TWO

End of Empire

Hayek Experiences Hyperinflation Firsthand, 1919–24

Friedrich Hayek endured a war quite different from that of Keynes, sixteen years his senior. As a fifteen-year-old schoolboy at the outbreak of the conflict in 1914, Hayek was tall for his age, which led strangers to ask him why he had not enlisted. The von Hayeks were patriotic Austrians, perfect products of fin de siècle Vienna, who did not doubt the emperor’s decision to fight alongside Germany. But it was not until March 1917, when he was nearly eighteen, that Friedrich, the eldest of three brothers, signed up to become an officer in the Austrian army.

His father, August, a medical doctor, was a university lecturer manqué who never overcame a feeling of failure at not achieving the status of full-time scholar. He consoled himself by lecturing part-time in botany at the University of Vienna. As in the Keynes clan, academia ran in the Hayek family. August’s father, Gustave, was a secondary-school natural science teacher, and his father-in-law, Franz von Juraschek, was one of Austria’s most prominent economists. August’s frustrated ambition appears to have been passed on to Friedrich, who entered war service with the intention of becoming a university lecturer as soon as peace was restored. “I grew up with the idea that there was nothing higher in life than becoming a university professor, without any clear conception of which subject I wanted to do. . . . I even thought of becoming a psychiatrist,”1 he recalled.

Unlike Keynes, who excelled at his studies, Hayek was a poor student and was twice removed from school, as he confessed, “because I ran into difficulties with my teachers, who were irritated by the combination of obvious ability and laziness and lack of interest I showed. . . . I consistently neglected my homework, counting on picking up enough during lessons to scrape through.”2 Much to his relief, Hayek discovered that naked intelligence put him near the top of his officers’ training class. “In spite of a lack of any special natural aptitudes, and even in spite of a certain clumsiness, I emerged among the five or six heading the list of some seventy or eighty cadets,”3 he remembered. By the time his training was complete, the war was entering its final year, which Hayek spent on the Italian front as a telephone officer. His life was endangered at least four times. Once, shrapnel nicked his skull. Another time he attacked a Jugoslav machine gun emplacement in full spate, which he drolly described as “an unpleasant experience.”4 He nearly hanged himself when parachuting out of an observation balloon still donning headphones. And he was in an observation aircraft that was attacked by an Italian fighter.

But for the most part the war meant interminable waiting accompanied by debilitating boredom. Hayek sought solace in reading, and after he was lent an economics book, he discovered the discipline that became his life’s passion. “The first two books of economics [I encountered] . . . were so bad that I’m surprised they didn’t put me permanently off,”5 he said. Hayek became interested in how a peacetime economy transformed during war, when the free market gave way to the state’s needs. He read the work of Walter Rathenau, an economist turned politician in charge of raw materials for the Austrian war effort. “I think his ideas about how to reorganize the economy were probably the beginning of my interest in economics,” said Hayek. “And they were very definitely mildly socialist.”6

“I never was a social democrat formally, but I would have been what in England would be described as a Fabian socialist,”7 Hayek remembered. It placed him to the left of Keynes, a lifelong member of the Liberals, a progressive party that urged a middle way between social democracy, which aimed to democratically introduce public ownership of the main industries, and conservatism, a belief in the status quo and the free market. “I never was captured by Marxist socialism,” Hayek said. “On the contrary, when I encountered socialism in its Marxist, frightfully doctrinaire form . . . it only repelled me. But of the mild kind, I think German Sozialpolitik, state socialism of the Rathenau type, was one of the inducements which led me to the study of economics.”8 While on leave, Hayek registered to study economics at the University of Vienna as soon as the war ended.

After the armistice on November 11, 1918, Hayek returned to a Vienna that had been transformed from the colorful, sophisticated, and confident city he once called home. The war also left Hayek in poor physical shape. In its final weeks he contracted malaria. In defeat, the Austro-Hungarian emperor Karl I, who had led an empire of fifty million, absolved himself from running the remnants of his former realm. As the war ended, separatist movements took advantage of the mayhem to set up independent states. The empire lost seven-tenths of its territory to new nations such as Czechoslovakia, Poland, and Jugoslavia. Hungary also detached itself from Austria and declared itself a Marxist Soviet republic. The revolutionary changes even affected the von Hayeks’ patronym: by decree of the new republican government in Austria, the prefix “von” was removed from the surnames of once prominent families.

The Treaty of Saint-Germain-en-Laye was no less burdensome to Austria than the Treaty of Versailles was to Germany. “German Austria,” the rump of land that, like a head without a torso, survived the dissolution of the Austro-Hungarian empire, was forbidden by the victors to call itself “German” and was prohibited from aligning itself with Germany without permission from the League of Nations. The depradations inflicted on the Austrian people during the war, as the Central Powers bankrupted themselves to pay for the conflict, became even more acute in peacetime. As Hayek remembered, “Vienna, which was one of the great cultural and political centers of Europe . . . became the capital of a republic of peasants and workers.”9 Stripped of its imperial supply routes, the city soon ran out of its meager stores of Hungarian wheat and Czech coal. Basic commodities such as bread and electricity were prohibitively expensive. Women and children begged on the streets.

It was into this hellish turmoil that Keynes’s Economic Consequences of the Peace landed and was eagerly devoured by Hayek and his friends. Keynes was, as always, motivated by a desire to ameliorate suffering and described the beggaring of the Austrians as one of the most notable inequities of the postwar settlement. He accused the Allied leaders of cold-hearted indifference to the Austrians’ plight. “Europe starving and disintegrating before their eyes was the one question in which it was impossible to arouse the interest of the Four [Allied leaders],”10 he wrote. Members of the quartet were so obsessed with revenge that they seemed blind to consigning the defeated nations to chaos and revolution. “The danger confronting us,” Keynes wrote, “is the rapid depression of the standard of life of the European populations to a point which will mean actual starvation for some (a point already reached in Russia and approximately reached in Austria.) . . . These in their distress may overturn the remnants of organisation, and submerge civilization itself.”11 The Austrians would not be able to afford the stinging reparations imposed on them, “for they have nothing,” Keynes wrote.12 In Austria, he wrote, “Famine, cold, disease, war, murder, and anarchy are an actual present experience.”13

Keynes quoted the German government’s view that reparation payments would turn the clock back half a century, to a preindustrial economy that could sustain only a fraction of Germany’s current population. “Those who sign this Treaty will sign the death sentence of many millions of German men, women and children,” he wrote. “The indictment is at least as true of the Austrian, as of the German, settlement.” Keynes quoted an editorial published in Arbeiter Zeiteng, the Viennese newspaper: “Every provision [of the Treaty of Saint-Germain] is permeated with ruthlessness and pitilessness, in which no breath of human sympathy can be detected, which flies in the face of everything which binds man to man, which is a crime against humanity itself, against a suffering and tortured people.” Keynes commented, “I am acquainted in detail with the Austrian Treaty and I was present when some of its terms were being drafted, but I do not find it easy to rebut the justice of this outburst.”14

Keynes pointed out an insidious threat to civil society in Germany and Austria: a rapid rise in prices. Even Viennese families like the Hayeks, who were comfortably well-off before the war, were not immune to this galloping assault on their living standards. A pair of shoes that cost twelve marks in 1913 changed hands for thirty-two trillion marks a decade later. A glass of beer cost a billion marks. Million-mark notes were used to light stoves. While the price of essentials soared, the savings of families like the Hayeks became worthless and their possessions sharply diminished in value. The government bonds that loyal and patriotic Austrians bought to fund the war became valueless.

For Hayek, nineteen years old, the end of hostilities entailed a change of career path. Although he had enrolled at the University of Vienna to study economics, while still in uniform he made alternate plans lest the war go on “indefinitely.”15 He plotted what he considered to be an honorable escape from the dangers of the front line: the Austrian diplomatic corps. He applied for a transfer to the air force, whose lengthy training would grant him time to study for the diplomatic academy’s entrance exam. “I didn’t want to be a coward, so I decided, in the end, to volunteer for the air force in order to prove that I wasn’t a coward,” he said. “If I had lived through six months as an air fighter, I thought I would be entitled to clear out. Now, all that collapsed because of the end of the war. . . . Hungary collapsed, the diplomatic academy disappeared, and the motivation, which had been really to get honorably out of the fighting, lapsed.”16

Hayek resumed his earlier plan and joined the University of Vienna law department, which taught economics. He began acquainting himself with the Austrian School of economics. When Hayek started studying economics, the Austrian School was not as distinct as it would become after confronting the Marxians who emerged after World War I, when it began to promulgate the virtues of leaving the free market alone, the laissez-faire approach to an economy. The Austrian School was particularly concerned with prices, in particular the “opportunity cost” of a product, that is, the alternatives that consumers choose between when buying competing goods. If a person buys a beer, he does so instead of buying wine; if a person invests money, she forgoes interest; if a person sells investments, he forgoes the price the investment may achieve later. And so on. It is the notion of opportunity costs that lies behind the capital theory of the various “stages of production” in which producers forgo making one good in order to provide a more valuable good later. Hayek started by reading the Principles of Economics and Investigations into the Method of Social Sciences by Carl Menger,17 who first postulated the notion of marginal utility: that the greater the quantity of a good, the less it may be perceived to be of value. He was taught by Friedrich von Wieser,18 who contended that prices were the key to understanding how the market works and that entrepreneurs play a key part in ensuring progress through developing new markets.

