If there are two things most people can agree on these days, they are that free market capitalism is the only practical way to organize a modern society and that the key to economic growth is "knowledge." So prevalent are these beliefs that their origins are rarely examined, which is somewhat surprising, since both statements can be traced back, in large part, to one man, Friedrich August von Hayek, a reserved Austrian economist who died in 1992. In November 1989, when the Berlin Wall came down, Hayek was a frail but mentally alert 90-year-old living in Freiburg im Breisgau, Germany, a picturesque town in the Black Forest. Hayek didn’t issue any public statements, but he thoroughly enjoyed watching the television pictures from Berlin, Prague, and Bucharest. "He would beam benignly, and the comment was ‘I told you so,’" said Hayek’s son.
|Illustration by Taylor Jones for the Hoover Digest.|
Hayek did indeed tell us so and at a time when that message was deeply unfashionable. In 1937, in the wake of the Great Depression and with capitalism and democracy under siege from communism and fascism, he published an academic article entitled "Economics and Knowledge," which pointed out that free markets were not just a political construct, as many critics claimed, but remained the best way of coordinating scattered information. Seven years later, when most of the world’s major economies were under unprecedented central control, Hayek published The Road to Serfdom, a damning indictment of socialism and state planning that once more, this time in plain English, laid out the fundamental advantage of the free market: by allowing millions of decision makers to respond individually to freely determined prices, it allocates resources—labor, capital, and human ingenuity—in a manner that can’t be mimicked by a central plan, however brilliant the central planner.
This argument is now widely accepted, but when The Road to Serfdom was published, Hayek later recalled, "it went so far as to completely discredit me professionally." Many of his colleagues interpreted the book as a dangerous and antediluvian attack on the welfare states that were being built in wartime Britain, where Hayek lived, and in other European countries. The reviews didn’t get any better for a long time. During the 1950s and 1960s, the Soviet economy appeared to be doing pretty well, and the social democracies of Western Europe, with their large and growing state sectors, prospered mightily. In 1967, Eric Hobsbawm, the Marxist historian, dismissed Hayek as a "prophet in the wilderness"; in the same year, Anthony Quinton, a British philosopher, dubbed him a "magnificent dinosaur."
If economic history had stopped when the Beatles split up, Hayek would have remained a museum piece favored mainly by right-wing cranks. Even when I began studying economics, at Oxford, during the early 1980s, Hayek, with his seemingly outlandish proposals to emasculate the trade unions and privatize the money supply, was still considered well beyond the pale. True, he had received the Nobel Memorial Prize in 1974, but that was seen within the profession as a political sop, with Hayek’s name added to balance that of his cowinner, Gunnar Myrdal, a left-wing Swedish economist. (Myrdal later said that he wouldn’t have accepted the award if he had known he would have to share it with Hayek.) I made it all the way through undergraduate and graduate school without reading Hayek, and I wasn’t unusual. Even today, eight years after Hayek’s death, there is no scholarly biography available. Most economics textbooks still don’t mention him, and his intellectual legacy is often obscured, even by his admirers.
In a forthcoming essay in the Journal of Economic Perspectives, for example, János Kornai, the Hungarian economist who holds a chair at Harvard, reports that several decades of comparing capitalism and socialism have convinced him of two things: capitalism is a necessary condition for democracy, and technological development is faster under capitalism because the system encourages innovation. Kornai mentions Hayek’s work in passing, but he doesn’t say that Hayek made precisely the same points more than 50 years ago, in The Road to Serfdom, and amplified them in a series of books during the ensuing 45 years. Hayek got some things wrong (he was tardy about acknowledging the need for government action to reduce unemployment during the 1930s, for example) and neglected others (such as inequality and pollution); but on the biggest issue of all, the vitality of capitalism, he was vindicated to such an extent that it is hardly an exaggeration to refer to the twentieth century as the Hayek century.
Hayek versus Keynes
Hayek wasn’t the most brilliant economist of his era (that was probably John von Neumann, the Hungarian mathematical genius who invented game theory) or the most eloquent (John Maynard Keynes, Hayek’s sparring partner during the 1930s, nabbed that title), but he was arguably the most durable. Like Karl Popper, Hayek was a product of fin de siècle Vienna. Critics can claim, with some justification, that his sunny view of capitalism reflected his initial vantage point above the clouds.
He was born into an upper-class Austrian family on May 8, 1899. After serving as an artillery officer in the First World War, Hayek entered the University of Vienna. After considering psychology, he settled on law and economics, subjects that appeared to offer brighter career prospects. Many of Hayek’s fellow students would gather at the Kaffee Landmann to discuss Marxism and psychoanalysis, but Hayek found these fashionable disciplines "more unsatisfactory the more I studied them."
