Monetary Calculation as a Scorecard
By Robert P. Murphy
In his magnum opus, Human Action, Austrian economist Ludwig von Mises stressed the importance of monetary calculation as an underpinning not just of a healthy economy, but also of civilization itself. In his words:
Monetary calculation is the main vehicle of planning and acting in the social setting of a society of free enterprise directed and controlled by the market and its prices. It developed in this frame and was gradually perfected with the improvement of the market mechanism and with the expansion of the scope of things which are negotiated on markets against money. It was economic calculation that assigned to measurement, number, and reckoning the role they play in our quantitative and computing civilization. The measurements of physics and chemistry make sense for practical action only because there is economic calculation. It is monetary calculation that made arithmetic a tool in the struggle for a better life.1
These are provocative claims, but in this essay, I explain why Mises thought that monetary calculation was essential to modern life.
Monetary Calculation in Practice
For more on monetary calculation, see Robert P. Murphy, Accounting for Capital and Income, Library of Economics and Liberty, July 7, 2014.
We can mentally organize the myriad events that occur during a certain time period in a modern economy by grouping them into millions of “operations.” A given operation absorbs certain inputs and emits certain outputs at various points during the time period.
Monetary calculation allows an analyst to evaluate any particular operation from the standpoint of profitability. Specifically, an accountant can add up the total (explicit and implicit2) monetary expenditures and receipts associated with the operation during the specified period. If the revenues exceed the costs, the operation was profitable, but if costs exceeded revenues, then it “lost money.”
The classification scheme by which we group particular events can differ, depending on the desired granularity of the analysis. For example, the CEO of a large chain of grocery stores may periodically review the profit and loss statements for each store. If a particular store is underperforming its peers, then the CEO may give a warning to that store’s manager and ultimately replace him if the problem is not rectified.
However, when the individual store manager gets the memo that his performance is unsatisfactory, he can look at the performance of the department managers within his particular location. While the CEO probably would not review reports on the third-quarter profitability of the store’s meat department, the store manager definitely would.
Indeed, correctly attributing the store’s performance to its individual components requires the various departments to settle up with each other in terms of money. When I was in high school, I worked in a grocery store’s dairy department. Our manager would order extra cases of creamer for the in-store café at the front of the building. (The café was a new feature at our upscale location, where customers could sit and drink coffee, eat the lunch they’d just purchased, etc.)
Of course, our dairy manager charged the café manager for the cases of creamer. To be exact, there was not an explicit transfer of cash, but the transactions were documented in money terms. I remember that my co-worker found this practice odd since, as she put it, “we’re all the same company.” But even at that age, I recognized that it was crucial to account for the fact that our department had an outflow of some of the creamer cases we had had trucked in, while the café was able to fill the creamer dispensers without having to pay outsiders for it. When our store manager reviewed operations, it would be important for him to know that some of the money that the dairy department had spent on creamer “inputs” did not show up as sales to outside customers because we were transferring some of the cases to the café on the other side of the store.3
The Flaw of Socialism
In Mises’ view (later elaborated by his follower Friedrich Hayek), a modern economy is far too complex to be centrally planned. Even putting aside concerns about dictatorship and shirking, a socialist system cannot implement an efficient use of society’s scarce resources because the planners would have no way of evaluating their blueprint—even after the fact—from the standpoint of citizen preferences.
To be sure, engineers and chemists could accurately report how much steel, glass, rubber, and labor hours of various qualities went into (say) a particular automobile factory and how many cars came out at the other end. But without a way to translate these disparate quantities of heterogeneous items into a common unit, there would be no way of telling whether the factory’s operations had been efficient during the period in question.
Lessons From Haiti
For more on aiding Haiti after the earthquake, see the EconTalk podcast episode Michael Matheson Miller on Poverty, Inc.
For more on socialism and prices, see Robert Heilbroner, “Socialism,” and Donald J. Boudreaux, “Information and Prices,” in The Concise Encyclopedia of Economics. See also Ludwig von Mises, Socialism: An Economic and Sociological Analysis, 1922, online at the Library of Economics and Liberty.
I didn’t fully recognize the power of the Misesian insight until 2010, when I volunteered for a reconstruction team operating in Haiti after their terrible earthquake. (Elsewhere, I have written a longer account of my experience.4) Volunteers would come and go, and at any given time, maybe 50 of us would go out early in the morning, perform what was often very difficult manual labor, take a lunch break, and then do another long burst of tough work.
We were all very motivated “to help,” but beyond that, we didn’t have much to guide us. At the end of each day, we could say with confidence that we had made the Haitians better off than if we had done nothing, but it wasn’t at all obvious that we were helping them as much as we could have with the resources at our disposal.
For example, we all had to choose which team we would join during a given block of time, but there were rules so that nobody hogged the “cushy” jobs (like staying inside and assembling poles that would be used to prop up tents). Indeed, everybody had to sign up at least once for the disgusting job of cleaning the bathroom at our camp. Even though these rules made sense from the perspective of “fairness” and maintaining team morale, they probably stifled our overall “output.” I noticed that I was very adept at assembling the poles for the tents, whereas I was unprepared for the heat of Haiti in April and therefore not particularly adept at breaking apart concrete blocks with a sledgehammer in the hot sun. (The earthquake had reduced many people’s properties to a pile of rubble.) To be a “tough guy,” I volunteered for “rubble crew” more than necessary, but I probably would have contributed more had I focused on pole assembly. Yet nobody but me (the professional economist in the group) was thinking like this. None of the team leaders had to provide an account of the resources (including the labor of the volunteers) used during a particular day and compare that to the amount of “help” (however quantified) their team had provided to the Haitians. In other words, there was no way for the team leaders to apply a cost/benefit test to their respective operations.
“Monetary calculation at least provided a coherent standard against which my manager could judge all of her decisions.”
In complete contrast, a for-profit operation in a market economy can make very precise calculations. When I worked at the dairy department in high school, we did have a “scoreboard” that was always lurking in the background, “keeping us on point.” Our manager knew whether it made sense to assign so many workers to a particular shift or whether to carry quarts of chocolate milk in addition to the white whole, 2%, and skim quarts. Monitoring of employee effort wasn’t perfect, of course, and there was still some guesswork, but monetary calculation at least provided a coherent standard against which my manager could judge all of her decisions.
The Social Function of Monetary Calculation
To the socialist writers of the 19th century, the “bottom line” calculated by accountants was an arbitrary social convention. But to Mises, the institution of private property and the widespread use of money provided an indispensable mental tool to guide the actions of entrepreneurs.
Consider: If a particular operation is unprofitable, that means that it absorbs resources that have a higher monetary value than the outputs it produces. In other words, everyone else in society outside of that operation thinks that its input resources are more valuable than its output goods (or services). This is feedback from everyone else telling the people running this operation: “You are reducing the value of economic resources available to the rest of us, so consider carefully what you have been doing. Is there a tweak you can make to your enterprise, so that you absorb fewer inputs and/or produce outputs that the rest of us value more highly?”
The entire economic “plan” of society is far too complex to entrust to any one group. Therefore, we need a system that disperses (limited) control over resources among billions of authorities. However, we can’t have chaos; there must be some mechanism by which each decision maker can receive feedback regarding his or her operation and its connection with all other operations. Mises argued that private property and money prices are what allow order to emerge in a decentralized economic system.
In this framework, a relatively high price for a resource is a signal that other operations are currently using it and consider it very valuable. For example, no sane homebuilder would consider coating the interior of a den with gold because “it would be too expensive.” However, the reason that gold is so expensive is that other operations—such as jewelry shops—are able to turn a profit even while spending large sums to acquire gold inputs. Indeed, it is the high unit price of gold that ensures that the yellow metal is used to make necklaces and earrings rather than wall paneling. By their spending decisions, consumers “instruct” the entrepreneurs on where to channel the limited gold supplies. This information also flows “up the pipeline” of sequences of operations to provide incentives for miners to invest more or less in heavy machinery and other inputs, in order to extract more gold from the earth.
In addition to steering resources in the present moment, market prices also guide entrepreneurial decisions over time. For example, if an operation absorbs $1,000 in inputs today and produces $1,100 in outputs three decades from now, then it is clearly unprofitable. The prices of bonds of various maturities show the entrepreneur that “the market” doesn’t actually value the output from this operation more than the inputs, once present and future dollars are put on the same footing. Positive interest rates implicitly penalize operations for tying up resources over time. An efficient operation not only must transform given inputs into appropriate outputs, but also must do so quickly enough.
Monetary calculation has its limits. For example, a city council might set aside urban land for a public park, even though this action would be “unprofitable” in a narrow accounting sense.
Even so, such oases of planning can be tolerated when placed in the context of a market economy. In particular, the city council would at least know the cost of its decisions because accountants could tell them the annual rental price of a parcel of real estate that they were considering for a “free” park. They admittedly would not be able to precisely quantify the benefit to the community of having a park (since they wouldn’t be charging admission), but at least knowing the cost would provide some discipline to their actions.
A modern economy is far too complex to be centrally planned by a committee of experts. Thus, we need a decentralized system in which people are free to start an operation and alter the existing patterns of resource usage. However, we do all rely on a finite amount of scarce resources, and so we want the system to limit the damage someone can do if he or she keeps making bad (however that is defined) decisions.
Ludwig von Mises showed that the institution of private property and the use of money achieve these objectives. Although it’s not perfect, monetary calculation provides the crucial feedback or “scorecard” to offer guidance to operations of all sizes.
Ludwig von Mises, Human Action (Auburn, Alabama: Mises Institute), Scholar’s Edition, 1998, p. 231. See also Human Action, paragraph 3.XIII.4 in the 4th revised edition, online at the Library of Economics and Liberty.
By “implicit” monetary expenditure, I mean the opportunity cost: what the owner of resources could have charged outsiders. For example, if a certain operation requires an annual explicit expenditure of $100,000 in hiring other workers, but also uses up the labor of the owner who otherwise could have hired out her services to others at $75,000 per year, then, when one judges whether the operation is profitable, the account should reckon the total labor expenditures at $175,000.
Note that it made much more sense for the dairy department to simply bump up the amount we ordered every shipment, and walk down the extra cases when the truck came in, rather than the café manager separately working out an arrangement with the warehouse. We went through far more cases of creamer than the café.