Hayek versus Keynes: The Road to Reconciliation

Published in The Cambridge Companion to Hayek, edited by Edward Feser, (Cambridge University Press, 2006)

‘[Keynes] was one of the great liberals of our time. He saw clearly that in England and the United States during the nineteen-thirties, the road to serfdom lay, not down the path of too much government control, but down the path of too little, and too late. …He tried to devise the minimum government controls that would allow free enterprise to work. The end of laissez-faire was not necessarily the beginning of communism’. (AFW Plumptre, ‘Keynes in Cambridge’, Canadian Journal of Ecoinomics, vol. 13, August 1947)


The passage of time reduces the Cambridge debates of the 1930s to family quarrels. On the flattened surface stand the twin peaks of Hayek and Keynes. Their intellectual antipody seems the more palpable, because they rarely found a common ground on which to engage. ‘Both sides launched their broadsides, and that was about it’. In economics they were so far apart that, except for one inconclusive and bad-tempered theoretical encounter in 1931-2, they worked out their theories independently each other. In his brief 1944 comment on Hayek’s Road to Serfdom, Keynes in effect accused Hayek of lacking a short-period theory of statesmanship; while Hayek accused Keynes (in many writings after Keynes’s death) of being blind to the long term consequences of the ‘dangerous acts’ Keynes sanctioned for a ‘community which thinks and feels rightly’. But again they did not engage directly, because whereas Hayek wrote systematic treatises on political and social theory, Keynes did not live long enough to answer him in his own coin.

Yet the brief encounter of 1944 discloses the common terrain on which they might have fruitfully argued out their differences. This is the grounds on which, and the methods by which, liberalism could most successfully be defended. For both men were liberals in all important senses of the term. They both repudiated central planning Russian style. They disagreed about whether liberal values could best be protected by more or less state intervention in the economy, but neither gave a very clear indication of ‘where to draw the line’.

The common ground was created by the run-up to the war, and by the war itself. The war clarified for both men the values they shared. ‘Our object in this mad, unavoidable struggle’, Keynes declared on 12 December 1939, ‘is not to conquer Germany, but…to bring her back within the historic fold of Western civilisation of which the institutional foundations are…the Christian Ethic, the Scientific Spirit and the Rule of Law. It is only on these foundations that the personal life can be lived’. The full employment which the war produced also whittled away their differences in economics. Hayek praised Keynes’s anti-inflationary pamphlet How to Pay for the War: ‘It is reassuring to know’, Hayek wrote to Keynes after reading his anti-inflationary pamphlet How to Pay for the War, ‘that we agree so completely on the economics of scarcity, even if we differ on when it applies’. In turn, Keynes cordially welcomed Hayek’s Road to Serfdom: ‘It is a grand book…Morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement, but in deeply moved agreement’.

This essay charts the path to their reconciliation.

ii. Different Temperaments, Different Backgrounds

Hayekians argue that Keynes represented the impatient, Hayek the patient, version of liberalism. [Hayek thought that Archilocus’s famous line ‘the fox knows many things, but the hedgehog knows one big thing’ summed up the difference betwen Keynes and himself. ] The one ‘big’ thing which Hayek ‘knew’ was that all state interference in the market system is evil.. The Fox, Hayek implied, knew this too, but felt he was clever enough to evade the trap, conjuring up new theories, arguments, policies for each occasion. Hayek, it might be said, was all of a piece; Keynes a man of many pieces. It is a self-serving Hayekian image, for the hedgehog wins the race in the end. Hayek was infuriated by the rapidity with which Keynes changed his theories. This seemed to show he lacked scientific principles. Statesmanship without principle,Hayek would have said, is the slippery slope to totalitarianism. Statesmanship without prudence, Keynes would have replied, is the royal road to disaster.

The contrast between the fox and hedgehog suggests another: that between the administrator/ politician and the scholar/scientist. Keynes came from an activist tradition: the ancient universities saw themselves as part of the British ruling class, pushing their graduates into the higher civil service. Keynes himself had three spells in Whitehall. As an emigre, Hayek had scholarly detachment forced on him.His thinking was never tested by the reality or prospect of action. However, Hayek was not quite so detached as he made out. His fear of inflation, linked to the destruction of his own family fortune and the Viennese middle class by post-war hyperinflation, coloured all his supposedly Olympian economics. He went on warning against the dangers of inflation in the 1930s long after deflation had become the problem.

The essential difference between them as theorists was that Hayek’s economics was reverential, Keynes’s was revolutionary. Hayek added important clarifications to the Austrian school of Bohn-Bawerk, Menger and Mises; Keynes saw himself as overturning ‘classical’ economics, including those of his ‘master’, Alfred Marshall. Hayek was much more learned than was Keynes in the history of economic thought: he is right to say that Keynes disliked the 19th century and lacked knowledge of its economics and economic history. Hayek thought about economic theory within the framework of a tradition; for Keynes the important thing was to get the argument right on the page (or on the day). Keynes was the more creative thinker. This was partly the result of an innate quality of mind; but it was also partly because his training in economics was so superficial. Keynes had no difficulty in seeing his ideas as original; to Hayek they were simply the latest instalment of age-old fallacies.

A final difference was one of intellectual manners. By the early 1930s, Keynes and his followers felt a sense of urgency, almost of desperation, to get their ideas accepted. It became the hallmark of Keynes’s coterie to regard every economist outside Cambridge as mad or stupid; argumentative good manners were sacrificed to world salvation. On the other hand, there is near unanimous testimony to Hayek’s intellectual hospitality. For example, when Robert Bryce, one of Keynes’s students, decided, in 1935, to do some missionary work at the LSE, ‘Hayek very courteously gave me several sessions of his seminar to expose [the new Keynesian ideas] to his students’. Hayek was much impressed by Menger’s remark that the final victory of a scientific idea could only be secured by letting every contrary proposition run a free and full course. Hayek’s hopes, and expectations, of truth were geared to the long-run; the short run was full of error. These errors must be allowed to burn themselves out, because that was how mankind learned wisdom. The Keynesian position –and this partly included Keynes – was much more peremptory: error must be extirpated to prevent catastrophe. The optimism of Cambridge confronted the fatalism of Vienna.

