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Why Did Hayek Have to Shock His Scientific Peers Out of Their Complacency?

Summary:
Hayek, in the context of describing how the prices continually adapts and guide adjustments by the participants to changing circumstances without any central direction, uses the term "marvel" to depict the functioning of the price system (87).*  In fact, he says he chose the word deliberately to "shock the reader" out of their complacency.  Remember, this article was written for the American Economic Review, and his readers were his professional scientific peers.  He was not trying to explain the functioning of prices to a popular audience.  It was professional scientific economists who Hayek was trying to  them about what their discipline taught. In the early 1930s, Hayek firmly believed that a modern trained economist would understand market theory and the price system, and the

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Hayek, in the context of describing how the prices continually adapts and guide adjustments by the participants to changing circumstances without any central direction, uses the term "marvel" to depict the functioning of the price system (87).*  In fact, he says he chose the word deliberately to "shock the reader" out of their complacency.  Remember, this article was written for the American Economic Review, and his readers were his professional scientific peers.  He was not trying to explain the functioning of prices to a popular audience.  It was professional scientific economists who Hayek was trying to  them about what their discipline taught.

In the early 1930s, Hayek firmly believed that a modern trained economist would understand market theory and the price system, and the role of private property and the freedom of contract in not only allocating resources efficiently, but through the opportunity for pure profit the source for innovation and growth.  In short, the trained neoclassical economist would know and appreciate  the functioning of the market economy just as their classical political economy predecessors, but with more technical sophistication.  The burden of the argument, in other words, would be on those who wanted to suspend or suppress the market system to justify their arguments for planning or interventionism.  The public may have been ignorant of the functioning of the price system, but professionally trained economists were not.

So how surprised he must have been when in the 1930s, the most sophisticated arguments for planning and interventionism came not from critics of neoclassical economics, but from the best and the brightest within the neoclassical literature -- many of whom where Hayek's own students and colleagues at LSE.  In retrospect, many assert that classical and neoclassical economists were never as "market fundamentalist" as Hayek and others may have thought.  Concerns with inefficiency, instability, and injustice in an economic system are indeed old and a common-theme throughout the 18th, 19th and into the 20th centuries.  At the time we are discussing, the US and the UK are suffering through the Great Depression, and the threats of right wing and left wing authoritarianism are becoming widely recognized to those in the western democratic countries.  But still was Hayek so wrong?

I will argue shortly based on some passages from Marshall's Principles that Hayek was actually right about what was understood, and as we will also see shortly that the transformation of intellectual nature of economic theorizing during the 1930s and 1940s resulted in knowledge lost.  But first, lets go back in time from 1945 to 1940, when Hayek responds to the market socialists about the price system and the problem of economic calculation under central planning.  "The fact is that it has never been denied by anybody, except socialists, that these formal principles ought to apply to a socialist society, and the question raised by Mises and others was not whether they ought to apply but whether they could in practice by applied in the absence of a market." (183)  This is a critical point, because the price system works by constantly adjusting to changing circumstances so individuals can realize productive specialization and peaceful social cooperation.  If the price system does its work to the end, the optimality conditions that follow from all gains from trade being exhausted and all least cost technologies being discovered would result. But as Hayek pointed out in "The Use of Knowledge in Society" the problems that economic theory must address "arise always and only in consequence of change." (82) And, if our tools of reasoning preclude our studying the processes of adaptation and adjustment to changing circumstances, then it is our tools that are failing us. "Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people's knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain." (91) That task that must be explained, Hayek had stressed, was the continuous process by which the dispersed knowledge of time and place in the minds of diverse participants in the market is communicated and acquired by other participants in the market by the price system so they can coordinate their plans with one another and realize the gains from trade and the gains from innovation.  Economic theory from the classics to the neoclassicals taught the basic lesson about the functional significance of property, prices and profit/loss in alerting, cajoling, and disciplining participants in the market.  As Hayek put it in "Individualism: True and False", the chief concern of these writers was "to find a set of institutions by which man could be induced by his own choice and from motives which determined his ordinary conduct, to contribute as much as possible to the need of all others; and their discovery was that the system of private property did provide such inducements to a much greater extent than had yet been understood." (12-13)

That last quote was mainly directed as Adam Smith and his contemporaries, but it can also be seen in the teaching of all the classical economists and early neoclassical economics from Smith to Alfred Marshall.  Marshall was the dominating figure in British economic thought and teaching from the 1890s to the 1930s.  His direct students held over half of all the chaired professorships in economics in the United Kingdom and the students of his students filled almost every teaching post throughout the United Kingdom.  His teaching spread through the US through the work of Jacob Viner and Frank Knight as well, as his textbook was used almost till mid-20th century before it was replaced.  I am working from the 8th edition, and I haven't checked earlier editions for consistency, but the quotes are extremely telling for the point Hayek was making.

