What most people don't understand about free market capitalism

Free market capitalism has been the single most important factor in reducing wide-spread poverty and deprivation across the globe. Unfortunately, neither its detractors (not surprisingly) nor many of its supporters (disappointingly) fully understand how free market capitalism works. This inclines many of them to want to use government to either “fix” it, or to “help” it. Rarely is either accomplished.

In an effort to more clearly explain how free markets work, I’d like to correct some rather common misconceptions I see or hear regularly. First, and perhaps most importantly, supporting free market capitalism is not the same as being anti-government. In order for free markets to function properly, a government must perform some basic functions very well. Chief among these functions is having a system in place that clearly identifies and supports property rights. Capitalism depends on the ability of individuals to own, improve, and sell property. But only governments can create the legal framework for property rights that can be enforced throughout society. There can be no free markets in governments that cannot give protection to individual property rights.

In addition, governments must also be able to enforce contracts between individuals and corporations.

The enforcement of contracts allows a multitude of very positive transactions to occur that otherwise would not. These transactions increase the overall welfare of society. Therefore, having a legal system in place that can enforce agreements between private parties is another essential government function necessary for free markets to exist and function properly,

Besides these two fundamental functions of government, free market capitalism also benefits when the government creates certain health and safety regulations as well as certain anti-trust and fraud penalties. And while there is room for disagreement as to what specific regulations can or should be imposed, it is clear that free markets can benefit from certain governmental regulations.

So, free-market capitalism is not anti-government. Nor is it pro-“Big Business.” Adams Smith, in his seminal work, The Wealth of Nations, pointed out that business owners (especially those of very large concerns) were as likely to try to impede free markets as to foster them. This is because free markets are ruthless in their operations. They do not play favorites. Established businesses will often try to convince governments to enact various regulations not for “health and safety” purposes, but in order to limit the amount of competition they face. One of the roles of legislators, then, according to Smith, was to protect free markets from the inevitable efforts of the leading “capitalists” to distort markets in favor of their particular business and at the expense of the overall society.

Another interesting misconception I often come across is that capitalism creates poverty – as if poverty did not exist prior to the emergence of capitalism as an economic system. In one sense this is true. “Poverty” as we understand it, certainly did not exist in the centuries before capitalism. What did exist was massive deprivation and destitution. As Nobel Prize-winning Economist Milton Friedman pointed out, it was only through the emergence of capitalism that large numbers of people were able to emerge out of subsistence living and begin to see real improvement in their living standards.

Corresponding to this misconception is another – that capitalism creates “income inequality.” Again, to believe this one has to ignore all of the recorded history in which wealth inequality existed prior to capitalism. In fact, capitalism introduced a major innovation that, while it doesn’t eliminate wealth inequality, helps to ameliorate it. That is income mobility. In free market capitalism, as opposed to any other economic system that has existed, individuals are not confined to their socio-economic status permanently. Through creativity, industry, perseverance, or even plain luck, they can improve their situation. Equally important, those who start off at the top can also lose their position – again free market capitalism plays no favorites.

There is also a tremendous amount of confusion about what free markets can and cannot accomplish. Free markets are extremely good at allocating scarce resources that have alternative uses, as economist and author Dr. Thomas Sowell has noted. They are successful at this because of a ruthless efficiency in transmitting information among the millions of buyers and sellers within the market. This information, communicated through prices, regulates the supply and demand of the various goods and services within society. There has not been system devised that can perform this function as efficiently as market capitalism.

However, markets have trouble with certain goods or services. Often referred to as “common” goods,can be helpful by creating public policies that require the parties to the transaction to “internalize” the cost of it to third parties.

these are functions that are necessary within a society that markets generally cannot provide. Usually because there is no way to ascribe property rights to the service. Examples would include public safety, national defense, public assistance, and certain environmental problems. These are where governments must step in and generally provide the good or service. Markets also have trouble with externalities. That is, incorporating the costs of a transaction that impacts third parties (pollution, second-had smoking, etc. are good examples of this). This is where government action

It is important to understand, however, that government’s ability to effectively correct “market failures” is also limited. Primarily by a deficiency in the information needed to be as effective as necessary. Public policies to impact economic performance are almost always after-the fact. Economist Robert Guell identifies three important constraints on effective government intervention in market activity.

First is the “recognition lag.” This is the amount of time it takes government officials to recognize there is a problem that may need government action. For example, the official definition of a “recession” is two consecutive quarters of negative economic growth. This means that half a year must pass before policymakers can even be sure there is a problem. This is followed by “administrative lag” which is the time it takes policymakers to actually devise a “solution” to the problem (which can also take months). Finally, there is the “operational lag” which is the amount of time it takes (often several more months) for the agreed upon solution to be implemented.

As Guell points out, the economy is not standing still waiting on policymakers to identify, create, and implement their solution. And in many cases, by the time the solution reaches its implementation phase, the problem has been corrected already. The information conveyed through markets is done so much more efficiently and with much fewer obstacles than information conveyed through government bureaucracies.

While free markets cannot, by themselves, solve a variety of social problems such as racism, sexism, drug addiction, etc., they can help reduce these. By forcing business owners and managers to choose between their bigotry and hiring the most productive employees, or serving the most customers, free markets can have a positive impact. And to the extent that they bring people of diverse backgrounds together to be equal participants within the market, further improvement in these areas can be found. However, it must be acknowledged that there is nothing inherent in free markets that will force bigots to reform.

However, the central insight of Smith’s exposition of capitalism was its benefit to society. Free market capitalism isn’t good because it allows a few people to get extremely rich, or that it allows companies to hire people, or that it allows new businesses to grow and develop. It is good because it is the best economic arrangement for increasing the living standard of the entire society. If you doubt this, simply as yourself this question, in which of the following years would I rather be poor:  2015, 1915, 1815, 1715, 1315, or 1015? When you think about it, it’s a pretty easy question to answer – especially if you live in a free-market, capitalist-based economy.

Whether you are evaluating the living standards of the poor, the amount of wealth inequality within

various societies over these time periods, or the ability of those who are most poor to rise out of it, 2015 by far, offers the most hope for the poor. And in countries that are based on some version of free-market capitalism, the poor live in far better conditions and have greater opportunity for social mobility than their counterparts living under other economic systems – regardless of the year.

In short, free-market capitalism offers the greatest opportunity for continuing to increase living standards, offering social mobility to those at all income levels, and spurring innovation. However, free markets, rather than being opposed to government, actually rely on governments to perform certain important functions. While they can help alleviate certain social problems, they are not a panacea for all social ills. Other institutions, both governmental and non-governmental, are needed to successfully address these problems.

Most importantly, free market capitalism is about benefiting society at large, not just a few people or corporations. If allowed to function properly, the ruthless efficiency of free markets will constantly challenge capitalists to improve their products, services and/or processes or risk extinction. This process of “creative destruction” as economist Joseph Schumpeter labeled it, is what continues to improve the living standards of the entire society.