The contrast which sums it up may be expressed by saying that Keynes believed that ‘in the long-run we are all dead’, whereas Hayek believed that in the long run we learn wisdom. Hayek never experienced, as a a young man, the equivalent of G.E.Moore’s liberating touch, which led Keynes to write in ‘My Early Beliefs’: ‘We entirely repudiated a personal liability on us to obey general rules…We repudiated entirely customary conventions and traditional wisdom’. Norman Barry comments: ‘There could not be a clearer contrast between this extravagant act-utilitarianism, and personalised, anthropomorphic view of the world’, leading to the doctrine of the philosopher king and the ‘social philosophy of impatience’, and Hayek’s ‘cautious rule-utilitarianism, with its almost metaphysical belief in the accumulated, but undemonstrable, wisdom, of traditional, impersonal rules of behaviour’.

This goes much too far, and the Hayekians never quote Keynes’s partial repudiation of his ‘early beliefs’. The sharpness of the contrast they draw between Keynes’s ‘act-utilitarianism’ and Hayek’s ‘rule-utilitarianism’ is surely untenable in view of what Keynes was saying and writing in the 1930s. It owes too much to Keynes own interpretation of his ‘juvenilia’. The later Keynes, at least, believed in a system of ‘Humean’ rules, flexibly applied, of which the Bretton Woods system he helped to establish is a good example. Keynes ‘grew up’ and his views shifted with the changing cultural, economic and political environment. Hayek gives the impression of never having been young.

Their temperamental and philosophical differences can be exaggerated. As has often been pointed out, they maintained cordial relations through all their disagreements. From a distance it is is easy to see how many presuppositions they shared. They both came to their economics through philosophy. Neither believed that economics was like a natural science. Both emphasised the importance of subjectivism in economic thinking. Both were critical of econometrics. Both subscribed to procedural theories of justice. Both were inegalitarians, believing in the beneficial spillovers from pockets of wealth. Neither was an ardent democrat.When Keynes wrote of the market system in 1936 that it is ‘the best safeguard of the variety of life’, preserving ‘the most secure and successful choices of former generations’ it may have been Hayek speaking. Both believed in the overriding power of ideas, and rejected or ignored explanations of events in terms of vested interests and technology. Both men admired Hume and Burke and delighted in the paradoxical wisdom of Mandeville. (Keynes’s General Theory is full of ‘unintended consequences’, eg the ‘paradox of thrift’. )What Hayek would have called Keynes’s ‘constructivist rationalism’ was tempered by prudence and regard for tradition. Hayek called himself an ‘Old Whig’, and Keynes had a good deal of whiggery in him.Both came to believe that Western civilization was precarious, which they found hard to square with their jointly held conviction that it was an evolutionary success story. In short, both were liberals, and finally understood, that on the great issues of political philosophy and personal freedom, they were in the same camp. It was on the means needed to preserve a free society that they differed. This disagreement centred on their economic theories. They disagreed about the stability properties of market economies, and therefore came to different conclusions about policy. Hayek had a more complete, better worked out, theory, which is why he held to it so intransigently. But Keynes was more creative, and in fact a better economist, which is why Hayek eventually abandoned economics for political philosophy.

iii. Starting Positions

Hayek believed that the market economy was a smoothly-adjusting machine in the absence of credit creation by the banking system. Keynes saw monetary ‘managment’ by the central bank, which could include credit creation, as the only way to keep it stable. This was the pith of their debate. Keynes won it, because he made the more relevant statements.

Hayek came to their debate in 1931 equipped with an ‘Austrian’ inter-temporal theory of value which Keynes lacked. This sought to demonstrate that an unimpeded market system –one in which relative prices were free to adjust demand and supply simultaneously in all markets – secured the full employment of resources not just at any moment of time but over time. The theory of capital and interest, which showed how this came about, rounded off neo-classical value theory, substituting the notion of dynamic for static equilibrium. The Austrians thus told a much more complete, and confident ‘market’ story than any available in Anglo-American economics.

In the Hayek story, the rate of interest was the price which adjusted decisions to save to decisions to invest, in line with individual time-preferences.A high rate of saving was key to a progressive economy, ensuring that increasing quantities of machinery, and decreasing quantities of labour, were applied to the production of consumer goods.

The only problem was that the situation in the 1930s did not fit Hayek’s story. There was massive unemployment of resources. So Hayek had to introduce money as the ‘loose joint’ in his theory in order the explain the phenomenon of the trade cycle. Monetary theory should concern itself with the question of ‘how and when money influences the relative values of goods and under what conditions it leaves these relative values undisturbed’. The main conclusion he drew from this analysis was that a credit-money economy will only behave like a barter-exchange economy if banking policy can keep money ‘neutral’ –that is, provide a constant supply of money per unit of output, and above all prevent inflation. This was difficult and almost impossible. So the trade cycle was inevitable. The best way of mitigating it – of limiting credit creation – was by rigid adherence to a full gold standard. In Hayek’s view, the great depression was the direct result of failing to follow this precept. Credit creation in the 1920s had distorted the system of relative prices, producing depression. There was no alternative to liquidating the inflation even though this might well deepen the depression for a time.

