All Commentary
Thursday, November 1, 1990

Markets and Pseudo-Markets

Dr. Boudreaux is studying law at the University of Virginia

The 1980s will be remembered as the decade in which “the market” gained a degree of respect worldwide that it never had or that it had only many decades ago. Most obviously, the overthrow of Communist regimes throughout Eastern Europe during the final months of 1989 holds promise for significant economic reforms that will introduce market mechanisms into those economies. Recent election results in Nicaragua, and current political maneuverings in the Soviet Union, also suggest that a continuation down the path toward freer markets is likely. Obviously, classical liberals should be pleased by these developments.

More time-tested reforms have taken place in the English-speaking world. In Great Britain, Margaret Thatcher’s program is an attempt to restore the market in that nation. And, of course, the United States in the 1980s was the Reagan era—a period in which “the free market” lost its vulgar connotation in the popular mind.

Although Thatcher’s and Reagan’s efforts deserve praise (especially when compared with the possibility of a continuation in the 1980s of 1970s-type policies), that praise should be only mild. The changes brought about were neither as extensive as those promised in the late 1970s and early 1980s, nor as permanent. Of course, Thatcher and Reagan faced political realities that made it extremely difficult to do more than bruise government on its lit-fie toe; any attempt to cut off an arm or leg of government almost certainly would have resulted in the loss of Thatcher’s or Reagan’s political head. It is a common theme that opponents of government intervention seldom win in battles with politically entrenched special-interest groups. It is also a common theme among classical liberals that ideas do matter and that long-run victory for the market is possible only with a fundamental change in the way people think about the role of government as compared with the role of the market.

I accept the claim that ideas matter. Therefore, I believe that the ideas marshalled in support of the market should be correct, promising neither too little nor too much. I argue here that a significant portion of the intellectual arguments under-girding the Thatcher-Reagan efforts were misguided. (Being a United States citizen, I confine my essay to the U.S. experience.) In brief, my thesis is that arguments in favor of “the market” are not necessarily arguments in support of classical liberal values. Restoration of “the market” is not an ultimate goal of classical liberalism. By focusing too much on “the market,” classical liberals and their friends can undermine the case for the ultimate classical liberal values of peace, prosperity, and liberty.

Arguments in support of these classical liberal values should focus, not on “the market,” but on the protection of private property and freedom of contract. It is these latter two institutions that are absolutely necessary for peace, prosperity, and liberty. Although private property and freedom of contract inevitably give rise to markets- -defined as the interactions of buyers and sellers for the purpose of exchanging ownership titles—markets as such are secondary phenomena in a classical liberal society. That is, classical liberals should aim their arguments at supporting private property and freedom of contract rather than directly at supporting “the market.” By doing so, free mutually beneficial exchange will be protected. More important, what I call “bastard markets” or pseudo-markets will be avoided. Pseudo-markets are markets that arise, not via the interplay of private property and contractual freedom, but via the suppression of these vital classical liberal institutions.

Pseudo-Markets versus Real Markets

An example of what I mean by pseudo-markets may be useful. Consider a manufacturing firm that has been purchasing its inputs from independently owned suppliers. Now suppose that a technological change occurs that allows this firm to increase the efficiency of its operation by merging with one of its suppliers. The institutions of private property and freedom of contract insure that this merger may take place. After the completion of the merger, no formal exchange occurs between the input-supply branch of the firm and the manufacturing branch. In a literal sense, a market relationship has been terminated. Suppose now that a court or an administrative government agency orders this merger dissolved. By forcing the manufacturing firm to sell its input-supply branch to an independent owner, a “market” relationship is (re)established: the manufacturing firm now engages in a greater number of formal exchanges than before because now it must purchase its supplies of this particular input from a separately owned firm.

But the market relationship created here by the court did not grow out of the institutions of private property and contractual freedom, instead, it resulted from the attenuation of these institutions. This is a pseudo-market; it is illegitimate from the perspective of classical liberalism. Compare this pseudo-market relationship with the market relationship that exits when the manufacturer and its input supplier voluntarily choose not to merge. In the latter case, the market grows out of the institutions of private property and freedom of contract. For this reason I call such a market—in this case for inputs—a “real market.”

A danger arises when people fail to account for the fact that protection of private property and freedom of contract is not synonymous with protection of markets. The danger is that the protective walls around private property and contractual freedom begin to crumble. The path is then opened for private property and contractual freedom to be violated by government. Few classical liberals will disagree with the claim that markets erected out of the material gathered from the dismantling of private property and contractual freedom promise neither lasting peace nor prosperity. And it can hardly be argued that these pseudo-markets are consistent with liberty.

When government has the power to use markets without respecting the private property and contractual freedom of its citizens, it can design and employ markets to achieve goals that have little to do with the individual goals of the people. As incongruous as it may seem, markets become a tool in the central planner’s kit of instruments for attempting to engineer society into some preconceived mold.

