Although Friedrich Hayek (1899–1992) contributed to many fields over the course of his intellectual career, there is a noticeable theme running through his work. This theme is the fragmented and dispersed nature of human knowledge. The human condition is such that nobody possesses more than an infinitesimal fraction of the total stock of “social knowledge.” To Hayek, the most important question in the social sciences is, what sorts of social, economic, and political institutions can best cope with the human condition? All of the contributions for which Hayek is most famous deal with this difficult problem in some way. By keeping this idea in mind, readers unfamiliar with Hayek will have access to an integrating principle by which the separate strands of his multifaceted work become intelligible as a coherent whole.
Knowledge, the Price System, and the Market Process
Hayek is most famous for his role in elaborating how the price system in market economies helps individuals cope with the fact that they have limited knowledge. In most introductory economics textbooks, the “economic problem” is defined as allocating scarce means among competing ends in the most efficient way possible. Hayek rejected this conception of the economic problem, suggesting instead that the problem was how best to harness the dispersed bits of knowledge, scattered throughout society in a highly fragmented and often not objectively quantifiable form. The information necessary to achieve an efficient allocation of resources, Hayek argued, is never available to a single mind or group of minds. How then can economic progress proceed?
Hayek’s answer was the coordinating role played by the price system in market economies. Conditional upon institutions that protect private property and uphold the rule of law, the prices of an economy’s various goods and services will represent, at any particular time, individuals’ “best guesses” of their resources’ value. A high price of oranges relative to apples means that, at the margin, an orange is a more highly valued resource than an apple. Individuals acting in the marketplace use prices as substitutes for knowledge, and as knowledge itself.
For example, if the price of apples rises, individuals will be led to consume fewer apples, which is desirable since apples are now more valuable at the margin. Individuals do not need to know why the price of apples increased; all they must do is observe the price change and adjust their behavior accordingly. In this way, the price system represents a vast information-feedback system, helping individuals in the course of their market activities effect an efficient allocation of resources, although overall efficiency is not the goal of any individual or group of individuals.
Hayek’s view of the informational role of prices also figures prominently in his view of the market as a process. To Hayek, the market is a network of continually adjusting exchange relationships between millions of individuals. At any one time, there will be errors embedded in the price system, because individuals are human and prone to making mistakes. However, the price system is precisely the mechanism that allows individuals eventually to discover their errors and correct them.
Many have mistaken Hayek as an “efficiency always” theorist, insisting that Hayek’s argument implies that market prices will necessarily be correct and contain all relevant information concerning relative resource scarcities. Hayek’s insight is much richer and more subtle: Given the very real possibility of error, the market process, comprised of individuals acting with the knowledge afforded to them by the informational role of the price system, will over time correct market inefficiencies and progress towards efficient resource allocation.
Money, Capital, and Business Cycles
Hayek’s work on money, capital, and business cycles won him the Nobel Prize in 1974, but is much more controversial than his work on knowledge and the price system. Hayek was firmly in the Austrian tradition with respect to his views on how a money-using economy functions, how the economy’s capital structure aligns producer supply with consumer demand, and how overly expansionary monetary policy can create errors in the price system, resulting in a boom-bust dynamic.
Hayek’s work on capital focuses on the capital structure. Capital goods (goods used to produce other goods) are heterogeneous. A specific combination of capital goods is necessary to produce each final consumer good. The capital structure is the economy’s network of capital goods, and must be coordinated not only across various goods and services, but across time. Capital-intensive production takes time, and consumers will only be willing to wait for the finished goods and services if the capital-production process adds enough value to compensate consumers for waiting. It is once again the role of the price system to effect this two-dimensional coordination (across goods and services, and across time).
Hayek argued the market process ordinarily yielded such coordination. If, for some reason, the economy’s capital structure was not well coordinated, there would be a profit opportunity available to a producer from engaging in a production process more in line with consumer demand, and the price system would help the potential producer acquire the information necessary to meet this demand in the least-cost manner.
However, if the price system was systematically in error, then there is the possibility that inter-temporal coordination will break down. Hayek argued that overly expansionary monetary policy introduced noise into the price system and made it more difficult for the price system to perform its informational role. Expansionary monetary policy, frequently accompanied in the short term by falling interest rates, incentivizes producers to engage in more capital-intensive production. If interest rates fell due to, say, an increase in savings, this response would be warranted. However, if the fall in interest rates is due solely to monetary injection, then the lower interest rate is sending a faulty signal. The more capital-intensive production processes seem more profitable in the short run, but in the long run are unsustainable.
Hayek’s exposition of this process, now known as Austrian business cycle theory (ABCT), made his business cycle theory the leading explanation of booms and busts in the early 1930s, and the principal rival to the theories of Keynes shortly thereafter. Austrian business cycle theory was forgotten after the Keynesian revolution, but the 2008 financial crisis precipitated renewed interest in Hayek’s ideas on business cycles.
Political Philosophy and the Free Society
When Hayek’s theories lost to those of John Maynard Keynes in the battle that set the terms of modern macroeconomics, Hayek for a time stopped working on technical economic theory and began working on what is often called “social philosophy.”
His most important works in this area are in political philosophy, ethics, and legal theory. All explore the virtues of a free society and describe the conditions necessary to its continuation. As in much of his other writings, Hayek finds a way to discuss what the fragmented and imperfect nature of human knowledge implies about governance.
For Hayek, liberty is desirable because none of us can predict the outcome of experimentation in the social world. If arbitrary measures of coercion by the state are used to privilege certain individuals or groups over others, the cost could be an important discovery that remains unknown due to the disadvantage incurred by those coerced. Since none of us can truly know ex ante where progress will come from, it is more effective—and more just—to afford each and every member of society the protection of general rules that prohibit the coercive apparatuses of society from discriminating on the basis of individual characteristics. This is the foundation of Hayek’s philosophy of governance, as laid down in what is arguably his most lasting contribution to political philosophy, The Constitution of Liberty.
His most well-known contribution to this field, however, began much earlier with The Road to Serfdom. Written in the 1940s, Hayek took on the claims of socialists that true liberation involved the combination of economic planning with political freedom. Hayek caused a stir by arguing these two goals were incompatible.
Economic planning, which in this context means the total planning of economic life by a centralized bureau that owns all of society’s means of production, would, instead of liberating individuals, enslave them. This is because labor is a factor of production, an input into final goods and services. If the planning bureau gets to decide what and how much should be produced as part of an master economic plan, it must necessarily dictate to individuals the terms under which they will consume—through the selection of who gets how much of the product—and produce—through forcing individuals into specific vocational activities and labor arrangements that must occur to execute the plan. The Western conception of the socialist ideal, if taken to its logical conclusion, would mean the destruction of individual autonomy.
Hayek’s thesis was highly controversial and won him the enmity of many left-wing academics (although Keynes, Hayek’s rival in economic theory, praised the work). Many today dismiss Hayek’s ideas, arguing that the high degree of freedom enjoyed by citizens of the Western world today refutes Hayek’s hypothesis. However, one cannot help but wonder whether Hayek’s arguments, published at a crucial moment in Western history, helped contribute to the stepping-back from the abyss. The West never truly embraced full-scale socialism, and it is interesting to consider whether Hayek, because he (along with others espousing similar ideas) were listened to at the right time, helped avert the future he foresaw in his ominous book.