Keynes v Hayek and Friedman
Since at least the mid-1930’s the two main competing economic models within Western democracies have been the neo-liberal model of Frederick Hayek and Milton Friedman and the model proposed by John Keynes.
Keynes was more favoured by policymakers following the publication of his General Theory in 1936 through to the 1970s.
Basics of Keynes Model
Keynes identified inflation and unemployment as the two major economic problems. His theory held that it was the role of government to manage aggregate demand (‘demand’), as the key driver of the economy. The factors influencing demand were fourfold- consumer (household) spending, private investment, government spending and international demand for the home country’s exports.
Unemployment results from insufficient demand. To increase demand you stimulate consumer spending by:
- reducing taxation (or increasing wages); and/or
- lowering the interest rate so business investment increases; and/or
- increasing government spending; and/or
- encouraging exports by lowering the exchange rate.
Inflation results from excessive demand pushing up prices. To combat inflation you take the opposite actions to those for combatting unemployment:
- increase taxes to lower consumer spending; and/or
- increase interest rates to restrain investment; and/or
- lower government spending; and/or
- increase the exchange rate.
Keynes thought unemployment and inflation could not co-exist. He thought if unemployment rose due to insufficient demand prices would inevitably go down.
Keynes’s recipe worked well between the end of WWII and 1973.
Cost-push inflation of the 1970s
In 1973 the oil embargo led to unemployment and inflation co-existing for the first time in modern economic history.
While inflation had also been contributed to by increased US government spending (without increased taxes) to finance the Vietnam war, the unique inflationary factor contributing to the 1970’s inflation was the oil embargo.
The rise in oil prices led to a type of inflation that was not caused by an increase in demand. Prices went up because the cost of energy had dramatically increased.
Keynes’ theories did not really include a method for combatting cost-push inflation.
The rise of neoliberalism
Keynes’s policies eventually began to be replaced by policies, known as ‘supply-side’ economics, as advocated by Hayek and Friedman.
In summary, these policies advocated a neutral state budget, interest rates as the key to macroeconomic management, privatization and de-regulation and, above all, an emphasis on micro-economic management through lowering the cost of production at the level of the individual business- restraining wages, innovation in production methods, improved quality etc.
The election of Margret Thatcher in Britain and Ronald Reagan in the USA marks the beginning of the neo-liberal period.
Neo-liberal economics were applied by both centre-right and centre-left governments.
Resurrection of Keynes
Keynesianism was resurrected following the global financial crisis (GFC) of 2008.
The GFC led to unemployment co-existing, not with inflation, but deflation.
Deflation can damage an economy because, if it creates an expectation of falling prices, consumer demand stalls. Also because prices can fall below the cost of production, leading to losses and insolvencies. Keynesianism was resurrected because following the GFC the fundamental economic problem was again one of stimulating demand. Though there was also another reason-the political demand for the public purse to bail out companies, especially the banks.
Removal of Keynesian economic levers in some countries
But Keynesianism post-GFC has not been the same as it was up until 1973.
Governments across Western democracies, especially those in the Eurozone, have now shed some of the fundamental economic policy levers of Keynesianism.
Countries in the Eurozone have no control over their interest rates or currency exchange rates. The only economic policy instruments they now have are taxes and government spending and these are also constrained. Article 121 of the treaty establishing the European Community imposes controls over inflation, public debt and the public deficit, exchange rate stability and the convergence of interest rates.
So even in EU countries with very high unemployment, like Spain and Greece, treaties with the European Union limit government spending and public debt so that the type of expansionary policies Keynes supported to fight unemployment are not possible.
Post GFC, Keynesianism did still involve injecting an enormous quantity of money into the financial sector to keep the economy functioning. These measures essentially converted a huge quantity of private debt into public debt.
Reference:
Maik says
I highly recommend all works by former UNCTAD Chief Economist Heiner Flassbeck on these matters, his books as well as his blog:
flassbeck-economics.com
I am from Germany and discovered your blog accidentally when I searched for further food of thought on Harari’s point of view on (evolutionary) humanism. I kept returning ever since, as a lot of your articles touch a cord on my own thoughts. It is unbelievable how the wrong understanding of economics up to the highest level advisory, particularly in Germany, is wracking the European Union – we shall not forget that the maastricht treaties were designed under the Aegis of Kohl and Mitterand back in the day, when Neoliberal thinking already fully unfolded.