What Rapping Keynes & Hayek Get Wrong

A video rap battle between Keynes and Hayek which criticizes TARP has gained much attention. But are the video's policy ideas any better?

The complexities of the 2008 financial crisis and the TARP rescue program have led many to seek an explanation for what happened. What no one could have expected was that one of the most popular videos to fill that niche would be a rap battle between John Maynard Keynes and Frederick Hayek. (Currently it has 1.6 million views on YouTube). The video seeks to educate viewers about the cause of the crisis, but what if the solution the video offered would have caused more harm than the much reviled TARP?  And why does the professor who helped make the video even agree this is possible?

The videos explain the financial crisis through a largely Austrian monetary school viewpoint. In the video, the argument made from Hayek is that the Federal Reserve provided cheap credit which created a fake boom market. The use of bailouts was merely a way to preserve distortions in the market. As for the threat that credit markets seized up, Hayek puts the blame on a "broke banking system."

Russell Roberts, is a Professor at George Mason University, and the academic behind the videos. In an interview with FrumForum, he gave his candid and negative view of TARP, calling it: "One of the most undemocratic and power grabbing actions in our lifetime, a really horrible precedent for a democracy." Roberts argued that the crisis had its roots in the moral hazards that had been established with the bailout of Long-Term Capital Management in 1998, the Mexican bailout in 1994, and other rescues. In his view, TARP only perpetuated bad habits, and now a firm line against future interventions needs to be drawn in the sand.

This mentality has been adopted in the wider conservative movement, and helps explain some of the hostility to the Fed's attempts at monetary stimulus.

However, this raises a question, what would the effect of cleansing two decades worth of moral hazard have on the real economy and the lives of American citizens? John Makin of AEI explained to FrumForum that this plan calls for large banks and companies to fail in order to allow the market to reset and for prices to drop. Makin acknowledged that there had been bubbles which distorted the market, but argued that the midst of a crisis was a bad time to put Hayek into practice: "The time to be Austrian is before the bubble, not after."

Makin added that proponents of letting prices fall are hoping that "if you let prices drop very far, the real value of people's money increases so they can spend more and they are out of the collapse." He described this thinking as an "intellectual bungee jump I'm not willing to take." With several decades worth of moral hazard responsible for higher prices, the inevitable question is how far they would have to then fall.

Makin suggested that prices may have to fall by as much as 10% or 20%. When prices fall dramatically, people are more likely to hold their money, putting the growth of the economy to a halt. Makin was pessimistic about what this could have led to. "Instead of a 4 or 5 percent drop in output, you are looking at a 15% drop in output and an unemployment rate of 25%."

When Professor Roberts was asked about this criticism of the policy solution he was advocating, he did admit that "it’s certainly possible that my preferred policy outcome of less intervention could have precipitated a more serious downturn then what we have had, and we've had a very serious downturn, and we're not coming out of it." It could not be denied however, that Russel's position is based on firm principles, as he notes, "when you make a bad bet, you should lose your money some time."

While it is impossible to prove that the economy would have truly crashed into a great depression, we do know from the recently opened books of those banks the Fed loaned to during the crisis that the Fed faced an unprecedented number of requests for loans from nearly all major banks that were on the verge of insolvency. It is largely understood that the major banks in America had more liabilities on their asset sheets then they had capital to pay off the debts.

Videos with a Hayek rapping about liquidity crunches can be an amusing way to learn about monetary policy, but when the jokes are over, the videos ultimately call for making the perfect the enemy of the good, at a potentially frightening cost to the average citizen. This is especially important to keep in mind as the government is in fact retreating from its ownership of the economy and not putting America on a “Road to Serfdom.” (AIG announced last Wednesday that it plans to accelerate the process of having the Treasury Department sell off its ownership of AIG stock, with a sale reportedly planned for March of 2011.)

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