The socialist calculation debate Karen I Vaughn

The socialist calculation debate is an episode in twentieth-century economic thought that has special significance for Austrian economics. On one side of the debate were economists either trained or influenced by the Austrian tradition of Menger, Wieser and Bohm-Bawerk who believed socialism and central planning could not improve upon the economic performance of a regime of private property and free markets. On the other side were professional neoclassical economists who were critical of market economics because of their perceived failures to achieve full employment, equitable income distributions and rational investment and who wished to find some method of central planning that would duplicate the potential efficiency of free markets without suffering their very real shortcomings.

The events of the debate are easily recounted (Vaughn, 1980). It began in 1920 when Ludwig von Mises wrote an article claiming that socialist central planning was inherently irrational and hence impossible to achieve. Mises was answered, directly and indirectly, by neoclassical economists such as H.D. Dickinson, Maurice Dobb, Abba Lerner and Oskar Lange who understood his reasoning but believed they could design a socialist economy that met Mises's objections and would actually improve upon the economic performance of market economies. Friedrich Hayek, Mises's younger colleague, entered the fray in the 1930s and wrote a series of profound critiques of socialism that were largely misunderstood by the opposition. By the mid-1940s, conventional opinion held that Mises had been wrong and socialism was in fact possible, and the Austrians lost the debate. That opinion was to hold for most of the next 40 years, until the disintegration of communism and the obvious economic failures of central planning required a re-evaluation of the Austrian arguments.

Despite the Austrian school's putative defeat, the debate was a watershed event in the development of Austrian economics. What began as a challenge to conventional views about the feasibility of central planning evolved into a debate not only about alternative political and economics institutions, but also about the status ami usefulness of neoclassical economic theory itself. During the course ol the mote than 20 years during which the debate was carried on, Austrian economics underwent a transformation that eventually redefined what Austrian ci nnomics meant and what it had to contribute to economic science ( Vaughn, 1990) Many of the issues first raised during this m

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ili hale arc unresolved in either the Austrian 01 the < hum niinual hum la-.sn ,d literature to this day.

Mises and the old Marxists

I hc set of writings that were to constitute the debate ovn • • niiouin . ah ula lion tinder socialism were generally responses to Mines aillcle, I • "iionu.

• alculation in the socialist commonwealth' (1920) This artii le was din • led ptitnarily at an audience of older Marxists who, despite their heliel in die superiority of conscious control of economic life, were astonishingly iiik on cerned about the details of actually running a centrally planned economy

II avoie, 1985, pp. 28ff). Many of them believed it was enough to eliminate private property and money in order to eliminate scarcity. What plans they did advocate for running a socialist society paid little attention to the ac i tainting that would be necessary to make certain that income matched out goings, let alone to efficient use of resources.

Mises, reiterating arguments made earlier by Wieser and Barone (Hayek, 19 VS, pp. 245ff) argued that the economic problem of managing scarcity was unavoidable in the real world and would be no less a problem for a socialist as for a capitalist economic order. In a capitalist regime, the way resources were managed was through private property and exchange in markets The necessary accounting that makes certain that expenditures do not exceed Income and that measures in some way the efficiency of resource use. he argued, were market prices. Prices are ratios of exchange values, ami hem e are necessary to allow people to weigh the relative values ol' alternatives and to make 'economic' decisions. Not only did Mises assert the impoiiam e id prices to making rational economics decisions, he also insisted dial the only way in which meaningful prices could be established wns In a regime ol private property and free exchange. Central planners might try to decree prices for resource management but, unless these prices bore a close relation ship to the way individuals value alternative goods, they would be meaning less. And the only way to ensure that prices bore the required relationship to individual judgements of value is to allow them to be established freely in markets. Socialist economy, therefore, was impossible.

Mises not only charged socialism with being unable to establish prices that actually measured relative resource scarcities, he also criticized the ability of central planning to produce the goods and services that needed to be priced. State-run firms, he argued, where managers were neither owners nor respon sible to owners, would be riddled with inefficiencies. Without the incentives that llow from property ownership, managers would act irresponsibly with the resources under their direction, tending to take greater risks with tin linn's resources than would private managers. There would be lilllc dlieil accountability to consumers.

To modern ears, Mises's argument might seem incomplete, but it does not seem very radical. Certainly, the claim that prices are necessary for efficient economic choice is well established and that bureaucrats face different incentives from workers in the private sector is by now totally uncontroversial, What seemed intolerable to Mises's contemporaries, however, was his insistence that only free markets and private firms could establish economically meaningful prices and produce wealth efficiently. This was regarded as a gross overstatement of the advantages of the free market. Surely, given the economists' knowledge of mathematics and statistics, it would be possible for prices to be established in some other more 'equitable' way than through the rough and tumble of the market.

