Economic Miscalculation

To take a break from debating the nuances of banking theory with fellow Austrians — although, do not fret, we will soon return to the topic of fractional reserve banking — I want to bring attention to a recent post, by blogger Lord Keynes (LK), on Austrians and economic calculation in a society in which goods are predominately in private hands.  LK points out that the original socialist calculation debate revolved around the inability to coordinate resources in a society without a pricing process; that is, where the means of production are in the “common” hands, or publicly commanded.  He then wonders how Austrians (amateur or otherwise) can accuse him of not understanding economic calculation (since he does not argue in favor of a socialist economy), and concludes that these Austrians must be referring to the theory of intertemporal discoordination.

While the theory of intertemporal discoordination is one facet of the theory of economic coordination (or, more accurately, a theory of what occurs when prices are distorted and there is serious and prolonged discoordination), it is a minor one (although, one of the best elucidated to-date).  How Austrian business cycle theory fits into the framework of coordination can be best picked up from a reading of lecture two and lecture three of Friedrich Hayek’s Prices and Production, which explains the intertemporal coordination of producers’ goods in conditions of equilibrium.  The real substance of coordination theory in the Austrian exposition of the business cycle is not in the explanation of how resources are misallocated, but rather in how resources are allocated without interference or distortion.

The same idea applies to the interpretation of the socialist calculation debate.  Mises’ criticism of the socialist economy revolves around the idea that central, or government, rationing of resources (without a pricing process) is bound to fail, and that a capitalist system in which the means of production are individually owned and where these individuals can apply means and ends in accordance with their scale of values, guided by money prices, will more efficiently allocate resources.  Coordination theory is not in the criticism of the socialist economy, rather in the elucidation of the pricing process.  Mises was using his understanding of economic calculation to criticize a society without it.  A complete integration of the theory of the pricing process did not come about in economics until 1940, with the publication of Mises’ Nationalökonomie.

Thus, the real value of coordination theory is not in being able to show how socialism is an economically destructive method of resource distribution, but in understanding how resources are efficiently allocated in a market economy.  That is, how exactly individuals use the pricing process to allocate between means and ends, based on individual and subjective ranking of preferences.  Why do some Austrians critique non-Austrian economists for “not understanding” economic coordination, even if the targets of the criticism are not socialists?  Because coordination theory provides the basis for a criticism of any type of allocation of resources that is not by merit of individual valuation in a market economy, constrained by profit and loss (the mechanism by which bad decisions allow for the redistribution of goods to better decision-makers).  This point is what I attempted to bring up and prove in my piece “Government Spending is Bad Economics.”

Blogger LK did, in fact, provide a few comments in response to my piece on economic calculation and government spending, but he missed entirely the substance.  Instead of understanding the argument, he attacked my position on idle resources on the basis that I rather see an individual unemployed than put to use — his criticism was, essentially, an appeal to emotion. (Also, for what it is worth, my argument in that piece is not an ethical one, nor am I [in general] someone who agrees with Rothbardian ethics.)  He does not consider the fact that the input of labor is necessarily is necessarily tied to the input of producers’ goods, and that an efficient input of both requires the economization of means and ends by the individual.  More fundamentally, he does not recognize the fact that the government has certain qualities (outlined in my article) that put it outside of the sphere of the private market (and, if you believe the government provides necessary things, for good reason).  In short, he does not address the meat and bones of my argument, which has every thing to do with economic calculation (he even argues that my conclusion that the government is disequilibrating is unsupported, even though the support is found in the substance of the article he is responding to).

I will reiterate what economic calculation is, or the theory of economic coordination: it is the means by which individuals allocate the means of production, by individual valuation guided by the pricing process and constrained by profit and loss.  In other words, coordination theory essentially looks at how the economy operates; how millions of individuals, each with different and oftentimes contradictory objectives, bring about market harmony.  Not emphasized by the focus on coordination are the crucial forces of discoordination (or, disequilibrating forces, if you prefer); these are, nonetheless, another aspect of economic calculation, or coordination theory.

