At England’s stately University of Cambridge in fall 1905, a clever post-graduate mathematics student named John Maynard Keynes began his first and only course in economics. He would spend eight weeks studying under the renowned Professor Alfred Marshall. During the summer Keynes had read the then-current (third) edition of Marshall’s Principles of Economics, a synthesis of classical and new doctrines that was the leading economics textbook in the English-speaking world. Marshall was soon impressed with Keynes’s talent in economics. So was Keynes himself. “I think I am rather good at it,” he confided to an intimate friend, adding, “It is so easy and fascinating to master the principle of these things.” A week later he wrote:
“Marshall is continually pestering me to turn professional Economist.”1 At an Austrian army encampment on the bank of the Piave River in northern Italy during the last months of the First World War, a lull in combat gave a young lieutenant named Friedrich August von Hayek the chance to open his first economics texts (not counting the socialist pam-phlets he had read during college), two books lent to him by a fellow officer.
He later wondered why the books had not given him “a permanent dis-taste for the subject” because they were “as poor specimens of economics as can be imagined.” Returning to the University of Vienna after the war, the young veteran “really got hooked” on economics when he discovered a book by the retired professor Carl Menger. Menger’s Principles of Economics (Grundsätze der Volkswirtschaftslehre) of 1871 had colaunched a marginal-ist-subjectivist revolution in economic theory, a revolution that provided the new ideas in Marshall’s synthesis. Hayek found it “such a fascinating book, so satisfying.”2
1 Robert Skidelsky, John Maynard Keynes, vol. 1 (London: Macmillan, 1983), pp. 165–6.
2 F. A. Hayek, Hayek on Hayek: An Autobiographical Dialogue, ed. Stephen Kresge and Leif Wenar (Chicago: University of Chicago Press, 1994), pp. 47–8. Hayek identified the
Keynes and Hayek would come to play leading roles in the clash of eco-nomic ideas during the Great Depression. Their ideas have informed the fundamental debates in economic policy ever since. In 2010 and 2011 their intellectual rivalry even became the subject of two viral rap videos.3
JoHn MAynARD KEynES
John Maynard Keynes (1883–1946) was the son of the English economist John neville Keynes. At the University of Cambridge, where his father lec-tured, he studied mathematics but also pursued interests in philosophy and, as noted, took one economics course from Marshall. After a brief stint in the civil service Keynes began lecturing in the Cambridge economics depart-ment in 1909, sponsored by Marshall, and became editor of the Economic Journal two years later. In 1915 he became an adviser to, and then an official within, the UK Treasury. Four years later, at age thirty-six, Keynes was a British delegate to the Versailles Peace Conference following the First World War. His best-selling insider’s account and critique of the peace treaty, The Economic Consequences of the Peace (1919), brought him widespread fame.
In the next three decades Keynes kept busy writing books and articles, lecturing at Cambridge, editing The Economic Journal, speculating in the London financial markets, and advising the British government.4 In all this activity, Keynes displayed what Daniel yergin and Joseph Stanislaw have described as a “dazzling, wide-ranging intellect . . . combined with chronic social and intellectual rebellion, orneriness, and the lifestyle of a Bloomsbury bohemian and aesthete.”5 Although his sexual relationships as a young adult had almost entirely been with men,6 Keynes around 1922
authors of the two awful books only as “Gruntzl and Jentsch.” He may have meant Josef Grunzel, Grundrisse der Wirtschaftpolitik (Vienna: Hölder, 1909–10), and Carl Jentsch, Grundbegriffe und Grundsätze der Volkswirtschaft (Leipzig: Grunow, 1895).
3 “Fear the Boom and Bust” and “Fight of the Century,” written by John Papola and Russ Roberts, available online at econstories.tv. Within a month of its January 2010 release on youTube the first video had registered more than 800,000 views. In July 2011 its count reached 2.5 million, while the sequel (released April 2011) surpassed 1 million views.
4 For a detailed chronology of Keynes’s career, see http://www.maynardkeynes.org/keynes-career-timeline.html. The authoritative biography is Robert Skidelsky, John Maynard Keynes, 3 vols. (London: Macmillan, 1983, 1992, 2000), also available in an abridged sin-gle volume (new york: Penguin, 2005).
5 Daniel yergin and Joseph Stanislaw, The Commanding Heights: The Battle for the World Economy (new york: Simon & Schuster, 2002), p. 40. Bloomsbury was a fashionable neighborhood in London.
