FIVE

The Man Who Shot Liberty Valance

Hayek Arrives from Vienna, 1931

Lionel Robbins and William Beveridge appointed themselves seconds in the most telling duel in the history of economics. Friedrich Hayek arrived in London in January 1931 to take up Robbins’s invitation to deliver four lectures based on his study of the business cycle and his attempt to prove, in “The ‘Paradox’ of Saving,”1 that recessions were not caused by a lack of desire from customers to buy goods.

Hayek’s first port of call, however, was not the London School of Economics, at Houghton Street off the Strand in London, but Cambridge, fifty miles north, where he was invited to deliver a lecture to the Marshall Society, an intense group of economists made up mostly of associates of John Maynard Keynes. The society, dedicated to the memory of the father of Anglo-Saxon economics, Alfred Marshall, was the spiritual home of Cambridge economics. It was a living reminder to Hayek that he had landed in alien territory, where the Austrian School’s writ did not run. As Cambridge economists were wont to say, “Everything can be found in Marshall.”2 Hayek wanted to prove them wrong. With typical nerve, he strode into the lion’s den.

It was in the nature of the ever-charming Keynes and the lure of his maverick ideas that he should gather about him a group of fiercely loyal disciples. Keynes had always enjoyed small clusters of intimates, from his early days as a member of the “Apostles” at Cambridge, a so-called secret society of like-minded young men devoted to the ideas of the English philosopher G. E. Moore, then as a core member of the Bloomsbury Group. As a charismatic teacher of economics at King’s College, he offered a tight set of young men—Cambridge was in those days an overwhelmingly male bastion—generous and avuncular advice. He chose as his favored pupils those with original casts of mind who were capable of keeping him amused in lengthy conversations. The Marshall Society included a more exclusive band of followers who jokingly referred to themselves as the “Cambridge Circus.”

One was Richard F. Kahn,3 who remembered how he felt on first meeting the great man, slumped horizontally in an armchair with his long legs outstretched, in his sumptuous rooms in King’s College decorated with murals by Vanessa Bell and Duncan Grant. “I actually trembled as I was about to enter Keynes’s rooms in [King’s] College for my first supervision [informal College teaching],” Kahn recalled. “But as soon as the three other students and I had settled down round the open fire, we found talking to us—and encouraging us to talk—a man who was friendly and genial, and anxious to build up our confidence.” It was Keynes’s ability to combine awe with accessibility that invested his closest admirers with a devotion that bordered on the spiritual. He was far more than a sublime teacher; he was worshipped as a guru and sage. Kahn recalled that “the publication of the ‘Treatise’ on 31 October 1930 led almost immediately to a group of younger Cambridge economists getting together to discuss the basic issues, stimulated by the knowledge that Keynes would shortly be embarking on a new book [The General Theory of Employment, Interest and Money].”4

Another important member of the circle, Austin Robinson, may have been the person to first dub the weekly informal seminar the “Cambridge Circus.” “We were busily reading [A Treatise on Money] and digesting it,” he wrote. “Inevitably some of us—Richard Kahn, Joan Robinson5 [Austin’s wife], Piero Sraffa,6 James Meade,7 and myself—found ourselves arguing together about it. What came to be called the ‘Circus’ first emerged by accident rather than design.”8 In addition to these five were C. H. P. Gifford, A. E. W. Plumptre, L. Tarshis, and a small number of undergraduates. Each new member was subjected to a searching interview by Kahn, Austin Robinson, and Sraffa. The group met regularly between January and May 1931 and enjoyed heated debate, though, in true Cambridge fashion, no offense was taken however sharp the disagreement or pointed the words. As Austin Robinson recalled, “It is only by argument, by conflict if you like, that economics makes progress.”9

The Circus, which first met in Kahn’s rooms in the Gibbs Building in King’s and later in the Old Combination Room at Trinity College, provided Keynes with a sounding board, a group of trusted young economists with whom he could check galley proofs of The General Theory, and, important to his duel with Hayek, a loyal phalanx of disciples ready to defend their patriarch at every turn. Keynes did not attend Circus meetings. One of the regulars, James Meade, a fellow of Hertford College, Oxford, who was spending a year in Cambridge, recalled that “from the point of view of a humble mortal like myself, Keynes seemed to play the role of God in a morality play; he dominated the play but rarely appeared himself on the stage. Kahn was the Messenger Angel who brought messages and problems from Keynes to the ‘Circus’ and who went back to Heaven with the result of our deliberations.”10

Kahn was an indifferent physicist turned inspired economist thanks to his mastery of mathematics, winning a first-class degree before being elected as a fellow of King’s in 1930. Kahn’s switch of subject led the Austrian School economist Joseph Schumpeter,11 with a typical lack of sensitivity, to inform him that “many a failed race-horse makes quite a good hack.”12 Keynes thought Kahn had “as much natural aptitude for economics as anyone whom I have taught since the war.”13 Kahn was highly intelligent and meticulous in his logic, but he lacked the confidence to press his ideas on others. Soft spoken, impeccably mannered, and known to his peers as “Ferdinand,” his middle name, he was perhaps the most important in a line of young men on whom Keynes bestowed the title “Favorite Pupil.” An orthodox Jew, Keynes affectionately dubbed him the “Little Rabbi.”

Despite a lifetime of studying economics, becoming a professor of economics at Cambridge from 1951 to 1972, Kahn published little and remains best known as the chief artisan in Keynes’s atelier. Schumpeter was to make amends for his earlier tactlessness by crediting Kahn with a large portion of The General Theory, writing that Kahn’s “share in the historic achievement cannot have fallen very far short of co-authorship.”14 Schumpeter cited Kahn’s devotion to Keynes as an example of the generosity that typified Cambridge scholars. “They throw their ideas into a common pool. By critical and positive suggestion they help other people’s ideas into definite existence. And they exert anonymous influence—influence as leaders—far beyond anything that can be definitely credited to them from their publications.”15

Austin Robinson, a fellow of Sidney Sussex College, Cambridge, arrived from India in April 1919, having piloted flying boats during World War I, and was, like many of the generation of Cambridge undergraduates who survived the war, motivated by the prospect of making the world a better place. “We were determined that the problems of the world should never again have to be settled by war,” he wrote. “Naïve we may have been, but we were nonetheless sincere.”16 He heard Keynes, fresh from the Paris peace talks, deliver a series of lectures that would become The Economic Consequences of the Peace. Robinson was smitten. After a spell doing good works in Liverpool, he returned to Cambridge to study economics. “My economics was concerned with improving the state of the world—with making it a somewhat better place for the poor as well as for the rich,” he recalled.17 His memory of the Circus was that he, Kahn, and others began meeting and that “Keynes knew of our meetings and asked Kahn what we were discussing, and Kahn conveyed to him our problems and difficulties.”18

Austin Robinson’s wife Joan, née Joan Violet Maurice, a graduate in economics from the women’s college Girton, became, according to Keynes’s biographer Skidelsky, “the only woman (so far) among the great economists.”19 Like her audacious major-general father, Sir Frederick Barton Maurice, who accused Prime Minister David Lloyd George during World War I of misleading Parliament over the number of British troops on the Western Front, Mrs. Robinson relished controversy and was a fierce advocate of the causes she supported. Her stock-in-trade was the ad hominem assault. As one contemporary recalled, “Hayek reproached her for assuming that, if people did not agree with her, they must be of extremely low intelligence, with their morals probably not the best either, so that argument back and forward with her was often difficult, to say the least.”20 She was to make a significant contribution to economics not only through her close collaboration with Kahn on Keynes’s General Theory but also through her work on “imperfect competition” and for her pioneering work in salvaging the reputation of Karl Marx as an economist. She and Austin Robinson were ostensibly happily married with two daughters, but her close intellectual collaboration with Kahn led them to become lovers. The couple was once surprised by Keynes in flagrante, Keynes telling Lydia that the pair were “lovingly entangled on the floor of Kahn’s study, though I expect the conversation was only on ‘The Pure Theory of Monopoly.’”21

Hayek first encountered the Circus when he gave his talk to the Marshall Society as a prelude to his debut at the LSE. There were several factors working against his delivering a knockout blow in Keynes’s backyard. He was suffering from a high temperature and, befuddled, rushed his preparation for the lecture, which entailed condensing the upcoming four dense, theoretical lectures written for the LSE into a single talk. This left him ill-equipped to anticipate the cool reception from a group that was at best skeptical of anything emerging from the Austrian School.

