Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 23 August 2012

Hayek versus Keynes and the Eurozone

The editors of the EUROPP blog, run by the Public Policy Group at the London School of Economics, wanted to contrast Hayekian and Keynesian views of the Eurozone crisis, by running posts from either side. Here is the Hayekian view, from Steven Horwitz, and for better or worse I provide the Keynesian view here. To be honest it is my view of the Eurozone crisis, which I think owes a lot to Keynesian ideas – it is absolutely not an attempt to guess what Keynes would have said if he could speak from the grave.

While regular readers of my blog will not find anything very new here, I personally found it useful to put my various posts into a brief but coherent whole. What struck me when I did so was the gulf between my own perspective (which is not particularly original, and borrows a great deal from the work of others like Paul De Grauwe), and that of most Eurozone policymakers. It is a gulf that goes right back to when the Euro was formed.

Much of the academic work before 2000 looking at the prospects for the Euro focused on asymmetric or country specific shocks, or asymmetric adjustment to common shocks due to structural differences between countries. My own small contribution, and those of many others, looked at the positive role that fiscal policy could play in mitigating this problem. Yet most European policymakers did not want to hear about this. Instead they were focused on the potential that a common currency had for encouraging fiscal profligacy, because market discipline would be reduced.

Now this was a legitimate concern – as some Greek politicians subsequently showed. However what I could not understand back then, and still cannot today, is how this concern can justify ignoring the problem of asymmetric shocks. I can still remember my surprise and incomprehension when first reading the terms of the Pact – what were Eurozone policymakers thinking? My incredulity has certainly been validated by events, as the Eurozone was hit by a huge asymmetric shock as capital flowed into periphery countries and excess demand there remained unchecked. Now countercyclical fiscal policy in those countries would not have eliminated the impact of that shock, at least not according to my own work, but it would have significantly reduced its impact.

When I make this point, many respond that fiscal policy in Ireland or Spain was probably contractionary during this time – am I really suggesting it should have been tighter still? Absolutely I am, and the fact that this question is so often asked partly reflects the complete absence of discussion of countercyclical fiscal policy by Eurozone policymakers. Brussels was too busy fretting about breaches of the SGP deficit limits, and largely ignoring the growing competitiveness divide between Germany and most of the rest. (Maybe this is a little unfair on the Commission. I have been told that when the Commission did raise concerns of this kind, they were dismissed by their political masters.)

If periphery countries had pursued aggressive countercyclical fiscal policies before 2007, would the Eurozone crisis have started and ended with Greece? Who knows, but it certainly would have been less of a crisis than the one we have now.

This is just one aspect of the policy failure that is the Eurozone crisis. Another is the fiction of expansionary austerity, and yet another is the obsession by the ECB with moral hazard (or even worse their balance sheet). As I say at the end of my EUROPP post, there is a pattern to all these mistakes. It reflects a world view that governments are always the problem, and private sector behaviour within competitive markets never requires any intervention. Whether you attribute that view to Hayek, or Ordoliberalism, or something else is an interesting academic question. But what the Eurozone crisis shows all too clearly is the damage that this world view can do when it becomes the cornerstone of macroeconomic policy.


  1. Tuchman's Guns of August was still on my desk from a re-read when I read your post.

    The story of the Euro is far different from the one you tell. Europe's history is simple and awful for it has never found a means or method for protecting small states, that want to be neutral, from big ones, but it will not take the only rational political step: free but total political union.

    Keynes doesn't have a damn thing to do with it. And, Keynes is not in any way responsible for any of mess, for he would have realized that "competitiveness divide between Germany and most of the rest" would lead to crisis after crisis.

    Second, capital did not flow into "periphery countries," for capital is investment and had it flowed, there would have been no "competitiveness divide." Spending flowed, raising the prices (I assume) of Greek Isles, etc.

    Thus, in the most narrow of senses, Keynes is right about the solution. What the periphery needs short term, at least, is the return of spending, which might set the condition for tackling the competitiveness divide.

    As for Hayek, he has never had and will never have anything to contribute to solving any problem. For starters, how does a Hayekian go about assuring the neutrality of small countries? When cooperation and co-ordiantion is needed among many governments, a world view that gov't is the problem cannot lead to solutions.

