The economic calculation problem of socialism is similar to the problem of economic calculation under monopoly. However, the absence of private ownership under socialism adds an additional layer of chaos to socialism, which is exacerbated under democratic political competition. This is what makes monarchy preferable to democracy, yet inferior to a free market of security.
The idea of a free market in security and justice was first formulated by Franco-Italian economist Gustave de Molinari in the mid-19th century essay The Production of Security. In this essay, de Molinari applies modern economic analysis to the problem of the state, and finds that economists who opposed salt monopolies must also oppose monopolies of security or else contradict themselves. de Molinari’s still-revolutionary innovation was introducing economic analysis to the process of government.
Defending monopoly was not a problem for socialist ideologues (according to Marx, the end result of capitalism was monopoly) until early in the formation of the Soviet Union, when Ludwig von Mises published Economic Calculation in the Socialist Commonwealth. His argument was that without capital markets, and thus prices for capital, the socialist economy was unable to economize and would thus end up producing a lot of the wrong things. Socialists dismissed the critique by claiming that Soviet planners were just as capable of making economic valuations as capitalists, and there was nothing exceptional about the market process that could not be simulated under socialism. The system went on producing a lot of the wrong things until the Soviet Union gave up and dropped dead. It was eventually Hayek who would clarify the debate, and refute the socialist objection to the economic calculation problem, by pointing out the key difference between a socialist and free market economy: in the socialist economy, there is only one economic calculator in the capital markets, while in the free market economy every individual is an economic calculator of the capital markets. This makes the free market economy several orders of magnitude more productive with the capital stock.
To make sense of this comparison at all, we must first understand Hayek’s distinction between tacit knowledge and scientific knowledge.
Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active coöperation.
We must look at the price system as such a mechanism for communicating information if we want to understand its real function—a function which, of course, it fulfils less perfectly as prices grow more rigid.
The Use of Knowledge in Society, Friedrich A. Hayek 1945
As Hayek explains it, the total human knowledge contains both so-called scientific knowledge, such as the Pythagoras theorem, the species of plant life, or the structural moments of bridges, and facts about time and place, such as the relative need for housing in the Yukon territory. While scientific facts are common to everyone, and, assuming they are not under dispute, can be known best by a select group of scientific experts, knowledge about time and place is literally infinite, and every individual human being has a different perspective of it by the fact that each individual takes on a different journey through their lives. From the fact that such knowledge can only be earned from experience, it follows that it cannot possibly be centralized. That is what makes central planning undesirable.
How does this fact introduce an economic problem? For Robinson Crusoe, alone on his island, the sum total of human knowledge is only his own perspective and experience. He alone can make use of the island’s capital goods, and so he can decide how to make the most economic use of these goods based on his knowledge of their productive value. The economic calculation problem, as introduced by Mises and expanded by Hayek, does not arise until a second person arrives on the island, Friday, who has his own perspective and knowledge of the productive value of the island’s capital. As such, Crusoe and Friday can disagree on the use of this capital.
This disagreement is resolved through trade. Suppose that Crusoe believes that a net can produce an extra 12 fish a day, while Friday knows, from growing up in a fishing village, that it can produce 30, Friday can attempt to convince Crusoe that producing a net is much more valuable than building more shelter. This process of sharing information is not free, it consumes time and can fail if only experience provides confidence in this fact. As such, Friday can more easily trade with Crusoe for the capital needed to produce the net, and while Crusoe may not believe that Friday is making a good investment, Friday will be justified once the productivity of the net that only he believes in is achieved. As such, the division of knowledge is an aspect of the division of labor.
Extrapolated to a global economy of billions of humans, it means that for each capital good, irrespective of it being small in scale (a farm or shop) or large in scale (the Apple Computers corporation), there is only one individual who is best suited to owning this good and achieving the highest productivity from it. To own capital, in this sense, is to be able to make use of it as the individual best deems it without having to provide any justifications to people who do not have the appropriate knowledge. The capitalist does not need to explain his decisions concerning his capital, for the reason that this would not be an economy of knowledge.
What is the economy of knowledge under a monopoly? A monopolist is granted exclusivity in the production of a specific good or class of goods, and thus is de facto the exclusive employer of the capital goods involved in this production. A monopolist can only achieve this position by destroying all competing producers of security in the market, or by obtaining the privilege of a monopoly from the monopolist producer of security. The original monopoly is therefore the classical monarchy, which forbids all other sources of justice from operating within the state. The monarchy could sometimes sell monopolies to individuals in return for immediate cash, such as a monopoly on salt. What did such a monopoly mean for the consumers of justice or salt? It meant that other producers could not act upon their advantageous experience or knowledge of unfulfilled opportunities, and because of this the supply of salt and justice was inferior to its full potential, and also for this reason the capital goods used in the production of monopolized goods had lower market value than their full potential. That being said the monopolist of salt may be limited to the role of a Robinson Crusoe of the salt market, but he was still a rational economic actor, he still had the incentive to increase and improve his capital and could produce high quality salt, although in reduced supply. He might even sell his monopoly to another monopolist, who would yet again be a Robinson Crusoe of salt but with higher productivity. In either case, however, there would not be the possibility for a second salt producer, and thus the salt market would be below its full potential supply to the detriment of salt consumers.
