The Price of Civilization: Reawakening American Virtue and Prosperity (5 page)

The Case for a Mixed Economy

We need to understand precisely where the free-market ideology goes awry. A good starting point is the most basic functioning of the market economy, notably the law of supply and demand. It is when supply and demand stop functioning effectively that government must step forward.

In a competitive market, where there are large numbers of potential suppliers and consumers, the price of each good and service adjusts to balance the supply and demand. If at the current price firms want to supply more than is demanded by consumers, the price will decline, leading firms to cut back on their supplies and consumers to step up their purchases; if at the current price firms want to supply less than is demanded by consumers, the market price will rise, leading firms to increase their supplies and consumers to trim their purchases. When the balance of supply and demand is reached for each and every good or service, we say that the economy has reached “market equilibrium.”

The key idea of Adam Smith, the late-eighteenth-century founder of economic science, is that the market equilibrium is reached without a central planner and that it has desirable results for the nation, notably in the forms of high productivity and wealth. With every firm and household pursuing its own self-interest, the resulting market equilibrium can almost miraculously lead to the well-being of all. Smith gave a famous and enduring name to the process by which
the individual actions of millions of individuals and firms combine for the common good: the “invisible hand,” encapsulating the paradox that self-interest in the marketplace can lead to the common good. As Smith famously declared:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages [in supplying what we demand as consumers].
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In modern scientific terms, the invisible hand of the marketplace is called a
self-organizing system
. The idea is that a highly complex and productive system can create an orderly division of labor—and a benefit for the entire population—through the self-interested actions of the individual actors of the system. There is thus no need for a central power to move the society’s resources here and there.

Smith brilliantly recognized that the self-organized market equilibrium is likely to result in a high level of productivity and therefore a high level of income and wealth of the population. In modern jargon, we say that the competitive market equilibrium is
efficient
, meaning that there is no waste of resources.
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Well-functioning markets squeeze out waste in the use of resources. A wasteful firm is outcompeted by a more efficient, lower-cost firm. An artificial scarcity created by one business is undone by the entry of a competitor. And so on throughout the economy, until waste is squeezed from the system.

Why Markets Need Government

Unfortunately, free markets by themselves are not able to ensure the efficiency of the economy. Governments are needed to provide
certain public goods, such as highways, that markets by themselves will either not provide or not provide to the right scale. Private markets work well when there are many suppliers and consumers, as is the case for goods and services such as clothing, furniture, automobiles, hotel services, restaurants, and the like. They begin to misfire when economic logic calls for a
single supplier
, for example to operate the police force, fire department, army, court system, highway network, or electricity distribution system.

In such cases, society basically needs just one supplier or at most a very small number, rather than many. We don’t want competing armies or competing police and fire departments in our cities. Similarly, we need just one highway and power line from city A to city B, not several competing highways each offering the same route.

Free markets also fail when producers cause adverse spillovers to the rest of society, such as by polluting the rivers with toxic chemicals or emitting climate-changing carbon dioxide into the air from a coal-fired power plant. In such cases, the private economy tends to oversupply the goods in question, unless there are specific regulations or levies imposed on the offending actions. We say that the market needs “corrective pricing,” such as a tax levied on the pollutant, in order to reduce negative spillovers.

Private markets fall short in the case of scientific research as well, where spillovers of knowledge occur. Scientists don’t—and shouldn’t—own the rights to their basic scientific discoveries. Imagine if Isaac Newton’s estate held a patent or copyright on the gravity equation. The implication is that one of humanity’s most important activities—scientific discovery—needs to be promoted in ways other than the pure profit motive. This is done through status (such as receipt of the Nobel Prize), financial support from philanthropists, government grants (for example, through the National Science Foundation and the National Institutes of Health), government prizes, and other nonbusiness approaches (such as volunteer work and open-source creations such as Linux and Wikipedia).

Free markets also need governments to help regulate the marketplace
when information between buyers and sellers is “asymmetric.” When sellers have inside information unavailable to buyers, fraud and waste are rife. In the lead-up to the 2008 financial crash, for example, Wall Street sold toxic assets to unsuspecting German banks, thereby extending the bubble and increasing its ultimate cost. In a different sphere, some doctors increase their fees by prescribing medical tests and procedures that are not needed, while patients and insurers are unable to second-guess the medical advice. In both cases, the implication is the need for government regulation: of securities markets to prevent financial fraud and of health care insurers to prevent medical fraud.

It’s worth recalling that all great promoters of the market economy, including Adam Smith, John Maynard Keynes, Paul Samuelson, Friedrich Hayek, and Milton Friedman, were fully aware of the reality of public goods, environmental spillovers, and asymmetric information and therefore of the need for the government to be deeply engaged in public education, road building, scientific discovery, environmental protection, financial regulation, and many other activities. None ever denied a major role for government in a market system. That’s true not only of Keynes and Samuelson, who are famous for their championship of the mixed economy, but also of Hayek and Friedman, who are known for their advocacy of unfettered markets. It is only the present-day free-market acolytes of Hayek and Friedman who neglect the key role of government in ensuring the efficiency and fairness of a market system.