Hayek suffered from another significant inhibition. Notwithstanding the fourteen months he had spent in New York, his spoken English remained rudimentary. His Austrian accent was as thick as London smog and remained heavy for the rest of his life. When he came to address the Marshall Society, it did not help that he was often obliged to turn his back on his audience to draw on a blackboard a series of intricate, barely legible, and to the audience wholly incomprehensible diagrams. Keynes himself did not attend as he was in London, which may have encouraged his young followers to be even ruder to their guest than had he been present. In the circumstances, Hayek did well to last the distance.

It would be tempting to suggest that the Keynesians were so imbued with the lessons of their guru’s recently published Treatise that they shunned Hayek on the grounds that he was proposing an opposing economic theory. Quite simply, however, they could make neither head nor tail of the concepts Hayek was trying to explain. Even had they been issued a prepared text beforehand, they may have been none the wiser, for Hayek’s written English was in dire need of a good translator and editor and was even less comprehensible than his spoken English. As Hayek later admitted, the notions he referred to were taken for granted among Austrian School economists but were unfamiliar to the British economists, who treated continental economics with the deepest suspicion. Indeed, many of the arguments Hayek assumed his British audience would understand were not available in English.22

After spending more than an hour delivering his thesis and scribbling his spidery diagrams, detailing his explanation for why business cycles turn from boom to bust, Hayek invited questions from the floor. The young Keynesians gleaned that the main thrust of Hayek’s talk was that, contrary to Keynes’s assertion, he believed there was no direct link between aggregate demand (the total of goods that customers want to buy in an economy) and employment. Though always ready for a rough-and-tumble debate, not least when a misguided stranger dared enter their cosy world, the young Keynesians were for once quite lost for words. Hayek’s request for questions was met with a chilling hush.

The well-mannered Kahn offered a more or less objective account of this notable assault on Marshallian orthodoxy and the new Treatise thinking. His record is harsh, even though, written more than fifty years after the event, it was softened by the passage of time. Try as he might, Kahn could not disguise the fact that the reception must have been devastating even to a character as robust and intellectually secure as Hayek, whose calm air of confidence combined with an almost aristocratic arrogance perfectly fitted him for his celebrated role as a master contrarian.

“The members of the audience—to a man—were completely bewildered,” wrote Kahn. “Usually a Marshall Society talk is followed by a lively and protracted barrage of discussions and questions. On this occasion there was complete silence. I felt that I had to break the ice. So I got up and asked, ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ ‘Yes,’ said Hayek. ‘But,’ pointing to his triangles on the board, ‘it would take a very long mathematical argument to explain why.’”23

Joan Robinson, who had a reputation for ruthlessly dispatching her opponents, was less forgiving. “I very well remember Hayek’s visit to Cambridge on his way to the London School,” she recalled nearly forty years later. “He expounded his theory and covered the blackboard with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time. The general tendency seemed to be to show that the Slump was caused by inflation.” She cruelly summed up Hayek’s unfortunate debut on the British stage as a “pitiful state of confusion.”24

Hayek returned to London, somewhat chastened by his Cambridge experience but confident he would receive a warmer reception at the LSE. While acknowledging that the talks Hayek would give would be “at once difficult and exciting,”25 Robbins had high hopes that the lectures would transform the British intellectual landscape. To ensure that Hayek did not again endure the chilly reception served to him in Cambridge, the largest lecture theater was reserved, and an audience handpicked by Robbins was primed to welcome Hayek’s performance, come what may. Those who were not already familiar with Austrian School notions were urged to brush up their knowledge in advance so they could respond positively. Unlike at Cambridge, Hayek was given pride of place on the small elevated stage, with a dozen rows of wooden chairs set up below him and packed with about two hundred eager faculty and staff, and a further hundred or more crowding the gallery.

