FEATURE

KEYNES, HAYEK AND

THE GREAT RECESSION
The writings of Keynes and Hayek are rich with lessons on the causes of the
current crisis and ways out of it, says Robert Carling. This essay is based on
an address to the University of Queensland alumni meeting in Canberra on
26 September 2012

E
conomic history has unfolded before The rise and fall and rise of Keynes
our eyes over the past five years as Keynes’ name long ago became synonymous
the worst financial crisis, the deepest with fiscal stimulus (‘pump-priming’) and
recession (now dubbed the Great deficits in times of recession. The world quickly
Recession), and the weakest recovery (the Feeble embraced Keynesian pump-priming solutions
Recovery?) combined to deliver the biggest global when economies went into free fall in late
economic shock since the 1930s. The shock 2008, and even today there are voices in favour
was unevenly distributed, but its epicentre of more of the same, or at least a tolerance for
in the major advanced economies ensured large fiscal deficits as long as economic activity
the whole world suffered the fallout. Future remains subdued. However, we need only take
generations will look back upon this era with a little detour through the history of economic
fear and loathing just as we look back upon the thought to appreciate that the wisdom of this
Great Depression. rush to embrace Keynesian solutions is open
Similar to the turmoil of the 1930s to challenge.
revolutionising economic thinking then, the The early 1970s were the heyday of
shocks of the last few years have breathed new post-World War II Keynesianism, in Australia
life into old controversies about how economies as much as elsewhere. The Australian government
work, why crises happen, and how to recover and its key economic advisory body, the
from them. These controversies were never Treasury, accepted the Keynesian consensus
resolved, but went into hibernation during the in that they believed in the management of
Great Moderation—the era of almost continual aggregate demand through fiscal policy to
economic expansion, low inflation, falling dampen the business
interest rates, and booming stock markets from cycle. It is true that the
the early 1990s to 2007. Now, the arguments Treasury was also a strong
between Keynesians, Austrians and neo-classicists advocate of what are
have returned with as much vigour as ever before. today called supply-side
John Maynard Keynes and Friedrich von policies to strengthen the
Hayek were key protagonists in the economic economy’s productive
debates of the 1930s. Their theories, policy capacity. Moreover, the
prescriptions and teachings cover much of the Keynesianism that it
ground occupied by opposing camps in
the contemporary debate. For this reason, the
writings of Keynes and Hayek are rich with Robert Carling is a Senior Fellow at
lessons on the causes of the current crisis and The Centre for Independent Studies.
ways out of it.

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KEYNES, HAYEK AND THE GREAT RECESSION