Keynes approached the same phenomena from the standpoint of the quantity theory of money. This states that the price level changes proportionately to the quantity of money. As such it is purely a theory of the value of money, when the level of output is taken as given. As such it could not explain fluctuations in output. However, there was a tradition, going back to Hume, and latterly reinforced by Irving Fisher, which held that it took time for a change in the money supply to have its full impact on the price level, and that during the interval when prices were rising or falling the economy could either expand or contract. This was the approach Keynes used in his Tract on Monetary Reform (1923). To get his ‘transitional’ results he introduced uncertain expectations. When the price level was changing, uncertainty about future prices prevented the instant adjustment of nominal interest rates and wages necessary to validate the quantity theory of money. Businessmen made ‘windfall’ profits in the inflationary upswing and windfall losses in the deflationary downswing. ‘The fact of falling prices injures entrepreneurs; consequently the fear of falling prices causes them to protect themselves by curtailing their operations’. From the Tract comes his best-known phrase. Having agreed that the QTM was ‘probably true’ ‘in the long run’, he went on: ‘But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again’. This expresses, in typically striking language, his main requirement for a serviceable economic theory: it must be able to account for ‘tempestuous’ as well as ‘flat’ seasons, and prescribe prevention and cure for the former.

The institutional culprit in the Tract was the international gold standard, with sacrificed domestic price stability to exchange-rate stability. The policy conclusion was obvious: active monetary policy was needed to stabilise the domestic price level. This required abandonment, or at least severe modification, of the gold standard.

Both economists suffered from the handicap of using models to explain phenomena which could not occur if the models were correct. The models could be adjusted to reality only by means of ad hoc additions: Hayek’s ‘loose joint’ theory of money, Keynes’s ‘stickiness’ of key prices. Keynes’s approach was more politically attractive because it pointed to policies of prevention and cure, whereas Hayek’s enjoined stoicism. He rejected Keynes’s policy of stabilising the price level: a stable price level could disguise inflationary tendencies when prices ought to be falling. ‘The banks could either keep the demand for real capital within the limits set by the supply of saving; or keep the price level steady; but they cannot perform both functions at once’. Questions to do with the role of the state in the economy, of rules versus discretion in monetary policy, of knowledge and ignorance in economics, of prescribing for the long term or the short-term, all of which were to become the battleground between the Hayekians and the Keynesians, had been posed , though not yet sharply.

iv. Different Domains?

The main issue between Hayek and Keynes comes out in their explanations of the Great Depression. Both could claim to have predicted it. Hayek argued in the spring of 1929 that a serious setback to trade was inevitable, since the ‘easy money’ policy initiated by the US Federal Reserve Board in July 1927 had prolonged the boom for two years after it should have ended. The collapse would be due to overinvestment in securities and real estate, financed by credit creation. For Keynes, looking at the situation in the autumn of 1928, the danger lay in the ‘dear money’ policy initiated by the Fed in 1928 in an effort to choke off the stock market boom. Savings, Keynes argued, were plentiful; there was no evidence of inflation. The danger was the opposite to the one diagnosed by Hayek. It was that of under-investment. ‘If too prolonged an attempt is made to check the speculative position by dear money, it may well be that the dear money, by checking new investment, will bring about a general business depression’. For Hayek the depression was threatened by ‘investment running ahead of saving’; for Keynes by ‘saving running ahead of investment’.

Hayek’s attempt to integrate ‘monetary’ and ‘real’ theories of the business cycle, as expounded in his book, Prices and Production(1931), has six main elements:

1. Voluntary savings by individuals are decisions to give up a certain amount of consumption now in order to secure a greater quantity of consumption in the future.

2. New acts of saving cause the rate of interest to fall, thus reducing the cost of producer (or investment) goods relative to consumer goods.They thus send a signal to producers to switch from making consumer goods to making producer or investment goods. Capital and labour flow out of the consumer goods into the producer goods sectors, leading to capital deepening. (Hayek variously calls this process lengthening the ‘period of production’, increasing the ‘roundaboutness of production’, or switching to ‘more capitalistic methods of production’.) When completed, the elongated structure of production will make possible a greater amount of consumer goods per unit of capital and labour, ie., the price of consumer goods will be lower than before and the savers’ real income will have gone up.

3. Following the Swedish economist Wicksell, Hayek called the price which secures a balance between saving and investment the ‘natural’ rate of interest. The economy will be in equilibrium when the market, or actual, rate of interest equals the ‘natural’ rate.

4. This equilibrium condition is continually secured in a barter economy. It may be satisfied in a money economy in which money is kept ‘neutral’. Only a change in the ‘effective’ quantity of money could generate a disequilibrium process. When the banks create credit, a source of funds additional to voluntary savings becomes available to finance new investment. The market rate of interest falls, the money value of investment rises, and resources are attracted to the producer goods industries as before. But now the market rate is below the ‘natural’ rate. The signals producers get to invest in new productive facilities do not correspond to the willingness of consumers to forego consumption. Instead, these consumers are ‘forced to save’ by the rise in the prices of consumer goods.

5. The result is an unsustainable structure of production As the incomes of wage earners ‘catch up’ with the rise in prices, they will seek to restore their previous standards of consumption, thus liquidating the ‘saving’ needed to complete the roundabout processes. The turning point comes when the banks have to restrict credit (or raise interest rates) to protect their cash reserves. The crisis has to run its course, as the structure of production returns to its old proportions. Hayek describes this retrogressive movement as ‘capital consumption’. It necessarily produces an economic crisis, with unemployment appearing quickly in the investment goods sector and only gradually being re-absorbed in the ‘shorter’ processes. Pumping more money into the economy may help temporarily but will make matters worse in the end.
The situation [Hayek writes] would be similar to that of a people in an isolated island, if, after, having partially constructed an enormous machine which was to provide them with all necessities, they found they had exhausted all their savings and available free capital before the new machine could turn out its product. They would then have no choice but to abandon temporarily the work on the new process and to devote all their labour to producing their daily food without any capital’.

6. In an elastic money supply banking system, the business cycle can never be entirely avoided. ‘Money’, wrote Hayek, ‘will always exercise a determining influence on the course of economic events….’. There are both technical and political difficulties in keeping money ‘neutral’.The ‘natural’ rate is unknowable; price stability is no proxy, since it can conceal inflationary tendencies. The only practical maxim is that the banks should be overcautious in supplying credit in the upswing. However the risks of mismanagment can be mitigated by rigid adherence to the gold standard. Hayek rejected fractional reserve banking. All banks should hold 100% gold reserves against deposits. This would rapidly reverse credit creation, limit ‘malinvestment’, and ensure that the crisis is shallow and short-lived.

It is a very peculiar story. Hayek was never able to explain properly why the new structure of production made possible by credit creation was any less permanent than one which reflected voluntary decisions to save. As Keynes’s colleague Piero Sraffa pointed out, ‘One class has, for a time, robbed another class of part of their incomes; and has saved the plunder’. The ‘forced’ savings of the losers become the voluntary savings of the gainers; and if wage earners benefit in due course from the increased flow of consumption goods made possible by the more roundabout processes, the gainers do not thereby lose the additional real capital they have created. Few rejoinders show up more crushingly the limitations of Hayek’s analysis. Even worse, Hayek provides no explanation of why a change in the quantity of money should have any effect on the structure of production at all. His story presupposes that changes in money worked themselves slowly and unevenly through the price system. But this is inconsistent with his assumption of perfect foresight and perfectly flexible prices. On this assumption, he has not explained the genesis of the cycle, he has simply confirmed the quantity theory of money! A third fallacy was pinpointed by Keynes in his General Theory. This was the confusion of the rate of interest with the ‘marginal efficiency’ or expected profitability of capital. An increased desire to save does nothing in itself to improve profit expectations. Au contraire, by lowering the prices of consumer goods, it depresses the profit expectations of all producers. This leads to a fall in aggregate income and a fall in actual saving. There is nothing to cause the rate of interest to change. Yet Hayek never renounced his early cycle theory and was still using it to explain the ‘stagflation’ of the 1970s.

Keynes’s Treatise on Money appeared six months before Hayek’s Prices and Production.The following summary of the Treatise brings out the points of convergence and divergence in the two theories:

1. Voluntary savings by individuals represent decisions to give up a certain amount of consumption now in order to secure a greater quantity of consumption in the future.
2. The economy will be in (full employment) equilibrium when saving equals investment. This is equivalent to the market rate of interest being equal to the ‘natural’ rate.
3. Saving and investment can diverge for expectational reasons unconnected with changes in the quantity of money.
4. When ‘saving runs ahead of investment’ (the case which particularly concerned Keynes in the Treatise on Money) the economy goes into a ‘free fall’ till something ‘turns up’.
5. Keynes outlines the sequence in his ‘banana parable’. He envisages an economy which only produces and eats bananas. He supposes an increase in saving (‘for old age’) with no increase in investment in new banana plantations. The price of bananas must fall:

Well, that is splendid, or seems so. The thrift campaign will not only have increased saving, it will have reduced the cost of living….But unfortunately that is not the end of the story; because, since wages are still unchanged –and I assume for the moment that the selling price of bananas will have fallen, but not their costs of production –the entrepreneurs who run the banana plantations will suffer an enormous loss…equal to the new savings of those people who have saved…The continuance of this will cause entrepreneurs to try and reduce wages, and if they cannot reduce wages they will [put] their employees out of work..[My italics]

Keynes then discloses the ‘full horror of the situation’:

However much they [reduce wages] it will not help them at all, because ..the buying power to purchase bananas will be reduced by that amount; and so long as the community goes on saving, the businessmen will always get back from the sale less than their cost of production, and however many men they throw out of work they will still be making a loss.

No position of equilibrium is possible until one of four things has happened: either everyone is out of work and the population starves to death, or entrepreneurs combine to keep up prices, or the thrift campaign falls off or peters out, or investment is increased.

6. It was the task of monetary policy to prevent or offset this dire sequence of events by pumping money into the economy; it was, in fact, the only balancer in the system.

Keynes explained:

Those who attribute sovereign power to the monetary authority on the governance of prices do not, of course, claim that the terms on which money is supplied is the only influence affecting the price level. To maintain that the supplies in a reservoir can be maintained at any required level by pouring enough water into it is not inconsistent with admitting that the level of the reservoir depends on many other factors besides how much water is poured in.

One can see that the two models diverge with Keynes’s the third point. Whereas for Hayek savings are smoothly translated into investment, for Keynes there is nothing to align the two except stabilisation policy. Hayek was puzzled:

But what does it actually mean if part of current savings is used to make up for losses in the production of consumption goods…? It must mean that though the production of consumers’ goods has become less profitable, and that though at the same time the rate of interest has fallen so that the production of investment goods has become relatively more attractive than the production of consumption goods, yet entrepreneurs continue to produce the two types of goods in the same proportion as before. Mr. Keynes’s assertion that there is no automatic mechanism in the economic system to keep the rate of saving and the rate of investing equal might with equal justification be extended to the more general contention that there is no automatic mechanism in the economic system to adapt production to any other shift in demand.[My italics]

The italicised passage shows that Hayek had misunderstood the key point in Keynes’s theory. But his conclusion about the nature of the theory was correct: there was no automatic stabilising mechanism to be found in it.

Both men confronted the world depression with severely dysfunctional theories. Hayek was right to claim that Keynes had not shown how saving and investment could diverge within the model of the Treatise, unless there had been a prior change in the quantity of money. Hayek had not shown why credit creation should start a cumulative process bound to end in depression. But whereas Keynes’s policy of pumping purchasing power into a deflating system offered a hope of recovery, Hayek was still warning against Keynes’s reflationary remedies. This was to earn him a savage retrospective rebuke from his erstwhile disciple Lionel Robbins: ‘Assuming the original disagnosis of excessive financial ease and mistaken real investment was correct –which is certainly not a settled matter –to treat what developed subsequently in the way which I then thought valid was as unsuitable as denying blankets and stimulants to a drunk who has fallen into an icy pond, on the ground that his original trouble was overheating. I shall always regard this aspect of my dispute with Keynes as the greatest mistake of my professional career….’

