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Karl Marx (1818–1883)
Karl Marx was an extremely influential thinker whose ideas ignited the movement by a third of the world’s
countries towards communism in the 20th century.
Marx provided a criticism of capitalism. Capitalism is a system where the small minority – the
‘bourgeoisie’ (the owners of capital such as machines and factories) – are the ruling class, and the
masses – the ‘proletariat’ (the labourers) – provide the labour to produce goods and services. Marx
essentially believed that economic systems progress through different stages – capitalism is just one
stage in this development process and, due to its weaknesses and flaws, will eventually self-destruct,
leading to the final stage of communism.
Marx believed that capitalists (the owners of capital), whose objective is to make a profit, must end up
exploiting workers to achieve this objective. This means that workers will earn wages lower than their
true value. Capitalists will also have an incentive to replace labour with machines, creating both more
monotonous jobs as well as unemployment. The combined effect will be to create an exploited and
alienated workforce, leading to social unrest. He also believed that competition would cause many firms
to go bust, leading to a few firms holding monopoly power which would allow them to further exploit
both workers and consumers. This would also lead to owners of the bust firms joining the ever-increasing
proletariat majority, causing social tensions to further increase.
The capitalist economic system is also weak, Marx said, since it is an unplanned system which causes
one crisis after another. This impacts most negatively on the proletariat. Marx believed that revolution
among the proletariat was inevitable. Revolution would enable workers to seize the capital (so that
ownership would be among the majority). Economic planning would direct economic activity. As the
economic system moves towards communism, there would be abolition of private property replaced by
common ownership of resources. However, although Marx wrote a lot criticising capitalism, he wrote
relatively little on how communism would work.
Marxism has had a resurgence lately. Many global problems, such as the Global Financial Crisis and
growing inequalities observed in many economies, may have their root cause in the free market system.
Friedrich Hayek (1899–1992)
Friedrich Hayek was a key supporter of the free market and deeply critical of socialism (state planning).
He believed that the resource allocation brought about by individuals, spontaneously, by the operation
of market forces, would be far superior to any state planning system. He believed that governments
should not intervene in resource allocation decisions, except in the provision or protection of public
goods. While Hayek did not think that individuals make decisions about what to demand or supply based
on perfect information, he did believe that they have the best knowledge of their own situation. For
example, a consumer will have the most accurate knowledge of his/her particular tastes, and a manager
will know what raw materials he needs to make his product.
Price movements will occur as individuals and firms participate in the market. These price movements
will be observed, and individuals and firms can choose how they wish to act in terms of their demand or
supply decisions, with the information they each have. The price mechanism acts as a communication
network.
The market will aggregate all these individual decisions, so ultimately the market will reflect all the
information available to society as a whole. This means the outcome in terms of resource allocation will
be the best that it can be. If government officials made decisions on how resources should be allocated,
this would not be successful since these officials lack sufficient information about markets to be able to
make informed decisions.
With the real-world failings of communism and the questioning of the effectiveness of Keynesian
demand-side management, free market advocates such as Hayek have had more prominence again since
the late 20th century.
iedrich A. Hayek, who died on March 23, 1992, at the age of 92, was probably the most prodigious
classical liberal scholar of the 20th century. Though his 1974 Nobel Prize was in Economic Science, his
scholarly endeavors extended well beyond economics. He published 130 articles and 25 books on topics
ranging from technical economics to theoretical psychology, from political philosophy to legal
anthropology, and from the philosophy of science to the history of ideas. Hayek was no mere dabbler;
he was an accomplished scholar in each of these fields of inquiry. He made major contributions to our
understanding in at least three different areas—government intervention, economic calculation under
socialism, and development of the social structure. It is unlikely that we will see the likes of such a wideranging scholar of the human sciences again.
Hayek was born into a family of intellectuals in Vienna on May 8, 1899. He earned doctorates from the
University of Vienna (1921 and 1923). During the early years of the 20th century the theories of the
Austrian School of Economics, sparked by Menger’s Principles of Economics (1871), were gradually being
formulated and refined by Eugen von Boehm-Bawerk, his brother-in-law, Friedrich Wieser, and Ludwig
von Mises. When Hayek attended the University of Vienna, he sat in on one of Mises’ classes, but found
Mises’ anti-socialist position too strong for his liking. Wieser was a Fabian socialist whose approach was
more attractive to Hayek at the time, and Hayek became his pupil. Yet, ironically it was Mises, through
his devastating critique of socialism published in 1922, who turned Hayek away from Fabian socialism.
The best way to understand Hayek’s vast contributions to economics and classical liberalism is to view
them in light of the program for the study of social cooperation laid out by Mises. Mises, the great system
builder, provided Hayek with the research program. Hayek became the great dissecter and analyzer. His
life’s work can best be appreciated as an attempt to make explicit what Mises had left implicit, to refine
what Mises had outlined, and to answer questions Mises had left unanswered. Of Mises, Hayek stated:
“There is no single man to whom I owe more intellectually.” The Misesian connection is most evident in
Hayek’s work on the problems with socialism. But the insights derived from the analysis of socialism
permeate the entire corpus of his work, from business cycles to the origin of social cooperation.
Hayek did not meet Mises when he was attending the University of Vienna. He was introduced to Mises
after he graduated through a letter from his teacher, Wieser. The Hayek-Mises collaboration then began.
For five years, Hayek worked under Mises in a government office. In 1927, he became the director of
the Institute for Business Cycle Research which he and Mises had set up together. The institute was
devoted to theoretical and empirical examinations of business cycles.
Building on Mises’ The Theory of Money and Credit (1912), Hayek refined both the technical
understanding of capital coordination and the institutional details of credit policy. Seminal studies in
monetary theory and the trade cycle followed. Hayek’s first book, Monetary Theory and the Trade Cycle
(1929), analyzed the effects of credit expansion on the capital structure of an economy.
