Blog : Why Socialism Must Always Fail: Ludwig Von Mises on Economic Calculation under Socialism

6573 posts
3/10/2008 7:42 am

Why Socialism Must Always Fail: Ludwig Von Mises on Economic Calculation under Socialism

"Without calculation, economic activity is impossible. Since under Socialism economic calculation is impossible, under Socialism there can be no economic activity in our sense of the word ... All economic change, therefore, would involve operations the value of which could neither be predicted beforehand nor ascertained after they had taken place. Everything would be a leap in the dark. Socialism is the renunciation of rational economy." -- Ludwig von Mises, Socialism, 1981, pp. 103-105.

Von Mises Socialism

First published in 1922 (under the title Die Gemeinwirtschaft), Mises' masterpiece Socialism was the lone dissenting voice to challenge the prevailing intellectual orthodoxy of his time.

In the aftermath of the Russian Revolution, an entire army of "useful idiots" (as Lenin contemptuously called Western intellectuals) were proclaiming the superiority of socialism. Blind to the massive evidence of socialism's failure that started accumulating as soon as the Bolsheviks came to power, collectivists throughout the world were singing paeans to the wave of the future that would allegedly sweep the outmoded capitalist methods of production into oblivion.

An essential aspect of Mises' exposition of the irrationality inherent in socialism is his concept of "economic activity." Mises does not use this notion to describe any processes entailed in producing goods. Arbitrary production plans set by the caprice of some commissar or planning board do not constitute economic activity. To qualify as economic activity in Mises' use of the term, production must be guided by rational principles.

The context in which Mises establishes the irrationality of socialism rests on the fundamental economic difference between capitalism and socialism, which economically consists of the private vs. communal ownership of the means of production.

Economic calculation in a capitalist economy

Under capitalism every individual plays a dual role in the determination of economic values. First as a consumer, secondly as a producer. As a consumer, he establishes the valuation of goods and services ready for consumption. As a producer, he allocates productive resources to the uses that yield the highest product. This is the very essence of the free market mechanism, which ensures rationality in production and consumption alike.

As a consumer, each individual spends his money on the goods and services that best satisfy his needs. The pattern of consumer preferences is conveyed to producers in the form of prices. This is the crucial function performed by market prices under capitalism.

Prices of consumer goods and services are the signals producers use to determine what goods and services are to be produced. Let's look at how this works.

Let's say that shampoo has a high price on it. This means that consumers value shampoo a lot, which is why they are willing to pay such a high price for it. The high price acts as a signal to producers. It tells them that they can make a large profit by producing and selling shampoo. As a result, they will shift resources to the production of shampoo. The end result is that more resources will be used to produce shampoo because this good is highly valued by consumers.

A high price indicates to producers that consumers place a high value on a certain good or service. From the producers' perspective, the high price means that they can realize a large profit by producing and selling this good or service. Thus the pursuit of profit induces producers to direct more resources to the good or service in question.

In contrast, a low price signals that consumers do not particularly value a good or service. The low price shrinks the producers' profit margin, so they will naturally shift resources away from this good or service. As a result, rationality is achieved by producing more of the goods and services that are highly valued by consumers and less of those that are not preferred by consumers.

The market mechanism also achieves rationality in production. Again, the role of prices is essential. In this case the signals guiding the actions of producers are the prices of productive resources (land, labor, capital, technology). A high price for a certain factor of production indicates that this resource will raise the cost of production and thus lower the producers' profit margin. Therefore producers will end up using less of this particular resource.

In contrast, a low price for a resource signals that producers can lower the cost of production and thus increase their profit margin by using this factor of production. The end result is rationality in production by lowering costs through the increased use of less costly resources and the corresponding reduced use of costlier ones.

This is the very essence of the price system that ensures rationality in consumption and production alike. This is because prices are formed as the result of the actions of consumers who spend their own money on the goods and services they desire and resource owners who sell the resources they own in the market.

Economic calculation under socialism: "a leap in the dark"

Since under socialism there is no private ownership, those actions are rendered impossible. In the most consistent versions of socialism (such as the War Communism implemented right after the Russian Revolution), money is abolished and goods and services are distributed by governmental decree. This is a bona fide recipe for total irrationality.

More "moderate" versions of socialism do not eliminate money. They allow individuals to have some income which they can spend as they see fit. This enables the establishment of prices for consumer goods and services, which give socialist planners (who play the role of "producers" under socialism) some signals as to the goods and services that need to be produced.

However, this signal is distorted, as consumers do not earn their income in a free market. Instead, their income is determined by socialist planners, who arbitrarily set the prices of resources (rents, wages, interest rates). Resource prices set in this manner are totally disconnected from the facts of reality, as there are no price signals conveying to planners information about those facts."

Since, by definition, productive resources are not privately owned under socialism, there can be no market where the prices of those resources are formed by the interaction by demand and supply.

Even if socialist planners have some knowledge of the goods and services that need to be produced, the obstacles they face in selecting the proper methods of production are impossible to overcome. In the absence of private ownership of the factors of production, there be no market where the prices of those resources are established.

In producing any good or service, socialist planners are confronted with a vast array of resource combinations. Some processes are more land-intensive, others more labor-intensive, still others more capital-intensive. Furthermore, there is an enormous variety of different types of land, labor, and capital. Similarly, there is a multitude of technologies to choose from.

Without the guidance of price signals, there is only one way of selecting among those alternatives: The planners' whim. This exposes the utter irrationality of socialism, eloquently expressed in Mises' statement that "Everything would be a leap in the dark."

The problems of socialism are not based on the irrationality or dishonesty of public planners

Mises' critique does not even address the critical issue of incentives. He did not claim that, since the profit motive is absent under socialism, bureaucrats have no incentive to try to follow the guidance of reason in their production decisions. To the contrary, Mises readily accepted that government officials are totally dedicated to the efficient production of goods and services.

The problem he identified was not lack of motivation on the part of planners. Instead, the cause of socialism's irrationality is that those highly motivated and competent civil servants have no rational mechanism to guide their productive efforts and thus any decisions they make are necessarily arbitrary. Their position is akin to that of the captain of a ship in the midst of the ocean without a compass. No matter how able he is, any efforts he makes to set the course of his ship are doomed from the outset.

Although Mises' analysis is purely economic, it illustrates the effects of an abstract philosophic principle in an economic practical context. That principle is that capitalism is the only economic system based on reason, while socialism rests on arbitrary whim. While capitalism cannot be effectively defended solely on economic grounds, Mises' exposition is of tremendous value to philosophical defenders of capitalism.

Mises' conclusion can be combined with the defense of capitalism on the basis of the rational moral code defined by Ayn Rand (in "The Virtue of Selfishness" and "Capitalism: The Unknown Ideal"). In a brilliant demonstration of the power of integration, the philosophy of reason and sound economic theory concur to uphold the rationality of capitalism and expose the patent irrationality of socialism.

The truth of Mises' analysis was confirmed by historical experience. The irrationality of socialism was revealed in the fate of all socialist experiments conducted throughout the twentieth century. Stalin's Ukraine famine, the widespread starvation brought about by Mao's "Great Leap Forward," the decadent misery that is a daily fact of life in North Korea, Vietnam, Cambodia, Cuba, and all other socialist utopias is writ large for the full slate of the practical manifestations of Mises' conclusion that "Socialism is the renunciation of rational economy."

Now if only the economic professors at Yale and Harvard could grasp this fact.