Capitalism and Freedom

The Cold War between state-sponsored Soviet socialism and the Western world’s capitalism ended in a decisive victory for the latter camp. As communism crumbled, politicians and intellectuals of all stripes reached a similar verdict: liberal-democratic capitalism was the only game in town. As Margaret Thatcher famously put it, “there is no alternative.”

That’s a view which has been increasingly challenged in the decade since the 2008 financial crash. In the US, self-declared “democratic socialist” Bernie Sanders is one of the frontrunners to lead the Democratic party into the 2020 presidential election. On Amazon, books with titles like Communism for Kids meanwhile race up the bestseller lists. The idea that the state can and should play a role in the economic life of our societies is back in fashion.

All that would have worried Milton Friedman, one of the twentieth-century economists most closely associated with the argument that economic freedom is the only guarantor of political liberty. As he saw it, the road to hell really is paved with good intentions. What starts out as a promise to redress market imbalances ends up aiding monopolies, undermining living standards and – paradoxically – increasing inequality.

Was he right? Well, that’s something you’ll have to decide for yourself as you read these blinks. Along the way, you’ll learn

• why government spending doesn’t necessarily lead to economic growth;
• how a negative income tax could boost social welfare; and
• why basic education benefits society as a whole but university education doesn’t.

Economics and politics are often taught as separate subjects in school. We typically learn that economics is about material well-being, while politics is about individual freedom. Follow that approach to its logical conclusion and you soon end up with the idea that any political system can be combined with any economic system.

But that’s a mistake. In reality, you can’t mix the state-led socialist economy of the Soviet Union with the individual political freedoms of the US to create a kind of “democratic socialist” society. Why not? Well, economic and political freedoms are actually interdependent and, if you curtail the former, you also limit the latter.

Imagine a hypothetical British holidaymaker in the aftermath of the Second World War set on taking a vacation in the US. As he goes about booking his travel, he realizes he can’t afford the trip, because the government’s capital controls mean that sterling is undervalued relative to the dollar.

Now compare that to the case of an American citizen who isn’t allowed to visit the Soviet Union because she holds pro-capitalist views. In both cases, restrictions on economic and political freedoms have the same result: they prevent individuals freely pursuing their own dreams and destinies.

That means you need a system that guarantees both the economic and political liberties we need to thrive. That system is called free-market capitalism. Let’s take a closer look at how it works in practice.

The most important point is that the government’s role in this ideal society is strictly limited. Its purpose is to guarantee basic law and order rather than infringe upon our individual freedoms. Think of it as setting the rules of the game. Buying and selling is a basic economic freedom, and we’re at liberty to use it as we please. The government, on the other hand, has only one job: to enforce individuals’ property rights and protect them against theft and extortion.

When governments restrict themselves to this role, the free market can take care of the rest – how people want to live their lives, what they want to buy and sell and, ultimately, who they want to be.

You’ve probably heard politicians arguing that the government needs to intervene in the economy to ensure that it functions properly. You might also have come across the notion that free-market capitalism is inherently unstable and causes financial crises when it’s left to its own devices. Both ideas are popular among advocates of big government, but they’re rooted in bad economics.

To understand why, we have to look at where they came from. In the aftermath of the Great Depression, a new consensus emerged. Economists began arguing that boosting government expenditure with an eye to correcting market contractions was the best way of promoting stability. At its most basic, this boils down to a theory promoted by the British economist John Maynard Keynes that every dollar of government spending creates another dollar of increased wealth for private individuals.

That’s known as the Keynesian balancing wheel of government spending. There’s just one problem: it doesn’t work in the way it’s supposed to. When private spending decreases, Keynes’ followers claim, the government needs to step in and do their own spending to maintain economic balance. In the real world, however, these programs inevitably take too long to roll out and lead to all kinds of unintended consequences.

Drawing down such programs, for example, usually takes just as much time as it did to get them up and running. That means that they’re still in place even after the economy has recovered and people are being taxed to cover a useless policy, thereby sucking value out of the economy.

That’s a typical example of the ability of Keynesian economics to solve problems in theory that it can’t tackle in reality. The theory just isn’t capable of creating the conditions for its own success. Take the argument that government spending boosts individuals’ spending. The behavior of large groups of people is so complex that it’s impossible to accurately forecast their actions. Evidence from the Great Depression meanwhile suggests that lots of folks responded to such policies by saving rather than spending money!

