EIGHT

The Italian Job

Keynes Asks Piero Sraffa to Continue the Debate, 1932

It was in eager anticipation of Keynes’s response that Hayek and Robbins published the second installment of Hayek’s “Reflections on the Pure Theory of Money of Mr. J. M. Keynes” in the February 1932 issue of Economica. Hayek’s argument was again delivered in a voice of indignant incomprehension. Sentences such as “The point in question concerns a statement so extraordinary that, if it were not clearly in his book in black and white, one would not believe Mr. Keynes to be capable of making it” were typical of his stance of faux disbelief. The tenor of the second part of his critique was little different from the uncompromising language in the first that had prompted Keynes’s even more intemperate reply.

Hayek again scolded Keynes for his imprecise use of economic terms, but the main thrust of his argument cut to the heart of his disagreement with Keynes. Hayek confronted the central theme of Keynes’s repeated public pronouncements: the means whereby a government might with intellectual justification interfere in the market to counter high unemployment at the bottom of the business cycle.

“Like so many others who hold a purely monetary theory of the trade cycle,” wrote Hayek, “[Keynes] seems to believe that, if the existing monetary organisation did not make it impossible, the boom could be perpetuated by indefinite inflation. . . . Hence he was quite consistent when, despairing of a revival of investment brought about by cheap money, he advocated, in his well known broadcast address, the direct stimulation of the expenditure of the consumers . . . for, on this theory, the effects of cheap money and increased buying of consumers are equivalent.”

The radio broadcast to which Hayek was referring was the one in which Keynes urged “patriotic housewives” to “sally out tomorrow early into the streets and go to the wonderful sales.”1 The broadcast echoed his familiar refrain, that “in the chief industrial countries of the world, Great Britain, Germany, and the United States, I estimate that probably 12,000,000 industrial workers stand idle. . . . Many million pounds’ worth of goods could be produced each day by the workers and the plants which stand idle.”2 In the second part of his “Reflections,” Hayek took Keynes at his word and attempted to put a price on what Keynes did not quantify when he proposed curing unemployment “at all costs.” Hayek concluded that the price was roaring inflation, and having witnessed hyperinflation destroy civil order in Vienna and undermine his family’s savings, he believed it a price too high to pay.

Hayek summarized Keynes’s explanation of the business cycle. “Since, according to [Keynes’s] theory, it is the excess of the demand for consumers’ goods over the costs of the available supply which constitutes the boom, this boom will last only so long as demand keeps ahead of supply and will end either when the demand ceases to increase or when the supply, stimulated by the abnormal profits, catches up with demand. Then the prices of consumers’ goods will fall back to costs and the boom will be at an end, though it need not necessarily be followed by a depression; yet, in practice, deflationary tendencies [falling prices] are usually set up which will reverse the process.”3 Hayek denied there was anything much new about this account of a boom. “In essence [Keynes’s explanation] is not only relatively simple, but also much less different from the current explanations than its author seems to think.”4

Hayek addressed why he believed Keynes’s idea of increasing investment by reducing interest rates, thereby boosting production, was shortsighted and, after a while, ineffective. “He considers what I have called changes in the structure of production (i.e. the lengthening or shortening of the average period of production) to be a long-run phenomenon which may, therefore, be neglected in the analysis of a short-period phenomenon, such as the trade cycle,” wrote Hayek. “I am afraid that this contention merely proves that Mr. Keynes has not yet fully realized that any change in the amount of capital per head of working population is equivalent to a change in the average length of the roundabout process of production and that, therefore, all his demonstrations of the change in the amount of capital during the cycle prove my point.”

Furthermore, “If the increase of investment is not the consequence of a voluntary decision to reduce the possible level of consumption for this purpose, there is no reason why it should be permanent and the very increase in the demand for consumer goods which Mr. Keynes has described will put an end to it as soon as the banking system ceases to provide additional cheap means for investment.”5 He concluded, “It is not difficult to understand, in the light of these considerations, why the easy-money policy which was adopted immediately after the crash of 1929 was of no effect.”6

Hayek specifically addressed the implications of Keynes’s repeated assertion that in the absence of private investment, where savings and investment were out of step, demand could be maintained at a high rate and jobs restored by government-funded public works. Hayek was so sure he had refuted what he believed to be one of Keynes’s central contentions that he emphasized the importance of the passage by highlighting it in italics. “Any attempt to bring about an increase in investment to correspond to this ‘saving’ which is already required to maintain the old capital would have exactly the same effect as any other attempt to raise investment above net saving; inflation, forced saving, misdirection of production and, finally, a crisis.”7

It was a forceful rebuttal of Keynes’s ideas. But Hayek was too late; Keynes’s caravan had moved on. After the initial flurry of counterargument in his response to the first part of Hayek’s critique, Keynes had decided to ignore Hayek’s continuing criticism. He was now fully occupied with developing an intellectually watertight explanation, which had long eluded him, for why raising public investment in place of absent private investment at a time of recession would put the jobless to work without prompting the crisis Hayek believed to be inevitable. The result would be his monumental General Theory of Employment, Interest and Money.

Keynes’s decision not to respond was a significant setback for Hayek. By splitting Hayek’s review into two parts, Robbins and Hayek had failed to gain Keynes’s full attention. Having exploded at the tone of the first part, and having accused Hayek of deliberately misunderstanding his argument, Keynes had no intention of returning to the debate. Thus the first and perhaps best chance to nip Keynesianism in the bud was lost. Had Hayek first published the second part of his “Reflections,” which addressed the nub of Keynes’s interventionist thoughts, or published the whole of his critique in a single pass, he may have held Keynes’s wandering attention long enough to stop him in his tracks. Instead, perhaps because neither Hayek nor Robbins had expected Keynes to respond so quickly to the first part, the more substantial and persuasive line of Hayek’s argument was left unanswered by Keynes.

Instead, Keynes set a hound onto Hayek in the shape of the young Circus member Piero Sraffa. The decision to assign Sraffa to the task was an act of outright hostility. Of all Keynes’s disciples, Sraffa, a formidable figure with short dark hair, a high forehead, and a small black moustache, who had written a searching analysis of inflation in Italy during World War I, was the perfect person to take on Hayek. He was a brawler, forensic when taking apart an argument and caustic when articulating criticisms. Even the formidable Joan Robinson, an eager warrior in the Cambridge–London School of Economics skirmishes, considered Sraffa, ostensibly a shy and well-mannered soul, the only person she genuinely feared.

Sraffa’s close friend the philosopher Ludwig Wittgenstein was so in awe of the Italian’s argumentative skill that after an encounter with Sraffa he said he felt like the bare trunk of a tree that had been stripped of its branches.8 “The tree, freed of its old wood, could sprout powerfully from the new,”9 he wrote. Another student of Sraffa’s modus operandi reported that it “would be a frontal attack on carefully chosen strategic points in the theoretical structure. No time would be wasted in offering all possible, subsidiary and peripheral criticism.”10 It was an ideal technique for use against the meticulous, almost mechanical mind of Hayek. The result, according to one Austria School devotee, was “an onslaught conducted with unusual ferocity.”11

Sraffa owed his mentor Keynes a particular debt. Born in Turin to a law professor and his wife, he studied from 1921 to 1922 at the LSE and while in London was introduced to Keynes by Mary Berenson,12 wife of Bernard Berenson,13 the American art critic and dealer based in Florence. Returning to Italy to become a political economy professor in Perugia, Sraffa found himself a marked man. He was a friend of the Italian communist leader Antonio Gramsci and his socialist counterpart Filippo Turati, which was enough to make Sraffa an enemy of the state according to Mussolini’s fascist party, which rose to power in 1922. Leftists were being removed from state jobs and replaced by fascists, and violence by fascist gangs was becoming increasingly commonplace.

It was Sraffa’s reputation as an economist with an original cast of mind that led Keynes to commission him to write an article for the “Reconstruction in Europe” series, a piece that was sharply critical of the three largest Italian banks. The piece was so damning of Italian banking practices that it drew the attention of Mussolini himself, who was, coincidentally, in the midst of trying to solve a banking crisis by using state funds to rescue the ailing Banco di Roma. Sraffa’s piece was perfectly timed to cause the maximum mischief, and Keynes was delighted. Mussolini, however, was not. He decried Sraffa’s article as a “slander against Italy,”14 the unpatriotic act of a radical agent paid by foreigners. In threatening telegrams to Sraffa’s father Angelo, Mussolini demanded that a retraction and apology be published. Sraffa told his father that his article was wholly based on verifiable facts and that he stood by his words.