Postwar Vienna was a perfect place for Hayek to explore economics. He was not immune from the raging inflation (rising prices) around him. His father, who as a physician was able to adjust his fees upward, could fund his son’s university fees, but there was no money to finance his travels to study elsewhere. When the University of Vienna closed in the winter of 1919–20 because of a shortage of heating fuel, Hayek spent eight weeks in Zurich, Switzerland, at the expense of botanist friends of his father, who, according to Hayek, “as part of the general efforts on behalf of the undernourished German and Austrian children, wanted to help the son of a friend who had recently returned from the war and not only needed some feeding up but was also suffering from malaria.”19

“Zurich in 1919–20 gave me a first taste in the postwar period of what a ‘normal’ society could be like, Vienna still being in the throes of inflation and semi-starvation,”20 said Hayek. He had hoped to take a second degree at the University of Munich as he was an admirer of the sociologist Max Weber,21 who taught there. The plan collapsed, however, when in June 1920 Weber, at age fifty-six, died of influenza, though that was not the main reason for Hayek’s change of mind. As he explained, “The later stages of the Austrian inflation would in any case have made it altogether impossible for my father to pay the costs of my studying for a year in Germany.”22 But some good was to come from the disappointment. Instead of spending a year in Bavaria, Hayek was compelled to find a job. In the process he met the man who would become the most important and long-lasting influence on his life and work, Ludwig von Mises, an economics lecturer at the University of Vienna with close contacts in the Austrian government who had studied the rising prices engulfing his country. The long-nosed Mises, a difficult, self-obsessed personality who sported a Charles Chaplin moustache, was to become the father of market economics, the author of a penetrating study of the inadequacies of socialism, and the inspiration for those who believed the amount of money in an economy was the key to understanding inflation.

Having spent as much time studying economics and psychology as law, which he deemed “a sideline,” Hayek completed his degree within two years, graduating in November 1921. It was Wieser who commended Hayek to Mises for a job as a legal assistant to a government body set up to administer the settling of war debt between Austria and other nations. Hayek therefore began working in a field similar to that of Keynes. Hayek’s first meeting with Mises was less than promising. In a letter of commendation, Wieser had described Hayek to Mises as “a promising economist,” to which the egotistical Mises said to Hayek, “Promising economist? I’ve never seen you at my lectures.”23 Nonetheless, Mises offered him the position, which he took up in October 1921.

Hayek experienced Austria’s runaway inflation with each salary check. His first month’s pay was five thousand old kronen, but the following month he was paid fifteen thousand kronen to compensate for the fall in the value of the currency. By July 1922 Hayek was paid a million kronen to keep pace with the hyperinflation.24 In just eight months Hayek was awarded two hundred pay rises. In January 1919 an America dollar bought 16.1 austrian crowns; by May 1923 it bought 70,800 crowns.25 The Austro-Hungarian Bank printed bank notes night and day to keep up with demand.

In The Economic Consequences of the Peace, Keynes had raised the perils of inflation running out of control in language that would be hurled back at him by Hayek and his “sound money” followers. Keynes was aware that the fixed relationship between currencies before World War I, pegged to the price of gold, had been overtaken by events, because governments had printed money to pay for the war. Keynes reminded readers that the undermining of currencies was an invitation to revolution. “Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency,” wrote Keynes. “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”26 Keynes gave credit to the Bolshevik leader for his perspicacity. “Lenin was certainly right,” he wrote. “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.”27 In November 1918, by Keynes’s reckoning, “in Russia and Austro-Hungary this process [of printing money] has reached a point where for the purposes of foreign trade the currency is practically useless.” But Keynes cautioned that “the preservation of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay.”28 For those, like Hayek, huddled in winter coats in their apartments because they could not afford fuel, Keynes’s warning rang true.