The socialist solution

While Mises's argument may not have convinced dyed-in-the-wool Marxists, he did present a challenge to conventional neoclassical economists who understood the necessity of prices for efficient resource allocation but who were also critical of the market failures associated with capitalism. They took it for granted that central planning was the way to correct those failures and concentrated their attention on trying to find ways to duplicate the efficiency of market pricing in socialist regimes.

Some of the proposals were reflections of the economics profession's newly developing romance with mathematics and statistics. Hence several economists (see in particular Dickinson, 1933) proposed variations on the theme of using extensive statistical sampling to estimate demand equations for all relevant goods and, together with estimated production functions, 'solving' for equilibrium prices. They were subject to swift and telling rebuttal by critics, the foremost being Friedrich Hayek. As a professor at the London School of Economics from 1932, Hayek was in the thick of the attempts by socialist economists to resolve the problem of planning. In his response to the proposals to set prices via central planning, Hayek raised issues that were to define the Austrian side of the socialist calculation debate.

Hayek basically had two kinds of arguments against the socialist proposals. The first had to do with the kind of knowledge socialist planners would be able to employ in their decision making and the second had to do with the incentives facing actors in socialist economic institutions. For example, contrary Id the 'mathematical solution' to socialist planning, Hayek argued that, in an advanced economy, Ihere are typically hundreds of thousands of products bough) .mil '.old every day. Even if it were possible to define all of the products to be priced, il would be a virtual impossibility either to gather enough relevant data to specify the demand and supply equations or to actually solve a system ol hundreds of thousands of simultaneous equations

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(especially without the aid of computers, as wns iln < . * -. * in I'JIIM (Haw I 1935, pp. 209-13).

While Hayek had a number of other cogcnl ciillelsiii' tin mh mli .ii iool> llus one to heart immediately. As a consequence, one ol tIt« h iiuiobi i «> .l n I.nnge, devised an ingenious system to generate econoinli pin • in a • hi hally planned economy that did not require widespread ,iaii>.iic al daia gath ering or the solving of numerous simultaneous equations bin siill yn Ided e(|uilibrium prices that duplicated the success ol the market while setting up iin institutional structure that would also guarantee a fairer income disinhu lion than capitalism was capable of achieving.

Lunge's trial and error solution

Lange's solution (1939) to the problem of pricing in a centrally planned economy is worth examining for several reasons. First, for over 50 years it was regarded by professional economists as the answer to Mises and to the Austrian criticism of rational central planning. Second, it demonstrates in a clear-cut form the way economists understood both the workings of an actual economy and the relationship of economic theory to economic reality. The simultaneous equation' solution to pricing under socialism was an attempt to employ the mathematics of Walrasian general equilibrium theory. Lunge also attempted to employ Walrasian theory, but from a different perspective lb-argued that a socialist economy could be run in the following way All consumer goods would be bought and sold in private markets, but 'thr menus of production' would be produced in state firms that would he uud< i tin direction of the central planning board (hereaflei, CPU) Tin ( I'll unuld communicate a set of prices to the state firms and the linns would be in structed to minimize cost subject to those prices The Inilllaiu < ol l ang« plan was that it was irrelevant what the initial prices at fun 11 v n uin • tin firms would also be instructed to communicate to lire < I'M anv itiiplu • - m shortages of goods. From that information, the < I'M. acting as Walia-auctioneer, would either raise or lower price ai i oidingly llein i . |i.isl as m real markets, prices would be the consequent c ol a iiitouneiuenl' oi D ial and error process that would eventually settle into equilibrium Tins obviated the need for detailed statistical knowledge ol supply and demand anil allowed the C !PB to operate effectively on a minimum ol mloi million

Hayek responded to this scheme by raising olqci lions that were latci to he recognized as being particularly Austrian Insiphis into the naluie ol a mm I • i economy. He argued first that it would be viilually Impossible loi a < I'll correctly to define all the products that are bought ami sold even in i apilal goods markets. Lange was tacitly assuming all pnulm i ib|uiivi|y definable and easily categorizable. Rather, llayel ai|im .1 - a|>iial I >m t<

heterogeneous in nature, often tailored to the Individual n i III I angi scheme, the CPB would set prices, not for real goods that people wish to buy and sell, but statistically tractable aggregates that suited no one in particular (Hayek, 1948, pp. 188-9, 193).

Hayek also argued that the products that people buy and sell are not solely objective entities. There is a large non-material component to goods, involving, for example, ease of availability, quality of service or reputation of supplier, that could not figure in government statistics. Even if goods could be correctly defined, however, Hayek believed that trial and error pricing was still doomed to failure because it could not respond as quickly or in the same way to changes in economic conditions as could individuals operating in decentralized markets. Lange's error was to presume that, once established, equilibrium prices would remain stable for long enough periods of time for CPB prices to be relevant to efficient decision making. At the time, Hayek argued that the socialists suffered from an excessive preoccupation with equilibrium states (1948, p. 188) to the exclusion of consideration of market processes. The implication was that equilibrium was a useful tool for organizing theories about the direction of change of market prices but that, in real life, prices were constantly undergoing a myriad of small adjustments made by actual buyers and sellers in response to changing conditions. Centrally directed trial and error pricing could not duplicate the efficiency of these small adjustments because they would be looking at statistics rather than actual conditions in markets.

This line of argument led Hayek to emphasize the importance of specialized, particularized knowledge for the efficient operation of market systems. The knowledge that is important in markets is not usually scientific, abstract knowledge such as is assumed, for example, in the theory of production functions, but detailed knowledge of 'time and place' that an actor may not even know he possesses until called upon to make a decision. Hayek was later to emphasize even more the role of tacit or inarticulate knowledge in markets, leading Austrians to adopt the 'knowledge problem' as a central concern of their research.

Like. Mises before him, Hayek also objected to the cavalier way state firms were imagined to behave under socialism. Hayek also argued that the incentive structure facing state employees was relevant to their behavior and that they would be unlikely to behave in the same way as private workers (1948, pp. 198 9) Where Mises had argued that they would engage in more risky behavior Mince Iheir own weallh was not at stake, Hayek presented a more convincing picture ol state managers who would be loath to take any risk at all for feat that a negative irsult could not be justified after the fact. He reasoned that all prodin Hon derisions were based on conjectures about future states of the world that* ould not be predicted with certainty. Even costs were not objective numbers but the subjectively estimated value of imagined for-

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giinc alternatives. Hence, where a manager's ilni .mn windd 1« aih|o« I In review hy a higher and more remote authority, that mming» i would liy in make decisions that could easily be justified according i• • iepi>iiabl> • hi. n i lather than the decision that seemed more profitable aciotdlng In hi . nvvn specialized or personal knowledge.

Despite Hayek's many telling criticisms of market socialism, hy ill» mi.I

.11«- of the 1940s the Austrians were considered by the economU s pn»l»->

to have lost the debate. The mainstream of the profession an epted the Ingh al cogency of Lange's plan and regarded Hayek's criticisms as mium cnmplh a linns that in no way undercut the possibility of socialism. It was not until the 1990s, when the Soviet Union imploded, and when formerly communist muntries all over the world were trying to reintroduce market economies as quickly as they could, that it was generally conceded that the Austrians had been correct after all in their assessment of the possibility of a centrally planned economy that could match the efficiency of capitalism.

While history may have presented a practical vindication of Mises and Hayek, on the theoretical level, aspects of the debate are still being waged. I lie heart of the Austrian critique (admittedly only fully articulated even by Austrians in the last decade) is that static equilibrium theory does not capture the important features of real market economies. Not only individual valuations aie subjective in nature; so are expectations and the knowledge they hold about the real world. Indeed, Hayek's early conjectures about economi« s and knowledge have become a primary focus of the modern Austiian school Similarly, the rejection of static equilibrium as a tool for designing an eco nomic system has led to an investigation of the importance ol real lime t»> mil understanding of economic theory. The early recognition ul the Inconilvi s problem in socialist firms led Austrians to question the gennal lelaiionshlp between institutions, rules structures and market activity And dually, llnytl liustrations during the calculation debate led him to irasseil in mnie modem form the eighteenth-century discovery of markets as essentially unplanned and unplannable social orders, thereby providing Auslilans with an aitlcula tion of their paradigm. How they will carry that tesearch forward in the future is still to be seen.

See nlso:

Chapter 4: Market process; Chapter 25: Priccs um! kiiowledye, ( 'hnplci M c '»tinptflltlmi.

t 'huptcr 33: Comparative economic systems

Bibliography

Dickinson, H.D. (1933), 'Price Formation in a Soclullll < ..minium y /. ."iniiih •'

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