(This essay was published in Hong Kong Economic Journal on 2 January 2013)
In the previous article I wrote about Schumpeter’s analysis of capitalism and democracy, which led him to predict that, much to his regret, socialism would eventually replace capitalism. Even though his prediction turned out to be incorrect, he made valuable contributions in his development of the concepts of creative destruction and electoral competition.
Schumpeter believed that the capitalist engine of creative destruction would lead to economic displacements and disruptions as the old was replaced by the new and this would create a political backlash in democratic society that would make capitalism vulnerable to socialist persuasion. He believed that ultimately socialism would prevail and that socialism could be compatible with democracy.
Milton Friedman, writing twenty years later, disagreed with Schumpeter on this final crucial point. In Capitalism and Freedom (1962), Friedman cited numerous examples to show why democracy and socialism could not coexist. Friedman, however, shared Schumpeter’s concern that democracy could undermine capitalism under some circumstances, and like Schumpeter, he believed capitalism and democracy would be mutually supporting if and only if there was a commitment to a laissez faire system.
Exchange Control Effects Freedom
For Friedman, free competitive capitalism represented economic freedom and open electoral competition represented political freedom. He tried to demonstrate that there was an intimate connection between the two and thought Schumpeter was mistaken to believe society could still have political freedom when economic freedom vanished under socialism.
Friedman’s first example was exchange controls. He observed that a British citizen living in the UK after World War II could not spend his vacation in the US because of the exchange control. At the same time, a US citizen in the McCarthy era could not spend his vacation in the Soviet Union because of his political views. The British citizen was subjected to an economic limitation on freedom and the American citizen a political limitation. Friedman reasoned that in terms of final effect there was no essential difference between the two.
A citizen is deprived of a part of his personal freedom when a law compels him to save 10% of his income to purchase a retirement plan; to give up an occupation of his own choosing unless he can get a license for it; to be fined for selling a product below the price set by an authorized dealer because it violates “fair trade laws”, face prohibitions on “parallel imports”, or “quota restrictions”; and so on. Such economic restrictions on freedom are important because of their effect on the concentration and dispersion of power.
As a form of economic organization, competitive capitalism protects economic freedom directly because it separates economic power from political power and keeps government out of economic activities. A limited government will exercise minimal power over economic activities. Individuals are then free to make voluntary economic choices for themselves through private markets.
To Friedman “the fundamental threat to freedom is the power to coerce, be it in the hands of a monarch, a dictator, an oligarchy, or a momentary majority. The preservation of freedom requires the elimination of such concentration of power to the fullest possible extent and the dispersal and distribution of whatever power cannot be eliminated – a system of checks and balances.”
Friedman believed it was no accident that historically political freedom had emerged under free market capitalism. Capitalism was for him a necessary condition for political freedom, although he recognized that it was clearly not a sufficient condition given the many examples to the contrary. For instance, fascist states emerged in capitalist economies like Germany, Italy and Japan before World War II. Friedman did not study the reasons for this, but he did believe the Great Depression contributed to the rise of fascism. The severe effects of economic contraction made people willing to tolerate extreme political parties and suppress political freedoms.
Political Freedom May Not Imply Economic Freedom
Friedman was concerned that in a socialist economy, economic activity would be largely owned by the state. When this happened, he believed political freedom would also be curtailed. A citizen who owes his daily bread to the state cannot reasonably be expected to bite the hand that feeds it. Moreover there would not be easy alternative sources of funding to support political activities hostile to the state.
He cited the striking example of the experience of Winston Churchill. “From 1933 to the outbreak of World War II, Churchill was not permitted to talk over the British radio, which was, of course, a government monopoly administered by the British Broadcasting Corporation…He was not permitted to talk over the radio to the British people because the BBC was a government monopoly and his position was too controversial.”
In contrast to the BBC, Friedman cited the example of privately owned American movie studios in Hollywood during the McCarthy era. About 150 writers were blacklisted as suspected communists or fellow travelers, and films involving Communists and anyone who refused to testify at the 1947 hearings on Communism were also barred from Oscar competition. However, they could still find work. Writer Dalton Trumbo used a pseudonym for the film The Brave One, which won an Oscar for best writing; he had been one of the original Hollywood Ten writers who refused to testify at the 1947 hearings. Frank King the producer of the movie claimed that “We have an obligation to our stockholders to buy the best script we can. Trumbo brought us The Brave One and we bought it…” and insisted the writer was “a young guy in Spain with a beard”.
Friedman writes: “If Hollywood and the movie industry had been government enterprises in England [and] it had been a question of employment by the BBC, it is difficult to believe that the Hollywood Ten would have found employment.” The preservation of political freedom was more effective in the US precisely because the movie industry operated along free enterprise capitalist terms that permitted those writers who were blacklisted to be employed anonymously.
