Keynes v Hayek: Two economic giants go head to head

John Maynard Keynes and Friedrich August Hayek were two prominent economists of the Great Depression era with sharply contrasting views. The arguments they had in the 1930s have been revived in the wake of the latest global financial crisis.

The contemporary relevance of their ideas has even been debated in a rap video. More than 1,000 people attended a BBC Radio 4 debate at the London School of Economics to hear supporters of the two economists argue their case.

When discussing Hayek it is important to correct a misconception: Hayek's is not a "do nothing" theory.

It does not deny that we should maintain spending when boom turns to bust. But it goes further.

Unlike Keynes, Hayek believed that genuine recovery from a post-boom crash called not just for adequate spending, but for a return to sustainable production - production purged of boom-era distortions caused by easy money.

Hayek was dismissed as someone who wanted to "liquidate labour, liquidate stocks, liquidate the farmers," and so on.

But an unsustainable boom is one after which some things really do need liquidating. The straightforward recipe for the revival of healthy investment following the 2008 crisis was to liquidate.

Liquidate Bear Stearns! Liquidate Fannie Mae and Freddie Mac!

Liquidate, in short, the whole sub-prime bubble-blowing apparatus that was nurtured by easy monetary policy.

That would have meant letting insolvent banks that lent or invested unwisely go bust.

But instead our governments chose to keep bad banks going and that is why quantitative easing has proven a failure.

Quantitative easing failed because almost all the new money the government created has gone to shore up the balance sheets of irresponsible bankers.

Now those banks sit on piles of idle cash while other businesses starve or cannot get started for want of credit.

The economy is like a drunk throwing up the morning after the night before.

It is disgorging itself - or trying to disgorge itself - of bad investments it was tempted to undertake largely because of easy money.

Giving it still more money will not prevent the inevitable suffering.

It might mask or delay it somewhat, but only at the cost of more suffering later.

This is not the sort of advice that governments welcome.

They want a painless, easy cure like the one Keynesians offer.

But, as Hayekians warned again and again, there is no painless recovery from an unsustainable boom.

The only way to have no pain is to avoid the boom itself.

Keynes's theory was forged in the Great Depression of 1929-1932 - the biggest economic collapse of modern times.

As their economies contracted, governments responded to their mounting budget deficits by raising taxes and cutting spending.

The Great Depression bottomed out at the end of 1932, with British unemployment having reached 20%, American unemployment even higher.

Keynes wrote the General Theory in 1936 to explain why the recovery was so feeble.

His revolutionary proposition was that following a big shock - usually a collapse in investment - there were no automatic recovery forces in a market economy.

The economy would go on shrinking until it reached some sort of stability at a low level.

Keynes called this position "under-employment equilibrium".

The reason was that the level of activity - output and employment - depended on the level of aggregate demand or spending power.

If spending power shrank, output would shrink.

In this situation it was the government's job to increase its own spending to offset the decline in public spending - that is by running a deficit to whatever extent necessary.

To cut government spending was completely the wrong policy in a slump.

When an economy is booming, a hair shirt at the Treasury is the right policy, when it is stagnating it is the wrong policy.

Keynes's message was: you cannot cut your way out of a slump; you have to grow your way out.

Eighty years on we have still not fully learnt the lesson.

Three years after the collapse of 2008, our economy is flat: there are no signs of growth, nor can the Osborne policy of a thousand cuts produce any.

It was Friedrich Hayek, who represented the orthodox theories which Keynes attacked.

According to Hayek the main cause of slumps was excessive credit creation by the banks leading to overspending.

The boom was the illusion; the slump the reality.

The situation following an injection of money by the banking system would be similar to that of a people on an isolated island, if, after having partially constructed an enormous machine… they found they had exhausted all their savings before the new machine could turn out its products.

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 bread without any capital.

That is, go back to growing their own food - much as the Russians did when their economy collapsed in the early 1990s.

Keynes was scathing in his comment on Hayek's book, Prices and Production, which he called "one of the most frightful muddles I have ever read".

"It is an extraordinary example of how, starting with a mistake, a remorseless logician can end in Bedlam."

Hayek gave up serious economics, though not serious writing.

He and Keynes developed a wary respect, and even liking, for each other. "We get on very well in private life", Keynes wrote. "But what rubbish his theory is."

Keynes's magnetism made a deep impression on Hayek, but he never stopped believing that his influence on economics was "both miraculous and tragic".

The Keynes vs Hayek debate will be broadcast on BBC Radio 4 on Wednesday, 3 August at 20:00 BST and will repeated on Saturday, 6 August at 22:15 BST. You can listen again via the BBC iPlayer or by downloading the Analysis podcast.

Share your thoughts on the Keynes vs Hayek debate on Twitter using #lsehvk