The Keynesian construct, on which Congress’s stimulus plan is based, is alluring because it can be expressed as an equation and because it identifies levers for policymakers to pull to fix an economic crisis: If aggregate demand falls, then government must supply the deficit though increased government spending to maintain employment.

It all seems so simple. Could this framework be leaving something out? For an answer, turn to Friedrich Hayek’s 1974 Nobel Prize lecture (via Don Boudreaux at Cafe Hayek). Hayek pointed out that

unemployment indicates that the structure of relative prices and wages has been distorted (usually by monopolistic or governmental price fixing), and that to restore equality between the demand and the supply of labour in all sectors changes of relative prices and some transfers of labour will be necessary.

In other words, bad economic news tells us that adjustments are needed across various sectors in the economy, but Keynesianism says only: Maintain overall demand. In fact, said Hayek, pumping up aggregate demand distorts the price signals that would bring about the needed adjustments, which can be avoided only so long as government continues to pursue inflationary policies. Hayek attributed the stagflation of the 1970s to the demand management that Keynesianism had prescribed in earlier decades:

… the very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.

Hayek’s lecture actually concerned the larger topic of intellectual hubris that can result from misapplying scientific methods. Keynesianism, he argued, gave policymakers the illusion of control over the economy, when in fact they were as ever hampered by the knowledge problem. The “knowledge problem” is the reality that government planners can never possess the sort of local and specific knowledge that they would need to make better economic decisions than would occur in a free economy. Hayek concluded:

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants. There is danger in the exuberant feeling of ever growing power which the advance of the physical sciences has engendered and which tempts man to try, “dizzy with success”, to use a characteristic phrase of early communism, to subject not only our natural but also our human environment to the control of a human will. The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.