Fear the Boom and Bust: Keynes vs. Hayek - The Original Economics Rap Battle!

Fear the Boom and Bust: Keynes vs. Hayek - The Original Economics Rap Battle!

I love this video, so I'm going to try to help explain some of the key concepts which may be unfamiliar.

Solution:
Steer Markets vs. Set Free

Keynes believed that Monetary and Fiscal policy are both good. Hayek thought they are both bad.

Definitions from provided by Wikipedia:

Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.
In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure (spending) to influence a country's economy. The use of government revenues and expenditures to influence macroeconomic variables developed as a result of the Great Depression, when the previous laissez-faire approach to economic management became unpopular.

Problem:
Low Interest Rates vs. "Animal Spirits"

According to Milton Friedman, who supported Monetary but not Fiscal Policy,

When it comes to the 1930s, history has not looked kindly on Hayek's arguments.  The classic study of the depression by Milton Friedman and Anna Schwartz, decades later, made a convincing case that it was caused by the US central bank pumping too little money into the economy, not too much.

Facts be damned, with low interest rates savers and lenders do worse while borrowers and investors benefit, so there is often a clear bias for supporting low or high interest rate policy.

The Animal Spirits refer to the irrational herd aspect of human psychology. Bear Markets go down and Bull Markets rush boldly into the unknown.

A 1901 cartoon depicting financier J. P. Morgan as a bull with eager investors.

"Sticky Wages"

Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change.  Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time.  For example, the price of a particular good might be fixed at $10 per unit for a year. Partial nominal rigidity occurs when a price may vary in nominal terms, but not as much as it would if perfectly flexible.  For example, in a regulated market there might be limits to how much a price can change in a given year.
In his The General Theory of Employment, Interest and Money, John Maynard Keynes argued that nominal wages display downward rigidity, in the sense that workers are reluctant to accept cuts in nominal wages.

Aggregate Demand

It is often said that in modern capitalism production and Gross Domestic Product (GDP) are "the only thing that matters", but in fact GDP must be met by aggregate demand!

In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time.[1] It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amount of goods and services that will be purchased at all possible price levels.

Production without demand is not bennfial to the economy.

C+I+G=Y

The formula for both AD and GDP. To many economist they are the same thing, but to a Kensian they merely average out over a long runl

Consumption + Investment + Government Spending = AD and GDP

This is an antiquated model for a "closed economy".

In an open economy a "d" follows to indicate "domestic" and X (exports) are added: Y = Cd + Id + Gd + X.

Econ Math get's pretty complicated, and both Hayek and Kaynes stressed the imposibility of perfectly modeling the economy.

Circulation Theory of Money

Ludwig von Mises another Austrian economist sums up the critism well,

"The main deficiency of the velocity of circulation concept is that it does not start from the actions of individuals but looks at the problem from the angle of the whole economic system. This concept in itself is a vicious mode of approaching the problem of prices and purchasing power. It is assumed that, other things being equal, prices must change in proportion to the changes occurring in the total supply of money available. This is not true."

Broken Windows

An old Joke:

I was out breaking windows one day when a police officer approached me.
"WHAT ARE YOU DOING!", she said.
"Stimulating the economy", I replied.

The joke is based on a statement from Bastiat, Frédéric's "That Which Is Seen, and That Which Is Not Seen" (1850)

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son has happened to break a pane of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation – "It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade – that it encourages that trade to the amount of six francs – I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."

In other words, it is not just the circulation of money but addition to the current stock of goods that produces wealth.

Liquidity Trap

A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest."

Defered Time Theory of Interest

In the most common context, interest is an amount charged to a borrower for the use of the lender’s money over a period of time.

For example, if you have borrowed $100 and you promised to pay back $105 after one year then the lender in this caseis making a profit of $5, which is the fee for borrowing his money.

Looking at this  from  the  lender’s  perspective,  the  money  the lender  is investing  is changing value with time due to the interest being added.  For that reason, interest is sometimes referred to as the time value of money.

Austrian Perpective

The Austrian School is a heterodox school of economic thought that is based on methodological individualism—the concept that social phenomena result exclusively from the motivations and actions of individuals.
Although the Austrian School has been considered heterodox since the late 1930s, it attracted renewed interest in the 1970s after Friedrich Hayek shared the 1974 Nobel Memorial Prize in Economic Sciences.

Capital Structure

Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

Malinvestment

In Austrian business cycle theory, malinvestments are badly allocated business investments, due to artificially low cost of credit and an unsustainable increase in money supply. Central banks are often blamed for causing malinvestments, such as the dot-com bubble and the United States housing bubble. Austrian economists such as the Swedish central bank's Nobel Memorial Prize in Economic Sciences laureate F. A. Hayek advocate the idea that malinvestment occurs due to the combination of fractional reserve banking and artificially low interest rates misleading relative price signals which eventually necessitate a corrective contraction—a boom followed by a bust.

Credit crunch

A credit crunch  (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks.[1]  A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs).  Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises).[2]