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Friday,
November 1, 2019 / 10:32PM /
By Randal K. Quarles / Header Image Credit: WFBJP
Being
an address given by The Federal Reserve Vice Chair for Supervision, Randal K. Quarles
at "The Road To Serfdom At 75: The Future Of Classical Liberalism and The
Free Market", 9th Annual Conference of The William F. Buckley,
Jr., Program at Yale, New Haven, Connecticut, USA.
I
am delighted to be back in New Haven and particularly to be in the company of
so many students interested in thinking rigorously about ideas. And I am honored
to be participating in the William F. Buckley, Jr., Program's conference today
on Friedrich Hayek and the future of classical liberalism.1
Over the course of this afternoon, you will hear a series of
presentations that put Hayek's thinking in the context of contemporary
developments and that offer a variety of perspectives on his intellectual
legacy. Hayek was a prolific-some might even say profligate-thinker. He was at
various times, and in various modes, an early neuropsychologist, an
epistemologist, a theoretical economist, a political philosopher, a moral
philosopher, a philosopher of science, a historian of ideas, a public
intellectual, and a social polemicist. This vast range has caused some to
undervalue his contributions as an economist, notwithstanding his eventual
Nobel Prize-when Hayek moved to the United States in 1950, the University of
Chicago Economics Department would not hire him because, as Milton Friedman
said, "At that stage, he really wasn't doing any economics," and Paul
Krugman famously said that "the Hayek thing is almost entirely about
politics, not economics."2 Others believe his broader thought, while seminal, was
inconsistent across these various areas, and Hayek himself never demonstrated
how it all hung together. In my contribution to the discussion today, I want to
examine a particular example of the lasting effect that Hayek has had on
economic thinking-one pertaining to the importance of freely determined prices
for producing efficient economic outcomes-and consider how Hayek's insights in
this area can, in fact, tie together the various strands of his larger
philosophy.
So as not to appear entirely out of touch with more immediate
developments, I will end by descending from the empyrean to the terrestrial
with a discussion of the economic outlook and the Federal Open Market
Committee's (FOMC) policy decision from earlier this week.
Hayek
and Economics
Hayek's
contributions to economics ranged widely, and many were important and of
lasting influence. Among them were his studies of the relationship between the
economic and political arrangements of a society. That body of work included,
of course, his celebrated book The Road to Serfdom, which was
published 75 years ago this year and is a focus of this event, as well as his
later monograph, The Constitution of Liberty.3 In addition, Hayek contributed prominently to monetary
analysis. His work in this area included the theory of the business cycle that was
part of the thinking of the Austrian school of economics.4 It also included Hayek's studies of the feasibility and
implications of private-sector currency issuance-contributions that have
informed modern-day analyses of the repercussions of electronic money.5
Today, however, I will be concerned instead with still another key
contribution that Hayek made to economic analysis: understanding the operation
of the price system. This contribution was formalized in his most famous paper
in the economic-research literature: his article "The Use of Knowledge in
Society," which was published in the American Economic Review in
September 1945.6
Hayek
(1945) Revisited
It
is worth outlining the basis for the high esteem in which economists hold
Hayek's 1945 contribution. In 1974, the press release by the Royal Swedish
Academy of Sciences that announced Hayek's Nobel Prize in Economics stated:
"The Academy is of the opinion that von Hayek's analysis of the functional
efficiency of different economic systems is one of his most significant
contributions to economic research in the broader sense. ...His guiding
principle when comparing various systems is to study how efficiently all the
knowledge and all the information dispersed among individuals and enterprises
[are] utilized. His conclusion is that only by far-reaching decentralization in
a market system with competition and free price-fixing is it possible to make
full use of knowledge and information."7
In
the research that the academy described, Hayek's 1945 paper was the key
article. More recently, this paper received further prominent acclaim when it
was categorized by an expert panel as being one of the top 20 articles ever
published in the American Economic Review.8
With regard to the paper's contribution to the understanding of
economic processes, an illuminating discussion was provided in 2005 by Oliver
Williamson-himself later a Nobel laureate in economics. Williamson cited
Hayek's 1945 paper, along with Adam Smith's The Wealth of
Nations from the eighteenth century, as forming the core of a
"venerated tradition in economics" of studying the notion of
"spontaneous order" arising from a freely operating market system.9
How
does Hayek's case for the price system fit in alongside the other work that
Williamson mentioned? As Paul Samuelson-yet another Nobel Prize winner-had
occasion to note, the argument for the price system that Hayek articulated in
1945 was complementary with, but distinct from, the argument that Adam Smith
espoused in The Wealth of Nations.10 Smith focused on how market mechanisms guide producers
toward satisfying consumers' wants. Hayek instead stressed how the market
mechanism makes, as he put it, "fuller use...of the existing
knowledge" than a directed economy is able to do.11
Hayek
emphasized that the signals transmitted by the various individual prices in the
economy could, together, serve as a useful means of guiding overall resource
allocation. The reason is that prices convey messages to consumers and
producers even when the information that drives prices is not aggregated or
directly observed.12 For example, a large increase or decrease in the price of
gasoline conveys information that influences consumer behavior and that also
affects the behavior of energy producers, even when neither of these sets of
market participants are aware of the precise factor initiating the price
change. As a related matter, Hayek recognized that prices transmit information
even in a situation in which much of that information is not explicitly
disclosed by one market participant to another, or even consciously articulable
by any market participant at all. Hayek believed that all of us "know"
many things that we cannot articulate but that we nevertheless act on in
practical situations, and the price system can therefore aggregate and transmit
that knowledge which we could not otherwise convey.
