Keynes and Hayek Head to Head | Roger W. Garrison

okay people quiet it down it must be time to start today we're going to do a little exercise showing the difference between Hayek and Keynes and the nature of the exercises we start with Keynes and we morph into Hayek and you pay attention to what we had to change to do the morphing and I'll give you an idea of who's more nearly right and it will also give you an idea about who's more nearly general in other words what's the real general theory Keynes called his theory the general theory so keep in mind how general is it so we'll see about that there they are and I'll show you the day's just to show you that that iock was younger than Keynes by about 16 years but he held his own against Keynes they didn't know each other and know each other fairly well when LSE had to shut down and move to Cambridge during World War two Keynes actually helped Hayek find an apartment they were there were personal friends but of course they didn't see eye-to-eye on macroeconomics they did debate one another you'd have put debates in quotes what they did actually was review one another's books and pretty hostile with a lot of hostility especially Keynes talking about the high X prices and production and so and in my judgment if you look at the original literature they don't really come head to head you know you don't really see what the difference is and so my objective is to put them head-to-head it's really not as difficult as it might seem there are little known photograph but eventually a hike just despaired and and bailed out of technical economics and did political economics starting with the road to serfdom came around Leyden life with a few more articles about macroeconomics sometimes they've been lamenting that he had abandoned the debate with Cain okay let me give you just two sweeping summaries of what's gone going on here I talked about visions visions and frameworks visions is something that Shoom Peter talks about economists typically have a pre-analytical vision of how the economy works it's that this before the analytical framework that shows how it works so what's the Keynesian vision he sees the economy is in some kind of a circular flow at which spending and earning are brought into balances by changes in the level of employment that should strike a chord with you who have taken taken principles level courses in macro high exhibition of economy suggests that means ends framework well of course I mean that's minger that's Mises and so on so instead of circular flow you're getting means-ends you've got the time element and on the ground floor of that vision in which means are produced or our means of production are transformed over time into consumable output so the transformed over time is key because you got the time element right in there now the graphical depiction of the circular flow appears as a Keynesian cross I'll remind you if you have forgotten from your principles class how a circle becomes a cross the crosses intersection identifying a particular state of the economy in terms of full employment unemployment or whatever in which the economy income and expenditures are in balance then graphically the means-ends appear as a hiking triangle we saw that yesterday the triangle shape depending the intertemporal pattern of investment in equilibrium the pattern of investment corresponds to the intertemporal preferences of consumers in the marketplace okay that's the general visions and frameworks now I apologize just a little bit for a brief review of the Keynesian circular flow framework I hope I don't give you bad feelings but I think we can do an exposition that might bring a little more understanding to it then then you've got when you were in a principles course the circular flow in envisions business organizations it's just sort of a shell it's a place where factors or protections are bought and output is sold downstairs here we have workers consumers investors those are the people all downstairs that that deal with one another through business organizations so you've got a flow of Labor and other factors of production and I write it that way without listing the other factors because those other factors kind of drop out of sight pretty quickly that's just part of the background the the labor is the key factor here so those people are providing their labor services and they get paid for it called income that's only half the story of course if you look at the other side of the circle you have goods and services being produced by in the firm's and it has to be paid for that's the expenditures all right so there you have the circular flow the interest rate is not in play directly but can be at least in a minor way with the policy action so the interest rate is more or less a policy lever there's federal reserve policy you can have a high interest rate and the economy's kind of slow in circulating or a low interest rate and it'll circulate factor this is off now let me turn it on it circles okay your textbook didn't do it that way it is circulating kind of slowly well of course look the interest rate is 6% what do you expect if you want to goose it up a little bit turn it over to 2% he goes faster okay if that starts giving you inflation hey turn it back down you know it goes back to its old level so this is sort of a Keynesian mindset that we haven't exactly completely gotten rid of yet all right all right enough of that nonsense now we've got a big job because there's there's Keynes and you circular flow here's Hayek and of course he has the means ends framework the structure of production was over we've got to morph from a circle to a triangle and the triangle that changes shapes you remember that you have a number of stages of