By Edward Zelinsky
Public pension plans should not invest in private equity deals. These deals lack both transparency and the discipline of market forces. Private equity investments allow elected officials to assume unrealistically high rates of return for public pension plans and to make correspondingly low contributions to such plans. This is a recipe for inadequately funded pensions, an outcome good for neither public employees nor taxpayers.
Ben Bernanke. Source: United States Federal Reserve.
Testifying recently before the House Committee on Financial Services, Federal Reserve Chairman Ben Bernanke confirmed that short-term interest rates will effectively be kept at zero for the near future. This comes as no surprise to the millions of Americans who today receive nonexistent returns on their passbook savings and money market accounts.
In this low return environment, public defined benefit pension plans generally assume that they can earn annual investment returns in the vicinity of 8%. Such aggressive return assumptions allow governors and legislators to authorize smaller tax-financed contributions to such public pensions on the theory that anticipated investment gains will fund the retirement benefits promised to public employees.
A primary defense of this practice is that plans’ assumptions should reflect long-term experience. From this vantage, the current low interest rate environment is an historic anomaly. For the long run, the argument goes, public pension plans will earn higher returns.
Whatever the theoretical merits of this approach, it is troubling in practice, an invitation to push into the future the problem of inadequately funded public pension plans. That problem exists today and needs to be confronted today, as the Baby Boomer cohort retires in unprecedented numbers and places corresponding demands on public and private retirement plans.
A second defense of high assumed rates of return is that public pension plans can earn aggressive gains through so-called “alternative” investments such as private equity partnerships. Publicity about Mitt Romney’s IRA has focused attention on the often lucrative results obtained by at least some private equity investors. Many public pension plans have effectively become addicted to private equity deals and their promises of outsized investment returns.
It is, however, doubtful that these promised returns are generally obtained by the private equity industry or that such returns are obtained on the scale sought by public pension plans. Private equity is, by definition, private. Much of the good news we hear about this industry comes from the industry itself. Since there are no active markets for these investments, investors in private equity deals are ultimately dependent upon valuations by the sponsors of these deals.
In a recent paper, Professor K.J. Martijn Cremers of the Yale School of Management concluded that private equity investors have in the last 10 years done no better than investors in the stock market. Others, such as Professor Steven Kaplan of th
Adrian Vermeule is John H. Watson Professor of Law, Harvard Law School. His book Law and the Limits of Reason is now available. He has also written, Mechanisms of Democracy: Institutional Design Writ Small (2007) and Terror in the Balance: Security, Liberty and the Courts, co-authored 
with Eric A. Posner (2007). In the post below Vermeule looks at F. A. Hayek.
In the current economic crisis, a small group of unelected bureaucrats effectively sets policy. The group includes Henry Paulson, the treasury secretary, and Ben Bernanke, the chair of the federal reserve. Is it desirable for major questions of economic policy to be decided by a small group of people? Indeed, many observers think that Bernanke has consistently followed Paulson’s lead. On this view, national economic policy is in effect set by a single person. Is this acceptable? And what are the alternatives?
These questions are addressed in one of the most widely-praised articles of the twentieth century: “The Use of Knowledge in Society,” published by F.A. Hayek in 1945. Hayek argues that the “economic calculus” of the marginalist economists does not provide an answer to the “economic problem of society.” The basic problem, Hayek argues, is that “the data from which the economic calculus starts are never for the whole society given to a single mind which could work out the implications and can never be so given” (emphasis added; internal quotation marks omitted). Because society’s problem is to “utiliz[e] … knowledge which is not given to anyone in its totality,” there is a problem with centralized planning, defined as planning “by one authority for the whole economic system” - what Hayek repeatedly refers to as “the planner.” As against this, Hayek favors “decentralized planning by many separate persons.” The key consideration is whether it is feasible to “put at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals.” Hayek thinks it is not feasible, so that competition and the price system are indispensable. The “single mind” of “the planner” cannot account for the tacit knowledge, and knowledge of local conditions changing over time, that the price system automatically takes into account.
