Irving Fisher, Friedrich Hayek and Milton Friedman Walk Into a Bar…

If you’re wondering where Lord Keynes is, he’s on the other side of the bar, pouring the drinks.

If those four names don’t mean anything to you, don’t fret. The joke is on them.

They are the four economists whose theories of the business cycle are the source of all the controversy today. They each have different views on the causes and cures of economic downturns. All economic policy stems from one of their prescriptions for the world’s economic troubles today. Thus, the one you agree with will shape your view of what should, or should not, be done about the economic crisis the world faces.

Anyway, the four economists have decided to have a get together (with the aid of some time travel) to sort out once and for all what can be done about economic depressions. Keynes, who co-owns the bar with Federal Reserve Chairman Ben Bernanke and President Barack Obama, has agreed to host the event and provide the social lubricant on the house. Along with a free lunch.

After some jovial sarcastic comments about how depressions cannot occur because the free market is always in equilibrium, the four intellectual enemies get down to business.

Irving Fisher, the eldest of the four, begins the discussion:

‘Too much debt is the problem. An economy that has borrowed too much money will experience a depression. It’s as simple as that. Here are the key factors:

(1) Debt liquidation – people and businesses default on their debt

(2) This causes the money supply to fall and there is distressed selling to pay off debt

(3) The value of money rises and prices fall (deflation)

(4) The net value of businesses fall ($ debt stays the same while $ assets fall due to falling prices)

(5) Profits fall

(6) Trade and employment decrease

(7) There is a loss of confidence

(8) People hoard money, as its value increases

(9) There are ‘complicated disturbances in the rate of interest’

Everyone nods in agreement. Fisher, an advocate of prohibition policies, gulps down some cranberry juice (he was also a health guru) and continues:

We can’t really stop the indebtedness from occurring, so we are stuck with many of the problems of the business cycle. But if we can stop the price level from falling, the contagion won’t spread. Viable businesses won’t be exposed to the falling prices of what they sell and so their debt levels should remain manageable. In other words, we can take the deflation out of the depression. That will make the downturn much milder.

Hayek, bored with the discussion so far, puts Keynes’ homebrew up to the light and examines it closely before asking Fisher:

And how do you plan to fix the price level?

Keynes sets down his already empty glass and comes to Fisher’s rescue:

Government spending! (Hic) If prices are falling, that’s a problem of aggregate demand. (Hic) Kick start spending and the economy will get going again. (Burp)

Hayek, offering his own glass of beer to Keynes, asks ‘and how will the government pay for the spending?

Friedman, known for his ability to demolish the economics behind just about any government policy … except the monetary kind … puts down his bourbon and takes a deep breath.

Keynes is right about aggregate demand. But government spending causes a whole bunch of problems. Better to let the central bank handle this one. By engaging in some monetary stimulus with lower interest rates and more money, prices will stay stable and aggregate demand will be stimulated. That demand will keep prices up, along with the inflationary effects of more money.

Hayek asks Friedman the same question:

And how will the private sector pay for the spending? It seems to me that both Keynes and Friedman propose encouraging more borrowing. They propose more debt to solve the problem of indebtedness.

For government to spend, it must tax or borrow. In a depression, tax revenues fall and raising tax rates would reduce economic growth. If the government borrows, it will merely join the debt cycle, eventually becoming over indebted itself.

As for monetary stimulus, lowering interest rates will only encourage more debt. And printing more money will only stimulate growth if the banks lend out the new money – which means there will be more debt.

Both your policies advocate returning to what caused the problem – reflating the bubble. If they work, it will only make it bigger next time around.

Keynes dismisses this pessimism with his time-honoured philosophy: ‘Who cares? We’ll be dead by then.’

Friedman asks Hayek; ‘So what should be done then?’ Keynes chimes in; ‘Yeah, doing nothing would mean a terrible depression.’

Hayek sighs.

No. Doing nothing would have avoided the problem in the first place. You are right that over indebtedness causes a depression. People, businesses and governments all realise they cannot afford the debt. They invested the money in things that do not justify the cost of the debt by providing revenue that exceeds the debt. Now they have to liquidate that debt by paying it off or defaulting. And that causes the deflationary contagion that Fisher fears.

But why is there so much debt in the first place? And why was it so poorly invested? None of you seem to explain that. And don’t tell me it’s just a cycle. People make mistakes, but they only do it as a group at the same time when there is a reason for it – a cause.

Remembering that debt and money are synonymous in the monetary system we live in, it should become obvious. Who controls the price and quantity of money? The government and/or the central bank do. Along with the private banks that can create money out of thin air, as Fisher often laments.

Just as price controls, rationing and fraud wreak havoc in any industry they are employed in by government and monopolists, so they wreak havoc in the banking industry – the industry of money. And money is half of every transaction.

If government keeps interest rates too low and creates too much money, which is then multiplied by the banks, there is too much debt. Eventually this will lead to the over indebtedness that causes a depression. The money and debt vanishes because it was never real. It only existed as bookkeeping entries on the central banks and private banks balance sheets.

Profitable investments are financed by real savings – deferred consumption – not imaginary money created out of nothing. Entrepreneurs are fooled by this sleight of hand on the part of their bankers. They think they are investing real savings, with the consumption that was deferred becoming their demand in the future. But, as the savings weren’t real, the consumption wasn’t deferred and so never materialises. Thus, the malinvestments are exposed.

