crushingly the limitations of Hayek's analysis.

(2) Even worse, Hayek provides no explanation of why a change in the quantity of money should have any effect on the structure of production at all. [:]

• His story presupposes that changes in money worked themselves slowly and unevenly through the price system. 
• But this is inconsistent with his assumption of perfect foresight and perfectly flexible prices. On this assumption, he has not explained the genesis of the cycle, he has simply confirmed the quantity theory of money! 

(3) A third fallacy was pinpointed by Keynes in his General Theory. This was the confusion of the rate of interest with the 'marginal efficiency' or expected profitability of capital.

• An increased desire to save does nothing in itself to improve profit expectations. 
• Au contraire, by lowering the prices of consumer goods, it depresses the profit expectations of all producers. This leads to a fall in aggregate income and a fall in actual saving. There is nothing to cause the rate of interest to change. 
• Yet Hayek never renounced his early cycle theory and was still using it to explain 'stagflation' of the 1970s.

Keynes's Treatise on Money appeared six months before Hayek's Prices and Production. The following summary of the Treatise brings out the points of convergence and divergence in the two theories:

1. Voluntary savings by individuals represent decisions to give up a certain amount of consumption now in order to secure a greater quantity of consumption in the future.
2. The economy will be in (full employment) equilibrium when saving equals investment. This is equivalent to the market rate of interest being equal to the 'natural' rate.
3. Saving and investment can diverge for expectational reasons unconnected with changes in the quantity of money.
4. When 'saving runs ahead of investment' (the case which particularly concerned Keynes in the Treatise on Money) the economy goes into a 'free fall' till something 'turns up'.
5. Keynes outlines the sequence in his 'banana parable'. He envisages an economy which only produces and eats bananas. He supposes an increase in saving ('for old age') with no increase in investment in new banana plantations. The prices of bananas must fall:

Well, that is splendid, or seems so. The thrift campaign will not only have increased saving, it will have reduced the cost of living. ... But unfortunately that is not the end of the story; because, since wages are still unchangedㅡand I assume for the moment that the selling price of bananas will have fallen, but not their costs od productionㅡthe entrepreneurs who run the banana plantantions will suffer an enormous loss...equal to the new savings of those peope who have saved...The continuance of this will cause entrepreneurs to tray and reduce wages, and if they cannot reduce wages they will [put] their employees out of work.. [Italics put by the author is not shown]

Keynes then discloses the 'full horror of the situation':

However much they [reduce wages] it will not help them at all, because..the buying power to purchase bananas will be reduced by that amount; and so long as the community goes on saving, the businessmen will always get back from the sale less than their cost of production, and however many men they throw out of work they will still be making a loss.

No position of equilibrium is possible until one of four things has happened: either everyone is out of work and the population starves to death, or entrepreneurs combine to keep up prices, or the thrift campaign falls off or peters out, or investment is increased.

6. It was the task of monetary policy to prevent or offset this dire sequence of events by pumping money into the economy; it was, in fact, the only balancer in the system.

Keynes explained:

Those who attribute sovereign power to the monetary authority on the governance of prices do not, of course, claim that the terms on which money is supplied is the only influence affecting the price level. To maintain that the supplies in a reservoir can be maintained at any required level by pouring enough water into it is not inconsistent with admitting that the level of the reservoir depends on many other factors besides how much water is poured in.

One can see that the two models diverge with Keynes's the third point. Whereas for Hayek savings are smoothly translated into investment, for Keyne there is nothing to align the two except stabilisation policy. Hayek was puzzled:

But what does it actually mean if part of current savings is used to make up for losses in the production of consumption goods...? It must mean that though the production of consumers's goods has become less profitable, and that though at the same time the rate of interest has fallen so that the production of investment goods has become relatively more attractive than the production of consumption goods, yet entrepreneurs continue to produce the two types of goods in the same proportion as before. Mr. Keynes's assertion that there is no automatic mechanism in the economic sytem to keep the rate of saving and the rate of investing equal might with equal justification be extented to the more general contention that there is no automatic mechanism in the economic system to adapt production to any other shift in demand. [Italics put by the author is not shown]

The italicised passage shows that Hayek had misunderstood the key point in Keynes's theory. But his conclusion about the nature of the theory was correct: there was no automatic stabilising mechanism to be found in it.

Both men confronted the world depression with severely dysfunctional theories.

• Hayek was right to claim that Keynes had not shown saving and investment could diverge within the model of the Treatise, unless there had been a prior change in the quantity of money. 
• Hayek had not shown why credit creation should start a cumulative process bound to end in depression. 
• But whereas Keynes's policy of pumping purchasing power into a deflating system offered a hope of recovery, Hayek was still warning against Keynes's reflationary remedies. This was to earn him a savage retrospective rebuke from his erstwhile disciple Lionel Robbins : 

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‘Assuming the original diagnosis of excessive financial ease and mistaken real investment was correctㅡwhich is certainly not a settled matterㅡto treat what developed subsequently in the way in which I then thought valid was as unsuitable as denying blankets and stimulants to a drunk who has fallen into an icy pond, on the ground that his original trouble was overheating. I shall always regard this aspect of my dispute with Keynes as the greatest mistake of my professional career...’