Keynes directed his thoughts toward practical remedies for price inflation and sinking currency values. He was commissioned by the editor of the Manchester Guardian, C. P. Scott, to edit a series of supplements addressing the problems of European reconstruction. This new set of arguments from Keynes quickly proved a huge international success. Among other languages, the supplements were translated into German, and Hayek, Mises, and others keenly devoured each issue.

“We all read eagerly his famous contributions . . . and my admiration for him was only enhanced by the fact that he anticipated in the Tract on Monetary Reform [Keynes’s 1923 book, largely drawn from his Guardian contributions] my first little discovery,”29 Hayek recalled. The “little discovery” that Keynes had “anticipated” was that by fixing a currency’s price to gold—“the gold standard”—domestic prices would fluctuate and could not be controlled. Governments were faced with a choice: to have a fixed-price currency or fixed domestic prices. As Keynes put it, “If the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.”30 At this moment, Keynes and Hayek were thinking along similar lines—simultaneous inspiration, perhaps—despite Mises’s warning to Hayek that Keynes “was supporting a good cause with some very bad economic argument.”31

Keynes received extravagant fees for the Guardian supplements. C. P. Scott often became frustrated with Keynes, calling him “a brilliant and original thinker” but also “the most obstinate and self-centered man I ever encountered.”32 Among those Keynes persuaded to contribute were H. H. Asquith, the British wartime prime minister; Ramsay MacDonald, the future British Labour prime minister; Léon Blum, who was to become prime minister of France three times; Sidney Webb, cofounder, with his wife Beatrice, of the Fabian social democratic movement in Britain and of the London School of Economics; Walter Lippmann,33 the American journalist; Maxim Gorky, the Russian author; Harold Laski of the London School of Economics and Political Science; Oxford historians Richard Tawney and G. D. H. Cole; the chief German negotiator at the Paris peace talks, Carl Melchior; even the queen of Romania. To add a Bloomsbury twist, Keynes commissioned Duncan Grant and Vanessa Bell to illustrate the cover.

In the first supplement, published in April 1922, Keynes contributed three articles, including two that would form the first chapters of A Tract on Monetary Reform. The subject was of paramount interest to the former belligerent countries, whose currencies had almost without exception been steeply devalued since 1914. Keynes believed nations would pay a high price if they restored their currencies to prewar values, and proposed instead a new order fixing the currencies at their current prices, with sterling allowed to revalue upward by no more than 6 percent a year.34 This was opposite to the line advocated by the British Treasury and the Bank of England, both of which wanted sterling to be restored to its prewar value.

The cost of returning currencies to the prewar parities was massive deflation (a continuing drop in prices) accompanied by high interest rates and selling as many goods abroad as goods imported. Or as Keynes put it, “to work and slave.” Despite Mises’s misgivings, Hayek found little in Keynes’s analysis to disagree with. It was Keynes who advocated neither inflation (rising prices) nor deflation but steady prices to avert more injustice being visited on European families. Indeed, when he wrote, “He who neither spent nor ‘speculated,’ who made ‘proper provision for his family’ . . . has yet suffered her heaviest visitations,”35 he might have been describing the Hayek family, brought to near penury by their patriotism.

Keynes introduced in the supplements the first step toward recommending that governments manage their economies, a line of thinking that would set him apart from Mises, Hayek, and other devotees of the free market. European governments were being obliged to choose between inflation and deflation. For Keynes, this was evidence that laissez-faire was no longer appropriate. He advocated instead that the government act to prevent prices from fluctuating.

Mises and, eventually, Hayek believed that the “natural forces” of the market that worked toward an “equilibrium” could restore order to a fluctuating economy. For Keynes, “sitting quietly by” and being buffeted by “chance causes deliberately removed from central control” was unnacceptable because such an approach would lead to mayhem, not to firm, unshakable price levels. Keynes concluded, “We must free ourselves from the deep distrust which exists against allowing the regulation of the standard of value to be the subject of deliberate decision.”36

In a withering assault on the maintenance of the value of the American dollar by hoarding gold, a policy he dismissed as “burying in the vaults of Washington what the miners of the Rand have laboriously brought to the surface,”37 Keynes added an observation that would inform his arguments about the relative virtues of the free market and those of a managed economy. By his reckoning, the gold standard—by which the price of a currency was fixed to the price of gold—was not a true free-market device because its exchange price was set by central bankers. “In the modern world of paper currency and bank credit there is no escape from a ‘managed’ currency, whether we wish it or not,” he argued. “Convertibility into gold will not alter the fact that the value of gold itself depends on the policy of the Central Banks.”38 It was a line of thinking that Hayek, too, would come to adopt.

