VI. Main Themes Restated 18. PERSONAL RECOLLECTIONS OF KEYNES

Professor Hayek here brings together some of the major threads in his criticisms of Keynes and the macro approach. He points out that the Keynesian concept of what may be called ‘full’ unemployment assumes implicitly that all resources are freely available and that consequently any increase in money incomes will increase output, thus reviving the inflationist fallacies which in 1931 he had supposed to have been eradicated. Professor Hayek emphasises that the Keynesian mode of thinking systematically eliminates from consideration those price inter-relationships which operate in the real world; that the General Theory was, in very large part, simply a tract for the times.

Even to those who knew Keynes but could never bring themselves to accept his monetary theories, and at times thought his pronouncements somewhat irresponsible, the personal impression of the man remains unforgettable. And especially to my generation (he was my senior by sixteen years) he was a hero long before he achieved real fame as an economic theorist. Was he not the man who had had the courage to protest against the economic clauses of the peace treaties of 1919? We admired the brilliantly written books for their outspokenness and independence of thought, even though some older and acuter thinkers at once pointed out certain theoretical flaws in his argument. And those of us who had the good fortune to meet him personally soon experienced the magnetism of the brilliant conversationalist with his wide range of interests and his bewitching voice.

I met him first in 1928 in London at some meeting of institutes of business cycle research, and though we had at once our first strong disagreement on some point of interest theory, we remained thereafter friends who had many interests in common, although we rarely could agree on economics. He had a somewhat intimidating manner in which he would try to ride roughshod over the objections of a younger man, but if one stood up to him he would respect him forever afterwards even if he disagreed. After I moved from Vienna to London in 1931 we had much occasion for discussion both orally and by correspondence.

Keynes Changes His Mind

I had undertaken to review for Economica his Treatise on Money which had then just appeared, and I put a great deal of work into two long articles on it. To the first of these he replied by a counterattack on my Prices and Production. I felt that I had largely demolished his theoretical scheme (essentially Vol. I), though I had great admiration for the many profound but unsystematical insights contained in Volume II of the work. Great was my disappointment when all this effort seemed wasted because after the appearance of the second part of my article he told me that he had in the meantime changed his mind and no longer believed what he had said in that work.

This was one of the reasons why I did not return to the attack when he published his now famous General Theory—a fact for which I later much blamed myself. But I feared that before I had completed my analysis he would again have changed his mind. Though he had called it a ‘general’ theory, it was to me too obviously another tract for the times, conditioned by what he thought were the momentary needs of policy. But there was also another reason which I then only dimly felt but which in retrospect appears to me the decisive one: my disagreement with that book did not refer so much to any detail of the analysis as to the general approach followed in the whole work. The real issue was the validity of what we now call macro-analysis, and I feel now that in a long-run perspective the chief significance of the General Theory will appear that more than any other single work it decisively furthered the ascendancy of macro-economics and the temporary decline of micro-economic theory.

I shall later explain why I think that this development is fundamentally mistaken. But first I want to say that it is rather an irony of fate that Keynes should have become responsible for this swing to macro-theory. Because he thought in fact rather little of the kind of econometrics which was just then becoming popular, and I do not think that he owed any stimulus to it. His ideas were rooted entirely in Marshallian economics, which was in fact the only economics he knew. Widely read as Keynes was in many fields, his education in economics was somewhat narrow. He did not read any foreign language except French—or, as he once said of himself, in German he could understand only what he knew already. It is a curious fact that before World War I he had reviewed Ludwig von Mises’s Theory of Money for the Economic Journal (just as A.C. Pigou had a little earlier reviewed Wicksell) without in any way profiting from it. I fear it must be admitted that before he started to develop his own theories, Keynes was not a highly trained or a very sophisticated economic theorist. He started from a rather elementary Marshallian economics and what had been achieved by Walras and Pareto, the Austrians and the Swedes was very much a closed book to him. I have reason to doubt whether he ever fully mastered the theory of international trade; I don’t think he had ever thought systematically on the theory of capital, and even in the theory of the value of money his starting point—and later the object of his criticism—appears to have been a very simple, equation-of-exchange-type of the quantity theory rather than the much more sophisticated cash-balances approach of Alfred Marshall.

Thinking in Aggregates

He certainly from the beginning was much given to thinking in aggregates and always had faible for the (sometimes very tenuous) global estimates. Already in discussion of the 1920s arising out of Great Britain’s return to the Gold Standard his argument had been couched entirely in terms of price- and wage-levels in practically complete disregard of the structure of relative prices and wages, and later the belief that, because they were statistically measurable, such averages and the various aggregates were also causally of central importance, appears to have gained increasing hold upon him. His final conceptions rest entirely on the belief that there exist relatively simple and constant functional relationships between such ‘measurable’ aggregates as total demand, investment, or output, and that empirically established values of these presumed ‘constants’ would enable us to make valid predictions.

There seems to me, however, not only to exist no reason whatever to assume that these ‘functions’ will remain constant, but I believe that micro-theory had demonstrated long before Keynes that they cannot be constant but will change over time not only in quantity but even in sign. What these relationships will be, which all macro-economics must treat as quasi-constant, depends indeed on the micro-economic structure, especially on the relations between different prices which macro-economics systematically disregards. They may change very rapidly as a result of changes in the micro-economic structure, and conclusions based on the assumption that they are constant are bound to be very misleading.

Let me use as an illustration the relation between the demand for consumers’ goods and the volume of investment. There are undoubtedly certain conditions in which an increase of the demand for consumers’ goods will lead to an increase of investment. But Keynes assumes that this will always be the case. It can easily be demonstrated, however, that this cannot be so and that in some circumstances an increase of the demand for final products must lead to a decrease of investment. The first will generally be true only if, as Keynes generally assumes, there exist unemployed reserves of all factors of production and of the various kinds of commodities. In such circumstances it is possible at the same time to increase the production of consumers’ goods and the production of capital goods.

The position is altogether different, however, if the economic system is in a state of full or nearly full employment. Then it is possible to increase the output of investment goods only by at least temporarily reducing the output of consumers’ goods, because to increase the production of the former, factors will have to be shifted to it from the production of consumers’ goods. And it will be some time before the additional investment helps to increase the flow of consumers’ goods.

Full Employment Assumption

Keynes appears to have been misled here by a mistake opposite to that of which he accused the classical economists. He alleged, with only partial justification, that the classics had based their argument on the assumption of full employment, and he based his own argument on what may be called the assumption of full unemployment, i.e., the assumption that there normally existed unused reserves of all factors and commodities. But the latter assumption is not only at least as unlikely to be true in fact as the former; it is also much more misleading. An analysis on the assumption of full employment, even if the assumption is only partially valid, at least helps us to understand the functioning of the price mechanism, the significance of the relations between different prices and of the factors which lead to a change in these relations. But the assumption that all goods and factors are available in excess makes the whole price system redundant, undetermined and unintelligible. Indeed some of the most orthodox disciples of Keynes appear consistently to have thrown overboard all the traditional theory of price determination and of distribution, all that used to be the backbone of economic theory, and in consequence, in my opinion, to have ceased to understand any economics.

It is easy to see how such belief, according to which the creation of additional money will lead to the creation of a corresponding amount of goods, was bound to lead to a revival of the more naïve inflationist fallacies which we thought economics had once and for all exterminated. And I have little doubt that we owe much of the post-war inflation to the great influence of such over-simplified Keynesianism. Not that Keynes himself would have approved of this. Indeed, I am fairly certain that if he had lived he would in that period have been one of the most determined fighters against inflation. About the last time I saw him, a few weeks before his death, he more or less plainly told me so. As his remark on that occasion is illuminating in other respects, it is worth reporting. I had asked him whether he was not getting alarmed about the use to which some of his disciples were putting his theories. His reply was that these theories had been greatly needed in the 1930s, but if these theories should ever become harmful, I could be assured that he would quickly bring about a change in public opinion. What I blame him for is that he had called such a tract for the times the General Theory.

The fact is that, although he liked to pose as the Cassandra whose dire predictions were not listened to, he was really supremely confident of his powers of persuasion and believed that he could play on public opinion as a virtuoso plays on his instrument. He was, by gift and temperament, more an artist and politician than a scholar or student. Though endowed with supreme mental powers, his thinking was as much influenced by aesthetic and intuitive as by purely rational factors. Knowledge came easy to him and he possessed a remarkable memory. But the intuition which made him sure of the results before he had demonstrated them, and led him to justify the same policies in turn by very different theoretical arguments, made him rather impatient of the slow, painstaking intellectual work by which knowledge is normally advanced.

He was so many-sided that for his estimate as a man it seemed almost irrelevant that one thought his economics to be both false and dangerous. If one considers how small a share of his time and energy he gave to economics, his influence on economics and the fact that he will be remembered chiefly as an economist is both miraculous and tragic. He would be remembered as a great man by all who knew him even if he had never written on economics.

I cannot from personal knowledge speak of his services to his country during the last five or six years of his life when, already a sick man, he gave all his energy to public service. Yet it was during those years when I saw most of him and came to know him fairly well. The London School of Economics had at the outbreak of war been moved to Cambridge, and when it became necessary in 1940 for me to live wholly at Cambridge, he found quarters for me at his College. On the weekends for which, so far as possible, he sought the quiet of Cambridge, I then saw a fair amount of him and came to know him otherwise than merely professionally. Perhaps it was because he was seeking relief from his arduous duties, or because all that concerned his official work was secret, that all his other interests then came out most clearly. Though he had before the war reduced his business connections and given up the bursarships of his college, the interests and activities he still actively pursued besides his official duties would have taxed the whole strength of most other men. He kept as informed on artistic, literary and scientific matters as in normal times, and always his strong personal likings and dislikings came through.

Wide Intellectual Interests

I remember particularly one occasion which now seems to me characteristic of many. The war was over and Keynes had just returned from an official mission to Washington on a matter of the greatest consequence which one would have assumed had absorbed all his energy. Yet he entertained a group of us for part of the evening with details about the state of the collection of Elizabethan books in the United States as if the study of this had been the sole purpose of his visit. He was himself a distinguished collector in this field, as of manuscripts of about the same period, and of modern paintings.

As I mentioned before, his intellectual interests were also largely determined by aesthetic predilections. This applied as much to literature and history as to other fields. Both the 16th and 17th centuries greatly appealed to him, and his knowledge, at least in selected parts, was that of an expert. But he much disliked the 19th century and would occasionally show a lack of knowledge of its economic history and even the history of its economics surprising in an economist.

I cannot in this short essay attempt even to sketch the general philosophy and outline on life which guided Keynes’s thinking. It is a task which has yet to be attempted, because on this the otherwise brilliant and remarkably frank biography by Sir Roy Harrod is hardly sufficient—perhaps because he so completely shared and therefore took for granted the peculiar brand of rationalism which dominated Keynes’s generation. Those who want to learn more about this I would strongly advise to read Keynes’s own essay ‘My Early Beliefs’ which was published in a little volume entitled Two Memoirs.

In conclusion I want to say a few words about the future of Keynesian theory. Perhaps it will be evident from what I have already said that I believe that this will be decided not by any future discussion of his special theorems but rather by the future development of views on the appropriate method of the social sciences. Keynes’s theories will appear merely as the most prominent and influential instance of a general approach whose philosophical justification seems to be highly questionable. Though with its reliance on apparently measurable magnitudes it appears at first more scientific than the older micro-theory, it seems to me that it has achieved this pseudo-exactness at the price of disregarding the relationships which really govern the economic system. Even though the schemata of micro-economics do not claim to achieve those quantitative predictions at which the ambitions of macro-economics aim, I believe by learning to content ourselves with the more modest aims of the former, we shall gain more insight into at least the principle on which the complex order of economic life operates, than by the artificial simplification necessary for macro-theory which tends to conceal nearly all that really matters. I venture to predict that once this problem of method is settled, the ‘Keynesian Revolution’ will appear as an episode during which erroneous conceptions of the appropriate scientific method led to the temporary obliteration of many important insights which we had already achieved and which we shall then have painfully to regain.

(Personal Recollections of Keynes & the ‘Keynesian Revolution’)

19. GENERAL AND RELATIVE WAGES

Two major points are made in these two extracts (from a draft of an essay on Competition As A Discovery Procedure—published later in a revised form in German).

Professor Hayek first emphasises the role of the pricing system, and especially of price changes, as a means of adapting the economy to the unforeseeable changes that make up the real world. Without such continuous adaptations real income and the stock of real resources would necessarily be lower than they could be with an optimal use of the pricing system. Professor Hayek here develops the concept of the pricing system as a transmitter of empirical knowledge, a concept first systematically propounded in his early essays on ‘Economics and Knowledge’ (1937), and ‘The Use of Knowledge in Society’ (1945).

Applying this approach to the labour sector, Professor Hayek, in the second extract, shows the role of changes in relative wage rates in reallocating labour between industries, thus facilitating the continuous adaptation to ever-changing circumstances necessary even for the maintenance of real income and wealth. Where such changes in wage rates are prevented by institutions, such as unions, the aggregate real income of the community is kept below the level it might have reached.

The inefficacy of non-market wage-rate fixing, whether by trade unions or other bodies, as a method of raising the real incomes of all members of the working class is argued here.

The consequences of this misinterpretation of the market as an economy that can and ought to satisfy different needs in a predetermined order of importance, are particularly evident in the efforts of policy to alter prices and incomes in the interest of what is called ‘social justice’. Whatever meaning social philosophers have attached to this concept, in the practice of economic policy it has almost exclusively meant only one thing: the protection of groups against the necessity of a descent from the absolute or relative material positions that they have for some time occupied in society. Yet this is not a principle on which it is possible to act generally without destroying the whole foundation of the market order. Not only the continuous increase but in some circumstances even the maintenance of the present level of real income depends on adapting to unforeseen changes; such adaptation involves a reduction in the relative and perhaps even the absolute share of some, although they are in no way responsible for the situation.

Unpredictability and the Price System

The point which we must constantly keep in mind is that all economic adjustment is made necessary by unforeseen changes; the whole point of employing the price mechanism is to inform individuals that what they have been doing or can do is now in greater or lesser demand for some reason which is no responsibility of theirs. Adaptation of the whole order of activities to changed circumstances rests on changes in the remuneration offered for different activities, without regard to the deserts or faults of those concerned.

The term ‘incentives’ is often used in this connection, with the somewhat misleading connotation that the main problem is to induce people to exert themselves sufficiently. The main guidance which prices offer us is however not how much but what to do. In a continuously changing world even maintaining a given level of wealth requires continuous changes in the activities of some, that will be brought about only if the remuneration of some activities is increased and that of others decreased. These adjustments are needed merely to maintain the total income stream under relatively stable conditions; no ‘surplus’ will be achieved under them, which could be used to compensate those injured by changing prices. Only in a rapidly growing catallaxy can we hope to avoid absolute declines in the position of some.

Modern economists often seem to overlook that even the relative stability shown by many of those aggregates which macro-economics treats as data is itself the result of a micro-economic process of which changes in relative prices are an essential part. It is only thanks to the market mechanism that another is induced to step in and fill the gap caused by the failure of one to fulfill the expectations of his partners. In fact all those aggregate demand and supply curves with which we like to operate are not really objective given facts but results of the continuous processes of the market. Nor can we hope to learn from statistical information what alterations in prices or incomes are necessary to bring about adjustments to such inevitable changes. But the chief point is that in a democratic society it would be wholly impossible to bring changes about by commands which are not felt to be just and whose necessity can never be clearly demonstrated. Deliberate regulation in such a political system must always aim to secure prices which appear just, which in practice means preserving the traditional income and price structure. But an economic system in which each gets what the others think he ‘deserves’ would necessarily be highly inefficient—quite apart from also being an intolerably oppressive system. Every ‘incomes policy’ is therefore likely to prevent rather than facilitate those changes in the price and income structure that are required to adapt the system to changed conditions.

It is one of the paradoxes of the present world that the communist countries are probably freer than the ‘capitalist’ countries from the incubus of ‘social justice’ and more willing to let those suffer against whom developments turn. At least for some Western countries the position is so hopeless precisely because the ideology which at present dominates politics makes those changes well-nigh impossible that would be necessary in order to bring about that rapid further rise in the position of the working class which, in turn, would eclipse this ideology.

Wage Rigidities

Market forces are relatively sturdy; they tend to reassert themselves in the most unexpected manner when we think we have driven them out. Nonetheless in the Western world we have succeeded in isolating the most ubiquitous factor of production from such forces. It is generally accepted that the most severe difficulties of contemporary economic policy are due to what is usually described as the rigidity of wages, which means in effect that both the wage structure and the level of money wages have increasingly become impervious to market forces. This rigidity is usually treated by economists as irreversible, so that we must adapt our policies to it. For thirty years the discussion of monetary policy has been concerned almost entirely with the search for expedients by which to circumvent it. I have long felt that these monetary devices provide merely a temporary way out, and can but postpone the day when we will have to face the central issue. They also make the real solution, which cannot forever be avoided, more difficult because by accepting these rigidities as unalterable we increase them and give the sanction of legitimacy to what are anti-social and destructive practices. I have largely lost interest in current discussions on monetary policy because it seems to me that in its failure to face up to the central issue, it passes the buck, in an irresponsible manner, on to our successors. We are of course in this respect already reaping the harvest of the work of the man who set this fashion since we are already in that long run in which he knew we would be dead.

It is a great misfortune for the world that these theories were formed as a result of an exceptional and unique situation in which it could be properly argued that the problem of unemployment was largely a problem of a too-high level of real wages, and in which the much more crucial and general problem of the flexibility of the wage structure could be neglected. As a result of Britain’s return to gold in 1925 at the 1914 parity, a situation had been created in which it could be plausibly argued that all real wages in Britain had become too high for her to achieve the necessary volume of exports. I doubt whether the same has ever been true of any other important country, and even whether it was entirely true of the Britain of the 1920s. But of course Britain had then the oldest, most firmly entrenched and most comprehensive trade union movement in the world which by its wage policy had largely succeeded in establishing a wage structure determined much more by considerations of ‘justice’, which meant little else than the preservation of traditional wage differentials, and which made those changes in relative wages demanded by an adaptation to changed conditions ‘politically impossible’. No doubt the situation then meant that full employment required that some real wages, perhaps those of many groups of workers, would have to be reduced from the position to which they had been raised by deflation. But nobody can say whether this would necessarily have meant a fall in the general level of all real wages. The adjustment of the structure of industry to the new condition that adjustments in wages would have induced might have made this unnecessary. But, unfortunately, the fashionable macro-economic emphasis on the average level of wages prevented this possibility from being seriously considered at the time.

Importance of Relative Wages

Let me put these conditions in a more general form. There can be little doubt that the productivity of labour, and hence the level of real wages, depends on its distribution between industries and occupations, and that the latter, in turn, depends on the structure of relative wages. If this wage structure has become more or less rigid, it will prevent or delay adjustments in industrial structure to changing conditions. It would seem probable that in a country in which the relations between different wage rates have long remained practically unchanged, the level of real wages at which full employment can be maintained would be considerably lower than it could be.

Indeed it would seem that without the rapid advance of technology and the relatively high level of capital formation to which we have become accustomed, a fully rigid wage structure would prevent most adaptations to changes in other conditions, including those necessary to maintain the initial level of incomes; wage-rate rigidities would thus lead to a gradual fall in the level of real wages at which full employment could be maintained. I know of no empirical studies of the relations between wage flexibility and growth but I should be inclined to expect that such a study would show a high positive correlation between the two magnitudes: not merely because growth will lead to changes in relative wages but even more because such changes are essential to adapt to the new conditions which growth requires.

But to return to what appears to me to be the crucial point: I have suggested that the level of real wages at which full employment can be maintained is dependent on the structure of relative wages, and that in consequence, if this structure is rigid and the relation between wages remains constant while conditions change, the level of real wages at which full employment can be maintained will tend to fall, or at least not rise as fast as it might because of the beneficial effects of other circumstances. This would mean that the manipulation of the level of real wages by monetary policy is not really a way out of the difficulties which the rigidity of the wage structure creates. Nor can we expect that any sort of ‘incomes policy’ or the like will offer a way out. In the end it will prove that the very rigidity in the wage structure which trade unions have created in the presumed interest of their members is one of the greatest obstacles to the advance of the real income of the working classes as a whole: real wages and other incomes will not rise as fast as they could if some real wages were allowed to fall, absolutely or at least relatively.

The classical aim, which, in the words of John Stuart Mill, was ‘full employment at high wages’, can therefore be achieved only by an efficient use of labour which requires the free movement of relative wage rates. That illustrious man, whose name for this reason I believe will go down to history as the grave digger of the British economy, chose instead full employment at low wages. For this is the necessary result if the rigidity of relative wages is accepted as unalterable, and attempts made to correct its effects by lowering the general level of real wages by the roundabout process of lowering the value of money. We see now clearly that this evasion of the central issue has offered only a temporary way out and that we have probably reached the point when we must face the evil at its source. We can no longer close our eyes to the fact that the interests of the working class as a whole demand that the power of particular labour unions to preserve the status of their members be curbed. The practical problem seems now to be how we may assure the working class as a whole that if the status of particular groups is not protected, this policy will not only not endanger but indeed enhance the prospects of a rise in its real wages.

(From a draft paper referred to in the introductory note)

20. CARACAS CONFERENCE REMARKS

In this final extract Professor Hayek graphically illustrates the dilemma created by inflation, which leaves the economy, as he says, grasping a ‘tiger by the tail’. Unless there is a continuous acceleration in the rate of increase of prices, recessionary symptoms begin to appear . . . so that ultimately the choice is between a runaway inflation and an extensive depression and readjustment to a non-inflationary situation.

Twenty years ago I lost interest in monetary matters because of my disillusionment with Bretton Woods. I was wrong in my prediction that the arrangement would soon disappear. Its main innovation has been to impose the responsibility for restoring balance in international payments on the creditor nations. This was reasonable in the deflationary 1930s, but not in an inflationary period. Now we have an inflation-borne prosperity which depends for its continuation on continued inflation. If prices rise less than expected, then a depressing effect is exerted on the economy. I expected that ten years would suffice to produce increasing difficulty; however, it has taken 25 years to reach the stage where to slow down inflation produces a recession. We now have a tiger by the tail: how long can this inflation continue? If the tiger (of inflation) is freed he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished! I’m glad I won’t be here to see the final outcome . . .

(Notes of comments by F.A. Hayek on a paper presented to
the Mont Pèlerin Conference, Caracas)