The Free Market—Efficient, Amoral, and Ready to Go


Adam Smith and John Maynard Keynes featured in articles by Ray Evans and Geoffrey Luck in the June issue of Quadrant. Evans and Luck directed some personal barbs at Smith and Keynes respectively, seemingly influenced by the skewed perspective of the Austrian school economist Murray Rothbard. This rankles but is not central to my theme. Central is the juxtaposition of two giants of the past who effectively sit at opposite ends of the political economy spectrum and whose economic legacies shed light on the regress of economics from its positive beginnings to its dismal modernity.

The economics of Smith and Keynes is a stark contrast of supply-side economics with demand-side. This has morphed, as it was bound to do, as I will explain, into a contrast of promise with despondency. Fortunately, commercial life goes on whether economics and economists are right or wrong. While it is true to say that wrong economics wielded by public-sector economists can do significant damage, any despondency about the economic future is greatly exaggerated. It stems from a lack of understanding of the way free-market economies work, what drives them, and how resilient they are.

Adam Smith’s positive economics, which set the agenda for economic thinking for 160 years, has been drowned out by the intrinsic negativism of Keynesianism. Keynesianism has done a much better job than Malthus ever did in transforming economics into the dismal science. And yet the facts confound the science. The evidence is overwhelming: in spite of profligate governments, discriminatory and burdensome taxation, ever-increasing regulation, and arbitrarily-imposed “redistributive justice”, efficient and amoral free-market economic forces have always found ways through to make us all richer.

Au contraire Geoffrey Luck, the efficiency of the free market and its morality are not open to debate. The economic progress of mankind in the face of bouts of despotism, wars, natural disasters, population explosions, uncontrolled people movements on a vast scale, and government meddling, is testimony to its enduring and ruthless efficiency. And it will be resilient enough to get the Western world out of the economic mess governments have created. As to its morality, that is a non-issue. To question the morality of the free market is akin to questioning the morality of the tides or the orbits of the planets. Morality simply doesn’t come into it. Outside of the strictures of the law of the land, the free market is unencumbered by requirements to produce outcomes satisfying some moral order. If it were not, it wouldn’t be free.

Of course, to say something is not open to debate doesn’t mean it won’t be debated. An invitation to debate whether bodies of different weight fall at the same rate in a vacuum would probably draw some willing to put the nay case. What it means in this context is that debating the efficiency or morality of the free market would be an empty exercise. To have meaning, the debate would need to be couched in different terms. The pertinent terms are clear enough. They are as follows. Could the performance of the free market (however efficient it is) be bettered through a different set of arrangements orchestrated by government? And should distributive outcomes (the moral order in this context) be evened out by government?

A first thing to say is that economics is not like physics or chemistry. Controlled experiments can’t be undertaken. Nothing can be proved. Everything remains frustratingly up in the air; ripe for exploitation by any itinerant crank who has read an expurgated Reader’s Digest version of an economics book. If we are led to the truth it’s through the deliberations of people of learning, with great minds, who have diligently examined historical experience and arrived at consistent and logical conclusions. Unfortunately, great minds have reached quite different conclusions. The result is that we have the left and right sides of politics. Singlehandedly, economics has wrought the divide which dominates political affairs.

Nicholas Wapshott (Keynes Hayek: The Clash That Defined Modern Economics, 2011) has popularised a comparison between the theories and conclusions of Keynes and Hayek. While this throws some light on the economic divide and the resulting political divide, it is more showbiz than substance. Hayek, justifiably acclaimed as he is for exposing the flaws, futility and dangers of economic planning, is a bit player in the development of the divide. Austrian economists, of whom he is a leading light, remain bit players to this day. Effectively, they added nothing of substance to the insights of classical economics.

The key to the divide can be traced back from Keynes, who is the economics standard-bearer for the Left (Karl Marx having long departed the scene) to John Stuart Mill, who actually grappled with Keynesianism in prescient fashion before it was invented and, ultimately, to the father of classical economics, and economics itself, Adam Smith. While Mill is a splendid and almost peerless standard-bearer for free-market economics, he doesn’t quite have the credentials that come with being the first among the giants.