production like that and the thing can even change in response to that interest rate something gets ignored by Keynes so we've got a lot of work to do now I'll call your attention to the circle again because look you have income on one side and expenditures on the other and when that thing circulates those two have to be in balance the integers have to equal income y equals C plus I C plus IR the expenditures for a wholly private economy okay probably write this down here in Keynesian equilibrium income equals expenditures y equals Z for a wholly private economy then y equals C plus I for a mixed economy C plus I plus G for my sophomores here in Auburn I like to write out holy WH o L my private economy because I had some students who thought I was saying hol Y holy for the private economy that religious tinge to it but no just completely private all right so there there's that circular flow but now expenditures on the vertical axis and income on the horizontal and course for them to be equal that's given by the 45 degrees that's where your point of reference that's those are possible equilibrium rates of circulation there what standard of course in Keynesian theory sort of bedrock is that consumption equation that shows that income Rises or consumption Rises as income Rises but not as fast as income and even at zero income you spend a little something called it a as income Rises you increase your income with a slope of B which is something less than 1 that's the consumption equation that's also bedrock is very stable it doesn't shift around it just sits there and then on top of that you you put investment C plus I and of course what you're going to notice here is that unlike the Austrian view where C is traded off against I here you just add them up C plus I to get total expenditures all right we would add government if we're going to deal with a mixed economy but I don't need that for the lecture today and those three components are distinguished largely if not completely in terms of their stability properties you know consumption is stable investment is unstable and government is stabilizing that's the that's the Keynesian view and we can see exactly where C plus I equals y has to be that intersection with the 45-degree line and that's where you have equilibrium income and to get there the income level has to change the employment level has to change so the economy spirals up or spirals down until it finds that particular place so there's an income equals consumption plus investment that's what you learned in in your principles course ok now according to Keynes he says it's by accident or design that the economy is actually performing at his full employment potential what is the excluding year some seulji anything is either accurate in or design no no what is is he's excluding is the impersonal forces of the marketplace getting us to full employment he doesn't count on that doesn't kind of the smithy and invisible hand getting a sarah tu you just happen to be there or it's by design which means policy prescription but we're going to assume as Keynes does that initially at least we start out at full employment okay now one way to show that is using that production possibilities frontier if you're at full employment it means you're on the frontier and so you can see where consumption is on the left side up to the vertical distance up to the consumption equation and we just look where that puts us on the right here and we're on the production possibilities frontier with a level of investment my investment scale is a little broader than the one on the left that they're measuring that same investment magnitude so that shows you the economy is fully employed there happens to be right now initially it is case doesn't show it that way what he does is he looks at that income level and sees what the labor market looks like supply and demand for labor and the market clearing wage rate he doesn't think of it quite that way he thinks of it as the supply of labor and the going wage rate and then looks to see if demand is strong enough to clear the market at that going wage because that going wage keeps going okay it doesn't change it's sticky as your textbooks explain but those are two different ways of showing that the economy is at full employment at this point okay total in or at least labor income is just the wage rate times the number of worker hours body was sold so that labor income is shown in that bottom graph and for Keynes he treats that as if it were total income he knows it's not he says he knows it's not but he says well total income moves pretty much in proportion with labor income in other words he doesn't allow for changes in the distribution of income between the factors of production you know you don't get more profits and less wages or more wages and less profits you just get total income which is proxied by labor income and besides he explains labour is the lion's share of income anyway so this is why I call it labor based economics because he just takes labor income to be a total income or at least to be a proxy for total income okay so I've labeled that Y sub Fe full employment income that's where we happen to start and I bring back my circular flow he equals y now it looks to me like it's all working fine you're at full employment you know what's what's the problem what's the problem well the problem is yeah you're there now but you probably won't stay there and why not and he explains he says a collapse and investment activity the claps are being attributable to a waning of animal spirits animals parents that's the psychological thing in other words for no known reason investors get cold feet they lose their cool lose their fire in the belly and become pessimistic and pull back on investment and that's what causes the claps it's the it's the waning of animal spirits now I don't have a graph I don't have an axis for animal spirits but there they are now I would cool the heels out of any investor and and when there's a waning of animal spirits that investment curve shifts downward okay well you look now and see the expenditures are less than income people aren't spending all their income meaning they're they're producing stuff and getting paid for but they're not buying all of it it's just piling up at the firm is excess inventories there are the excess inventories on the left and here they are on the right piling up of excess inventories okay that's going to cause problems now the problems with what happened what happens in is the economy spirals down okay expenditure has fallen and so people are laid off income Falls expenditure Falls more and the economy crashes and and moved down until it's once again a local repo so there is a new equilibrium okay and you can see all the parameters here investment fell that much you called it Delta I and the change in investment income fell that much that's Delta Y and you know what the relationship is between those two is the multiplier Delta y equals 1 over 1 minus B that's the slope of the consumption equation times Delta I that's the famous Keynesian multiplier the 1 over 1 minus B and the general theory Keynes estimates it to be about 10 okay with our recent stimulus packages it shows up to be somewhere between 1 and point 9 okay it doesn't help us out the stimulus doesn't help us now but that's the multiplier and importantly here look what happens to consumption the consumption equation doesn't change but we move down along it and so consumption gets reduced by Delta C so what you see everything goes down investment goes down income goes down consumption goes down and in terms of PPF you're inside the frontier alright that's that's the whole story and we want to take a look look at that you see what happens in the labor market demand for labor has fallen but the wage rate hasn't changed and I'd like to note that the going wage keeps going even after the market conditions that gave rise to it are gone that's part of Keynes's general theory well how general is it now this little exercise goes on but I think you've got the flavor so I'm going to skip gee can I skip I guess I have to do something like this yeah hey then let me skip to the morphing and so what I want to do now is carry this PPF along with my demonstration of Keynesian theory and so I started once again at full employment like so get the waning of animal spirits and now when I pulled the trigger how it's going to spiral down we're going to go down to that equilibrium point but watch what happens in the ppm it goes into the interior we're in a depression right that's part of the Keynesian story Keynes couldn't object to that he just didn't show it graphically he just showed it absolutely labor market it doesn't clear you've got unemployment and so you are inside the PPF you're not at full employment any longer let's let a further waning decrease investment even more and it you go down further all right like so again the wage rate doesn't change you've just got less employment okay now what I want to show you is let me back up here you know if you look at the path that those points have traced out you'll find out it's linear and you could trace it back up to full employment and even beyond for beyond canes we just call that inflation okay if you go beyond the PPF you get more income and more expenditures in nominal terms but not in real terms so that's just inflation up there and we can even draw a line like so I call it the Keynesian demand constraint because the Cannes Cannes economy is constrained to be in or moving towards this equilibrium position which is somewhere along that upward sloping line that's that's the story and you might think that in in principles textbook that line and even the equation of that line would have great significance but I challenge you to find a principals level textbook or an intermediate level or advanced level that that shows that line okay it's not there and yet it's the line that's easy to derive here I just say no just so I got you see I got my construction right if investment were to fall fair to zero which means we'd be down there on the consumption function then that would give you that vertical intercept of that demand constraint all right and what I need now is an equation for the line I'm not going to drive it for you but I'm going to tell you how to drive it and I'll show it to you what you did in your principles classes you took the two equations that are on the board c plus i that's y equals c plus I and then C equals a plus B y so that's the equilibrium condition y equals c plus I and the consumption equation is C equals a plus B y well what did you do with that and your principals class you solve it for equilibrium income in their right you solve it for equilibrium income and that's all you do with it but what I like to do with it is take those two equations and eliminate the Y and solve it for C as it relates to I how this consumption move when investment move and when you do that what you find is that it's a sure enough it's linear and the vertical intercept is a over 1 minus B and the slope is B over 1 minus B so that's the equation of the demand constrained you can doodle and drive it if you want to and what you notice about it is that the coefficient of I is positive because B is less than or B is positive in less than 1 so 1 minus B is positive and B over 1 minus B is positive so it gains constrains consumption and investment to move up and down together which precludes by construction any movement along the frontier all right I'll show you an example actually comes from Keynes that's what I'm going to do now but first I'll mention that when I first got my book published time and money I thought gee I might be the first macro economist actually to put that equation in print all right I've never seen in print anywhere else I'll be the first economist to put in print and when I got my copy with the first printing I opened it up to page 136 I wanted to make sure I wanted to see it you know and it turns out it wasn't there there was a blank space where the equation was supposed to go but they left it out ok so I failed I tried okay but I failed if you if you get my book at the library or here in Auburn it does have that equation because throw it over there and put it in ok but you have to get the second and third printing or whatever to to get to get that particular equation okay now Keynes recognizes the essence of this line and what he says and this is in not in the general theory but in the article he wrote a year later later called the general theory of employment and he wrote it to tell people what he meant by the general theory okay and this is one of the things he meant for simplicity this is my rendition right here but I'm going to show you Keynes the Keynesian quote let let a be 0 well it's not 0 it's some amount some positive but let it be 0 let B be 0.9 which is what gives you that multiplier of 10 and then you you get that equation as C equals 0.9 you see how you plug in and get that so that's the example that Keynes is using and here's what he says if for example the public are in a habit of spending nine tenths of their income on consumption goods that's the B is 0.9 it follows that if entrepreneurs were to produce consumption goods that it cost more than nine times the cost of investment goods and that's the point 9y over there they are producing some part of their output that can't be sold at a price which covers the cost of production so he's saying the economy is limited to producing consumption and investment along that line and then here's what he says about it this formula is not of course quite so simple as in this situation right because a is positive but there's always a formula more or less of this kind relating the output of consumption goods which it pays to produce to the output of investment Goods the conclusion appears to me to be quite beyond dispute yet the consequences which follow from it are at the same time unfamiliar and of the greatest possible importance so he's saying look people the economy moves along that straight line we've got to understand that and we got to see how important it is well it is important if it were true because it means you can't move along the PPF and that you're likely to either be in a depression or in some inflationary spiral of course that's what Keynes actually believed okay now I want to keep track of the interest rate in a way that Keynes actually wouldn't object to and I'll put it downstairs here we got the rate of interest in saving invest just a loanable funds market that we use yesterday and if that investment is the current level of investment then there must be some market clearing there in that loanable funds market okay so I'm just going to carry about along Keynes wooden object it carrying it along he just says it's not going to help you figure out anything carry it along if you want and here Keynes was he was willing to make several different arguments that weren't mutually consistent at some points in the book he would say neither saving nor investment depend on the interest rate which means are both straight up and down and only by coincidence would would they be together and in other instances he says okay they slope like Dennis Robertson thinks they do but they moved together they moved back and forced together and so it doesn't help you out I think it was laying hoovered that argue that pointed out that Keynes was arguing like a lawyer yeah oh we've got a lawyer how many lawyers that we have in here okay well cover your ears company those the lawyer argues my client didn't borrow your lawnmower and it was already broken when you lent it to him and it was still in perfect condition when he returns okay now of course the theory is it can get the jury to go for either any one of those arguments you've got what you want okay so Keynes just want to say quit looking at the loanable funds market that's not that's not where the story is okay and he would use several different arguments for that but he wouldn't he couldn't quite object to that in fact I'll show you he uses it for his own purposes so he argued that both curves as conventionally drawn shift together leaving the interest rate unchanged I said you can't determine the interest rate by supplying the man of loanable funds because of one shifts the other shifts and is the same interest rate so you need a different theory for what the interest rate is it turned out to be the liquidity preference theory but we're not going to go in that direction so now we've got loanable funds market in play and we see here a decreased investment is company by a leftward shift of the demand for loanable funds isn't it people aren't going to invest as much they don't need to borrow as much money and so I'm going to show that same movement that I showed earlier of investment falling in that top diagram but at the same time the demand for loanable funds is going to shift to the left all right that's that registers an investment too so let's watch it shift there it goes all right now you might think you might think that when that happens that puts downward pressure on interest rates and it causes the economy to adjust to these new market conditions and Hayek says no no no don't worry about that because before that can happen something else happens can you guess what else happens the economy crashes okay and when the economy crashes that means income goes down it means consumption goes down and it means saving goes down which is to say saving shifts to the left right so when you show the economy crashing and watch it crash and watch the saving curve shifts to the left validating that old interest rate so the interest rate didn't change at all all right we've moved down into the PPF along the Keynesian demand constraint and I've struck an equilibrium in terms of income and expenditures it pained me to do this but I showed that inside the frontier as a solid point which means equilibrium okay the Keynesian economics called unemployment equilibrium and and I showed the loanable funds in equilibrium to as Keynes would say okay now a point that I made yesterday and I want to okay so the the particular supply and demand diagram for loanable funds in the general theory is in there to make this specific point this is this is the curve that Howard the Heron said he needs to put in if that's what he's going to throw out so he has this diagram in there and he threw it out and it's worthwhile I think to bring that up that's the general theory is on page 180 you find the one and only died one and only one diagram that's in the general theory can you see any mistake that you'd take points off of already if you were grading this this graph what's wrong with that graph didn't label the axes okay oh all right it could have been you know it could have been the publisher after all they left out my equation you know that so we won't blame him for that but you can see if it's called saving and investment that's on the vertical axis so we can put that on there for him on the horizontal axis is interest rate he calls it R as in rate of return so that's that's the interest rate down there but the interest rate is the price right and the other is the quantity so he's got he's got to turn Cronk wise and we can fix it that we can flip it around and that's what I want to do here and bring it out like that so you can compare it to what I've got in my PowerPoint and then you see a whole bunch of shifts of the supply of loanable funds he's got he's got a concave instead of convex it I don't know why I messed it up that way but he did and some of the shifts though are just to show that income is a parameter in other words at higher income you save more lower income you save less and so so this curve shifts with income it's incomes a chef parameter and you demonstrates that well let's let's get rid of those that were just demonstrating that income is a shift parameter and now this is what you've got all right and what's this point well if you read the text closely it don't have to be too closely you see that if the economy is in a supply and demand equilibrium there and if investment demand Falls like that then the economy will spiral down and income will fall too and because income Falls savings will fall and it falls by the same amount and so the interest rate doesn't change now what you see as as that diagram is in there to make the exact point that I've made with my celery loanable funds market so he's making the very same point and we could do it over on his own diagram it'd just be turned at right angles he's saying the same thing okay I think that's significant and let me push it a little further Keynes also denied that an increase in saving would have the effect wouldn't have there oh he denied that it would have the effect imagine my local funds theorist and because of his paradox of thrift okay and and this is directly out of the general theories there's every attempt to save more by reducing consumption well that's how you save more will so affect incomes that the attempt necessarily defeats itself that's a very strong statement in it well that's see how that works if people actually do start saving more now for the first time we were to get that consumption equation falling he said it doesn't fall this is a good thing that involved because if it did we'd be in trouble so the consumption falls while if it falls C plus I falls there fully because I sitting on top of C alright but also that demand constraint will fall because the intercept is a over 1 minus B and if that vertical intercept changes then the demand constraint Falls too and of course in the third diagram the savings curve will shift to the left that's what we mean by or I'm sorry that it saved me serve will shift to the right that's what we mean by an increase in saving so let's watch those shifts so it goes like that now we're real close to a Hayekian diagram aren't we we've got an increase in saving and Hyack would say well look Maynard savings increased the interest rate is bit down it gives you increased investment in the early stages and that's that's how the market translates saving into more future consumption and Keynes actually didn't even follow the argument that far but he says well never mind Hayek because before that happens something else happens what do you think it is you you guys are quick learners ok the economy crashes I tell my sophomores on my on my exams of if I tell you the Keynesian theory something happens it almost doesn't matter what the economy crashes so let's watch it crash whoop now watch it crash okay now so importantly what you see look at the savings function it shifts it back to where it was okay in other words it shifted to the right because people want to save more it's shifted back to the left because people had less income out of which to save all right well that's exactly the paradox of thrift that's what Keynes means by the paradox of thrift don't save more because if you do you'll throw the economy into a dumper people be earning less and they'll be lucky to save what they used to say all right that's the paradox of thrift hence the paradox okay now to resolve the paradox of thrift and this is what we're going to do our morphing to resolve the paradox of thrift requires that we replace the Keynesian cross which reflects the economy circular flow with a hiking triangle which depicts the memes ends in their temporal sequence well let's do that let's see how this works now you can see we're consumption is in the C plus I diagram but that consumption is represented in the Austrian view by that Hayek in triangle there's consumption and we're just going to stick our Hayek in triangle in there and substitute that out for the Keynesian cross and even now you can look and see how similar what I've got on the board is to the Austrian view but I'm going to let it behave like Keynes thought it behaved Keynes assumed a quote fixed structure of Industry this is in Chapter four of the general theory called choice of Units it's sort of a throat clearing chapter where he says okay here are my assumptions one is the fixed structure of industry which translates into a fixed structure of production in the Hayekian view and so the triangle can change in size but it doesn't change in shape because that is fixed all right we begin at full employment once again but we're going to assume that the OIC the labor markets represented is representative of each of the stages of production that make up the economy's capital structure he talks in terms of the labor market not stage specific labor markets and so to show the labor market we would do it like this that one labor market supply and demand for labor pertains to all the stages of production and which would actually be true if that stages if those stages of production were fixed okay so the market mechanism in play here is still those envisioned by Keynes so don't expect wonders to have don't don't see you're not going to see poetry and motion here and now we'll let the amount of savings increase to see if paradoxical it is and you see the effect on the right two diagrams we don't have savings represented specifically in the hiking triangle so it doesn't show up there but when the economy crashes watch what happens to the structure it crashes all down along the stages of production is that there's nothing there but a derived demand effect there's no interest rate effect in fact there's no change in the interest rate so even if the interest rate had an effect there would be no effect because the interest rate didn't change and so the economy once again is in the dumper and labor is unemployed now let me remind you that this is what Keynes called the general theory this is the general theory how general is it all right might be interested to know if you didn't know already that he actually cribbed that title from you-know-who Einstein Einstein's general theory of relativity Keynes was an admirer they said oh I've got the general theory of employment all right they were admired one another Einstein admired Keynes and when Einstein start talking about the macroeconomy sounded like Kings right so it's not all that general got okay so here it just says note that sole effect is the derived demand effect interest rates out of play left which if of saving took the downward pressure off of interest rates and in any case the capital structures assumed to be fixed okay all right now we're gonna do the bonafide morphing here I'm going to make three modifications in changing some assumptions and I want to see if any of you object to those modifications and then note what it does to the theory the first is divide the structure in the stages of production they don't all behave the same and of course that's easy to do divide it into stages of production there it is the second allow for stage specific labor markets not just one labor market that it pertains to everything in which wage rates is just to change market conditions in other words get rid of this throat-clearing assumption that the wage rates are sticky downwards and so can we do that you know okay now we're just about got the Austrian view only one thing is in our way get rid of the dang Keynesian demand constraint and what you can see here is if you look at that triangle at and you can see that it's flexible they can change in shape and it's changed in shape by movements of Labor from one stage to another then that's what allows the economy to move along the PPF alright so the economy no longer needs to move up and down along that demand constrain you can move along the PPF so we have to get rid of the demand constraint there gives you a build feel good is in there you're really the main constraint right and now forgive my hyperbole here the paradox of thrift becomes a gateway to growth okay with wage rates and interest rates both adjusting to changing market conditions the economy can move along the PPF and the structure of production can adjust to an increase in saving and so what's the increase in saving the adjustment and there you get the poetry in motion we've morphed from Keynes to Hayek this is one of Hayek's overall criticisms of Keynes that you can see how it applies mr. Cain's aggregates can feel the most Munda mental mechanisms of change if you allow for those mechanisms of change then you get entirely different results okay that's it

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Keywords: Keynes, Hayek, head, to, Ludwig, von, Mises, Institute, University, 2011, Austrian, Economics, Liberty, Property, Peace, economy, economic, canada, america

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Length: 44min 13sec (2653 seconds)

Published: Wed Aug 17 2011