6 Keynes recorded his sexual affairs in secret diaries. For some details see the appendix, “A Key for the Prurient: Keynes’s Loves, 1901–15,” in D. E. Moggridge, Maynard Keynes: An Economist’s Biography (London: Routledge, 1992).
surprised his Bloomsbury friends by taking up with Lydia Lopokova, a Russian ballerina. They married in 1925 and remained happily married for the rest of his life.
In A Tract on Monetary Reform (1923), Keynes argued against a post-war return to the gold standard at the traditional parity, on the sensible grounds that it would require a painful deflation of prices and wages. The central bank should instead let the exchange rate float and target the price level. In A Treatise on Money (1930, 2 vols.), published early in the Great Depression, Keynes offered a theory of the business cycle that drew on the work of his teacher Alfred Marshall and on the Swedish economist Knut Wicksell. Hayek severely criticized the work in a lengthy two-part review. Keynes went back to the drawing board and authored the book for which he is best known, The General Theory of Employment, Interest, and Money (1936). There he argued that the economy’s current aggregate out-put is governed by its current aggregate demand, and that the most volatile component of aggregate demand is current investment spending. Keynes’s diagnosis of the Great Depression boiled down to: investors had lost their nerve. His remedy: government must expand its spending to boost aggre-gate demand and particularly investment. We will consider this theory and its predecessors in more detail in Chapter 5.
FRIEDRICH A. HAyEK
Friedrich August von Hayek (1899–1992) was likewise born into an intellectual family, his father a professor of botany at the University of Vienna. After serving the last year of the First World War as a draftee on the Italian front, Hayek returned home to study economics and psychology at the University of Vienna, finally choosing economics in part because the job prospects were better. He studied with Friedrich von Wieser, a fol-lower of the pioneering neoclassical economist Carl Menger (whose ideas are discussed in Chapter 8). After graduation he secured a job working under Vienna’s leading economist, Ludwig von Mises. From March 1923 to May 1924 Hayek took a leave of absence to visit the United States, where he met many of the leading American economists of the day. After his return to Vienna he headed a business cycle research institute that Mises had founded.
Initially socialist in his sympathies as a student, Hayek was deeply influ-enced by Mises’s critical book on Socialism (1922), and later reinforced Mises’s arguments with his own critique of contemporary “market socialist”
ideas (see Chapter 2). A collection of Hayek’s articles, Individualism and
Economic Order (1948), included his critiques of market socialism and also important essays on crucial role of market prices as signals that enable soci-ety to coordinate the efforts of millions of decentralized decision-makers.
Hayek emphasized the “marvel” that the price system achieves an intricate economic order coordinating millions of plans and bits of dispersed knowl-edge – thereby allowing the efficient use of resources – without central design.7
Hayek’s early works were mostly devoted to the problem of business cycles. He wrote Monetary Theory and the Trade Cycle (German edition 1929) and Prices and Production (1931), the latter in English based on guest lectures Hayek had given at the London School of Economics. The LSE eco-nomics department headed by Lionel Robbins hired Hayek in the wake of the lectures, and he taught there until 1950. In Hayek’s business-cycle the-ory, based primarily on earlier work by Mises and Wicksell, the economic boom period is fueled by artificially cheap credit. (Both Keynes and Hayek drew from Wicksell’s work, but they drew from different parts.) The credit-fueled boom inevitably ends in bust because the unsustainably low interest rate has lured investment into forms that turn unprofitable when, as it must, the interest rate rises toward equilibrium. We will consider this theory and its predecessors in detail in Chapter 3. Prices and Production was severely criticized by Keynes and others. Returning to the drawing board, Hayek published Profits, Interest, and Investment (1939) and The Pure Theory of Capital (1941).
During the Second World War, Hayek published the popular book for which he is best known, The Road to Serfdom (1944). In it he warned of the dangers of central planning for personal and social freedom (see Chapter 6). Hayek founded the Mont Pelerin Society in 1947 as an organization to rally the few remaining classical liberal intellectuals who shared his oppo-sition to the trend toward a larger government role in the economy and society (see Chapter 8).
With his research migrating from pure economics into social philoso-phy, and with his decision to leave his first wife to marry another woman (which estranged him from Robbins), Hayek moved to a position in the
7 For an intellectual biography of Hayek see Bruce Caldwell, Hayek’s Challenge (Chicago:
University of Chicago Press, 2004). See also Gerald P. o’Driscoll, Jr., Economics as a Coordination Problem: The Contributions of Friedrich A. Hayek (Kansas City: Sheed Andrews & McMeel, 1977); and G. R. Steele, The Economics of Friedrich Hayek (new york:
St. Martin’s Press, 1993). For Hayek’s own reminiscences see F. A. Hayek, Hayek on Hayek:
An Autobiographical Dialogue, ed. Stephen Kresge and Leif Wenar (Chicago: University of Chicago Press, 1994).
