Two 20th century giants in economics

THIS is a story of two British economists (one of them naturalised) who lived and worked in Britain and the United States and whose conflicting economic theories have dominated for a long time all policy decisions regarding how much state control should be exercised over the economic activities of a nation. They also created two opposing schools of thought to which most of the modern economists belong.
There were striking similarities and great differences between these two men. Both of them were university professors and men of great erudition. Coming from similar social backgrounds, they developed completely different ideologies. Although they never became close personal friends, they shared some exciting but dangerous moments during the war years.
According to Nicholas Wapshott, the veteran Reuters columnist and writer, in 1942, during the Second World War, they took turns at night on the rooftop of the King's College watching the sky to give early warning of German bombing raids on Cambridge. Friedrich Hayek won the Nobel Prize in Economics in 1974.No one doubts that John Keynes would have won it as well, had it existed when he was alive. (Keynes died in 1946. The Nobel Prize in Economics was first introduced in 1969.)
John Maynard Keynes was born on June 5, 1883 in Cambridge into a distinguished English family of academics. He was educated at Eton and King´s College, Cambridge where he earned great reputation as a brilliant all-rounder -- a good mathematician who also loved Classics, a popular student leader, a brilliant writer and a persuasive speaker.
Friedrich August Von Hayek was born on May 8, 1899 in Vienna, Austria into an aristocratic family of academics. His father was a medical doctor and taught at the University of Vienna. Hayek completed his studies in law, psychology and economics at the University of Vienna and earned a doctorate in 1923. Later, he held teaching positions at the University of London, the London School of Economics and the University of Chicago. In 1938 he became a British citizen.
In 1927, when Hayek was working at the Austrian Institute of Economic Research, Keynes was already famous. Hayek had become a great admirer of Keynes after reading The Economic Consequences of the Peace in which Keynes vehemently criticised the terms of the Versailles Treaty. Keynes had argued that the treaty was so humiliating and reparations conditions imposed on Germany and Austria so severe that millions would be thrown into absolute misery and possible death. What was worse, Keynes argued, was that the treaty would destroy all hopes of a permanent peace in Europe and pave the way for the next world-wide confrontation among the European powers. (It is a pity that the Allied Powers did not pay heed to Keynes. If they had taken his opinion into consideration, most probably the Second World War could have been avoided.)
Hayek, who had served in the Austrian army and seen the post-war miseries in the streets of Vienna and other towns and villages of the dissolved Austro-Hungarian Empire, considered Keynes as a hero who had resigned his position in protest as the Versailles Peace Conference adviser to Lloyd George, the British prime minister. Hayek himself was forced to renounce his family´s aristocratic title. So it was natural that he would take the initiative to start a personal relationship with Keynes. In 1927, Hayek wrote a letter to Keynes asking for a book on economics written by an Anglo-Irish economist called Francis Ysidro Edgeworth. In reply, Keynes merely sent a postcard in which he wrote that he did not have any spare copies of that particular book. After the publication of Hayek's Prices and Production in 1931 and The Pure Theory of Capitalism in 1941 in London they came to know each other better even though their ideological differences continued.
Conventional economic theories of the twenties believed in automatic adjustments of the free market to create more jobs, increase production and restore prosperity. According to these theories, government spending would merely increase budget deficits and lead to a decline in private investment.
In the twenties, it was basically a theoretical debate among the economists. The crash of 1929 changed all that. Urgent measures had to be taken to stop the downward spiral movement of the US economy. Following the conventional wisdom of automatic adjustment, President Hoover merely took measures to balance the budget. Unfortunately, it had just the opposite effect. A contracting economy had already caused government revenues to fall. Further tightening of the budget meant cutting government spending. Not only there was no recovery, the situation actually kept on getting worse.
It was at this point that Keynes came up with a new theory, which is now known as demand management theory. He said that in depression periods, market forces were not enough to achieve recovery. The government, instead of depending on the theory of competitive adjustment, should play a more active role. He felt that in minor recessions, monetary policy in the form of easier credit and lower interest rates could restore aggregate demand. But in cases of depressions, he recommended "deficit spending in public works and financial help by the government to the afflicted groups" to stimulate the economy.
Keynes was not talking specifically of a big government but of the need to watch, control and intervene when it was necessary to increase demand and create employment. In formulating the New Deal, which played a significant role in bringing the US back to the path of economic recovery, President Roosevelt took into account the recommendations made by Keynes.
On the other hand, Hayek was in favour of a minimal state and no intervention by the state in economic affairs. This theory found strong political resonance in the conservative circles of the US and the UK. President Ronald Reagan and Prime Minister Margaret Thatcher were great fans of Hayek. In his books The Road to Serfdom and The Constitution of Liberty, he warned that the expansion of government in the form of state intervention in economic affairs would eventually lead to totalitarian regimes like that of Hitler's.
In his opinion, organised labour unions, rent control and even agricultural subsidies would lead to corruption and inefficient markets. Hayek argued that as more and more power is transferred to the central government, the citizens would gradually lose their "freedom from coercion." Hayek recommended a minimal state because he felt that the market itself was a form "spontaneous order." Hayek's theory was interpreted by some as a kind of wild capitalism.
So what is the conclusion? Who is right?
I agree with Hayek when he says that no government can know enough about a society to plan all economic activities completely and effectively. But in a competitive market economy like ours, no one is thinking of Soviet-style planning. Lack of space does not allow us to enter into a detailed discussion on this subject.
But the current global crisis has proven beyond any doubt that the market has become very complex and that it has no automatic mechanism to correct its own excesses and abuses, hence the need for government regulation and control. The government must maintain a careful watch on all the main economic indicators and manage them simultaneously by taking timely remedial actions. "Priority must be given to whichever indicator is moving toward a danger zone." Most economists now agree that tougher regulation and closer supervision would have avoided the recent sub-prime mortgage bubble, the credit bubble and the housing bubble which have plunged the whole Western World into an unprecedented economic crisis and the consequent miseries.

The writer is a Daily Star columnist and an Officer of the Royal Order of Isabel la Católica of Spain.