At this stage, Hayek was mildly socialist. His views changed as he studied under leading members of the pro–free market Austrian school of economics, especially Ludwig von Mises—who in 1922 published a critical book on socialism. Hayek became von Mises’s research assistant, and his mentor’s teachings—especially those that dealt with the central importance of entrepreneurship in what von Mises termed the capitalist discovery process—remained with him for life.
Hayek’s view of capitalism as a spontaneous information-processing machine was one of the great insights of the century.
After earning his economics doctorate in 1923 and spending just over a year in New York working as a research assistant at New York University, Hayek went to work for von Mises at the Abrechnungsamt in Vienna, a government office that dealt with official debts and other state financial issues. The two great issues of the day were inflation and what drives business cycles. On the former, Hayek deferred to von Mises, who, in protomonetarist fashion, argued that the only way to end the hyperinflation that plagued Germany and Austria was to stop the government from printing more money. Business cycles—the tendency for economies to oscillate between booms and recessions—were another matter; neither the Austrian economists, such as von Mises, nor the American neoclassicists, like Columbia’s John Bates Clark, could explain them properly, and this failure was recognized as a gaping hole in economic theory. Hayek set out to fill the gap. His theory, which was eventually expostulated in a 1931 book, Prices and Production, portrayed economic slumps as the inevitable product of prior booms, during which growth had become "unbalanced," with investment in the expansion of industrial capacity outstripping the supply of savings in the economy; recessions, in this view, were a way of restoring the balance between savings and investment.
Hayek’s ideas attracted attention in England, where one of the great economic debates of the century was unfolding. On one side, John Maynard Keynes and his young Cambridge acolytes were developing the theory that economic downturns were caused by a lack of overall demand in the economy and could be prevented by cutting taxes and increasing public sector spending. On the other side, figures such as Lionel Robbins, at the London School of Economics, were defending the traditional view that recessions were "nature’s cure" and that the only way to forestall them was through wage cuts and government retrenchment. Robbins spotted Hayek’s work and saw a potential ally against Keynes. He invited Hayek to the LSE, first as a guest lecturer and then, in 1932, as a full-time professor. Keynes dismissed Hayek’s theory as "one of the most frightful muddles I have ever read"; and for the ensuing five years the cannons pointing north from London and south from Cambridge were rarely silent, with virtually everybody in the British economics profession taking one side or the other. The two primary combatants, however, remained on surprisingly amicable personal terms. "Hayek has been here for the weekend," Keynes wrote to his wife in March 1933. "We get on very well in private life. But what rubbish his theory is."
In the end, Keynes won the battle over macroeconomic policy. The intellectual framework he set out in The General Theory of Employment, Interest, and Money, which was published in 1936, is still used by central banks and governments the world over to manage their economies. Hayek’s work on business cycles is rarely referred to these days—although his argument that periods of overinvestment tend to end in slumps has never been fully refuted. (Certainly, few inhabitants of Indonesia, South Korea, or Thailand would quibble with it after their experience in the past few years.) Whether Keynes, who died in 1946, won the larger war over the proper role of governments and markets is another question. A less intellectually self-assured man than Hayek might have changed or, at least, questioned his views. Hayek found his isolation increasingly discomforting, but it served only to convince him that the rest of the world was on the wrong track.
Refuting Central Planning
In 1937, Hayek published "Economics and Knowledge." The paper attracted little public attention at the time, but, in retrospect, it marked the origin of what became Hayek’s most lasting contribution to economics: the notion that free markets and free prices are a means of conveying and exploiting information. In any society, the central economic problem is how to best organize production and employ available resources in order to satisfy the needs and desires of millions of different people. Many of Hayek’s contemporaries believed that the best way forward was via central planning, which would allow resources to be directed to socially useful areas while avoiding the chronic instability of capitalism. Hayek begged to differ. Centralized systems may look attractive on paper, he argued, but they suffered from a basic and incurable ailment: the "division of knowledge" problem. In order to know where resources should be directed, the central planner needs to know both what goods people want to buy and how they can most cheaply be produced. But this knowledge is held in the minds of individual consumers and businesspeople, not in the filing cabinets (or, later, computers) of a government planning agency, and the only practical way for customers and firms to relay this knowledge to each other, Hayek argued, is through a system of market-determined prices.
"We must look at the price system as such a mechanism for communicating information if we want to understand its real function," he wrote in a 1945 paper, "The Use of Knowledge in Society." In a market system, people simply go out and buy the things they like, leaving unwanted goods on the shelves. If they want more of something—say, heating oil—it becomes scarce and its price rises, thereby prompting oil companies to increase production and consumers to economize. If people decide to use less oil, say, because natural gas has become cheaper, the price of oil will fall, and its production will be scaled back—all this taking place without any orders being issued by a government agency. "I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind," Hayek wrote.
