In the late 20th century, Austrian economics was troubled by a controversy between Misesians and Hayekians.
On the one hand, Misesians like Joseph T. Salerno (1990, 1991, 1993, and 1994) and Murray Rothbard (1991, 1992, and 1994; see also Herbener 1991) charged Hayek and his followers (like Israel M. Kirzner) with deviating from the “pure” Misesian orthodoxy on the nature of coordination in market systems.
Two of major antagonists – Rothbard and Kirzner – were both students of Mises.
In short, the Misesians charged that there was serious chasm between Mises’s and Hayek’s understanding of markets. It is a surprisingly interesting debate, and elucidates some important points about modern Austrian economics.
First, the nasty nature of the debate drove an exasperated Israel M. Kirzner to this astonishing statement:
“Salerno (quite unsuccessfully, it must surely appear) seeks to refute Leland Yeager’s definitive paper (Yeager, 1994) demonstrating that Mises’s thesis does, after all, require that we attribute to Mises at least implicit recognition of Hayek’s “knowledge problem,” Salerno sums up as follows: ‘Thus market oriented PC [i.e., perfect competition] theorists, such as Hayek and Yeager, and neoclassical socialist GE [i.e., general equilibrium] theorists are brothers under the skin’” (Kirzner 2000: 157). ….So on the face of it, this must have been a serious dispute!
“The biting sarcasm employed in this assertion is but a relatively mild example of the rhetorical excesses appallingly to be found in the ‘two paradigm’ literature against such writers as Hayek, Lachmann, and others charged with having diverged from the asserted ‘Misesian paradigm.’ I take this opportunity strongly to protest the use of verbal terrorism in Austrian economics. Even if (which is far from being the case) the asserted criticisms of Hayek, Lachmann, and others were valid, there would be absolutely no justification for the manner in which these great economists have been treated in the literature under discussion. The near-demonization of Hayek and Lachmann for alleged deviations from an asserted Misesian orthodoxy is a most distressing phenomenon. If Austrian economists (and the Review of Austrian Economics) are to be able to work constructively in the rough and tumble of the intellectual market place, anything approaching rhetorical brawling must once and for all be rejected.” (Kirzner 2000: 162–163, n. 2).
What was the dispute about? Let us review it below.
I. Misesian Socialist Economic Calculation versus the Hayekian Knowledge Problem
First, the dispute concerns the differences between Mises’s original “socialist calculation problem” and Hayek’s “knowledge problem.” Kirzner argues that Salerno and Rothbard came to the “unwarranted conclusion … that the Misesian calculation problem has nothing whatever to do with Hayek’s knowledge problem” (Kirzner 2000: 157).
In contrast, Salerno argues that Hayek’s “knowledge problem” is different from Mises’s original “socialist economic calculation problem,” and even Kirzner concedes that Mises did not formulate the “calculation problem” in terms of knowledge (Kirzner 2000: 158).
And, indeed, according to Rothbard, Hayek misunderstood Mises’s socialist calculation problem:
“It is now universally acknowledged that Ludwig von Mises, allegedly the loser in the famous socialist calculation debate that he launched in 1920, was really right: clearly, socialism cannot calculate, it cannot run a complex modern economic system. But it has only recently become clear, through the insights of Professor Salerno, precisely why Mises was right, and also how the Misesian message was systematically distorted, from the 1930s until recent years, by F.A. Hayek and his followers. For Hayek and the Hayekians, obsessed with the alleged ‘problem of knowledge,’ have systematically misinterpreted Mises as maintaining solely that the Socialist Planning Board, facing the uncertainty of a dynamic economy, lacks the knowledge enabling it to plan the production and allocate the resources of a socialist economy. In contrast, the market economy, through its price signals, conveys that needed knowledge from and to the various participants in the market economy.The difference between Mises’s and Hayek’s idea on the price system is summarised by Salerno:
Mises, while not disputing the importance of knowledge and its dissemination through the price system, was, however, arguing a totally different point. From 1920 on, he reasoned as follows: assume the best for the Social Planning Board. Assume that, by some magical process, it has been able to discover and know absolutely all the value-scales of consumers, all technological methods, and compile an inventory of all resources. Suppose, then, Mises says, we grant total knowledge of all these data to the Socialist Planning Board. It still will not be able to calculate, still will not be able to figure out costs and prices, particularly of land and capital goods, and therefore will not be able to allocate resources rationally. The real problem of the Planning Board, then, the major thing denied that Board by absence of a market, is not knowledge but economic calculation.
