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Hayek and Keynes: Two fellow economists

LiveMint logoLiveMint 09-06-2014 V. Anantha Nageswaran

In May, three economists, Paul Beaudry, Dana Galizia and Franck Portier, published a paper (Reconciling Hayek’s and Keynes’ views of recessions) on the views of the Austrian economist Friedrich Hayek and the irrepressible British economist John Maynard Keynes on economic recessions. Hayek was of the view that recessions were consequences of excess capital accumulation in the preceding cycle. Keynes felt that recessions were caused by insufficient aggregate demand. The authors note that both were two sides of the same coin. In one sense, they are correct. After all excess supply is in relation to demand. So, one can say that either supply is in excess or that demand is deficient. Even though this formulation appears to suggest that the difference between the two was a matter of semantics, the prescriptions that flowed from these two formulations were rather different. Before delving into their policy prescriptions, the authors examined if episodes of recessions in the US were preceded by excess capital investment.

They found that it was indeed the case. They found that severe recessions were preceded by high accumulation of all three classes of capital: housing, durables and physical capital. To that extent, Hayek was right. Now, comes the question of dealing with it. Hayek advocated doing nothing. Excesses will work themselves out, given time. The parallel with individual cases of excess accumulation of fat or food is striking. Excess fat is to be burnt and excess intake of food is addressed through fasting. It should work well for the economy too. The prescription for indigestion caused by overeating is not more food. However, extending the principle from individuals to economies may be less than straightforward.

When economies go into liquidation mode to deal with past excesses, it results in unemployment and uncertainties about future employment. That leads households to pare back on their consumption, further exacerbating the excess supply situation. The resulting recession can be deep and painful. Addressing the weak demand or consumption through stimulus measures helps to ease the pain of recession with one downside. The adjustment of the economy is never complete or the adjustment is prolonged. In the end, the economy might be more inefficient than before. So, what is the answer? Let things take their own course or intervene to relieve the pain?

Murray Rothbard, belonging to the same Austrian school of economics of which Hayek is the father, famously asserted in his monograph Economic depressions: Their cause and cure that faced with a depression that the best thing governments could do was to do nothing. It is easier written in books than observed in practice. Democratic governments cannot appear to be unresponsive to public misery. Authoritarian governments derive their legitimacy from economic success. Hence, both are naturally hardwired to intervene.

But, the fallacy may lie with the uncritical thinking that intervention has to be only a case of more spending on the part of government, in order to compensate for the lack of spending on the part of the private sector—individuals and businesses. Animal spirits in the economy could be revived through many ways. Acts of leadership are valid economic stimulus as public spending is.

There are other things to keep in mind too. Economic stimulus, necessitated by recessions, cannot become a permanent feature of the economy nor should they be undertaken without extracting reciprocal commitments from its beneficiaries. These are easier written about than done. Usually, stimulus beneficiaries are those who are well organized and can lobby their case for relief more loudly and effectively. They may not be the most deserving. Hence, they will also be most reluctant to see them withdrawn expeditiously. That is why government stimulus measures end up outlasting their usefulness and economies become permanently less efficient with every business cycle that does not purge itself fully of previous excess.

One answer is to avoid getting into a situation where government intervention is needed to revive the economy. It means that ensuring that excess investment and capital misallocation does not take place. Both monetary and fiscal policies can be effective in doing so. The downside risk is that, in good times, people do not heed warnings and frown up on efforts to rein in the party as needless scare mongering. Those who are profiting the most from the boom conditions are the loudest to warn the authorities—fiscal or monetary—to keep their hands off. They are the ones who queue up first for government support when the party ends.

Repeated iterations of this process over many economic cycles has given us Thomas Piketty’s inequality in the 21st century. Our response to his diagnosis is to find spreadsheet errors just as we did to Carmen Reinhart and Kenneth Rogoff when they warned against governments accumulating more debt in response to economic slowdowns. World economies are not yet safe from some economists.

V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.

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