While a profound division existed between the British school of economics, centered around the techings of [[Keynes]]’s mentor [[Alfred Marshal]] at Cambridge, England, and the continental variety, which focused on the theories of capital investment (the money invested in a business expounded in Vienna by [[Hayek]]’s mentor [[Ludwig von Mises]]), there was agood deal of contact, and a fair degree of misunderstanding, between the two camps. Marshallian economics was based on a commonsense understanding of the subject and how business worked in practice, emanating from the mercantist tradition that had made Britain the most successful comercial nation in history. The notions of the “Austrian School” where more theoretical and mechanistic, deriving from an intellectual rather than a practical understanding of how business might work. p3
2. End of Empire
The Austrian School was particularly concerned with prices, in particular, the “opportunity cost” of a product, that is, the alternatives that choose between when buying competing goods. If a person buys a beer, he does so instead of buyign wine; if a person invests money, she forgoes interest; if a person sells investments, he forgoes the price of the investment he may achieve later. p20
He was taught by [[Frederich von Wieser]], who contended that prices were the key to understanding how the market works and that entrepreneurs play a key part in ensuring progress through developing new markets. p20
3. The Battle Lines are Drawn
It was [[Mises]] who sowed doubt’s in [[Hayek]]’s mind about the virtues of socialism. p29
As [[Hayek]] put it, “Socialism promised to fulfill our hopes for a more rational, more just world. And then came [Mises’s Socialism]” Our hopes were dashes. Socialism told us that we had been looking for improvement in the wrong direction.
[[Mises]]’s principal objection to a communist or socialist society was that it ignored the price mechanism he believed essential for any economy to operste efficiently. He argued in Economic Calculation that because in a socialist society the government ownded the main industries–“the means of production”–and therefore set the prices of goods, the key purpose of prices, to distribute scarce resources, was made redundant. He claimed that “every step that takes us away from private ownership of the means of production and from the use of money also takes us away from rational economics.” p30
“It’s obvious that an individualist society left to itself does not work well or even tolerably” [[John Maynard Keynes]] declared. “The more troublesome the times, the worse does a laissez-faire system work.” p32
Or, put briefly, the public good was the sum of the individual self-interests of all individuals combined. p35
He believed int a “middle way” between capitalism and socialism democracy, and between what he believed to be the primitive dogmatisms of both sides. p36
It was [[Keynes]]’s connection that at the bottom of the economic cycle a chronic shortage of demand caused a slowing of the economic activity, which resulted in unnecessary unemployment. He argued that in the absence of private enterprise ensuring adequate demand, governments should provide demand of their own through public works. (He had yet to concoct an intellectual justification for why this was so.) … He conteded that when a central bank reduced interest rates, it interfered with the natual equilibrium between individuals’ savings and the investment in capital goods (machinery used to make products). More capital goods were bought with the cheaper money than could be sustaing by the genuine level of saving, which led to disequilibrium. Over time, the central bank was left with a dilemma: either continue reducing interest rates to provide even more investment, which again would pump too much money into a system chasing too few goods, provoking inflation; or increase interest rates, which caused investment to slow then shudder to a halt, bringing about a worse slump than the one the central bank was attempting to avoid in the first place. p41-42
[[Hayek]] suggested that the price mechanism reflected the tendency toward equilibrium and than any attempt to artificially alter prices would have dire consequences. p43
[[Keynes]] believed it was a government’s duty to do what it could to make life easier, particularly for the unemployed. [[Hayek]]believed it was futile for governments to interfere with forces that were, in their own way, as immutable as natural forces. p 43
4. Stanley and Livingstone
… what [[Hayek]] called “the employment function” the direct correlation between employment and aggragate demand (the total amount of goods that customers want to buy in an economy). p 49
[[Hayek]] argued the production was not a single process with a single end product and price. There were likely to be economies of scale in any production spurred by new investment that would resuce the price og goods, making them affordable, so there would be no glut. p49
What caused the crash? What lessongs can be learned to prevent it from happening again? And what can be done to alleviate the miser of unemployment unleashed by the catastrophe.? p52
Though [[Keynes]] owned no American shares, he was caught by the speed othe market collapse. The fotune he has amassed by market speculation was wiped out by the crash. p52-53
One of the book’s central themes, and one he believed added a novel dimension to the way an economy should be understood, was to draw a clear distinction between savings and investment (ro capital outlay). Up to that point economists had assumed that over time savings and investment were of equal value. But [[Keynes]] suggested that because one group of people saved and quite another invested, an imbalance tended to occur. When the amount invested was larger that the amount saved, the result was a boom accompanied by price inflation. Conversely, when savings tan ahead of investment, a state of depression occurred, accompanied by deflation and unemployment. p54
Throughout A Treatise, [[Keynes]] assumed that a state of equilibrium would be reached where savings and investment were equal and prices were stable, whatever interest rate set by the central bank, and at that time there would be full employment. His view was that “monetary theory when all is said and done, is little more than a vast elaboration of the truth that ‘it all comes out in the wash.’” p55
…the “multipier effect”: every job created by the government would add a further job to supply that new worker with goods. p58
5. The Man Who Shot Liberty Valance
“The ‘Paradox’ of Saving,” that recessions were not caused by a lack of desire from customers to buy goods. p65
The arguments [[Hayek]] was about to expound, on the key role the supply of money plays in the workings of an economy, were important first shots inthe way against [[Keynes]] and Cambridge.
