– July 2, 2010

On Wednesday, I posted a link to F.A. Hayek’s “The Use of Knowledge in Society”. Like Leonard Read’s “I, Pencil”, Hayek’s knowledge paper explains why it is impossible for an economy to be centrally planned. I have mentioned this idea in earlier posts, but it is always worth mentioning again as the lessons learned never seem to stick. Read’s piece speaks of the problem of scale. Economies are large and complex, making it impossible for any one person or entity to possess the knowledge needed to produce a functioning economic system. There is no Maestro with the talent to direct the symphony of the market.

Hayek argues along much the same line. Yet there is a subtle difference between the two. While Read admits to the complexity and the shared knowledge necessary for economic activity, Hayek argues that there is a process by which actors gain that knowledge, and that tampering with that process stops the flow of knowledge. It is through the actions of individuals in the exchange of the market that information passes. This information, in Hayek’s paper, comes through the formation of prices that arise from voluntary trade. Each individual entering or exiting the market sends a signal through the economy that allows others to judge value.

What happens when this signal is altered or halted as it flows through the market process? Confusion. There are unintended consequences to every action. As the Fed or Congress clamp down in one area of the market, some other area malfunctions because the signals have been disrupted. Regulations in one area of a complex economy necessarily affect another area. There is a ripple effect due to the interconnectedness of the system. To return to Read’s example, if you regulate trees, you have de facto regulated pencils.

When we allow large, complex regulations into financial markets, the markets’ signals are no longer the correct ones. New procedures and risks arise, unforeseen, due to the distortions created. The ripple continues on. There is no regulation more large or complex than direct control by a central authority. The Federal Reserve System has taken direct control of the money, as other central banks have done in other nations. If changing one area of the market can create distorted signals, how much disruption takes place when the entire market is no longer allowed to function? The Fed has taken over the trees, the mining, the saws, the motors, and all the rest. How do we expect to avoid mistakes and crises when the information of the market is no longer at hand?

Tom Duncan
Sound Money Fellow
Atlas Economic Research Foundation

Image by renjith krishnan / FreeDigitalPhotos.net.

Tom Duncan

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