While Sraffa remained in Italy as the banks prepared to file a libel lawsuit, Keynes moved fast. He offered Sraffa safety in the shape of a Cambridge economics lectureship. Sraffa, who had to step down from a state job in Milan because of the banking furor, set off for England, only to be detained by customs officials at Dover after the British Home Office received a tip from Italian authorities that he was a dangerous revolutionary. Sraffa was sent back to Calais in northern France, and when the crisis subsided,15 he took up the post Keynes had created for him.

Although Sraffa joined the Circus, his age—he was just over thirty, so a little older than the others—and his reputation for exposing errors in the work of classical theorists set him apart from the others. One of the first tasks Keynes gave him was to translate his Tract on Monetary Reform into Italian. Then Keynes asked Sraffa to review Hayek’s Prices and Production in the Economic Journal of March 1932. He could not have chosen a more formidable champion.

Like the LSE lectures on which it was based, Prices and Production is not an easy work to fathom. As John Hicks, an LSE lecturer sympathetic to the Austrian School who would later soar to prominence for translating Keynes’s notions into a simplified mathematical model,16 wrote, “Prices and Production was in English, but it was not English economics. It needed further translation before it could be properly assessed.”17 Nor are the arguments Sraffa employed against Hayek easy to follow. Even Chicago School economist Frank Knight,18 steeped in Austrian School thinking, found the whole matter too obtuse. As he wrote to Oskar Morgenstern, “I wish [Hayek] or someone would try to tell me in a plain grammatical sentence what the controversy between Sraffa and Hayek is about. I haven’t been able to find anyone on this side who has the least idea.”19

What could not be missed, however, was the personal, sarcastic, and unforgiving tone of Sraffa’s assault. Sraffa opened his critique by describing Hayek’s LSE lectures as “a feat of endurance on behalf of the audience as much as of the lecturer. . . . There is one respect in which the lectures. . . . fully uphold the tradition which modern writers on money are rapidly establishing,” writes Sraffa, “that of unintelligibility.” While Sraffa complimented Hayek on concentrating on the way the amount of money in the system affected commodity prices, rather than looking at prices in general, “in every other respect the inescapable conclusion is that [Hayek’s thoughts] can only add to the prevailing confusion of thought on the subject.”20

In Prices and Production, Hayek had sought to prove that if money is lent at a rate that is out of step with the sum of savings, it is invested in production that cannot sustain itself. When further funding dries up, factory owners find they do not attract customers and some lines of production are brought to an abrupt halt. In other words, when the price of borrowing money is out of kilter, it corrupts the ordered stages of production of goods until, after a period of crisis, the economy finds a new equilibrium. Hayek suggested that there was an ideal rate at which money should be lent, a rate that sustained production at all stages without waste and provided goods at prices consumers could meet. That was the “natural rate of interest” that effectively left money with a “neutral” role, because it had no bearing on the “natural” operation of the productive system.

Sraffa’s approach to his task was clear. He had been commissioned to assess Prices and Production and to direct attention to Hayek’s errors. He was not concerned with defending Keynes’s theories. Sraffa first takes Hayek to task for considering that money could ever be neutral, “that is to say, a kind of money which leaves production and the relative prices of goods, including the rate of interest, ‘undisturbed,’ exactly as they would be if there were no money at all.” Sraffa accuses Hayek of a rudimentary error by reminding him that his notion of neutral money is confounded by “the beginning of every textbook on money. That is to say, that money is not only the medium of exchange, but also a store of value.” Sraffa describes Hayek’s theories as “a maze of contradictions [that] makes the reader so completely dizzy that when he reaches the discussion of money he may out of despair be prepared to believe anything.” As for the elaborate theory of the stages of productions that Hayek liked to explain with triangular diagrams, Sraffa dismisses it as “a terrific steamhammer in order to crack a nut—and then he does not crack it. Since we are primarily concerned in this review with the nut that is not cracked, we need not spend time criticising the hammer.”

