Friday, November 14, 2014

Math Without Numbers: Why Socialism Fails

Every economy is faced with the same fundamental questions? How those questions are answered makes all the difference in the world.

There are certain inescapable facts, which are imposed on us by reality. Human nature requires we interact with the world around us if we are to survive. We need to harvest food and to produce shelter. We need medical care to avoid disease and death. The fundamental realities of life require economic production; without it we perish.

Economics is the study of how humans act upon resources to produce goods and services, which are wanted and/or needed. But once an economy is in place certain questions inevitably arise.

Most of us instinctively know these fundamental questions. What should be produced? For whom should it be produced? How should it be produced?

If someone wishes to build a swimming pool he has already answered the first and second question for himself, but that final question is the tough one. It is not simply a question of engineering. This question implies some very fundamental dilemmas.

One could build a swimming pool using several laborers with shovels digging a hole. One could also bring in a backhoe to dig the same hole. And, of course, there are questions of size and depth to consider. Which technique should be used to actually construct the pool? Would it be better to have a plastic pool that sits above ground? Now it seems that it would take an expert to answer these questions. Yet everyday people answer these questions on a daily basis. How do they do it?

The means for answering these questions is the price mechanism. When offered the alternative of using men with shovels or a backhoe the consumer compares costs. If the backhoe is less expensive he will go with that option. But if the men with shovels are cheaper than chances are he’ll use this alternative. At each step of the process he compares costs. Throughout the economy people make fundamental choices based on prices. The possibilities of consumption or production are endless. We take our own subjective values and then we compare prices and from that we make economic decisions.

We live in a world of scarcity. An economist defines scarcity as any good that, if priced at zero, would be in short supply. If we could have as much of anything we wanted for free would there be any left? Chances are we would run out very quickly. Since people want it and there is not enough to give people all they want this good or service has value. That simply means it is something that we seek to keep or to gain. It has value because people want it. The cheaper it is the more of it they want. We use money as a means of expressing that value.

One important function of prices is to allocate resources. If the movies were free we would have a hard time finding seats. Even “free” seats would still need to be allocated. There still would be a cost in that scarce resources are being used, but it would not be a cost in terms of money. Instead it would take time standing in line.

Just as some people have more money than others, some people have more time than others. Movie theaters allocate seats by selling them. Since the seat is not free the demand is reduced to a manageable level. Prices are used to allocate seats. This principle applies to everything from apples to dentists, from toothpaste to diamonds.

Consider some of the items we want or need. The list is endless. People want chocolate, TVs, computers, mince, automobiles, eggs, books, haircuts, etc. Each item we want has a price but these prices can fluctuate madly. An egg is not as expensive as a car and TVs cost more than chocolate bars. Why do the prices vary and change?

Karl Marx and various socialists argued that value a good is determined by the value of the labor necessary to produce it. This theory was quite common in early economic thinking and at first glance it seems to have some merit. One the earliest economists was Adam Smith, often considered the father of free market economics, and he thought that labor created value. Smith said that labor “is the real measure of the exchangeable value of all commodities.” Another early economist, David Ricardo, said, “the quantity of labor must augment the value of that commodity on which it is exercised.” Marx simply built his theories on the ideas of early free market economists. He said: “A use value, or useful article, therefore, has value only because human labor in the abstract has been embodied or materialized in it.”

This concept of the labor theory of value is fundamental to Marxism. Without it the entire system falls apart. Marx argued that value is created by labor. He then asked how is it that a capitalist makes a profit? The capitalist hires workers, perhaps to produce chairs. He pays for the resources necessary and then he pays the laborer to produce the chair. He takes the finished product and sells it and hopefully makes a profit. But how is it possible to make a profit if the value of the chair is equal to the value of the labor needed to produce it, along with the value of the labor of the resources used in the production? Marx had only one answer: the capitalist can only make a profit by neglecting to pay the laborer the full value of his labor. From this he argued that capitalists exploit workers and steal from them the full value of their labor. This, he felt, meant a perpetual state of class warfare between workers and capitalists.

Marx’s logic was impeccable and if the labor theory of value is correct then Marx was correct. But is value determined by labor? If you think about it for a few seconds you start to see problems in this theory. And if we go back to our chair example we can see why. How much is a chair worth? The usual answer is: that depends on what chair you are talking about. If we take a George II mahogany Windsor armchair with shaped bowed front and balustrade splats on cabriole legs, produced around 1750, the current value is around $12,000. In 1750 I doubt the price would have been anywhere near this amount. The labor needed to produce the chair hasn’t changed but the value of the chair has skyrocketed.

A few years ago I found a 1936 copy of Ayn Rand’s novel We the Living, which I bought for $9.00. Even that price was well above the original. A few months later I sold it for $750.  Once again the value increased without any additional labor.

In some situations the reverse is true as well. I could take some canvass and some paint and spend days working on my own masterpiece and yet find that no one will pay anything for it. In fact the chances are pretty good that I’d have a hard time giving it away. The canvass and paint had a higher value before I mixed my labor with them.

Entrepreneurs sometimes make mistakes. They hire workers and buy resources to produce a product. Then they find that when the product is offered on the market that no one is interested in buying it at the price necessary to make a profit. Eventually they start lowering the price and if they still find no demand for the product they have no alternative but to sell it below cost. There are situations where the price of a product could be below the money paid to labor to produce the product. Of course such situations play no role in Marxist theory.

The economist Ludwig Mises explained the problem of value which plagued the classical economists and which lead Marx to his theory. Mises wrote:

“...The classical economists failed in their endeavors to provide a satisfactory theory of value. They were at a loss to find a solution for the apparent paradox of value. They were puzzled by the alleged paradox that “gold” is more highly valued than “iron” although the latter is more “useful” than the former. Thus they could not construct a general theory of value and could not trace back the phenomena of market exchange and or production to their ultimate source, the bahavior of the consumers.”

Marx and other classical economists ignored consumers when they tried to theorize on prices and value. Marx talks about workers and capitalists but says little about consumers. He didn’t see them as particularly important in the scheme of economics. All this was to change when a group of economists around 1870 started exploring a different theory of value. They observed how people acted in the economic world and concluded that value is subjective, not objective. Something has value because someone wants it. And since human wants vary from one person to another then values fluctuate. Subjective values determine the demand for a good or service.

On the other side there is the availability of the good or service or what is called the supply. Together they form the important economic principle of supply and demand. A large supply with no demand will mean a very low price. A low supply with high demand will mean a high price. The paradox of value, which Mises talked about, had finally been solved. And the cost of labor was irrelevant. But with the subjectivist theory of value the fundamental principles of Marxist theory collapsed.

The Marxist, however, continued to try and make their theory work in spite of this fundamental flaw.  Interestingly no nation adopted Marxist economic theories until after they had already been thoroughly repudiated.  And in the span of one lifetime Marxism was implemented and collapsed. In 1920 Mises argue that Marxism couldn’t work because it couldn’t make economic calculations.

Marx devised an economic theory where prices and profits were eradicated.  This, he believed would lead to plenty for all and end exploitation of labor. But now the Marxists were faced with the paradox of value. Because they were trying to implement an economic policy based on an antiquated concept of value they couldn’t make the economic calculations necessary.

N.G. Pierson
The Dutch economist N.G. Pierson wrote an essay in 1902 entitled Het waardeproblem in een socialistische Maaschappij” or The Problem of Value in the Socialist Community.  Pierson said that under socialism:
“One problem above all would remain and, appearing in the most diverse forms, would call for practical solutions. I mean the problem of value. The problem of value? These words will astonish many of my readers; this will be the last thing they expected. The problem of value in a socialist society? Surely, if socialism is realized there will be no value phenomena and therefore no value problem. Then everything will be a mere question of technique.”

Pierson said that the problem was not a technical one “but rather a decision as to the most profitable way of employing material things, and the rightness of such a decision must depend upon the rightness of the evaluation which preceded it.”

Even under Marxism items have value. The government might distribute meat equally to consumers but vegetarians would not necessarily be pleased with what they received. They would be quite happy to exchange their meat for something else, which they valued higher. Pierson argued that as long as the Marxist state could provide everything people wanted in unlimited amounts then there would be no problem of vale. But, the moment there was scarcity, which there was from the very beginning, then individual consumer values would once again arise.

“Thus the commercial principle, which such a society sought in vain to abolish, comes once more into the foreground. Profits which the State should have been able to claim for itself fall to individual persons. The phenomenon of value can no more be suppressed than the force of gravity. .... to annihilate value is beyond the power of man. Value is not the effect but the cause of exchange. Things do not have value because they are exchanged; they are exchanged because they have value—more value for some people than for others.”

The Marxists dreamed of replacing economic value with state planning. In fact Marx called for the abolition of money and prices. The entire price system was to be demolished and replaced with the political allocation of goods and services.  But Marxists were quite vague on how all of this would work out. Elizabeth Tamedly in her Socialism and International Economic Order notes that: “The socialist founding fathers openly refused to express themselves in detail on the working of a socialist economic order.” W. Euken said: “When Lenin, in 1917, wrote State and Revolution, he had no conception of the problem of economic calculation and of the difficulties involved in centrally directing the economic process of a modern national economy. His goal was ‘to organize the entire economy according to the model of the post office”... this is not surprising: for one who believes, with Marx, in the predetermination of historical development, economic calculations in a centrally administered economy pose no problem to be mastered beforehand by thought.”

Euken is correct. Marx did believe that communism was inevitable. Since it was inevitable then there really was no need to discuss how it would actually work in practice. Problems of economic calculation wouldn’t come up in a Marxist society because Marx, by faith, simply believed they wouldn’t come up. Frank Vorheis, in Comprehending Karl Marx, said that Marx predicted “a working-class revolution that will overthrow capitalism. A new way of producing, a new way of thinking, a new way of relating, a new history are coming, but Marx never told us what they would be.”

We have now uncovered two of the major problems of Marxist thinking. Firstly, Marx had no concept of a realistic theory of value. He built his theories on the errors of Smith and Ricardo. Secondly, he believed in the inevitability of communism. Because of this he saw no need to grapple with such fundamental problems as how would economic calculation take place within a socialist system.

