During the Great Depression, John Maynard Keynes and Friedrich Hayek were building their economic models. After fighting out their fundamental differences at various debates, Keynes prevailed. But Hayek didn’t quit and was awarded the Nobel Prize for Economics in 1974.
Hayek was an ardent believer in Classical Liberalism during a time when its feasibility was being questioned because of the Great Depression. With his in-depth understanding of Economies and Politics, Hayek was able to grab people’s attention to his arguments. Hayek built on, what started as the simple concept of ‘laissez faire’ and redefined its meaning to a philosophical one. Most people know him for merely economics, but his plan was much larger than that. Hayek believed that larger social ends could be achieved by changing the economic system.
Born into an Austrian family of limited means, Hayek’s early lessons were about poverty and suffering. He served in the army during World War I, an experience that inspired him to look at what’s wrong with the society. Hayek was moved by the destructive effects of war on the economy and human dignity.
Later Hayek studied at the University of Vienna, where his association with the Austrian School of Economics began. Soon Hayek, along with the Austrian School, launched an attack on socialism. They wanted to dismantle the misconception of the “welfare state”. Hayek began writing several scholarly articles, including his most famous work The Road to Serfdom. This highly controversial book became an international bestseller. In the book, Hayek argued that by countries like the US Britain would unwittingly go down the same road as Soviet Russia if they continued embracing massive government welfare state programs.
After a long stint with the London School of Economics, Hayek moved to the University of Chicago, where he published two more books that brought him a lot of acclaim.
Hayek and the Business Cycle
Hayek believed the state to be an inefficient allocator of resources. The state really has no way to know what’s best for the people. Only the people themselves have full or partial knowledge of their interests and, therefore, the choices must be made by them alone.
In his book Prices and Production (1931), Hayek wrote about the evils of a centrally planned economy. His works show that such a system creates artificial demand and distorts price signals. Often, stimulus provided by the central authority gives rise to inflationary pressures and exerts a downward pressure on the interest rate. This discourages savings and people tend to overspend. This in turn leads producers to believe that there is demand for their products. In order to capitalize on this demand, the producers expand their production, bringing about a period of boom in the economy. While this may sound great at first, the joy is short-lived. The moment the central authority removes or reduces the stimulus, a reverse cycle takes place and the producers suddenly realize that there was no real demand for their products! As producers scramble to minimize their losses, layoffs take place and the situation worsens. This finally results in a period of downturn in the economy, characterized by high unemployment and high inflation.
Hayek on Price Signals
In a scholarly article named The Use of Knowledge in Society, published first in September 1945, Hayek wrote, “Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people… The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.”
Hayek explained that any change in the price of a commodity reflects its availability. When the price of a commodity rises, one of two things can happen. The producer can increase his production and bring down the costs (through economies of scale). On the other hand, some consumers may choose not to continue consuming the product, on account of the price rise, which brings down the demand and eventually the price.
Prices perform the function of a language in economic transactions, Hayek said, adding that a free price system would not only allow individuals to maximize their own interests, but would also result in the allocation of resources at a socially optimum level.
Friedrich Hayek has influenced politicians and economists throughout the 20th century. His works continue to be researched and studied by economists even to this day.