Free Markets and Limited Government Reconceived – Niskanen Center

The modern market system, with its far-flung and highly intricate division of labor, is a miraculous social technology with incredible powers to incentivize and coordinate the invention, production, and distribution of goods and services. It is the primary engine of the modern wealth explosion, which began two-and-a-half centuries ago in England and whose continued progress has now made possible what all prior generations would have considered utterly fantastic: the liberation of humanity from the Malthusian prison of mass privation. Were not there yet, but with the riches we have already heaped up, the eradication of extreme poverty from Planet Earth is now a realistic goal.

Many brilliant scholars have contributed to our understanding of this astonishing phenomenon. Adam Smith deserves pride of place among them, but after him (on my scorecard, at least) the most profound insights have come from a pair of Austrian-born economists, F. A. Hayek and Joseph Schumpeter. From Hayek we learned how the market order, especially through the mechanism of freely moving prices, acts as a gigantic information-processing system, allowing people to make use of and act upon widely dispersed knowledge that otherwise would be completely inaccessible to them. And from Schumpeter, with his celebration of entrepreneurship and creative destruction, we gained appreciation for capitalisms incessant and unruly dynamism. Although we benefit greatly from the efficient use of existing information as described by Hayek, the greatest gifts of the market economy come from the incentives it provides for the discovery and application of new, socially useful knowledge.

The free-market intellectual movement has done much to further develop and more widely disseminate these insights, and for that we are in its debt. But in appreciating the world-transforming virtues of the market system, it is vitally important for us to keep in mind this qualification: a well-functioning market system is neither self-executing nor self-sustaining. To achieve what they are capable of, markets need to be embedded in and supplemented by supportive legal, political, and social institutions. Alas, the free-market movement has done a bad job of recognizing this fact and its implications for policy. This blind spot is the result of flawed ideology, as I described in the previous essays in this series. But it also reflects the fact that the movement has been led by economists, and as that discipline has professionalized, its practitioners have tended to narrow their focus and take the existence of the market order as given.

But the market order is not a given. Start with the fact that all the worlds richest, freest, most advanced economies today belong to countries with large, powerful states, elaborate regulatory codes, and extensive provision of social insurance and other public goods. If modern, large-scale, impersonal markets were truly self-executing and self-sustaining that is, they emerged naturally and spontaneously and thrived wherever they are not smothered by overbearing government we should expect to see flourishing market economies in the worlds most lightly governed places. Yet if we look at, say, the tribal areas of Pakistan, where the writ of the central government barely reaches, or Somalia, which lacked any central government at all from 1991 to 2006, we see nothing of the kind.

Not only do prosperous market economies and strong states go together in the present day, but history shows that the two emerged and developed in tandem. Early modern Europe was the scene of both intensive state-building and a commercial revolution that set the stage for industrialization. Although the two developments were distinct and at times in conflict, overall, the rise of the modern nation-state helped to midwife the subsequent wealth explosion.

Centralized states contributed to market development on a number of fronts. By deterring and repelling foreign aggression, they protected local economies from the devastation of war. And because there was military advantage in commercial strength and the resources for war-making it provided, rulers of centralized states had strong incentives to promote economic development. Centralized systems of taxation allowed integrated national markets to emerge and the division of labor to develop accordingly. The growth of effective bureaucracies provided a check against rent-seeking by local interests and made possible more efficient systems of taxes with lower deadweight losses. Centralized states with the capacity to enforce their laws nationwide allowed economic life to be governed by a system of general and abstract rules, which then created the freedom to plan and invest within the context of those rules. And the growth of cohesive national identities built around a common language and history lent cultural support to the provision of public goods and governance that promoted the national interest over the perpetuation of local privileges.

When we move forward in time to take a closer look at the present, we see the coevolution of state and market has been carried to the point that what started as a haphazard partnership is now full-fledged complementarity between the public and private spheres. As my Niskanen Center colleague Ed Dolan has documented in a pair of essays, the size of government (as measured by government expenditures as a percentage of GDP) shows a strong positive correlation with measures of economic freedom and well-being. In other words, the relationship is precisely the opposite of what you would expect if you think that big government is the enemy of markets and market-mediated prosperity. What drives the decidedly pro-market tilt of larger government is a strong correlation between the size of government and the quality of government that is, the integrity and effectiveness of legal and political institutions as measured by judicial independence, impartiality of courts, adherence to due process, free and fair elections, relative absence of corruption, and related indicators.

In other words, a flourishing market economy requires, not small government, but high-quality government which we can also refer to as high state capacity, or effective government. The private sector and the public sector are not antagonists, as libertarian ideology would have it. On the contrary, they are necessary complements: The health of the former depends on the health of the latter.

