Thoughts on “Hayekian Insights for Trying Economic Times”
by Fred Smith | Posted September 28, 2011
Following a recent panel at the Cato Institute commemorating the publication of a new edition of F.A. Hayek’s The Constitution of Liberty, Arnold Kling brought to my attention a recent essay on Hayek by Bruce Caldwell. On the panel, Caldwell provided a thorough and concise refutation of George Soros’s blatant misreading of Hayek. Naturally, I sought Caldwell's essay out.
In this work, “Ten (Mostly) Hayekian Insights for Trying Economic Times,” Caldwell seeks to “identify 10 key themes to be found in the writings of Hayek and others in the tradition to which he belonged that may provide some insights into how we might respond to the current dilemmas that we face.” The essay is thought-provoking, and several points are worthy of further discussion.
Theme #1: The business cycle is a necessary and unavoidable concomitant of a free-market money-using economy.
Caldwell cites Austrian business cycle theory to proffer an explanation of the recent financial crisis:
Hayek’s theory offers a pretty good description of at least part of what happened in the latest meltdown, especially in terms of the Federal Reserve’s interest rate policy and its effects on the housing sector. In Hayek’s theory, problems start when the market rate of interest is held too low for too long. This always politically popular policy leads to malinvestment — too many investment projects get started that cannot ultimately be sustained. When people realize what has happened, investment spending collapses and a recession begins. The dangers of a prolonged low-interest-rate regime in distorting how the various factors of production in the economy are allocated — what the Austrians call the structure of production — is something to take away from the theory, especially given the political popularity of such a policy.
My understanding of the Austrian business cycle theory is the same as Caldwell’s, but I characterize it a bit differently. As I understand it, a fiat monetary system creates money and then disperses it via banks — in the U.S., the 12 regional Fed banks — to selected customers and then out to the rest of the economy. When the flow waxes or wanes, the wave crests, and troughs move over various segments of the public, leading to higher or lower investment and consumption.
These monetary phenomena may not accord with the underlying realities of consumer demands. That mismatch can beget over- or underinvestment, thus creating a bubble and then the inevitable collapse. Commodity markets have evolved many mechanisms to reduce the severity of such fluctuations — including hedging, stockpiling, and alternative technologies.
Would a competitive money supply reduce the business cycle problem in a similar fashion? I recognize that the idea may be viewed as radical, but then many classical liberal concepts are seen as radical in our illiberal political environment.
Theme #2: The 1970s show why Keynesian economics was rejected.
In the late 1960s and 1970s, Keynesian policies created their own backlash — a consequence of the economic calamities they begat.
When inflation began to appear in the late 1960s due to LBJ’s deficits, a precisely calibrated income tax surcharge designed to tamp down demand was imposed. Yet because it was viewed as temporary, it had no effect, and inflation continued to rise. This was the first signal that the machine metaphor might have been the wrong one.
Things got much worse in the 1970s as inflation turned into stagflation. The main lesson of the 1970s was that once inflation gets started, it is very difficult to get rid of it. To fight it, the government has to tighten up the economy. This in turn induces unemployment, and because the effect on inflation is not immediate, for a time both the unemployment rate and the inflation rate go up together.
Sadly, Keynesian economics was not rejected for long. We’re all Keynesians again — falling prey to government “stimulus” and scientistic fallacies. Government doesn’t need to “prime the pump.” Rather, we need a deregulatory stimulus to free the nation’s creative economic forces. As Wayne Crews, CEI’s vice president for policy, puts it:You don’t need to teach the grass to grow; simply move the rocks off of it!
Theme #3: Some regulation is necessary . . .
The comment by Caldwell that I most enjoyed at the Cato forum was his citing of Hayek’s response to Wassily Leontief’s furious attack on him, which essentially boiled down to, “How dare you criticize planning!” Hayek’s answer was that the question was not whether to plan or not, but rather, Who should plan for whom.
In his essay, Caldwell defines this distinction: “The sort of planning that Hayek favored was a general system of rules, one that would best enable individuals to carry out their own plans.” He adds, “For markets to work effectively, they must be embedded in a set of complementary social institutions.” Indeed, the regulatory disciplines of a competitive marketplace are generally far more effective than the regulatory disciplines of a politicized bureaucracy.
Theme #4: . . . but a lot of regulation is fraught with problems and will make matters worse.
Caldwell makes an important point about the speed and wisdom of bureaucrats:
The basic Austrian insight here is that entrepreneurs (including those who realize there is money to be made from devising ways of getting around regulations) are always forward-looking, while regulators and legislators are almost of necessity backward-looking.
While there might be a handful of individuals knowledgeable in the complexities of financial engineering, the likelihood that such individuals will find employment in a federal regulatory agency satisfying is nil.
And even if such wise individuals existed and were willing to toil away in government planning offices, their actions would still be hampered by the fact that no one else would know what they’re up to at any one time, and how long it would be before they would change course.