Keynes also began testing the logic behind the notion that over time an economy would come to rest at a point where everyone was employed, a “truth” taught to him by Alfred Marshall that was also a main tenet of the Austrian School. In diagnosing the relationship between money and prices over time, Keynes concluded that “in the long run” there must be a constant relationship between the quantity of money in a system and stable prices. However, “this long run is a misleading guide to current affairs,”39 he argued, as what changed prices in relation to the quantity of money over time was the speed with which money is spent (the “velocity of circulation”), which could alter prices out of proportion to the quantity of money. While equilibrium depended on “the long run,” he averred, in what was to become one of his most famous remarks, that “in the long run we are all dead.”40

The observation was aimed at the relationship between money and prices, but Keynes was to discover that “in the long run we are all dead” held a wider truth for all attempts to assess the role equilibrium theory played in economics. Though it would be some years before Keynes came to abandon his belief in equilibrium theory, he had found a means of explaining why the promised state of equilibrium did not cure persistent high unemployment. Though equilibrium theory suggested that in the long run a state would be reached where everyone was employed, Keynes found that the long run was an elusive timescale that was always set at some indeterminate time in the future. Like a carrot on a stick to urge a donkey forward, the long run was forever out of reach. For those who were later to suggest that public spending remedies for unemployment would lead to inflation in the long run, he had provided himself with a ready riposte: “in the long run we are all dead.”

Keynes’s views on the role the exchange rate played in determining inflation were particularly pertinent to Hayek and others in the Austrian School. While most European governments had allowed their currencies to float free pending a broader decision about whether the continent should restore itself to the economic conditions of 1914, the Austrian government had decided to raise the value of the kronen without delay. A loan from the League of Nations to Austria was conditional up on public expenditure cuts, including the abolition of seventy thousand government jobs and ending food subsidies. In 1925 the kronen was linked to the price of gold at a high value. While Keynes’s Guardian articles addressed the principles involved in managing exchange rates, Hayek and his colleagues were witnessing at close quarters the painful consequences of measures to improve the value of the kronen.

Hayek soon became restless and decided to visit America to witness firsthand how unbridled capitalism operated. Thanks to his inflation-adjusted government salary, Hayek’s income had kept pace with rising prices and he had even been able to save a little. In the spring of 1922, Mises introduced Hayek to Professor Jeremiah Whipple Jenks of New York University, who was visiting Vienna after he had served as part of a group of financial experts, including Keynes, who had been hired by the German government to advise it on how to stabilize the value of the mark.41 Jenks, who was planning to write a book on the Central European nations’ war-ravaged economies, invited Hayek to Manhattan to work as a researcher on the project.

Money was so tight that Hayek set off across the Atlantic with a one-way fare as he could not afford a round-trip. To save the price of a telegram, Hayek did not inform Jenks of his arrival date. Hayek disembarked at the passenger liner quay on Manhattan’s West Side in March 1923 with just twenty-five dollars in his pocket and presented himself at Jenks’s NYU office only to be told the professor could not be contacted. Hayek found himself in a strange land, penniless, without a friend. He decided to take a job until Jenks returned, and was offered one washing dishes in a Sixth Avenue restaurant. An hour before he was due to plunge his hands into the suds, he received a call from Jenks’s office saying that the economist had returned. This was the nearest Hayek came to performing manual labor. Indeed, in all his ninety-two years, he never worked for the private sector.

Hayek set about his new American life with gusto. He began work on a Ph.D. at NYU under the supervision of J. D. Magee, a professor of economics; gate-crashed lectures by Wesley Clair Mitchell, an established authority of business cycles,42 the phenomenon whereby economic booms (periods of fast economic growth) were followed by slumps (periods of contracting economic activity); and attended seminars by the German socialist J. B. Clark at Columbia. Hayek was intrigued by the secretive workings of the Federal Reserve Board, whose gold hoarding and money manipulation Keynes had addressed at length. Hayek went on to work briefly for Willard Thorp, an economic adviser to President Wilson at the Paris peace talks, during which time he mined information about fluctuations in the industrial performance of Germany, Austria, and Italy, which led him to consider the nature and predictability of the business cycle.

In May 1924, short of money and out of luck, Hayek set sail back across the Atlantic. At home he found a letter awarding him a Rockefeller fellowship that, had he received it earlier, would have funded his stay in America for another year. But the offer came too late. Hayek would not return to America for another twenty-five years.