One can see how Hayek’s intransigent methodological individualism (or what Caldwell calls his ‘profound epistemological pessimism’) hampered his economics. It led him to repudiate Keynes’s espousal of macroeconomic remedies for depression, and indeed macroeconomics itself. He claimed that only subjective valuations count as causes: total quantities can exert no influence on individual decisions. This claim pinpoints the weakness in the Austrian economics of the day: the lack of a theory of expectations. Keynes understood that collective expectations entered into individual valuations, and that by controlling aggregates, governments can influence individual expectations. In reviving the neo-classical approach, Milton Friedman never repudiated macroeconomics. Today’s ‘inflation targeting’ depends crucially for its success on ‘managing’ expectations, much as Keynes advocated in the Tract.

Keynes’s (eventual) position was also problematic. He shared much of Hayek’s epistemology (wholes have only a fictitious existence, social science is a moral, not natural, science, econometrics is philosophically flawed) yet still believed in macroeconomic policy which depends on national income accounts, econometric modelling, and government manipulation of aggregates. He thought government could manage total spending power only in a rough and ready way which would still be an improvement on laissez-faire. But the next generation carried this project much further. They thought the problem of limited knowledge facing the central manager was a contingent one, and that as statistics improved, so would the possibility of control. This reached its apogee in the ‘fine-tuning’ approach of the 1960s.

Hayek’s repudiation of macroeconomics was proclaimed as a methodological principle; but one suspects it stemmed more from his exaggerated pessimism about the results of macroeconomic policy; in contrast, Keynes’s embrace of macroeconomics derived from his eagerness to equip governments with the tools of economic managment, even before his theory was really up to it. Keynes erred on the right side. He may have exaggerated the wisdom and integrity of governments. But he was surely right to believe that enough collective knowledge existed to improve the working of economies.

In his rejoinder to Hayek’s attack on his Treatise on Money, Keynes noted that ‘our theories occupy…different terrains’, Hayek’s being a theory of dynamic equilibrium, his own being a disequilibrium theory. Both theories subsequently changed, but brought no meeting of minds. Ironically, Hayek dropped Walraisian equilibrium theory at exactly the moment Keynes embraced it. In his 1936 lecture ‘Economics and Knowledge’, he redefined equilibrium as a situation in which there exists a mutual coordination of plans. But given its impossible knowledge requirements, on which Hayek laid increasing stress, it became a purely fictional construction, of no predictive value. His eventual position seems to have been that though an unmanaged market system had no strong tendency to full employment, monetary policy designed to improve the situation would only make matters worse as well as being inflationary. He came to regard his most important contribution to economics as his depiction of the market order as a discovery technique rather than a determinate system.

In Keynes’s General Theory of Employment, Interest and Money (1936) the economy was always in equilibrium, but this need not be, and mostly was not, a full employment one. Keynes’s adoption of the equilibrium method can be seen as the culmination of his attempt to provide a theoretical rationale for activist government. He needed the device of a determinate equilibrium to give government a determinate target. The Keynesian model is taught as a model of output determination. This reconciled Keynes to the mainstream, which craved an economics of certainty, and fitted the growing mathematicisation of economic technique. What got sidelined was his most persistent insight, which had to do with the effect of uncertainty on economic behaviour.

Hayek had been too badly mauled in his exchanges with Keynes and the Keynesians in 1931-2 to review Keynes’s magnum opus. But events were finally bringing them back onto to the same intellectual and political terrain. Full employment, Keynes thought, occurred only in ‘moments of excitement’. The second world war was one such moment. The road to reconciliation was opened up by the fact that during the second world war, the economy was fully employed, and the problem which now exercised Keynes was a problem in the theory of value: how to transfer resources to the war effort without inflation.

iv. How to Pay for the War

A war economy is faced not by inadequate but by excess demand, by inflationary, not deflationary, pressure. At the same time it needs a high level of saving to effect the transfer of production from consumer to war goods. This transfer can be effected either by inflation-induced ‘forced saving’ or by heavy taxation.and other controls on civilian consumption. This is classic Hayekian territory. Keynes sought to avert the twin evils of inflation and confiscation by an imaginative plan for ‘compulsory saving’ or ‘deferred pay’.

His plan was announced in two articles in The Times on 14 and 15 November 1939, later expanded into a pamphlet ‘How to Pay for the War’. His analysis of the problem was quite ‘Austrian’. The government had started pumping money into the economy to expand war production. This was equivalent to extra investment in more ‘roundabout processes’ whose aim was to produce a greater quantity of a particular kind of consumption good –guns, tanks, aircraft. However since this extra investment did not represent any willingness of the public to reduce its consumption of civilian goods, the price level was pushed upwards. In Hayekian terms consumers were ‘forced to save’ by rising prices. But, after a lag, incomes too would start to rise and consumers would want to restore their previous consumption standards. Civilian consumption could then be suppressed only at the cost of further and increasing inflation, or by price controls and rationing, or a mixture of both.

Keynes proposed an ingenious alternative. Consumers would be ‘forced to save’, not by inflation or rationing but by means of a temporary, graduated surcharge on their post-tax incomes the proceeds of which which would be made available as post-war credits. They would be left free to spend their reduced incomes as they pleased. The great advantage of compulsory saving, as Keynes saw it, over orthodox taxation or inflation, was that workers would not lose the benefit of their higher wages, only be obliged to postpone their spending. This was the plan which Hayek enthusiastically endorsed in The Spectator of 24 November 1940, without pointing out that the calculation of how much ‘money’ to take out of the economy was highly dependent on putting numbers to the aggregative analysis of the General Theory, one which Hayek repudiated on methodological grounds.

In the expanded pamphlet, How to Pay for the War, published on 27 February 1940, Keynes was forced to add sweeteners for the trade unions in the form of family allowances and ‘iron rations’ at subsidised prices; and a concession to the orthodox (including Hayek) in the form of a capital levy to discharge the liability created by the deferred pay. His plan (as opposed to the arithmetic underpinning it) was adopted only in part by Kingsley Wood in his budget of April 1941: in practice, Keynes lost the argument to the central planners, and regulation of aggregate spending took second place to manpower planning, physical allocation of inputs, and rationing of consumer goods. The legacy of his plan, though, was a technique of macroeconomic managment, which was not tied to these wartime expedients.

It is the underlying philosophy rather than the details of the scheme that concerns us here, and which won Hayek’s approval. Keynes explained to the Fabian Society of 21 February 1941 that he had been searching for an alternative to the ‘old-fashioned laissez-faire’ solution of inflation, the ‘new fashioned totalitarian’ method of comprehensive rationing which would reduce Britain to a ‘slave state’, and the compromise between them of ‘a totalitarian solution for a narrow range of necessaries and inflation over the remaining field of consumption’. ‘The abolition of consumers’ choice in favour of universal rationing is a typical product…of Bolshevism’, he wrote. Similarly the release of deferred pay after the war, ‘by allowing individuals to choose for themselves what they want, will save us from having to devise large-scale government plans of expenditure which may not correspond so closely to individual need’. He wrote: ‘I am seizing the opportunity to introduce a principle of policy which may be thought of as marking the line of division between the totalitarian and the free economy. For if the community’s aggregate rate of spending can be regulatred, the way in which personal incomes are spent can be safely left free and individual’.

Keynes’s most complete statement of his ‘Middle Way’ philosopy came in an article for the American journal New Republic on 29 July 1940:

The reformers must believe that it is worth while to concede a great deal to preserve that decentralisation of decisions and of power which is the prime virtue of the old individualism. In a world of destroyers, they must zealously protect the variously woven fabric of society, even when this means that some abuses must be sdpared. Civilisation is a tradition from the past, a miraculous construction made by our fathers…hard to come by and easily lost….

The old guard of the Right, on their side, must surely recognise, if any reason or prudence is theirs, that the existing system is palpably disabled, that the idea of its continuing to function unmodified with half the world in dissolution is just sclerotic. Let them learn from the experience of Great Britain and of Europe that there has been a rottenness at the heart of our society, and do not let them suppose that America is healthy.

These were the very questions which exercised Hayek as he wrote the Road to Serfdom.

v. The Road to Serfdom debate

Hayek’s Road to Serfdom arose out of his famous attack on central planning. The early socialist justification of a publicly-owned, centrally-planned economy was that it would ‘perfect’ the market system by eliminating the ‘waste’ associated with private ownership, monopoly, and booms and slumps. Ludwig von Mises (1920) had argued that efficient central planning was impossible, because if all capital were publicly owned there would be no market for capital goods in terms of which competing investment projects could be properly costed. ‘Instead of the economy of ‘anarchical’ production the senseless order of an irrational machine would be supreme’. To counter this, Oscar Lange and A.P.Lerner (1936-7) said that the planning authority could cause state-run firms to respond appropriately to simulated market signals, provided they were required to minimise their costs and equate marginal costs and market prices. The planning authority would announce starting prices for all capital goods, like an auctioneer. Shortages and surpluses at the initial prices would indicate to the planning authority the need to raise or lower relative prices until, through a process of trial and error, an equilibrium price structure was obtained. Hayek attacked such an idea as Utopian: ‘To imagine that all this adjustment could be brought about by successive orders by the central authority when the necessity is noticed, and that then every price is fixed and changed until some degree of equilibrium is obtained is certainly an absurd idea’. Central planning was doomed to failure because the knowledge necessary to make it work could never be assembled. So it was bound to be inefficient. Further, it ignored the role of market competition in discovering new wants and processes. It thus froze economic development.

In the Road to Serfdom Hayek attacked central planning not just because it was inefficient and retrogressive, but on the ground that it was destructive of liberty. This was for two reasons. First, outside wartime or temporary enthusiasm, there is never sufficient voluntary consent for the goals of the central plan. So resistance develops, which has to be suppressed. Secondly, partial planning creates problems which to the planner appear soluble only by more extensive planning. ‘Once the free working of the market is impeded beyond a certain degree, the planner will be forced to extend his controls until they become all-comprehensive’. Thus attempts to direct production into certain channels or achieve a particular distribution of income all involve ‘progressive suppression of that economic freedom without which personal and political freedom has never existed in the past’. Fascism and Communism were totalitarian culminations of what had started as democratic socialism. (Hayek had a chapter on the socialist origins of Nazism). Both involved the ‘coercive organisation of public life’. Western democracies were fighting fascism without realising that they had started down the same slippery slope. Against the planners, Hayek set out to uphold the ‘fundamental principle that in the ordering of our affairs we should make as much use as possible of the spontaneous forces of society, and resort as little as possible to coercion…’

Hayek was careful not to identify economic liberalism with laissez-faire – a mistake made by 19th century liberals. The state was needed for all sorts of purposes, not least to provide and enforce a legal framework for competition. Hayek distinguished between the rule of law and legality. The rule of law requires that ‘government, in all its actions, is bound by rules fixed and announced beforehand’. But planning requires ‘discretionary rules to be changed as circumstances change’. Thus planning is incompatible with the rule of law. To have a rule of the road is different from a policeman telling people where to go. A liberal order requires a consciously contrived constitution. Hayek thought that a world government would be needed to entrench economic liberalism internationally.

As Hayek saw it, the planning cult arises from the strata of scientists and engineers mistakenly supposing that science can settle matters of politics and morality. But Hayek also acknowledged that capitalist failure to provide security was an important source of collectivist feeling. Minimal indispensable security should be provided ‘outside the market’ for its victims – a rare concession to prudence. But he was deeply suspicious of public works. At this point the argument with Keynes was joined, though not by name.