believed in was of the symmetrical kind, circumstances of the 1930s.) He did not believe
which sought to tighten fiscal policy in an that an easy monetary policy would be effective
inflationary upswing as well as loosen it in in sparking a recovery in those circumstances,
a downturn, not the one-sided expansionary and therefore, advocated two key changes in
Keynesianism more popular with politicians. fiscal policy: first, that the government should
Despite these qualifications, it is correct to say not struggle to balance its budget in the face
that the Treasury at the time advised the of falling revenue; and second, that it should
government within a Keynesian framework. borrow to fund a large-scale public works
Not long into the 1970s, however, program. The first is not at all controversial
Keynesianism began a retreat that continued today. Only the terminology has changed to
up to the 1980s, initially because it had no something like ‘let the automatic fiscal stabilisers
answer to the stagflation of that era. This work.’ But it was quite a radical thought in
revision of Keynesian thinking strongly the 1930s. It is the second prescription that
influenced the Commonwealth Treasury, which remains controversial.
had a major falling-out with the Whitlam After the war, the reinterpretation of Keynes
government in 1974 over the latter’s refusal to continued in earnest and led to notions such
countenance fiscal tightening in the midst of as using fiscal policy to fine-tune the economy
rampant inflation and an economic downturn. and influence the level of consumer spending.
The Treasury eventually won that argument. But Keynes never advocated fine tuning. His
Keynesian fiscal policy, if not exactly dead context was that of a deep slump, not an
and buried, went into cold storage just like in ordinary business cycle, and his version of
other countries. But then it made a spectacular pump-priming was a blunt instrument, not
comeback with the onset of the global financial a scalpel. He is also reported to have rejected
crisis in 2008, and was embraced once again by the idea of using fiscal policy to boost consumer
the Commonwealth Treasury as well as economic spending through temporary cash payments
managers all around the world. or tax cuts for households. His response to that
idea was similar to Milton Friedman’s later
Keynes and the Keynesians permanent income hypothesis.2 Keynes’ name
Strange though it may seem, there is an essential has become associated with big government
distinction between Keynes and the Keynesians. and deficit financing as a normal state of
Many of the things that have been said and affairs, but he never advocated them. In fact,
done in the name of Keynes since World War he is on record saying there was no need for
II are nowhere to be found in his writings the size of government to exceed 25% of the
and statements. They are actually interpretations economy—a figure that has been far exceeded
and embellishments of what he wrote and in all developed countries.
said. This process started even before Keynes When the counter-Keynesian revolution
died. He is reported to have said after some came in the 1970s, it jettisoned what the
discussions with Keynesian economists in the Keynesians had advocated, and to a lesser extent,
United States that he was the only non- undermined the crux of Keynes’ own theory.
Keynesian in the room. We can only imagine Fine tuning was discredited. The failure of fiscal
what he would have made of some of stimulus in conditions of stagflation came to
the policy views attributed to him since his be widely accepted. The ‘rational expectations’
death in 1946. school undermined Keynes’ theoretical
We cannot know how his thinking would foundations.3 The fiscal multiplier was thought
have evolved in the modern world, but the to be much smaller than previously believed.
essence of his General Theory1 in the 1930s was Activist fiscal policy was thought more likely to
that fiscal pump-priming should be used in be destabilising than stabilising. These revisionist
the context of a deep and lingering slump and thoughts culminated in the view that fiscal
deflation. (In that sense, the General Theory policy should focus on medium- and long-term
was actually a theory tailored to the specific goals, such as strengthening the supply side of

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 KEYNES, HAYEK AND THE GREAT RECESSION

the economy, while short-term management did not follow the Keynesian formula. There
should be left to monetary policy. The budget were few ‘shovel-ready’ public works projects,
would fluctuate symmetrically between deficit and much of the stimulus was aimed at consumer
and surplus, but mainly on account of automatic spending. In addition, they were too eager to
responses of revenue and expenditure to the ignore the lessons of the counter-Keynesian
business cycle, not activist stabilisation policies. revolution of the 1970s and 1980s. Had they
The extent to which that message was heeded those lessons, they would have known
internalised in policy circles has been overstated. that stimulus was subject to various endogenous
Keynes and Keynesians came to be viewed offsets such as leakage into imports. Because of
with much reservation, but were not totally these offsets, stimulus can end up being quite
rejected. In Australia, for example, we still had weak per dollar of stimulus applied, especially
some discretionary fiscal stimulus in the early in an open economy. The fiscal multiplier
1990s recession. By and large, the political is thus small and tends to shrink to zero the
temptation to tinker with fiscal policy for more time passes after the stimulus is applied.4
short-term economic management went At best, fiscal stimulus in 2008–09 acted as
untested for an unusually long time during the a circuit-breaker to soften the downward
Great Moderation, until the global financial economic spiral. It did not kick-start a sustained,
crisis and the Great Recession, when the robust recovery, nor should it have been
Keynesians came in from the cold. expected to. And in many countries, it ratcheted
Most countries applied large doses of fiscal up already uncomfortably high or unsustainable
stimulus in 2008 and 2009, with Australia’s levels of public debt, thereby adding to the risk
being among the largest even though the of future instability.
recessionary forces here were not as strong as
elsewhere. Three years on, the discretionary
stimulus has been withdrawn here and elsewhere,
At best, fiscal stimulus in 2008–09
even though large fiscal deficits remain in most acted as a circuit-breaker to soften the
countries. However, the cessation of discretionary downward economic spiral. It did not
stimulus is not universally accepted. There are kick-start a sustained, robust recovery,
many prominent and vocal advocates of further nor should it have been expected to.
rounds of stimulus—not in Australia but in
the countries experiencing feeble recoveries or
renewed recessions. At the same time, most of Australia was at least starting from a position
these countries are also under pressure to curb of fiscal strength, with no net public debt at
their deficits and debts—hence, the debate over the Commonwealth level. The Commonwealth
‘austerity versus growth.’ budget would have gone substantially into deficit
even if there had been no discretionary fiscal
Does fiscal stimulus work? stimulus, simply through the loss of revenue
Was the world right to go back to Keynes? from lower taxable profits and other incomes and
The economic conditions of 2008–09 were higher expenses on items such as unemployment
more like the 1930s than at any other time since benefits—the operation of the automatic
then, and governments could have been excused stabilisers. But was the additional widening of
for thinking that if ever there was a time for the deficit through a large discretionary stimulus
Keynesian pump-priming, that was it. Even so, necessary, and was it the key factor in avoiding
there is a strong case that policymakers expected an economic slump? The conventional wisdom
too much from fiscal stimulus in 2008–09. believes so, but it attributes too much of our
So rushed were they to do something as their good fortune to fiscal stimulus and not enough
economies collapsed around them that the to other advantages such as the strength of our
measures taken were of poor quality. (Indeed, banking system, the swift loosening of monetary
that is an inherent problem with an emergency policy, the large depreciation of the Australian
stimulus.) Certainly, the type of stimulus applied dollar, and the policy measures taken to ensure

