Thoughts on economics and liberty

Tag: F.A.Hayek

Hayek and Mises vindicated: Macro-economist admits to pretence of knowledge

I chanced upon Ricardo J. Caballero's article in The Journal of Economic Perspectives (Fall 2010), entitled, "Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome". This paper is available at the SSRN website (here) and I'd strongly encourage you to read it.

I have had a bitter-sweet relationship with economics, with macro-economics being the bitter part. What puts me off macroeconomics is its delusional approach to society. Plug in some equations, imagine a few assumptions, and then cook up a monstrous 20 page series of mathematics to come out with something that pretends to tell us something about society. What put me off truly from this discipline was to hear praise about a pathetic Indian anti-poverty program based on imaginary set of mathematical calculations. 

The subject of macro-economics is so divorced from reality that it tests one's patience. One doesn't know what is sensible and what is nonsense masquerading as sense.

The discipline of macroeconomics perhaps has its roots in the IS-LM models that came about after Keynes, based on simplistic and grandiose assumptions about the entire economy. Even later, rational expectations models, turned out to be quite a damp squib because of the dramatic imagination involved.

Before Keynes, economists perhaps never aspired to predict the macro-economy as a whole (except for the study of business cycles). They tried to measure it, understand its dynamics, but never to predict its future course. 

Since Keynes a lot changed. Every macro-economist worth his salt spends an inordinate amount of effort in trying to predict the economy based on a few key variables and equations. And it is these people who parade about, offering predictions about the future on TV that the world sees. People therefore think of economists as predictors of the economy, than analysts of human freedom.

I would prefer that they restrict themselves to the study of freedom. More insights about "macroeconomic policy" are found in Hayek than in any standard advanced textbook on macro-economics. Surely Mises's warning against mathematical economics (discussed in my blog post here) has been vindicated.

Anyway, here are few extracts from the Caballero paper:

The recent financial crisis has damaged the reputation of macroeconomics, largely for its inability to predict the impending financial and economic crisis. Of course, it is well-known that certain elements can increase the fragility of a financial system, such as high levels of leverage or mismatches between short-term liabilities and long-term assets, and that these issues may justify policy intervention. But knowing these mechanisms is quite different from arguing that a severe crisis can be predicted. 

What does concern me of my discipline, however, is that its current core—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.
The dynamic stochastic general equilibrium strategy is so attractive, and even plain addictive, because it allows one to generate impulse responses that can be fully described in terms of seemingly scientific statements. The model is an irresistible snake-charmer. In contrast, the periphery is not nearly as ambitious, and it provides mostly qualitative insights.
Moreover, this tension is not new to macroeconomics or even to economics more broadly. In his Nobel-prize acceptance lecture, Hayek writes:
“Of course, compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the process of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm” (von Hayek, 1974).
One reading of Hayek's comment is as a reminder of the dangers of presuming a precision and degree of knowledge we do not have.
There is no doubt that the formalization of macroeconomics over recent decades has increased its potential. We just need to be careful to not let this formalization gain its own life and distract us from the ultimate goal, which is to understand the mechanisms that drive the real economy. The idea is to place at the center of the analysis the fact that the complexity of macroeconomic interactions limits the knowledge we can ever attain.
I am almost certain that if the goal of macroeconomics is to provide formal frameworks to address real economic problems rather than purely literature-driven ones, we better start trying something new rather soon. The alternative of segmenting, with academic macroeconomics playing its internal games and leaving the real world problems mostly to informal commentators and “policy” discussions, is not very attractive either, for the latter often suffer from an even deeper pretense-of-knowledge syndrome than do academic macroeconomists.

Core and Periphery

The ultimate goal of macroeconomics is to explain and model the (simultaneous) aggregate outcomes that arise from the decisions made by multiple and heterogeneous economic agents interacting through complex relationships and markets. Neither the core nor the periphery is able to address this incredibly ambitious goal very satisfactorily. The periphery has focused on the details of the subproblems and mechanisms but has downplayed distant and complex general equilibrium interactions. The core has focused on (extremely stylized) versions of the general equilibrium interactions and has downplayed the subproblems.
The natural next step for the core, many would argue, is to add gradually the insights of the periphery into its dynamic stochastic general equilibrium structure. I am much less optimistic about this strategy, as I think it is plagued by internal inconsistencies and pretense-of-knowledge problems.
The Periphery
I believe that up to now the insight-building mode (both past and present) of the periphery of macroeconomics has proven to be more useful than the macro-machine-building mode of the core to help our understanding of significant macroeconomic events. I believe it would be good for macroeconomics to (re)orient a larger share of its human capital in this direction, not just for the study of crises but also for its broader concerns. It is only natural for macroeconomists to want more, but it is the rushed process to fulfill this ambition that I believe has led the core right into Hayek’s pretense-of-knowledge syndrome.
The Core
If we were to simply use these stylized structures as just one more tool to understand a piece of the complex problem, and to explore some potentially perverse general equilibrium effect which could affect the insights isolated in the periphery, then I would be fine with it. My problems start when these structures are given life on their own, and researchers choose to "take the model seriously" (a statement that signals the time to leave a seminar, for it is always followed by a sequence of naive and surreal claims).
My point is that by some strange herding process the core of macroeconomics seems to transform things that may have been useful modeling short-cuts into a part of a new and artificial “reality,” and now suddenly everyone uses the same language, which in the next iteration gets confused with, and eventually replaces, reality. Along the way, this process of make-believe substitution raises our presumption of knowledge about the workings of a complex economy, and increases the risks of a “pretense of knowledge” about which Hayek warned us.

