Abstract
This paper re-examines Hayek's insights into the problem of knowledge in markets, and argues that his analysis remains pertinent but has serious flaws. His central thesis—that the market price system is essential for communicating information and coordinating transactions wherever knowledge is dispersed and innovation renders the future uncertain—remains a potent explanation for the failures of central economic planning. His analysis that aggregate statistics necessarily abstract from contextual and tacit knowledge has important but widely ignored implications for the contemporary use of statistics in financial risk models. The recent financial crisis, however, shows that market prices can give very misleading signals for long periods, and it represents a key example of ways in which Hayek's thesis is incomplete. In particular, Hayek's analysis falls short by ignoring the role of dominant narratives, analytical monocultures, self-reinforcing emotions, feedback loops, information asymmetries and market power in distorting the wisdom of prices.
Highlights
This paper re-examines Hayek’s insights into the problem of knowledge in markets, and argues that his analysis remains pertinent but has serious flaws
Hayek invented one of the great metaphors of economics to explain the role of the price system in solving the problem of knowledge: he described “the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers”; and he continued: The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction (1948b [1945], 87)
He argued that the “blind transfer of the striving for quantitative measurements” from the natural sciences to the study of human relations—on the grounds that it is somehow more scientific than qualitative analysis—is “probably responsible for the worst aberrations and absurdities produced by scientism in the social sciences” (Hayek 2010 [1952], 114). Such an approach tends to ignore anything not measurable, abstracts from differences between subjective assessments, and homogenises frames of reference—with a consequent inevitable loss of analytical and interpretive texture. It abstracts from local contextual factors and any tacit knowledge that cannot be codified in data, “lumping together [...] items which differ as regards location, quality, and other particulars, in a way which may be very significant for the specific decision” (Hayek 1948b [1945], 83)
Summary
When Hayek claimed that the central problem of economics is the “division of knowledge” (Hayek 1948a [1937], 50), he was consciously aping Adam Smith’s analogous focus—the division of labour. I think, discern three further steps in his argument that are more or less explicit in his use of the slippery term “subjective” in his discussion of knowledge He inherited from Menger and others in the Austrian School a subjective theory of value, where “value is conferred on resources by the subjective preferences of agents and cannot be explained as an inherent property of any asset or resource” (Gray 1998, 16). He sees the illusion of objective and complete knowledge as what inevitably leads to error (Hayek 2010 [1952], 93) Thirdly, given his understanding of the subjective nature of value and the partial and perspectival nature of all knowledge, Hayek bought into the postKantian view that it is our particular interpretations and opinions that guide behaviour and (in part at least) construct social reality in their own image. He speaks of much knowledge being “by no means ‘in existence’” in ready-made form, adding: “Most of it consists in a technique of thought which enables the individual engineer to find new solutions rapidly as he is confronted with new constellations of circumstances” (Hayek 1997a [1935], 95)
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