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KEYNES, HAYEK AND THE GREAT RECESSION

the banking system was not starved of funds. actually put forward. His detractors even blame
The expansionary effect of fiscal stimulus in him for helping cause the global financial crisis
2008–09 softened the brief downturn that by promoting a culture of greed and laissez
Australia experienced, but the fact that Australia faire. This is nonsense. It is possible, however,
did not have a deep slump had more to do to piece together a Hayekian explanation of
with the other strengths listed above than with the Great Recession. In fact, Hayek is much
the fiscal stimulus. Meanwhile, the enduring better at explaining how the Great Recession
legacy of the stimulus is an addition of tens of came about than explaining how to make a fast
billions of dollars to the public debt. exit from it.
Another question is whether the countries Hayek and the Austrian school of
still experiencing weak recoveries or a relapse economists, to which he belonged, believed
of recession would be correct to apply more that the supply side of the economy was the
stimulus or delay deficit-cutting measures until key, not as Keynes thought the demand side.
their economies are stronger. Here the answer Focusing on how economies got into crises in
almost certainly is ‘no.’ In addition to all the the first place, they pointed the finger at easy
general reasons cited above to question the money policies, excessive credit growth, and
effectiveness of stimulus, these countries’ public what are today called ‘bubbles’ or ‘mal-
debt burdens are now such a prominent part investments.’ These were supply-side distortions
of their problems that it is difficult to see how that would eventually lead to a crisis and
adding to those burdens (which is what fiscal a slump of the worst kind, namely, one
stimulus would do) can be part of the solution. grounded in crippled balance sheets—be they
For example, public debt in the United States of financial institutions, households, businesses
has already risen to 80% to 100% of GDP or governments. The 2008–09 slump and
(depending on how it is measured), and the the feeble recovery since are balance sheet
long-term projections of its growth under phenomena that can be traced back to a long
current policies are quite horrendous. There series of episodes of easy money policy and
is great uncertainty about how and when rapid credit expansions in the major countries.
fiscal sustainability will be restored. Businesses Clearly, the behaviour of banks exacerbated
are hoarding mountains of cash rather than the crisis and regulation was deficient, but this
investing. Any additional fiscal stimulus now does not invalidate Hayek’s explanation. Hayek
would be neutralised by an adverse response would never have said the banks should have
from the private sector, which would attempt to gone unregulated. He would have said, ‘Get
save more in the face of even greater uncertainty. the regulation right and apply it in a consistent
The deficit does not need to be eliminated and predictable way.’ This was not done in the
overnight to resolve this uncertainty, but United States before or during the crisis. The
a credible plan to put the public finances on regulators responded erratically and arguably
a sustainable footing over the next several made the crisis worse.
years, backed up by concrete actions and
commitments, would do wonders for confidence Hayek’s answer
and investment. Hayek could not offer a quick escape route
from the current malaise. He certainly would
Hayek’s world view not have agreed with Keynesian pump-priming.
Hayek never published a critique of Keynes’ Hayek is associated more than anything else
General Theory, but it is clear from his writings with the principle of economic freedom, and he
that he had a very different view of the world. always argued that the best thing governments
This view has been subject to a great deal of could do to promote freedom and prosperity
misunderstanding because Hayek’s name, like was to provide a stable, predictable framework
Keynes, has been taken and attached to all of policy and regulation under the rule of law,
manner of proposals and ideas that he never with limited government, low and stable tax

