Friedrich Hayek’s devotion to the free market
After the Soviet Union collapsed in 1991, the Nobel Laureate Milton Friedman observed:
There is no figure who had more of an influence, no person had more of an influence on the intellectuals behind the Iron Curtain than Friedrich Hayek. His books were translated and published by the underground and black market editions, read widely, and undoubtedly influenced the climate of opinion that ultimately brought about the collapse of the Soviet Union.
Friedrich Hayek believed that the prosperity of society was driven by creativity, entrepreneurship and innovation, which were possible only in a society with free markets. He was a leading member of the Austrian School of Economics, whose views differed dramatically from those held by mainstream theorists.
Hayek preferred most activities to stay in private hands; he did nonetheless see the need for a limited role for government, to perform the tasks of which markets were incapable. These included outlawing poisonous substances and preventing crime, but also providing a basic safety net through a comprehensive system of social insurance. He wrote:
there can be no doubt that some minimum of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody . . . . Where, as in the case of sickness and accident, neither the desire to avoid such calamities nor the efforts to overcome their consequences are as a rule weakened by the provision of assistance, where, in short, we deal with genuinely insurable risks, the case for the state’s helping to organize a comprehensive system of social insurance is very strong.
But Hayek, accepting inequality, was not in favour of government interventions to redistribute wealth; societal progress in his view was driven by the ideas of a few, who deserved proportionate reward.
In the late 1920s, Hayek wrote a number of articles in which he began to articulate his business cycle theory. Specifically, he disputed the use of fiscal policy in moderating the ups and downs of the economy. By contrast, in the 1930s, John Maynard Keynes came to dominate thinking during the Great Depression by arguing that downturns were the consequence of weak aggregate demand. The economy was subject to bouts of optimism and pessimism known as “animal spirits”. However, government policy could do much to offset the impact of these on national output and employment.
Hayek’s model of the business cycle is more nuanced and harder to grasp. This may be one of the reasons it was not so widely accepted, both at the time and subsequently, by economists and policy-makers. Hayek’s model is as follows. First, there are many different stages of production in creating final goods. Each final good reflects the processing of primary and intermediate goods. At each stage of production there is a requirement for businesses to install capital goods such as machines. These are not the same for different factories and cannot easily be transferred across sectors or stages of production. Therefore, once installed, the stock of capital can only be used to produce certain goods.
So it is possible for capital to be allocated inefficiently in the economy if it is directed to areas where demand has been temporarily boosted and cannot be sustained. As capital investment is not reversible or transferable, capital is essentially stuck and abandoned if under-utilized. The savings that funded the investment have been wasted, and could have been used more efficiently elsewhere in the economy. Hayek believed that this misallocation of capital could arise from monetary policy, specifically if interest rates had been held too low, which would lead to bad investments.
This, according to Hayek, accounted for the Great Depression. The US Federal Reserve had kept interest rates too low throughout the 1920s. As a result, much of the capital investment was inappropriate and unsustainable going into the 1930s. A recession ensued as this build-up in capital was abandoned.
Hayek believed that the government should resist the urge to interfere. He viewed recessions as a necessary evil, simply periods of liquidation resulting from the past over-accumulation of capital. Hayek outlined this theory of business cycles in Prices and Production; it was largely rejected.
During the latter years of the Second World War, Hayek became an increasingly obscure academic. But that was to change abruptly with the publication of The Road to Serfdom in 1944. It would make him one of the world’s best-known thinkers.
The Great Depression had shaken belief in the capitalist system, and during the war citizens had become habituated to centrally planned economies. Hayek wanted to warn the British public about the dangers resulting from government control of economic decision-making through such central planning, whether communist or fascist. For Hayek, economic freedom was intimately connected to individual liberty. Centralized planning, he argued, was inherently undemocratic: the will of a small number is imposed on the populace; as a consequence individual freedoms are sacrificed. Hayek’s view was that because the planners in such an economy take all the decisions, individuals cannot decide for themselves what to produce, how much to make and what price to sell it for. In a planned economy, prices and quantities are set by central planners, and individuals have no choice but to participate in a plan that they have no say in creating. Jobs, moreover, are often centrally allocated in such a system. Hayek argued that such an abandonment of individualism leads not only to a loss of freedom and the creation of an oppressive society, but also, ultimately, to totalitarianism, with the individual trapped in a state of serfdom. With each intervention by the state, the citizen loses a little more freedom.
In Britain, the Road to Serfdom did not have quite the political influence Hayek had hoped for – and considerably less than it enjoyed in the US, where it was a surprise success among non-specialist readers, making Hayek a household name. In Britain, the welfare state took hold after the hostilities of the Second World War came to an end. Winston Churchill quoted Hayek’s book heavily in the 1945 election campaign against Clement Attlee’s Labour Party as an anti-socialist text. Labour won a landslide victory.
Hayek had always been interested in psychology, and after the success of The Road to Serfdom he spent five years working on his next project, The Sensory Order. Published in 1952, the book set out a division of knowledge within societies where each person’s share of knowledge was infinitesimally minuscule, which limited the knowledge attainable for any individual.
