Friedrich Hayek’s The Pretence of Knowledge

Introduction

In 1974, as the world economy suffered a severe bout of stagflation - a ruinous combination of stagnant economic growth coupled with high inflation - Friedrich Hayek was awarded the Nobel Prize in Economics. 

Hayek chose to address the stagflation issue in his Nobel acceptance speech entitled The Pretence of Knowledge. 

In the address, the Austrian economist argued that the stagflation was caused by misguided Keynesian full employment policies.

And he argued that these full employment policies were rooted in an erroneous attempt by economists to imitate the techniques of the physical sciences.

In making his critique of this policy, he restated several of the economic ideas with which he is most associated: spontaneous order, markets as mechanisms for effectively aggregating dispersed information, and the idea that limits to their knowledge mean economists and the state are unable to use policy changes to achieve desired economic ends. 

He also laid out his answers to some of the central questions in the philosophy of economics: Is economics a science? Should economists adopt the research techniques and methodologies of the natural sciences, or is there something fundamentally different about the study of human behavior and institutions that precludes the use of these approaches? Should the success or failure of economics as a discipline be measured by its ability to predict (and perhaps even control) the future or are there obstacles that make that too high a bar to clear?

Economists Have Wrongly Applied The Methods Of the Physical Sciences To Economics

Hayek believed that the stagflation ailing the global economy was, at its core, the result of a failure of the philosophical approach to economic research adopted by economists. 

The Austrian argued that economists had erred by attempting to imitate the research methodology of the physical sciences.  

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. (¶ 2)

Hayek refers to this attempt by economists to imitate the methods of the physical sciences as “scientistic.”

It is an approach which has come to be described as the “scientistic” attitude[.] (¶ 2)

And he critiques this “scientistic” attempt to imitate the physical sciences as being, in actuality, unscientific because it involves the application of tools from one discipline to another discipline for which they are inappropriate. 

[The scientistic approach] as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word, since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.” I want today to begin by explaining how some of the gravest errors of recent economic policy are a direct consequence of this scientistic error. (¶ 2)

[T]he confidence in the unlimited power of science is only too often based on a false belief that the scientific method consists in the application of a ready-made technique, or in imitating the form rather than the substance of scientific procedure, as if one needed only to follow some cooking recipes to solve all social problems. It sometimes almost seems as if the techniques of science were more easily learnt than the thinking that shows us what the problems are and how to approach them. (¶16)

The Economy Is Too Complex For Economists To Generate The Precise Results and Predictions Of The Physical Sciences

Hayek argues that the complexity of the subject matter of economics means that economists are incapable of producing the precise results that are offered by the physical sciences. 

Why should we, however, in economics, have to plead ignorance of the sort of facts on which, in the case of a physical theory, a scientist would certainly be expected to give precise information? It is probably not surprising that those impressed by the example of the physical sciences should find this position very unsatisfactory and should insist on the standards of proof which they find there. The reason for this state of affairs is the fact …. that the social sciences, like much of biology but unlike most fields of the physical sciences, have to deal with structures of essential complexity, i.e. with structures whose characteristic properties can be exhibited only by models made up of relatively large numbers of variables. (¶ 9)

There are some special problems, however, in connection with those essentially complex phenomena of which social structures are so important an instance, which make me wish to restate in conclusion in more general terms the reasons why in these fields not only are there only absolute obstacles to the prediction of specific events, but why to act as if we possessed scientific knowledge enabling us to transcend them may itself become a serious obstacle to the advance of the human intellect. [emphasis added] (¶ 17)

The chief point we must remember is that the great and rapid advance of the physical sciences took place in fields where it proved that explanation and prediction could be based on laws which accounted for the observed phenomena as functions of comparatively few variables – either particular facts or relative frequencies of events. …. [But a] theory of essentially complex phenomena [e.g. economic phenomena] must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions – with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts. (¶ 18)

Thus, Hayek argues, economists are relegated to merely making “pattern predictions” as opposed to the strong predictions made in the physical sciences.

This corresponds to what I have called earlier the mere pattern predictions to which we are increasingly confined as we penetrate from the realm in which relatively simple laws prevail into the range of phenomena where organized complexity rules. As we advance we find more and more frequently that we can in fact ascertain only some but not all the particular circumstances which determine the outcome of a given process; and in consequence we are able to predict only some but not all the properties of the result we have to expect. Often all that we shall be able to predict will be some abstract characteristic of the pattern that will appear – relations between kinds of elements about which individually we know very little. Yet, as I am anxious to repeat, we will still achieve predictions which can be falsified and which therefore are of empirical significance. (¶ 21)

(Competing view: Milton Friedman argued that, not only is prediction possible in economics, but that the accuracy of its predictions should be the metric by which we evaluate the strength of an economic theory.)