Publication of that book prompted an invitation from Lionel Robbins for Hayek to lecture at the London
School of Economics. His lectures there were published in a second book on the “Austrian Theory of the
Trade Cycle,” Prices and Production (1931), which was cited by the Nobel Prize Committee in 1974.
Hayek’s 1930-1931 lectures at the London School were received with such great acclaim that he was
called back to the prestigious University of London and appointed Tooke Professor of Economic Science
and Statistics. At age 32, Hayek had reached the pinnacle of the economics profession.
The Mises-Hayek theory of the trade cycle explained the “cluster of errors” that characterizes the cycle.
Credit expansion, made possible by the artificial lowering of interest rates, misleads businessmen; they
are led to engage in ventures that would not otherwise have appeared profitable. The false signal
generated by credit expansion leads to malcoordination of the production and consumption plans of
economic actors. This malcoordination first manifests itself in a “boom,” and then, later, in the “bust” as
the time pattern of production adjusts to the real pattern of savings and consumption in the economy.
Hayek versus Keynes
Soon after Hayek’s arrival in London he crossed swords with John Maynard Keynes. Keynes, a prominent
member of the British civil service then serving on the governmental Committee on Finance and Industry,
was credited by the academic community as the author of serious books on economics. The HayekKeynes debate was perhaps the most fundamental debate in monetary economics in the 20th century.
Beginning with his essay, “The End of Laissez Faire” (1926), Keynes presented his interventionist pleas
in the language of pragmatic classical liberalism. As a result, Keynes was heralded as the “savior of
capitalism,” rather than being recognized as the advocate of inflation and government intervention that
he was.
Hayek pinpointed the fundamental problem with Keynes’s economics—his failure to understand the role
that interest rates and capital structure play in a market economy. Because of Keynes’s unfortunate
habit of using aggregate (collective) concepts, he failed to address these issues adequately in A Treatise
on Money (1930). Hayek pointed out that Keynes’s aggregation tended to redirect the analytical focus
of the economist away from examining how the industrial structure of the economy emerged from the
economic choices of individuals.
Keynes did not take kindly to Hayek’s criticism. He responded at first by attacking Hayek’s Prices and
Production. Then Keynes claimed that he no longer believed what he had written in A Treatise on Money,
and turned his attention to writing another book, The General Theory of Employment, Interest, and
Money (1936), which in time became the most influential book on economic policy in the 20th century.
Rather than attempting to criticize directly what Keynes presented in his General Theory, Hayek turned
his considerable talents to refining capital theory. Hayek was convinced that the essential point to convey
to Keynes and the rest of the economics profession concerning monetary policy lay in capital theory.
Thus Hayek proceeded to set forth his thesis in The Pure Theory of Capital (1941). However correct his
assessment may have been, this book, Hayek’s most technical, was his least influential. By the end of
the 1930s, Keynes’s brand of economics was on the rise. In the eyes of the public Keynes had defeated
Hayek. Hayek lost standing in the profession and with students.
During this time, Hayek was also involved in another grand debate in economic policy—the socialist
calculation debate, triggered by a 1920 article by Mises which stated that socialism was technically
impossible because it would lack market prices. Mises had refined this argument in 1922 in Socialism:
An Economic and Sociological Analysis, the book which had profoundly impressed the young Hayek when
it appeared. Hayek developed Mises’ argument further in several articles during the 1930s. In 1935, he
collected and edited a series of essays on the problems of socialist economic organization: Collectivist
Economic Planning. Additional Hayek essays on the problems of socialism, and specifically the model of
“market socialism” developed by Oskar Lange and Abba Lerner in their attempt to answer Mises and
Hayek, were later collected in Individualism and Economic Order (1948).
Again, the economics profession and the intellectual community in general did not appreciate Hayek’s
criticism. Had not modern science given man the ability to control and design society according to moral
rules of his own choosing? The planned society envisioned under socialism was supposed to be not only
as efficient as capitalism (especially in view of the chaos capitalism was said to generate with its business
cycles and monopoly power), but socialism, with its promise of social justice, was expected to be fairer.
Moreover, it was considered the wave of the future. Only a reactionary, it was argued, could resist the
inevitable tide of history. Not only had Hayek appeared to lose the technical economic debate with Keynes
and the Keynesians concerning the causes of business cycles but, in view of the rising tide of socialism
throughout the world, his general philosophical perspective was increasingly labeled as a primitive
version of liberalism.
The Road to Serfdom
Hayek, however, kept on refining the argument for the liberal society. The problems of socialism that he
had observed in Nazi Germany and that he saw beginning in Britain led him to write The Road to Serfdom
(1944). This book forced advocates of socialism to confront an additional problem, over and beyond the
technical economic one. If socialism required the replacement of the market with a central plan, then,
Hayek pointed out, an institution must be established that would be responsible for formulating this plan.
Hayek called this institution the Central Planning Bureau. To implement the plan and to control the flow
of resources, the bureau would have to exercise broad discretionary power in economic affairs. Yet the
Central Planning Bureau in a socialist society would have no market prices to serve as guides. It would
have no means of knowing which production possibilities were economically feasible. The absence of a
pricing system, Hayek said, would prove to be socialism’s fatal flaw.
In The Road to Serfdom Hayek also argued that there was good reason to suspect that those who would
rise to the top in a socialistic regime would be those who had a comparative advantage in exercising
discretionary power and were willing to make unpleasant decisions. And it was inevitable that these
powerful men would run the system to their own personal advantage.
Hayek was right on both counts, of course—on the economic as well as the political problem of socialism.
The 20th century is replete with the blood of the innocent victims of socialist experiments. Stalin, Hitler,
Mao, Pol Pot, and a host of lesser tyrants have committed heinous crimes against humanity in the name
of one or another variant of socialism. Totalitarianism is not a historical accident that emerges solely
because of a poor choice of leaders under a socialist regime. Totalitarianism, Hayek shows, is the logical
outcome of the institutional order of socialist planning.
After the defeat in the public forum of his critique of Keynes and the controversy that arose over the
debate on economic calculation under socialism, Hayek turned his attention away from technical
economics and concentrated on restating the principles of classical liberalism. Hayek had pointed out the
need for market prices as conveyors of dispersed economic information. He showed that attempts to
replace or control the market lead to a knowledge problem. Hayek also described the totalitarian problem
associated with placing discretionary power in the hands of a few. This led him to examine the intellectual
prejudices which blind men from seeing the problems of government economic planning.
During the 1940s, Hayek published a series of essays in professional journals examining the dominant
philosophical trends that prejudiced intellectuals in a way that did not allow them to recognize the
systemic problems that economic planners would confront. These essays were later collected and
published as The Counter-Revolution of Science (1952). The Counter-Revolution, perhaps Hayek’s best
book, provides a detailed intellectual history of “rational constructivism” and the problems of “scientism”
in the social sciences. It is in this work that Hayek articulates his version of the Scottish Enlightenment
project of David Hume and Adam Smith of using reason to whittle down the claims of reason. Modern
civilization was not threatened by irrational zealots hell-bent on destroying the world, but rather it was
the abuse of reason by rational constructivists trying to consciously design the modern world that had
placed mankind in chains of his own making.
In 1950, Hayek moved to the University of Chicago, where he taught until 1962 in the Committee on
Social Thought. While there, he wrote The Constitution of Liberty (1960). This work represented Hayek’s
first systemic treatise on classical liberal political economy.
In 1962, Hayek moved to Germany, where he had obtained a position at the University of Freiburg. He
then increasingly centered his efforts on examining and elaborating the “spontaneous” ordering of
economic and social activity. Hayek set about to reconstruct liberal social theory and to provide a vision
of social cooperation among free individuals.
With his three-volume study, Law, Legislation and Liberty (1973-1979) and The Fatal Conceit (1988),
Hayek extended his analysis of society to an examination of the “spontaneous” emergence of legal and
moral rules. His political and legal theory emphasized that the rule of law was the necessary foundation
for peaceful co-existence. He contrasted the tradition of the common law with that of statute law, i.e.,
legislative decrees. He showed how the common law emerges, case by case, as judges apply to particular
cases general rules which are themselves products of cultural evolution. Thus, he explained that
embedded within the common law is knowledge gained through a long history of trial and error. This
insight led Hayek to the conclusion that law, like the market, is a “spontaneous” order—the result of
human action, but not of human design.
Hayek’s work in technical economics, political and legal philosophy, and methodology of the social
sciences has attracted great interest among scholars of at least two generations, and interest in his work
is growing. His contributions to economic and classical liberalism are vast and will live on in the
progressive research program he has bequeathed to future generations of scholars.
Friedrich Hayek lived a long and fruitful life. He had to endure the curse of achieving fame at a young
age and then having that fame turn to ridicule as the Keynesians and socialists gained popularity and
the intellectual and political world moved away from his ideas. Fortunately he lived long enough to see
his towering intellect recognized again. Both Keynesians and socialists were eventually defeated soundly
by the tide of events and the truth of his teachings. Classical liberalism is once again a vibrant body of
thought. Austrian economics has re-emerged as a major school of economic thought, and younger
scholars in law, history, economics, politics, and philosophy are pursuing Hayekian themes. We may
mourn the loss of this great champion of liberalism, but at the same time we can rejoice that F. A. Hayek
left us such a brilliant gift
A great scholar is defined not so much by the answers he provides as by the questions he asks.
Successive generations of scholars, intellectuals, and political activists throughout the world will long be
pursuing questions that Hayek has posed.
Peter J. Boettke
Peter J. Boettke
Peter Boettke is a Professor of Economics and Philosophy at George Mason University and director of the
F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center.
He is a member of the FEE Faculty Network.
Friedrich A. Hayek
TAGS Austrian Economics Overview
WORKS PUBLISHED INMises Daily ArticleThe Journal of Libertarian StudiesQuarterly Journal of Austrian
EconomicsAustrian Economics NewsletterWho Is ...Articles of Interest
A claim for equality of material position can be met only by a government with totalitarian powers.
F. A. Hayek (1899–1992) is undoubtedly the most eminent of the modern Austrian economists, and a
founding board member of the Mises Institute. Student of Friedrich von Wieser, protégé and colleague
of Ludwig von Mises, and foremost representative of an outstanding generation of Austrian School
theorists, Hayek was more successful than anyone else in spreading Austrian ideas throughout the
English-speaking world. He shared the 1974 Nobel Prize in Economics with ideological rival Gunnar Myrdal
"for their pioneering work in the theory of money and economic fluctuations and for their penetrating
analysis of the interdependence of economic, social and institutional phenomena." Among mainstream
economists, he is mainly known for his popular The Road to Serfdom (1944).
READ FULL BIO
F. A. Hayek’s life spanned the twentieth century, and he made his home in some of the great intellectual
communities of the period.
Born Friedrich August von Hayek in 1899 to a distinguished family of Viennese intellectuals, Hayek
attended the University of Vienna, earning doctorates in 1921 and 1923. Hayek came to the University
at age 19 just after World War I, when it was one of the three best places in the world to study economics
(the others being Stockholm and Cambridge).
Like many students of economics then and since, Hayek chose the subject not for its own sake, but
because he wanted to improve social conditions—the poverty of postwar Vienna serving as a daily
reminder of such a need. Socialism seemed to provide a solution. Then in 1922 Mises published his Die
Gemeinwirtschaft, later translated as Socialism. “To none of us young men who read the book when it
appeared,” Hayek recalled, “the world was ever the same again.” It was around this time that Hayek
began attending Mises’s famed Privatseminar. For several years the Privatseminar was the center of the
economics community in Vienna.
Later, Hayek became the first of this group to leave Vienna; most of the others, along with Mises himself,
were also gone by the start of World War II.
At the L.S.E. Hayek lectured on Mises’s business-cycle theory, which he was refining and which, until
Keynes’s General Theory came out in 1936, was rapidly gaining adherents in Britain and the U.S. and
was becoming the preferred explanation of the Depression. Hayek and Keynes had sparred in the early
1930s in the pages of the Economic Journal, over Keynes’s Treatise on Money.
Within a very few years, however, the fortunes of the Austrian School suffered a dramatic reversal. Mises
left Vienna in 1934 for Geneva and then New York, where he continued to work in isolation; Hayek
remained at the L.S.E. until 1950, when he joined the Committee on Social Thought at the University of
Chicago. Other Austrians of Hayek’s generation became prominent in the U.S. but their work no longer
seemed to show distinct traces of the tradition founded by Carl Menger.
At Chicago Hayek again found himself among a dazzling group. But economic theory, in particular its
style of reasoning, was rapidly changing. In addition, Hayek had ceased to work on economic theory,
concentrating instead on psychology, philosophy, and politics, and Austrian economics entered a
prolonged eclipse.
When the 1974 Nobel Prize in economics went to Hayek, interest in the Austrian School was suddenly
and unexpectedly revived. Hayek’s writings were taught to new generations, and Hayek himself appeared
at the early Institute for Humane Studies conferences in the mid-1970s. He continued to write, producing
The Fatal Conceit in 1988, at the age of 89.
Hayek died in 1992 in Freiburg, Germany, where he had lived since leaving Chicago in 1961.
Among mainstream economists, he is mainly known for his popular The Road to Serfdom (1944) and for
his work on knowledge in the 1930s and 1940s. Specialists in businesscycle theory recognize his early
work on industrial fluctuations, and modern information theorists often acknowledge Hayek’s work on
prices as signals, although his conclusions are typically disputed. Hayek’s work is also known in political
philosophy, legal theory, and psychology.
Within the Austrian School of economics, Hayek’s influence, while undeniably immense, has very recently
become the subject of some controversy. His emphasis on spontaneous order and his work on complex
systems has been widely influential among many Austrians. Others have preferred to stress Hayek’s
work in technical economics, particularly on capital and the business cycle, citing a tension between
some of Hayek’s and Mises’s views on the social order.
Hayek’s writings on capital, money, and the business cycle are widely regarded as his most important
contributions to economics. Building on Mises’s Theory of Money and Credit (1912), Hayek showed how
fluctuations in economy-wide output and employment are related to the economy’s capital structure. In
Prices and Production (1931) he introduced the famous “Hayekian triangles” to illustrate the relationship
between the value of capital goods and their place in the temporal sequence of production.
In Monetary Theory and the Trade Cycle (1933) Hayek showed how monetary injections, by lowering
the rate of interest below what Mises (following Wicksell) called its “natural rate,” distort the economy’s
intertemporal structure of production. Most theories of the effects of money on prices and output (then
and since) consider only the effects of the total money supply on the price level and aggregate output
or investment.
Hayek’s writings on dispersed knowledge and spontaneous order are also widely known, but more
controversial. In “Economics and Knowledge” (1937) and “The Use of Knowledge in Society” (1945)
Hayek argued that the central economic problem facing society is not, as is commonly expressed in
textbooks, the allocation of given resources among competing ends.
It is rather a problem of how to secure the best use of resources known to any of the members of society,
for ends whose relative importance only those individuals know. Or, to put it briefly, it is a problem of
the utilization of knowledge not given to anyone in its totality.
Clearly, the Austrian revival owes much to Hayek. He ranks among the greatest members of the Austrian
School, and among the leading economists of the twentieth century. His work continues to be influential
in business cycle theory, comparative economic systems, political and social philosophy, legal theory,
and even cognitive psychology. Hayek remains one of the most intriguing intellectual figures of our time.
http://hayekcenter.org/ resource for Hayek
Adam Smith (1723–1790)
Adam Smith is viewed to be the founder of classical economics and was a key advocate of the market
economy. The Wealth of Nations, which Smith wrote in 1776, remains a classic book in economics. His key
conclusion is that, by pursuing their own self-interest, individuals would be led ‘as by an invisible hand’,
with resources allocated in such a way that is in the best interests of society.
He was writing at a time when most firms were owned and run by single individual capitalists who had
an active, hands-on approach to running their businesses. Like today, most capitalists ran their
businesses with the self-interested aim of maximising profit. Consumers also had their own self-interest
at heart when making decisions about what to buy.
Smith argued that these self-interest objectives, via the operation of the price mechanism, leads to the
optimum resource allocation and therefore the best outcome for society. The ‘invisible hand’ enables
consumers and producers to interact in the market so that both can achieve their objectives.
For example, if consumers suddenly want more robot vacuum cleaners, then this will push up the price
in the market: consumers are competing with each other for the existing number of robot vacuum
cleaners. Firms currently in the market will react by wanting to supply more of the product since there
is greater scope to make higher profits, while new suppliers will be enticed into the market to take
advantage of the profit opportunity. (Smith said low barriers to entry were essential to make this
happen.) More resources are then being allocated to the production of robot vacuum cleaners, which is
precisely what consumers wanted. Therefore everyone is happy.
Smith believed that competition in markets ensures that firms, whose main objective is to maximise
profits, produce their goods at the lowest possible cost. This benefits society and ensures markets will
use resources efficiently.
Smith recognised the dangers of monopoly power but at the time of his writing this was not viewed as
being too significant. He also believed prices would end up being ‘fair’ but that competition was essential
in achieving this (low barriers to entry are necessary to prevent firms from gaining monopoly power).
