At Pragmatically Distributed we don’t mind ambitious multi-objective programming: We know how to hit our objectives. Today’s objectives – Demonstrate what role the state should play in economic value signalling, and justify the state designing the business environment differently for different sectors of the economy rather than treating all sectors equal.
We will also wean you Libertarians off of primitive Anarcho-Libertarianism and mold you into Capitalists worthy of Alexander Hamilton and Abraham Lincoln. Or, at least, we will mold those of you talented enough to adopt Hamilton’s Robber Baron Capitalism. Which is probably only a small number of you people, but that is of no consequence. It suits Hamiltonian interests given we are targeting an elite audience rather than a mass one; we can and will do very well by preferring quality to quantity.
To meet our goals we take Ludwig von Mises’ subjective theory of value, and use it to reject both Austrian economics and Progressive economics in favor of Alexander Hamilton’s Capitalism.
As a refresher, here is how Hamiltonians define the three major economic systems; Capitalism, Libertarianism, and Liberalism:
- Capitalism – Government actors set the common business environment without favoring particular private actors; individual private actors are then free to take any business action within the boundaries of the established environment.
- Libertarianism – Private actors set the common business environment without favoring particular private actors; individual private actors are then free to take any business action within the boundaries of the established environment.
- Liberalism – Government actors set the common business environment without favoring particular actors; government actors then decide on all individual economic actions within the boundaries of the established environment.
We now introduce Alexander Hamilton’s Laws of Economics. Each of these laws are true for all types of economic systems.
Hamilton’s First Law of Economics – National Economic Performance is the Result of Process Efficiency
National economic performance is the aggregate of how efficiently processes satisfy customer demand with goods and services.
For any nation the more efficient the aggregate operations of individual producers are, the more optimal is the aggregate allocation of national economic resources.
Hamilton’s Second Law of Economics – How Efficient Processes are is a Function of a Triangle of Value Signals from the Customer, Producer, and Business Environment
Production processes are efficient if they allocate a minimal amount of resources (relative to alternative processes) to produce the most valuable (in the opinion of the customer) goods or services.
A Triangle of Value Signals influences how efficiently processes allocate resources in production. The three value signals operations are based on are:
- What the customer views as valuable.
- How valuable satisfying demand is to the producer.
- How clearly information about value relevant to a given business environment is signaled to all economic actors in that environment.
The conditions of any given business environment depend on many factors, some of which are under a nation’s control, some of which are not: external military threats, degree and type of business competition, geography, natural resources, and so forth.
As far as environmental influences are under the control of government, those influences depend on the government acting as a neutral arbiter in the creation and enforcement of common rules for all individual actors. What role and influence the government should have in shaping the business environment is a special focus of this article.
When a producer tries to satisfy customer demand, the producer aligns their processes to use resources. If a process is efficient, fewer resources per unit produced will be allocated to that process, leaving those resources free to be used by other processes.
To create efficient processes, producers must be able to accurately (to the degree measurable) interpret value signals from the consumer and the economic environment. If the producer cannot accurately read what is valuable to the consumer and in the relevant economic environment, the producer cannot determine what activities are actually valuable to the producer. Without knowing what is valuable to the customer, producer, and environment, processes cannot be efficiently aligned to resources.
Governments should keep in mind there is a Darwinian advantage to be gained if producers with inefficient processes are driven out of business – if inefficient producers are driven out of business proportionally more resources become available as inputs for the processes of more competitive producers. The more resources become available to a growing share of efficient producers, the more efficient (hence, more powerful) a nation’s economy in its entirety becomes.
Hamilton’s Third Law of Economics – Consumer Demand Leads to a Natural Self-Sorting of Producers into Sectors
Types of customer demand leads to the creation of different sectors because different types of consumer demand frequently require producers to design different types of processes in order satisfy different demands: The medical industry exists to satisfy medical needs; the financial sector exists to satisfy financial needs, the housing sector exists to satisfy housing needs. Each of these sectors have developed substantially different types of medical, financial, and housing processes to satisfy the demand in their respective sectors.
