Sunday, March 14, 2010

Two Conceits, Planning and Finance

It’s time to step back and think about the larger implications of the economic meltdown—what it says about our times and the ideas that have ruled them. I want to draw a parallel between 2008 and 1989, the failure of finance and the failure of planning.

The starting point should be the insight of Hayek and his Austrian colleagues that most economically valuable knowledge is local and tacit. Only those directly involved in the production and consumption of goods and services can really know about quality, difficulty, uncertainty and other not-fully-quantifiable or codifiable dimensions of economic life. This is why organization and control has to be decentralized.

The Austrian prediction of the downfall of central planning was finally validated in 1989—even sooner, for those who were following the internal debates about prices and planning taking place in the Communist world. By the fall of the Berlin wall there were no defenders left for the notion, or “conceit”, that a single, all-powerful bureau could intelligently manage a complex modern economy.

In very general terms, planning failed on two counts, both related to the ubiquity of local and tacit knowledge. First, because crucial economic information could not be codified, relations between the center and the enterprises had to be based on trust. One way the planners could convince themselves that their underlings were reporting correctly was, to put it bluntly, terror: the threat that misreporting or failure to follow orders would be punished as an “economic crime”, with horrible personal consequences. We still see the reflection of this approach in China. Yet sufficient trust could not be established even in the most autocratic regimes, and as political systems liberalized, the scope for these principal-agent conflicts grew ever larger. One universal post-1989 discovery is that the official statistics were rubbish, and there were dark practices in every corner.

The second problem is simply the complexity of modern economic life and its resistance to being encapsulated into the statistics that planners depend on. Plans were “wrong”, not just for errors in judgment or poorly chosen models, but because they were inherently unable to supply the answers to the questions that were most pressing on the ground. They could not make use of the non-quantifiable information that producers and users of goods possessed, nor could they interact constructively with the decision-making that is unavoidable at a local level. The great dream of computerization, for instance, that advocates thought would revolutionize central planning, never panned out. This was the purest, most direct vindication for the Austrian critique of centralized socialism.

The fundamental contradiction of Austrian thought, however, is between its awareness of the person-, activity-, and placed-based nature of knowledge and its assumption, never really defended, that markets can succeed in assembling this knowledge and guiding local decision-making. In saying this, I am not claiming that markets should have no role or cannot accomplish any informational or allocative function—only that they do not solve the problem posed by the centrality of local and tacit knowledge. But don’t take my word for it; see how this conceit collapsed in the financial meltdown of the past two years.

The “financialization” revolution of the post-1980 period was based on the assumption that market valuation of assets was rational and correct, and that owners of these assets would, in the process of maximizing their wealth, provide the best possible guidance for the dispersed producers whose work created the revenue flows which the assets capitalized. Control of enterprises would be transferred to the financial markets, which would decide which producers would be supported or shut down, and which would choose managers and evaluate their performance.

Alas, the same two faults we witnessed with central planning were reproduced in “central markets”, dishonesty and decision failure. In modern economies, for instance, intangible factors play perhaps the largest role in wealth creation, and this defeats any attempt to base valuation solely on accounting algorithms. Unscrupulous actors, interested only in their own personal gain, used this opportunity to deceive regulators and counterparties, to the extent that trillions of dollars were transferred to insiders while the rest of us were stuck with claims on fictitious assets. Whole companies were brought down, for instance, by equity funds that quietly stripped them of their financial value, leaving them too indebted to survive, and leaving gullible buyers of this debt with shredded balance sheets. No doubt a large part of this fraud could have been avoided had the insiders not gamed the political system and eviscerated regulation, but it would be a mistake to simply assume that regulation alone would be enough. The problem of the regulator is not so different from that of the central planner: how do you know whether an instrument or deal is value-destroying if you cannot independently ascertain what the actual value is?

Similarly, even well-motivated “abstract investors”, owners of funds who shuffle claims on a wide variety of enterprises and rely only on accounting data, and not the local and tacit knowledge of those on the scene, cannot really know what actions will make production more efficient at using resources and meeting social needs. The problem is the inability of accounting data to encompass the dispersed and non-codifiable information that workers, buyers, and managers generate and rely on. The “market for corporate control”, for instance, simply assumes that the information available to financial markets is sufficient to determine which managers are doing their jobs well and which need to be sacked. There are some success stories, in which entrenched managers, demonstrably failing in their obligations, were flushed out by external investors, but also many horror stories in which hard-earned craft and wisdom were expunged, and viable enterprises were destroyed. The inability of financial markets to assume the role of global economic management should not be laid at the feet of any particular individuals; it is intrinsic and is due to the same factors that caused central planners to fail.

Perhaps the main difference between 1989 and 2008 is that we had a ready narrative for the collapse of state-managed economies: for decades the failure of Communism had been predicted and explained for us, and the message was transmitted through the mass media for all to hear. The message regarding the shortcomings of financial markets is not as well-developed, however, nor is it being disseminated with the same ideological fervor. Yet experiences do not teach lessons all by themselves; they need to be narrated and understood. If we are to benefit from the upheaval we are still going through and find our way to a more stable and socially rational system of economic organization, we will need to clarify the story and find words to tell it.


Kaleberg said...

It's good to see someone drawing the parallel between the failure of free market capitalism and the failure of centrally planned communism. Of course, you might think we would have learned something from the late 20s and early 30s when capitalism did a similar face plant, but theology is theology.

john c. halasz said...

The old Stalinist central planning mechanism had long since become a Potempkin village, with figures widely known to be falsified. But, in the meantime, in accordance with Hayek's line of argument, it had devolved into, in effect, an industrial barter system, with a highly energetic and resourceful managers. Gorbachev was the last one to have realized the situation, attempting to officially de-centralize the central planning mechanism, while, in actuality, effectively re-centralizing it, provoking further decline in output. After the collapse, the residual barter system was the only thing that enabled some limited survival, as ostensible wages weren't paid for months at a time. Meanwhile, the systematic looting of the country and its resources and residual capital stocks began, with a massive exportation of capital, thanks to neo-liberal "shock therapy" and the opening up of the capital account. Funny how such policies end up working exactly in the inverse way they are ostensibly intended to, eh?

A market mediated system of production, on the other hand, requires access to credit to balance operations under changing cyclical conditions. But precisely for that reason, it tends to rely on short-term measures of investment profitability and to generate stocks of fictitious paper capital, to paper over and disguise mis-realizations and imbalances in real productive investment and the depreciating value of real capital stocks. And, needless to say, when financialized criteria entirely take-over from "internal" investment decisions, as with PE LBOs, the fictitious capital overwhelms the profitability of real investment and leads to collapse.

Damned if you do, damned if you don't, I guess...

Brenda Rosser said...

"The message regarding the shortcomings of financial markets is not as well-developed, however, nor is it being disseminated with the same ideological fervor...."

And the failure of the financial markets had everything to do with global central planning.

"...due to the same factors that caused central planners to fail."

Eleanor said...

Back when I had a job, I did accounting; and one of the things I habitually did was wander around and talk to people -- partly because I enjoyed it, but also because I understood more if I did this. The numbers by themselves were not adequate.

And I always pointed out that accounting tends to ignore things that are not easily quantified -- or recognizes such things in a way that's often flat out wrong.

Which gets us back to local information.

Shane Taylor said...
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gordon said...

Very interesting, Eleanor. That reminds me of a book I read ages ago about the shortcomings of most management and cost accounting systems. It was Kaplan (ed.) "Measures for Manufacturing Excellence". I don't know whether things have improved generally since then, but obviously not at Enron.

The "local information" idea is generally taken to refer to local management, but of course if information systems are poor, management is in the dark too. And of course, they may be practicing "control fraud", in which case they don't care.

Economist's View has a recent post on Hayek which is interesting reading, plus some good comments: