History of thought course video: Hayek and the knowledge problem

Not surprisingly, given the title of this blog and the focus of my research, the last video in the series for my history of economic thought course provides an introduction to Hayek and the knowledge problem.

Hayek’s work in the 20th century explored a range of ideas, one of the most important of which was the argument that the fundamental economic challenge in a society is the coordination of plans and actions among agents in an economy, all of whom have diverse goals and make choices based on their own perceptions and private knowledge. The knowledge problem has implications for questions from the socialist calculation debate of the 1920s and 1930s to the modern policy analyses of the regulatory state.

Happy birthday Hayek!

Lynne Kiesling

Today’s Hayek’s birthday, a worthwhile landmark for reflection on his work and why it’s important to read. I assign “The Use of Knowledge in Society” in every class I teach, and I recommend it if you haven’t yet read it. Here Hayek argues that the fundamental economic problem societies face is not the allocation of a given set of resources based on a given set of preferences and technical capabilities; instead, the coordination of decisions and actions among interacting individual agents with diffuse private knowledge and plans forms the basis of economic activity. The diffuse and private nature of knowledge hampers such plan coordination, but out of human interaction, institutions emerge that enable decentralized coordination. Prices and market processes compose an institution for coordination in the face of the knowledge problem. Moreover, Hayek argued, knowledge transcends “scientific” information, there is no given and uniform set or distribution of data, and such information fails to capture all knowledge relevant to both static and dynamic decision-making and coordination.

Hayek’s substantial insight in this work, one that has become largely incorporated into mainstream economics, is that the price system operating through market processes is an effective, parsimonious (but not perfect) means of generating, signaling, and aggregating such knowledge. Prices cannot convey all individual knowledge pertinent to a particular economic decision, but they do serve as knowledge surrogates by communicating some private knowledge (Horwitz 2004). Coordination of individual actions and plans emerges as a beneficial consequence of the price system; thus the price system and market processes enable emergent, or unplanned, order.

Hayek characterized the fundamental economic problem not as the static allocation of scarce resources among uses by omniscient agents, but rather as the coordination of actions and plans among dispersed agents with diffuse private knowledge. In his statement that “… the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess” (p. 519), Hayek draws on the earlier arguments of the socialist calculation debate and of his (1937) work. The “man on the spot” (p. 524) has subjective, private knowledge of “the particular circumstances of time and place” (p. 522), and that knowledge is among the decision-relevant data that cannot be aggregated except through a decentralized system of prices and a market process of exchange to determine those prices. Prices economize on the communication and interpretation of knowledge among dispersed agents.

How do individuals learn the plans of others? How do we learn when we are wrong and take action accordingly? Prices and market processes provide feedback channels. Feedback loops, learning, adaptation to a changing environment and changing actions and plans of others, interdependence of agents and their actions in a complex system, and how prices and markets serve as feedback loops making a complex system adaptive – all are important implications of Hayek’s argument. Prices provide profit opportunities and realized profits, and those realized profits serve as feedback that can spur the discovery of new products, services, business models, or other ways to create value through economic activity. Alert entrepreneurs see these opportunities, learn from observed and realized feedback, and adapt their plans accordingly. Prices enable “error detection and correction within the market” (Boettke 1998, p. 135). Markets are processes for social learning and provide feedback channels for entrepreneurial alertness.

This post is drawn from my article, “Knowledge Problem” (SSRN link), which is included in the forthcoming Oxford Handbook of Austrian Economics (Peter Boettke and Chris Coyne, eds.).

New paper: Knowledge Problem

Lynne Kiesling

I have a new paper that may be of interest to KP readers, since the subject of the paper is the same as the name of this site: Knowledge Problem. I am honored to have been invited to contribute this paper to the forthcoming Oxford Encyclopedia of Austrian Economics (Peter Boettke and Chris Coyne, eds.). Here’s the abstract:

Hayek’s (1945) elaboration of the difficulty of aggregating diffuse private knowledge is the best-known articulation of the knowledge problem, and is an example of the difficulty of coordinating individual plans and choices in the ubiquitous and unavoidable presence of dispersed, private, subjective knowledge; prices communicate some of this private knowledge and thus serve as knowledge surrogates. The knowledge problem has a deep provenance in economics and epistemology. Subsequent scholars have also developed the knowledge problem in various directions, and have applied it to areas such as robust political economy. In fact, the knowledge problem is a deep epistemological challenge, one with which several scholars in the Austrian tradition have grappled. This essay analyzes the development of the knowledge problem in its two main categories: the complexity knowledge problem (coordination in the face of diffuse private knowledge) and the contextual knowledge problem (some knowledge relevant to such coordination does not exist outside of the market context). It also provides an overview of the development of the knowledge problem as a concept that has both complexity and epistemic dimensions, the knowledge problemʼs relation to and differences from modern game theory and mechanism design, and its implications for institutional design and robust political economy.

In this paper I analyze the development of the two categories of the knowledge problem — the complexity knowledge problem and the contextual knowledge problem — and explore both the history of the development of these concepts and their application in robust political economy and new institutional economics. As is the hallmark of a good research project, I think on balance I learned more than I created in the process of writing this paper.

One other thing I made sure to include was a discussion of how the knowledge problem and its development relates to game theory and mechanism design, through the work of Oskar Morgenstern (and then through some of the work of Herb Simon and Vernon Smith, among others).

Tying together economics, institutional design, history of thought, and epistemology, I hope you find this paper informative and useful! I’ll also make sure to update when the full volume is available.

An example of what not to do in persuasion

Lynne Kiesling

Alex Tabarrok has an excellent post this morning at Marginal Revolution:

David Warsh and Paul Krugman try to write Hayek out of the history of macroeconomics. …

It is true that many of Hayek’s specific ideas about business cycles vanished from the mainstream discussion under the Keynesian juggernaut but what Krugman and Warsh miss is that Hayek’s vision of how to think about macroeconomics came back with a vengeance in the 1970s. …

… Hayek was an important inspiration in the modern program to build macroeconomics on microfoundations. The major connecting figure here is Lucas who cites Hayek in some of his key pieces and who long considered himself a kind of Austrian.

I offer this as a cautionary “what not to do” note to students in particular, but also to all of us. In the piece to which Alex is responding Krugman chooses his definition of “modern macroeconomics” in a way that clearly maps into his preconceptions and reflects his confirmation bias. Such a rhetorical stratagem is unscientific and anti-intellectual. It’s also easy to critique (no disrespect intended for Alex’s good, pointed critique) by simply looking at the literature and seeing that modern macro encompasses a breadth of ideas and approaches, many of which are substantially informed by models and methodological approaches that Krugman chooses to reject.

Thus both on intellectual grounds and with a view toward crafting an argument that is persuasive to those who don’t already agree with you and share your worldview, don’t do this. Being more ecumenical and treating the contributions of your intellectual opponents with respect will make your arguments more thorough, effective, and persuasive.

On a substantive note, I’d like to echo the recommendation that Jacob Levy made in the comments on Alex’s post; the conclusion of Warsh’s essay is a good one, and suggests that incorporating more of a complexity approach into macro would enable us to build better models:

That said, it is pleasing to think that Hayek himself may yet turn out to have been a very great economist after all, far more significant than Myrdal or Robinson, when seen against the background of a broader canvas. The proposition that markets are fundamentally evolutionary mechanisms runs through Hayek’s work. Caldwell, of Duke University, notes that, starting with the Constitution of Liberty, “the twin ideas of evolution and spontaneous order” become prominent, especially the idea of cultural evolution, with its emphasis on rules, norms, and decentralization.

These are today lively concepts in laboratories and universities around the world. “It could have been that Hayek was running a different race, and the fact that he didn’t do well in the Walrasian race was that he wasn’t running in it—he was running in the complexity race,” says David Colander, of Middlebury College. Hayek may yet enter history as a prophet of evolutionary economics, a discipline dreamt of since the days of Thorstein Veblen and Alfred Marshall in the late nineteenth century but not yet forged, whose great days lie ahead.

UPDATE: See also Pete Boettke on this same theme, motivated by Alex’s post.

Penn Jillette and Hayek: “I don’t know”

Lynne Kiesling

Penn Jillette, the taller and more vocal half of the magic performance duo Penn & Teller, has written a lovely and thoughtful essay as a companion to his appearance last night on Piers Morgan’s CNN show. It defies excerpting, so I encourage you to click through and read it in its entirety.

His theme: “I don’t know”, particularly with respect to religion and to helping the poor, leading him to conclude that he is an atheist libertarian. For example, about helping the poor he writes

Then he asked me what we could do to help poor people. I said I donated money, food, medical care, and services and he said, “No,” he meant, what could society do to solve the problem of poor people. Again, I was stumped.

He said the government had to do it, which I interpreted as another way of saying he didn’t know, but he thought that made me look mean … even though I do care and do try to help. …

And I don’t think anyone really knows how to help everyone. I don’t even know what’s best for me. Take my uncertainty about what’s best for me and multiply that by every combination of the over 300 million people in the United States and I have no idea what the government should do.

In this essay Jillette is channeling some of the most important ideas about the knowledge problem developed by Hayek and others, ideas that are the foundation of what we do here at KP — the limits of individual knowledge, the necessary limits of collective knowledge, and the humility that should arise as a consequence, both individually and in collective action/policy situations. Jillette is also channeling a lot of David Hume’s skepticism, not just in terms of religion but also in terms of empiricism and the limits of human reason.

Jillette’s essay is also charming in tone, reflecting respect for those who disagree with him and those with different life experiences and abilities. A very thought-provoking read.

Quote of the day: Hayek on expediency and freedom

Lynne Kiesling

Pace Don Boudreaux for my shamelessly copying his “quote of the day” meme … my quote of the day is this striking one from Hayek’s essay “Principles or Expediency” (1971):

From the insight that the benefits of civilization rest on the use of more knowledge than can be used in any deliberately concerted effort, it follows that it is not in our power to build a desirable society by simply putting together the particular elements that by themselves appear desirable. Though probably all beneficial improvements must be piecemeal, if the separate steps are not guided by a body of coherent principles, the outcome is likely to be a suppression of individual freedom.

The reason for this is very simple though not generally understood. Since the value of freedom rests on the opportunities it provides for unforeseen and unpredictable actions, we will rarely know what we lose through a particular restriction of freedom. Any such restriction, any coercion other than the enforcement of general rules, will aim at the achievement of some foreseeable particular result, but what is prevented by it will usually not be known. The indirect effects of any interference with the market order will be near and clearly visible in most cases, while the more indirect and remote effects will mostly be unknown and will therefore be disregarded. We shall never be aware of all the costs of achieving particular results by such interference.

And so, when we decide each issue solely on what appears to be its individual merits, we always overestimate the advantages of central direction. Our choice will regularly appear to be one between a certain known and tangible gain and the mere probability of the prevention of some unknown beneficial action by unknown persons.

Certainly captures some themes we’ve been exploring around here lately.

Sidney Hook’s 1960 review of Hayek’s “The Constitution of Liberty”

Michael Giberson

Francis Fukuyama’s review of the new edition of F. A. Hayek’s “The Constitution of Liberty” has prompted a small eruption of commentary in the econoblogosphere.  (See here and here, for example.)

I thought there might be some interest in Sidney Hook’s review of the original edition of “The Constitution of Liberty,” published in the New York Times Book Review on February 12, 1960. Here is an extensive selection from the review:

Of Tradition and Change

by Sidney Hook

Even those who accept little of his argument will find Friedrich A. Hayek’s comprehensive analysis of the nature of freedom an interesting and provocative work. “The Constitution of Liberty” develops the basic assumptions from which he derived the views expressed fifteen years ago in his book “The Road to Serfdom.” They are applied in a free-ranging way to an impressive variety of themes and social disciplines. The result is a reflective, often biting, commentary on the nature of our society and its dominant thought by one who is passionately opposed to the coercion of human beings by the arbitrary will of others, who puts liberty above welfare, and is sanguine that greater welfare will thereby ensure.

Admitting that there are few who would openly oppose the value of liberty, Mr. Hayek, who is Professor of Social and Moral Science at the University of Chicago, contends that its traditions and safeguards are constantly being eroded in the democratic welfare states of Europe and America. Economic and other social controls have invaded what should be regarded as man’s private sphere. While the Communist threat to the survival of free society may be more immediate, the more formidable danger comes from within in the form of a poisonous ideology wrapped in a dough of flabby rhetoric about democracy, iced over with sugary formulae of goodwill and social justice.

The first two parts of the book concern themselves with the value of freedom and its relation to the rule of law; the third is devoted to showing how these are subverted by the measures of the welfare state all along the line. In a concluding eloquent postscript, “Why I am not a conservative,” the author indicts the Conservatives, especially in England, for being somewhat infected with socialist principles, as shown by their fear of uncontrolled social forces, and their efforts to discredit free enterprise, especially in agriculture. […]

There are two clear merits possessed by this book outside of the validity of its argument. It has a courage and honest not often avowed by those opposed to modern trends of social legislation. The author does not believe in mitigating social inequalities or even establishing equality of opportunity. He is opposed to any measures which would curtail the accidental advantages not only of being better endowed by nature but of being socially better born.

The law can protect mean only in their liberty to get as much property as the rules of the market permit; it should not be used to redistribute income and consequent privilege merely because it turns out that to those who hath shall be given and from those who hath not shall be taken away. Progressive taxation is discriminatory against the rich. A tax should consist of the same proportion of a man’s income whether he earns ten hundred or ten million dollars. That this would cut into one man’s food, but only into another’s number of yachts is irrelevant. The price of liberty, so conceived, is so high one wonders why anyone not well endowed would want it.

The second and greater merit of Mr. Hayek’s work is that it challenges the first principles of any view in which in the interest of human welfare and social justice seeks some control of the economy. This embraces not only Socialists, New and Fair Dealers but also Herbert Hoover. Every generation takes its first principles too much for granted. It is a salutary experience to rethink them in light of their alternatives.

Only a treatise as long as Mr. Hayek’s could do critical justice to it. One can challenge his failure to grasp the ways in which private property as well as public can be used to control the lives and freedom of those dependent upon it for their livelihood. One can challenge his assumption that a theory of market prices can take the place of a theory of social justice. More far reaching, however, in its practical implications is his notion that the original sin of the social reformer consists in the view that human intelligence can direct or control social change. According to the author wisdom must rely only on the slow non-rational processes of trial and error, on the traditions and customs of the past rather than on human plans and contrivance. […]

It is demonstrable that Hayek suffers from the defects of the very rationalism he condemns. His antitheses between tradition and reason, experience and experiment, are analytically untenable and historically unjustifiable. Intelligent social control always learns from experience and history. It no more need take the form of a Utopian blueprint than concern for history need make a fetish of the past. Revolutions have more often been the result of unendurable evils that intelligent reforms would have abolished … than of the imperialism of reason.

In the light of the evidence it is the author who appears doctrinaire, as one who refuses to learn from history. A generation ago he predicted that planning would lead to the eclipse of our freedoms. The state of liberty in England is healthier than when he made his dire prediction; and in this country, far better than in the heyday of unregulated capitalism. In countries where freedom has been lost, its destruction preceded the introduction of planning.

Planning need not be all or none. In a political democracy, it can take plural forms resulting in a mixed economy. That there are threats to freedom in some types of planning cannot by gainsaid. But there are also threats to freedom, even if more indirect, in a pure market economy. It is doubtful whether free cultures could survive severe depressions again. […]

The tendency of the author to think in terms of either-or instead of more-or-less vitiates the discussion of other basic themes. Although the essence of freedom for him is equality before the law, he ignores the extent to which social inequalities result in the imposition of unequal penalties under the law. His conception of the just law makes it compatible both with treating and mistreating everybody equally under the same rule. […]

As a cautionary voice Mr. Hayek is always worth listening to. He is an intellectual tonic. But in our present time of troubles, his economic philosophy points the road to disaster.

The review noted that the price of the original 570 page hardback from the University of Chicago Press was $7.50 in 1960, or about $54.59 in today’s dollars according to the inflation calculator. That compares to $81.22 for the hardback of the new “definitive edition” at Amazon today and $16.50 for the paperback version.