The Magazine

Dueling Economists

A century of back-and-forth between Hayek and Keynes.

Jul 1, 2013, Vol. 18, No. 40 • By CHARLOTTE ALLEN
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John Maynard Keynes (1883-1946), godfather of the “stimulus” and the “multiplier,” and Friedrich Hayek (1899-1992), who argued that government intervention in the economy breeds prosperity-killing economic distortions, weren’t just polar opposites in economic theory. They were real-life sparring partners. And as Nicholas Wapshott points out in his double biography, their ideas played themselves out in Great Britain, where both Keynes and Hayek lived and taught, and in the United States, where the economic philosophies of both informed the highest levels of policy-making—at different times, of course.

Friedrich Hayek, 1960, John Maynard Keynes, 1944

Friedrich Hayek, 1960, John Maynard Keynes, 1944

bettmann/corbis, time & life pictures/getty images

During the 1930s, Keynes, at Cambridge, and Hayek, at the London School of Economics, debated each other in person, by proxy (both had coteries of disciples), and in newspaper columns, and exchanged febrile levels of correspondence over a harsh review that Hayek had given Keynes’s A Treatise on Money (1930). They also spent a night together as unlikely comrades in 1942—on the roof of the King’s College Chapel at Cambridge, where they stood, shovels in hand, as part of a volunteer brigade set up to deflect whatever incendiary bombs the Luftwaffe might pour (but fortunately never did) upon that great medieval edifice. 

 One of the few things that Keynes and Hayek (who became a British subject in 1938) had in common was a loathing of Nazi Germany, each for different reasons. Another thing that Keynes and Hayek had in common was outrage at the bleeding of Germany and its World War I ally, Hayek’s native Austria, by the Treaty of Versailles and its Austrian counterpart, the Treaty of Saint-Germain-en-Laye. The brutal reparations exacted by the victorious Britain, France, and the United States, the forced dissolution of the Austro-Hungarian Empire (in whose army the patriotic Hayek had enlisted at age 17), and the resultant massive inflation that beggared the middle classes threatened to destroy Austrian civil society. Keynes, by then a British Treasury official who had tried unsuccessfully to dissuade the Allies from seeking the ruin of enemies already starving from wartime privation, published The Economic Consequences of the Peace in 1919, a damning account of the Versailles negotiations that accurately predicted the extremist politics that were to follow. The book made Keynes “something of a hero to us Central Europeans,” Hayek later recalled. It was the last time—except, perhaps, for that night defending King’s College Chapel—that the two were to see eye to eye.

Keynes was the son of a Cambridge economist, John Neville Keynes. His mother, Florence, had graduated from Cambridge’s all-female Newnham College, and she later became the first woman mayor of the town of Cambridge. So it was, perhaps, inevitable that Keynes would eventually fall under the spell of his father’s Cambridge mentor, Alfred Marshall (1842-1924), then England’s leading economist. Marshall shepherded Keynes out of his chosen field, mathematics, and into economics. Keynes worked in the civil service’s India Office and, in 1909, became a lecturer at Cambridge, where he continued to teach off and on for the rest of his life. At Cambridge, the young Keynes also fell in with the Bloomsbury Group: Lytton Strachey, Virginia Woolf, E. M. Forster, and the like. Keynes was by then a notoriously promiscuous homosexual, which made him a natural for Bloomsbury; but his interest in the mundane field of economics (in the eyes of artsy Bloomsburyites), as well as the patriotism that prompted him to join the Treasury’s war operations in 1915, led to a rift. The final break came in 1925, when Keynes married a Russian ballerina, Lydia Lopokova, whom the group despised as an intellectual lightweight. (It was nonetheless a surprisingly happy marriage, given Keynes’s sexual history.)

Keynes was not a socialist, but he did believe that market capitalism alone could not prevent, say, the runaway inflation he observed in postwar Germany and Austria. He also rejected the classical economics theory, propounded by his mentor Marshall, among others, that while supply and demand may never be entirely congruent—there will always be “business cycles” that generate job losses as the cycles play themselves out—a kind of equilibrium of nearly full employment will even things out in the long run.

“In the long run, we are all dead,” Keynes famously declared, throwing down the gauntlet to classical economics. He believed that governments have a duty to intervene in the short run to smooth out the harsh effects of fluctuating business cycles. He argued that such phenomena as recessions and falling prices (deflation) were the result of an irrational discordance between savings and private investment at the low end of business cycles, when potential investors might be reluctant to put their money into the capital equipment that could generate the production of goods that would lead to higher employment among the producers. 

In order to get people back to work, Keynes advocated that the government itself create jobs by way of public-works projects to be financed by government borrowing. Keynes argued that every new job thus created would generate a demand for goods that the newly hired could now afford—which would, in turn, generate even more jobs manufacturing and selling those desired goods. This was the famous “multiplier effect,” more fully developed by Keynes’s Cambridge disciple Richard Ferdinand Kahn (1905-1989). Then, as prosperity rushed back under demand-instigated production, governments flush with tax revenues from the newly re-employed could easily repay the borrowed money. As a corollary, Keynes urged Western nations to abandon the gold standard, whose strictures he viewed as interfering with the government’s ability to expand people’s purchasing power (and thus jump-start the economy) during depressed times by increasing the money supply. Keynes singlehandedly invented the modern concept of “macroeconomics,” the big-picture perspective of economic transactions that implies direction from the top.

On a 1934 visit to America to convince Franklin Roosevelt of the virtues of massive public-works spending—or, skipping public works and putting the unemployed directly onto the dole—Keynes explained to FDR’s skeptical labor secretary, Frances Perkins (as she later recalled),  

[A] dollar spent on relief by the government was a dollar given to the grocer, by the grocer to the wholesaler, and by the wholesaler to the farmer, in payment of supplies. With one dollar paid out for relief or public works or anything else, you have created four dollars’ worth of national income.

Friedrich Hayek scratched his head over such supposed multiplier magic as much as Perkins did. His family had been part of the prosperous Viennese lesser gentry—Hayek was second cousin to the philosopher Ludwig Wittgenstein, and his surname had been “von Hayek” until the Austrian government banned titles of nobility in 1919—whose savings were incinerated by postwar inflation. Hayek’s father, a physician, could barely afford his son’s tuition at the University of Vienna, much less his son’s eclectic intellectual interests, which included a desire to study sociology with Max Weber at the University of Munich—a hope dashed when Weber died in 1920. When Jeremiah Whipple Jenks, a New York University economist, invited Hayek in 1923 to be his research assistant for a book about Central Europe’s war-ravaged economies, Hayek had trouble scraping up enough money for a one-way passage to Manhattan. 

He had met Jenks through the most important personal contact he ever made in his life: with Ludwig von Mises (1881-1973), one of the founders of the so-called Austrian School of economics and a lecturer at Vienna, where Hayek was obtaining a doctorate in law during the early 1920s. Mises was a classical economist and then some. He taught Hayek that government intervention in the workings of markets was, at best, ineffectual—because there was no way that a centralized bureaucracy could anticipate or plan for the myriad individual decisions that constituted a functioning economic system. At worst, government intervention on borrowed money (as Keynes advocated) generated wasteful misallocations of funding into capital projects whose economic value was questionable—or private investment would have funded them on its own. The end result, when the government subventions stopped and the plants fell idle, was persistent unemployment—a “collapse at the bottom of the business cycle,” Wapshott writes. As Hayek said in one of his lectures: 

The situation would be similar to that of a people of an isolated island, if, after having partially constructed an enormous machine which was to provide them with all the necessities, they found that they had exhausted all their savings and available free capital before the new machine could turn out its product. They then would have no choice but to abandon temporarily the work on the new process and to devote all their labor to producing their daily food without any capital.

In 1928, Hayek was invited to debate Keynes at a meeting of the London and Cambridge Economic Services. Hayek’s critique during the course of that debate—plus an essay entitled “The Paradox of Saving” (1929), which argued that private investment was a generally rational process that produced exactly the goods that would find ready sales (so government intervention was always a distortionary mistake)—earned Hayek an invitation to lecture at the London School of Economics in 1931. The LSE’s head, the economist Lionel Robbins (1898-1984), had been converted from socialism by Austrian-School theory, and Hayek’s lectures generated a faculty position for him. 

