Come, let us go down and confuse their language so they will not understand each other.-Genesis 11:7
The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. -Friedrich August von Hayek
A price system is an information exchange network. It works best when built on top of a globally-shared neutral monetary medium. The more complex society becomes, the more pressing the need for a neutral monetary standard that doesn’t introduce noise into economic signals.
Knowledge Loves Company
One of the most profound insights in economics is Hayek’s take on the nature of prices. In a short and readable article called “The Use of Knowledge in Society,” Hayek explains why there wouldn’t be any exchange — nor any complex society — without the existence of prices.
Prices Are Data Reflecting The Economic RealityA modern economy generates billions of pieces of possibly-relevant information about people’s preferences, investors’ risk appetite, resource scarcity, manufacturing circumstances of particular goods and so on. We need to continually share this information to be able to coordinate our efforts. As the great economist Leonard Read pointed out, no single mind knows how to produce even a simple thing such as a pencil. Economic reality undergoes constant change. Similarly, the price system is in continuous flux, which makes it hard to paint an accurate picture of what’s really going on. When prices emerge in an unobstructed manner, they reflect reality and we can cooperate well. When prices are prevented from emerging or adjusting freely — and thus no longer reflect reality — our ability to cooperate is hindered.
As Hayek says, prices communicate the “knowledge of the particular circumstances of time and place.”. The dominant “use of knowledge in society” isn’t via books, TVs or classrooms; it’s the price system that is mankind’s main knowledge exchange network. And it’s amazingly efficient.
A brief example. Turkey grows around 80% of the world’s hazelnuts. Now imagine something happens in Turkey: a civil war, a hazelnut blight, a meteor strike. How does the rest of the world find out that something happened and that walnuts or peanuts should now be used whenever possible? Not from a TV. The skyrocketing price of hazelnuts breaks the story first. The price communicates only the most relevant information: that hazelnuts have become relatively more scarce. It doesn’t matter where in the world hazelnuts are produced or what happened there, what matters is that the nuts are now pricier and people need to economize.
“In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned.” -Hayek
A price system is a minimum viable medium of knowledge transfer. It allows us to cooperate globally, even if we don’t share the same language, culture or worldview, because these factors do not matter for economic cooperation. Prices are objective guides in our joint struggle to survive and prosper.
There are billions of possible pieces of information that could be relevant to any production process, consumer decision or investment opportunity. Without prices to communicate the knowledge of local circumstances, we would be groping in the dark. And that is precisely what societies without a price system ended up doing: from the Inca empire to the Soviet Union, societies without a working price mechanism turned into slave states which saw little to no progress.
Oi, That’s Noise Money You Got There
We have already established that for prices to convey economic signals properly, they need to represent the underlying economic reality. But prices are often actively prevented from doing so. There are three factors that affect how well prices do their job: how prices emerge, how they propagate and the quality of the price-carrying medium (the money).
How prices emerge: Prices need to arise out of the concept of private property, i.e. privately owned money and capital, land and buildings, machinery and technology, etc. With property in private hands, the incentives are in place to utilize it efficiently. Rewards for good decisions as well as punishments for bad ones accrue to those who are most receptive of them. On the other hand, protecting property owners from bearing the brunt of bad decisions — as is the case with bailouts or subsidies — is a sure way to cripple the price system, as prices then no longer carry the risk component. For a popular illustration of such moral hazard, see the movie The Big Short.
How prices propagate: Even if prices emerge undisturbed from the foundation of private property, price regulation can kill the signal before it is propagated. In the…
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