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Monday, October 29, 2012

Economics and the Calculation Problem

Can a rationally planned economic order outperform the market process as a means of using resources efficiently?  This is the central question behind one of the most important debates in the history of economic thought. Its answer has profound implications for the material well-being of societies.

By the early 1900s economists were in broad agreement on the free-exchange system’s effectiveness in bringing about an efficient use of resources. Despite this, the system did not want for enemies. Marx and his disciples disparagingly called it “the capitalist mode of production,” though the word “capitalist” actually derived from free-market critics of mercantilism. Dissidents accused the system of leading to socially detrimental outcomes in the form of market power wielded by large businesses and recurring cycles of boom and bust. Critics maintained that these shortcomings were the inevitable result of an “anarchic” system of production. However, if the means of production were brought under rational control, these deficiencies could be avoided. Combined with expert management, state socialism—the system characterized in theory by collective ownership of the means of production—would result in increased material abundance and a more socially just distribution of wealth.

Enter Mises

In 1920 the Austrian economist Ludwig von Mises took on the critics in his essay “Economic Calculation in the Socialist Commonwealth.”  Mises explained that the largest challenge facing any economic order was the employment of capital goods—things like machines and factories, whose purpose was to make other goods for final consumption. This insight has important implications for deciding not only what goods to produce, but also how these goods should be produced. For example, if a railroad company wants to build a new branch line, should it use steel or titanium rails?  Both projects are technologically feasible, but only a working price mechanism conveys that, at the margin, titanium is much more expensive than steel, meaning titanium should be saved for more urgently desired (and thus higher-yield) investment projects. Socialism, by collectivizing the ownership of capital goods, necessarily destroys the markets in which these goods are traded, thus making rational economic calculation impossible. With no markets for the factors of production, there can be no prices for the factors of production. With no prices for the factors of production, it is impossible to discern which lines of production are profitable. With no information regarding profitability, nobody could properly determine what goods to produce nor how to produce them. Given these informational difficulties, Mises explained, it would be impossible for socialism to produce material abundance to the same degree as the free-exchange system.

Mises’s claim was fiercely debated in academic circles in the 1920s and 1930s. Socialist intellectuals came to accept that some sort of price system is necessary for the rational use of resources. However, these intellectuals did not endorse the free-exchange system. Instead, economists such as Oskar Lange and Abba Lerner maintained that as long as there is a market in final consumers’ goods, a socialist planning board could use the prices that emerged on that market to discern the correct use of capital goods. For example, by allowing the price mechanism to function in the market for chocolate, socialist planners could use the resulting price of chocolate to impute the appropriate prices for goods used to produce chocolate, such as cocoa and mixers. Using the consumer goods prices as data, socialist planners could construct a system of equations of costs and revenues. Next they could solve that system for the efficient quantity of a given good, which could be produced in a way that minimized costs. In this way, the socialists could have their cake and eat it too. They could keep a functioning price mechanism, which would ensure the generation of data needed to allocate resources efficiently, and also organize production in a way that would avoid the inefficiencies and inequities of the capitalist system.

Leading the charge against this particular brand of socialism was F. A. Hayek, who was Mises’s greatest student and a towering figure in theoretical economics in his own right. Hayek pointed out a grave flaw in the socialists’ models: They assumed they had all the relevant information to solve the equations. In fact this information is dispersed throughout the economy and does not exist in any single mind or group of minds. Often this information takes the form of specialized knowledge (such as local business conditions or subjective value rankings) which by its very nature could not be quantified in the socialists’ equations but was still indispensable for resource allocation.

Two-Way Streets

Furthermore, market transactions are not a one-way information system, as the socialists presumed. Individuals use prices as knowledge surrogates when they make their decisions, and when they trade in the market, they feed their own knowledge back into the price system for others to utilize. Hayek famously used the example of tin: If the price of tin rises, a consumer does not need to know why, out of the infinite number of possibilities, this occurred. All he needs to know is that tin is more expensive, which means he must give up more resources to acquire the same quantity as before. He is led to economize on tin, saving what amount remains for uses that bring a greater return. By divorcing market prices from the process by which they are generated, Hayek argued, the market socialists robbed prices of any meaningful epistemological content, so their solution failed on its own terms.

Unfortunately Hayek’s arguments were either ignored or misinterpreted. By the 1940s it was widely agreed that the defenders of free exchange had been soundly defeated. Central planning could allocate resources efficiently as long as a few key aspects of a market system were retained. As a consequence, the various experiments with central planning in the communist nations of the mid-twentieth century were given intellectual legitimacy. Statistics detailing massive production of capital goods, such as steel and concrete, poured out of those countries’ economic bureaus, which seemed to give empirical confirmation to the supremacy of socialist production under central planning. All the while, many of the world’s leading economists, including Nobel laureate Paul Samuelson, pointed to cases such as these when instructing new economics students.

In the end Mises and Hayek were vindicated in no less grand a forum than the world political stage. By the 1980s it was obvious that living standards of citizens in communist countries were far below those of citizens of countries which had retained (more or less) the free-exchange system. The increased internal unrest in the Soviet Union and its suzerainties became increasingly hard to ignore. The collapse and formal dissolution of the Soviet Union in December 1991 demonstrated once and for all the contradictions inherent in nonmarket allocation schemes. Only market-guided resource use—the system of free exchange—could lead to widespread material abundance. Any attempt to suppress this system, however well-intentioned, was doomed to bring about nothing but lower standards of living.

Ultimately the socialist calculation debate demonstrates the incredible importance of ideas in shaping the course of societies. Only if the crucial insights discovered by luminaries such as Mises and Hayek are accepted and put into practice can societies continue to prosper.