The Myth of the Free Market, Part 1

Matt Yglesias has a good post on the New Urbanists versus suburban sprawl, entitled “All Planning is Planning.” The post could just as well have been titled, “All Markets are Distorted Markets,” subtitle: “There is no such thing as a free market.” There never has been and there never will be.

It’s no secret that Americans love the free market. As such, anyone arguing that the free market doesn’t exist is likely to called all sorts of things. So before proceeding, let me just assert that I am not anti-market. I like markets. They are the most efficient information-gathering mechanism there is. They are also unparalleled at allocating resources efficiently. Markets also allow personal freedoms to coexist with material wealth. But note: none of that implies that they are “free.”

First, what is a market? An abstract place where commodities are bought and sold, and where prices are determined by the countless decisions of individuals to buy or sell. Economic theory shows that the prices that emerge from the interaction of aggregate supply and demand are efficient – that is, they maximize the total amount of utility in a society. Secondly, what do people mean by a free market? Usually, a market that is free from government intervention, monopolistic price manipulation, or any societal institution that would distort the price of that same commodity absent those forces.

Unfortunately, the idea of a market free of government intervention is already paradoxical. For a market to deal with the volume of trade necessary to price goods and allocate them efficiently (as opposed to a small-town bazaar dealing in local in-kind exchange), society will need currency as well as legally-enforcable property rights. “Legally-enforceable” implies a need for police and a judiciary. We clearly need some kind of “minimalist state” to provide these necessary conditions.

However, no market society has even been governed by a state this minimal, because of the fact of public goods and the free rider problem. A public good is any “non-excludable good” like missile defense that – once it exists – you can’t keep your neighbor from “using” if he doesn’t pay his share. A free market would systematically undersupply public goods, causing a market failure. The efficient solution is for the government to enforce citizens’ contributions to these public goods. I don’t want to go into the economics of public goods, but note that they are a phenomenon found in neoclassical economics. There is nothing ideologically suspect about the argument that the government should provide public goods. So without departing from orthodox economic theory, we already see that the minimalist state is quite extensive: currency, property rights, police, judiciary, and public goods. (Note that in some sense, these are all public goods.)

Now, once you grant that the government should – and does – provide public goods, the argument that the free market exists goes out the window. First of all, the government acts according to political logics, which means that the government rarely acts efficiently, and often acts irrationally – and therefore we cannot argue that market outcomes will be at all optimal. But secondly – and, I think, more importantly, – public goods tend to be foundational. Think of the massive legal system that creates, enforces, and interprets our law. Think of the massiveness of the American infrastructure: the highway system, the electrical grid, airports and air control, dams and reservoirs, etc. There are infinitely many versions of the American infrastructure that could have been created – infinitely many combinations of rail versus road, the interstate going by this city or that city, or power being provided by nuclear or coal – but only one version of that infrastructure came into existence, and that happened largely because of political calculus.

The point is that all economic activity in the United States is dependent on these massive preconditions. Economic activity in the United States is not rational according to some Platonic notion of “the most rational possible,” but rather all economic activity in the United States is rational conditional on the current legal system, transportation system, income distribution, etc. Furthermore, the funding of all of these public goods requires that the government collect substantial revenues through taxes. Whatever tax system the government selects out of the infinitely-many possible tax systems will, of course, further distort the market.

So yes, in some sense, after we have factored in all of these preconditions without which there wouldn’t be a market, the market activity that follows can be considered free. But the size of the intervention is already so great, that no one can claim that market outcomes are maximally efficient. They are only efficient conditional on the massive and indispensable interventions that came before. Any existing market, then, is a paltry shadow of the idealized free market.

Here comes the moral.

Like I said, I believe in much of neoclassical economics. I believe that there is no more efficient mechanism for the distribution of resources than the market. I also believe that the government rarely operates efficiently.  Yet, I continually advocate for government interventions to steer the market. This is only a contradiction if you don’t understand why I kept bolding the word conditional. Government intervention into the economy is necessary and inevitable, and lamenting that fact is merely petulant: the alternative is no market at all. However, the shape of government intervention is anything but inevitable: it is determined by political calculus. And because I believe that our current institutions create market outcomes that are less efficient and less just than would other institutions, I will continue trying to change the political calculus that has created these institutions. If we had ideal institutions, I would be more than happy to sit back and let the market go its merry way, doing as it will.

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I am aware this post wasn’t thrilling. But consider it as a prelude to Part 2, where I argue that the “free market” has the cachet it does because of the convergence of three seemingly independent trends – two which are innocuous, and one which is insidious.

In this post, I did not want to be unnecessarily provocative, so I stuck close to mainstream economics. But the argument goes deeper than this. In Part 3, I’ll argue this point again by going where respectable economists fear to tread: theories of labor…