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Book Review
by Richard M. Ebeling, September 1995

The Collected Works of F.A. Hayek, Vol. 9: Contra Keynes and Cambridge, Essays and Correspondence, edited by Bruce Caldwell (Chicago: University of Chicago Press, 1995) 269 pages; $37.50.

In 1941, American economist Kenneth Boulding reviewed Friedrich A. Hayek's The Pure Theory of Capital. He contrasted Hayek's views with those of John Maynard Keynes, and observed: "Mr. Keynes's economics of ... [the] short-run ... like Hitler's, may be admirable in producing spectacular immediate successes. But we need Puritan economists like Dr. Hayek to point out the future penalties of spendthrift pleasures and to dangle us over the hell-fire of the long run."

What Professor Boulding was referring to was that throughout most of the 1930s, Friedrich Hayek and John Maynard Keynes had been the two leading protagonists in a grand debate over the nature and causes of the Great Depression and the public policies likely to be most efficacious in bringing the depression to an end.

By the 1930s, Mr. Keynes was one of the most renowned economists of the English-speaking world. In 1919, he attained world fame with his book The Economic Consequences of the Peace, in which he criticized the harsh terms imposed upon Germany in the Treaty of Versailles. In the 1920s, as a teacher at Cambridge University, he was molding a new generation of young economists in his own image. Then in 1930, Mr. Keynes published a two-volume work, A Treatise on Money, which he hoped would establish his reputation not merely as an eloquent critic of contemporary public policy, but as one of the leading economic theorists of his day, it turned out to be a hope that was dashed under the methodical blows of a young Austrian economist, Friedrich A. Hayek.

In Vienna, Hayek was a member of the "Mises Circle," a group of young Austrian economists who formed themselves around Ludwig von Mises. Mises had gained prominence with his book The Theory of Money and Credit (1912), in which he demonstrated that inflations and depressions had their origin in mismanagement of the money supply by government central banks. In 1926-1927, Mises had helped Hayek establish the Austrian Institute for Business Cycle Research, of which Hayek served as director and Mises as acting vice president. Through the institute's monthly Bulletin, Hayek applied Mises's "Austrian Theory of the Business Cycle" to analyze the distortive effects of European and American monetary policies, which lead to the start of the Great Depression in 1929.

Hayek was invited to deliver a series of lectures on money and the business cycle at the London School of Economics in February 1931, which were then published later that year as Prices and Production. In this work, Hayek presented his version and elaboration of Mises's theory of booms and busts. The success of these lectures resulted in Hayek's being offered a permanent position on the faculty of the LSE in autumn 1931.

He also had been asked to write a lengthy two-part review essay of Keynes's A Treatise on Money, which appeared in the journal Economica in August 1931 and February 1932. But even before the second part of this review had appeared, Keynes angrily replied in the November 1931 issue of Economica, with an attack on Hayek's Prices and Production, to which Hayek responded in the same issue. As editor of the Economiclournal, Keynes then assigned Hayek's book to be reviewed by a young Italian economist named Piero Sraffa. Sraffa's extremely critical review appeared in the March 1932 issue of the Economic Journal, with Hayek's reply in the June 1932 issue.

For the first time, these reviews and responses have been brought together and now reprinted in the latest volume to appear in The Collected Works of F.A. Hayek: Contra Keynes and Cambridge. The volume also contains a portion of Hayek's and Keynes's personal correspondence, in which they continued their debate.

Two crucial questions separated Hayek and Keynes. Is the market economy stable and self-correcting in the face of some imbalances between supplies and demands, most especially in the relationship between savings and investment? And, how are economy-wide fluctuations in employment, output, and prices to be analyzed — with the tools of traditional market-price theory, or with a different and new set of theoretical tools, which under Keynes's influence became standard, textbook "macroeconomics" theory?

Both in The Treatise on Money and in his later, more famous book, The General Theory of Employment, Interest and Money (1936), Keynes argued that there were strong forces at work in a market economy that could result in there occurring an imbalance between the savings decisions of one group of people and the investing decisions of another. If this happened, then all that some people had saved may not be invested by others. This, in turn, would result in a situation in which total spending on consumption items and investment activities might turn out to be less than the total costs of production that businessmen had incurred to bring various goods to market. With total business revenues earned being less than the total costs of production in the economy as a whole, resulting losses would act as an inducement for employers in general to cut back production and cut the number of workers they employed. Keynes believed that there was no assurance that the market, by itself, could return to a condition of full employment production. This led him to the idea that only government intervention to stimulate economic activity and create new "aggregate demand" could get an economy off the floor of a depression.

Hayek's response was that Keynes, in a fundamental sense, had failed to fully understand the nature of the workings of a market economy and the role of the price mechanism. "[Keynes] was neither a highly trained economist nor even centrally concerned with the development of economics as a science," Hayek said in one of his later essays.

Furthermore, Hayek argued, Keynes's very approach of aggregating all the individual supplies and demands for a multitude of different types of goods into macro "totals" distorted any real understanding of the actual relationships in and between actual markets. "Mr. Keynes' aggregates conceal the most fundamental mechanisms of change," Hayek said in 1931.

In a complex market economy, it was one of the functions of the rate of interest — as the price for the exchange of goods across time — to bring the supply of savings into balance with the demand to borrow funds for investment purposes. Changes in the rate of interest (reflecting a change in savings) assured such a proper balance and guided potential investors into using those funds for investment projects involving a period of time consistent with the available savings needed to sustain them. Keynes's argument that this was not the case led Hayek to state:

"Mr. Keynes' assertion that there is no automatic mechanism in the economic system to keep the rate of saving and the rate of investing equal might with equal justification be extended to the more general contention that there is no automatic mechanism in the economic system to adapt production to any shift in demand. I begin to wonder whether Mr. Keynes has ever reflected upon the function of the rate of interest in ... society."

If there occurred prolonged unemployment and industrial depression, Hayek argued, the cause was to be found in prices for goods and resources (including labor) being kept too high relative to the actual supply and demand conditions in various markets. The solution was a free, competitive process to bring prices and costs into proper balance, and with this a return to full employment. Keynes's emphasis on aggregates hid all the actual pricing problems under the cover of macro "totals."

Likewise, Keynes's solution for the unemployment problem — increases in aggregate demand, through government deficit spending — was merely a short-run panacea that created the illusion of a return to prosperity, when in fact it was merely exacerbating the long-run difficulty of returning to a normal and stable market situation. Keynes's inflationary cure to economic problems only set the stage for a later economic depression.

Only during the last fifteen or twenty years have economists started to free themselves from Keynes's influence. These essays by Hayek, some written long ago, can help us understand how and why economic theory and policy went down a wrong path. And more important, they can assist us in having a better understanding of the actual nature of government-created inflationary processes and why they always generate the conditions for a future depression. Or as Professor Boulding had expressed it, Hayek reminds us of the long-run penalties of Keynesian-type short-run panaceas.

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