No Individual (Including An Economist) Can Ever Have All The Relevant Data

Hayek argues that in economics, researchers can never have all the relevant data needed to effectively apply quantitative techniques to the study of the economy. 

Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. (¶ 4)

This is because outcomes in the market depend on numerous factors including the actions and information sets of many dispersed economic actors.

Therefore, Hayek claims, no single individual (including an economist) can ever know, let alone quantitatively measure, all the of the factors that determine market outcomes.   

While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process …. will hardly ever be fully known or measurable. (¶ 4)

This is particularly true of our theories accounting for the determination of the systems of relative prices and wages that will form themselves on a wellfunctioning market. Into the determination of these prices and wages there will enter the effects of particular information possessed by every one of the participants in the market process – a sum of facts which in their totality cannot be known to the scientific observer, or to any other single brain. (¶ 11)

Economists Have Erroneously Focused On Those Limited Things That Can Be Quantified

Hayek argues that in a world in which all the relevant factors that determine economic outcomes are not observable nor measurable, social scientists have often attributed undue importance to those factors which are measurable. 

And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. (¶ 4)

And he claims that economists - concerned with imitating the quantitative techniques of the physical sciences - often insist on a narrow focus only on those aspects of the economy which are measurable, to the exclusion of the numerous factors that shape economic outcomes which are not measurable. 

This exclusion of unquantifiable factors can lead economists to accept as “scientific” theories which are false: the methods of the physical sciences have been deployed (to the satisfaction of the economist), but many relevant unquantifiable factors have not been accounted for.

This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes. (¶ 4)

It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.  (¶ 5)

On this standard there may thus well exist better “scientific” evidence for a false theory, which will be accepted because it is more “scientific”, than for a valid explanation, which is rejected because there is no sufficient quantitative evidence for it. (¶ 6)

[I]n my field, but I believe also generally in the sciences of man, what looks superficially like the most scientific procedure is often the most unscientific, and, beyond this, that in these fields there are definite limits to what we can expect science to achieve. This means that to entrust to science …. more than scientific method can achieve may have deplorable effects. (¶ 16)

Economists Cannot Substitute Probabilities For The Precise Information They Lack

Hayek also argues that economists cannot, in the absence of precise information about relevant factors that determine the outcome of some economic event, turn to the use of probabilities. 

This is because, he argues, economics deals with “phenomena of organized complexity.” 

That is, economic outcomes depend not only on the properties of the individual elements of the economy, but also on the way they interact with one another. 

In some fields, particularly where problems of a similar kind arise in the physical sciences, the difficulties can be overcome by using, instead of specific information about the individual elements, data about the relative frequency, or the probability, of the occurrence of the various distinctive properties of the elements. But this is true only where we have to deal with what has been called by Dr. Warren Weaver …. “phenomena of unorganized complexity,” in contrast to those “phenomena of organized complexity” with which we have to deal in the social sciences. Organized complexity here means that the character of the structures showing it depends not only on the properties of the individual elements of which they are composed, and the relative frequency with which they occur, but also on the manner in which the individual elements are connected with each other. In the explanation of the working of such structures we can for this reason not replace the information about the individual elements by statistical information, but require full information about each element if from our theory we are to derive specific predictions about individual events. (¶ 10) 

Algebraic Techniques Can Be Insightful in Economics, But Cannot Be Used For Prediction

Hayek suggests that the use of algebraic equations by economists can be useful, given the absence of precise numerical data about the economy.

I want to do this to avoid giving the impression that I generally reject the mathematical method in economics. I regard it in fact as the great advantage of the mathematical technique that it allows us to describe, by means of algebraic equations, the general character of a pattern even where we are ignorant of the numerical values which will determine its particular manifestation. We could scarcely have achieved that comprehensive picture of the mutual interdependencies of the different events in a market without this algebraic technique. (¶ 12)

But he argues that mathematical economics cannot be used to predict economic outcomes.

It has led to the illusion, however, that we can use this technique for the determination and prediction of the numerical values of those magnitudes; and this has led to a vain search for quantitative or numerical constants. (¶ 12)

This happened in spite of the fact that the modern founders of mathematical economics had no such illusions. It is true that their systems of equations describing the pattern of a market equilibrium are so framed that if we were able to fill in all the blanks of the abtract formulae, i.e. if we knew all the parameters of these equations, we could calculate the prices and quantities of all commodities and services sold. But, as Vilfredo Pareto, one of the founders of this theory, clearly stated, its purpose cannot be “to arrive at a numerical calculation of prices”, because, as he said, it would be “absurd” to assume that we could ascertain all the data. (¶ 12)

Our Limited Capacity To Understand The Economy Limits Our Ability To Effectively Shape Society

Hayek argues that the limitations of economics as a discipline also limit our ability to control and shape society through progress in the field. 

Of course, compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. (¶ 22)

As discussed below, Hayek’s view that our limited capacity to understand and make predictions about economic events is central to his criticism of governments trying to use fiscal and monetary policy to maintain full employment (i.e. shape society to our liking).

Markets Effectively Process Information Dispersed Among Numerous Individuals, Something The State Cannot Do

Recall that we detailed above Hayek’s argument that no single individual could comprehend all the relevant factors that go into determining price and wage outcomes in the market. 

And this, for Hayek, implies that economists are unable to make predictions about economic events. 

But, Hayek argues, the market succeeds where individual cognition fails: the strength of markets is that they are capable of aggregating the small bits of information about economic circumstances possessed by many geographically dispersed individuals whereas individuals or small groups of individuals (e.g. state planners) never could. 

It is indeed the source of the superiority of the market order, and the reason why, when it is not suppressed by the powers of government, it regularly displaces other types of order, that in the resulting allocation of resources more of the knowledge of particular facts will be utilized which exists only dispersed among uncounted persons, than any one person can possess. (¶ 11)

Hayek further claims that erroneous attempts to “shape society to our liking” based on false economic theorizing interferes with the ability of markets to perform this function. 

Markets, he argues, are “spontaneous ordering forces” which were not deliberately designed by humans but which nevertheless help us achieve our ends and are more efficient at handling information about the economy than the state.

[T]he erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. We are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based – a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed. (¶ 22)

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals. (¶ 23)

Keynesian Full Employment Policies Are To Blame For The Stagflation of the 1970s

For Hayek, the stagflation of the 1970’s reflected a failure of the economics profession (Keynesian economists in particular).

[E]conomists are at this moment called upon to say how to extricate the free world from the serious threat of accelerating inflation which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things. (¶ 1)

He attacks, without naming it directly, the Keynesian policy of attempting to ensure full employment by maintaining aggregate demand at appropriately high levels.

Hayek argues that Keynesian full employment policies cannot alleviate unemployment in the long term, as they lead to a misallocation of resources which will likely lead to even greater unemployment later. 

[E]xtensive unemployment …. cannot be lastingly cured by the inflationary policies recommended by the now fashionable theory. (¶ 7)

In fact, in the case discussed, the very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity. The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because, as this view is sometimes misrepresented, this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate. (¶ 15)

Hayek argued that the Keynesian perspective on the relationship between full employment and aggregate demand was developed by the erroneous application of scientific procedure in economics. 

The theory which has been guiding monetary and financial policy during the last thirty years, and which I contend is largely the product of such a mistaken conception of the proper scientific procedure, consists in the assertion that there exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services; it leads to the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level. Among the various theories advanced to account for extensive unemployment, this is probably the only one in support of which strong quantitative evidence can be adduced. I nevertheless regard it as fundamentally false, and to act upon it, as we now experience, as very harmful. (¶ 3)

According to Hayek, Keynesians who proposed a policy of ensuring sufficiently high aggregate demand as a method of ensuring full employment on the grounds that they found a positive correlation between aggregate demand and employment have, in the application of their quantitative methods, ignored unquantifiable factors which were the true cause of unemployment. 

The correlation between aggregate demand and total employment …. may only be approximate, but as it is the only one on which we have quantitative data, it is accepted as the only causal connection that counts. (¶ 6)

And this mistaken application of quantitative scientific methods to economics had, according to Hayek, put the world in its present predicament of rampant inflation. 