Admittedly, Keynes was not a central planner in Hayek’s sense: he did not want to ‘direct[] the use of the means of production to particular ends’. But here the slippery slope argument could be used. Keynes was surely the intellectual leader of those ‘many economists [who] hope… that the ultimate remedy [for general fluctuations in economic activity and recurrent waves of large-scale unemployment] may be found in the field of monetary policy…[or].. from public works undertaken on a very large scale’. But ‘if we are determined not to allow unemployment at any price, and are not willing to use coercion, we shall be driven to… a general and considerable inflation [as a way of securing reduction in real wages]’. Inflation would suppress information given by the system of relative prices, and so would lead to pressure to fix prices. He warned that on matters of public spending: ‘we shall have carefully to watch our step if we are to avoid making all economic activity progressively more dependent on the direction and volume of government expenditure’.

Keynes read the Road to Serfdom while crossing the Atlantic on his way to the Bretton Woods conference of July 1944. It caught him in an anti-collectivist mood. He was annoyed with his more collectivist followers like Thomas Balogh who opposed his plans for reestablishing a liberal world order. (In his last,posthumously published article he even praised the ‘invisible hand’. ) The war context is also important to understand both Hayek’s polemic and Keynes’s response. For war purposes, economy and society were already highly planned. The question was how much freedom the return to peace would bring. On the necessity of a return to freedom, Keynes was fully with Hayek. On 28 June he wrote him a generous and thoughtful letter, congratulating him on having written a ‘grand book’ , and adding that ‘we all have the greatest reason to be grateful to you for saying so well what needs so much to be said…Morally and philosophically I find myself in a greement with virtually the whole of it; and not only in agreement, but in a deeply moved agreement’.

Keynes would have endorsed all that Hayek wrote of the connection between political and economic liberty, of the importance of allowing the individual to be judge of his own ends, of competition as a better way of adjusting individual efforts to each other than any other, of the advantages of de-centralised decision-making, and so on. He would have agreed with him that democracy is a means, not an end. He would have applauded his discussion on international freedom, and the conditions needed to secure it. He would certainly have endorsed his strictures against excessive state spending.. He might even have agreed with much of Hayek’s account of the reasons for the decay of European liberalism.

However, he made several criticisms.

(1) ‘You admit…that it is a question of knowing where to draw the line. You agree that the line has to be drawn somewhere, and that the logical extreme is not possible. But you give us no guidance whatever as to where to draw it. It is true that you and I would probably draw it in different places. I should guess that according to my ideas you greatly under-estimate the practicability of the middle course. But as soon as you admit that the extreme is not possible…you are, on your own argument done for, since you are trying to persuade us that so soon as one moves an inch in the planned direction you are necessarily launched on the slippery path which will lead you in due course over the precipice’.

Keynes was suggesting that for Hayek, as for Keynes himself, ‘where to draw the line’ was a matter of judgment, not principle. This is a cogent criticism, which has been echoed by libertarians. Ayn Rand denounced Hayek as a ‘compromiser’. De Jasay argues that Hayek leaves the ‘state’s place in society…ad hoc, open-ended, indeterminate’. The state, Hayek says, should provide a social safety net. But at what level should it be set? Should it include health care and education? He has only a hazy notion of public goods. As a utilitarian, Hayek rejected restrictions on the scope of the state derived from natural law theory. His justification of liberty is instrumental: the central planner has less knowledge than exists.His is not a negative theory of liberty, but a theory of liberty bounded by the law. Provided the law is properly constituted it is necessarily consistent with liberty. But his distinction between general rules and those designed to benefit particular groups does not do the libertarian work he wants it to: perfectly general rules, like conscription or prices and incomes policies, can be highly coercive. It is hard to extract a theory of liberty or justice from Keynes’s scattered remarks on the subject. But there is no evidence that he ever embraced a positive (or ‘enabling’) theory of liberty, or thought of justice in other than contractual terms. In economics, Keynes’s distinctive point of intervention was confined to managing aggregate demand: macroeconomic managment was his alternative to micro-economic control. As he wrote in the General Theory ‘..if our central controls succeed in establishing a volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into own… [and] there is no more reason to socialise economic life than there was before’. This begs the question of how much reason there was before, on which Keynes did not pronounce.

(2)’What we need therefore’, Keynes continued, ‘is not a change in our economic programmes, which would only lead in practice to disillusion with the results of your philosophy, but perhaps even….an enlargement of them’. Keynes had spelled out what he meant in the General Theory: ‘It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated…with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease while preserving efficiency and freedom’. Now Keynes accused Hayek of putting ideology ahead of statecraft – a good conservative (and indeed Whig) criticism. Hayek was vulnerable to this charge. He offered no convincing analysis of the forces tending to diminish the attraction of classical liberalism and enlarge the role of the state. He ascribed the retreat from liberalism to intellectual error. His belief that anti-liberal ideas were dysfunctional residues of earlier conditions and would wither away with further evolutionary progress remains to be tested, but does not stand up well in face of Keynes’s claim that empires and social systems rise and fall in the short-run.

Keynes made the telling point that policies which took no precautions against slumps were likely to produce ‘disillusion’ with liberal values. In fact he might well have pointed out that it was not the habits of mind of the scientist or engineer but the economic consequences of Hayek’s liberalism which led to disillusion with liberal philosophy. Whatever the ‘totalitarian’ tendencies in German thought and Weimar practice, it is highly unlikely that Hitler would ever have come to power but for the Great Depression, which caused six million unemployed and a 40% contraction in German industrial output. The socialist creep which Hayek castigates could never have led to totalitarianism without the help of the economic misfortune to which the economic policy of classical liberalism was indifferent. On the other hand, Hayek was right to point out –after Keynes’s death – that, by destroying the rules which restrained government economic intervention, Keynes had opened the door to a hubristic form of Keynesianism which took no account of Keynes’s own self-imposed limits.

