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Theoretical Economics: My Time With Friedrich Hayek -- And Why Understanding Him and Keynes Is Central to This Election, Part 1

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When President Obama and Governor Romney faced off in the debate this past month, the ghosts of two titans of economic theory stood behind them -- John Keynes and Friedrich Hayek. As we seek to choose our next president, we are also still trying to decide, as a nation, whether to risk our still-fragile economic recovery on the competing theories of Keynes and Hayek. As Obama said during the debates, "There's a fundamentally different vision of how we move this country forward."

Keynes was a British economist (b. 1883 - d. 1946) who advocated the use of fiscal and monetary policies by governments to ease the pain of recessions. In contrast, Hayek, who was born in Austria in 1899 and became a British subject in 1938, defended "classical liberalism," a school of thought that favored strictly limiting government's role in the economy, cutting deficits and letting recessions run their course -- because recessions force businesses to liquidate bad investments, becoming leaner and more competitive, and the consumer ultimately benefits.

Today, we call classical liberalism "libertarianism." In its purest form, it has been advocated by Ron Paul and Libertarian Party candidate Gary Johnson. Vice-presidential candidate Paul Ryan has also cited Hayek as a personal economic hero.

Although President Obama has downplayed a connection between his stimulus package and Keynesian economics, Keynes would have approved of a stimulus package to cushion the severity of the 2008 financial crisis -- although he probably would have said it was too small! Keynesians believe recessions are caused by lack of demand and that the government's role is to increase demand through government spending and monetary inflation. Keynes advocated running a deficit during a recession in order to help keep demand high through government spending. Although during the second debate, Obama said, "I don't believe government creates jobs, I believe the free enterprise system is the greatest economic system ever known," nonetheless his stimulus package was a Keynesian government intervention designed to staunch the loss of jobs.

The Austrian School, as Hayek's followers became known, argued that savings and information drive the economy, and that the less regulated the economy is, the more efficient it will be. With fewer regulations and subsidies, prices are able to fluctuate honestly reflecting the true desires of people. This provides information that helps businesses make good decisions and use resources wisely, thereby effectively raising everyone's living standards. Both communities believe in freedom of speech, religion and press.

Romney is in line with Hayek, for example, when he says the American auto industry should have been allowed to go bankrupt. On the other hand, Romney said in the second debate that he would use tariffs to compete with China -- a concept that would have been anathema to Hayek.

Clearly, the theories of these two legendary economists are still influencing the national debate. With so many of our political discussions ahead of the election revolving around economic policy issues, I thought it would be of value for me to share my personal experience with Friedrich Hayek.

On a warm day in the summer of 1977, I was in the small office I shared with Susan Cole at the Institute of Humane Studies (IHS) in Palo Alto. We were part of a group of 20 young American economists to study at IHS for several months and to write and present papers to each other. We all knew that in midsummer Friedrich Hayek, who had won the Nobel Prize three years before, would be visiting us. I tried to pretend that was not important to me, but I was as excited to meet this living legend as everyone else in our group.

We had all been put through a rigorous pre-selection process that spring. For me, this procedure had almost been a disaster. I had taken few "pure" economics courses, preferring instead to tackle the subject by taking classes in finance and business economics. I soon discovered that my arguments in favor of subjectivity in economics, and against mathematical truths, worked against me in the high-level economics courses at the University of Michigan.

In the Business School, where I was studying for an MBA, my preference for non-mathematical methods was also criticized. My resume looked rather bare next to those of the elite young economists in America who had applied for the IHS summer program with published dissertations and Ph.D.s. What's worse, during my phone screening, I was loud and aggressive, and came across as if I had a chip on my shoulder -- I was not an Ivy Leaguer and came, instead, from the working-class town of Flint, Michigan. When the final cut came, I was rejected, receiving the painful call in my room on campus in Ann Arbor.

Heartbroken, I went home to Flint for spring break, and phoned Lou Spadaro, a mentor who had great influence with the IHS. I pled my case: "I have done original work in theory," I told Lou, "and my methodology paper was provocative. I've performed the first statistical test of the Austrian theory of the trade cycle." Then I played my trump card: "I could represent the Midwest, which is always being left out. If they let me in, I know I will add value." Soon Professor Spadaro and a mentor, Leonard Liggio, called me with the news -- I was in!

To read Part 2, click here.