At the Niskanen Center, we are developing a new, distinctive policy vision based on the recognition that a strong, effective private sector and a strong, effective public sector go together. In particular, our advocacy of a free-market welfare state highlights the interdependence between vibrant, dynamic markets and the robust provision of social insurance and other public goods. A well-designed welfare state supports market functioning by expanding peoples capabilities and allowing them to participate in economic life at a higher level; by protecting against dislocation and waste through mitigating otherwise uninsurable risks; and by making creative destruction politically sustainable through ensuring that the rules of the game work for the benefit of all. Meanwhile, the wealth generated by innovative and robustly competitive markets makes possible the social investments and protections of the welfare state.

When we see that markets work best, not in the absence of government but in the presence of good government, we are able to see the ideals of free markets and limited government in a new and clearer light. Freeing those vital principles from the misunderstandings created by libertarian ideology, we can reconceive them so that they serve, rather than undermine, the cause of effective government on which our freedom and prosperity depend.

Thus reconceived, the concept of free markets is no longer associated with the overall size and scope of government. Rather, the free in free markets describes certain key attributes of a well-functioning market system. Markets are free, not when they are unregulated, but when the rules that define them allow for wide freedom of action along a number of key dimensions: free entry, free exit, freely moving prices, free trade across national boundaries, freedom to hire and fire, freedom to take a job or quit, freedom to introduce new products or production methods without prior permission, and freedom to invest. The commitment to free markets is based on evidence, not ideology: Wherever competitive markets are a workable method of organizing production and distribution, they tend to function best when new firms are free to enter and existing firms are free to compete on price and quality. Accordingly, the commitment is robust but not dogmatic: a strong but rebuttable presumption in favor of entrepreneurship and competition.

When we understand free markets this way, we are in a much better position to recognize what kinds of regulatory policies actually support market functioning and what kinds undermine it. Because the association between free markets and deregulation has been broken, it is easier to see that regulations that are effective in preventing harms to workers, consumers, third parties, or the environment are actually pro-market: Such rules make possible the Invisible Hand that guides private profit-seeking to serve the public good. And when we no longer see regulation as something imposed on business by nefarious bureaucrats, it is easier to recognize those cases where regulation is actually used as a tool by business to gain advantages it couldnt win in the marketplace.

Once we recognize that free markets are always embedded in a larger system of rules and institutions, it becomes clear that the problem of regulatory capture is both perennial and symmetrical. First, perennial: Regulatory capture stands revealed as the inexpungable Achilles heel of capitalism. Capitalism cannot work without good rules, but it is always in the interest of powerful economic actors to twist and rewrite those rules so that their narrow interests are served in preference to the larger public interest. And symmetrical: Regulatory capture can lead to the absence of good rules just as well as the presence of bad ones. Regulatory loopholes that allow polluters to foul air and water without consequences create rents just as surely as do regulatory barriers to entry that shield incumbents from new competition. Regulatory capture is the name for all cases where the rules enable narrow interests to profit by imposing costs on the rest of us, whether that is because those rules bind the rest of us inappropriately or because they grant impunity to narrow interests when they harm others.

And what becomes of the principle of limited government when ideologically predetermined limits on the size and scope of government have been abandoned? Freed from the hopeless task of specifying in advance when government can and cannot solve collective problems and improve lives, we can direct our energies toward strategies for controlling government power that are actually viable. The first great check on government, of course, is public accountability: Legislative and executive power are vested in elected officials who are chosen via universal adult suffrage. Partisans of small government tend to be less than enthusiastic about democracy, seeing it as vulnerable to redistributionist excess. In fact, universal suffrage is a vitally important shield of our liberties, which is precisely why oppression and exclusion from the franchise often go together and why historically oppressed groups focus so much energy on gaining, protecting, and exercising their right to vote.

Popular government alone, however, is no guarantee of effective government: In the words of James Madison, we are in need of auxiliary precautions. Specifically, government power needs to be limited by procedural rules that channel its exercise into designated structures of authority and decision-making. Here we are talking not just about the formal, written Constitution, but about all broadly constitutional rules that establish the processes of government. Such rules empower government even as they set boundaries outside which its authority is absent: Without a stable institutional structure, it is impossible to govern coherently, much less effectively.

As to how government authority and decision-making should be structured, the guiding principle is the ultimate end of all republican governments: the public interest. Ensuring that government of the people, by the people is also for the people requires governing structures that can filter the raucous cacophony of public opinion and focus the muddled signals of vote tallies to enact government policies and programs that redound to the general welfare. Two fundamental attributes of good constitutional design can be mentioned here: Good government requires deliberation, and deliberative government requires effective representation of all affected interests.

Contemporary governance is infernally complicated, which means that effective governance depends on large amounts of information gathering, analysis, and debate in short, deliberation. Necessary elements include the systematic collection of statistical and other data, processes for tapping expert opinion, and of course broad, open channels for input from affected interests and the broader public. As the last point indicates, deliberative government is impossible without wide representation. Decision-making works best when it incorporates the perspectives of all significant constituencies that will be affected; government capture is the regular result when one narrow interest succeeds in dominating the decision-making process. Ensuring that government is truly representative begins with zealously protecting voting rights but hardly ends there; every aspect of the policymaking process the accessibility of the decision-making venue, the intelligibility of the subject matter, the openness to opposing views needs to be evaluated for its effect on who actually gets seats at the table.

Just a couple of concrete examples can illustrate the larger point. Small-government advocates may find it counterintuitive, but as my colleague Steven Teles and Lee Drutman have argued, upgrading and professionalizing congressional staff would be a powerful tool to limit the power of special interests to manipulate government to their own narrow ends. With extremely limited in-house expertise on staff, legislators are forced to depend on information supplied by interested parties information carefully selected to favor a particular point of view. Accordingly, improved deliberative capacity can be a bulwark against rent-seeking. And as much as the information at the disposal of decision-makers matters for good policy, so too does the locus of decision-making. Take land use, for example: Decisions made hyper-locally, on a parcel by parcel basis in obscure meetings of zoning boards, ensure massive overrepresentation of immediate neighbors and their NIMBY instincts relative to would-be residents who at the time may be living in another metropolitan area. Moving decision-making up to higher levels of government with broader constituencies would make land-use decisions more representative and, as a consequence, less exclusionary.

For the cause of effective government, the public interest serves as both the ultimate empowering principle and the ultimate limiting principle. Classical republicanism envisioned a comprehensive and monolithic public interest, but in a liberal democratic republic such as ours, we recognize that the interests shared by all in a sprawling, ethnically and religiously heterogeneous, commercial and pluralistic country are necessarily thin and abstract. Accordingly, the idea of the public interest serves to impose fairly strict boundaries on the proper business of government. As a limiting principle, the public interest rules out policies that benefit narrow interests to the detriment of the rest of us, as well as policies that aim at public goals but fail to achieve them. Given the current state of the American political economy, the standard of effective government in the public interest provides anybody with a critical stance toward government an ample supply of policies and programs to find fault with and oppose.

The nature of the critical stance, however, is markedly different from the one based on small-government ideology. The move can be described as one from anti-government to anti-corruption, with corruption defined broadly to include all deviations from good government. The state is no longer the adversary; on the contrary, the health of the state is the foundation of our freedom and our prosperity. The adversary now is whatever imperils the health of the state, with that health understood as fidelity to the public interest. Waste and failure to achieve objectives are one species of corruption; another is the undue influence of narrow interests on government, whether that influence results in inappropriate action or inappropriate inaction.

An American center-right that abandoned its misguided attachment to small government for small governments sake, and instead based its critical stance toward government on the standard of effective government, would of course look very different from the right we have today. But it would be able to draw on a rich historical tradition within the Republican Party. That tradition was especially vital at the partys outset. The founding generation of Republicans were strong proponents of energetic and effective government, supporting public goods in the form of canals and land-grant universities as well as a kind of proto-social insurance in the form of free land for homesteaders and pensions for Civil War veterans. And while they were at it, they effected the single greatest limitation on government power and triumph for individual freedom in American history: the liberation of four million African Americans from slavery.

As industrialization took off after the Civil War, Republicans became the party of big business a partnership that led in some good directions and a number of bad ones. But even as support for business became the dominant tendency within the party, the good-government, anti-corruption tradition remained robust and influential at least until relatively recently. That tradition is visible in the Mugwumps, that initial group of dissident Republicans to choose country over party; the push for civil service reform; the embrace of progressive reform by Theodore Roosevelt; opposition to the corruption of urban machine politics; the moderation of Dwight Eisenhower and his refusal to relitigate the New Deal; and most recently, the maverick conservatism of John McCain.

There is no hint of anti-government animus in this tradition: Public service is seen as a high calling, duty and honor are trumpeted as virtues, and corruption is condemned as a betrayal. While the small-government tradition within the GOP is an outgrowth of the partys close relationship with business, the good-government tradition has benefited from the partys connection to the military. It is no accident that the most prominent figures of the good-government tradition within the GOP Theodore Roosevelt, Dwight Eisenhower, and in our time John McCain first achieved fame as war heroes.

Whether a decent, constructive center-right in America can be reestablished after the descent into plutocratic populism remains to be seen: A necessary, if not sufficient, precondition is a sound electoral thrashing for Trump and his enablers. What I am certain of is that American politics badly needs a decent, constructive center-right, and that among its necessary elements are a sound understanding of and firm commitment to free markets and limited government. I hope that the thoughts provided here will prove useful to the project of regrounding those principles on a firm intellectual foundation in the event they can find a political home.

This essay is part 3 of a three-part series. For part 1 and part 2, see here.

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Free Markets and Limited Government Reconceived - Niskanen Center