That may or may not be true, but you haven’t answered my question,’ Friedman points out. ‘Now that we are in debt, what should we do?

Hayek smiles. ‘Buy gold.

While you, Markets and Money reader, have been busily following Hayek’s financial advice, the world’s policy makers have been doing the opposite. They have been following Keynes’ and Friedman’s advice. The central bankers have been lowering interest rates and printing money. The politicians have been borrowing and spending.

The combination of Friedman’s monetary stimulus and Keynes’ fiscal stimulus has kept the price level stable. But there has been no recovery in nations that suffered from over indebtedness. At least not of a respectable kind. And now sovereign debts are looking shaky.

Other nations, which were merely affected by the global financial crisis, but did not suffer from over indebtedness themselves, are looking shaky too. China is the big one. It has been brought to the brink of too much debt itself after engaging in government stimulus on a grand scale. With inflation already high and the excessive leverage already in the government sector, there is little room to manoeuvre compared to 2008. Another economy saving stimulus will be difficult.

So whether it’s Europe, the USA, or China, Australia would be in trouble.

The odd thing is that all three seem destined for serious trouble, but markets still look poised to suffer when one of them hits the brick wall of reality. Why aren’t markets factoring in the unavoidable crisis?

Some markets are. Yields on troubled European bonds have been steadily rising, indicating higher risk. All the talk about bond holders having to share in the pain of a bailout is rather ignorant considering many bondholders would already be facing massive unrealised losses. German newspaper Bild is reporting (in German) that part of the new bailout package for Greece declares Greece officially bankrupt and bondholders are facing tough choices.

Despite that, the news of the new Greek bailout sent markets flying, just adding to the illusion of hope. It’s time to head for the lifeboats, not bail out the water.

Unless you’re a trader that is. Murray Dawes has his Slipstream Trader subscribers poised to profit from all this uncertainty. To find out about his latest analysis, you can watch this free video.

Maybe stocks are rising because markets are factoring in some serious inflation. Stocks often go up in such an environment, while bonds fall. The inflation hawkish Germans are putting their time where their mind is on this one. A new gold panning craze has sprung up. And it’s front web-page news.

Here in Australia, Qantas pilots are making the front page. They are threatening industrial action over a number of issues. Apparently they will be announcing something on the topic to their passengers during international flights.

Our bet is their concerns are caused by inflation too. Living costs are rising, requiring regular renegotiation of contracts. This is the sort of thing inflation does to a society. Binding contracts become manipulated as prices move about. Former Federal Reserve board member Henry C. Wallich wrote in 1978; ‘Inflation introduces an element of deceit into most of our economic dealings.’ And it’s usually both sides that feel deceived.

Why Qantas pilots consider themselves to be owed a job more than whoever would replace them is a mystery to us. Supposedly it has something to do with their passport. We’ve never understood the nationalistic argument. ‘Send aid to poor countries, but don’t give them any jobs…’ Anyway, surely an employer has the right to choose who works for them. To be honest, employers are required to run their business in the best way by law. And by their shareholders.

The best’ is largely defined by what customers want. So, depending on what the pilots actually say on our international flight on Sunday, that part of their PR campaign might be the best way to go about getting their way – influence the customers instead of fighting the employer. No doubt we’ll be back with the same issue in a few years time though. Inflation doesn’t stop.

Until next week,

Nick Hubble
Markets and Money Australia Weekend

Nick Hubble
Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

Leave a Reply

4 Comments on "Irving Fisher, Friedrich Hayek and Milton Friedman Walk Into a Bar…"

Notify of
Sort by:   newest | oldest | most voted

Excellent Nick. Colourful little distractions such as the gold panning article a great idea.
Agree with Murrays short term neutral stance, cant be too careful shorting markets and he’s done well to get his results. I’m certain this market will trap some shorts sooner or later. It likes to make other people pay for elevating tricks.

Good article Nick,but will any politician listen, of course not,and its all up to them is it not.The banksters will have their way and we the poor taxpayers will foot the bill as usual.Here in the UK, we wait with bated breath as what happens in the eu effects us here.Yesterday a report said twenty two (22) shops close down every day in the UK and the rest are having permanent sales,a scenario soon to be in Aus maybe. I am returning to Australia soon and due to the exchange rate my savings are dwindling as i write,could someone from… Read more »
Join the crowd shortchanged. I work in the Middle East with a salary in US Dollars. The value of my income has slumped by over 40% in the past 2 years. I’ve had it – I’m outta here at the end of the year. And it is happening in OZ – I was home for hols in June – the prices of food and basics literally blew me away. Shops are closing and business is as bad as its been in the local’s living memory. We live in the Riverina Area of NSW. Local wine and orange industries – which… Read more »
Nicholas Wapshott
If you would like to know what actually happened in the original debate between Keynes and Hayek you may be interested to know that my book Keynes Hayek: The Clash That Shaped Modern Economics is published by W.W.Norton in the US in October and in Australia by Scribe. Professor John B.Taylor of Stanford and the Hoover Institution says: “Nicholas Wapshott brings the Keynes-Hayek fight of the 20th century back to life, making the clash both entertaining and highly relevant for understanding economic crises of the 21st century.” Sean Wilentz, Professor of History at Princeton, says, “‘Nicholas Wapshott’s Keynes Hayek is… Read more »
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to