Do only socialist economics lack economic coordination?  This is the claim that LK essentially makes when he balks at Austrians who accuse him of not understanding “economic calculation.”

If economic calculation describes the private allocation of economic goods, then government spending must necessarily be outside the scope of economic calculation (or coordination).  That this is true is by the public nature of government.  Government disrupts economic calculation.  It does this through the distribution of wealth (a non-market method of distribution of wealth), through outright public spending, or by skewing individuals’ value rankings (by, for example, subsidizing products).  That government is not within the scope of coordination theory does not really say anything with regards to whether it is good or not.

Before we can judge the merits of government spending we need to answer the following questions:

  1. Do we know how the private economy works?
  2. Do we know where the private economy (market process) fails?
  3. If the market process fails at a given point, is the government an adequate solution?

The stage of the debate is still at question one, since an Austrian will accuse others of not knowing how the private economy (market process) works (much like Hayek accused Keynes of not knowing).  For instance, an Austrian will tell a Keynesian that the market does not fail at intertemporal allocation, whereas a Keynesian (at least one loyal to Keynes’ business cycle theory) will tell you that it does.  Others might tell you that the market fails where there is imperfect information or imperfect competition, with varying degree of specificity.  The varying degrees of specificity come in depending on how much each economist understands that the market is a process.  The details of specificity are up for debate, which is still within the realm of the first question.

Economists like LK need to understand, though, where exactly Austrians stand on the debate with regards to question 1.  So far, he has shown that he does not.  When Austrians refer to “economic calculation,” they are referring to a very broad set of economic theory which describes the forces of coordination and discoordination which characterize the market process.  It is theory which describes the working of a market economy, or an economy in which the means of production are privately owned.

The same is true the other way around.  I feel as if few Austrians truly understand where Keynes, for instance, stood on economic coordination.  Most Austrians or quasi-Austrians interpret Keynes in the same vein as “vulgar Keynesianism.” This is not so.  Keynes, and many economists before and after him who were/are not Austrians, held a particular economic perspective that is actually much more complicated than Austrians perceive.  That is why when most Austrians give a caricature of Keynesian economics they end up undermining their own arguments.  Everyone has jumped to answer questions 2 and 3, when the debate on 1 was never finished.

Even considering the fact that all sides need to shape up a bit, I hope that non-Austrians will walk away from this post with a better understanding of what “economic calculation” is (at least, under an Austrian lens).  Economic calculation is more than just business cycle theory; it is a term that encompasses all of catallactic theory (that is, theory of exchange).  It deals with the market economy and the allocation of the means of production.  To an Austrian, economic calculation is the meat and bones of economic theory, in that it forms the structure around which all other catallactic theory revolves around.  There is still much to disagree with — I am sure that many will disagree with this post itself —, but the first step to solving a disagreement is understanding where your opponent is coming from.

17 thoughts on “Economic Miscalculation

  1. Bob Roddis

    1. I’ve decided that I look at most economic theory from the standpoint of it being various proposals for government action (or non-action). When you file a civil action via a complaint, you must list and describe each element of the cause of action. Similarly, I insist that the interventionist must, in the very least, identify and describe in detail the basis for sending out a SWAT team and interfering with peaceful use of private property. For example, DK claims that market fails, but his description of the facts leading up to 1920 consist of problems induced by WWI. Obviously, when I insist upon such a requirement to interventionist types, they do not seem to understand at all what I’m getting at. This is also why I insist that the Keynesians have the burden of proof to disprove our theory AND to initiate the force they claim is so necessary.

    2. I’ve been an Austrian for 39 years now. LK’s response, while more sophisticated than most due to his research abilities, is typical. I’ve never met an anti-Austrian who understood the generic concept of economic calculation or how interference with it is problematic. It is almost as though the opponents simply do not want the Austro-libertarian version of things to be true and they constantly look for reasons to justify their uninformed disbelief. This has always been and will be a problem going forward. See below.

    3. Mike Norman MMT blogger Tom Hickey writes:

    Moreover, as long as labor is commodified, the Hegelian master-slave relationship persists, with in Hegel’s words, “only one free.” And, of course, masters do what it takes to keep it that way by keeping the slaves in line with carrots and sticks. Commodified labor is just an variation on this relationship, as Marx explained in criticism of the classical economics of Smith and Ricardo.

    Then, Mike Norman MMT blogger Matt Franko chimes in:

    It’s like these Rockwell types don’t understand these processes so they make regulation of them “taboo”, and instead advocate for “freedom” because they cannot understand the processes and systems that others advocate for the regulation of.
    Its like he’s a “witch doctor” or something if you can see what I mean; a primitive leader of primitives who cannot begin to understand something so they make it “taboo”.
    Education may be the best way to counter this but the Rockwells of the world have to be willing to really bear down intellectually and learn something new…

    http://tinyurl.com/7uy47p2

    These guy know nothing of Austro-libertarian thought. What else is there to say?

    4. They are still citing Michael Emmett Brady over at Unlearning Economics:

    http://tinyurl.com/7ce5g6g

    I thought the comments on DK’s blog straightened them out long ago.

    Reply
    1. Jonathan Finegold Catalán Post author

      With regards to your #1, I think that is an approach to libertarianism (political philosophy). I don’t think it’s a valid approach to economics. There could, conceivably, be an instance where government intervention may make the market more efficient (by whatever standards [Kaldor-Hicks criteria?]). Economically, we may find that this interventionism is preferred. Politically or philosophically, we may disagree with the economic fact on different grounds.

      Reply
      1. Bob Roddis

        I basically agree with you about #1. However, the interventionist position, to be correct, must still rest upon a true understanding of reality, something they seem to be unable to grasp. Their failure to grasp reality should always undermine their analysis whether we are discussing pure econ or law or political philosophy.

        Reply
  2. UnlearningEcon

    ‘and that a capitalist system in which the means of production are individually owned ‘

    This is blatantly false when you look at capitalism in the real world. Large amounts of people own no means of production and are forced to work for wages to subside.

    Can I ask exactly what Austrians and RWers in general have against market socialism? It combines something you love (the price system) with something you basically ignore (work).

    Reply
    1. Jonathan Finegold Catalán Post author

      I don’t know what a RWer is. Two things,

      1. That the means of production are privately own doesn’t imply that every individual owns at least one unit of these means of production. Although, in economies like that of the United States, it turns out that most people do actually own at least part of the means of production. At the very least, each individual at least technically owns his or her own labor, which is a means of production.

      2. How do you define market socialism? And, how do you suppose that Austrians “ignore work?”

      Reply
      1. Silvano

        Just two points.

        Before industrial revolution many “revolutionary” philosopher thought that the central issue was the redistribution of the land (the main mean of production) in order to create a society of “equals”. To distribute pieces of land of the same productivity to each family seemed a very “fair” idea to fight poverty. In reality it was quite stupid from an economic point of view. And it was quite stupid even if indeed there were surely valid reasons from a legal standpoint to question the distribution of lands since going back through the time each title of possession was based upon a primitive act of violence (war, robbery, etc.).
        Masses are like Homer Simpson and Homer Simpson can’t rule the world. Even if he wakes up and starts a revolution he’s destined to be condemned by the iron law of oligarchies (Bakunin, Pareto, Mosca, Mitchell, knew it much better than Marx).

        Reply
      2. UnlearningEcon

        1. Fair point, I guess I misread that. But labour is pretty useless without capital/land. What I’m getting at is that private ownership of the means of production tends to generate inequalities and power asymmetries.

        2. Worker ownership. And I have never seen an Austrian talk much about capitalist workplaces – your analysis is all based on the market system and consumer sovereignty.

