Let’s Move Past the Hayek-Keynes Debate

Let’s Move Past the Hayek-Keynes Debate

The debate between Hayek and Keynes on the question of depressions still looms large in the economics profession, at least in the way it’s taught and communicated, and – in some corners – still in the way it’s conducted. Formative as that debate was, being several decades prior to the ‘expectations revolution’, neither one had the right tools to even pose the question adequately. And as great as the rap battle is – and it is truly great – returning to this debate in the modern era keeps these ill-posed framings on life support, framings that should at this point be relegated to history of thought.


Consider two stories about intertemporal decisions. Consumers face a choice between consumption today and consumption later. In practice, they effectuate this choice by either consuming today, or…

The demand for capital goods is primarily determined by…

So if consumers shift their preferences to reduce consumption today in favor of consumption later, the demand for capital goods…

which affects the economy by…

Both of these are pretty inadequate stories, for different reasons.


Notice how many assumptions are being made in both of these stories.

Critics of Keynes frequently note that Keynes neglected the role of the interest rate in coordinating intertemporal decisions. In fact, Keynes seems to have the upper hand here. It’s difficult to imagine a world where an autonomous fall in the demand for a particular consumer good would lead the owner of the capital goods further up the supply chain (whether durable or circulating) to anticipate an increase in future demand for that good, as would be necessary for him to increase investment in that line (though Garrison tries to do exactly this with the Saving-Up-For-Something notion in Time and Money, ch. 3). As Keynes points out, a fall in the interest rate does not by itself send such a signal.

On the other hand, it’s also hard to imagine expectations reacting so mechanically to current conditions as in Keynes’ story. Friedman’s critique of Keynes with the Permanent Income Hypothesis argued that consumption-smoothing on the consumer side prevents the volume of spending from reacting wildly to transitory income shocks. Similarly on the producer side, “production smoothing” (partly of choice because the shock is seen as transitory, partly of necessity due to capital immobility) means that an increased demand for future income at the expense of present income should not lead to the spiraling depression that Keynes feared.

The whole discussion seems to rest on the contrived example. Just as we do comparative statics exercises where the demand for a good rises, can we not imagine the demand for future income in general rising as well?

Likely not. While preferences over consumer goods make sense to think of as exogenous, the preference for future consumption over present is endogenous to expectations of the size of future income. As with Scott Sumner’s dictum to “Never reason from a price change”, positing an endogenous variable changing autonomously leads us to tell causally confused stories. In this case, never reason from a change in time preference.

In fact, the demand for future consumption must be distinguished from both the demand for capital goods and the demand for money. And doing so rigorously requires tools to think about expectations that had yet to be developed at the time.


What’s missing in both of these stories is the way banks and other financial institutions link together expectations with the volume of spending, and how this coordinates intertemporal consumption decisions.

Because the ability to finance capital goods played such a crucial role in Hayek’s story of how intertemporal decisions get coordinated, he looked at banks’ ability to mark up their balance sheet in order to finance capital projects very skeptically. If banks are willing to finance any profitable project at the going rate, there’s nothing to nail down the demand for capital goods. Money lending is a “loose joint” in the economic system, as he put it.

Keynes, on the other hand, was skeptical that any amount of liquidity would lead banks to invest in capital projects during a downturn. In his story it is not consumers who hoard money balances in base money, but banks who fail to lend the money that consumers have deposited, on the basis of self-fulfilling expectations of poor demand for final goods. Even Hicks’ later elaboration with the idea of an “elasticity of expectations” (Value and Capital, ch. 16) is similarly mechanical, hence his similar pessimism about the stability of the dynamic capitalist system.

Though much attention has been paid to their opposing remedies, it’s striking that both of them conclude that the capitalist system is inherently unstable, for quite opposite reasons that nevertheless center around the role of expectations in credit creation. A more rigorous theory of expectations, however – take Lachmann or Lucas, as you prefer – puts both of these fears to rest. It is not merely that current prices are determined by expectations, which both Hayek and Keynes appreciated, but that expectations themselves are determined by looking forward, and not merely mechanically.

If this is the case, if banks are able to increase the volume of circulation in response to improved expectations, but if those expectations are informed not merely by current demand conditions but also by long-term forecasts, fractional-reserve banking systems will not be prone either to inflationary spirals (as Hayek feared) nor to deflationary spirals (as Keynes feared). The interest rate is an important brake on investment, but quantitatively, the availability of expected profitable investments seems to be the more important limitation, especially in the era of excess reserves.

It is true as well that the availability of financing can be an important hindrance during a crisis too. Where banks are ordinarily able to take advantage of profitable opportunities, a fall in the volume of spending can dry up liquidity and make it impossible to finance what would otherwise be profitable projects. In this case, the problem is not self-fulfilling expectations (per Keynes), but neither is it simply the relative price of capital goods to consumer goods reasserting itself (per Hayek). Rather, a collapse of liquidity has made it more difficult to effectuate positive long-run expectations. People do, after all, generally expect recoveries to follow recessions.

