Laissez-Faire Economic Theory
Why Pure Laissez-Faire Economics Doesn't Work
Laisssez-faire economics is a theory that restricts government intervention in the economy. The economy is strongest when all the government does is protect individuals' rights.
Laissez-faire is French for "let do." In other words, let the market do its own thing. If left alone, the laws of supply and demand will efficiently direct the production of goods and services. Supply includes natural resources, capital, and labor.
Demand includes purchases by consumers, businesses, and the government.
In a laissez-fair economy, the only role of government is to prevent any coercion against individuals. Theft, fraud, and monopolies prevent the rational market forces from operating.
Laissez-faire policies need three things to work. They are capitalism, the free market economy, and rational market theory.
Capitalism is an economic system where private entities own the factors of production. In the 1987 movie Wall Street, Michael Douglas as Gordon Gekko summed up the philosophy of laissez-faire capitalism. He famously said, "Greed, for lack of a better word, is good." He argued that greed is a clean drive that "captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind."
To Gordon Gekko, intervention had made the United States a "malfunctioning corporation." But greed could still save it if the government allowed it to operate freely.
The advocates of laissez-faire capitalism agree that greed is good. As President Reagan famously said, "Government is not the solution to our problem, government is the problem." In laissez-faire, the government should let capitalism run its own course with as little interference as possible.
Capitalism requires a market economy to set prices and distribute goods and services.
Businesses sell their wares at the highest price consumers will pay. At the same time, shoppers look for the lowest prices for the goods and services they want. Workers bid their services at the highest possible wages that their skills allow. Employers seek to get the best employees at the lowest price. Like an auction, this sets prices for goods and services that reflect their market value. It gives an accurate picture of supply and demand at any given moment.
A market economy requires private ownership of goods and services. The owners are free to produce, buy, and sell in a competitive market. The force of competitive pressure keeps prices low. It also ensures that society provides goods and services efficiently. As soon as demand increases for a particular item, prices rise thanks to the law of demand. Competitors see they can enhance their profit by producing it, adding to supply. That lowers prices to a level where only the best competitors remain. This efficient market requires that all have equal access to the same information.
The government protects the markets. It makes sure no one is manipulating the markets and that all have equal access to information. For example, it is in charge of national defense to protect the markets.
Rational Market Theory
Laissez-faire economics assumes that free market forces alone correctly price every investment. Rational market theory assumes that all investors base their decisions on logic. Consumers research all available information about every stock, bond, or commodity. All buyers and sellers have access to the same knowledge. If someone tried to speculate and drive the price above its value, the smart investors would sell it. Even a well-run mutual fund could not outperform an index fund, if rational market theory is true.
In the 1980s, this theory went even further. Its proponents said that stock prices rationally price in all future values of an asset. Investors incorporate all knowledge of present and expected future conditions in their trades. The best motive for a company's CEO is to pay with future stock options.
But, studies found no relationship between a CEO's pay and corporate performance.
Rational market theory ignores mankind's reliance on emotion when buying even a single stock. Investors often follow the herd instead of the information. Greed, in this case, led them to overlook dangerous warning signs. The result was the 2007 financial crisis.
Ayn Rand argued that pure laissez-faire capitalism has never actually existed. The closest was in the second half of the 19th century. The government should only intervene to protect individual rights, especially property rights. The government protects these rights by banning coercion and physical force between people.
Rand said that capitalism had its own morality that should be protected. It allows each person to reach their full potential. She agreed with the Founding Fathers that each person has a right to life, liberty, property and the pursuit of happiness. They do not have an inalienable right to a job, health care, or education.
Rand's philosophy ignores that emotion, not rational facts, rules most people’s decisions. It overlooks the advantage rich children have when competing with poor ones. Those born into poverty don't have the opportunities to reach their potential. They don't start on a level playing field.
Ludwig von Mises
Ludwig von Mises argued that laissez-faire economics leads to the most productive outcome. A government could not make the myriad economic decisions required in a complex society. It should not intervene in the economy, except for the military draft. He believed that socialism must fail. Mises was the last member of the original Austrian school of economics.
Examples of Laissez-Faire Policy
The U.S. Constitution has provisions that protect the free market.
- Article I, Section 8 protects innovation as property by establishing a copyright clause.
- Article I, Sections 9 and 10 protects free enterprise and freedom of choice. They prohibit states from taxing each others' goods and services.
- Amendment IV protects private property. It limits government powers by protecting people from unreasonable searches and seizures. Amendment V protects the ownership of private property. Amendment XIV prohibits the state from taking away property without due process of law.
- Amendments IX and X limit the government's power to interfere with any rights not expressly outlined in the Constitution.
Make sure to understand these provisions in the context of more recent legislation. Laws created since the Constitution grant favor to many particular segments and industries. These include subsidies, tax cuts, and government contracts.
Laws protecting individual rights have been slow to catch up. Many still contest laws that prohibit discrimination based on gender or race. In some instances, corporations have more rights than individuals.
The United States has never had a free market as described by Rand and von Mises. As a result, attempts at laissez-faire policies have not worked.
President Herbert Hoover was the most infamous proponent of laissez-faire policies. He believed an economy based on capitalism would self-correct. He worried that economic assistance would make people stop working. His commitment to a balanced budget in the face of the 1929 stock market crash turned the recession into the Great Depression.
Even when Congress pressured Hoover to take action, he focused on stabilizing businesses. He believed their prosperity would trickle down to the average person. He lowered the tax rate to fight the depression, but only by one point. Despite his desire for a balanced budget, Hoover added $6 billion to the debt.