As a country, we love to throw around words like freedom, liberty, and free markets without much thought to what they mean. What is it that makes us free? What are the liberties we have and why do they exist? When people discuss the freedom of a country, especially economic freedom, they are really discussing the philosophies of two long dead economists Keynes and Hayek.

Let’s say that two people live on a tropical island. One is named John and the other is named Fred. There isn’t a way off the island, and for the purposes of the story there isn’t anything off the island. The island is their world. On this island there are coconuts and in the water there are fish. John is a very good fisherman, but he can’t climb trees very well. Fred climbs like a monkey but has no patience for fishing. Now, Fred is able to keep himself fed on coconuts, and John can sustain himself on fish, but as one would imagine, that gets pretty boring after a while. One day the two men get to talking and begin to complain about their diets. Fred is tired of fish all the time and John is tired of coconuts. The two men decide to trade some of their food for the others. John wants coconuts and Fred wants fish, so when they trade they are both better off because trade is a win/win situation. There was no loser in the deal, both made the choice to trade and both were better off for it. Now let’s suppose that a government is added to the island and they decide that because fish are harder to catch, there must be a subsidy for John and they then tax Fred 2 coconuts. One goes to pay the tax collector and the other goes to John. The two men were happy where they were and it is possible that John can no longer afford fish.

The model is simplistic but, it drives home the point that government intervention in a market tends to just muddy the waters and make everything less efficient.

When people think of famous rivalries they immediately think of Muhammad Ali and Joe Frasier or Coke and Pepsi or possibly even Microsoft and Apple but, in the world of economics there is only Keynes vs Hayek. It could be argued that these two, long dead, economists have the most meaningful impact on your life than any other men in history. Governments rise and fall in one camp or the other and Presidents win and lose elections because of the philosophies of these two men. This argument has become the economic and political fight of the century. (Stories, 2010)

In the red corner we have Friedrich August Hayek was an Austrian economist who immigrated to England to teach at the London School of Economics. He saw Hitler take power in Germany as well as elected in Austria with 98% of the vote. He watched as his country lost its freedom for the “greater good.” He observed conditions within Europe and documented the rise of Stalin as well as Franco and Mussolini. He watched Europe fall to tyranny and, as an economist, was able to track exactly how it got to where it was. He found that socialism inevitably leads to tyranny. He compiled all of this information into his 1944 book The Road to Serfdom. In it he warned against printing money without gold or other precious metals backing it. He believed that the free market is the most efficient way to preserve our freedom and conduct business. Simply put, he believed that government should be as small as possible and stay out of the economy and our lives because, it is impossible for government to make decisions for you better than you can. Under Hayek’s philosophy prices rise and fall with supply and demand and that a depression can be solved by letting the market settle on a new equilibrium. (Hayek, 1944)

In the blue corner we have John Maynard Keynes a British economist. Keynes served as a financial advisor to England during both world wars. He also watched the deep depression that happened between the wars. He saw the British government step in during the time of war to facilitate the British war machine. He saw unemployment at nearly zero and the total output of the country rising as the government spent more than it collected in taxes to fund the war. This experience became the foundation for his magnum opus 1936 The General Theory of Employment, Interest, and Money. The General Theory has been the blueprint of nearly every world power’s economy for the past 30 years. Simply put, the more the government spends, the more the people have in their pockets to spend on other things and the money circulates. He theorized that the way to fix a depressed economy is to print money and spend it to get the people money to spend for others to spend and so on. (Keynes, 1936)

As you can see, these two theories are the polar opposites of each other. These two schools of thought became known as the Austrian school of economics and the Keynesian school or Keynesianism. The question is who is right? I intend to answer this question in three ways. First we will look at government spending in the American economy during the great depression, World War 2, and after. We will look at government intervention in markets and its effects. Lastly we will look at the effectiveness of a central bank, fiat currency, and its effects on the economy as well as on the money itself. In the words of the rap battling parody of F A Hayek, “prepare to get schooled in my Austrian perspective”. (Stories, 2010)

Government spending on the economy 1929-1948

The great depression and World War II were some of the world’s darkest times. Many economists to this day see the depression and the apparent economic boom during and after WWII as evidence of validity of Keynesian government spending. There are three very prevalent myths about the great depression that should clear up thinking on the matter. First it is important to understand something of the depression before we pick apart its causes and ends. It began in 1929 with the stock market crash. At the end of 1928 the Federal Reserve, America’s central bank, began raising interest rates because stock of speculation, in other words, prices were rising without actual value being added to the economy. It should be noted that the purpose of the Fed at this time was to prevent a crash. When industry slowed in 1929 and overall growth turned negative beginning the recession that led to the crash. In 1933 unemployment was at an all-time high of 25%. (world, 2013)

