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Talking points for the Keynes-Hayek Debate

Here is the prepared version of my opening statement for the Keynes-Hayek debate sponsored by Reuters that was held in New York City tonight. Due to time constraints, I skipped over some bullet points.

The video recording is now available: here.

• Friedrich Hayek developed a business cycle theory that explains how overly cheap credit from the central bank gives rise to an investment boom. In the boom, because interest rates are unsustainably low, investment is badly misallocated
o The boom is bound to go bust.
o Hayek’s theory doesn’t explain every recession in history, but it certainly does fit our recent housing boom and bust.
• The fit between Hayek’s theory and recent events is why we see the revival of interest in Hayek
o It’s why there’s a Hayek-Keynes rap video (“Fear the Boom and Bust”) with 3 million views.
o It’s why Nick Wapshott made Hayek the co-star of his book
o It’s why we are here discussing Hayek as the alternative to Keynes in anti-recession policy.
• By the way, for an account of the broader intellectual context of the Keynes-Hayek dispute, let me modestly recommend my forthcoming book, The Clash of Economic Ideas: Policy Debates and Experiments of the Last Hundred Years
o Available April 2012 from Cambridge University Press.

• In stark contrast to Hayek, the Keynesian theory of depressions offers no theory of the boom-bust cycle.
o Keynesian models completely abstract from the structure of production in the economy.
o The Capital stock is just one big uniformly productive lump
 Investment just makes the lump bigger, so there is no such thing as over-investment or wrongly directed investment
 it doesn’t matter where investment goes
 Employment is just employment.
o Keynesian models consequently fail to see how labor and capital are misallocated in a credit boom
o Or why economic recovery and sustainable growth are not just about aggregate demand.

• After the dot-com bubble burst in 2001, the Fed ramped up aggregate demand with rapid monetary expansion and ultralow interest rates, as Keynesians recommended.
o The Fed almost seemed to be trying to create a housing bubble to replace the Nasdaq bubble
o That experiment didn’t work out so well, did it?
o We have permanently reduced our real standard of living for wasting so much capital overinvesting in housing during the boom.

• So, What would Hayek have us do? Two things:
o Create a consistent monetary environment for saving and investment, without interest-rate distortions
o let necessary economic recalculation and adjustment take place.
• Critics have tried to tar Hayek as someone indifferent to the deflationary collapse of spending in the early 1930s, as though he counseled doing nothing to stop it.
o It's a bum rap.
o If they would actually read Hayek’s 1931 book Prices and Production, or his 1937 book Monetary Nationalism and International Stability, they would learn that he actually counseled central banks to prevent a collapse in spending.
o Hayek understood that a spending collapse has dire real consequences due to price stickiness.
o He did not subscribe to the Panglossian model of frictionless markets that some critics find a convenient straw man.
• Hayek explicitly called for constancy of what he called “the total money stream,” i.e. stabilization of nominal GDP.
o He was a forerunner of NGDP targeting
o To keep “the total money stream” constant means expanding the quantity of high-powered money to offset any forces shrinking the broader stock of money, or any increase in hoarding
o We can fault Hayek personally for failing to stay on this message consistently in the early 1930s.
 He himself later pleaded mea culpa on that.
o But his explicit monetary policy norm – to maintain nominal spending, is clear, and sensible, and not “do nothing”
 It would have prevented the deflationary spiral of the early 1930s, if the Fed had listened
 It would be an improvement today over the Fed’s unanchored policy

• Hayek’s perspective has further implications for re-starting sustainable economic growth after the bust:
o Don’t undertake public works whose costs exceed benefits—they are a waste
o Let market forces correct the real capital misallocations created by easy money during the boom
o Let artificially high asset prices fall relative to consumer prices
 Preferably not by inflating consumer prices.
o Let unemployed talent and idle machines move as rapidly as possible into appropriate and sustainable new employments.
 This means avoiding bailouts and subsidies and other forms of cronyism that misdirect investment
• If our goal is sustainable real growth, then we need to recognize that, contrary to Keynes, we cannot restore prosperity by building pyramids.

