Submittred By:

Atta ur Rehman
Submited To:
Mam, Ayesha Malik

Semester 8th

Registration:
04202113038
A Comparative Analysis of the Austrian School and the Keynesian School of
Economics

Abstract
This paper explores the differences between the mainstream economic interventionist
view associated with John Maynard Keynes and the heterodox, non-interventionist
Austrian School perspective associated with Friedrich Hayek on the Great Recession
of 2007-2009. The literature review compares and contrasts articles explaining each
view as they attempt to solve the problem of ending the recession. The heterodox
Austrian School/Hayekian view is that central banks should take a hands-off approach
to recessions, whereas the mainstream neo-Keynesian view is that central banks
should take a more active role through monetary easing in an attempt to end the Great
Recession. These two approaches are at odds with each other, but through this
thorough and robust analysis, we will understand the similarities (if any) as well as
substantial differences and what they can tell us for the next recession. Also included
is a section on Methodology to highlight the differences in how economists of both
camps conduct their research and present their findings to argue their case. The paper
uses an analytical framework to show how the Austrian/Hayekian and Keynesian
approaches differ both in content and methodology. The Keynesian perspective makes
use of graphs and empirical data in the primary sources referenced to prove that the
federal government and the Federal Reserve should have acted more quickly to
implement an interventionist economic recovery. On the other hand, the
Hayekian/Austrian approach makes use of methodological individualism and
praxeology as the lens with which to examine the Great Recession and to show that
such economic interventionism had the opposite of the intended effect; intervention,
according to the Austrians, made the crisis worse. Not only are their conclusions
different, but the means by which they examine the crisis are different as well. Finally,
the paper examines some areas for future research on both sides to make each case
stronger. Special emphasis is placed on how to develop the arguments of these two
views further with regard to future recessions, particularly of the magnitude of the
2007-8 financial crisis. Keywords: Great Recession, Keynes, Hayek, central banks,
Austrian Business Cycle Theory, monetary policy.
Introduction

Economic theory serves as the backbone of policymaking, investment decisions, and

the general understanding of how societies allocate scarce resources. Among the
diverse schools of thought in economics, two stand in sharp contrast due to their
foundational principles, methodologies, and policy implications: the Austrian School
and the Keynesian School. This assignment presents a comprehensive comparative
analysis of these two influential economic traditions, exploring their origins, core
tenets, differing views on markets and government intervention, and their relevance in
contemporary economic debates.

I. Historical Background

The Austrian School

The Austrian School of economics emerged in the late 19th century with the
publication of Carl Menger’s "Principles of Economics" (1871). Alongside
contemporaries such as Eugen Böhm-Bawerk and Friedrich von Wieser, Menger laid
the groundwork for what became a heterodox tradition in economic thought. The
school gained further prominence in the 20th century through figures like Ludwig von
Mises and Friedrich A. Hayek, who contributed significantly to monetary theory,
business cycle theory, and critiques of socialism.

The Keynesian School

The Keynesian School was founded in the aftermath of the Great Depression. The
economic devastation of the 1930s undermined classical economic assumptions about
market self-correction. In response, British economist John Maynard Keynes
published "The General Theory of Employment, Interest, and Money" (1936),
which challenged classical economics and called for active government intervention
to manage aggregate demand. Keynesian economics became the dominant framework
in macroeconomics during the mid-20th century and continues to influence modern
economic policy.
II. Methodological Foundations

Austrian Methodology: Praxeology and Subjectivism

The Austrian School employs praxeology, the deductive study of human action.
Austrians argue that economics is not an empirical science like physics, but rather a
branch of logic based on the axiom that humans act purposefully. This methodology
prioritizes logical reasoning over mathematical modeling or statistical inference.

Austrians also emphasize methodological individualism—the belief that only

individuals act and make choices—and subjective value theory, which posits that the
value of goods and services is determined by individual preferences rather than
objective measures.