The first myth is that Herbert Hoover was subscribed to a small government Austrian philosophy and not only allowed the collapse but that he was the cause of it because he didn’t do enough to stop it. The truth is exactly the opposite; Hoover was a CEO and tried to run the country like a business. He followed the Keynesian playbook to a T by deficit stimulus spending, or borrowing money to spend more than the country was taking in, in order to get people working again i.e.: the hoover dam. (Learn Liberty, 2011) On the surface this would seem to help the economy, but the government was only masking the symptom of unemployment buy not creating permanent jobs. The government was borrowing money to build roads and dams, but this was unsustainable and at some point the country would have to get back on its own feet. Hoover also raised tariffs, or taxes on goods coming into the United States. Again, this seems like a way to help the farmers who were experiencing a drought. This answer too was shortsighted because in protecting the prices of things like wheat and corn for American farmers, it hurt the average man because now prices that would have been much lower for basic foodstuffs were much higher as a result of the government. It was exactly this kind of intervention that Hayek warned about. (Hayek, 1944)

The second myth was that Franklin D Roosevelt’s New Deal ended the great depression. The New Deal was Roosevelt’s plan for fixing the economy by spending money. In many ways it was a continuation and acceleration of Hoover’s plan. When hoover lost the election in 1932, Roosevelt was elected to fix the economy. The problem with that thinking is that it requires the president to intervene. When a detoxing addict cries and begs for a hit, the worst thing you can do is give it to him. Most experts now agree that the new deal elongated the depression instead of helping. The rest of the world recovered much more quickly than we did. The easiest way to show this would be Great Britain. They followed us into the great depression and an argument could be made that they had it worse, but their healthy fear of government control led them to take a more hands off approach. They pulled out of the depression by 1933, and afterword had a time of economic growth. America on the other hand pulled out of the depression much later, which will be discussed in myth 3. (Chitester, 1977-1978)

The third myth is that World War II ended the great depression and saved the economy. The numbers do seem to prove it, unemployment was down to zero and GDP, the total amount of goods and services the country produces, skyrocketed. First, let it be said that it is really easy to get to zero percent unemployment, start a war and institute a mandatory draft. This myth can be easily debunked with logic. Let’s say that everyone was employed making shells and tanks for the military, we would have full-employment but, nothing to eat. People work to live better and provide for themselves and their family. Prosperity only emerges when people produce what is demanded. With that in mind, it would be difficult if not impossible for society to prosper in wartime America, even though we had full employment and our GDP skyrocketed with the production of every new weapon of war. The demanded resources that were being produced were rationed and thus less of those products were consumed. When you strip out the war production, we didn’t emerge from the depression till around 1948. (USgovernmentspending.org, 2013)

With these three myths debunked it is clear that government spending, especially money it doesn’t have is a short term fix elongating a long term problem

Government intervention in markets and their effects

In the model of the island and coconuts we saw some of the effects of government intervention. There are two ways that government intervenes in markets, from the suppliers and the consumers.

When the government wants to affect the supply of a good, it is normally done through tariffs, regulation, and taxation. As stated earlier, government tariffs are taxes on foreign goods to limit their ability to be competitive in the US. Have you ever wondered why there is high fructose corn syrup in nearly everything but actual sugar is quite rare? It is because we tax sugar which normally isn’t made in the US and give tax breaks for corn farmers because corn is one of America’s biggest export goods. This brings the price of producing corn down and the cost of sugar to everyone else way up. The second way governments get in the way is through regulation. As companies have more and more hoops to jump through, they have to spend more and more money on jumping through those hoops. The cost of the hoop jumping is then tacked onto the product and we, the common man, has to pay more than we would have to otherwise. It could be said that those hoops have to be there to keep us safe, but we as consumers make decisions about these sorts of things all the time. When you go to that hole in the wall restaurant for really cheap food, you are making a decision and taking a risk. If that restaurant were found or even thought to be serving horse meat, you would have grounds to sue and they would be ruined. So the market weeds out bad service and standards on its own making government involvement redundant and wasted tax dollars. The last way that government affects the suppliers in markets is through taxation. Simply put, a tax on a corporation is actually a tax on the consumer because they raise prices to compensate. The world renowned Economist Milton Friedman loved to say, “Can you tax business? What is business? There is no business to be taxed. There are people, only people can pay taxes. Can I tax this floor or this building? Only people pay taxes, either the worker makes less, the consumer pays more, or the shareholder pays the tax.”

