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Institutional Reform
1. Introduction
In his widely and justly acclaimed treatise Knowledge and Decisions (1980),1
Thomas Sowell explicitly acknowledges his indebtedness to F. A. Hayek, and
the book may be interpreted as variations on and applications of Hayekian
themes. Sowell's primary stress is on the diffusion of localized knowledge
among all participants in social interaction and upon the possible benefits
achievable by an appropriate matching ofthe informational and institutional
structures. The mismatch between the hierarchically organized decision-
making institutions that presume and require a centralization of knowledge
that simply does not exist is an identifiable and reformable source of ineffi-
ciency.
The Hayekian emphasis on the diffusion of knowledge or information is
corollary to a second major Hayekian theme, one that has eighteenth-
century origins, a theme that stresses the spontaneous coordination of the
results that emerge from the operation of decentralized institutional struc-
tures (the market). This theme is of course encapsulated in the principle of
the invisible hand, perhaps the major intellectual discovery in the whole his-
From Liberty, Market and State: Political Economy in the 1980S (Brighton, England:
Wheatsheaf Books, ]986),75-86. Copyright ]986 by James M. Buchanan. First published
in Great Britain in 1986 by Wheatsheaf Books Ltd, Brighton, Sussex. Reprinted by per-
mission of Pearson Education Limited.
This chapter was initially presented as a paper in a Liberty Fund Conference in Savan-
nah, Georgia, in March 1982.
1. Thomas Sowell, Knowledge and Decisions (New York: Basic Books, 1980).
311
312 The Constitution of Markets
tory of economics, and upon which the normative precept of laissez-faire was
constructed and defended.
The coordination emerges as an unintended consequence of human ac-
tions that are motivated by divergent localized purposes. An understanding of
the principle of such coordination enables the economist to shed the vulgar
prejudice towards "constructed" or "planned" integration and to suggest that
laissez-faire maximizes not only liberty but also the wealth of the nation. This
principle of spontaneous order, "the logic ofliberty;' to introduce Michael Po-
lanyi's felicitous designation, becomes the Lakatosian hard core for the econ-
omist, around which and from which his research programme emerges.
I endorse fully both of the Hayek-Sowell central themes noted, and I yield
to no one in my admiration for Hayek's insightful contributions and for
Sowell's imaginative applications. However, there is a third theme that has
become increasingly important in Hayek's recent writings, and which is not
wholly absent from Sowell's treatise, that does give me concern. This theme
involves the extension of the principle of spontaneous order, in its normative
implications, to the emergence of institutional structure itself. As applied to
the market economy, that which emerges is defined by its very emergence to
be that which is efficient. And this result implies, in its turn, a policy precept
of non-intervention, properly so. There is no need to evaluate (indeed there is
no possibility of evaluating) the efficiency of observed outcomes independent
of the process; there exists no external criterion that allows efficiency to be de-
fined in objectively measurable dimensions. If this logic is extended to the
structure of institutions (induding laws) that have emerged in some historical
evolutionary process, the implication seems dear that that set which we ob-
serve necessarily embodies institutional or structural "efficiency." From this it
follows, as before, that a policy of non-intervention in the process of emer-
gence is dictated. There is no room left for the political economist, or for
anyone else who seeks to reform social structures, to change laws and rules,
with an aim of securing increased efficiency in the large. Any attempt to
design, construct, and change institutions must, within this logical setting
strictly interpreted, introduce inefficiency. Any "constructively rational"
interferences with the "natural" processes of history are therefore to be stu-
diously avoided. The message seems dear: relax before the slow sweep of
history. Shades of the Hegelian mysteries!
Cultural Evolution and Institutional Reform 313
In some parts of his recent writings Hayek has come close to the counsel
of despair sketched out above.' In yet other parts of his work, however,
Hayek himself seems clearly to be a "constructive rationalist:' or a "rational
constructivist:' since he does not shy away at all from advancing specific pro-
posals for institutional-constitutional reform. Two examples are provided in
his widely discussed proposal for the denationalization of money issue' and
in his proposal for changes in the division of functions as between two sepa-
rate elected assemblies.'