His next major work was The Constitution of Liberty. Hayek set out to show that liberty drove wealth and growth rather than the other way round. The more government is restricted, the more likely to arise are the individual spontaneity and creativity so vital to the advancement of knowledge and civilization. The implication is that government should have a very limited role, not just in the economy, but also wider society. In this book, he also laid out his thoughts on global inequality across nations. He did not think it was wholly a bad thing, in that it reflected the progress made by advanced Western countries, which would allow other countries to catch up faster than the centuries it took for Western countries to become advanced. on the same basis, he was also comfortable with inequality within societies, believing that diversity was necessary for society to prosper. In Hayek’s view, society evolves so that the behaviour of successful individuals is adopted and imitated. The evolution of society is shaped by the new ideas of a comparative few. People with the better ideas determine developments; thus the market is an evolutionary mechanism where the economically talented prosper.
It took four years for Hayek to finish The Constitution of Liberty, completing the manuscript in 1959 to mark his sixtieth birthday. The book was intended for a general readership, and Hayek considered it his magnum opus. The Constitution of Liberty, he hoped, would be The Wealth of Nations for the twentieth century. Yet it did not come close to reaching the popularity of The Road to Serfdom.
He then wrote Law, Legislation and Liberty, the follow-up to The Constitution of Liberty. The book was published in three volumes: Rules and Order (1973), The Mirage of Social Justice (1976) and The Political Order of a Free People (1979). Hayek’s progress on the book was slow, in part because between 1969 and 1974 his work was interrupted by ill health and depression.
The Nobel Prize in Economics was established in 1969. It was rumoured that the committee was keen to award the prize to Gunnar Myrdal, one of the pioneers of the Swedish welfare state, but it had been specified at inception that no Swede could win in the first five years. Thus in 1974, the sixth year, Myrdal duly received it. However, the prize was shared with Hayek. Both economists were reportedly surprised: Hayek because he had won; Myrdal because he hadn’t won outright. The Nobel Prize rejuvenated him, and seemed to restore both his health and his motivation.
In 1976, Hayek published The Denationalization of Money, where he ventured the idea that money should be issued by private firms rather than by government. His reckoning was that competition between money providers would favour the most stable of the currencies in circulation. The same competition would also enforce self-regulation. Cyptocurrencies such as Bitcoin may end up providing the opportunity to observe Hayek’s theory in action.
Hayek’s body of work made a profound impression on the politicians who introduced free-market economics into the British and American economies in the 1980s. Hayek had been associated with the Institute of Economic Affairs (IEA), since its establishment in 1955, which in turn had been closely associated with Margaret Thatcher. She famously interrupted a speaker who was urging the Conservatives to take a middle way on a variety of policy issues by pulling out a copy of The Constitution of Liberty, banging it on the table and proclaiming: “This is what we believe!” on her tenth anniversary as prime minister, Thatcher wrote to Hayek thanking him for his contribution to ideology and policy. She was an admirer: “Adam Smith, the greatest exponent of free enterprise economics, till Hayek and Friedman”, she wrote. Thatcher also remarked: ‘All the general proposition favouring freedom I had either imbibed at my father’s knee or acquired by candle-end reading of [Edmund] Burke and Hayek”.
The Fatal Conceit was Hayek’s last major work. Seven years in the making and published in 1988, it detailed the flaws in socialism. In many ways, it was intended to be the crowning summary of his life’s work – an epilogue to Law, Legislation and Liberty. The insight was that the price system was an instrument which enables millions of people to adjust their efforts to events and conditions of which they have no concrete direct knowledge. With knowledge of prices, people can choose to produce certain goods or work in certain industries. The economy as a whole operates efficiently even though no one has coordinated its efforts. The book was not well received. It marked the end of his professional career.
A year later, Hayek witnessed the fall of the Berlin Wall and the disintegration of the Soviet Union that followed it. This avid defender of capitalism lived long enough to see its victory over communism, but only just. He died in 1992, at the age of ninety-two.
Despite his significant acclaim, Hayek was adamantly opposed to the pedestals on which economists can be placed. In his Nobel Prize speech he said:
I must confess that if I had been consulted whether to establish a Nobel Prize in economics, I should have decidedly advised against it. . . It is that the Nobel Prize confers on an individual an authority which in economics no man ought to possess. The influence of the economist that mainly matters is an influence over laymen: politicians, journalists, civil servants and the public generally. There is no reason why a man who has made a distinctive contribution to economic science should be omnicompetent on all problems of society – as the press tends to treat him till in the end he may himself be persuaded to believe. one is even made to feel it a public duty to pronounce on problems to which one may not have devoted special attention.
But whether Hayek was comfortable with it or not, he had a profound and far-reaching impact. The former US Treasury Secretary and Harvard Economist Larry Summers said of Hayek: “What’s the single most important thing to learn from an economics course today? What I tried to leave my students with is the view that the invisible hand is more powerful than the [un]hidden hand. Things will happen in well-organized efforts without direction, controls, plans. That’s the consensus among economists. That’s the Hayek legacy”.
Linda Yueh is a fellow in economics at St Edmund Hall, Oxford, and Adjunct Professor of Economics at London Business School. Her new book is The Great Economists: How their ideas can help us today