Laissez-Faire Economic Theory

Laissez-faire Economics Depends on Three Components

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Laissez-faire economics is a theory that restricts government intervention in the economy. It holds that the economy is strongest when all the government does is protect individuals' rights. 

Laissez-faire is French for "let do" or "leave us alone."

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.

The only role of government in a laissez-faire economy is to prevent any coercion against individuals. Theft, fraud, and monopolies prevent rational market forces from operating.

Key Takeaways

  • The laissez-faire economic theory advocates little or no government interference
  • It believes the rational free market forces of demand and supply are sufficient
  • According to laissez-faire, greed drives growth
  • President Hoover's laissez-faire economics worsened the Great Depression 

The Three Components of Laissez-Faire Economics

Laissez-faire policies need three components to work: capitalism, the free market economy, and rational market theory. 

Capitalism

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 when he famously said, "Greed, for lack of a better word, is good."

Gekko 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." Government intervention had made the United States a "malfunctioning corporation" in the mind of Gordon Gekko, but he felt that 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 Ronald Reagan 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.

Free Market Economy

Capitalism requires a market economy to set prices and to distribute goods and services. Businesses sell their wares at the highest price that 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 will allow, and employers strive to get the best employees for the least compensation.

Like an auction, the free market 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 rather than emotion. 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 the rational market theory is true.

Rational market theory also states 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. In fact, research has found an inverse relationship between a CEO's pay and corporate performance.

Rational market theory ignores mankind's reliance on emotion when buying even a single stock. In contrast to this theory, investors often follow the herd instead of the information. In this case, greed leads them to overlook dangerous warning signs. The 2007 financial crisis was a prime example.

Proponents of Laissez-Faire

Ayn Rand argued that pure laissez-faire capitalism has never actually existed. She said the government should only intervene to protect individual rights. 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, universal health care, or equity in education

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.

Mises believed that socialism must fail.

Laissez-Faire Policy in the U.S. Constitution

The U.S. Constitution has provisions that protect the free market:

  • Article I, Section 8 protects innovation as a property by establishing a copyright clause
  • Article I, Sections 9 and 10 protects free enterprise and freedom of choice
  • Both prohibit states from taxing each other's goods and services
  • Amendment IV protects private property and protects people from unreasonable searches
  • 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

History of Laissez-Faire in the United States

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 cases, corporations have more rights than individuals.

The United States has never had a free market as described by Rand and 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 that 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's laissez-faire approach to the Depression added $6 billion to the debt. 

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