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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“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.