Because satisfying different types of desires requires different types of business processes, different sectors ultimately allocate different types of resources in their business operations that are often not needed in other sectors: Medical processes are allocated medical resources, financial processes are allocated financial resources, housing processes are allocated housing resources.
Obviously, there is overlap across sectors in terms of what processes they run, what customer needs they serve, and what resources they allocate. The medical, financial and housing sectors all use marketing processes to advertise their products to customers; they all use energy resources…
But there is sufficient difference in processes, customer needs, and resources that the businesses within each of these sectors naturally self-sort themselves into competitive niches based on these three factors.
Thus, when executives in the housing sector scan their environment for risks and opportunities they usually do not consider businesses operating in the medical industry to be their competition because the housing industry is not in competition for resources with the medical industry to satisfy the medical needs of customers with medical processes.
In practice, even if without realizing it, both governmental actors and private actors analyze and act on how the economy sorts itself into sectors this natural self-sorting into sectors.
Hamilton’s Fourth Law of Economics – What is Interpreted as Economically Valuable Can be Altered Radically by Changes to Economic Incentive Structures
Incentive structures can greatly influence economic activity because the consumer, producer, and economic environment exchange signals in a continuous feedback loop of value signals:
If, because of incentives, one of these three interprets value in a different way, what the other two view as valuable will likely change because value information is signaled back and forth between all three.
A change in perceived value can completely alter whether and how effectively a producer engages in an economic activity. Therefore, incentive structures hold a direct and powerful causal relationship over how prosperous an economy is.
In an ideal network of economic signals:
Each individual consumer determines what is valuable for themselves and signals what it is they demand.
In deciding whether to satisfy customer demand is valuable to the producer, producers interpret these customer signals and scan their business environment for information about value.
If the quality of signal feedback falls low enough economic activity risks halting entirely.
Hamilton’s Fifth Law of Economics – Value is not Objectively Quantifiable
In science objective measurement is possible when there is agreement among different scientists about what qualifies as a unit of measure for a kind of scientific phenomena : Luminosity, chemical reactivity, radioactive decay are objectively measurable because scientists agree on what qualifies as a unit of each measure for each type of phenomena.
However, as von Mises pointed out, economic value is not objectively quantifiable for many different reasons.
Not least of these is because individual economic actors usually value the same opportunity differently due to different individual preferences.
Suppose you were offered two choices: You will win $100 million if a coin is flipped twice and comes up heads twice. Or, you may skip the coin toss and be handed $1 million immediately.
Which choice is most valuable for you?
That depends on what your preferences are. If you are worth $200,000 you will most likely take the guaranteed $1 million.
But if you are worth $200 million you are much more likely to gamble on the coin toss.
The same opportunity is valued differently because different actors often have very different tolerance levels for risk.
Therefore neither of the choices can be assigned an objective value.
There are number of reasons why economic value is inherently subjective are essentially limitless because of uncertainty and subjectivity:
- Preferences for economic actors often change.
- Many, if not all, economic actors are at least partially irrational. In game theory and related economic fields what is meant by “irrational” is not that an actor is “illogical”, but that the actor does not follow their own preferences no matter if their preferences are illogical: If a person prefers to buy a car that is yellow but has no windows vs a car that is blue and has windows, and if the person buys the yellow car, that person is considered rational in game theory because they acted according to their preferences, and despite their preference arguably not being logical. They would be “irrational” only if they bought the blue car despite preferring the yellow one.
- Economic decisions are always made under conditions of randomness, risks, and incomplete information about the present and future. If a manufacturer unexpectedly loses a supplier due to an earthquake and can only buy equivalent supplies at a higher price from other suppliers, what the manufacturer originally wanted to produce may no longer be valuable to the manufacturer. Supplies that were initially valuable in the present may not be in the future and there is no way for the manufacturer to know in advance. It can only take measures to mitigate risk, but risk can never be eliminated or anticipated for every possible scenario.
- After an economic action is complete it is impossible to know for sure whether alternative actions were superior in value because whatever alternatives there were can never be rerun under exactly the same circumstances as the choice already made. Would Apple have been better off producing a TV screen instead of Apple Watch? It is impossible to say for certain.
Because value is inherently subjective, the final cost of any good or service is, in reality, a compromise between the perceived values of everyone involved in the sale or purchase of the good or service.
When a bakery puts a price on a loaf of bread, did everyone involved in creating and buying bread agree that its final price reflected the cost of its inputs and its value to the consumer?
That depends on answers to questions such as can it be objectively proven whether a bakery paid too much, too little, or the right amount of money for flour? Everyone involved in creating flour would have a different answer. To a consumer it may seem the baker paid too much if the consumer feels the finished bread costs too much. The workers at the flour mill may feel the flour cost too little.
None of these questions be answered with an objective, numeric, value because each actor involved in the activity will have a different opinion, none of which can be proven to be superior.
Given how uncertain and subjective every economic action, from the simplest to the most complex, is shrouded by subjectivity and uncertainty greed turns out to be good after all.
Greed is good because greed is defensive in a world of so much doubt because greed prods actors to accumulate resources that may well come in as handy reserves during downturns.
Comparison of Economic Systems as Relates to the Above Laws
Now we take what has been discussed to shed new light on the three major economic systems, Capitalism, Libertarianism, and Socialism.
The subjective theory of value raises this question: If we acknowledge value (in the broad sense that von Mises defined it) is subjective, why should we conclude certain types of economic systems allocate capital more efficiently than others if value is inherently subjective?
The answer is that, although value is not completely quantifiable, processes that generate similar types of goods and services are comparable enough across types of economic systems that we can be confident (if not entirely sure) that some processes are more efficient because of the type of economic system practiced.
Pragmatically Distributed argues Capitalism is superior because it leads to relatively more optimal processes vs the other two systems.
First, we consider the old debate between Capitalism and Socialism.
Capitalism has been said by its advocates to be superior because private producers are best positioned to understand the needs of the buyer.
But in the context of this article, with its focus on value signalling, it could equally be said that Socialism fails because it ignores the value signals coming from the consumer side of the Triangle of Value Signals.
For processes to be efficient, value input must be received from the consumer, producer and the environment.
In Communist systems the government dictated what should be produced based on what the government felt was valuable, and with only minor concern given to what the citizen desired. In a sense the government’s preferences replaced the consumer’s preferences. But as it turned out, the government could not effectively substitute the consumer’s preferences because the latter’s preferences were too nuanced for a distant central government to imitate.
The result of ignoring consumer preferences – as well as environmental mistakes such incentivizing Communist governments to act as monopolies thanks to there being no competitors in production – was that Communist nations were unable to allocate resources to emerging opportunities, and were burdened with highly inefficient processes that used too many resources to produce goods that were efficiently produced at a higher level quality in the West.
This broken system of signalling is why the GDR had to make due with Trabants while West Germany was home to BMW and Porsche.
Notice that, out of all the items made by the Soviet Union, Soviet production was most efficient at producing weapons because the customer that demanded the weapons, the Soviet government, had a better understanding of what it preferred and could signal those preferences to the Soviet arms industry. When it came to building arms, Soviet value signalling was not as broken as in other activities.
Classic Socialism assumed that state actors could replace the role of the consumer in determining what is valuable for the consumer because value was assumed to be objectively discoverable given enough “scientific” information. Their assumptions were, in a certain sense, Newtonian.
But as we demonstrated in Law V, value is inherently uncertain, Heisenbergian. In an uncertain world Capitalism is superior to Socialism because Capitalism enjoys superior processes thanks to its acceptance of the legitimacy of value signals from the producer, consumer and environment.
Standard economic textbooks downplay the subjective nature of value (though this is now broadly accepted across economic disciplines) because subjectivity fundamentally contradicts Progressive economic propaganda.
If economic value is inherently subjective then the Progressive social engineer has no more special insight into what is economically valuable (and therefore has no right to demand more power over the economy) than anyone else: What the Progressive thinks is economically valuable can never be more than a reflection of their subjective preferences and opinions, not a scientific reality as they would have it.
To the credit of all game theory literature beginning with von Neumann and John Forbes Nash, game theorists have always accepted the subjective value of economic decision making, in addition to non-economic decisions. Instead of trying to quantify economic value, game theory tries to predict behavior given certain incentive structures.
