The American Presidential Election:Hayek versus Keynes Revisited

Prof. Harold Chorney, Concordia university Montreal, Québec

Hayek Versus Keynes Revisited :Macroeconomic Policy and the American 2012 Presidential election    paper to be presented to MPSA meeting, Chicago. 2013    Provisional copy

The recent American presidential election revealed that little has been learned from the tragic circumstances of the great depression by at least one of the great American political parties . During that depression one of the great theoretical and technical debates was over the appropriate economic policy to rescue America from the deep depression it fell into after the crash of 1929 and the failure of the American administration of Herbert Hoover whose intentions may well have been better than his historical reputation suggests, to respond aggressively enough to stimulate the economy. His error was compounded by the failure of the Federal Reserve to act aggressively enough with respect to the money supply and the level of interest rates cuts needed to pull the U.S. out of its deep slump.

During this period the great debate in economic theory and policy was between the Austrian economist Freidrich Hayek who was brought to London to a position at the LSE in order to counter John Maynard Keynes  and his circle at Cambridge. Hayek’s views about the crash and crisis was based on a strong belief in the efficacy of markets and their natural path of evolutionary development including their capacity to heal and the original over investment theory of crisis that he developed at length in his work on the business cycle and prices and production. Keynes himself a student of  one of the leading  founders of market neo classical thought, Alfred Marshall,  was a major advocate of market capitalism . But Keynes’s experience in the first world war and its aftermath had taught him that market perfection and theory needed to be adjusted for the real practical problems that beset problem solving, particularly when politicians are involved and human emotions and reason itself are the subject of destabilizing uncertainty.




The 2012 Presidential campaign was largely fought over the issue of unemployment, slow economic growth and the relative  failure or success of President Obama’s economic policy which sought to promote a rapid recovery from the crash and subsequent prolonged business cycle  downturn.  The economic recession accompanied as it was by severe financial instability  had turned out to be the worst recession since the great depression . Indeed, as it initially unfolded in 2008-09 it

threatened to be even worse although the collapse in the GDP was considerably smaller than in the period following 1929. There were , of course, other issues including foreign policy, immigration, education, leadership and health care but it does seem clear that macro-economic policy debates played a leading role  in the election.

Exit polls from Fox News for example, reveal that the economy ranked first as the most important issue chosen by 59 % of some 26,656 respondents to the poll as compared to health care 18 %, the deficit 15 % and foreign policy 5 %. This preference for the economy was stronger among Republicans than Democrats for among the voters sampled who ranked it first, 51 % supported Romney while 47 % supported Obama. For those who ranked health care first  75 % preferred Obama while 24 % preferred Romney. For those who supported the Tea party not surprisingly 87 % supported Romney  11 % Obama.(  see  Fox news election day exit polls    /   The Washington Post exit polls showed that 30 % of those polled rated the economy as poor and they overwhelmingly voted for Romney. 45 % of voters rated the economy as not so good and their vote split between Romney and Obama with Obama having a slight edge. 23% rated the economy as excellent or good and they strongly supported Obama. (http://www.washington

Both the Republicans and the Democrats argued that their approach to managing the economy was the superior choice. The fact that unemployment had dropped below 8 %(as of  September 2012) was proof to the Democrats that their policy had been the correct one. In the case of the Republicans the proof  that supported their position lay in the fact that unemployment had been stuck above 8 % until September and had only dropped because of the increase in discouraged workers who had dropped out of the labour market. Even now with the rate having dropped to 7.7 % as of February, 2013 (U.S. Bureau of Labor statistics)the Republicans are very reluctant to admit that Obama’s strategy of stimulus has been the driver of the reduction. Instead they begrudgingly suggest the explanation is in the potentially “inflationary” nature of the expansion of the balance sheet at the Federal Reserve conducted by Fed chairman Ben Bernanke. They also point out that the drop in unemployment is rather slow in coming and that a large number of Americans remain unemployed. This is, of course, correct , but nonetheless the Democrats are correct to point out that the rate has slowly but steadily dropped. Even the broad measure of unemployment U6 has also fallen to 14.3 %.This is still very elevated but substantially improved over what it had been a year after President Obama had taken office.

Furthermore , Democrats make it clear that the Republicans through their strategy of obstruction and gridlock have prevented the passage of any further stimulus bill or specifically targeted investments in education, infrastructure or capital works designed to target unemployed workers and lower the rate more quickly.

Currently as I write this in March 2013 we are at the beginning of the sequestration experience with a monthly total of 100 billion $ of cuts being imposed across the board in all areas of government services including defense, income transfers to the poor, border security and guide tours of the White House. This impasse may continue for some time as the Republicans so far have refused to agree to tax increases or the closing of loopholes and the Democrats refuse to countenance cuts in what they regard as key aspects of the social democratic minimum.

In the view of a Canadian outsider and I say this  with the greatest respect to both sides in this debate, the President seems to have made a mistake in agreeing originally to the sequester believing I suppose that it would never happen, perhaps thereby misjudging the Republicans and the tea party groups’ determination to cut back government expenditures and their apparent antipathy to the current status of the social democratic minimum in American society.(See my discussion of Ira Katznelson’s concept of the social democratic minimum  and the notion of entitlements on my blog Dec.8, 2012)

But what theoretical models and arguments lay behind these two opposing positions.? The debate just like the debate in the 1930s turned around two diametrically opposite models of macro-economic behaviour. The Republicans under the leadership of Mitt Romney and the influence of the Tea party drew their economic advisors for example Douglas Holz Eakin, Robert Lucas,John Taylor and other Chicago oriented freshwater economists  from new  classical economics, the tradition of laissez-faire and the tradition of Austrian economics represented by Von Mises and Friedrich Hayek and their approach to business cycle theory, as well as classical economic thinking which has its spiritual home in Chicago. The new classical macroeconomics which banished the notion of aggregate demand and substituted rational expectations for uncertainty and less than full employment was in many ways a restatement in a more mathematically sophisticated way of much of what Hayek argued.( On uncertainty in Hayek as opposed to in Keynes see the work of Stephen Block and his contribution to the discussion on the Hayek list with Steve Horowitz

President Obama and the Democrats and their policy advisors drew instead from the work of John Maynard Keynes and American Keynesians like Alvin Hansen, John Kenneth Galbraith and James Tobin and contemporary exponents of these views include Joseph Siglitz, Paul Krugman, Jared Bernstein, Alan Blinder, Brad Delong and other Keynesians and post Keynesians including myself.

The populist  work of Thorstein Veblen also played a role. The crisis theory of Hyman Minsky also had influence, at least on Wall Street. The paper explores these issues and documents the historical roots of the two campaigns in these two competing paradigms.

During my career as both a student and as a professor I have  had the pleasure of meeting a number of leading British and American Keynesians. I listened to Galbraith in person on a number of occasions, attended personal talks by Joan Robinson and Roy Harrod, met Geoff Harcourt at Cambridge, spent some time with Robert Eisner, met the Keynesians at McGill who were closely linked to Cambridge and discussed Keynes with Robert Skidelsky in Keynes’s former house at Tilton near Lewes 23 years ago in Sussex,(which incidentally is apparently part of the Gage estate . General Gage lost the Battle of Bunker Hill to the American revolutionaries ( see N.Wapshott, Keynes Hayek:The clash that defined modern economics,p.307, note 24. NY:W.W.Norton, 2011) )I was educated in Keynes’s economics at the University of Manitoba by teachers who had close contact with the first generation of Keynesians and at the London School of Economics where I also took lectures from Harry Johnson, a leading monetarist economist who along with Friedman must be considered one of the founders of the modern monetarist school. Johnson was a fellow student at Chicago with my M.A. supervisor Rubin Simkin who remained a Keynesian despite his Chicago studies. I also on one occasion heard Hayek himself speak at the LSE. My first supervisor at the LSE was Max Steuer, an American whose family had a personal connection to FDR. I also have come to know full employment oriented American economists like Helen Ginsburg and political economists like Trudy Goldberg who have been very active in promoting full employment in policy circles.I also wrote about quantitative easing which I called temporarily monetizing more of the debt during a slump as a useful policy approach during the 1980s and 1990s. So I have a long standing interest in and knowledge of these debates.

It is striking how much of that old debate between these giants of economic policy thought and macroeconomics had come to life again in the recent Presidential campaign.

Keynes’s economics is usually associated with President Roosevelt’s New Deal. A careful study of the New Deal reveals that Roosevelt began his Presidency on a rather conventional sound finance basis. Indeed during the 1932 election campaign he ran on the slogan of a balanced budget. It was only after the failure of these ideas to reverse the depression that he gradually changed his position so that by 1938 he was firmly in the Keynesian camp. But almost from the beginning of his presidency Roosevelt recruited reformers and Keynesian economists to his side . These included the following : Mariner Eccles, the Utah banker who ended up chairing the Federal Reserve who independently had arrived at positions similar to those of Keynes; Rex Tugwell who was part of the brain trust around Roosevelt; Lauchlin Currie, a Canadian who had studied economics in Britain at the LSE and also at Harvard and had become convinced of the rightness of Keynes’s views and who, in turn,  recruited number of younger Keynes inclined economists to come and work for Roosevelt; Adolphe Berle  a lawyer who in 1932 with Gardiner Means  wrote the definitive book The Modern Corporation and Private Property on concentration of ownership and the need to do something about it through policy reform.  Currie recruited John Kenneth  Galbraith who had studied Keynes carefully and spent a year at Cambridge immersed in the Keynes circus in 1937 and Harry Dexter White. who was to play a key role at Bretton Woods in 1944. All of them played important roles in Roosevelt’s administration.(see J.K.Galbraith, Economics in Perspective,pp 178-266; Michael Hiltzik, The New Deal; and Richard Parker’s biography of Galbraith, John Kenneth Galbraith:His Life, His Politics, His Economics.)

The essence of Keynes‘s General Theory was that after a financial crash an economic slump was inevitable due to the collapse of aggregate demand and the shattering of confidence on the part of both entrepreneurs and investors and consumers. Aggregate demand was composed of C +I+G-T +X-M where C was consumption, I was investment, G was government spending on consumption and investment and T was taxes, X was exports and M imports.

The appropriate policy response in such circumstances was to stimulate the economy through government expenditures while at the same time keeping taxes low , rates of interest low and promoting confidence in the possibility of recovery by diminishing fear and uncertainty and reawakening animal spirits thereby stimulating consumers to spend and entrepreneurs to invest. Keynes developed, along with his colleague R.F.Kahn, the notion of the multiplier which made the case for arguing that a given program of additional investment would have a multiplied impact on the GDP. Kahn showed in his research and published work that depending upon the marginal propensity to consume of average consumers the initial money spent would be multiplied as it circulated through the economy with each subsequent consumer spending a declining amount in each subsequent round. Using a geometric progression he was able to calculate the size of the multiplier. Once adjusting for leakages for money not respent or spent on foreign imported goods Kahn and Keynes believed the multiplier would be about 2 to 2.5.

The multiplier became an issue in the American political campaign when critics of the stimulus claimed basing themselves on the research of Robert Barro, a Chicago School leaning economist that the multiplier was very small and even less than one. Keyesians and the Congressional budget Office dispute this and argue the multiplier was between 1.5 and 2.5 depending on where in the economy the first round spending took place. It was highest if infrastructure was targeted. (see the discussion of this on my word press blog)

The General Theory also demonstrates that unemployment is not voluntary because of inadequate job search or because workers are unwilling to accept the wages on offer. Rather the labour market clearing mechanism does not work in the way that classical economists like Hayek or Friedman believe it to work. Keynes argues that attempts to cut the  level of real wages so as to bring labour supply and labour demand into equilibrium will not work because the wage cuts are socially destabilizing and too onerous to tolerate in a democratic society. Furthermore, no worker nor its trade union on their own can determine the rate of inflation which is the outcome of millions of decisions. Consequently Keynes rejects the second classical postulate that the wage is always equal to the marginal disutility of work. Contrary to the classical position in a slump it is possible to reach a stable situation at considerably less than full employment, particularly if interest rates cannot be lowered further –the liquidity trap position.

Savings are a subtraction from spending so during a slump it is advisable to concentrate of stimulating spending since savings do not automatically flow into investment. Instead ex ante savings will lead to the economy adjusting downwards to bring savings ex post into equality with investment but at a lower level of economic activity. Keynes and Keynesians therefore believed that in the circumstances of a slump following a financial crash it is necessary to use deficit finance to finance a stimulus program focused on investment, consumption and restoring entrepreneurial animal spirits. This stimulus needs to be accompanied by an accommodating monetary policy of as low as possible interest rates too ensure that the deficit is effective and to prevent any financial crowding out. Keynes also establishes the fact that financial markets are governed by considerable uncertainty and hence are prone to periodic crisis. He elaborates this position in his chapter of the GT devoted to long term expectations.

“ In one of the greatest investment markets in the world , namely New York,, the influence of speculation is … enormous. .. Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be.” Hence, investors in the markets who rely on this sort of judgment are apt to have very short time horizons and be searching for capital appreciation primarily. This makes them speculators rather than investors. “Speculators do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.” (p.159  GT.)Keynes believes that the socially important function of financial markets in allocating job creating investment is harmed by the focus on speculation rather than investment. Recent events appear to confirm this. Investment is simply too important a component of aggregate demand to be left to the unregulated financial markets.

Regulation of the investment process and the financial markets is an essential necessary aspect of any recovery program. From this quick and simplified summary of Keynes’s theory and policy prescription it will have become clear that despite an imperfect fit there is a strong association with President Barack Obama’s program that was presented and defended in the Presidential election of 2012. It is not a perfect fit because of President Obama’s rather un-Keynesian willingness to emphasize deficit reduction before the economy has sufficiently recovered from the slump. I suppose this was because it was considered too hard of a sell politically after the negative reaction to the stimulus by Republicans and many ordinary citizens who confused it with the TARP bailout. (See the discussion of this in Paul Krugman, End This Depression Now )But it is otherwise quite Keynesian including a sometimes reluctant  defense of stimulus-albeit too small of a stimulus in the view of Krugman , Stiglitz and indeed myself, as well as a defense of Fed chairman Ben Bernanke’s policy of low interest rates brought about through quantitative easing, a policy reform I have long advocated, and an attempt to reregulate the banking and financial sectors.

Who were the advocates of this Keynesian thrust to the Obama presidency? Jared Bernstein, Larry Summers, Christina Romer, Peter Orzag, Tim Geithner, Gene Sperling,  Ben Bernanke, Alan Kreuger, Austin Goolsbee, Dan Tarullo were among the leading economic advisors during Obama’s first term. Rahm Emannuel was involved as a Obama’s chief of staff but he too was a business oriented finance man. But none of them, with the possible exception of Bernstein or in a very new Keynesian  narrow way, Summers could really be considered major Keynesian thinkers or Keynes specialists. Orzag was a specialist on budget matters and a fiscal conservative. Geithner, an historian by training was also a Republican and not a keen advocate of reregulation. Romer and Summers became defenders of Keynesian stimulus and the concept of aggregate demand during the first term in office. (See Susskind pp353-355)Obama apparently got his motivation to focus on infrastructure from his encounter with Alan Kreuger(Ron Susskind, Confidence Men p.19) who during his election  campaign had briefed Obama on what to do in case the housing bubble burst. In fact, at this point in Obama’s Presidency he seemed to have been more of a fiscal conservative than a Keynesian. Indeed, this is the argument of both Krugman and Stiglitz.

Summers had spent a fair bit of time on Wall street and had become a far more conservative advocate of deregulation than his uncle would ever had been, the Nobel prize winning Keynesian, Paul Samuelson. Ben Bernanke was a thoughtful monetarist Republican who because of his deep knowledge of the great depression was committed to keeping interest rates as low as possible. Goolsbee had originally advised Obama as he began  his campaign for the Presidency and his orientation was toward deficit reduction. Because of this mixture of personnel and agendas that ranged from Ben Bernanke’s intelligent monetarism to Bernstein’s informed progressive Keynesianism and the competing positions of the personalities involved there was no clear Keynesian spokesman on the economy. According to Susskind and to Alan Blinder who is a major neo-classical Keynesian economist this lack of a clear spokesperson harmed the political success of the Keynes program. (Blinder, p.217)Stimulus became an unwelcome term toward the end of the first term.

Health care, also an economic program as well as key social policy became the priority. The passing of Obama care is a major achievement of the Democratic administration with positive Keynesian consequences. However, Krugman points out that Obama could and should have passed a much larger stimulus package but did not because of the political opposition to it by the Republicans and some Democrats. But it was also because Summers had originally advised against it on the grounds , very un-Keynesian grounds one should add, that too large a package might spook the markets or the public and be counterproductive. This advice was delivered to the President as part of a 57 page memo on economic policy drafted by Summers for President elect Obama in December 2008. Summers also suggested erroneously in political terms that if the stimulus turned out to be too small more could be added later while an excessive stimulus could not easily be subtracted. (See Krugman, End this Depression Now! , p 125) So it would seem that, although, from hindsight, the Democrats were more or less Keynesian, much of it was the result of the circumstances of the crash and slump that obliged them, as it would oblige any rational government which was committed to pragmatic reason to undertake a stimulus and Keynesian measures coupled with a relatively liberal position on health care. However, the coalition government of Cameron, Clegg and Osborne in the U.K. and their dogmatic austerity policy demonstrates a different policy with quite different results can emerge.

But the Keynesian character of the Obama election campaign is the product of these circumstances and the ferocious anti Keynesian platform of Mitt Romney and the Republicans. Let us examine the extent to which it reflects Hayekian economics.

Friedrich Von Hayek came to maturity in Austria as a young man after the defeat of world war 1 and the devastating hyperinflation of the early 1920s. He came from a middle class household whose financial status had been destroyed by the great hyperinflation that in the minds of the Austrians and Germans was due to the destruction of the war and the excessive reparations demanded by the Allies  which Keynes had denounced in The Economic Consequences of the Peace.(See also Constantino Bresciani-Turroni, The Economics of Inflation:A study of currency depreciation in post-war Germany, Northhampton:Augustus M.Kelly, 1968 first published in Italian, 1931 as Le Vicende del Marco Tedesco.see in particular Lionel Robbins’s forward to the edition.Also see Wapshott; and Harold Chorney, The theory of the business cycle in Hayek, Schumpeter and Keynes, paper presented to the Association for Heterodox Economics meeting  July 7, 2001, London, U.K. posted on my blog, Sept. 13, 2011)Because Keynes had taken such a harshly critical view of the reparations, Hayek was initially well disposed therefore to Keynes. But  he was brought to London by Lionel Robbins

to lead the opposition to Keynes’s and Cambridge’s challenge to orthodoxy. He had met Keynes earlier in London in 1928 at an economics conference sponsored by Cambridge and the LSE. (Wapshott, p46)

Robbins wanted to challenge the hegemony of Cambridge in economics and he  recruited Hayek to give four lectures in February 1931 on the subject of his book Prices and Production in which he argued against the effective demand and public works stimulus orientatation of Keynes’s research and in favour of a theory that associated the slump with over investment in certain capital sectors. Hayek argued exactly opposite to Keynes that interest rates had been below the natural rate and that it was this that had triggered the crash and the slump. Unlike Keynes he also argued that markets were largely organic institutions that were self -correcting if not tampered with and allowed enough time to heal. Keynes’s circle at Cambridge was quick to reject Hayek’s argument because in the midst of the slump with unemployment soaring and unsold goods, suggesting as Hayek reportedly did to Richard Kahn and his Cambridge colleagues that the slump was due to inflation and going out to buy an overcoat would cause unemployment to rise, (See Wapshott, p.71)  seemed absurd. Keynes’s circle was not impressed.

Nevertheless, Hayek’s views are worth exploring because once properly understood they offer certain insights into business cycle theory. I remain a Keynesian but I respect the scientific effort which Hayek made(and Milton Friedman for that matter to make sense out of monetary policy and the mysteries of the business cycle. Furthermore as I wrote in 2001

in the clash between Hayek and Keynes and the reception of Keynes by Schumpeter and his own very different brand of market oriented conservatism there lies a fruitful terrain of debate and intellectual inquiry that can still be of considerable service more than half a century later whatever ones preferred theory of beliefs. What follows is partly taken from 2001 paper and further research on Hayek since then.



Friedrich Hayek’s theory of the trade cycle emerged out of the work he did in the 1920s and 1930s in response to the European economic crisis that followed World War I.  He was heavily influenced by his mentor Ludwig von Mises whose classic work The Theory of Money and Credit borrows from Knut Wicksell’s distinction between the natural and monetary rate of interest and Bohn-Bawerk’s work on the roundabout production of capital. (Prices and Production; Monetary Theory and The Trade Cycle) In both of these works he cites Mises extensively as a pioneer in the Mises-Wicksell theory of the trade cycle and its origins in divergences in the natural or equilibrium rate of interest from the market rate. (See for example, pp116 in Monetary Theory and the Trade Cycle)

Schumpeter argues in his History of Economic Analysis that Wicksell had no monetary theory of the cycle.  But “he opened the road for one”.  Knut Wicksell was a student of Eugene Bohm Bawerk and it is quite logical that the Austrian School should have been influenced by his work. (Laidler, citing Business Cycles also briefly mentions the work of Wicksell and the role of the rate of interest in the pace of capital investment, particularly in the area of railway construction.(p.127 & 604)

Wicksell’s cumulative process itself was built upon David Ricardo’s explanation of how new money inserted itself into circulation.  Ricardo’s theory, according to Schumpeter had been ignored until Wicksell revived it in his discussion of the cumulative process.

Wicksell pointed out that if banks keep their loan rate below the real rate –which as we know he explained on the line of Bohm Bawerk’s theory – they will put a premium on expansion of production and especially on investment in durable plant and equipment; prices will eventually rise; and if banks refuse to raise their loan rate even then, prices will go on rising without any assignable limit even though all other cost times rise proportionately. (p.1118)(See Hollander, 1992pp289ff&Ricardo, Principles of Political Economy, pp511) It is significant that Hayek began his lectures in London with a history of monetary thought and the relationship of money to prices and the role of individual exchange in the development of society. His goal was to clearly establish  the central place of money and exchange in a market capitalist society and their impact upon relative prices. (Wapshott, pp74-75) He was also determined to show the importance of the price of money, that is the interest rate and the round about method of production. (ibid) In order for capital rich goods to be manufactured people in Hayek’s scheme had to save. Relying on bank credit to promote capital construction was less reliable . Hayek believed that in a slump savings were insufficient to restore roundabout methods of production necessary to sustain a capital boom. Keynes actually tried to answer Hayek in the GT on this point in his chapter on Sundry Observations on the Nature of Capital in which he examines round about methods of production and the fallacy of equating an act of consumption with an act of saving in terms of its impact upon effective demand. For Keynes it is simply a false conflation to argue that an act of savings motivated by a desire for wealth “must, by increasing demand for investments provide a stimulus for their production, so that current investment is promoted by individual saving to the same extent as present consumption is diminished. “ (p.211,GT)

For Schumpeter, the Wicksellian emphasis upon a possible divergence between the real rate and the monetary rate of interest doesn’t alter the fact that interest is a net return to physical goods but permits one to regard the money rate “as a distinct variable in its own right that depends, partly at least upon factors other than those that govern the net return to physical capital (natural or real rate).”  In equilibrium they are equal but they are no longer fundamentally the same thing.

This distinction would later show up in the work of Keynes who uses the term own rate of interest to correspond to the natural rate and develops along with Irving Fisher the related, but not identical, notion of the marginal efficiency of capital i.e the marginal rate of return over cost.(p.1119 & Keynes, GT, pp.191ff, p.356, pp135ff).

According to Schumpeter Wicksell’s cumulative process need only be adjusted to yield a theory of the cycle.

Suppose that banks emerge from a period of recovery or quiescence in a liquid state.

Their interest will prompt them to expand their loans.  In order to do so they will, in general, have to stimulate the demand for loans, by lowering their rate until these are below the Wicksellian real rate.  In consequence firms will invest – especially in durable equipment with respect to which the rate of interest counts heavily(at least in the long run capital intensive investment) – beyond the point at which they would have to stop with the higher money rate that is equal to the real rate.”

The process is self-limiting however as the boom in investment inevitably leads to overinvestment and excessive inventories of capital goods which in turn leads to widespread losses, liquidation of loans and eventual depression.  Von Mises took up Wicksell’s and Bohm Bawerk’s notions and sketched out a theory of the cycle that was further elaborated by Hayek.

During the great depression particularly in the early years following the crash of 1929 Hayek’s theory which is clearly derived from the Austrian tradition and in turn from Wicksell and traceable back in certain respects to Ricardo attracted a number of important adherents, including many younger economists like Abba Lerner, Nicky Kaldor, Lionel Robbins and J.C. Gilbert.  Many of these soon gravitated away from Hayek to Keynes at Cambridge.  Robbins stuck with Hayek but later admitted he had erred in promoting the Hayekian view as a corrective to the deep depression of the 1930s.(See the discussion of this in J.C. Gilbert, 1982 p.91) and in Robbins’ autobiography, 1971.

Indeed while the Hayek version of the cycle has a number of fascinating aspects to it and can be quite useful in certain circumstances its policy prescription while comforting to the laissez-faire orientation of the Austrian school was politically inopportune during the great depression and economically also flawed.  This lack of political realism, however, was of no concern to Hayek.  In his preface to the second edition of the Denationalization of Money Hayek insisted upon the importance of asserting what he believed to be correct regardless of the practical implications.

