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Reading Hayek: liberty, capitalism and Austrian economics


Hungy Ye

By

October 6th, 2013


Who was Friedrich Hayek? Hungy Ye looks into the key ideas of the free market’s most influential proponents.


Friedrich von Hayek (1899 – 1992) was a Nobel-prize winning economist and one of the most influential thinkers in politics and economics of the 20th century. He is famous for his work on what is commonly referred to as supply side or Austrian Economics: an alternative to ‘mainstream’ Keynesian business cycle theory.

His works are underpinned by the belief that modern civilisation is based on the development of liberty and individual freedom and that economic progress depended on the preservation of these rights.[i] Because of this Hayek was a fierce critic of planned economics and any form of government controls, especially in monetary policy. Hayek’s view of the economy was that intervention in free markets leads to inefficient outcomes in the short run, and over an extended period leads to the concentration of power in the hands of a few individuals.

As a member of the Austrian school of economics (so named because many prominent proponents of it have come from Austria), Hayek consolidated the theory that business cycles are caused by the oversupply of credit resulting in overproduction[ii]. When credit is available too freely, producers will be incentivised to undertake risky ventures. This results in a build up of output that gives the impression of a booming economy. Next, the market being flooded by cheap goods will result in lower than expected rates of return for investors who used borrowed money for funding. Investors unable to pay back their debts would cause economy wide defaults known as ‘the bust’[iii]. Thus it is the production of goods that drives the economy, and not the demand.

At the risk of vastly oversimplifying Hayek’s work, his key argument is that there is a natural rate of interest[iv] which will optimise the level of production – and this rate should be determined by market forces. Attempts by the government to use monetary policy to control aggregate demand will inevitably be destabilising and cause repeated cycles of booms and busts. This stands in contrast with the neoclassical Keynesian economics where recessions are caused and exacerbated by under consumption, an approach that governments worldwide have relied upon since its development in the 1930’s by J.M. Keynes.

During his Nobel prize speech titled ‘The Pretense of Knowledge’, Hayek described economies by definition as being necessarily comprised of many individual agents, which results in essential complexity[v]. This is to say that no economy can be reduced to a simple set of rules and variables at the aggregate level without losing out on important details. Thus it is impossible for any individual or group such as the government to know the true state of the economy at any one time, or make accurate predictions on how interventions on economies will behave. Whilst the speech was a criticism of the Keynesian policies that had been adopted by governments, its purpose was to raise the issue of the role of government in managing the economy, another heavily discussed topic.

In Hayek’s earlier work ‘The Road to Serfdom’, Hayek argues that handing too much power to the government will always result in the creation of authoritarian dictatorships. While social planners may be well meaning in their intentions to build a stable society and economy, due to the complexity of managing an economy this will result in increasingly stricter controls on citizens when progress does not go according to plan[vi]. Over time this results in the creation of a totalitarian, ultra-nationalistic or socialist government where individuals have very little freedom.

Thus the role of governments should be limited only to responsibilities that free markets fail to provide, such as enforcing contracts, providing basic public services and correcting externalities. His ideals form the core of modern day libertarianism, whose proponents campaign for smaller governments and less market distortions such as taxes and tariffs. The most radical and perhaps well known ‘Tea Party’ movement in the United states seeks to close down the US Federal Reserve, ending the government’s control of interest rates, which is what Hayek would have advocated.

History has proven that Hayek’s theory on central planning to be largely correct, however there has been mixed success in empirically proving his views on economic management. Keynesian policies provide a way for governments to steer the economy whilst Hayek’s Austrian school proposes that there should be no steerage at all, a tough sell to policy makers worldwide.

 

Further reading:


[i] Henderson, D. R. (2013). Friedrich August Hayek. Retrieved from Library of Economics and Liberty: http://www.econlib.org/library/Enc/bios/Hayek.html

[ii] Hayek, F. A. (1931). Prices and Production. New York: Augustus M. Kelly Publishers.

[iii] Flanders, S. (2012, September 24). Masters of Money: Friedrich Hayek. Retrieved from BBC News:        http://www.bbc.co.uk/news/business-19706272

[iv] Financial Times. (2013, October). Financial Times Lexicon. Retrieved from Financial Times:    http://lexicon.ft.com/Term?term=Austrian-economics

[v] Hayek, F. A. (1974, December 11). Prize Lecture: The Pretence of Knowledge. Retrieved from Official Website of the Nobel Prize: http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1974/hayek-lecture.html

[vi] The Mises Institute. (2013, September). The Road to Serfdom Illustrated. Retrieved from The Mises Institute: http://mises.org/books/trts/

 

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

  • Joey Moloney

    Great read Hungy!

    There are two issues I take with the Austrian approach thought – I’d be interested to get your thoughts on them.
    1) A market determined interest rate sounds great, but it relies on the assumption that banks are inherently rational and all-knowing in their risk-taking. Without the safety of a central bank providing intra-day loans and exchange settlement accounts, it seems banks would be substantially less stable.
    2) The push toward smaller government makes no sense if one is happy to concede that government should correct externalities. The larger the private sector grows, the more externalities are created, thus the bigger government must get.

    Cheers,

    Joey

    • Elijah

      Joey,

      I would have thought that the Austrian school’s main concern in the area of financial markets was the fractional reserve banking system. Their argument is that this type of banking system ultimately leads to extensive centralisation, inflation and is inherently unstable; they believe in “sound money”. They also take the view that central banks are susceptible to political incentives (and thus won’t necessarily always act in the interests of the community…they’re sceptics) and that this is particularly dangerous when they have a monopoly on money. Rothbard has written a lot in this area. I would recommend reading some of his stuff to get a better idea of the core Austrian/anarcho-capitalist arguments in relation to banking. I’d also recommend you look up an activist group called “Positive Money”. Positive Money likewise are against the fractional reserve banking system and believe that conventional monetary theory is wrong. I think you might find this of interest as they consider central banks’ role in controlling money hopeless – it is private banks that really make money in the economy. They’ve got a good series of youtube videos.

      On you second point: there are ways to deal with negative externalities other than government. Ronald Coase had interesting ideas with his Coase theorem. In some cases, this may be a more effective way of dealing with negative externalities. I’m not totally sure the Austrians (especially not the anarcho-capitalists like Rothbard) would be at all happy about government dealing with externalities at all. But then again, measures which are most effective in dealing with negative externalities are usually based on manipulating incentives and adjusting people’s behaviour in the market. This is quite different (I think) from direct government control of industry. It is theoretically different when a government implements a tax on cigarettes to stop people from smoking, as opposed to a government that takes over tobacco companies and/or bans cigarettes.

      The point I’m really trying to get at is that negative externalities can be eradicated without the need for an expansion in the size and scope of government. Therefore I can’t agree with your assertion that negative externalities produced by the private sector necessarily means an increase in the size of government. The fact of the matter is that there are other (arguably more effective ways) of dealing with negative externalities than government.

      Elijah

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