There may be few instances in which the superstition that only measurable magnitudes can be important has done positive harm in the economic field: but the present inflation and employment problems are a very serious one. Its effect has been that what is probably the true cause of extensive unemployment has been disregarded by the scientistically minded majority of economists, because its operation could not be confirmed by directly observable relations between measurable magnitudes, and that an almost exclusive concentration on quantitatively measurable surface phenomena has produced a policy which has made matters worse. (¶ 13)

Hayek points to what he believes is the actual cause of unemployment ignored by Keynesians plagued with a “scientistic” attitude because it does not lend itself to quantification and the application of the methods of the physical sciences: distortions of the market by monopolies or the government. 

We possess a fairly good “qualitative” knowledge of the forces by which a correspondence between demand and supply in the different sectors of the economic system is brought about, of the conditions under which it will be achieved, and of the factors likely to prevent such an adjustment. …. We have indeed good reason to believe that unemployment indicates that the structure of relative prices and wages has been distorted (usually by monopolistic or governmental price fixing)[.] (¶ 7)

But when we are asked for quantitative evidence for the particular structure of prices and wages that would be required in order to assure a smooth continuous sale of the products and services offered, we must admit that we have no such information. We know, in other words, the general conditions in which what we call, somewhat misleadingly, an equilibrium will establish itself: but we never know what the particular prices or wages are which would exist if the market were to bring about such an equilibrium. We can merely say what the conditions are in which we can expect the market to establish prices and wages at which demand will equal supply. But we can never produce statistical information which would show how much the prevailing prices and wages deviate from those which would secure a continuous sale of the current supply of labour. Though this account of the causes of unemployment is an empirical theory, in the sense that it might be proved false, e.g. if, with a constant money supply, a general increase of wages did not lead to unemployment, it is certainly not the kind of theory which we could use to obtain specific numerical predictions concerning the rates of wages, or the distribution of labour, to be expected. (¶ 8)

It has, of course, to be readily admitted that the kind of theory which I regard as the true explanation of unemployment is a theory of somewhat limited content because it allows us to make only very general predictions of the kind of events which we must expect in a given situation. But the effects on policy of the more ambitious constructions have not been very fortunate and I confess that I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge that is likely to be false. (¶ 14)

Other Social Science Disciplines Also Suffer From “Scientism” 

Hayek also suggests that other social science disciplines have erroneously attempted to imitate the methods of the physical sciences (i.e. have adopted a “scientistic” attitude).

[I]t is by no means only in the field of economics that far-reaching claims are made on behalf of a more scientific direction of all human activities and the desirability of replacing spontaneous processes by “conscious human control”. If I am not mistaken, psychology, psychiatry and some branches of sociology, not to speak about the so-called philosophy of history, are even more affected by what I have called the scientistic prejudice, and by specious claims of what science can achieve. (¶ 17)

Summary

Hayek’s 1974 Nobel acceptance speech argued that Keynesian full employment policies were to blame for the stagflation of the 1970s. 

He argued that these full employment policies were rooted in an erroneous attempt by economists to imitate the techniques of the physical sciences.

In making this critique, Hayek articulated his views on some of the central questions in the philosophy of economics.

He argued that the economy is too complex for economists to generate predictions as the physical sciences do. 

He further argued that no one individual could possess, let alone process, information about the current state of the numerous factors that determine economic outcomes. 

Where the individual (and small groups of individuals such as state planners) fail, the market mechanism succeeds: the great strength of markets is that they are able to aggregate the small pieces of knowledge possessed by numerous dispersed individuals to generate appropriate prices and wages. 

Our limited knowledge and inability to make predictions means we cannot use state policy to achieve economic outcomes we desire (e.g. full employment).

Many of the factors which determine economic outcomes are qualitative and cannot be quantified. 

Therefore, it is a mistake for economists to focus excessively on what is quantifiable: while the use of quantitative techniques may provide the sheen of scientific rigor, in fact it is unscientific because it disregards much of what is important about the economy. 

Algebraic techniques and equations can be useful in economics but cannot be used for prediction. 

And economists cannot substitute probabilities for the precise data they lack. This is because economic outcomes depend not only on the properties of the individual elements of the economy, but also on the way they interact with one another.

Therefore, economists should not attempt to imitate the methods of the physical sciences. 

Keynesian economists who claimed to have found a quantifiable relationship between aggregate demand and full employment, and therefore recommended governments target certain levels of aggregate demand to maintain full employment, had come to this conclusion and policy recommendation through the erroneous application of scientific techniques to economics. 

Now the consequence of this methodological error - stagflation - was wreaking havoc on the global economy. 

Written By: Aiden Singh Published: May 6, 2020