When government wants to affect the demand of a good, they tax it, regulate it, or ban it. It first must be noted that banning it never helps; prohibition is always a bad idea from an economic standpoint. Just as speakeasies sprang up as quickly as the police could shut them down in the 20’s, marijuana grow-houses will always be there. If someone wants a product there will be someone to meet that demand and thus we see the free market finding a way. Taxing and regulating things only works as long as the cost is not more than the customer is willing to pay. We regulate cigarettes and alcohol but the people who shouldn’t have them always find a way. If we taxed cigarettes an extra 10 dollars, a black market would emerge. (Learn Liberty, 2011)

In both instances we see that government intervention in the market leads to redundancy, inefficiency, and a waste of your tax dollars. The market regulates itself through prices. If people charge more than something is worth, no one buys it. If someone charges not enough, they either catch on quick or go out of business, making room for more efficient companies. (Hazlit, 1962)

Central Banks and Fiat Money

There was a time in our nation’s history that you could take your dollars to a bank and exchange them for gold. Every dollar printed was tied to gold owned by the government and that kept a lid on spending. In the same way that a household might begin to pay in cash to make sure they stayed within a budget, the government was held accountable in the same way. This also meant that the value of the dollar was tied to the value of gold. This began to change during the great depression, where the government saw the lure of Keynesian deficit spending and ran up an enormous debt. To be fair, in terms of our current national debt it didn’t even make a dent. To bring it back to our model, the family got a credit card. Roosevelt ran a deficit of 30% of GDP, meaning that he basically spent a everything the government made plus a third of value of every good and service produced by everyone in the country combined. (Tullock, 2013) When the dollar left what was referred to as the gold standard, everything changed for America. Now, politicians could spend as much as they like because the dollar was the most stable currency. This meant that the world began to use dollars for international trades, because there were so many of them and America wasn’t going anywhere. This was our Achilles heel, because all of a sudden we could print and print and the world still wanted more. This is known as inflation. If you imagine that there are 100 dollar bills in the world, you own 100th of America, if there are 100 billion dollars in the world, you own 1 billionth of America. It is a crude example, but it makes the point. This is how we have amassed such a large debt, by spending and printing. This is how we fund social security, FAFSA grants, 2.5 wars and everything else the government does. The interesting part is that it is in the best interest of the countries that hold our debt to keep buying it so that the dollars we owe them are still worth something. A dollar is only worth what someone will give you for it. (Hazlit, 1962)

As it can be plainly seen, the ideas of Keynes are like a college student who has partied too hard and drank too much. In the morning this person, in lieu of sobering up, decides to continue to drink in order to not have to feel the effects of the hangover. It may work for the short term but at some point the bottom drops out.

Works Cited

Chitester, B. (Director). (1977-1978). Milton Friedman: Free to choose [Motion Picture].

Hayek, F. A. (1944). The Road to Serfdom. Chicago: University of Chicago.

Hazlit, H. (1962). Economics in One Lesson. New York: Three Rivers Press.

Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: Palegrave-Mcmillan.

Learn Liberty. (2011, June 17). Top Three Myths about the Great Depression and the New Deal. Retrieved from Youtube: http://www.youtube.com/watch?v=7QLoeehMw0w

Stories, E. (2010, January 23). “Fear the Boom and Bust” a Hayek vs. Keynes Rap Anthem. Retrieved from You Tube: http://www.youtube.com/watch?v=d0nERTFo-Sk

Tassava, C. J. (2010, 02 05). The American Economy During World WarII. Economic History Association Encyclopedia, pp. 1-5.

Tullock, G. (2013, 09 03). Government Spending. Retrieved from The Concise Encyclopedia of Economics: http://www.econlib.org/library/Enc1/GovernmentSpending.html

USgovernmentspending.org. (2013, 03 09). US government spending since 1900 . Retrieved from USgovernmentspending.org: http://www.usgovernmentspending.com/spending_history

world, T. c. (2013, 03 09). Great Depression in the United States. Retrieved from Wikipedia: http://en.wikipedia.org/wiki/Great_Depression_in_the_United_States