One problem with the use of pseudo-markets, of course, is that the central planner may desire a set of social outcomes that is different from that which contributes most to the welfare of the people. More fundamentally, political support for pseudo-markets can be purchased in democratic societies only when voters are promised specific benefits that the market supposedly will bring them. This support requires an explicit listing of what the pseudo-markets promise to do (e.g., reduce prices, increase employment opportunities, and so on). But such political support is tenuous because, by their nature, markets are simply a forum for ex-change-markets can expedite the exchange only of that which already has been produced. Although the signals sent out by market exchanges are crucial in the determination of what goods are produced and how, these signals emerge only in the actual process of market exchange. Thus, specific accurate predictions about the benefits and costs of a system of market exchange can seldom, if ever, be made.

Market signals—which relate relative intensities of consumer wants and relative scarcities of alternative inputs—cannot be predicted independently of the process that generates them because markets synthesize a vast amalgam of information “bits.” The signals sent out on the basis of this synthesis result in specific outcomes, the details of which no one ever could have hoped to predict. Markets, therefore, are a poor tool to use in at tempting to attain specific results. Thus, political support for markets based only on the promise of specific outcomes too often, if not invariably, leads to disappointment among those who lent their support to the market. In the face of such disappointment over the specific performance of the market, the political coalition built up to support the market dissolves. Support for the market eventually evaporates, and this “experiment” with the market is abandoned because of the popular belief that the market failed.

Consider, for example, the Reagan tax cut in 1981. The promised result was that government revenue would increase because of the “Laffer Curve” effect. Although debate still goes on about the actual revenue effects of this tax cut, the consensus seems to be that government tax revenues did not increase as a result of the 1981 tax- rate cut. That is, the specific market outcome that was anticipated did not happen. Reagan’s market experiment with lower tax rates was widely viewed as having failed, and the stage was set for 1982′s tax hike.

In contrast, had the 1981 tax cut been based upon arguments in support of private property, the observed outcome of the tax cut would have occasioned far less criticism. No one could have argued that the tax cut didn’t fulfill its goal. Under these circumstances, we very well might have avoided the 1982 tax increase.

Whenever pseudo-markets are created, they are usually intended to serve the interests of a politically well- organized group. But even when such markets fulfill their intended purpose, they seldom make a net positive contribution to the welfare of society.

An example of this recently occurred in the airline industry. United Airlines spent a great deal of resources developing its Apollo computerized reservation system. When United bought the rights to Pan Am’s Pacific routes, the court refused to allow the purchase unless United agreed to make its reservation system available for use by its competitors on terms that did not discriminate against its competitors and in favor of United.

By requiring United to deal with its rivals on terms that it would not have otherwise agreed to, the court, strictly speaking, created a market. But notice that United’s right to dispose of its property as it sees fit has been pushed aside by the court. Exchanges will be made that would not have taken place in the absence of the court’s decision. Clearly, the airlines who now have the right to purchase use of the Apollo reservation system from United are benefited by the court’s ruling; the court’s creation of this market helps these airlines.

However, consumers won’t benefit. Because the incentive to invest in the development of such reservation systems is reduced by the precedent set in the United-Pan Am case, fewer such systems will be developed in the future. In its attempt to protect the market for United’s rivals, the court found it necessary to modify United’s freedom of contract and private property rights. The result will be that airlines, on the whole and in the future, will be less efficient than they otherwise would be, and consumers will ultimately bear the cost of the forgone improvements in efficiency.

The Role of Classical Liberalism

Classical liberals should focus on the explication and defense of private property and freedom of contract, pointing out how these institutions are indispensable for well-functioning markets and for free and prosperous societies. The role of classical liberal principles is to restore private property and contractual freedom to their place of primacy in Western civilization—and to continue to introduce these principles to non-Western nations.

Classical liberals have the responsibility of opposing those who seek to engineer society through selective introduction of market mechanisms. The classical liberal must work to persuade others that markets that emerge out of the interplay of private property and contractual freedom are the only markets that promise genuine net benefits to society. The classical liberal must further remind others that markets created by the suppression of these institutions are not the type or form of economic organization that classical liberalism champions.

As we begin the new decade, the risk of disenchantment with the market is high. By failing to recognize the distinction between pseudo-markets and real markets, voters may well decide that the market is not all that it was claimed to be at the beginning of the 1980s. What the classical liberal must do is, to be sure, defend markets, but defend them only insofar as they are a natural and healthy result of private property and freedom of contract. It is the intellectual and moral foundations of these latter institutions that must be supported by sound classical-liberal argument. If classical liberals meet this challenge, restoration of the market—the real, not pseudo, market—will follow.

  • Donald J. Boudreaux is a senior fellow with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University, a Mercatus Center Board Member, and a professor of economics and former economics-department chair at George Mason University.