This does, indeed, seem to be the way central banks are looking at the problem of business cycles today: the best response is to provide sufficient liquidity so that expectations can reassert themselves, and in particular that interest rates are low enough that gains from beyond the recovery can be profitably capitalized into the present. Whether they have been successful or not, whether they even have the right tools to do so, is a separate question entirely. But by continuing to cast monetary policy in the light of the Keynes-Hayek debate, we miss entirely the logic behind what monetary policy is trying to accomplish, let alone whether it’s been successful.

In fact, I may even go so far as to say that nothing written prior to the expectations revolution (1950s-70s) on the topic of business cycles is worth reading today. Formative as this debate (along with many others) have been, there is no reason not to avail ourselves fully of the tools and mental models available to us today that were not available at the time.


  1. Hayek acknowledges that expected returns are important, but takes it for granted that an increase in the availability of funds signals that the future demand will be there.
  2. Keynes acknowledges that financing is important, but takes it for granted that savings “will always keep pace” with investment (“Alternative Theories of the Rate of Interest”).


BankingBusiness cycleCapitalMacroeconomicsMoneyF.A. HayekJohn Maynard KeynesMilton FriedmanRoger Garrison


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  • 1


    Apr 13, 2020 at 13:49 | Reply

    Hmm, I would have focused on something else in why the debate between them is not very significant for understanding modern macro, that has little to do with the precise causal account of the business-cycle they give.

    The most plausible reading of both is that they believe in a concept of uncertainty that is at odds with most of what came after. In that sense it is Keynes and Hayek vs. the moderns.

    Harro Maas has a nice chapter in which he contrasts Tinbergen and Keynes, who in their causal account of the business cycle were not necessarily very much apart. But it does capture the difference between pre-war, post-war macro well. He calls it the model-builder vs. the dramatist

    • 1.1

      Cameron Harwick

      Apr 13, 2020 at 13:55

      I know that it’s usually presented in broad strokes as more about the merits of interventionism, is that what you have in mind?

    • 1.2


      Apr 13, 2020 at 14:07

      No. I think that is precisely wrong, the debate about interventionism will always be with us. But it is the Post-Keynesians (think Davidson) and the Austrians (perhaps some evolutionary thinkers) vs. modern-macro.

    • 1.3

      Cameron Harwick

      Apr 13, 2020 at 14:14

      Mm, interesting. Like mechanistic vs process-based? Can you say more?

    • 1.4


      Apr 13, 2020 at 14:37

      Yes that is part of it. But more importantly I think that with only a little bit of exaggeration macro-economics and also the entity of ‘the economy’ (as manipulable object) is invented in the 1930s. GDP is important for that, models of the Tinbergen/Klein, and the IS-LM interpretation of Keynes are as well.

      After that whether you are on Friedman’s side, or even on Lucas’ side you essentially view the economy as a manipulable object. The debate is first about the optimal instrument to manipulate – monetary or fiscal – and later about limitations to manipulation with Lucas, although Tinbergen’s instruments and targets was in some sense also about limitations. I am not very familiar with Macro after the 1980s debates.

      But I think it is safe to say that Hayek and Keynes are both out of place in these debates. Their theories are ultimately about the dynamics of a ‘natural system’. In my Tinbergen book I hope to bring out some of the transformation this involved.

      Keynes and Hayek are onlookers, the later macro-people think the policy-maker is inside the system. And the models do this. Lucas vs. Tinbergen is about how to best position the policy-maker.

    • 1.5

      Cameron Harwick

      Apr 13, 2020 at 14:42

      I don’t usually get excited about biographies, but now I’m intrigued. Will look forward to your book then!

  • 2


    Apr 13, 2020 at 14:01 | Reply

    Is a “well-developed theory of expectations” even a thing? :p

    In all seriousness, I think that a “well-developed theory” of anything must, in one way or another, be algorithmic, and I think the special thing about human expectations is that they are radically non-algorithmic. QED, no “well-developed theory of expectations.”

    • 2.1


      Apr 13, 2020 at 14:07

      Yeah, that does seem hard. As an admitted amateur at economics (I’ve read the classics but no formal study), does the field have answers to this or is a “well developed theory” just not a reasonable thing to see in the area of expectations?

      The question of what parts of economics are amenable to algorithmic theories has always seemed a tricky one.

    • 2.2

      Cameron Harwick

      Apr 13, 2020 at 14:16

      Very much agree. But at least we know enough now (following the Lucas Critique) to say exactly *why* expectations have to be non-algorithmic and some of the consequences of that!

    • 2.3


      Apr 13, 2020 at 21:05

      Do we really need the Lucas Critique for that? I think Shackle expressed to the non-algorithmic nature of expectations plenty well and I at least find those themes in Keynes’ writings on probability in economics, though the latter might be me reading theories into Keynes.

    • 2.4

      Cameron Harwick

      Apr 13, 2020 at 21:30

      Personally I find Shackle a bit frustrating to read (lots of insisting, rather less arguing than I would like), but even so, how many people have read Shackle vs. how many have read Lucas?

    • 2.5


      Apr 13, 2020 at 22:55

      Lucas probably, but, then again, Marx is probably the most well read economist. :p

  • 3


    Apr 13, 2020 at 14:04 | Reply

    I love this. I have grappled with this question in a vague, uneducated way for a long time without being able to really put into words what seemed missing from both of their approaches. I think you have given me the terminology to define my discomfort though. I still lack any familiarity regarding modern thinking on expectations to be able to understand what is needed, but now I know what it is that I don’t know here… Any recommended reading on the “expectations revolution (1950s-70s)” that I can start with?

    Yes, that means my understanding of economics is 70 years out of date, what of it?

    • 3.1

      Cameron Harwick

      Apr 13, 2020 at 14:32

      Will try to find some good summaries since a lot of the original material is not very digestible (Lucas in particular is a real chore)… off the top of my head I’d mention a few things that Wikipedia would probably summarize well:

      • The permanent income hypothesis, on why long-run expectations matter for current consumption behavior
      • The Lucas critique, on how expectations react to policy changes and why that matters for the effectiveness of policy
      • Rational expectations, which is often criticized as being for all intents and purposes probabilistic omniscience, but I think is the most successful way that the non-mechanistic nature of expectations has been incorporated into formal modeling so far. Simplistic, but not mechanistic, and so a major improvement on previous techniques.
      • Lachmann’s hermeneutic approach to expectations, that the formation of expectations is an act of interpretation, and what that entails for how we do economic analysis. Trying to find a concise summary, but Chapter 2 of “Capital and its Structure” might be a good place to start. https://mises.org/library/capital-and-its-structure
    • 3.2


      Apr 13, 2020 at 14:33

      Thanks. I have done some reading about “rational expectations” and the problems therein, but I know I have a long way to go to a real understanding of the state of the science here…

  • 4


    Apr 13, 2020 at 14:38 | Reply

    Why are expectations relevant?

    • 4.1

      Cameron Harwick

      Apr 13, 2020 at 14:49

      Because both of them were asking questions about the stability of the capitalist system to shocks, where expectations are central. But both of them also had big blind spots about expectation formation at crucial points in their stories. Which is understandable in the 30s, but not really something you can get away with after the 70s.

    • 4.2


      Apr 13, 2020 at 15:05

      Agree but you also forgot one of the more important reasons. Expectations are related to the credibility and effect of policies. So for example if the loosening by the Fed in 2008 was not enough (allowing TIPS to fall to deflationary levels) then expansionist policy that still made possible inflation below two percent might be seen as contractionary relative to market expectations of a long term commitment to 2 percent inflation. Furthermore all policy then suffers from endogeneity (Lucas critique) which entails a problem of common knowledge and how we infer what people believe about how reactions occur, etc. into a rabbit hole.

    • 4.3

      Cameron Harwick

      Apr 13, 2020 at 15:08

      Good point! So almost everything that old economists regarded as an exogenous shock would have to be postfixed with “relative to expectations”

    • 4.4


      Apr 13, 2020 at 15:12

      The shocks can easily be exogenous but not the policy responses. You will recall a point I made in class that policies favoring universal benefit such as stable monetary policy or non-crony deregulation are not long term credible in weak states and hence induce preference for patronage because only direct benefits are credible and observable.

  • 5


    Apr 13, 2020 at 15:16 | Reply

    no one finds this opinion unpopular… (expectations are simply rational btw)

    • 5.1

      Cameron Harwick

      Apr 13, 2020 at 15:28

      I’d say “you’d be surprised” but surely you’re cynical enough not to be

  • 6


    Apr 13, 2020 at 15:58 | Reply

    Cough, cough, ahem, cough, cough. Um, I have a worked-out theory of expectations meant to solve the “Lachmann problem” that we need a theory of expectations in which each person’s actions are animated by the spontaneous activity of a free human mind.

    It addresses pretty much all the issues coming up on this thread, including Keynes vs. Hayek on expectations and uncertainty. Spoiler alert: though they both have “radical uncertainty,” their theories are really quite different even at the philosophical or epistemological level.

    I also penned a book that fits my thinking and theory into both the literature on macroeconomics up to about 2014 or so *and* works up a theory of confidence.

    • 6.1

      Cameron Harwick

      Apr 13, 2020 at 16:02

      Yes! I think I absorbed it so thoroughly that I forgot where I picked it up from. Ken, this is a good one too.

  • 7


    Apr 13, 2020 at 16:20 | Reply

    Great discussion!

  • 8


    Apr 14, 2020 at 8:10 | Reply

    Have you read the correspondence between Hayek and Myrdal wrt expectations?

    • 8.1

      Cameron Harwick

      Apr 14, 2020 at 11:42

      I haven’t, but that sounds interesting! Do you have a link?

    • 8.2


      Apr 14, 2020 at 11:45

      I don’t have it on hand. But perhaps Richard Ebeling does.

      I believe O’Driscoll discussed it in his dissertation but it has been a long time since I’ve looked at this stuff.

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