  • Arteaga

    Thats certainly what the Hayek of the 30s will have prescribed. I wonder if the late Hayek of the "Denationalization of Money" would have agreed. ¿Any thoughts on that?

    • Larry White

      Hayek of Denationalization certainly had a different idea, and free banking is still another, but with so little time I had to leave that can of worms unopened.

  • Isaac 'Izzy' Marmolejo

    The debate as a whole was very mediocre. It seemed more of a conservative-v-liberal debate and, most of the time, the "defenders" of Hayek tended to equate Reaganomics with Hayekian economics. Kinda sucks that White had to deal with all of this :p. Maybe the debate would have been worth something if the Hayek panel included Roger Garrison or Selgin to help White out.
    Nevertheless, my favorite part of the debate is when White called out all the economists out for assuming they know Hayek yet also claiming that they avoided reading 'Prices and Production'

    • I agree, Izzy. I was disappointed with both sides of the debate and wish more time would have been spent attacking the principles of Keynesian theory instead of the political practice of it. Otherwise you open the door to legitimizing the success or failures of a policy without any counterfactuals (ie. the stimulus wasn't big enough). I wrote a blog post about the problem of addressing the debate from a liberal or conservative angle because they lead to equally fallacious conclusions.

    • Larry White

      It would have been great to have had Garrison or Selgin on the team.

  • RickDiMare

    Larry, I think your talking points represent a fair view of Hayek (though I'm certainly no Hayek expert), but I think it has become fashionable to place too much blame on Keynes, who died in 1946, and according to Milton Friedman, would be "horrified" at what we now call "Keynesian economics:"

    And this is not to mention that during Keynes' life, the Fed was always constrained by note redeemability, which notes didn't become irredeemable until 1965, well after Keynes died.

    My point is that in focusing mainly on Keynes as the culprit of profligate spending, we may be overlooking the fact that the U.S. is now more likely to be in the realm of Georg Knapp's ideas, with money existing almost entirely by government decree and income tax regulation.

    • Larry White

      In my own remarks I focused not on Keynes himself, but on "Keynesian models" and the theories of "Keynesian economists."

  • isarjano

    Dear Prof. White,
    Congratulations for yesterday performance. It was great to see at least a real hayekian defending Hayek!
    I have a question. You answered to the public about what the Fed should do now and you said that targetting a NGDP growth of 5pct was probably the less distorsive. I read Prof. Selgin making the case for a 3 pct instead in a debate with Sumner in Cato Unbound. I understand that Hayek proposed to keep the money stream constant. Should I understand he advocated then a 0 pct expansion in M x V? Why do you have different targets in mind? What's the rationale?
    Some market monetarists want a much more agressive target as they want to catch up with the trend established previous to the contraction.
    Last question : what M is the most relevant to stabilize the NGDP? M1, M2?
    Many thanks in advance,
    Ivo Sarjanovic

    • George Selgin

      Ivo, NGDP measures aren't composed by taking some measure of M and a corresponding measure of V and then multiplying the two. Instead, V is itself derived, being the quotient of two observable values, Py (e.g., NGDP) and M. Hence there aren't several measures of NGDP each corresponding to a particular value of V.

      • Prof Selgin,

        Is the policy suggestion of nominal GDP targeting a core idea of free banking, or is it just a prescription for monetary policy in a world of second best with a central bank? Will you be at the monetary conference at Cato next week? If you are, hope to see you there!

    • Larry White

      I should have had a better thought-out answer ready to the question about what the Fed should do now. I don't favor a 5% over a 3% target growth path for NGDP; I offered it as an example of a policy precommitment that would provide an improvement starting from where we are now with 2% or so inflation expectations and a central bank issuing fiat money. I should have said that we could then reduce the path to 3%, or whatever fixed path would least distort the loanable funds market, and that ultimately we should abolish the Fed and fiat money.

