Monetary Policy and the Knowledge Problem

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. --F. A. Hayek (1988: 76) The knowledge problem in economics is most closely associated with Friedrich Hayek, who articulated it in analyzing the role of prices in markets, the socialist calculation debate, and monetary policy. In tins article, I summarize and apply Hayek's analysis to contemporary monetary policy debates. I also connect Hayek's work with that of Milton Friedman, who articulated his own version of the knowledge problem in his monetary work. Friedman's views in this area are underappreciated. Hayek argued that knowledge is inherently dispersed and localized across the population of economic agents. It is not possible to assemble the totality of knowledge existing in society in any one mind or place. Individuals may reveal their localized knowledge by their actions, but only if incentivized. Moreover, knowledge is often tacit and cannot be articulated. What the totality of individuals knows far exceeds what any policymaker can know, no matter his or her expertise and wisdom. Hayek on the Knowledge Problem Hayek presented his analysis of the knowledge problem in society in the course of what came to be known as the socialist calculation debate (Hayek [1935] 1975a). (1) He developed the argument further in a series of lectures and articles in the 1930s and 1940s. They were made more accessible by being reprinted in one place (Hayek 1948). Early supporters of socialism supposed they could dispense with economic problems. Some thought of societal resource allocation as an engineering problem. Hayek (1975a: 5) pointed out that engineering problems involve a singleness of purpose. Resource allocation involves competing uses of resources, and accounting for opportunity costs is necessary (Hayek 1975a: 6-7). What is being introduced here is the basic knowledge problem of a diversity of actors with different preferences. The difficulty for socialists wanting to abolish private property and markets was "how in the absence of a pricing system the value of different goods was to be determined" (Hayek 1975a: 27). He supported Mises' argument that only a system of money prices, including for factors of production, could produce a rational solution to resource allocation. That system necessitated private property, including in capital goods. Hayek's essays bookended the 1935 volume. His concluding chapter dealt with various responses to Mises' original critique. These were the "alternative socialist systems which differ more or less fundamentally from the traditional types against which the criticism was directed" (Hayek 1975a: 202). The debate took many twists and turns, but I will follow the knowledge argument. Hayek reiterated that knowledge is dispersed, and for any variant of central planning, it must somehow become concentrated in one mind or those of a very few experts. Much knowledge is not preexisting, but it is created only in the process of adapting to change (Hayek 1975a: 210-11). (2) "Every passing whim of the consumer is likely to upset the carefully worked out plans" of the central planning authority (Hayek 1975a: 214). Hayek (1975a: 227) emphasized the importance of disruptive change and the dynamic nature of the economic problem. Economists ignored the importance of change because of "the excessive preoccupation with the conditions of the hypothetical state of stationary equilibrium" (Hayek 1975a: 226). In response to suggestions for marginal cost pricing in a socialist state, Hayek (1975a: 229) argued that "the competitive or necessary cost cannot be known unless there is competition." What are the assumed "givens" or data of an economic model are information to be discovered in the real world in a competitive process. That is the knowledge problem in a nutshell. The socialist calculation debate ended inconclusively for many economists, "a draw" as Caldwell (2004: 338) phrased it. …