Yet who were the theorists who believed the contrary? The article does not identify even one. Although it is true that some socialist economists spoke of “the central planner,” or of a centralized computation of resource allocation, this was mostly a methodological shorthand, not a serious claim. There is a reason for the straw-man quality of Hayek’s argument: neither socialist economists nor democratic theorists commonly believe that “the planner” or a “single mind” will make laws or choose policies - not even if that single mind is some sort of huge, personified leviathan-mind. Leaving aside the socialists as of mainly historical interest, let us focus on the democratic theorists. A large and important subset of these are themselves in the business of figuring out how a collective group of minds can best use their multiple perspectives and private information. These democratic theorists see the epistemic virtues of democracy precisely in the fact that democracy organizes and draws upon the information and insights held by the collective, through some mix of deliberation or voting or both. The Marquis de Condorcet’s famous Jury Theorem underscored that under well-defined conditions a group whose average competence is better than random will be more likely to make accurate decisions, through majority voting, than will even the single best mind in the group. John Dewey saw democracy as the application of “organized intelligence” to public matters, through free inquiry and common deliberation. Likewise, the pre-eminent critic of parliamentary democracy, Carl Schmitt, captured the classical democratic view perfectly when he described democratic parliaments as “the place in which particles of reason that are strewn unequally among human beings gather themselves and bring public power under their control.” In this picture — held in common by Condorcet and Dewey, democracy’s most optimistic proponents, and Schmitt, its most piercing critic — what democracy does, through both voting by citizens and lawmaking by elected representatives and specialized bureaucracies, is to aggregate information and reasoned argument into decisions superior to those a single mind would reach. Of course Condorcet and Dewey, not to mention Schmitt, disagree about many things, not least the role of deliberation in politics. Yet none of them suggests that laws or policies should be chosen by some “single mind”; indeed their view is exactly the contrary.
The basic problem with “The Use of Knowledge in Society” is what we might call the Hayek Fallacy: a false comparison between the aggregate product of many minds and the product of a single mind. Perhaps that comparison is relevant in special contexts, such as the question whether a judge or a jury should be responsible for the verdict. However, in a comparison between markets and either socialist or democratic lawmaking - the major comparison that concerned Hayek - the comparison is not relevant and Hayek’s argument is not relevant either. Hayek went astray by reifying or personifying “the planner” or the “single mind” who choo ses policies, and then overlooking that in any recognizably complex modern state, especially democratic states, policies are chosen by highly complex institutional structures and processes that themselves aggregate multiple sources of information. None of this is to say anything substantive about when or under what conditions collective or democratic policymaking will better aggregate and utilize dispersed information or tacit knowledge than the market will. It is to say that Hayek’s analysis cannot help us figure out those questions.
Versions or relatives of the Hayek Fallacy pop up in many other contexts. One important context is the comparison between lawmaking by common-law courts and lawmaking by legislatures. In the sharpest case for this comparison, the issue is whether a vague or ambiguous or highly general written constitution - like the United States Constitution - should be given content by judges deciding constitutional cases in common-law style over time, or rather by legislatures and presidents enacting laws and making rules to which the judges defer. Here the Hayek fallacy is to say that the aggregate wisdom of many judges over time, drawing when appropriate upon the aggregate wisdom of broader social traditions and norms, will outperform “the lawmaker,” whose epistemic capacities are inferior. The problem is that there is no such “lawmaker.” Rather there is a large modern legislature with many hundreds of members, who in turn draw upon the expertise of thousands of staff and upon information supplied by the bureaucracy, citizens, and interest groups. Moreover, the legislature can delegate, as appropriate, to a gigantic cadre of agencies who themselves use expert panels and citizen input to formulate policies. The litigation process might or might not outperform this massively complex, integrated lawmaking machine in constitutional matters, if we judge performance on the sort of epistemic or informational grounds Hayek favors. However, a comparison between the many minds of the judges, on the one hand, and some personified lawmaker, on the other, contributes nothing. In modern lawmaking, that comparison is never at issue.
Although I agree that the comparison between “one mind” and “the contributions of many minds” is a misleading way to frame the difference between market and political processes, Hayek’s goal with that comparison was to make the same point that you are: the question is how well various sets of institutions make use of knowledge in society. In his later work, he makes much more clear that the point at issue is precisely whether political processes do better or worse in general at making use of knowledge than do market processes.
What your argument above misses is Hayek’s lifelong emphasis on the relevance of the knowledge of time and place and tacit forms of knowing, each of which cut against your claim that the knowledge of experts enables political processes to overcome the Hayekian knowledge problem. This is exactly what Hayek denied, mostly because he believed that expert, articulable, knowledge was only a small part of what mattered for social coordination. Inarticulate knowledge was at least as important, and he argued that market processes were far superior at making such knowledge available to others via the price system than are political processes.
He might have been wrong about that, but your argument in the last paragraph is equally fallacious as a critique of Hayek because you overlook a key component of this thinking. And it’s one that, frankly, is in the article that you purport to be criticizing.