Having said that, however, Friedman also believed the relationship between political and economic freedom was complex and not unilateral. In the nineteenth century greater political freedom led to the endorsement of a laissez faire system. But in the twentieth century the tendency to collectivism greatly accelerated with the further extension of political freedom. Welfare rather than freedom became the dominant concern in democratic countries.
Promoting Free To Choose
Democratic governments in capitalist economies became increasingly involved in economic production and the regulation of private enterprises. Redistribution also grew rapidly as governments enacted numerous social transfer programs in response to interest group lobbying efforts. Figure 1 shows that the average government expenditures as a share of GDP grew in developed economies from 10.7% in 1870 to 45.6% in 1996. Moreover, average government expenditure on subsidies and transfers grew even more dramatically from 1.1% in 1870 to 23.2% in 1995.
The continued growth of government intervention in economic and social activities signaled the decline of capitalism and the rise of socialism that Schumpeter had predicted. Friedman feared that the growing power of the state in economic activity would not only sap the creative energies of the capitalist engine, but also lead to the loss of personal freedoms. A larger state was a more powerful state and a greater threat to individual liberty.
Like Schumpeter, Friedman was worried about the future of capitalism. But unlike Schumpeter, he did not believe the future of capitalism could be predicted. On this issue, Friedman was greatly influenced by Karl Popper’s view that the future of any society depended on the knowledge that people possessed and that could be discovered. Since it was not possible to predict what kind of knowledge would be discovered, it was therefore impossible to predict the future of society.
Instead, Friedman was more interested in persuading the public of the benefits of capitalism and freedom for human society. He believed that if people became better informed they would choose capitalism and freedom and he used many examples to help ordinary citizens understand his point. His book Capitalism and Freedom was written in a language that could be accessible to the ordinary citizen. Free to Choose, written jointly with his wife Rose, was even more oriented towards the ordinary citizen.
In Capitalism and Freedom, Friedman set out in thirteen chapters an agenda of policies that governments in a democratic society should pursue in order to preserve economic and political freedom. His discussions were incredibly original and refreshing at the time, and full of real practical sense. People who have read his book and heard him speak were often convinced by his arguments and many were inspired.
Barriers to Entry Create Monopolies
Friedman first argued that the role of government should be limited largely to that of a rule maker and umpire, maintaining law and order and providing national defense and a stable monetary framework. These rules should be applied to all, both the ruler and the ruled. Although the need for government arises because absolute freedom is impossible and conflicting claims to freedom of action among individuals must be resolved, he showed that the market can resolve these in the vast majority of situations through voluntary exchange. There is no need for individuals to conform to a government-mandated outcome.
However, two situations might allow for a possible role for government action or intervention. The first is monopolies and the second is externalities.
In the case of monopolies he argued that the vast majority are created by government and should be ended. (A recent example of a government created monopoly in Hong Kong is the licensing of additional free-to-air broadcasting stations.) Friedman also opposed the licensing of occupations arguing that such barriers of entry create monopolistic powers in pricing. They only deprive customers of their full choice. By the same token he opposed labor unions as creating market power for union members at the expense of non-union workers.
In those few situations where there is a natural monopoly, he wrote, “there are only three alternatives that seem available: private monopoly, public monopoly, or public regulation. All three are bad so we must choose among evils.” After examining the results of public regulation studied by Henry Simon and of public monopoly studied by Walter Eucken, he writes, “Having learned from both, I reluctantly conclude that, if tolerable, private monopoly may be the least of the evils.”
Friedman further observed that the choice among the three alternatives should not “be made once and for all”. A natural monopoly may on occasion justify a de facto public monopoly, but it should not be protected from competition by making it illegal for anyone else to enter the business. Over time the technical conditions of a natural monopoly could change with technology and other factors so that it ceases to be a natural monopoly. He reasoned a public monopoly would be more likely to prevent the emergence of new competitors than a private monopoly would. For this reason, one can understand why he believed that over the longer term a private monopoly was the lesser evil.
This is a concept unfortunately not embraced in Hong Kong. The recently adopted Hong Kong Competition Ordinance (2012) exempts all public monopolies from having to comply with the new legislation, thereby leaving those areas where competition is most needed totally beyond the reach of the new legislation.
Interventions Erode Public Trust
Friedman was prepared to allow government involvement where necessary, but he believed in many cases this was unjustified. Rather, government should encourage private provision and open competition. An example he cited was parks. A public city park might be justified on the grounds that it was very difficult to identify those individuals who would benefit from it and to charge them for the benefits they received. In a national park, on the other hand, it would be relatively easy to collect fees from individual users, so these parks could be operated by private enterprises, which would be more likely to introduce modern management practices and technological innovations for conservation.
On monetary policy, Friedman advocated the adoption of a constitutional monetary rule that would require the central bank to increase money supply at a fixed rate to preserve price stability and accommodate the average growth of the economy. He did not believe that central banks should have other objectives like full employment. And he was in favor of a high degree of autonomy for the central bank under these constitutional rules. He believed money was a crucial public good and the maintenance of its value was akin to maintaining public trust in government and the capitalist economy.
Money was too important to be exploited for short-term political and policy purposes, according to Friedman. He understood that business cycle fluctuations were a constant source of stress for the capitalist economy. The Great Depression had been an important cause of the rise of socialism and the welfare state. Sound money would reduce business cycle fluctuations by creating a less uncertain long-term policy environment. An active government relying on discretionary short-term interventionist policy measures would only increase uncertainty.
Friedman’s distinction between policy rules and discretionary policy interventions was a path breaking idea in policy reasoning and inspired a huge amount of Nobel class research. The idea is based on a story every child learns in kindergarten. It is the story of the little boy who cried wolf to fool the villagers, only to find that on the third time, when the wolf really did appear, nobody believed his cries anymore. Governments that intervene frequently lose the trust of the public so that further policy interventions have no effect.
Friedman next showed why free trade and free capital flows were desirable. An open international economy requires a consistent set of international payment arrangements. Only two systems were compatible with free markets and economic freedom: a unified international monetary system like the Gold Standard or a freely floating exchange rate system.
Free Markets Reduce Discrimination
He recognized at the outset that in a world where national governments were democratically elected, it was difficult to sustain the Gold Standard. He believed the return to the Gold Standard after World War I was the single most important reason for the subsequent Great Depression that led to the rise of fascism in Germany.
Democratic governments that were held hostage to politicians and voters looking for short-term policy fixes could not be trusted to maintain policy discipline in an open international economy. They had to be discouraged from “defending” the exchange rate in the face of international economic fluctuations and delaying necessary and inevitable adjustments. It was far better for them to adopt a floating exchange rate regime instead.
Friedman was critical of Keynesian fiscal policy, arguing that its short-term stimulation effects in stabilizing the economy were greatly exaggerated for both theoretical reasons and on empirical grounds. Moreover, he showed why fiscal spending would “crowd out” private spending. Government spending today leads to public debts that have to be financed by future taxes. The private sector would naturally anticipate this reduction in their future incomes, which would lead them to curtail their consumption and investment spending. If government spending were more wasteful and less productive than private spending, which Friedman believed to be the case, then the overall economy would be more harmed than helped.
Friedman also argued that the free market was the best defense against discrimination – racial, sexual, religious and so on – because employers who practiced discrimination would be punished by the market by lower earnings if they refused to hire the most productive workers regardless of their background.
In education and housing, he was in favor of using vouchers as a subsidy to help those who could not afford to pay the market price, but at the same time maintaining competition so providers would perform and respond to consumer preferences. Public provision of education and housing was not necessary for helping the poor. Although most countries used this excuse when funding these services, the real effects had been to protect the interests of existing providers by limiting competition.
For this same reason, Friedman argued against most forms of publicly funded and provided social welfare measures, including a compulsory mandatory old age social security system, because these deprived people of a choice in old age insurance plans and how much to save. He preferred always to offer people alternatives without compulsion, and favored a competitive provision of such services rather than a public monopolistic provision.
A Radical Not A Conservative
He was also critical of the income redistribution effects of these schemes, believing instead that poverty alleviation should be separately dealt with rather than bundled with compulsory public retirement insurance schemes. To tackle poverty Friedman proposed using a “negative income tax” or an “income guarantee scheme” to supplement low income households directly with income rather than indirectly with subsidized services.
Subsidizing services often benefited the provider more than the consumer, especially if free entry into service provision was limited, were inefficient and were sometimes wasteful if not fraudulent. Dispersing cash on a means tested basis or through the tax system would give the maximum benefit to low-income households using the cheapest means. Friedman’s proposal was widely supported by a broad political spectrum of economists.
Friedman’s contributions were not limited to setting the agenda for free market capitalism. He also believed political freedom depended on economic freedom. His work in Capitalism and Freedom showed how an incredibly wide range of policy choices could be devised to achieve the same set of policy objectives in a manner consistent with the exercise of free choice.
Friedman was tireless in his endeavor to speak “truth to power”. For him this power was vested in the public. He believed it was not fruitful to convince politicians of his ideas; rather it was the people who should be convinced, who would then tell the politicians what they must do to keep their jobs. Friedman told economist that they should not be devising policy schemes that were politically feasible or acceptable, but what should be adopted as a first-best solution.
Although the media has labeled Friedman as a conservative, he was actually a radical who wanted to change the status quo of the rising social welfare state in the twentieth century and stem the slide into socialism. Friedman accomplished a great deal in his lifetime in convincing the public to limit the growth of government, but his long agenda remains largely unfinished.
Milton Friedman, Capitalism and Freedom, University of Chicago Press, 1962.
Joseph Schumpeter, Capitalism, Socialism and Democracy, Harper and Brothers, 1942.