One can see how monarchy, despite being a monopoly of the production of justice, might still supply the market for justice adequately, at least in comparison to other forms of government. For one thing, in order to first set up a monarchy, one must be competent enough to wipe out the competition. Similarly one can only purchase a salt monopoly if enough capital has been accumulated to pay off the monarch. So while a monopoly is exploitative, it is not inefficient. However, due to its exploitative nature, and because some people would tend to be more exploited than others, monarchy produced revolutionary uprisings. Some of these uprisings replaced the monarchy with an electoral republic, which we may call the American system, while others with a radically socialist single-party rule, which we may call the Soviet system.
Mises’ critique was leveled at the Soviet system of socialism, but how would economic calculation differ between Soviet socialism and monarchy? Under monarchy the production of security is monopolized, but there is no incentive to monopolize any other capital market other than as an emergency liquidity measure. Under Soviet socialism two things happen, the party becomes a semi-hereditary ruler of the state (where the dictator appoints the peers who will select the next dictator), and the state implements monopolies in every industry. So, while the state has an incentive to preserve and increase capital (and this was seen in the violent industrialization of the USSR leading up to WWII), it has no means of knowing how best to do this due to the party being the single economic calculator implementing the plan. The only alternative, as Mises explained, is to import prices and techniques from the free market countries and attempt, with more or less success, to replicate them in a different time and place. Eventually the system must fail to keep up with those differences, and Soviet-style socialism must end in an economic collapse.
This must not necessarily involve a political collapse. If the party, which rules the state securely and permanently, can give up its policy of total monopolization and allow other capitalists to enter the market, thus expanding economic calculation to the whole population, it can rejuvenate its economy and continue to rule (and exploit) a dynamic and prosperous state. This was the choice made by the Chinese Communist Party, and today its grip on power is stronger than ever, and so is the health of the Chinese state. The Communist Party of the Soviet Union, on the other hand, chose to preserve socialism but instead reform politics to the American system, and the result was total social and financial collapse.
What is economic calculation under the American system? First, we must define the American system as a bipartisan (or multipartisan as in some Western European states) political power-sharing constitution, which may or may not be democratic or egalitarian in nature, (universal suffrage did not arrive until the 20th century, when the modern political parties were already long established in power) and where periodically reoccurring elections turn the state over to the most popular party, which may rule until it falls out of favor. Under such a system the ruling party does not own the state and can only exploit it in the extreme short-term, however the means of exploitation are deliberately inefficient, requiring long public debate and transfers of information in order to decide action in any sphere, thus making it difficult to exploit the weak faction but also making it next to impossible to properly employ capital. Not only is there only one economic calculator in the American system, it is a collective economic calculator that requires that many individuals, some obviously lacking in intellect, be convinced through persuasion of the value of an action before enough agreement has been organized to act. The American system has therefore two perverse incentives, the incentive to rapidly consume the state’s capital stock, and the incentive to disrupt the operations of the state through endless information transfers.
While the state is small and acting merely as a general, absent-minded protector of the market economy (the utopian “minimal state”), its inefficiencies are barely noticeable, and only the occasional visit to the post office provides evidence of the system’s failures. But while it grows larger and takes monopolies over greater numbers of industries (the most destructive of all being the production of money through a central bank) the American system’s flaws become more and more destructive, and economic chaos follows. It was thus that the Soviet system, shortly after adopting the American system of political competition, rapidly fell apart financially, its assets looted by the oligarchs who kept the ruling party in power. Thus again, as Hayek wrote in The Road to Serfdom, the expansion of socialism in states run on the American system can only result in the establishment of a dictatorship that will do away with the deliberate inefficiencies of the system, all the while handing over unlimited power to the dictator. This is what unfolded in Germany’s short-lived American-style Weimar Republic. The continued expansion of the USA’s executive branch along with the expansion of socialism in the USA will eventually produce a similar dictatorship.
By its nature and the fact of the division of knowledge, the American system of government can only function at all if the state is small. Tragically, its success as a small state allows its conversion into an enormous imperial state, and as it adopts socialism its flaws become more evident and more destructive. The end result of this transformation can be only total collapse or dictatorship. How can we protect ourselves from this event? The nature of the American system creates an opportunity to reintroduce a free market in security. While it struggles to prevent its own collapse and transforms itself into a dictatorship, it will be helpless to prevent the rise of independent societies within its borders capable of producing security against the state’s exploitation. Such is not the case in the Chinese state, where upstart societies will be immediately crushed. Thus, when American government completes the transition to dictatorship, the dictator will have power only over the members of the state apparatus itself, and the American system will give way to a free market system.