5. Economic Freedom

This page is dedicated entirely to the concept of economic freedom. Under the common theme “Expanding Economic Freedom” I will publish a total of three articles. The first is called “Foundations” and deals with the very concept of economic freedom and its roots in economic theory.

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Expanding Economic Freedom, Part I:

Foundations

 

S R Larson

Economic freedom is a very frequently used term in public policy and in politics. Politicians with a conservative or libertarian leaning often advocate economic freedom as a means to create more jobs and increase prosperity. The legislative practice of economic freedom tends to concentrate on reducing the presence of government in our economy: lower taxes, less regulations and reduced government spending (usually in that order).

While there is plenty of economic research that shows that less government is better than more government, its practice requires a more comprehensive analysis than a general attempt to roll back taxes, regulations and government spending. There are good ways to reduce the presence of government in our economy, and there are bad ways to do it. If done wrong, the roll-back of government can backfire and cause more problems than it solves. An example is the tax cuts during the Reagan and Bush Jr. administrations: the positive effects of the tax cuts were lost because they were not coupled with spending cuts. The end result was a surge in revenues, due to the growth effects of lower taxes, but also a sustained deficit. The revenue surge was never big enough to catch up with ever increasing spending.

Out of this kind of one-sided practice of economic freedom came a new government burden on the economy: the federal debt.

This paper is not aimed at explaining in detail how, in every turn, we can put economic freedom to work in legislation. That would require a far more ambitious endeavor than this paper. Instead, the purpose is to explain the fundamental principle – the overarching guideline – for any policy aimed at putting economic freedom to work.

Economics and Economic Freedom

How hard is it really to protect and expand economic freedom? Can’t we “just do it”?

There are two answers to this question. The first is: if it was that easy it would have been done already. You could point to Hong Kong and suggest that yes, it is that easy. But the United States is not Hong Kong. For one, the U.S. constitution defines a constitutional republic, not a dictatorship.

This leads over to the second answer: not everyone is convinced of the virtues of economic freedom.[1] To see why, let us do an experiment. Let us suggest that in order to safeguard economic freedom, all our legislature has to do is introduce an economic freedom checkpoint for all its bills. The checkpoint’s function would be to mandate that the legislature can only approve bills that will either expand economic freedom or leave it unchanged. Bills that restrict economic freedom would automatically fail.

This sounds like a good idea at first glance. But if you suggest it to legislators, their first comment is going to be that they need a clear and simple definition of economic freedom. If not, the checkpoint would be worthless.

The purpose of this paper is partly to respond to this request. The purpose is also to provide a definition of economic freedom that can serve as a foundation for any comprehensive effort at educating the general public about the virtues of economic freedom. In a matter of speaking, the purpose here is to provide the foundation upon which arguments, legislative initiatives and educational efforts can be built so as to promote and expand economic freedom.

In the more formal context of modern scholarly research, the roots of our modern concept of freedom can be found in the fertile intellectual soil of early Renaissance thought. Contributions primarily by Italian philosophers challenged the collectivist Aristotelian view of the individual that prevailed in Europe’s academic circles at that time. Where the Aristotelians regarded the individual as merely a piece of a collective “intelligence”, the founders of Humanism suggested that the individual is more than essentially a body walking the Earth. Unlike their collectivist opponents, the Humanists did not think of the individual as returning to the collective body after death. Instead, they claimed, the individual keeps living in spirit form, still as an independent entity, in the afterlife.[2]

What might seem like a trivial exercise of academic eclecticism was actually groundbreaking at the time. The early Humanists discovered a wonder of nature: the individual.

With this discovery came the need to recognize the individual as a sovereign entity in our society. During Enlightenment this need led to the definition of a dynamic between the state and the individual. In pre-Enlightenment theory, government had been viewed, explicitly or implicitly, as the Earthly representation of the Aristotelian collective intelligence. The Humanist challenge to the superiority of the collective demanded a new role for the state.

A dynamic tension was born, a tension between the individual and the state. This tension, which defines our freedom, has been the focal point of political philosophy throughout the centuries.

Freedom has remained a topic of controversy all the way from the birth of Humanism to today’s public policy battlefields. A breakthrough for the notion of economic freedom came during the 18th century in France, when increasingly successful merchants began challenging the regulations put in place by the monarch. It was out of their challenge that the term laissez-faire was born as a symbol of economic freedom.[3]

Defining economics

Our conventional, modern take on economic freedom was born from this plain, simple demand for a regulations-free business climate. It reflects a static view of the economy, one where there are two states of economic affairs, one with government regulations and one without, that can be isolated in time and compared as two objects of matter. It is, of course, not possible to reduce the economic system to such simplistic terms. Economics is the study of flows of economic activity where time is as important a dimension as space.

Does this mean that the French merchants who originated the term laissez-faire had it wrong? No, of course not. Their sense of what was good for their business was obviously accurate, or else they would not have made the effort to approach the monarch about it. But in order to explain the full meaning of a policy for economic freedom we need a comprehensive analysis that is founded in a thoroughly methodological analysis of the economic system.

The problem with economic freedom lies not in its theory or its consequences, but in its attainability. What in theory looks like a simple enough set of reforms – deregulation and removal of government from the economy – is in reality a long and crooked road with many speed bumps. The crooks and bumps are inherent to the economic system. They not only define our road to economic freedom but also our ability to practice economic freedom even under ideal circumstances.

To get to the nature and attainability of economic freedom we need to start with a definition of the tool that we use for our study. That tool, obviously, is the science of economics, which was eminently defined by British economist GLS Shackle as:[4]

The study of how humanity copes with its needs by means of the resources that the natural world and its own social organization provide.

 In other words, economics must view the economy in a broader social context.

Shackle is obviously not the only one who acknowledges the social context of economic activity. This was a hallmark of political economy, a pre-economics discipline that evolved in Britain during the 19th century. It formed the thinking of such notable scholars as Marshall, Pigou, Harrod, Kahn and Keynes.

Austrian thinkers also approached the economy from a broader social context. In Human Action von Mises points to the general framework within which we can understand the difference between static and dynamic methodology of economics:[5]

The intricacy of a precise definition of the scope of economics does not stem from uncertainty with regard to the orbit of the phenomena to be investigated. It is due to the fact that the attempts to elucidate the phenomena concerned must go beyond the range of the market and of market transactions. In order to conceive the market fully one is forced to study the action of hypothetical isolated individuals on one hand and to contrast the market system with an imaginary socialist commonwealth on the other hand.

The problem for the British political economists, the Austrians and various flavors of Keynesians is that they have yielded the development of methodological rigor to mainstream economics. Since the concepts that directly or indirectly define economic freedom have been the property of non-mainstream, or heterodox, economists this has created an unintentional dividing line between mainstream economics and the concept of economic freedom.

As a result, Shackle’s open-ended definition of economics, which easily incorporates the study of economic freedom, has been over-run by tighter definitions that fit the technical rigor of modern economics. As a result, modern economics has evolved based on its methodology, not based on the questions with which it is challenged. Therefore, modern mainstream economics will be of no help as we approach the concept of economic freedom. Its methodological emphasis on closed-system analysis serves a well-defined purpose, but it does not fit our analytical needs here.

This is not to say that Shackle’s definition puts us on a straight path to understanding economic freedom. There is quite a bit of work to be done between Shackle and the legislative application of the concept of economic freedom.

Toward a definition of economic freedom

To start the process of tying Shackle’s definition of economics to the practice of economic freedom, let us examine Shackle’s definition in more detail. It has two components: human needs and social organization.

When human needs are at the starting point of a scientific inquiry, the inquiry must unfold along a path dictated by our acts to satisfy those needs. Therefore, our work on economic freedom must focus on the conditions under which such satisfaction is possible.

Some schools on the outer rim of economics tend to dismiss the methodological implications of making human needs the starting point of economics. Austrian economic theory and Marxism are good examples of heterodox (non-mainstream) theories that center in on other elements of the economy than human needs. Common to these two theoretical branches is that they emphasize a mechanical construct over the role of the individual economic agent.

Shackle, on the other hand, saw the path that economics would need to take from this starting point. The route to a good scientific inquiry starts with furnishing the individual economic agent – the human being – with the appropriate tools to pursue that satisfaction. The primary tool is knowledge; Shackle puts knowledge above all other tools; we can only act to satisfy our needs…

 if there is knowledge of the needs and the [available] resources. Knowledge exists in the minds of individuals. This is the only form in which it can be effective and usable.

Knowledge thus becomes the driving force of economic activity. This has one profound consequence: it mandates that economic analysis always be concerned with our movement through time.

Knowledge ties us to time, creating a continuum of confidence. Confidence, in turn, allows us to take action to satisfy our needs. The more we perceive that we know about the future, the farther into the future we are ready to extend our plans for economic activity. In applicable terms, this means making spending commitments in the form of, e.g., car payments or savings for retirement and children’s college funds.

The confidence continuum runs between two extremes: complete confidence (sometimes referred to as perfect foresight in the economics literature) and fundamental uncertainty. All the points within the continuum represent our ability to foresee the future. The extremes of the continuum, perfect foresight and fundamental uncertainty, mark the outer limits of human ability to accurately predict tomorrow or any other point in the relevant future.

Shackle’s emphasis on knowledge is fundamental: because of the scarcity of resources available to us at any given point in time, we need to make plans to secure our access to resources in the future. We can only make such plans if we are able to collect and process information – create knowledge – about the future.

The pursuit of knowledge, which enables the satisfaction of needs, creates a dynamic foundation for the practice of economics. By recognizing the human being and her pursuit of knowledge and resources as the starting point of economic analysis, we make the individual a sovereign economic agent. This provides a natural opening toward an analysis of the conditions and challenges that await the individual as she tries to satisfy her needs.

Shackle’s second component in his definition of economics is the social organization. Except under extreme circumstances irrelevant in economics, a social organization is necessary for our pursuit of resources to satisfy our needs. The formalization of these interactions is our social organization.

Broadly understood, the social organization is the outermost humanly created framework that surrounds the economy. It consists of moral, constitutional and legal institutions, including the structure and protection of property rights and other elements that help determine how well the economy performs.

Prior to the discovery of the individual there was no established understanding in our societies of how the social organization can invade the lives of individuals. People without means were, in effect, the property of people with means. There was no opposite pole to the social organization. The discovery of the individual changed that. Since then political philosophy and social science in general have been concerned with defining the tension between the two poles.

Shackle defines economics as a science that studies the ability of individuals to satisfy their needs within the tension between the individual and the social organization. Since the social organization is legally defined by the state, economic freedom de facto becomes the dynamic between the individual and the state. As a result, the study of economic freedom is, fundamentally, the study of individual activity toward satisfying needs conditioned by the dynamic interaction between the individual and the state.

Time, uncertainty and instability

Proponents of economic freedom commonly assume that economic freedom brings about a state of economic harmony. This is, however, a misconception of the nature of the economic system and thereby a misunderstanding of the foundations of economic freedom. The economic system, even in its purest free-market form, is plagued by business cycle swings and radical leaps – up as well as down – in economic activity. Government makes a difference for the worse by regulating the use of private economic resources and by taxing and redistributing income and wealth among private citizens. Its negative impact increases with the size of government. However, the forces that cause swings in the business cycle, and bring about growth periods and recessions, are inherent to the economic system.

This means that any policies aimed at bringing about more economic freedom, and even policies aimed at preserving economic freedom at its maximum, must be designed with due recognition of both the potentials and the limitations of economic freedom. This habit can be broken by a better understanding of the foundations of economic freedom.

A good way to elucidate these foundations is to find a precise definition of economic freedom. F.A. von Hayek makes a succinct contribution:[6]

[The] freedom of our economic activity which, with the right of choice, inevitably also carries the risk and responsibility of that right.

In other words, Hayek acknowledges the dynamic context within which the pursuit of freedom takes place. This is a step toward recognizing the fundamental tensions that define economic freedom.

Milton Friedman explains economic freedom somewhat differently:[7]

Economic arrangements play a dual role in the promotion of a free society. On the one hand, freedom in economic arrangements is itself a component of freedom broadly understood, so economic freedom is an end in itself. In the second place economic freedom is also an indispensable means toward the achievement of political freedom.

Just like Hayek, Friedman points to the dynamic nature of the economy and the pursuit of economic freedom. As a general statement on the role of freedom in the economy his definition also complies with Shackle’s definition of economics and the economic system.

Friedman’s definition reinforces that any pursuit of economic freedom – whether scholarly or practically – is an entirely empirical matter. When he says that economic freedom is a means to other policy ends he also stipulates a testability criterion for economic freedom. Economic freedom must provide a quicker, less costly path to that end than competing policy means.

This is the strength of his contribution. At the logical level, he fails; formal logic bans an object from being both an end and a means to an end at the same time, but the world of empirical science does not always conform to formal logic. Furthermore, Friedman strengthens his contribution by exemplifying his testability criterion: economic freedom removes obstacles in the way of a man’s pursuit of individual goals. This definition is widely shared in the literature.[8]

When we combine Friedman’s testability criterion for economic freedom with the dynamic property of the economic system, we have the elements of a workable definition of economic freedom. But before we can call it a day we need to formalize our theory to a point where we have a clear testability criterion. In order to do so we need to put economic freedom in the context of the individual, time and uncertainty, much as Shackle implied.

Because time is omnipresent in our lives, it is also omnipresent in our economic activities. Economic analysis must begin with the recognition of time. Unfortunately, not all economic analysis does this. On the contrary, the methodology of what economics literature recognizes as established microeconomic theory implicitly assumes that time is not a relevant factor in economic behavior. Its starting point is instead a theory of human behavior that, in order to work in its purest form, effectively isolates individuals from each other. This theory is known to students of economics as “utility maximization” or “profit maximization” or, in rare cases, maximization of other variables.

The problem with the theory of maximization is that maximization behavior is entirely an ex-ante activity, based on the notion that a consumer (entrepreneur) can isolate a path through time and space along which he can perfectly foresee the outcome of his decisions. In order to do so with the perfection that the theory prescribes, the economic agent must be in full charge of  his input in the form of an action as well as his output in the form of experienced utility (profits for entrepreneurs).

Perfect pursuit of utility (profits) is possible only when time stands still. However, time prevents the creation or isolation of any such path. The point of maximum pursued by economic agents in standard microeconomic theory exists only in a time vacuum.

Mainstream theoreticians have a standard answer to the criticism that their theory is fundamentally incompatible with time: people do not act to maximize utility or profits; they act as if they maximize utility or profits. But in order to do so, people will have a comprehension of life without time – they need a grasp of the time-frozen path from their action to the consequence of the action.

This reasoning to defend mainstream maximization theory exhibits troubling properties. It adds an element of complexity in order to defend the theory, but the new element does not add any explanatory power to the theory. It does not help the theory explain more economic behavior than the theory was designed to do without it. The new element is simply added to defend the existing theory.

Kuhnian theory of science recognizes this as a defensive move of a dominating but challenged paradigm. A classic comparison in science history is the retrogressive orbits phenomenon. When terra-centric astronomers could not explain planetary movements as observed by heliocentric astronomers they added a new element to their theory. Instead of stipulating that planets moved in circular orbits around the Earth, they changed planetary orbits to include complicated loops, thus hoping to stave off the criticism that helio-centricists had presented them with.

Mainstream economics clings to the maximization theory with a similar desire to complicate in order to defend. In a matter of speaking, time has thrown a wrench in its machinery. It takes people’s focus away from the ideal, static path to a maximum of utility or profits. Instead, time introduces uncertainty into our lives. Time keeps the future open: its infinite horizon creates an infinite number of possible outcomes of every human action.

In his essay Uncertainty, Evolution and Economic Theory, Armen Alchian characterized the infinite horizon of time as a pattern of overlapping outcomes of our actions.[9] His point is that when an economic agent is faced with uncertainty, he has no way of distinguishing the possible outcomes of his actions from each other. Because it is impossible to make these distinctions it is also impossible to identify a path from decision to maximization. In fact, the very presence of uncertainty in our lives not only renders the maximization principle meaningless, but also provides a necessary condition for profits.

In other words, the very pursuit of profit makes impossible the maximization of profits:

In the presence of uncertainty – a necessary condition for the existence of profits – there is no meaningful criterion for selecting the decision that will “maximize profits.” The maximum-profit criterion is not meaningful as a basis for selecting the action which will, in fact, result in an outcome with higher profits than any other action would have, unless one assumes nonoverlapping potential outcome distributions.

An assumption of non-overlapping outcomes is, again, identical to assuming that uncertainty – and thereby time – is irrelevant to human action. Instead of the pursuit of maximization of profits or utility, Alchian suggests that entrepreneurs and consumers pursue “positive profits” and, by implication, “positive utility”. In decision-making they pursue the actions that will yield positive profits and positive utility by the highest possible certainty.

This does not mean that economic agents cannot achieve maximum profits or utility. But maximization has a practical meaning only as an ex post outcome. Because of the pervasiveness of time it is not possible to build a link from any ex-ante maximization decisions to ex post maximization outcomes:

It must be noticed that the meaningfulness of “maximum profits” – a realized outcome which is the largest that could have been realized from the available actions – is perfectly consistent with the meaninglessness of “profit maximization” – a criterion for selecting among alternative lines of action, the potential outcomes of which are describable only as distributions and not as unique amounts.

In reality, businesses realize positive profits while consumers realize positive utility. This condition for human behavior is weaker than the “maximum” condition but it relates better to the real-life economy. In a free market, positive profits are the reward for a more successful business performance than one’s competitors.

An important consequence of this definition of human behavior is that economic activity becomes free in its methodological foundations. A theory that stipulates maximization has a deterministic view of individual action; a theory that stipulates pursuit of positive outcomes provides the individual with an open end toward her own goals. Her preferences do not have to follow the closed-circuit utility functions used in mainstream theory; the individual is free to pursue her goals according to much more individualized preferences.

Alchian’s open-ended theory of human behavior is compatible with Friedman’s definition of economic freedom. His definition is well matched with Alchian’s use of time and uncertainty as constraints on individual action. However, his definition of economic freedom is prescriptive: it defines economic freedom a something we ought to pursue, as opposed to a descriptive definition that would tell us what economic freedom actually is.

Spontaneity and Economic Freedom

A recurring theme in the literature on economic freedom is that it allows economic activity to unfold spontaneously. Friedman alludes to this when he talks about freedom in economic arrangements. The idea of spontaneity has also made its way deep into the public policy literature on economic freedom.

In his book Realizing Freedom Tom Palmer outlines a contemporary view of economic freedom that is generally accepted as a libertarian definition.[10] Palmer thoroughly covers the literature in defense of free market capitalism, explaining that the free market is the home of a superior wealth-creating mechanism known as the spontaneous order. William Niskanen also makes a strong case for spontaneity and voluntary exchange as the wealth-creating driving forces of the free market.[11]

The term “spontaneous order” has a slight oxymoronic touch to it: it is questionable how something can be orderly and spontaneous at the same time. But the analytical intention behind the term obviously goes deeper than that. Just as with Friedman’s definition of economic freedom, the purpose is to emphasize the freedom of the individual economic agent to create economic order without the interference of government. For this purpose the term “spontaneous order” fills its purpose.

There is a methodological problem with the term, though. It is difficult to talk about “order” in the context of economics. While, again, the intention behind Palmer’s and Niskanen’s use of the term is to stay clear of deeper analytical waters, “spontaneous order” is nevertheless a hallmark of the Austrian school of economics. Its use in the context of economic freedom is more widespread than indicated by the examples provided here.

Economic activity is a complex flow of individual actions which fit together in the same economy with varying degree of friction. This is not a controversial observation; even Austrian theorists recognize the flow theory. Hayek, for one, makes references to it in his The Fatal Conceit.[12] Economic activity never halts or pauses for us to study it isolated from time. We can abstract a still picture, which in turn would allow us to identify some sort of order. However, the best way to understand how the economy works is to look at the flow of activity. It avoids the unnecessarily complicated methodological step of first bringing the flow to a halt, then studying it as if it was not a flow.

The correct term for a flow of various economic activities, where the relations between the activities do not change dramatically, is “stability”. In terms of our definition of the economy, derived from Shackle, this would mean that the economy is a flow of more or less stable activities pursuing scarce (or limited) resources through voluntary interaction. The stability of the economy is deliberate: it is created by economic agents and does not come about by random chance.

