Hayek and the Socialist Calculation

by James Hanley

Apparently Hayek is in season again. James K discussed him just over a week ago, now Jason K (no relation, so far as we know) features him at his real job, and meanwhile Adam Davison comments on him as Paul Ryan’s “guru,” prompting a response from Richard Epstein. So how can I not want to weigh in?

My comments here are mainly stimulated by david’s responses to James K and me, concerning Hayek and the socialist calculation debate, an issue david seems to think Hayek lost. My argument is that not only did Hayek win the intellectual argument, but that he did so so successfully that liberals have mostly adopted his position.

As a beginning point, it’s important to recognize that one can appreciate Hayek’s ideas and influence* without having to love Austrian economic theory. You can gain a lot from reading Hayek without ever approaching Mises, Rothbard, and Böhm-Bawerk, you can (and should) disdain gold-buggery, and free-market fundamentalism is wholly optional (as Epstein notes, Hayek supported both unemployment insurance and publicly provided health care**).

My focus here is on Hayek’s role in the socialist calculation debate, particularly in response to comments on James K’s post by david, who said one correct thing and several incorrect things about the debate. The correct thing was that “the economists of the era read the debate as a loss by the Austrians.” Indeed they did, but this was because they didn’t really grasp Hayek’s real argument. Not all economists do today, because they think they know it, and disliking Austrianism, don’t have an interest in exploring it more carefully. But I think it is more widely understood today than it was in the 1930s and ‘40s.

Among his incorrect contributions were to suggest that Hayek’s argument was in fact inferior to Oskar Lange’s defense of socialist calculation. As I will show, Hayek’s argument was not only superior, but that more than Lange’s approach it shapes how we view the role of the government in the economy today.

He also argued that today we engage in the kind of central planning Hayek said was impossible, citing wealth transfers, and seeming to suggest that dealing with macro issues like inflation and unemployment are part of central planning. These things are not planning, as understood in the context of the socialist calculation debate, and explaining what socialist planning and calculation meant will make clear why.

Central planning is the effort to determine and produce, from a public agency called (as a generic term) a Central Planning Board, the composition of a society’s economic output. E.g., how many houses will be built, how many cars produced, how many gas grills (and how much gas for those grills, how many hot dogs to grill on them, as well as how many buns for those dogs, how much ketchup, mustard relish, and jalapenos to put on them, how many potato chips to sit alongside the dogs, how many paper plates for them to sit on, how much beer and soda to drink with them, and how many cups to hold that beer and soda, and how many trash bags to hold the resulting waste). The idea is that a central planner can do this more efficiently than the diffuse, not centrally-organized, market can do it. After all, how could a process in which nobody was in charge, nobody looking down from above and viewing the process as a whole, do an efficient job of supplying as much as was desired, without either underproducing or overproducing those things? Who would let a bunch of workmen acting individually build houses without a foreman?

Unemployment and inflation, by contrast, are aggregate outcomes that are theoretically detachable from the actual composition of the society’s economic output. When the Federal Reserve pumps more money into the economy, it is attempting to reduce unemployment by increasing output, but it is not concerned about the composition of that output. The Fed doesn’t care if the result is jobs making houses, jobs making cars, or jobs making gas grills, just so long as jobs are created somewhere. By pumping in money, the Fed is just lubricating the system, and letting the millions of individuals within the system determine the changed composition of its output.

Similarly with transfers. On James K’s post, david argued that “the modern welfare mixed-economy state… does exactly enact these transfers, via widespread and large taxes…You are protesting very hard that a world that you already live in is utterly impossible to conduct, even in theory.” But with transfers government is not attempting to produce the most efficient economic output, it is trying to ensure a minimum standard of living for the poor. And while it does sometimes try to shape the composition of the economic product the poor demand with their welfare—WIC tells you exactly how many gallons of milk, cartons of eggs, and boxes of cereal you can get—it is trying only to shape the recipients’ purchases with that portion of their income, not their total set of economic spending, and it does so for reasons other than seeking economic efficiency—usually a combination of paternalism, moralism, and rent-seeking by the providers of those goods. Transfer payments in our economy are not a serious effort at creating an efficient allocation of society’s output.

Planning, by contrast, is the effort to centrally determine the composition of the economic output, and calculation simply refers to the means–whatever they may be–by which the central planner determines how much of each of these things to produce. The original socialist claim was that government determination of this distribution, in a system without prices, could do a better job of determining the efficient amount than could the decentralized market process. Mises (last mention, I promise) responded that socialism could not do this because without prices it lacked the information to determine how much of each thing was demanded. After all, an increase in the price of propane gas tells us demand has risen relative to supply–where would that information come from without prices? And it is price changes that cause us to change our behavior to automatically adjust the economy appropriately. I.e., if the price of propane rises, I’ll grill fewer hot dogs, as will many others, and that reduces the demand on the gas, bringing supply and demand back into line, as well as encouraging a shifting of the supply to its more highly valued uses (heating hot tubs, perhaps). Without prices, demand doesn’t respond, so suddenly there is a shortage. The Planning Board, without prices, wouldn’t be able to see where the most highly valued use was, and couldn’t shift the propane gas to that use and away from the lower valued use, so there would be too much continued use of gas for cooking hot dogs and too little for heating hot tubs—an economic inefficiency. The result is that a socialist economy would necessarily be inefficient; i.e., it could not provide the set of goods and services desired by the society.

Mises’ argument successfully persuaded socialist-leaning economists like Oskar Lange and Abba Lerner that prices are necessary. Their response, though, was that the prices didn’t need to be set in the market, but could be set by the central planner. The Central Planning Board would set “quasi-prices” for raw resources to the state-owned businesses, which would then attempt to minimize their costs and set their own prices (for finished products) at a point that would equal their marginal costs. The Planning Board then would respond as resource providers did in the market, by adjusting resource prices up and down according to shortages and surpluses. After all, they correctly pointed out, it’s the extra hotdogs sitting on the shelf that ultimately cause the meat producer to lower prices, and if the meat producer can recognize too many hot dogs in inventory, so can a Planning Board specifically tasked with the responsibility for doing so.

It’s a brilliant response, because it simply says that the firms will respond in the same way that neo-classical economics predicts firms will act. By grounding their argument in neo-classical theory, the socialists persuaded most economists that they had won the argument. At least in theory. Many recognized that in actual reality there was too much going on in an economy, too many products and prices for the planners to be able to acquire, analyze, and act on the information in a timely enough manner, so they doubted the functional utility of planning. But the theory is what really mattered—perhaps we couldn’t do planning now, but given sufficient technological breakthroughs in technology for gathering and analyzing information (superduperÜbercomputers) we could. The Austrians, the discipline thought, had lost the most important argument, the theoretical one.

And in fact Hayek’s first arguments did focus mostly on the functional impossibility of gathering sufficient information, which is why he was perceived to have lost the debate. But his arguments moved beyond just the technical difficulties of information acquisition, and that’s where he intellectually won the debate. But many neo-classical economists (at least at the time) never really understood that his argument had taken a new line.

That line was two-fold: a consideration of the real function/nature of the market, and a consideration of bureaucratic vs. entrepreneurial response to incentives.

First, Hayek (and other Austrians) rejected the neo-classical equilibrium model of the market, in which the central economic problem is how best to allocate a given set of resources. Instead, they view the market as dynamic, perpetually in disquilibrium, a process of discovering what it is that people value.

Consider the price of airline seats, for example. A Central Planner would try to analyze what “the” price for airline seats should be, and therefore how many airline seats should be made available. But as the commercials for online ticket sellers like to point out to us, the guy in the seat next to you probably paid a different price than you did. Airlines don’t expert or try to find an equilibrium price for seats, but try to sell one to you for as much as you’ll pay, and one to me for as much as I’ll pay ( with a certain minimum below which they no longer think it’s worthwhile to sell that seat). They are continually trying to discover how much each of us is willing to pay at any given moment in time, in conditions that continually change (although of course some conditions—demand for flights to Hawaii in August vs. December–are more predictable than others). All that can be aggregated into an average, but even the average is a continuously moving number. There are too few constants in the economy, and too many variables, to use any set of equations to determine the correct outcome.

But even more than that, the market functions to ferret out currently unknown valuations. A Planning Board would look at a surplus of hot dogs sitting on the shelf and adjust the price of the meat input accordingly. But a market-firm would look at that surplus and devise a jalapeno-bourbon infused hotdog, to entice us to buy more dogs. It might sell, or it might not—nobody can know in advance, so an efficient allocation of meat, jalapenos, and bourbon for the purpose of hot dog production cannot be predicted. Or if the price of meat rises, the Planning Board might allocate less meat to the hot dog manufacturers so that there were fewer hotdogs, whereas the private hot dog manufacturer might respond by looking for substitute products (perhaps adding soy to the dogs as a meat substitute), or focusing on higher margin products, such as gourmet hot dogs, for which they can charge prices that will cover the increased meat cost. Will those plans work? Nobody knows in advance, which means the efficient allocation cannot be predicted, which means the Central Planning Board cannot efficiently plan.

Both in theory and practice, the responses of a Planning Board are not identical to the responses of an entrepreneurial firm, because they have different purposes and incentives. The Planning Board’s purpose is to organize an efficient allocation of an extant set of products/services. The entrepreneurial firm’s purpose is to make as much money as it can. This results in different incentives–the Planning Board has no incentive to look for new products/services, or even to look for substitutes for (or less costly ways of producing) extant products, while the private (entrepreneurial) firm has exactly that incentive to find new sources of value. In fact the Planning Board has precious little incentive to allocate extant products efficiently because it can’t go out of business if it fails to do so. In contrast, the firm has an incentive to be entrepreneurial when prices change for the worse, because in a very Darwinian process, those that don’t change appropriately will disappear while those that do will thrive.

Without intending any kind of triumphalism, I think it’s fair to say that this is an area where a libertarian-friendly argument has mostly won liberals over, to the extent that most liberals today find it odd to think of total economic planning as a liberal idea. Sure, they tend to favor some degree of planning. They may favor Obama’s green jobs initiative, or approve the bailout of General Motors (particularly with the requirement that GM produce a specific product, an electric car), and to some extent the Affordable Care Act (although it is more an effort to constrain total spending than to dictate just how much of each medical service should be provided). But generally they no longer see the government as appropriately determining the overall composition of economic output or of setting prices for the whole economy.

But up through the 1950s, at least, this was very much a strain of liberalism. The New Deal and even more the central planning effort of WWII seemed to support the real functionality of the idea.*** The most famous contemporary economist, and the one most beloved by liberals, Galbraith, not only worked for the Office of Price Administration during WWII, but came away from the experience believing that there was great virtue in having government do so. And while not a total planner, he thought government should restrict spending on private consumption and shift those resources to public amenities (such as cultural venues like art museums and concert halls, not simply parks or infrastructure like sewer systems). That is, much, if not all, of the society’s economic output, should be determined by the Planning Board, in the name of efficiency. (Ironically, Galbraith, like the Austrians, disdained quantitative economics in general. And it’s of interest to note that Galbraith’s “dependence effect” argument for limiting private consumption, in essence the last gasp defense of central planning, was eviscerated by none other than Hayek as a non-sequitur.) As much as Galbraith’s critique of advertising is still admired by liberals today, almost none of them share his suggestions for government ordering of the economy with any great seriousness.

It’s not just that everyone became persuaded by Hayek. The more important factor was the grotesque failure of centrally planned economies to satisfy their citizens’ material desires, and the failure of nationalized industries in mixed-economies to perform efficiently. But for those paying close attention, Hayek provided the explanation for, even the prediction of, that failure. He made it intellectually scrutable to economists, however loathe they were/are to acknowledge Austrianism in general.

As Keynes famously said, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” That is Hayek’s victory—we nearly all agree with his critique of central planning without recognizing his role in shaping that consensus.

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* And he was influential, winning the Nobel Memorial Prize for Economic Science, despite Adam Davidson’s odd claim that Hayek was “largely ignored,” and his patently false claim that “[a] few years ago, it was probably possible to fit every living Hayekian in a conference room.” But later in his piece Davidson does show some decent, if incomplete, understanding of Hayek, and a clear understanding of the ways in which Paul Ryan cherry-picks his Hayekianism.
** Although it’s likely he under-estimated the difficulties with both, and possibly would not have continued to support them had he lived (even) longer. But it suffices to show he was not the knee-jerk anti-government rabid-free marketer that he is sometimes portrayed as having been.
*** And today it’s hard for us to recognize just how much the Depression persuaded people that market systems were ultimately unfunctional, even among those who would not cotton to real Marxism. If you see markets as the cause of the Great Depression, it’s not hard to believe that government could hardly do any worse, and had at least a fighting chance to do better.