Keynes vs. Hayek
Updated February 16, 2013
The Babysitting Co-op
The best way to understand modern macroeconomics is through Paul Krugman’s parable of the babysitting co-op. The parable—based on the true story of the Capitol Hill Babysitting Co-op—involves a group of couples who agree to babysit for each other. In order to equally distribute the labor, each couple was given 14 coupons, each good for one hour of babysitting.
The problem, as Krugman tells the story, occurred when winter rolled around. Couples wanted to stay indoors in winter and save up their coupons for the summer months. Despite couples being willing and able to babysit, there was simply no demand for babysitting. Nobody went out, and nobody babysat. “In short,” Krugman writes, “the co-op had fallen into a recession.”
“Classical” economics presents an easy solution to the recession: high supply and low demand means that the price of babysitting should fall. Instead of getting one coupon for an hour of babysitting, babysitters should be willing to accept half of a coupon. Wages should fall until supply meets demand. When summer comes, higher demand will push the price back up; the system self-regulates.
For a variety of reasons, however, classical economics doesn’t actually work as an empirical matter. As John Maynard Keynes recognized, wages are “sticky”; they don’t fall like they should. This could be because companies are hesitant to reduce their employees’ salaries, unions prevent wages from being renegotiated downwards, or companies are afraid that lowering wages will cause their best employees to be poached by other firms. Employees will fight hard against wage decreases because most people live their lives locked into nominal-dollar contracts. My landlord won’t care that my wages have fallen when he comes looking for rent, the bank that gave me an auto loan won’t care that my income is lower—ditto for my cable company and my cell phone provider. If a company has ten employees, each employee would much rather the company lay off one person at random than give everyone a 10% pay cut. So, sticky wages prevent supply and demand from fixing the unemployment problem; this may even be for the best, to avoid the necessity of wholesale renegotiation of contracts every time the economy slows down.
Keynesians have an easy alternative solution: print more coupons. If people want to hoard coupons, the “central bank” should just give them more coupons, so they’ll be more willing to part with a few of them. An injection of new coupons into the system will get everybody willing to spend a few more nights babysitting during the winter months. And, when summer rolls around, if there is too much demand (i.e., so many coupons that everybody wants to go out on the same night, leaving nobody left to babysit), then the central bank will just shred a few of everyone’s coupons.
The Austrian economist is shocked at the Keynesian solution. The market didn’t want more babysitters. Why on earth should a central authority cause people to babysit when the market clearly doesn’t want it? After all, this is all well and good when we’re talking about babysitting, but what if we’re talking about houses? Say (hypothetically speaking) there was a surplus of houses on the market, causing an economic slowdown. Isn’t lowering interest rates (or printing money, which is the same thing) just going to further inflate and already inflated housing bubble? Aren't we just pushing off the Day of Reckoning, when the bubble bursts, thereby making the inevitable burst that much worse?
The Keynesian doesn’t see the problem. What’s the problem with the central bank keeping the babysitting economy “artificially” afloat? With adequate financial stewardship, why does the bubble necessarily need to burst? True, in the long run, the market may always trend towards equilibrium, but, as Keynes famously remarked, “in the long run, we are all dead.” What good is it to know that summer is coming if you can’t feed your family during the winter?
What is a Recession?
Austrian economists, however, think that the Keynesian picture misinterprets what's going on with the babysitting co-op. Keynes sees recessions as shortfalls of aggregate demand for goods and services. If so, this means that there is a surplus of the supply of goods and services. But this doesn’t make sense. Society isn’t poorer. There are the same number of people willing and able to work the same number of hours. If people want to stay inside during the winter, then the market will reward entrepreneurs who provide indoor services. The ex-babysitters should be willing to accept a coupon for an hour of, say, cooking a meal for another family. The market will lead people into higher-demand industries, people will get paid for their labor, and supply and demand will meet. Demand failures are structural, not aggregate. Left to its own devices, the market will never let aggregate supply and demand stray far from each other.
Unfortunately, this picture is wrong both theoretically and empirically. Empirically, if unemployment is structural, people with high-demand skills should prosper during a recession, and we don’t see this. Since 2008, every industry has suffered, and it's not clear what sort of "restructuring" could occur to fix things. And as a matter of theory, it seems that Austrians are looking at the world backwards. Austrians look at the recession and conclude that people are hoarding money because they don’t want babysitters. However, the truth is actually the converse: people don’t want babysitters because they want to hoard money! People today are so nervous about the future that, in a cashless society (where people couldn't stuff money into their mattresses), people would accept negative interest on their bank accounts rather than buy things. This sort of behavior simply isn't accounted for in the Austrian view of the world.
A recession, in the Keynesian view, is a classic coordination game; everybody would be better off if everyone started moving at the same time, but resources lie idle because everybody’s waiting for somebody to tell them when to start. And that somebody is the government.
The Austrian still doesn’t accept the Keynesian picture. The huge mismatch of supply and demand we’re seeing now was created by years and years of government meddling with the economy. If we have what looks like a long-term failure of aggregate demand, it is only because the government has so perverted the structure of the economy that the market will take a long time to re-equilibrate. If there is a disequilibrium in the market, the market will fix it better than the government can. The government does not—indeed, cannot—know what the best solution is, and trying to fix the problem is likely only to make it worse.
This is the key to understanding the Austrian view of the world. There is a natural business cycle, but the cycle is exacerbated by government intervention. By trying to dig us out of recessions, the government creates bubbles in sectors that wouldn't otherwise occur, sowing the seeds of the next recession. When it tries to contain economic booms, the government straps bricks to our feet for when the inevitable rebalancing occurs. The inability of a central planner to know what the market wants makes any attempt to manage the economy counterproductive.
Gold!
So, the Austrian approach requires the government to be completely hands-off. The government should not create artificially loose credit (i.e. print money) in order to spur the economy, nor should it create artificially tight credit (i.e. destroy money) in or to slow down the economy. Indeed, in the ideal Austrian world, the government should be constrained to a fixed amount of currency that it may put in circulation.
Which brings us to gold.
The gold standard, as I understand it, is a means to an end. The point is not that money necessarily must be tied to something tangible, but that when a government can print notes that represent money, it must be tied to the mast so as to be able to resist the temptation to manipulate the economy through the supply of notes.
A complaint one often hears from Austrians is that the US is “debasing” the dollar with programs such as quantitative easing. However, it’s not really clear what that means. There has not been any substantial inflation since 2008, and, if anything, the dollar is stronger against other currencies than it was in 2008. So, what’s the problem with quantitative easing?
As far as I can tell, the answer is that the Day of Reckoning is always right around the corner. All it’s going to take is one more financial crisis—one more crisis induced, Austrians would say, by artificially easy credit—before the entire “fiat money” system collapses and people flee to “sound money” such as gold. Thus, every time the government creates money, it is further impoverishing the citizens whose bank accounts will buy less and less gold when the Day of Reckoning comes.
Wall Street Hoarders
But monetary policy is only one of the levers that government can use to manipulate the economy. What about fiscal policy? When the economy is slow and monetary policy can’t pick up the slack, the modern view is that government should borrow money and spend it in ways that stimulate the economy.
Opposition to fiscal stimulus is where I get genuinely confused. If you read blog posts by Cato, or by the economists that Paul Krugman attacks, you frequently see the same argument: expansionary fiscal policy doesn’t make sense, because every dollar that the government borrows from financial institutions is a dollar that could have been invested—more efficiency—in the private market.
The problem is, in a liquidity trap such as the Great Recession, this is patently false.