Smith also wrote about the process of specialisation and the division of labour, and how this production
method could increase production and create wealth. By breaking down the production process into
smaller, specialised parts, productivity rises. This is because this process helps incorporate some
automation into the production process, which speeds up production. Workers also spend less time
switching between tasks and the repetition of tasks makes their efficiency increase.
Evaluation:
Most economists would argue that free markets are the most efficient (in terms of using resources in
the best possible way to meet the needs and wants of consumers). However, when equity is
considered, most economists would also argue that free markets lead to an unequal distribution of
income and wealth, since owners of capital and entrepreneurs tend to accumulate the most
income/wealth and many people, such as the sick or elderly, are unable to work. As a result, most
economies today are mixed economies, where markets allocate many resources, but governments
intervene to different extents in order to ensure a minimum standard of living and to correct other
market failures.
Governments intervene by raising revenue through taxes and redistributing income in the form of
benefits and direct provision of services such as healthcare.
Three Economists and Their Theories
The three most important economists were Adam Smith, Karl Marx, and John Maynard Keynes
(pronounced canes). Each was a highly original thinker who developed economic theories that were put
into practice and affected the world's economies for generations.
Adam Smith and His Invisible Hand of Capitalism
Adam Smith, a Scot and a philosopher who lived from 1723 to 1790, is considered the founder of
modern economics. In Smith's time, philosophy was an all-encompassing study of human society in
addition to an inquiry into the nature and meaning of existence. Deep examination of the world of
business affairs led Smith to the conclusion that collectively the individuals in society, each acting in
his or her own self-interest, manage to produce and purchase the goods and services that they as a
society require. He called the mechanism by which this self-regulation occurs “the invisible hand,” in
his groundbreaking book, The Wealth of Nations, published in 1776, the year of America's Declaration
of Independence.
While Smith couldn't prove the existence of this “hand” (it was, after all, invisible) he presented many
instances of its working in society. Essentially, the butcher, the baker, and the candlestick maker
individually go about their business. Each produces the amount of meat, bread, and candlesticks he
judges to be correct. Each buys the amount of meat, bread, and candlesticks that his household needs.
And all of this happens without their consulting one another or without all the king's men telling them
how much to produce. In other words, it's the free market economy in action.
In making this discovery, Smith founded what is known as classical economics. The key doctrine of
classical economics is that a laissez-faire attitude by government toward the marketplace will allow the
“invisible hand” to guide everyone in their economic endeavors, create the greatest good for the
greatest number of people, and generate economic growth. Smith also delved into the dynamics of the
labor market, wealth accumulation, and productivity growth. His work gave generations of economists
plenty to think about and expand upon.
Karl Marx: It's Exploitation!
Karl Marx, a German economist and political scientist who lived from 1818 to 1883, looked at
capitalism from a more pessimistic and revolutionary viewpoint. Where Adam Smith saw harmony and
growth, Marx saw instability, struggle, and decline. Marx believed that once the capitalist (the guy with
the money and the organizational skills to build a factory) has set up the means of production, all value
is created by the labor involved in producing whatever is being produced. In Marx's view, presented in
his 1867 tome Das Kapital (Capital), a capitalist's profits come from exploiting labor—that is, from
underpaying workers for the value that they are actually creating. For this reason, Marx couldn't abide
the notion of a profit-oriented organization.
This situation of management exploiting labor underlies the class struggle that Marx saw at the heart
of capitalism, and he predicted that that struggle would ultimately destroy capitalism. To Marx, class
struggle is not only inherent in the system—because of the tension between capitalists and workers—
but also intensifies over time. The struggle intensifies as businesses eventually become larger and
larger, due to the inherent efficiency of large outfits and their ability to withstand the cyclical crises
that plague the system. Ultimately, in Marx's view, society moves to a two-class system of a few
wealthy capitalists and a mass of underpaid, underprivileged workers.
Marx predicted the fall of capitalism and movement of society toward communism, in which “the
people” (that is, the workers) own the means of production and thus have no need to exploit labor for
profit. Clearly, Marx's thinking had a tremendous impact on many societies, particularly on the USSR
(Union of Soviet Socialist Republics) in the twentieth century.
In practice, however, two events have undermined Marx's theories. First, in socialist, centrally planned
economies have proven far less efficient at producing and delivering goods and services—that is, at
creating the greatest good for the greatest number of people—than capitalist systems. Second,
workers' incomes have actually risen over time, which undercuts the theory that labor is exploited in
the name of profit. If workers' incomes are rising, they are clearly sharing in the growth of the
economy. In a very real sense, they are sharing in the profits.
While Marx's theories have been discredited, they are fascinating and worth knowing. They even say
something about weaknesses in capitalism. For instance, large companies do enjoy certain advantages
over small ones and can absorb or undercut them, as shown by examples as old as Standard Oil (now
ExxonMobil) and General Motors and as recent as Microsoft and IBM, in high technology, and ConAgra
and Dole in agriculture. In addition, as we will see in Wealth and Poverty, income distribution in U.S.style capitalism, which is a “purer,” less-mixed form of capitalism than that of Europe, can tend to
create a two-tier class system of “have's” and “have not's.”
Keynes: The Government Should Help Out the Economy
John Maynard Keynes, a British economist and financial genius who lived from 1883 to 1946, also
examined capitalism and came up with some extremely influential views. They were, however, quite
different from those of Karl Marx and, for that matter, Adam Smith. In 1936, he published his General
Theory of Employment, Interest, and Money. We will examine Keynes's theories later. They mainly
involve people's propensity to spend or to save their additional money as their incomes rise, and the
effects of increases in spending on the economy as a whole.
The larger significance of Keynes's work lies in the view he put forth about the role of government in a
capitalist economy. Keynes was writing during the Great Depression. It's worth noting at this point that
in the United States unemployment reached about 25 percent and millions of people had lost their life
savings as well as their jobs. Moreover, there was no clear path out of the depression, which led people
to seriously question whether Smith's invisible hand was still guiding things along. Was this worldwide
collapse of economic activity the end of capitalism?
