Monday, August 18, 2008

Why Central Economic Planning Fails

First let me define what i mean by central economic planning: It is a committee of people that is far removed from the actual place of economic activity and are trying to dictate the affairs thereof. For example, a bureaucrat in Washington D.C. decides the appropriate amount of federal money Billings, Montana necessitates to improve its roads (who would know better but the residents of said location); or for the Federal Reserve System to identify the exact interest rate that will equilibrate providers of money with users of money. In order to adequately ascertain the exact amount needed in both cases, the policymakers would need an excessive amount of information extracted from the market. This means that they would have to turn to everyone participating (and even those that do not) in the economy. Even if such information could be obtain (which is impossible) they would still have difficulty collecting it in real time. Even if that impossibility might conceivably be possible they would still be exposed to the vagaries and volatility of individual sentiments. The data, thus, would be quite chaotic.

This is at the heart of what the 1974 Nobel Laureate in Economics, Frederich Hayek, explained in his excellent work, "The Use of Knowledge in Society." We live in an age where scientific knowledge dominates policymaking and assume that this is all to it. But "there is beyond question a body of very important but unorganized knowledge which cannot be possibly call scientific in the sense of knowledge of general rules: the knowledge of the particular circumstance of time and place." In other words, individual transactions will be predicated on the assumption that one has unique information over the other, and thus not reveal it. That is, you are not going to show your edge to your competitor. In order to accept Hayek's view, which i share, one must renounce to all central economic planning because it will ultimately fail. Communism failed because its systems could not capture all data for appropriate decision making. In fact, communism did something that is difficult to accomplish: the value of a final product was less than the sum of the value of its inputs. Socialism fails for the same reason. You may ask, "what about Europe? Socialism seems to work there." The reason it has held up over there is that Europeans get a tremendous defense subsidy from the U.S. Being an empire, the U.S. has taken (whether it likes it or not) on the defense cost of European nations. It has done this since the end of WWII.

But to regress to our main point, policymakers do not consider "the knowledge of the particular circumstance of time and place" because (i think) it requires of them a genuine act of introspection about the consequences of their actions and to consider that they may have the whole thing wrong. This requires them to be humble--hardly a trait of politicians and their subservient bands. But more importantly, acceptance of this knowledge also requires rejection of positivism (see the end of my previous post). Many financial and economic assumptions would immediately come into question, such as the efficient market hypothesis, rational expectations, and Keynesian economics, to name a few. By no means i'm implying we should throw "the bathwater with the baby," but simply to recognize the danger to blindly accepting mathematical or empirical results without critical thinking. The former is no substitute for the latter. In spite of this axiom, we live in a world that believes empiricism is sacred. As long as this continues, there will always be market crashes, country crises, and (in our lifetime) world-wide economic chaos when our monetary system fails. "There is something fundamentally wrong," wrote Hayek, when our analysis does not consider "the unavoidable imperfection of man's knowledge and the consequent need for a process by which knowledge is constantly communicated and acquired." This continues to be true today.

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