08. The Debate on the Socialist Calculation Debate (video)

0:00This is the debate on the socialist calculation debate. The socialist calculation debate raged in England in the 1930s and earlier in Germany in the 1920s. It was resurrected by Austrian economists who debated the meaning of the debate itself during the 1990s. It actually continues today, though I think the two sides have grown closer. I have the infamy of having sort of started the second debate, the debate on the debate. Though before my article had appeared in 1990, there was an article by Israel Kirzner in the late 80s on the Socialist Calculation Debate, pointing out that Austrians could learn quite a bit still from that debate, despite the fact that it had taken place 50 years earlier.

0:56And so, in part, mine was a response to his article, though his article wasn't really controversial. First, let's talk about what the calculation debate was all about. Then I'll give you my take on it, which is not the take of others, but we've become, I think, closer, as I'll show you. Basically, the debate was started by Ludwig von Mises in the 1920s, in his famous article, Economic Calculation in the Socialist Commonwealth, which was published in 1920, and then was incorporated into a book that he wrote on socialism in 1922.

1:42Basically, Mises' achievement in this article, I think this is one of the greatest articles of the 20th century, by the way, was to destroy the intellectual foundations of the case for social central planning. But secondly, it was really a revolutionary breakthrough in economic theory, demonstrating the nature and necessity of the price system, and here I do agree with Israel Kirzner. And thirdly, it was really the completion of the Mangerian Revolution. What Mises did in this article was to show how subjective values were transformed into objective prices which could be used as meaningful cardinal numbers in economic calculation.

2:28So, it was a step in the direction of the completion of the Mangerian debate, which was fully completed, as I said, with his Human Action, in which he completely gave us a complete theory of monetary calculation. In 1920, he only gave us those parts of monetary calculation or the theory of monetary calculation that were necessary to show the impossibility of socialist central planning. The word impossibility now has to be carefully parsed. When Mises said that socialist calculation was impossible, or he sometimes says that socialist economy is impossible, He did not mean that you couldn't have a group of people owning all the factors of production and producing something.

3:21What he meant was that they would not be able to determine if they were producing the optimum pattern of output, even from their own point of view. That is, he was saying that they could not economically allocate resources to the highest valued uses. even if they themselves determine the scale of values for society. The reason is without a price system you could never find the costs of these various goods in which you had output. Right, so Mises' thesis was as follows. He said that the rational allocation of resources was impossible without monetary calculation.

4:09And the reason why, well, the reason why this was so was because without a price system, there would be no way of determining how much the production of any particular good costs and without knowing the cost of various goods, you could never determine the most profitable line of production. And he points out that there were three preconditions, institutional preconditions, real world preconditions for economic calculation. The first, he said, was private property in all orders of goods, both consumer goods had to be privately owned and traded as well as capital goods and natural resources. Secondly, there had to be a freedom to exchange. If there was a system that existed in which people were allowed to own property but could not exchange it, and that system has existed in history at times where, for example, in the Middle Ages, land couldn't be alienated from the families that owned it.

5:06Without that freedom to exchange, the freedom to exchange was the second prerequisite of economic calculation. And third, there had to be sound money, because all prices in the real world market economy are money prices. Now what he points out is that socialism really abolishes all three. It abolishes private property in all orders of goods because the capital goods are owned by the state. And it abolishes the freedom to exchange because the state, being the monopolist of these goods, cannot trade with itself. So, since there is no exchange possible in capital goods, there can be no price of these goods.

5:52And without prices of these goods, there's no way to determine cost of production. Let me give you a simple example of this. Mises never denied that the central planners could know their, what we might call their, technical production function. I'll make sure I do this right. Chad, I'm getting a shadow. Hit the lights, okay, so make sure I do everything.

6:36This is a production function for an automobile. Not being very technically oriented, I don't really know how many tons of steel are in an automobile, maybe two or something. But anyway, let's assume that the central planners know through their teams of engineers and so on, exactly how many tons of steel, P tons of steel are required for production of an automobile, plus a certain number of hours, Q number of hours of machine time, plus a certain number of hours of unskilled labor and of engineering labor, Plus a certain number of square feet of factory space and a certain number of kilowatt hours of electricity and v-hours of managerial labor.