Keynes believed that there was only one way out, and that was for the government to start spending
in order to put money into private-sector pockets and get demand for goods and services up and
running again. As it turns out, President Franklin D. Roosevelt gave this remedy a try when he started
a massive public works program to employ a portion of the idle workforce. However, the United States
entry into World War II rendered this a less than pure experiment in government spending. The war
effort boosted production to extremely high levels (to make guns, ammunition, planes, trucks, and
other materiel) while simultaneously taking millions of men out of the civilian workforce and into
uniform.
EconoTalk
Keynesian economics is an approach to economic policy that favors using the government's power to
spend, tax, and borrow to keep the economy stable and growing. A Keynesian is an economist or other
believer in Keynesian economics.
The validity and desirability of Keynes's prescription for a sluggish economy—using government
spending to prime the pump—are still debated today. Again, we will look at the theory and practice of
what came to be known as Keynesian economics later.
Many other economists of note advanced theories and otherwise added to the body of knowledge in the
science. We will look at their ideas as they arise in our examination of economics. However, Adam
Smith, Karl Marx, and John Maynard Keynes (later Lord Keynes) are widely recognized as the most
influential—Smith because he founded and formalized the science of economics, Marx because he
challenged capitalism and had such a forceful impact on society and politics, and Keynes because he
prompted new practices as well as new theories in the world of economic policy. Keynes also played a
key role in the founding of the International Monetary Fund and in other political economic measures
taken at the end of World War II.
What Is Keynesian Economics?
FINANCE & DEVELOPMENT, September 2014, Vol. 51, No. 3
Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou
PDF version
The central tenet of this school of thought is that government intervention can stabilize the economy
Just how important is money? Few would deny that it plays a key role in the economy.During the Great Depression of the 1930s, existing economic theory was unable either to explain the
causes of the severe worldwide economic collapse or to provide an adequate public policy solution to
jump-start production and employment.
British economist John Maynard Keynes spearheaded a revolution in economic thinking that overturned
the then-prevailing idea that free markets would automatically provide full employment—that is, that
everyone who wanted a job would have one as long as workers were flexible in their wage demands
(see box). The main plank of Keynes’s theory, which has come to bear his name, is the assertion that
aggregate demand—measured as the sum of spending by households, businesses, and the
government—is the most important driving force in an economy. Keynes further asserted that free
markets have no self-balancing mechanisms that lead to full employment. Keynesian economists
justify government intervention through public policies that aim to achieve full employment and price
stability.
The revolutionary idea
Keynes argued that inadequate overall demand could lead to prolonged periods of high unemployment.
An economy’s output of goods and services is the sum of four components: consumption, investment,
government purchases, and net exports (the difference between what a country sells to and buys from
foreign countries). Any increase in demand has to come from one of these four components. But
during a recession, strong forces often dampen demand as spending goes down. For example, during
economic downturns uncertainty often erodes consumer confidence, causing them to reduce their
spending, especially on discretionary purchases like a house or a car. This reduction in spending by
consumers can result in less investment spending by businesses, as firms respond to weakened
demand for their products. This puts the task of increasing output on the shoulders of the government.
According to Keynesian economics, state intervention is necessary to moderate the booms and busts in
economic activity, otherwise known as the business cycle.
There are three principal tenets in the Keynesian description of how the economy works:
• Aggregate demand is influenced by many economic decisions—public and private.Private sector
decisions can sometimes lead to adverse macroeconomic outcomes, such as reduction in consumer
spending during a recession. These market failures sometimes call for active policies by the
government, such as a fiscal stimulus package (explained below). Therefore, Keynesian economics
supports a mixed economy guided mainly by the private sector but partly operated by the government.
• Prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic
shortages and surpluses, especially of labor.
• Changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run
effect on real output and employment, not on prices. Keynesians believe that, because prices are
somewhat rigid, fluctuations in any component of spending—consumption, investment, or government
expenditures—cause output to change. If government spending increases, for example, and all other
spending components remain constant, then output will increase. Keynesian models of economic
activity also include a multiplier effect; that is, output changes by some multiple of the increase or
decrease in spending that caused the change. If the fiscal multiplier is greater than one, then a one
dollar increase in government spending would result in an increase in output greater than one dollar.
Keynes the master
Keynesian economics gets its name, theories, and principles from British economist John Maynard
Keynes (1883–1946), who is regarded as the founder of modern macroeconomics. His most famous
work, The General Theory of Employment, Interest and Money, was published in 1936. But its 1930
precursor, A Treatise on Money, is often regarded as more important to economic thought. Until then
economics analyzed only static conditions—essentially doing detailed examination of a snapshot of a
rapidly moving process. Keynes, in Treatise, created a dynamic approach that converted economics
into a study of the flow of incomes and expenditures. He opened up new vistas for economic analysis.
In The Economic Consequences of the Peace in 1919, Keynes predicted that the crushing conditions
the Versailles peace treaty placed on Germany to end World War I would lead to another European
war.
He remembered the lessons from Versailles and from the Great Depression, when he led the British
delegation at the 1944 Bretton Woods conference—which set down rules to ensure the stability of the
international financial system and facilitated the rebuilding of nations devastated by World War II.
Along with U.S. Treasury official Harry Dexter White, Keynes is considered the intellectual founding
father of the International Monetary Fund and the World Bank, which were created at Bretton Woods.
Stabilizing the economy
No policy prescriptions follow from these three tenets alone. What distinguishes Keynesians from other
economists is their belief in activist policies to reduce the amplitude of the business cycle, which they
rank among the most important of all economic problems.
