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Keynes vs. Hayek

Millions of jobs lost, trillions in revenues evaporated, and communities throughout the globe in immense hardship – these are some of the consequences of the current economic crisis. It started in 2008 with the bailout of Bear Sterns and the fall of Lehman Brothers, and soon spread throughout the world, or at least many claim so. Now, some six years later, when the initial wave of Keynesianism and calls for bailouts seem to be weakening, one can notice a slight change in the debate over the crisis. The Austrian perspective is seen to be gaining more support, and the question of desirability of central banks is being reopened once more.

In the past, authors alike Bernanke praised achievements of the Federal Reserve and central banks in general. They argued that these institutions are to be recognized for their maintenance of price stability, and safeguarding of the financial system. In their view, central banks, on top of effectively implementing their monetary policy, can mitigate moral hazard problems through regulation. This, however, seems a rather ambitious claim, given the current state of the economy.

Too big, too bad

To many it seems obvious that central banks are to be blamed for the hardships caused by the 2008 crisis. They argue that central banking in its current form increases moral hazard problems, and promotes misallocation of resources. First, moral hazard problems in banking are associated mostly with the status of ‘too big to fail’. Given the internal interconnectedness of current financial systems, it is argued that if some of the biggest banks fail, this will have negative ramifications for the whole system, and could possibly result in further bank failures, thus starting a vicious circle. Following this logic, many governments in recent years argued that bank bailouts are necessary for protection of their financial and economic systems. Knowing this, the biggest banks had incentive to increase their risk – since if their investments turned bad, governments were ready to step in, and if otherwise, they stood to make much larger profits. This need not imply that all banks followed such reasoning. However, if even a single one had, it would have immediately gained a competitive advantage over the rest of the industry, and thus boosted its financial performance on the expense of its more responsible competitors. As a result, current standards of financial analysis would identify it as a ‘better business’, and call for increased investment. If other banks wished to stay in the business in the future, they had to follow, since the next crisis would still be too far in the future to ensure timely punishment of their risk-seeking competitor. Thus, it happened that risky and often dubious investments spread throughout the financial industry in the years preceding the current crisis.

No way out

A simplistic and often idealised response to this problem is a call for increased financial regulation. Even if the assumption that this regulation would be effective at the time of its implementation is granted, its effectiveness is still most likely to suffer from lag caused by the constitutional system of the host country and dynamic character of the financial industry itself. In other words, what may be a sound financial regulation today, need not make sense tomorrow. The only way states could ensure full control over the risk taken by the bank, would be their nationalisation. Such drastic intervention would decrease the efficiency of the financial system, as well as leave the doors opened for private misuse of the nationalised banking sector. A noteworthy example is the situation in Eastern European countries after the fall of communism. Nationalised banks were politically forced to extend loans to individuals affiliated with the government, which then turned bad the moment these individuals cashed in their investments, and left the region.

Hayek told you so

The second (and far more serious) objection to the current system is the argument by the Austrian-school economists. They argue that monetary intervention to reduce interest rates does not solve any problems of the economy. According to them, it only postpones those problems and makes them worse. Low interest rates, in Hayek’s view, encourage unproductive investment – one that is most likely to turn bad the very instance interest rates return to their competitive levels. Therefore, he argued that such policy not only magnifies the economic turmoil in the future, but also causes large losses of capital, caused by its incorrect use. His views have been neglected in past years, mainly due to the believe that the economists achieved full control of the economy – a period referred to as the great moderation. Not many, however, noticed that this period was exactly what Hayek was warning for. Low interest rates in the beginning of the 21st century caused growth of one of the largest asset bubbles in the economic history, and planted seeds of the 2008 recession.

As if it wasn’t bad enough

On the other hand, Keynes noted: “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.” His contemporary followers agree that there are many issues with the current central banking system, and that much can be improved. However, they also believe that sitting back and waiting for the good times to come may prove to be more costly than expansionary intervention. This is supported by current research, which suggests that prolonged recessions fundamentally harms the economy and decrease its long run potential. More precisely, in period of prolonged unemployment workforce loses its working habits and skills, and thus becomes less productive, which implies a decrease in the long run potential of the economy.

In the aforementioned discussion the importance of central banking, a reform was outlined. However, it left the reader short of a clear-cut answer to the question of what to do next. It is clear that severe moral hazard problems come along with increased financial regulation. Nonetheless, it is also clear that prolonged crises leave scars on the economy and the society of a troubled nation. The ultimate choice between lower long run income with better allocation of the investment, and shorter recessions accompanied with increase in moral hazard problems, is all up to the reader. At the end of the day, he or she will vote for politicians representing these conflicting policy choices.


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