7:22If you combine all of those things according to a technological recipe, which they also know, you'll get one automobile. The key is, is it worth producing that automobile? Given that, all of those things are non-specific inputs, meaning that they can be used to produce many other goods in an industrialized economy. Are you using those goods in the most valuable manner, from their own point of view? And the answer, of course, is no, because the units in which these goods are specified are heterogeneous. There's no way to add up kilowatt hours with square feet of factory space, with hours of machine time, with tons of steel, and come up with one unitary cost figure.

8:11There's no way to do that. So that was Mises' main objection. Now, we know that there are certain other problems arise once there are no objective prices for these things. For example, should the production, it would be better to produce these automobiles with, let's say, more capital-intensive methods. So, instead of just Q hours of machine time, would it be better to have Q plus A hours of machine time? In other words, why not have more machines operating, maybe in the case of turning the factory into run by, mainly by robots, okay, with one or two people just manning the computers that control the robots, okay, and reducing the amount of labor.

9:11So, reducing the amount of unskilled labor to R minus B, okay? So they can't know, even if they decided somehow that this was the best use, that they wanted another automobile, they don't know the cheapest way of producing that automobile. Should they produce it in a more capital-intensive fashion, or less capital-intensive fashion, okay? Also, let's assume now that they're producing a run of automobiles,

10:07should be. Again, remember, take the U.S. economy, and hold that in your mind, imagine all the different uses of steel, there's a certain amount of steel in the economy, and there's only one optimal pattern for using that steel. Now, entrepreneurs operating under a market economy can easily figure out the best use of the whole stock of steel. There's a certain demand, as we'll see, based on their forecast of future prices, and they Based on those forecasts, bid for the steel, and let's say the steel is $300 a ton, then every use of steel that is expected to increase revenue in the different industries in the economy by at least $300 will absorb some of the steel.

10:55Anyone who has a prospective use of steel that has a marginal revenue product in addition to total revenue that is less than $300 will not get any of the steel. Supply and demand, the market will clear, we'll have a supply and demand, an equilibrium price, an equilibrium quantity that's exactly equal to the available stock of steel. How does the economy solve this problem of determining whether, the market economy, determining whether or not we should produce this automobile? Well, under market economy, where the three preconditions of economic calculation are fulfilled, where there is private ownership in the means of production, every single unit of every single input, of the hundreds of thousands of different inputs and types of labor and so on, maybe millions, has a market price, every single one.

11:50So that any conceivable and technically feasible production project or production process can be, the cost of that process can be determined. So, let's say that this is the decision about producing a Ford Taurus and the total cost, which is the sum of all of the prices of the inputs, is $18,000, including the interest return on the investment of capital. And the price of the automobile itself, let's say, is $21,000. Now, that's not the current price, that's the expected price.

12:38The current price might be less. But next year, at the end of this process of assembling this course, entrepreneurs, as we'll see, may expect that the price would go from $17,000 and it could shoot up to $21,000. So it's the future price that is important. In any case, then that is telling them that they are taking resources that have a lower value in all other uses in the economy, at least a lower perspective value, and they are redistributing this entrepreneur to a more highly valued use from the point of view of consumers. On the other hand, should the cost exceed the expected price, should the cost be maybe $22,000 per car for this bundle of resources that is needed to produce a car, then the loss would indicate that it's not rational to produce that good, because you're misallocating resources.

13:36You're taking resources that could produce goods worth about $22,000 on the market to consumers and using them to produce a good that's worth only $21,000. Now, is that to say entrepreneurs using economic calculation are infallible? Well, of course not. In the first quarter of this year, GM lost $2 billion. They're laying off 25,000 workers. What does it mean that economic calculation doesn't work? What that means is that in the past they've overestimated the demand for their products and therefore they anticipated a higher selling price but at least they know that they're making mistakes and at least they know that they have to restrict production of these automobiles which they are in fact doing.

14:27They're laying off, as I said, 25,000 or 28,000 in the next few years in two years, and they're going to reduce their total capacity for producing vehicles from six million, I read, to five million. So it tells you when you're doing something wrong. Now, my opponents in the debate, Israel Kirzner, Pete Becky, Steve Horowitz, would say something like, well, they would agree with me, and one of the things that this tells us is that this market economy is an error correction process, Process, or it's a corrective process. No, it's not a corrective process, because it doesn't mean that things can't change, that there's not continual changing going on, so that they can't simply follow the past losses and say, aha, once and for all we need fewer cars and that's what we're going to do. In fact, things could turn around in 90 days, or things could turn around in two quarters. They have to forecast that this trend will will continue into the future in order to make that decision to cut the number of automobiles.

15:37If they believe that gasoline prices would dramatically drop, if they have some information that indicates that gasoline prices will dramatically drop, let's say, in six months, and that the demand for automobiles will skyrocket, particularly the models of their firm, then they wouldn't blindly cut back, simply follow prices and say, hey, we're losing money, we lost two 2 Billion Dollars in the first quarter, we're going to lay off workers. In fact, they might actually expand. So, it is not a corrective process, it's a selective process, meaning it selects those entrepreneurs that are continually making the right decisions in a world of uncertainty and change. Let me mention something else that Mises makes clear, that there is a difference between what we call economic calculation and valuation.

16:29Mises never denied that an individual or a small family living in isolation, what we call in economics a household economy, couldn't figure out the cost of production without money. Money is only needed in a complex industrial economy in which you have heterogeneous capital goods which could be used in different uses. where all capital goods only had one use. If every resource only had one use, there would be no problem of monetary calculation. If it couldn't be used anywhere else, and it could only be used to produce cars, then all the resources that could be used to produce cars would produce cars. Because they can't be used anywhere else. They have no opportunity costs, in other words. But what Mises says is that in a household economy, people can figure out opportunity costs.

17:18So let's take the famous Robinson Crusoe, his value scale, that's his value scale for allocating, let's say, 12 hours of labor a day, let's say he sleeps 12 hours a day, and he's going to do it in 4 hour units, okay, and let's say that's his value scale, that he prefers 4 coconuts highest on his value scale, then 2 fish, 3 pounds of mushrooms, 1 salad, The question then becomes, what's the cost of producing one sack of berries, let's say it's fourth on his list?

18:03Well, he could easily see since the natural resources aren't really scarce, it's really his labor that's the scarce good here. His labor in this situation has a cost of the expected utility of three pounds of mushrooms. He will only engage in production processes which have a higher value than the utility of three pounds of mushrooms. So what if he suddenly finds that there's rabbits, or rabbit, I don't know if that's a quarrel, but he finds that there are rabbits on the island, and he says to himself, now wait a minute, can I afford to hunt that rabbit? In order to hunt that rabbit, I don't want to give up anything that's more valuable that I could produce in those four hours, right now.

18:56So, it's a matter of his value scale. The current cost of labor is the expected utility from three pounds of mushrooms. If he expects that rabbit will satisfy him more than the mushrooms, then what will he do? The benefit from the rabbit is higher than the cost, the cost being always the last, and the least most valuable use of the resource that is currently undertaken, so what he will do then is to devote the resources to hunting the rabbit. If the benefit from the rabbit is lower than the cost, then he will not. So Mises says that yes, you can run a socialist economy within a small household, or an individual can.

19:42You can run it without calculation, but you cannot run it in a system in which you have a multitude of heterogeneous goods, capital goods, inputs, which are nonspecific, which could be used in many different, but not all, production processes. I have a friend in Montana who used to live in New Jersey and I grew up with her and in any case, she actually married a real cowboy, believe it or not, from Montana, they live on a ranch, and one day she called me up and we were talking and she says, you know, I've got a new house.

20:30I said, well, so you moved off the ranch? She said, no, no, no. She said, we had the house shipped in. So I said, what? She said, well, here in Montana, since labor is so scarce in Montana and therefore has a much higher value, you know, herding cattle, which they actually do, they have cattle drives and everything, It's very scarce and expensive. They don't build the houses on site. In fact, her house was built in Nebraska, and these huge trucks haul the modular pieces of the house to the area where they're going to be built, and they put them together. So, it's very capital intensive. It uses a lot of capital because capital is relatively cheaper than labor. Whereas in the Northeast, of course, where labor isn't scarce, no one in their right mind would ever think of buying a house somewhere else and then having it shipped to where it's going to be the residence.

21:23Now, could a socialist planner ever figure this out? That you should build houses hundreds of miles away and then have them shipped? Without economic calculation, it's very unlikely. I mean, they might figure it out, but it's extremely unlikely. Let me just mention a few conclusions that we get from Mises' analysis. He tells us that a socialist economy is literally impossible because it cannot calculate the opportunity costs of production and investment decisions, which I've just shown you. Even the term socialist planning or socialist economy is an oxymoron.

22:13Now, why is it an oxymoron? It's an oxymoron because not only do socialist planners make mistakes, but they can never know if they're making mistakes. They're in a desert without a compass, and they might want to get to a particular point, but they don't even know which direction they're going. So, in the same sense that Robinson Crusoe rationally allocates his resources, his labor, to the most highly valued consumer goods, the market economy, with cardinal prices generated through entrepreneurial bidding and entrepreneurial forecasts, can in effect allocate goods to their highest valued uses from the point of view of consumers. So the market economy operates rationally in the same sense that Robinson Crusoe operates rationally.

23:01The Soviet Union does not, or the former Soviet Union, or any other centrally planned economy, cannot do that. So in that sense, they don't economize, there is no such thing as a socialist economy. It's an oxymoron, an inconsistent use of words. The reason being that they don't know how to allocate all these different resources with multiple uses among the most valuable uses. Even if they themselves are going to determine as dictators the most valuable uses. They can never know the trade-offs. Because, think about it, in our economy today, resources, let's take the U.S. economy, the available stock of capital goods, which approaches millions and millions and millions of units of capital goods, can be reallocated an infinite number of ways.

23:57There's an infinitude of different economies that we could create out of existing resources. In other words, there's an infinite number of different patterns of outputs that could be produced today. How do we figure out the right one? Well, we never know the... There is a way of forecasting the right one, and that is through market prices and economic calculation. What happened in the Soviet Union was that they used a system called gross output planning. And the Central Planning Board was a ghost plan. And basically what they did was that they would specify quantitative targets for output. Now it's very difficult to specify the exact quality of the types of output that you're giving the various firms, socialist firms, the targets for.

24:49So basically they motivated the managers by giving them bonuses for meeting or exceeding the targets and they got a trip to the gulag for not meeting the targets consistently. But what's interesting then, it turned into a system of mutual lying, of course. You want a bonus, but on the other hand, if you exceed your target one year and get a big bonus, what happens next year? They raise the target. They say, aha, this factory has greater capacity. So the manager will always lie and say, that target's way too high. He'll try to get it down. And he'll make sure he maybe exceeds it a little bit, but not by much. And on the other hand, they know, the commissars of each industry know that he's lying.

25:36And so they'll raise it. So the information is completely distorted. The incentive is that information is not accurate. One of the jokes that was often made about the Soviet Union, or one was when it was actually a cartoon, and I can draw it here, and what it was was there was a huge nail. and the nail is being is on a long train okay so you have a train here it's carrying the nail to wherever it's supposed to go you know when it's you know a hundred ton nail or something like that and then there's the commissar you know he's got that big big furry hat on yeah I like that and then there's a He's a plant manager and he's saying, well, comrade, he says, I've met my output target for this year, which was, let's say, 100,000 tons of nails.

26:48He would always make the nails in the easiest possible way that permits him to meet his target. So that's an exaggeration, but the truth is that many houses and structures in the Soviet Union were unfinished, even though they couldn't be used because they didn't have roofs. And the reason why they didn't have roofs is because the small roofing nails that you need weren't being produced because they were more costly to produce, so you were in danger of not meeting your target. You've got to use more resources to make the smaller ones than the larger ones. And there are stories about smaller sizes of women's clothing not being available, everybody walking around in huge clothes, and so on.

