A modern course in economics will not tell you what’s wrong with socialism

“Socialism” is an elastic term, with a different meaning and connotation for everyone, which lets every believer in a socialist future off the hook since they can always say that’s not what I have in mind and it’s not what I mean. Moreover, I leave out the politics which is what everyone normally thinks about, since every socialist state – except the one that socialists imagine in their minds and discuss in public before they set one up – is about milk and honey for everyone, equality for all, and happiness to the fullest extent that human life can create. It is a fantasy world entirely removed from the reality of life.

Here I will define socialism as a system in which the economy is directed by the government through some kind of centrally-determined plan, rather than the economy being allowed to run on its own by itself through the decisions made by the individual owners of businesses. Nationalisation, massive levels of public sector spending, price controls and heavy-handed regulation of whatever is left in private hands are the mainstays of a socialist economy. If all it were was the normal operation of an entrepreneurial-driven market economy then there would be no need to set up anything new. Since socialists never specify beyond pie-in-the-sky what they intend to do – only the outcomes they promise to achieve – the best we can do is see what is found in the socialist literature of the past and present, as well as the practice of various socialist states, also both past and present.

I will add that macroeconomics as it is now taught, which sees only a positive role for large levels of public spending and thinks that an economy is perennially in danger of a failure of demand because of decisions to save rather than spend, are nine-tenths of the journey towards an acceptance not only of socialism, but of its necessity. The role of government in managing the economy and filling in the expenditure gaps with its only massive levels of expenditures is mainstream theory taught all over the world.

The basis for the presentation is my belief that a modern course in economics, based on standard economic texts in which the standard economic theories are presented, will leave a student without an adequate understanding of why a socialist economy cannot work, and in many cases with no such understanding at all.

This is based on my observation that very few – whether an economist or otherwise – can explain why socialism inevitably leads to poverty, although anyone willing to look can see this is true. There are innumerable political and philosophical reasons for fearing socialist ideas:

  • centralised political control
  • extraordinary power granted to government
  • loss of political freedom
  • diminished personal responsibility
  • diminished independence
  • encourages sloth

The presentation is based on my just-published, “I, Mechanical Pencil” which has been put out by the CIS and which you can find a copy of here.

My approach to the presentation is first to list the six absolutely essential elements of an economy, the absence of any one of which will cause the economy to cease working other than in the most rudimentary way. These six are:

(1) entrepreneurs who make decisions for themselves
(2) an independent financial system
(3) an operating price mechanism
(4) business profitability as the major determinant of what is produced and how it is produced
(5) sound government regulation, and
(6) a robust defence of property rights.

(1) Entrepreneurs

Every productive enterprise must be run by someone. There are many decisions to be made, all of which require a constant ability for someone to respond both to opportunities that present themselves and the problems which are both frequent and inevitable. In a market economy, productive enterprises are run by individual members of the community who do so because that is how they seek to earn their incomes. No entrepreneur is a government employee, nor are they chosen by governments to run these firms. Instead, entrepreneurs are the individuals who truly care about the welfare of the business, partly because every mistake takes money from their pockets, but also because the business is their creation in the same way that a work of art is the creation of an artist.

Entrepreneurs are not mere managers nor can they be replaced by managers. They are the individuals for whom the business is their own, and which they spend their lives trying to shape into as good a business as it can possibly be. It is not just a job. It is a vocation.

Yet no text on economics discusses the role of the entrepreneur. You can do ancillary courses in which the entrepreneur is discussed, and these are almost entirely courses that focus on innovation. The actual superintendence of a business is seen as of almost no relevance to the operation of a firm.

It is also the entrepreneur who determines what will be produced, and is entirely responsible for the commercial introduction of innovation onto the market.

(2) An independent financial system

Similarly, finance is not discussed as part of the education of an economist. There is money, banking, interest rates and the role of saving that do get a run through, but the determination of which firms are determined to be potentially the most viable by those who make lending decisions is at most a paragraph worth of discussion.

More crucial, the very issue at stake in the decisions that go behind finance is the allocation of a nation’s available saving among all the alternative uses that savings might be channelled towards. And here there are two massive blunders which almost totally obscure what it taking place.

Saving is discussed almost entirely (perhaps entirely) as a flow of money. And in a standard macro analysis, it is made up of the difference between current income and current consumption: S = Y – C.

Then, beyond this, the level of saving is taken to be the sum of money that is generated during the course either of the quarter or the current year, but whatever period is chosen, the present, or near present is all that counts.

Thus, the very concept of saving is totally lost. What is actually being determined by finance decisions is completely misstated. Saving is not a sum of money, saving is that stock of productive assets (eg machines and buildings) and available labour that can be used to build additions to the nation’s capital stock. What those who provide finance actually do is determine to whom to give sums of money that allow particular businesses to purchase in the various forms of capital and labour with which they can complete their own investment projects.

More destructive still is the imbedded Keynesian belief that recessions are caused by excess saving. The entire and madly destructive theory that explains recessions as a sign of that savings levels are higher than businesses wish to invest has led to decisions across the world for governments to engage in largely wasteful and unproductive spending to soak up those savings, as if sums of money sitting in bank accounts or in some other way left unspent is evidence that our savings are being left unused.

The reality is that virtually every form of saving (capital equipment and labour) are owned by someone who does everything they can to ensure that the capital and labour they own (the labour is, of course, their own labour) are being put to work. There are periods of transition when capital and labour are idle – factories close and people lose their jobs for all kinds of reasons – but unemployed workers along with whomever owns the capital will do everything they can to find alternative forms of work. We systematically ruin our economies by following Keynesian models and prescriptions.

(3) An Operating Price Mechanism

This is the one that counts since it is both the most obscure but also the most important. This was the issue at the heart of the “socialist calculation debate” that went on from the 1920s and through until the 1950s and then ceased. No one, other than in a few classes here or there, is ever taught anything at all about any of this.

More to the point, in a world in which there are infinitely more uses for most of the resources that are available, and also many ways that any particular output could be produced, there is an absolute need to ensure that some means to choose the least resource-intensive means to produce each good or service. Unless you understand why a business cannot decide which way to produce using the fewest resources if there is no price system in existence, you will never be able to undermine socialism. Here is a made-up example for the production of a number of units of X.

X = 2A + 3B + 4C + 9D
X = 3A + 4B + 3C + 7D
X = 7A + 5B + 2C + 4D

All of these might be ways to make the same number of units of X but unless you know in a realistic way how much A, B, C and D cost, you cannot determine which way to produce at the lowest cost. These are not technical questions but entirely economic.

What is the relative value of a tonne of steel in comparison with a tonne of copper? Is it cheaper to build a wall out of plaster or out of wood? Only in a market system, where the producers of every single input have to price what they sell to earn a positive return on their outlays, can there even be an estimate made of which array of inputs would provide the lowest cost to the economy in providing the same utility to the buyer.

As in the above example, you will still get X irrespective of which combination of inputs is chosen, but some of those resources are rare and have other more valuable alternative uses. Without a price mechanism based on the proper relative valuation of the output, that can only be determined in a market setting by entrepreneurs, a central planner cannot even begin to decide how to go about producing anything.

And it has ever been thus in every attempt to introduce socialism. Every socialist economy immediately loses its bearings because it has no means to decide which alternative would use up a smaller proportion of the resource base of the economy, and if it cannot do that, it will choose means of production that will waste prodigious amounts of resources on each particular item so that fewer items in total can be produced.

There was a long debate over whether central planners could manufacture a reasonable facsimile of relative prices that happen naturally through entrepreneurial pricing on the market. It was at one time understood even among the defenders of socialism that an answer to this question was crucial if a socialist system was to function. And the fact is, that this issue was never properly resolved, as was evident by the collapse of the Soviet Union in the late 1980s.

The most astonishing example was the different standards of living in East and West Germany. The differences were immense since the East Germans could not even remotely maintain the same living standards, and this was even though they tried to determine costs by using the relative prices generated in West Germany and apply these to their own production techniques. But as close as they were both geographically and culturally, the relative price structure generated automatically in the West were near useless to the central planners in the East since they did not in any way reflect their own production costs.

(4) Business Profitability

For reasons that I will not explain here, but every economist is taught, the ideal model of the operation of an economy is described as PERFECT Competition, and is contrasted with all other forms which are described as Imperfect Competition. For some reason, the ideal form of market structure is one in which, as it says below, “no one earns a profit”.

Perfect Competition – No One Earns a Profit

In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply ‘takes’ and charges the market price (P* in Figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.


The conception to reach this conclusion is so entirely static that it is absurd to think of this as in any way representative of the operation of a market economy. The very existence of profit shows, so far as economics is concerned, that the economy is not running at peak efficiency. There are also questions of an improper distribution of income since in a truly competitive economy, and in the long run, a larger return than the absolute minimum somehow implies that the market is not functioning at its optimal level. All other market structures, which in reality represents about 98% of the economy, are inefficient because firms are able to adjust their level of supply to earn a profit above the efficient minimum. But the existence of profit, as defined within an economics text, is a negative.

(5) Sound Government Regulation

There are schools of economic thought for which the very notion that government regulations have any role to play is anathema. There is no doubt that there can be over-regulation, and we experience just that everywhere today. The principle seems to be that if someone can think of some negative potential in some action, that it will either be examined to death or forbidden. But the opposite principle is just as bad, that business should just be allowed to get on with things without any scrutiny or direction from government.

The point here is not just that regulation is essential, but that regulation must be limited to just those forms of control that will actually pass some kind of cost-benefit test. Here the issue for modern economics is not that there should be regulation. That is much of what an economics course now is – a discussion of market failure and the need to remedy the errors of the market. So in this instance, the point here is to recognise that some regulation is essential.

This is from Mises’s Human Action. And while it is clear that Mises is reluctant to state that there is such a role for governments because of the principle of give-them-an-inch-and-they-will-take-a-mile, nevertheless, he does accept that government does indeed have such a role.

There are certainly cases in which people may consider definite restrictive measures as justified. Regulations concerning fire prevention are restrictive and raise the cost of production. But the curtailment of total output they bring about is the price to be paid for avoidance of greater disaster. The decision about each restrictive measure is to be made on the ground of meticulous weighing of the costs to be incurred and the prize to be obtained. No reasonable man could possibly question this rule. (Mises [1949] 1963: 748)

Regulatory overkill has been a disaster for the functioning of our economies. I truly never understand how the entrepreneurial types I know put up with it. You would think that those who set the rules are doing so with the intent of killing businesses off.

(6) Property Rights

Socialist governments are notoriously opposed to the private ownership of the means of production. “Expropriate the expropriators” is the ancient expression. Nationalisation of the commanding heights of the economy and whatever.

Whether this is driven by envy or by some unstated economic rationale, the aim to achieve something described as “equality” is the mantra. The result is that those who produce are taxed to provide incomes to those who produce less or produce nothing at all. And in the socialist commonwealth, the levelling is complete, with the masses living in poverty and those at the top living upon the meagre levels of wealth the economy might be capable of producing.

If property rights are included in a standard text, it has escaped me. There is nothing in how modern economics is taught, with it abstract and often mathematical discussion of the operation of the various forces to produce the strangest economic notion of all – equilibrium – that anywhere mentions that only if the producers of capital believe they will maintain the ownership of what they have crafted, will that capital come into existence in the first place.

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