Hayek Was Right, Keynes Was Not An Economist
Perhaps we should have listened to Friedrich Hayek, when he said that his friend Lord Keynes was not an economist. This description of Keynes by Hayek is extracted from a video interview with Leo Rosten in 1975:
He was a man with a great many ideas who knew very little about economics. He knew nothing but Marshallian economics. He was completely unaware of what was going on elsewhere. He even knew very little about nineteenth century economic history. His interests were very largely guided by aesthetic appeal, and he hated the nineteenth century and therefore knew very little about it, even about its scientific literature.
We must pick Hayek’s introductory statement apart, because despite Keynes’s alleged ignorance of economics, in modern times he became the most influential economist after his General Theory was published in 1936. He sanctified a new specialisation of macroeconomics which dominates economic literature today. He inspired a succession of influential economists, who were and still are devoted followers. He was also the ultimate establishment man (which Hayek never was). He won a scholarship to Eton and attended Cambridge University, where his father lectured on economics and moral sciences. It was at Cambridge where he fell under the influence of Alfred Marshall (1842-1924). Hence Hayek’s reference in the clip above to Marshallian economics.
Marshall took the view that past prices, or data, form the basis for estimating prices in the future, while accepting unforeseen factors would affect them such as variations in demand and the interplay with variations of demand for other goods. He downplayed consumer subjectivity in common with his predecessor, William Stanley Jevons, who firmly believed prices could be mathematically modelled. Marshall didn’t go the whole hog, taking a quasi-mathematical approach, which started being geometric-based analysis but evolved into differential calculus. This clashed fundamentally with Hayek’s Austrian tradition, which had been established by Carl Menger in his Principles of Economics published in 1871.
But Hayek’s inference that by ignoring Menger’s subjectivity, Marshallian economics was in error, is more than one school criticising another. Marshall’s approach got stuck without satisfactory outcomes, while Menger’s theory led to further discoveries by those who followed him: von Bawerk, von Wieser, von Mises and of course Hayek himself.
While Keynes’s views took on those of his mentor, he also laid increasing emphasis on mathematical analysis of economics. In this there can be no doubt that he was for ever influenced by Marshall’s teachings. The attraction of Marshall’s approach to a non-economist (such as Keynes) was that philosophical reasoning would be substituted by mathematical suppositions. Applied with inductive reasoning, data could then be used as the basis for generalised forecasts of economic outcomes and form the basis of the state’s management of the economy.
In the tradition of Adam Smith, Jevons Marshall and Pigou all assume a cost of production theory of prices. Yet our own experience tells us this cannot be true. Manufacturers will estimate a price-point for their product on the basis of evolving consumer intelligence. They will try to make a profit by adjusting their cost of production to meet that price point, not the other way around. When a manufacturer produces a range of products, one or more of them might be marketed for sale at a loss in order to complete a product range. In a free-market economy, any manufacturer who fails to respond to changing consumer commands will go out of business. Therefore, the cost of production takes a back seat. It is only government and government-sanctioned monopolies that manage to work on a cost-plus basis.
How consumer preferences change in the future cannot be known: the best guess for future prices for their niche products is made by skilled entrepreneurs immersed in their own niche markets. Marshall’s mathematically geometric approach of projecting prices on the basis of past supply and demand becomes no more than a what-if exercise, and not a viable basis for price theory. If, as Hayek intimated, Keynes had been aware of what was going on elsewhere in the field of economics, he might have understood the flaws in Marshallian economics.
That Keynes hated the nineteenth century is an interesting observation. If true (and Hayek would have been in a position to know, so we should not doubt it) it could explain an antipathy to the economic theories of free trade established by the likes of Cobden in England and Bastiat in France. But surely, he would have seen the progress free trade brought to a nation. Surely, he would have understood Ricardo’s theory of comparative advantage and the benefits it brought.
Equally, he could have been deterred by the writings and philosophies of Marx and Engels, which imparted a primal threat to the establishment. Marx inspired the early organisers of the Labour Party, which was founded in 1900 having evolved out of the trade union movement and the socialist parties of the nineteenth century. By the early 1920s it overtook the Liberal Party to be the main opposition to the Conservatives, forming its first government in 1924, twelve years before Keynes published his General Theory. The threat to the establishment had infiltrated parliament itself.