No one present doubted the importance of the event to the future of economic theory and the reputation of the LSE. The arguments Hayek was about to expound, on the key role the supply of money plays in the workings of an economy, were important first shots in the war against Keynes and Cambridge, and would indirectly provide the foundation for the monetarist counterrevolution that would eventually come to challenge Keynesianism. Hayek’s first talk, “Theories of the Influence of Money on Prices,” was an overview of the relationship between money, prices, and production.

He opened by acknowledging that the British Treasury’s decision to return sterling to the gold standard at its pre–World War I parity had provided ample evidence that “the contraction of circulation”26 of money (the reduction of money changing hands) leads to a reduction in industrial production. He bemoaned the fact that recent turbulent economic events, in Britain and Europe, had done little to help further the understanding of the key role that monetary forces played in the economy. He blamed this on “a certain change of attitude on the part of most economists in regard to the appropriate methodology of economics, a change which in many quarters is hailed as a great progress: I mean the attempt to substitute quantitative for qualitative methods of investigation.”27 He insisted that measuring elements of the economy was no substitute for understanding how an economy worked. He derided attempts “to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production”28 in mathematical equations as if economics were a science no different from physics or chemistry. The true key to understanding economic activity, he argued, was the choices individuals made, which were so many and diverse they could not be easily measured. By the same token, he dismissed assumptions based on general price levels. Far more telling, he argued, were the myriad different prices agreed in the countless individual transactions that together made up the economy.

In a wide-ranging historical review of monetary theory, Hayek cited, with admiration, Richard Cantillon,29 the Irish-French economist of the early eighteenth century who pioneered an understanding of monetary forces. Cantillon had traced how the new injection of money, in the form of gold and silver deposits discovered by seventeenth-century explorers in South America, increased the purchasing power of those who brought the precious metals back to Europe. Their new wealth led the explorers to spend more, which caused prices to rise, which in turn swelled the coffers of the sellers of goods, who in turn spent more, and so on. Cantillon, and later the Scots philosopher David Hume, observed that over time the general effect of the new supply of money helped only those who discovered and produced it, and that the rest of society ended up suffering as the new supplies of silver and gold raised prices. Although he considered it useful, Hayek said he had reservations about Cantillon’s theory as “the effects may be quite opposite depending upon when the additional money comes first into the hands of traders and manufacturers.”

Hayek then addressed an element missing from Cantillon and Hume, “the influence of the quantity of money on the rate of interest, and through it on the relative demand for consumers’ goods on the one hand and producers’ or capital goods on the other.”30 A glut of money tended to lower the price of borrowing, which caused consumer goods to increase in price while making saving less attractive. He traced how the relationship between money and interest rates had been explored by thinkers such as Henry Thornton,31 David Richard,32 and Thomas Tooke,33 and how the link between money and capital, in the shape of “forced savings,” was addressed by Jeremy Bentham, Thomas Malthus,34 John Stuart Mill,35 Léon Walras,36 Knut Wicksell, and Eugen von Böhm-Bawerk. In drawing attention to what he perceived as a flaw in Wicksell’s logic, Hayek took a swipe at the central assumption in Keynes’s Treatise on Money,37 that if the “natural rate” of interest and the “market rate” of interest were identical, prices would remain stable.38 Exactly why he disagreed with Wicksell—and Keynes—Hayek promised to expand on in a later lecture.

But in his first lecture he did set forth a notion that cut to the heart of his difference with Keynes. “It seems obvious as soon as one once begins to think about it that almost any change in the amount of money, whether it does influence the price level or not, must always influence relative prices. And, as there can be no doubt that it is relative prices which determine the amount and the direction of production, almost any change in the amount of money must necessarily also influence production.”39 He believed he was on the verge of a breakthrough in the theory of money that would “no longer [be] a theory of the value of money in general, but a theory of the influence of money on the different ratios of exchange between goods of all kinds.”40

Hayek then made a startling declaration: money has no intrinsic value. “There is . . . no need for money in this sense—the absolute amount of money in existence is of no consequence to the well-being of mankind—and there is, therefore, no objective value of money in the sense in which we speak of the objective value of goods. What we are interested in is only how the relative values of goods as sources of income or as means of satisfaction of wants are affected by money.”41

For those in the audience, not least those who had read and digested with a skeptical eye Keynes’s Treatise, published three months before, Hayek’s lecture offered a new direction in which to start reassessing economic theory. In sharp contrast to the reception in Cambridge, Hayek’s first lecture in London was met with warm applause. Importantly, the ever-competitive Robbins was delighted by what he heard and was convinced he had found the right man to challenge the potent new theories Keynes was propagating.

