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Keynes v. Hayek: The Great Depression

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Christopher Roberts

on 19 November 2013

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Transcript of Keynes v. Hayek: The Great Depression

John Maynard Keynes (1883-1946)
Government Intervention
Keynes believed that demand, not supply, drives the economy. His principle of effective demand is a fundamental aspect of modern macroeconomic thought.
Overview: Solutions
Keynes on government intervention
Born in Cambridge, England
Studied at King's College, Cambridge
Studied under Alfred Marshall and Arthur Pigou
Considered the founder of modern macroeconomics
Keynesian Economics, followers and fiscal policy
Avoiding the depression meant making up for the fall in aggregate demand on the private side, with spending on the public side by the government:
“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” (General Theory, Book 3, Chapter 10)
Although Keynes advocated for the government to put the unemployed to work, he never directly called for deficit spending- that, along with the idea of fiscal stimulus came from his followers
Keynesians believed that fiscal stimulus - spending by the government- would boost aggregate demand through the money multiplier, even if the government had to run budget deficits. The key concept was the money multiplier. In essence, an initial increase in the money supply “created” more money through fractional reserve banking, putting more money in the system to spend. Thus higher levels of consumption would stimulate aggregate demand, output would rise and subsequently employment would rise as well, rejuvenating the economy
Keynesian economic was highly influential as counter- cyclical fiscal policy throughout much of the 20th century
Keynesian policy brought with it significant costs such as the threat of inflation, or today high debt from deficit spending. Moreover, economists note several lags of fiscal policy- recognition, legislative and implementation amongst the most critical.
Keynes v. classical economics
Keynes is considered the founder of modern macroeconomics. Classical economics- from Turgot to Smith and Say- believed the economy centered on production and/or supply. Keynes flipped the field on its head by stating aggregate demand was the key determinant of economic equilibrium
Keynes: Explanations for the Great Depression: Where Classical Economics Went Wrong
In his seminal work, Keynes examines the state of unemployment in the United States during the Great Depression. According to Classical Economics, the explanation for unemployment is simple: labor is not willing to decrease its wages to a low enough point such that supply and demand equilibrate (The General Theory, Book I, Chapter 2). Keynes points out two problems with the classical theory in particular: First, it assumes that a decline in real wages would cause a decline in employment, and second, at a deeper level, that there may be no method by which supply and demand of labor can actually equilibrate (The General Theory, Book I, Chapter 2).
He rejected traditional ideas of how savings and investment worked and called for a huge role for government- in direct contrast to the laissez-faire policies advocated by mainstream economics.
"There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a
state of continuous full employment; — any more than for the belief than an open-market monetary
policy is capable, unaided, of achieving this result. The economic system cannot be made self-adjusting along these lines."—Keynes (The General Theory, Book V, Chapter 19)
Hayek's Critiques on Solutions to the Great Depression
Keynesian Explanations for The Great Depression
Instead, Keynes offers a couple explanations for The Great Depression. For one, Keynes discusses the extravagant levels of investment with the United States during the five years leading up 1929 (The General Theory, Book III, Chapter VIII ). In Keynes’ mind, that meant that there was over-investment, meaning the the payoff for investment was consequently quite low and “effective demand” was diminished and consequently hurt the economy. When the United States dipped back into crisis in 1932, Keynes also blamed a liquidity crisis, when “scarcely anyone could be induced to part with holdings of money on any reasonable terms.”
"In the United States, for example, by 1929 the rapid capital expansion of the previous five years had
led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant
which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside."—Keynes (The General Theory, Book III, Chapter 8)
"the granting of credit to consumers,
which has recently been so strongly advocated as a
cure for depression, would in fact have quite the
contrary effect; a relative increase of the demand for
consumers' goods could only make matters worse"
Prices and Production

Hayekian Economics
As a strong proponent of free market economics, used the term 'spontaneous order' to describe the process through which an unfettered free market efficiently allocates resources
Against central planning since markets are needed to generate information for economic decisions
Believed progressive taxation does not uphold equal pay for equal work tenet society seems to value
Free trade is critical to increasing national income
"resist the well-meaning but dangerous
proposals to fight depression by 'a little
inflation'" -
Prices and Production

