Friedrich A. Hayek: Champion of

Individual Liberty, Limited Government, and Free Markets

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Economic Fallacy

It amazes me to see so many lay-people as well as professional economist who subscribe to Keynesian economic theory, i.e. government intervention is necessary for a smoothly functioning system.  The current claim by the Democrats that the Health Care system is another example of a free market failure is typical fallacious reasoning.

The basis that is used for this is usually the Great Depression.  

In 1920's were a period of tremendous economic expansion; the nation's total realized income rose from $74.3 billion in 1923 to $89 billion in 1929 (20% growth over 6 years).  Then in October 1929, the stock market crashed, but though this is often cited as the primary cause of "The Great Depression", it was actually only a trigger for a recession, much like we have recently seen.  The actual exacerbating causes were inept government intervention.

"The Depression, I may say, which started in 1929 was rather mild from 1929 to 1930. And, indeed, in my opinion would have been over in 1931 at the latest had it not been that the Federal Reserve followed a policy which led to bank failures, widespread bank failures (40% of banks closed), and led to a reduction in the quantity of money. 

What happened was that for every $100 of money, by which I mean the cash that people keep in their pockets, and the deposits they have in the bank, for every $100 of money that there was in 1929, by 1933 there was only $67. The Federal Reserve allowed the quantity of money to decline by a third. While, at all times, it had the possibilities and the power of preventing that from happening." - Milton Friedman

In addition to these mistakes, we can look at another analysis of the causes and see that they also contributed as well.  But where this authority sees the contributing factors as due to a lack of government intervention, it is astonishing to see the same factors pointing to the culpability of government intervention:

In contrast, economist Charles Kindleberger, in The World in Depression, 1929-1939, sees the depression as a global event caused by a lack of world economic leadership. According to Kindleberger, Britain provided leadership before World War I. It fostered global trade by keeping its markets open, promoted expansion by making overseas investments, and prevented financial crises with emergency loans. After World War II the United States played this role. But between the wars no country did, and the depression fed on itself, Kindleberger argues. No country did enough to halt banking crises, and the entire industrial world adopted protectionist measures in attempts to curtail imports. In 1930, for example, President Herbert Hoover signed the Smoot-Hawley tariff, raising tariffs on dutiable items by 52 percent. The protectionism put an extra brake on world trade just when countries should have been promoting it. - Concise Encyclopedia of Economics (excellent treatment of the entire scope - highly recommended)

Looking at Kindleberger's premise, I don't see how he can feel there was not government intervention based on the protectionist measures widely adopted - other than the failures already pointed out by Friedman.  

And the third major factor was the false faith in the Gold Standard, which caused conflicting monetary policies restricting intervention to prevent monetary contraction:

"Maybe—and maybe not. In fact, the Federal Reserve faced conflicting demands to end the depression and to protect the gold standard. The first required easier credit, the second tighter credit. The gold standard handcuffed governments around the world. The mere hint that a country might abandon gold prompted speculators and international depositors to change local money into gold or a convertible currency. Deposit withdrawals spread panic and squeezed lending. It was a global process that ultimately forced all governments off gold. In May 1931 there was a run against Creditanstalt, a large Austrian bank. The panic then shifted to Germany and, in late summer, to Britain, which left gold in September.

The United States was trapped by the same forces. After Britain went off gold, for instance, the Federal Reserve raised interest rates sharply to stem gold outflows. The discount rate went from 1.5 to 3.5 percent, which, considering the condition of the economy, was a huge increase. The best evidence that the gold standard fostered the depression is that once countries abandoned it, their economies usually began growing again. This happened in Germany, Britain, and, after Roosevelt left gold in March and April 1933, the United States." - Concise Encyclopedia of Economics 

It is subsequently argued that much of Roosevelt's New Deal  - apart from ending the Gold Standard - actually did nothing to aid economic recovery and actually much to hinder it.  Roosevelt was not only responsible for the start of the welfare state in the US, but also the seeds of class warfare carried on to this day by Roosevelt's descendants - the Democratic Party. "Roosevelt increasingly blamed the depression on the wealthy—"economic royalists," as he called them." - Concise Encyclopedia of Economics 

Once World War II began Keynesian economics was fully adopted for the war controlled economy and hailed as a great success for ending the Great Depression and eventually the post-war recovery.  This fallacious reasoning went on until the 70's when the economy was overtaken by inflation and stagnation, despite huge regulatory increases and deficit spending - a circumstance which should have been impossible in Keynesian economic theory.

Some interview excerpts from "The Commanding Heights" about this period and what it took to turn it around into the greatest economic expansion the world has ever seen before:

U.S. Supreme Court Justice STEPHEN BREYER heading a Senate investigation of airline regulations: "And it turned out that 5 percent of their (Civil Aeronautics Board) time went to stop prices that were too high and 95 percent of their time went to stop prices that were too low, but always the effort was to keep the price high and not low...(after the CAB was closed down) 20 years later, the industry was employing two times as many people to fly almost three times as many passengers."

"MARGARET THATCHER (interviewed in 1993): The spirit of enterprise had been sat upon for years by socialism, by too-high taxes, by too-high regulation, by too-public expenditure. The philosophy was nationalization, centralization, control, regulation. Now this had to end.

NARRATOR: Thatcher squeezed government spending and cut subsidies to business. Thousands of bankruptcies and higher unemployment followed. Many saw her as uncaring. Britain had rarely been so divided.

PAUL VOLCKER: It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon...

LARRY LINDSEY, Assistant to the President for Economic Policy: Jimmy Carter was maybe the high point of Keynesian behavior. And it simply was not working.

GEORGE SHULTZ: Toward the end of the Carter administration, with inflation out of control, Paul Volcker was made chairman of the Federal Reserve. He understood the problems...

NARRATOR: Volcker used a blunt weapon: He tightened the money supply. The economy went into a nosedive. Facing a presidential election, Carter was reluctant to back such harsh measures.

Carter's rival was the Republican Ronald Reagan. Reagan shared the same economic philosophy as Margaret Thatcher. For over 20 years, he had been campaigning against the Keynesian orthodoxy and for Hayek and Friedman's ideas of free markets and freedom.

NEWT GINGRICH, Speaker, U.S. House of Representatives, 1995-1999: Reagan knew Hayek personally; he knew Milton Friedman personally. And Reagan was, in a sense, their popularizer. So he was the person who would take these people who were very profound but not very easy to communicate. I don't think you'd ever get Hayek on the Today show, but you could get Reagan explaining the core of Hayek with better examples and in more understandable language.

RONALD REAGAN, U.S. President, 1981-1989 (in a campaign speech): Vote for me, if you believe in yourself, if you believe in your right to control your own destiny and plan your own life, yes, and have a say in the spending of your own money.

The president is going to have more government on the backs of the people and of business and of industry, the working people, in order to try to solve the problems that were created by too much government on our backs...

MILTON FRIEDMAN: The situation was this: The only way you could get the inflation down was by having monetary contraction. There was no way you could do that without having a temporary recession.

GEORGE SHULTZ: Obviously, who wants a recession? But I can remember President Reagan using those famous words: "If not now, when? If not us, who?"

NARRATOR: Reagan offered Volcker his moral support in the fight against inflation. As Volcker tightened the money supply, the economy slowed and contracted. Unemployment hit 10 percent. Nobody had realized quite how tough it would be.

All across the heartland of America, ordinary people were hurting...

PAUL VOLCKER: If you had told me in August of 1979 that interest rates, the prime rate would get to 21.5 percent, I probably would have crawled into a hole. I would have crawled into a hole and cried, I suppose. But then we lived through it. (laughs)

NARRATOR: It had taken three years -- three years of growing public anger, three years of real hardship for millions of Americans. But by 1982, the dragon of inflation had been slain.

PAUL VOLCKER: What changed drastically in the 1980s and running through today is the kind of presumption that inflation is bad. The primary job of a central bank is to prevent inflation. That's a very different environment than the '50s and '60s...

NARRATOR: Reagan and Volcker had set the United States on a new economic course.

RONALD REAGAN: From our very first day, we have been working to undo the economic wreckage they left behind.

NARRATOR: They called his policy Reaganomics. It had four key elements.

The first was the concept of sound money. The second was deregulation. The third was modest tax rates. And the fourth was limited government spending. Sounds pretty conventional now, but when Reagan was elected, he was vilified by his opponents as being some radical extremist.

RONALD REAGAN: They just can't accept that their discredited policies of tax and tax, spend and spend, are at the root of our current problems.

NARRATOR: Reagan's tax cuts, the biggest in history, led to huge deficits. But the economy started to grow steadily again.

MILTON FRIEDMAN: There's no doubt in my mind that those actions of Reagan, lowering tax rates, plus his emphasis on deregulating unleashed the basic constructive forces of the free market, and from 1983 on, it's been almost entirely up.

Thus, in a very brief overview, the firm conclusion that von Mises, Hayek, and Friedman were right and Keynes was wrong.  To see how Keynes' and Hayek's economic theories played out around the world and eventually ended in the recognition of the superiority of free markets, watch or read "The Commanding Heights" PBS online documentary.  It is extraordinary.  But not surprising when you hear how Keynes, in his later years, tells Hayek that he was probably right, but died before he could refute himself.


All information on this and referred pages should be distributed widely (with appropriate references to sources) to spread Hayek's principles to as many people as possible and move our countries toward more ideal conditions for all people.

Feel free to contact me with questions and comments: St. Augustine, Florida, USA - These pages last updated: July 17, 2003.

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