Hayek noted in
The Road to Serfdom
that we should not confuse the opposition to central planning with “a dogmatic laissez faire [free market] attitude.” The correct position, said Hayek, lies

in favor of making the best possible use of the forces of competition as a means of coordinating human efforts, not an argument for leaving things just as they are. It is based on conviction that, where effective competition can be created, it is a better way of guiding individual efforts than any other.…
Nor does it deny that, where it is impossible to create the conditions necessary to make competition effective, we must resort to other methods of guiding economic activity
.
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(Emphasis added.)

Hayek acknowledged, as had Adam Smith before him, “a wide and unquestioned field for state activity” in the economy. Indeed, Hayek reminds the reader of
The Road to Serfdom
that Adam Smith himself called on the government to provide those services that “though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expense to any individual or small number of individuals.”
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In other words, Hayek sides with Adam Smith in recognizing the importance of government provision of public goods.

Fairness and Sustainability

Though efficiency is a great virtue, it is not the only economic goal of interest to the society.
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Economic fairness is also crucial. Fairness refers to the distribution of income and well-being, as well as to the ways that government treats the citizenry (including fairness in levying taxes, awarding contracts, and distributing transfers).

Most people would regard as unfair a market equilibrium in which some individuals are super-rich while others are dying of extreme poverty. In such a circumstance, most people would regard it as fair (or “just” or “equitable”) for the government to tax the super-rich in order to provide basic resources for the poor such as food, shelter, safe water, and access to health care. Indeed, a solid 63 percent of Americans concur that “It is the responsibility of government to take care of people who can’t take care of themselves.”
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The sentiment that government should help the poor who cannot help themselves has been an enduring value in American society.

The rule of law is also a matter of fairness. We demand equal
treatment of citizens under the law. We expect that income transfers from the rich to the poor should follow due process, not an arbitrary levy or Robin Hood–style confiscation. The rebelling American colonists in 1776 did not object to taxation per se, but to taxation without representation.

Fairness entails not only the distribution of income within society at a point in time but also the distribution of income across generations, a concept that economists also call “sustainability.” If the current generation depletes the earth’s scarce natural resources, for example by using up its fossil fuel and freshwater aquifers, or acidifies the oceans through carbon dioxide emissions, or drives other species to extinction, it severely diminishes the well-being of the generations to come. Those future generations can’t defend their interests today, since they’ve not even been born.

Sustainability, or fairness to the future, therefore involves the concept of
stewardship
, the idea that the living generation must be stewards of the earth’s resources for the generations that will come later. That’s a tough role to play. There is nothing natural or innate about it. We need to defend the interests of those whom we’ve never met and never will. Yet those are our descendants and our fellow humanity. Alas, it’s a role that we’ve mostly ignored till now, to the increasing peril of all who will follow.

The Libertarian Extreme

A small number of Americans reject the very idea that government should promote fairness, or even efficiency for that matter, through the power of taxation. They hold that the only ethical value that matters is liberty, meaning the right of each individual to be left alone by others and by the government. In that philosophy, known as
libertarianism
, individuals have absolutely no responsibility to society other than to respect the liberty and property of others.
This extreme philosophy has been embraced by some of America’s richest individuals, such as Charles and David Koch (combined net worth: $44 billion), who have used their great fortunes, based on an inheritance, to try to instill their libertarian views throughout the society.
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According to libertarians, America should be governed not by social responsibilities but by free-market forces and voluntary private contracts, with the government devoted solely to maintaining law and order, including the protection of private property. Taxes should be slashed to the minimum, as there is little or no legitimate role of government beyond the bare bones of the military, police, prisons, and courts.
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Libertarians don’t believe in levying taxes even to build roads and other infrastructure, believing instead that such investments should be left to the free market.

Libertarians argue that taxation is little more than government extortion. Most Americans disagree. Though we don’t love paying taxes, we accept the
legitimacy
of taxes as long as they are properly voted into law and the revenue is used honestly and sensibly. In a 2009 Gallup survey, 61 percent of Americans declared the amount of income tax that they would pay that year as “fair,” as opposed to 35 percent who called their income tax “not fair.”
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Libertarians aim to absolve the rich of any social responsibilities toward the rest of society. As a school of thought, libertarianism is based on three kinds of arguments. The first is a moral assertion: that every individual has the overriding right to liberty, that is, the right to be left alone, free from taxes, regulations, or other demands of the state. The second is political and pragmatic: that only free markets protect democracy from government despotism. The third is economic: that free markets alone are enough to ensure prosperity.

Such an approach, while promising liberty, democracy, and prosperity, is a grand illusion. We know from both historical experience and economic theory that free markets alone cannot begin to ensure
efficiency and prosperity; without government, we’d lack the highways, safe environment, public health, and scientific discoveries that make us productive. We know from historical experience that countries will not risk their democracies by levying taxes. Indeed, the heavily taxed countries of Scandinavia score higher than the United States on rankings of quality of governance and control of corruption. We also know from experience and moral tradition that although liberty is indeed an important value, it’s not the only one that counts. If we have to choose between the liberty of a billionaire to avoid paying taxes and the needs of a poor and hungry child in need of food that would be supplied by those taxes (through food stamps, for example), most of us would choose the needs of the hungry child over the “liberty” of the billionaire to avoid helping the child.