Hayek, Keynes and Friedman about the Crisis in the Eurozone


The financial crisis of 2008 pushed the world economy into a depression. After a year or so many economies, such as those of the BRIC-countries, recovered; the eurozone, however, stayed behind. Empirical research of Eichengreen (2012) shows that those countries, which stimulated their economies performed significantly better than countries, which implemented austerity programmes. Eurozone policies harmed the eurozone over a long period, and that makes it necessary to find out why the eurozone leadership was and still is so stubborn in keeping the wrong direction. In this article we will discuss the theoretical contributions of three outstanding economists, who dominated economic science during the twentieth century: Hayek, Keynes and Friedman. We will see that the policy debates inside the eurozone were dominated by the ideas of Hayek and Friedman, while it seems almost forbidden to speak about Keynes. This bias will appear the most important reason why the eurozone has failed, and why so many economists attribute the failure to the existence of the euro rather than to ineffective monetary, budget and income policies.

We will first discuss the contributions of Hayek, Keynes and Friedman. We will see that they all experienced chaotic situations full of uncertainty, which had an effect on the way they framed the world. Hayek and Keynes do not attach value to large econometric models, and use their intuition – fed as it is by studying phenomena from different perspectives. Friedman, however, studied mathematics and classical liberal economics, and tried to confirm his liberalism by applying econometric tools. The article argues that especially in times of uncertainty the realism of the axioms chosen are the decisive criterion when shaping policies rather than finding empirical fit by means of econometrics.

Hayek (1899 – 1992)

Friedrich von Hayek was born in Vienna in 1899. His parental background was academic, noble and rich. He grew up in a time of instability and social unrest. During the period 1916-1918 Friedrich served the Austrian army as artillery officer during WWI. He was shocked by the atrocities of a war, and decided to study law, philosophy and political science. Social conflicts, he thought, could be solved by the application of the classical liberal idea: every person is responsible for his own well-being. Society is not a community and collective solutions never work, but are the source of all evil.

In 1927 ( 28 years old) he became Director of the Austrian Institute for Business Cycle Research. When in 1929 Wall Street crashed, Hayek was shocked – he had not foreseen it. Nevertheless he did not promote government intervention to prevent or attack the depression. In 1931 he went to London on the invitation of the famous neoclassical philosopher Lionel Robbins. His ‘assignment’ was to reduce the enormous influence of Keynes in England. Hayek failed and 1950 he moved to Chicago, an academic paradise for every classical liberal. His major concern was the influence of collectivist ideas such as fascism and socialism. Free markets are the solution to all economic problems, always and everywhere. Ideas rule the world, and the creativity of entrepreneurial persons is the source of novelty and wealth.

His economic analysis runs as follows. The world is essentially organic rather than mechanic, which means that relationships between variables are dependent of an ever changing context. History evolves and chaotic times are followed by more harmonious periods. Governments neither have the incentive nor the information to improve the economic results of a free market society. The sequences of booms and busts are natural. If governments intervene the fluctuations become larger, thereby aggravating the negative social effects. History shows that there are two government interventions, which cause most economic trouble. In the first place, central banks try to improve economic performance by setting the market interest rate lower than the natural rate (= rate of interest rate in case of a perfectly free market). In the second place, governments give some unions the monopoly right to bargain about the wage rate on behalf of all the workers – be it on sector or on national level. Then actual wage rates are higher than their natural level (= wage rates in case of a free market society). In the first case private investments become higher than natural, leading to price inflation, which is followed by wage inflation. It means that goods prices, wage rates and interest rates are not reliable signs of scarcity anymore. This seduces market participants to make wrong decisions. When they discover their mistakes they reduce their spending, leading to a bust. Only when the prices approach their natural level, spenders are seduced to make right decisions again.

Political democracy is vulnerable for an electorate that also aims at social goals, such as higher than natural wages and higher than natural levels of employment. Voters should abstain from these goals, and stick to the principle of individual economic freedom.

Applied to the eurozone it means that the ECB should stop its policy of very low interest rates and so-called quantitative easing. Deregulation of the financial markets is good, and governments should not bail out banks in case of bankruptcy. It goes without saying that governments should finance their expenditures by means of taxes – not by borrowing money from the public. It would reduce the space for the private sector to start economic activities. When looking at the daily eurozone practice, we see that the German and the Dutch central bank (chaired by Weidmann and Knot respectively) are inclined to support Hayek’s view on monetary policy. Also Hayek’s distaste for regulation is supported by these banks; both try to reduce minimum required solvency rates to a very low 3-4 %.

Keynes (1883 – 1946)

John Maynard Keynes was born in Cambridge in 1883. He studied mathematics, philosophy and history. Later the famous Alfred Marshall seduced him to study economics. Keynes was not only an economic theoretician, but also worked for the Treasury and wrote many texts about the big policy issues of his time: the German reparation payments in 1918, the negative role of the gold standard in times of deflation en de Great Depression. According to Keynes a free market economy was not a stable system. External and internal shocks could make recessions deeper than normal, leading an economy into a depression. Price, wage, and interest rate reductions would make the depression worse – lower income, lower spending, lower production, lower employment, etc. The government is the only institution, which is big enough to get the economy recovered. By increasing government investments, which are financed monetarily, employment, production and income will be stimulated. When the economy approaches full employment prices might rise. If the competitiveness of the economy should be improved, nominal wages should not be linked to the level of goods prices. Then competitiveness increases because of a decrease in the real wage rate.

Market participants are irrational actors, who are inclined to be overoptimistic in times of booms, and over-pessimistic in times of busts. This holds for investors as well as organizations of workers. It means that effective regulation of financial and labour markets are necessary ingredients for a stable economy and society. Financial organizations, such as banks, should build buffers in during booms, so as to survive during busts. Wage determination could not be left to individual employers and individual workers. Institutions should be set up to prevent wages from increasing too much during boom periods, and from decreasing too much in bust periods.

Applied to the eurozone it means that the low interest rates, caused by the structural excess of savings should be kept stable by the central bank. The tendency of paying off loans by private actors should be compensated by monetarily financed increases in government investments. The budget rule of the eurozone must be abandoned. In the first place, it makes effective stimulus impossible. In the second place, by mentioning numbers it falsely suggests as if it is possible to calculate appropriate numbers for many different countries over a very long period. The crisis of the last eight years shows the opposite.

Friedman (1912 – 2006)

Milton Friedman was born in New York in 1912. He began his studies with mathematics in 1928. Later – under the influence of the Great Depression – he took economics as his major at Rutgers University, New Jersey. Later he went to Chicago and was influenced by classical liberal economists, such as Knight and Stigler. After WWII Friedman was offered a position in Chicago. He saw himself as a supply side economist: small government, barely any regulation, and restrictive monetary policies. Supply side economics says that ‘every supply creates its own demand’. If the supply conditions for firms to invest are good, they will demand for investment goods, thereby stimulating the demand for goods. Favourable supply conditions are the presence of free markets, including free and flexible prices, wages and interest rates. In 1956 he reformulated the classical quantity theory, which says that increases in the money supply, which are higher than the structural increase of the potential production, leads to inflation. In 1963 he and Anna Schwartz published a book about the American monetary history. By means of econometric research he claimed that the relationship between money supply and inflation was a stable one. During the thirties of the twentieth century the American central bank allowed the money supply to decrease. Deflation was the result, making it impossible for the real wage rate to decline. His conclusion was that (only) in case of sound monetary policies capitalism is a stable system.

Applied to the eurozone it means that Friedman considers Southern European economies to be badly institutionalized; so badly that Northern and Southern European economies should not have a common currency. Floating currencies mean that the South is permanently confronted with increasing import prices – an incentive to re-institutionalize the economy. As long as there is a common currency the central bank should lower the interest rate and let the money supply increase. This is supposed to prevent the economy from diving into a depression. Banks , which are heavily involved in bad loans to Southern customers should restructure their loan structure – don’t suggest that all loans will be paid back in the end. This is the only way to regain the trust of the clients.

Scientific foundation of a policy recipe: realism of the axioms or empirical fit

Hayek was impressed by the negative effects of collectivist ideas, such as fascism and communism, and was dedicated to the liberal cause straight from the beginning. According to him reality was far too complex to be modelled and to be managed. Every individual or small groups of volunteers can take decisions and execute their plans – not large entities, such as governments. Econometric models are useless, and falsely suggest that reality is determined by a few simple mechanisms. Entrepreneurs, free markets, competition and innovation are the relevant concepts when trying to understand the functioning of a market economy.

Keynes was impressed by two phenomena. In the first place, markets in the manufacturing sector were increasingly dominated by a few very large companies. They want stability rather than competition, and set their prices on a level, which give them a satisficing profit over a couple of years. In the same sector employers appeared increasingly willing to accept wages, which stabilize the labour markets. This makes the firm’s environment more manageable. In the second place, Keynes discovered that in case of wage flexibility a wage reduction in a depression makes the depression worse (Keynes 1936, ch.19). In booming time investors, employers’ organizations and unions are inclined to be overoptimistic. But as soon as things go wrong, it is rational for the firms as well as for the individual workers to decrease their spending in reaction to their lower income! Hayek and Friedman were supply-siders – the level of demand does not matter. If relative prices are such that profits are possible, firms will invest! When looking at the duration of the First Great Depression of the thirties in the previous century and the Second Great Depression we face in the eurozone now, Keynes cannot be neglected.

Philosophically Friedman was a classical liberal. In Chicago he was surrounded by many famous economists, who advocated pure capitalism. In 1962 he wrote Capitalism and Freedom, and in 1980 he wrote – together with his wife Rose – Free to Choose; a bestseller on the global market of books on the economy. Scientifically he was an opportunist. The theory behind an empirical hypothesis does not matter. Whether the axioms are realistic or not, it is the prediction of future empirical developments that is decisive. His monetary research has been criticized heavily. More generally econometrics requires stable periods, and they are rare in human history. Moreover, practice shows that different hypotheses can be confirmed with the same data set. And the same regressions can be explained by theories derived from different perspectives. In chaotic situations, as we live now, econometrics makes less sense. Some mathematical modelling of the analysis and reliable construction of empirical indicators of theoretical phenomena are useful activities always and everywhere.

Realism of axioms are decisive in times of uncertainty

Both Hayek and Friedman have written books, in which they explained their economic philosophy. Hayek’s Road to Serfdom (1944) offers a nice summary of all his later work on this topic. To understand Hayek’s work on economic theory, knowledge of his axioms is a necessary condition. Hayek was not impressed by sophisticated econometric work, but he liked to refer to the ‘fact’ that there is a significant correlation between individual economic freedom and welfare. Friedman’s Capitalism and Freedom functions in the same way. When he started his empirical research he knew already more or less the outcomes. In case of the relationship between the money supply (M) and inflation (P), he had only to find out which empirical definition of the money supply correlated best with which empirical definition of inflation.

Keynes’ study of mathematics and philosophy brought him in a position, which was opposite to the mechanic and micro-views of mainstream economics. Society is an open system, which reacts like an organism. He saw the government as the mind of society; therefore the government should be led by small groups of wise men and women, who learned to view problems from different perspectives. In most periods econometrics makes no sense. Wise people must fix a number, which reflects the warranted economic growth rate. Fiscal, monetary and incomes policies can be derived from it.

We see that in truly important practical matters, it is not econometric research but a deep insight into the structure of reasoning, which is decisive in the debate about policies. Academic research and educational programmes should take this ‘fact’ into account.


Eichengreen, B. Macroeconomic and financial policies before and after the crisis, in: Obstfeld, M., D. Cho, A. Mason (eds.) (2012), Global Economic Crisis: Impacts, Transmission and Recovery, Cheltenham: Edward Elgar.

Friedman, M.(1962), Capitalism and Freedom, Chicago: Chicago University Press.

Friedman, M., Schwartz, A. (1963), The Monetary History of the United States, Princeton University Press.

Friedman, M., Friedman, R. (1980), Free to Choose, New York: Avon Books.

Hayek, F. (1931), Prices and Production, London.

Hayek, F. (1944), The Road to Serfdom, London.

Keizer, P. (2015), Multidisciplinary Economics, A Methodological Account, Oxford: Oxford University Press.

Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: McMillan.



Piet Keizer

Associate Professor of Economic Methodology

Utrecht University School of Economics


Aantal woorden: 2236





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