Keynes vs. Hayek (stimulus vs. austerity)

A summary of Hayek's work, in case you are interested in the Keynes vs. Hayek debate (aka stimulus vs. austerity) (my previous posts in the subject here, here, here, and here)
"The discussion was very similar to the modern austerity versus stimulus debate, although at the time the major players were still busy fully developing their theories.  Keynes favored temporary and limited government socialization of investment as a means of using unspent money to recover the “gap” in aggregate demand, as well as general monetary stimulus.  He believed that banks do not do an adequate or complete job in financial intermediation through the loanable funds market — a form of disconnect between savings and consumption.  More specifically, he did not see a reason as to why savings are necessarily invested, seeing this as a natural fault in the capitalist system.

Hayek essentially agreed that the business cycle was characterized by a massive loss in investment and productive capabilities.  It was in his identification of the causes for this loss where he differed with Keynes.  The differences in business cycle theory also led Hayek to radically different ideas on the nature of the recovery.

In short, Hayek borrowed from Mises the idea that an increase in the supply of money distributed through the loanable funds market could distort the prices of capital goods relative to consumer goods. This would lead to an investment boom which would gradually spread up the structure of production — this facet formed the crux of Hayek’s work on business cycle theory in Prices and Production.  However, investments require capital goods, and by distorting prices what occurs is an increase in the quantity demanded without a previous increase in their supply.  The insufficient quantity of capital goods leads to the necessary liquidation of impossible investments, once prices increase enough to reveal their unprofitability — what Mises and Hayek term “malinvestments.”

While the recession is characterized by the mass liquidation of malinvestment, what this really entails is a capital restructuring.  The different processes of production that make up an economy must be reorganized in accordance with consumer preferences, including intertemporal preferences (the relationship between savings and consumption).  This process of reorganization is carried about by the individual capital-controlling entrepreneurs, each of which uses her best judgment in economizing her stock of capital goods.

Mises and Hayek saw government expenditure as counter-productive, because it negatively intervenes in the process of economization.  In other words, on average, government socialization of investment — whether it manifests through forced wealth redistribution or actual public investment (e.g. public works) — leads to less productive outcomes than what the alternative would have been had those resources been only been economized in the market process.  More elementarily, since government acts outside of the profit and loss jurisdiction, government cannot accurately calculate the net (un)profitability of its investments."

Keynes and Lenin on inflation

An interesting quote from Keynes's "The Economic Consequences of the Peace":
"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. – As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Though I encountered this (apparently well-known to the economists) quote in no connection to the current economic crisis, the context is very relevant. In his book "The Economic Consequences of the Peace" Keynes analyses the likely consequences of the peace treaty, imposed on Germany in the aftermath of the World War 1, and correctly predicts the rise of the extremist forces. The extreme inflation that followed the War indeed had contributed to the coming of Nazis to power. The knowledge of the impoverishing caused by the inflation and of its the disastrous political consequences is the the underlying basis for the anti-inflation stance so popular today in Germany.

Hayek vs. Keynes rap

Hayek vs. Keynes
Pay attention to small hints, such as the Keynes's "The general theory of the employment..." instead of the bible in hotel room, or the bartenders Ben (Bernanke) and Tim (Geithner) serving Keynes drinks, from which he later has hang-over.

Added later: here is the full commentary for this video

History of Keynes and Hayek

Some worthy reading on the history of economics and the two influencial economists (I have mentioned Keynes-Hayek debate in the past here.)

One quote:
"After Britain declared war on Germany, Hayek found himself shut out of war work on account of his alien status, despite having become a British citizen. His contribution, he decided, would be to write a book warning Western intellectuals that -- as he had concluded from his own country’s history in the 1920s and 1930s -- the road to totalitarianism, whether of Hitlerian or Stalinist variety (Stalin then being Hitler’s ally), started on the slippery slope of well-intentioned government interference in the private sector."

Keynes vs. Hayek debate is still alive

Here is an enlightening article about the two theoretical approaches to the economic crises, pioneered by John Maynard Keynes and Friedrich von Hayek. The author claims that the Hayek's approach has been discredited, and that the Keynesian stimulus is the only salvation to the World economy. (In case you have no time to read the whole article, I provide a few relevant quotes below.)

It is worth however noting that the Keynes vs not-Keynes division among the American economists passes precisely along the Republican-Democrat divide. This seems consistent, since the Democrats support more socialist society with a greater role of the government in regulating markets. But in Europe, which is essentially the Democratic ideal of the welfare state, the view seems to be just the opposite - the European Union response to the escalating debt crisis consists of imposing more and more austerity measures in Greece, Spain, Ireland, Italy etc.

This is probably the result of the different economic backgrounds, resulting in the drift of the two continents towards the middle ground, which humorously could be described as the difference between "Continental" and "English-speaking" approach.

The quotes: according to Hayek "the “crisis” results from over-investment relative to the supply of savings, made possible by excessive credit expansion. Banks lend at lower interest rates than genuine savers would have demanded, making all kinds of investment projects temporarily profitable.

But, because these investments do not reflect the real preferences of agents for future over current consumption, the savings necessary to complete them are not available. They can be kept going for a time by monetary injections from the central bank. But market participants eventually realize that there are not enough savings to complete all the investment projects. At that point, boom turns to bust."

The Keynes's position is just the opposite: "under-investment relative to the supply of saving – that is, too little consumption or aggregate demand to maintain a full-employment level of investment – which is bound to lead to a collapse of profit expectations."

Consequently the two economists offered different recipes for dealing with economic crises: "Whereas for Hayek recovery requires the liquidation of excessive investments and an increase in consumer saving, for Keynes it consists in reducing the propensity to save and increasing consumption in order to sustain companies’ profit expectations. Hayek demands more austerity, Keynes more spending."

The last recession is commonly blamed on the sub-prime mortgage crisis: the sharp drop in the price of real estate assets made these assents cheaper than the amount of money previously borrowed to purchase them. This explanations seems to be taken directly from the Hayek's book. Ironically, the stimulus approaches (i.e. more spending) adopted by both George W. Bush and Barack Obama, are the prescriptions taken from Keynes.