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Global macro & geopolitics from a small economy perspective

Keynes, Hayek, and the role of government

David Skilling
2 September 2011

This is the latest edition of an email series containing reflections on globalisation, policy, and public sector issues. In an increasingly uncertain, complex and turbulent world, with significant economic and social policy challenges, the appropriate role of government is the subject of much debate. This week’s Observer provides a perspective on how governments should think about their role in the economy, drawing on an almost 70 year old correspondence between Keynes and Hayek.

Keynes & Hayek
John Maynard Keynes and Friedrich Hayek corresponded in 1944, after the publication of Hayek’s ‘Road to Serfdom’. They were writing towards the end of a prolonged period of extraordinary economic and political turbulence, and with major unsettled policy issues, which perhaps makes their debate relevant to us.

Both men put issues of risk and deep uncertainty at the heart of their thinking, and this informed their perspectives on the role of government. One of Hayek’s big ideas was the distributed nature of knowledge and the inability of the government to access this information, with the implication that the government should stay away from planning. Indeed, Hayek believed that any economic planning was a slippery slope to totalitarian rule – and over subsequent decades wrote much on constitutional rules to limit the role of government in the economy (and society). In response, Keynes noted that he was in “deeply moved agreement” with Hayek on his preference for a limited government role. But he also noted that a line needed to be drawn somewhere, as governments always had a role, and that the slippery slope notion was not plausible. Specifically, Keynes believed that the government had a role in managing the macro consequences of private decision-making in conditions of deep uncertainty – and that a failure to discharge these responsibilities could undermine support for a market-based, democratic system. Keynes emphasised the importance of discretion in policy-making, perhaps having seen the negative effects of rules like the gold standard in the UK. And I think that Keynes was largely right.

Although the differences between Keynes and Hayek are often reduced to perspectives on fiscal stimulus or austerity, I think there are two implications arising from this correspondence that are more relevant for current debates: the importance of discretion in policy-making; and the need to manage the inevitable relationship between politics and economics.

The centrality of discretion
In a world of deep uncertainty and economic turbulence, policy-making discretion becomes even more important. Robust rules are unlikely to work well, as it is not possible to specify all the relevant states of the world; balanced budget rules or exchange rate arrangements may need to be changed if the world changes, for example. Often we simply don’t know enough to establish rules. Governments can clearly get things wrong, but tying the government’s hands generates economic and political exposures as well. As former British PM Harold Macmillan observed when asked about the greatest challenges to governing; “Events, my dear boy, events”.

One practical solution is ‘constrained discretion’, where guidelines and expectations are stated but not in a binding way. Indeed, a good example of this is the Bretton Woods institutions, of which Keynes was a primary architect. Countries had significant autonomy in terms of how to manage their economies, as long as they were consistent with some broad guidelines on the permissible size of the external balance. [An unfortunate irony is that Keynesians over the next decades turned Keynes’ thinking into rules-based demand management that was pushed beyond tolerable limits, leading to excessive public debt and inflation.]

Rules are easier for governments to administer and monitor. But in a turbulent world, with limited knowledge, intelligently-applied discretion and judgement is more important than ever. This places additional demands on strategic public sector capacity, and governments may need to deliberately invest to build this capacity.

Economics and political economy
Before economics became a branch of mathematics, it was often called political economy. The economy – and economic policy – was seen as necessarily embedded in the social context rather than standing apart. But there has been a concerted push over the past few decades to insulate economic policy from politics – to make it a technical or scientific exercise – in the pursuit of efficiency. However in many areas of policy, it is not clear that this is sustainable – or desirable.

Keynes worried about the robustness of support for a market-based system in times of slow and turbulent growth, which is an important part of why he saw a necessary role for government in the economy. He recognised that politics and economics are inevitably related, and that policy-makers need to think hard about the broader social environment. Issues of unemployment, income inequality, and the allocation of risk in an economy, are not just social issues – they also affect the social consensus around the way in which economies are run. In this view, politics is not so much a constraint on efficiency as much as a necessary foundation. Policy-makers need to think about balancing current performance and the underlying health of the system. This also suggests that policy discretion matters; a rules-based system may not be responsive enough (by design) and so may make the system more fragile.

These are messages that have particular relevance now, given the widespread economic challenges and the increasingly apparent domestic impact of globalisation. In a globalising world, there is really no such thing as domestic policy any more, and policy-makers need to determine how to position their countries in a way that works well on both economic and social dimensions.