Keynes Vs Hayek

The Great Depression isn’t just history. It’s the moment we keep dragging into today’s fights about stimulus, deficits, inflation, and what government should do when millions can’t find work. We sit down with Dr. Nicholas O’Neill from Arizona State University’s School of Civic and Economic Thought and Leadership to make the Keynes vs Hayek divide clear, concrete, and rooted in the world that shaped it. 

We rewind to a time when “economic crisis” often meant weather, harvest failure, and the price of bread, then follow the shift into industrial capitalism where recessions look like collapsing demand, shuttered factories, and mass unemployment. From there, we walk through the 1920s boom, speculative bubbles, tightening monetary conditions, the 1929 crash, and the deflationary spiral that turned fear into bank failures and prolonged joblessness. 

Hayek’s Austrian economics warns that manipulating money and credit can corrupt price signals and lock in bad decisions, making downturns worse. Keynesian economics argues the opposite danger: when uncertainty spikes, people and firms can hoard cash, starving the economy of spending and trapping it in high unemployment unless public policy jump-starts demand through countercyclical fiscal spending. We also clear up a common myth about the New Deal, then land on an unexpected civics takeaway: Keynes and Hayek modeled serious, respectful disagreement in private letters, even while arguing in public. 

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School of Civic and Economic Thought and Leadership

Center for American Civics

Transcript

Meet Keynes And Hayek

SPEAKER_00 0:48

Welcome back to the Civics in Year podcast. I'm really excited today to have one of the professors from the School of Civic and Economic Thought and Leadership with us today, Nicholas O'Neill. And we're going to actually be talking about Keynes and Hayek. And Keynes has come up in a lot of our other podcasts. So we thought it would be a really good thing to kind of just have this conversation about what these economic policies are. So, Dr. O'Neill, could you please introduce yourself for our listeners?

SPEAKER_01 1:20

Hi, I'm Dr. Nicholas O'Neill, and I'm an assistant teaching professor in the School of Civic in Economic Thought and Leadership here at ASU.

SPEAKER_00 1:28

Perfect. So can you just briefly introduce who are these two characters we're talking about? Keynes and Hayek, and what was the historical context that they were really responding to?

