The first is from the textbook I’ve used for many years in my introductory microeconomics class by Heyne, Boettke, and Prychitko:

(1) …the demonstration by modern political economists of the tendency within democratic governments to concentrate benefits and disperse costs within policy-making has been one of the most important contributions to our intellectual understanding of why good politics is not necessarily good economics (331).

Political Manipulation

For example, it would be grossly inefficient to implement a government project that costs $3 million but only provides a total benefit of $1 million.  But if through political manipulation you could make everyone in a community of one million pay an equal share of the cost and at the same time hand over the benefit of the project to say 1,000 people, it may well be enacted.  That’s because the no one would pay more than $3, while beneficiaries would be getting $1,000 each.  The gainers would fight a lot harder to pass the project than the losers would to fight it.

Now, this from Friedrich Hayek’s The Road to Serfdom:

(2) Against the innumerable interests which could show that particular measures would confer immediate and obvious benefits on some, while the harm they caused was much more indirect and difficult to see, nothing short of some hard-and-fast rule would have been effective (71).

Hayek is talking here about why sometimes a dogmatic resistance to all government intervention has been helpful in preserving liberty.  But I would like to point out that the kinds of measures he has in mind are things such as minimum-wage laws that appear to benefit workers at the bottom of the wage scale but, as is well established in the economics literature, actually price lower-skilled workers out of the market over time.  Currently in the state of New York it is illegal for anyone to work in most jobs for less than $7.25 an hour, which means if your labor is worth less than that to employers, as is likely the case if you are young, you will not be hired.

At first glance these two statements appear to be saying more or less the same thing.  Both identify a source of systematic government failure: concentrated benefits versus dispersed costs; or immediate/obvious benefits versus harm that is indirect/difficult to see.  Both identify interventions that benefit only some while the consequences fall elsewhere or elsewhen.  And both imply that the outcome of these interventions will tend to be undesirable to someone.

Contrasts

The Heyne et al. statement (1) is in terms of “benefits” and “costs” while the Hayek (2) talks about benefits and harm.  Perhaps you could interpret “harm” as the “cost” that is dispersed in the first statement, although “harm” has a more general meaning that may not be easily quantifiable, such as undermining the norm of preserving the free market.

Furthermore, (1) focuses on concentrated benefits, while (2) on the immediate and obvious benefits.  Beneficiaries of the government project get $1,000 while only some under the minimum-wage benefit at all.  Now beneficiaries in both cases can see immediately what they are getting, but there is a certain sense in which those proposing the minimum-wage law (mistakenly) believe it will benefit everyone, not just a few, while people in the concentrated benefits approach are fully aware that only a few will indeed benefit from the intervention.

The costs in (1) are dispersed while the harm in (2) is indirect and difficult to see.  The $3-per-person cost of the government project is certainly not indirect or difficult to see; rather everyone, both gainers and losers, do see it but it’s too small an amount for most to bother with.  Few have an incentive to do anything about it.  However, the harm of the minimum-wage law is indeed indirect and difficult to see.  Acquiring that knowledge is hard.

Time is not necessarily an element in (1) but it is in (2), in fact it’s because some time has to pass before you can see the full consequences of an intervention that they are often difficult to see.

Inefficiency and Error

Finally, the nature of government failure in (1) is based on inefficiency: the total costs exceed the total benefits.  Government failure in (2), on the other hand, is based on error.  (1) implies that inefficiency is systematic because the political rules of the game make people follow perverse incentives, while (2) implies that error is systematic because of a failure to learn.  And (1) suggests that people can manipulate the system with full knowledge of all the consequences so that they can effectively concentrate benefits on themselves or their cronies and disperse the costs among taxpayers; while (2) suggests that the harm that a policy causes is largely unintentional and the result of ignorance.

The first approach emphasizes incentive problems, the second knowledge problems.  Neither is necessarily better than the other, but there are occasions when one or the other might be more appropriate.  Often both are applicable to the same intervention.  For example, some political economists argue that labor unions say they favor raising the minimum wage to express solidarity with their non-union brothers and sisters but really support it because it insulates its members a little more from unskilled workers.  One author has even characterized the approach to political economy that emphasizes “concentrated benefits, dispersed costs” as “a proposition about inferring intentions from outcomes” (47).  I would not go that far.

(If you’d like to read a lengthier treatment of this topic check here.)

One commenter on Facebook noted that we should not be surprised that market critics expect perfection when so many economists and others use models that do indeed stress how markets solve problems “perfectly.”  This is quite correct, and it raises some points worth exploring in more detail.

The mainstream economists’ foremost model describes “perfect competition.” It shows how, under particular assumptions, markets will produce ideal results: Resources will all be allocated to their highest valued use, prices of goods will reflect marginal costs of production, and producers, knowing exactly what goods consumers want, will produce them at minimum average total costs.  Any firm that makes a profit above opportunity cost will attract in new rivals to compete away those excess profits.  The world of perfect competition is a world of optimal resource allocation across the board.

To get that result, the model requires five assumptions:

1. Everyone has perfect relevant information;
2. There is a large number of buyers and sellers so no one has monopoly power;
3. Each market has one perfectly identical product;
4. Everyone takes the price determined by the market as given;
5. There is costless mobility of resources.

