F.A. Hayek and Why Government Can't Manage Society, Part II

F.A. Hayek and Why Government Can't Manage Society, Part II

By Richard Ebeling - June 30, 2015

It is seventy years, now, since near the end of the Second World War Austrian economist, and much later Nobel Prize winner, Friedrich A. Hayek published his most famous article, "The Use of Knowledge in Society," in September 1945, demonstrating why it is impossible for a system of socialist central planning to effectively manage a complex and ever-changing economy better than a functioning, competitive free market order.

All the necessary knowledge to comprehensively and successfully plan an entire society does not exist in any one place or in the mind of any one person or group of people. Instead, the knowledge of the world is dispersed and decentralized among all the minds of all the people in the world.

To effectively utilize it for all to benefit it is essential to rely upon the market and the competitive price system, through which everyone is able to communicate with each other for the minimal amount of information to coordinate their activities with all the others in society.

Hayek's Message About Prices Still Relevant in a Post-Socialist World

With the failure and implosion of Soviet-style socialist central planning, Hayek and other thinkers like him were shown to have been right. Socialist central planning is dead, relegated, to use Marx's phrase, to the "dustbin of history."

The issues confronting societies, now, are not markets versus socialist planning but the form that markets can take on, and in this setting the degree to which government should or can regulate and intervene into the workings of the market system.

Influencing and moving markets in one direction compared to another through government regulatory and fiscal policies are a far cry, it is said, from the "old days" of those calling for and predicting the "end of capitalism."

But a logical extension of Hayek's argument against central planning is that any interferences with the price system or the autonomy of market participants to act on their own best judgment in their respective local circumstances of time and place must necessarily prevent the "knowledge problem" of economic coordination from being most effectively solved.

Prices, in other words, need to be able to tell the truth: What are the actual demands of market participants for various consumer goods and services, and what are the actual available supplies and alternative demands for the scarce means of production with which those desired consumer and other goods may be manufactured (what economists called the "opportunity costs" of the land, resources, labor and capital in their competing uses on the supply side of the market)?

Interest Rate Manipulation Distorts Savings and Investment Decisions

Market rates of interest represent a critical network of prices. Hayek made his early reputation as a money and business cycle theorist in opposition to Keynes's policy proposals for "activist" monetary and fiscal policy.

Hayek argued that market-based interest rates are essential for coordinating the decisions of income earners concerning how much of their income and wealth to divide between consumption and savings with the decisions of potential borrowers desiring to use the savings of others to undertake time-consuming investment projects that will bring forth desired consumer goods at some point in the future.

Monetary central planners through the central banking system attempt to influence interest rates and the types and amounts of investment spending through increasing the quantity of money in the banking system. The artificially lowered interest rates reduce the cost of borrowing and raise the prospective profitability of possible investment projects that would not have seemed worth undertaking at a higher market-established rate of interest.

The increase in the money supply creates the illusion that there is more savings available to be borrowed to start, complete and sustain investment projects than there are actual real saved resources to do so.

Borrowers and investors are misinformed by an important market signal to use their special and localized knowledge of time and place in misdirected ways that are inconsistent and eventually unsustainable with the real amount and types of scarce resources with which to undertake their investment projects, given people's actual decisions to save portions of their income, and thus "free up" a certain amount of resources for future-oriented production.

Precisely because the multitudes of individuals participating in the social system of division of labor cannot know all the others with whom they are interdependent in the complex networks of supply and demand, and therefore directly know what others are planning to do with their income and resources, everyone is dependent on the truthfulness of the price system through which all those individuals coordinate their diverse decisions and actions.

By falsifying interest rates – the inter-temporal prices connecting savings choices with investment decisions – governments and central banks potentially set in motion distortions and imbalances in the use of resources, capital and labor that manifest themselves in the form the booms and busts of the business cycle.

Government manipulation of prices, therefore, can be just as disruptive as the abolition of prices by political edict. Just as automobile traffic on the road system would be chaotic if the traffic lights were turned off, it can be equally disruptive and dangerous if red lights are turned to green when the perpendicular traffic at an intersection is simultaneously given a green light signal as well.

Minimum Wage Laws Cause Unemployment and Distort Resource Use

The same applies with the recent political push to raise the U.S. minimum wage law from its current level to $15 per hour or more. Critics of the minimum wage increase have rightly emphasized that doing so will potentially drive many marginal workers out of their existing jobs and prevent other jobs from ever materializing.

Setting a minimum wage below which no worker may be legally employed runs the risk of pricing out of the market those unskilled or low-skilled workers who employers find contribute a value to their production activities less than what the government mandates they are to be paid.

None of us pays more for something than we think it to be worth. This applies no less to employers whose only means of paying those they employ are the revenues they earn from selling products and services to the buying public. For an enterpriser to remain in business, costs of production cannot persistently be above the revenues received from sales of goods and services to consumers. Labor costs are no less a determinant of profit or loss than other expenses of doing business.

But besides this, the manipulation of wage rates through minimum wage laws also influences and disrupts the use of scarce resources in comparison to their allocation in a purely market-determined network of wages for different types and skills of labor.

Minimum Wage Can Result in Capital Replacing Labor When Not Needed

A number of both advocates and critics of a minimum wage increase have pointed out that some businesses have suggested that raising labor costs in this manner may result in replacing some workers with capital.

Computer tablets at restaurant counters can replace waiters and waitresses in taking orders conveyed to the cooks and chefs in the kitchen (as has already been happening in some places). And in Japan they have even been experimenting with robots that bring food orders to the counter or the restaurant tables in place of human servers.