He opened by acknowledging that the British Treasury’s decision to return sterling to the gold standard at its pre-Wrold War I parity had provided ample evidence that “the contraction of circulation” of a money (the reduction of money changing hands) leads to a reduction in industrual production. p72
He derided attempts “to establish direct causal connections between the total quantity of money, the general level of all prices, and perhaps, also the total amount of production” in mathematical equations as if economics were a science no different from physics or chemistry. The true key to understanding economic activity, he argued, was the choices individuals made, which were so many and diverse they could not be easily measured. By the same token, he dismissed assumptions based on the general price levels. Far more telling, he argued, were the myriad different prices agreed in the countless individual transactions that together made up the economy. p73
A glut of money tended to lower the price of borrowing, which caused consumer goods to increase in price while making saving less attractive. p74
[[Hayek]] then made a startling declaration: money has no intrinsic value.
“There is… no need for money in this sense–the absolute amount of money in existence is of no consequence to the well-being of mankind–and there is, therefore, no objective value of money in the sense in which we speak of the ibjective value of goods. What we are interested in is only how the relative values of goods as sources of income or as means of satisfaction of wants are affected by money” p75
…how did methods of production needing less capital progress to methods needing more capital? The answer was simple: when people spend less on consumer goods and saved more, their savings were invested in capital goods. But there was another way: more capital goods might be produced when money was made available to producers by bank loans. p76
In brief, there was no easy way out of a slump. In the long run the free market would restore an economy to an equilibrium where everyone was employed. p77
…the uncomfortable truth is that only time will cure an economy in imbalance. p78
[[Hayek]] suggested that the amount of money in an economy, and the speed with which it passed from one to another, held the key to understanding how the system worked. p78
6. Pistols at Dawn
“Nonetheless, in the event, the Treatise proves to be so obviously–and, I think, adminttedly–the expression of a transitory phase in a process of rapid intellectual development that its appearance cannot be said to have that definitive signigicance which at one time was expected of it.” p 88
[[Hayek]]’s main objection to [[Keynes]]’s treatise, however, is his ignoring Austrian notions of capital theory, in particular the implications to prices and demand of “roundabout” means of production of capital goods that he had so singularly failed to explain adequately in his lecture to the Marshall Society. [[Hayek]] drew attention to two notions at the hear tof their conflicting views of how the need for an equilibrium between savings and investment; nor could he accept [[Keynes]]’s assertion that the importance of the divergence between investment and savings was that it adversely affected the stability of prices. p91
7. Return Fire
Cooler hands than [[Hayek]] and [[Keynes]] may have spotted the many similarities between their arguments and concentrated on the interesting differences. p98At this stage of the argument, little seperated them. Both had assimilated ideas from the “classical school” which based its reasoning on the cost of a product, such as its scarcity, and the cost of land and wages, as well as the “neoclassical school,” which took into account the value of a good dependent on its usefulness, and the idea of “marginal utility,” which suggested that the more there was of a good, the less value it held in the eyes of a buyer. [[Keynes]], however, was already exploring how demand, supply, and prices could be manipulated, while Austrian School thinking led [[Hayek]] to believe that interfering with the free market would lead to unforseen consequences. p102
8. The Italian Job
He was now fully occupied with developing an intellectually watertight explanation, which had long eluded him, for why raising public investment in place of absent private investment at a time of recession would put the jobless to work without prompting the crisis [[Hayek]] believed ti be inevitable. The result would be his monumental General Theory of Employment, Interest and Money. p113
In Prices and Production, [[Hayek]] had sought to prove that if money is lent at a rate that is out of step with the sum of savings, it is invested in production that cannot sustain itself. When further funding dried up, factory owners find they do not attract customers and some lines of production are brought to an abrupt halt. In other words, when the price of borrowing money is out of kilter, it corrupts the ordered stages of production of goods until, after a period of crisis, the economy finds a new equilibrium. [[Hayek]] suggested that there was an ideal rate at which money should be lent, a rate that sustained production at all stages without waste and provided good at prices consumers could meet. That was the “natural rate of interest” that effectively left money with a “normal” role, because it had no bearing on the “natural” operation of the productive system. p116
