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Hayek in 20th century macroeconomics

At Marginal Revolution, Alex Tabarrok notes David Warsh’s claim, seconded by Paul Krugman, that “Friedrich Hayek is not an important figure in the history of macroeconomics.” Apparently Warsh and Krugman have no memory of the 20th century. The big issue of the century in economic theory and economic policy, spanning macroeconomics and microeconomics, was the contest between central planning and markets. Hayek and Ludwig von Mises were by far the most prominent economists who argued long and loud that central planning was disastrous, not just because of the viciousness of communist dictatorships, but because even under ideal conditions it could not generate and use effectively the knowledge necessary to maintain modern standards of living. For a long time they were considered to be naive. As late as 1989, Paul Samuelson was still writing in his best-selling economics textbook, "The Soviet economy is proof that … a socialist command economy can function and even thrive." About a hundred million people died proving that Karl Marx, his followers, and credulous souls inclined to give central planning the benefit of the doubt, such as Samuelson, were wrong, and that Mises and Hayek were right.

In comparison to the gigantic contest between central planning and markets, all the other economic issues of the century look insignificant. (Yes, even the Great Depression. How many Americans starved to death at the depth of the Depression in 1933? Not many. How many Ukrainians starved to death in the same year as a result of Joseph Stalin's drive to collectivize agriculture? Millions.) Even so, on a lower plane of significance, I think that Hayek’s revival of the idea of free banking will eventually be recognized as an important event in the history of macroeconomics. It took more than half a century for economists to acknowledge the importance of Hayek’s insights on central planning. It may take just as long with free banking.

  • "This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.

    But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims". – F.A. Hayek, from the essay The Pretense of Knowledge

    • RickDiMare

      Great quote by Hayek, which causes me to consider whether the U.S. has ever really had a free market system, a necessary pre-condition for a free banking model to thrive.

      I mean, before the Civil War we had slavery, and then, both during and after the Civil War—which made it necessary to build railroads, power and communication lines, etc.—and to this day, there's been a heavy (often concealed) private influence on markets through the use of what Henry George (1839-1897) calls "hybrid currencies."

      And ever since the steam engine came into use in the mid-1890's, the model which began during the Civil War (this unhealthy anti-free-market marriage between government and private enterprise) was simply extended into the ocean shipping industry, auto manufacturing, airline and technology industries, etc.

  • Paul Marks

    I have read both Warsh and Krugman's attacks upon the late F.A. Hayek.

    Neither attack contained any substantial argument or evidence – they were just abuse.

    As has been pointed out on this site before, I am a layman (not an academic economist).

    However, if Warsh and Krugman are examples of what an academic economist is (and the standard of "argument" that is expected from them) then I am glad I am a layman.

    As for the issue of whether the United States had a free market (not something that is really in the Warsh or Krugman articles).

    The United States Federal government, even as late as 1929 – let alone before the Civil War, was only 3% of the economy, total govenrment (including State and local government) was only about 12% of the economy.

    On slavery – some States, before the Civil War, had slavery, but most States (including the most important States economically) did NOT.

    On railroads – some railroads were subsidized by government in American history, but some were NOT. Certainly there would have been railroads without governmetn subsidy.

    Ditto with roads.

    As for power and communications – again there is no evidence that government intervention was required.

    To say "there was sometimes a subsidy – therefore subidies were needed" is to make the mistake of the German "Historical School" that Carl Menger refuted in the "War of Method" of the late 19th century.

    I am not making the mistake of an "arugment from authority" here – see Menger's "The Errors of Historicism" (1883 if my memory does not fail me), Menger's ARGUMENTS are the key thing (not his name). Menger REFUTES his opponents – unlike Warsh and Krugman who just SNEER.

    As for "free banking".

    If you mean money lending (either by an individual or by an enterprise) there is no reason whatever why it would need a perfect free market (with no taxation or whatever) to thrive.

    A person (or a "bank") may lend out up to 100% of the money they have (either their own – or money that is entrusted to them TO BE LENT OUT) I have no problem with that – it is up to them.

    However, if by "free banking" you mean lending out money that DOES NOT REALLY EXIST (a "fraction" of eleven tenths of the money – or a hundred tenths of the money) then things are less well – one will have boom/bust events.