      • As of right now, I'm skeptical of NGDP targeting because productivity gains should result in lower prices (assuming a fixed money supply). A lower price level would not drag an economy because lower prices would stimulate consumer demand, thereby increasing velocity. Plus productivity gains affect the more volitile/elastic factor input prices of commodities and the marginal productivity of capital. So without the need of increasing base money, the producers price level would drop faster than the consumer price index, explaining how producers can make profits in a market of falling nominal prices. I of course would favor NGDP targeting to CPI targeting, but as of now I see no reason why a fixed money supply wouldn't be ideal.

  • Robert Dell

    OK, but didn't Keynes have a boom-bust "theory" based upon his perception that there could be big autonomous swings in animal spirits among businessmen? Maybe that's not really a theory?

    • Larry White

      It's not what I'd call an explanation.

  • Paul Marks

    An obvious point to make is that it is that F.A. Hayek did not create this theory.

    The idea that boom/busts are caused by an expansion of bank credit (i.e. loans that are not from real savings) is an old one – it goes back to the 18th century (at least).

    However, even in its modern form what is now called the "Austrian" theory is, in fact, the theory of Ludwig Von Mises (Theory of Money and Credit in 1912 – right to Human Action in 1949). Hayek did not create the theory.

    Of course there are plenty of details (malinvestment not overinvestment – and on and on), but the basic matter is that borrowing must be from real savings – not the govenrment printing press, or from banker book keeping tricks.

    As for the gap between the monetary base and "broad money" (i.e. bank credit). Government (or the "private" Federal Reserve if one has to call it that) seems to be trying to deal with that by producing more "narrow money" and (in various ways) handing it out to the banks (to back up their broad money credit bubble).

    Presently the banks can borrow money (created by the Fed – from NOTHING) at about zero percent interest and lend it back to the government (in various ways) at an interest rate of several per cent (keeping the difference as profit).

    If the public really understood what was going on – it would be a lot more than a few thousand far leftists on the streets.

    Virtually the entire population would be after the bankers – and they would be torn to pieces.

    As for the survival of the banks – perhaps they can survive, as long as they ignore political pressure (in both the United States and Britain) to "get the lending going again".

    As long as they do not build new inverted pyramids of debt (of credit money) on top of the money they have been, de facto, given – they might just survive (as zombie banks – Japanese style).

    Of course, even in a semi free market, the major banks would have gone back in 2008 – shut their doors (as should happen to the major European banks now).

    But then (even in a semi free market) the great Federal Reserve credit money expansion orgy (of Alan Greenspan) would not have happened in the first place.

    Every step of the way every possible real correction (that might have limited bank credit money expansion) was shut off by another expansion of the money supply by the Fed (going right back to 1987).

    It has been unfortunate – and continues to be unfortunate.

  • Arteaga

    Today i attended to a very interesting discussion at my university in Mexico City (National Autonomous University of Mexico) which currently is hosting a congress of the European Society for the History of Economic Thought. The debate was mainly between Japanese Hiroyuki Okon (who has been an adjunct scholar of the Ludwig von Mises Institute) and Austrian Heinz D. Kurz (director of the Graz Schumpeter Centre), and so it was mainly a debate Hayek-Schumpeter (which i think it would be a nice theme to study – instead of just focusing of the Hayek-Keynes stuff-). The schumpeterian guy argued that the ABCT was rubbish, first and foremost because Böhm-Bawerks capital theory is wrong, time preference its not a determinant of long term interest rates, in fact that rate is only a trend of the short rates fixed by bankers who are themselves imbued in the invention-innovation-imitation process. Well, it was just a brief commentary; i would rather like to see more attention focused on a Schumpeter-Hayek debate, than one about Keynes-Hayek. Cheers.

    • That's interesting. I haven't read directly from Schumpeter yet, but I appreciate a lot of his contributions. That being said, in the tradition of Mises and Hayek, I feel that the interest rate is a reflection of time preference, opportunity cost and risk compensation. There can be short run volitility in prices in any market, but a more long term disequilibrium caused by central bank intervention will drive the business cycle. If interest rates were not a market phenomenon, wouldn't interest rate speads of bank deposits and bank lending spread ad infitum? Wouldn't the spread between long term and short term debt remain constant?

  • Karl Smith dissaproves of both Keynes-Hayek debates: