Evolution of Economic Thought

Ludwig von Mises and F. A. Hayek:  Economic Calculation and Keynes vs. Hayek

Ludwig von Mises.jpg

Ludwig von Mises (1881 - 1973)

The Basic Question:  Is Socialism Possible (not is it moral - is it possible)?

Remember first the definition of socialism (which is why this term is used quite frequently in this discussion):

Prior to Mises raising the calculation problem in 1920, the critics of socialism concentrated on the incentive problem:

According to many socialists – the problem was due to the fact that man’s nature had been formed and could be changed:

 

Although Mises talked about the incentive issue – that was not his main point.

What Mises did was to say, OK, assume there is no incentive problem (we have all become the “socialism man”) – if that is the case, then will socialism be a successful economic system.  His answer was “no.”

Let’s look at his famous writing, “Economic Calculation in the Socialist Commonwealth” (1920) - your reading:

Mises first talked about:

People usually talk about the distribution of consumption goods (lower order goods) in the Socialist Commonwealth.

Who is to do the consuming and what is to be consumed by each?  Socialists emphasize equality in terms of consumer goods – we all have the same “equal” distribution.

But, Mises said, this is of secondary importance.  Can have exchange among consumption goods under socialism within the narrow limits permitted. 

But the major problem is that no production goods will ever be exchanged and therefore it will be impossible to determine their monetary value.

If we can’t determine that – then the consumer goods to be distributed will be few (there is no way of “economizing” on the use of resources and determined haphazardly by planners – have nothing to do with the wants of the people.)

Money could never fill in a socialist state the role it fills in a competitive society in determining the value of production goods.  Calculation in terms of money will be impossible.

Hence—it then becomes “impossible in any socialist state to posit a connection between the significance to the community of any type of labor and the apportionment of the yield of the communal process of production.”

So remember – labor is included here!  What should people do?  What should they train to become? There are no answers in socialism.

 

The Limits of Monetary Calculations

1.       First:   Monetary value does not include value outside of exchange relations. For example, " the beauty of a neighborhood or of a building, the health, happiness and contentment of mankind, the honor of individuals or nations, . . ." 

            And these are important - "they are just as much motive forces of rational conduct as are economic factors in the proper sense of the word, even where they are not substitutable against each other on the market and therefore do not enter into exchange relationships."

            But Mises says this does not make economic calculation any less significant.  These are all "goods of lower order" and we can still make decisions in our lives while taking them into account.

       

          Second:  Money is no yard-stick of value!  Value is not measured in money, nor is price.  They merely consist in money.

Money as an economic good is not a stable value – its value is determined by S & D like any other commodity and subject to diminishing marginal utility.

But these fluctuations are comparatively trivial in regard to its exchange –relations - most especially if we have "good" or sound money that does not change in value drastically (through inflation by a monetary authority for example).

2.      

 

 

 

 

 

The Two Conditions for Economic Calculation

1.  Capital goods must be exchanged in a market - just like consumer goods.  "Firstly, not only must goods of a lower, but also those of a higher order, come within the ambit of exchange. . . ."

For example:  A resource is “worth” this much (say $100,000) in market A and this much (say $200,000) in market B – it is comparable.  But these prices (or values) only arise out of exchange.

The human mind cannot orientate itself properly among the bewildering mass of intermediate products and potentialities of production.  We must have some “aid to the human mind” for deciding where resources should go. 

And in order to gain this “aid” – we need exchange – which means we need private property rights in the means of production!

With private property everybody is a consumer and everybody a producer … and thereby resources flow in economically “correct” directions.  Correct meaning – towards more highly valued uses, not wasted.

A socialist economy will have to be a static economy.

There is only groping in the dark!  There is no trial and error.  There is no entrepreneurial discovery!

2.  We must use money!  Using money in the exchange relationship allows a monetary price to come about in a market.  This price gives us an idea of the value that many people put on a good -- lower order and higher order (consumer or capital).

Money is the common denominator that makes valuation comparisons possible –

Conclusion

So Mises concludes that in order to have a successful economy (where the basic necessities of life are met), we must have:

Economic Calculation:  “the decision-making ability to allocate scarce capital resources among competing uses.”

Austrian economist Pete Boettke sums in up this way (quote):

1.       Without private property rights in the means of production, there will be no market for the means of production.

2.       Without a market for a means of production, there will be no monetary prices established for the means of production.

3.       Without monetary prices, reflecting the relative scarcity of capital goods, economic decision makers will be unable to rationally calculate the alternative uses of capital goods.

Mises (from Human Action):  “Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation.  The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds.  The retrospective establishment of the outcome of past action becomes accounting profits and losses.”

So market prices in capital goods (which we have already learned reflect the subjective value of individual consumers) – determine the potential costs of production – which then determine if a profit will be made or not.

Example:  Under socialism – imagine this scenario:  the government owns all means of production.  So it owns a plant that makes hamburger patties.  It also owns the ranches that produce the cows, the truck company that transports the meat, etc.

The “planners” are trying to decide if this is the best use of this plant - the best use of the trucks, of the land that houses the cow ranch.  All they can do is guess.  So therefore, they make hamburgers that nobody wants, and they don’t make hot dogs that a lot of people want.  They use these capital goods in unproductive ways – ways that waste resources.  Even to the point of not being able to meet the basic necessities of life.

 

 

The Economic Calculation Debate

F. A. Hayek (1899-1992) vs. J. M. Keynes (1883-1946)

  

"When the definitive history of economic analysis during the 1930s comes to be written, a leading character in the drama (it was quite a drama) will be Professor Hayek. . . . It is hardly remembered that there was a time when the new theories of Hayek were the principal rival of the new theories of Keynes" (Sir John Hicks, 1967).

 F. A. Hayek:  Hayek was born into a family of intellectuals in Vienna.  He earned doctorates from the University of Vienna (1921 and 1923).  Influenced by Menger's Principles of Economics (1871), his ideas were also gradually refined by Eugen Boehm-Bawerk, Friedrich Wieser, and Ludwig von Mises.

Note on Mises:  Although this debate is famous in terms of Hayek and Keynes, as we just saw Mises was central to understanding the concept of economic calculation and why, under a planned economy, it would be impossible to know where resources should be allocated without the knowledge generated from market prices. 

I agree with economist Joseph Salerno that:

“Economic Calculation in the Socialist Commonwealth” surely ranks among the most important economic articles written this [20th] century."

"The Hayek-Keynes debate was perhaps the most fundamental debate in monetary economics in the 20th century. Beginning with his essay, 'The End of Laissez Faire' (1926), Keynes presented his interventionist pleas in the language of pragmatic classical liberalism. As a result, Keynes was heralded as the 'savior of capitalism,' rather than being recognized as the advocate of inflation and government intervention that he was." (P. Boettke).  Remember, "classical liberalism" is not the "liberalism" of today.

The "First" Debate

Point:  Hayek - the fundamental problem with Keynes's economics was his failure to understand the role that interest rates and capital structure play in a market economy. Because of Keynes's use of aggregate (collective) concepts, he failed to address these issues adequately in A Treatise on Money (1930).

Hayek pointed out that Keynes's aggregation tended to redirect the analytical focus of the economist away from examining how the industrial structure of the economy emerged from the economic choices of individuals.

 

Counter Point:  Keynes did not take kindly to Hayek's criticism. He responded at first by attacking Hayek's book Prices and Production (1931). Then Keynes claimed that he no longer believed what he had written in A Treatise on Money, and turned his attention to writing another book, The General Theory of Employment, Interest, and Money (1936), which in time became the most influential book on economic policy in the 20th century.

No Counter Point from Hayek:  Rather than attempting to criticize directly what Keynes presented in his General Theory, Hayek turned his talents to refining capital theory. Hayek said that part of the reason he didn't respond to Keyne's General Theory was because Keynes was always changing his mind -- so why take the time to write a response when Keynes will probably change his mind later anyway. 

 

Some historians of thought think that if Hayek had responded to the General Theory -- history would have been very different?

By the end of the 1930s, Keynes's brand of economics was on the rise. In the eyes of the public Keynes had defeated Hayek. Hayek lost standing in the profession and with students.

The Letters to the Times of London (as per Gerold P. O'Driscoll, WSJ, July 7, 2010)

Keynes (et. al.) Point:  In bad economic times we need spending -- whether on consumption or investment - didn't matter.  A "lack of confidence" in private spending was the reason that savings did not turn into investment -- therefore, lack of demand!

Public (government) spending is necessary to offset the private savings.  Deficit spending.

 

Hayek (et. al.) Point:  Three "areas of contention" -

1. Saving vs. hoarding.  If people in the economy are hoarding money such that the demand for money is greater than the supply of money - not good.  But this is not "saving" in the classical sense.

 

2.  It does matter whether spending is on investment or consumption.  Investment is done on capital goods (private investment) - which then leads to an increase in production - income - and then spending.  (Say's Law).  This follows from above -- the savings will flow into investment in the securities markets.

 

3.  Government spending financed by deficits not so good!  There is a big difference between public debt and private debt and also public spending and private investment.  This is where Hayek talks about "readjustment" of resources to where they should be in order to create value for society and thereby increase economic growth.  Private financial markets gain a lot of knowledge about who should and should not be able to acquire debt for a reason.  And private debt is paid back through productivity -- not public debt.

 

    This is all related to the economic calculation debate.  If government planners are spending on roads, "new municipal swimming baths" and the like they are "groping in the dark" with respect to the value of these so-called investments.

 

So during the 1930s, although Hayek did not directly review Keynes' book, Hayek was involved in the economic policy debate - the socialist calculation debate, triggered by by Mises which stated that socialism was technically impossible because it would lack market prices (cited above and your reading).

 

 

The Economic Calculation Debate - General Question with Respect to Keynes:  To what extent can the economy be successfully planned and manipulated by government planners?

    Hayek:  In a way, this was a continuation of Hayek's arguments against Keynes for his "aggregates" -- but also against his call for economic planning.

Again, the economics profession and the intellectual community in general did not appreciate Hayek's criticism.

"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." F. A. Hayek - The Use of Knowledge in Society.

Focus is on coordination - how do coordination and economic order emerge from the unintended consequences of millions of economic actors?

Emphasis on knowledge - Dispersed economic agents have knowledge of time and circumstances which cannot be fully aggregated or understood by central planners.  Government planners have a knowledge problem.

". . . 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 because 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." (The Use of Knowledge in Society)

 

Two Kinds of Knowledge in Society:

    Scientific:

 

    Individual knowledge of time and circumstances (dispersed throughout society):

 

 

    Can planners possess the knowledge necessary to move resources to where they are useful to people?  Even move resources such that the basic necessities of life are met?  Is economic calculation possible without market prices, profits and losses?

Emphasis on prices:  Informational role of prices - prices serve as a learning mechanism which allows economic agents to economize on the quantity of information they must process in making choices. 

Emphasis on change:  "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." (The Use of Knowledge in Society)

Incentive Issues:  Hayek pointed out that political agents will often face perverse incentives -- in the absence of private ownership, political agents will lack the incentive to allocate resources in an economically efficient manner (where people can use them).  This is true even if they had the knowledge to do so - which they do not.

    Keynes:  Main work was The General Theory of Employment, Interest and Money (1936) - Response to the Great Depression and the "failure" of Classical economics.

Emphasis on demand - and the psychological reasons to consume or to invest:

    "When employment increases, D1 [consumption] will increase, but not by so much as D [change in income]; since when our income increases our consumption increases also, but not by so much.  The key to our practical problem is to be found in this psychological law." (The General Theory)

Emphasis on aggregates:

    Looking at aggregate demand - and how this demand can be manipulated by government. 

Was emphasis on uncertainty:  But the uncertainty was one of the decision makers.  Should they invest or not?  Depends upon the expected rate of profit -- which is uncertain, for example.  There was not an emphasis on the uncertainty of economic planners!

Really an entirely different way of looking at the economy and what was important to our understanding of it.

 

 

 

Summing Up:  Keynes vs. Hayek

The original question:  To what extent can the economy be successfully planned and manipulated by government planners?

Keynes:  Government planners can effectively manipulate the economy as desired in order to overcome the "failures of the market" due to inadequate demand - "psychological law".  Planners should be able to use discretionary policy (at their discretion).

Hayek:  Due to the knowledge problem and incentive issues, government planners will be ineffective when attempting to plan an economy.  Interventions will generate unintended (bad) consequences.

 

Video if we Have Time

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