My aim in this chapter is to reconcile the Hayek critique of constructive
rationalism with his advocacy of institutional reform. In an earlier paper I
criticized Hayek's extension of the principle of emergent and spontaneous
order to institutional and legal structures.' In that paper I presented the
Hayek stance as being internally contradictory; I made no attempt to remove
or resolve the contradiction. My effort at reconciliation in this chapter is
prompted specifically by an initial and highly stimulating paper by Professor
Viktor Vanberg, who sought not only to reconcile the contradiction within
Hayek's own work but also to reconcile Hayek's approach with my own,
which Vanberg called that of the "contractarian constitutionalist.'" The ideas
that I present in this chapter are fully consistent with Vanberg's argument,
and in a sense reflect little more than my own variations, as initially devel-
oped in a prefatory note designed to accompany the ultimate publication of
his paper in monograph form.
2. See especially Rules and Order, Vol. 1 of Law, Legislation and Liberty (Chicago: Uni
versity of Chicago Press, 1973).
3. See F. A. Hayek, Denationalization ofMoney, Hobart Paper 70 (London: Institute of
Economic Affairs, 1976).
4. See The Political Order o/a Free People, Vol. 3, Law, Legislation and Liberty(Chicago:
University of Chicago Press, 1979).
5. See lames M. Buchanan, "Law and the Invisible Hand," in Buchanan. Freedom in
Constitutional Contract (College Station: Texas A&M University Press, 1977), 25-39.
6. Viktor Vanberg. "Libertarian Evolutionalism. Constructivist Rationalism, and Con-
tractarian Constitutionalism-The Issue of Constitutional Reform," presented at Liberty
Fund Conference on Economic and Philosophical Foundations of Capitalism. Freiburg,
Germany, February 1981. A revised version of this paper is published as a Walter Eucken
Institute monograph. Liberaler Evolutionismus oder VertragstheoTetischer Konstitutionalis-
mu,? (Tubingen: ). C. B. Mohr, 1981).
314 The Constitution of Markets
that those very changes that may well reflect movement towards local optima
can shift the whole system away from rather than towards some global op-
tima? If this possibility is admitted, what rules out the legitimacy of extend-
ing entrepreneurial effort to effect changes in the large, to act as "rational
constructivists;' and to discuss alternative grand designs for the whole set of
rules that exist?
At this point it is useful specifically to recall the central logic behind the
conclusion that the market process generates coordinated results that are, in-
deed, likely to be more "efficient" than any alternative organizational struc-
ture for delivering ordinary goods and services. The market accomplishes
this "miracle" because self-seeking individuals, who are presumably made
secure in their persons and properties by the legal framework, carry out ex-
changes largely if not exclusively in separation or isolation from spill-over ef-
fects on other individuals who are not directly parties to the exchanges in
question. In somewhat different and perhaps more familiar terms, the results
of efficiency-seeking in the small, guarantee efficiency in the large because
Pareto-relevant externalities are either absent or insignificant. The institu-
tions of property and contract are presumed to be such that third-party or
neighbourhood effects are minimized.
But we cannot simply extend such logic backwards, so to speak, and pre-
sume that, for the organization of "institutional exchanges" any such sep-
arability exists. Almost by definition, an institution or rule constrains the
behaviour of many parties in a relevant interaction. In a very real sense,
"publicness" necessarily enters which, in turn, ensures that "exchanges"
must be complex in the sense of including all affected parties if they are to
meet any efficiency test analogous to the market. This publicness of institu-
tions suggests that any correspondence between efficiency in the small and
efficiency in the large vanishes. Entrepreneurial efforts applied at the insti-
tutional margins, in the small, may represent efficiency gains, in the small,
but there is no implication that these, taken separately, enhance efficiency in
the large since, by definition, all parties affected are not brought into the
agreed "exchanges" that are made.
Hayek seems to raise his objections against any attempts to look and sug-
gest improvement in the whole structure of institutions, referring to such ac-
tivity as dangerous "rational constructivism." At the same time, however,
Hayek proposes basic changes in the institutional-constitutional structure of
Cultural Evolution and Institutional Reform 317
ability to act, and the set of institutions within which we may act, always
within these rules for behaviour. The culturally evolved rules for behaviour
clearly impose constraints on this set of institutions, but they need not define
a unique and specific institutional structure.' There are many possible struc-
tures within which men may behave, and these structures (sets of institu-
tions) may be normatively evaluated one against the other. The discussion of
institutional structures that are inconsistent with the nature of man as he
exists is properly subjected to Hayek's contempt. Such discussion charita-
bly interpreted may seem little more than romanticizing about unrealizable
Utopias. But, when taken seriously, the romantic delusions wreak havoc on
constructive dialogue.
As among those alternative sets of institutions that do not place unduly
severe demands on man's behaviour in accordance with the culturally evolved
rules, there are clearly "better" and "worse" adjectives and adverbs to be
assigned, given sound analysis along with defensible evaluative standards.
Hayek's proposals for constitutional-institutional reform can be interpreted
as suggestions that existing institutions are indeed "worse" than that set
which he proposes in their turn. His effort in presenting these reform pro-
posals can be interpreted as rational constructivism in the sense that he is
examining the whole complex network of interaction in recognition of the
inherent publicoess embodied in rules-institutions. In advancing these pro-
posals for change, Hayek is not directly relying on the processes of institu-
tional selection in any analogue to natural selection to generate efficiency in
the large. He is not expressing confidence that entrepreneurial efforts by
limited-vision participants exerted on the margins of institutional change
\vill ensure movement towards the ideal society. In this respect, Hayek's po-
sition seems to be quite different from that expressed by other economists
who do indeed reflect some such confidence.'
a gross return of s6. all of which is now retained by the taxpayer. There is a
net loss of value of S4 in the economy. despite the gain to the taxpayer. In an
overall or global sense. the economy is less efficient than it was before the
discovery of the loophole.'
As more and more taxpayers learn of the new tax-exempt options. the
economy becomes less and less efficient until, at some point, it may seem
evident to all concerned. including governmental decision-makers. that
structural changes in the tax code are required. Institutional reform may
then emerge that will tend to enhance efficiency in the large. to shift the
economy towards some sort of global optimum.
In a sense. of course, such institutional reform can be interpreted as be-
ing produced by the responses of persons to the increasing "badness" of the
situations that they confront. But there are dramatic differences between
this path of institutional change and the selection process that characterizes
the competitive market economy. In the latter-that is. in the market-
entrepreneurial effort that is successful displaces values by higher values.
That is to saYI a successful entrepreneur makes a profit on his venture; he
increases localized efficiency. He may also create bankruptcy (losses in capi-
tal values) on the part of his competitors. But the gains in value to the entre-
preneur, along with the owners of scarce inputs and consumers generally.
will more than offset the losses incurred by those persons who are damaged.
The efficiency of the economy as a whole. in the large, is increased, not de-
creased. as a result of each and every successful entrepreneurial venture.
As the tax-adjustment example shows clearly, however, comparable entre-
preneurial effort decreases overall efficiency, or at least may do so. Ultimate
institutional reform that may reverse this localized drift towards inefficiency
in the large is postulated only because of some faith that a developing gener-
alized recognition of the need for more basic structural change will emerge.
Here there is no direct correspondence between the decentralized, localized
responses to the limited-information settings in which persons separately
9. The illustration is, of course. oversimplified and the conclusion depends on the sat-
isfaction of some conditions. If the $5 collected by the government should be totally
wasted, the discovery of the loophole would then increase rather than decrease efficiency.
If, however. as much as $1 is spent productively, even on pure transfers, the conclusion
holds.
Cultural Evolution and Institutional Reform 321