The Great Economists

by Linda Yueh

  Hayek had not considered himself a contender because his work in technical economics was too far in the past. Many American economists had forgotten him altogether; it was over ten years since he had left Chicago. The highest prize in economics rejuvenated him, and helped to restore both his health and motivation.

  The 1970s had seen the major economies hit by stagflation (a combination of high inflation and high unemployment) in the aftermath of the 1973 oil price spike. In line with his previous theory of the business cycle forty years earlier, Hayek felt that the high inflation of the 1970s would lead to an economic crisis on the same scale as the Great Depression. Inflation had to be stopped in its tracks, even at the expense of short-run output and employment.

  In 1976, a couple of years after he won the Nobel Prize, Hayek published The Denationalization of Money, where he ventured his idea that money should be issued by private firms rather than the government. His reckoning was that competition between money providers would favour the most stable of the currencies in circulation. The same competition would also enforce self-regulation. The work was widely derided. Milton Friedman pointed out that there was nothing in current law to prevent bilateral trade using any medium of exchange accepted by all parties. Curiously, the recent rise of cryptocurrencies, such as Bitcoin, which are digital currencies that can be used to make purchases on the internet, are an example of non-governmental money.

  Nevertheless, Hayek’s body of work had made an impression on the politicians who would introduce free-market economics into the British and American economies in the 1980s. Hayek had been associated with a London-based think tank, the Institute of Economic Affairs (IEA) since its establishment in 1955. He had been contacted by the IEA’s founder, the businessman Antony Fisher, after he had read The Road to Serfdom. The idea of the IEA was to promote free markets and the limitation of government intervention in the economy. The IEA had been closely associated with the Conservative Party leader Margaret Thatcher, who became the British prime minister in 1979. She was greatly influenced by Hayek’s thinking and regularly quoted him in Cabinet and other meetings. On one occasion she interrupted a speaker who was urging the Conservatives to take a middle way on a variety of policy issues by pulling out a copy of The Constitution of Liberty, banging it on the table and proclaiming: ‘This is what we believe!’19 Thatcher had made Hayek relevant again. On her tenth anniversary as prime minister, she wrote to Hayek thanking him for his contribution to ideology and policy.

  The Fatal Conceit was Hayek’s last major work. Published in 1988, it pointed out the flaws and errors in socialism. In many ways, it was designed to be the crowning summary of his life’s work and an epilogue to Law, Legislation and Liberty. The insight was that the price system is an instrument which enables millions of people to adjust their efforts to events and conditions of which they have no concrete, direct knowledge:

  It took me a long time to develop what is basically a simple idea … I gradually found that the basic function of economics was to explain the process of how human activity adapted itself to data about which it had no information. Thus the whole economic order rested on the fact that by using prices as a guide, or as signals, we were led to serve the demands and enlist the powers and capacities of people of whom we knew nothing … Basically, the insight that prices were signals bringing about the unforeseen coordination of the efforts of thousands of individuals … became the leading idea behind my work.20

  In essence, Hayek had built on Adam Smith’s ‘invisible hand’ and specifically homed in on the role of prices in determining the value of goods and services in an economy. With a knowledge of prices, people can choose to produce certain goods or work in certain industries. The economy as a whole operates efficiently even though no one has coordinated their efforts. The book was seven years in the making, and not well received. It marked the end of his professional career.

  A year later, it was tremendously fitting that Hayek would witness the fall of the Berlin Wall and the disintegration of the Soviet Union that followed it. He lived long enough to see the victory of capitalism over communism, but only just. In 1992 he died at the age of ninety-two.

  Hayek and the global financial crisis

  At the time of his passing, Hayek had seen the dominance of capitalism over communism at the end of the Cold War between the Soviet Union and the United States. Yet, just two decades later, the capitalist system would face another great challenge. The 2008 financial crisis led to disillusionment with capitalism’s excesses.

  What would Friedrich Hayek have made of the 2008 global financial crisis that incited the recent backlash against capitalism? Hayek had argued that the Federal Reserve played a role in precipitating the Great Depression by keeping interest rates too low through the 1920s so that bad investments culminated in the Great Crash of 1929. It is likely he would have made a similar argument about Fed policy in the run-up to the global financial crisis.

  Hayek would have probably traced it back to the steep cuts in interest rates the Fed made when the US economy looked like it was faltering after the bursting of the dotcom bubble. Between 2000 and 2004, the US interest rate was cut from 6.5 per cent to just 1 per cent. Inflation was low and growth was weak, so the Fed acted to ease the economic slowdown by cutting interest rates to try to boost investment and consumption. But this led to too much and riskier borrowing in the housing market, which would lead to bigger problems in sub-prime mortgages just a few years later. Hayek would have objected to central banks believing that they can successfully intervene in the economic cycle.