After much trial and error, these core models have managed to generate reasonable numbers for quantities during plain-vanilla, second-order business cycle fluctuations. However, the structural interpretation attributed to these results is often naïve at best, and more often is worse than that
A theory is no longer testable when rejection is used not to discard the theory, but to select the data moments under which the core model is to be judged. This practice means that well-known major failures just become “puzzles,” which are soon presumed to be orthogonal to the output from the quantitative model that is to be taken “seriously.” 
By now, there are a whole set of conventions and magic parameter values resulting in an artificial world that can be analyzed with the rigor of micro-theory but that speaks of no particular real-world issue with any reliability.
However, I think this incremental strategy may well have overshot its peak and may lead us to a minimum rather than a maximum in terms of capturing realistic macroeconomic phenomena. We are digging ourselves, one step at a time, deeper and deeper into a Fantasyland, with economic agents who can solve richer and richer stochastic general equilibrium problems containing all sorts of frictions.
Given the enormous complexity of the task at hand, we can spend an unacceptably long time wandering in surrealistic worlds before gaining any traction into reality.
We ultimately need to revisit the ambitious goal of the core, of having a framework for understanding the whole, from shocks to transmission channels, all of them interacting with each other. The issue is how to do this without over-trivializing the workings of the economy (in the fundamental sense of overestimating the power of our approximations) to a degree that makes the framework useless as a tool for understanding significant events and dangerous for policy guidance.
Facing and Embracing Economic Complexity
One of the weaknesses of the core stems from going too directly from statements about individuals to statements about the aggregate. The nodes of economic models are special, for they contain agents with frontal lobes who can both strategize and panic, and it is these features that introduce much of the unpredictability in the linkages I mentioned earlier.
Haldane (2009) compares the recent financial crisis to the Severe Acute Respiratory System (SARS) outbreak earlier in the decade. Morbidity and mortality rates from SARS were, “by epidemiological standards, modest.” Yet SARS triggered a worldwide panic, reducing growth rates across Asia by 1–4 percentage points. Parents kept their children home from school in Toronto, and Chinese restaurants in the United States were the targets of boycotts. Faced with Knightian uncertainty, people conflated the possibility of catastrophe with catastrophe itself.
Some Policy Implications of a Confusing Environment
[Sanjeev's note: In this section, Caballero deteriorates into a confused Keynesian, and starts prescribing statist interventions of all sort. Let me warn you in advance about this section!!]
We need to rework the mechanism the core currently. The problem is that we do not know the mechanism, not just that we don’t know its strength.
For now, we shouldn't pretend that we know more than this, although this is no reason to give up hope. We have made enormous progress over the last few decades in the formalization of macroeconomics. We just got a little carried away with the beautiful structures that emerged from this process.
[These guys don't give up even after the theory has failed. Sanjeev]

The Pretense of Knowledge
The root cause of the poor state of affairs in the field of macroeconomics lies in a fundamental tension in academic macroeconomics between the enormous complexity of its subject and the micro-theory-like precision to which we aspire. The modern core of macroeconomics swung the pendulum to the other extreme, and has specialized in quantitative mathematical formalizations of a precise but largely irrelevant world.
From a policy perspective, the specifics of a crisis are only known once the crisis starts. For this reason, my sense is that, contrary to the hope of policymakers and regulators, there is limited scope for policy that can in advance eliminate the risk or costs of financial crisis, beyond some common-sense measures (like capital requirements for financial institutions) and very general public–private insurance arrangements (like deposit insurance).
The challenges are big, but macroeconomists can no longer continue playing internal games. The alternative of leaving all the important stuff to the “policy”-types and informal commentators cannot be the right approach. 
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Hayek’s brilliant depiction of the price system

In my previous blog post I cited Hayek's article, The Use of Knowledge in Society. In 1998 I was the first in the world to publish it online with permission from the American Economic Association (permission dated .19th of November, 1998 – see copy of permission). Subsequently I note that is it now widely available on the internet. That's really good, for this is one of the most brilliant pieces ever written. For those interested in a more detailed investigation of the price system, and hence in a more detailed understanding of the free society, this outstanding article (reproduced below) must be considered mandatory reading. Of course, it is only an introduction. To get an even clearer understanding there is no substitute for reading Hayek's many wonderful books.

The Use of Knowledge in Society

By F. A. Hayek (The American Economic Review, Volume 35, Issue 4 (Sep., 1945), 519-530).


What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions. The conditions which the solution of this optimum problem must satisfy have been fully worked out and can be stated best in mathematical form: put at their briefest, they are that the marginal rates of substitution between any two commodities or factors must be the same in all their different uses. This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solu­tion of the economic problem of society, does not yet provide an answer to it. The reason for this is that the "data" from which the economic calculus starts are never for the whole society "given" to a single mind which could work out the implications, and can never be so given. The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circum­stances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate "given" resources—if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality. This character of the fundamental problem has, I am afraid, been rather obscured than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathe­matics. Though the problem with which I want primarily to deal in this paper is the problem of a rational economic organization, I shall in its course be led again and again to point to its close connections with certain methodological questions. Many of the points I wish to make are indeed conclusions toward which diverse paths of reasoning have unexpectedly converged. But as I now see these problems, this is no accident. It seems to me that many of the current disputes with regard to both economic theory and economic policy have their common origin in a misconception about the nature of the economic problem of society. This misconception in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature.


In ordinary language we describe by the word "planning" the com­plex of interrelated decisions about the allocation of our available resources. All economic activity is in this sense planning; and in any society in which many people collaborate, this planning, whoever does it, will in some measure have to be based on knowledge which, in the first instance, is not given to the planner but to somebody else, which somehow will have to be conveyed to the planner. The various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process. And the problem of what is the best way of utilizing knowledge initially dispersed among all the people is at least one of the main problems of economic policy—or of designing an efficient economic system. The answer to this question is closely connected with that other question which arises here, that of who is to do the planning. It is about this question that all the dispute about "economic planning" centers. This is not a dispute about whether planning is to be done or not. It is a dispute as to whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals. Planning in the specific sense in which the term is used in contemporary controversy necessarily means central planning—direction of the whole economic system according to one unified plan. Competition, on the other hand, means decentralized planning by many separate persons. The half-way house between the two, about which many people talk but which few like when they see it, is the delegation of planning to organized industries, or, in other words, monopoly. Which of these systems is likely to be more efficient depends mainly on the question under which of them we can expect that fuller use will be made of the existing knowledge. And this, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans in with those of others.


It will at once be evident that on this point the position will be different with respect to different kinds of knowledge; and the answer to our question will therefore largely turn on the relative importance of the different kinds of knowledge; those more likely to be at the disposal of particular individuals and those which we should with greater confidence expect to find in the possession of an authority made up of suitably chosen experts. If it is today so widely assumed that the latter will be in a better position, this is because one kind of knowledge, namely, scientific knowledge, occupies now so prominent a place in public imagination that we tend to forget that it is not the only kind that is relevant. It may be admitted that, so far as scientific knowledge is concerned, a body of suitably chosen experts may be in the best position to command all the best knowledge available—though this is of course merely shifting the difficulty to the problem of selecting the experts. What I wish to point out is that, even assuming that this problem can be readily solved, it is only a small part of the wider problem. Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowl­edge which cannot possibly be called scientific in the sense of knowl­edge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation. We need to remember only how much we have to learn in any occupation after we have completed our theoretical training, how big a part of our working life we spend learning particular jobs, and how valuable an asset in all walks of life is knowledge of people, of local conditions, and special circumstances. To know of and put to use a machine not fully employed, or somebody's skill which could be better utilized, or to be aware of a surplus stock which can be drawn upon during an interruption of supplies, is socially quite as useful as the knowledge of better alterna­tive techniques. And the shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others. It is a curious fact that this sort of knowledge should today be generally regarded with a kind of contempt, and that anyone who by such knowledge gains an advantage over somebody better equipped with theoretical or technical knowledge is thought to have acted almost disreputably. To gain an advantage from better knowledge of facilities of communication or transport is sometimes regarded as almost dis­honest, although it is quite as important that society make use of the best opportunities in this respect as in using the latest scientific discoveries. This prejudice has in a considerable measure affected the attitude toward commerce in general compared with that toward pro­duction. Even economists who regard themselves as definitely above the crude materialist fallacies of the past constantly commit the same mistake where activities directed toward the acquisition of such prac­tical knowledge are concerned—apparently because in their scheme of things all such knowledge is supposed to be "given." The common idea now seems to be that all such knowledge should as a matter of course be readily at the command of everybody, and the reproach of irra­tionality leveled against the existing economic order is frequently based on the fact that it is not so available. This view disregards the fact that the method by which such knowledge can be made as widely available as possible is precisely the problem to which we have to find an answer.


If it is fashionable today to minimize the importance of the knowl­edge of the particular circumstances of time and place, this is closely connected with the smaller importance which is now attached to change as such. Indeed, there are few points on which the assumptions made (usually only implicitly) by the "planners" differ from those of their opponents as much as with regard to the significance and frequency of changes which will make substantial alterations of production plans necessary. Of course, if detailed economic plans could be laid down for fairly long periods in advance and then closely adhered to, so that no further economic decisions of importance would be required, the task of drawing up a comprehensive plan governing all economic activity would appear much less formidable. It is, perhaps, worth stressing that economic problems arise always and only in consequence of change. So long as things continue as before, or at least as they were expected to, there arise no new problems requiring a decision, no need to form a new plan. The belief that changes, or at least day-to-day adjustments, have become less im­portant in modern times implies the contention that economic problems also have become less important. This belief in the decreasing im­portance of change is, for that reason, usually held by the same people who argue that the importance of economic considerations has been driven into the background by the growing importance of technological knowledge. Is it true that, with the elaborate apparatus of modern production, economic decisions are required only at long intervals, as when a new factory is to be erected or a new process to be introduced? Is it true that, once a plant has been built, the rest is all more or less mechanical, determined by the character of the plant, and leaving little to be changed in adapting to the ever-changing circumstances of the moment? The fairly widespread belief in the affirmative is not, so far as I can ascertain, borne out by the practical experience of the business man. In a competitive industry at any rate—and such an industry alone can serve as a test—the task of keeping cost from rising requires constant struggle, absorbing a great part of the energy of the manager. How easy it is for an inefficient manager to dissipate the differentials on which profitability rests, and that it is possible, with the same technical facilities, to produce with a great variety of costs, are among the commonplaces of business experience which do not seem to be equally familiar in the study of the economist. The very strength of the desire, constantly voiced by producers and engineers, to be able to proceed untrammeled by considerations of money costs, is eloquent testimony to the extent to which these factors enter into their daily work. One reason why economists are increasingly apt to forget about the constant small changes which make up the whole economic picture is probably their growing preoccupation with statistical aggregates, which show a very much greater stability than the movements of the detail. The comparative stability of the aggregates cannot, however, be ac­counted for—as the statisticians seem occasionally to be inclined to do—by the "law of large numbers" or the mutual compensation of random changes. The number of elements with which we have to deal is not large enough for such accidental forces to produce stability. The continuous flow of goods and services is maintained by constant de­liberate adjustments, by new dispositions made every day in the light of circumstances not known the day before, by B stepping in at once when A fails to deliver. Even the large and highly mechanized plant keeps going largely because of an environment upon which it can draw for all sorts of unexpected needs; tiles for its roof, stationery for its forms, and all the thousand and one kinds of equipment in which it cannot be self-contained and which the plans for the operation of the plant require to be readily available in the market. This is, perhaps, also the point where I should briefly mention the fact that the sort of knowledge with which I have been concerned is knowledge of the kind which by its nature cannot enter into statistics and therefore cannot be conveyed to any central authority in statistical form. The statistics which such a central authority would have to use would have to be arrived at precisely by abstracting from minor differ­ences between the things, by lumping together, as resources of one kind, items which differ as regards location, quality, and other particu­lars, in a way which may be very significant for the specific decision. It follows from this that central planning based on statistical informa­tion by its nature cannot take direct account of these circumstances of time and place, and that the central planner will have to find some way or other in which the decisions depending on them can be left to the "man on the spot."


If we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization. But this answers only part of our problem. We need decentralization because only thus can we ensure that the knowledge of the particular circumstances of time and place will be promptly used. But the "man on the spot" cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system. How much knowledge does he need to do so successfully? Which of the events which happen beyond the horizon of his immediate knowledge are of relevance to his immediate decision, and how much of them need he know? There is hardly anything that happens anywhere in the world that might not have an effect on the decision he ought to make. But he need not know of these events as such, nor of all their effects. It does not matter for him why at the particular moment more screws of one size than of another are wanted, why paper bags are more readily available than canvas bags, or why skilled labor, or particular machine tools, have for the moment become more difficult to acquire. All that is significant for him is how much more or less difficult to procure they have become compared with other things with which he is also con­cerned, or how much more or less urgently wanted are the alternative things he produces or uses. It is always a question of the relative importance of the particular things with which he is concerned, and the causes which alter their relative importance are of no interest to him beyond the effect on those concrete things of his own environment. It is in this connection that what I have called the economic calculus proper helps us, at least by analogy, to see how this problem can be solved, and in fact is being solved, by the price system. Even the single controlling mind, in possession of all the data for some small, self-contained economic system, would not—every time some small adjust­ment in the allocation of resources had to be made—go explicitly through all the relations between ends and means which might possibly be affected. It is indeed the great contribution of the pure logic of choice that it has demonstrated conclusively that even such a single mind could solve this kind of problem only by constructing and constantly using rates of equivalence (or "values," or "marginal rates of substitution"), i.e., by attaching to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-end structure. In any small change he will have to consider only these quantitative indices (or "values") in which all the relevant information is concentrated; and by adjusting the quantities one by one, he can appropriately rearrange his dispositions without having to solve the whole puzzle ab initio, or without needing at any stage to survey it at once in all its ramifications. Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere, and that in consequence they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin, but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.


We must look at the price system as such a mechanism for com­municating information if we want to understand its real function—a function which, of course, it fulfills less perfectly as prices grow more rigid. (Even when quoted prices have become quite rigid, however, the forces which would operate through changes in price still operate to a considerable extent through changes in the other terms of the contract.) The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on, and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement. Of course, these adjustments are probably never "perfect" in the sense in which the economist conceives of them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or "normal" level. I have deliberately used the word "marvel" to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. But those who clamor for "conscious direction"—and who cannot be­lieve that anything which has evolved without design (and even without our understanding it) should solve problems which we should not be able to solve consciously—should remember this : The problem is pre­cisely how to extend the span of our utilization of resources beyond the span of the control of any one mind; and, therefore, how to dispense with the need of conscious control and how to provide inducements which will make the individuals do the desirable things without anyone having to tell them what to do. The problem which we meet here is by no means peculiar to eco­nomics but arises in connection with nearly all truly social phenomena, with language and most of our cultural inheritance, and constitutes really the central theoretical problem of all social science. As Alfred Whitehead has said in another connection, "It is a profoundly erroneous truism, repeated by all copy-books and by eminent people when they are making speeches, that we should cultivate the habit of thinking what we are doing. The precise opposite is the case. Civilization ad­vances by extending the number of important operations which we can perform without thinking about them." This is of profound sig­nificance in the social field. We make constant use of formulas, symbols and rules whose meaning we do not understand and through the use of which we avail ourselves of the assistance of knowledge which individually we do not possess. We have developed these practices and institutions by building upon habits and institutions which have proved successful in their own sphere and which have in turn become the foundation of the civilization we have built up. The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utiliza­tion of resources based on an equally divided knowledge has become possible. The people who like to deride any suggestion that this may be so usually distort the argument by insinuating that it asserts that by some miracle just that sort of system has spontaneously grown up which is best suited to modern civilization. It is the other way round: man has been able to develop that division of labor on which our civilization is based because he happened to stumble upon a method which made it possible. Had he not done so he might still have de­veloped some other, altogether different, type of civilization, something like the "state" of the termite ants, or some other altogether un­imaginable type. All that we can say is that nobody has yet succeeded in designing an alternative system in which certain features of the existing one can be preserved which are dear even to those who most violently assail it—such as particularly the extent to which the indi­vidual can choose his pursuits and consequently freely use his own knowledge and skill.


It is in many ways fortunate that the dispute about the indispensa­bility of the price system for any rational calculation in a complex society is now no longer conducted entirely between camps holding different political views. The thesis that without the price system we could not preserve a society based on such extensive division of labor as ours was greeted with a howl of derision when it was first advanced by von Mises twenty-five years ago. Today the difficulties which some still find in accepting it are no longer mainly political, and this makes for an atmosphere much more conducive to reasonable discussion. When we find Leon Trotsky arguing that "economic accounting is unthinkable without market relations"; when Professor Oscar Lange promises Professor von Mises a statue in the marble halls of the future Central Planning Board; and when Professor Abba P. Lerner re­discovers Adam Smith and emphasizes that the essential utility of the price system consists in inducing the individual, while seeking his own interest, to do what is in the general interest, the differences can indeed no longer be ascribed to political prejudice. The remaining dissent seems clearly to be due to purely intellectual, and more particularly methodological, differences. A recent statement by Professor Joseph Schumpeter in his Capitalism, Socialism and Democracy provides a clear illustration of one of the methodological differences which I have in mind. Its author is pre­eminent among those economists who approach economic phenomena in the light of a certain branch of positivism. To him these phenomena accordingly appear as objectively given quantities of commodities impinging directly upon each other, almost, it would seem, without any intervention of human minds. Only against this background can I account for the following (to me startling) pronouncement. Professor Schumpeter argues that the possibility of a rational calculation in the absence of markets for the factors of production follows for the theorist "from the elementary proposition that consumers in evaluating (`de­manding') consumers' goods ipso facto also evaluate the means of production which enter into the production of these goods.'[1] Taken literally, this statement is simply untrue. The consumers do nothing of the kind. What Professor Schumpeter's "ipso facto" pre­sumably means is that the valuation of the factors of production is implied in, or follows necessarily from, the valuation of consumers' goods. But this, too, is not correct. Implication is a logical relationship which can be meaningfully asserted only of propositions simultaneously present to one and the same mind. It is evident, however, that the values of the factors of production do not depend solely on the valua­tion of the consumers' goods but also on the conditions of supply of the various factors of production. Only to a mind to which all these facts were simultaneously known would the answer necessarily follow from the facts given to it. The practical problem, however, arises pre­cisely because these facts are never so given to a single mind, and because, in consequence, it is necessary that in the solution of the problem knowledge should be used that is dispersed among many people. The problem is thus in no way solved if we can show that all the facts, if they were known to a single mind (as we hypothetically assume them to be given to the observing economist), would uniquely determine the solution; instead we must show how a solution is pro­duced by the interactions of people each of whom possesses only partial knowledge. To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world. That an economist of Professor Schumpeter's standing should thus have fallen into a trap which the ambiguity of the term "datum" sets to the unwary can hardly be explained as a simple error. It suggests rather than there is something fundamentally wrong with an approach which habitually disregards an essential part of the phenomena with which we have to deal: the unavoidable imperfection of man's knowl­edge and the consequent need for a process by which knowledge is constantly communicated and acquired. Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people's knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain. I am far from denying that in our system equilibrium analysis has a useful function to per­form. But when it comes to the point where it misleads some of our leading thinkers into believing that the situation which it describes has direct relevance to the solution of practical problems, it is time that we remember that it does not deal with the social process at all and that it is no more than a useful preliminary to the study of the main problem.

[1] J. Schumpeter, Capitalism, Socialism, and Democracy (New York, Harper, 1942), p. 175. Professor Schumpeter is, I believe, also the original author of the myth that Pareto and Barone have "solved" the problem of socialist calculation. What they, and many others, did was merely to state the conditions which a rational allocation of resources would have to satisfy, and to point out that these were essentially the same as the condi­tions of equilibrium of a competitive market. This is something altogether different from showing how the allocation of resources satisfying these conditions can be found in prac­tice. Pareto himself (from whom Barone has taken practically everything he has to say), far from claiming to have solved the practical problem, in fact explicitly denies that it can be solved without the help of the market. See his Manuel d'economie pure (2nd ed., 1927), pp. 233-34. The relevant passage is quoted in an English translation at the begin­ning of my article on "Socialist Calculation: The Competitive 'Solution,' " in Economica, New Series, Vol. VIII, No. 26 (May, 1940), p. 125.

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The magic of the price system

This is an extract from BFN, as well, and outlines the magic of the price system.

The Price System

The price system is the counterpart of our body’s autonomic nervous system or the instinctive brain. This system instantaneously regulates millions of transactions in the world every second. There is no conscious effort needed to ensure its success. This fabulous price system is not the product of human design, but a ‘natural’ feature of the human world, something like language which is a universal feature of all societies. Indeed, Friedrich Hayek observed in his paper of 1945 on ‘The Use of Knowledge in Society’[i] that if the price system ‘were the result of deliberate human design, […] this mechanism would have been acclaimed as one of the greatest triumphs of the human mind’.

Indeed, this paper by Hayek provides us with perhaps the finest description of the price system provided by anyone so far. Hayek showed in his paper how the price system captures information not only of our personal preferences, our relative valuations and our knowledge of local conditions and special circumstances, but also how it then transmits the relevant part of this information to everyone else in the world who needs to know through a sequence of negotiations and trades. He then showed how the changes to the information which is relevant to us flow back rapidly in the form of the prices we pay locally.

The system succeeds in this enormously complex task by offering the right ‘inducements which will make the individuals do the desirable things without anyone having to tell them what to do’ (Hayek). Because of the exceptional power it commands over people, governments seek to influence our behaviour through this system, either intuitively or from cussedness. They lower prices through subsidies, increase them through taxes, or at times even fix prices directly.

As the Invisible Hand is perhaps not as visible as we would like it to be yet, let’s hear the arguments from Hayek himself:

  • [T]he economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place.
  • In a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people.
  • Through it not only a division of labour but also a coordinated utilization of the resources based on an equally divided knowledge has become possible.
  • Prices act as ‘a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials. […] (In this way) a solution is produced by the interactions of people each of whom possesses only partial knowledge’.

It is crucially important that every Indian citizen is able to visualize the Invisible Hand clearly in his or her mind’s eye. So let’s put on our hats. Off we go to Africa!

*  *  *

Hello! We are now standing on the outskirts of Yelwa in Nigeria.

Let’s assume that China has suddenly increased its demand for steel as the production of its new car – the pilot of which was a closely guarded secret – starts to ramp up. As this sudden increase in demand for steel was not anticipated by the market, prices of steel jump up in response.

Now let’s meet Moremi. She is a poor housewife living on the outskirts of Yelwa, blissfully ignorant of this trivia about new Chinese cars. All she knows is that suddenly her careful plans have gone awry. Moremi had been mulling over the past month about upgrading from her terracotta cooking pot to a metal one for which she had been saving some money. But she now finds that the price of the steel pot she had wanted has suddenly increased.

What has happened, of course, is that the relevant information on the new Chinese car has been passed on to Moremi by the market. The Nigerian manufacturer of steel cooking pots has had to pay more for steel inputs. The local grocery shop, experiencing the higher wholesale price set by the manufacturer, has had to pass on this increased cost to consumers. In this manner, the production of new cars in China has changed things in Yelwa – Moremi is forced to rethink her choices. Steel is now deployed towards its most profitable and hence most productive use, diverting it from the production of household pots and pans. Given the higher price of steel pots, she can now either sacrifice other domestic needs and buy the high-priced steel pot or she can choose a cheaper aluminium pot instead, and keep the change. Moremi considers all options and opts for the aluminium pot.

So, is that a bad thing to have happened? Yes, our sympathies are with Moremi for not having achieved her most preferred outcome. But we also notice that everything that has happened has been just. Free peoples have made their individual decisions based on relevant information, with each of them working in his or her self interest. No one has cheated any other person. Also, everyone has become better off through these trades. For instance, by buying the aluminium pot Moremi has become a little bit better off than before; she is now more productive in her domestic work. The local grocery shopkeeper is a little better off than before, having marked the aluminium pot up to the price that is sufficient to allow his business to survive in the competitive retail market. We note that the free market doesn’t guarantee we will get what we want. It does ensure, though, that everyone involved will become at least a little better off each time they decide to trade.

More importantly, a number of things happen after Moremi buys her aluminium pot. Her choice is quickly communicated to all relevant producers in all parts of the world; people who have never heard nor will hear of Moremi. No emails or letters are sent by anyone; instead, with all other ‘Moremis’ (namely, buyers placed in a similar position to Moremi) of the world substituting towards aluminium pots, the demand for aluminium pots now begins to rise. This raises the price of aluminium metal by a wee bit. That increase in price then sends a signal to aluminium suppliers in distant Australia to increase their production of aluminium to take advantage of this higher price. More people are hired in Australia and start digging up more bauxite. In this way the entire world shifts, ever so slightly, in an invisible but exquisitely coordinated manner, to a substitute metal – aluminium.

In this magical way, thousands if not millions of people worldwide act in ways they would not have, had China not decided to produce more cars. Most importantly, these direct effects also have second order effects down the line. Since Moremi had some spare change left over after buying the aluminium pot, she takes her family out to the movies. That shifts the demand for movies and more movies are made the following year, in response; and so on. Thus, the entire world is integrated and coordinated by prices – each decision affecting every other decision. And thus, in choosing whether to eat cereal or fruit for breakfast, or in deciding upon the amount of milk or sugar we put into our tea, each of us impacts the demand for, and supply of, all products in the world.

It is this dissemination of relevant information from hundreds of lands and thousands of people back to everybody’s doorstep in every corner of the world at an amazing speed that Hayek was writing about. Only a free market can accomplish these amazing feats through the price system. Nothing else has the ability to always produce the locally optimal outcome for all parties involved in a trade, down to the level of crushed-ice candy sold to a child by a bicycle-riding vendor in a hot and dusty village in Bihar – a village that can only be reached after travelling through miles of narrow, bumpy roads.

In this manner the prices of all things in the world and all quantities of products and services produced in the world are in tenuous balance or equilibrium. Even the slightest change is communicated to everybody else but only to the extent that these other individuals need to know. This balance is called the (competitive) general equilibrium of all world markets operating simultaneously and optimally at each instant. This general equilibrium represents the ultimate outcome of the Invisible Hand, which has thus coordinated, unerringly, the optimal production and consumption decisions throughout the world by ensuring that everyone’s preferences and budget constraints are instantaneously in equilibrium, with prices communicating the relative values of things. Technically we say that at such a point the marginal rates of substitution[ii] for each of the n products in the world are equalized for each of the n individuals on this planet.

Indeed, if a supremely intelligent and knowledgeable ‘social planner’ could replicate the entire series of incidents and information leading to a particular set of purchases, then people would end up buying exactly those goods they have been actually purchased. That is the only just outcome. That there is no possibility of such a social planner existing should of course be obvious by now. No one can or should attempt to replace the Invisible Hand.

Risks of Interfering with the Price System

As massive flows of price-related information rush across the globe instantaneously without any coordinating individual, no government can imitate the phenomenal agility and justice of markets. Alternatives to free-market capitalism that try to interfere with prices, or otherwise try to apply brakes on the market, lead to completely unintended consequences, and that society then goes down the slippery slope to self-destruction. Governments simply cannot improve upon, in any way, the natural agility and merit-based reward processes of free markets.

Sadly, governments are often arrogant, believing they know better for us than we do for ourselves. Many immature Third World governments find it extremely hard not to interfere with the price system. (Even the ‘mature’ First World can’t stop giving subsidies to its farmers as in the case of USA and Europe, thus making these unfortunate farmers globally uncompetitive). Interference with prices has great pitfalls. The basic problem with such interference is that normal incentives are distorted and people stop doing their very best, leading to sub-optimal outcomes for everyone.

To examine what can happen if we interfere with the price system, let us stay with Moremi. In a twist to the original story, let’s assume that Nigeria is now a socialist country, its government being driven by the objective of equality. Out of the sheer concern they feel for Moremi’s ‘plight’ in not having been able to purchase the steel pot, the socialist leadership of Nigeria decides to influence the price system in order – in the words of Minister Sodeinde – ‘to set things right’. Following is a description of what the Nigerian Government did and what happened then:

  • Price fixing: The first thing the government did was to fix a maximum retail price for steel pots, at a price equal to what was prevailing for these pots prior to the rise in world steel prices. But the Nigerian Government clearly could not control global steel prices, and so the prices for steel inputs used by the Nigerian pot manufacturer did not budge by one kobo (100 kobo=31 Indian paise). The wholesalers wouldn’t pay the producer one more kobo either since the maximum retail price had been fixed by the government and retailers wouldn’t buy from wholesalers at a higher price than before. Each pot produced thus led to a loss for the producer who had no choice but to tell the government he was going to shut down, throwing 100 workers out of work.
  • Direct government subsidy: Realizing that this would lead to a major political problem, the Nigerian Government quickly changed this policy. The government promised to lower excise duties for all users of steel. The pot manufacturer resumed making pots. But the government’s revenues fell. As a result, a long anticipated bridge over a stream in Yelwa had to be scrapped. There was no money left for it. That then led to significant public protests on the streets.
  • Forced private subsidy: Reeling from these street demonstrations, the Nigerian Government restored the excise duty. In its place, it made a law by which the only electric company of Nigeria, which had not yet been nationalized, was required to subsidize electricity supply to all Nigerian industry. In order to meet the very significant increase in costs arising from this compulsory subsidy for industry, the electricity company then had no choice but to raise electricity prices for consumers. That was disastrous, for it led to a massive nation-wide protest!

And of course, while implementing these policy changes the government had to hire tens of new bureaucrats to write hundreds of pages of new regulations. That not only wasted tax-payers’ money but also squandered the productive time of businesses that now had to read those hundreds of new pages of regulation and were burdened with additional record keeping requirements. (Such are only a few of the socialist nightmares we have gone through in India!)

This whole fiasco turned out to be a very expensive lesson in elementary economics for Nigeria (read: India, of course), leading to the lesson that there is no free lunch. Somebody has to pay for the ‘benevolence’ of governments, which means robbing Peter to pay Paul. Robbing people distorts the incentives in a society and people do not take optimal decisions. It is better not to rob people. Even a toddler can see that. And yet it is a mystery why most grown-ups can’t understand that.

Fortunately for the Nigerian people, its government quickly realized that interfering with the price system was becoming counterproductive. It then switched completely to capitalism. The happy ending to our trip to Africa is that Nigeria is now the world’s purest capitalist society, and the world’s richest. Moremi now lives in a large beautiful house with four bedrooms and a lovely garden. She has three computers and two cars. There are long queues in the West of highly skilled professionals desperately wanting to migrate to Nigeria.

So what did the Government of Nigeria do to ensure that poor Moremi became a wealthy citizen? Well, it did (almost) nothing! Its new and highly successful policy was called laissez faire, or leaving the people alone. As Moremi was not desperately poor, she did not need direct funding through a negative income tax. She was therefore free to develop on her own. The previous welfare programs did no good to anyone but merely sapped the self-respect of the poor and encouraged rampant corruption in society. The government scrapped all kinds of social welfare programmes.

Being left alone, Moremi felt motivated to think for her own future. Her self-awareness and capacity grew greatly over the next two years. With thrift and good personal character, Moremi took advantage of the many opportunities thrown up by her newly free society. She attended night classes and obtained a law degree at the age of 42. Then she quickly established herself as the best lawyer in Yelwa. She later joined politics and become the Prime Minister of Nigeria. In her time, Nigeria went to a level of greatness that no socialist leader could possibly have dreamed of. Moremi’s government scrapped all regulations that were not fully compatible with freedom. In doing so, Moremi completely liberated the energies of the Nigerian people.

Moremi became the role model for all women all over the world. Moremi finally became the Secretary General of the United Nations (UN) and was instrumental in shutting down the scandalous, corruption-ridden welfare programmes of this completely unaccountable, bureaucratic behemoth. Consequently, the UN is no longer in the business of welfare but follows Moremi’s strict guidelines.  It insists on freedom (capitalism) as the sole principle of governance in poor countries that seek its help. It teaches people how freedom will help their society become wealthy through their own effort. It explains to people why charity is almost invariably the worst form of human abuse.

The Role of Profit

Profit is the direct signal that a society – indeed the world – gives to each of us to provide the particular product or service. The producer who gives us the most value receives our vote in the market each time we buy his product. That producer then becomes profitable, which means he continues to exist, even expand. In this way, only the best providers of goods and services for each rupee spent get to stay. Providers who fail to provide us with value, at least relative to other providers, are politely shown the door. We don’t like to kill them for under-performance because we are a civilized society. We simply bankrupt them.

By ensuring that only the best producers survive, everyone benefits. Rewarding only those who give us the greatest value is obviously a very sensible thing to do. In this manner, an entire society becomes smarter, more effective and more productive; and enormously richer. Profit is a critical market signal that must be allowed to flourish by governments which should step aside completely and let businesses become as profitable as they can possibly be; and each person as rich as he can possibly become. That is the sure recipe for the success of a society.

[i] Published in the American Economic Review, Vol. 35, No. 4, September 1945. Freely available on the internet.

[ii] A representation of our preference to shift our purchases from an existing good to another.

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The nonsense of ‘social justice’

Social justice does not belong to the category of error but to that of nonsense. … [T]he prevailing belief in ‘social justice’ is at present probably the gravest threat to most … values of a free civilization.

Given that most educated people chant the mantra of social justice, it must have taken quite a bit of courage to argue – as Hayek did, years ago – that the idea of ‘social justice’ is nonsense. The ‘derivatives’ of social justice: things like ‘justice across generations’, ‘economic justice’ (economic redistribution), even affirmative action; must equally be placed in the category of nonsense.
It is impossible for anyone to provide a coherent definition of ‘social justice’ since it is impossible to arrive at a general rule or principle that clarifies what it stands for in every possible case. It should also be obvious, upon reflection, that the concept of justice and accountability is an attribute of individual human conduct. Entire groups can never be accountable for anything. Thus children, always born innocent, can never be implicated in the misdeeds of their forefathers. We must deliver justice to individual adults, not to entire societies. Only guilty individuals must be punished, not innocent parties.
There does exist, however, a general principle to reduce relative disadvantage across society, a principle that can be applied unequivocally in every case: the principle of reasonable equality of opportunity (not perfect equality of opportunity). This is ensured by providing (not by directly managing the delivery of) school education to the children of the poor. After that is done, individual initiative and luck should determine the achieved outcomes. 
– My editorial in Towards a Great India, 15 November 2009. 
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