This view of capitalism as a spontaneous information-processing machine—a "telecommunications system" was how Hayek referred to it—was one of the great insights of the century. It may have been implicit in the work of some previous economists, notably Adam Smith, but Hayek was the first to spell it out.
| The collected papers of Friedrich Hayek are housed in the Hoover Institution Archives. The extensive collection includes many of the original manuscript drafts for The Road to Serfdom (shown here), as well as other of Hayek’s important writings. The collection also includes the decades-long correspondence between Hayek and Karl Popper, in which they discuss their various intellectual endeavors and critique each other’s work.
Hoover Institution Archives
Even left-wing economists, who regarded capitalism primarily as a system of social exploitation, were eventually forced to concede the acuity of Hayek’s analysis, and this resulted in elaborate efforts to construct a viable form of "market socialism," one that would combine common ownership of the means of production with freely determined prices. Hayek was always skeptical of these efforts. In a socialist system, prices could not play the same role that they do under capitalism, he argued, because under socialism there would be no competitive firms to react to the prices by innovating and redirecting resources. This point was confirmed in practice, as anybody who had the misfortune to drive an East German Trabant motorcar or to wear a Romanian suit, the prices of which were supposedly set in the market, would gladly testify.
Since the collapse of communism, of course, Hayek’s arguments have become commonplace. From Mexico to China, the first move of reformist governments has been to privatize state-owned businesses and liberalize prices, usually with positive results.
The Road to Serfdom
When the Second World War broke out, many British economists entered the wartime civil service, but Hayek, who had taken British citizenship in 1938 and supported the Allies wholeheartedly, was excluded because of his background. The snub gave Hayek time to write The Road to Serfdom.
Unlike Hayek’s earlier work, The Road to Serfdom was an explicitly populist tract, conceived in response to the growing support among British intellectuals for increased state intervention in the economy. Sir William Beveridge, a former colleague of Hayek’s at the LSE, had published two famous papers that laid the intellectual basis for the postwar welfare state. To Beveridge, capitalism needed saving from itself with a large dose of government control. Left untended, it had given the world, first, a Great Depression and, ultimately, fascism.
Hayek never accepted that fascism was a capitalist phenomenon. To him, Stalin and Hitler were two suits in the same closet, and the closet was marked "collectivism." Hayek dedicated his book "To the Socialists of All Parties." It was directed primarily against "classical Socialism," by which he meant "nationalization of the means of production," but what made it so controversial was the comparisons he drew between Nazi Germany and the way things were heading in the democracies. "Although few people, if anybody, in England would probably be ready to swallow totalitarianism whole, there are few single features which have not been advised by somebody or other," Hayek wrote. "Indeed, there is scarcely a leaf out of Hitler’s book which somebody or other in England or America has not recommended us to take and use for our own purposes."
In the United States, where opposition to the New Deal and to wartime industrial planning was strong, The Road to Serfdom caused a sensation. More than 600,000 copies were sold, and Hayek went on a wildly successful speaking tour, becoming something of a celebrity in the process.
In retrospect, it is clear that Hayek seriously exaggerated the threat to liberty presented by social democracy of the sort practiced in Western Europe. For example, his attacks on compulsory health insurance, state-financed education, and regional development programs—all of which were intended to help people fulfill their individual potential—were often overheated.
A less intellectually self-assured man than Hayek might have changed or, at least, questioned his views. Hayek found his isolation increasingly discomforting, but it served only to convince him that the rest of the world was on the wrong track.
All the same, the context in which Hayek was writing must be recalled. Many of his brightest pupils were Socialists or Communists; the true nature of Stalin’s regime was not yet commonly known; and capitalism had disgraced itself, for all to see. If the lure of central planning was to be repelled, lectures about the merits of Adam Smith and J. S. Mill would not suffice. The link between collectivism and tyranny would have to be spelled out in language that the man in the corner pub could understand. "Planning leads to dictatorship," Hayek wrote, "because dictatorship is the most effective instrument of coercion and the enforcement of ideals and, as such, essential if central planning on a large scale is to be possible." If these passages evoke memories of George Orwell, it is hardly surprising. Orwell reviewed Hayek’s book favorably, and in many ways The Road to Serfdom was the nonfiction precursor to Animal Farm, Orwell’s 1945 fable about the dangers of collectivism.
From Chicago to Stockholm
When he returned to London from America, Hayek was an internationally renowned (and, in many quarters, reviled) figure. In 1950 the University of Chicago offered him a position, although not one in economics.
