Economic Thoughts, Part IV: The Abuse of Reason, Fallacies & Dangers of Centralized Planning, Prices & Knowledge, and Understanding Limitations

This posting is Part IV in a series of postings about economic thoughts.

This posting contains excerpts from a January 2005 Reason magazine article, entitled Hayek for the 21st Century, which discusses biographer Bruce Caldwell's thoughts on Nobel Laureate Friedrich Hayek's ideas regarding: (i) the abuse of reason; (ii) fallacies and dangers of centralized planning; (iii) prices & knowledge; and, (iv) understanding limitations.

The Abuse of Reason

Bruce Caldwell: In the 1930s, Hayek was writing articles criticizing the economics of socialism...In Hayek’s Challenge, I mention [sociologist] Karl Mannheim in particular as a figure who argued that planning was the only way to avoid totalitarianism, but everyone was making a similar sort of argument. Hayek turned that on its head and said that extensive planning of the economy was in fact the road to serfdom, to less and less freedom.

He was engaging a widespread belief that socialism was not only more just but more efficient than capitalism, that it was the way to make the world work better. Not just economics should be planned. Science should be planned. Everything should be planned. There was an influential magazine around at the time called Science. Virtually every third or fourth week, they’d run an editorial that said we need to have scientists helping plan all sorts of things. Not just the war effort, but everything about the economy to make it work better. This is what everyone who was "intelligent" thought.

If you look at the early 1930s, there was this sense that the Soviet Union had a huge commitment to science and scientific progress...

His critique of the way "science" gets used in social settings. Science is a very powerful tool that has brought a lot of technological and material progress. But the mistaken notion that we can plan social structures and social realities and social institutions in the same way that we can accomplish goals like putting people in space is very, very seductive. That belief is something that never goes away. Hayek’s critique of that mind-set is part and parcel of The Road to Serfdom and many of his other writings. Road is part of a larger effort called "The Abuse of Reason Project," which attacked what he eventually called "rationalist constructivism," the idea that we are able to reconstruct or correct society along rational lines.

He argued that you can’t easily improve on what he called "spontaneous orders." There are many situations in which an order has arisen by individuals following rules. They often can’t articulate why they follow the rules, some of them are moral rules, whatever, and this has lead to a certain amount of coordination of people’s activity. To the extent that it’s done, that it’s allowed, groups that have followed those rules tend to prosper. That’s what he defined as "a spontaneous order."...Language, the market, money, and more reflect this.

To simply come in and say, "OK, this stuff all needs changing," ignores that social evolution has taken place through time...

The way socialism was implemented in the 20th century is one of the pre-eminent examples of what goes wrong when you try to reconstruct society along more "rational" lines...

Fallacies & Dangers of Centralized Planning

Reason: Give us the stripped-down version of The Road to Serfdom.

Caldwell: Let’s say you agree that the definition of socialism is the ownership of the means of production by the state. That means the state is making decisions about production...

Hayek’s point is that when people are not under war conditions, they have many different values. So the question then becomes, if you have socialism, who makes the decision of what gets produced? If people have different values, they are going to disagree with the planners. The planners end up being frustrated because they are unable to decide what to produce and gain full consensus. So they completely take over the production process. Hayek argues that you can’t make that neat separation between economics and politics that implicitly fills in the claims of the socialists.

...I think his argument was shown to be absolutely correct. States that went to full socialization of production also placed considerable restrictions on personal liberty and decision making. You don’t get the kind of choice that you get under a more liberal system…

Prices & Knowledge

Reason: Beyond his critique of wide-scale social planning, what would you say are Hayek's other major contributions to 20th century thought?

Caldwell: Another very important one has to do with the role of prices in coordinating social action where knowledge is dispersed.

...The model that was then used to describe how an economic system works assumed that all agents had full knowledge and that [an efficient distribution of goods and services] gets obtained [through various transactions]. Some of the socialists argued that the differences between socialism and capitalism, or the market system, were really about what set of people [made the transactions]. Under socialism, you had planners; under capitalism, you had individuals.

Reason: And the socialists argued that their planners could coordinate the production and distribution of goods and services with less trial and error, more quickly, more efficiently?

Caldwell: That's right, because they would be centrally gathering information. The socialists argued that individual entrepreneurs are just looking over their own markets whereas the planners are taking everything into account.

Hayek said, "Well, wait a second, this does not make sense. Markets do a lot of stuff, but this model does not shed light on what markets do." He zeroed in on the critical assumption of full or perfect information. He said that in the real world, we have millions of individuals who have little bits of knowledge. No one has full knowledge, and yet we see a great deal of social coordination. As Frederic Bastiat said, "Paris gets fed." No one intentionally plans on feeding Paris, but millions upon millions of people get up every morning and get what they want for breakfast. How does that happen? Hayek's answer is that a market system ends up coordinating individual activity. Millions of people are out there pursuing their own interests, but the net result is a coordination of economic activities. And prices are the things that contain people’s knowledge.

