From Don Boudreaux.  Teachers in particular will want to steal Bourdreaux eye opening thought experiment.

blogs Hayek’s “The Use of Knowledge in Society”.

There’s the famous tin story.  There’s the famous pencil story.

Now — joining the pantheon of divided knowledge economics — make way for the Cuban toilet paper story.

Where no man has gone before.   ht: Instapundit.

English major and Marxist social critic Rob Horning reviews The Myth of the Rational Market:  A History of Risk, Reward and Delusion on Wall Street by TIME magazine’s Justin Fox:

Fox’s account of the rational market revolves around the long-held dream of discovering a method to pin down the intrinsic value of an asset—what it should trade for, so that mispricings could be systematically exploited by investors and the potential for bubbles negated. Unlike Marx, who, drawing on Ricardo, tried to trace value back to the notion of socially necessary labor, 20th century economists start from the premise that markets alone reveal the “true” value of assets by aggregating all the information gathered by all the various parties participating in exchanges and transmuting all that data into a simple, immediately comprehensible metric: price.

Austrian economist Friedrich Hayek wrote the classic exposition of the idea in The Use of Knowledge in Society.  Hayek noted that “the ‘data’ from which the economic calculus starts are never for the whole society ‘given’ to a single mind which could work out the implications and can never be so given.” And economic conditions are changing by the moment, requiring different responses and different calibrations of potential future returns. Therefore, no group of bureaucrats can ever be in a position to plan economic development, à la a Soviet Five-Year Plan. Instead, a “rational economic order” requires markets, which serve as mediums of information exchange as well as the exchange of goods.

It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

Moreover, the market allows participants to make economically sound decisions without particularly knowing why. “The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.”

But this seems to present a conundrum. Market participants are expected to use their unique and specific knowledge to take advantage of errant prices and thereby correct them. In financial lingo, this is known as arbitrage. But at the same time, they must accept the information that a price is an accurate reflection of conditions they can’t be aware of and aren’t qualified to second guess. So they are in the position of having to trust the market’s wisdom while simultaneously correcting it. They have to understand their own limits and constantly exercise subjective, contingent judgment.

To his credit, Hayek recognized this: “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.” In other words, economists must be careful not to assume away the gap between the isolated, subjective views on the economy and the unknowable totality of objective reality, or to ignore the perpetual need for individual judgment.

But as Fox’s account so punctiliously reveals, influential economists and finance scholars would repeatedly ignore Hayek’s warning in favor of pursuing financial “innovation” that has since been proven specious at best. They chose to overlook the psychological vagaries involved with market behavior—the Keynesian concern with investor confidence and “animal spirits” as well as the decision-making anomalies later taken up by the behavioral economics movement, which Fox covers at the end of his book—in favor of formulas built on the presumption that investors always acted with predictable rapacity and efficiency. Perfect judgment was conveniently regarded as automatic.

Hayek consistently asserted that the work of John Maynard Keynes was a retrograde throwback to the backward looking, pre-marginalist, objective cost, distributional thought of the classical British economists, a brand of thinking that had been smuggled into post-marginalist economics by Alfred Marshall.  For Hayek, the modern marginalist economics of Menger, Knight, Wieser, and Jevons looked at prices as guides to future marginalist decision making, especially alternative subjective cost considerations in the reorganization of alternative production plans.  The retrograde economics of Marshall, Mill, Ricardo, and Keynes looked at prices as objective measures of aggregate quantities of objectively defined goods from the past which could by used in an economist’s mathematical logarithm to map out the necessary determination of the next sequence of objectively defined and measurable aggregate quantities and prices.

Given that background, I don’t believe it is entirely a coincidence that Hayek’s break though 1936 articulation of his long-growing insight into the role of price signals into the coordination of production plans and consumer goods across time came just eight months after the publication of Keynes’ muddled account of backward determined objective “aggregates” which logrithmically determining the next round of objectively measurable aggregates, published in his General Theory. Here is Hayek explaining his own breakthrough year of 1936 to Armen Alchian in an interview from 1978:

ALCHIAN:  Two things you wrote that had a personal influence on me, after your Prices and Production, were ["Economics and Knowledge"] and “The Use of Knowledge in Society.” These I would regard as your two best articles, best in terms of their influence on me.

HAYEK: “Economics and Knowledge” — the ’37 one — which is reprinted in the volume [Individualism and Economic Order], is the one which marks the new look at things in my way.

ALCHIAN: It was new to you, too, then? Was it a change in your own thinking?

HAYEK: Yes, it was really the beginning of my looking at things in a new light. If you asked me, I would say that up till that moment I was developing conventional ideas.  With the [Nov. 10, 1936] lecture to the Economics Club in London, my presidential address, which is “Economics and Knowledge,” I started my own way of thinking.

Sometimes in private I say I have made one discovery and two inventions in the social sciences: the discovery is the approach of the utilization of dispersed knowledge, which is the short formula which I use for it; and the two inventions I have made are denationalization of money and my system of democracy.

ALCHIAN: The first will live. [laughter] How did you happen to get into that topic? When you had to give this lecture, something must have made you start thinking of that.

HAYEK: It was several ideas converging on that subject.  It was, as we just discussed, my essays on socialism, the use in my trade-cycle theory of the prices as guides to production, the current discussion of anticipation, particularly in the discussion with the Swedes on that subject, to some extent perhaps Knight’s Risk, Uncertainty and Profit, which contains certain suggestions in that direction–all that came together. And it was with a feeling of a sudden illumination, sudden enlightenment, that I — I wrote that lecture in a certain excitement. I was aware that I was putting down things which were fairly well known in a new form, and perhaps it was the most exciting moment in my career when I saw it in print.

ALCHIAN: Well, I’m delighted to hear you say that, because I had that copy typed up to mimeograph for my students in the first course I gave here. And Allan Wallace, whom I guess you must know, came through town one day, and I said, “Allan, I’ve got a great article!” He looked at it, started to laugh, and said, “I’ve seen it too; it’s just phenomenal!” I’m just delighted to hear you say that it was exciting, because it was to me, too.

But when did the idea hit you? When you started to write this paper, started to think about it, there must have been some moment at which you could just suddenly see you had something here. Was there such a moment at which you said, “Gee, I’ve got a good paper going here”?

HAYEK: It must have been in the few months preceding that, because I know I was very unhappy about having to give the presidential address to the Economics Club.  Then I hit on that subject, and I wrote it out for that purpose. How long it was exactly before the date [of the address] I couldn’t say now, but I do know that the idea of articulating things which had been vaguely in my mind in this form must have occurred to me when I was thinking of a subject for that lecture — the presidential address at the London Economics Club.

Nobel Prize winner Edmond Phelps channels Friedrich Hayek and re-introduces Frank Knight in a brutal take-down of a failed generation botching up the works because they are fatally ignorant of how a capitalist economy actually works.  What Phelps is too delicate to say is that the elite have been well schooled in their ignorance by professors of economics who have drilled them in mathematical constructions which can do nothing else but create a deep misunderstand of the market process and the inherent economic uncertainty which exists within that process.

In this section, Phelps contrast the inadequate economic vision of Joseph Schumpeter with the deeper insights of Friedrich Hayek:

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? Joseph Schumpeter’s early theory proposed that a capitalist economy is quicker to seize sudden opportunities and thus has higher productivity, thanks to capitalist culture: the zeal of capable entrepreneurs and diligence of expert bankers. But the idea of all-knowing bankers and unerring entrepreneurs is laughable. Scholars now find that most growth in knowledge is not science-driven. Schumpeterian ­economics – Adam Smith plus sociology – captures very little.

Friedrich Hayek offered another view in the 1930s. Any modern economy, capitalist or state-run, is a great soup of private “know-how” dispersed among the specialised participants. No one, he said, not even a state agency, could amass all the knowledge that each participant “on the spot” inevitably acquires. The state would have no idea where to invest. Only capitalism solves this “knowledge problem”.

Later, Hayek fleshed out a theory of how capitalism makes “discoveries” on its own. He had no problem with the concept of an innovative idea, for he understood that, even among experts, knowledge is incomplete about most things not yet tried. So he felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” (as Hayek’s hero, David Hume, would have put it) a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism. The latter are too bureaucratic to learn about ideas from below and unlikely to obtain approval from all the social partners of the ideas that do get through ..

UPDATE:  See also this related article by Jerry Muller.  [Ht to Alan Furth.]  Here’s Muller:

From the point of view of top management, the diversity of operations means that executives were managing assets and services with which they have little familiarity. This has led to the spread of pseudo-objectivity: the search for standardized measures of achievement across large and disparate organizations. Its implicit premises were these: that information which is numerically measurable is the only sort of knowledge necessary; that numerical data can substitute for other forms of inquiry; and that numerical acumen can substitute for practical knowledge about the underlying assets and services.

A good deal of our current economic travails can be traced to this increasing valuation of purportedly objective criteria, so denoted because they can be expressed and manipulated in mathematical form by people who may be skilled at such manipulation but who lack “concrete” knowledge or experience of the things being made or traded. As Niall Ferguson has put it, “Those whom the gods want to destroy they first teach math.” …

Read the whole thing.