By: L. Carlos Lara and Robert P. Murphy
Friday, August 20, 2010
"A bureaucrat differs from a non-bureaucrat precisely because he is working in a field in which it is impossible to appraise the result of a man's effort in terms of money.
Ludwig von Mises (1)
Once a market develops the use of money, entire new vistas open up for economic development. Because the money commodity exists on one side of every transaction, merchants and consumers can quickly grasp the relative scarcity of various goods and services. In other words, the use of money allows people to reduce economic operations down to a common denominator.
As in so many other areas, Hayek was one of the few economists to grasp the significance of this fact. Hayek viewed the price system in a market economy as a type of communication network, in which people "on the ground" in one area transmitted relevant information to everyone else through their buying and selling decisions. In a famous 1945 journal article Hayek wrote:
We must look at the price system as such a mechanism for communicating information if we want to understand its real function....The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.
But I fear that [economists'] theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism...The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction....
I have deliberately used the word "marvel" to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.(2)
We are now beginning to see how social institutions help humans cope with the all-pervading problem of scarcity. The reason it took scholars of the caliber of Friedrich Hayek to understand the true function (and hence importance) of private property and market prices, is that these indispensable tools were not designed by anyone. Since no single person invented money, many intellectuals take its services for granted and indeed imagine a utopia which abolishes money altogether. In this context, Ludwig von Mises' famous critique of socialism is an excellent illustration of the fatal conceit.
Mises on Economic Calculation: The Fundamental Problem With Socialism
In the chronology of Austrian economists, Mises actually predates Hayek. Indeed, Hayek credits Mises' 1922 book Socialism with converting Hayek from being a socialist! In a Foreword (written in 1978) to the book, Hayek explains how he came to know Mises, and the effect he had:
When Socialism first appeared in 1922, its impact was profound. It gradually but fundamentally altered the outlook of many of the young idealists returning to their university studies after World War I. I know, for I was one of them.
We felt that the civilization in which we had grown up had collapsed. We were determined to build a better world, and it was this desire to reconstruct society that led many of us to the study of economics. Socialism promised to fulfill our hopes for a more rational, more just world. And then came this book. Our hopes were dashed. Socialism told us that we had been looking for improvement in the wrong direction.
A number of my contemporaries, who later became well known but who were then unknown to each other, went through the same experience: Wilhelm Röpke in Germany and Lionel Robbins in England are but two examples. None of us had initially been Mises' pupils. I had come to know him while working for a temporary Austrian government office which was entrusted with the implementation of certain clauses of the Treaty of Versailles. He was my superior, the director of the department.
Mises was then best known as a fighter against inflation. He had gained the ear of the government and...was immensely busy urging the government to take the only path by which a complete collapse of the currency could still be prevented. (During the first eight months I served under him, my nominal salary rose to two hundred times the initial amount.)
...Socialism shocked our generation, and only slowly and painfully did we become persuaded of its central thesis.(3)
What was Mises' "central thesis" concerning socialism, that had so shocked Hayek and his peers? In a nutshell, Mises argued that the socialist planners would find it impossible to rationally allocate society's scarce resources. Even if they had the best intentions, and even if they had at their fingertips all of the relevant knowledge from various experts, Mises argued that the socialist planners would have no way of determining whether their plans for industry were a good idea, or whether an alternative set of instructions would be better.
The market economy solves this problem through the profit-and-loss test. In a capitalist society, every scarce resource—including capital goods such as tractors and factories—is subject to private ownership. This allows the formation of market prices for every unit of every resource. When an entrepreneur in a market economy wants to know if he is running a successful business, he has a simple and objective criterion: He can see if the revenues from his customers are greater than his expenses. If they're not, that means the entrepreneur is losing money, and in a market economy an unprofitable operation is soon shut down.
Now the socialists looked upon this practice with scorn. After all, money isn't everything! Who is to say that a particular firm making diapers, for example, shouldn't continue turning scarce resources into more boxes of diapers, even past the point of profitability, in order to help struggling mothers with infants? The socialists thought the accountant's "bottom line" was an arbitrary quirk of a market economy, and that it didn't correspond to anything "real" that would exist in a socialist world.
Yet Mises demonstrated that the socialists were simply wrong. Although there are limits to the guidance given by monetary accounting, Mises pointed out that it gives people some guidance. Think about it: When a particular enterprise is unprofitable, it means that the owner is spending more money on inputs than his customers are willing to spend on the outputs. Loosely speaking, we can say that the owner is destroying wealth, because he is transforming resources of a high market value into finished products of a lower value.
Mises explained that the market prices of the "means of production" were not arbitrary, but instead reflected their relative scarcities. For example, a pound of copper (as of this writing) fetches a higher market price than a pound of aluminum. This isn't some irrelevant factoid of capitalist countries, but instead refers to a genuine relationship between the difficulty in producing copper vs. aluminum, compared to the uses people have of the two different materials. The reason entrepreneurs can afford to pay so much more for a pound of copper, is that there are some products that can be made with copper and not aluminum, and consumers are willing to pay for these products.