All of this may end up being a market-based "wave of the future" to the extent that an aging and retiring population makes certain types of labor more scarce and expensive to employ over time. The demands for labor and their rising cost of employment over many decades in the twentieth century was a major factor behind the reduction in domestic servants in middle class households and their replacement with laborsaving home appliances and conveniences to do everyday housework.

Another example is how the greater cost efficiencies of office and laptop computers resulted, over time, in the disappearance of large numbers of secretaries employed in the "typing pools" of many large and small businesses throughout the economy.

By artificially raising the price and therefore the cost of certain types of labor through minimum wage legislation, the price system for workers no longer is fully telling the truth about who is available for work and at what market-determined wages to assist producers and enterprisers on deciding what would be the most appropriate use and combinations of labor and capital given the real, underlying supply and demand conditions in the market.

Capital that would be more profitably and efficiently utilized in other sectors of the economy will be drawn into these labor-saving activities due to the government imposing this higher wage floor for labor. This may occur, as a consequence, years or decades before the market would have determined that this was the best use for scarce laborsaving capital resources, and in some cases when it might never have been profitably desirable to redirect capital into those uses at all, if not for the minimum law.

So by manipulating workers' wages through minimum wage legislation, people will, again, potentially make misdirected decisions on how best to use their local knowledge of their own particular place and circumstances in the market because the price of hiring labor will not be telling the truth.

Government Regulations Prevent the Use of Personal Knowledge

This is no less the case with government production regulations and restrictions. In a dynamic market, individuals are constantly coming up with new ideas based on changing supply and demand situations that create the incentives and profit-oriented alertness to discover and imagine new possibilities about what products to produce and how to produce them.

In a world in which change seems to come swift and fast, flexibility and adaptability to such change are keys to business success in meeting and beating the competition in capturing consumer sales. Compare the market world of today with that of twenty or ten or even five years ago, and you see the technological discoveries and applications that have transformed everyday life in ways that we often forget to fully appreciate since they have already become so taken for granted.

It has been pointed out that in the U.S. the private sector spends about $2 trillion a year on compliance with government regulations, which in the Code of Federal Regulations take up over 175,000 pages of rules, commands, restrictions and prohibitions. 

Businessmen and those they employ must apply their knowledge and time to meet the demands of politicians and bureaucrats rather than utilizing them toward consumer-oriented production, innovation and improvement in all that their enterprises do.

At the same time, these thousands of pages of regulations serve as straightjackets that limit and inhibit entrepreneurial ability to take advantage of the changing circumstances of time and place because any and all responses, changes and adjustments are confined within the existing permissible rules and regulations imposed on the marketplace by the heavy hand of government.

Of course, appreciating the full impact of this is impossible to completely know precisely because it is part of what Frederic Bastiat explained as the "unseen." These are all those market activities and outcomes that never occur, or at least not in their entirety, because the regulatory structure prevents or modifies all the forms they would have taken on in a more free-market institutional environment.

That we cannot fully see or know all of these "might-have-beens" if not for government regulation does not any the less change the fact that individuals in the marketplace are prevented or restricted in how best to use the knowledge that they only possess and which the government regulators can never know or appreciate in the same way each of the individuals in the market do in their respective places in the division of labor.

The More Complex the Society, the Less Government Can Do Successfully

Another way of saying all of this is that Hayek challenged the entire trend of collectivist thinking and policy advocacy – whether in the form of central planning or price and production interventionism – by emphasizing the limits on what man can successfully command and control in the social and economic order of things.

For decades the socialists and interventionists argued that the more complex the society the less it could be left to the unhampered workings of the market system. The more intricate the social order and people's relationships in it, the more there needed to be a centralized political guiding hand to assure that it did not fall into chaos and disharmony.

Hayek turned this argument on its head. He insisted that the more complex the social and economic system the less any single or handful of human minds could comprehend, master or manipulate the relationships for better outcomes than when the market was left free.

If we wish to use all of that ever more complex "knowledge of the world" for the benefit of all, we must leave alone those who possess it in decentralized fragments, and who know best its use through their own actions and interactions in their corners of society. We need to allow all of that dispersed knowledge to be effectively coordinated in an increasingly global community of commerce, culture and creativity through the mechanism of competitively formed market prices to give each the minimal amount of necessary information about all the others with whom they are interdependent so to integrate what each does with the actions of everyone else.

In "The Use of Knowledge in Society," Hayek summarizes his argument:

We must look at the price system as . . . 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, and how little the individual participants need to know in order to be able to take the right action . . .

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 the mere the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to change of which they may never know more than is reflected in the price movement.

Hayek went on to refer to the "marvel" of all the complex knowledge and actions of multitudes of millions of people the price system successfully and constantly tends to coordinate even in the face of continual unanticipated and uncertain change. Hayek said:

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 change 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.

Of course, the competitive price system is not the creation or design of a grand council or benevolent king. Trade, competition and prices emerged "spontaneously" out of people searching for avenues and opportunities to improve their circumstances through discovered mutually advantageous exchange.

The Significance of Hayek's Contribution to Human Knowledge

The fact that the market price system has emerged and evolved over centuries and not been created by the fanfare of a political command makes most people not even realize its importance, with it being taken for granted like language, or customs and manners, all of which makes society and social life possible but are also not the designs of political leaders.

Looking over the last seven decades since the appearance of Hayek's "Use of Knowledge in Society," we can now appreciate that in retrospect it represents one of the most important contributions to man's understanding of how the world in which he lives and works is made possible without the guiding hand of government command.

And just how relevant his argument remains today in the face of political regulations and controls that prevent that "marvelous" price system from most effectively integrating and coordinating the actions of billions of people whose freedom to use their own bits of unique knowledge and knowhow is critical for the continuing advancement of mankind.

Dr. Richard Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. - www.thedailybell.com