In his second lecture, given the following day and titled “The Conditions of Equilibrium between the Production of Consumers’ Goods and the Production of Producers’ Goods,” Hayek addressed an important and, in light of the world slump, a highly topical subject: under what conditions do resources come to be left unused? He declared that to explain any economic phenomenon it was convenient to assume that over time an economy would reach a state of equilibrium in which all resources would be fully employed. But there would be times in the interim when all available resources were not used.

Of all the ways that production could be increased, Hayek suggested, the most effective was by employing capital to satisfy later demand in what—and here he borrowed from the Austrian economist Eugen von Böhm-Bawerk—he called “roundabout” methods of production. Hayek drew a diagram on the blackboard in the shape of a triangle, like the ones that had so baffled his Cambridge audience. He argued that to meet future demand, entrepreneurs over time invest in a succession of intermediate capital goods, such as tools and machinery, that are, in the main, sold to other producers of capital goods. In due course, the employment of these roundabout methods of production led to the provision of more consumer goods in the future. Entrepreneurs were prepared to delay making profit by investing in such intermediate production methods because it would allow them to produce more consumer goods in the future, thereby fulfilling the desires of consumers, who save today to have more tomorrow.

Which brought Hayek to the core question of his second lecture: how did methods of production needing less capital progress to methods needing more capital? The answer was simple: when people spent less on consumer goods and saved more, their savings were invested in capital goods. But there was another way: more capital goods might be produced when money was made available to producers by bank loans. This second method, he said, was not real saving but “forced saving” because the new investment had come about not because of an increase in savings but simply because it suited banks to lend. When the money lent to producers was reduced to its former level, the capital invested in equipment was lost. “We shall see in the next lecture,” he said ominously, “that such a transition to less capitalistic methods of production necessarily takes the form of an economic crisis.”42

Once again the audience was left on the edge of their seats. In his third lecture, the following day, Hayek invoked the work of his mentor Ludwig von Mises. Hayek opened the talk, titled “The Working of the Price Mechanism in the Course of the Credit Cycle,” with a quote from Mises: “The first effect of the increase of productive activity, initiated by the policy of the banks to lend below the natural rate interest is . . . to raise the prices of producers’ goods while the prices of consumers’ goods rise only moderately. . . . But soon a reverse movement sets in: prices of consumers’ goods rise and prices of producers’ goods fall, i.e., the loan rate rises and approaches again the natural rate of interest.”43

With his usual impeccably meticulous if forbiddingly desiccated approach, Hayek described how an unwarranted increase in borrowing led over time to a dislocation in the production process of capital goods, which in turn caused a collapse at the bottom of the business cycle. To help those without a remorselessly analytical bent, Hayek offered an example. “The situation would be similar to that of a people of an isolated island, if, after having partially constructed an enormous machine which was to provide them with all necessities, they found out that they had exhausted all their savings and available free capital before the new machine could turn out its product,” he said. “They would then have no choice but to abandon temporarily the work on the new process and to devote all their labor to producing their daily food without any capital.”44

In the real world, Hayek suggested, the result was persistent unemployment. He offered a simple if unpalatable truth to those, like Keynes, who advocated increasing the demand for consumer goods to increase employment: “The machinery of capitalistic production will function smoothly only so long as we are satisfied to consume no more than that part of our total wealth which under the existing organization of production is destined for current consumption. Every increase of consumption, if it is not to disturb production, requires previous new saving.”

Hayek also confronted another Keynesian remedy, that if an idle plant was brought into use it would spur a depressed economy back to life and increase employment. “What [economists like Keynes] overlook is that . . . in order that the existing durable plants could be used to their full capacity it would be necessary to invest a great amount of other means of production in lengthy processes which would bear fruit only in a comparatively distant future.”45 He went on, “It should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect.” Such “artificial demand,” he suggested, would merely postpone the day of reckoning. “The only way permanently to ‘mobilize’ all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure.”46 In brief, there was no easy way out of a slump. In the long run the free market would restore an economy to an equilibrium where everyone was employed.

