With the economy anemically plodding along, political gridlock has hit Washington. President Obama insists that the key to job creation and economic growth is another round of stimulus. That’s a political non-starter for the House Republicans who believe that lowering taxes and reducing federal spending is necessary for the private sector to pick up again.
This political polarization is another round in the “fight of the century,” an economic dispute that’s gone on for the last eighty years between “conservatives” and “liberals.” It’s an ideological battle that has led to numerous vituperative debates through the years.
Hoover Institution fellow Russ Roberts (host of the indispensible Econtalk podcast) and Nicholas Wapshott, a British journalist, discussed these competing economic visions on the October 17th edition of Econtalk. The interviewer, Roberts, is a noted Hayekian and progenitor of the sensational Youtube series on two of the 20th century’s most prolific economists. Wapshott is author of the recently published Keynes Hayek: The Clash That Defined Modern Economics.
The conversation briefly gave biographical sketches of the life and thought of the two economists. Hayek was an Austrian classical economist who believed that government should steer clear of planning the economy. Unintended consequences would no doubt ensue if government sought to manage the economy. Let the business cycle correct itself, Hayek claimed.
These words rang hollow during the midst of the Great Depression. Seemingly, the classical economists had no solution to solve rampant unemployment. Unemployment remained astronomically high year after year. When would the misery end?
British economist John Maynard Keynes’ General Theory offered a panacea for the depressed economy. Keynesianism, as it came to be known, called for government intervention in economy during business cycle downturns. It had a moral responsibility to do so; when people hurt, government must act.
How would this work? Government should pump demand (spending) into the economy during recession because the private sector was incapable of doing so. This made fiscal policy (the use of government spending) key to turning the economy around.
Hayek warned that injecting demand into the economy would create inflation. He feared that once the pump was primed, it would be impossible to control. This was not out of the realm of possibility. After all, Hayek had seen the horrors of hyperinflation destroy Germany following the Great War. Inflation’s impact on the social fabric concerned the Austrian economist.
Keynes said inflation was a tolerable trade-off if it put people back to work. This ultimately was reflected in the Phillips Curve, a graph which dealt with the inverse relationship between inflation and unemployment. Full employment created inflation while rising unemployment would bring inflation down. Government planners would use the Phillips Curve to manage the macro-economy and handle the twin challenges of inflation and unemployment.
The perceived success of the New Deal made Keynesianism triumphant in America. Many felt that Roosevelt had saved the country by using Keynesian policies to get the country out of the Depression. Successive administrations followed the Keynesian playbook for decades. Even Republicans bought into the argument. The nominally conservative President Richard Nixon famously proclaimed “we’re all Keynesians now.”
This went on for forty years. The academic world considered Hayek’s warnings, and indeed his scholarship, out-of-date. Russ Roberts sardonically compared this period as Hayek’s time in the desert, referring to the forty years the Israelites spent wandering in search of the Promised Land.
This period of Keynesian hegemony ended abruptly in the 1970s when stagflation hit the Western world. Stagflation, or high unemployment and high inflation, threw Keynesian economists for a loop. Stagflation, in their mminds, simply could not happen. Yet its impact led to a decade of economic malaise.
Around this time, classical economics began a renaissance and Hayek’s work garnered praise and admiration around the globe He received international recognition when the Nobel Committee awarded him its economic prize in 1974.
The Austrian delivered a famous acceptance speech in Stockholm, which was titled “The Pretence of Knowledge.” This was his retort to Keynes and the “General Theory” (something he had famously eschewed after Keynes’ book came out). Hayek condemned what he perceived as “the pretense of knowledge” that government planners possessed. Tinkering with the economy was detrimental and ineffectual because experts in Washington lacked the knowledge to plan the macro-economy.
Economics was not a physical science, Hayek argued. Keynesianism rested on the micromanaging of the macro-economy and claimed its theory would solve fluctuations in the business cycle. That was a Sisyphean task because no one (or group of bureaucrats in Washington) had the requisite knowledge of every sector of the economy. It was too vast and too complex for even a super-computer to fully grasp.
Hayek’s solution was simple: let the price system work. The price system gave individuals the best way to make sense of the fluctuating market. This provided what Hayek called “spontaneous order,” something which benefitted the social order and was superior to any state design.
At the conclusion of his address, Hayek implored his contemporaries to show some humility and recognize the limits of human reason. Interventionists always thought their “plans” would work and would produce greater economic growth and prosperity for all. But instead, their “plans” led to less freedom and prosperity for the masses.
These unintended consequences should teach planners a lesson. State intervention could not work because man lacked the knowledge to plan the macro-economy. Pursuing such aims would ultimately destroy civilization.
Keynesians scoffed at this critique, then and now. But considering the malaise that’s afflicted theUnited States during the last four years -high unemployment, growing political unrest, loss of faith in government and institutions- Hayek’s warning now appears prescient.