By Dr. Hassan Shirvani—
Conservatives tend to idolize the Austrian economist Friedrich Hayek (1899-1992) in the same way that liberals like to lionize the British economist John Maynard Keynes (1883-1946). Indeed, during the Great Depression of the 1930s, the debate between the supporters of Hayek and Keynes dominated much of the academic economic scene. The general consensus that eventually emerged was that Keynes had won the debate, with Hayek being forced to abandon economics in favor of political philosophy. However, during the 1970s and 1980s, with the revival of conservative economics under the Reagan and Thatcher administrations, there was renewed interest in the economic teachings of Hayek. This was partly the result of the new phenomenon of stagflation, a combination of high inflation and economic stagnation, brought about by sharp increases in oil prices, which standard Keynesian policies failed to address. To overcome the stagflation, many followers of Hayek pushed for freer markets, deregulation, and smaller economic roles for governments through lower taxes and scaled down social programs. One effect of this growing reliance on free markets and deregulation was the emergence of new financial products in the housing sector, a development that soon created a massive housing bubble. When this bubble subsequently burst in the late 2000s, the outcome was a widespread financial panic and the Great Recession.
The foregoing has led many Keynesians to consider the Hayekian push for free markets and financial deregulation as the culprit for the financial crisis, a pattern familiar from many similar historical episodes in the past. For followers of Hayek, however, the crisis was largely caused by the misguided governmental housing policies whose financings required easy monetary policies. More specifically, supporters of Hayek claim that the current financial crisis, like many others before it, has a monetary root. This so-called monetary theory of the business cycle, where monetary policy is largely held responsible for the cycles of boom and bust in the economy, is hardly original with Hayek. Indeed, it can be traced to the Swedish economist Knut Wicksell (1851-1926), among others. According to this theory, the “natural” rate of interest in any economy is determined by the supply of available savings and the demand for investable funds. The interest rate movements will thus serve as an adjustment mechanism to equilibrate the sudden shifts in savings and investments. For example, if there is an increased propensity to save, the resulting glut of savings will lower the interest rate, thus encouraging more borrowing and investment. Likewise, any sudden increase in demand for investment funds will raise the interest rate and, hence, induce more savings.
According to Hayek, however, there are occasions when central banks will try to lower the “market” interest rate below its natural level to stimulate more investment. This additional investment, which is financed by printing money and not by increased saving, will soon create an unsustainable inflationary boom, as increased investment is not matched by reduced consumption, which will eventually turn into a bust. According to this scenario, the recent US financial crisis can thus be considered a direct result of the Fed‘s easy monetary policy in the early 2000s to deal with the aftermath of the dotcom crash. To avoid economic busts, therefore, we must avoid economic booms. And when economic busts do occur, we must resist any misguided urge to help the distressed economy to get back on her feet. Rather, we just need to wait for financial excesses to work themselves out, not unlike coping with the inevitable morning hangover resulting from a night of binge drinking.
As Keynesians see it, however, there are two fundamental problems with the foregoing Hayekian analysis. First, as Keynes argued, savings are primarily determined by incomes and not by interest rates. This idea can be tested by the recent global crisis. If Hayek was indeed correct, then the recent collapse of housing investment should have resulted in reduced demand for investment funds and, hence, in lower interest rates. The lower interest rates should have, in turn, produced lower savings, that is to say, higher consumption. The higher consumption should have then offset the reduction in investment, hence keeping aggregate spending constant and the global economy in full employment. In fact, however, as Keynes had asserted, the collapse of incomes that accompanied reduced housing investments caused reduced consumption expenditures which, reinforcing the reduction in investment, caused the severe worldwide recession. Second, as to the Hayekian assertion that the presence of cheap money is necessarily tantamount to excessive speculative investment, no such rush to borrow and invest has been observed in recent years despite massive injections of cash by major central banks into the global economy. As Keynes correctly emphasized, such capital expenditures would only occur if their returns are sufficiently attractive, a condition definitely not met during the recent crisis. This explains why, over the past six years, despite extremely low interest rates, there has been no meaningful revival of business investment.
In the light of the foregoing, it is clear that the recent painful global recession demands strong fiscal actions to complement the weak business investments. By recommending policy passivism and overly emphasizing the role of money in the economy, Hayek proved his economic views largely irrelevant during the Great Depression. The Great Recession provides no more support for those same views.
Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics