Economic Calculation Problem - Theory - Financial Markets

Financial Markets

The fifth condition for successful economic calculation is the existence of well functioning financial markets. Economic efficiency depends heavily upon avoiding errors in capital investment. The costs of reversing errors in capital investment are potentially large. This is not just a matter of rearranging or converting capital goods that are found to be of little use. The time spent reconfiguring the structure of production is time lost in the production of consumer goods. Those who plan capital investment must anticipate future trends in consumer demand if they are to avoid investing too much in some lines of production and too little in other lines of production.

Capitalists plan production for profit. Capitalists use prices to form expectations that determine the composition of capital accumulation, the pattern of investment across industry. Those who invest in accordance with consumers desires are rewarded with profits, those who do not are forced to become more efficient or go out of business.

Prices in futures markets play a special role in economic calculation. Futures markets develop prices for commodities in future time periods. It is in futures markets that entrepreneurs sort out plans for production based on their expectations. Futures markets are a link between entrepreneurial investment decisions and household consumer decisions. Since most goods are not explicitly traded in futures markets, substitute markets are needed. The stock market serves as a ‘continuous futures market’ that evaluates entrepreneurial plans for production (Lachmann 1978). Generally speaking the problem of economic calculation is solved in financial markets.

"The problem of economic calculation arises in an economy which is perpetually subject to change ... In order to solve such problems it is above all necessary that capital be withdrawn from particular undertakings and applied in other lines of production ... is essentially a matter of the capitalists who buy and sell stocks and shares, who make loans and recover them, who speculate in all kinds of commodities” – Mises

The existence of financial markets is a necessary condition for economic calculation. The existence of financial markets itself does not automatically imply that entrepreneurial speculation will tend towards efficiency. Mises argued that speculation in financial markets tends towards efficiency because of a “trial and error” process. Entrepreneurs who commit relatively large errors in investment waste their funds over expanding some lines of production at the cost of other more profitable ventures where consumer demand is higher. The entrepreneurs who commit the worst errors by forming the least accurate expectations of future consumer demands incur financial losses. Financial losses remove these inept entrepreneurs from positions of authority in industry.

Entrepreneurs who commit smaller errors by anticipating consumer demand more correctly attain greater financial success. The entrepreneurs who form the most accurate opinions regarding the future state of markets (i.e. new trends in consumer demands) earn the highest profits and gain greater control of industry. Those entrepreneurs who anticipate future market trends therefore waste the least amount of real capital and find the most favorable terms for finance on markets for financial capital. Minimal waste of real capital goods implies the minimization of the opportunity costs of capital- economic calculation. The value of capital goods is brought into line with the value of future consumer goods through competition in financial markets, because competition for profits among capitalist financiers rewards entrepreneurs who value capital more correctly (i.e. anticipating future prices more correctly) and eliminates capitalists who value capital least correctly.

To sum things up, the use of money in trading all goods (capital/labor and consumer) in all markets (spot and financial) combined with profit driven entrepreneurship and Darwinian natural selection in financial markets all combine to make rational economic calculation and allocation the outcome of the capitalist process.

Mises insisted that socialist calculation is impossible because socialism precludes the exchange of capital goods in terms of a generally accepted medium of exchange, or money. Investment in financial markets determines the capital structure of modern industry with some degree of efficiency. The egalitarian nature of socialism prohibits speculation in financial markets. Mises therefore concluded that socialism lacks any clear tendency towards improvement in the capital structure of industry.

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