To early 20th-century intellectuals, capitalism looked like anarchy. Why, they wondered, would we trust deliberative, conscious guidance when building a house but not when building an economy?
It was fashionable among these socialist intellectuals to espouse “planning” as a much more rational way to organize economic activity. (F.A. Hayek wrote a famous essay on the phenomenon.) But this emphasis on central planning was utterly confused both conceptually and empirically.
Ludwig von Mises made the most obvious rejoinder, pointing out that there is “planning” in the market economy, too. The difference is that the planning is decentralized in a market, spread out among millions of entrepreneurs and resource owners, including workers. Thus, in the debate between socialism and capitalism, the question isn’t, “Should there be economic planning?” Rather, the question is, “Should we restrict the plan design to a few supposed experts put in place through the political process, or should we throw open the floodgates and receive input from millions of people who may know something vital?”
Planning is decentralized in a market, spread out among millions of entrepreneurs and resource owners, including workers.
This second question came to be known as the “knowledge problem.” Hayek pointed out that in the real world, information is dispersed among myriad individuals. For example, a factory manager in Boise might know very particular facts about the machines on his assembly line, which socialist planners in DC could not possibly take into account when directing the nation’s productive resources. Hayek argued that the price system in a market economy could be viewed as a giant “system of telecommunications,” rapidly transmitting just the essential bits of knowledge from one localized node to the others. Such a “web” arrangement (my term) avoided a bureaucratic hierarchy in which every bit of information had to flow up through the chain of command, be processed by the expert leaders, and then flow back down to the subordinates.
Complementary to Hayek’s now-better-known problem of dispersed knowledge, Mises stressed the calculation problem of socialist planning. Even if we conceded for the sake of argument that the socialist planners had access to all of the latest technical information regarding the resources and engineering know-how at their disposal, they still couldn’t rationally “plan” their society’s economic activities. They would be “groping in the dark.”
By definition, under socialism, one group (the people running the state, if we are talking about a political manifestation) owns all of the important productive resources — the factories, forests, farmland, oil deposits, cargo ships, railroads, warehouses, utilities, and so on. Thus, there can be no truly competitive markets in the “means of production” (to use Karl Marx’s term), meaning that there are no genuine prices for these items.
Because of these unavoidable facts, Mises argued, no socialist ruler could evaluate the efficiency of his economic plan, even after the fact. He would have a list of the inputs into a certain process — so many tons of steel, rubber, wood, and man-hours of various types of labor. He could contrast the inputs with the outputs they produced — so many houses or cars or bottles of soda. But how would the socialist planner know if this transformation made sense? How would the socialist planner know if he should continue with this operation in the future, rather than expanding it or shrinking it? Would a different use of those same resources produce a better result? The simple answer is that he would have no idea. Without market prices, there is no nonarbitrary way of comparing the resources used up in a particular process with the goods or services produced.
In contrast, the profit-and-loss test provides critical feedback in the market economy. The entrepreneur can ask accountants to attach money prices to the resources used up, and the goods and services produced, by a particular process. Although not perfect, such a method at least provides guidance. Loosely speaking, a profitable enterprise is one that directs scarce resources into the channel that the consumers value the most, as demonstrated through their spending decisions.
A profitable enterprise is one that directs scarce resources into the channel that the consumers value the most, as demonstrated through their spending decisions.
In contrast, what does it mean if a particular business operation is unprofitable? It means that its customers are not willing to spend enough money on the output to recoup the monetary expenses (including interest) necessary to buy the inputs. But the reason those inputs had certain market prices attached to them is that other operations were bidding on them, too. Thus, in Mises’s interpretation, an unprofitable business enterprise is siphoning away resources from channels where consumers would prefer (indirectly and implicitly) that the resources be deployed.
We must never forget that the economic problem is not to ask, “Will devoting these scarce resources to project X make at least some people better off, compared to doing nothing with these resources?” Rather, the true economic problem is to ask, “Will devoting these scarce resources to project X make people better off compared to using the resources in some other project Y?”
To answer this question, we need a way of reducing heterogeneous inputs and outputs into a common denominator: money prices. This is why Mises stressed the primacy of private property and the use of sound money as pillars of rational resource allocation.