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Keynesian vs Hayekian Economics – The Solution To Our Recession?

Posted November 7th, 2011 in Economics by Jeremy Waller

During the 1930’s John Maynard Keynes unleashed an economic storm that revolutionized government economic policy much of which is still being practiced today.

John Maynard KeynesKeynes 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

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?

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13 Responses so far.

  1. LaTisha says:

    This is my fav video on economics! I found it while I was studying for the economics portion of the CFA exam.

  2. There really is no easy answer. For Keynes, he was only proved right becacuse of the spending in WWII. The difference between now and FDR’s time was he wasn’t in debt for $14 trillion. And the thing about Hayek, is that we’ve seen from the age of the Robber Barons what happens with free market capitalism.

  3. Awesome video. I wonder if Bernanke has watched this?

    I side with Hayek’s thoughts but do feel that individuals should be regulated to follow certain rules (ala Tony’s Robber Barons). The problem with the current stimulus is that it seems to have been stuck with the banks and not getting to the private sector.

    However, loans simply borrow from future GDP and bring forward consumption. Because I bought a new car when I really couldn’t afford one, I have to spend future earnings on that depreciating piece of metal instead of something else at the time. It would have been better to spend real savings instead of the illusion so that future wages could be invested productively.

    Many are making that shift toward Hayek’s way of thinking so consumerism (thus 70% of the economy) is down until individual balance sheets get repaired while at the same time banks and companies are hoarding cash. Thus we be in a funk!

    • Jeremy says:

      Like you hit on, I think what we are seeing is the reality of the paradox of thrift. People are saving cash due to uncertainty. However, while saving may benefit individuals, it lowers consumption – which makes it kind of difficult to get out of a recession…

  4. It’s a trillion dollar question now. But we are not as bad as some in east Europe.

  5. Aloysa says:

    Interesting. I actually should admit that I’ve never heard about neither of those theories. I am not sure that we will ever find the answer to your question. No doubt, a lot of things and theories will be tried. Some of them will work, some of them won’t.

  6. PKamp3 says:

    I’m definitely in Hayek’s corner – but I don’t think Keynes would like what has been done in his name today. Sure, he said, “in the long run we’re all dead” (and never had children), but although he believed in deficit financing, he was also against structural deficits.

    Keynes is probably spinning in his grave because of the things that have been done in his name lately. Nice post!

    • Jeremy says:

      It’s interesting to read theories that have been attributed to both economists which they never held themselves. There are several interviews with Hayek in which he very much opposed certain positions that some other economist attributed to him. I think it would be fascinating to actually get their take on the economy today.

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