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April 2010

Keynes or Hayek?

Strap yourself in - it's the 1970s all over again

Auckland city's economic scoreboard

In 1975, Margaret Thatcher famously walked into the Conservative Research Centre, reached into her briefcase and took out a book. It was Friedrich von Hayek's The Constitution of Liberty. She held the book up for all to see. "This", she said sternly, "is what we believe", and banged Hayek down on the table.

For the next 35 years, Hayek's philosophy of free markets governed the streets of the developed world. Government intervention and many other Keynesian ideas were disregarded - trade barriers fell, state owned companies were sold and the control of inflation was thrust onto centre stage.

Then, in late 2008, Lehman Brothers collapsed, sending shivers down the spine of the financial world. A recession gripped the major centres as company after company went into liquidation. Unemployment soared, beneficiary numbers marched upwards, exchange rates became highly volatile, and the price of gold sky rocketed as investors looked for safety. Politicians meanwhile, began marking out an escape route characterised by mass bailout packages.

In response to these events, The Guardian newspaper in the UK published an article titled ‘The epic battle has begun', describing the sway back to Keynesian economics from the Hayek approach of the past three decades. "The gloves are off" The Guardian wrote, "and an epic ideological battle has begun." Keynes and Hayek were again in the ring together.

After October 2008, the Hayek-inspired leaders of the financial system were caught in the headlights, grasping for an explanation to the crisis. This was no easy task. To the disbelief of many of his followers, the Chairman of the Federal Reserve, Alan Greenspan famously acknowledged, in reference to his free-market ideology; "I have found a flaw. I don't know how significant or permanent it is."

Representative Henry Waxman pressed for clarification of this remarkable statement, "In other words Mr. Greenspan, you found that your view of the world, your ideology, was not right, it was not working."

"Absolutely, precisely," Greenspan replied. "You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well."

Since the events of October 2008, the world has changed somewhat. Governments around the world have set forth on a 'Keynesian adventure', flooding financial markets with bailout funding. Friedrich von Hayek would not be pleased. According to Hayek, sound investment is governed by the perception of risk, and if investors are to be bailed out each time they make errors in the judgment of risks, what is to become of their behavior in the future?

Hayek may have been less critical of the New Zealand response however, which differs substantially from other countries. Our bailout package has been less expansive, with the main thrust coming from the retail guarantee scheme, which was designed to restore confidence in the overall finance sector. New Zealand resisted the temptation to bail out individual finance companies as was done at length in the United States. Further, New Zealand has been significantly more careful with deficit spending, looking to contain the growth of net public debt over the coming years. However, being such a small open economy, New Zealand is always at the mercy of the international financial system, a system that has been engulfed with public funding to keep it alive.

Published April 2010