Regulation also inserts uncertainty. As Hayek put it, “the more the state ‘plans,’ the more difficult planning becomes for the individual.” There was plentiful evidence of this in the recent downturn. In the fall of 2008, each announcement by the Fed and the Department of the Treasury, while meant to reassure the markets, produced more and more panic. It also froze people into inaction. One could imagine the decision-making process that took place in many people’s minds: “Should I hold onto my house that is underwater, in the hopes of a government bailout? Should I buy a car now that the prices are low or wait for some government program that will cause them to fall even lower? A stimulus plan is coming, and I don’t know what it will look like; probably best to delay all decision-making for now, to wait and see.”
Over and over again, we encounter examples of people basing their decisions on trying to guess what the government is going to do. Contrast this with what happens in well-functioning markets, where people make their decisions principally by looking at changes in market prices, prices that reflect underlying scarcities.
Indeed, government bureaucrats have no means to convey information as effectively as prices can.
Theme #5: The economy is an essentially complex phenomenon for which precise forecasting — on which the construction of rational policy depends — is ruled out.
Exactly — and when we put all our eggs in the same basket, the results of errors are magnified. “[T]he things that we actually do know all concern limitations on our knowledge and on our ability to formulate and carry out rational policy,” Caldwell notes; and continues:
This does not mean that policymakers cannot get things right when it comes to managing the economy as a whole. It is just that sometimes stabilization policy stabilizes the economy, and sometimes it destabilizes it, and we usually can’t tell in advance — and sometimes not even in retrospect — which scenario is unfolding or has unfolded.
Theme #6: In any complex social order, any action may have both good and bad unintended consequences.
One reason for optimism is the fact that the term “unintended consequences” has entered the public policy debate. Perhaps the fallacies of central planning are becoming clearer?
The bad side of unintended consequences is that many attempts to impose our will on the complex adaptive system that is the economy cause things to happen that were not part of our original intention. For example, as everyone recognizes, a market system does not satisfy our longings for “social justice.” In response, well-intentioned people — or those with interests who can play on the sentiments of the well-intentioned — naturally seek to make adjustments in a market system so as to produce more desirable results. Unfortunately, time and again, history has demonstrated that . . . all sorts of pernicious effects will occur that were not part of the original intention.
As I’ve argued before, during the Great Depression, people wisely distrusted big business, so they turned to big government — which had never been tried in peacetime — as a more attractive option. Today neither is trusted, which improves the odds for a more realistic comparative assessment of markets vs. government.
Theme #7: Basic economic reasoning captures what we can know and say about the essentially complex phenomenon that we call the economy.
Following Hayek, Caldwell describes the market economy as a mechanism for the efficient allocation of scarce goods. He is pleased that "basic insights about the workings" of the market are now built into economic education:
These tools allow us to talk about the fundamental fact of scarcity, the choices that scarcity makes necessary, the costs of choice, and the ways to push back against scarcity, at which point the notions of the division of labor, specialization, comparative advantage, the productivity of capital, and the gains from trade are introduced. If one adds to these the concepts of elasticity of demand and supply, and some basic intuitions about market structures, one can explain a lot about the world, as anyone who has ever taught an introductory economics course knows.
Here I have some major disagreements. I find the view of economics as a system for efficiently allocating scarce goods, a view that Caldwell seems to favor, overly static. I prefer the Coasian view of the market as a set of institutions for lowering the transaction costs of voluntary exchanges. In this regard, I’m influenced by Joseph Schumpeter, who noted:
A system — any system, economic or other — that at every given point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no given point of time, because the latter’s failure to do so may be a condition for the level or speed of long-run performance.
I recall my own undergraduate one-year course in economics. When presented with the positive-sum nature of exchange driven only by self-interest, I asked, “Why wouldn’t the party that held both items in a given transfer just stop the transaction at that moment?" Most transfers involve a period when one party holds both items and at that (possibly brief) moment, short-term self-interest would entice that party to not complete the transaction and singularly benefit. My professor didn’t understand my concern, and only years later did I come to understand that markets “work” because both parties hope to engage in future transactions. If they default once, they will face either cultural or legal sanctions and will at least find it hard to identify future transaction partners. That is, before a world of voluntary exchanges can occur, institutions (cultural or legal sanctions, an expectation of future exchanges) must exist — institutions that discipline transfers. (In a priori probabilistic terms introduced by Ronald Coase, the transaction costs must have been reduced earlier to make such transfers mutually advantageous.
Of course, when I asked my question, economics professors had no interest in or understanding of the role of institutions in lowering transaction costs, of making markets possible. And often they still don't have that interest or understanding. Most people trying to understand why markets exist are unaware of the evolution of the institutions that make voluntary exchange viable. Naiveté about “markets” has led to “market socialism” and “market mechanisms” and other collectivist beliefs that markets can be created from whole cloth by means of top-down political planning. Consider, for example, the various emission trading systems that are now being proposed. The late Warren Nutter aptly noted: “Markets without property rights are a grand illusion.” He was discussing the mechanical attempts in Russia after the fall of the Iron Curtain to replicate markets, but the principle is true elsewhere.
