What Would Hayek Do?
Four years after the crash, the U.K. is still trying to spend its way out of recession.
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By EAMONN BUTLER
"Why did no one see this coming?" asked Queen Elizabeth II at the London School of Economics shortly after the 2008 crash. The LSE's finest stared at their shoes.
Mainstream—Keynesian—economists have been humiliated. They did not predict the crash, cannot explain it and their supposed solutions have been failing since 2008. Only their disparaged, so-called Austrian School colleagues—followers of the late Friedrich Hayek—have a convincing narrative and a plan to fix things. Trouble is, there are precious few Hayekians in government.
So, four years on, we are still trying to spend our way out of recession. U.K. Chancellor George Osborne's much-vaunted 2% spending cuts—spread over two years—announced in his budget this week hardly dent the 53% rise in public spending under the previous government. For all his supposed "austerity," Mr. Osborne has added as much to U.K. net debt in less than three years as his supposedly spendthrift predecessor Gordon Brown did in 10. Indeed, the £759.5 billion debt Mr. Osborne inherited will soar to £1.6 trillion by 2017-18. Meanwhile, big doses of "quantitative easing" have failed to revive things. Despite a sliding pound, U.K. exports are stagnant. Official growth forecasts have been halved. This Keynesian-style spend-borrow-print policy just isn't working.
Step forward Friedrich Hayek. He knew a thing or two about banking crises. When economists were throwing their hats into the air to welcome the Roaring Twenties, he knew things weren't right. He started researching business cycles and predicted that the boom would turn to bust. Four years later, Wall Street crashed.
The boom, Hayek explained, was caused by central banks making credit too cheap. That spurred people to borrow for spending and investments that were ultimately unviable. The fractional-reserve banking system compounded the fake boom by creating new money to throw at the borrowers.
Associated Press
Friedrich Hayek
The same happened this latest time round, say the Austrians. Booms make central bankers look brilliant, so Alan Greenspan kept interest rates far too low for years. Meanwhile, the Bank of England let inflation rise at a time when—with cheap Chinese imports flooding in—prices should actually have been falling. Britons, among others, borrowed to buy houses we can not pay for and invested in producing luxuries that people can no longer afford. The government joined in on the spree: that 41% spending-to-GDP ratio in 2007 was up from about 35% in 2000.
Now that reality has reasserted itself, all those misplaced assets must be written off. Some can be reshuffled into uses that make more sense. Others just have to be scrapped. That is and will continue to be a painful process. Production chains are long and complex and there will be losses all round. And the boom was long, so many investment mistakes have accumulated. But Britain has to restructure. The Keynesian spend-borrow-print prescription of reigniting the boom is like trying to deaden a hangover with another drink, say the Austrians.
Curing the underlying problem would be a lot easier if governments would let markets do their job, rather than smother them with taxes and regulations. Market prices tell us where we should be investing. Except artificially low interest rates, which persist today, have kept everyone thinking that credit grows on trees. Minimum wages and price controls, too, stifle the signalling function of prices. Hayek would scrap them. Employment regulations must also be curbed—they gum up the labor market and slow the movement of workers from failing boom-time companies to emerging, productive ones. By raising the cost of market entry, regulations also stymie competition, which is exactly what markets require if they're to add value to the economy.
High taxes also discourage start-ups and so, again, hamper assets from being shuffled into more productive uses. Higher tax rates don't even necessarily help balance governments' books. Entrepreneurs (and movie stars) are leaving France in droves to escape François Hollande's disastrous wealth and income taxes. The U.K.'s 2010 hike in capital-gains taxes, to 28% from 18%, has been followed by a 76% drop in asset disposals since, according to research published last month by the Adam Smith Institute.
These burdens on business need to be reduced, and if it does mean lower revenues and more checks on government spending, fine: Westminster's outlays have ballooned over the last two decades. But Hayek was no fan of hair-shirt austerity—deep and sudden spending cuts, he thought, could damage a country's delicate capital structure. The best time for ambitious government cut-backs would have been during the boom, but it's too late for that now. Better instead to let interest rates rise; incentivize people to once again save for investment; and pronounce dead those zombie firms that have only been kept going through cheap credit. Some quantitative easing had its place after the crash when banks stopped lending, but ongoing Keynesian efforts to refuel the boom with still more QE are, today, sheer fantasy.
The banks' fractional reserve system makes the boom-bust cycle worse, creating money on the upswing and destroying it in the slump. Hayek would want real controls on them—but not the dodgy Basel conditions in which one bank's loans count as another's capital. Robert Miller, in his new Adam Smith Institute Paper, "What Hayek Would Do," suggests instead curbing the banks' ability to create and destroy money by forcing them to keep high (30% or more) reserves of hard cash.
As for central bankers, we need to take away their punch bowl. They've proven repeatedly that they're not to be trusted with interest rates. Hayek suggested they should lose their monopoly over currency: Legal tender rules should go, and private firms ought to be allowed to compete and issue their own notes. Competition in currency would keep interest rates sound.
Farfetched? Maybe. But when you look at bond rates and realize that private companies today are often trusted rather more than governments, perhaps not.
Mr. Butler is director of the Adam Smith Institute in London.
