by Linda Yueh
Hayek would say that he and Keynes differed on most aspects of economics. Keynes was a pragmatic English economist focused on the practicalities of the subject and had little time for the more systematic European modes of thought. Hayek was the exact opposite. So, on technical matters, they could hardly agree on the meaning of terms, let alone understand each other. Where the argument was most public was over the drivers of fluctuations in the economy or business cycles. Keynes believed that recessions were the consequence of weak aggregate demand. The economy was subject to bouts of optimism and pessimism known as ‘animal spirits’. However, government policy could do much to offset the impact of these on national output and employment.
Hayek’s model of the business cycle is far more nuanced and harder to understand. This may be one of the reasons it was not so widely accepted, both at the time and subsequently, by economists and policymakers. Hayek’s model is as follows. First, there are many different stages of production in creating goods. Each final good reflects the processing of primary and intermediate goods. At each stage of production there is a requirement for businesses to install capital goods such as machines. These are not the same for different factories and cannot be easily transferred across sectors or stages of production. Therefore, once installed, the stock of capital can only be used to produce certain goods.
So, it is possible for capital to be allocated inefficiently in the economy if it is directed to areas where demand has been temporarily boosted and cannot be sustained. As capital investment is not reversible or transferable, capital is essentially stuck and abandoned if under-utilized. The savings that funded the investment have been wasted, and could have been more efficiently used elsewhere in the economy. Hayek believed this misallocation of capital could arise from monetary policy, specifically if interest rates had been held too low, as that leads to bad investments.
This, according to Hayek, accounted for the Great Depression. The US Federal Reserve had kept interest rates too low throughout the 1920s. As a result, much of the capital investment was inappropriate and unsustainable going into the 1930s. A recession ensued as this build-up in capital was abandoned.
In stark contrast to Keynes, Hayek believed the government should then resist the urge to interfere. He viewed recessions as a necessary evil, simply periods of liquidation resulting from the past overaccumulation of capital. This is similar to what Nobel laureate Paul Krugman calls the ‘hangover theory’ of recessions.10 Any policy that stimulates the economy may relieve some short-term suffering, but would ultimately prevent recovery by helping to maintain inefficient capital stock levels. It is the economic equivalent of the ‘hair of the dog’. After a hard night of excessive drinking, a shot of vodka might perk you up for an hour or so, but will eventually lead to an even worse hangover.
As a theory of business cycles, Hayek’s approach in Prices and Production was largely rejected. A few years later, in 1936, Keynes’s General Theory swept all before it on both sides of the Atlantic. Even the London School of Economics essentially became Keynesian. Later on, Milton Friedman and Anna Jacobson Schwartz, in their 1963 book A Monetary History of the United States, would provide a widely accepted explanation of the Great Depression linked with the tightening of the money supply as the banking system folded. By contrast, Hayek’s views that low interest rates during the 1920s led to the depression received little credence.
Keynes was very much the showman, witty and articulate. Hayek, by contrast, lacked charisma and the power of communication. He spoke with a thick Austrian accent and was by several accounts a poor teacher. It is said that his students at the LSE asked him to lecture in German as it was more understandable. His writing was not always that easy to follow either. Milton Friedman was a staunch admirer of Hayek, but still described Hayek’s 1941 Pure Theory of Capital as basically unreadable.11
Suffice it to say that Keynes was more interventionist in the economy than Hayek. He agreed with Hayek over the evils of communism and fascism, but believed the market economy was unable to always self-regulate efficiently. Keynes was not an advocate of government intervening in business activities, but thought it should provide the conditions under which such activities take place. But while Keynes was telling politicians they could make things better, Hayek was telling them they would just make things worse. It cannot be a total surprise that they were more readily drawn to the Keynesian view.
Hayek’s path to fame
In the late 1930s Hayek simply became forgotten as an economist and his views were no longer a topic of academic discussion. Hayek himself also began to step away from technical economic theory and towards broader issues of social inquiry. He had not forgotten his background in the Austrian School, which was firmly at odds with social planning and excessive government intervention in the economy. His contemporary von Mises had questioned how it would be possible for any economic system, by which he meant communism, to exist without a price mechanism to allocate and incentivize economic activity. He believed that critics of capitalism, and, at the time of the inter-war years, there were many, failed to point out how a socialist system could be properly organized. Without prices, there would be no way for the baker to know how much to sell his bread for.
Collectivist Economic Planning, which Hayek edited in 1935, marked his transformation from economic theory to political philosophy. He argued that society is more efficient when rules or laws enable each individual to use their own knowledge and abilities for their own purpose rather than conform to the plan of a central authority. He was opposed to the idea that it was possible to manage a technologically advanced society from a central perch. The role of the government is to help individuals maximize their own talents, ideas and knowledge. Hayek’s fundamental belief is that fragments of knowledge could not be brought together into a single brain. Given the complicated nature of technologies and production processes, it would require knowledge that no single person or a committee could possess. However, a pricing system with profit incentives could establish a market, provided it was backed with recognition of private property, contracts, laws, societal norms and the ability to exchange goods.
