Fake Money, Fake Knowledge

How Coercion Corrupts the Price System

The market is a system for testing truth. Prices are claims about the reality of supply and demand, and the market is the means for testing the truth of those claims: those who profit are those whose claims were proven true, while the claims of those who suffer loss were false. At least, that is the intended purpose of the market, and of money. How do we know this? To answer this, we first must understand what money is, and for this task we will lean on F.A. Hayek’s key insights into money and the price system. So, what is money?

Money is a system for transmitting information, according to F.A. Hayek. Prices are a distributed means for consolidating and expressing information about changes in scarcity, supply of, or demand for a good which serves to coordinate human action. In his essay, “The Use of Knowledge in Society,” Hayek discusses the problem inherent in constructing a rational economic order. Specifically, he describes the knowledge necessary to act on economic issues to be tacit, local, and dispersed among many individuals, and because of the nature of the information—that it changes moment to moment—any attempt to consolidate information in a central authority creates inefficiencies. He tells us that prices are a decentralized system that conveys information to all actors within the market.

Hayek discusses how all the seemingly infinite pieces of information regarding a product and the variables relating to its supply and demand are compressed and expressed through prices:

“The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.”

Though we can’t help to think that in the more-than-a-metaphor of engineers watching the hands of a few dials, that those dials are measuring something particular to the system. It could be engine temperature, air pressure, fluid levels, any number of things, but those dials don’t just convey any information, they convey information relevant to the engineer, and to the system with which he is working so that he may act to maintain the system and keep it running.

As with the dials, it seems there should be particular information that money should convey. Hayek does not make this explicit, but the idea he has in mind seems to be that money should relay information relating to supply and demand of the good or service in question.

What seems to be just at the cusp of Hayek’s idea, or perhaps an implicit assumption, is that the mechanism that makes the price system function effectively is feedback in the form of profit and loss. Hayek’s successors Israel Kirzner, and Murray Rothbard both make this explicit, as does his mentor Ludwig von Mises. Mises wrote in Human Action that “profit and loss are the instruments by means of which consumers pass control of production into the hands of those who serve them best at the lowest cost.” All of these ideas, building from Hayek, point to the market as a price system that communicates knowledge, and self-corrects by giving positive feedback (profit) to contributors of information that is accurate, and negative feedback (loss) to contributors of information that is inaccurate.

Taken together, we see the price system as one that both communicates information, and also filters it, generating an output of truth, or reality. When an entrepreneur adjusts prices or makes purchases based on information that is untrue, or not aligned with the realities of supply and demand, he suffers a loss, whereas when his actions are aligned with the realities of supply and demand, he profits. This feedback is essential for the price system to function properly.

In other words, the price system improves knowledge because it attaches consequences to claims about reality. So we should understand money, or the price system, as an epistemic discovery system that utilizes consequence to self-correct toward real conditions. It is a decentralized means for discovering truth, truth being real preferences of people, real demands, and real supply constraints.

But what about instances when the price system seems to detach from reality? The Tulip Mania seems the perfect example: from 1634 tulip bulb prices began rising, peaking in a mania in 1637, with single tulip bulbs selling for prices equivalent to luxury houses. Doesn’t this prove the price system doesn’t generate truth as its output, or knowledge based in reality, but instead captures sentiment, or worse, is manipulated or controlled by the whims of those with large sums of wealth?

This seems to get at the heart of what the price system is, once again. If the price system were not a discovery process, and true value, or real supply constraints or future consumer demand was known, there would be no need for speculation, and no need for anyone to ever lose. But it is unknown, and cannot be known until discovered, and the means for discovery of these truths is through trial and error in the price system. In the short term, prices can disconnect from reality—but if it is so clearly disconnected from reality, then you, or any other actor in the market, can make money by short-selling it. But for most people, it is only obvious in hindsight—because we don’t know, and can only be certain after the price system has filtered truth and we are looking at it after the fact.

In another sense, the price system did convey truth in the moment, but it was not a lasting truth: demand for tulip bulbs was high, and they were scarce, especially those affected by the mosaic virus at the time. If the mosaic virus had wiped out the entire population of a particular variety of tulip, and you held the only bulb remaining, what would it be worth? Would we still be looking back and making fun of people paying so much money for tulip bulbs? Did the price system prevent the potential extinction of a variety of plant? I don’t know, and I certainly won’t argue that’s the case, but that is the whole point: we don’t know.

In our previous essay, “The World Is Fake, By Our Design,” we discussed how people earn money, or create value by operating in reality, or are producing value in relation to reality. While other means of acquiring money exist that do not require this production of value, these alternate means corrupt value itself. In a world where money must be earned through value creation and not other means, every purchase or sale in the market reflects information about people’s valuations of different goods and services (demand), relative to the productive value their work generates. If people assess something incorrectly, they suffer a loss, yet if their assessment of the value of goods and services is accurate, they profit. In this way, people are in a sense voting on what they believe is valuable or invaluable, or what they need or want, and over time, the price system aligns towards truth, and it seems what is truly valuable endures.

So where does fake knowledge play into all of this?

There is a type of information, or knowledge, that can be introduced into the price system that is neither “true” nor “false” in the sense we have described above. Let us call it fake information, or fake knowledge. And because the price system’s filter handle’s only information of a certain type, this fake information bypasses the filter and wreaks havoc on the system. Where does this fake knowledge come from?

When a government restricts ownership of a resource, or through legislation and coercive means causes some other affect on supply or demand that does not exist in reality, prices react to it. This transmits information to other actors in the market, and so perhaps we would say the money is still working, still transmitting information. But in truth there is a problem when “knowledge” is no longer discovered, but instead is created, and injected into the price system. The problem with created knowledge is threefold: the truth of it—that it will be enforced—is known with certainty before it is tested by the price system, it carries no risk of loss, and it still rewards knowers of the knowledge with profit. Why are these issues?

The creation of knowledge misaligns incentives within the price system. Discovering knowledge is difficult, costly, and risky, but creating knowledge is none of these. The price system changes from a system of who can discover the most knowledge to who can create the most knowledge, and created knowledge can only exist through coercive imposition. It changes the game from one of who can benefit the system and everyone in it the most, to who can seize power and impose the most inefficiency and constraints on the system.

Maybe we are thinking, how do we know that created knowledge exists only through coercive imposition? How do we know that coercive knowledge is always inefficient? Fake knowledge is information whose truth is guaranteed by coercion rather than tested by consequence in reality. To better understand what fake knowledge is, and how it comes about, we will explore a military example.

Imagine you are a platoon leader responsible for 9 vehicles. You secure them with keys, and label each key with a keytag corresponding to the bumper number of each vehicle. The vehicle bumper numbers are A11, A12, A13—through A19, and now the keytags are labeled accordingly.

So where is this fake knowledge we are speaking of? Well, the Company keymaster inspects the keys and informs you that your labeling is incorrect, and that the keys must be relabeled using the numbers 1 – 100, in order. So you remove the previous labels, and label the keys as you are ordered to do: Key “1” corresponds to “A11,” Key 2, to “A12,” and so on. This is one layer of fake knowledge. Now, if someone unfamiliar comes upon the keys and vehicles, he must first learn that key 1 belongs to “A11” and so on, or consult the keymaster every time.

But there is no need for the layers of fake knowledge to stop here. The Battalion keymaster imposes another standard: the keys must now be labeled alphabetically. Now we have keys labeled A – Z, in order, and the Battalion keymaster knows that Key A corresponds to key 1, Key B corresponds to Key 2, and so on. So if someone needs to know how to unlock vehicle A11, they find key A, ask the Battalion keymaster which key “A” references, and learn it references key 1, then they find and ask the company keymaster which vehicle key 1 references, and learn it references A11. We have added another layer of fake knowledge. This creation of fake knowledge can be done ad infinitum.

What is going on here? The original intuitive labeling A11 → A11 minimizes translation cost. The first imposed numerical labeling introduces friction, the second imposed alphabetical labeling introduces more friction, yet within the imposed system, knowing the translation layers becomes valuable. In other words, value detaches from reality; the inefficiency—the fake knowledge—becomes valuable, and he who knows it, becomes valuable, creating further incentive for individuals to create more layers of fake knowledge so that they can know it, and become more valuable themselves, compounding the dysfunction of the system. But it is only valuable so long as coercive authority forces navigation of it.

We already see this affect in play throughout our modern day lives. The IRS tax code is thousands of pages, expanding into tens of thousands when interpretations and case law are included. In education and healthcare, the number of administrators has far outpaced their intended purposes of healing and educating. As regulation and bureaucracy expand, so too does the economic value of those who can interpret and navigate them. Once again, the mastery of navigating imposed architecture becomes more profitable than improving the underlying product or service.

To be clear, I’m not claiming that fake knowledge is not functionally important within the system we are operating, on the contrary, it is vitally important, it is just arbitrary and inefficient, and because of this, would cease to exist as functional knowledge within a system if left up to voluntary means.

So what does this mean for the price system?

Let us recall that we described the price system as a decentralized epistemic discovery system that utilizes consequence in the form of profit and loss to self-correct toward real conditions. True information is profitable, and false information is unprofitable. What are the implications of the existence of fake (but “true”) information that can be infinitely created, to the integrity of an epistemic discovery system that rewards true information?

As Charlie Munger says, show me the incentive, and I’ll show you the behavior. In the case of the price system and of fake information, we have an incentive to create infinite fake information to profit from in the price system, without ever exposing ourselves to downside risk (loss), because the information is manufactured and enforced through coercive means, so must be true. The best entrepreneurs are no longer incentivized to increase efficiency of production and provision of value to customers. On the contrary, the best entrepreneurs are incentivized to add layers of fake information to the system which decreases efficiency, but guarantees profit. And why take risk if you do not have to? Most importantly, if you take risk in a competitive market when you don’t have to, you will lose to those who do not take risk; the only companies that will endure are those which are the best at operating within the system, in this case, those who create the most fake information. The greater the share of coercively manufactured signals, the more the incentive shifts toward distortion-navigation, and the more detached value becomes from reality.

We may be inclined to argue that legislation sometimes corrects distortions rather than creates them. The necessity for legislative intervention to correct distortions is a separate debate. The point here is that whenever the creators of price-affecting policy create “fake knowledge,” they distort the epistemic price system’s grounding in reality.

So with the inclusion of fake knowledge we have a price system that incentivizes inefficiency and coercion, not good service and efficient products for customers. Fake knowledge can only exist through coercive means, and those coercive means guarantee its profitability rather than testing its accuracy, removing downside risk from actors within the price system. The removal of downside risk in the price system prevents it from self-correcting towards true knowledge (real efficiency, and real customer preferences). Coercion alters the incentive structure of the price system, shifting it away from discovery and toward creation and navigation of imposed constraints. Voluntary systems, on the other hand, optimize for survival under consequence, which tends to align with reality.

In Hayek’s described system, you have a decentralized knowledge database that contains a feedback system that is self-correcting toward reality and truth. In a price system with any central control, you create a feedback system that only compounds its dysfunction by further incentivizing it, providing financial reward for creating fake knowledge instead of for contributing real value to a real pool of meaning. The question at hand seems to be: should profit be earned through discovering reality or by creating and navigating artificial constraints?