Why Free Markets Succeed and Governments Fail
by Michael S. Rozeff
by Michael S. Rozeff
New (or radical) liberals and private property anarchists affirm market success and government failure. Socialists affirm market failure and government success. Success at what? Success at creating value for individuals. Adam Smith called it the wealth of nations, but wealth is only a proxy measure of value and one that does not entirely get at the essentials of why free markets succeed.
Over 225 years later there is still disagreement over how to create value. Fortunately, some of the human race know how to create it without prompting from theorists and controlling from governments. Others, the socialists, don't. In modern-day America, they think that value is created by maintaining huge armed forces with hundreds of bases all over the world, invading other nations, monitoring everyone's communications, licensing television and radio stations and a hundred other occupations, taking from the haves and giving to the have-nots, forcing everyone to join a government health care plan, forcing everyone who works to pay a Social Security tax which is then given away to the elderly, taking property for private business projects, regulating the mileage of an automobile, forcing security markets to have a national price system, forcing toilets to be smaller and washing machines to be front-loading, paying farmers not to produce or paying them to produce, not producing or working the land if there is some strange insect or lizard living on it or if a stream flows through it, regulating trade, regulating interest rates, controlling money, etc., etc. Being as human as the next person, socialists have no end of ideas. Unfortunately, they are all bad.
Both sides cannot be correct. One side favors freedom of choice over private property (or capitalism). The other favors government control over private property (or socialism.) There is no mixed way, middle way, third or fourth way, because new liberals and socialists affirm opposing principles of freedom of choice over private property. As socialism waxes, free markets wane and vice versa. As free markets wane, value creation subsides.
Value creation and destruction in brief
The term "free markets" is shorthand for free and voluntary property exchanges of all sorts, private exchanges of private property that are neither coerced nor coerce others. Exchanges are also termed trades or transactions. It's basic economic logic that every such transaction is expected to bring greater value (or utility) to those on either side of the trade. The Toyota buyer expects to gain and so does the Toyota dealer. That's why they trade. It's by way of such value-creating trades that markets create value spontaneously and cooperatively.
The greater the personal valuation of an item is compared with its cost to the person, the more the value creation that has occurred. The amount of value creation is actually invisible and not measurable. Internet access may cost $360 a year, but it may be worth far more than that to a buyer. Since each person and only that person knows what something is worth to him, his actions help to determine and decide the value creation (along with the many other actions of manufacturers and other buyers who affect the price). He is the judge, and only he can be the appropriate judge. Socialists can't properly judge because they are clueless about personal valuations.
If markets do not produce something at all, like front-loading home washing machines or automobiles with six air bags, it is because most people do not value it more highly than what it costs them. They won't willingly buy it. If they must buy such a machine because that's all that manufacturers are allowed to make, some people will buy if its value is still higher than its cost. But the excess of their personal valuation over the price paid will be reduced. The regulation acts like a tax. Or it acts like a tie-in sale: you must buy washing capacity tied in with front-loading and unloading that you don't want. There will be invisible value destruction because front-loading is not worth as much to the buyers as top-loading. Other people may use the old top-loading machines longer, replace the tubs and motors, or buy a second-hand machine. Value is again being destroyed compared with simply buying a new top-loading machine. More or less the same type of analysis applies to all socialist meddling in free markets.
The term "government" is shorthand for an organization that intrudes upon free and voluntary exchanges. It coerces individuals. It interferes with trades and transactions: limits them, or stops them altogether, or taxes them, or regulates them. Governments trench upon private exchanges and private property, interrupting cooperation and trade. It's by way of such forceful intrusions that governments destroy value. (This raises a question not addressed here: If governments are destructive, why do we have them and why have they grown over time?)
It is obvious that a government is not set up to work as individuals work, to produce food or clothing or shelter or health care. It's nothing like a business. It's set up mainly to pass laws.
Rozeff's law of organizational growth is that organizations by and large do what they are set up to do and try to do more of it. Businesses produce and sell, and usually try to grow and do more. Charities distribute wealth and usually try to do more. Art museums display art (they claim) and usually try to accumulate more. Governments, financed by forced exactions called taxes, make laws and force people to live by them. Following Rozeff's law of organizational growth, they try to make more laws, use more force, and levy more taxes. Unfortunately, they succeed. We get more socialism, more value destruction, and less value creation. Theories don't get any simpler than this.
Fire and water don't mix
Free markets and government are polar opposites, not complements. Whereas market transactions involve freedom of choice over private property, government transactions involve the opposite, compulsion and control that seize private property. These two principles of human activity can no more have the same effects than do fire and water. If one principle succeeds, then the other must fail because they work in opposite ways.
One cannot mix these two methods of organizing human activity and expect something new and better to emerge. Mixing fire and water produces nothing but lifeless ashes. The idea that government is necessary for a free market to work, or that it helps a free market work, or that a mixed economy of free markets plus government is superior to a free market economy is, for all practical purposes, entirely faulty. If 99.9 percent of the government's laws were removed from the books today, this would end an enormous amount of government intrusion that destroys wealth. Value creation in free markets would rapidly accelerate. All that would remain would be laws against crimes. And Bruce Benson and others make the excellent case that there is no aspect of maintaining laws that has not in the past and cannot now or in the future be handled and handled better by a free people than a government.
Free markets and governments both operate under difficult circumstances that feature uncertainties about the future, what things people value, and how much they value them. Freedom of choice clearly doesn't mean perfection on earth. There are uncertainties about what things people really want and what they will give up to get them. There are uncertainties about how to produce what people want and what other competitors are now or might eventually produce. There are uncertainties about future prices, values, costs, profits and losses. Exchanges create value but in many cases people are feeling their way toward those exchanges that they expect will create value, and there are no roadmaps that list the routes, the rest stops, the gas stations, and the distances. And the nature of these exchanges often changes unceasingly. Collections of telephones or automobiles or computers or dresses, ice creams, and books show remarkable changes over time in what was exchanged.
Since there are always risks, uncertainties, limitations, and lack of knowledge, an individual who decides how to use his property can make an error. There can be a profit but also a loss. Toyota may beat out Chevrolet, which loses business. The internet may deliver a movie, not the local theater which loses business. A restaurant meal may disappoint, and the consumer loses. A computer may crash minutes after the warranty expires. No one wants or likes losses.
The individual who decides matters bears the responsibility for the outcomes. Accountability for the decision falls on the decision-maker. Since the result of a choice can be a gain or a loss and since gains are preferable, each buyer and seller has an incentive to choose transactions that amplify the gains and diminish the losses. Do distant socialists in government exercise the same care? Are they even capable of exercising such care? No and no.
Because each person decides many matters, the individual experiences the outcomes of his decisions, and experience is the best teacher. One learns what sells or doesn't, where to buy and where not to, what to buy and what not to, what to invest in and what not to, etc. One learns how to create value, not lose it.
Learning to create value
Precisely how each of us works out our value creation is not possible to say. I might guess that each individual has an incentive to investigate, to learn, and to take care, but overdoing any of these can be counterproductive. I might say that waste, haste, and misinformation create losses, and maybe they usually do. But speed, adaptability and responsiveness can pay off. What seems to be misinformation can turn into serendipity. What looks like waste may have long-run payoffs. A reasonable generalization might be that faulty judgment, errors, and lack of foresight bring losses, while accurate judgment and foresight bring gains. In any event, freedom of choice is a necessary condition for individuals to feel and think their way toward that set of characteristics or behaviors that bring them gains and avoid losses. They cannot do this if their choices are controlled by others.
We look around and what do we see? One man relies on what his parents taught him. Another reads a book. Others use trial and error. Still others believe in research, prayer, imitation, inspiration, science, or art. Some listen to friends or their mates. Some believe in government. No one knows all the answers or even knows where to go to find them. No one knows all the questions. No one has a lock on the characteristics or information or procedures that create success. Book after book after book is written, each providing new keys. The dimensionality of the issues involved in creating value is infinite. Nevertheless, we do it. We create value.
Why are free markets better than governments at creating value? Here's another reason. Free markets are dispersed markets in which, under uncertainty, different people try many different ways to create value using both local information they possess and global information that they glean from the activities of others. These trials have some degree of independence from each other. This has a social benefit. It creates a beneficial diversification effect that operates in insurance-like fashion. Furthermore, losing trials are quickly terminated. But winning trials can be extended over the whole society to enhance value creation.
We cannot analyze the particular pathways inside each person by which freedom of choice over private property encourages them to amplify gains and discourages them from making losses. Every life is a series of experiments in creating value. What is important to one person may seem crazy to another. But we can understand the basic foundation that, when it is in place, allows each of us to find greater success and avoid loss. That foundation is individual freedom of choice over private property. That foundation stimulates every behavior and incentive for behavior that each of us thinks will bring gain to us and discourages every one that we think brings loss to us.
How does this foundation encourage success? How do free markets succeed in encouraging value creation? There are many reasons, some of which I've already mentioned. Now I mention a few more. As Hoppe has argued, if each of us keeps what we own without it being taken by government, each of us has the maximum incentive to increase what we own and make the best use of it so as to create value. As Mises has pointed out, free markets have prices. Prices reduce the dimensionality of the value creation problem. We can easily find out what something costs and compare it to our personal valuations. Businesses have a clear measure of success: profit or loss. Government does not. One of Rockwell's favorite themes is that accountability and responsiveness are characteristic of business activity in free markets because of the direct link between service to buyers and profit and loss. There is no such direct link between voters and government, nor is there a clear link between a given product and a given vote. Hayek and others have emphasized that value creation requires specific knowledge that is available only to individuals, that is, it's widely dispersed. Free markets are the natural way for individuals to bring that knowledge to bear in their choices. Mises, Rothbard and Austrian economists emphasize the role of free market entrepreneurial activity in seeking out new opportunities for value creation and bringing them to fruition. By contrast, governmental entrepreneurialism is directed at new restrictions that promote value destruction.
Where there is freedom of choice over property, individuals decide every aspect of a trade: when, what, how, how often, how much, where, at what price, at what quality, and with whom. The individuals decide on every aspect of a trade that they think affects value for them. Some of these choices are of the "yes/no" variety, to be sure. Many transactions are small in size. But every choice counts and in the aggregate they make their impact felt. Value creation arises from an infinite number of finely-tuned individual decisions.
If government (a set of other people) is in the picture, deciding these matters in the place of free individuals, how does it decide? By a clumsy and ineffective voting and logrolling method, by arbitrary exercise of power, and by whim and by interest group. It decides mainly by laws — limiting, seizing, regulating, taxing, redistributing, wasting, absorbing, and destroying property. When it decides for everyone and replaces the free market by its own production of services like defense, its value destruction is amplified. The experiences of every Communist country are testimony to that fact.
July 18, 2006
Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.
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