As the Second World War started to wind down, Hayek had become an increasingly obscure academic. However, that was to change abruptly with the publication of The Road to Serfdom in 1944. It would make him one of the world’s best-known thinkers.
The Great Depression before the war had shaken belief in the capitalist system and people had become used to centrally planned wartime economies. Hayek wanted to warn the British public about the dangers resulting from government control of economic decision-making through continued central planning, whether communist or fascist. He argued that the abandonment of individualism led not only to a loss of freedom and the creation of an oppressive society but inevitably also to totalitarianism and effectively the serfdom of the individual. Centralized planning was undemocratic because the will of a small number was imposed on the people and the rule of law and individual freedoms were sacrificed.
The Road to Serfdom received positive reviews upon publication. The Second World War was not quite over, but by now it was simply a question of when, rather than if, the Axis powers would be defeated. Across Britain, the question ‘what next?’ was already being asked.
The book was to make Hayek famous, and not just in economic or academic circles. Keynes referred to it as a ‘grand book’,12 and sales far exceeded Hayek’s modest expectations for what he had earlier described to his publisher, Routledge, as a semi-popular work. The initial 2,000 print run sold out within days. Routledge ordered another 2,000 copies and over the next two years fought a generally losing battle to keep up with demand. Wartime rationing of paper did not help matters, and Hayek often referred to The Road to Serfdom as that ‘unobtainable book’.13
However, it was in America where its success far exceeded expectations. The book was primarily written for a British audience and its academic tilt meant it wasn’t expected to do well there. Furthermo
re, it was at odds with the post-war political climate of the day in America, and had already been rejected by a number of US publishers. However, the University of Chicago Press agreed to publish the book and the US edition was published in September, six months after the British version, again with an initial 2,000 print run.
It took off in a big way. A glowing review in The New York Times promoted interest, and soon the publishers realized they had a success on their hands. Another 5,000 copies were released and, just days later, 5,000 more. The book reached real prominence when Reader’s Digest, which followed the NYT in describing it as ‘one of the most important books of our generation’, published a twenty-page precis. In those pre-TV days, its readership of 6 million could launch a blockbuster, and it made Hayek a household name in the US as people looked to life after war.
In Britain it did not quite have the political influence Hayek had hoped for. After the end of the Second World War, the welfare state was established in the UK. Conservative Prime Minister Winston Churchill had quoted and used Hayek’s book heavily in the 1945 election campaign against Clement Attlee and the Labour Party as an anti-socialist text. It did not have much resonance with the British public, though, as Labour won a landslide victory. It is fair to say that Hayek was not a supporter of the new interventionist government.
Hayek preferred most activities to stay in private hands, but did see the need for a limited role of government in markets to perform the tasks that markets were not capable of. These included outlawing poisonous substances and preventing crime, but also providing a basic safety net. He wrote:
there can be no doubt that some minimum of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody … Where, as in the case of sickness and accident, neither the desire to avoid such calamities nor the efforts to overcome their consequences are as a rule weakened by the provision of assistance, where, in short, we deal with genuinely insurable risks, the case for the state’s helping to organize a comprehensive system of social insurance is very strong.14
In many ways Friedrich Hayek was at his peak in terms of celebrity and reputation after the publication of The Road to Serfdom. He had conceived the idea of setting up a society to bring German scholars back into mainstream classical thought after the Second World War, and a couple of years later, between 1 and 10 April 1947, the first Mont Pelerin Society conference took place in Switzerland. Hayek invited intellectuals who supported classical liberalism – in all, thirty-nine individuals from ten countries. Hayek was the first president and stayed in post until 1961. It continues today in the same liberal tradition, and eight Nobel Prize winners have been members.
Hayek had always been interested in psychology and after the success of The Road to Serfdom he indulged himself working on his next project, The Sensory Order. Published in 1952, the book set out a division of knowledge within societies where each person’s share of knowledge was infinitesimally minuscule, which limited the knowledge attainable for any individual.
By this time, Hayek was drifting away from the London School of Economics. It is fair to say that he was no longer producing technical work. Keynes’s death in 1946 had made it impossible to engage with him, thus removing one of Hayek’s motivations. A messy divorce from his wife, Hella, also caused him to lose friends in London, among them his one-time biggest supporter, LSE’s Lionel Robbins, who was appalled at Hayek’s treatment of his ex-wife. Hayek had always believed he had married the wrong person,15 admitting he had been on the rebound after discovering that his childhood sweetheart and distant cousin, Helene Bitterlich, had married another. He left Hella and their two children in 1949 and filed for divorce. In the face of Hella’s objections, it was granted in 1950 via a court in Arkansas, where he was a visiting lecturer at the time and where the divorce laws were permissive. Helene was recently widowed, and a few weeks later the couple were married in Vienna. Hayek resigned from the LSE and the newlyweds moved stateside to start a new life in Chicago.