Mainstream economists have picked up on this and talk about prices as containing information. Modern information theory certainly nods to Hayek as a precursor. He argued that pricing contains knowledge of specific time and place and the man on the spot. Prices contain knowledge that is tacit, that can't really be expressed by individuals. Individuals make actions in markets, and that's what causes prices to be what they are. People are acting in markets. They are not always explicitly saying why they are acting, but they are acting on their knowledge of local situation, the past, and more...

Understanding Limitations

Reason: What do you think Hayek's legacy in the 21st century will be?

Caldwell: To the extent that the ideas in papers like "The Theory of Complex Phenomena" get developed, that could be a big part of his legacy. He didn’t get very far in developing the concept, but it's the basis for his claims that what we can know in the social sciences is ultimately very limited. It holds that pattern predictions are the best that we can often do when it comes to society. He suggested that it's better to provide explanations of the principle by which something works than to make precise predictions of how people will act.

Reason: So he taught us that the starting point of our plans has to be a recognition of the necessary limits of our understanding, that the grand old Enlightenment dream of total knowledge has to be replaced with one that is limited and provisional.

Caldwell: That is a Hayekian theme. One of the things that I take away from Hayek is you can’t really prove any of this stuff in a traditional way. What you can do is develop a way of thinking and all sorts of different evidence that ultimately convinces you that this is an appropriate way of looking at this particular type of social phenomenon. I think this is part and parcel of Hayek’s method. It’s certainly what I took from him in my book.

Understanding the limits of what we can do is an important legacy. And so is understanding that in trying to do too much, we often end up making situations much worse.

Part V to follow...

For previous postings on Economic Thoughts, refer to:

Part I: What is Economics?
Part II: Myths About Markets
Part III: Why Policy Goals are Trumped by Incentives They Create & the Role of Knowledge in Economics

Jason Steorts also did a review of Bruce Caldwell's book on Hayek in the February 23, 2004 edition of National Review (available only via Digital NR), where he adds some additional perspective on Hayek's contribution to our understanding of economic issues:

...Hayek's antipathy toward socialistic meddling was but one manifestation of his more general concern with what he called the "knowledge problem" - his insights into which are, according to Caldwell, his most important contribution to economics.

In the 1937 essay "Economics and Knowledge," Hayek formulated the "knowledge problem" this way: "How can the combination of fragments of knowledge existing in different minds bring about results which, if they were brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess?" Hayek's answer was that market institutions manage to gather the "fragments of knowledge" and co-ordinate individuals toward efficient outcomes. No one knows just what combination of production inputs will minimize costs and produce the quantity of goods that satisfies demand. But the operations of the market, in which prices are not fixed but respond to changes in supply and demand, are a "discovery procedure" (as Hayek would later put it) for such information.

...note how Hayek's answer diverges from standard neoclassical economic theory. In the textbook version, individuals are assumed to have perfect rationality and foresight. They then unfailingly make decisions about the allocation of their resources that maximize their utility. While this model no doubt has its uses, its unrealistic assumptions are often seized upon to discredit laissez-faire economics.

Hayek, like many of his peers (and the Austrians in particular), was also inclined toward skepticism of the elusive, perfectly rational homo economicus. But rather than take the apparent implausibility of the standard model as a reason to reject free markets, Hayek saw that free markets helped compensate for the limitations of human knowledge and rationality. By spontaneously gathering dispersed information and coordinating it through the setting of prices, markets make the choices of individual men both better informed and more rational than they would otherwise be. Hayek also understood - long before most, and to his great credit - that the incompleteness of any individual's knowledge makes central economic planning both impossible and undesirable. (Undesirable in that the planner must, as Hayek explained in the 1939 pamphlet "Freedom and the Economic System," "impose upon the people the detailed code of values that is lacking" - paving a path toward despotism.)

Caldwell goes on to show how Hayek's reflection on the knowledge problem led him to conclusions about the methodology of economics. Just as no central planner knows enough to bring about an efficient economic outcome, no economist knows enough to make precise forecasts. Instead, economists must content themselves with offering general explanations of the principles by which economic outcomes arise, and making predictions about the pattern of future events (rather than predicting specific outcomes). This skepticism continues to rub economists of a positivist persuasion - which is to say nearly the entire field - the wrong way...

...The positivist hope has been that such work [analyzing social phenomena] would establish law-like relations between events and economic outcomes; but for Hayek - and, as is clear by the end of the book, for Caldwell too - such ambitions smack of hubris...