There is always contention about attributing originality. Ray Evans seems to be unequivocal about it: “Adam Smith was not the founder of economics”. Many years ago a left-wing colleague at the University of Adelaide repeatedly told me that the Polish economist Michal Kalecki had independently developed Keynes’ General Theory. Of course I had not read Kalecki. Few people had. Justifiably or not, Keynes retained his exclusive authorship. Irving Fisher (The Theory of Interest, 1930) put it well: “In economics it is difficult to prove originality; for the germ of every new idea will surely be found over and over again in earlier writers.” I dare say other disciplines suffer from the same ambiguity. Seldom does something of substance come out of a vacuum. Galileo, Newton, Einstein, Adam Smith; all surely leant on their predecessors and contemporaries. That hardly takes away from their achievements and their impact.

It is a sterile endeavour to try to attribute invention or originality to those who lacked the finesse or energy or communication skills or sheer luck to publish their results in a way that could be understood and gain currency. To quote Terence Hutchinson (Before Adam Smith: The Emergence of Political Economy 16621776): “political economy, in any intellectually serious form, hardly existed before the appearance of The Wealth of Nations”. W.B. Todd in his introduction to an edition of The Wealth of Nations (Clarendon Press, 1976) approvingly quotes Dugal Stewart, whose life intersected Smith’s:

perhaps the merit of such a work as Mr Smith’s is to be estimated less from the novelty of the principles it contains, than from the reasonings employed to support these principles, and from the scientific manner in which they are unfolded in their proper order and connexion.

Adam Smith is undoubtedly a giant on whose shoulders others stood and continue to stand. He elegantly set out the enriching effects of free markets just as he emphasised their amorality: “It is not from the benevolence of the butcher [etc] that we expect our dinner, but from their regard to their own interest.”

It is not Keynes versus Hayek, but Keynesianism versus Smith that holds the key to the economic and political divide. It also holds the key to understanding the state of the economic world in which we live. An important distinction between Keynes’s economics and Keynesianism is an essential part of the story. Explaining this involves grappling with the relationship between investment and saving: one of the most slippery concepts in all of macroeconomics. Is this fit material for a Sunday afternoon reading Quadrant? Slippery though it is, it can be easily grasped if approached in the right way. The right way is to distinguish between stocks and flows.

Adam Smith’s perspective was retrospective. He explained how things worked out as they did. He dealt in stocks by observing that capital accumulation requires the availability of savings. In other words, the only way you can take time out to build a boat on a desert island is if you’ve saved some coconuts and berries to tide you over. You can’t do the investment unless you have the stock of savings. This analysis is perfectly sound.

Keynes’s perspective was prospective. His objective was to explain how things would or might work out. He dealt in flows by observing that the flow of capital accumulation (investment) and savings are always, by definition, equal. Keynes was right. Hard thinking to understand this equality is best not undertaken and, fortunately, is not required. An accounting exercise suffices. Income equals investment plus consumption. Income minus consumption equals savings. Ergo investment equals savings. This analysis is perfectly sound. On its face it also seems innocuous. But it is the “singularity” from which the Keynesian revolution sprang and upended economics.

Like Fred Astaire and Ginger Rogers performing the tango, the flow of investment and savings move as one. But as we know, all unseen, Fred is doing the leading. Keynes had investment doing the leading. All of his revolution then fell into place once investment, as he thought, was hostage to entrepreneurial “animal spirits”. He observed that such spirits can wax and wane, and go into lengthy periods of funk when entrepreneurs become pessimistic about their ability to produce things that people will want to buy at profitable prices.

As George Gilder (Wealth and Poverty, 2012 edition) perceptively notes, “the actual works of Keynes … are far more favourable to supply side economic policy than current Keynesians comprehend”. Keynes, he suggests, got right the role of entrepreneurial “animal spirits” in driving growth. He “restored to a position of appropriate centrality in economic thought the vital role and activity of the individual capitalist”. Unfortunately Keynes then took the eccentric path of suggesting that the “socialisation” of investment was the way to ensure sufficient investment and full employment. I don’t want to go into this in any detail because nobody else did; and certainly not his acolytes. They jumped ship at this point to save themselves—I assume from potential ridicule—and separately developed Keynesian economics.

