Following the Crash of 1929, an epic debate began between liberals who believed in capitalism’s automatic stabilisers and John Maynard Keynes who did not. Today, in Bailoutistan (Greece and the other fallen eurozone countries), this debate has taken an interesting, sad, twist.
Hayek vs Keynes
In the aftermath of the Crash of 1929, Keynes famously criticised the conventional wisdom of his time (the so-called Treasury View) which held that, given sufficient time, the economy would adjust to any recession by letting wages and interest rates fall until the entrepreneurs’ ‘animal spirits’ are stirred sufficiently to stimulate both the additional employment and investment necessary to end the recession. Keynes’s objection was that, following a massive financial crisis that manages to infect the ‘real’ economy, it is highly likely that the large diminution in output, investment and income will lead to a ‘bad’ equilibrium. To a situation where unemployment is sustainably high (and unresponsive to wage reductions that cause labour to become dirt cheap), investment is rarer than snow in the desert (even after interest rates have crashed to zero; the so-called liquidity trap) and, generally, to an economy stuck in a new underemployment equilibrium from which it will not escape even if prices are free to adjust to their heart’s content. Under those circumstances, thought Keynes, to target government budget deficits, by means of government spending cuts, is precisely wrong. His proposition was that, once an economy finds itself locked into an underemployment equilibrium, any attempt to try to “cut itself out of the slump” is tantamount to cutting one’s nose to spite one’s face. No, for Keynes the trick was to “grow out of the depression”.
At the time, the Treasury View (i.e. that automatic stabilisers would do the trick) seemed increasingly pie-in-the-sky and vulnerable to Keynes’s quip that “in the long run we are all dead”. It took an outsider’s intervention to articulate (a) the strongest critique of Keynes, and his advocacy of government intervention during a slump, and (b) the most powerful defence of the market’s superiority as a resource allocation mechanism which government meddling can only stunt and harm – with long term detrimental effects for all. That ‘outsider’ was none other than Friedrich von Hayek.