As for Hayek’s central contention, that “there can be no doubt” that, if producers employ credit that is larger than the amount of saving, that inflation and collapse will ensue, Sraffa throws Hayek’s words back at him. “As a moment’s reflection will show, ‘there can be no doubt’ that nothing of the sort will happen. One class has, for a time, robbed another class of part of their incomes; and has saved the plunder. When the robbery comes to an end, it is clear that the victim cannot possibly consume the capital which is now well out of their reach.” While Hayek contended that when easy credit was cut off manufacturers were left with redundant machinery, Sraffa suggests that the factory owners got to keep their plant, which could be brought into use when the market picked up. All this was paid for by their customers. Hayek predicted disaster for factory owners if banks lent at too low a rate. Sraffa counterargued that during the period when additional capital unbacked by savings was available, manufacturers would earn enough to put aside cash to pay the interest on the additional capital when its provision came to an end. In the meantime, producers would have gained the means to make a greater number of goods at a lower price. Thus, far from being inflationary, reducing interest rates to bolster production tended in the long run to reduce prices.

After concluding with the uncompromising judgment that “Dr. Hayek’s discussion is utterly irrelevant to money and to inflation,” Sraffa accuses Hayek of “running away from his problem of neutral money” and inadvertently landing “right in the middle of Mr. Keynes’s theory.” According to Sraffa, Hayek was not an opponent of Keynes but an unwitting admirer and supporter. “And here this review must stop,” Sraffa declares, adding the teasing line, “Space does not allow of an adequate criticism of the new and rather unexpected position taken up by Dr. Hayek.”21

Hayek lost no time in penning a reply to Sraffa’s review for the next edition of Economic Journal. In his usual sarcastic style, he feigned compassion for Sraffa’s plight “at having spent so much time on a work from which he has obviously derived no profit and which appears to him merely to add to the prevailing confusion of thought on the subject.” He confronted Sraffa’s criticism of what Hayek claimed to be his novel contribution to economics, that “capital accumulated by ‘forced saving’ [would] be, at least partly, dissipated as soon as the cause of ‘forced saving’ disappears.” Hayek agreed with Sraffa, that “it is upon the truth of this point that my theory stands or falls.”

In repeating his explanation for what pertains when new capital unbacked by savings is injected into an economy, Hayek put emphasis on the fact that those employed would eventually be paid more, as the additional money hosed into the system would prompt wage inflation. The incremental spending on wages rather than capital would, he suggested, over time slow up the growth in producers’ goods and a new equilibrium would be reached where interest rates would be “the same rate as before the forced saving took place, and [producers’] capital worn down to something approaching its former state.” The fact that producers may be left with idle equipment did not mean that the value of their plant had not diminished, for it had. Unused machinery was less valuable than productive plant, and in the meantime producers had to pay interest on their borrowing.

Challenging Sraffa to justify his “surprisingly superficial objection to this analysis,” Hayek switched gears, asking, “Does he belong to the sect which believes in [employing idle plant] by stimulating consumption” as Keynes believed? As for Sraffa taunting Hayek by saying he appeared to be in agreement with Keynes on a number of matters, Hayek was having none of it. “I venture to believe that Mr. Keynes would fully agree with me in refuting Mr. Sraffa’s suggestion,” he wrote. “That Mr. Sraffa should have made such a suggestion, indeed, seems to me only to indicate the new and rather unexpected fact that he has understood Mr. Keynes’s theory even less than he has my own.” To which Keynes appended a mischievous footnote: “With Mr. Hayek’s permission I should like to say that, to the best of my comprehension, Mr. Sraffa has understood my theory accurately.”22

Sraffa instantly wrote “A Rejoinder” that appeared in the same issue of the Economic Journal as Hayek’s response. First came the ritual baiting of his subject. “This specimen of Dr. Hayek’s manner of arguing is by itself such an eloquent illustration of my review that I am reluctant to spoil it by comments,” he wrote. What Hayek called “forced saving,” which would lead to catastrophe, Sraffa preferred to call “spoilation,” in which “those who had gained by the inflation chose to save the spoils” and “those on whom forced saving had been inflicted would have no say in the matter.” Sraffa contended that far from ending in catastrophe, as Hayek suggested, “forced saving”—which may perhaps better be described as “inappropriate lending”—ended happily. From the moment that inflation ends as “the newly started processes of production begin to yield consumable products, . . . entrepreneurs will be able to meet their outgoings for current production and for maintenance of the increased capital entirely out of their receipts from sales, without need of any additional inflationary money.” This could only happen, Sraffa agreed with Hayek, if wages did not rise to meet the new costs. “I contend that this will not happen,” Sraffa declares, for the reason Hayek gives in a footnote to his previous article: “Except for such amounts as may be absorbed in cash holdings in any additional stages of production.” “Exactly,” Sraffa exclaims. “If Dr. Hayek had taken as much pains in writing his book as his reviewer has taken in reading it he would remember that under his assumptions such cash holdings will absorb not merely certain exceptional amounts, but the whole of the additional money issued during the inflation; that consequently incomes cannot rise at all, and there will be no occasion for any dissipation of capital.”

In his article Hayek challenged Sraffa to reveal what he really believed, as the intellectual basis of his thought had been left unstated. Now Sraffa responded with the deepest ridicule. “After [Sraffa’s exposition of the flaw in Hayek’s logic], Dr. Hayek will allow me not to take seriously his questions as to what I ‘really believe.’ Nobody could believe that anything that logically follows from such fantastic assumptions is true in reality. But I admit the abstract possibility that conclusions deduced from them by faulty reasoning may, by lucky accident, prove quite plausible.” Sraffa had intended the sentence to be a knockout blow.

There was one last piece of tidying up for Sraffa. In his arguments about the natural rate of interest, which at a time of equilibrium left money effectively neutral, what Hayek called the “money rate,” Hayek had conceded, on Sraffa’s prompting, that there was no single overall natural rate but a succession of different natural rates that were appropriate for different commodities. Having considered the matter further, Sraffa was ready to pounce. The Austrian School economist Knut Wicksell, who had developed the notion of the natural rate and money rate of interest, had acknowledged that there was no single natural rate but a number of different natural rates for each commodity. There was, for instance, a natural rate for apples and a different natural rate for wool. Sraffa’s solution was to notionally weight each of the natural rates so that there emerged a composite natural rate that equalled the aggregate money rate for the whole of the economy at a time of equilibrium. “This way of escape was not open to Dr. Hayek,” crowed Sraffa, “for he had emphatically repudiated the use of averages.”23 And on that sour note the to-and-fro between Hayek and Sraffa came to an abrupt end.

This side duel in the great Keynes-Hayek debate was technical, obtuse, difficult to follow, and ill-tempered. Much of it amounted to little except an exercise in logistical sparring between two heavyweight thinkers. Hayek was convinced that the economy as a whole was an elusive subject that could only be understood, and even then only partially, by considering the interaction of individuals in the marketplace. Keynes, however, was in the process of making a breakthrough in thinking that would emerge only on publication of The General Theory. He believed an economy could best be understood by grasping the big picture, looking from the top down at aggregates of such elements of the economy as supply, demand, and interest rates. Hayek was stuck in what came to be known as “microeconomic” thinking, looking at the different elements such as costs and value that made up an economy, while Keynes was making the leap to a new way of considering the working of the economy: macroeconomics, which appraised the economy as a whole. It is little wonder that the arguments between Keynes and Hayek before The General Theory was published settled so little, for they were attempting to explore by wholly microeconomic means the profound difference that was emerging between Hayek’s microeconomic approach and Keynes’s nascent macroeconomic notions.

There was no meeting of minds. As Frank Knight sighed, “I should like to see some headway which I do not see towards establishing terms and concepts in which economists could talk to each other and when they argue, argue issues rather than disputing about the meaning of each other’s assertions.” As for the Hayek-Sraffa sideshow, he wrote, “I haven’t seen anyone who could tell what Sraffa and Hayek were arguing about.”24

It was far from clear at the time that the debate between Hayek and Sraffa would be of any importance to the history of economics. Some suggested it amounted to nothing but letting off steam, “the almost juvenile sparring of two young Turks.”25 However, Ludwig M. Lachmann, Hayek’s graduate assistant at the time of the Sraffa exchange, recalled that “the more perceptive sensed that they were witnessing a clash of two irreconcilable views of the economic world. The less perceptive were just puzzled by what the two contestants were after. But nobody liked what he saw. . . . That these were the opening shots in a battle between two rival schools of economic thought was not one that would readily occur to the average Anglo-Saxon economist of the 1930s.”26