Thus, to Hayek, if the Planning Board could by some magic know, as people come to know through the market, consumer values, technologies, and resources, it could rationally plan and allocate resources fully as well as the market. As usual for Hayek and the Hayekians, the argument for the free market and against statism rests only on an argument from ignorance. But to Mises, the problem for the Planning Board is not knowledge but calculability. As Salerno puts it, the knowledge conveyed by present (or ‘immediate past’) prices rests on values, techniques, and resources of the immediate past. But what acting man is interested in, especially the entrepreneur in committing resources into production and future sale, is future prices and future costs. The entrepreneur, who commits present resources, does so because he appraises—anticipates and estimates future prices—and allocates resources accordingly. It is, then, the appraising entrepreneur, driven by his quest for profits and for avoidance of losses, who can calculate and appraise because a genuine price system exists in the means of production, in land and capital goods, that is, a system of exchanges of privately-owned capital resources. Only such a pricing system allows for calculation.
Salerno points out that for Mises, knowledge and appraisal on the market are complementary, and have very different natures and functions. Knowledge is an individual process, by which each individual entrepreneur learns as much as he can about the largely qualitative nature of the market he faces, the values, products, techniques, demands, configurations of the market, and so on. This process necessarily goes on only in the minds of each individual. On the other hand, the prices provided by the market, especially the prices of means of production, are a social process, available to all participants, by which the entrepreneur is able to appraise and estimate future costs and prices. In the market economy, qualitative knowledge can be transmuted, by the free price system, into rational economic calculation of quantitative prices and costs, thus enabling entrepreneurial action on the market.
As Salerno notes: ‘competition therefore acquires the characteristic of a quintessentially social process, not because its operation presupposes knowledge discovery [as with Hayek-Kirzner], which is inescapably an individual function, but because, in the absence of competitively determined money prices for the factors of production, possession of literally all the knowledge in the world would not enable an individual to allocate productive resources, economically within the social division of labor.’
In short, the entire Hayekian emphasis on ignorance and ‘knowledge’ is misplaced and misconceived.” (Rothbard 1992: 19–21).
“The price system is not—and praxeologically cannot be—a mechanism for economizing and communicating the knowledge relevant to production plans. [which is position of Hayek – LK] The realized prices of history are an accessory of appraisement, the mental operation in which the faculty of understanding is used to assess the quantitative structure of price relationships which corresponds to an anticipated constellation of the economic data. Nor are anticipated future prices tools of knowledge; they are instruments of economic calculation. And economic calculation itself is not the means of acquiring knowledge, but the very prerequisite of rational action within the setting of the social division of labor. It provides individuals, whatever their endowment of knowledge, the indispensable tool for attaining a mental grasp and comparison of the means and ends of social action.” (Salerno 1990: 44).So according to the Misesians both a market economy and a socialist planned economy are subject to the “knowledge problem.”
“There is a significant implication of our interpretation of Mises’s critique of socialism. Although the market economy has perfectly solved the problem of economic calculation—its very existence attests to the veracity of this conclusion—praxeologically, at least, it is on all fours with socialism with regard to the knowledge problem. For the imperfection of knowledge deriving from uncertainty of the future is a category of all human action, which cannot be overcome by recourse to the market price system, entrepreneurial alertness, the competitive discovery process, and so on.” (Salerno 1990: 48).
According to the Misesians, the primary reason why a socialist, planned economy cannot work is (allegedly) that it lacks money prices for factors of production.
II. Hayekian Prices as Signals that Solve the “Knowledge Problem”
Secondly, we have the role of prices as signals for communicating knowledge in Hayek’s thought.
Salerno argues that Kirzner’s entrepreneurial discovery process is derived from Hayek’s view of prices as communicating knowledge to ignorant market participants so that their ex ante plans for production and consumption are coordinated (Salerno 1993: 126), even though Kirzner himself recognises that exogenous change thwarts such a long-run equilibrating tendency and that the market is “never in or near a state of equilibrium” (Salerno 1993: 128).
But Hayek apparently held a different view. Even when Hayek abandoned his belief in the real existence of an equilibrium state and the belief in strict ex ante plan coordination, he still required a real world condition of close correspondence or proximity to such a state (Salerno 1993: 127–128).
Salerno contends that:
“as Hayek points out, in order for prices to fulfill their knowledge-disseminating and plan-coordinating functions, the economy must subsist in a state of what I will call ‘proximal equilibrium,’ wherein realized prices are always fairly accurate indicators of future prices.” (Salerno 1993: 128).Thus, in Hayek’s view, there is a real-world tendency for “market prices to conform to their equilibrium levels” (Salerno 1993: 128).
Rothbard points to the distinction between Mises’s concept of equilibrium and that of Hayek:
“The Misesian concept of equilibrium is as a remote goal, toward which economic processes are tending, but which they would only reach if divine intervention froze for many years all the relevant data of the economy: values, knowledge, technology, resources, expectations. But for Hayek ever since the 1920s (and for Kirzner following him), general equilibrium, while not actually extant, is right around the corner: in what Salerno calls ‘near equilibrium.’ It is only in near, or virtual, equilibrium, whether that of Hayek, Kirzner, or Schumpeter, that entrepreneurial creativity would be at all disruptive or disequilibrating; in a Misesian market economy, on the other hand, creativity would simply and smoothly change the remote equilibrium toward which the economy will be tending.” (Rothbard 1994: 560).In a world where the economy is in a state close to equilibrium and prices are normally near their long-run equilibrium values, expectations become “a trivial byproduct of the knowledge culled from past prices” (Salerno 2010: 232). That is to say, Hayekian theory has an utterly unrealistic view of the economy and of expectations. And this is according to Misesians, not non-Austrian critics of Hayek.
On the other side, Kirzner agreed that, for “Mises (as Salerno and Rothbard correctly point out) prices are not primarily signals economizing on the cost of communicating information” (Kirzner 2000: 159), but nevertheless Kirzner maintained the fundamental compatibility of Mises’s and Hayek’s viewpoints.
So what are the conclusions from all this? They are as follows:
(1) Austrians are deeply divided on the significance and even truth of Hayek’s “knowledge problem”;But the Misesians, even with their criticism, have no better theory.
(2) the Austrians cannot get their story straight on what it is that makes rational economic calculation in a planned economy impossible;
(3) there is some merit to the Misesian critique of Hayek, in that the Hayekian idea of an economy normally in “near equilibrium” or “proximal equilibrium” is wholly unrealistic and the role of prices in Hayek’s thought is erroneous.
Both Misesians and Hayekians live in a fantasy world, with respect to the price system. Both are dependent on the notion of universally flexible prices created by the dynamics of supply and demand curves, tending towards their market-clearing values. Both have failed to grasp the widespread reality and significance of fixprice markets and price administration. The real-world and widespread existence of fixprice markets “necessarily means that administered prices are not market-clearing prices and nor do they vary with each change in sales (or shift in the virtually non-existent market or enterprises ‘demand curve’)” (Lee 1994: 320, n. 18). Hence there is no reason why a market economy in general (outside of its flexprice markets) tends to equate supply with demand by means of flexible prices, and “in actual adjustment of supply and demand, prices play only a very subordinate role, if any [sc. role]” (Kaldor 1985: 25; my emphasis).
Hayek’s “knowledge problem” and his attempted solution are mostly a pseudo-problem and pseudo-answer, because Hayek was assuming a world in “proximal equilibrium,” without genuine uncertainty and without a proper role for diverging and subjective expectations.
To the extent that markets have coordination (as opposed to fictitious tendencies to long-run equilibrium states), they do so largely by “quantity signals,” that is, demand, sales volume, and signals from changes in inventories/stocks.
