The “Invisible Hand” Vs Planned Economies

Still under the weather to the point that I’m very surprised this turned out as long as it did.  I was really expecting to do a short one.

Let’s go back to the beginnings of economics as a science, with Adam Smith and the Wealth of Nations.  One of the key elements of The Wealth of Nations was Smith’s “invisible hand”–each individual acting according to his or her self-interest in combination with all the others engaging in voluntary exchanges, with each only making the exchange if they believe they’ll benefit from it.  We might think of that as much like the way the mostly random individual motion of molecules biased toward higher to lower energy states causes the wind and the rain without the direction of any particular molecule or group of molecules.

In the 18th and 19th centuries much of our understanding of the natural world through the mechanism of science blossomed.  With so much increased understanding, and new discoveries on a regular basis, it was perhaps inevitable that people would think that conscious direct, “managed” or “controlled” economies would be more efficient than the unconscious action of Smith’s “invisible hand.”

The result was the development of socialism–the idea that the “means of production” (capital) should be taken out of individual hands and directed for the “common good.” Marx and Engles added the idea of a “workers revolution” with violent overthrow of the existing order to accomplish that transfer of means of production from those who have built and accumulated it to “the workers”.

It was an interesting idea, of scientifically managing the economy for everyone’s benefit.  And it’s popularity was widespread.  By the early 20th century it was considered the inevitable wave of the future.

There were, however, problems.  For example, whether one was taking outright ownership of the means of production (socialism/communism) or leaving people with ownership “on paper” and “merely” taking control (fascism/naziism) you’re left with the problem of who makes the decisions and how to ensure the decisions they make are actually for the “common good” and not for their own self-interest.  That, by itself, is a serious problem that remains unsolved to this day.

As serious as that problem is, a second problem is even worse.  In an economy based on voluntary exchange, each individual, knowledgeable about their own particular situation, makes the best choices for themselves.  If I, for instance, am going to buy a car, I can look at the various offerings and find the combination of price, features, and performance that best suits my needs.  If the cars available are too expensive, or don’t suit my needs, I can look at motor scooters or even bicycles.  If a lot of people decide cars are too expensive, the people producing cars find they aren’t able to sell them and have to do something to either increase their sales (reduce prices or add features that attract people back to car buying) or accept lower sales volumes which will mean less resources (steel, plastic, energy, and labor among many others) going into car production and instead being available for other industries.

But it’s not just cars.  The same kind of decision is made for each of the thousands upon thousands of goods and services people trade each day.  Do we raise price on paperclips and increase production, using more steel for this and less for butter knives?  Do we produce more laptop computers and fewer desktops?  Do we string more fiber optic cable or maybe put up more satellites for computer networking?

It is simply not possible for any human or committee to have sufficient knowledge to make those decisions in such a way as to provide the goods and services that the people want in amounts coming anywhere close to matching demand.  Indeed, it might not even be something that could be solved by sufficient knowledge.  Economies may well be chaotic systems where even a very small difference in one part could lead to large and unpredictable changes elsewhere.

Milton Friedman used the example of a pencil to illustrate that idea.  No one person can make a pencil.  You have the wood, that comes from certain trees.  There’s the steel of the saws used to cut the tree.  The people making the brass for the ferrules do not need to know how many pencils will be produced.  They only need to know the price people are willing to pay for that brass.  The people mining graphite don’t need to know the mix of graphite and clay for a number 2 pencil.  Again, they just need to know how much they can sell at what price.  And so on and so on, thousands of people from around the world cooperating without even knowing it simply because of the action of the price mechanism.

Consider instead the old Soviet Union.  The planning committees would get catalogs from the West so that they could get some idea of what relative prices “should be”–relying on societies where the price system and voluntary exchanges worked things out to figure out what they simply could not from scratch.

It’s even worse when the price to be determined is that of labor.  Consider unpleasant or dangerous jobs in the US–lineman working for electric utilities, garbage collection.  These jobs usually pay pretty well.  The danger or unpleasantness of the job is going to make many people hesitant to enter those fields.  Going up tall towers in the middle of thunderstorms to restore electricity to people’s homes?  Not me.  Going around in a truck, picking up disgusting, vile smelling garbage cans to dump into the back of that truck?  I’ll pass, thank you.  But somebody’s got to do those jobs so how do you entice them?  Wages and benefits are the usual method.  If you’re not getting enough people to do it, then you end up having to offer more to get people to decide it’s worth it.

For a command economy it’s simply not possible for the decision makers to know what wages and benefits will attract enough people to each of the myriad jobs that go into making up an economy.  The result is that one has to use some kind of “force” to accomplish it.  A common tactic is simply to set arbitrary standards (often “competitive examination”) for the safe jobs with more pleasant working conditions and leave others with no choice but to take jobs they would never take at that level of pay and benefits in a freer market economy.

In the end, due not just to the venality but the insufficient knowledge, command economies begin to resemble feudal states, with people bound to their status not because of their individual abilities and choices, but because of what those “commanding” the command economy decides.  The bulk of the people become, essentially, serfs.

But don’t just take my word for it.  F. A. Hayek said it much better, and at greater length, in his book “The Road to Serfdom”: