Debates between ‘Hayekian’ and ‘Keynesian’ perspectives constitute one of the main conceptual fault-lines of the Eurozone crisis. In the first of two EUROPP articles covering this debate, Steven Horwitz discusses Friedrich Hayek’s work and why it presents a compelling case against governments using increased public spending to solve Europe’s economic problems.
As EU economies continue to struggle, economists like Paul Krugman are calling for another round of stimulus spending, believing that the size of the programmes adopted early in the global recession were insufficient. Desperate politicians may well choose to go in that direction, if for no other reason than that the arguments against doing so are often not very effective.
So why not another round? The most powerful argument against more stimulus comes from Friedrich Hayek and the Austrian school. The key to their view is their understanding that economic resources, whether capital or labour, are not fungible. That is, capital goods and human beings have a multiple, though not infinite, number of ways they can contribute productively to the value creation process.
The productive structure of an economy is like a jigsaw puzzle where the pieces of capital and labour must fit together in particular combinations. Only specific pieces can be linked with others. However, unlike real jigsaw puzzles, we don’t have a picture of the pattern we are creating. Instead, we have prices, profits, and losses to inform us when pieces do or do not fit together appropriately. If those signals are working well, we will have success at fitting pieces together in ways that are orderly. The interesting thing about that orderly use of the jigsaw puzzle pieces is that we might not need to use all the pieces at any one time to generate a recognisable and desirable pattern.
One way of understanding the boom that produced the bust and the subsequent slow recovery is that artificially low interest rates generated by the central bank and government interventions in housing markets weakened the price and profits signals that inform us of whether the pieces fit. The result was a puzzle that used almost all of the pieces, but forced them together in ways that did not produce a recognisable pattern. In other words, the economy’s productive structure was not sustainable, as we discovered in 2008. The recession is the dismantling of that puzzle and the recovery is the attempt to reconstruct it, but this time in such a way that the pieces actually fit together. Where we are now, in a world of high unemployment rates and low investment, is the equivalent of lots of puzzle pieces sitting around not being put together.
What advocates of stimulus are arguing is that we need spending, just any old spending, to jump start struggling economies. But this argument must assume that it does not matter which capital and which labour are brought out of idleness and into what sorts of activities. They must of necessity ignore the specificity of resources and their limited complementarity. It does us no good to try to force pieces together that don’t fit, as that’s what got us in trouble in the first place. And the point of doing a jigsaw puzzle of this sort is to get the pieces to fit in a way that forms an orderly pattern, not to simply use them all up.
The assumption in most stimulus spending is that there are projects just waiting to be pursued if only we would spend the money. What is overlooked is whether the capital and labour that are idle are the resources best suited to those projects, not to mention whether consumers and citizens even want those outputs in the first place. Just buying, hiring, and producing for the sake of “doing something” will create a structure of production that is quickly found to be unsustainable. A few projects may be “shovel ready,” but most will require engineers and others to do the planning. If the unemployed are mostly construction workers and financial managers, these projects will not be able to find the engineers they need at wages they can afford, and unemployment will not be reduced.
Politicians and bureaucrats lack the knowledge to know which pieces fit with which pieces as they cannot know the nature of the idled resources and what consumers want. They are unable to know what is needed to create a sustainable recovery. One of the most fundamental insights of Hayek and the Austrians was that prices, profits, and losses serve as knowledge surrogates to coordinate the decentralised decisions of producers and consumers, themselves often based on knowledge that they could not communicate any other way.
Politicians who are structurally unable to know how best to allocate stimulus resources will inevitably distribute them to those persons and groups who will give them the most electoral support. The Austrian caution about the limits of politicians’ knowledge suggests that no matter what is drawn up on the blackboard, the politicisation of stimulus spending is not an accident and cannot be avoided. Stimulus spending that goes to groups that will provide the most votes will ensure that the right combinations of capital and labour will not be formed.
So what can we do? The answer lies in the criticism: free up competition, prices, profits, and losses so that entrepreneurs and others can finish the process of tearing down the mistakes of the boom and figure out how to reallocate those resources to their new best uses. That process takes time, but if politicians cease meddling in it and start allowing market processes to do their job, particularly by allowing failed firms to go bankrupt and sell off their assets for more valuable uses, recovery will take place more quickly.
Before the advent of Keynesianism, most recessions were very short lived as producers were left free to shuffle the jigsaw pieces into better combinations. It is the very lack of trust in markets, and the misguided trust in the political process, that Keynesianism produced that now leads us to think stimulus spending is necessary and effective. Hayek and the Austrians give us good reasons to think otherwise.
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Note: This article gives the views of the author, and not the position of EUROPP – European Politics and Policy, nor of the London School of Economics.
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Steven Horwitz – St. Lawrence University
Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY. He is the author of two books, Microfoundations and Macroeconomics: An Austrian Perspective (Routledge, 2000) and Monetary Evolution, Free Banking, and Economic Order (Westview, 1992). He has written extensively on Austrian economics, Hayekian political economy, monetary theory and history, and the economics and social theory of gender and the family.
In a sense this seems half-right. Although it surely contains a serious factual distortion in saying that ‘Before the advent of Keynesianism, most recessions were very short lived’.
The reality is that it doesn’t need governments to misallocate resources with serious and difficult to reverse consequences. Market mechanisms are also prone to quantitative and qualitative failure.
‘…free up competition, prices, profits, and losses so that entrepreneurs…’
Sure, but the ‘entrepreneurs’ of free-market myth have largely been replaced by global corporations who are as political as governments, but without the (albeit limited) accountability.
Some further thoughts at http://www.futureeconomics.org/2012/07/keynes-is-all-we-need
The small business person has not been replaced by big business. Far from it. There are more small businesses (in the modern sense) now than there ever have been. Free business owners and they will hire. This is the only way out of the depression trap. The problem is the Keynesians would prefer to hold to their faith than allow the Austrians to with the great economic debate.
“Market mechanisms are also prone to quantitative and qualitative failure.”
er,no -not without an existing previous intervention from the govt or monopolist of the day(central bank etc).ofcourse,some sector of the economy may be in trouble because of local issues,but an economy wide recession is always set in motion because the commodity called money -which is one half of all transactions in the economy-is centrally planned and interest rates determined not by profit and loss,but by men with econometric models which have nothing to do with reality .
central planning fails.always.money is no different.
corporations are only political in asmuch as the political system allows them.if the govt is willing to hand out favors and violate property rights ,then you can be sure corporations will line up to curry favors.i am not sure it is a chicken and egg problem.the power lies with the govt .the corporations are only piggybacking on it.
corporations dont like free market capitalism any more than trade unions.both exist to serve the entrenched and keep out competition
I think the onus is on you and your ilk to demonstrate conclusively that all economic woes stem from government action. In practical terms, it’s not a very helpful argument anyway, since governments will always be with us (unless we favour the weakest going to the wall). In essence you are pinning your hopes on an extremely unstable equilibrium, even if you can show it is an equilibrium.
Better to work out how to reduce the political demand for governments to intervene by building an intrinsically more stable economy, where price signals and profit signals relate to long-term welfare and not short-term market advantage.
no,the onus lies with the interventionist -because markets are voluntary.if you want to use violent methods/force to prevent the results of some voluntary actions,the onus is on you to show that these actions indeed are 100% foolproof.
since we have to live with governments,it is better to err on the side of less regulation than more because the conseuquences of more regulation is unknown and definitely unpredictable.
to summarize: market failures are caused by intervention of the govt.voluntary actions might produce results which you or i might not like -but if they are the result of free choices,they cant be termed as market failure.
interventionists havent seen a market failure they couldnt want to improve
What about the involuntary consequences of voluntary actions? Might they justify force – if they cause death for example?
‘since we have to live with governments,it is better to err on the side of less regulation than more…’
Sorry, that’s just bad logic. Even if the ideal were no government at all, it doesn’t then follow that less government is always better than more. See http://en.wikipedia.org/wiki/Theory_of_the_second_best
“Before the advent of Keynesianism, most recessions were very short lived”
Honestly, what drug is this fella on? Is it too much to ask of a professor of Economics to know something about a period known (for obvious reasons) as the Great Depression? Or did Keynesianism cause that? Remember, Keynes published his Magnus Opus in 1936. Anyone would like to guess which landmark period in economic history inspired him to write what he did?
This is slightly unfair, after all Keynes was one of the world’s most prominent and influential public intellectuals in the 20s and 30s, and had published various significant works in that period (principally: The Economic Consequences of the Peace, The Economic Consequences of Mr. Churchill, and A Treatise on Money).
Also, Horwitz does not suggest that the policies undertaken were in fact those recommended by Keynes or any of Keynes’ works; he merely suggests they were recognisably Keynesian (given how we use the term). Now FDR and Hoover didn’t do too much stimulus spending in the crude AD/AS sense, but certainly they engaged in many unprecedentedly interventionist policies that might reasonably be described as Keynesian.
Since this was indeed the first recession where politicians undertook public works programs, tried out direct employment etc. (Keynesian or not), in any significant way in response to business conditions or economic conditions, the broad analysis Horwitz wants to make doesn’t face refutation (look at the shorter recessions/depressions in previous periods for comparison).
If the best you can do to support your “arguments” is cite Wikipedia, then you’ve lost already.
Reading comprehension pro-tip: “Most” does not equal “all”
I think Mr. Horwitz would argue that government intervention prolonged the depression even though the term Keynesianism hadn’t been coined yet.
I think the evidence is quite overwhelming that more government produces more bad results. Your position requires faith that many of us are not willing to give.
Man has been trying for a long time to fine-tune government (ie: fix “market failure” or eliminate corruption) and it is has not shown promising results.
Until or unless government stops using force and coercion upon innocent parties to obtain its goals, I will continue to advocate less of it. I am afraid that you will have to continue to justify violence to attain your ideal size and scope of government, because it is unattainable without it.
The writer expresses a very negative view of the adaptive powers of “the economy”. In other arguments an Austrian, or free-marketeer, would laud the self-organizing ability of the economy, but here they suddenly go all pessimistic (the market is fooled by central banks and never learns about central banks, and the deceived market starts mis-allocating resources). The claim that some parts of the economy (jigsaw) can only fit in one place also seems very pessimistic. To take the specific example of the limited number of engineers, it seems to me that the available engineers would plan things to use the available resources and could in fact put unused resources to work to produce something (maybe not the same thing that could be produced if there were more engineers and fewer labourers for example, but still something). The Austrian view expressed here seems to be that there is only one way for the economy to be arranged, which doesn’t sound right.
“Before the advent of Keynesianism, most recessions were very short lived”.
Except for the Great Depression of 1929-41; the Long Depression of 1873-94 (more like a series of bank panics); the extended slump of 1837-1852. And a number in Europe. . . .
I am not an expert but have been interested in politics/economics since 1990 or so. I discovered the Austrian/Libertarian perspective proper in 2007 while following Ron Paul’s presidential run and all the murkiness of understanding suddenly became clear to me. Some then I have read and read and read but am still a beginner. But I can understand why we are in the mess we are in whereas others can’t. I find that I agree 100% with the above article. But, what I have realised is that this perspective will never become mainstream and that the ones who adopt it do so for their own betterment in terms of business and organizing their own future. Few Austrians busy themselves with changing the world – rather, they understand no one will listen and so get on with applying its principles to their own business lives. For those that are so ready to jump up and criticise it, I suggest you take a closer look – you might be surprised.