As for [[Hayek]]’s central contention, that “there can be no doubt” that, if producers employ credit that is larger than the amount of saving, that inflation and collapse will ensure, [[Sraffa]] throws [[Hayek]]’s words back at him. p117
[[Hayek]] was convinced that the economy as a whole as an elusive subject that could only be understood, and even then partially, by considering the interation of individuals in the marketplace. [[Keynes]] however was in the process of making a breakthrough in thinking that would emerge only on publication o The General Theory. He believed an economy could best be understood by grasping the big picture, looking from top down at aggregates of such elements of the economy as supply, demand, and interest rates. [[Hayek]] was stuck in what came to be known as “microeconomic” thinking, looking at the different elements such as costs and value that made up the economy, while [[Keynes]] was making the leap to a new way of considering the working economy: macroeconomics, which appraised the economy as a whole. p121
9. Toward The General Theory
But the objection of Circus members to both fallacies suggested to [[Keynes]] what was to become a pivotal element of The General Theory, that overall output was not fixed and could be raised through increased investment to a point where everyone in an economy was employed. p128
[[Keynes]] believed that the chronic unemployment endured in Britain and America i nthe 1920s and 1930s was evidence that the full employment equilibrium was a fallacy. p128
The more Kahn explored the problem of how to assess how many would be indirectly emplyed as a result of the goverment eploying workers, the more he was amazed by how accurate [[Keynes]] and Henderson’s guesswork had been. p130
Again, a pivotal theme of The General Theory was on display: that national income was equal to the sum of the incomes of those emplyed. p135
This was [[Keynes]]’s first suggestion that tax breaks couldb e used to stimulate the economy, a policy that became a hallmark first of Keynesians… p135
This implies that the national currencies of each participant would stand in some defined relaitonship to gold. p137
10. Hayek Blinks
[[Keynes]], who believed that the financial mayhem had been exacerbated by the deflation of prices through the Federal Reserve’s raising of interest rates. p141
[[Keynes]] denied one of the most commonly accecpted laws governing economics. Say’s Law, which says that supply creates its own demand. p148
Denying Say’s Law was central to the fresh thinking in The General Theory, leading to the notion of “liquidity preference,” [[Keynes]]’s explanation for why savings did not automatically translate into investment. p148
For classical economists, interest rates depended on the relationship between savings and investment: if too many people saved, interest rates fell, encouraging them to invest in businesses to maximize their yield; if too fiew saved, interest rates rose to attract more savers. [[Keynes]] explored the motivation of savers and came to a quite different conclusion. He believed that rather than lodge money in a bank or invest in stocks and shares, savers often preferred to keep their savings in"liquid" form (i.e., cash), so that they could take advantage of rapidly changing curcumstances. The notion of liquidity preference upset the traditional understanding of the relationship between savings and investment, for if a saver believed he would get a better deal by waiting, he would keep his savings in cash, or jewelry, or gold. The implication was clear to [[Keynes]]. Because of liquidity preference, interest rates were kepy higher than necessary because banks had to offer savers a premium to part with their money. p149
[[Keynes]] introduced other novel concepts, among them the multiplier. Each pound spend was worth far more than a single pound, as the money was spent again and again as it worked its way through the system. p149
…his central argument–that increasing aggregate demand was tge key to full employment–should not become waylaid by semantics. p152
[[Keynes]]’s principal aim in writing The General Theory was to alter the way economists thought about the operation of the economy and through them to persuade decision makers to adopt measures to increase aggregate demand. p152
[[Hayek]]’s response, so keenly awaited by classical economists throughout Britain and the continent, was a yawning silence. p152
11. Keynes Takes America
In the opening sentence, he declared, “This book is chiefly addressed to my fellow economists,” an admission that a decade spent trying to persuade politicians and public servants to heed his call to reduce enemployment via publicly funded works had made little headway. p154
At their meeting, [[Keynes]] launched into a technical explanation for how Kahn’s multiplier ensured that borrowing to pay for public works should be considered investment, not expenditure, and that public works would soon pay for themselves through taxation revenue of those newly re-employed. p161
…he reiterated his belief that government-funded aid to alleviate unemployment was appropriate only at the bottom of a cycle, or during a recession, and that it was not appropriate to continue pumping money into the system when an economy had recovered. p165
..his pioneering work on compiling statistics about national income and gross national product were called into evidence to fuel [[Keynes]]’s argument that bolstering aggregate demand wold boost economic growth. p166
…the complex interrelationship [[Keynes]] suggested between interest rates, liquidity-money supply, investment-savings, and the national income that became famous among economists as the IS-LM (Investment / Saving / Liquidity preference Money supply) model. p169
12. Hopelessly Stuck in Chapter 6
He said he was “puzzled” in particular by two reasons, [[Keynes]]’s account of the relationship between savings and investment, and the notion of liquidity preference. p174
He admitted to a feeling, “then only dimly felt,” that [[Keynes]]’s new work was hard to confront because it was a macroeconomic, rather than microeconomic, account of the workong of the economy. It was [[Hayek]]’s belief that an economy’s operation could be explained only through an understanding of the unnumerable individual choices that together contributed to the whole economy. He suggested that it was too difficult to adequately express objections to [[Keynes]]’s top-down approach to economics when is counterarguments assumed that the key to understanding economics was bottom-up. p175
The notion of an economy reaching a state of equilibrium is commonplace in economic theory, the best-known example in the debate between [[Hayek]] and [[Keynes]] being the assuption, held by classical economists, that over time, when savings and investment became perfectly aligned, an economy would come to rest at a state of full employment. [[Keynes]] challenged the existence of such an equilibrium. p178
[[Hayek]] looked afresh at the notion of an equilibrium and, contrary to his former belief, became convinced that there is rarely if ever a time when an economy comes to rest. p179
An equilibrium can be predicted only if the intentions of each of the participants is known, and that is impossible both in theory and in practice. p179
But, [[Hayek]] reminded his audience, the perfect market does not exist. Economic decisions in real life are made by individuals based on partial knowledge of current conditions coupled with their best guess of what may happen. Each individual comes to a different (and often contrary) juedgement about what those conditions might be. p180
…that it is through prices that the communal wisdom of what is going on in the market is reflected, and that when outside forces such as governments interfere in the setting of prices, it is tantamount to trying to regulate the speed of a car by holding the needle of the speedometer in place; and that no single person, not even an “omniscient dictator,” as he out it, can know the minds, desires, and hopes of all the individuals that make up an economy. p180
[[Hayek]] dismisses [[Keynes]]’s notion of what prices represent as a profound misunderstandint of how prices are truly determined. [[Hayek]]’s belief that prices are the key to understanding the process of production–indeed, are the basis for understanding the working of an economy as a whole–and that prices are based on the scarcity of goods, rather than the relationship between what [[Keynes]] described as the imbalance between savings and investment and the “real cost” of production, causeshim to disregard without explanation the whole of [[Keynes]]’s complex counterarguments. p185
“we cannot, as some writers seem to think, do more or less what we please with the economic system by playing on the monetary instruments.” p187
13. The Road to Nowhere
“I wish I could make my ‘progressive’ friends here understand that democracy is possible only under capitalism and that collectivist experiments lead inevitably to fascism.” p193
The principal targets of The Road to Serfdom are what [[Hayek]] themed the twin evils of socialism and fascism. p194
He asserted that the common perception that the extremes of Left and Right were polar opposites was a misapprehension, for both, by replacing market forces with comprehensive state planning, assaulted individual liberties. He reiterated his belief that as economic planners cannot know the will of others, they end up acting like despots. p194
“It has frequently been alleged that I have contended that any movement in the direction of socialism is bound to lead to totalitarianism.” p196
