Robust Political Economy

One of the greatest criticisms of classical liberalism has always been its reliance on the “idealised theoretical conditions”. Perfect knowledge among buyers and sellers, perfect competition, perfect mobility of factors of production, absence of externalities and transaction fees: the examples are countless. Similarly, the benevolence of agents, that is, the tendency to act towards societal welfare, rather than self-interest, was one of the governing “idealised theoretical conditions” of socialism and even classical liberalism. Under these mirage-like ideal conditions, both communism and capitalism could theoretically prove that they were extremely efficient in maximising social welfare. Similarly, under constraints, anarchies and authoritarian regimes proved to be more effective in imparting social and economic justice than a democracy ever could.

In the context of political economic systems, ‘robustness’ refers to a political economy’s ability to produce social welfare-enhancing outcomes especially in the face of deviations from the ideal assumptions about individuals’ motivations and information. Essentially, a political and economic system becomes ‘robust’ if it can withstand the realities and imperfections of human behaviour. Robust political economy requires that both the assumptions of agent’s benevolence and omniscience be relaxed. Such that the incentive issues and knowledge problems can be adequately addressed.

The two significant deviations that any theoretical robust political economy creates from a classical or socialist theory, is in the following respects:

  • Perfect Rationality: As opposed to the assumption, human beings are not fully rational agents—they also are not omniscient beings. Whenever they make decisions, they do so in a context of considerable uncertainty and there is always imperfect information.

  • Benevolence: The second human imperfection is the problem of ‘limited benevolence’. People may, under certain circumstances, act out of self-interested motivations. They may be opportunistic. Therefore, we need to evaluate institutions in terms of the incentives they provide to channel potentially opportunistic actors to behave in a way that increases the overall well-being in society—that generates positive rather than negative sum gains.

A robust political economy deals adequately with both of these issues. When information is costly, imperfect, and asymmetric, a robust political economy can still produce rational allocation. Likewise, when men are selfish knaves, a robust political economy nevertheless produces socially beneficial outcomes. In short, conditions shy of omniscience and benevolence do not cause the system to falter. Even in the face of these problematic imperfections, a robust political economy performs well.

The first easy case to deal with is the combination of self-interested individuals and classical liberalism. The classical economists sought out to show that even in the worst-case scenario of a society, populated by completely self-interested individuals, the market would ensure that the desires of men would be satisfied without any problem. Adam Smith’s famous invisible-hand postulate illustrated how the process of selfish individuals, each pursuing his or her own interests, leads to the promotion of society’s interests as a whole. His most famous quote from the Wealth of Nations summarises this point nicely: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love.” Indeed, he argued that liberalism could not only deal with a world of selfish individuals but also harnesses each man’s self-interested motivation for the benefit of everyone. This is because of the fundamental principles of exchange and private property, which would serve to guide the actions of both parties, and lead to a steady flow of resources and shifts in commodities according to changes in preferences of the consumers.

However, a tougher question to ask is: Can classical liberalism thrive in imperfect knowledge? Hayek’s famous 1945 essay, The Use of Knowledge in Society addressed this very question. Hayek pointed out that analogous to the division of labour, there exists an equally important division of knowledge in the market. No one person has all the knowledge necessary to make the market function effectively. However, precisely because knowledge is dispersed among the millions of individuals who comprise society, through the price system, the market is able to effectively coordinate the disparate plans of all market participants. Prices enable producers to evaluate the past successes or failures of market actors to determine whether they have adequately satisfied the desires of consumers. The price system, built on the diverse and decentralised knowledge of the individuals who compose the market, allows all market participants to economise on costly information. Therefore, in a way price becomes the indicator of knowledge and information in the market. The price of a particular commodity is eventually set depending upon the amalgamation of knowledge of all the players.

Hayek showed that by way of the price system, markets are able to cope with radically dispersed information and individual ignorance. By assuming the worst case about the information held by actors under liberalism and by showing liberalism’s ability to thrive on this ‘imperfection,’ Hayek demonstrated the robustness of liberal political economy. Hayek broadened his argument for the robustness of liberalism in the Constitution of Liberty and later in Law, Legislation, and Liberty where he developed the idea of the importance of particular institutions as the backdrop against which, erring and ignorant agents can learn to adapt their behaviour so as to coordinate their activities with those of others. According to Hayek, the institutions of private property, contract and consent, embedded in a system of general rules that protect these institutions, are crucial in ensuring that economic actors are able to utilise their individual knowledge of time and place in making decisions in such a way that their plans may be realised.

Although after the fall of the Soviet Union and the communist bloc in the early 1990’s, classical liberalism has proven to be the more robust system of the two, yet, during the Cold War, these ideological differences rested at the heart of the conflict between the United States and Soviet Union. Proponents of socialism often argued that without assumptions of perfect knowledge and benevolence, classical liberalism became so flawed that decentralised decision-making could not be trusted. They contended that the real world deviates so strongly from these idealised theories that the government’s role in the central planning and forcefully deciding the combination of goods and services to be produced was vital to maximise welfare. The central reasoning for this proposition was that the robustness of classical liberalism is based on the “invisible hand” of Adam Smith, which neither relies on benevolence nor on perfect knowledge.

Hayek and Mises believed in disproving the socialism theory under the best-case scenario. They didn’t focus on the incentive problem of the people at the various positions of the hierarchical structure. Thus, they took benevolence as a given assumption. However, the imperfect information problem was wide open to be attacked. They contested the information available with the authority, and went on to say that due to delays in receiving the information or stagnancy of decision in the market, there would be extreme mismanagement between the wants of the consumers and resource allocation of the producers. Thus, the theory of socialism would lead to a most definite market failure, which is inevitable in the long run.

Even so, we can clearly see, in governance systems across the globe, that classical liberalism with its minimal interference by the government and unprecedented decentralised decision-making is not followed in its crude format. A stronger role for the government, in sectors like education, healthcare and public services is widely practiced and argued for. Managing a political economy, in some terms, is truly a balancing act. Whenever dogma prevails over practicality, robustness diminishes, be it the 1991 fall of the USSR or the 2008 financial crash. At the end, “robustness” is vastly dependent on adaptability and as long as governments and communities show greater adaptability to newer challenges, more real and robust political economies will continue to emerge.


Ashima Makhija

I am pursuing Economics (Honours) from Shri Ram College of Commerce, University of Delhi. I spend my time solving fictional murder mysteries and avoiding real-life mysteries (seriously, when did I last open my course book?).

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