        Reply
        1. Jonathan Finegold Catalán Post author

          I think whether or not that (economic inequality) is true is up for debate. I believe that market economies tend to actually reduce economic inequality (and agree with the fact that market economies also tend to increase all incomes, in absolute terms) and tend towards the elimination of power structures. I see the former as an inescapable conclusion if we know that the ultimate source of all practical scarcity is the scarcity of human labor — that is, if there are essentially unlimited wants, the main obstacle towards achieving unlimited satisfaction is human labor (even the supplies of other inputs are constrained by the availability of human labor). The latter I have discussed on this blog before.

          In that post I also discuss, although only in a sentence or two, the emergence of worker ownership in firms. But, of this this has to be constrained by economic calculation and profit/loss. Any attempts to circumvent economic calculation is going to lead to the emergence of a loss (whether in terms of opportunity cost, or outright capital consumption).

          Reply
        2. Silvano

          1. And capital / land is useless without human labor. Basically speaking what is a resource and what is not relies upon human (subjective and inter-subjective) knowledge. The age of stone didn’t finish because no stones remained, the same has been with labor intensive agriculture and the same probably will be with oil and gas. Wages are deductions from profit: if you are self employed you get the entire profit (no exploitation), if you set up a 50%/50% partnership with someone else you divide 50%/50% of the final profit (no exploitation), if you hire someone you anticipate the means of production while the worker is paid before the economic and financial cycle of production reach the end (no exploitation). The worker is a deduction from your profit: you may layoff him and substitute him with a more efficient machine while continuing to be self employed. Generally people aren’t happy when companies reduce their labor force because of automation (I never heard a socialist commenting this facts like a “reduction in the number of exploited workers”).
          2. I don’t know in Usa, but cooperatives of workers do exist in many countries. In Italy, Spain, France, Argentina there are examples of almost bankrupted factories bought by the same workers (generally they are SME). But broadly speaking that’s not possible in capital intensive factories like shipbuilding, automakers, etc. since workers can’t anticipate the means of production and waiting for the end of economic process before getting paid. Secondly even in cooperatives time after time all are equals but someone is more equal than other since a successful organization in order to advantage from economies of scale and scope tend to became complex and produces hierarchies. Generally speaking workers aren’t so interested in owning particular means of production: they’re interested in getting a bigger share of the pie: unionism is quite different from socialism / communism. The former developed in a (almost) natural way, the latter is eminently an ideology developed by (bourgeois) intellectuals.

          Reply
          1. UnlearningEcon

            I don’t want to derail too much so this will be my final reply. But this is a pretty big statement:

            ‘Generally speaking workers aren’t so interested in owning particular means of production: they’re interested in getting a bigger share of the pie’

            That cannot simply be asserted and requires further debate.

          2. Jonathan Finegold Catalán Post author

            I think a “bigger piece of the pie” is almost the same thing as owning the means of production. If you own savings then you own the means of production.

          3. Silvano

            I meant higher wages, more benefits, early retirements, etc.
            All the classical requests advanced by Unions.

            Unionism is quite different from the socialization of the means of production.

    2. Fernando

      Alex, I would agree that one sholud study both Mises and Menger to understand monetary theory. In terms of Hayek’s Denationalization of Money I am more spilt. Yes, it is correct that it probably was the spark that ignited the modern research on Free Banking. On the other hand Hayek’s results in DoM I generally think are wrong. Therefore, I would not use it for my starting point when studying Free Banking George Selgin is the man! And I think Market Monetarists can learn a great deal by studying George’s papers and books. But again George does not consider himself an Austrian. I think he in general dislikes these labels.

      Reply
  3. Silvano

    The calculation problem is quite interesting. In my opinion it reveals also a slight asymmetric approach in the field of corporate governance.
    Austrians (in short) consider a firm almost like an island of commanded economy. This insight is well explained in MES by Rothbard where he shows why the reduction of an entire market into a single firm is impossible. Problems related with vertical integration and transfer prices are indeed well known in academic and business literature.
    I wonder why many issues raised by Public Choice aren’t extensively applied in analyzing corporate governance. In particular few things are said about the public company model and managerial capitalism. In MES Rothbard says that anyhow even minority shareholders can vote selling their share. That’s obviously true, but it doesn’t address the core of the problem, i.e. the division between formal and effective ownership, the dispersion of the ownership among a myriad of marginally insignificant shareholders and the fact that mutual fund managers can be captured like many regulators (indeed it happens often). And in my opinion is also a line of defense too much neoclassical (EMH, shareholder value and modern finance theory, etc.). Obviously in a free market economy firms aren’t “hard to die” like tax funded institution, but every Austrian economist has been always aware of the difference between entrepreneurs and managers. Mises explicitly denies the fact that capitalists and managers incentives could be aligned. But this fact wasn’t so relevant at the time when Mises wrote “Socialism” and “Human Action” nor when Rothbard wrote MES.
    Even in a very political biased sector like financial sector, we can hardly say that shareholders (i.e. capitalists) didn’t pay a price after financial meltdown. Maybe not enough from a purely free market perspective, but failures and huge losses are undeniable. Lots of banks literally disappeared. Despite this fact many managers lost almost nothing (unless we consider a real loss the interruption of the possibility to cumulate bonuses year after year thanks to the easy money pushed into the system by the Fed) and many of them escaped with huge golden parachute just before being bailed out by the government. The personal wealth of many CEOs has been protected.
    Two free marketers and Austrian sympathetic economists, Kevin Dowd and Martin Hutchinson, in their book “Alchemists of loss” blame some features of managerial capitalism to be prone to cronyism (not only in financial sectors) inducing rent seeking behaviors and moral hazard. They suggest also that these facts probably played a significant role in the rise of inequalities.
    Institutional features and agency costs weaken the bounds between capitalists and means of production while new elites of “temporary owners” arise. They can calculate but despite this fact are less motivated to allocate resources properly. Probably saying that Austrians are asymmetric is excessive, but surely they didn’t spend much time in inquiring the relationship between economic calculation, entrepreneurship and corporate governance in public companies (if there is no government to blame for something).

    Reply
    1. Jonathan Finegold Catalán Post author

      There is a lot of info in your comment, so I’m just going to respond very generally, hoping to provide some sort of research agenda.

      1. Peter Klein has done work in firm size and management, and has (attempted) to forge a link between the firm, management, and economic calculation.

      2. There is a lot of special interests in business; but, nobody ever denied this, and in fact, one of the big questions economics has always attempted to answer is: how do people with their own interests in mind create aggregate harmony through their actions? This is what the theory of coordination (and discoordination) attempts to answer.

      3. On the more specific claim that managers and owners were protected from bankruptcy in 2008, this is not true. It might be true in some instances (I am not sure), but as far as I know many (if not most) of the owners and managers of the big financial firms that fell suffered horrible losses. I am not at home right now to check, but this is the impression, for instance, I got from Jeffrey Friedman’s and Wladimir Kraus’ Engineering the Financial Crisis. They reviewed and ultimately found nothing in the thesis that financially protected management ran their companies into the ground on the basis that they would not suffer the consequences of such actions. It seems to me that the idea that management is financially protected is, generally speaking, a myth perpetuated by those who have adopted moral hazard theories of the recession.

      Reply
  4. Silvano

    1. I know he wrote some books about the theory of the firm but I have to it.
    2. Yes, but I was just addressing some cronyism of managerial capitalism and changes occurred in the last 30-40 years.
    3. Well, mostly I’m referring to top management (stockholder and midde management suffered losses, I agree). Recently I read Financial Fiasco (Norberg), Maniac, Panics and Crashes (Kindleberger) and Alchemists of loss (Dowd, Hutchinson). I think evidences are mostly anecdotal (and not empirically assessed). Anyhow in many case it is what I saw in Europe, working in banking sector.

    Reply

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