The Chicago School of economics was a school of thought based on free-market economics and a libertarian philosophy. It was not quite the same thing as the actual economics faculty within the university. Although the Chicago School was happy to identify with Hayek, given how well he fitted with their approach, he was not coveted by the Economics Department itself. The Road to Serfdom was recognized as an important book, but still mainly treated as a popular rather than a scholarly text. In the department’s view, Hayek was now off the beaten track of economic research and no longer at the forefront of the technical work done at the university.
Furthermore, life in America in the 1950s was much different from the Great Depression years of the 1930s, and there was less interest in business-cycle theory, where Hayek’s main research interests had been situated. In fairness, the lack of enthusiasm between Hayek and the Economics Department was probably mutual, since Hayek himself no longer considered himself solely an economist.
Instead, Hayek joined the university’s John U. Nef Committee on Social Thought as Professor of Social and Moral Science. This multidisciplinary faculty consisted of a range of social and natural scientists, including the writer T. S. Eliot and the 1938 Nobel laureate in Physics, Enrico Fermi, allowing Hayek to study interests outside mainstream economic theory.
His next major work was The Constitution of Liberty. Hayek set out to show how liberty drove wealth and growth rather than the other way round. The more government is restricted, the more likely to arise are the individual spontaneity and creativity so vital to the advance of knowledge and civilization. He also reiterated previous arguments about the division of knowledge, and how it would be practically impossible for one human mind to comprehend and make efficient use of all the knowledge that guides society. The implication is of a very limited role for government in not just the economy, but also society.
In this book, he also laid out his thoughts on global inequality across nations. He did not think it was wholly a bad thing, in that it reflected the progress made by advanced Western countries, which would allow other countries to catch up faster than the centuries it took for Western countries to become advanced. On the same basis, he was also comfortable with inequality within societies, believing diversity to be necessary for society to prosper. There would be no mutual progress without inequality. According to Hayek, this was not an ethical consideration but historically observable: ‘Recent European experience strongly confirms this. The rapidity with which rich societies here have become static, if not stagnant, societies through egalitarian policies, while impoverished but highly competitive countries have become very dynamic and progressive, has been one of the most conspicuous features of the post-war period.’16
In Hayek’s view, society evolves so that the behaviour of successful individuals is adopted and imitated. The evolution of society is shaped by the new ideas of a comparative few. People with the better ideas determine developments; thus the market is an evolutionary mechanism where the economically talented prosper. Society can choose between equality and productivity. However, he did not agree with entrenched status quos, and the power, wealth and privilege they bestowed.
It took four years for Hayek to finish The Constitution of Liberty, completing the manuscript in 1959 to mark his sixtieth birthday. The book was published in February 1960 and intended for a general readership. Hayek considered it his best work, his magnum opus, and had suitably high expectations. The Road to Serfdom he described as a semi-popular book, but The Constitution of Liberty was, he hoped, to be The Wealth of Nations for the twentieth century.17
Unfortunately for Hayek, it would not come close to reaching the popularity of The Road to Serfdom. This time the book was not reviewed in Time or Life, and the Reader’s Digest did not consider it suitable for a condensed version. Perhaps The Constitution of Liberty just did not capture the mood of the time in the way that The Road to Serfdom had as people looked beyond the Second World War. In 1962 Milton Friedman publis
hed Capitalism and Freedom, which he also felt was underappreciated.
Friedrich Hayek left Chicago and America in 1962, citing financial reasons. His divorce from Hella and frequent trips to Europe had put some pressure on his finances. He decided to re-enter the German-speaking world at the University of Freiburg in West Germany. He stayed there until 1969, when he spent a year as visiting professor at UCLA before he returned to Austria and the University of Salzburg. He would make one final move, returning with Helene to Freiburg in 1977, where he spent his remaining days.
During this time, his effort was predominately dedicated to writing Law, Legislation and Liberty, the follow-up to The Constitution of Liberty. It is fair to say that Law, Legislation and Liberty was far more abstract than his earlier books. He made no effort this time to write for a general audience, assuming readers were familiar with his previous work.
The book was published in three volumes: Rules and Order (1973), The Mirage of Social Justice (1976) and The Political Order of a Free People (1979). One of the reasons it took so long to write is that between 1969 and 1974 his progress had been interrupted by ill health and depression. However, two events were to revitalize him.
The Nobel Prize in economics had been established in 1969. It was rumoured that the committee were keen to award the prize to Gunnar Myrdal, one of the pioneers of the Swedish welfare state, but it had been specified at inception that no Swede could win in the first five years. The sixth year was 1974, and Myrdal duly received the award that year. However, the prize was shared with Hayek. Both economists were reportedly surprised, Hayek because he had won; Myrdal because he had to share the award.18