In Mises' view, the entrepreneur in a market economy acts as a "mandatary of the consumer," meaning that he acts as the consumer's agent or representative. Armed with a knowledge of how much money consumers will spend on various goods and services, the entrepreneurs enter the markets for raw materials, labor, and other resources and engage in a bidding war with each other. A high price for a pound of copper, compared to a low price for a pound of aluminum, is the market's way of signaling that copper is more important for pleasing consumers, and that entrepreneurs should exercise more care when using it in their operations.
It is this framework that led Mises to trumpet the notion of "consumer sovereignty," which claims that the real power in a capitalist system does not lie with the capitalists, as the Marxists believed:
The capitalists, the enterprisers, and the farmers are instrumental in the conduct of economic affairs. They are at the helm and steer the ship. But they are not free to shape its course. They are not supreme, they are steersmen only, bound to obey unconditionally the captain's orders. The captain is the consumer.(4)
Mises went on to say that not only was the consumer the one in charge, but that he was a fickle commander at that:
The real bosses [under capitalism] are the consumers. They, by their buying and by their abstention from buying, decide who should own the capital and run the plants. They determine what should be produced and in what quantity and quality. Their attitudes result either in profit or in loss for the enterpriser. They make poor men rich and rich men poor. They are no easy bosses. They are full of whims and fancies, changeable and unpredictable. They do not care a whit for past merit. As soon as something is offered to them that they like better or is cheaper, they desert their old purveyors.(5)
Now that we understand Mises' conception of the profit-and-loss system, and how it leads entrepreneurs in a capitalist economy to cater to the desires of the public, we can grasp his critique of socialism. In a socialist society, the State nationalizes all of the "means of production," including the capital goods and natural resources such as farmland and coal mines.
Because the State is the sole owner of the means of production, there can be no market prices for them. Yet this means there can be no monetary calculation, and consequently no way of determining whether the resources being used up in a particular operation could be better deployed elsewhere in the system.
For example, the socialist planners might order a group of comrades to take a certain amount of rubber, steel, electricity, and so forth, in order to produce 500 automobiles. After the fact, there is simply no way for the planners to know whether the output was "worth it." So long as the cars were suitably engineered, the planners would know that the subjects were better off with the cars than without them; in other words, the cars would be valuable. But the true question was whether the cars would be more valuable than other potential goods that could have been produced with the resources that were used up while making the cars.
Thus we see the fundamental problem with socialism. Before Mises, the debate over the "planned economy" had centered on incentives. To wit, in a system that followed the communist principle, "From each according to his ability, to each according to his needs," would the workers actually push themselves as hard as they do under capitalism? In other words, if the State took all the production and threw it into one giant pie, to be distributed in a way that didn't depend on each person's contribution, then wouldn't the overall pie shrink?
Compelling though this objection may have been, the socialist theorists claimed that the greed and self-centeredness of the average man was due to his growing up in a capitalist system. Once socialism had swept the world, they claimed, a new "Socialist Man" would emerge who enjoyed producing for his strangers as much as for his own family.
In this context, we see how powerful Mises' critique was. Mises concedes for the sake of argument that every worker and factory manager faithfully obeys the orders of the central planners. He also concedes for the sake of argument that the planners have all the relevant technical and practical knowledge in every single industry in the economy. Even so, because they lack market prices, the socialist planners have no means of feedback, no means of determining whether their grand plans are using resources efficiently. As Mises summarizes in his grand treatise Human Action:
The paradox of "planning" is that it cannot plan, because of the absence of economic calculation. What is called a planned economy is no economy at all. It is just a system of groping about in the dark. There is no question of a rational choice of means for the best possible attainment of the ultimate ends sought. What is called conscious planning is precisely the elimination of conscious purposive action.(6)
More than any other school of economists, the Austrians recognize the social function of market prices and profit-and-loss calculations. Despite its flaws, the capitalist society—in which private individuals buy and sell the means of production in an open market—is the only one that can possibly yield an efficient use of scarce resources. Of course entrepreneurs in a market economy make mistakes all the time. But the crucial point is that their mistakes are registered as such by the suffering of losses. There is no such feedback in a socialist system of outright central planning, and thus no mechanism to bring the planners' decisions into alignment with the ever changing conditions of production and the tastes of the consumers.
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1Ludwig von Mises, Bureaucracy, p. 53, available at:
http://mises.org/etexts/mises/bureaucracy/section1.asp. Accessed June 4, 2010.
2 Friedrich A. Hayek, "The Use of Knowledge in Society" (1945), American Economic Review, XXXV, No. 4, pp. 519-530, available at: http://www.econlib.org/library/Essays/hykKnw1.html. Accessed June 4, 2010.
3Hayek, Foreword to Ludwig von Mises, Socialism (Indianapolis: Liberty Fund, 1981), pp. xix and xxi.
4Mises, Bureaucracy, p. 226.
5Mises, Bureaucracy, p. 227.
6Mises, Human Action (Auburn, AL: The Ludwig von Mises Institute, 1998), p. 696.
L. Carlos Lara is President of United services and Trust Corporation, a Management Consulting Firm specializing in Business Consulting, Corporate Trust Services, Corporate and Private Seminars and Speaking Engagements. Visit him or contact him at www.usatrustonline.com.
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