Saturday, 3 December 2016

The Humble Economist

Most of my friends would consider this title a contradiction in terms. A laughable description, perhaps even ironic. And I would agree. Very few economists are humble, yours truly included. We draw conclusions on theory or evidence, more or less rigorous, we play amateur political philosophers from time to time  what my lefty/sociology friends like to call 'Economic Imperialism'  and we make positive or normative judgements about individuals' psychology. We design models, often highly-sophisticated mathematical models, capturing various parts of the world, trying to imitate the world and its vast outcomes as (in)accurately as possible.

But the real task of a real economist is to reach the following insight:
The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. - Hayek (1988)
Paul Krugman has an infamous quote about an Economist's Creed ("I understand the Principle of Comparative Advantage" and therefore "I advocate Free Trade." ). Oddly enough, I find myself in agreement with Dr. Krugman, but would add Hayek's quote from The Fatal Conceit above; that's really the essence of economics, as two friends inadvertently reminded me of yesterday.

Let me develop the meaning and implication of this a little bit more.

Hayek's great contribution to economic theory is captured in his well-known essay The Use of Knowledge in Society. Although hardly an easy read, its central message is simple enough: markets work because prices send information. That information allows us to act in accordance with everyone else, allows us to form plans about the future that are coherent and consistent with the plans of others. That is, Hayek realizes the fundamental truth long since learned (and surprisingly often unlearned) in the economics profession that opportunity costs exist; there is no free lunch. Use of resources for some purpose precludes the use of those resources for some other purposes elsewhere. The Use of Knowledge in Society teaches us that in order for society to function we need a system that makes our future plans about those resource compatible with one another. If I want to drink this glass of orange juice in the next hour, and my flatmate has the same plan for the same glass of orange juice there is conflict. Some less-sophisticated ways of solving this conflict is me bashing him in the head. The more sophisticated version is communication and negotiation. In this simple example it's easy enough to simply speak to one another and agree on who gets the orange juice, but for millions of people in global supply chains of complex products, that's virtually impossible. Instead, by relying on markets and prices, we convey the same information: those who can use resources most profitably and better serve the wants and desires of consumers, more urgently, get access to them.

But the brilliance hardly stops there. The value of this information system is even better under changing conditions. Hayek's famous example uses an increase in the demand for tin. World prices of tin are bid up, which gives consumers and businesses using tin a tangible signal (= the price) to cut back on their less-essential usage; some of their use of tin is now more urgently needed elsewhere. How could they know? The simply use profit-and-loss calculations to determine if that same amount of tin at higher prices can be profitably used at these higher prices. But the change in prices also work for producers of tins, who are given a very good instruction to mine more  often tin that was prohibitively expensive to access at the lower prices, but can now, at higher prices, be mined. The beauty here is that neither participant need to know why there is higher demand for tin.

Where I ultimately want to go with this is the following untenable critique against Hayek, that this market-price-story somehow should run counter to (radical) uncertainty that I was praising the other week. This concept, as understood by Keynes or Knight or Schumpeter (or, for that matter, Hayek's mentor Mises), contrary to what many critics may claim, is perfectly compatible with Hayek's argument. This is blogger Lord Keynes quoting economist Michael Brady:
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. (Brady 2011: 15).
While this is all true, its ability to destroy Hayek's idea is virtually non-existent. The hurdle Hayek's argument has to overcome is not complete information (as visualized in Economists' models Perfect Information) of present, past and future, but the much easier target of relativity; it only has to deal with new, previously non-existent information better than any alternative system. Which leads me into the most important implication of this idea: most government activity doesn't incorporate this, and is thus redundant. There is no generally no market price for taxation or regulation or welfare benefits or minimum wage laws and the incentives for such systems are all perversely misaligned, often contrary to their stated purpose.

Radical uncertainty is real and a great many things backfire on our presumptious attempts at control top-down or centrally plan aspects of our economies. We cannot control something that we do not understand, and so we should, in political philosopher Michael Huemer's brilliant words (In Praise of Passivity) err on the side of political passivity. Hayek's knowledge problem means that any government action is less able to incorporate dispersed knowledge among multitudes of individuals, than its comparable market system. In no way is that an appeal to perfect information, but such unattainable goals are nirvana fallacies anyway, and so we can safely discard them. 

Letting go of our childish notion and uneducated conviction that more (or "better") governments can solve economic ills is the core lesson of Hayek's work; central planning does not – and cannot – have enough information do work better than markets. That's the humble lesson every economist has to learn and the real take-away point of the socialist calculation debate, especially for those in favour of expanded governments. 

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