Freeman

ARTICLE

Modernization and Central Planning

JANUARY 01, 1991 by E.C. PASOUR

Dr. Pasour is a professor of economics at North Carolina State University at Raleigh.

The failure of collectivism as a productive economic system in Eastern Europe and the Soviet Union was fully predictable from the economic calculation debate that occurred more than 50 years ago. Ludwig von Mises and F. A. Hayek demonstrated that the structure of production in a centrally directed system cannot reflect human wants efficiently because the knowledge necessary for economic calculation cannot be coordinated and transmitted in the absence of market prices. The significance of the economic calculation debate was lost in the aftermath of the Keynesian revolution of the 1930s, but its importance for economic growth and development is slowly but increasingly being recognized.

The effect of modernization of the economy on the ability to plan through central direction is one issue in the calculation debate that has received relatively little attention. The argument sometimes is made that a modern urban industrial economy must have an active and extensive government. Yet, one cannot conclude that more government planning is required as the economy becomes more complex. Indeed, a strong case can be made that market signals have become ever more important in the information explosion that is inextricably linked with the increased complexity of the economy.

The following analysis first discusses possible ways of coordinating economic activity. The impli-cations then are shown for central direction and economic progress.

Functions of an Economic System

The general task of coordinating economic activity in any society may be divided into a number of interconnected and overlapping functions. These fundamental tasks fall into a more or less logical sequence. The first is to decide what is to be done. That is, it must be determined what goods and services are to be produced and in what proportions. The second problem is to organize production or, equivalently, to get done the things that are to be done—this involves decisions concerning how to produce. The third function is that of determining people’s incomes. That is, some procedure must be used to apportion the goods and services among the members of society. The fourth function is that of rationing or adjusting consumption to production. Seasonally produced goods, including many agricultural products, must be rationed over time; the consumption of all goods and services must be adjusted to the existing stock, including current rate of output. The fifth function is to provide for economic progress through increases in technology, including changes in types of business organization.

The functions just described are highly interre-lated. For example, decisions about what to produce and how to produce are closely related to incomes received by resource owners. Increased incomes of corn producers will lead to more corn production. An increase (or decrease) in the profitability of corn produced using chemical methods of weed control will influence the method of production (that is, how to produce).

The first four functions are relatively short run in nature, dealing with an economic system operating under “given conditions” including resources, wants, and technology. These functions constitute the problems of the so-called “stationary economy” in which there is no economic growth and the wealth and income of individuals remain unchanged.

Possible Types of Economic Organization

The problems just described must be coped with in any society, and several methods of organizing economic activity have been tried or proposed. These types are described here not because they are realistic alternatives in a modern society, but rather to highlight the problems that arise in the absence of market signals.

Status and Tradition or Caste System. This is the nearest approach to a mechanical division and coordination of economic activity. It is possible to imagine a social order in which specialization of activities is achieved on a purely customary basis. In such a system, rigid social custom, as in a caste system, determines the allocation of resources, techniques of production, and assignment of individuals to their tasks. This method of coordinating economic activity holds little attraction for most people in the modern world because a society organized on the basis of status and tradition necessarily would be unprogressive.

Command or Militaristic System. In this system, the whole structure of society including determination of policies, division of labor, and distribution of income would be dictated by an absolute monarch. Therefore, the preferences of individuals either in consumption or in production need not be considered. The organization of production might be worked out to a high degree of intricacy, as in the legendary Soviet five-year plans, but coordination of economic activity is the Achilles’ heel of this and other systems of central planning. The model of central planning based on the ruler’s preferences is quite similar to that of collectivist systems in the Soviet Union, Eastern Europe, Chi-na, and other countries during the post-World War II era.

Democratic Socialism. A society organized on this principle would resemble the previously described command system in its main structural features. Again, the government owns the means of production. The purported theoretical difference is that economic decisions in democratic socialism are made by the will of the majority as expressed through the political process.

However, this supposed difference is more apparent than real and has little practical significance. A centrally directed system is plagued by information problems even if decision makers in the political process are completely altruistic and fully desire to promote the public weal. Elected and appointed public officials have no way to divine the “public interest.” A planner, regardless of technical expertise, cannot obtain the information on consumer preferences, resources, and production opportunities that would be necessary to determine the “correct” pattern of production, even if he wishes to do so. In reality, of course, individuals in the political process are likely to be influenced by more selfish short-run goals such as getting reelected, increasing agency size, and so on.

In short, there is no way to coordinate economic activity efficiently in the absence of private property and the associated price signals. Attempts to simulate market conditions through central direction are futile because there can be no competitive behavior without dispersed power and responsibility. If all property is collectivized and all pricing centralized, there is no scope for a mechanism that can reproduce in any significant respect the functioning of the entrepreneurial market process. Therefore, attempts to achieve the beneficial results of free enterprise in a collectivist system are doomed to fail.

The Private Property System. Economic functions are achieved through exchange in impersonal competitive markets in the decentralized free enterprise system. The most interesting feature of the market order is that it is, in a sense, automatic and unconscious. No one ever planned the system, and no one assigns the participants their roles or directs their activities. Instead, market prices are uniquely valuable in coordinating and transmitting information to participants throughout the production and marketing process. In so doing, market prices provide indispensable signals to market participants in decisions concerning what to produce, how to produce, and the rationing of goods and services; market prices also largely determine individual incomes.

Implications for Central Planning and Economic Progress

What are the implications of the preceding discussion? There are only two possible ways of coordinating economic activity in a modern society—the market and central planning. However, there is only one means that is consistent with economic progress. The economic calculation debate demonstrated that successful planning is impossible in the absence of private property and the associated market prices. Without these signals, there is no possibility of calculating costs or revenues and no way of determining whether the most highly valued products have been produced. That is, the decentralized market system is the only way that ever-changing valuational signals can be coordinated systematically and transmitted by millions of individual consumers and producers.

Markets are unique not only in facilitating the use of information already possessed by market participants, but also in playing a crucial role in the discovery of new information. That is, market prices stimulate entrepreneurial discoveries, including the productive use of information that was not previously recognized. The recognition of the market as a discovery process highlights another key shortcoming of central direction—the lack of economic progress, including innovation and change. Consider the problem of how decisions are to be made about allocation of venture capital, new products to produce, new types of capital investment, and so on.

Managers of government enterprises have an incentive to play it safe. If a venture is successful, the government official may receive some extra compensation, but is affected relatively little compared to a private entrepreneur. If the venture fails, however, the government bureaucrat may lose his job. Thus, the tendency is to avoid risky ventures. In contrast, the decision maker in the profit and loss or market system is a residual claimant. He bears the loss if actions taken prove unsuccessful; he reaps the gains from decisions that turn out tobe profitable. Thus, the decision maker in the market has a much greater incentive to undertake risky ventures. The conclusion is that lack of incentive to provide economic change and progress is a chief defect of all alternatives to free markets.

In short, market signals are crucial elements in the incentive mechanism of the capitalist system. In conjunction with residual claimancy, prices provide a uniquely successful way to reward effective actions and to penalize ineffective actions.

Implications of the Information Revolution

How does modernization of the economy affect the usefulness of markets in coordinating economic activity? The information revolution involving computers, fax machines, and so on, not only has spurred economic innovation, but also has dramatically increased and accelerated the amounts of data transmitted. Moreover, capital transactions increasingly are being freed from the confines of national boundaries. For example, entrepreneurs using computer modems can send production orders throughout the world. The trend clearly is toward more decentralization, not increased centralization.

The information revolution has had a pronounced effect on the structure of production. In finance, communications, transportation, and other areas, capital is becoming “miniaturized.” Richard McKenzie writes: “A knitting loom that used to be the size of a car now takes up the floor space of a birdbath but is several times more productive than its forerunner. Firm records that once were crowded into file drawers can now be etched on chips or the back of credit cards. Plants that once rose several floors, spanned hundreds of acres, and employed thousands fit today in one story on a one-acre concrete slab and employ fewer than a hundred.”

Economic problems, as emphasized by Hayek, always arise as a consequence of change. Technological innovations in production and marketing have greatly increased the economic coordination problem. Moreover, much of the information important in economic decision making is specialized to time and place and cannot be conveyed in statistical form to any central authority. Under these conditions, decisions by the “man on the spot” become more and more important and central planning less and less feasible.

In the wake of the economic calculation debate, socialist planners visualized “market socialism” in which planners using high-speed computers could simulate the information provided by private property and the associated market signals. Data processing developments have indeed played a key role in the information revolution, but the results have not been those anticipated by socialist theorists.

The increase in technology related to the generation, processing, and transmission of information hasn’t lessened the need for market signals. Instead, the result has been just the opposite. The dramatic increase in information processing puts central planning at an even greater disadvantage when contrasted with market planning. As the amount of information increases, it becomes more and more difficult to discover, coordinate, and transmit information throughout the world economy through central direction. This means that collectivism becomes ever more outdated in an increasingly interdependent world. George Gilder describes the stark implications of collectivism for modernism: “If the politicians want to have central planning and command, they cannot have dynamism and life. A managed economy is almost by definition a barren one, which can progress only by borrowing or stealing from abroad.”

Conclusions

There are two basic ways to organize economic activity—central direction and the entrepreneurial market process. However, in a modern economy there is no feasible alternative to widespread use of market signals. As the complexity of the economy in manufacturing, communications, transportation, banking and finance has increased, the amounts of information generated and the speed of transactions have also increased. It becomes more and more difficult under these conditions to convey, coordinate, and transmit information between market participants through administrative procedures. This means that with modernization of the economy, Planning by central direction has become less and less efficient relative to planning through markets.

The economic crises in the Soviet Union, Eastern Europe, and other collectivist systems throughout the world are not accidents that just happened. The breakdown of collectivism is directly associated with the economic information revolution occurring throughout the world.

Mises and Hayek failed to convince socialist theorists of the importance of free enterprise and private property during the economic calculation debate that raged from 1920 throughout the 1930s. However, now they have been fully vindicated in their contention that “market socialism” and other central planning techniques that purport to yield the advantages of decentralized competitive markets are doomed to fail. And it is ironic that information processing by high-speed computers, once thought to be the salvation of socialist planning, has instead turned out to be merely another nemesis.


1.   Ludwig von Mises, “Economic Calculation in the Socialist Commonwealth,” part III in Collectivist Economic Planning, edited by F. A. Hayek (Clifton, N.J.: Augustus M. Kelley, 1974 reprint of 1938 edition); F. A. Hayek, Individualism and Economic Order (Chicago: The University of Chicago Press, 1948).

2.   This function often is referred to incorrectly as income distribution in a free enterprise exchange economy. However, “There is in the operation of a market economy nothing which could properly be called distribution. Goods are not first produced and then distributed, as would be the case in a socialist state.” (Ludwig von Mises, Human Action [Chicago: Henry Regnery Company, 1966], p. 254)

3.   Richard B. McKenzie, “The Twilight of Government Growth in a Competitive World Economy,” Cato Policy Analysis No. 111 (Washington, D.C.: The Cato Institute, August 19, 1988), p. 3.

4.   George Gilder, Wealth and Poverty (New York: Basic Books, 1981), p. 237.

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