Fight of the Century? Well, that was Joe Frazier against Muhammad Ali, New York 1971, right? Wrong! For an economist, the Fight of the Century refers to the intellectual debate between the illustrious economists, John Maynard Keynes (1883-1946) and Friedrich August Hayek (1899-1992). A battle at least as hot as the boxing fight, if not even much hotter!

What was this all about? And does it have to do anything with Georgia? It does…

A LACK OF DEMAND…

What are the causes of recessions and unemployment? Keynes had a very clear idea about this. During a slump, he argues, the capacity of an economy is simply not used to its fullest. Factories are producing just a certain fraction of what they could produce, mines are not operating at their maximum output rates, providers of services are waiting around, not serving anybody. In a recession, economic resources stay idle, though in principle they could be used instantaneously. A downturn is not caused by exogenous circumstances, but it is rather what one might call a coordination problem – nothing restricts the society to produce more but the fact that economic agents cannot concert their actions.

In order to get the idle resources back into usage and for moving the economy back to its capacity limit, additional demand is necessary. As free markets are failing to generate this demand (otherwise there would be no recession), the government should help out and spend money on infrastructure, education, social causes, and whatnot.

A straightforward question is why markets do not generate the necessary demand without government intervention. Keynes, like his classical predecessors from the 19^th century, believes an economy to be a kind of circular system. The income of people is spent on consumption and investment, fostering economic activities which, in turn, create the incomes of people. Yet according to Keynes, this cycle is defective: people are only spending parts of their income on investment and consumption, causing a leak in the otherwise closed circular flow of capital.

But where does this leak come from? Keynes has a hard time explaining this. In his magnum opus “General Theory of Employment, Interest and Money”, published in 1936, he lists eight different reasons why people do not spend or invest their income. For example, he postulates the motive of flexibility: if you consume or invest all your money, you are not ready to react optimally to future developments. Another reason is an alleged deep-rooted “hoarding” motive of humans.

Keynes suggests that by smartly stimulating demand, the government can counter a downturn and keep the economy close to its capacity limit all the time. Yet even Keynes admitted that there is a price to pay for this, coming in the form of inflation. Even in a recession, there will be some companies that already operate at their capacity limits. If demand is now artificially stimulated, they cannot increase output but have to react to this increased demand by raising prices. This gives rise to the famous Phillips Curve, drawn into a chart that shows inflation on one axis and unemployment on the other axis. If Keynes’ argument is right, one should expect the Phillips Curve to be downward sloping (higher unemployment corresponds to lower inflation, and vice versa). Empirically, this trade-off seems to hold for some countries in some time spans, but the evidence is not as clear as one might expect if one subscribes to Keynes’ views.

… OR STRUCTURAL PROBLEMS?

Hayek, on the other hand, thought that recessions were not only inevitable but were even necessary for renewing and revitalizing an economy. For understanding his argument, one should look at an individual company. Take, for example, a firm that produces cars. Clearly, not all decisions made by this firm will be optimal. For example, it cannot be ensured that all investments turn out to be profitable. The company may have spent huge amounts of capital on the development of a new car model, but finally, it turns out that the innovations incorporated in that car do not match the taste of the customers. Even worse, technical problems may prevent the new model from reaching maturity in the first place, rendering all the investments useless. If such an unfortunate event occurs, the company has to implement harsh saving measures, including laying off personnel, reducing output, and shutting down whole units.

According to Hayek, wrong decisions and misdirected investments that occur on the level of individual companies are aggregated in the economy. As the companies are all interconnected, the inevitable restructuring of one company and the implied reduction of spending adversely affects other companies, increasing the likelihood that also other companies must make adjustments. What Hayek considers to be a recession is a situation when substantial parts of the economy make painful adjustments at the same time.

This very positive view on recessions was shared by the Austrian economist Joseph Schumpeter (1883-1950). In 1934 he wrote: “Artificial stimulus leaves the part of the work of depressions undone.”

Hayek was explicitly against government interventions because he thought that they would even aggravate the misallocation of capital. In his view, the information necessary to make optimal economic decisions was dispersed among millions of people, and no single actor had sufficient knowledge to positively influence the economic system. This argument, which was also at the core of his rejection of socialism, he summarized in a 1980 interview with the British journalist Bernard Levine (which can be seen at Youtube): “The knowledge of facts is widely dispersed. You want to make use of knowledge possessed by millions of people […], but you can’t possibly concentrate this knowledge.”

AND GEORGIA?

The ideas of Keynes and, to a lesser extent, those of Hayek is so ubiquitous in economic debates that it is quite easy to find examples that relate to Georgia.

A Georgian politician recently expressed the opinion that the inflation-induced through the depreciation of the lari might be beneficial to the Georgian economy. This is a typical Phillips Curve argument: if we have higher inflation, we will have lower unemployment. When it comes to import-induced inflation, however, this reasoning is completely mistaken. According to Keynes, the causality has one dominant direction: increased demand causes inflation, not the other way round. There may be a couple of reasons why a devaluation of the lari may be good for the Georgian economy, but it is not through its inflationary effect.

Another issue that indirectly relates to Keynes is the recent depreciation of the lari itself. It is driven by foreign capital moving back to Europe and the USA, reducing the demand for lari. How did this come about?

The world’s leading central banks reacted to the 2008 financial crisis by drastically increasing the amount of money. To this day, just the U.S. Central Bank FED has pumped about 4000 billion dollars into the economy (since 2008). This was very much driven by Keynes’ theories – countering a crisis by increased government spending (in this case: central bank spending). As a consequence of this policy, interest rates in the economically advanced countries went down, almost to 0, giving a strong incentive for investors to bring their capital to countries like Georgia, where interest rates were much higher. Now the central banks are slowly moving away from this policy of “monetary easing”, the capital returns to Europe and the US, and the lari depreciates as a result.