The Anti-Keynes : Friedrich Hayek sheds light on our economic troubles

In the current economic-policy debate, the ideas of John Maynard Keynes are resurgent. Here are some of the results: Federal deficit spending soon will reach, and far exceed, previous peacetime peaks. Current projections indicate the budget deficit may surpass $1.1 trillion (that’s trillion with a “T,” one thousand billion) in fiscal 2009. Deepened by emerging stimulus expenses, the deficit may top $1.4 trillion, or about 10 percent of gross domestic product. The federal government will borrow slightly less than half of what it spends.

Before he became the great intellectual opponent of socialism, Friedrich Hayek was a technical economist and Keynes’s foremost intellectual disputant during the Great Depression. Given the renaissance in Keynesian thinking, it is fruitful to revisit some of Hayek’s analysis for the light it may shed on our current circumstances.

Crucial elements in Hayek’s thought are that (1) prices are the signals of worldwide supply and demand for various goods and services, (2) interest rates are vital in guiding production decisions, (3) profits guide resources to those who use them most effectively, and (4) the smaller government is, the better. It could hardly be said that any of these insights informs current policy. Hayek’s wisdom is being ignored, a fact that does not bode well for the future of the economy.

It is entirely possible — even likely — that there will be a short-lived turnaround in the economy in the second half of 2009. Both the federal government and the Federal Reserve have been dumping money into the economy and spending like there’s no tomorrow. Since 2001, the Fed has followed the most erratic course in its history; the fiscal reversal from a modest federal budget surplus to a prospective $1.4 trillion–plus deficit in this same period is unprecedented in peacetime. Hayek was an agnostic, but if he happens to be watching these developments from a perch in the afterlife, he must be agitated.

Let us focus first on the Fed, since it is the main culprit in the current mess — much as it was during the Great Depression, when its mismanagement of the money supply turned a recession into a catastrophe. The federal-funds rate, the Fed’s favored tool for influencing the economy, stood at 6.5 percent in early 2001 — in hindsight, excessively high. The Fed undoubtedly contributed to the downturn of 2000–01 by raising the funds rate between 1998 and 2000.

As a result of the economic downturn it helped cause, the Fed began to cut the funds rate in 2001. The rate had been reduced to the 4 percent range before September 11. The Fed then cut it to 1 percent, where it remained through 2004. At that point, concerned about inflation and heedless of the huge concurrent appreciation in home prices — many financed through adjustable-rate mortgages — the Fed raised the funds rate to 5.25 percent between 2004 and June 2006. This will be remembered as one of the most destructive policies the Federal Reserve Board ever pursued.

Hayek emphasized the importance of government-influenced interest rates in his early economic work in the 1920s and 1930s. He was among the first to consider himself a monetarist, meaning an economist who emphasizes the effects of monetary policy on the broader economy, but his brand of monetary economics was very different from that of his most famous colleague and intellectual compatriot, Milton Friedman. Hayek and Friedman taught together for a dozen years at the University of Chicago during the 1950s and early 1960s, and both were members of the Mont Pelerin Society, an international organization devoted to classical liberalism, from the 1940s to the 1980s.

Hayek argued that if interest rates are too low they will attract resources to areas of the economy that would not otherwise be attractive investments. This was certainly the case in the housing bubble. The Fed played at least as important a role as inadequate lending standards in the escalation of house prices between 2002 and 2006, when many real-estate markets saw double-digit annual increases in the sales price of a good that could be acquired for a single-digit down payment. This was the Greenspan housing bubble.

That lending standards for purchases and refinancing also collapsed at this point compounded the problem, of course. Hayek’s view was that prices, including the price of borrowing, broadcast important production and resource-direction signals throughout the economy. If the price of money (which is to say, interest) is unstable, or if it becomes possible to borrow for certain economic activities but not for others, this will distort decisions to buy, sell, or invest. Artificially low interest rates helped create an expectation of ever-rising prices, which attracted many home-buyers who otherwise would not have chosen to purchase houses at what were already historically high prices.