Our preference for stability is a direct consequence of time. Because of the infinite horizon of time, our future is always by default fundamentally uncertain. Uncertainty stifles economic activity; when we can create a predictable future, we are more confident to committing our time and resources to economic activity today. Confidence, in turn, comes from stability, and stability is created by deliberate human action.

Economic agents act to create a predictable, stable economy by means of explicit contracts (an apartment lease or an employment contract), explicit habits (such as always shopping for groceries in the same few stores) and implicit contracts (Wal-Mart keeps its assortment of products largely the same over time so as to cut search costs for us consumers). In theory, this is the exact opposite of a “spontaneously” driven economy. There is nothing spontaneous about acts that seek to minimize the risk for random or uncertain future events.

However, if we interpret “spontaneity” less rigorously than Austrian theorists would want us to, the term makes sense in the context of a flow of economic activity. The spontaneous moment is not in the activity itself, nor in the manner in which economic agents interact. Instead, it lies in the response to changed circumstances. When economic agents are presented with a reason to change their interaction with others, they can do so at their own discretion, when they want to and to whatever extent they prefer.

Herein lies the spontaneity of economic behavior. However, its relevance in defining the nature of the economy is weaker than the resistance to change: economic agents pursue stability by default, spontaneity by exception.

This does not mean that spontaneity is irrelevant as a concept in defining economic freedom. On the contrary, it is in times when economic agents need to respond to unforeseen events that spontaneity becomes critical. It means that we can change our economic arrangements – to use Friedman’s term – entirely according to our best judgment. This means that we can seek out new solutions to the satisfaction of our needs based on free-market principles: it is in the response to unforeseen events that the absence of government regulations and other incursions becomes critical.

We are now at a point where we can define economic freedom:

Economic freedom is the freedom of private citizens to stabilize and to spontaneously reorganize their economic activities based entirely on their preferences for the content and predictability of outcomes of economic activity.

Or, in so many words:

Economic freedom is economic stability created and managed by free markets.

What does this mean for actual economic policy? Part II will address that question. Stay tuned.

Endnotes


[1] Larson, S R: Ending the Welfare State: A Path to Limited Government that Won’t Leave the Poor Behind; Outskirts Press; forthcoming.

[2] Cassirer, E, et al (eds.): The Renaissance Philosophy of Man, University of Chicago Press, Chicago, IL 1969.

[3] Keynes, John M: The End of Laissez-Faire: The Economic Consequences of the Peace; University of Pennsylvania Press, Philadelphia, PA 1992.

[4] Shackle, GLS: Epistemics and Economics: A Critique of Economic Doctrines, Transaction Publishers 2009. See especially p. 23.

[5] von Mises, L: Human Action: A Treatise on Economics, Vol. II, Liberty Fund, Indianapolis, IN 2007. See especially p. 232.

[6]Hayek, F A: The Fatal Conceit: The Errors of Socialism; University of Chicago Press, Chicago, IL 1991.

[7] Friedman, M: Capitalism and Freedom, University of Chicago Press, Chicago, IL 2002; p. 8.

[8] Scully, G W: The Theory and Measurement of Economic Freedom, in Rowley and Schneider (eds): The Encyclopedia of Public Choice, Springer, 2003. Ludwig von Mises vaguely falls within this category: Human Action: A Treatise on Economics, Vol. I, Liberty Fund, Indianapolis, IN 2007; chs 3 and 6.

[9]Alchian. A A: Collected Works, Vol. I, Liberty Fund, Indianapolis, IN 2009

[10]Palmer, T G: Realizing Freedom: Libertarian Theory, History, and Practice, Cato Press, Washington, DC 2009

[11]Niskanen, W A: Reflections of a Political Economist: Selected Articles on Government, Policies and Political Processes, Cato Press, Washington, DC 2008

[12] Hayek (1991). See especially pp. 38-47.

3 comments

  1. Pingback: New Project on Economic Freedom | The Liberty Bullhorn
    • S R Larson

      Unfortunately, last spring most of my attention was focused on getting Industrial Poverty out, then other work took over. However, I have resumed work on this project, partly with reference to the new talks about economic freedom zones in the United States. Thanks for the reminder. It helps me prioritize.

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