Hayek's
analysis had implications for the viability of different economic systems. With
regard to centrally planned economic systems-which had considerable support in
the West in 1945, in light of the increased use of government economic controls
in many countries during World War II and the dismal performance of market
economies during the Great Depression-Hayek's analysis suggested that these
systems would likely exhibit great inefficiency. To Hayek, it was totally
unrealistic to expect an economy to operate efficiently if it was based on the "direction
of the whole economic system according to one unified plan," as such a
plan lacked the valuable information embedded in market-determined prices.13
The
economist Gregory Mankiw has elegantly summed up Hayek's insight here:
"Information is very, very dispersed among the population. ...Nobody can
possibly know all the information you need to run a centrally planned
economy."14 Hayek's economic analysis therefore complemented the
philosophical and political arguments he marshaled against centrally planned
economies in The Road to Serfdom. Again, it is important to
recognize that this is not a contingent or technological problem. It is not
only that the dispersion of knowledge makes it hard to gather, although that is
certainly true-but if that were the only issue, then perhaps future advances in
technology such as quantum computing would remove that obstacle. Rather, as
already mentioned, we all know many important things that we cannot articulate;
and many of these things we come to know precisely through our participation in
trade and exchange through the market. This type of knowledge (a) is by its
nature not conveyable to a central planner because we are not fully aware of
all we know, and (b) would not even exist apart from the social interactions
facilitated by the market which a central planner would replace.
The
flip side of Hayek's analysis was that, while there are insurmountable
obstacles to economic efficiency via a central plan, an efficient economy may
still be obtainable by letting the price system work. To quote Mankiw again,
Hayek's analysis implies that "markets figure out a way to aggregate, in a
decentralized way, dispersed information into desirable outcomes."15 Furthermore, this mechanism does not require the government
or any one individual to process that dispersed information into a central
network or to be able to aggregate the information into a statistical series.
It is, instead, sufficient for the proper operation of the price mechanism that
the relevant information be embodied implicitly in the economy's multiplicity
of prices of individual goods and factors of production. This information is
recorded in such prices because they respond to the behavior of individual
buyers and sellers in the economy.16 Consequently, as longtime Hayek scholar Gerald O'Driscoll
has observed: "What particularly recommends the price system to Hayek is
the 'economy of knowledge' with which it operates. It is [in Hayek's
description] nothing short of a 'marvel.' "17
How
Hayek (1945) Has Influenced Economics
Hayek's
1945 paper has had a great influence on subsequent economic research. It has
been found to be highly relevant to a variety of areas of economic inquiry. For
example, Hayek's analysis has proved valuable in the development of standard
microeconomics, since his contribution deepened economists' understanding of
the working of the price system and promoted further investigation of the
question of how decentralized information is transmitted by markets.18 Hayek's emphasis on prices as processors of information has
also had applications to international trade theory.19 And in macroeconomics and monetary theory, Milton Friedman's
Nobel lecture, published in 1977, cited Hayek's 1945 paper when arguing that,
because it disrupted the signals arising from relative-price movements,
inflation both lowered the efficiency of the economy and led output to deviate
from its natural (or full-employment) level.20 Hayek likened the price mechanism to a "system of
telecommunications," and Friedman's description of inflation as a form of
"static" interrupting price signals was in keeping with this analogy.21
Hayek's ideas on prices influenced Joseph Stiglitz in his analysis
of markets with asymmetric information and Roger Myerson's insights on
mechanism design theory. Each of these bodies of work earned a Nobel Prize.22
Qualifications
and Extensions
I
do not want to leave the impression, however, that all of the conclusions in
Hayek's 1945 paper have become unchallenged principles chiseled into the
economic consensus. On the contrary, one of the reasons why the paper has been
so influential is that it remains a benchmark reference for understanding the
case for relying primarily on a market system, based on freely determined
prices, for determining the production and allocation of resources. The paper
has therefore set a high bar for preempting the price system or for other
interventions in the market: When economists point to cases in which market