Spending isn’t the only way governments intervene in markets – there’s also monetary policy. The outcome, however, is the same: the more governments intervene in economic life, the worse the results.

Take the Great Depression. The severity of the crisis was amplified by the government’s mismanagement of the money supply via the Federal Reserve, the US central bank. Between July 1929 and March 1933, the money supply dropped by a third. The Federal Reserve, which had a free hand in making policy, actively decided to do nothing. That error transformed what would have been a minor contraction into a full-blown crisis.

So what should the Federal Reserve have done? If it had stuck to a much more narrowly defined and specific role – simply maintaining the money supply – the Depression wouldn’t have been nearly as severe. Instead, incomes were halved and prices plummeted by over thirty percent between 1929 and 1933.

That means it’s vital to restrict the Federal Reserve’s role in future to prevent repeats of such crises. Rather than giving a small number of bureaucrats the power to determine monetary policy as they see fit, the central government’s role in economic life should be limited to expanding the monetary supply by a fixed, predictable amount each year.

That would prevent governmental interference in markets and curtail state lending and investment, thus eliminating the instability caused by the government’s intervention in the economy. A reasonable target would be a 3 to 5 percent expansion annually – a small but ultimately positive amount that should be permanently fixed.

Most people agree that governments have a legitimate role to play in education. While it’s true that state education provides society with a productive labor force, governments should restrict their focus to “K-12” schooling – education from kindergarten to twelfth grade.

Why? Well, that’s where the neighborhood effect comes in. That’s a way of describing how individual actions affect other people regardless of whether they’ve consented or not. This can be positive or negative. In the case of K-12 schooling, the neighborhood effect is clear: an educated society benefits everyone to a much greater extent than living in an uneducated society. If people couldn’t read, write or do basic arithmetic, social life as we know it would break down.

But once you progress beyond the last year of high school, education becomes much more niche and the neighborhood effect no longer applies. At that point, the government should cease to play an active role in education. If, say, someone receives a PhD in a subject like particle physics, it’s no longer clear that this directly benefits society in the same way that basic literacy does. In fact, it mainly helps the individual holder of the degree. It’s hard to justify why the government should tax everyone to fund such educational programs.

That said, governments also need to reform the way they cover the costs of K-12 schooling. Currently, children are forced to attend local schools that are maintained and run with funds raised through direct taxation. A better way of doing things would be to create a voucher system in which every family receives an allotted amount of money per child which they could use to pay for a school of their choice.

This would force schools to compete with one another in the marketplace rather than relying on government subsidies. That wouldn’t just improve efficiency and drive down costs but also create better curricula. Currently, governments determine what children learn, but while there’s plenty of consensus about what young kids should be learning, it isn’t nearly as clear what teenagers ought to study.

In a market system, this would be determined by the needs of communities. Schools with the best-suited curricula would attract more students and thereby set a new market standard, which other schools would then follow.

Monopolies emerge when companies gain so much control over a given product or service that they can determine the price at which it’s sold rather than the free market. That makes monopolies the ultimate enemy of economic freedom. So how do they arise?

The root of the problem is the absence of competition in markets. But let’s define our terms here. In a free-market capitalist economy, “competition” isn’t about mindless rivalry, that is, the desire to beat opponents or drive them out of the market. Rather, it’s about the number of alternatives in economic life. A healthy, competitive economy is one in which individuals have numerous choices about which goods and services they wish to voluntarily exchange.

Right, now that we’ve clarified what we mean by competition, let’s take a closer look at monopolies. They generally arise in one of two ways.

First off, there are monopolies caused by technical limitations. This covers situations in which having multiple companies in one sector is simply impractical. Think of water or electricity services, for example. It just isn’t feasible for competing companies to lay their own pipes or cables under every city.

These monopolies may be inevitable, but that doesn’t mean they should be run by the government. In fact, it’s better if they’re managed by unregulated, private sector companies. That’s because government monopolies are much less accountable when they don’t play by the rules. No wonder – they’re backed up by state power!

Distortionary government assistance like tariffs can also lead to the emergence of monopolies. Take steel tariffs. If a government sets a tariff on foreign steel imports, it eliminates competition in the steel industry as a whole. That creates the perfect conditions for monopolies to develop. The absence of competition meanwhile leads to private collusion as multiple providers join forces to set the price of goods and services.

If the US implemented tariffs on foreign steel, US steel manufacturers would only have to collude with one another rather than with their global counterparts. That would substantially lower the bar on monopolistic behavior.

In the societies of the past, people were born into a class or caste that determined what kind of work they could do. That meant that it was virtually impossible to earn large amounts of money. Capitalist society is different. Anyone can do any job they please. As a result, people have access to much higher potential incomes. This creates the conditions for social mobility and a wealth of opportunities – features unique to capitalist societies.

But if people are to be truly free when it comes to choosing their occupations – and destinies – the government needs to stop policing and redistributing incomes. After all, there’s a good reason why some jobs are more handsomely rewarded than others. Folks who work in difficult or unappealing jobs deserve to be paid more than those in cushier positions. When the government regulates incomes, fewer people will want to do these difficult jobs, causing labor shortages in various economic sectors.

So what’s the alternative to such intervention? Well, a good start would be to abolish progressive income taxation and replace it with a flat rate system. The redistribution of wealth through progressive taxes is designed to reduce income inequality and unequal living standards. But here’s the issue: it’s based on a misunderstanding of “equality.”

Income redistribution only affects equality of outcome, that is, the size of your paycheck. A genuinely free society, by contrast, emphasizes equality of opportunity, or our equal ability to make something of ourselves through hard work. Redistribution privileges one social group – in this case, the less well-off – over others, and leads to inequality of opportunity. The second upshot of such a policy is that it disincentivizes people who work in difficult, well-paid jobs, thereby undermining innovation.

A flat rate system would do away with these problems. Everyone would pay a fixed portion of their income to the government. That wouldn’t just redress inequalities of opportunity – it would likely boost government revenues as it would eliminate the complicated system of loopholes typical of progressive income tax codes.

Social welfare programs invariably claim to reduce inequality. Time and again, however, they fail in their stated objectives and actually end up making society less egalitarian.

Take public housing. Run by an inefficient bureaucracy rather than efficiency maximizing market forces, public housing programs not only reduce the overall supply of housing, but confine poor people to a small number of dangerous neighborhoods.

But that’s not even the worst of it. Social security policies that force people to pay for old age insurance throughout their lives are even more damaging. Why? Two key points stand out. First off, it’s essentially a redistributive tax, since wealthy people will contribute more in absolute terms over the course of their lives. Secondly, it’s extremely paternalistic in its assumption that people can’t be trusted to save enough money for retirement on their own.

Both of these factors make such policies unacceptable for freedom-loving capitalists. Rational adults shouldn’t be treated like children who can’t take care of their own interests!

That means that it’s time for governments to scrap these inefficient, taxpayer-funded welfare programs. They should be replaced with a negative income tax to help reduce the burden on the poorest members of society.

Here’s how it would work. All government welfare schemes would be abolished. Anyone who failed to earn a minimum level of income would instead receive a direct cash payment from the government. This would alleviate poverty in the most efficient way possible, since it would streamline government and do away with the need for expensive bureaucratic departments to oversee welfare programs. Taxpayers, meanwhile, wouldn’t need to pay nearly as much of their income into the system, thereby increasing the productive circulation of money in the economy.

It’s also important to remember that rolling back the state wouldn’t leave a vacuum – after all, there are charities and philanthropists. In fact, privately run charities subject to market pressures are often much more effective and agile in providing help than slow and inefficient government departments.

Most importantly, allowing individuals to choose how they spend their excess income would preserve their individual freedom – something that egalitarian, progressive income taxation systems simply can’t do.

The key message in these blinks:

Milton Friedman’s classic text on economic and political liberty is premised on the idea that society has become overly fixated on egalitarianism and that this has undermined freedom. Expensive and cumbersome governmental attempts to intervene in the economy and redistribute resources, he argues, aren’t just extraordinarily wasteful – they also lead to all sorts of unintended outcomes. Restraining the state and giving people more choice, Friedman concludes, will ultimately produce the best outcomes: economic stability, individual liberty and protections for the least well-off that actually work.

What to read next: Free to Choose, by Milton Friedman

In these blinks, we’ve explored Milton Friedman’s understanding of liberty at the macro level of government policy, but he was just as concerned with the micro level: individuals. So, if you’re fascinated by Friedman’s reflections on freedom, why not take a look at Free to Choose, his study of the relationship between individuals’ economic choices and self-interest.