Ann Pettifor

Eight fallacies in the LSE Keynes/Hayek debate

Tonight, Wednesday 3 August 2011 at 08.00pm BST (GMT +1), BBC Radio 4 will broadcast a debate which took place at the London School of Economics (LSE) on 26 July.  This broadcast will be repeated on Saturday, 6 August, at 10.15 p.m BST (GMT +1).

Along with my colleagues Prof. Victoria Chick and Douglas Coe at PRIME  we have written the following response to the debate:

Debaters considered whether Keynes or Hayek had the solution to the present financial crisis. The economist George Selgin and philosopher Jamie Whyte spoke for Hayek; Keynes’s biographer Robert Skidelsky and the economist Duncan Weldon spoke for Keynes.

On the one hand we are pleased that the BBC and the LSE now acknowledge rival positions to the present austerity policies of Western governments. On the other  we are concerned that the debate might have served mainly to reinforce existing prejudices, rather than to clarify the substance of the matters under discussion, matters which – there can be no doubt – are of the most profound importance.

Lord Skidelsky provocatively but justly reminded the audience that in the early 1930s, the same orthodoxy driving western austerity policies directed the actions of Germany’s 1931 Bruning government and paved the way for the rise of Nazism. These actions – vigorously opposed by Keynes – were the final straw for a Germany crushed by defeat and the disastrous boom-bust cycle that followed their return to the gold standard. Reparations were easily circumvented by wildly excessive borrowing from financial interests around the world, in a manner that even Keynes did not anticipate. It was these financial and fiscal policies that brought Hitler to power.

With financial interests still firmly in the ascendency and reactionary right-wing forces increasing their grip in the United States and much of the Western world, we must not forget these lessons from history, which formed the background to the original debate between Keynes and Hayek themselves. The stakes are high indeed.

Keynes shared with Hayek a preference for the economy to be primarily the province of the private sector. However, he recognised that ‘the market’ did not always best serve the common good and therefore that state intervention was necessary – and not just during a slump. In this he was diametrically opposed to Hayek.

For Keynes, the market’s major flaws were rooted in monetary arrangements that favoured speculation and excess consumption rather than productive activity. In addition, in a slump, the pessimistic outlook of producers and investors allowed the slump to persist and needed the stimulus of public works expenditure.

The LSE debate neglected the subtleties of the respective positions of Hayek and Keynes and reinforced many of the most common and most dangerous fallacies about Keynes’s contribution – and even established some new ones.  While both economists were misrepresented to some extent, our main concern must be to rectify distortions about Keynes. There are eight misrepresentations that we want to bring out.


1.   Hayek as “an opponent of financial excess”

From 1971 through the early 1980s, restraints on the financial sector were steadily unwound. These actions were prompted by Hayekian ideals of liberalism, as is well known.  The Hayek supporters at the LSE debate dissociated themselves from this liberalisation, the cause as we now know, of the rapid expansion of the money supply before the crash. Hayek might not have predicted this consequence of liberalisation, but its disastrous consequences are now plain to one and all. Perhaps this is why the debaters dissociated themselves from this aspect of Hayek’s position. Instead they castigated the conduct of the liberalisation policy rather than the policy itself. Indeed the ideal of liberalisation was scarcely mentioned, for to do so would be to acknowledge the existence of an alternative: Keynes’s managed financial system.


2.   Keynesian policy as “promoting the big state”

Keynes’s most substantial legacy was a financial system managed by the state.  This system prevailed from the end of the gold standard until the 1970s. This management ensured that on the one hand low long-term interest rates facilitated both private and public sector investment; on the other, restraints on

banks and capital mobility kept speculation and excessive consumption at bay. Keynes had devised and helped implement a financial system that was conducive to production and investment rather than speculation and consumption.  A larger state rightly prevailed than in the 1920s or 1930s, but ironically Keynes’s state was still smaller than the state that prevailed after the counter-revolution of financial liberalisation

The post-war world was one in which the state and the private sector operated powerfully in tandem, supported by a greatly revised monetary architecture.

As we have stressed, Keynes was concerned mainly with the effective operation of the private economy.


3.   The inflation of the 1970s as “the fault of Keynesian policies”

The inflation of the 1970s began just after the Keynesian post-war mechanisms for the regulation of finance started to be dismantled. In Britain, controls on banking and capital mobility were relaxed, and liberalised arrangements were restored, beginning with Competition and Credit Control (1971) (evaluated as “all competition, no control” by most economists). The root cause of the inflation of the 1970s was the massive expansion of the money supply that followed the deregulation of credit control, as both Friedman’s monetarism and Keynes’sGeneral Theory, Ch. 21, predict.

The inflation of the 1970s was not the consequence of Keynes’s policies but of the dismantling of his policies for restraining the finance sector. In the past, the inflationary 1970s would have been understood as a ‘bankers’ ramp’.


4.   Keynes as “advocate of deficit spending”

While the importance of Keynes’s monetary policies is scarcely recognised, even his fiscal policies are severely misrepresented. Most prominent and pernicious of all is the idea that he advocated deficit spending. From his earliest contributions to the debate on fiscal policy, Keynes was concerned to establish how public works expenditure would pay for itself and would constitute a relief rather than a burden to the public finances. As we have shown in ‘The economic consequences of Mr Osborne’,[i] the outcomes of public expenditure policies over the last century vindicate his analysis. It remains a puzzle why even Keynes’s most ardent champions neglect the evidence.


5.   Keynes as “a supporter of wasteful expenditures”

Even after being corrected by Lord Skidelsky in an earlier exchange during the LSE debate, George Selgin repeated the false charge that Keynes supported “indiscriminate spending.”

As Lord Skidelsky emphasised during the debate, Keynes was concerned to revive private investment. He argued that government spending was the only possible means of doing so when businesses were in deep recession (elsewhere Keynes had also recognised the burden of heavy indebtedness on business). Given that the state had to spend to revive the private sector, it was more sensible for government to spend on socially useful activities. But failing that, even spending on socially useless ventures for reviving the private sector was better than nothing.

What Keynes actually said was this:

… ‘wasteful’ loan expenditure may nevertheless enrich the community on balance. Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.[ii]

(Keynes’s attack on the principles that ‘stand in the way of anything better’ continues for a further two pages.)

The sort of misrepresentation that Selgin engaged in serves him and public debate very badly.

Equally fallacious is the Hayekian charge that public expenditure diverts resources from the private activities that should be the basis of any free society. Keynes showed that in a recession no private activity would emerge of its own volition: resources would simply be left idle. To wait for some pre-ordained and virtuous private expansion would be to wait forever while unemployment grew and society crumbled.


6.   Roosevelt’s New Deal as “trivial in scale and impact”

The economics profession has recently been willing accessory to the idea that the New Deal was economically without meaning. Sadly – as Selgin trumpeted with some glee during the LSE debate – this idea is associated with Christina Romer, the Chair of the US Council of Economic Advisors in the early years of Obama’s Presidency. Under Romer, the EAC championed fiscal expansion to counter the effects of the ‘great recession’. But Romer appears to have been compromised by her earlier claims that fiscal policy was unimportant in the Great Depression. In 2009 she attempted to set the record straight:

One crucial lesson from the 1930s is that a small fiscal expansion has only small effects. I wrote a paper in 1992 that said that fiscal policy was not the key engine of recovery in the Depression. From this, some have concluded that I do not believe fiscal policy can work today or could have worked in the 1930s. Nothing could be farther from the truth. My argument paralleled E. Cary Brown’s famous conclusion that in the Great Depression, fiscal policy failed to generate recovery ‘not because it does not work, but because it was not tried’.[iii]

But this is to demean Roosevelt’s courage and achievements as well as to misrepresent the facts.  Romer’s earlier conclusion follows from a failure to understand that the public sector deficit or surplus does not measure the policy stance, but reflects the outcome of policy. If spending is successful in raising income, higher tax revenues and lower benefit expenditures automatically reduce the deficit.

Instead of relying on abstract analysis in evaluating government expenditure during the great depression, let us look at the figures that are readily available on the Bureau of Economic Analysis website.


Table 1: US Government consumption and investment expenditures

The increases in state spending in the mid-1930s have no precedent in peacetime.[iv]

The Hayekians at the LSE debate also argued that World War Two did not bring the Great Depression to an end. The idea is ludicrous from any but the most perverse of perspectives. Note that the end of the Great Depression began as Roosevelt’s spending began in earnest, as this chart of unemployment shows:


US Unemployment rate

The set-back in 1938 follows the Roosevelt administration’s cuts in government spending in 1937.


7.   The 2008-9 financial rescue as “‘Keynesian”

A new fallacy following from the debate came from the Hayek supporters’ attribution of the recent financial rescues and their alleged ill-consequence to Keynes. Yet a good part of the LSE discussion was preoccupied with Hayek’s own view that the growth in the money supply must be maintained in a slump, especially given a decline in its velocity of circulation (i.e an increase in hoarding). But Hayek did not take this view at a time when it was most needed in the face of the Great Depression, as he himself later confessed:

I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. …

The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose.[v]

The bail-out of the banks surely prevented – or at least postponed – a severe decline in the money supply. Keynes, if faced with the 2007-8 crisis, might also have supported such policies, and he would have been familiar with quantitative easing, though he would have understood it as open market operations with the aim of bringing down the long-term interest rate on government bonds. However, his primary concern with the creation of new money would have been to finance state expenditure on socially useful projects, not to bail out the finance sector.


8.   The failure of stimulus as “a failure of Keynesian policy”

In a similar way, Keynesian policy was roundly blamed, during the LSE debate, for the failure of the stimulus to the wider economy in 2008-9, especially when judged against Romer’s claims in her original case for stimulus. But the stimulus was not Keynesian. It was deeply compromised by political and mainstream economic bias toward consumption. The stimulus that was delivered  was founded mainly on tax cuts and increases in transfer expenditures (not least to vehicle manufacturers for ‘scrappage’ schemes). These policies were the least unpalatable to the mainstream economists that were, and remain, influential over policy. Certainly these policies helped support demand and prevented a more severe decline. But Keynes would have understood them as temporary expedients, inadequate to restore the economy to health, not least because they stimulated consumption expenditure, not investment.

As discussed above, Keynes championed fiscal policies based on public works expenditures, but these were supported by important changes to the monetary environment so that long-term interest rates were deliberately reduced and investment expenditures could be financed by the creation of new money at near-zero short-term interest rates. Quantitative easing (again with uncertain support from the Hayekians), although it successfully reduced the cost of government borrowing, thus making government’s stimulus programme cheaper, it also gave reserves to the banks.  This allowed them to persist in their speculative behaviour. Even in its support of government stimulus, quantitative easing is only one half of a Keynesian policy. The other half concerns the direction of government expenditure itself.

It is not good enough to ridicule Keynesians as bemoaning an incorrect stimulus. It is entirely legitimate to criticise the detail of the stimulus package, though it should be recognised that those Keynesians who failed to distance themselves at the time from the direction of the stimulus have undermined their case.


In conclusion

In the 1930s, austerity was tried by President Hoover and by the MacDonald and Chamberlain Governments. These efforts failed terribly. But they set the stage for Roosevelt’s New Deal and a quiet, but decisive, change in UK policy. When spending was expanded, the world economy began a slow journey to recovery.

We remain convinced that an impartial assessment of the facts and of the data show no ambiguity about these conclusions. Even Milton Friedman refuted the Hayekian approach, telling an interviewer in 1999:

I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. … I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm.[vi]

Our plea is that those economists who have access to a public platform to champion Keynes do so by engaging with the full scope of his arguments. In the 1930s, his meticulously derived case for public works spending and the large-scale reform of finance silenced Hayek. His case must not be diminished, for a diminished Keynes cannot silence his rivals today.

In the 1930s, the Keynes–Hayek debate was resolved decisively in favour of Keynes. In denying or encouraging ignorance of these facts, economists allow politicians to view austerity as  potentially successful, and to ignore the disastrous consequences of austerity in the 1930s.

These are not arcane matters, but urgent issues of current policy.



[ii] General Theory, pp. 128-9.

[iii] Christina Romer (2009) ‘Lessons from the New Deal’, Testimony of Christina D. Romer before the Economic Policy Subcommittee Senate Committee on Banking, Housing and Urban Affairs, March 31, 2009.

[iv] The average annual growth of real expenditures between 1934 and 1936 was 10%; from the end of the Korean war to 2010, the average growth was 2%.

[v] Friedrich A. Hayek, A Discussion with Friedrich A. von Hayek (Washington, DC: American Enterprise Institute, 1975), p. 5, 12.

[vi] Gene Epstein, “Mr. Market [Interview with Milton Friedman].” Hoover

Digest, no. 1 (1999).


7 thoughts on “Eight fallacies in the LSE Keynes/Hayek debate”

  1. It is a pity that Keynes never ‘got’ the land/rent issue. A Keynesian stimulus would be greatly enhanced if (all) land rent were collected for public benefit together with frequent land valuation. This is because all public expenditure on good and necessary infrastructure projects feeds directly into land values and thus generates a powerful positive feedback mechanism as increasing revenues => increasing infrastructure renewal => increasing land values.

  2. I think the main problem we have is that the forces driving policy are not that bothered about short-term financial collapse if, in the long run, it causes a lowering of expectations which serves the interests of the plutocrats that have captured government and the regulatory authorities.

    There remains a residual belief among those who argue that accelerating inequality and the polarization of wealth and political power does not lead to optimum outcomes, that the Randian libertarians in charge of the asylum will eventually listen to reason. Unfortunately: “It can’t be bargained with. It can’t be reasoned with. It doesn’t feel pity, or remorse, or fear. And it absolutely will not stop, ever.”

    Just as the drive to austerity in Argentina was repeated in Russia, now Greece and Ireland, so it will come to Portugal, Spain, Italy, the UK, France and Germany – no nation can withstand the ‘market’ (i.e. a gamed system rigged by a handful of major banking institutions and abetted by the ratings agencies). Capital can simply be sucked out of each national economy at will, ratings can be downgraded at the whim of the agencies in the interests of their paymasters.

    The wiping out of welfare and privatisation of the public realm is not an unfortunate consequence of a genuine effort to restore the public finances, it is the prime objective of an ideology that insists that markets must always be more efficient than any form of government action – because it serves the interests of those that benefit from the contention that ‘Taxation is theft’.

    The ‘invisible hand’ of the neoliberals neatly masks the mechanisms of the market, as the idea that the aggregation of individual self-interest must always lead to the optimum outcomes appears to square the circle between the utilitarian idea of the greatest good and the maintenance of individual liberty.

    In reality, as we’ve seen in the last 30 years, deregulated markets act in the interest of a tiny minority – and that’s the way they like it.

  3. “A larger state rightly prevailed than in the 1920s or 1930s, but ironically Keynes’s state was still smaller than the state that prevailed after the counter-revolution of financial liberalisation. The post-war world was one in which the state and the private sector operated powerfully in tandem, supported by a greatly revised monetary architecture.”

    I’m a touch unclear here. Is the argument that the state and the private sector operated powerfully in tandem AFTER the counter-revolution of financial liberalization? Or that they operated powerfully in tandem while still in the context of the smaller state that presaged financial liberalization?

  4. the need for policy makers to seriously consider a Keynesian response is more urgent then ever. Economic nemisis faces the global markets otherwise.

  5. Thomas Riepenhausen

    Quite interesting! However, do you think the level of private debt is irrelevant? Do you think all sovereign debt can be payed – by the US, GB, Euro-countries? And when you favour public investments – with new money -, is this not just what Japan has done for 20 years? Shall that be paid back some day?

    1. Thomas, thank you for this. No I do not think that the level of private debt is irrelevant. On the contrary. However am also clear that it will not all be repaid – much of it is unpayable. And that means for the private, corporate as well as sovereign sectors. And so creditors have to prepare to take losses. The best way to ensure that losses are fair and that debt write-off is orderly, is through fair, orderly re-structuring processes – for the private as well as the public sector.

      As to Japan: I am no expert on what has happened there, but my understanding is that Japan tightened fiscal policy too quickly, that the Bank of Japan lowered interest rates too slowly, and that the economy stalled. Public spending has to work hand in hand – through carefully and delicately handled processes – with monetary policy, to stimulate economic activity – both private and public. Fiscal policy cannot do it alone…..and my understanding of the problems in Japan is that this careful co-ordination was not managed properly.

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