Knowledge Problem in Central Banking – Part I

In my previous posts, Andreas Hoffmann and I discussed the problem of unintended consequences in monetary policy, particularly as applied to the U.S. Federal Reserve and the European Central Bank in the context of the 2008 crisis. This post tackles a related issue: the so called “knowledge problem.” This term was coined after Hayek’s engagement in the debate on the feasibility of economic calculation under socialism. It has also been applied to central banking; even though banking faces different problems than those Hayek was concerned about, there are some common threads. This first post discusses Hayek’s “knowledge problem.” Our next post extends the problem to monetary policy.

The economic calculation problem: The economic calculation problem refers to the impossibility of economic calculation under socialism. This debate took place in the early 20^th century. Socialism was understood as an economic arrangement where there are no property rights on the factors of production. Because of this, market prices for factors of production cannot exist, as without property rights, market transactions cannot happen. In a very small community, this might not be an issue, because each member has an intimate knowledge of his fellow villagers. Given the small population involved, information on how to allocate resources can be acquired through other means and sorting out how much food to produce, etc., is simpler. Low technological expertise also means that there are only a few options of how to produce any given good, so there is no need to deal with advanced and complex (“roundabout”) production processes. An even smaller example of this situation is a household, where family members don’t trade among themselves. But applying socialist arrangement to large societies, where this personal and intimate knowledge across members of society is lacking, is much more complicated. Economics tries to explain how coordination is possible with anonymous transactions and without given information. If intimate knowledge of a society’s preferences are unknown, and there are no prices to channel these preferences, establishing an economic order is not feasible. When economic rationality is not an option, another guide needs to be chosen, i.e. a dictator ruling the society, asking the Gods for guidance, intuition, etc. But despite its imperfections, economic rationality is essential, as it looks at the most efficient way to organize a large society.

Hayek’s knowledge problem: Hayek raises a number of issues; we will focus on two of the most relevant ones. The first one is the dispersed nature of the information required to plan an economy centrally. To assume that information is given does not to solve the problem so much as it avoids it. And it happens to be that this required information is dispersed in tiny bits across all market transactions. This information is not located in one place. Each single transaction that happens in the market represents a bit of information. Hayek’s main point is not that the government lacks calculating power to collect and run the optimization problem and determine how to allocate resources. Rather, Hayek’s point is more subtle, emphasizing the fact that without market transactions, there is no such information in the first place. Exchanges generate this information; this is why each price is a piece of information. Market transactions and information are two sides of the same coin and cannot be separated. To avoid market transactions by eliminating private property rights on the factors of production also eliminates the process that generates the information required by the central planner. Quite a “catch-22.”

The two previous paragraphs talk about information, which is a quantitative concept and, as such, can be complete or incomplete. But embedded in Hayek’s argument is knowledge, which is a qualitative concept and therefore can be neither complete nor incomplete. Data such as prices is objective, but knowledge is subjective. This points to another problem that the central planner faces: that of knowing how to process the information. Having complete information is not enough to efficiently allocate resources (i.e. be in equilibrium). The right knowledge is also needed. What is the economic view of the world held by the central planner? Is the planner, for instance, a monetarist, a Keynesian, a Marxist, an Austrian, etc? The same perfect information would trigger different policies for each economic view of the world.

What does this have to do with central banking? At first glance, the problem of central banking does not seem to have much overlap with Hayek’s knowledge problem (as applied to the socialist debate.) Central banks may have monopoly powers, but that is a different issue than the elimination of private ownership of the factors of production. Market prices still exist, and the price of money does not disappear either. Private property on money is not eliminated, rather, the supply of base money is eliminated. Central banks usually have access to a good quantity and quality of information, but they do face a knowledge problem as defined above. These particular problems are discussed in the next post.

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