But bubbles cannot last forever. As Greenspan’s chairmanship was coming to an end, the Fed began its relentless campaign to raise the federal-funds rate, which reached 5.25 percent in 2006. In retrospect, it is impossible to justify the rise to that level. The excessive increase in the rate between 2004 and 2006 triggered the financial crisis that emerged in August 2007. Policies pursued by the Fed since that time, under chairman Ben Bernanke, have been positive and appropriate; even so, in retrospect it would have been better to lower the federal-funds rate even more in 2007. This might have prevented the financial carnage of late 2008.

What does the future hold? Hayek subscribed to the “quantity theory of money” — that prices will rise if the money supply increases — though he was more concerned with how changes in interest rates distort economic activity than with the influence of money on aggregate prices. Nonetheless, he would have certainly held that the unbridled growth in the money supply in the last quarter of 2008 — some 12–13 percent growth in M1 (essentially, currency plus checking deposits), an annualized rate of increase of more than 50 percent — could not continue without escalating inflation.

It is likely that at some point the Fed will raise interest rates and curtail existing measures to increase liquidity in financial institutions. Or it may allow prices to inflate. The United States could be in for a double-dip recession in which economic activity responds to the unprecedented fiscal and monetary stimulus but then hits a wall as interest rates and prices rise. Hayek’s adversary, Keynes, recommended fiscal policy rather than monetary policy as the way to steer an economy, and this seems to be the Obama administration’s intention.

Its $800 billion–plus stimulus package amounts to a short-term boost to the economy of about 2 percent of gross domestic product per year. That’s not a small amount of money, and, together with the Fed’s own monetary stimulus, it should lead to short-term economic growth. But in the long run (which Keynes deprecated), truth keeps the score, and it is unlikely that the fiscal policies being adopted by the Obama administration will resolve the fundamental economic difficulties before us. It’s not going to represent change Hayek could believe in, but rather more of the same.

Hayek’s argument for less government was efficiency. In the private sector, if one can sell a product for more than it costs to produce, then it is efficient to continue producing. But without a price mechanism, how is the efficiency of a government action to be judged?

Hayek emphasized that specific policies are more important than a generalized commitment to free-market principles. He argued this point in The Road to Serfdom (originally published in March 1944 in England, 65 years ago next month): “Probably nothing has done so much harm to the liberal cause as the wooden insistence of some liberals on certain rough rules of thumb, above all the principle of laissez-faire.” He acknowledged that government has a vital role to play in society, and that how government performs this role is important to the economy.

Hayek also warned in The Road to Serfdom against government’s consuming too large a proportion of economic output. He worried about the state of freedom and economic productivity in a society dominated by government: “We can unfortunately not indefinitely expand the sphere of common action and still leave the individual free in his own sphere. Once the communal sector . . . exceeds a certain proportion of the whole, the effects of its actions dominate the whole system.”

Keynesian ideas of expansive and activist government are prominent now, but it is unlikely that they will provide the right antidote to the maladies that confront the global economy. Hayek’s prescription — free markets, limited government, a stable monetary policy, low taxes, and light but appropriate regulation — is more likely to produce lasting prosperity in the long run.

Yes. Trillion is Ten raised to the twelve. Million is ten raised to the 6. So a million million is a trillion.

Let’s say we now have 10 million people unemployed today. For a trillion, we can give each and everyone of them $100,000 and deposit it in their bank account.

"In the current economic-policy debate, the ideas of John Maynard Keynes are resurgent. Here are some of the results: Federal deficit spending soon will reach, and far exceed, previous peacetime peaks. Current projections indicate the budget deficit may surpass $1.1 trillion (that’s trillion with a “T,” one thousand billion) in fiscal 2009. Deepened by emerging stimulus expenses, the deficit may top $1.4 trillion, or about 10 percent of gross domestic product. "

"But...but, he studied at Harvard..."

Interesting article, and many interesting points.

I absolutely disagree with this one, though . . .

At that point, concerned about inflation and heedless of the huge concurrent appreciation in home prices — many financed through adjustable-rate mortgages — the Fed raised the funds rate to 5.25 percent between 2004 and June 2006. This will be remembered as one of the most destructive policies the Federal Reserve Board ever pursued.

A Federal funds rate of 5.25% should have been perfectly reasonable at the time -- especially when you consider that it had been raised to that level over a period of two years from a historic low point.