This is why in game theory’s payoff grids the value of a given action to a single actor is given in rank order of preference – i.e., for player A a payoff of 3 vs a payoff of 2 is not necessarily 50% more valuable than a payoff of 2. A rank of 3 merely tells the statistician that a rational actor will, other factors equal, always choose an action that yields 3 instead of 2. Rank order is also why in game theory payoff grids for individual actors are not directly cross-comparable across other actors.
The great failure of Liberal economic systems is that Liberals assume government can make decisions on economic value because economic information is Newtonian.
The greatest strength of Austrian economics is von Mises’ subjective theory of value because the Austrians treat economics as a system of subjective preferences and incentive structures, as does game theory.
But Austrian economics has its limits. In the end Austrian Libertarianism, like Socialism, is inferior to Hamiltonian Capitalism
As it turns out, Mises’ theory of subjective value instead proves Hamiltonian Capitalism is superior to Anarcho-Libertarianism.
The subjective value of economics undermines two core concepts of Austrian economics that conflict with Alexander Hamilton’s version of Capitalism. First, that there is no role for the state in the free market; second, that the government should not treat different sectors of the economy with different policies.
To put the Austrian critique in this article’s terms, the problem with the modern Progressive state is that it has given in to the temptation to warp the value signalling environment of the market in favor of social engineering because Progressives prefer social engineering.
This point is absolutely correct.
Where Austrian economics fails is in its belief that the temptation to distort value signals disappears if the state is abolished. In reality, absent a central state to set common environmental rules and conditions, private actors would have the same temptation to distort economic signals in favor of their own preferences and profit motives than they would in an environment where a Capitalistic state exists.
In a pure Libertarian system the power – and temptations that come with that power – to establish common rules is atomized across many different private actors instead of being concentrated in the hands of a centralized state.
The state is accused by Austrians of being obsolete and unnecessary because it does not have profit motives like private actors. This is fair if the government orders, or excessively pressures, private actors to take particular actions. Their criticism is not fair of government’s traditional role as neutral arbiter for all actors – if private actors had the role of neutral arbiter delegated to them, as Austrians wish, the duty of private actors to be neutral arbiter would directly conflict with their own profit motives. Because private actors have a profit motive to alter common rules to direct value to themselves, private actors cannot take on the role of governments unto themselves.
In a truly Anarch0-Libertarian system, the environment of value signalling would break down and decision making would halt. In this system no one would be able to trust that signals coming from their environment were realistic, or instead being manipulated to serve the profit motive of individual actors.
The Capitalistic State’s Interest in Sector Models
A poor environment of market signalling is disastrous, a good environment is excellent.
For the Capitalistic state, what model should it use to judge whether its environment of economic signals is healthy?
One of the most informative viewpoints a government has at its disposal is to model national economic performance in terms of whether sector environments are efficient.
The basic relationship between actors and the state in the Hamiltonian model of Capitalism holds true when specified to a model of value signals – Capitalism is best in value signalling networks because individual actors are free to act on what they think optimal value is for them so long as common rules are obeyed.
Breaking down an economy into sectors with different needs is wise because different types of pricing information are relevant and needed in some sectors environments, but not others. The environmental effect of drug testing regulations are most relevant to price signals in the pharmaceutical sector, to the financial sector drug testing is not relevant to their price signalling environment.
The state should monitor the environment of different sectors because if one is failing it could mean there is a problem with that sector’s environment that warrants government action. Of course sectors could fail not because there is anything wrong with the environment but because of natural economic forces such as one sector becoming technologically obsolete. But it is appropriate for the government to at least consider whether sector performance is a natural result of the business environment or if corrective measures are needed.
Thinking of economic environments by sector is appropriate because if government nurtures a broad range of sectors (its national “portfolio” of sectors) the national economy can better handle downturns in a particular sector because other sectors serve as “backups” to make up for underperformance elsewhere.
Refining the Hamiltonian definition of Capitalism, the state should be concerned with the environment of price signalling, and consider sectors that have specific price signalling needs. And the advice given by Libertarians that the state should treat different sectors differently deserves to be abandoned as obsolete.