Shining Knight of the free market

Milton Friedman wrote that Frank Knight was "one of the most original and influential social scientists of the 20th century". Dustjacket endorsements do not come much better than that. But do these volumes justify the description?

From his humble origins as a farm labourer in the 1930s and 1940s, Knight emerged as a crucial figure in the development of the Chicago School of Economics, possibly the single most important economics faculty in the world in the second half of the 20th century. Paul Samuelson, a Nobel prizewinner with a different ideological bent than Friedman, reports himself as being "bewitched" by Knight as a student.

But there is an immediate contrast between Knight's work and much of present-day economics. These two lengthy volumes contain hardly a single equation, in contrast to the pages of applied maths that often pass for economics these days. Methodologically at least, it seems as if Knight's legacy is weak. This impression is reinforced when examining the titles of the essays and papers in this well-organised collection. Only a minority of them relate explicitly to economic theory. The very first paper is on "The limitations of scientific method in economics". Many of them are concerned with much wider topics of ethics and philosophy: "The ethics of competition", "The rights of man and natural law", "Philosophy and social institutions in the West", to give just three examples.

Knight was writing firmly in the 19th-century tradition of political economy and saw these areas as ones where economists, both through the content of their discipline and through the analytical training it gave, could make important contributions.

Many of his essays are inspired by the defence of liberal society and liberal economic institutions. During the most productive period of his life, roughly 1920 to 1950, these were under threat from fascism and communism. From the vantage point of 2001 and the complete victory of capitalism, it is easy to forget that for much of the 20th century the superiority of the western market economies over their rivals was not always obvious. For most people in the West, life was a pretty grim struggle. Knight believed that the market economies were superior, both in terms of efficiency and of morality, and returned again and again to these themes in different contexts.

It may seem surprising to place the words morality and market economy together. Many look with disapproval on what they perceive to be the harshness of the Reagan and Thatcher years. The world order of triumphant capitalism is under literal attack from eco-warriors and other dissident groups. In this context, Knight's writings have a very modern flavour. His specific theme was the defence of the market economies against the planned ones, but his ideas are sufficiently general to be very relevant in today's contexts.

He described the economic system as one which is "at the same time a want-satisfying mechanism and a competitive game". This gives rise to three ethical ideals that are in conflict. The first is the principle of distribution according to effort. The second he describes as the principle of "tools to those who can use them", regarding this as a necessary condition of efficiency. As Knight points out, however, it does involve giving the best player the best hand and the fastest runner the benefit of the handicap. So it conflicts starkly with the third ideal, which is to maintain conditions of fairness in the game.

A substantial part of these two volumes explores this theme, and how the conflicts might best be resolved. These essays are definitely worth reading today by anyone with an interest in the important area of economics and morality. A few, such as a 1928 review of the third volume of Werner Sombart's work on capitalism, are dated by their very nature. But most raise general principles that all social scientists today ought at least to be aware of and to think about.

A second main topic that runs through the essays has a flavour that is increasingly modern. Namely, the limitations to knowledge both in economics and through the social sciences. Economists ought to find Knight's arguments stimulating. Knight was a technically accomplished economist by the standards of his time, and could write with authority on theoretical issues such as the business cycle, and the quantity of capital and the rate of interest. His doctoral dissertation of 1921 introduced his famous distinction between risk and uncertainty, years before Keynes stumbled towards it. But he stressed the deep limitations of the conventional economic approach.

Knight believed strongly that the liberal, market economy offered the best hope for humanity. But he was equally insistent that this view did not simply follow from a logical grinding out of the assumptions and equations of free-market economic theory. Indeed, he rejected very firmly the orthodox economic view that agents act in rational pursuit of a given set of tastes and preferences. "How far is life rational?" Knight asked rhetorically, answering "not very far". He believed that life is an attempt to find out our wants, rather than "on the basis of knowledge of them to produce and enjoy them to the greatest possible extent", the study of which still constitutes the core of economic teaching.

Knight diverged further from orthodoxy, arguing that all individuals are different, whereas conventional thought today makes great use of the "representative agent", allowing the behaviour of an individual to proxy that of the system as a whole. He anticipated the non-linear advances of the past two decades, postulating that such differences are "affected to a large degree by imperceptible differences in the situation". Moreover, he stated firmly the principle of path-dependence: "the behaviour of human beings depends upon their previous history".

These insights are the basis of modern complexity theory, a rapidly growing discipline attracting a multi-disciplinary interest ranging from economists to theoretical physicists, and one that offers better explanations of many phenomena in the social sciences than does conventional thinking. Complex-systems analysis places firm limits on prediction and control in the social sciences. Knight's insights in this area, lacking the techniques now available, mark him out as a truly outstanding thinker.

Paradoxically, he remained committed to the traditional concept of perfect competition as the benchmark against which all other systems should be measured. This idealised world of a large number of very small firms does not permit the existence of increasing returns, of the efficiency gains that sheer size allows. Yet the history of the western economies in the 20th century has been essentially one of managerial capitalism, a phrase coined by Robin Marris in the 1960s. Prosperity has flowed not from the small-scale operations of myriad tiny firms, but from the successful management of enormous enterprises.

Overall, these are two very well-produced volumes that any library should have. Together, they are perhaps a bit expensive for most individuals, but economists who wish to think more deeply about their discipline will want them on their shelves. Yet the essays cover a very wide range of topics far beyond economic theory, dealing with many of the fundamental issues in the social sciences, and have a much broader appeal.

Paul Ormerod is chairman, Post-Orthodox Economics.