During the 1930’s John Maynard Keynes unleashed an economic storm that revolutionized government economic policy much of which is still being practiced today.
Keynes recognized that markets do not work perfectly and that businesses do not always make decisions that are economically efficient. This can cause an economy to operate below its natural gross domestic product. When this is sustained for a period of time, supply exceeds demand.
When the demand for goods and services is insufficient, unemployment increases which decreases demand further which eventually leads to a recession.
The most severe of which, The Great Depression, was when Keynesian economic theory began to gain ground.
Keynes argued that during economic contraction, action should be taken by the public sector to both increase spending (via stimulus) or enact monetary policy that encourages the private sector to increase spending.
Does any this look familiar to what we’ve seen over the last few years?
In the same fashion that our government has tried to stimulate the economy through spending, Roosevelt fought The Great Depression through various spending programs.
And what finally pulled us out of the recession was the massive increase in spending associated with World War II.
Enter Friedrich Hayek
Friedrich Hayek was the polar opposite of J. M. Keynes. He agreed with many points of classical economics including free-market capitalism.
Hayek was against the socialist view held by Keynes and believed that economies strived towards equilibrium and that prices should be determined by supply and demand.
Much of his views are reflected in Austrian economics.
Hayek argued that the business cycle is driven by credit. Low interest rates drive the creation of excessive credit which leads to speculation and poor allocation of resources.
In other words, artificially cheap capital causes businesses and individuals to invest in ideas and ventures that would not normally be considered. At some point, all of this creation of credit cannot be sustained and a tipping point is reached which causes a sharp contraction in money supply leading to a recession.
If you want an example of this, look no farther than the real estate market in California.
Access to cheap capital caused banks to offer creative (read: insane) financing that enticed borrowers to purchase real estate that they couldn’t afford.
All was well and good until the credit bubble burst – buyers couldn’t get financing, causing demand to plummet, causing oversupply, causing a crash in real estate prices.
Austrian economist Steve H. Hanke posits that the current recession is the direct effect of the Fed’s interest rate policies.
Do These Economic Giants Have The Solution To Our Financial Woes?
If Keynes were still alive, he would argue that the government should spend more. They should keep pumping money into the economy – racking up huge deficits (more so then they currently are). The key is increase the velocity of money, increasing demand and pulling us out of the recession.
If Hayek were still with us, he would argue that government intervention is what got us into this mess in the first place. He would say that the government should step back and let the market sort itself out. Any additional government intervention is just pouring gas on the fire. Actually, Ron Paul’s position on the economy is probably pretty close to the position Hayek would hold.
Do you think Keynes or Hayek is right? Or, are both wrong and is there another solution to the economy?