Unfortunately, modern economics is often based on static equilibrium models designed to be solved rather than to resemble reality. Coase became a nonperson in the economics profession (as did most Austrians), in large part because he kept asking embarrassing questions of this sort.
Theme #8: Demands for social justice can be satisfied.
I believe that this was Hayek’s biggest mistake.
Somewhat controversially in the eyes of certain Austrians and libertarians, Hayek argued that in a society that had reached the general level of wealth that Britain or the US had achieved, “there can be no doubt that some minimum of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody,” and also that the state should “assist the individuals in providing for those common hazards of life against which, because of their uncertainty, few individuals can make adequate provision.”
Granted, Hayek’s concept of a “safety net” was quite minimal in comparison to that of our modern welfare state, but to argue for it in the first place leads inevitably to unsustainable middle-class entitlements. We may not be able to avoid such policies altogether, but to endorse them is to endorse the instability of the welfare-regulatory state. Hayek struggled with this dilemma; I do not think he ever resolved it. (This may be the reason that, in a previous Cato panel, Richard Epstein argued that Hayek never overcame his social democratic roots.)
Theme #9: Freely adjusting market prices helps solve the knowledge problem and allow social coordination (the basic Hayekian insight).
Here I agree completely. I consider Hayek's “The Use of Knowledge in Society” the most important essay in economics. The idea embodied in that work was the essence of the market calculus debate between von Mises and Hayek on one side and Lerner, Lange, and Kornai on the other. Caldwell offers a good summation of Hayek’s view.
The question that must be solved in constructing a rational economic order in such a world is: How can we use the knowledge that is dispersed among millions of fallible market agents so as to achieve some level of social coordination and cooperation?
Hayek’s answer was that a market system with freely adjusting market-determined prices is, when embedded within an appropriate institutional structure, a marvelous mechanism for coordinating human action.
Unfortunately, many modern economists — including some self-avowed “free market” economists — have ignored Hayek’s view on this topic, as the vogue for Pigouvian taxes and quotas illustrates.
Theme #10: The basic "public choice" idea is true: more often than not, government cures are not only worse than the disease, but lead to further disease.
I largely agree with Caldwell’s valuation of public choice economics in helping to explain why government grows and rarely recedes.
Public choice theorists believe that politicians, like everyone else, act in their own self-interest. If consumers maximize utility, firms maximize profits, and politicians maximize votes, what do bureaucrats maximize? The answer is troubling: Bureaucrats have an incentive to maximize the size of the bureaucracy under their control.
However, I find that public choice focuses too heavily on economic motivations, without taking other factors into account. Public policy is a two-tier process that includes both economic and ideological interest groups. Public choice thinkers tend to ignore the motivations of the latter, even though their influence is often much greater than that of business people or other economically motivated groups.
Bruce Yandle’s “Baptists and bootleggers” paradigm illustrates how economic and ideological groups often interact to pursue shared agendas. One group — the Baptists — advocates prohibition on moral grounds, while another unrelated group — the bootleggers — profits from the extralegal opportunities created by policies resulting from the former’s moral crusade. There has, however, been too little attention paid to the ideological groups.
Much of publicpolicy is driven by ideological groups crafting narratives that effectively link their favorite policies with core social values. Aaron Wildavsky and Mary Douglas argued that people respond to a policy by a quick decision as to whether that policy advances or threatens their core values. That decision will be influenced by the narratives communicated about policy.
Today’s “Baptists” are often environmental, labor, “consumer,” “human rights” groups advocating government intervention in the economy to advance some feel-good cause. To date, free market advocates have been far less effective than the left in crafting narratives that persuade a majority of people that classical liberal policies advance core values — whether these be equality, fairness, order, or security — better than do statist ones.
In conclusion, I should note two questions that I believe Hayek neglected to explore adequately. The first is: why do so many bad policies evolve and survive? (Granted, Hayek's “The Atavism of Socialism” essay deals with that theme to some extent.) The other question is: how could Hayek's own ideas be implemented? His focus on “What do we know and how do we know it?” was crucial, but more attention to “How do we change it?” would have been valuable.
Hayek did have a change agenda — one I agree with — but he did not clarify sufficiently what we could do to bring that about. His recommendation to fight the war of ideas is necessary, but not sufficient. Still, few others have done as much as Hayek, whose work I consider critical in the battle for the future of civilization.
Fred Smith is the founder and president of the Competitive Enterprise Institute, a free market public policy group and international NGO in Washington, DC. He addresses complex policy issues ranging from the environment to corporate governance and is a frequent guest on national TV and radio programs, as well as a prolific writer. As a former policy analyst with EPA, he speaks with candor about the true cost of government regulation.
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