Rather than seeing unbalanced government budgets as wrong, Keynes advocated so-called
countercyclical fiscal policies that act against the direction of the business cycle. For example,
Keynesian economists would advocate deficit spending on labor-intensive infrastructure projects to
stimulate employment and stabilize wages during economic downturns. They would raise taxes to cool
the economy and prevent inflation when there is abundant demand-side growth. Monetary policy could
also be used to stimulate the economy—for example, by reducing interest rates to encourage
investment. The exception occurs during a liquidity trap, when increases in the money stock fail to
lower interest rates and, therefore, do not boost output and employment.
Keynes argued that governments should solve problems in the short run rather than wait for market
forces to fix things over the long run, because, as he wrote, “In the long run, we are all dead.” This
does not mean that Keynesians advocate adjusting policies every few months to keep the economy at
full employment. In fact, they believe that governments cannot know enough to fine-tune successfully.
Keynesianism evolves
Even though his ideas were widely accepted while Keynes was alive, they were also scrutinized and
contested by several contemporary thinkers. Particularly noteworthy were his arguments with the
Austrian School of Economics, whose adherents believed that recessions and booms are a part of the
natural order and that government intervention only worsens the recovery process.
Keynesian economics dominated economic theory and policy after World War II until the 1970s, when
many advanced economies suffered both inflation and slow growth, a condition dubbed “stagflation.”
Keynesian theory’s popularity waned then because it had no appropriate policy response for
stagflation. Monetarist economists doubted the ability of governments to regulate the business cycle
with fiscal policy and argued that judicious use of monetary policy (essentially controlling the supply of
money to affect interest rates) could alleviate the crisis (see “What Is Monetarism?” in the March 2014
F&D). Members of the monetarist school also maintained that money can have an effect on output in
the short run but believed that in the long run, expansionary monetary policy leads to inflation only.
Keynesian economists largely adopted these critiques, adding to the original theory a better integration
of the short and the long run and an understanding of the long-run neutrality of money—the idea that
a change in the stock of money affects only nominal variables in the economy, such as prices and
wages, and has no effect on real variables, like employment and output.
Both Keynesians and monetarists came under scrutiny with the rise of the new classical school during
the mid-1970s. The new classical school asserted that policymakers are ineffective because individual
market participants can anticipate the changes from a policy and act in advance to counteract them. A
new generation of Keynesians that arose in the 1970s and 1980s argued that even though individuals
can anticipate correctly, aggregate markets may not clear instantaneously; therefore, fiscal policy can
still be effective in the short run.
The global financial crisis of 2007–08 caused a resurgence in Keynesian thought. It was the theoretical
underpinnings of economic policies in response to the crisis by many governments, including in the
United States and the United Kingdom. As the global recession was unfurling in late 2008, Harvard
professor N. Gregory Mankiw wrote in the New York Times, “If you were going to turn to only one
economist to understand the problems facing the economy, there is little doubt that the economist
would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of
recessions and depressions remains the foundation of modern macroeconomics. Keynes wrote,
‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually
the slave of some defunct economist.’ In 2008, no defunct economist is more prominent than Keynes
himself.”
But the 2007–08 crisis also showed that Keynesian theory had to better include the role of the financial
system. Keynesian economists are rectifying that omission by integrating the real and financial sectors
of the economy.■
Sarwat Jahan is an Economist and Chris Papageorgiou is a Deputy Division Chief in the IMF’s Strategy,
Policy, and Review Department. Ahmed Saber Mahmud is the Associate Director of Applied Economics
at Johns Hopkins University.
Free Market Maven: Milton Friedman
By Andrew Beattie
Milton Friedman and John Maynard Keynes are as integral to the story of economics as Adam Smith
and Karl Marx. What Keynes wrought, Friedman undid, and supporters of the free market are deeply in
debt to this Chicago school academic for his effort. In this article, we will look at the life and
contributions of Milton Friedman. (To learn more about these great economic thinkers, read our related
article The History Of Economic Thought.)
The Father of Income Tax Withholding
Milton Friedman was born in Brooklyn in 1912, one of four children born to Jewish immigrants. He
studied at Rutgers University, Chicago University and Columbia, focusing on mathematics and
economics. During his Ph.D., WWII broke out and Friedman took a break to work for the Treasury
Department. He was part of a think tank that brought about income tax withholding as a "temporary"
measure to help fund the war. Though he never questioned the necessity of it in wartime, Friedman
later regretted having forced withholding on Americans. Friedman was appalled when the government
made the emergency measure a permanent part of its peacetime taxation. (Learn how Milton
Friedman's monetarist views shaped economic policy after World War II, read Monetarism: Printing
Money To Curb Inflation.)
First Blood - Attacking the Keynesian Assumptions
Friedman continued his studies after the war and began to show his free-market colors in a time of
Keynesian domination. Taking up a teaching post at the University of Chicago, Friedman wrote free-
market analysis of the damage done by rent controls and monopolistic practices in the medical
profession. In 1957, Friedman launched his first direct attack against Keynesian thinking with "A
Theory of the Consumption Function" - an attack on one of the assumptions of Keynes' model. (Learn
more about Keynes' models and policies in Giants Of Finance: John Maynard Keynes.)
Keynesians support short-term solutions to spur consumer spending and the economy. The idea is that
by giving a temporary tax break like a stimulus check, the government can spur spending without
giving up future tax revenues by making a meaningful tax cut – in short, the government gets to have
its cake (economic recovery) and eat it too (maintain future taxes). Friedman took on this idea and
analyzed actual empirical evidence. This was in contrast to Keynes and his followers who rarely did
actual empirical studies.
Friedman showed that people adjusted their annual spending habits in response to real changes in
their lifetime income, not temporary changes to their current income. In practice, this means that
something concrete like a raise may prompt a family to spend more, but a short-lived boost from a
stimulus check will not. This was the first crack in the Keynesian framework, but it was quickly followed
by further attacks on the many dubious assumptions underlying the theory. (Find out how tax breaks
can help the economy in our frequently asked question How do government-issued stimulus checks
affect the economy?)
