Hayek contra Friedman

Hayek and Friedman’s Conflicting Diagnoses of the Great Depression

In the beginning was the Great Depression. 

It was from that mysterious episode that there emerged modern macroeconomic debates. Not only the familiar divide between ‘Keynes and the Classics’, but also the less well known but (I believe) ultimately more significant divide between ‘Historical Liberalism’ and ‘Neoliberalism’.

This last divide is manifested in Hayek’s and Friedman’s differing diagnoses of the Depression. Both Hayek and Friedman blamed central banking for the disaster. But for different reasons. And for different type of reason.

Put simply, Friedman had a Political Economy account of central banking’s responsibility for the Depression, whereas Hayek had a Pure Economics account of central banking’s responsibility for the Depression.

Hayek provides his account in Prices and Production of 1931, the book of a series of lectures he gave as a newly appointed professor at LSE. (The man who had him appointed him – Lionel Robbins - gave a popularised version of Hayek’s contentions in his The Great Depression of 1934.)

  

Prices and Production argued that an actively monetary policy amounted to a price distortion. Specifically, a loose monetary policy reduced the market price of investment below the opportunity cost of investment. Loose policy was, in effect, a subsidy on capital accumulation, and like all subsidies it could only do harm. Thus in the 1930s Hayek was criticising activist monetary policy on market success grounds. The free market would generate a socially efficient outcome, and active monetary policy distorted that outcome, and so wasted welfare.   

By contrast Friedman’s Monetary History of United States of 1963 criticises activist monetary policy on government failure grounds. To explain: Friedman’s case against central banking was not that central banking took something good (the free market outcome), and made it bad. That was not his position. To Friedman active monetary policy could often do good. Years later Hayek would spotlight Friedman’s optimism about the potential of monetary policy:

I don't like criticizing Milton Friedman … but …   if I told him … that I very much doubt whether monetary policy has ever done anything good, he would disagree. http://www.cato.org/pubs/policy_report/cpr-6n3-hayek.html

Friedman’s optimism about the potential of monetary policy arose from his judgement that there could be ‘market failure’ (in the form of bank runs, for example). The problem with active monetary policy was that the Central Bank did not with any reliability correct such market failures; rather it frequently mismanaged interventions that could be managed improvingly, and so making things worse. Thus Friedman’s criticism of active monetary policy was not pinned on the perfection of the market; but a defect in government.

Friedman’s position flags a key differentiation of Neoliberalism from ‘Historical Liberalism’ (that is, classical liberalism before the Great Depression): Neoliberalism shifted the burden of the case for limited government from market success to government failure.

The starting point of this shift was the Neoliberal acknowledgment that the free market outcome need not be the best of all feasible worlds. But this left neoliberal supporters of economic freedom with problem; why reject shifting that imperfect market outcome by some ‘economics of control’? To plead the incapacity of the state to implement a perfecting shift would be beside the point; the advocate of regulation hardly needs the state to be capable of a perfecting shift to make their case for regulation; an improving shift would be sufficient. And pleading the incapacity of the state to make even a small improving shift would be implausible. The inevitable bungling and ignorance of government will not convict the state of such complete incapacity. Bungling and ignorance does not (after all) imply that laws against theft are worse than useless: so why should it imply that laws against (say) monopoly pricing are worse than useless? In the face of some market failure, surely the government was capable of making things at least marginally better? As Friedman would be the first to insist, while the Fed could not have prevented a recession in 1929, it could have prevented a depression.

The riposte of neoliberalism to the regulatory advocate was not that government could not intervene improvingly, but that government would not intervene improvingly. It would choose (perhaps unwittingly) to not to intervene in a way that would be improving. This is the meaning of ‘government failure’.

Both Hayek’s and Friedman’s positions were, to be sure, underargued. There were gaps in ‘the pure economics’ of Hayek, while Friedman’s Political Economy was a collection of observations rather than a theory.

Hayek never articulated with the requisite rigor how looser a monetary policy would constitute a subsidy for investment. For it is not clear how in a competitive market a looser monetary policy can reduce ex ante real interest rates. It should only affect nominal interest rates (to the extent that the policy innovation is predicted), or ex post real rates (to extent that the policy innovation is unpredicted). But not ex ante real interest rates. In the same vein, it was also unclear how a looser policy would increase investment in the face of a wish of the public not to save any more. On this particular, Hayek’s references to ‘forced saving’ were more evocative than clarifying.

Friedman in a similar way can be criticised for having little offer in terms of a fundamental theory of government failure. With specific respect to the Great Depression, he argued that, in the absence of strong personalities, the Fed's committees drifted between policies, and never maintained a course. In post-War period Friedman’s criticism of policy drift became a criticism of policy ‘churning’; where ‘importance-maximising’ central bankers made waves in order to maintain their role as ‘players’. Both these are interesting suggestions, but far from a fully-fledged theory of government failure.

Nevertheless, one can still reasonably dichotomise criticisms of current monetary policy activism into market success critiques, and government failure critiques. Market success critiques would in the contemporary world turn, I suggest, on the thesis that monetary policy was underpricing risk; reducing the private price of risk beneath the social opportunity cost of risk. And government failure critiques ? I think they might find some material in the premium our time places on celebrity and self-dramatisation. In economic life we hail the risk-taking, rule breaking, routine-smashing ‘entrepreneur’ over the prosy Marshallian ‘saver’ and ‘firm’. And in policy I put to you we are all now Schumpertarian policy pirates; engrossed in innovative, ‘aggressive’ ‘blue-sky’ polices.

If you look at the history of financial crises, it shows that an aggressive and creative response is the best way to ensure minimal damage to the economy. 

 Ben Bernanke, Time, 27 December 2010