28 Feb 2011 | History

Economic Thinkers - Men of Conscience 

Friedrich Hayek and Milton Friedman were two of the most influential economic thinkers to follow Keynes, albeit in a very different direction, argues Edward Russell-Walling.

Economic schools of thought rise and fall, but the best of them change the way we look at economics forever. Such was free market thinking, together with its hard-line prodigy, monetarism. Though enthusiasm for monetarism has since cooled, it was the hot idea of the 1970s and early 1980s. Criticised for inadequacy in the face of the recent financial crisis, it has nonetheless focused lasting attention on money supply growth as a key cause of inflation.

Monetarism was a conspicuous element in a broader wave of free market thinking that refuted Keynesian demand-based economics. Market freedom is strongly associated with the Chicago School, successive generations of influential academics at the University of Chicago, which has produced one third of all Nobel economics prize winners since 1969. These included Friedrich Hayek (the 1974 laureate) and monetarism’s leading light, Milton Friedman (1976). The pair provided the intellectual backbone for the free market policies of both British Prime Minister Margaret Thatcher and US President Ronald Reagan.

Different commentators have described each man as the pre-eminent economist of the latter half of the 20th century. Born and raised in Austria, Hayek (1899-1992) was a prominent member of the Austrian School, which opposed Marxism and any idea of government intervention in the economy. Ironically, Austrian economics ceased to have any physical connection with Austria in the 1930s, as its proponents moved to Britain and the US – Hayek taught at the London School of Economics from 1931 to 1950, before heading off to Chicago.

THE ROAD TO FREE MARKETS

During World War II, Hayek was concerned that government controls advocated by British socialism echoed those of Germany’s National Socialists, and wrote The Road to Serfdom as a warning. It attracted considerable attention in Britain and the US, was seized upon by Mrs Thatcher and shot back up last year’s bestseller lists after on-air praise from conservative US TV host Glenn Beck.

The building blocks of the ‘Austrian’ economy are people and all their individual spending and saving choices. Those millions of decisions – the market – are the basic economic data; data that central planners are in no position to measure or understand. In this state of ignorance, government should not attempt to steer the economy. Hayek deconstructed the business cycle to provide an important example of what could go wrong.

Capital, money and the business cycle were closely intertwined, he argued. The cycle had its origin in market intervention – an expansion of credit by the central bank. More money in the system would drive interest rates down. Artificially low rates would stimulate a boom, prompting people and businesses to borrow and to make capital investments they would not have made had they known they were getting distorted signals from the credit market. This misallocation of capital would sow the seeds of the next bust.

HAYEK’S INFLUENCE ON FRIEDMAN

The young New York-born Friedman (1912-2006) was attracted by Hayek and his ideas. He became, if anything, an even more impassioned advocate of free markets, calling for a volunteer army, education vouchers and the abolition of medical licences (insisting that freer competition would oblige doctors to charge less). His Studies in the Quantity Theory of Money (1956) and A Monetary History of the US, 1867-1960 (1963) were the bibles of monetarism.

Classical laissez-faire economics taught that, if left to their own devices, economies tended towards equilibrium in the long run. John Maynard Keynes argued that this was not possible without high unemployment unless government stimulated demand in bad times by spending more. Although this would boost inflation, Keynesians accepted a trade-off between higher but stable inflation, and output and unemployment.

Monetarism maintained that money was neutral and that, while increases in the money supply would affect output and employment in the short run, in the long run they would not. They would, however, push up prices. “Inflation is always and everywhere a monetary phenomenon,” claimed the diminutive (5’2”) Friedman. That’s why today some worry about the effects of quantitative easing, which creates new money, on future inflation.

Friedman’s prescription was that government should keep the money supply stable, expanding it each year only in line with economic growth. Apart from that, it should desist from applying stimuli or brakes and let the market deliver the desired equilibrium. Instead, government should improve supply side dynamics, optimising work and output by lowering taxes, privatising, removing red tape and making labour markets more productive and flexible. This was ‘supply side economics’, to distinguish it from Keynesian demand management. The stagflation of the 1970s – unemployment and high inflation – prompted some governments, notably in the UK and US, to adopt supply side policies and to target money supply growth as a way of controlling inflation.

The link between money supply alone and inflation turned out to be less definitive than the monetarists would have liked, and many central banks have since switched from monetary to direct inflation targeting. The European Central Bank is a notable exception.

The big idea behind monetarism has not entirely gone away, and the Hayek and Friedman zeal for market freedom continues to inform current thought. Many orthodox economists now accept that economics is as much art as science, and happily combine elements of Keynesianism and Friedmanism in their thinking. In a 1998 memoir written with his wife, Friedman was justifiably able to claim his place “in the mainstream of thought, not, as we were 50 years ago, a derided minority”.

Author:  Edward Russell-Walling
Edward Russell-Walling writes on financial and economic affairs for the Financial Times, The Banker and New Stateman.  His book, The House of Money: A History of the Great Banks, from the Medici to Goldman Sachs, will be published later this year.