  What would Hayek have advised during the global financial crisis itself? Since, for him, recessions were not necessarily pleasant but better for long-term health, he would not have in principle opposed the liquidation of the investment banks Bear Stearns and Lehman Brothers, or the government-supported lenders Fannie Mae and Freddie Mac. In theory, his work through the years points to a ready acceptance that insolvent institutions, or those that lent badly, should be allowed to go bust. What is not clear is whether he would have felt the need to bail these institutions out in order to prevent the systemic failure of otherwise sound businesses that their collapse might instigate.

  We can be more certain that Hayek would be strongly against the huge quantitative easing (QE) programmes whereby central banks injected large amounts of cash into the US, European and Japanese economies. In the 1970s, he favoured allowing the economy to right itself without government intervention, even at the cost of higher unemployment in the short run. He would have thought that QE was nothing more than a bailout of failed institutions, primarily used to shore up their balance sheets and provide liquidity to the banks that had acted irresponsibly before the crash. The flow of easy money would simply allow the liquidation and restructuring of bad investments to be prolonged. QE has been described by Stanford economist John Taylor as ‘mondustrial policy’ (‘monetary-industrial policy’) since it represents discretionary government involvement in the economy to support certain industries.21

  Naturally, Hayek’s starting position is that all of this should have been unnecessary in the first place. The pain of the recession could have been avoided had the boom in lending and vast credit expansion not occurred. The standard viewpoint as people survey the wreckage caused by financial markets was that they were not regulated enough. Followers of Hayek, though, would go the other way. It wasn’t the case that financial markets were allowed too much freedom, but that they just were not free enough. Prior to the crisis, they would say there was an abundance of regulation already in place. Government regulations actually created a false expectation among investors that they were protected from risk and default. If financial markets were unregulated, Hayek would argue, they would naturally develop the institutions that ensure trust and their reputation.

  This view has been aired in the annual Hayek Lecture hosted by the Institute of Economic Affairs since his death in 1992. For instance, the 2012 lecture, ‘Why We Still Need to Read Hayek’, w
as given by John Taylor, who reflected on the tumultuous events of the global financial crash and what Hayek might have made of the post-crisis problems in the US economy.

  Taylor set out the free-market principles he believed that allowed America to prosper: ‘people are free to decide what to produce, what to buy, where to work, how to help others’. These choices should be made ‘within a predictable policy framework based on the rule of law, strong incentives from the market system and a limited role for government.’22

  These principles have sometimes been abandoned, with unfortunate consequences. Leading up to the Great Depression, the Fed sharply reduced the growth of the money supply, the government raised tax rates and tariffs and went beyond market principles in the National Industrial Recovery Act. In the 1960s and 1970s there were short-term stimulus packages as well as wage and price controls. The financial crisis reflects the latest abandonment of Hayek’s principles. Governments bailed out financial institutions and responded to the crisis with aggressive monetary policies.

  Avoiding these interventions would allow economic growth, in Hayek’s view, driven by the market and not by government policies, to resume. Once the foundations of a market economy were properly set, including appropriate regulation of the financial system, then economic prosperity would return. And that would mean that there was a chance of restoring faith in the capitalist system.

  Hayek would probably have agreed with a paraphrased version that substituted ‘capitalism’ for ‘democracy’ in an observation by his supporter Winston Churchill: ‘No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except all those other forms that have been tried from time to time.’23

  Hayek’s influence

  In 1979 Friedrich Hayek remarked: ‘I have arrived at the conviction that the neglect by economists to discuss seriously what is really the crucial problem of our time is due to a certain timidity about soiling their hands by going from purely scientific questions into value questions.’24

  Hayek was not timid and robustly promoted the ideology of the capitalist system. This avid defender of capitalism would certainly stand up for the free market as being preferential to the alternatives. None other than former British prime minister Margaret Thatcher, whose ethos was based on free-market principles, was an admirer: ‘Adam Smith, the greatest exponent of free enterprise economics till Hayek and Friedman …’25 Thatcher also remarked: ‘All the general propositions favouring freedom I had either imbibed at my father’s knee or acquired by candle-end reading of [conservative politician Edmund] Burke and Hayek …’26

  Friedrich Hayek, though, was concerned about the pedestal upon which economists can be placed. In his 1974 speech accepting the highest prize in economics, he said:

  I must confess that if I had been consulted whether to establish a Nobel Prize in economics, I should have decidedly advised against it … It is that the Nobel Prize confers on an individual an authority which in economics no man ought to possess … [T]he influence of the economist that mainly matters is an influence over laymen: politicians, journalists, civil servants and the public generally. There is no reason why a man who has made a distinctive contribution to economic science should be omnicompetent on all problems of society – as the press tends to treat him till in the end he may himself be persuaded to believe. One is even made to feel it a public duty to pronounce on problems to which one may not have devoted special attention.27

  Hayek was certainly influential, and whether he was comfortable with it or not, his influence remains evident today. Former US Treasury Secretary and Harvard economist Lawrence Summers said of Hayek: ‘What’s the single most important thing to learn from an economics course today? What I tried to leave my students with is the view that the invisible hand is more powerful than the [un]hidden hand. Things will happen in well-organized efforts without direction, controls, plans. That’s the consensus among economists. That’s the Hayek legacy.’28

  CHAPTER 9

  Joan Robinson: Why are Wages so Low?