Keynesian Methodology: Aggregates and Empiricism

In contrast, Keynesians use an empirical and aggregate approach. Keynesian

models rely heavily on statistical analysis, econometrics, and macroeconomic
aggregates such as gross domestic product (GDP), inflation, and unemployment rates.
The school embraces mathematical modeling to predict economic behavior and the
impacts of policy changes.

Keynesians focus on aggregate demand as the primary driver of economic output

and employment, arguing that economic downturns result from insufficient demand
rather than supply-side inefficiencies.

III. Views on Markets and Government

Austrian Perspective: Market Spontaneity and Government Harm

Austrians hold a deep skepticism toward government intervention, arguing that

free markets, through the price mechanism, are capable of allocating resources
efficiently. Hayek, in particular, stressed the importance of dispersed knowledge and
warned that central planning cannot replicate the information processed by
competitive markets.
From this perspective, government policies such as price controls, subsidies, or
central banking distort market signals and lead to inefficiencies, malinvestment, and
long-term instability.

Keynesian Perspective: Market Failures and the Need for Intervention

Keynesians argue that markets are not always self-correcting, particularly in the
short run. They assert that active fiscal and monetary policies are essential for
stabilizing the economy during recessions or periods of high inflation.

Government spending, according to Keynesians, can "jump-start" demand during

economic downturns. Public investment can stimulate economic activity and reduce
unemployment, creating a multiplier effect that benefits the broader economy.

IV. Theories of the Business Cycle

Austrian Business Cycle Theory (ABCT)

The Austrian theory of the business cycle, developed primarily by Mises and Hayek,
attributes economic booms and busts to monetary expansion by central banks. When
interest rates are artificially lowered, it leads to malinvestment—resources are
allocated to unsustainable projects that would not be viable under natural interest rates.

Eventually, these investments fail, triggering a recession. The Austrian solution is to

allow the market to correct itself, letting failing businesses go bankrupt and avoiding
further distortions.

Keynesian Business Cycle Theory

Keynesians argue that the business cycle is primarily driven by fluctuations in

aggregate demand. A lack of consumer and business confidence can lead to reduced
spending and investment, creating a downward spiral of lower output and higher
unemployment.

Keynesians advocate for counter-cyclical policies, such as increased government

spending or tax cuts during downturns, and reduced spending or increased taxes
during booms to stabilize the economy.
V. Monetary and Fiscal Policy

Austrian Approach

Austrians are typically opposed to central banking and advocate for a return to
sound money, such as a gold standard. They criticize the Federal Reserve and other
central banks for manipulating interest rates, which they believe causes booms and
busts.

On fiscal policy, Austrians support balanced budgets and reduced government

spending. They argue that government debt crowds out private investment and that
deficit spending leads to inflation and long-term economic instability.

Keynesian Approach

Keynesians support active monetary policy, including interest rate adjustments and
quantitative easing, as tools to manage demand and control inflation or deflation.
They also see deficit spending as a necessary and effective tool during economic
downturns.

Rather than fearing public debt, Keynesians argue that as long as a country controls
its currency and inflation is stable, deficit financing can be beneficial for stimulating
economic growth.

VI. Employment and Unemployment

Austrian View

Austrians see unemployment as a result of market distortions, particularly in wages

and prices. They argue that if wages were allowed to adjust freely, labor markets
would clear, and unemployment would be minimized. Minimum wage laws, unions,
and welfare programs are viewed as impediments to employment.

Keynesian View

Keynesians emphasize the concept of involuntary unemployment, where individuals

willing to work at the prevailing wage rate cannot find jobs due to insufficient
aggregate demand. In this context, wage flexibility may worsen unemployment by
reducing income and further depressing demand.

Keynesians therefore support government job programs, unemployment benefits,

and public investment to reduce unemployment.

VII. Inflation and Deflation

Austrian Perspective

Austrians define inflation as an increase in the money supply, rather than just rising
prices. They warn that excessive monetary expansion leads to hyperinflation and a
loss of trust in currency. Austrians are also wary of deflation, but see it as a natural
corrective process following an inflationary boom.

Keynesian Perspective

Keynesians define inflation in terms of rising prices and generally view moderate
inflation as a sign of healthy economic growth. They are more concerned with
deflation, which can lead to a liquidity trap and further reduce spending and
investment.

Inflation targeting by central banks is seen as a crucial tool for maintaining

macroeconomic stability.

VIII. Crises and Recession Responses

Austrian Response

Austrians believe that recessions are necessary corrections of prior distortions and
advocate for non-interventionist policies. They argue that attempts to stimulate the
economy only delay the inevitable correction and result in a more severe crash later.

For example, during the 2008 financial crisis, Austrian economists like Ron Paul and
Peter Schiff argued against bailouts and monetary stimulus, claiming they would only
exacerbate the problem.
Keynesian Response

Keynesians support stimulus measures to prevent economic collapse. During the

2008 crisis, Keynesians such as Paul Krugman advocated for massive government
spending, arguing that austerity would deepen the recession.

They point to the New Deal, post-WWII spending, and the 2009 stimulus package as
examples of successful Keynesian policies in times of crisis.

IX. Modern Applications and Influence

Austrian School Today

Though considered a heterodox tradition, the Austrian School maintains influence

through libertarian think tanks like the Mises Institute and public figures like Ron
Paul. It has also seen a resurgence among cryptocurrency advocates, who view
Bitcoin as a form of sound money resistant to inflationary central bank policies.

However, mainstream economists often critique Austrians for their lack of empirical
rigor and resistance to mathematical modeling.

Keynesian School Today

Keynesianism, particularly its modern form known as New Keynesian Economics,

remains central to most macroeconomic policymaking and academic research.
Institutions like the IMF, World Bank, and central banks use Keynesian-inspired
models for forecasting and policy recommendations.

New Keynesians have integrated some microeconomic foundations and rational

expectations into their models, responding to criticisms from both the Austrian and
Monetarist schools.

XI. Case Studies and Real-World Applications

The Great Depression

The Great Depression is often cited as a turning point in economic thought. The
Austrian School interpreted the crisis as a result of malinvestment and monetary
expansion during the 1920s, advocating for liquidation of unprofitable enterprises and
a return to market equilibrium. In contrast, Keynes saw it as a failure of aggregate
demand and argued for massive public works programs and fiscal stimulus.

In practice, the U.S. response under President Franklin D. Roosevelt aligned more
closely with Keynesian prescriptions, particularly through the New Deal programs.
These interventions helped mitigate the worst effects of the Depression, though debate
continues about their overall efficacy.

The 1970s Stagflation

The 1970s presented a serious challenge to Keynesian economics. The simultaneous

rise in unemployment and inflation, known as stagflation, contradicted the traditional
Keynesian Phillips Curve, which suggested an inverse relationship between inflation
and unemployment.

Austrian economists argued that stagflation was a predictable outcome of prolonged

monetary expansion and advocated for monetary restraint and structural reforms. This
era saw a rise in Monetarist and supply-side critiques of Keynesianism, but it also
opened a window for Austrian ideas to gain traction.

The 2008 Financial Crisis

During the global financial crisis of 2008, Keynesianism saw a resurgence.

Governments around the world enacted large fiscal stimulus packages to counter the
collapse in private demand. The U.S. implemented the American Recovery and
Reinvestment Act (ARRA), injecting $831 billion into the economy.

Keynesians such as Paul Krugman argued that these measures were essential and
should have been even larger. Austrians, however, contended that the crisis was the
inevitable result of years of credit expansion and malinvestment facilitated by the
Federal Reserve. They warned that stimulus policies would only delay necessary
corrections and create new bubbles.
XII. Philosophical Underpinnings

Austrian Philosophy: Individualism and Spontaneous Order

The Austrian School is grounded in classical liberalism and libertarian thought.

Influenced by thinkers like John Locke and David Hume, Austrian economists
emphasize individual liberty, private property, and limited government.

F.A. Hayek’s work on spontaneous order illustrates the belief that complex social
orders, like markets, emerge naturally from individual actions rather than from central
planning. This reflects a deep commitment to freedom and skepticism toward
collective authority.

Keynesian Philosophy: Social Responsibility and Pragmatism

Keynesianism is rooted in a more pragmatic and utilitarian view of economics.

Keynes himself was not opposed to markets but believed that they often fail to
provide full employment or equitable outcomes. His philosophy emphasized the
responsibility of the state to ensure economic stability and social welfare.

This view aligns with modern progressive political ideologies, which advocate for
government intervention to correct market failures, reduce inequality, and provide
public goods.

XIII. Contemporary Relevance

Austrian Economics in the 21st Century

Austrian economics has seen renewed interest in the context of the 2008 crisis, the
rise of cryptocurrencies, and growing skepticism toward central banks. Bitcoin’s
emergence as a decentralized currency has been championed by Austrians as a form
of digital sound money. They argue that blockchain technology can reduce the need
for central monetary authorities.

Additionally, Austrian perspectives have influenced libertarian political movements,

particularly in the United States. Politicians like Ron Paul and think tanks like the
Mises Institute have kept Austrian ideas in the public discourse, even as they remain
outside mainstream academia.

Keynesian Economics in the 21st Century

Keynesianism remains deeply embedded in policymaking. Central banks,

particularly the U.S. Federal Reserve and the European Central Bank, use Keynesian-
inspired models for inflation targeting and interest rate management.

The COVID-19 pandemic further reinforced Keynesian principles, as governments

worldwide implemented record levels of stimulus spending to support households
and businesses. Programs such as direct cash transfers, unemployment benefits, and
small business loans demonstrated the continuing relevance of demand management
strategies.

XIV. Areas of Overlap and Potential Synthesis

Though often presented in opposition, some contemporary economists have explored

areas of convergence or synthesis between the Austrian and Keynesian schools:

1.

Recognition of Uncertainty: Both schools acknowledge the importance of

uncertainty in economic decision-making, though they treat it differently.
Hayek’s emphasis on dispersed knowledge and Keynes’s concept of “animal
spirits” reflect shared concerns about the unpredictability of markets.

2.
3.

Critiques of Mathematical Modeling: Some post-Keynesians and Austrians

share skepticism about over-reliance on formal models that assume perfect
information or rational expectations.

4.
5.
 Institutional Economics: There is growing interest in integrating Austrian
insights on entrepreneurship and institutional dynamics with Keynesian
concerns about macroeconomic instability.

6.

However, fundamental differences in methodology and policy prescription remain

significant barriers to a full synthesis.

XV. Conclusion

The Austrian and Keynesian schools represent two of the most influential yet
contrasting paradigms in economic thought. The Austrian School prioritizes
individual decision-making, sound money, and non-interventionist policies, grounded
in a philosophical commitment to liberty and methodological individualism. The
Keynesian School, by contrast, emphasizes aggregate demand management,
government intervention, and empirical analysis, grounded in a pragmatic approach to
real-world problems.

Each school has made enduring contributions to economic understanding and policy.
Austrian insights into the dangers of central planning and the informational role of
prices have shaped debates about markets and liberty. Keynesian economics,
meanwhile, has transformed how governments respond to economic crises, elevating
the role of fiscal and monetary policy in stabilizing modern economies.

Ultimately, the tension between these two schools reflects broader debates about
freedom versus security, rules versus discretion, and theory versus practice. In a
complex and rapidly changing world, both Austrian and Keynesian perspectives
continue to offer valuable insights—and sharp challenges—to policymakers,
economists, and citizens alike.
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