In the 1930s, Friedrich Hayek blamed slumps on something that happened before them. What?
Hayek argued that when a central bank pushes interest rates down, cheap credit lures firms into investments they would not otherwise make. In his view, the bust that follows is the economy undoing those mistakes.
- The two sides
- John Maynard Keynes (1883 to 1946) of Cambridge, and Friedrich Hayek (1899 to 1992), Austrian-born, at the London School of Economics from 1931
- When
- From 1931, during the Great Depression; the argument has run ever since
- First exchanges
- Hayek's critical review of Keynes's A Treatise on Money (1930), and Keynes's reply attacking Hayek's Prices and Production (1931)
- The question
- What causes slumps, and should governments spend to end them?
- Key books
- Keynes: The General Theory (1936). Hayek: Prices and Production (1931), and later The Road to Serfdom (1944)
What the argument was about
Both men were trying to explain the slump that began in 1929 and the mass unemployment that came with it. They knew each other's work well and argued in print. Hayek wrote a long critical review of Keynes's Treatise on Money. Keynes replied forcefully and attacked Hayek's own book, Prices and Production. Other economists criticised both, and each man reworked his ideas.
The two cases
Keynes
The case
A slump happens when total spending falls too low. Firms will not hire people to make goods they cannot sell, so unemployment can last for years. Cutting wages makes it worse, because lower pay cuts what workers spend. A government should fill the gap by spending more, and borrowing to do so, until full employment returns.
The evidence it points to
Britain's long spell of high unemployment between the wars, which The General Theory was written to explain. After the Second World War, most Western governments managed demand in this way, and it stayed the prevailing approach until the 1970s.
Hayek
The case
A slump follows a boom built on cheap credit. When a central bank pushes interest rates artificially low, firms make long-term investments that savers' real choices do not support. The bust is the economy correcting those mistakes, so the way to prevent busts is to avoid the credit boom.
The evidence it points to
His warning, from 1958 onwards, that fighting unemployment with ever more money would bring rising inflation, which many economists now accept. He also argued that prices pull together knowledge spread across millions of people, which no planner could gather.
Ideas from the debate
Can you name the four ideas, two from each side, at the heart of the debate?
Total spending in an economy: consumption, investment and government spending. For Keynes, a shortfall in it explained mass unemployment.
Can you think of an example?
Households worried about their jobs save more and spend less, so shops order less and factories cut shifts.
A government spending more than it raises in tax, and borrowing the difference, to support demand in a downturn.
Can you think of an example?
In a recession a government builds roads and schools with borrowed money, putting idle workers back on wages.
Investment drawn in by credit that a central bank has made artificially cheap, which would not have been made otherwise.
Can you think of an example?
Cheap loans lead developers to start many new housing estates. When rates rise again, buyers cannot afford the homes and building stops half-way.
The information needed to run an economy is spread across millions of people, so no central planner can gather it. Prices pass it on.
Can you think of an example?
When tin becomes scarce, its price rises. Users of tin cut back without needing to know why it is scarce.
Check yourself
Three of these are Hayek's ideas. Which one is not?
Where the debate stands today
Most economists came to believe that Keynes won the argument of the 1930s, and Keynesian ideas shaped policy until the 1970s. Hayek never accepted that view. He shared the 1974 Nobel prize with Gunnar Myrdal for work on money and economic fluctuations. In the 1970s Milton Friedman's monetarism, a separate school, eclipsed Keynesian economics. Today most economists accept parts of both cases: that monetary and fiscal policy both affect demand, and Hayek's points about inflation and about the knowledge that prices carry.
Check yourself
A central bank holds interest rates very low for years, and a building boom follows. Whose theory predicts that the boom will end in a bust?
Check yourself
Who argued that cutting wages in a slump would make unemployment worse, because lower pay cuts what workers spend?
Check yourself
Whose theory calls investment drawn in by artificially cheap credit malinvestment?
- The Great DepressionThe slump both men were trying to explain.
- The end of the Great DepressionHow the slump actually ended.
- The Great InflationThe 1970s inflation that turned many economists towards Hayek's warning.
- Aggregate demandKeynes's central idea, defined and drawn.
In the 1930s Keynes and Hayek argued over what causes slumps. Keynes blamed too little spending and wanted governments to borrow and spend until full employment returned. Hayek blamed booms built on cheap credit and wanted them avoided. Keynes's view shaped policy until the 1970s; today most economists accept parts of both cases.