Joan Robinson, one of Keynes’s acolytes at Cambridge, reportedly said that Keynesian economics had to be explained to Keynes. Conjecture the scene with all around him singing his praises for developing this new economics. “But—but that’s not what I meant”, was probably stillborn on his lips as he savoured the accuracy of his prediction to George Bernard Shaw that he was about to revolutionise economics.

Enough of conjecture; in jumping ship his acolytes and subsequent followers developed an economics (Keynesianism) which said, well, if entrepreneurs are worried about their products not being bought we’ll supplement demand through dollops of government expenditure. How did this catch on and become entrenched in the language and policy of economics? Perhaps the allure of its surface simplicity effectively veils its simplistic core. Who can say? I have to admit to succumbing to its allure for some years in the distant past. But, simplistic or not, make no mistake; Keynesian economics has shown itself to be strong enough to repel all challenges. The bulk of the economics professions, including many economists of renown, have kept the faith over six decades and more. It is a powerful explanation of the way the world works. It is not easily taken apart. If it were, it would have been. And, as tilting at windmills is a wearying task, it is fortunate that my objective is not to rail against Keynesianism per se—at least not right now. My objective is to uncover its implications for the way the economic world is viewed and to contrast this with what I believe to be a more accurate vision courtesy of Adam Smith, albeit with some help, perversely enough, from Keynes’s entrepreneurial man.Smith concentrated his economics on production (based on the scope for exchange, the potential extent of the market, and the benefits of the division of labour). So unconcerned was he about demand that he was insistent that “what is annually saved is as readily consumed as what is annually spent”. This perceptively pointed the way to Say’s Law before J.-B. Say, as it did to Mill’s later spirited rejection of the possibility of any endemic shortage of demand. Gilder charges that Smith puts the mechanism of the market at the centre of capitalist growth rather than entrepreneurial man. “Man, however, not mechanism is the heart of capitalist growth.” This, I think, does too little justice to both Smith and to the role of market mechanisms.

Who does Gilder think Smith had in mind in deciding what and how much to produce? Smith also identified saving (“parsimony” or “frugality”) as the essential ingredient of capital accumulation by which nations grow “opulent”. Again it was implicit that particular men of vision put savings to work. However, it must be conceded that this wasn’t made explicit; as Keynes rightly made it explicit. To that more limited extent Gilder’s charge sticks. As to market mechanisms; successful entrepreneurs operate in sync with the market and with market prices even while hoping to mould them. It is a two-way street. Producing something for ten dollars which can only be sold for nine doesn’t work, however apparently inspired the venture. Prices move instructively to guide entrepreneurs in individual product markets. And when it is all put together hesitantly and with many hiccups, supply overall (near enough) matches demand. As Mr Micawber might have said, result happiness. Keynes simply ignored market prices, and this is fatal to economic analysis. His economics was all macro and no micro. Smith specifically had prices shifting resources from one endeavour to another as market prices differed from what he called “natural prices” (costs of production). That his costs were expressed as labour costs is incidental and probably reflects, in large part, the times in which he lived.

Economics can say very little about the world without explicitly considering the role of markets and prices. Gilder understates the case; Smith did not; Keynes ignored the whole matter. On the other hand, Keynes trumped Smith in explicitly giving entrepreneurial expectations primacy in driving economic growth in an uncertain world. Maybe if Smith’s economics doesn’t quite do it alone, bringing along Keynes’s entrepreneurial man completes the picture. The combination of the two provides an insightful perspective on the current economic malaise and also an instructive set of tools. In contrast, the current economic malaise has left Keynesianism bereft of insight and answers.

Imagine a world of unemployment, where industry is producing less than its capacity, where consumers are cautious and uncertain and saving more of their income than they formerly did, and where government has built up onerous debt and is running large deficits. Not too much imagination is required. It is real life in the United States, in most of Europe and, to a lesser extent, in Australia.