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One can see how Hayek's intransigent methodological individualism (or Caldwell calls his 'profound espistemological pessimism') hampered his economics. It led him to repudiate Keynes's espousal of macroeconomic remedies for depression, and indeed macroeconomics itself. He claimed that only subjective valuations count as causes: total quantities can exert no influence on individual decisions. This claim pinpoints the weakness in the Austrian economics of the day: the lack of a theory of expectations. Keynes understood that collective expectations entered into individual valuations, and that by controlling aggregates, governments can influence individual expectations. In reviving the neo-classical approach, Milton Friedman never repudiated macroeconomics. Today's 'inflation targeting' depends crucially for its success on 'managing' expectations, much as Keynes advocated in the Tract.

Keynes's (eventual) position was also problematic. He shared much of Hayek's epistemology (wholes have only a fictitious existence, social science is a moral, not natural, science, econometrics is philosophically flawed) yet still believed in macroeconomic policy which depends on national income accounts, econometric modelling, and government manipulation of aggregates. He thought government could manage total spending power only in a rough and ready way which would still be an improvement on laissez-faire. But the next generation carried this project much further. They thought the problem of limited knowledge facing the central manager was a contingent one, and that as statistics improved, so would the possibility of control. This reached its apogee in the 'fine-tuning' approach of the 1960s.

Hayek's repudiation of macroeconomics was proclaimed as a methodological principle; but one suspect it stemmed more from his exaggerated pessimism about the result of macroeconomic policy; in contrast, Keynes's embrace of macroeconomics derived from his eagerness to equip governments with the tools of economic management, even before his theory was really up to it. Keynes erred on the right side. He may have exaggerated the wisdom and integrity of governments. But he was surely right to believe that enough collective knowledge existed to improe the working of economies.

His rejoinder to Hayek's attack on his Treatise on Money, Keynes noted that 'our theories occupy...different terrains', Hayek's being a theory of dynamic equilibrium, his own being a disequilibrium theory. Both theories subsequently changed, but brought no meeting of minds. Ironically, Hayek dropped Walarsian equilibrium theor at exactly the moment Keynes embraced it. In his 1936 lecture 'Economics and Knowledge', he redefined equilibrium as a situation in which there exists a mutual coordination of plans. But given its impossible knowledge requirements, on which Hayek laid increasing stress, it became a purely fictional construction, of no predictive value. His eventual position seems to have been tht though an unmanaged market system had no strong tendency to full employment, monetary policy designed to improve the situation would only make matters worse as well as being inflationary. He came to regard his most important contribution to economics as his depiction of the market order as a discovery technique rather than a determinate system.

In Keynes's General Theory of Employment, Interest and Money(1936) the economy was always in equilibrium, but this need not be, and mostly was not, a full employment one. Keynes's adoption of the equilibrium method can be seen as the culmination of his attempt to provie a theoretical rationale for activist government. (...)

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iv. How to Pay for the War

A war economy is faced not by inadequate but by excess demand, by inflationary, not deflatinary, pressure. At the same time it needs a high level of saving to effect the transfer of production from consumer to war goods. This transfer can be effected either by inflation-induced 'forced saving' or by heavy taxation, and other controls on civilian consumption. This is classic Hayekian territory. Keynes sought to avert the twin evils of inflation and confiscaion by an imaginative plan for 'compulsory saving' or 'deferred pay'.

His plan was announced in two articles in The Times on 14 and 16 November 1939, later expanded into a pamphlet 'How to Pay for the War'. His analysis of the problem was quite 'Austrian'. The government had started pumping money into the economy to expand war production. This was equivalent to extra investment in more 'roundabout processes' whose aim was to produce a greater quantity of a particular kind of consumption goodsㅡguns, tanks, aircraft. However since this extra investment did not represent any willingness of the public to reduce its consumption of civilian goods, the price level was pushed upwards. In Hayekian terms consumers were 'forced to save' by rising prices. But, after a lag, incomes too would start to rise and consumers would want to restore their previous consumption standards. Civilian consumption could then be suppressed only at tha cost of further and increasing inflation, or by price controls and rationing, or a mixture of both.

Keynes proposed an ingenious alternative. Consumers would be 'forced to save', not by inflatin or rationing but by means of a temporary, graduated surcharge on their post-tax incoms the proceeds of which would be made available as post-war credits. They would be left free to spend their reduced incomes as they pleased. The great advantage of compulsory saving, as Keynes saw it, over orthodox taxation or inflation, was that workers would not lose the benefit of their higher wages, only be obliged to postpone their spending. This was the plan which Hayek enthusiastically endorsed in The Spectator of 24 November 1940, without pointing out that the calculation of how much 'money' to take out of the economy was highly dependent on putting numbers to the aggregative analysis of the General Theory, one which repudiated on methodological grounds.

In the expanded pamphlet, How to Pay for the War, published on 27 February 1940, Keynes was forced to add sweeteners for the trade unions in the form of family allowances and 'iron raions' at subsidised prices; and a concession to the orthodox (including Hayek) in the form of a capital levy to discharge the liability created by the deferred pay. His plan (as opposed to the arithmetic underpinning it) was adopted only in part by Kingsley Wood in his budget of April 1941: in practice, Keynes lost the argument to the central planners, and regulation of aggregate spending tool second place to manpower planning, physical allocation of inputs, and rationing of consumer goods. The legacy of his plan, though, was a technique of macroeconomic management, which was not tied to these wartime expedients.

It is the underlying philosophy rather than the details of the scheme that concerns us here, and which won Hayek's approval. (...)