Once again Hayek scored a bull’s-eye with his audience. Here at last was a cogent, convincing repudiation of Keynesian interventionist notions. Hayek showed that the remedies coming from Cambridge, which appeared so plausible, were riddled with logical flaws. Having the best of intentions was not enough. Addressing the symptoms of a depressed economy by investing with borrowed money only made matters worse. Instead Hayek offered a sober remedy of his own: forget about quick fixes, the uncomfortable truth is that only time will cure an economy in disbalance. Beware smooth-talking doctors, such as Keynes, who offered a quick cure, for they are charlatans, snake-oil salesmen, and quacks. Every short cut only leads back to the start. There are no soft options. Only the long haul will provide a true recovery. The market has its own logic and contains its own natural remedy. It was not Hayek’s role to offer bromides as he, unlike Keynes, was no political agitator.

In his fourth lecture, the day after, Hayek ventured into the still largely unexplored territory of monetary theory, which would eventually underpin the main thrust of the theoretical opposition to Keynesian ideas. Hayek suggested that the amount of money in an economy, and the speed with which it passed from one to another, held the key to understanding how the system worked. “Under the existing conditions, money will always exert a determining influence on the course of economic events and . . . therefore, no analysis of actual economic phenomena is complete if the role played by money is neglected,” he declared.47 But he stressed that monetary theory, though an essential tool to a better understanding of the economic system, had severe limitations. It was good for normal times, but not perhaps for the times the world was currently enduring.

Hayek believed that for an economy to work most effectively it was essential that money operate as a neutral factor. “The increase or decrease of the quantity of money circulating within any one geographical area serves a function just as definite as the increase or decrease of the money incomes of particular individuals, namely the function of enabling the inhabitants to draw a larger or smaller share of the total product of the world,” he said.48 To increase the supply of money inflicted unnecessary burdens on certain sectors of society. “The increase of the amount of money only means that somebody has to give up part of his additional product to the producers of the new money.”49 He was at pains to stress that the creation of additional money entailed money as measured not only by bank notes but also by bank loans, “book credits,” and forms of credit not connected to banks. “The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided,” he said.50

To avoid the most extravagant swings of a business cycle, he argued, banks should keep their lending in close check. “Bankers need not be afraid to harm production by overcaution,” he said. The judicious action of banks was perhaps all that could be achieved in terms of keeping monetary policy under control. “Under existing conditions, to go beyond this is out of the question. In any case, it could be attempted only by a central monetary authority for the whole world: action on the part of a single country would be doomed to disaster.”51

Although the removal of money as a source of disequilibrium was important, he warned that a strict monetary policy was no cure-all. “It is probably an illusion to suppose that we shall ever be able entirely to eliminate industrial fluctuations by means of monetary policy,” he said. But those, like Keynes, who believed an economy worked best when there was a certain amount of inflation were misguided. “The most we may hope for is that the growing information of the public may make it easier for central banks both to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by ‘a little inflation.’”52

So Hayek came to the end of his quartet of lectures. “In the event the lectures were a sensation,” recalled Robbins, “partly for their revelations of an aspect of classical monetary theory which for many years had been forgotten.”53 There was a sense, according to Joseph Schumpeter, that Hayek was saying something new and startling.

Although Hayek’s lectures raised as many questions as they answered, Robbins was particularly pleased, for they had achieved exactly his intended purpose, to introduce British economists to “this great tradition [the Austrian School], [that] will do something to persuade English readers that here is a school of thought which can only be neglected at the cost of losing contact with what may prove to be one of the most fruitful scientific developments of our age.”54

The talks served as an extended job interview for Hayek, who dearly wished to join the LSE faculty. It was with delight, then, that on the strength of the lectures Beveridge offered Hayek a visiting professorship, and the following year awarded him the Tooke Chair in Economic Science and Statistics.55 According to Robbins, “There was a unanimous vote in favor.”56 Hayek accepted the post without reservation.