Chicago’s economics department had refused to accept Hayek, despite his promarket views. "My understanding is that this was because, at that stage, he really wasn’t doing any economics," Milton Friedman, who joined the Chicago faculty in 1946, told me recently. Hayek joined the Committee on Social Thought, which John Nef, an economic historian, had recently set up, attracting over time a host of distinguished figures, including T. S. Eliot, Michael Polanyi, and Hannah Arendt. The new job suited Hayek well. He had little sympathy for the mathematical direction in which economics was going, considering it a futile application of the methods of classical physics to social phenomena that resisted Newtonian mechanics. (Hayek believed that the economy was an innately "complex" and unpredictable beast—a lesson taken up by some economists only in the last decade or so, as they have begun to apply evolutionary models and chaos theory to economics.)
His weekly seminar, "The Liberal Tradition"—Hayek always used the word "liberal" in its nineteenth-century sense—covered a panoply of thinkers, from Locke to von Mises. The seminar formed the basis for The Constitution of Liberty, published in 1960, which some consider to be Hayek’s finest book. (Its fans included Margaret Thatcher, who, during a visit to the Conservative Party’s research department in the mid 1970s, slammed a copy of it on the table and declared, "This is what we believe.") Capitalism had proved remarkably effective at raising living standards, Hayek argued, but its success wasn’t automatic; it depended on the existence of a generally accepted set of social norms (among them the sanctity of private property), a system of laws reflecting these norms, and a government that enforced the laws fairly, rather than discriminating arbitrarily among individuals. If any of these things were absent, economic development would be stymied.
Hayek was by no means antigovernment on principle. He simply believed that, unless there are strong and specific arguments to the contrary, the market is usually the most efficient method of providing goods and services.
The pertinence of Hayek’s analysis has been amply demonstrated since the collapse of communism. Many Western economists, including most of those who acted as advisers to postcommunist governments, believed that the collectivist economies could be transformed merely by freeing prices and privatizing state-owned firms. In Hungary, Poland, and Czechoslovakia—where capitalism predated communism, the rule of law was firmly established, and governments tended to respect private contracts—the optimists were proved, pretty much, right. In the former Soviet Union—where capitalism had never taken deep root, legal contracts were an alien tradition, and official corruption was rampant—the optimists got it horribly wrong. In Russia, for example, prices have been freed and firms have been privately owned for more than five years, but the economy is still only half the size it was before communism collapsed.
Never entirely comfortable with the informality of life in America, Hayek felt the lure of the old Europe from whence he came. In 1962, he accepted a post at the Albert-Ludwigs-Universität, in Freiburg, a reputable institution, though not one on the level of Chicago or the LSE. Hayek loved the Black Forest scenery, but the move wasn’t completely successful. During the late 1960s, he began to suffer from deep and paralyzing depressions and often seemed unable to work. This was the era when faith in the power of government was at its highest and support for free markets was at its lowest. "He was depressed, I think, mostly because he saw the condition of the world as depressing, and he felt he wasn’t receiving the kind of recognition he hoped for," Milton Friedman told me.
Given the intellectual climate of the time, the 1974 Nobel Prize came as a complete surprise to Hayek, and it had a remarkably rejuvenative effect. Suddenly, he found the energy and inspiration to think, write, and travel again. In 1988, at the age of 89, he published The Fatal Conceit, an astonishingly erudite book that stressed the evolutionary nature of capitalism. By gradually learning to follow a few rules—honesty, how to exchange goods for money, respect for private property—he maintained, man had "stumbled upon" an extremely effective, though unplanned, method of coordinating human activity. Socialism, Hayek explained, was a futile attempt to overturn the evolutionary process. A year later, as if on cue, communism collapsed.
A Legacy for a New Century
During his years in intellectual exile, Hayek inspired or founded a network of libertarian groups, including the Mont Pelerin Society, the Atlas Economic Research Foundation, and the London-based Institute of Economic Affairs. These organizations kept Hayek’s ideas in circulation, but they also ensured that his legacy was appropriated by the far right. This is unfortunate. Hayek always saw himself as a nineteenth-century Whig, rather than a twentieth-century conservative, and, unlike many of his latter-day "followers," he was by no means antigovernment on principle. He simply reestablished the Victorian presumption that, unless there are strong and specific arguments to the contrary, the market is usually the most efficient method of providing goods and services. Where the market failed, though, the government should step in, providing defense, public infrastructure, and even a guaranteed minimum income for all citizens. It is quite possible to be a Hayekian and still believe in active government. "All I am arguing about is that, where you can create a competitive condition, you ought to rely upon competition," he insisted during a 1945 radio discussion. These days, everybody from Bill Gates to Jiang Zemin would agree with that statement.