Backing up for a minute—prior to the 2008 economic crisis, the US money supply (M2—roughly the amount of money people had in their bank accounts) was about $8 trillion. Banks kept only the minimal legal reserve on their balance sheets, which gave us a monetary base of about $800 billion (a 10:1 M2/MB ratio). In the years since financial insanity struck, the Fed's quantitative easy has more-than-tripled the monetary base, to $2.7 trillion. In the same time, M2 has increased to about $10.4 trillion, giving us a roughly 4:1 M2/MB ratio. Why has the ratio decreased so much? Because banks have $1.5 trillion in excess reserves at the Federal Reserve. Banks have simply hoarded most of the extra money created by the Fed, without lending it out. This makes very little sense; that $1.5 trillion is sitting in accounts at Federal Reserve banks, which earn only 0.25% interest—a rate that could probably be beat out on the market. This hoarding is irrational and fear-drive, and is one of the big unexplained stories of the financial crisis. And it goes a long way to explaining why U.S. monetary policy since 2008 has not been as effective as the Fed hoped.
The Babysitting Co-op
The best way to understand modern macroeconomics is through Paul Krugman’s parable of the babysitting co-op. The parable—based on the true story of the Capitol Hill Babysitting Co-op—involves a group of couples who agree to babysit for each other. In order to equally distribute the labor, each couple was given 14 coupons, each good for one hour of babysitting.
The problem, as Krugman tells the story, occurred when winter rolled around. Couples wanted to stay indoors in winter and save up their coupons for the summer months. Despite couples being willing and able to babysit, there was simply no demand for babysitting. Nobody went out, and nobody babysat. “In short,” Krugman writes, “the co-op had fallen into a recession.”
“Classical” economics presents an easy solution to the recession: high supply and low demand means that the price of babysitting should fall. Instead of getting one coupon for an hour of babysitting, babysitters should be willing to accept half of a coupon. Wages should fall until supply meets demand. When summer comes, higher demand will push the price back up; the system self-regulates.
For a variety of reasons, however, classical economics doesn’t actually work as an empirical matter. As John Maynard Keynes recognized, wages are “sticky”; they don’t fall like they should. This could be because companies are hesitant to reduce their employees’ salaries, unions prevent wages from being renegotiated downwards, or companies are afraid that lowering wages will cause their best employees to be poached by other firms. Employees will fight hard against wage decreases because most people live their lives locked into nominal-dollar contracts. My landlord won’t care that my wages have fallen when he comes looking for rent, the bank that gave me an auto loan won’t care that my income is lower—ditto for my cable company and my cell phone provider. If a company has ten employees, each employee would much rather the company lay off one person at random than give everyone a 10% pay cut. So, sticky wages prevent supply and demand from fixing the unemployment problem; this may even be for the best, to avoid the necessity of wholesale renegotiation of contracts every time the economy slows down.
Keynesians have an easy alternative solution: print more coupons. If people want to hoard coupons, the “central bank” should just give them more coupons, so they’ll be more willing to part with a few of them. An injection of new coupons into the system will get everybody willing to spend a few more nights babysitting during the winter months. And, when summer rolls around, if there is too much demand (i.e., so many coupons that everybody wants to go out on the same night, leaving nobody left to babysit), then the central bank will just shred a few of everyone’s coupons.
The Austrian economist is shocked at the Keynesian solution. The market didn’t want more babysitters. Why on earth should a central authority cause people to babysit when the market clearly doesn’t want it? After all, this is all well and good when we’re talking about babysitting, but what if we’re talking about houses? Say (hypothetically speaking) there was a surplus of houses on the market, causing an economic slowdown. Isn’t lowering interest rates (or printing money, which is the same thing) just going to further inflate and already inflated housing bubble? Aren't we just pushing off the Day of Reckoning, when the bubble bursts, thereby making the inevitable burst that much worse?
The Keynesian doesn’t see the problem. What’s the problem with the central bank keeping the babysitting economy “artificially” afloat? With adequate financial stewardship, why does the bubble necessarily need to burst? True, in the long run, the market may always trend towards equilibrium, but, as Keynes famously remarked, “in the long run, we are all dead.” What good is it to know that summer is coming if you can’t feed your family during the winter?
What is a Recession?