On page 269, the first page of Book V which is a discussion of those principles of price theory that Hayek mentioned above, we are told that while the equilibrium position provides the "theoretical backbone" the general relations of demand and supply are "connected with the adjustment of price".  In the subsequent pages, we will learn from Marshall about the logic of the law of one price, as well as the principle of substitution which in turn leads to the equi-marginal principle.  But we also learn that "It is not indeed necessary for our argument that any dealers should have a thorough knowledge of the circumstances of the market." (278) The adaptations and adjustments on the market guided by relative prices do not require any concept of perfect knowledge.   These adaptations and adjustments are bring "into play forces" that steer the market process in the same way that "if a stone hanging by a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position."  But, Marshall continues, "in real life such oscillations are seldom as rhythmical as those of a stone hanging freely from a string; the comparison would be more exact if the string were supposed to hand in the troubled waters of a mill-race, whose stream was at one time allowed to flow freely, and at another partially cut off.  Nor are these complexities sufficient to illustrate all the disturbances with which the economist and the merchant alike are forced to concern themselves." (288)

Well, lets consider the plight of businessmen in their commercial ventures according to Marshall, "who bears the penalty of any error in his judgment; and who, if his judgment is approved by events, benefits the community as well as himself. Let him be considering whether to erect dwelling houses, or warehouses, or factories, or shops." (297) He must estimate the costs and he must anticipate what price he may be able to charge. "He brings this estimate of cost into relation with the estimate of the price he is likely to get for any given building together with its site.  If he can find no case in which the demand price exceeds his outlays by enough to yield him a good profit, with some margin against risks, he may remain idle." (298)

Indeed, it is "the alert business man" (ibid.) that must deploy his judgment to push investments in this or that direction.  He must engage, Marshall is telling us just as Mises and Hayek later stressed, in rational economic calculation.  There must be a mechanism in place that can sort between the array of technologically feasible production projects for those that are economically viable.  And, Marshall tells us, the alert business man "never assumes that roundabout methods will be remunerative in the long run. But, he is always on the look out for roundabout methods that promise to be more effective in proportion to their cost than direct methods; and he adopts the best of them, if it lies within his means." (299)

Marshall, just like the Austrian economists, was concern with the coordination of economic activities through time, and thus the market processes that guide investment and production decisions, as well as exchange and consumption decisions.  Both sides are, as Marshall says, "calculating" to discover, to learn, to strive for the least cost and most beneficial path for to achieve their ends.  It is a process of continuous adaptation and adjustment to changing circumstances and how this process works is through the movement of prices.  Economic forces at work are studied by looking at price adjustments and the multiple margins of adjustment that are made on both sides of the market to changes, and how those adjustments bring about the balancing of supply and demand and the tendency toward equilibrium.  As my colleague Richard Wagner likes to say, equilibrium propositions are in the background, but the processes of adjustment are in the foreground of analysis in the classical political economists and the early neoclassical economists.  In the 1930s this intellectual orientation began to switch, and for those educated after the orientation shift find it often impossible to capture this earlier dynamic adjustment economics and what it means for scientific inquiry.

Hayek was caught by surprise in the 1930s and 1940s and it lead him in a variety of directions to get economics back on track by first recapturing the Smithian political economy project and the translating the Austrian schools technical refinement of the classical system.  Knowledge was definitely lost, and it had to be regained.  Thankfully, while Mises and Hayek were among the first, they weren't alone, and in the postWWII period this richer understanding of market theory and the price system would emerge in the work of Alchian, Buchanan, Coase, Demsetz, Kirzner, North, and Vernon Smith.  None of these developments relied on perfectly rational actors with full and complete information interacting in zero transaction costs environments.  "The continuous flow of goods and services," Hayek stressed, "is maintained by constant deliberate adjustments, by new dispositions made every day in the light of circumstances not known the day before, by B stepping in at once when A fails to deliver." (83) The adjustments in the market are never "perfect", but they are ongoing and as Hayek stressed the model of general competitive equilibrium made economists "blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency." (87)**

The work is straightening all this out is still before the new generation of economists, and if they hope to make progress they will need to "shock" other professional economists out of their complacency.  Contemporary discussions of monopoly, monopsony, even inequality and mobility all are begging for a price theoretic and market process analysis.

*Hayek, "The Use of Knowledge in Society" was published in the AER in 1945, all my citations to Hayek will be to the reprints of his articles in Individualism and Economic Order (Chicago, IL: University of Chicago Press, 1948).

**Liberty Matters (September) is hosting a dialogue this month on many of these issues.

Peter Boettke
Peter Joseph Boettke (January 3, 1960) is an American economist of the Austrian School. He is currently a University Professor of Economics and Philosophy at George Mason University; the BB&T Professor for the Study of Capitalism, Vice President for Research, and Director of the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at GMU.

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