  It is one of the most pressing questions in American economic policy. Jason Furman, chairman of former US President Obama’s Council of Economic Advisers, told me that the question he was asked most often by the president was: ‘What’s going on with wage growth? And what does that mean for the future of the economy?’1

  The leader of the most powerful country in the world was asking this question. And it’s not just a problem for America. It’s a big issue for Britain and other major economies, ranging from Germany to Japan. Wages, after accounting for inflation, for the average worker in America have been stagnant for forty years. In the UK, there’s been an unprecedented fall in real earnings since the 2008 global financial crisis. In Germany and Japan, median wages earned by people in the middle of the distribution have been stagnant for about two decades.

  With the economic recovery underway in the United States and Britain, unemployment has come down dramatically to long-term levels of less than 5 per cent. So, it looks like employment has recovered from the recession. A healthier labour market usually means jobs and also better wages. Yet, puzzlingly, wages are not growing well.

  It’s not what models of perfectly competitive labour markets would predict. In those theories, workers are paid the value of their output so their wages would not be low if the economy was growing and more of what they produced was demanded. But as Joseph Schumpeter said in Chapter 7, perfect competition is one of the unrealistic constructs of economics that helps with solving mathematical equations but isn’t how the real world operates.

  This is where the sole female among the Great Economists in this book made her seminal contribution. Joan Robinson rejected perfect competition and sought to explain how imperfections can lead to discrepancies in wages and employment that are actually observed in markets. Because of her path-breaking work, Joan Robinson is viewed as ‘the most important woman in the history of economic thought’.2 Her place among the Greats, particularly at a time when there were few female economists, is noteworthy. Even now, women are significantly under-represented in the economics profession. Of the over 50,000 academic economists in the world, less than one-fifth are women.

  Robinson’s first book, The Economics of Imperfect Competition, was published in 1933 and brought her international recognition. Her ground-breaking manuscript was finished just three years after she began her study of economic theory. It changed the way that we think about how prices and wages are determined. She analysed price determination under monopolistic conditions, where there is monopoly power and less than perfectly competitive markets. In other words, markets were not full of firms too weak to influence the industry, the prices of goods or the pay of workers. She argued that where there was imperfect competition, workers are paid less than the market value of their labour. Widely read on both sides of the Atlantic, the book quickly became a standard text in this new research field of imperfect competition. It was reprinted thirteen times between 1933 and 1965.

  Robinson’s work followed Keynesian thought, so it disputed the neoclassical economic notion of perfectly competitive markets. In other words, she sided with John Maynard Keynes against their Cambridge predecessor, Alfred Marshall. The year after Keynes’s The General Theory of Employment, Interest and Money appeared in 1936, she published Essays in the Theory of Employment, which refined and extended Keynes’s ideas specifically in the labour market. She followed that work with another book, Introduction to the Theory of Employment, impressively in the same year. It was the first textbook that would ingrain Keynesian concepts into economics.

  Although she had been a follower of Keynes, she later concluded that neither neoclassical nor Keynesian economics could account for long-term economic outcomes. But she thought that Keynesian economics had the best shot. So, her last major work attempted to explain how economies develop. Published in 1956, The Accumulation of Capital presented a theory of how capital accumulation in the economy, which
consists of investment by firms and the government, changes over time in an attempt to better explain the long-run dynamics of growth.

  Robinson was plied with honours throughout her long career. But she was also controversial. Although she was one of the most influential and prolific economists of the time, with a publication record stretching from 1932 to two years after her death in 1983, she was never awarded the highest prize in economics. Nobel laureate Paul Samuelson said: ‘I was surprised that she never received the Nobel Prize.’ He added: ‘She has been a very contentious figure, but also a very important figure.’3 Robinson was under consideration by the Swedish Academy in the mid-1970s and apparently short-listed but repeatedly passed over.

  The possible reasons why she went from Keynes’s inner circle to an outsider are varied. In addition to growing scepticism over Keynesian economics, Joan Robinson rejected even her own earlier work rooted in Keynesianism as she sought new answers to the long run. She also rejected the mathematical focus of economics that had gradually emerged, led by Irving Fisher and others discussed in earlier chapters. One of her favourite sayings was: ‘I never learned mathematics, so I had to think.’ When she was approached to serve on the board of the Econometric Society, she refused on the basis that she could not read the highly technical articles published by the leading in-house journal, Econometrica, which were about quantification and theory.4

  Writing a book on Marxian economics as she moved beyond Keynesianism also contributed to her marginalization from mainstream economists. And her support of the communist regimes of China and North Korea did not make her popular. She did not hide her beliefs; she even dressed up in Vietnamese peasant outfits to give lectures.5 A part of it also probably reflected the challenges she faced in a male-dominated era and profession.