Keynes v. Hayek: A Dialogue With Two of My Children
By Art Carden
The long-promised but slow-in-coming dialogue promised here.
PERSONS OF THE DIALOGUE
Jacob Carden, Age 4
Taylor Grace Carden, Age 2
Dad: Art Carden, an Economist, Age 34
Scene: Chuck E. Cheese’s in Vestavia Hills, Alabama.
Dad: Children, I notice you aren’t eating your pizza. Eat your pizza.
Jacob: Why should we? We’re not hungry at the moment, we would rather play, and besides, we can save the pizza and have it for lunch tomorrow.
Dad: Lay aside for the moment questions of authority. I’ll ignore your disobedience for now. What we have here is a question of macroeconomics.
Taylor Grace: Macroeconomics?
Dad: Yes, macroeconomics. We’re interested in why we have business cycles. Know that if you don’t eat your pizza, aggregate demand will surely collapse.
Taylor Grace: How do you know?
Dad: It’s obvious, isn’t it? By saving the pizza, you lower our planned expenditures. By lowering our planned expenditures, you create a vicious spiral leading to unemployment, at least in the short run.
Jacob: Do explain.
Dad: Here’s what happens. You don’t eat your pizza, so we save it for tomorrow. Since you’ll eat the pizza tomorrow instead of (say) peanut-butter-and-jelly sandwiches, which means we will need to spend less on groceries. Our local grocer will observe an increase in inventories. Observing this increase in inventories, he will then cut back on his orders of new goods.
Taylor Grace: Such as?
Dad: Peanut butter, jelly, and bread, in our example. Producers of peanut butter, jelly, and bread will, in turn, cut back on their orders of peanuts, grapes, sugar, salt, wheat, and so on. The cycle continues until planned expenditure is again equal to actual expenditure. We end up with output below the economy’s potential. So eat your pizza: American macroeconomic stability depends on it.
Jacob: You might be right in a sense, Dad, but you should remember your Hayek: “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.” What do you do with your savings from lower grocery purchases, what signals do your rising savings send, and how will entrepreneurs respond?
Dad: Do continue. What do you mean?
Jacob: Presumably, your additional saving winds up in the bank, shifting the supply curve for loanable funds rightward. Taylor Grace is illustrating by drawing a helpful diagram on a napkin. This lowers the interest rate. In response, firms increase the quantity of loanable funds they demand. And furthermore…
Taylor Grace: …the lower interest rate suggests to investors that consumers are willing to sacrifice present consumption to get future consumption. “Temporally remote” projects, meaning things like asteroid-harvesting ventures initiated by firms like Planetary Resources, will now be profitable because of the lower interest rate.
Jacob: So what we would actually observe is a reduction in employment opportunities in industries that produce goods for immediate consumption. That much is true. However, this reduction in current consumption frees up resources (like labor and capital) that can be used by firms like Planetary Resources–firms engaged in production processes that won’t yield consumable output for a very, very long time.
Dad: So what is the mechanism?
Taylor Grace: Like we said, the interest rate sends the signal. Roger Garrison explains it in this lecture and this essay (Taylor Grace is fiddling with Dad’s iPhone now). In late-stage industries–those producing for current consumption–the “derived demand” effect dominates the interest rate effect. In the short run, these industries contract. However, in early-stage industries–which produce goods that go into far-future consumption–the interest rate effect dominates the derived-demand effect. As Garrison puts it, following Hayek, we have here “an economy working right” in which an increase in saving leads not to a recession, but to a capital restructuring. And one that, I might add, leads to greater economic well-being in the long run.
Jacob: So don’t try to guilt us into eating pizza we’d rather save until tomorrow. If you want to discuss it further, we’ll be playing Skee-Ball.