Hayek mounts his first assault on Keynes

Friedrich Hayek arrived in London in January 1931 to take up an invitation to participate in the most telling duel in the history of economics. His aim, in four lectures at the London School of Economics: Overturn the theories of John Maynard Keynes, and prove that recessions were not caused by a lack of desire from customers to buy goods.

    In his second lecture, Hayek addressed an important and, in light of the world slump, a highly topical subject: Under what conditions do resources come to be left unused? He declared that to explain any economic phenomenon it was convenient to assume that over time an economy would reach a state of equilibrium in which all resources would be fully employed. But there would be times in the interim when all available resources were not used.

Of all the ways that production could be increased, Hayek suggested, the most effective was by employing capital to satisfy later demand in what he called “roundabout” methods of production. Hayek drew a diagram on the blackboard in the shape of a triangle. He argued that to meet future demand, entrepreneurs over time invest in a succession of intermediate capital goods -- such as tools and machinery -- that are, in the main, sold to other producers of capital goods. In due course, the employment of these roundabout methods of production led to the provision of more consumer goods in the future. Entrepreneurs were prepared to delay making a profit by investing in such intermediate production methods because it would allow them to produce more consumer goods in the future, thereby fulfilling the desires of consumers, who save today to have more tomorrow.

Core Question

This brought Hayek to the core question of his lecture: How did methods of production needing less capital progress to methods needing more capital? The answer was simple: When people spent less on consumer goods and saved more, their savings were invested in capital goods. But there was another way: More capital goods might be produced when money was made available to producers by bank loans. This second method, he said, was not real saving but “forced saving” because the new investment had come about not because of an increase in savings but simply because it suited banks to lend. When the money lent to producers was reduced to its former level, the capital invested in equipment was lost.

“We shall see in the next lecture,” he said ominously, “that such a transition to less capitalistic methods of production necessarily takes the form of an economic crisis.”

Dislocation and Collapse

In the third lecture, with his usual impeccably meticulous, if forbiddingly desiccated, approach, Hayek described how an unwarranted increase in borrowing led over time to a dislocation in the production process of capital goods, which, in turn, caused a collapse at the bottom of the business cycle. To help those without a remorselessly analytical bent, Hayek offered an example.

“The situation would be similar to that of a people of an isolated island, if, after having partially constructed an enormous machine which was to provide them with all necessities, they found out that they had exhausted all their savings and available free capital before the new machine could turn out its product,” he said. “They would then have no choice but to abandon temporarily the work on the new process and to devote all their labor to producing their daily food without any capital.”

Persistent Unemployment

In the real world, Hayek suggested, the result was persistent unemployment. He offered a simple, if unpalatable, truth to those, like Keynes, who advocated increasing the demand for consumer goods to increase employment: “The machinery of capitalistic production will function smoothly only so long as we are satisfied to consume no more than that part of our total wealth which under the existing organization of production is destined for current consumption. Every increase of consumption, if it is not to disturb production, requires previous new saving.”

Hayek also confronted another Keynesian remedy, that if an idle plant was brought into use, it would spur a depressed economy back to life and increase employment. “What [economists like Keynes] overlook is that … in order that the existing durable plants could be used to their full capacity it would be necessary to invest a great amount of other means of production in lengthy processes which would bear fruit only in a comparatively distant future.”

Artificial Demand

He went on, “It should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect.” Such “artificial demand,” he suggested, would merely postpone the day of reckoning. “The only way permanently to ‘mobilize’ all available resources is, therefore, not to use artificial stimulants -- whether during a crisis or thereafter - - but to leave it to time to effect a permanent cure.” In brief, there was no easy way out of a slump. In the long run, the free market would restore an economy to an equilibrium that allowed everyone to be employed.

Hayek scored a bull’s-eye with his audience. Here at last was a cogent, convincing repudiation of Keynesian interventionist notions. Hayek showed that the remedies coming from Cambridge, which appeared so plausible, were riddled with logical flaws. Having the best of intentions wasn’t enough. Addressing the symptoms of a depressed economy by investing with borrowed money only made matters worse. Instead, Hayek offered a sober remedy of his own: Forget about quick fixes, the uncomfortable truth is that only time will cure an imbalanced economy. Beware smooth-talking doctors, such as Keynes, who offered a quick cure, for they are charlatans, snake-oil salesmen, and quacks. The market has its own logic and contains its own natural remedy. 

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Subpages (1): How Hayek engaged Keynes