There is a lot more to the story of the U.S. economy than meets the eye. I have my own theories, but the fact that the economy began to unravel with the first signs of collapse in the summer of 2007 is no coincidence.

1.4 trillion is just this years deficit spending, which gets added to the National debt.

Now, Our National debt is about 20 TRILLION dollars. (conservative) If 1.4 is 10% of GNP, 20 Trillion close to 150% of GNP!!!

How the heck do we repay that? We can't even pay the interest on that!

Buy a wheel barrow while a few dollars still buys one, you are going to need it.

Paint "My wallet" on the side. Collect all the copper pennies you can. They will be worth something at least.

Or maybe not. Not since 82. Now they are all alloys of copper nickle and zinc worth 1/5 their face value. By copper pipe and wire instead.
Make your own post Obama liberty pennies dimes and quarters by wieght.

My theory is the economy started to unravel once it became clear the Bush tax cuts would not be extended past 2010. That meant the upper income folks knew that the ‘end was nigh’ and investment and other decisions started getting pulled in.

a recession was then inevitable.

81 and earlier pennies are mostly copper, and worth 96% of their copper metal value.
1942-45 nickles are silver and worth .81 cents metal value.

1916-45 mercury dime is silver and worth $1.04 metal value

1946-64 Roosevelt dime is silver and worth $1.04 metal value

1932-64 quarter is silver and worth $2.62 metal value

1916-47 half dollar is silver and worth $5.25 metal value

1948-63 half dollar is silver and worth $5.25 metal value

1964 kennedy half dollar is silver and worth $5.25 metal value

1965-70 half dollar is 40% silver and worth $2.14 metal value

1878-1921 Morgan dollar is silver and worth $11.22 metal value

1921-35 peace dollar is silver and worth $11.22 metal value

1971-1976 Eisenhower Dollar 40% silver and worth $4.59 mwtal value

My theory is that the "Bush tax cuts" were never intended to extend past 2010 -- so the expiration of those tax cuts had almost no bearing on the economy at all.

The 2010 sunset provision was included in the original legislation simply to allow members of Congress to cover their @sses and institute a massive tax hike without having to vote on it.

My theory is that the severe economic contraction was the inevitable -- and well-planned -- result of idiotic fiscal policy under which the U.S. government implements massive new domestic spending programs while at the same time spending hundreds of billions of dollars on major military campaigns overseas.

What you're seeing now is no different than the last time this idiocy took place (LBJ's combination of the "Great Society" and the Vietnam War).

It all started after McCain's acceptance speech was so bad that investors realized Obama was going to win. Because Obama had declared he would raise capital gains taxes, investors decided to get out while they could still pay only 15% on their gains.

Then when middle America saw the IRA values dropping like a stone, the Boomers, who are retiring soon or already, stopped their usual prodigal spending that used to keep the economy afloat.

Add that to the Democrats corrupt feeding at the pig trough of Fannie and Freddie and certain banks and the house of cards they were standing on began to come down.

Nope.
They were intended to be renewed ... by a Republican Congress.

The idea was that they could get re-elected by promising tax cuts for the next few years. The other ploy was that they had some pay-go rules (since ignored) so a temporary tax cut was ‘cheaper’ than permanent one - even though the cap gains tax cut paid for itself!

Obviously, the political ploy backfired and we now have an economic mess because the Democrats hate tax cuts.

Nobody plans a bad economy deliberately.
But liberalism and socialism create it because they have a grudge against the wealth-creators. I like Rush’s term - their “War on Prosperity”. That’s what it is.

Wow, great info. Do you have a link to a spreadsheet with the denonimation, its year, its precious metal weight(s), and current value? This would be a handy log for coins.

It's time to keep the change around. I always pull out older change even if it's beat up since there's more valuable metal content. You can expect to see more older coins during hard times. I saw an elderly lady spending a $5 gold receipt bill at a Kroger in Texas about 1986-87.

Planning ahead already saved me $100K in my IRA by bailing from the market before it tanked.

According to Jonah Goldberg in Liberal Facism, Keynes was a reprehensible dude.

He was the chairman of the British Eugenics Society in the forties, right about the time Adolf was gaining notoriety for his Eugenics beliefs.

Doesn’t matter a lick to liberals.

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