Tuesday, 22 February 2011

Friedrich Hayek and Practical Economic Theory

Business Mirror

The continuing global economic crisis has prompted many ordinary people to look closer at the way economies function. Or perhaps I should say, people are trying to understand why economies stop functioning properly.

The crisis has highlighted a distinction between the two most prominent schools of economic thought. It is incorrect to assume that there are only two divisions in economic theory. However, in this age of simple black-and-white thinking, it basically comes down to 1) a belief that the government can effectively control and manage a nation’s economy and 2) that the private sector, free-enterprise system is best qualified.

The former is embodied in some but not all of the writings of John Maynard Keyes, called Keynesian economics. A simple definition would be that “Keynesian economics argues that private-sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the public sector, including monetary-policy actions by the central bank and fiscal-policy actions by the government to stabilize output over the business cycle.” Or let the government take care of the economy. The ultimate logical conclusion of Keynesian economics would be for private ownership of business but with very rigid government control over production, wages, privies, and completion.

The other theory is that the private sector is better qualified and the role of the government is to facilitate the private sector’s strengths and step in to help smooth private-sector weaknesses. This idea is sometimes called a “laissez-faire” system where the government stays completely out of the picture. But this is not accurate. Even the most strident belief in the free markets acknowledges that the government has a critical role to play in an economy. However, the government cannot effectively or successfully control the economy.

One important economist, a proponent of what might be called “anti-Keynesian” economics, was the late Austrian economist Friedrich Hayek. Hayek died in 1992 after winning the Nobel Prize for Economics in 1974. He is of the “Austrian School” of economics. Hayek’s Nobel Prize was for his work in the theory of money and economic fluctuations and analysis of the interdependence of economic, social and institutional phenomena. Perhaps the key to his thesis is the interdependence of various factors that make up an economic system. His most important work for public consumption is Road to Serfdom. A well-known quote from the book is “When economic power is centralized as an instrument of political power it creates a degree of dependence scarcely distinguishable from slavery.” Too much government economic control leads to economic slavery.

We would like to believe that economics is only numbers. Not true at all. Producing wealth as well as spending that wealth is as much a function of the emotions as it is of the brain. Otherwise, all cars would be painted white and there would be only one style of shoes. In fact, an ideal function economy would be best served if manufacturers only produced one model of white car and only one type and color of shoes. That way, there would never be unsold inventory and it would be much more economically efficient to produce a limited variety of goods.

But Hayek knew that people want different colors of cars and that it was the private sector that could best, from a profit standpoint as well as serving consumer interests, adapt to the emotions of the marketplace. Not so the government.

The Heritage Foundation, a Washington, D.C., conservative think tank, assembled “Hayek’s Top 10 Dos and Don’ts in a Recession.” The following is abbreviated from their web site with my comments. It is important for us to understand what Hayek has to tell us as economies with the proper government intervention have created the best wealth creating engines for their citizens.

1. Recessions are bound to happen: it is all about the normal ups and downs of the business cycle. “Downturns are not aberrations but rather painful and necessary medicine for restoring equilibrium to the economy”.

2. A stimulus will only stimulate the deficit: what is the last thing a failing business does to try to solve the problem (just before they go under); borrow more money. And that is what has happened in the US where the stimulus has only dug the economic hole deeper because of taking on more and more debt.

3. Pure laissez-faire doesn’t work either: ‘Some regulation is necessary for individuals to carry out their plans and for the market to function. Hayek, therefore, endorsed “general rules, equally applicable to all people and intended to be permanent, which provides an institutional framework within which the decisions as to what to do and how to earn a living are left up to the individuals.”

4. Central planning and excessive regulation do not work: “The desire to plan and to subject the economy to the rule of experts endangers liberty.” The more a government tries to control business, the more business fails. Price controls create shortages. Wage controls create unemployment. They never have worked even in the short term. No examples of success, not one. Hayek: “The more the ‘state’ plans, the more difficult planning becomes for the individual.”

5. The economy is too complex for precise forecasting: you cannot accurately forecast consumer habits in the future. That is why department stores have sales; to get rid of items that they were sure shoppers would buy and then did not.

6. The rule of unintended consequences: History shows that when trying to realize certain ends—particularly when their achievement involves interfering with the workings of the price mechanism—all sorts of pernicious effects will occur that were not part of the original plan. See No. 4 above.

7. Leave social justice out of it: “Free markets necessarily lead to an unequal distribution of wealth and, just as inevitably, fuel calls for egalitarian social justice.” The ultimate “social justice economics” is communism. Not one successful example, unless you consider everyone being poor economic justice, exists in communism’s 100-year history.

Why have the less-developed countries including the Philippines performed better in the last three years? Because in the 21st century, these are the freest economics on the planet.


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