If the proportion as determined by the voluntary
decisions of individuals is distorted by the creation
of artificial demand, it must mean that part of the
available resources is again led into a wrong direction
and a definite and lasting adjustment is again postponed.
Prices and Production
Hayek's Cure to the Depression
Believed that government debt financing crowds out natural investment and mortgages from future generations
in his letter to The Times, he said "the right way for them to proceed is not to revert to their (the Government) old habits of lavish expenditure"
Abolishing restrictions on trade and free movement of capital is way out of Depression
Preventative economics - Fix the bust by preventing the boom in the first place. Boom was caused by easy money and low interest rates. Advises against such policy in the future
References attached.
Hayek v. Keynes
Keynes' economic thought was for the most part fundamentally new.
Premise that demand determined equilibrium and was the central premise of the depression- and its cure.
rejection of neoclassical economics
Hayek believed that easy credit and government policy predicated the boom-bust cycle
advocated more traditional, classical economic reforms
Hayek: Problem of Credit Value
In Hayek's paper titled, "Intertemporal Price Equilibrium and Movements in the Value of Money" published in 1928, he asserted that credit based market sysems would function as a fair system of trade under the condition that economic policies be put in place to regulate credit expansion. However the economic policies in place prior to the 1929 crash did not accomplish this. Additionally, Hayek asserted that systems of credit must be backed up by a gold supply to ensure and protect credit value. Prior to the crash, credit value was not backed up, and as a result there was the public belief that the value of credit was significantly greater than the value credit actually held.
During an interview, Hayek attributed a root to the economic credit value situation in the early 20th century being the late "attempt to return to the gold at the old parity in the 1920s, which in a sense was quite unnecessary." Hayek believed that this attempt came simply too late, as gold had already devalued by 30% by the early 20th century. Banks did not possess any concrete commodity of substantial value to back up the credibility of a bank's total value and assets.
Hayek: Problem of National Economy
A cause of the great depression came from the under regulated economy that functioned as an economy tied to personal political agenda. Hayek argued that money should not be nationalized. By nationalizing money, you immediately provide a very small group of people the ability to manipulate and control the structure an entire nation's economy. Hayek reasoned that inherently the economy is organic and acts as a means for which individuals acquire various goods they need to survive. In order for this to function successfully, individuals must be able to make rational decisions independently with an understanding of current market values. The reason the 1929 crash was so detrimental was due to the fact that millions of individuals were making economic decisions based on the belief that they had an economic worth that did not actually exist. There was no system in place that could successfully educate and prevent people from falling into this mass false-belief of the market's value.
Hayek: Problem of Unions
The Constitution of Liberty,
Hayek discussed the negative affects of trade unions. The main goal of a union is to create a monopoly, and by legalizing unions, monopolies are in turn legalized and supported. Resultantly, unions "came to be treated not as a group which was pursuing a legitimate selfish aim and which, like every other interest, must be kept in check my competing interests possessed of equal rights, but as a group whose aim - this exhaustive and comprehensive organization of all labor - must be supported for the good of the public."
Labor unions exist as a threat to individual liberties, however the public majority is generally unaware of the danger unions truly pose. Labor unions have the ability to manipulate and influence wages. Striking and withholding labor allows union laboreres to raise and fix wages at a greater value than the wages would naturally have if all willing workers, union and non-union, were able to compete for employment. Hayek stated that "while the real wages of all the employed can be raised by union action only at the price of unemployment, unions in particular industries or crafts may well raise the wages of their members by forcing others to stay in less-well-paid occupations."

Keynes v. Hayek: The Great Depression
In the modern economy of recent history, including the 1930s, there was substantial capacity for production- supply could be extremely high. Keynes recognized the amount of "slack" in the economy, the under-utilization of resources. The economy was not running at optimal capacity but not because of lack of supply but rather demand.
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