Without the price system the Marxist regimes were groping in the dark. The best they could do was to look at what prices were in capitalist societies and try to mimic what was being done there. Socialism survived as long as it did because it was able to copy capitalist allocation of resources. And they were notorious for stealing technology from the allegedly decadent West. Socialism was inefficient because it was never quite sure what was the most profitable way in which to use various resources. Even copying capitalism couldn’t work because resource values are not the same in all places at the same time. Since the combination of resources and labor are virtually endless the economic calculation problem continued to get worse and worse. Socialist economies were famous for producing items that no one wanted while failing to produce what consumers demanded.

Yuri Maltsev, who was senior researcher at the Institute of Economics in the Soviet Union, explained the problem:
“Socialism attempted to replace billions of individual decisions made by sovereign consumers in the market with “rational economic planning” by a few vested with the power to determine the who, what, how and when of production and consumption. It led to widespread shortages, starvation, and mass frustration of the population. When the Soviet government set 22 million prices, 460,000 wage rates, and over 90 million work quotas for 110 million government employees, chaos and shortages were the inevitable result. The socialist state destroyed work ethic, deprived people of entrepreneurial opportunity and initiative, and led to widespread welfare mentality. The real character of the so-called centrally planned economy is well illustrated by a quip I heard several years ago by Soviet economist Nikolai Fedorenko. He said that a fully balanced, checked, and detailed economic plan for the next year would be ready, with the help of computers, in 30,000 years. There are millions of product variants; there are hundreds of thousands of enterprises; it is necessary to make billions of decisions on inputs and outputs; the plans must relate to labor force, material supplies, wages, costs, prices, “planned profits,” investments, transportation, storage, and distribution. These decisions originate from different parts of the planning hierarchy. They are, as a rule, inconsistent and contradictory to each other because they reflect the conflicting interests of different strata of bureaucracy. Because the next year’s plan must be ready by next year, and not in 29,999 years, it is inevitably neither balanced nor rational.”

Polish economist Jacek Kochanowicz says that under socialism “there is no private ownership of the means of production. They are not exchanged, and as a consequence, it is impossible to establish prices that reflect actual conditions.” The abolition of the market required another method to determine efficient use of resources. In the end the Soviets were forced, by necessity, to use coercion and raw power to impose their schemes. The abolition of the rational method of determining value required substitution by the irrational. Mises argued that what the Marxists were doing was abolishing economics altogether. “Without economic calculation there can be no economy. Hence in a socialist state wherein the pursuit of economic calculation is impossible, there can be — in our sense of the term — no economy whatsoever. ...Socialism is the abolition of rational economy.”

But, how is it that order emerges from the apparent anarchy of the free market? Every economy is always in a constant state of flux. Economies are ever changing. What is true at one time is no longer true seconds later. Consumer demands fluctuate. People move from one area to another and with them their demands also move. Consumer preferences are ever fickle yet it is the consumer who runs the economy. Without his purchases production would not take place.

The reason that economic calculation can take place in a free market economy and not under socialism is because of the price system. All the variables, which are necessary for rational planning, are condensed in a free market into the price. A consumer does not need to know that an unusual freeze in Panama destroyed a large amount of the banana crop. All she needs to know is that the price of bananas increased. The higher price indicates a lower supply and the consumer never needs access to the reasons why the price increased. If bananas are more expensive, but apples are cheaper, she may switch to apples. The consumer acts as if she knows why the price has increased. She makes her choices based on the price. But her choices are consistent with all the facts even those which she does not know.

The price mechanism takes all the variables and puts them into one unit of measurement, which everyone understands—prices. If prices are high we buy less. If prices are low we buy more. But if prices are abolished then we must rely on some other method of allocation. Thus when the Marxist abolished private markets they were required to resort to central planning. But with central planning they needed to understand millions of variables. Unable to do this they guessed. And more often than not they guessed wrong. The result was the collapse of socialism, which was so dramatically illustrated with the tearing down of the Berlin Wall.

In a free market planning is not done centrally but is diffused throughout society. Instead of one group planning everything millions of individuals plan the segment of the economy, which they know best. Because knowledge is diffused throughout society central planning is impossible. Diffused knowledge requires diffused decision-making. This is done in free markets where each decision-maker uses the price system to make his decisions. This means each small producer makes economic calculations based on costs. From this he determines the most efficient way to do what he does. In the free market the end results evolve from the bottom whereas in socialism they are imposed from the top.

The importance of economic calculation cannot be overstated. When economic calculations are abolished the result is chaos. Marxism failed because it thought it could order an economy without such fundamental economic features as private property, free exchange of goods and services, and the price system. With the abolition of these features the ability to make rational economic decisions vanished as well. Making economic calculations without prices is like trying to do math without numbers. Marxism was plagued from the very beginning because it relied on ancient, but erroneous, theories. Because of Marx’s irrational faith in the inevitability of communism socialist theoreticians never really tried to understand the problems of value and economic calculation. The inevitable result was dictatorial regimes followed by collapse and chaos.

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