A REQUIEM FOR THE WELFARE ECONOMICS PARADIGM.

The Hoover Institution honors Thomas Sowell and John "Grumpy Economist" Cochrane will offer thoughts on Mr Sowell's Knowledge and Decisions, which is somewhere amid the stacks of books still to read while I am able, and perhaps, based on the contents of the essay, will be moved to the top of a pile.  (Postseason baseball has not turned out to the Brewers' advantage, which might free up some reading time.)

Professor Cochrane's essay opens with material that ought be second nature to any second-year economics student.

Prices silently guide people, who ruthlessly act in their selfish interest or to maximize profits of their companies, to make all these adjustments in the most efficient way.

Prices convey information, including what we now call “private information,” like who can more easily get along without orange juice for a while or what plot of land is best suited for growing oranges. Prices are the wires that connect the processors of the economy. Prices are the pheromones that socially organize our ant colony. Prices are signals, wrapped in incentives. Prices are efficient, sufficient statistics for decisions, giving just enough information. You don’t need to know whether there was a freeze in orange country, or a train derailment, or a new fad raising others’ demand. You just look at the price, and your own self-interest, and you act with the socially efficient response.

So wrote Friedrich Hayek (1945) in his celebrated essay “The Use of Knowledge in Society.” I read this essay, as many economists do, in graduate school in the early 1980s. I thought it was wonderful. Hayek undoes a grand conceit: Introductory economics courses teach the “first welfare theorem:” that the market, if absolutely perfect, can just achieve the same result as a benevolent planner. The classes quickly move on to describe how hypothetical planners can solve myriad market “imperfections.” But planners can never have or process the necessary information. The theorem should be rewritten: Planners can never hope to achieve what markets do.

But I also noticed that despite the then 40 year passage of time, few others seemed to have followed up on this spectacular insight. Hayek seemed to stand alone. Every other paper we read spawned thousands of followers. Where were Hayek’s followers? (They were there, of course. But unlike Hayek, “Austrians” never made it to the academic mainstream that gets assigned in graduate schools.)

Then I found the just-published Knowledge and Decisions, Tom Sowell’s economic masterpiece. (I read several other eye-opening Sowell books at the same time, especially his works on race, and culture. But it is not my task to share that experience today.) This was a world-view-changing experience, a few crucial steps down the yellow-brick road that made me the classical liberal with many adjectives that I am today.

It might be that many economics classes focus on the way in which the "benevolent planners" can improve on those outcomes because somewhere in any economics student is the aspiration to be the next Robert Reich or Joe Stiglitz or Fred Kahn.

The welfare economics paradigm begins with some fairly tight theorizing (under conditions 1, 2, 3, and 4, a competitive equilibrium exists and is Pareto optimal. The role of government becomes either to provide the basic rules of trading, or to make transfers of endowments to provide the initial allocation from which the Pareto optimal equilibrium will emerge) and continues with additional theorizing (under any of conditions 1', 2', 3', and 4' existence or Pareto optimality do not follow) leading to proposals for policies that a properly-informed government can implement. Here is where the paradigm breaks down, as there is a great deal of research, which the public choice advocates view as persuasive, to the effect that traders can discover and improvise ways to eliminate the inefficiencies, or that the theoretically preferable policies break down, or that the agents of the government are themselves rational maximizers.

That's from an early Cold Spring Shops post responding to a Brad DeLong call for a positive theory of "government success," which the likes of Hayek and Sowell would argue is like a positive theory of water flowing uphill.  "The sparring in the journals over whether the Welfare Economics Paradigm or the Public Choice paradigm or some institutional approach or extensions of price theory better makes sense of the anomalies is also good for people who make a living by writing in academic economics, or about academic economics."

But then, I had the advantage of learning my price theory from George Stigler's Theory of Price and one of the Alchian and Allen texts.  Thus, Thomas Sowell arguments would not surprise me.  "Sowell synthesized the 'UCLA view' of the economy, combining a bit of Chicago and a bit of Austrian economics."

There's much more in Knowledge and Decisions, and perhaps there is an opportunity for a student versed in the mathematics of contemporary economic theory to make formal much of the following.

Sowell studies markets and prices, sure, and all that goes wrong when you silence prices. But the heart of his book studies other social organizations, including political organizations, courts, corporations, regulatory agencies, universities, bureaucracies, cultures, communities and even families. Each of these organizations also produce, procure, validate, and transmit information to “decision-making units,” which then face varying incentives to acquire and use information in private or socially efficient way — or not.

The result is a comprehensive and novel view of social organization, including economics. In traditional economics, as repeated in introductory classes, we regard the economy as a machine for producing and allocating scarce goods and services. No. Information itself is the important scarce good in the economy. When you buy even a pencil you are really buying the skill and knowledge of the lumberjack, sawmill operator, carbon miner, pencil machine designer, lawyer, accountant, store operator, and so on. Much traditional analysis of political and social institutions focuses on morals, power, social justice and so on. No, information and incentives are the key determinant of political structure and outcomes.

Sowell’s style is rich by profusion of example, though each synthesized in a general statement. He richly contrasts the actual operation of poltical instiutions with the folly of common enthusiasms that ignore incentives and information in the quest to assign decisions and power to the state. “Central Planning” is so passé that nobody would advocate it by name, yet its poisonous successors travel the world around us.

And yes, the popularity of "common enthusiasms" is often the wishful thinking that the holder of those enthusiasms also holds power, which might be one of the selling points for studying economics.

Academic economists almost always ignore this question. We study what the hypothetical perfectly informed benevolent dictator should do. And usually that means “us,” if only someone would put us in charge. Until someone does, and then academics seldom perform better than others put in a system full of informational frictions and incentive distortions.

There's a lot more in the essay.  One more quote, and then I suggest, dear reader, scroll over and read the whole thing.

Knowledge and Decisions did not emerge from a vacuum, nor does it speak in a vacuum. But it has not had the influence I think it deserves.

This is not a dead book, to be admired on the shelves for its one time accomplishments, This is a live book, which can and should inspire new thinking today. As Hayek inspired Sowell, and left plenty for Sowell to do, so Sowell should inspire a new generation of economists, political scientists, cultural critics, and public intellectuals to stand on his shoulders, and write the next great book on information in markets and social and political organization.

Contemporary economics largely ignores Sowell’s insights and approaches. It is also, like the economics of Sowell’s time, a target-rich environment. Contemporary information economics is full of criticism of markets and other decentralized mechanisms, leaning unthinkingly to state intervention, just as the economics of Hayek’s time ignored the information problems facing the planner. It ignores look-out-the-window realities, and has not been subject to the kind of validation or refutation that Sowell’s fact-based analysis can offer. Sowell also left quite a few important questions open, especially how to reform our social and political systems, and, as Sowell might put it, how and by whom that decision can be better made.

Mainstream economics ignored Hayek for 45 years until Sowell produced his masterpiece. That it has largely ignored Sowell for another 45 years means that the ground is ripe for another masterpiece.

Perhaps I should make a small contribution toward keeping the book alive by reading it and posting one of my long-delayed book reviews.