Friend of Investors and Savers
Instead of trying to boost the economy by trying to fool consumers, Friedman believed the same ends
could be met by minimizing government involvement. This would be achieved by lessening taxes in the
long term and ceasing inflationary policies. Inflation, Friedman pointed out, was just another attempt
to fool consumers into thinking they were earning more, when the corresponding rise in the cost of
living was actually canceling out any gains in wages. Friedman and the other economists at the
Chicago school led attack after attack on concepts like the Keynesian multiplier and the damage of
saving.
Friedman took issue with the Keynesian multiplier because it gave any form of government spending even debt spending - a superior rating over private investment. Friedman pointed out that the more
the government borrows to spend, the more pressure there is to inflate the currency to meet the
payments in the future. Furthermore, government spending crowds out private investors who will sit
on their capital when the government is paying for everything. Friedman argued that, at best, the
multiplier was unjustified and the implications of government deficit spending needed to be looked at
in a broader sense to measure the true impact.
Friedman Makes a Depressing Discovery
In his book, "A Monetary History of the United States" (1963), Milton Friedman and his coauthor Anna
Schwartz showed how it was monetary policy, and not a failure of free market capitalism, that led to
the Great Depression. Friedman surveyed almost a century of monetary policy during crashes, booms,
recessions and depressions, and came to the conclusion that the Fed was a main cause of the
depression because it shrunk the money supply by over a third between 1929 and 1933. This
contraction turned a crash, something the U.S. had bounced back from many times before, into an
extended depression. The connection was never made before because no figures on money supply
were published until after Friedman and Schwartz's book. (Learn more about the Great Depression in
What Caused The Great Depression? and The Great Depression (1929) section of our Crashes Special
Feature.)
Free Market Hero and Hard Money Advocate
Friedman began to focus more and more on the role of money in the economy. Originally, he
supported a gold standard to check inflation and prevent bank runs, but he moved toward a hard
money policy where the amount of money in circulation would increase at the same pace as the
nation's economic growth. He believed this would be a sufficient check to keep governments from
printing as much money as they pleased, while still increasing the money supply enough to allow
growth to continue. In 1962, Friedman's book "Capitalism and Freedom" set him up in the academic
and public arenas as one of the rare defenders of free market capitalism.
"Capitalism and Freedom" espoused the free-market solutions to many problems and caught a lot of
attention for proposing a negative income tax for people under a certain income and school vouchers
to improve the education system. Friedman also wrote a regular column in Newsweek to explain both
free-market principles and his monetary stance. In the 1980s, Friedman took his defense of the free
market onto the airwaves with a PBS show called "Free to Choose" followed by a book of the same title
that arguably made him the most famous economist alive.
Friedman Advocates for Currency Trading
In keeping with his opposition to Keynesian thinking, Milton Friedman took an active dislike to the
Bretton Woods Agreement, an attempt to fix currencies rather than let them float in free-market
fashion. In 1967, Friedman was positive that the British pound was overvalued and attempted to sell it
short. He was refused by all the Chicago banks he called and vented his indignation in his Newsweek
column, laying out the necessity of floating currencies for both public futures and a currency trading
markets.
Friedman's articles inspired Leo Melamed of the Chicago Mercantile Exchange to push for the creation
of a forex market in 1972. Melamed consulted with Friedman about the probability of Bretton Woods
falling apart - an event the viability of the new markets depended on. As Friedman assured Melamed,
the Bretton Woods agreement collapsed and one currency after another was given over to float. The
currency market is now the largest in the world, and is much more efficient than arbitrary pegging.
(Learn the basics of the forex market by reading Getting Started In Forex.)
Stagflation and the Rise of Monetarism
Before his public success in the 1980s, Friedman had already gained considerable clout in economic
circles. When the Keynesian system buckled under stagflation in the 1970s, academics began to take
Friedman's anti-inflation, hard money policies much more seriously. Monetarism started to eclipse
Keynesian solutions. Friedman and other Chicago School economists became economic advisors to
many governments. Collectively, they urged policies for hard money and small government, a
throwback to the days of Adam Smith. (Read Stagflation, 1970s Style to learn more about how Milton
Friedman's monetarist theory helped bring the U.S. out of the economic doldrums.)
Friedman and the Chicago school garnered several Nobel Memorial Prizes in Economic Sciences for
their work in dismantling the most damaging Keynesian concepts, but Friedman said himself in a 1998
speech, "We have gained on the level of rhetoric, lost on the level of practice." By this he meant that
academic circles had accepted free market principles as superior to Keynesian thinking, but
governments were still enamored with Keynes. According to critics of Keynesianism, Keynesian
economics is attractive to governments because it justifies even their most wasteful projects and
excuses the bureaucratic excesses of big government. Friedman and his colleagues brought another
alternative to big government, but felt that few governments were willing to give up the reins. (To
learn more about the Nobel Memorial Prize in Economic Sciences, read Nobel Winners Are Economic
Prizes.)
Nobel End
Milton Friedman came to the forefront of economics at a time when free market economists were in
short supply. At every opportunity, Friedman argued passionately against government intervention and
in favor of the free market. A firm believer in freedom, both in the markets and in personal life,
Friedman was a member of the Mont Pelerin Society and later served as its president. He allowed that
free market capitalism may not be the perfect solution, but asserted that it was by far the best out of
all the alternatives known to us today.
Friedman's awards and recognition are numerous, including his 1976 Nobel Memorial Prize, but the
highest praise is that he continued to toil tirelessly defending freedom and debating all comers right up
to his death in 2006. Countries like India and China that took Friedman's message to heart and, many
believe they are now reaping the economic benefits as a result. Friedman's free market ideals provided
a new way of looking at the economy and offered alternative ways for countries to build and maintain
strong economies.
Read more: Free Market Maven: Milton Friedman
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