Bread Prices And Preindustrial Crises

Say’s Law Meets Mass Unemployment

The Business Cycle And The 1920s

Crash Spiral And Early Responses

Hayek On Money And Price Signals

Keynes On Fear And Idle Cash

What The New Deal Actually Did

Civil Discourse From Two Rivals

SPEAKER_01 1:42

Yeah, so I think that to understand the economic debates between Keynes and Hayek during the Great Depression and New Deal eras, uh, we actually have to first travel back in time so that we can understand what was new about them. So I approached the history of economic thought as a process of people trying to make sense of a changing world to understand and explain the phenomena they see happening around them, which means we have to look at their historical context. So if we look back to the 18th century, we find that political economists weren't really thinking about things like recessions or unemployment because they didn't really exist in the sense that we think about them today, which itself was a paradox driven by the fact that economic crises existed so routinely in that period. So, in an overwhelmingly agricultural economy, as was the case everywhere in the world before the 20th century, what matters most is how much it costs a family for their daily bread, because this is the single most important expenditure. And this in turn is determined by something as fickle and unpredictable as the weather. So a famous example here might be the French Revolution. In July 1788, you have a massive hailstorm sweep across northern France, destroying the fall harvest and grain supplies throughout the area around Paris. As bread became too expensive to afford, workers and peasants rose up in spontaneous attacks on the aristocracy and began the process of reckoning with France's system of finances and taxation that would eventually topple the monarchy. So these types of rapid changes in economic fortunes fell most heavily on the poor, and they happened very frequently, but it they occurred randomly as a result of the weather. So the response was to provide temporary relief, either through private charity or government caps on bread, or occasionally just seizing silos of stored grain. But as soon as the weather cooperated with the farmers, the harvest came in, the price of bread dropped, and normal economic life moved on. So if we think of the classical economists that began with Adam Smith in the late 18th century and continued through the middle of the 19th century, we find the emergence of a theory that we now call Say's law, after the French political economist Jean-Baptiste de Say. So there wasn't actually any economic law stated as such at the time, and Say, as well as people like John Stuart Mill, had nuanced and evolving views about this, but to boil it down, it was the belief that because supply creates its own demand, which is to say that the wages paid to workers will be spent by them on your products, and that anything sold must be simultaneously something bought, then outside of minor sectoral imbalances, you can't have a recession, so you don't need to worry about it. But increasingly over the 19th century, people found that you do need to worry about it because economic downturns kept happening. But they changed in two key ways. First, as global markets knit together disparate regions, the cost of one's daily bread stabilized, because now the spike in prices from a freak regional storm like in 1788 in Paris could be met by importing grain from some distant place like the American Midwest, which meant that agricultural crises ceased to be a reality for much of the world. But as these same markets spread around the world, a new type of economic problem began to appear. In the 1840s, the potato blight in Ireland and climatic conditions elsewhere did lead to widespread starvation and hunger. But at the same time, a speculative bubble that had built up around a surge of railroad construction popped, suddenly impoverishing not just the poor, but the well-to-do. And as rich and poor alike pulled back their spending, artisans had to close their shops and workers found themselves thrown out of the factories. And in places where manufacturing was widespread, you suddenly had up to 90% unemployment in some industries. This created a new and distinctly modern problem. What do you do when you suddenly have workers who want to work but can't? A line of thinkers, likely familiar to listeners of this podcast, from John Locke to Alexis de Tocqueville, had argued that such pauperism, which was the new term they came up with to describe this new problem, didn't exist, just epidemics of laziness. Or at least that doing anything to address pauperism would only lead to more laziness. But as hungry and unemployed masses rose up throughout Europe in 1848, they demanded that something be done to help those cast out of work against their will when it wasn't their fault. And this marked the beginning of a modern approach to relief during a slump, not by providing food, but providing work to the unemployed. It's also what led Karl Marx to dismiss simply ameliorating conditions of unemployment. Whereas the earlier classical economists had largely rejected the possibility of recession. Looking at 1848 and its aftermath, Marx imagined a future of recession after recession, in which the poor would be systematically ground down by poverty and crisis until they rose up and overthrew the system of capitalism in its entirety. What's interesting is that by the end of the 19th century, mainstream economics had rejected and embraced both sides of this view. Any observer in the 80 years between the revolutions of 1848 and the onset of the Great Depression in 1929 would have lived through recession after recession, downturns too devastating to ignore or explain away. Yet they would also have seen recovery after recovery, and with them the gradual rise of standards of living. A new generation of economists by the early 20th century across a whole range of schools of economic thought could largely agree on the existence of a business cycle. They believed the business cycle to be a natural and recurring process in which the boom times laid the seeds of their own demise and led to an economic slump that would shudder many businesses and throw workers out of work, leading to less consumer demand and capitalist investment as everyone tightened their belts, thereby exacerbating the downturn. But then eventually, workers desperate for any work would accept lower wages. Business owners would see a good deal and hire them, spending would pick up, wages and investment would increase, and the economy would recover to newfound heights. Some economists focused on the pain felt by the working class during the downswing and advocated for programs to provide relief to the unemployed and to protect their wages. Others focused on the greater efficiency and vibrancy of the economy on its upswing, hailing the process of creative destruction, and thus advising against excessive state intervention. But nearly everyone agreed that periodic business cycles were naturally occurring events, with the boom times leading to bad times, with the bad times again leading to boom times. And this was the thinking that dominated in the United States at the outset of the Great Depression, and that determined the response of the New Deal. In the aftermath of the First World War, the U.S. struggled to restore the gold standard by raising interest rates just as consumers demanded access to a whole new range of goods like radios, automobiles, and the high life of the jazz age. What made this possible was the advent of mass production techniques, the power plants and forest assembly lines that could churn out more products more cheaply than ever before, bringing even things that until recently would have been unattainable luxuries into reach for middle-class consumers. Throughout the 1920s, as consumers kept buying these new goods, capitalists kept producing them. And so investors poured money into these new technologies and found themselves richly rewarded. The interest rates were high, but so were stock valuations, and crucially, so were profits. But then something shifted after 1927. Stock valuations became untethered from their expected returns. Speculators betting on agricultural commodities began predicting prices to rise, even as mass-produced farm technology meant they were actually dropping. All manner of credit began to flow to consumers until they were deep in debt. And when the Federal Reserve raised interest rates to slow down the speculation, people just kept buying and betting at higher rates. Until 1929, when the bubble popped. The crash on Wall Street set in train catastrophic unraveling of the economy. By 1932, not only had the stock market lost 90% of its value, but production had dropped by more than half. Half the population either couldn't find full-time work or any work at all, and 600,000 homeowners were in default on their mortgages. Mainstream economics understood this to be a business cycle and recommended both relief and investments to help blunt the downturn. For Herbert Hoover, this meant seeking investments from American businesses, promoting charity efforts for the unemployed, and wherever possible, trying to get planned infrastructure projects underway as quickly as possible. But it didn't mean spending money that wasn't there. And so the U.S. entered a spiral where prices kept dropping, which hurt farmers, workers, and businesses alike, and fear became so great that everybody held on to whatever assets they could. And this made matters even worse when the depositors, afraid of losing their life savings, demanded their money back from banks, setting off a series of bank collapses around the country. But there were a couple of dissenting voices that broke with the mainstream perspective that recessions and recoveries were both natural. The first has been most prominently connected with the Austrian economist Friedrich Hayek. Originally from Vienna, Hayek had by this point recently taken up a position at the London School of Economics. He was a member of a group of economists who argued that there was nothing natural or inevitable about widespread economic downturns. This was rooted in the belief that what we called the economy was actually just the aggregate of the countless decisions each of us makes every day as we try to figure out what's best for us. The problem is that in making these decisions, each of us actually knows very little and sees only that which is limited by the horizon of our daily lives. Nonetheless, we have to make these decisions on the basis of what knowledge we have, reacting to changes in the world around us, constantly course correcting as new information comes in. And while this is true of the individual, Hayek argued, humans are social creatures. We depend on our interactions with each other and respond to each other. Thus, if we begin to zoom out from the individual and look at the actions of society as a whole, what we find is an organic order that is constantly fluctuating, but always gravitating toward balance. The economy is never in a stable equilibrium, but always moving toward it and revolving around it. Within this process of bringing individual actions into a stable social order, money plays an extremely important role for Hayek. If I'm deciding what to buy, I don't need to know that a new gold mine was recently discovered in Australia or that there was a strike at a textile factory in Canada. All I need to know is that gold is getting cheaper and cotton shirts more expensive, and I can adjust my spending or investment decisions accordingly. If this is true, if we are given the freedom to adjust our decisions, widespread recessions cease to be a problem. A downturn somewhere will send a ripple of price signals throughout the economy, we'll each adjust our decisions to account for the new information and resume our tendency towards stability. But what happens, Hayek asked, if the information we depend on to make these decisions is corrupted? What happens if instead of relying on prices to communicate information, the money supply itself is altered? For Hayek, if out of fear of the suffering of workers or business owners in one sector experiencing a decline, we throw money at them? We prevent the price system from accurately communicating that something is off balance there. Instead, we continue to spend or invest our money in ignorance of what is going on, and so cumulatively make ignorant and stupid decisions. Sooner or later, as bad decisions pile up on each other, we'll see new problems pop up here and there, throwing money at each to soothe a different constituency, and ultimately only letting the problem get bigger and bigger until it blows up in our face. And so, to prevent short-term pain, we've instead created a Great Depression. Now, when this happens, and these economists believe that eventually it must, the temptation will be to flood more money into the system, to cushion the workers and business owners from their own short-sighted or bad decisions. But doing so will only prolong the problem. And so, in the event of an economic crisis, the only way forward is to remove government from the economy to the greatest extent possible, restore a stable money supply, and allow the workings of the free market to lower wages and shutter companies until investment is again in line with spending, and we can gradually return to the path of growth and efficiency. At the same time Hayek was making these arguments, the British economist John Maynard Keynes was rapidly becoming one of the most influential economists of his day. By all accounts a magnetic personality and renaissance man, Keynes taught at Cambridge University, just 60 miles away from Hayek in London. In contrast to Hayek, Keynes agreed with most of his contemporaries that business cycles and downturns were periodic and natural occurrences. Where he disagreed, however, was that the recovery process was similarly natural and inevitable. The key difference, he argued, was that decisions around whether to spend money, save it, or invest it were partially determined by objective external economic factors, but also partially determined by psychological factors, including most importantly, fear and uncertainty about the future. Most mainstream economists at the time believed that in an economic downturn, businesses would seek to cut costs by firing workers and reducing investments, but that eventually the lure of cheap labor and the availability of cheap capital would entice them to begin reinvesting and rehiring, driving unemployment down and wages and thus consumption up until an equilibrium was reached. For Keynes, however, this outcome was not guaranteed. Money, he reminded his readers, was not just a measure of value or means of exchange of value, but also a store of value over time. In instances of fear about continued economic upheaval and limited investment prospects, people would be likely to hold on to their cash, neither spending it nor investing it, but preferring to hold on to liquid assets. If this happened, the downturn would eventually stabilize, but at a level of prolonged high unemployment and low output. In short, for Keynes, it was possible for a country to find itself in a position where the natural functioning of a depressed economy would actually impede economic recovery rather than stimulate a new round of growth. In this case, the solution was to take the pools of money sitting idly and instead turn them to productive use, which is to say, borrow or tax money from those without an immediate use for it, the rich, and use it to hire those in need of a job, the poor. On the one hand, doing so would provide immediate relief for the unemployed, but it would also lead to a recovery for the economy as a whole, catalyzing an increase in consumer spending that would encourage businesses to invest more, in turn hiring more workers, and continuing until the economy had returned to full employment. Once done, Keynes concluded, the government should begin repaying the debts it accrued during the downturn and balance its budget. An upside of such counter-cyclical spending being that it would absorb excess money during the boom period and thus help moderate both halves of the business cycle. Given what appears to be two strongly opposed positions, we might expect that there had been a ferocious debate between Hayek and Keynes. But there really wasn't, at least not directly. Keynes had rushed out a 1931 book exploring some of these ideas, to which Hayek wrote a couple of critical reviews, prompting a short response from Keynes, but that's about it. They were otherwise soon engaged in different topics and furthering their own research, even if the differences between them remained. Similarly, speaking about both Hayek and Keynes in the context of the Great Depression is somewhat anachronistic. On the one hand, Hayek's influence on the economics profession in the early 1930s was very limited, and his advice of doing nothing in the face of widespread unemployment and economic suffering was unlikely to be politically popular. Keynes, meanwhile, was likely the most influential, or at least the most famous, economist of his time. But his ideas were never really applied by the Roosevelt administration as part of the New Deal. Upon coming into office in 1933, Roosevelt pursued three economic goals, his three R's, relief, reform, and recovery. As we have seen, providing economic relief to the suffering poor was nothing new or even particularly controversial at the time. The scale on which Roosevelt attempted it was oppressive. But hiring workers for infrastructure projects, supporting farmers by boosting prices for their products, supporting those too old to work, or providing mortgage relief to underwater homeowners were all within the realm of relief that wasn't really different in kind from what had come before. And I'll leave it to my colleagues discussing the political ramifications of the New Deal to discuss his controversial reforms and regulations of business and labor in this period, except to say that both Hayek and Keynes were very critical of these programs. But if what we're talking about in terms of Keynesian recovery is large deficit spending designed to stimulate economic recovery, we don't really find any. Throughout the early 1930s, under both Hoover and Roosevelt, deficit spending by the government was modest at best, coinciding with a very slow and partial recovery. And in 1937, Roosevelt became determined to balance the budget at all costs, which prompted a recession within the Depression. It was only at this point, by 1938 or 1939, that he turned to embrace counter-cyclical deficit spending, but this had at least as much to do with arming for World War II as it did with economic recovery. So, if the debate between Keynes and Hayek was neither as heated as we might imagine nor influential on the programs of the New Deal, why talk about them today? Well, as the economic historian Barry Eichengreen has argued, the Great Depression stir serves as the testing ground for all economic theories in the popular imagination. It is the point in the past where we turn to resolve the debates of today. And as we live in a polarized country, we project our own divisions and dissatisfactions back on that earlier period. In both cases, the historical myth tends to obscure the historical reality and to provide further impetus to our own divisions. But, this being a civics podcast, I actually think there is a very important lesson we can learn from the Keynes-Hayek debate, albeit one that has more to do with politics than economics. So both Keynes and Hayek differed sharply in their economics, and their published exchanges could often be quite acerbic. But we also have their letters to one another from this period. And if we look there, we find an instructive case of civil discourse. As Hayek was reviewing Keynes's book and Keynes responding to Hayek's, they wrote letters back and forth, asking for clarifications, definitions, explanations. They didn't end up agreeing with each other, but each was determined to try to understand the other. Not just as a caricature or a straw man, but to hear the opposing argument presented in its best possible form. Both knew that doing so would ultimately push them to rethink their own assumptions and improve their own ideas. And they were able to do so without turning against one another. During the Second World War, as Nazi bombs were dropping on London, Hayek was relocated to Cambridge, where he and Keynes stood on the rooftops side by sides, scanning the night skies for enemy bombers. Keynes wrote a glowing review of Hayek's most popular book, The Road to Serfdom. And Hayek in turn wrote a considerate eulogy lamenting Keynes's early loss. I don't know whether they were friends, but through their disagreement, they found a way to respect each other and continue working together for the greater good. And I think that might be the greatest lesson from them we could learn for today.

Closing Thoughts And Thanks

SPEAKER_00 22:12

Dr. O'Neill, thank you so much. I think you really highlighted how economics and civics and history, it uh the threads all tie together, right? We can't talk about one without talking about another. And I'm so glad you talked about these letters because I did not know about them. So I wrote myself a note to look. But I I love that these two economists did model that civil discourse. And you can disagree on theories, but those conversations probably made them both better economists because of that exchange. with one another. So thank you so much for your expertise, for the storytelling too. I think understanding the story of how these theories come up is so important, especially when we get to the Great Depression. So thank you so much for your time and expertise.

SPEAKER_01 23:03

Yeah. Thank you for having me.