Economics play a very important role in our daily lives. It is not just about markets, numbers, graphs, and econometrics. Instead, it overlaps with the politics. Sometimes, the domestic economic discourse matches with the dominant international economic order; however, the clash can occurs that ultimately determines either both sides need to align following a mutual compromise or the one side mustmould its path to comply with the established order. The Keynesian-Hayekian divide perfectly exemplify this interplay, influencing not only the national economies but also the global governance.
After the end of World War 2, the Keynesian ideas resulted in the establishment of Bretton Wood system that reshaped the post-war politics of international economic relations. For instance, it created IMF, and World Bank, and fixed the exchange rates against the U.S. dollars (with US dollar agreed to be the reserve currency). The main purpose was to shift from the free market principle to the government-led economy in order to absorb the shocks of the devastating wars as the situation otherwise could have resulted in some unprecedented mass-scale poverty, unemployment, droughts, and devastation. The U.S. was the main proponent of the Keynesian school of economics.
Conversely, the Hayekian ideas (can be analysed under the broader umbrella of Neo-liberalism) were adopted after the stagflation and oil crisis of 1970s and suggested the revival of free market principles, privatization (accumulation by dispossession according to neo-Marxists), and deregulation. Once again, the U.S. led the change and at it announced that the U.S. dollars are not longer backed by the gold standards and introduced Washington Consensus, untimely increasing the surveillance role of IMF.
It showcases that economics and politics are interlinked as a single political decision reshaped the entire trajectory of economic relations at global level.
To start with the epistemic debate, Karl Merger’s work “The Principle of Economics” laid the foundation of the Austrian School of Economics. He argues against the government intervention into the market. Some of his ideas – such as the focus on individualism, and free market economy – overlaps with the work of classical economists such as Adam Smith. But, Austrian School negates the earlier thoughts. For instance, Merger rejects the labour theory of value and instead proposes the subjective theory of labour value. Similarly, he questions the effectiveness of Say’s laws and proposes the consumer rationality.
Instead of arguing that market equilibrium will be establish automatically, he proposes the idea of marginal utility. Moreover, his principle stance is that economy can function effectively with “bottom to top approach” instead of centralized government planning that overlooks this aspect. His deductive approach not follows mythological rigor and empirical evidences. Yet, it can be said to be an extension of the laissez-faire principles with some modifications.
The Keynesian Economic Model, in contrast, emerged in response to the Great Depression of 1929. In his phenomenal work, “General Theory of Employment, Interest, and Money”, John Maynard Keynes supports government intervention to create a multiplier effect that can ultimately lead towards stabilizing the market. Roosevelt’s “New Deal”, and Obama’s “ARRA” are the perfect examples to understand the Keynesian shift in the post-recession economy of the United States. He negated both Classical and Austrian school.
His concept of “The Animal Spirit” exposes the vulnerability of the free market and irrational decisions of the individuals for the economic growth of the society. He proposes that government should initiate deficit spending during the hard times to create an effective demand. Otherwise, the false promise of Market’s self-correction principle will inflict havoc on every segment of the society.
The evolution of economic thoughts – from Classical to Austrian and Keynesian – follows a basic principle: the well-being of society. However, the philosophical and practical difference makes both schools rival to each other. One such difference between both is the status of money. According to Merger, money has “intrinsic value” owing to its “social origin”. Arguing this, he says, money and markets both evolved in a parallel way; hence, money must be backed by silver or gold and must serve its individual purpose. Keynes, in contrast, considers gold standard as “barbarous relic”. He argues that the state backed fiat money is a better solution to encompass the evolving trends of modern economies.
Apart from that, both schools differ in their conception of the role central bank and the government plays in the market. Economists like Hayek and Mises criticize central bank by using the derogatory word “distorting force”. As Austrian Business Cycle Theory (ABCT) says, the central bank plays a negative role in creating artificial boom and bust cycles that end up in depression and slump.
In short, Austrian School advocates for the free banking system with minimal or no intervention by the government. Keynesian School, on the other hand, views the role of central bank in a positive manner. As Keynes puts in, markets are not always self-correcting and it is the responsibility of the government to redirect central bank to adopt that monetary policy which serves the best interests of the masses in a short-term duration. By stabilizing aggregate demand, unemployment can be reduced and recessions can be prevented from expanding. Although there is a limit that business cycle cannot be changed altogether towards a positive trajectory, efficient and timely intervention can prevent the longevity of its crusts and troughs, leading towards a gradual stabilization.
Both schools also differ in their methodological approaches. Austrian School treats Economics as social science and avoids econometrics and complex empirical research designs. Instead, it assumes that human choices are subjective in nature and cannot be measured. Based on the logic of priori axiom, it simply adopts deductive reasoning.
As Hayek says, “Economic is not quantifiable”. Conversely, Keynesian school and all its variants uses mythological rigor and positivist approach to analysis the real world events. For instance, Keynes used quantitative and qualities research methods to analyse the Great Depression and concluded by proposing a parallel microeconomic model. Similarly, neoclassical Keynesian economist followed the same trajectory. As said by Paul Samuaelson, “We can’t use introspection and pure logic as a substitute for imperial testing”.
Another major difference is their focus on the time frame. Keynesian School focuses on the short-term economic revival while the Austrian School advocates for long-term implementation of laissez-faire economic model. As said by Keynes “In the long term, we are all dead”. It showcases how important it is to protect the human agency instead of following any hard-core economic model.
During the major historical instances of recession or depression, all the major governments adopt Keynesian principles to stabilize the struggling economy. For instance, in the context of 21th century, either during the recession of 2008 or COVID-19, majority of the governments intervened into the market to avoid the catastrophic results. Austrian School, in contrast, sticks to its hard-core principles when addresses the economic discourse during the time of recession. It says that recession and glitches in the economy will help remove the inefficient and unnecessary businesses, ultimately ignoring the humanitarian implications of economic downturn.
Despite their wide support base, both schools face criticism over their core arguments. For instance, the Keynesian argument of increasing artificial demands failed to address the stagflation crisis of 1970s. Moreover, the logic that more tax should be collected during the economic boom to support the government intervention during the time of recession sounds unrealistic.
Instead, it is hard in economics to test a theory as any failed attempt would lead to the downfall of the government and massive protests, making it hard to test. Austrian School, on the other hand, faces backlash due to its unfalsifiable nature. As Paul Krugman puts in, it is more of a branch of philosophy instead of economic theory. Nonetheless, Interplay of both theoretical perspectives is necessary for the smooth functioning of a government.
In conclusion, one can say that the clash between the both schools is still relevant in the contemporary international political economy. For instance, after the ASEAN crisis (1998), global financial crisis (2008), and COVID (2019), states emphasized and adopted Keynesianism (government’s intervention into the market) but revived Hayekian thought (individual freedom) in the long-term because of the fear of turning towards authoritarism. This unique blend of state-market relationship shows the overlapping nature of politics and economics, yet with the competing visions.
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