The Calculation Problem And The Knowledge Problem: Two Sides Of One Coin

THE ANALYSES OF Mises and of Hayek as to the feasibility of a socialist economy are complementary. Mises showed that socialism is incapable of achieving an efficient use of society’s resources, because its economic planners have no means by which to perform economic calculation. Hayek showed that the reason market prices can be used for economic calculation is that they reflect the best possible estimate of how useful the various factors of production will prove to be in satisfying consumer demand. Today’s prices for the factors of production are largely determined by those entrepreneurs who previously estimated consumers’ wishes most successfully. Their past successes increased the funds at their disposal, giving them greater means with which to bid for currently available resources. Each entrepreneur is able to use his personal knowledge of his “particular circumstances of time and place” in deciding what price to offer for various factors of production.

A socialist planner could slap some arbitrary “price” on every good and then proceed to calculate the outcome of alternative ways of producing goods based on those numbers. However, since they have no relationship to the actual wishes of the consumers, they are prices in name only, merely a pale imitation of market prices. As Mises wrote in Human Action:

Even if, for the sake of argument, we assume that a miraculous inspiration has enabled the director [of a socialist economy] without economic calculation to solve all problems concerning the most advantageous arrangement of all production activities and that the precise image of the final goal he must aim at is present to his mind, there remain essential problems which cannot be dealt with without economic calculation. For the director’s task is not to begin from the very bottom of civilization and to start economic history from scratch. The elements with the aid of which he must operate are not only natural resources untouched by previous utilization. There are also the capital goods produced in the past and not convertible or not perfectly convertible for new projects… [in which] our wealth is embodied. Their structure, quality, quantity, and location is of primary importance in the choice of all further economic operations. Some of them may be absolutely useless for any further employment; they must remain “unused capacity.” But the greater part of them must be utilized if we do not want to start anew from the extreme poverty and destitution of primitive man… The director cannot merely erect a new construction without bothering about his wards’ fate in the waiting period. He must try to take advantage of every piece of the already available capital goods in the best possible way.
Lacking real prices, the socialist director has no clue as to that “best possible way.”

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The Knowledge Problem

MISES’S STUDENT, F.A. Hayek, brought into relief an aspect of the problem facing socialist planners that was only implicit in the work of his mentor. In his famous essay, “The Use of Knowledge in Society,” Hayek noted the importance of “the particular circumstances of time and place” in making sensible economic decisions:
Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active co-operation. We need to remember only how much we have to learn in any occupation after we have completed our theoretical training, how big a part of our working life we spend learning particular jobs, and how valuable an asset in all walks of life is knowledge of people, of local conditions, and of special circumstances. To know of and put to use a machine not fully employed, or somebody’s skill which could be better utilized, or to be aware of a surplus stock which can be drawn upon during an interruption of supplies, is socially quite as useful as the knowledge of better alternative techniques. The shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices-are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.
In the same essay, Hayek offers an example of how the price system enables the changing circumstances of a market participant to potentially influence the choices of other actors throughout the entire economy, thereby adjusting supply and demand to new conditions:
Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes.
Have you ever read the list of ingredients on a package of, say, “Puffy, Deep-Fried Cheese Thingies,” and found something along the lines of: “This product contains one or more of the following: coconut oil, palm oil, soybean oil, corn oil, canola oil, peanut oil, motor oil, snake oil.” When I first did so, I was puzzled as to how a manufacturer could be uncertain about just which oils were in its product. Of course, I was mistaken as to what the list meant. For any particular batch of Puffy, Deep-Fried Cheese Thingies, the manufacturer certainly knows which oil it is using.
In fact, the vague nature of the list is an illustration of Hayek’s point. The producer of Cheese Thingies believes (rightly or wrongly) that its customers don’t care too much about exactly which sort of oil was used to fry the Thingies in the bag they just bought, so long as the taste is pretty much the same as the ones they previously have eaten. Therefore, whenever the manufacturer must buy cooking oil, it purchases whatever one is cheapest at that time.
The goal of the manufacturer is simply to increase its profits. However, because it responds to price signals in its efforts to do so, it also, as an unintended consequence of pursuing its own end, helps to allocate resources to their most urgent use. Users who have a greater need for a currently more expensive variety of oil, for example, a producer of West African foods who can only achieve an authentic taste with palm oil, will acquire that oil in the Cheese-Thingies manufacturer’s stead. It is as Adam Smith noted long ago: “It is not from benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”
Of course, market prices do not “measure” consumer demand; they only paint a rough picture of it. Prices must always be interpreted by the entrepreneurs, who are eager to profit from any perceived discrepancy between current market conditions and the true desires of the consumers. The market process is driven by the continuing efforts of entrepreneurs to better understand what consumers really want, given the currently available resources. Such knowledge is certainly not available to any person in the absence of the market process, just as the knowledge of how to swim cannot be acquired without getting in the water.
Only in the imaginary state of an evenly rotating economy would prices precisely reflect consumer demand. In the real world, where the conditions presented to humans by nature continually change and human learning is an ongoing process, we will never reach a state of complete and final equilibrium. In the world in which we live, no price is ever perfectly adjusted to the true state of the consumers’ desires. Nevertheless, market prices are the best possible means for making those desires known and for motivating entrepreneurs to fulfill them.

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The Calculation Problem

PICTURE YOURSELF AS the head planner of a global socialist state. The recent spring months in the Northern Hemisphere have been unusually hot and dry. Your minions come to you to ask how to adjust the agricultural plan for the upcoming summer. All of the farm managers are crying out for more water, but there is not enough to meet all of their requests, while still supplying the city-folk with drinking water and keeping the factories that use water up and running.

Your alternatives are legion. To help comprehend the multitude of options facing you, consider some of the numbers involved. In 1999 there were over two million farms in the U.S. alone. If the growing season was dry across the Northern Hemisphere as a whole, then millions of other farms will have been affected.

Since water is extremely divisible, you could allocate to any particular farm perhaps one of millions of different amounts of water. Of course, to be useful, the water must arrive at the farm. There are probably many ways to deliver it. For any particular farm, you might decide to re-route city drinking water to it, build an aqueduct servicing its area, construct a de-salinization plant nearby, have trucks regularly deliver it water, or some other method of which I haven’t conceived. Each strategy will differently affect other water users.

A particular farm, given its allotment of water under the new plan, might cope in a variety of ways. Water conservation devices could be installed, different crops raised, less total weight of crop produced, or, I’m sure, the reduced supply might be dealt with by other means that a farmer could tell you about but I can’t. The central plan must take into account all such possibilities. And you, as the central planner, might also consider closing some farms, thereby freeing resources for other employment. Just what is the number of possible solutions you might consider? Is it in the trillions? Quadrillions?
How can you decide which course of action you should take? Unfortunately, there aren’t any rational means by which you can decide. You must simply venture a guess as to how the plan should be adjusted, then order your minions to so adjust it. You can’t arrive at a reasoned answer to your dilemma because you lack market prices for the factors of production to which you must assign a use. Market prices are the foundation of business accounting. Without them, there can be no meaningful calculation of the profit or loss resulting from any enterprise. (Sometimes socialists claim that is unimportant, since profit and loss are concepts that only apply to the market economy. As we have seen, that is not true: all human action aims at profiting the actor and seeks to avoid loss. Socialism cannot dodge the fact that the means we use to achieve our goals are scarce, and, therefore, must be economized.)

The central feature of socialism is that the factors of production must not be under private control. If they were, then greedy capitalists would use their ownership of those goods to exploit the workers. Instead, capital goods should be controlled by “the public,” which always, in practice, means the state.
Therefore, the market process, the ceaseless striving of entrepreneurs to locate price discrepancies and profit from them, thus better adjusting production to the wishes of the consumers, is absent from the socialist economy. Unfortunately for the hopes of socialists, there is no adequate substitute. The mathematical equations describing the equilibrium prices of the evenly rotating economy are of no use in determining what actions, if undertaken in the real world, would move prices toward that equilibrium. Attempts to create “pseudo-markets” among socialist managers, hopefully resulting in “market-like” prices, are similar to playing chess against one’s self: without the real competition that exists among private property owners, the socialist managers lack both the incentives and the feedback necessary to drive the market process towards the discovery of better prices.

To aid in understanding this crucial fact, let’s now envision a drought in a place where water is bought and sold on a free market. (The U.S. is not such a place, as local, state and federal agencies all continually intervene in the market for water.) There, it is the interplay of the choices of all affected individuals that determines the response to a drought. Most of those individuals are better aware of their own circumstances and options than is anyone else. Perhaps Farmer Joe has some rolls of black plastic sitting around in his barn. When water prices rise in response to the drought, he finds it worth his while to unroll them and lay them around his crops, thereby reducing his need for water. For some time Farmer Mary has been thinking of installing a drip irrigation system; in response to the price rise she calculates that it is now profitable to do so. Other farmers may dig deeper wells, or invest in a water cooperative that will build an aqueduct, or plant a different crop that needs less water. Entrepreneurs operating in the water market will be on the lookout for local price variations, which are a sign of differing, but as yet unmet, urgencies in the demand for water. They will attempt to take advantage of price discrepancies by diverting water from places where the price is lower to those where it is higher.
Some farmers may need extra cash to see them through the drought period. Which are worth investing in, and which ones will not weather the crisis even if granted credit? A local water dealer decides the question based on his personal knowledge of how long a farmer has been his customer, how strong the farmer’s ties to the community are, and how quickly he has paid his bills in the past. People who have dealt with local merchants long enough to become a “regular customer” know that they try to determine which customers should be extended credit during a rough time, in the hope of retaining them as patrons when better times return.

Suppose that as a socialist state’s chief central planner, you are considering how to allocate your country’s steel supply. You know of a multitude of things that might be made with it. You also know that your subjects want cars, tractors, microchips, strong buildings, and electrical wire, among the many goods that could be made from that steel. However, because you don’t have an infinite amount of steel, to say nothing of the complementary goods and services that are needed to produce useful items from steel, you must decide which of its possible uses are most important. You hope to use it to produce, at the least cost, those things most desired by the consumers in your country.
You are faced with a hopeless task! Lenin promised that under socialism “the population will gradually learn by themselves to understand and realize how much and what kind of work must be done, how much and what kind of recreation should be taken.” But such learning cannot occur if there are no market prices alerting individuals to the opportunity to profit by adjusting their actions to better meet the wishes of their fellows. You, the planner, will end up in a fix like the one Mises described in Economic Calculation in the Socialist Commonwealth:
There will be hundreds and thousands of factories in operation. Very few of these will be producing wares ready for use; in the majority of cases what will be manufactured will be unfinished goods and production goods. All these concerns will be interrelated. Every good will go through a whole series of stages before it is ready for use. In the ceaseless toil and moil of this process, however, the administration will be without any means of testing their bearings. It will never be able to determine whether a given good has not been kept for a superfluous length of time in the necessary processes of production, or whether work and material have not been wasted in its completion. How will it be able to decide whether this or that method of production is the more profitable? At best it will only be able to compare the quality and quantity of the consumable end product produced, but will in the rarest cases be in a position to compare the expenses entailed in production.

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The Rule Of The Worst

MANY SUPPORTERS OF socialism are quite pleasant, decent people. They became socialists because of their genuine concern for the welfare of the weak and the poor. They are appalled if someone tells them that they promote tyranny. True, they admit, the record of past attempts to create heaven on earth has not been pretty: the Soviet Union, Communist China, Nazi Germany, and other utopian experiments resembled hell more than heaven. But, they assert, that was because of the evil nature of the people who took over. They advocate a utopia ruled over by kindly, open-minded, tolerant people—people like them. A planned economy run by such people would undoubtedly be preferable to one run by, say, Pol Pot, who murdered roughly one third of his countrymen during his reign in Cambodia.

However, in what is probably the most famous book to emerge from the Austrian School, The Road to Serfdom, Hayek explained why nice people are unlikely to remain in charge of a socialist state. A centrally planned society requires that a single will direct all its members’ efforts. It might be the will of a sole dictator, of a ruling committee, or even of “society as a whole,” as represented by opinion polls or elections. In any case, all productive efforts must contribute to a single master plan.

However that plan is formulated, it is inevitable that many people will disagree with at least some part of it. How should dissent be handled? For instance, the nation’s coal miners might find the wage assigned to them by the plan to be too low. They refuse to work for such paltry pay.

In a market society, the miners would be free to seek other employment offering a higher wage. Free competition between employers seeking to attract workers will tend to move wages toward a level where it just barely profits an employer to engage the last worker he hires. (That is the marginal worker.) If someone can’t find work at the pay he believes he deserves, the workings of the market process don’t guarantee that he really isn’t worth as much as he thinks he is. But in a market, entrepreneurs will continually be searching for such undervalued resources, thereby raising the price they fetch.

However, in a socialist state, the coal workers can’t go look for other work—the plan has assigned them to the coal mines. If 10,000 coal miners are in the plan, then 10,000 there must be—otherwise, the plan becomes irrelevant. And the planners cannot simply raise the miners’ wages until they agree to work—the level of those wages is already in the plan. Raising it will require re-planning the entire economy.

What can the directors of the socialist economy do? The inclination of the well-meaning, decent socialists will be to talk things over with the miners. The planners should find out what grievances the miners have, determine what conditions would make them happier, and inspire them to work because of their patriotic duty to contribute to the common good. Based on the outcome of such a dialogue, the plan can be modified. But once several similar dialogues are underway in different industries, production will slow to a crawl throughout the economy.

The residents of a nation attempting to centrally plan the economy soon will be faced with a choice. They can either abandon their march toward socialism, or opt for a strongman who promises to get things done. If they do not turn away from central planning, then a strongman will soon be in charge, as happened in Germany in the 1930s, when Hitler came to power. Then, when the coal miners refuse to dig coal at the wage allotted to them in the master plan, the solution is simple: “Shoot them!” As Hayek says, “the totalitarian dictator would soon have to choose between disregard of ordinary morals and failure.” Under a strongman, the people believe that they have some hope of being able to heat their houses, even if the hope comes at the cost of the coal miners’ liberty, and, ultimately, the liberty of everyone.

A market-based society may seem harsh at times. If miners don’t accept the wage offered by a mine owner, he might fire them and hire replacements. But at least the miners have the opportunity to seek work elsewhere, at the highest wage they can find. When the government is the only employer, there is nowhere else to go, and no one else with whom to negotiate.

As Hayek says in The Road to Serfdom, the dream of non-totalitarian socialists relies on “the miracle of a majority’s agreeing on a particular plan for the organization of the whole of society.” Absent such a miracle, it is “the lowest common denominator which unites the largest number of people.” Whatever set of prejudices can most easily connect with the most ignorant members of society will tend to win the most allegiance. Social interaction is increasingly reduced to a contest over who can mug whom most quickly.

As that happens, it behooves minorities to watch their backs. The temptation for the leaders to organize a pogrom against some minority group will be tremendous. As Hayek says, “it seems to be almost a law of human nature that it is easier for people to agree on a negative program—on the hatred of an enemy, on the envy of those better off—than on any positive task.” Totalitarian regimes tend to demonize some unpopular minority, such as Jews in Nazi Germany, kulaks in the Soviet Union, intellectuals in Pol Pot’s Cambodia, or East Asians in Idi Amin’s Uganda.

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The Creative Powers of a Free Civilization

Civilization advances by extending the number of important operations which we can perform without thinking about them. Operations of thought are like cavalry charges in a battle-they are strictly limited in number, they require fresh horses, and must only be made at decisive moments.
A. N. WHITEHEAD

1. The Socratic maxim that the recognition of our ignorance is the beginning of wisdom has profound significance for our understanding of society. The first requisite for this is that we become aware of men's necessary ignorance of much that helps him to achieve his aims. Most of the advantages of social life, especially in its more advanced forms which we call "civilization," rest on the fact that the individual benefits from more knowledge than he is aware of. It might be said that civilization begins when the individual in the pursuit of his ends can make use of more knowledge than he has himself acquired and when he can transcend the boundaries of his ignorance by profiting from knowledge he does not himself possess.

This fundamental fact of man's unavoidable ignorance of much on which the working of civilization rests has received little attention. Philosophers and students of society have generally glossed it over and treated this ignorance as a minor imperfection which could be more or less disregarded. But, though discussions of moral or social problems based on the assumption of perfect knowledge may occasionally be useful as a preliminary_exercise in logic, they are of little use in an attempt to explain the real world. Its problems are, dominated by the "practical difficulty" that our knowledge is, in fact, very far from perfect. Perhaps it is only natural that the scientists tend to stress what we do know; but in the social field, where what we do not know is often so much more important, the effect of this tendency may be very misleading. Many of the utopian constructions are worthless because they follow the lead of the theorists in assuming that we have perfect knowledge.

It must be admitted, however, that our ignorance is a peculiarly difficult subject to discuss. It might at first even seem impossible by definition to talk sense about it. We certainly cannot discuss intelligently something about which we know nothing. We must at least be able to state the questions even if we do not know the answers. This requires some genuine knowledge of the kind of world we are discussing. If we are to understand how society works, we must attempt to define the general nature and range of our ignorance concerning it. Though we cannot see in the dark, we must be able to trace the limits of the dark areas.

The misleading effect of the usual approach stands out clearly if we examine the significance of the assertion that man has created his civilization.and that he therefore can also change its institutions as he pleases. This assertion would be justified only if man had deliberately created civilization in full understanding of what he was doing or if he at least dearly knew how it was being maintained. In a sense it is true, of course, that man has made his civilization. It is the product of his actions or, rather, of the action of a few hundred generations. This does not mean, however, that civilization is the product of human design, or even that man knows what its functioning or continued existence depends upon.!

The whole conception of man already endowed with a mind capable of conceiving civilization setting out to create it is fundamentally false. Man did not simply impose upon the world a pattern created by his mind. His mind is itself a system that constantly changes as a result of his elldeavor to adapt himself
to his surroundings. It would be an error to believe that, to achieve a higher civilization, we have merely to put into effect the ideas now guiding us. If we are to advance, we must leave room for a continuous revision of our present conceptions and ideals which will be necessitated by further experience. We are as little able to conceive what civilization will be, or can be, five hundred or even fifty years hence as our medieval forefathers or even our grandparents were able to foresee our manner of life today.

The conception of man deliberately building his civilization stems from an erroneous intellectualism that regards human reason as something standing outside nature and possessed of knowledge and reasoning capacity independent of· experience. But the growth of the human mind is part ofthe growth of civilization; it is the state of civilization at any given moment that determines the scope and the possibilities of human' ends and values. The mind can never foresee its own advance. Though we
must always strive for the achievement of our present aims, we must also leave room for new experiences and future events to decide which of these aims will be achieved.

It may be an exaggeration to assert, as a modern anthropologist has done, that "it is not man who controls culture but the other way around"; but it is useful to be reminded by him that "it is only' our profound and comprehensive ignorance of the nature of culture that makes it possible for us to believe that we direct and control it. He suggests at least an important corrective to the intellectualist conception. His reminder will help us to achieve a truer image of the incessant interaction between our conscious striving for what our intellect pictures as achievable' and the operations of the institutions, traditions, and habits which jointly, often produce something very different from what we have
aimed at.
There are two important respects in which the conscious knowledge which guides the individual's actions constitutes only part of the conditions which enable him to achieve his ends. There is the fact that man's mind is itself a product of the civilization in which he has grown up and that it is unaware of much of the experience which-has shaped it-experience that assists it by being embodied in the habits, conventions, language, and moral beliefs which are part of its makeup. Then there is, the further
consideration that the knowledge which any individual mind consciously manipulates is only a small part of the knowledge which at anyone time contributes to the success of his action. When we reflect how much knowledge possessed by other people is an essential condition for the successful pursuit of our individual aims, the magnitude of our ignorance of the circumstances on which the results of our action depend appears simply staggering. Knowledge exists only as the knowledge of individuals. It is not much better than a metaphor to speak of the knowledge of society as a whole. The sum of the knowledge of all the individuals exists nowhere as an integrated whole. The great problem is how we
'can all profit from this knowledge, which exists only dispersed as the separate, partial, and sometimes conflicting beliefs of all men.

In other words, it is largely because civilization enables us constantly to profit from knowledge which we individually do not possess and because each individual's use of his particular knowledge may serve to assist others unknown to him in achieving their ends that men as members of civilized society can pursue their individual ends so much more successfully than they could alone. We know little of the particular facts to which the whole of social activity continuously adjusts itself in order to provide what we have learned to expect. We know even less of the forces which bring about this adjustment by appropriately coordinating individual activity. And our attitude, when we discover how little we know of what makes us· co-Operate, is, on the whole, one of resentment rather than of wonder or curiosity. Much of our occasional impetuous desire to smash the whole entangling machinery of civilization is due to this inability of man to understand what he is doing.

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Monopoly, Crises, and Unemployment

Monopoly and the French Revolution. Monopoly as a political phenomenon. Business-cycle theories. Boom and depression. Easy money. Unemployment in the modern world. Theories of unemployment. Keynes. Depression and unemployment.


The scientific study of economic phenomena began contemporaneously with the emergence of our modern industrial economy, and the subsequent development of economics has paralleled technological improvements in production as well as progress in such auxiliary fields as communications and banking. The economic theory with which we are familiar today is no less an offspring of the Industrial Revolution than is our actual economic system, which, rightly or wrongly, has been dubbed capitalism.
Among the phenomena that economists encountered in carrying on their investigations were monopolies, crises, and unemployment. They consequently took it for granted that these abnormalities are inherent characteristics of the capitalist system, or the economy of free enterprise. It is therefore appropriate to devote some attention to the nature of these three phenomena in order to see whether they are, in fact, compatible with modern capitalism, and whether they are produced by it or by other causes.
The word “monopoly” (from the Greek monos = only, and polein = to sell) means literally “one and only seller.” Exclusive control can be exercised over a work of art, an invention, a whole class of commodities, or the supply of labor in a particular enterprise (as happens when labor unions bar from employment in it, by means of a “closed shop” contract, anyone outside their own ranks). In economics the term “monopoly” is used to denote any situation that interferes with the free play of supply and demand. Generally, however, what one has in mind in using the term is only a monopoly on the side of the suppliers of commodities in the market. One speaks of a tobacco monopoly, a match monopoly, a gasoline monopoly, a meat monopoly, etc., meaning that a person or a group of persons—or the government itself—has complete control over the supply of these commodities or at least a control sufficiently great to enable the monopolist to impose his prices on the public and to regulate consumption accordingly, limiting it to the quantity that he deigns to make available on the market.
Monopoly is as old as history. Already in the most ancient communities we find state monopolies of salt, of precious metals, of perfumes and dyes, and even, during the decline of the Roman Empire, of articles of prime necessity like cloth and cereals.
During the Middle Ages the guilds enjoyed a double monopoly: they controlled production, and they monopolized the labor force in each enterprise. The law granted the masters of the guilds the exclusive right to carry on production, to admit or reject new members, to educate the apprentices, and to train them to become masters. This situation continued into the era of the absolute monarchs, although the latter gradually arrogated to themselves many of the powers previously enjoyed by the guilds and granted licenses for production that enabled the Crown to bring in revenue to the state and, at the same time, to support its favorites at court. One has only to recall the monopolies that Henry II of France granted to his mistress, Diane de Poitiers. Indeed, a good part of the nobility lived off the income from monopolies.
Nor was England free of them. In fact, it was on their account that the Declaration of Independence of the United States proclaimed the principle of freedom of labor, or the right to the “pursuit of happiness.” Similarly, on September 14, 1791, the French Constituent Assembly, after reaffirming the Declaration of the Rights of Man originally formulated during the period from August to October in 1789, declared an end to “nobility, peers, distinctions among the estates of the realm, feudal rights, hereditary judgeships, the sale or inheritance of public offices, privileges and exemptions from the law common to all Frenchmen, wardenships, and guilds of artisans, craftsmen, or members of the same profession.” Later it promulgated the Constitution of 1791, of which Article 16 stated that “every citizen has the right to enjoy in freedom his property and income and the fruit of his labor and industry,” and Article 19 granted every person freedom to “engage in such business or to practice such profession, art, or craft as he shall find profitable.” A regime of economic liberty was established, and monopolies were suppressed. And, to prevent these same citizens from restricting this liberty and obstructing the free play of supply and demand by means of combinations in restraint of trade, the penal codes forbade and still forbid “conspiracies to effect a change in the price of goods.”1
Monopoly, then, is not compatible with our modern economy. Indeed, it is impossible in a system of free enterprise. To be sure, there will always be entrepreneurs who, not content with the profits to be derived from the supply and demand on the market, will band together (however many “antimonopoly laws” there may be on the statute books) to monopolize particular commodities or services in order to obtain exorbitant prices for them. But where there is free enterprise there will not be lacking another group of entrepreneurs, no less powerful than the first, prepared to lure away their customers with lower prices. Free competition will then reassert itself, and the two groups will engage in a “price war” until the prices obtained leave only a normal profit. This is possible, of course, only if neither of the competing groups enjoys an official protection that the other does not have and that renders the protected group superior to its rival in the market. This protection, in the form of licenses authorizing the establishment of particular industries, prohibitively high tariffs on foreign products, tax exemptions, production or export subsidies, etc., may be extended in view of some well- or ill-understood national interest, or because the country is in a state of war, or simply, as in the days of Louis XIV, in order to grant favors to the friends (who sometimes are also the partners) of the authorities. In all countries there are innumerable cases of this kind in which it is not always possible to determine whether the motive is a desire on the part of the government to protect a more or less well-understood national interest or to prepare for war, or whether what is involved is nothing more nor less than official corruption. But it is impossible to find a single example of a monopoly that has ever existed without official protection.
The term “crisis” denotes a maladjustment in economic life that gives rise to a general depression, but one not caused by external circumstances like natural catastrophes, epidemics, wars, or revolutionary inventions or discoveries. A free economy involves a certain automatism, so that any partial disturbance of it is corrected by the action of the forces at work. Thus, if a commodity is produced in excess of the demand for it, its price falls, and production of it is restricted until the demand once again increases and prices normalize themselves. If a commodity is in short supply, its price rises and attracts to the market new producers, who cause the price to fall to a normal level. But there are times when this self-corrective process does not seem to occur, and crises arise. Then economists seek an explanation and a remedy for them. Since the time of Sismondi (1773–1842) crises have been described as periodic infirmities to which a free economy is subject (cyclical crises) and as a result of the “anarchy of production.” Karl Marx held both views at the same time, although it is evident that they are mutually contradictory, since an economy in which there are periodic phenomena that can be calculated and predicted can hardly be characterized as anarchic.
If, as we have said, a crisis is a maladjustment in economic life, there can be many different kinds of crises. Generally, however, when one speaks of a crisis, what is meant is a crisis due to a falling off of sales, a failure of the market to absorb the products that are brought to it. It is not surprising, therefore, that the economists of an earlier age explained this kind of crisis by attributing it to a lack of money. Yet it is obvious that this explanation is not satisfactory. In general, commodities are distributed in accordance with the supply of money available. If this is meager, commodity prices will be low, but no disturbance will be produced in the economy. Commodities will be worth less, but money will be worth more, and consequently everything that is brought to the market will be absorbed. This is the way Adam Smith and Jean-Baptiste Say explain the matter, and no one has succeeded in refuting them.
A variant of this doctrine is that of overproduction. It has been said that the crisis occurs when producers produce beyond the needs of the consumers, so that there is a glut on the market; for the consumers, even though they have the money to buy the commodities offered for sale, simply do not want them. In reply to this contention one need only observe that, up to the present day, there has never been a time when the world has produced enough for everybody. The great economic problem is that of scarcity, which still continues to exist to a frightful extent. Mankind still does not produce enough to provide for even the most pressing necessities. A general overproduction of commodities is a myth, and not an actual fact. At any given time and place there may be a surplus of particular goods, but not of all goods. In such cases the mechanism we have already described comes into play, and normal conditions are restored without any important disturbances in the economy, even though the readjustment may ruin particular producers who have erred in calculating their production or in forecasting market conditions. This is a case of uneven production, which a third theory of the crisis considers as its explanation. But the core of truth in this doctrine—i.e., the occurrence of such local and temporary surpluses in the production of particular commodities—does not explain the crisis as a phenomenon of general economic disturbance.
Rodbertus, Marx, Henry George, and economists of their persuasion, as well as some more recent authors who consider themselves liberals, like Carlos P. Carranza,2 explain the crisis as a result of the concentration of capital. According to them (in spite of some minor variations in their doctrines), the producers accumulate and employ in increasing production the ground rent and the surplus value that they withhold from society or from the worker, thereby reducing the purchasing power of the masses. At the moment when this money is reinvested in the construction of new units of production (factories, workshops, granaries, etc.), wages are distributed to many workers, and there is a boom in the market as more money flows into it although the supply of goods has not yet increased, since the new units in the process of construction are still not producing. By the time they finally do so, there is an abundance of commodities on the market that cannot be absorbed, and a crisis ensues. This explanation is also mythical and erroneous, because it never happens that all producers reap profits, save, and invest at the same time. Even if this were true of each one of them, there would still be lacking the necessary synchronization that would alone explain the general crisis.
Approaching the problem of crises from another point of view, the currency school, which appeared in England in the second half of the nineteenth century, and the Viennese school conceive of the cause in monetary terms. As we have already observed, money, although essentially a medium of exchange, has other functions and effects that give it a life of its own. Any abnormalities arising—or rather, induced—in the value of money convert it from a regulator into a disturber of economic life. In a word, crises arise, not from a lack, but from an excess, of money.
This does not mean that crises are caused by inflation. As we have seen, inflation, when it takes place in the natural course of events, does not disturb the equilibrium of the market. What is economically detrimental is the discrimination that results from an inflationary policy on the part of the government. A distinction therefore has to be made between inflation per se and credit expansion, otherwise known as an easy-money (or cheap-money) policy. Inflation takes place in the natural course of events whenever the supply of money on the market increases more than that of goods. This occurred in Europe when gold was shipped there from the Indies, and in the world in general during the period of the “gold fever” that accompanied the discoveries of new deposits of ore in the United States and South Africa. But when governments resort to the printing press to produce the currency needed to pay for the services and materials of a swelling bureaucracy and more or less spectacular programs of public works, what occurs is both an inflation, because more money enters the market without a corresponding increase in the supply of goods, and, at the same time, an expansion of credit, because the public works stimulate the development and growth, above and beyond the normal needs of the country, of industries engaged in carrying out the government program and unable to subsist without it.
Credit expansion pure and simple takes places when, in an effort to force an increase in the country’s production beyond the normal development of its economic life, a policy is adopted—by the government, of course—of accelerating production, or, as W. A. Lewis3 calls it, mobilizing resources. This policy consists simply in making money available (generally in the form of bank credit at low interest rates) to those who wish to establish or expand branches of production that are considered advantageous to the country. A boom supervenes: factories or farmhouses are built; machinery is manufactured, imported, and set up; a bureaucratic personnel is organized. All this means money passing through many hands and reaching the market to buy consumers’ goods that have not increased to the same extent. The result is that, in accordance with the law of supply and demand, and in spite of the price ceilings imposed by the government, prices rise. With the increase in prices, wages too have to be raised, and there is an illusion of prosperity. But a time comes when the money available for the expansion of production is used up, and the industries thus created have to live on their own resources. Very few can do so. Some industries prove to have been poor investments and go out of business entirely. Others produce goods for which there is no demand, like machinery for still other industries that have not expanded or consumers’ goods that are priced too high to compete with those already on the domestic or foreign market. A crisis results: prices have risen, the value of the monetary unit has depreciated, production useful and necessary to the country has not increased, sales fall off, workers lose their jobs, unemployment is on the rise, and a painful period of readjustment begins. The policy of credit expansion, instead of increasing the wealth of the country, has dissipated a good part of it. One is reminded of the old story of the milkmaid and the pitcher of milk. With the proceeds from the sale of the milk she dreams of buying some sheep; from the sheep she hopes to get enough to purchase a cow; etc., etc. But in the midst of her daydreams the milkmaid stumbles, the pitcher is shattered, and nothing remains but her tears. If one tries to build on illusions, one is sure to suffer disillusionment sooner or later.
We have seen, then, that crises, like monopolies, do not and cannot have any place in an economy of free enterprise. They are not essential elements or necessary effects of it; neither are they defects in it. They are, on the contrary, the consequences of political interference with the free-market economy.
As we shall see, the same holds true for unemployment.
As long as methods of production remained primitive, unemployment was unknown. The wretched poverty that prevailed before the Industrial Revolution was due precisely to the meager productivity of the methods then in use and to the lack of the manpower needed to produce enough to satisfy the necessities of everyone. The introduction of machinery, above all in the English textile and weaving industry, left large numbers of workers jobless. Much more yarn and many more fabrics were produced with one machine and a couple of workers than with many hand looms and large numbers of weavers. This gave rise to several grievous incidents in the textile centers of Europe—notably in Lancashire, England, and the areas of Lyon, the Franco-Belgian frontier, and Catalonia. The workers displaced by the machine rioted and burned—or tried to burn—the factories. But they soon came to realize that mechanization reduced the price of the product and left the consumers with money to buy other commodities that formerly had not been within their reach. Producers expanded their enterprises and hired the hands left idle by the introduction of machinery into the textile industry. On the other hand, mechanization in general created in turn a vast industry devoted to the manufacture of machinery that likewise more than absorbed those unable to find work in the factories.
Between 1848 and 1914, unemployment as a mass phenomenon disturbing the whole economy was unknown. Some industries declined, others prospered, and the workers who were discharged from the former found employment in the latter. Besides, as there was at that time complete freedom of migration and of labor throughout the world, those who were not satisfied with the conditions of employment in one country emigrated to wherever wages were higher, and thus a relative prosperity was in the process of being generally diffused.
With the advent of the First World War, conscription and the demands of war production (arms, munitions, clothing, and food—in Germany, for example, eighty per cent of all the production of food and clothing was for the army) resulted in a great scarcity of labor. Taking advantage of this situation, the trade-unions succeeded in forcing wages upward. When the war came to an end, the labor force increased enormously, for the returning soldiers were added to those who had taken their places during the hostilities and had flocked to the factories from the country or from domestic life (women especially), without any corresponding increase in the demand for goods, since every member of the actively employed working population produces for several members of the general population.
But three other factors played a role in this situation. A great part of the labor force created during the war was fitted to work only in war industries, and these had shut down. On the other hand, wages had gone up, while the normalization of production was causing prices to fall, so that these wages now exceeded the value of what the workers were producing. Industrial equipment had been used up, and there was no capital available to replace it, much less to add to it to give work to the unemployed. After all, the war had been immensely destructive. It had impoverished the world, and there was no other recourse but for everyone to restrict his consumption. For the worker this retrenchment had to consist in contenting himself with a lower wage rate, so that the product of his labor could be offered for sale at prices obtainable in an impoverished market.
But this was contrary to the policy of the trade-unions, and the governments found themselves obliged to resort to unemployment benefits to take care of those who had been thrown out of work. As they lacked the money for this, they had to fabricate or create it: the printing presses were set rolling, and there was money for everybody, but devalued money, because prices rose as fast as the supply of money increased. Those workers who were unwilling to accept a direct cut in their wages had them reduced indirectly in the form of monetary devaluation; but, in addition, the unemployed, who could have increased production by accepting lower wages, did not do so and thereby retarded the return to normalcy. Something similar happened after the Second World War. In England, for example, the Labor Government had to devalue the pound sterling, because high wages raised production costs to the point where it became difficult to export.
From what has been said here, it follows that unemployment is not an essential element of what has been improperly called the capitalistic economy. On the contrary: the natural tendency of such an economic system is toward an increase in production and, concomitantly, in jobs. When a new machine produces more goods with less labor, this does not mean that the supernumerary workers are left idle, for they either remain in the same industry tending new machines or transfer to another in greater need of their labor. The characteristic feature of an economy of free enterprise is that it provides work for everybody who wants it and an ever increasing supply of goods and services. But in order for this to occur, it is necessary that there be no interference with production on the part of either pressure groups or the state. If pressure groups exact wages that render production no longer profitable, or if the state imposes on profits taxes that make it impossible for enterprises to maintain or increase their productive equipment, then a brake is put on production, and job opportunities are correspondingly contracted.
Thus, both the theory of so-called “institutional unemployment” and the theory of the “industrial reserve army” of Marx and Engels are quite untenable. According to the first, capitalism always involves periods of general unemployment, and, according to the second theory, unemployment is chronic. Both theories, as we have seen, contradict the facts and the very essence of an economy of free enterprise. There is no unemployment in normal times, much less during a period of prosperity. There is unemployment when there is a crisis, i.e., when the action of pressure groups renders production unprofitable by raising costs above market prices. There is also unemployment when the fiscal policies of the government prevent the increase in the accumulation of capital goods from keeping pace with and, if possible, surpassing the increase in the population and thereby raising the general standard of living. Another cause of unemployment is nationalism and its corollary, economic protectionism and migration barriers, which place difficulties in the way of the normal world-wide distribution of goods and services.
Even less tenable is the doctrine given currency a few years before the Second World War by the English economist John Maynard Keynes (later Lord Keynes). Paradoxically, this doctrine attained its greatest popularity precisely at the time when, according to the reports of his intimate friends, Lord Keynes himself was beginning to recognize its falsity, and when he was on the point of making a public declaration to that effect; in any case, he died without having done so. According to this doctrine, unemployment is due to saving and is to be combatted by resorting to every means to force those who have money to spend it—as if bringing money to the market had the magic power of raising up new plants and factories. In reality, the only effect of such a policy is to increase the price of goods and, by the same token, to reduce the general standard of living. Where money is really needed is in production for the purchase of more machinery and equipment, the employment of more workers, and the manufacture of more goods for the market with the object of lowering the cost of living. And this is precisely what saving does. He who saves money does not keep it under a mattress, as people did in the mercantilist era, but invests it to produce a profit or to yield interest. Either he puts it into real property or into mortgages, and thereby favors the expansion of housing and the employment of construction workers; or he invests it in equities and buys shares of productive enterprises, which are also thus enabled to expand; or he lends it at interest to entrepreneurs, with the same result for the general well-being. Saving and capital accumulation, then, are the great factors making for an increase in production and a consequent abundance of jobs and a lowering of prices. The liquidation of savings, the spending of money in the market in order to acquire consumption goods, has the opposite effect: the stagnation of production, a rise in prices, a diminution in the purchasing power of the general public, a slump, and, consequently, mass unemployment. The Keynesian formula, therefore, leads to results that are exactly contrary to those it is aimed at attaining.

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