Austrian economists, however, think that the Keynesian picture misinterprets what's going on with the babysitting co-op. Keynes sees recessions as shortfalls of aggregate demand for goods and services. If so, this means that there is a surplus of the supply of goods and services. But this doesn’t make sense. Society isn’t poorer. There are the same number of people willing and able to work the same number of hours. If people want to stay inside during the winter, then the market will reward entrepreneurs who provide indoor services. The ex-babysitters should be willing to accept a coupon for an hour of, say, cooking a meal for another family. The market will lead people into higher-demand industries, people will get paid for their labor, and supply and demand will meet. Demand failures are structural, not aggregate. Left to its own devices, the market will never let aggregate supply and demand stray far from each other.
Unfortunately, this picture is wrong both theoretically and empirically. Empirically, if unemployment is structural, people with high-demand skills should prosper during a recession, and we don’t see this. Since 2008, every industry has suffered, and it's not clear what sort of "restructuring" could occur to fix things. And as a matter of theory, it seems that Austrians are looking at the world backwards. Austrians look at the recession and conclude that people are hoarding money because they don’t want babysitters. However, the truth is actually the converse: people don’t want babysitters because they want to hoard money! People today are so nervous about the future that, in a cashless society (where people couldn't stuff money into their mattresses), people would accept negative interest on their bank accounts rather than buy things. This sort of behavior simply isn't accounted for in the Austrian view of the world.
A recession, in the Keynesian view, is a classic coordination game; everybody would be better off if everyone started moving at the same time, but resources lie idle because everybody’s waiting for somebody to tell them when to start. And that somebody is the government.
The Austrian still doesn’t accept the Keynesian picture. The huge mismatch of supply and demand we’re seeing now was created by years and years of government meddling with the economy. If we have what looks like a long-term failure of aggregate demand, it is only because the government has so perverted the structure of the economy that the market will take a long time to re-equilibrate. If there is a disequilibrium in the market, the market will fix it better than the government can. The government does not—indeed, cannot—know what the best solution is, and trying to fix the problem is likely only to make it worse.
This is the key to understanding the Austrian view of the world. There is a natural business cycle, but the cycle is exacerbated by government intervention. By trying to dig us out of recessions, the government creates bubbles in sectors that wouldn't otherwise occur, sowing the seeds of the next recession. When it tries to contain economic booms, the government straps bricks to our feet for when the inevitable rebalancing occurs. The inability of a central planner to know what the market wants makes any attempt to manage the economy counterproductive.
Gold!
So, the Austrian approach requires the government to be completely hands-off. The government should not create artificially loose credit (i.e. print money) in order to spur the economy, nor should it create artificially tight credit (i.e. destroy money) in or to slow down the economy. Indeed, in the ideal Austrian world, the government should be constrained to a fixed amount of currency that it may put in circulation.
Which brings us to gold.
The gold standard, as I understand it, is a means to an end. The point is not that money necessarily must be tied to something tangible, but that when a government can print notes that represent money, it must be tied to the mast so as to be able to resist the temptation to manipulate the economy through the supply of notes.
A complaint one often hears from Austrians is that the US is “debasing” the dollar with programs such as quantitative easing. However, it’s not really clear what that means. There has not been any substantial inflation since 2008, and, if anything, the dollar is stronger against other currencies than it was in 2008. So, what’s the problem with quantitative easing?
As far as I can tell, the answer is that the Day of Reckoning is always right around the corner. All it’s going to take is one more financial crisis—one more crisis induced, Austrians would say, by artificially easy credit—before the entire “fiat money” system collapses and people flee to “sound money” such as gold. Thus, every time the government creates money, it is further impoverishing the citizens whose bank accounts will buy less and less gold when the Day of Reckoning comes.
Wall Street Hoarders
But monetary policy is only one of the levers that government can use to manipulate the economy. What about fiscal policy? When the economy is slow and monetary policy can’t pick up the slack, the modern view is that government should borrow money and spend it in ways that stimulate the economy.
Opposition to fiscal stimulus is where I get genuinely confused. If you read blog posts by Cato, or by the economists that Paul Krugman attacks, you frequently see the same argument: expansionary fiscal policy doesn’t make sense, because every dollar that the government borrows from financial institutions is a dollar that could have been invested—more efficiency—in the private market.
The problem is, in a liquidity trap such as the Great Recession, this is patently false.
Backing up for a minute—prior to the 2008 economic crisis, the US money supply (M2—roughly the amount of money people had in their bank accounts) was about $8 trillion. Banks kept only the minimal legal reserve on their balance sheets, which gave us a monetary base of about $800 billion (a 10:1 M2/MB ratio). In the years since financial insanity struck, the Fed's quantitative easy has more-than-tripled the monetary base, to $2.7 trillion. In the same time, M2 has increased to about $10.4 trillion, giving us a roughly 4:1 M2/MB ratio. Why has the ratio decreased so much? Because banks have $1.5 trillion in excess reserves at the Federal Reserve. Banks have simply hoarded most of the extra money created by the Fed, without lending it out. This makes very little sense; that $1.5 trillion is sitting in accounts at Federal Reserve banks, which earn only 0.25% interest—a rate that could probably be beat out on the market. This hoarding is irrational and fear-drive, and is one of the big unexplained stories of the financial crisis. And it goes a long way to explaining why U.S. monetary policy since 2008 has not been as effective as the Fed hoped.
So, with $1.5 trillion in excess reserves, U.S. financial institutions could plug the entire projected 2013 deficit by buying $900 billion of Treasury Bonds—which earn up to 3.17% interest—and still have $600 billion left to lend to private institutions. Government borrowing is not "crowding out" any private investment. If banks are not investing in private enterprises, it is only because they do not want to.
It’s All About the Benjamins
So, leaving aside the incorrect "crowding out" argument, why don't Austrians like fiscal stimulus? There are several reasons. First, Austrians are naturally allied with Libertarians with respect to the size of government, and less deficit spending means a smaller government. Second, the Austrian argument against stimulus is his constant refrain against malinvestment. To the extent that poor central planning exacerbates the ups and downs of the business cycle, deficit spending is bad for economic health.
Finally, Austrians hate deficit spending because, at its core, fiscal stimulus is the same thing as monetary stimulus. If I deposit $1,000 in a bank and the bank lends all of that money to the federal government, M2 doubles. The bank's act of lending causes there to be more money in the world. So, whether the Federal Reserve creates extra money or banks lend it out, the money supply increases, and with it the distortion of the market.
Indeed, the fact that extending credit “creates” money provides yet another reason why Austrians dislike the Fed. Banks can afford to lend out 90% of their deposits because there’s no real danger of a run on the bank. If the bank has a temporary blip where people demand more deposits than are in the bank, the Fed can always act as a lender of last resort to prop up the bank. Thus, the existence of the Fed means that banks extend credit more easily and on riskier loans, once again distorting the market.
It’s All About the Benjamins
So, leaving aside the incorrect "crowding out" argument, why don't Austrians like fiscal stimulus? There are several reasons. First, Austrians are naturally allied with Libertarians with respect to the size of government, and less deficit spending means a smaller government. Second, the Austrian argument against stimulus is his constant refrain against malinvestment. To the extent that poor central planning exacerbates the ups and downs of the business cycle, deficit spending is bad for economic health.
Finally, Austrians hate deficit spending because, at its core, fiscal stimulus is the same thing as monetary stimulus. If I deposit $1,000 in a bank and the bank lends all of that money to the federal government, M2 doubles. The bank's act of lending causes there to be more money in the world. So, whether the Federal Reserve creates extra money or banks lend it out, the money supply increases, and with it the distortion of the market.
Indeed, the fact that extending credit “creates” money provides yet another reason why Austrians dislike the Fed. Banks can afford to lend out 90% of their deposits because there’s no real danger of a run on the bank. If the bank has a temporary blip where people demand more deposits than are in the bank, the Fed can always act as a lender of last resort to prop up the bank. Thus, the existence of the Fed means that banks extend credit more easily and on riskier loans, once again distorting the market.