Moreover, profits are actively created and managed by means of cost of production plus profit markup pricing. The profit markup is often stable, which leads to some degree of stability of profits (Gu and Lee 2012: 461). Stable profits in turn allow stable margins for internal financing of investment (Melmiès 2012). The advantages of price setting to businesses include the reduction of the occurrence of price wars, goodwill relationships with customers, and stable selling costs (Gu and Lee 2012: 461). Empirical studies show that, outside given limits, businesses find that variations in their set prices produce no significant change in sales volume, and, above all, when prices are cut, this does not necessarily lead to changes in short term market sales (Gu and Lee 2012: 462). And experiments with prices adjusted downwards to a significant extent show that this causes a severe blow to profits, so severe indeed that enterprises quickly abandon all such experiments (Gu and Lee 2012: 461).
This is the reality of prices in a capitalist economy.
There is a further criticism of Hayek’s knowledge problem that can be made, according to Michael Emmett Brady.
Brady argues that Hayek’s concept of uncertainty and the role of knowledge are quite distinct from that of fundamental uncertainty as defined by Frank Knight and Keynes:
“Uncertainty for Hayek means that each individual decision maker only has a small piece of the puzzle. However, as a whole, the aggregated set of all decision makers have a complete set of all relevant knowledge. There are no pieces missing, lacking or unavailable from the puzzle. Market prices organize and synthesize the aggregate amount of knowledge so that market price signals, understood only by savvy, knowledgeable entrepreneurs, [eliminate] … any uncertainty.” (p. 14)BIBLIOGRAPHY
“Keynes, Knight and Schumpeter deny Hayek’s claim that the market generates price vectors which concentrate the knowledge so that savvy, knowledgeable entrepreneurs can act on this information and solve the problem of uncertainty. Uncertainty means vital important information is missing. Pieces from the puzzle are missing and will not turn up in the future” (p. 14).
“Hayek could not accept the standard concept of uncertainty as defined by Keynes, Knight and Schumpeter because it would then be impossible for market prices to concentrate knowledge that did not exist. In conclusion, nowhere in any of Hayek’s three articles on Knowledge in Economics in 1937, 1945 and 1947 does Hayek deal with the standard view that uncertainty means knowledge that is not there.” (p. 15).
Brady, Michael Emmett. “Comparing J.M. Keynes’s and F. von Hayek’s Differing Definitions of Uncertainty as it Relates to Knowledge,” January 30, 2011.
Gu, G. C. and F. S. Lee. 2012. “Prices and Pricing,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 456–463.
Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.
Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.
Hayek, F. A. von. 1945. “The Use of Knowledge in Society,” American Economic Review 35.4: 519–530.
Herbener, Jeffrey M. 1991. “Ludwig von Mises and the Austrian School of Economics,” Review of Austrian Economics 5.2: 33–50.
Lee, F. S. 1994. “From Post Keynesian to Historical Price Theory, Part 1: Facts, Theory and Empirically Grounded Pricing Model,” Review of Political Economy 6.3: 303–336.
Melmiès, J. 2012. “Price Rigidity,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.
Rothbard, Murray N. 1991. “The End of Socialism and the Calculation Debate Revisited,” Review of Austrian Economics 5.2: 51–76.
Rothbard, Murray N. 1992. “The Present State of Austrian Economics,” Working Paper from the Ludwig von Mises Institute, November.
Rothbard, Murray N. 1994. Review of Bruce Caldwell and Stephan Boehm (eds.), Austrian Economics: Tensions and New Directions, Southern Economic Journal 61.2: 559–560.
Salerno, Joseph T. 1990. “Ludwig von Mises as Social Rationalist,” Review of Austrian Economics 4: 26–54.
Salerno, Joseph T. 1991. “Commentary: The Concept of Coordination in Austrian Macroeconomics,” in Richard M. Ebeling (ed.), Austrian Economics, Perspectives on the Past and Prospects for the Future. Hillsdale College Press, Hillsdale, MI.
Salerno, Joseph T. 1993. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6.2: 113–146.
Salerno, Joseph T. 1994. “Reply to Leland B. Yeager on ‘Mises and Hayek on Calculation and Knowledge,’” Review of Austrian Economics 7.2: 111–125.
Salerno, Joseph T. 2010. Money, Sound and Unsound. Ludwig von Mises Institute, Auburn, Ala.