“I strongly feel that the chief task of the economic theorist or political philosopher should be to operate on public opinion to make politically possible what today may be politically impossible, and that in consequence the objection that my proposals are at present impracticable does not in the least deter me from developing them.” (quoted in Daniel B. Klein, What do Economists Contribute? p.148, 1999)

In the long run, of course, the debate turns on the price and inflation consequences of prolonged low rates of interest and substantial deficit financed stimulation of investment.  But Keynes himself, as opposed to many of his followers harboured similar doubts about the long run sustainability of low unemployment without the return of inflationary pressures.  Notwithstanding his famous remark about “in the long we are all dead” Keynes understood the dangers of excessive inflation.  But during the depths of the great depression he was convinced that the short and medium run counted for more in terms of the priority of relieving the suffering of the unemployed.  As the economy recovered and the increase in aggregate demand played itself out partly in increased employment and partly in rising prices, he was prepared to take action once unemployment had fallen to reasonable levels.(See his discussion in The General Theory, the chapter on prices and his fundamental equations in Vol.1 of The Treatise on Money)

J.C. Gilbert has argued as long ago as 1953 that there ought to be a way to reconcile Hayek’s trade cycle theory, cleared of whatever errors it contains with the seminal arguments of Keynes, similarly cleansed of error.

“It seems clear that a synthesis of Austrian and Keynesian theory would be a step in the right direction…Hayek’s particular emphasis upon the immobility of labour and the heterogeneity of capital goods (can be) of vital importance in certain contexts.  There is a danger of thinking too much in terms of aggregates.” (Gilbert, p.92)  There may well be slumps that grow from the inflation process and the attempt to eliminate them that match rather well Hayek’s theories.

But as I shall argue below there is also a major Keynesian component even to these sorts of slumps that ought to be considered when searching for appropriate policy responses.  The re-emergence of rational expectations monetarism which had blindly asserted that inflation causes unemployment in all circumstances contains an arrogant positivistic certainty that I suspect that Hayek himself would have found unattractive.

Hayek however shared the view that in a slump the best option was to keep interest rates  high enough ,so that there was sufficient supply of  investment in round about capital rich processes and  income growth to encourage saving. Keynes did not agree and argued that Hayek and the Austrians had conflated the marginal efficiency of capital with the interest rate . (GT p.193) Indeed, Keynesians argue that one needs an accommodating monetary policy with low rates of interest to accompany a stimulative fiscal policy.

Hayek and Keynes

Hayek, of course, goes much further than D.H. Robertson in warning against artificially stimulating demand through the expansion of bank credit.  But Robertson also was worried about the eventual inflationary consequences of excessively expanded credit financed demand.  But then even, Keynes in his writing and in conversation with fellow economists was concerned that artificially lowered unemployment would entail price rise.  It was just that he appreciated how far they were away from that point during the deflationary era of the early 1930s.  (See Presley’s excellent discussion of Robertson’s work.  On Keynes’ debate with Robertson see CW, Vol.xiii part one preparation; see also Robertson’s definition of lacking, automatic lacking, dislacking, dissaving and hoarding and dishoarding, same vol. p302ff from a letter to Keynes, Sept.2, 1932)

Hayek has related the story of how he encountered Keynes not long before his tragic premature death and warned him about the dangers of inflation.  Keynes responded that he knew there might well be problems, particularly if some of his more dogmatic Keynesian followers dominated policy.  But he was confident, he told Hayek, that when the time would come he could easily use his command of verbal discourse to shift public opinion in the necessary direction.(A Tiger by the Tail, p.103, 1972)

In addition to these intellectual influences of Wicksell, Mises and Bohm-Bawerk, Hayek was profoundly affected as I suggested above by the peculiar circumstances of Vienna during his youth.  The Austrian socialists had come to power in 1919.  As in Germany under Weimar the problem of post war hyper inflation reared its ugly head.  Many of the wealthy classes including Hayek’s own family suffered a dramatic erosion of their life savings and wealth.  As Dostaler puts it “He live through the insecurity, the political crisis and the fear of an uprising from the extreme left.”

The Viennese social democratic municipal administration had resorted to heavy taxation to finance worthwhile housing projects.  But in the polarized circumstances of the 1920s these projects aroused resentment among the more affluent classes.  Hayek was deeply affected by these events and the construction of his theory of cycles based on the erosion of savings through excessive monetary expansion easily took root.  It was perhaps for this reason that Hayek so vehemently disagreed with Keynes about the role of saving in the economy.(Dostaler, p.149) Hayek also spent more than a year in the United States in 1923 and 1924 studying in New York attempts by the Federal Reserve to control US business cycles.

Hayek shared with Schumpeter a certain skepticism about the excessive cost of eliminating cycles.  Like Schumpeter he preferred to see cycles as an inevitable aspect of economic growth and development.  In the case of Schumpeter whose own theory of the cycle is heavily imbued with notion of waves of technological innovation and gales of creative destruction he eventually came to believe that Keynesian style regulation of the cycle would lead to excessive regulation and the destruction of the creative entrepreneurial spirit. (See his class Classic, Socialism and Democracy & his own work Business Cycles.)


In Hayek’s further development of the theory of the cycle he deepened the understanding that Wicksell, Bohm Bawerk and Mises had provided of the inflationary process.  Unlike the quantity theory with which his own theory is sometime wrongly conflated Hayek had a conception of relative prices that differs markedly from broad quantity theory aggregate conceptions.

Like Keynes but unlike Milton Friedman, Hayek believed in the non-neutrality of money.(Laidler in Collona&Hagermann)  Unlike Keynes, however, Hayek’s conception of the non-neutrality of money does not lead him away from laissez-faire.  For Keynes the non-neutrality of money is an important reason for rejection of Say’s law and all that it implies.  In Hayek it leads him to rather different conclusions.

In the Bohm Bawerk scheme of things round about production involved the key element of time and therefore, as in Keynes, elements of risk and uncertainty. (See the William Greer’s work that compares Frank H. Knight and Maynard Keynes’ notions of risk and uncertainty, Ethics and Uncertainty)

As Laidler effectively describes it “A decision to save was simultaneously a decision to consume at some time in the future, and simultaneously a decision to invest was a decision to devote currently available resources to the production of goods of a higher order which would then be used to produce goods of the first order at some future time.”(p.5)

Interestingly in Keynes a decision to save was a decision not to consume currently and a decision to invest was a decision usually made by a different actor from the one who decided to save thereby complicating the equalization of savings and investment over time except through the process of income adjustment.  In both the uncertainty was born of the introduction of temporality into the process.(See Shackle, Keynes and Fitzgibbons)

In the Bohm Bawerk schema the rate of interest would bring into equilibrium the savings and investment decisions inter-temporally (See Laidler p.5)  In the Keynes schema it was income aggregation that adjusted to ensure equilibrium of the savings and investment.  Because of Keynes’ Marshallian roots such an equilibrium process was presented as instantaneous but in actual fact Keynes’s argument could lend itself to a more complex adjustment process.

In the Austrian school the Wicksellian notion of divergence between the real rate and the money rate became the basis for a theory of the cycle.  The inter-temporal adjustment process could get out of wack as overinvestment as part of a boom driven by excessive monetary expansion resulted in a later bust and a liquidation of unhealthy capital.

Hayek explored this process in some detail in Prices and Production. His famous triangle diagrams in which he broke down the production process into its intermediate and final phases were intended to show the detailed process by which the expanded length of production attributable to the reduction in interest rates and the rise in the capital intensity of manufacture led to an overproduction of intermediate producer goods.  This overproduction entailed forced savings, a rise in prices,followed by a crisis due to overproduction..(Prices and Production pp.38ff; see also Desai & Redfern in Collona)

There would appear to be some relevance to this theory with respect to the sort of boom that occurred in the dot-come industries and the over-expansion of the hardware components sectors of the high tech sector.  The case of Nortel industries, a Canadian company in origin, is a revealing case in point.  The expansion of Nortel and the resulting bubble in its share values during 1999 and 2000 was followed by a resounding crash.  Share values fell from $120 plus per share to just over 15$ Canadian a share by late June 2001.  Major layoffs also occurred in the sector.  But the collapse having occurred the question is what is the best policy response to it.  Hayekians, would argue in favor of higher interest rates whereas Keynesians would argue in favour of low rates to restore confidence and stimulate demand.

From a contemporary “Keynes” point of view that I myself tend to, what undoes the former boom is the maladjustment between the distribution of wealth and income between savers and the average consumer.  As the boom intensifies it is accompanied by the contradictory monetary policy of the central bank and the excessive expansion of private credit renders the average consumer highly vulnerable to the ensuring contraction.  Additionally the pressure of the central bank to prevent undue monetary expansion also leads to excessive surpluses in public finance that while comforting to financial interests unduly constrains aggregate demand and simultaneously push investors toward riskier private issues.

The following crash in values and waves of bankruptcy reinforce consumer pessimism and depress animal spirits among investors.  The contractionary phase of the cycle is unleashed.  Relying upon the Hayekian policy prescription of higher interest rates after the crash has occurred will have a perverse effect of strengthening the downturn.

On the other hand, if the bank rate is raised sufficiently prior to the long boom getting out of hand but careful attention is paid to the impact of rises in the rate so that the rate rises are not excessive the boom may be managed to sustain the growth in employment and economic wealth.  This, however, assumes that excessive fiscal prudence doesn’t tip the economy into a slowdown despite the careful management of the bank rate.  Repaying the bondholders, as usually occurs under surplus budget regimes usually will complicate the problem of sustaining a boom.  The money will return to savers who will then more likely seek new investment rather than new expenditures.  Since no new net issues of debt occur in a surplus these would be investors are pushed toward riskier investments and quasi-hoarding.  This too undermines the boom.

As well, the overall inflationary environment must be accounted for.  If inflation is very low, say 1 to 3% there is a strong likelihood that debtors will be feeling the pressure of a rising private debt burden.  To the extent that debtors exceed savers their reaction in their purchasing behaviour will help influence the outcome in a contractionary fashion.

Some critics of Hayek argue that interest plays too small of a role in the overall scheme of investment to play such a critical role in cycle theory.  But here I believe Hayek is on stronger ground than his critics.  Despite the evidence of considerable internal financing most of my discussions with business people including those who manage huge funds exceeding 100s of millions of dollars reveal that interest rates still play a very important role, both in determining investments and equally importantly in affecting consumer behavior.  The initial Radcliffe view that tended to downplay monetary policy was clearly mistaken.

On the other hand, the orthodox view that dismissed fiscal policy I believe to be similarly mistaken.  Fiscal policy, particularly since it is bound up with debt management is very important.  One can best view the two as blades of a scissors that works best when co-ordinated to achieve the same objective.