At the same time, Keynes was on the radio urging Britons to spend their earnings on consumer goods instead of hoarding them in savings accounts, persuading the British government to abandon the gold standard—which Keynes blamed for having devastated the economy during the 1920s—and preaching the gospel of deficit spending. So, at Robbins’s urging, Hayek wrote a blistering, if impeccably polite, review of Keynes’s A Treatise on Money, a work that reiterated Keynes’s theories about the inadequacies of the market in alleviating human misery during economic downturns. Keynes responded to Hayek’s review with a riposte, and the two continued to debate for months in the pages of Economica, a journal edited by Robbins, and in a stream of letters. (Hayek even fired one off to Keynes on Christmas Day, 1931.) In retaliation for the assault on A Treatise on Money, Keynes dispatched one of his Cambridge disciples, Piero Sraffa (1898-1983), to spearhead a brutal critique of Hayek’s Prices and Production (1931).

 And so was launched a decades-long battle between John Maynard Keynes and Friedrich Hayek, lasting long after their deaths, in the hearts and minds of academic economists, the general public, and, most significantly, political leaders in Great Britain and the United States. It was a battle that Keynes won on almost every front, as Hayek was hampered by (among other things) a dense and nearly incomprehensible prose style that made figuring out what he was trying to say rough going. The one exception was Hayek’s runaway bestseller The Road to Serfdom (1944), which argued in simple, declarative language that central economic planning was not only counterproductive, but coercive and totalitarian. The book was, in part, Hayek’s brief against National Socialism. Keynes and other liberals had aligned Nazism and capitalism, but Hayek argued that Hitler’s corporatist ideology was profoundly antithetical to the workings of the free market. The success of The Road to Serfdom inspired Hayek to found, in 1947, the still-extant Mont Pelerin Society, then a rump group of friends of Hayek, including Mises, Robbins, the scientific philosopher Karl Popper, and Milton Friedman, then a 35-year-old economist at the University of Chicago. Friedman’s brother-in-law, Chicago law professor Aaron Director, had been taken by Hayek’s ideas while visiting him at the LSE, and had been instrumental in getting the University of Chicago Press to publish the American edition of The Road to Serfdom

Still, Hayek seemed determined to snatch defeat from the jaws of victory. For inexplicable reasons, he never got around to writing a sustained critique of Keynes’s magnum opus, The General Theory of Employment, Interest and Money (1936), effectively ceding the arguments to his rival. And unlike Keynes, who successfully transitioned from homosexual polyamorist to respectable husband, Hayek scandalized his LSE colleagues, especially Robbins, by abruptly leaving his wife of 24 years, Helen, with whom he had two children, in 1950, in order to marry his cousin Helene. Helen announced her intention to contest the divorce, so Hayek quit his LSE post and took a teaching job at the University of Arkansas, which was in a jurisdiction where the marriage laws were more permissive. Needing a larger salary to support two households, he sought a teaching job in the University of Chicago’s economics department—only to discover that, despite his friendships with Friedman and George Stigler (another Chicago economist), the popular success of The Road to Serfdom assured that Hayek would not be taken seriously as an academic economist. He did manage to secure a position with Chicago’s Committee on Social Thought—but as a professor of social and moral science, not economics. Hayek’s next book, The Constitution of Liberty (1960), which was supposed to be his own magnum opus (and set him up financially for life), proved to be a resounding flop, generating few sales and scathing reviews, even from Robbins. 

Membership in the Mont Pelerin Society dwindled. In 1960, Hayek suffered the first of several bouts of clinical depression, and the next year, he experienced the first of several heart attacks. In 1962, panicked over his diminished financial prospects and the idea of Helene living in poverty after his death, he left America to accept a teaching post at the University of Freiburg, and then, in 1969, at the University of Salzburg. In 1974, Hayek shared the Nobel Prize for economics with the Swedish Keynesian Gunnar Myrdal, but few American economists remembered who Hayek was.

Meanwhile, Keynes’s star soared. “We are all Keynesians now”—a phrase attributed to Richard Nixon when he took America off the gold standard in 1971, but actually composed by Milton Friedman—was an apt description of postwar leaders of all political stripes in Britain and, especially, the United States. FDR, although voicing a belief in “sound money,” made public-works schemes financed by tax dollars and swollen budget deficits a central feature of the New Deal. Furthermore, Keynesianism reverberated through university economics departments as the reigning orthodoxy, especially at Harvard, where the young John Kenneth Galbraith became so enamored of Keynes that he made a 1937 pilgrimage to Cambridge to study with the master. Roosevelt’s successor, Harry Truman, was famous for his disdain for economists—he declared that he wanted to meet a one-handed economist so as not to hear the words “on the other hand”—but his Employment Act of 1946 was essentially a Keynesian document toned down to meet Republican concerns about deficits.

Dwight D. Eisenhower might have been a Republican, but, according to Wapshott, he “spent taxpayers’ money like no peacetime president had before him, although he overcame conservative objections by passing off the expenditures as essential for national security.” (The Interstate Highway System that Eisenhower spearheaded in 1956 went under the moniker of the National Defense Highway program.) As Wapshott explains, Eisenhower was the first president to realize that government manipulation of the economy could be put to political use, to help win elections. That lesson got driven home the hard way in 1960, when a recession occasioned by Eisenhower’s belated attempts to cut public spending swept John F. Kennedy into the White House later that year. Writes Wapshott: “[S]uccess at the ballot box comes from managing the economy to bring the business cycle into line with the four-year electoral cycle.” Kennedy, and especially his big-spending successor Lyndon B. Johnson, learned that lesson well.

The fact that the 1960s represented an apex of prosperity for all classes of Americans helped. In 1965, Time made Keynes its Man of the Year, even though he had been dead for nearly two decades. Keynesianism underlay Nixon’s attempts at wage and price controls (not to mention his abandonment of the gold standard), Gerald Ford’s acquiescence in more of the same, and Jimmy Carter’s 1978 endorsement of the Humphrey-Hawkins Full Employment Act, which required the president and the Federal Reserve to keep aggregate demand high enough to guarantee everyone a job.

There was a respite during the late 1970s, when the chickens came home to roost: In the United States, there was “stagflation,” that combination of galloping unemployment and runaway price hikes that was not supposed to occur under Keynes’s paradigm; in Britain, there was a decline in living standards in an oppressively state-run economy. In 1979, Margaret Thatcher, who had read The Road to Serfdom as an Oxford undergraduate and revered the aged Hayek, became prime minister and began dismantling Britain’s bloated public sector. The following year, Ronald Reagan was elected president, with Hayek’s disciple Milton Friedman as an adviser. After a brief, inflation-killing recession attributable to Hayek’s tight-money policies that Reagan promptly put into effect, America bounded into “Reaganomics”-fueled prosperity. And yet, neither Reagan nor Thatcher could effect the near-privatized society that Hayek envisioned. Reagan, in particular, could not resist tinkering, as with the Reagan tax cuts (disapproved of by Hayek because there were few commensurate spending cuts). As a result, America went from the world’s largest creditor to the world’s largest debtor by the time Reagan left the White House.

It was the old problem, identified here by Wapshott: that it is more politically productive for a democratically elected government to manipulate prosperity into existence—even a short-lived and ultimately catastrophically damaging existence—than to allow market forces to run their course and generate the equilibrium that Hayek and the classical liberals predicted. Hence, such phenomena as George H. W. Bush’s 1990 tax hikes, despite his read-my-lips pledge; Newt Gingrich’s Contract with America, which was supposed to cut Big Government; Bill Clinton’s flirtations with Keynesian stimuli; and George W. Bush’s own capitulation to stimulus programs and massive bailouts in 2008, as recession crashed over the economy like a tidal wave.

Of course, Barack Obama’s presidency has been a kind of Keynesian dream come true, starting with an $800 billion stimulus package and including massive government investment in “green” technology (think Solyndra) and the shuffling of millions more Americans onto the dole by way of record food-stamp enrollment, near-interminable unemployment benefits, and the easing of work requirements meant to spur people off the welfare rolls. And all of this has been paid for, so to speak, by way of aggregate federal borrowing that is rapidly approaching $17 trillion.

There is, as Hayek might have predicted, no evidence that any of these panaceas has actually worked. So perhaps it is high time to give Hayek a chance to prevail in the Keynes-Hayek skirmishes—although, given the perennial allure of borrowed federal money, it’s probably more like a fat chance. 

Charlotte Allen is a frequent contributor to The Weekly Standard.