    Lending should be from REAL SAVINGS (not book keeping tricks).

    But this has nothing to do with whether the government subsdizes railroads – or whatever.

  • It must be "attack Austrians week," as I just came across this hit-job:

    Anybody care to respond to these rubes?

  • A person (or a "bank") may lend out up to 100% of the money they have (either their own – or money that is entrusted to them TO BE LENT OUT) I have no problem with that – it is up to them.

    You lend me your gold, and I buy Kurt's house with it. Kurt builds homes for a living. Kurt then entrusts the gold to you, and you lend it to someone who buys another house from Kurt, and so on. By the time Kurt has sold a dozen houses, you've lent the same gold a dozen times. By your own reckoning here, you have no problem with this sequence of events.

    Now think about fractional reserve banking.

  • Paul Marks

    Quite right Martin.

    As long as each time the lender (me or someone else) ACTUALLY HAD THE MONEY THEY WERE "LENDING OUT". Each time I lend the money out it must have been FIRST paid back to me (that little principle about something or someone not being in two places at the same time – you are not saying you are the Devil are you?).

    "Now think about fractional reserve banking".

    I have done – for almost 40 years (yes I was a terrible nerd as a child).

    I have no problem with you lending out nine tenths of your money (or the money entrusted to you – TO BE LENT OUT).

    Or ten tenths for that matter.

    It is the eleven tenths – or the one hundred tenths I have a problem with.

    If someone has 100 Dollars (physical Dollars) then they can lend out 100 Dollars (by the way – once they have lent out the 100 Dollars they DO NOT HAVE THE MONEY ANYMORE till when and IF it is paid back).

    Someone can not have a 100 Dollars and then lend out 1000 Dollars.

    And NO lending out the same 100 Dollars (and getting paid back) ten times is NOT the same thing.

    There is a simple test…..

    Is the monetary base (the notes and coins) the same size (or bigger) than bank credit (the money lent out).

    If it is – then no problem here, more along people.

    But if the "broad money" (the bank credit) is BIGGER than the amount of money (physical money) that actually exists…….

    Well then someone has been cooking the books – bit time.

    "But it says here in my ledger that we have a 1000 Dollars".

    Then SHOW IT TO ME.


    Otherwise you might as well say the following.

    "In my ledger I have 100 horses therefore I can lend out a 100 horses".

    If you only have 1 horse in the barn you can still only lend out ONE horse.

    And NO lending out the same horse 100 times is NOT the same.

    What is says in your ledger does not matter.

    What matters is how much money you have got in the vault.

    Otherwise you might as well try and lend out 100 horses – when you have only got one horse.

    One physical horse.

    Not all those wonderful horses – that only exist in your (cooked) ledger.


    You are only "repaid" when the money arrives – not when a cheque/check arrives (cheque/checks can BOUNCE).

    • What matters is how much money you have got in the vault.

      That's easy. I have no gold in my vault, because I lent it out. In fact, I lent out the same gold dozens of times, and dozens of different people all owe me the same gold at the same time, and you don't have a problem with it.

      I'm happy for you to trade however you like of course, but if someone issues promissory notes for gold to the owner of a house in exchange for the title to the house, understanding that the house has a market value in gold and that the title is therefore convertible to gold if necessary, I suppose that's none of your business, unless you're the home owner yourself. If you don't like this business model, you're free to refuse these notes in trade, and I wouldn't have it any other way.

      When you talk about jailing people in this line of business, you give me the creeps.

  • Paul Marks

    By the way – it does not matter whether one is dealing with commodity money or fiat money.

    If the money is (say) silver – then there is silver in your vault (or you do not have money – you have ledger horses).

    If the money is fiat (government command money) then the notes and coins (according to the legal tender laws) are what is going to be in your vault.

    And if you do not have it – then you do not have the money.

    You may have a real nice promise of future money (that draft or whatever), but that is not money.

    You have to wait till when and IF the money is repaid to you – before you can lend it out again.

    Same if you are one bank or many banks.

    In the case of many banks – you are waiting for other banks to get the money (the physical mone) to you.

    Unless, of course, you are playing a shell game.

    The smoke and mirror games of banking.

    Whether on a RELATIVELY small scale – as before the Federal Reserve was created (and it was created for the express purpose of backing up, and expanding, the scam), or the unlimited scale that has developed since the Federal Reserve was created.

  • Richard Schulman

    @Kurt Schuler

    Thanks for this marvelously trenchant post. Now if I can only figure out a wayto frame it and stuff it in the Christmas stockings of my Keynesian friends.

    • Bill Stepp


      And on the outside of the package you can write, "I survived a Keynesian brainwashing and lived to tell about it."

  • RickDiMare

    Could it be possible that we've already tried Hayek's free banking model, but it's been going by the name of "shadow banking"?

    Anyone care to share opinions about how shadow banking differs from free banking?

    "There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money." F.A. Hayek (1935)

  • Pedro Romero

    I agree with Kurt on both issues, the socialist and the free banking debates. But I also think that Hayek's work on complexity and evolutionary processes will be considered as pioneering ideas in both fields. For instance, in the paper at this link

    entitled "Topological isomorphisms of human brain and financial market networks" you can see that Hayek's theory of the interaction mind-physical phenomena or micro-macro cosmos is verified. I do not know of other economist who wrote about such highly abstract topics so early (not just 50s when he published, but since the 20s), with such prescience. (maybe Marshall is to some extent an exception)

  • Bill Stepp

    Shadow banks make loans, but don't issue deposits as commercial banks do. I think that's the core distinction; and there are regulatory differences.

  • Paul Marks

    Martin a noncrook can only lend out money once – before waiting for when and IF it is paid back.

    If the money is paid back, then it can be lent out again.

    By the way – in a fiat money system the money is fiat notes and coins (NOT words in a ledger). Of course in a commodity money system the money is the commodity (again the actual commodity not the WORDS "X amount of gold" in a ledger).

    If you are going to lend out one million Dollars you must have one million Dollars (the actual notes and coins) to lend out (not just the WORDS "one million Dollars" in a ledger), just as if you want to lend out one million horses you must actually have one million horses (animals) NOT just the words "one million horses" in a ledger. Or just one horse that you lend out one million times.

    Of course the above is only true for someone who does not wish to be corrupt (a crook), for those who do not care about basic honestly there are no rules.

    But there is still PHYSICAL REALITY. If you play the "credit expansion" game (i.e. the lending out of money that DOES NOT REALLY EXIST) you will indeed have a "boom" – but you will also have a "bust" (there is no escaping it).

    Investment must be from REAL SAVINGS (money that people earned but choose NOT to consume) – savings must represent a SACRIFICE of consumption (otherwise they are not "savings" at all).

    And lending is always a RISK.

    You may not get the money back – but you have lent it out (i.e. YOU DO NOT HAVE THE MONEY ANY MORE).

    That is why when banks pretend a loan is an "asset" they are playing a very wrongheaded game.

    A loan is no more an asset than a bet is.

    Let say I put a 100 Dollars on a horse called "Ron Paul" (no disrespect meant to the Congressman) to win a race.

    If the bet is at 2 to 1 – I will have 200 Dollars if I win. A hundred Dollar profit.

    But till I win (till the loan is paid back) I have nothing. I am down 100 Dollars.

    And if I lose offering the bookie the WORDS "one hunrded Dollars" in a ledger will not do – only 100 Dollars will do.

    If I do not have the actual money it is more than "the bubble" that is going to be broken – my legs are going to broken also.

    And quite rightly so.

  • Paul Marks

    By the way on the Hayek quote (that Rick provided). Hayek was quite right – an increase in bank credit does act like an increase in the money supply (TILL THE BUST).

    In the 1920s American output increased yet prices (I know that prices indexes are problematic – but generally speaking….) did not fall. Was this because new gold mines had been discovered?

    Not really – in reality the banks (following the lead of Ben Strong at the New York Federal Reserve) were expanding bank credit. This acted like an increase in the money supply – keeping up prices (and, also, producing a bubble in the stock market and real estate market – what Hayek calls the "Ricardo effect" of money getting to some places and pileing up there, not just going everywhere at once, although Richard C. thought of much the same thing).

    Of course when the bust came……

    By the way – even before the creation of the Federal Reserve, bank credit expansion would have had similar effects (although on a much smaller scale).