27:34Because you make things as large as possible. Now, on the other hand, if they specify a number, then you make a lot of small nails, and the large nails will disappear. And the one story that was told was about Khrushchev, who during a speech to the Pollock Borough berated, of all industries, the chandelier producers. Because they were making these huge heavy chandeliers that were crashing down and killing some of the comrades in their dachas, you know, in their vacation homes. Seriously. The joke that went around in the 1970s was that Khrushchev in the 50s had banged his shoe on the podium at the United Nations and he said, we will bury you meaning economically, we will bury you and so the Soviet economists told their western counterparts, we'll bury all of you except for Hans-Hermann Hoppe.

28:36We'll bury all of you except for Hong Kong because we need to know prices. We'll allow one small island where there are prices. And it was true that the Soviet Union was using world prices, at least for electricity and things that they traded in, and for steel and so on. But those prices were still inefficient because they didn't exactly reflect their local conditions. Now, what about the very existence of the Soviet Union? People later on said, well, you know, Mises is obviously wrong. Here it is, it's the 1930s and the Soviet Union hasn't collapsed yet. Well, Mises' impossibility thesis was not undermined. He pointed out, in his first article, he said, look, he said, real world socialist economies, such as the USSR, which was already in existence by 1920, he said, are not inconsistent with my thesis. He said, because they exist in a world of capitalist prices, He said it's just like the post office. The post office, as inefficient as it is here in the United States, can exist and can go on in a fashion by using the prices that are generated around it.

29:44But Lenin, on the other hand, said that he wanted to turn the whole economy into a post office. If you're turning the whole world into a post office, then you have the problem of economic calculation. Calculation. Now it's not to say that using world prices that don't reflect scarcities in your area or in your economy will allow you to be very, very productive and the Soviet Union wasn't very productive, okay, despite CIA, CIA statistics and then Paul Samuelson and Galbraith along with the CIA who claimed that the Soviet Union was catching us and that eventually there would be a convergence and their rate of growth would eventually surpass us and they'd And also in the Soviet Union there were black markets and there was a system of bribes between social enterprises, there was trade, even though it wasn't supposed to be, if someone had an excess of nails and needed copper wiring, they would trade, and there were brokers who would buy and sell, who would broker the deals, and so these were a system of bribes called BLAT. Also there was other black markets,

30:53Black Markets, the purchase of Beatle albums and jeans and so on in the Soviet Union. Because of foreign hard currency, the Soviet authorities looked the other way. Was there a true period of socialist economic planning? Yes, there was. War Communism. Socialism really existed from about 1917 to 1921 during the period of the counter-revolution in Russia, the war between the whites and the reds. There was also another group called the greens, they don't get much play, but they were an anarchist group that were fighting both the royalists, the czarists and the communists.

31:43In any case, everything started to break down. Lenin said, we are abolishing money, we're abolishing all accounting and money prices, and we're going to just have accounting in natural units. How could you have that? Natural units, as I showed, tons of steel, kilowatts, hours of electricity, they're heterogeneous. You can't add them up. You can't get a single figure for costs. In any case what happened was that you had houses, the whole system began to break down, very little was produced, people began to break up their furniture and then their houses for firewood, people moved from the cities, cities were emptying out by 1921, they were going into the countryside and leading a nomadic existence. That's what socialism leads to, a complete breakdown of the social division of labor.

32:31Universal Brigandage, forging and stealing, these small household groups or small bands fighting with one another for resources. So yes, socialism can exist after fashion, but it's impossible to run the social division of labor at a high level without economic calculation. And by the way, Lenin then reversed himself and instituted the New Economic Policy, by the way, the same name that Nixon took for his policy of wage and price controls. At least Lenin was moving in the right direction. He allowed some exchange and so on. Now, let me just talk a little bit about the intellectual division of labor and what I think is one of my contributions here.

33:25I mean, it's really in Mises, but I think I brought it out a little bit more. And this is the social appraisal process. How is it that we actually go about transforming subjective values for goods and entrepreneurs' qualitative knowledge about consumer values and their expectations about what market conditions will be in the future? How is all of that information and knowledge translated into objective cardinal numbers that can be used meaningfully in economic calculation? So I call this a social appraisement process. Mises uses the word appraisement in two different senses. And here's what we have. You have the entrepreneur at the center here.

34:16The entrepreneur wants to earn pure profit. He wants to buy resources at a price that is lower than the expected output.