“The fault is neither with the individual representatives nor with the parliamentary institutions as such but with the contradictions inherent in the task with which they are charged.” p197
[[Keynes]] reminded [[Hayek]] that [[Hitler]]’s rise was facilitated not by big government but ny the failure of capitalism and mass unemployment. p199
Over time The Road to Serfdom established itself as a key work in challenging the legitimacy and usefulness of economic planning. p202
The Road to Serfdom was a defining work that not only divided the Left from the Right but also the Right from the Ultra-Right. p205
14. The Wilderness Years
Thus, optimists and idealists tended to follow [[Keynes]]; pessimists found [[Hayek]] a sober guide to the disappointments of the real world. p208
While [[Hayek]] accepted that everyoone should be considered of equal worth, and treated equally under the law, he thought it ridiculous for governments to attempt to make everyone equal, or even to treat everyone the same by providing them with identical resources. It was the very differences between people the he thought essential for the maintenance of progress and prosperity. p219
15. The Age of Keynes
[[Keynesianism]] thinking was given a boost in 1948 with the publication by [[Paul Samuelson]]… Economics: An Introductory Analysis, which was to become the Keynesians’ bible. p232
[[Eisenhower]]’s remorse was that his administration’s vast spending on arms had led to the “military- industrial complex.” We must never let the weight of this combination endanger our liberties or democratic processes. p234
It was a hard lesson that all subsequent presidents learned: success at the ballot bos comes from managing the economy to bring the business cycle into line with the four-year electoral cycle. p235
…the “Philips curve” a trade-off between reducing unemployment and rising inflation. By formulating policy according to the [[Phillips curve]], Heller believed he had found a way to provide full employment without provoking higher prices. p239
[[Lyndon Johnson]]’s program was as radical as anything [[Franklin Roosevelt]] had attempted. He extended civil rights to African Americans, embarked on a “war on poverty” through federal entitlements, and instituted Medicare to give health care to everyone over age sixty-five and Medicaid for those who could not afford health insurance. p240
…he approved the devaluation of the dollar followed by the removal of the dollar from the gold standard; a financial stimulus to lower taces and increased spending that plunged the federal budget into a $40 billion deficit; cheap federal loands to prevent aircraft company Lockheed from going broke; and in August 1971, a legal ban on the raising of prices and wages. Later, free trade was abandonded and a 10 percent import levy was imposed. p243
16. Hayek’s Counterrevolution
He studied every peak and trough in American from the mid-ninteenth century on and discovered that each downturn was preceded by an explosion in the supply of money. p248
[[Keynes]]’s prescription for unemployment was public works. [[Hayek]] had attempted to show that such a policy directed labor into industries that failed as soon as the stimulus was withdrawn. [[Milton Friedman]] approached [[Keynes]] from another direction: an economy deep in recession did not so much need more demand than an adequate, but not too generous, supply of money. Setting the right level of money would result in a “natural level of emplyment,” which may or may not be full employment, while too much or too little money in the system would cause unemployment and/or inflation. p249
He described stagflation as a self-inflicted wound that “has been brought about by policies which the majority of economists recommended and even urged goverments to pursue.” p257
“It came to be considered part of [[Keynesianism]] doctrine that a little bit of inflation is a good thing,” [[Paul Volcker]] recalled. “What happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one.” p261
17. The Battle Resumes
Freshwater economists considered, like [[Hayek]], inflation to be a country’s worst curse; saltwater economists thought, like [[Keynes]], unemployment more serious. p267
Recessions, they claimed, were routine aspects of an economic cycle that must be endured, not cured. They preferred “supply-side” remedies that encouraged businesses to provide cheaper goods and thereby boost demand by removing goverment inhibitions such as regulations and business taxes. p268
They acknowledged the logic of supply-side reforms, but put more emphasis on the “demand-pull” remedies that concentrated on putting more oney into the system to make good more affordable. p268
By the early 1990s, [[Taylor’s rule]], showing trade-off between interest rates and the rate of inflation, named after the Stanford economist John Taylor, came to replace the Phillips curve, the trade-off between employment and inflation, as the equation of choice for those running the economy. p271