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A Manifesto

January 25, 2010 Leave a comment

I would like to elaborate on the statement I made earlier about my faith in the free market and to add some context regarding the relationship between economics and public policy.  I will begin with a brief history of economic thought.

In 1776,  modern economics was born with the publication of Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations.”  It is important to note that the global classical liberal movement had been going on for over a century and was already coming to fruition in the colonies that same year.  The conclusion of this work is best summed up in the famous “invisible hand” quote:

“…by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

This idea that people who are all pursuing their individual interests should end up pursuing their collective interests by sheer accident and with no explicit coordination or compulsion was (and still is) astonishing and ultimately toppled the prevailing economic paradigm that had gripped Europe for three-hundred years.  Following Smith, the study of economics became highly mathematical.  Instead of making 900 page verbal descriptions of the way markets work and what their outcomes are likely to be, economists began to use models to make concise and precise statements about these topics.   This allowed the concept of efficiency to be brought to bear and for a long time economic research continued to lend more and more credence to the idea that free markets are desirable.  In almost every model (with notable exceptions such as monopoly and common property) when left alone people reach an efficient outcome.  Over time, the main argument in favor of personal freedom became that it leads to efficient economic outcomes. 

Now the nice thing about models is that they allow us to create a controlled and simplified version of reality in which to do thought experiments.  The problem with models is that they are a controlled and simplified version of reality.  In other words, they rely heavily on the assumptions that go into them to begin with.  For instance the competitive model assumes that people have perfect information about all products and prices, that there are no transaction costs, and that property rights are well established.  While these models are tremendously helpful in illustrating certain concepts like Smith’s invisible hand, they are not capable of proving that in the real world every outcome is efficient with free markets.   The annoying problem with this is that people will go around observing things that they assume aren’t efficient and claim the model can’t be right (which remember is true).  But the dangerous problem with it is that once we accept the results of economic models as the basis for political philosophies, nearly any position can be supported by coming up with some set of assumptions that lead to the intended outcome.

The recent trend in economics is to use models with certain assumptions that can be called more realistic than those of classical economics and which usually require additional unrealistic abstractions.  Quite often, the result of this is that free markets lead to inefficient outcomes.  This has prompted Joseph Stiglitz to remark in 2001 that:

“The set of ideas that I will present here undermined Smith’s theory and the view of the role of government that rested on it.  They have suggested that the reason that the hand may be invisible is that it is simply not there–or at least if it is there, it is palsied.”

Now, lest I be misunderstood, let me say that I don’t mean to imply that this type of economic inquiry is an intentional attempt to further a particular political view over another.  Nor do I intend to imply that it is not a worthwhile area of intellectual pursuit.  In fact it is the area that I have chosen to pursue and I think it is very interesting and provides much insight into the way markets work.  But we shouldn’t be surprised that it is possible for free markets to be inefficient.  But consider the standard we are applying to freedom here.  If it isn’t logically guaranteed to lead to an outcome that is as good as it can possibly be, we’re ready to give it up and fly to other ills we know not of?  In most models the claim that the free market is inefficient is made in comparison to a situation in which all decisions are made by an omnipotent, omniscient and benevolent central authority.  Is that assumption more realistic than perfect information?  Becoming a slave do we say that we end the heartache and the thousand natural shocks that flesh is heir to?

The mistake that (classical)  liberals made was basing their entire argument on the perfection with which it is supported by abstract models of the economy.  Eventually we need to reestablish our value of freedom for freedom’s sake.  We need to be willing to say that we prefer freedom even if it doesn’t always lead to the ideal economic outcome.  We are willing to sacrifice some amount of economic efficiency in oder to be free.  The men who fought and died for America’s independence didn’t do so because they had read Adam Smith and were convinced that they would make more money if they had freer markets (or because the king wasn’t doing enough to create jobs…).  The plaque on the statue of liberty doesn’t say “bring me your huddled masses yearning for efficient markets.  Anyone who’s desire to be free is predicated on the perfection of the associated economic equilibrium is born to be a slave and we will not win them over.  After this is established we can say some things about what we believe to be fundamental concepts which bode well for the economics of freedom.  In this spirit I will outline the basic argument underlying my faith in the free market.

1. People will do what is most rewarding for them.  Rewards may take many forms.  It may be rewarding to work for the benefit of others or one’s country or sovereign etc.  One important form of reward is personal material gain (note that personal material gain can be redirected at the owner’s discretion).

2. People are creative.  People try to find ways to make their lives better and frequently find ways that have not hitherto been discovered.

3. By definition, an inefficient outcome leaves mutual benefits on the table.  If people could find a way to coordinate, someone could become better off without hurting anyone else.

4. With appropriate property rights, if deadweight losses are sufficiently large people will go to great lengths to find ways to capture them because they will get to keep some of the savings.  This will severely limit the extent of losses.  All deadweight losses are due to informational or incentive problems.  If these are large it will pay to find ways to solve them which will be possible provided that there is good contract law.  Someone who comes up with a more economically efficient way of organizing a market or carrying out a transaction will likely be able to capture some of the recovered gains.   This will incentivize people to work on their own to collaborate in pursuit of efficiency.

With these things in mind, it is difficult for me to imagine freedom leading to any kind of predictable economic catastrophe.  Furthermore, I believe a free market with well protected property rights (including contract law) will function much better than any other kind.  It’s not a proof but such an unqualified proof is not possible so lovers of freedom would do well to not make their arguments depend on it.

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