  2. I think there might be a small typo: Steven Horowitz from St Lawrence University.

    1. Whoops!Thanks for rescuing me from further embarrassment.

  3. This might be a rather common view among economists, but it's not exactly widespread across the public (at least on the Continent, although people should be more concerned with the euro there). Economists really have to hammer it until it reaches the press, and then the people, and then the policy makers. Misdiagnosing a disease is the surest way not to cure it.

    Note that Krugman goes even further. He says that not only is the euro not able to cope with asymmetric shocks, but that it creates such shocks.

    Finally, one thing strikes me in most posts I can read about the euro (including Krugman's, De Grauwe's, Wyplosz's or this one). They always refer to Europe or European leaders (here: "Brussels was too busy fretting about breaches of the SGP deficit limits"). But there's is no European government (I don't think the European Commission may pretend to that name). "Brussels" doesn't get it, because "Brussels" does not exist. Governments of member countries only think of their voters, and the forthcoming elections (note that if there was a European Government, Angela Merkel might decide to do what it takes to save the euro, lose the German election, and win at the upper European level).
    Before talking of financial transfers or fiscal integration, there is a need for a central government, and a central bank whose independence is not subordinated by the one of the Bundesbank.

  4. "Before the advent of Keynesianism, most recessions were very short lived as producers were left free to shuffle the jigsaw pieces into better combinations"

    No 1929 crisis or Great Depression ? Really ?

  5. Hayek versus Keynes

    ... is that really a dichotomy if one leave the details where they argued aside?

    One of the main basic points seem to me that Hayek states that mal-inverstment can never be turned into a working investment and if a State tries it will fail. Thus you should never bail out failed businesses. The EU just did that.

    Further regarding Keynes you can not end a recession by cutting spending, you need to keep the money flowing. The EU did the opposite.

    Instead to use a policy that combines both view like for example Island, the EU combined the "certain" policy failures regarding to both views.

    And with respect to Island framing economy as "Hayek versus Keynes" is imho misleading, there seems to be ground for synthesis.

    Anyway I'm just beginning to learn macro, so corrections are welcome.

  6. I'm going to stop writing unconstructive comments like this one ... tomorrow. But I can't resist.

    I think a lot of the utter failure of EuroZone policy making is not due to Hayek but to Bellman, Hamilton et al. Very smart people who developed useful tools -- think of them as better hammers. But almost all macroeconomists equiped only with those better hammers decided everything was a nail.

    The Eurozone crisis is not due to an asymmetric shock as asymmetric shocks are defined in the micro founded macro literature. No one has come up with an explanation of events in Ireland and Spain which isn't based on gross violations of the rational expectations assumption.

    Sensible macroeconomists who switch that assumption on and off at will had trouble explaining their concerns to policy makers, because the formal model had to be one of a country specific taste or technology shock. The possibility of asymmetric responses to shocks was either totally unexplained or based on governments messing up markets.*

    I'd say the problem was in small part due to the rejection of most of Keynes's thought by New Keynesians. Of course I'd also guess that academic economists weren't really influential at all -- that policy makers use us (OK to be honest no policy maker has bothered to use my though) to come up with arguments for policies which they choose for other reasons.

    But I also think that the logic of modern mainstream macroeconomics made it harder to warn of the dangers of say housing bubbles. I don't claim that economists would have warned specifcally of housing bubbles except for the fact that they feel that appeals to irrationality to be cheating, but I do think that playing with dynamic optimization helped blind economists to the risks of manias panics and crashes in general and helped renders those who saw tongue tied.

    Of course even if one accepts this reasoning one has to consider the advantages obtained by applying the mathematical tools of intertemporal optimization to macroeconomic models, such as ... uh ... ?

    * This makes the focus on eliminating employment protection in exchange for loans almost logical. Of course economic models suggest that a recession is not an ideal time to reduce firing costs since employment with nominal rigidity, a recession and firing costs is closer to flexibile wage/price and perfect competition employment -- the cyclical problem with firing costs is that they reduce net hiring in expansions. The policy demand is crazy but the craziness would not be clear to someone whose one's thinking were based on analyzing only models which deviate from Arrow-Debreu on only one way at a time (I'm quite sure this isn't the cause of the bad policy in this case).


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