Faith in Free Markets
by Joseph Rowlands

Free markets are well known to be efficient, to drive down costs through competition, and to increase the total amount of wealth produced. Unfortunately, people often treat free markets as some kind of magical process, guaranteeing efficient results no matter the circumstances. Anarcho-capitalists treat free market this way when they suggest a free market in coercion will lead to efficient result. But many others ignore the processes involved and believe that free markets just work. This can cause problems.

A common criticism of free markets, and those that support them, occurs when some significant problem is found in the economy. A recession is an example. The bursting of technology or real estate bubble is another. Widespread unemployment, inflation, spikes in gas prices, and many other events also count. Each one is viewed as some kind of problem with the free market. If it leads to disastrous results, how can anyone defend it?

The assumption here is that free markets just work, no matter what the circumstances are. Critics will mock supporters of free markets for taking it on faith that markets will perform perfectly, despite the contrary evidence. And for those who treat it is an automatic and dependable source of good, the criticism is valid.

One rebuttal often made is that we don't have a genuinely free market. There is plenty of government intervention of various types. So when something bad happens, you can blame it on the government intervention. This is true, but with a description of the details, it sounds a lot like supporters of communism who say it would work if practiced consistently, but that's never been tried. It's as if the economic system works by magic, but that these other factors somehow prevent the spell from working.

Instead, the free market needs to be seen as a myriad of individuals reacting to local incentives and information. Each attempts top optimize his own position by reducing costs, increasing profits, improving quality, or even moving into a more profitable field of work.

The advantage of this model is that we can see how apparently minor government interferences can cause massive effects on the economy, as well as why the market is unable to adjust to these problems.

Consider one kind of interference. The government might subsidize a particularly company or industry with a fixed amount of money (one time payout, instead of per unit payout). If the money goes to a single company, that company is able to sell its product at a lower price than its competitors. We can expect customers to react by shifting to the lower priced products, making the other companies less profitable as their revenue decreases.

Similar effects occur when an industry is subsidized. Allowing products to be sold at a lower price will shift purchases towards that industry. Other industries that satisfy the same needs will likely suffer the most.

Subsidizing an industry obviously has an effect on the economy, but it is limited in scope. If the subsidy is finite in scope, the companies that get it will be able to lower price a limited amount. If they lower prices too much, consumers may purchase too many products at that price, and eventually the company will start taking losses.

Another kind of interference can have a much larger effect. This is the price control. When the government sets a price, whether too high or too low, it can have drastic effects.

If a commodity like gasoline is price fixed below market rate, there will be shortages as consumers line up to purchase gasoline but there is not enough that can be produced at that price. Marginal producers will no longer be able to afford to supply gasoline to the market, and will close shop either temporarily or permanently. So not only will there be more customers trying to purchase at the lower rate, but there will be less supply available. If the price is set very low, it could potentially destroy the entire supply as no company can find a profitable way of bringing it to the market.

This massive effect can occurs with a single directive of government. It doesn't take massive taxation, redistribution, subsidies, or any other active participation in the market. It takes so little to have such an enormous effect.

Why is this? If we viewed the free market as some kind of magical institution, we wouldn't expect these seemingly minor interferences to have a bigger effect than the big interferences. If the market self-corrects, shouldn't it be able to handle a slight bump in the road?

If we don't think of the market as a single entity, but view it as millions of people making decision based on local incentives and information, it makes more sense. A subsidy will tend to have a more diminished effect because it introduces a finite quantity of disruption. The business that is subsidized will alter there price some, but as the subsidy is consumed they will have to adjust the pricing back to normal. A price control is different. It has a potentially infinite effect. There is no getting back to normal. It is a permanent change in the incentives of the market. Instead of gasoline being a profitable endeavor, it suddenly becomes permanently unprofitable.

A price control is far worse than a subsidy because a subsidy has a finite effect, while a price control has a permanent and infinite effect.

Some prices are far more important than others. If a single toy is price fixed, it's effect on the economy will be small because it will only alter the behavior of a small number of people. It's entirely different when a significant and widespread price is fixed. One example of this kind of price is the price of labor. A minimum wage law has a widespread effect.

A minimum wage law prevent people from working for a lower wage than the law allows. If an employee thinks it can make additional money by hiring someone, they will try. But a minimum wage law raises the amount of money needed to make hiring someone justifiable. If a new employee will likely increase revenue by X amount, but it takes more than X to hire the employee, they won't do it.

What makes this a significant price is that it affects the behavior of far more people. It's a incentive that impacts many, many decisions. Price fixing something small like a toy will only affect that local industry and some potential consumers. Fixing the price of labor would have a massive effect. It would be expected to increase unemployment significantly.

The minimum wage is a major price, but because there is so much variance in terms of productivity anyway, it tends to only affect a minority of the population. Even if 10% of the population become unemployed due to it, the other 90% would continue to operate about the same.

Another price that's even more significant is the interest rate. When the government lowers the interest rate, it makes it much less attractive to save/invest, and much more attractive to borrow. Like other price controls that set a price below market rate, this causes shortages as there are not enough suppliers (lenders) to satisfy all of the consumers (borrowers). However, the central banks acts as a lender, making money out of nothing, to cover this difference (in practice, they create the money in order to lower the rate, instead of lowering the rate and covering it with money).

Interest rates affect every business decision. Production always takes time, and the interest rate determines how much time a process can take and still be profitable. If you want to build a new product and need a loan, your prospect for paying back the loan depends on how much time it'll take you to complete the product and how high the interest rate is. The lower the rate, the more time you can take as you will pay less in interest. If the rate goes up, in order to complete production and pay the same amount in interest, you'd have to complete it sooner.

Every business has to consider interest rates, even if they aren't planning on getting loans. Investment is measured by the rate of return. If you take longer to complete, the rate of return goes down. Other investments may be a more profitable use of the money.

Lowering interest rates causes widespread economic distortions. The major problem is that prices are used to coordinate activities. Businesses can determine if they are using resources productively by determining if they can make a profit. If their revenue is greater than their costs, they were able to utilize the resources well. And the economy as a whole works because of that.

But price fixing distorts the incentives and information. When the government fixes a price, people act based on this new incentive. They act as if it was a proper indication of productivity. If a price is fixed too high, they will find alternative methods of production that avoid that input. If a price is fixed too low, they will want to use that input more, but they'll find out eventually that there's not enough to go around. The price may be fixed, but the underlying relationship has not changed. If gasoline is hard to come by, but the government sets the price low so it looks like it is plentiful, it only appears that way.

Similarly, when the interest rate is lowered, it appears there is wealth to be borrowed. It assumes that capital is plentiful, and people act as if it is. But setting a price doesn't change the reality. And printing money doesn't help. Inevitably it leads to more money chasing less wealth, and there will be shortages. If government continues to print money to maintain the illusion, they will have to chase less and less wealth with more and more dollars, and you get a bad case of inflation.

Critics of the free market point to the supposed ability of markets to self-correct and then ask rhetorically, "If all of these problems are caused by the interest rate or through printing money, why didn't the market adjust?". They aren't really looking for an answer, though. They are using it to claim it is absurd to think the markets are efficient.

In reality, the market is just millions or billions of people acting on local incentives and information. Price fixing changes the incentives for them, and continues to distort their choices. The market doesn't work by magic. It works by shifting production towards more profitable endeavors. But if profit is determined with false prices, the reality is that the profitable endeavors are no longer necessarily efficient.

Instead of being able to overcome any problem thrown at the market, we have to understand that markets self-correct through specific means, and governments can invalidate or subvert those means. Through the use of price fixing, the government can create massive distortions and shift production in countless and unexpected ways.

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