Smith explains why Mises predicted that “planned chaos” would emerge in a socialist economy and how F.A. Hayek elaborated on that insight.

George H. Smith was formerly Senior Research Fellow for the Institute for Humane Studies, a lecturer on American History for Cato Summer Seminars, and Executive Editor of Knowledge Products. Smith’s fourth and most recent book, The System of Liberty, was published by Cambridge University Press in 2013.

The idea of efficient planning in a socialist economy is plausible only if we assume that economic value is an objective feature of commodities, one that can be rationally ascertained apart from the give and take of market competition. Karl Marx (1818–1883) made precisely this assumption. Like David Ricardo and other economists in the classical school, Marx defended a labor theory of value. It is interesting to note that Marx finished only one volume of Capital (1867) during his lifetime, a book that was published as the theory of marginal utility was about to revolutionize economic thought. (The books by Menger and Jevons were published in 1871, that by Walras in 1874.) But this was one revolution that Marx failed to appreciate. By the time Friedrich Engels, using Marx’s notes, pieced together the second and third volumes of Capital (1885, 1894), the labor theory of value had ossified into a sacred relic for socialists and anarchists but found relatively few adherents outside those ranks.

Economic value, according to Mises and others in the Austrian School, is not an objective property of commodities. Rather, value is imputed to commodities according to their perceived utility in serving human wants. As Mises put it in Socialism: An Economic and Sociological Analysis:

Every man who, in the course of economic activity, chooses between the satisfaction of two needs, only one of which can be satisfied, makes judgments of value. Such judgments concern firstly and directly the satisfaction themselves; it is only from these that they are reflected back upon goods.

We compare our preferences by ranking them, not by measuring them. It makes sense, for example, to say that I like apples more than oranges, and oranges more than pears, and therefore that I like apples more than pears. But it makes no sense to say that I like apples twice as much as I like oranges, and oranges three times more than pears, and therefore that I like apples six times more than I like pears.

In other words, since economic value derives from estimates of personal satisfaction, and since there is no invariant unit of satisfaction that can serve as a standard of measurement, it is impossible to measure, compute, or add up the marginal utility of various commodities. We can rank values ordinally, but we cannot measure them cardinally. As Mises pointed out, this creates a problem when we need to make economic calculations:

Computation demands units. And there can be no unit of the subjective use‐​value of commodities. Marginal utility provides no unit of value…Judgments of value do not measure: they arrange, they grade.

Our subjective estimates of value may prove sufficient when dealing with simple situations, as when Crusoe, alone on his island, is calculating how to provide for his wants in the immediate future. But the problem of calculation becomes insurmountable in more complex situations, especially when a sophisticated division of labor is in place. When lengthy and complicated processes of production are involved, our estimates of subjective use value will fail to give us the information we need for long‐​range economic planning.

That which subjective use value cannot accomplish in a free market is accomplished instead by objective exchange value. By “objective exchange value,” Mises meant the money‐​price of a commodity, which serves as the required unit of economic calculation. Money, according to Mises, does not measure value, nor are prices somehow measured by money. Rather, prices are simply amounts of money. Mises called the price of a commodity its “objective exchange value” because that price–which arises from the interplay of the subjective valuations of those engaged in buying and selling–can serve as a practical means of economic calculation.

Calculations of this sort provide a control upon the appropriate use of the means of production. They enable those who desire to calculate the cost of complicated processes of production to see at once whether they are working as economically as others. If, under prevailing market prices, they cannot carry through the process at a profit, it is a clear proof that others are better able to turn to good account the instrumental goods in question. Finally, calculations based upon exchange values enable us to reduce values to a common unit. And since the higgling of the market establishes substitution relations between commodities, any commodity desired can be chosen for this purpose. In a money economy, money is the commodity chosen.

Money prices are necessary if we are to engage in long‐​range and complex calculations. They enable us to compare different production methods and determine which will produce the desired good at the lowest cost. Mises offered a concrete example of a problem that socialism is unable to solve, precisely because socialism, by prohibiting the private ownership of capital goods, also abolishes the market transactions that are required to generate prices for those capital goods.

Suppose…that the socialist commonwealth was contemplating a new railway line. Would a new railway line be a good thing? If so, which of many possible routes should it cover? Under a system of private ownership we could use money calculations to decide these questions. The new line would cheapen the transportation of certain articles, and, on this basis, we could estimate whether the reduction in transport charges would be great enough to counterweigh the expenditure which the building and running of the line would involve. Such a calculation could be made only in money.…We can make systematic economic plans only when all the commodities which we have to take into account can be assimilated to money. True, money calculations are incomplete. True, they have profound deficiencies. But we have nothing better to put in their place. And under sound monetary conditions they suffice for practical purposes. If we abandon them, economic calculation becomes absolutely impossible.

This is why Mises predicted the inevitable failure of central planning. His portrayal of socialism, first made in 1920, proved remarkably accurate, especially in regard to the Soviet Union.

All transactions…will be subject to the control of a supreme authority. Recourse will be had to the senseless output of an absurd apparatus. The wheels will turn, but will run to no effect.

Socialism, far from being more scientific and rational than the free market, actually annihilates the possibility of rational planning.

[I]n the socialist commonwealth every economic change becomes an undertaking whose success can be neither appraised in advance nor later retrospectively determined. There is only groping in the dark. Socialism is the abolition of rational economy.

The arguments of Mises caused some socialists to re‐​examine the plausibility of their own theories, and even caused some to embrace the free‐​market principles of classical liberalism. Among those former socialists was a young Friedrich Hayek, who would go on to become one of the twentieth century’s most influential advocates of free markets and limited government. As Hayek said of his generation in Vienna after WWI:

We felt that the civilization in which we had grown up had collapsed. We were determined to build a better world, and it was this desire to reconstruct society that led many of us to the study of economics. Socialism promised to fulfill our hopes for a more rational, more just world.

When Socialism first appeared in 1922, its impact was profound. It gradually, but fundamentally, altered the outlook of many of the young idealists returning to their studies after the First World War. I know, for I was one of them.

Hayek later expanded on the ideas of Mises, applying them in ways that enhanced our understanding not only of why socialism fails but of why capitalism succeeds. Hayek is perhaps best known for his argument that free markets are able to coordinate the dispersed knowledge of millions of people in a way that maximizes economic efficiency. As Hayek wrote in his 1945 essay, “The Use of Knowledge in Society,”

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate ‘given’ resources–if ‘given’ is taken to mean given to a single mind which deliberately solves the problem set by these ‘data.’ It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.

Thus prices in a free market, in addition to enabling us to make economic calculations, are also a sophisticated method for communicating knowledge. As Hayek put it, “We must look at the price system as such a mechanism for communicating information if we want to understand its real function.” (I would argue that this Hayekian insight is implicit in the Misesian argument about economic calculation.)

When governments forcibly intervene in market transactions, they reduce or distort the information that would otherwise flow through market channels. This will generate various problems, depending on the severity of the interventions, and those problems, in turn, will typically generate demands for even more intervention. Thus as interventions multiply, and despite the best intentions of planners, a country will become trapped in a downward economic spiral that will terminate in a highly regimented economy. This is the Road to Serfdom that Hayek described in his best‐​selling book. Or, as the title of a book by Mises put it, this is the way to Planned Chaos.

I have presented only a barebones summary of some arguments by Mises and Hayek against a command economy–arguments that will already be familiar to many libertarians. But I know that some libertarians have an allergic reaction to economic theory, so I wrote this two‐​part series in the hope that it will encourage such people to investigate the ideas and writings of Mises and Hayek in more detail.