Committee on Social Thought at the University of Chicago in 1950.8 There he wrote The Constitution of Liberty (1960), an exposition of his classical liberal political philosophy. He returned to Europe in 1962 to take a chair at the University of Freiburg in Germany. In 1974 he was corecipient of the Bank of Sweden Memorial Prize in Economic Science in Honor of Alfred nobel (hereafter we will abbreviate the prize’s name). Two years later, at the age of 77, he published a remarkably radical monograph calling for the Denationalisation of Money. He returned to the topic of socialism in his final work, The Fatal Conceit: The Errors of Socialism (1989).9
KEynES on THE EnD oF LAISSEz-FAIRE
Keynes flatly rejected Adam Smith’s doctrine of the invisible hand. In the opening paragraph of a 1924 lecture published in 1926 as an essay entitled
“The End of Laissez-Faire” he declared:
The world is not so governed from above that private and social interest always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened interest always operates in the public interest. nor is it true that self-interest generally is enlightened; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these.10 Specifically, Keynes denied that decentralized market forces were adequate for determining the volumes and allocations of saving and investment:
I believe that some coordinated act of intelligent judgement is required as to the scale on which it is desirable that the community as a whole should save, the scale on which these savings should go abroad in the form of foreign investments, and whether the present organisation of the investment mar-ket distributes savings along the most nationally productive channels. I do not think that these matters should be left entirely to the chances of private judgement and private profits, as they are at present.11
8 The other woman was his first cousin Helene, who had been his childhood sweetheart.
They had corresponded for years and reconnected in Vienna in 1946. Hayek spent the 1951 spring semester at the University of Arkansas to take advantage of the state’s liberal divorce laws. For more details on Hayek’s divorce see Alan Ebenstein, Hayek’s Journey: The Mind of Friedrich Hayek (new york: Palgrave Macmillan, 2003), p. 123.
9 F. A. Hayek, The Denationalisation of Money, 2nd ed. (London: Institute of Economic Affairs, 1978); Hayek, The Fatal Conceit: The Errors of Socialism, ed. W. W. Bartley III (Chicago: University of Chicago Press, 1988).
10 John Maynard Keynes, “The End of Laissez-Faire” [1926], in Keynes, Essays in Persuasion (new york: W. W. norton, 1963), p. 312.
11 Ibid, pp. 318–19.
In The General Theory Keynes would emphasize his view that market forces could not be counted on to deliver a great enough volume of invest-ment in the aggregate. An enlightened governinvest-ment should take control.
KEynES VERSUS HAyEK on THE RoLE oF GoVERnMEnT Keynes was a leading advocate of the view that government should take greater control over the economy. Hayek was a leading advocate of the view that government should interfere less with market forces. They serve as rep-resentatives of the opposing sides here because of their wide influence, not because either took the most polar position available. Keynes did not want to abolish markets the way communist thinkers would. Keynes explicitly rejected Russian communism for three reasons: (1) It “destroys the liberty and security of daily life”; (2) its Marxian economic theory is “not only sci-entifically erroneous but without interest or application for the modern world” and its Marxist literature more generally is “turgid rubbish”; and (3) it “exalts the boorish proletariat above the bourgeois and the intelligent-sia” – in other words, sneers at people like Keynes and his circle.12 Hayek did not want to abolish government the way anarcho-capitalist thinkers would.
(yes, there really are serious proponents of a stateless market economy.)13 For most of the twentieth century, Keynes’s view that government should take on a greater role in the economy prevailed among opinion-makers.
And the role of government grew. While Keynes was not an advocate of complete state planning, he did endorse greater planning. In a letter to Hayek, responding to Hayek’s critique of state planning in The Road to Serfdom, Keynes wrote:
I should say that what we want is not no planning, or even less planning, indeed I should say that what we almost certainly want is more.14
In The General Theory of Employment, Interest, and Money (1936) Keynes called for “a somewhat comprehensive socialization of investment” which
12 John Maynard Keynes, “A Short View of Russia” in Keynes, Essays in Persuasion, pp. 299–300.
13 Two important contributors are Murray n. Rothbard, For a New Liberty, rev. ed. (new york: Collier, 1978), and David D. Friedman, The Machinery of Freedom (Chicago: open Court, 1989). A well-known work in political philosophy, Robert nozick’s Anarchy, State, and Utopia (new york: Basic Books, 1974), devotes its first third to wrestling with anar-chocapitalism. Proponents and critics are both represented in Edward P. Stringham, ed., Anarchy and the Law (oakland, CA: Independent Institute, 2007).
14 Donald Moggridge, ed., John Maynard Keynes, The Collected Writings, vol. 27: Activities, 1940–1946 (Cambridge: Cambridge University Press, 1973), p. 387.
he believed would provide “the only means of securing an approximation to full employment.” His focus there was on economy-wide aggregates rather than on details of resource allocation. He emphasized that his proposal for
“socialization of investment” did not imply full State Socialism in the sense of outright government ownership of factories:
It is not the ownership of the instruments of production which it is impor-tant for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary.15
The government need not own the factories if it can otherwise bring about the proper volume of total investment spending. Keynes prescribed a greater volume of investment than he thought the market would deliver.
A greater volume of investment would reduce the rate of return on invest-ment. He envisioned the “euthanasia of the rentier” (the person who lives on interest income) and “the euthanasia of the cumulative oppressive power of the capitalist,” meaning a policy that would drive the rate of return so low – perhaps even to zero – that no wealth-owner could live solely on the returns from his investments.16
Keynes also suggested a greater role for government in labor mar-kets, questioning in a 1925 essay “whether wages should be fixed by the forces of supply and demand in accordance with the orthodox theories of laissez-faire, or whether we should begin to limit the freedom of those forces by reference to what is ‘fair’ and ‘reasonable’ having regard to all the circumstances.”17
PoLITICAL EConoMy In AMERICA’S PRoGRESSIVE ERA Economic ideas supporting the expansion of government’s role in the economy certainly did not begin with Keynes. Indeed they did not even begin in the twentieth century. In the late nineteenth century the United States, for example, entered a period of ideological change toward more active government, a period now called the Progressive Era. numerous
15 John Maynard Keynes, The General Theory of Employment, Interest, and Money (London:
Macmillan, 1936), pp. 377–8.
16 Allan H. Meltzer, Keynes’s Monetary Theory: A Different Interpretation (new york:
Cambridge University Press, 1988), emphasizes that “Keynes favored state direction of investment from the mid-1920s” (p. 5) and views The General Theory as Keynes’s attempt to provide a theoretical underpinning for that long-held belief.
17 John Maynard Keynes, “Am I a Liberal?” [1925], in Keynes, Essays in Persuasion, p. 333.
economists played important roles in the ideological and political move-ment, developing arguments and promoting legislation to increase the role of the federal government in the economy, from the Sherman Antitrust Act (1890) to the Pure Food and Drugs Act (1906) to the Federal Reserve Act (1913). As Thomas C. Leonard has put it, “In the three to four decades after 1890, American economics became an expert policy science and academic economists played a leading role in bringing about a vastly more expansive state role in the American economy.”18
In the late 1870s and 1880s young American economists were returning from graduate training in Germany with ideas and approaches that they developed into a school of thought that came to be known as institutionalist economics. In 1885 the thirty-one-year-old Richard T. Ely of Johns Hopkins University led a group of these economists in founding the American Economic Association (AEA). The AEA quickly became (and remains) the leading professional organization of economists, but among its original mis-sions was to organize economists opposed to laissez-faire ideas. The AEA’s initial Statement of Principles affirmed “the state as an agency whose posi-tive assistance is one of the indispensable conditions of human progress.”19 Ely and economist John R. Commons went on to influence labor policy reforms during the Progressive Era as leaders of the American Association for Labor Legislation (AALL). The AALL was founded in 1906 with Ely as its first president and Commons soon becoming its secretary.20
Ely and his compatriots saw themselves as a “new school” of dissenters from classical or neoclassical economics and from the doctrine of laissez-faire. Ely wrote in 1886 of “the controversy between the economists of the old school,” meaning the classical and neoclassical economists and defenders of laissez-faire, and the economists of “the new school in America,” meaning the institutionalists and Progressives like himself. He described the “new school” thinkers as scientific truth-seekers whose historical investigations
18 Thomas C. Leonard, “Eugenics and Economics in the Progressive Era,” Journal of Economic Perspectives 19 (Autumn 2005), p. 207.
19 on Ely’s life and influence see Benjamin G. Rader, The Academic Mind and Reform: The
19 on Ely’s life and influence see Benjamin G. Rader, The Academic Mind and Reform: The