Fourteen years ago I wrote a brief article about Frederich Hayek’s essay Individualism and Economic Order. Now 50 years after he won the Noble Prize in Economics I happened upon another of the great man’s essays The Use of Knowledge in Society. It focuses on one of Hayek’s major insights – the diffusion of knowledge across society as a whole such that no person or group possesses much knowledge as to the underpinnings of economic activity and why this inevitable lack of knowledge makes the failure of central planning inevitable.
Hayek was probably the most profound thinker of the 20th century on the organization of society. The quotations that follow are all from his essay on knowledge that appeared in the September 1945 issue of The American Economics Review. The complete essay is appended below.
He starts by stating that the economic calculus that prevailed when he wrote the piece and still endures uses data that are never “given to a single mind which could work out the implications and can never be so given.” The problem Hayek sees is that knowledge of how to make economic decisions is spread across the population in bits and pieces such that any individual or group possesses only a tiny fraction of the knowledge pertinent to the issue at hand. The best use of resources “is a problem of the utilization of knowledge which is not given to anyone in its totality.”
He defines planning as “the complex of interrelated decisions about the allocation of our available resources.” All economic activity is thus a form of planning. The problem is how is the best way to do so in the absence of most of the necessary information needed to do it efficiently. This activity will “have to be based on knowledge which, in the first instance, is not given to the planner but to somebody else, which somehow will have to be conveyed to the planner.”
Who is to do the planning? “Planning in the specific sense in which the term is used in contemporary controversy necessarily means central planning—direction of the whole economic system according to one unified plan. Competition, on the other hand, means decentralized planning by many separate persons.” Note the word contemporary which still holds true in an article written almost 80 years ago. It maintains purchase because there are still legions of economists, politicians, and large swaths of the populace who think it the best way to an efficient economic engine.
Thus the problem dealt with in Hayek’s essay is what is the best way to get information spread widely to decision makers. He believes unlike many economists who use arcane mathematical equations to make economic decisions that the knowledge needed is not scientific.
“It is, perhaps, worth stressing that economic problems arise always and only in consequence of change.” In other words, the economy is dynamic, not static. Central planners typically assume that when they change one variable of the economy all the others will remain as they were before the change. The Congressional Budget Office makes this assumption virtually every time they are asked to predict the effect of a change to the economy. The reality they ignore is that when one component of the economy changes all the others also adjust inevitably making the outcome impossible to predict. Nevertheless, the CBO confidently makes inaccurate predictions that our lawmakers profess to believe.
Hayek observes that “The continuous flow of goods and services is maintained by constant deliberate adjustments, by new dispositions made every day in the light of circumstances not known the day before.” You can easily assess the accuracy of plans made for years to come.
Hayek posits that economic problems can only be solved by some form of decentralization. Still, someone will have to make a decision no matter how small its reach. “The problem [remains] of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system.”
“How much knowledge does he need to do so successfully? Which of the events that happen beyond the horizon of his immediate knowledge are of relevance to his immediate decision, and how much of them need he know? There is hardly anything that happens anywhere in the world that might not affect the decision he ought to make.”
Hayek says the problem is solved by the price system. “Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people.” In a free market, even in a somewhat constrained market, the price of a good or service is sufficient to guide economic behavior even if the person making a decision has no idea what sets the price. Nikita Khrushchev said that after the triumph of world communism, Switzerland would be left alone so the true price of any commodity or service could be known.
“We must look at the price system as such a mechanism for communicating information if we want to understand its real function—a function which, of course, it fulfills less perfectly as prices grow more rigid…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.” The price system allows us to dispense with the need of conscious control.
Hayek quotes Alfred North Whitehead to support his argument that things work better when conscious control is not needed. “Civilization advances by extending the number of important operations which we can perform without thinking about them.”
Hayek has been dead for more than 30 years, yet his argument for restraint in the management of the economy is still often ignored. Consider the Federal Reserve Board. They think they can control the economy and promote the stability and health of the U.S. economy and financial system. That they seem to consistently get things wrong does not seem to concern them. They seek, among other goals, to keep inflation at 2% a year. They never comment that 2% a year doubles prices in 36 years. It also partially inflates away some of the debt they create by conjuring money from the ether.
The Fed’s chairman Jerome Powell justified lowering interest rates while inflation remained above 2% by saying “You say, ‘Why am I buying car insurance? Because I might have an accident,’” he said at an event this month. “The accident didn’t happen. Do you say, ‘Man, it was a stupid decision to buy car insurance?’ No.” The stupidest analogy of the century. The buyer of auto insurance has all the information he needs to make an informed decision. The Fed as Hayek repeatedly says operates mostly in an information vacuum. Its chairman is the captain of a ship with no maps, radar, or GPS.
Hayek explains why. To get the full statement of his ideas read his masterpiece The Constitution of Liberty.