This was no gentle Methodist revolution. Originally drafted in 1918 by Sidney Webb, an apologist for Soviet communism and the founder of the Fabian Society, Clause 4 of the Labour Party constitution bound it to the Marxian ambition to take into public ownership the means of production. This threat to the establishment raised the possibility, that consciously or unconsciously, Keynes’s ambition might have been to find another way for the state to control the economy, since free markets appeared to be under mortal threat from Marxism.
Certainly, before the Great War, in Cambridge the academic environment would have been conducive to these thoughts, with many professors sympathetic to Marxism. An alternative socialism was required, and Keynes was willing to invent it. The sentiment was there. In the Concluding Notes to his General Theory Keynes observes that “Since the end of the nineteenth century significant progress towards the removal of very great disparities of wealth and income has been achieved through the instrument of direct taxation – income tax and surtax and death duties – especially in Great Britain”.
There is no mention of the obvious drawbacks to a policy that seeks to level wealth towards the lowest common denominator. Keynes’s laudatory discourse on wealth redistribution quoted above is socialism raw in tooth and claw. It guarantees the state a substantial income to spend on its own bureaucracy and other ambitions. And the productive benefits of wealth, if it had not been destroyed through government attempts to remove wealth disparities, is entirely forgone.
Keynes was and still is seen by many to have established a middle way between socialism and free markets. This is equivalent to claiming that to sin a little is not to sin at all. But one cannot be selective over the application of a general theory. The redistribution of some wealth is fatally destructive of that wealth, and the more that is transferred the greater the economic cost.
Of course, redistribution of wealth through taxation is not the only method of wealth destruction. Inflation, the dilution of the money stock, is the most certain and undetectable method. In the General Theory, Keynes ducks entirely the role of bank credit in inflating the money-quantity. It is as if he is unaware of the inflationary consequences of the Bank Charter Act of 1845, which set in stone the facility for banks to expand credit. Evidence, perhaps, to support Hayek’s assertion about his lack of knowledge of nineteenth century economics.
Keynes was wholly unfamiliar with the ground-breaking progress of the Austrian School in this respect, particularly the 1912 work of von Mises’s The Theory of Money and Credit. Until it was translated, Keynes would have had no adequate explanation for the cycle of credit expansion and contraction, which fed the booms and slumps in the second half of the nineteenth century. Despite the population enjoying a lift in living standards through the industrial revolution, it was the periodic slumps which fed Marxian support.
The value of von Mises’s analysis of the credit cycle cannot be overestimated. It is a great shame for us all that Keynes was unaware of Austrian economic literature until it was translated from the German – too late to undermine the beliefs of a man whose thinking was becoming firmly set and would not be radically altered. It fundamentally contradicts Keynes’s assumption that the trade cycle can be managed. But Keynes’s mind was made up: a benign state had to progress beyond the lender of last resort function of a central bank. A central bank’s beneficial role in saving systemically important banks from collapse had been proved to everyone’s satisfaction in the late-nineteenth century. The next task was to justify wider state interventions to stop a repeat of the late nineteenth century slumps, and particularly, a repeat of the 1930s depression.
In the 1930s Keynes was moving from Marshallian inductive reasoning to goal-seeking a favoured outcome. In order to get there, he had to ditch elements of classical economics that got in his way. His goal was to end the periodic slumps, and his prejudice led him to a utopian world without them. The Concluding Notes in his General Theory set this out. He decries unnecessarily high rates of interest as an inducement to save, making the mistake of not understanding that rates set in a free market are a reflection of the time preference on goods. He goes on to say it would not be difficult to
…increase the stock of capital up to the point where its marginal efficiency had fallen to a very low figure… Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital.
This, it turns out, is the ultimate objective of Keynes’s economics. With the redistribution of wealth and the state ensuring the provision of capital at a low interest cost, the system of savings providing the investment and working capital for entrepreneurs would become redundant. The state would gain control over the deployment of capital, thereby ensuring close to full employment. The General Theory is not a book explaining economics to his followers at all, but a propaganda tool to lead them to his vision of a non-Marxist socialist nirvana.