mechanisms can be improved on by regulation or other public-sector
intervention, or to instances in which price signals do not appear to be
operating effectively, they need to identify a specific market failure as the
source of the inefficiency. Essentially, they need to establish instances in
which the price system can be improved on as a means of processing information.23
Even
Hayek acknowledged that the price mechanism works within an ecosystem of laws
and social institutions, and those may evolve in ways that interfere with the
signaling of prices. For example, one of the important events that raised
doubts about the functioning of the private market's pricing process occurred
in the years leading up to the financial crisis. This period featured pricing
by financial markets that seemed, in some prominent cases, not to be adequately
reflecting information about actual risks. Spreads on risky private-sector debt
reached very low levels, and damaging spillovers to the nonfinancial sector occurred
in the form of unduly high real estate prices and excessive leverage by
borrowers in the housing market. One of my predecessors at the Federal Reserve
Board, Donald Kohn, has noted the seeming herd-like behavior of financial
markets in the pre-crisis period that generated this situation-an
"underpricing of risk."24
The
financial crisis, and the deep recession that followed it, prompted changes in
the United States' regulatory framework. These changes have been designed to
make the financial system more resilient than it was before the crisis. By
creating appropriate incentives and rules, they should also encourage financial
markets to price risk more appropriately than they did in the years leading up
to the crisis-for example, by reducing the danger of investor complacency
regarding the riskiness of their investments and the possibility of adverse
scenarios. If we follow Hayek and regard the price system as like a
telecommunications network, and then apply that metaphor to the financial
sector, we can think of the institutional and regulatory changes to the
financial system over the past decade as designed to improve the reliability
and signal quality of the transmissions.25
How
does all of this relate to the larger questions of philosophy and social order
to which Hayek devoted much of his thought? Hayek's insights about the price
system depend importantly on his theory of knowledge: The information that is
available to us as a society is the aggregate of the highly dispersed and
sometimes inarticulate knowledge possessed by each of us individually. It is
not only hard to convey that information to a central authority for processing
into a rational decision-it is also conceptually impossible given the nature of
that knowledge. And, indeed, important parts of that knowledge will not even be
generated except through our interaction with each other through the mechanism
of the market. Trying to centralize economic decisionmaking, then, is not just
too hard to do as a practical matter. It would actually reduce the amount of
knowledge available to us as a society, by replacing those myriad individual
interactions in a free marketplace. Thus, even if some technological way to
aggregate information other than through prices could be invented, it would
lead to less efficient, less humane outcomes because it would be based on less
total human information.
The
price mechanism, then, is not just a matter of economics-it is a matter of
social and, indeed, civilizational progress. As Hayek says in The Constitution
of Liberty, "[C]ivilization begins when the individual in
pursuit of his ends can make use of more knowledge than he himself acquired and
when he can transcend the boundaries of his ignorance by profiting from knowledge
that he himself does not possess."26 I think this ties together the various threads of Hayek's
thought throughout a long life: his early work on psychology ("How do we
know?"), his later epistemology ("What do we know, and what does it
mean to know it?"), his economics ("How do we make knowledge
usable?"), and his social and political theory ("What institutions
will ensure that the greatest amount of human knowledge will be usable in the
pursuit of their human fulfillment?"). Contrary to those polemicists
across the ideological spectrum whose tendentious simplifications of Hayek's
thought would turn him into a crude icon rather than a complex thinker, this is
a deeply human, and a deeply humane, project. I will look forward to the
contributions of the others you will hear from today in how Hayek elaborated it
and how we can further these principles today.
Economic
Outlook and Monetary Policy
Now
I would like to turn to the current economic scene and this week's FOMC
decision. Let me start by saying that the U.S. economy is doing well, and I am
optimistic about the outlook. Economic conditions are currently very close to
meeting our-that is, the FOMC's-dual-mandate objectives of maximum sustainable
employment and price stability.
A particular source of strength has been the labor market. Setting
aside the monthly volatility and, specifically, the effects of the recent
strike at General Motors, labor market indicators are as strong as they have
been in quite some time. The unemployment rate has been running near a 50-year
low, and the proportion of the population currently employed is close to its
highest level in a decade. Encouragingly, labor force participation has held
up, as the tight labor market has motivated workers to either join or remain in
the labor force, halting, at least for the time being, a long-standing downward
trend. Although the pace of job gains has slowed this year, we expected some
deceleration because of how low the unemployment rate has fallen.
A strong job market and high employment have in turn supported
economic growth. Personal consumption expenditures (PCE) grew 2-1/2 percent over
the past four quarters, a healthy pace by historical standards and a major
contributor to overall growth since consumption represents over two-thirds of
economic activity. Because the labor market remains tight, I expect wage growth
to pick up, which would then in turn underpin further strength in consumption
and overall growth.
For
the other half of our mandate, inflation as measured by the PCE index was 1.3
percent over the 12 months ending in September, while core PCE inflation, which
excludes increases in the prices of food and energy, was 1.7 percent. While
these readings are below our 2 percent inflation objective, they are fairly
close, and my assessment is that inflation will inch toward our objective in
the coming months.
Outside
the near term, I am also optimistic about the longer-term potential of the U.S.
economy. I am heartened by a recent pickup in labor productivity growth. A
notable development of the post-crisis period has been the abysmal pace of
labor productivity growth. After averaging about a 2-1/4 percent pace in the
two decades leading up to the crisis, labor productivity growth has been closer
to 1 percent, on average, since 2011. While there has been much speculation, it
remains to be seen what has driven this slowdown. Consequently, the slowdown
could resolve unpredictably. Although the quarterly data are volatile, I have
been encouraged by a pickup in labor productivity in the first half of this
year, when it grew at a 3 percent annual rate. Further out, I admit to being a
bit of techno-enthusiast, and I see the potential for many emerging
technologies, including 5G communications, artificial intelligence and machine
learning, and 3-D printing, to further boost productivity growth in the coming
years.
Having
established my optimism, I will now circle back to some more worrying signs in
the recent data that suggest some headwinds are holding back growth. One
prominent factor weighing on a relatively robust domestic economy has been weak
growth among our trading partners. The International Monetary Fund projects
that global economic growth in 2019 will be the slowest since the financial
crisis. Partly as a consequence of weak foreign growth, U.S. exports have been
flat over the past year.
Another
weak spot has been investment. After a strong 2017 and start to 2018, business
fixed investment has tailed off this year and fallen outright in the second and
third quarters. I find the weakness of investment to be of particular concern
because increasing investment and the capital stock are important for raising
the potential capacity of the economy. It is likely that some of the weakness
in capital spending is a result of elevated uncertainty, for foreign growth
generally but also specifically for trade developments.
Against this backdrop, at our meeting earlier this week, we
decided to lower our target range for the federal funds rate for the third time
this year. We took this action to help keep the U.S. economy strong in the face
of global developments and to provide some insurance against ongoing risks. By
lowering the federal funds rate this year, we are supporting the continued
expansion of the economy. Overall, with these policy adjustments, I believe
that the economy will remain in a good place, with the labor market remaining
strong and inflation staying close to our 2 percent objective. We see the
current stance of monetary policy as likely to remain appropriate as long as
incoming information about the economy continues to be broadly consistent with
our outlook of moderate economic growth, a strong labor market, and inflation
near our symmetric 2 percent objective.
References
Footnotes
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12. 2019-2021 MTEF
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14. Slowing Growth
and Interest Rate Cuts in Frontier Economies
15. Nigeria - South
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16. Major UK Banks
Prepared for Brexit Challenges Ahead
17. CIV, Kenya and
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18. China Injects
$72b in Africa as Its Continental Influence Gathers Pace
19. September 2019
Global Monetary Commentary - Comercio Partners
20. Advanced
Economies at Late Stage in Business Cycle
21. World GDP Growth
to Hit an Eight-Year Low in 2020
22. South Africa's
Economy in Q2-19: Fragile Still?
23. Can SSA's
Biggest Economies Join The 2nd Monetary Easing Cycle?
24. Protectionism
Choking Global Growth Prospects
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