So with this knowledge of Hayek’s basic argument and his belief in the organic nature of the market and the threat posed by statist intervention let us examine the Republican campaign for the Presidency. The Romney campaign’s principal economic advisors in addition to himself were Glenn Hubbard of Columbia school of business, Greg Mankiw  from Harvard and Kevin Hassett of Columbia and the American Enterprise Institute. None of them could be thought of as Hayekians although all were influenced by the rational expectations new classical macroeconomics school which arrives at conclusions quite similar to Hayek. Mankiw understood new Keynesian thinking but  he had a negative view of original Keynesian ideas.(See his Principles book and see Forbes 11, 06 , 2012 John Tamny, Romney’s economic Advisors cost him the election.

Since Romney spent a fair bit of time with Ron Paul on the debates trail he would have been exposed to his Hayekian message and that of the Tea party which is quite Hayekian in its argument. The other figure with influence  seems to have been Paul Ryan, his vice presidential candidate who was his budget specialist and who claims to be influenced by Hayek’s work, The Road to Serfdom.

Among  the professional advisors in the Republican party like McCain’s chief economic advisor Douglas Holz Eakin,  Hayek’s views would be known but one could scarcely call any of them experts on Hayek, with the possible exception of Ron Paul.

But the Republicans clearly staked out a position on deficits, debt, stimulus, interest rates and monetary policy and business cycles and the power of the market economy to recover on its own that are very close to those of Hayek and the position he articulated against Keynes in the 1930s. Since the new classical macroeconomics developed by Robert Lucas, Robert Barro and other followers of laissez-faire had become mainstream in the economics profession and their deliberate discrediting of Keynes it is not hard to understand how Hayek’s ideas promoted by neo-con think tanks became front and centre in the Republican party.

Lets examine the Republican platform and its preamble. Its worth quoting a passage:

Many Americans have experienced the burden of lost jobs, lost homes, and lost hopes. Our middle class has felt that burden most acutely. Meanwhile, the federal government has expanded its size and scope, its borrowing and spending, its debt and deficit. Federalism is threatened and liberty retreats.

This is clearly Hayekian in origin. (Note that  John Boehner, the majority leader in the House has recently admitted there is no immediate debt crisis MSNBC March 18, 2013)

On employment the Republicans made it clear that they did not believe in the stimulus and that free market policies were the way to go. Again quoting from the platform :

“The best jobs program is economic growth. We do not offer yet another made-in-Washington package of subsidies and spending to create temporary or artificial jobs. We want much more than that. We want a roaring job market to match a roaring economy. Instead, what this Administration has given us is 42 consecutive months of unemployment above 8 percent, the longest period of high unemployment since the Great Depression. Republicans will pursue free market policies that are the surest way to boost employment and create job growth and economic prosperity for all.”

Unfortunately for the Republicans the rate of unemployment dropped further so that at election time in November  2012 unemployment had fallen to just under 8 %. Still not as good a rate as should have occurred but nonetheless headed in the right direction. But clearly once again we can see how closely the Republican position resembles that of Hayek during the 1930s. No to artificial jobs. No to Keynesian stimulus. Yes to free markets. Yes to the idea that the market naturally over time can cure its own ills,

The platform further suggests that tax simplification and deregulation should be priorities. But on infrastructure the Republicans are somewhat more  Keynesian rather than Hayekian. They want infrastructure investment partnerships with the federal , state and private sector and they embrace state promotion of private industry.

“The tax system must be simplified. Government spending and regulation must be reined in. American companies must be more competitive in the world market, and we must be aggressive in promoting U.S. products abroad and securing open markets for them. A federal-State-private partnership must invest in the nation’s infrastructure: roads, bridges, airports, ports, and water systems, among others. Federal training programs have to be overhauled and made relevant for the workplace of the twenty-first century. Potential employers need certainty and predictability for their hiring decisions, and the team of a Republican President and Congress will create the confidence that will get Americans back to work.”

Like Keynes they also believe in the importance of investor confidence. So it would seem that the Republican platform and campaign was based as was the Democratic campaign on a mixture of approaches,in the case of the Republicans Hayekian in large measure but with certain more pragmatic even if conservative notions which are not that alien to Keynes’s concerns.In the case of the Democrats largely Keynesian but with some influence from fiscal conservatism perhaps representing the President’s own beliefs.

There is little doubt that Paul Ryan and his austerity budget which the House approved  The Path To Prosperity:A Blueprint for American Renewal is inspired by Hayekian principles of letting the market do its work and smaller government. The Tea Party  and most house Republicans continue to advocate them. It is astonishing that after close to a century and all we know about the great depression and the post war period of prosperity that we should still be having this debate but it would appear that powerful ideas and policy regimes do not disappear but remain dormant ready to reawaken if the conventional wisdom should falter.



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About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
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One Response to The American Presidential Election:Hayek versus Keynes Revisited

  1. circuit says:

    Very good paper. Thanks for posting. I particularly appreciated the parts discussing some of the less well-known details, such as Keynes’s and Hayek’s similar views on the non-neutrality of money or Prof Robbins regret about promoting Hayek’s views.

    Your depiction of the lack of unity among Democratic Keynesians during Pres Obama’s first term makes sense…Arguably, this has been corrected. Even Summers these days (although he ain’t at the WH anymore) sounds like a true Keynesian.

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