(3) ‘But the planning should take place in a community in which, as many people as possible, both leaders and followers share your own moral position. Moderate planning will be safe if those carrying it out are rightly orientated in their own minds and hearts to your own moral position….. Dangerous acts can be done safely in a community which thinks and feels rightly which would be the way to hell if they were executed by those who think and feel wrongly’ Here Keynes is on much shakier ground. His dictum that ‘dangerous acts can be safely done in a community which thinks and feels rightly’ is obviously right at one level. It was safer for freedom to have Churchill running the war than Hitler, even though the wartime organisation of Britain and Germany was similar. But this is a static argument. What it ignores is the consideration that that the stock of ‘right feeling’ can be depleted by continuous governmental intervention; it is not independent of the acts being done. A society in which ‘dangerous acts’ by governments become continuous will lose its understanding of why they are dangerous –that is, its sense of what it is to be free. And this has happened to some extent.

(4) ‘I accuse you of perhaps confusing a little bit the moral and the material issues’. The likeliest reference is to the most passionate chapter of the Road to Serfdom, chapter VII, in which Hayek attacks socialists for decrying the money motive. Money, Hayek writes, is ‘one of the greatest instruments of freedom ever invented by man’. It is not material abundance that sets us free to choose non-economic ends: we discover our non-economic ends through economic activity, which forces us every moment to choose what is more or less important for us. Economic planning does not leave us in control of our non-economic ends; by controlling the means for our ends, the central planner will in effect choose our ends for us. Hayek also attacked the doctrine of ‘potential abundance’ –‘as palpably untrue as when it was first used over a hundred years ago’. ‘The reader may take it that whoever talks about potential plenty is either dishonest or does not know what he is talking about. Yet it is this false hope as much as anything which drives us along the road to planning’.

Much of this was contrary to what Keynes believed. Hayek was a fervent, consistent believer in the virtues of capitalism; Keynes’s belief was certainly not fervent, and perhaps only intermittent. He acknowledged that money was useful as a means; but regarded its pursuit as a deforming means, one that skewed life-choices away from the valuable to the less valuable, from the concrete to the abstract.

This disparagement of money-making goes back to Keynes’s student days. It was part of the intellectual atmosphere of his Cambridge and was dominant in the Bloomsbury Group. It was characteristic, one might say, of a rentier bourgoisie, which had already attained a standard of civilisation it regarded as good. Keynes’s subjectivism did not extend to ethical knowledge. As a follower of G.E. Moore, he believed, unlike Hayek, that certain states of mind were objectively good or bad and that this was intuitively known to those with educated perceptions, prior to experience. One’s ethical duty was to maximise good states of mind, for oneself and (more doubtfully) for everyone. In principle, states of mind were independent of material conditions –a poor man could be ethically good, and a rich man ethically bad. In practice, it was easier to be ethically good when free from poverty and irksome toil. Getting to this condition, however, involved bad states of mind. It meant a social system geared to pursuit of the economically efficient at the expense of the morally efficient.

This was how Keynes set up the dilemma in his futuristic essay ‘Economic Possibilities for our Grandchildren’ (1930) and also provided the solution: compound interest was making the world so much richer that our grandchildren, for the first time in history, would be in a position to lead good rather than merely useful lives.

‘I see us free, therefore, to return to some of the most sure and certain principles of religion and traditional virtue –that avarice is a vice, that the exaction of usury is a misdemanour, and the the love of money is detestable, that those walk most truly in the paths of virtue and sane wisdom who take least thought for tomorrow. We shall once more value ends above means and prefer the good to the useful. We shall honour those who can teach us how to pluck the hour and the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things, the lilies of the field who toil not, neither do they spin.

But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our goods for a little longer still. For only then can they lead us out of the tunnel of economic necessity into daylight’.

That Keynes accused Hayek of ‘confusing a little the material and the moral’ is understandable in light of the fact that the tension between economics and ethics was central to his philosophy, whereas it simply did not exist for Hayek. For Hayek there was no life beyond capitalism, no knowledge of the good life beyond the discovery process of the market. Subjective preferences applied in an unlimited future ‘The end- state cannot be distinguished from the processes which generate it’. The market system was a system of want discovery, not the most efficient route to Utopia. By modern standards, Keynes’s formula sounds parochial (he ignored the poverty of the non-Western world) and condescending in its claim to privileged knowledge of what is good. But the argument is far from over. Keynes could have pointed out that the constant stimulation of wants through advertising is a recipe for neither happiness nor goodness.

One line of criticism of Hayek fails. This is that he has been proved wrong –that democratic socialism did not collapsed into serfdom. Hayek at least safeguarded himself from such retrospective refutation. He was not predicting that totalitarianism would happen, he was warning against the totalitarian implications (‘unintended consequences’) of trying to direct economic life according to a central plan. He wrote that ‘the democratic statesman who sets out to plan economic life will soon be confronted with the alternative of either assuming dictatorial powers or abandoning his plans’. By the 1970s there was some evidence of the slippery slope…and then there was Thatcher. Hayek’s warning played a critical part in her determination to ‘roll back the state’. Equally, though, Keynes had earlier given liberalism an economic agenda to fight back against socialism and communism, by demonstrating that societies didn’t need public ownership and central planning to secure full employment. Both were lovers and defenders of freedom. Keynes had the grace to acknowledge Hayek’s role in its defence, which Hayek, with plenty of time for reflection, never had the generosity of spirit to reciprocate.

vi. Conclusion

How should we sum up the debate? In economics Keynes got the better of the argument and this advantage has persisted. Unlike Austrian economics, Keynesianism entered the policy mainstream and has lodged there, albeit in attenuated form. Hayek’s rejection of macroeconomics, and macroeconomic policy, marginalised him as an economist. One loss of his eclipse as an economist is the investigation of the effects of inflation on relative prices, which could have been carried out more successfully with modern mathematical techniques. In the realm of political economy, Hayek’s work has been much more successful mainly because it was only loosely connected to his technical economics, and because he lived so long.

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