Now imagine, along with most economists, most governments, and the IMF, you are locked into thinking like a Keynesian. In this mindset, demand drives growth. How in the world do you put things right; reduce unemployment and increase economic growth? More government spending is difficult. With so much outstanding debt to service, financial markets react badly to new debt. If only those pesky consumers still in jobs would lift their spending—presumably on existing products produced by existing industries and businesses—which they clearly don’t want to do. In the wings, the IMF wrings its hands about too much government austerity reducing demand; but less austerity putting the system at risk.

It is no wonder that the situation looks conflicted and hopeless and that despondency hovers. Focusing on demand is focusing on the cart when the focus should be on the horse. The horse in this case is production and those who drive production to new heights and how they do it. A particular variant of this intellectual myopia is treating business investment and consumer spending as similar parts of a congealed aggregate called domestic demand.

Business investment and consumer spending are chalk and cheese. They are quite different. One is the wellspring of producing more goods and services; the other eats them up. Buying and drinking wine (consumption) is not the same as, and comes after, planting vines (investment) and then picking, pressing, maturing and bottling (production). There are two essential sides to an economy: the producing side and the buying side. Both are necessary. However, boundless wants go unrequited without production. Business investment and production have primacy, not willy-nilly spending. Consumer spending and most government spending eat up production; they don’t add to it.

Christine Lagarde and her IMF economists recently claimed that the United States government’s “deficit reduction in 2013 has been excessively rapid and ill-designed”. The IMF also issued a mea culpa for underestimating the effect of austerity measures on economic growth in Europe. Where does this lead except to despondency? Excessive government expenditure results in untenable deficits and debt which can’t continue. But, apparently, cutting government expenditure results in untenable reductions in economic growth. What a dilemma. Just maybe the economics is wrong. There is no doubt that withdrawing wasteful government expenditure is disruptive. The process can be likened to withdrawing drugs from an addict. The initial effect is not pretty. But, given time, private sector investment and production will more than take up the slack.

It is silly to think that the IMF or anybody in the economics profession does not understand the role of business investment and production in contributing to economic growth. Of course they do; that isn’t the point. It’s the emphasis they give to the demand side of the economy in driving growth, courtesy of Keynesianism, that creates a policy dilemma and which, in turn, generates an air of despondency. Economic salvation lies on the supply side; on the Adam Smith side. The key is to give business the scope and freedom to invest by cutting the government’s claim on resources and by reducing regulatory obstacles to hiring labour, developing and using resources, and to exploiting opportunities. But let’s not fall into the trap of becoming despondent because economic policy-making is inept. Free markets are resilient and survive maladministration.

One important measure of this resilience, in keeping with Smith’s focus on the supply side and with Keynes’s focus on entrepreneurial man, is the continued development of new businesses throughout the course of economic cycles. As is generally the case, US data are more readily available than most. The Bureau of Labor Statistics publishes a quarterly series that it calls “births of business establishments”. I have converted this to an annual series of “new business start-ups” below.


New business start-ups (x 1000)

2002                812

2003                777

2004                829

2005                867

2006                872

2007                844

2008                796

2009                701

2010                742

2011                781

2012                769


There was a fall-off in new business start-ups in 2009 during the height of the recent recession (and of course a rise in business failures). But the impressive aspect of this data is how well start-ups held up and how quickly they began to recover.

It is often forgotten that the economy is a large venture. Booms and recessions represent the excess or paucity of icing on the cake. Free-market economies remain largely intact throughout business cycles and are continually providing price signals and throwing up business opportunities. Savings also tend to rise during recessions, providing the wherewithal to fuel investment in new opportunities.

As long as your focus is an Adam Smith one of looking at the supply side, the increased propensity to save is a promising development. If you are a Keynesian and preoccupied with demand you will find only cause for despondency in increased saving.

The sterling performance of free-market economies in increasing living standards decade after decade is a fair indication that, on the whole, optimistic predictions of economic outcomes consistently turn out to be closer to the mark than pessimistic ones. Which is not to say, of course, that the application of better economics would not improve outcomes.

Peter Smith’s book Bad Economics was published recently by Connor Court.



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