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 KEYNES, HAYEK AND THE GREAT RECESSION

rates, and sustainable public finances. mal-investments. It also threatens to undermine

Discretionary fiscal stimulus is the antithesis of the hard-won independence and credibility of
predictability and stability. It is a manifestation central banks. Central bankers understand this
of the arbitrary government intervention that but are haunted by the ghosts of the 1930s,
Hayek loathed. Whatever positive effect it might when the conduct of monetary policy made the
have on aggregate demand would be offset by Great Depression worse. They are determined
the harm it does to aggregate supply. This to ensure that monetary policy is doing
does not mean that Hayek-land is free of the everything possible this time to support
business cycle. Hayek accepted the inevitability economic activity, while buying time for
of the business cycle in a free-market system governments to implement structural policies
but saw it as a small price to pay for the benefits that can provide the foundations for a sustained
of the free market. He argued against policies recovery. Whether governments rise to the
that he believed would make the cycle worse. challenge remains to be seen. If they don’t, then
Hayek would be in favour of fiscal ultra-easy monetary policy cannot be a substitute
consolidation (so-called austerity) in the and will ultimately end in tears.
current environment, combined with tax and
expenditure reform and other structural policies Conclusion
to strengthen the long-run growth potential of These arguments will go on. The Great Recession
the economy. Even the Hayekian true believers brought a revival of Keynes, and to a lesser
would not offer that as the fast road out of extent the Keynesians, but already there is
trouble, but there probably isn’t a fast road. renewed understanding of the limitations of
fiscal stimulus and the urgency of fiscal
Ultra-easy monetary policy consolidation. With the passage of time and
Economic managers in the major countries dispassionate analysis, the balance may once
are now resting their hopes on unprecedented again shift from Keynes towards Hayek. Hayek
monetary policy interventions in the form of lost the argument with Keynes in the 1930s.
policy interest rates held at or near zero But he may yet have the last laugh.
for extended periods, and massive doses of
quantitative easing (or ‘printing money’)
administered by the monetary authorities of
the United States, Japan, the Eurozone and Endnotes
Britain. This ultra-easy monetary policy, as 1 The General Theory of Employment, Interest and Money
one writer has named it, constitutes one of the (London: Palgrave Macmillan, 1936).
boldest economic policy experiments ever 2 Friedman hypothesised that households’ spending
undertaken.5 Keynes would have said this will decisions were based mainly on their expected
sustainable income rather than short-term
be ineffective, like pushing on a string. Hayek
fluctuations.
would have said it may be effective in stimulating 3 Thomas Sargent and Neil Wallace, ‘Rational
something the longer it continues, but that it Expectations and the Theory of Economic Policy,’
will stimulate the bad with the good, create new Journal of Monetary Economics 2:2 (1976), provides
misallocations of resources, new bubbles, and an example of the rational expectations challenge
therefore, store up big problems for the future. to Keynes.
To Hayek and the Austrians, it is just more 4 The International Monetary Fund recently
of the easy money policies that ultimately reignited this debate by arguing that the fiscal
led to the current mess. Ultra-easy money is multiplier can be quite large, but the IMF has
providing short-term support to economic in turn been criticised for the quality of its data.
5 William White, ‘Ultra Easy Monetary Policy and
activity and helping keep deflation at bay,
the Law of Unintended Consequences’ (Federal
but it cannot produce a robust, balanced, Reserve Bank of Dallas, 2012).
sustainable recovery. It runs the risk of stoking
inflation and producing more bubbles and

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