Not in This World

Obviously these are extremely strong assumptions, pretty much none of which ever holds in the real world.  Not surprisingly, no part of the economy looks as perfect as the model predicts.  As Austrian economists have argued for decades, the fundamental problem with this model is that it misunderstands the nature of the economic problem.  In particular, by assuming everyone knows what they need to know and that firms are selling identical products, the model assumes away the discovery process at the heart of competition.  As F. A. Hayek wrote in “The Use of Knowledge in Society,” the fundamental problem facing us is a problem of the dispersion of knowledge.  Competition is justified by our very ignorance.  We need competition to figure out what demand is, what our costs are, and what sorts of products and features people want.

The deeper problem arises when economists and others confuse “perfect competition” and “free markets.”  The perfect-competition model may well have a few useful elements to it, but it is only a model and not a description of how real-world competition will or should work.  To the extent that defenders of markets rely on the model to argue for free markets, they are setting themselves up for precisely the response I discussed last week: Markets are in fact never perfect.  If we premise our case for their desirability on their alleged perfection, our case will be impossible to make.

Antitrust Fallacy

Thankfully, this confusion of perfect competition with laissez faire is less common than it used to be.  However, in antitrust law there still is often a presumption that any behavior which seems to deviate from the ideal of perfect competition is highly suspect.  The government’s challenge to the proposed merger of AT&T and T-Mobile is a good example. The merger would indeed reduce the number of competitors, but from a more Austrian perspective, the merger would be pro-competitive since it would better enable the combined company to take on Verizon.  Using the perfect-competition model as the goal of competition policy confuses the model with actual competitive processes and leads to really big policy errors.  As Robert Bork once said, using antitrust to make the economy look like perfect competition would have roughly the same effect as several well-placed nuclear weapons.

Defenders of markets make a mistake when they rely on perfect competition and similar models to defend free markets.  The perfect-competition model assumes away the key function of actual competition, which is to discover the very things the model takes as given.  Economists who ignore this point, as well as the messiness of markets, have no one to blame but themselves when the unavoidable imperfections of the market’s discovery process become the critics’ reasons for rejecting it.

But is that so? Without denying the value of perseverance, and recognizing that the slogan “never give up” can be useful in overcoming certain obstacles, we must keep in mind that failure can act as a guide to more worthwhile activities. For example, in 1921 Walt Disney started a company called the Laugh-O-Gram Corporation, which went bankrupt two years later. If a friend of Disney or the government hadn’t let him fail and move on, he might never have become the Walt Disney we know today.

More important than this individual learning process is the irreplaceable role failure plays in the social learning process of the competitive market. When we refuse to allow failure to happen, or we cushion its blow, we ultimately harm not only the person who failed but also all of society by denying ourselves a key way to learn how best to allocate resources. Without failure there’s no economic growth or improved human well-being.

Economists, especially those of the Austrian school, often emphasize how entrepreneurs discover new knowledge and better ways of producing things. But entrepreneurial endeavors frequently fail and the profits thought to be in hand often don’t materialize. According to the U.S. Small Business Administration, over half of small businesses fail within the first five years. But failed entrepreneurial activity is just as important as successful entrepreneurial activity. Markets are desirable not because they lead smoothly to improved knowledge and better coordination, but because they provide a process for learning from our mistakes and the incentive to correct them. It’s not that entrepreneurs are just good at getting it right; it’s also that they (like all of us) can know when they’ve got it wrong and can obtain the information necessary to get it right next time.

On this view failure drives change. While success is the engine that accelerates us toward our goals, it is failure that steers us toward the most valuable goals possible. Once failure is recognized as being just as important as success in the market process, it should be clear that the goal of a society should be to create an environment that not only allows people to succeed freely but to fail freely as well.

The Knowledge Problem

Understanding this point requires a broader vision of the market process. For Austrian economists the fundamental economic problem is not the efficient allocation of given resources to our most valued ends at a given time, but rather how we overcome the “knowledge problem”—the division of knowledge that characterizes the social world. It is more important to figure this out than to master the problem of resource allocation because new knowledge drives economic growth and creates prosperity. If the main task of the market were merely to allocate known resources to their most efficient uses, economic growth would seem impossible, since we would be stuck in a primitive world. Where is there any room for the innovation or change that drives progress and improves our lives? If a plow is deemed the most efficient use of iron and all iron is constantly allocated to making plows, how could iron ever be allocated for a new invention such as a tractor? The answer is that entrepreneurs change the most efficient use of resources by discovering new uses. By understanding the economic problem posed by limited, unique, and dispersed knowledge, we can better understand the role failure plays in coping with this problem.

Competition figures prominently in this system. Competition promotes entrepreneurial activity and the discovery of knowledge by empowering a variety of decision-makers to try to find new and better ways of using resources as well as new ends to achieve. This decentralization ensures that what F. A. Hayek called the local knowledge of time and place will be best used. Centralized planning, like other forms of government allocation, necessarily relies on the knowledge of fewer people, limiting discovery and restricting knowledge-dissemination to fewer channels. Competition is a better way to overcome the knowledge problem.

Failure and Opportunity

We can understand the role of failure if we recognize, as Ludwig von Mises did, that all human action intends to “remove felt uneasiness.” We are always striving to improve ourselves by achieving our highest valued ends as often as we can. On these terms, failure is all around us because no human ever achieves a complete lack of felt uneasiness. We always have unsatisfied ends. Israel Kirzner uses the term “alertness” to describe how the entrepreneurial element of human action identifies which ends to strive for and which means are available. Kirzner says that for market action to occur, entrepreneurs must first be alert to opportunities for profit. The possibility of profit keeps entrepreneurs alert to the ways people strive for ends or make use of means that fail to remove felt uneasiness. Once they’ve noticed this failure in human knowledge, the same opportunity for profit spurs entrepreneurial activity to find a new way to achieve those ends, or to find better ends themselves. So a failure in human knowledge becomes the catalyst for producing new knowledge via the entrepreneurial process.

When entrepreneurs attempt to correct a particular failure in knowledge, they often fail themselves and incur losses because of competition. Although bankruptcy is painful in the short term, such failure is an integral part of how entrepreneurial activity and the market function. Failure in a competitive society informs market participants about which activities or jobs to strive for and which to avoid, lest they waste time and money. Jobs that add value to society should be pursued, while those that fail to add value should be eliminated. Markets help guide market participants far better than any bureaucracy can because bureaucracies lack the market’s key components of competition, profit, and loss, which reveal failures and allow for their correction.

Because competition is a voyage into the unknown, we can only know after the fact what works and what does not. Thus economic failure is not “waste.” Calling entrepreneurial failure a “waste” implicitly assumes that one knew ahead of time what the best use of resources was. Such knowledge is not available to anyone, which is why failure is necessary to provide the needed signals.

The subsidies, bailouts, stimulus packages, and other interventions that now increasingly characterize the U.S. economy disrupt this process. Farm subsidies (including cheap water out west), for example, prevent entrepreneurs from finding and capitalizing on failures of knowledge in farming. While there may be new and better ways to grow food, it is difficult for entrepreneurs to find this out if farmers are kept afloat by the government. Perhaps decentralized, local farming would be discovered as more profitable if larger monoculture farms that are possibly damaging the environment were allowed to fail. By preventing inefficient methods of production from suffering losses, subsidies reduce the degree of failure in agricultural markets and make it harder to know that misallocation has taken place and to correct it.

Not letting Chrysler and General Motors fail during the Great Recession prevented an entrepreneurial response to this misuse of resources. The bailouts created two types of negative incentives. First, the companies were encouraged to keep making cars when their losses showed the resources and labor could better be used elsewhere. Second, the government deterred any new entrepreneur from entering the industry and doing things better. Many politicians defended the bailout because they did not want the hundreds of thousands of autoworkers to become unemployed. But when hundreds of thousands of workers become unemployed they do not disappear. They find different jobs that would contribute to society in a better way than working for a bankrupt auto company. The physical assets of bankrupt companies also get reallocated to alert entrepreneurs looking for bargains. Failure is necessary for learning and for success.

The Keynesian argument for government jobs programs is that any sort of work will restart spending in a recession, even hiring people to dig ditches and fill them up. But do a higher GDP and a job by themselves make society better off? Would it be better to have a 2 percent unemployment rate with 8 percent of the employed population doing jobs that don’t add real value (so around 10 percent of the labor force is not adding real value) or more unemployment with everyone who is working really adding value?

Unemployment

Unemployment is a form of failure, and it involves the same considerations as when businesses fail. If a job no longer contributes value this needs to be made clear so that those workers can find jobs that actually do. Imagine if the disemployment of farmers had been prevented during the transition to an industrial economy. In 1941, 41 percent of the U.S. workforce was in agriculture. In 2011 the portion was 3 percent. Where would industry be today if we had prevented the majority of the 41 percent from losing their jobs and finding new ones? It is right that this sort of “failure” was allowed to occur because the displaced farmers found new jobs in the cities and elsewhere. Those new jobs helped society transition from agriculture to industry to services, creating even newer jobs all along the way. This is strong evidence that learning from failure takes place in labor markets.

Autopoiesis (life’s continuous production of itself) is one of the principal characteristics of life, and constant change is its essence. This applies to the economy as well. For us to maintain or increase a high standard of living we must constantly change how we do things. This change won’t be fueled by lucky guesses or by bureaucratic decrees, but instead often by entrepreneurial activity in the face of failure in the market. Since that activity drives the train of progress, it is in society’s interest that the tracks be cleared of governmental obstacles.

Impersonality at the Macro Level

There is no better explanation of the how vast, impersonal cooperation works than Leonard Read’s classic essay, “I, Pencil,” in which he elegantly shows that no single person can know all that goes into the making of something as apparently simple as a pencil. That’s because a pencil is the tip of an enormous production iceberg, only one of whose roots stretches back, for example, to the iron mines that provide a single input for just one of the tools that goes into manufacturing the saw that cuts the wood from which a portion of the pencil shaft is made. The real wonder in this, however, is that no single person has to know. Tens of thousands, probably tens of millions, of people who will never meet nevertheless work together to make a single pencil.

Prices that emerge from the buying and selling of privately owned iron, wood, labor, tools, know-how, etc., as well as the market price of the pencil itself, are key in guiding the decisions at each of the dizzying number of stages of production. Again, no one can know, and no one need know, all of these stages.

Still, each worker, investor, manufacturer, financier, etc., does need to know, and know with expertise, the people with whom she has to deal in the stages immediately upstream and downstream from her position in the process.

Getting Personal at the Micro Level

Most of us wouldn’t hire a plumber without the recommendation of someone we trust, much less make a major investment in a business or lifestyle without first consulting a number of friends, colleagues, and professional advisers of one kind or another. In our daily affairs the personal plays an indispensible role.

My father sold his farm produce to the same market in Phoenix for many years. I recall that while each delivery was being unloaded and weighed he’d sit and chew the fat with the owners and managers of that produce market, while I waited impatiently to start back for home. At the time I didn’t appreciate what an important part of doing business those few minutes of socializing were in maintaining trust, as well as keeping in touch with the latest business news and opinion – information that meant much more coming from those guys than it would have coming from some anonymous source.

At the macro level, which encompasses the entire production process of a pencil (or of green onions), markets are highly impersonal. But at each of the myriad stages of that highly complex process, between for example the buyers and sellers of the cedar or rapeseed or raw carbon, is a relationship that is necessarily personal to one degree or another.

Of course, voluntary personal connections alone cannot solve the enormous knowledge problem that F. A. Hayek and others have identified. At the same time, however, what individuals have to know at the local level, even with the aid of money prices established on free markets, is enormous. While this may be obvious to most of us, I think it’s especially important for those of us who are devoted to understanding and explaining the market process not to lose sight of it, as we are sometimes apt to do when we marvel at the impersonality of the market.

Now, competition, by constraining the proclivity of some buyers and sellers to act dishonestly, can relieve much of our day-to-day worries about the trustworthiness of those we have dealings with. And what Elinor Ostrom might call the “nonmarket bases of the market process,” such as norms of reciprocity, conventions of fair play, and the like, do much the same thing. But as the sociologists Nicolas Christakis and James Fowler have recently written, norms and conventions are transmitted and reinforced though social networks. Prices are too.

Social Networks and Economic Freedom

Informal connections like I’ve described can of course exist in less free, more regimented societies. It’s just that the freedom to associate with strangers, which is an important part of economic liberty, gives rise to so many more of those connections. True liberty means not only being able to form ties with new people and new social networks, however, but also the freedom to cut ties to old business partners and customers, as well as to let go of old social networks, including those of friends, family, and community.

The ability to form and dissolve ties to social networks gives greater access to an existing array of diverse knowledge and tastes – much of which may not be useful but some of which undoubtedly is – while expanding the range of that diversity by stimulating new ideas in business, science, and culture. Liberty encourages economic progress and social diversity by giving each the freedom to move, not only from place to place but from one social network to another.

That freedom of movement, in physical and social space, is the essence of the free society.

I think so. It is best seen in the way mainstream economics tends to define the fundamental question concerning the “optimal allocation of resources.” Economics tries to explain how resources might (or might not) get optimally allocated to their various possible uses. In a world of limited resources and unlimited wants, how do we ensure that resources are devoted to people’s most urgent wants?

Most standard economic models seek to demonstrate how, under certain conditions, resources will be allocated optimally by the free market. Those same models can also show that if the specified conditions do not hold, then resources will be less than optimally allocated. This generally referred to as “market failure” because free markets fail to achieve that optimal allocation. Many mainstream economists argue that government can step in and either change the conditions under which the market operates, or directly allocate resources itself, so that society reaches that optimal allocation pattern.

Notice that optimal allocation is the goal. In other words, what is valuable about markets is the degree to which they “get it right,” with the “it” being the resource allocation. Government intervention is deemed justified by people who believe that, in some cases, it can allocate resources better than markets can.

Fundamentally Different

For Austrians, the fundamental issue is not whether markets get it right. True, Austrians think markets are pretty good and governments quite bad in that respect. And even though Austrians might explain things differently from the mainstream, there are plenty of mainstream economists who would agree with those general conclusions. Note, though, that the question here is still about getting it right.

Where the Austrian view differs, I would argue, is in understanding that markets are also really good at helping people to know when resources are not optimally allocated and providing the signals and incentives needed to correct the mistakes. Being adept at getting things right at a given point is of course a good thing. But it is probably more valuable — given that we aren’t likely to get things perfectly right on a regular basis — to be able both to know when we are wrong and to have an incentive to do better.

Government Failure

This approach provides a way to see the problems government has in allocating resources even remotely well: It’s not just that government gets it wrong at various points but that political processes do not have the same error detection and correction abilities that markets have. Political actors are far less likely to know when they’ve erred and to have the right incentives to correct things. Government is not only less able to get it right; it’s also less able to know when it’s got it wrong.

A whole new light is now shed on the idea of “market failure.” In this more Austrian view, markets frequently “fail” by not allocating resources optimally at a given time. But calling this a “failure” ignores the Austrian point that what markets are particularly good at is telling us that resources are not optimally allocated and providing the knowledge and incentives necessary to correct the errors. From the Austrian perspective, “failure” should refer not to suboptimal allocation at a given time, but rather the inability to detect and correct error. If we understand that the crucial question is how well alternative processes do those things, we realize that supposed market “failures” are better seen as opportunities for market successes.

Daniel Stone, in the November 13, 2010, issue of Newsweek, addresses the dilemma in his article “Hail to the Chiefs.” The essay’s subhead summarizes the problem: “The presidency has grown, and grown and grown, into the most powerful, most impossible job in the world.” Stone’s solution, as suggested by his article’s title, is to devolve presidential power either to cabinet members (oligarchy?) or to “outside agencies” (technocracy?).

Stone dismisses the notion that government or the president could simply do less. “It’s hard to imagine,” he writes, “how the office could sizably shrink, allowing the president to return to a more aloof, strategic role.”

The job’s impossibility stems from the sheer scope of government power and therefore the incredible array of issues with which any president must grapple: unemployment, Middle East peace, energy, homeland security, drug abuse, Iraq, offshore drilling and oil spills, foreign trade, terrorism, scandals, greenhouse-gas emissions, Afghanistan, North Korea, health care, the financial industry, pollution, education, transportation, nuclear proliferation, the national economy, the global economy—the list is endless. How can any one person competently deal with all that, no matter how many advisers he or she might have?

In Stone’s words, “Days in the West Wing are a constant, head-spinning oscillation between dozens of domestic, foreign-policy, and political eruptions and concerns.”

Imagine the mass of information flooding into the White House each day. Who could digest it? Some half-dozen aides are needed just to deal with incoming mail. Stone relates former chief of staff Rahm Emanuel’s instructions to senior staff members trying to deal with the daily deluge: “We need to make his memos shorter. Last night we sent the president a phone book.”

Yet a library of “phone books” would be needed to adequately cover all the issues a president attempts to handle. A country, not to mention the world, is too complex for anyone (or any group) to manage; they simply cannot gather, analyze, and act on the necessary mass of information in a timely fashion. In fact, this understates the problem: The most critical knowledge on which a society depends for its smooth operation—“knowing how” rather than “knowing that”—is widely dispersed and cannot be fully articulated. This is the “knowledge problem” emphasized by F. A. Hayek. Delegating power to cabinet members or agencies cannot solve that problem.

Consider the process by which a government policy is instituted. First, the goal must be clearly defined or the problem to be solved properly diagnosed. Next, a policy is formulated to achieve the goal or address the problem. Then a bill must make its way through Congress relatively intact. Once enacted, it has to be properly implemented and enforced. Finally, the policy’s impact must be monitored so that adjustments can be made in a timely manner. Performing any one of these steps successfully is difficult; performing all successfully is virtually impossible. And this only begins to identify the obstacles.

The chances of success decline rapidly as the complexity of the system to be controlled increases. Not only does predicting the impact of a given change become more difficult, but assessing the results also becomes harder. Did the policy really cause an observed behavior or was it the result of something else entirely? Further reducing the ability to determine cause and effect are the filters that ideology places on incoming information.

Ideological Filters

People use simplified models of the world to deal with its complexities. These models (aka paradigms, worldviews, or ideologies) provide logical frameworks for understanding cause and effect. Models also help filter out apparently unnecessary information from the flood of data we face every day, allowing us to concentrate on what we believe to be important. To the extent that our models are incorrect or only approximate reality, though, we can overlook important information that does not fit our worldview. This is known as “confirmation bias.”

Consider the CIA’s acceptance of the face the Soviet Union presented to the world during the 1970s, including its claim that its economy was enjoying an impressive 3 percent annual growth rate. President Ronald Reagan, familiar with free-market critiques of central planning, did not believe a command economy could work as well as the CIA thought. William Casey, Reagan’s CIA director, tasked agency analysts with exploring the possibility that the Soviet financial system was in fact crumbling. Specifically, Casey asked them what might be expected from a Soviet Union whose economy was shrinking.

The analysts speculated that popular discontent would rise. In response, Moscow would shift military spending to the civilian sector, perhaps by using steel to build locomotives instead of tanks. The Soviets might also purchase foreign technology to boost consumer-goods production, obtaining the necessary hard currency by increasing oil and gas sales to Europe.

Casey then asked analysts to determine whether any of these predicted signs of economic distress were in evidence. Within days, reports flowed in confirming the predictions. This data had long been available but was ignored as irrelevant given the assumption of a solid Soviet economy. (See articles by former intelligence official Herbert Meyer here and here.)

The lesson is not that models are inherently bad but that they must be periodically and critically examined to ensure they accurately mirror reality.

The Great Recession offers a more recent example of entrenched paradigms at work. There are many competing explanations for the current financial crunch: (1) an investment bubble produced by the Federal Reserve’s inflationary actions; (2) a housing bubble created by federal pressure on mortgage companies to lend to bad credit risks; (3) the federal government’s implicit backing of Freddie Mac, Fannie Mae, and other financial institutions, leading them to take excessive risks; (4) deregulation, notably the repeal of the Glass–Steagall Act; (5) unregulated derivatives trading; (6) housing speculators; (7) predatory lending; (8) Wall Street greed; and (9) tax cuts that allowed imprudent investments by wealthy individuals leading to a financial bubble.

Any of these views can be supported by citing isolated nuggets of carefully selected data. Predictably, libertarians and conservatives prefer explanations predicated on government failure. Proponents of government control favor theories rooted in market failure, while class warriors promote those blaming the rich in general and Wall Street in particular.

Theoretically, corrective policies based on each explanation could be implemented one after another. A policy’s success or failure might indicate whether the explanation on which it was based is correct. But a nation is not a laboratory, and uncertainty caused by such experimentation would bring the economy to a grinding halt. Furthermore, success or failure would not be conclusive. Opponents of a successful policy might argue that conditions improved despite, not because of, the action taken. Similarly, supporters of a failed policy could claim that things would have been far worse without it.

Rather than experimenting, policymakers might consult history to determine the results of similar past policies. Yet history is also seen through a filter. After 70 years of hindsight, economists and historians still argue whether market or governmental failure caused the Great Depression and whether the New Deal helped or hurt.

Politicians generally surround themselves with people who share their fundamental beliefs. The president’s staff controls the information he sees, and that information is likely to comport with their shared worldview. This alignment of “paradigm filters” exaggerates the importance of those bits of information that are consonant with the White House consensus and discounts those that are not. Failed programs are therefore more likely to be expanded than ended. The president and his advisers will want to believe that any problems were caused by insufficient funding or enforcement rather than an unsound worldview. Reinforcing this tendency is self-interest—admitting mistakes can shorten a politician’s career.

Increasing Efficiency, Dispersing Information

The notion that a president can oversee an economy is a fantasy. Unfortunately, although central planning has been discredited, Keynesian-style policies for maintaining employment or aggregate demand are still thought feasible—despite overwhelming contrary experience grounded in proper theory. But anything more complex than the most primitive economy simply is not amenable to such “assistance” from a central authority.

In Capital and Interest, Eugen von Böhm-Bawerk explained that economies become more efficient by employing increasingly “roundabout methods of production.” For example, a caveman could catch small animals for food with his bare hands, or he could increase his efficiency by using tools, perhaps using rocks or sticks as clubs. Hunting becomes marginally more complex, but the result is a bigger “harvest.” The caveman could raise his productivity further by crafting better tools—clubs, spears, snares, bows and arrows. It costs the caveman time and effort to construct tools and become proficient with them, but his investment is likely to be well rewarded.

The process of constructing hunting implements could itself be improved by fabricating tools such as knives and scrapers. The use of these tools is a further step removed from the process of hunting, constituting a yet more roundabout method of “producing” small game. This progression can be continued indefinitely as still other tools are created to facilitate the production of each new tool set.

Further efficiencies can be realized, as Adam Smith explained, through the division of labor. For example, while some cavemen hunt, others can concentrate on crafting snares or spears. With each improvement, either by creating new tools or further subdividing tasks, efficiency is increased, though at the cost of additional time and complexity. This process is repeated endlessly as economies advance.

In undeveloped countries, manufacturers must be relatively self-sufficient because suppliers and transportation are expensive and unreliable. This was true in the Soviet Union and in early twentieth-century America. The first U.S. automakers built their cars from the ground up. Nearly everything—nuts, bolts, springs, and engines—was made in a single factory. A company’s employees did everything from fabricating parts, to assembling them, to sweeping up afterward. As the nation’s economy and infrastructure developed, however, auto companies discovered they could make better cars at lower prices by purchasing components and services from specialized firms.

With inexpensive transportation, tools and subcomponents can now be fabricated far from final assembly points. Parts once built in one area of a plant then moved to another to be bolted onto a chassis are now transported from remote factories by ships, trains, and trucks over vast distances, often from other countries. Where once hundreds of companies helped to produce American cars, now tens of thousands from all over the globe help to produce far more vehicles of higher quality and with features unimaginable just a few decades ago.

With this explosion of companies comes an explosion of complexity. Those contributing to an end product’s manufacture may have no idea what that product is, where it will be built, or who will use it. Logistics is now key—ensuring that molded plastic parts, tires, paint, fasteners, adhesives, and countless other components from all over the world arrive at assembly lines in just the right number and at just the right time. All this complexity is managed by millions of people with local knowledge who quickly adapt to changes in everything from costs to the weather. None of this could be centrally directed by boards of bureaucrats incapable of even cataloging all the people, tasks, parts, and services involved before the list became outdated.

Managing the Unmanageable

As Hayek pointed out in his essay “The Use of Knowledge in Society,” the term “planned economy” is misleading. All economic activity is planned. The question is whether the planning is done by people on the scene with local knowledge and a stake in the outcome, or by remote bureaucrats with insufficient, outdated information and nothing to lose—bureaucrats ignorant enough to believe that people can be ordered like pieces on a chessboard and arrogant enough to try. Will planning be done by businesspeople who either replace faulty paradigms or fail, or by politicians holding fast to broken ideologies for fear of losing office?

Complex systems—from rainforests to economies—are less predictable than simpler ones. They are also harder to control because everything within them is interconnected. A tweak here or a prod there can have unintended and undesirable consequences. No one can anticipate how creative, entrepreneurial individuals will adjust their behavior to regulatory obstacles or stimulative measures. While a bad decision made at the local level can cause a manageable problem, that same decision made at the national level can create a nationwide or worldwide disaster.

The presidency has indeed grown beyond the capacity of any single individual. That is because government has ventured into areas where it has no business intruding. The answer is not to redistribute the government’s vast power but to radically reduce its power so that private individuals are free to control their own lives and property.

An example of this idea is “sex” versus “gender.”  Sex in this view refers to the biological characteristics of men and women, which are given to us by nature.  By contrast, “gender” refers to social characteristics we associate with males and females — what we call “masculinity” and “femininity.”  The argument is that these characteristics are “socially constructed” in the sense that there is no universal essence for either; instead, over time we have constructed those terms to mean certain things. For example, to be masculine is to be rational and aggressive while to be feminine is to be more emotional and passive.

As a libertarian who thinks Mises and Hayek have much to teach us about the world, I see nothing objectionable about the idea that many institutions are socially constructed.  In fact, I would argue it’s not only correct but that Mises and Hayek would have agreed.  Mises argued in the 1920s that our very thought processes are constrained by the language we speak, and Hayek’s work on how institutions, norms, and practices are unintended orders resulting from social evolutionary processes is completely consistent with the idea that many of our categories are “socially constructed.”

Beware Connotations

From a Mises-Hayek perspective the problem with that phrase is that the word “constructed” has connotations that can lead to intellectual confusion.  Normally that word suggests intentional planning.  When we construct a building, we don’t imagine it coming together without a master plan involving architects and engineers.  In the social world, by contrast, institutions emerge as the unplanned outcome of human action.  Or in Hayek’s phrase taken from the eighteen-century thinker Adam  Ferguson, they are the “products of human action, but not human design.”

The danger here is that once one sees social institutions as “constructed,” even “socially,” it’s easy to take the next two steps: thinking one can deconstruct and then reconstruct them. One of the great intellectual pastimes in the humanities and social sciences is to deconstruct social institutions by pointing out how they serve the interests of a specific group or enable one group to dominate another.  Again, this by itself is no problem as long as one understands that the process which created those institutions was not the result of human design.

Take the western family, a classic example of a socially constructed institution.  Yes, biology matters, but the particular ways in which we organize the family — the roles of “mother,” “father,” and “child” — are most certainly the product of a long social evolutionary process, which has varied across cultures.  In the West this process has benefited men more than women, which is often one of the major points made by those who want to deconstruct the family.  In fact, some will then argue that men must have controlled the construction process to benefit themselves.

No Conscious Design

And here is where a good dose of Mises and Hayek would help.  Once we recognize that institutions were never really constructed — in the sense of being the intentional product of human design — we can see that the family is not the result of planning and that even though it has perhaps disproportionately benefited men, it need not be because men, or anyone else, consciously designed it that way.  The Mises-Hayek perspective also shows that reconstructing the institution to address those supposed problems is simply not possible thanks to the limits to our knowledge and the way in which unplanned social processes make better use of that knowledge.

That is not to say we are helpless to change social institutions.  As Hayek argued, we can make changes at the margin or adjust one rule at a time, but we cannot redesign or reconstruct them from whole cloth.  Thinking we can do so is a mark of what Hayek called “constructivist rationalism”: the incorrect belief that we can design the social world as we please.  The common etymology is no coincidence, because another way of putting Hayek’s point is that what was never constructed by human design cannot be reconstructed by human design.  This is a lesson that more scholars using the language of social construction need to learn.

(I thank Aeon Skoble for comments on an earlier draft.)

Cohen provides what he terms “a compelling preliminary case for socialism.” He proceeds to identify two desirable features of a camping trip—equality and community—and then asks readers to consider whether those principles don’t also make socialism desirable for whole societies. Later he discusses the feasibility of socialism but never responds to the criticisms made by Mises and Hayek. Cohen thus builds his case on a foundation that was blasted to rubble decades ago.

He argues (rightly, in my view) that few would like a camping trip in which every act of cooperation took place within formal markets and explains persuasively why personal relationships are not mediated through markets. I do not charge my children for attending to meals and bath time, nor do I expect to be paid for accepting dinner invitations. There certainly are degrees to which our daily affairs are organized along “socialist” principles, but that’s irrelevant to the economic critique of socialism, which concerns economic calculation in a complex society when the means of production are not privately owned. As Mises and Hayek have shown, such calculation is impossible.

Arguments for socialism, Cohen’s included, crumble when they fail to recognize the problems inherent in socialist production. In constructing his example of the camping trip, Cohen begins by assuming “facilities with which to carry out our enterprise: we have, for example, pots and pans, oil, coffee, fishing rods, canoes, a soccer ball, decks of cards, and so forth.” The questions of what should be produced and how have just been assumed away. Cohen’s hypothesized camping trip is also (I assume) voluntary, which is at odds with the coercive nature of socialism.

For Cohen socialism’s problem is that designing production processes is difficult, but he thinks the problem can be solved by wise technicians and bookkeepers. Further, he seems not to understand the problems of competing claims to productive resources and competing ideas about what should be produced. Cohen doesn’t say what he would do with people who don’t wish to be reacquainted with their “species-essence,” as Marx put it, by abandoning the market in favor of allegedly “natural” socialism. Most telling of all, he never mentions the mountains of corpses produced by those who tried to implement his vision in the twentieth century. How do we avoid “the worst getting on top,” as Hayek put it?

Cohen calls the free market “a casino from which it is difficult to escape” and denounces the inequalities it produces. Markets, he contends, are based on greed and fear, but even if that charge were true, it isn’t clear that centralized control of the means of production would be an improvement. The organization of production, as he sees it, is a question of overcoming greed and harnessing generosity. Only someone who knows nothing about the twentieth century could think that putting government officials in charge of the economy overcomes greed and harnesses generosity.

Cohen’s misunderstanding of the market is also evident in his discussion of people like doctors, nurses, and teachers, who he thinks are motivated by higher ideals than narrow self-interest (though doctors and teachers are represented by powerful lobbying groups aiming to increase their incomes). He writes, “. . . market signals are not necessary to decide what diseases to cure or what subjects to teach, nor are they efficient means of deciding that.” That simply isn’t true. Market signals are of utmost importance; without them, we cannot know whether to devote our next dollar or hour to AIDS eradication or cancer research.

The book leaves the impression that Cohen’s vision of social organization is one with an army of smiling New Socialist Men and Women accepting orders from a small coterie of philosopher-kings who are blessed with knowledge of The Very Best. In the final analysis Cohen’s attempted “compelling preliminary case for socialism” is neither compelling nor convincing. The book will make excellent grist for the mills of freshman seminars, but it collapses under the slightest scrutiny.

For an economist this is a fascinating idea for a show; I’ll explain why shortly.  However, I was disappointed because the episode I saw turned into a typically maudlin “reality show” where the boss is humanized by the remarkable cast of characters who work in the stores.  For example, the CEO, unsurprisingly, was unable to cook a good burger or make the ketchup smiley face for the fries, which led to much teasing from the employees. Viewers got to see the great CEO brought down to earth.  And, of course, each of the featured employees had his or her own complex and often troubled life.  At the end the CEO provided goodies (including a college fund for one woman’s kids and a year’s worth of rent for another) to the faithful employees as a way of recognizing their problems and hard work.  He tells his assembled workers he has been humbled and changed by the experience.

This might make for good TV, but it’s pretty uninteresting as economics.  Looked at from the vantage point of Austrian economics, there’s a potentially better show lurking beneath the smiles and tears.

Markets as Ecosystems

One of the most fundamental contributions of Austrian economics is the identification of markets as ecosystems of knowledge.  Ludwig von Mises and F. A. Hayek both emphasized that a complex, advanced economy requires private property, exchange, markets, and prices to calculate value and determine the efficacy of one’s production activities.  Profits and losses, too, are key to providing feedback to firms.  The argument, particularly in the hands of Hayek and later Austrians, is that knowledge is too often dispersed, contextual, and/or inarticulate to be communicated and centralized.  This is the core of the Austrian argument against socialist planning.

As it turns out, the same issues arise within firms.  Large firms need ways of taking advantage of the fact that their scattered employees also have knowledge that cannot easily be communicated through the usual formal means that firms offer.  CEOs and other leaders might be utterly unaware of important information available on the shop floor unless they have processes by which that information can be communicated.  Employees may not even know they are doing something or know something that could be of great value to the firm as a whole.

The idea of an “undercover boss” would be a fun and interesting way to approach these problems.  The “undercover” part might be necessary to avoid employee self-consciousness or fear, which could undermine communication. But perhaps  not.  If more CEOs spent more time on the front lines, they might well find out some things they would otherwise miss.

Even in the disappointing episode I saw, there were two small examples of what  an undercover boss might discover.  First, one employee had invented a new dish (French fries and grilled mushrooms covered with cheese) that customers at his store loved.  The CEO thought it was great, and his “goody” for the employee was a promise to test it at several restaurants.  In another case a female employee who used dancing in her routine with customers caught his eye and he thought that might be fun if more employees did it too. So he asked the woman to become part of the training group.

A really interesting version of the show, at least to an economist, would be one that recognized the ignorance of those at the top and had the boss going undercover to improve the firm by learning from employees how best to serve customers.  Rather than making bosses look incompetent for not knowing how things work, make them and the employees look smart by showing what can be gained by observing frontline operations.

In a world where more and more work takes the form of services and creative jobs in which strict routines make little sense, frontline workers will continue to have more independence and responsibility.  Being observed by the boss is one possibly effective way for employees to transmit what they know up the chain of command so the knowledge can be effectively used by others.