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Happy Birthday Hayek!

08 May 2021

Today would have been Friedrich Hayek’s 122th birthday if he were still alive. Although many of his economic contributions have not necessarily lasted the test of time, one article he wrote which has is “The Use of Knowledge in Society”, which was featured in the American Economic Review’s compilation of the top 20 articles in its first 100 years.

In this article published in 1945, Hayek argues that the economic problem is a problem of allocating scarce resources - however, this allocation problem is really an informational problem, because the main difficulty is the fact that relevant knowledge is dispersed across individuals. How can we utilise this disaggregated knowledge? And who does the planning? One approach involves a central planner collecting information, while another involves decentralised individuals getting knowledge as needed.

Hayek notes that when it comes to knowledge regarding personal circumstances, this is an area where individuals have an advantage, because these circumstances constantly change and cannot be conveyed efficiently to a central authority. In that case, decisions should be left to people familiar and proximate to the situation via decentralisation. How can these people expand their limited knowledge beyond their individual circumstances? This is where the price mechanism comes into play: by providing people a comparative sense of affairs, this allows coordination of different people without requiring people to expand their limited fields of vision. Instead, it is sufficient that their limited fields of vision overlap enough via intermediaries to communicate the relevant information to everyone. Clearly the informational signals from prices are imperfect - they don’t tell people about the exact chain of events in the backgrounds, but they don’t need to. The simple fact that they push people in the right direction is all that is necessary.

There are several interpretations of Hayek’s article. The classical reading is from a microeconomic perspective i.e. firms will produce up to $P=MC$ and consumers will buy up till $P=MU$, such that the price mechanism aligns $MU=MC$. And as a corollary, this provides the basis for why sticky prices cause problems, motivating the New Keynesian story. But I think there are far more insights than just that.

1. Implicit in Hayek’s description is a recognition of the absuridty of a Walrasian auctioneer/Marshallian scissors and of the importance exchange plays in real life. This opens up an entire avenue of research on search and matching, where we have decentralised over-the-counter trading relationships in lieu of centralised spot exchanges by anonymous individuals.
2. Recognise that exchange is really monetary exchange, rather than barter. If economic coordination depends on monetary exchange, it’s not surprising that monetary problems (which include financial problems given financial assets have a range of moneyness) cause real problems - and so arises the various monetarist research programs.
3. Consider the importance of the word “coordination” - perhaps what really drives recessions is the fact that sometimes prices do not provide enough helpful information, causing coordination failures. This is the more heterodox readings of Keynesians, still pursued to this day by neo-paleo-Keynesians.
4. It is a reminder that exchanges allow efficient allocations - and so where exchanges cannot occur well, we do not necessarily get good outcomes. Think of how we do not get Pareto efficient outcomes in overlapping generations models or how public goods/information asymmetries cause issues.

There are few economics papers nowadays which have literally no mathematics. And rightfully so, given the technical progress we have made. But Hayek 1945 is a reminder that even a short bit of prose can tell us a lot!