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Home , Pushing on a string, Quantitative easing, Stimulus (economics)

FEATURE

KEYNES, HAYEK AND THE GREAT

The writings of Keynes and Hayek are rich with lessons on the causes of the current crisis and ways out of it, says Robert Carling. This essay is based on an address to the University of Queensland alumni meeting in Canberra on 26 September 2012

conomic history has unfolded before The rise and fall and rise of Keynes our eyes over the past five years as Keynes’ name long ago became synonymous the worst , the deepest with fiscal (‘pump-priming’) and recession (now dubbed the Great deficits in times of recession. The world quickly ERecession), and the weakest recovery (the Feeble embraced Keynesian pump-priming solutions Recovery?) combined to deliver the biggest global when economies went into free fall in late economic shock since the 1930s. The shock 2008, and even today there are voices in favour was unevenly distributed, but its epicentre of more of the same, or at least a tolerance for in the major advanced economies ensured large fiscal deficits as long as economic activity the whole world suffered the fallout. Future remains subdued. However, we need only take generations will look back upon this era with a little detour through the history of economic fear and loathing just as we look back upon the thought to appreciate that the wisdom of this . rush to embrace Keynesian solutions is open Similar to the turmoil of the 1930s to challenge. revolutionising economic thinking then, the The early 1970s were the heyday of shocks of the last few years have breathed new post-World War II Keynesianism, in Australia life into old controversies about how economies as much as elsewhere. The Australian government work, why crises happen, and how to recover and its key economic advisory body, the from them. These controversies were never Treasury, accepted the Keynesian consensus resolved, but went into hibernation during the in that they believed in the management of Great Moderation—the era of almost continual aggregate demand through to economic expansion, low , falling dampen the business interest rates, and booming markets from cycle. It is true that the the early 1990s to 2007. Now, the arguments Treasury was also a strong between Keynesians, Austrians and neo-classicists advocate of what are have returned with as much vigour as ever before. today called supply-side and Friedrich von policies to strengthen the Hayek were key protagonists in the economic economy’s productive debates of the 1930s. Their theories, policy capacity. Moreover, the prescriptions and teachings cover much of the Keynesianism that it ground occupied by opposing camps in the contemporary debate. For this reason, the writings of Keynes and Hayek are rich with Robert Carling is a Senior Fellow at lessons on the causes of the current crisis and The Centre for Independent Studies. ways out of it.

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believed in was of the symmetrical kind, circumstances of the 1930s.) He did not believe which sought to tighten fiscal policy in an that an easy would be effective inflationary upswing as well as loosen itin in sparking a recovery in those circumstances, a downturn, not the one-sided expansionary and therefore, advocated two key changes in Keynesianism more popular with politicians. fiscal policy: first, that the government should Despite these qualifications, it is correct to say not struggle to balance its budget in the face that the Treasury at the time advised the of falling revenue; and second, that it should government within a Keynesian framework. borrow to fund a large-scale Not long into the 1970s, however, program. The first is not at all controversial Keynesianism began a retreat that continued today. Only the terminology has changed to up to the 1980s, initially because it had no something like ‘let the automatic fiscal stabilisers answer to the stagflation of that era. This work.’ But it was quite a radical thought in revision of Keynesian thinking strongly the 1930s. It is the second prescription that influenced the Commonwealth Treasury, which remains controversial. had a major falling-out with the Whitlam After the war, the reinterpretation of Keynes government in 1974 over the latter’s refusal to continued in earnest and led to notions such countenance fiscal tightening in the midst of as using fiscal policy to fine-tune the economy rampant inflation and an economic downturn. and influence the level of consumer spending. The Treasury eventually won that argument. But Keynes never advocated fine tuning. His Keynesian fiscal policy, if not exactly dead context was that of a deep slump, not an and buried, went into cold storage just like in ordinary business cycle, and his version of other countries. But then it made a spectacular pump-priming was a blunt instrument, not comeback with the onset of the global financial a scalpel. He is also reported to have rejected crisis in 2008, and was embraced once again by the idea of using fiscal policy to boost consumer the Commonwealth Treasury as well as economic spending through temporary cash payments managers all around the world. or tax cuts for households. His response to that idea was similar to ’s later Keynes and the Keynesians permanent income hypothesis.2 Keynes’ name Strange though it may seem, there is an essential has become associated with big government distinction between Keynes and the Keynesians. and deficit financing as a normal state of Many of the things that have been said and affairs, but he never advocated them. In fact, done in the name of Keynes since World War he is on record saying there was no need for II are nowhere to be found in his writings the size of government to exceed 25% of the and statements. They are actually interpretations economy—a figure that has been far exceeded and embellishments of what he wrote and in all developed countries. said. This process started even before Keynes When the counter- died. He is reported to have said after some came in the 1970s, it jettisoned what the discussions with Keynesian economists in the Keynesians had advocated, and to a lesser extent, United States that he was the only non- undermined the crux of Keynes’ own theory. Keynesian in the room. We can only imagine Fine tuning was discredited. The failure of fiscal what he would have made of some of stimulus in conditions of stagflation came to the policy views attributed to him since his be widely accepted. The ‘’ death in 1946. school undermined Keynes’ theoretical We cannot know how his thinking would foundations.3 The fiscal was thought have evolved in the modern world, but the to be much smaller than previously believed. essence of his General Theory1 in the 1930s was Activist fiscal policy was thought more likely to that fiscal pump-priming should be used in be destabilising than stabilising. These revisionist the context of a deep and lingering slump and thoughts culminated in the view that fiscal . (In that sense, the General Theory policy should focus on medium- and long-term was actually a theory tailored to the specific goals, such as strengthening the supply side of

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the economy, while short-term management did not follow the Keynesian formula. There should be left to monetary policy. The budget were few ‘shovel-ready’ public works projects, would fluctuate symmetrically between deficit and much of the stimulus was aimed at consumer and surplus, but mainly on account of automatic spending. In addition, they were too eager to responses of revenue and expenditure to the ignore the lessons of the counter-Keynesian business cycle, not activist stabilisation policies. revolution of the 1970s and 1980s. Had they The extent to which that message was heeded those lessons, they would have known internalised in policy circles has been overstated. that stimulus was subject to various endogenous Keynes and Keynesians came to be viewed offsets such as leakage into imports. Because of with much reservation, but were not totally these offsets, stimulus can end up being quite rejected. In Australia, for example, we still had weak per dollar of stimulus applied, especially some discretionary fiscal stimulus in the early in an open economy. The fiscal multiplier 1990s recession. By and large, the political is thus small and tends to shrink to zero the temptation to tinker with fiscal policy for more time passes after the stimulus is applied.4 short-term economic management went At best, fiscal stimulus in 2008–09 acted as untested for an unusually long time during the a circuit-breaker to soften the downward Great Moderation, until the global financial economic spiral. It did not kick-start a sustained, crisis and the Great Recession, when the robust recovery, nor should it have been Keynesians came in from the cold. expected to. And in many countries, it ratcheted Most countries applied large doses of fiscal up already uncomfortably high or unsustainable stimulus in 2008 and 2009, with Australia’s levels of public debt, thereby adding to the risk being among the largest even though the of future instability. recessionary forces here were not as strong as elsewhere. Three years on, the discretionary At best, fiscal stimulus in 2008–09 stimulus has been withdrawn here and elsewhere, even though large fiscal deficits remain in most acted as a circuit-breaker to soften the countries. However, the cessation of discretionary downward economic spiral. It did not stimulus is not universally accepted. There are kick-start a sustained, robust recovery, many prominent and vocal advocates of further nor should it have been expected to. rounds of stimulus—not in Australia but in the countries experiencing feeble recoveries or renewed . At the same time, most of Australia was at least starting from a position these countries are also under pressure to curb of fiscal strength, with no net public debt at their deficits and debts—hence, the debate over the Commonwealth level. The Commonwealth ‘ versus growth.’ budget would have gone substantially into deficit even if there had been no discretionary fiscal Does fiscal stimulus work? stimulus, simply through the loss of revenue Was the world right to go back to Keynes? from lower taxable profits and other incomes and The economic conditions of 2008–09 were higher expenses on items such as unemployment more like the 1930s than at any other time since benefits—the operation of the automatic then, and governments could have been excused stabilisers. But was the additional widening of for thinking that if ever there was a time for the deficit through a large discretionary stimulus Keynesian pump-priming, that was it. Even so, necessary, and was it the key factor in avoiding there is a strong case that policymakers expected an economic slump? The conventional wisdom too much from fiscal stimulus in 2008–09. believes so, but it attributes too much of our So rushed were they to do something as their good fortune to fiscal stimulus and not enough economies collapsed around them that the to other advantages such as the strength of our measures taken were of poor quality. (Indeed, banking system, the swift loosening of monetary that is an inherent problem with an emergency policy, the large depreciation of the Australian stimulus.) Certainly, the type of stimulus applied dollar, and the policy measures taken to ensure

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the banking system was not starved of funds. actually put forward. His detractors even blame The expansionary effect of fiscal stimulus in him for helping cause the global financial crisis 2008–09 softened the brief downturn that by promoting a culture of greed and laissez Australia experienced, but the fact that Australia faire. This is nonsense. It is possible, however, did not have a deep slump had more to do to piece together a Hayekian explanation of with the other strengths listed above than with the Great Recession. In fact, Hayek is much the fiscal stimulus. Meanwhile, the enduring better at explaining how the Great Recession legacy of the stimulus is an addition of tens of came about than explaining how to make a fast billions of dollars to the public debt. exit from it. Another question is whether the countries Hayek and the of still experiencing weak recoveries or a relapse economists, to which he belonged, believed of recession would be correct to apply more that the supply side of the economy was the stimulus or delay deficit-cutting measures until key, not as Keynes thought the demand side. their economies are stronger. Here the answer Focusing on how economies got into crises in almost certainly is ‘no.’ In addition to all the the first place, they pointed the finger at easy general reasons cited above to question the money policies, excessive credit growth, and effectiveness of stimulus, these countries’ public what are today called ‘bubbles’ or ‘mal- debt burdens are now such a prominent part .’ These were supply-side distortions of their problems that it is difficult to see how that would eventually lead to a crisis and adding to those burdens (which is what fiscal a slump of the worst kind, namely, one stimulus would do) can be part of the solution. grounded in crippled balance sheets—be they For example, public debt in the United States of financial institutions, households, businesses has already risen to 80% to 100% of GDP or governments. The 2008–09 slump and (depending on how it is measured), and the the feeble recovery since are balance sheet long-term projections of its growth under phenomena that can be traced back to a long current policies are quite horrendous. There series of episodes of easy money policy and is great uncertainty about how and when rapid credit expansions in the major countries. fiscal sustainability will be restored. Businesses Clearly, the behaviour of exacerbated are hoarding mountains of cash rather than the crisis and regulation was deficient, but this investing. Any additional fiscal stimulus now does not invalidate Hayek’s explanation. Hayek would be neutralised by an adverse response would never have said the banks should have from the private sector, which would attempt to gone unregulated. He would have said, ‘Get save more in the face of even greater uncertainty. the regulation right and apply it in a consistent The deficit does not need to be eliminated and predictable way.’ This was not done in the overnight to resolve this uncertainty, but United States before or during the crisis. The a credible plan to put the public finances on regulators responded erratically and arguably a sustainable footing over the next several made the crisis worse. years, backed up by concrete actions and commitments, would do wonders for confidence Hayek’s answer and . Hayek could not offer a quick escape route from the current malaise. He certainly would Hayek’s world view not have agreed with Keynesian pump-priming. Hayek never published a critique of Keynes’ Hayek is associated more than anything else General Theory, but it is clear from his writings with the principle of economic freedom, and he that he had a very different view of the world. always argued that the best thing governments This view has been subject to a great deal of could do to promote freedom and prosperity misunderstanding because Hayek’s name, like was to provide a stable, predictable framework Keynes, has been taken and attached to all of policy and regulation under the rule of law, manner of proposals and ideas that he never with limited government, low and stable tax

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rates, and sustainable public finances. mal-investments. It also threatens to undermine Discretionary fiscal stimulus is the antithesis of the hard-won independence and credibility of predictability and stability. It is a manifestation central banks. Central bankers understand this of the arbitrary government intervention that but are haunted by the ghosts of the 1930s, Hayek loathed. Whatever positive effect it might when the conduct of monetary policy made the have on aggregate demand would be offset by Great Depression worse. They are determined the harm it does to aggregate supply. This to ensure that monetary policy is doing does not mean that Hayek-land is free of the everything possible this time to support business cycle. Hayek accepted the inevitability economic activity, while buying time for of the business cycle in a free-market system governments to implement structural policies but saw it as a small price to pay for the benefits that can provide the foundations for a sustained of the free market. He argued against policies recovery. Whether governments rise to the that he believed would make the cycle worse. challenge remains to be seen. If they don’t, then Hayek would be in favour of fiscal ultra-easy monetary policy cannot be a substitute consolidation (so-called austerity) in the and will ultimately end in tears. current environment, combined with tax and expenditure reform and other structural policies Conclusion to strengthen the long-run growth potential of These arguments will go on. The Great Recession the economy. Even the Hayekian true believers brought a revival of Keynes, and to a lesser would not offer that as the fast road out of extent the Keynesians, but already there is trouble, but there probably isn’t a fast road. renewed understanding of the limitations of fiscal stimulus and the urgency of fiscal Ultra-easy monetary policy consolidation. With the passage of time and Economic managers in the major countries dispassionate analysis, the balance may once are now resting their hopes on unprecedented again shift from Keynes towards Hayek. Hayek monetary policy interventions in the form of lost the argument with Keynes in the 1930s. policy interest rates held at or near zero But he may yet have the last laugh. for extended periods, and massive doses of (or ‘printing money’) administered by the monetary authorities of the United States, Japan, the Eurozone and Endnotes Britain. This ultra-easy monetary policy, as 1 The General Theory of , Interest and Money one writer has named it, constitutes one of the (London: Palgrave Macmillan, 1936). boldest experiments ever 2 Friedman hypothesised that households’ spending undertaken.5 Keynes would have said this will decisions were based mainly on their expected sustainable income rather than short-term be ineffective, like pushing on a string. Hayek fluctuations. would have said it may be effective in stimulating 3 Thomas Sargent and Neil Wallace, ‘Rational something the longer it continues, but that it Expectations and the Theory of Economic Policy,’ will stimulate the bad with the good, create new Journal of Monetary 2:2 (1976), provides misallocations of resources, new bubbles, and an example of the rational expectations challenge therefore, store up big problems for the future. to Keynes. To Hayek and the Austrians, it is just more 4 The International Monetary Fund recently of the easy money policies that ultimately reignited this debate by arguing that the fiscal led to the current mess. Ultra-easy money is multiplier can be quite large, but the IMF has providing short-term support to economic in turn been criticised for the quality of its data. 5 William White, ‘Ultra Easy Monetary Policy and activity and helping keep deflation at bay, the Law of Unintended Consequences’ (Federal but it cannot produce a robust, balanced, Reserve of Dallas, 2012). sustainable recovery. It runs the risk of stoking inflation and producing more bubbles and

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