4 Misconceptions About Free Markets

By Andrew Beattie AAA

Economics has a bad reputation for being an imprecise and contradictory science. Former U.S. President Harry S. Truman famously wanted a one-armed economist, so he didn't have to hear "on one hand" followed by "on the other hand." Unfortunately, economics and the policies it inspires, impacts every corner of the globe. In this article, we'll look at four of the most dangerous misconceptions that have hounded free market economists, since the days of Adam Smith.

Tutorial: Economics Basics

Inflation is Inevitable
It seems like inflation is a natural phenomenon; your father paid a quarter for a movie and your grandfather paid $3 for a suit, but you pay $5 for a cup of coffee. The ugly truth is that there is nothing natural about inflation. Inflation is a product of printing presses and, worse yet, operates as an additional tax upon people's earnings. Inflation can help select groups in the short-term, for example, a farmer might command a higher price and make more profit, until the price of other supplies catches up. However, it helps only the government, in the long term, by giving it more funds to allocate while also lessening the real value of its debts.

It is no coincidence that the primary beneficiary of inflation, and sole proprietor of the printing presses, has great difficulty "controlling inflation." There are many different solutions to inflation, but the motivation to stop it, is what critics cite as lacking. (To learn more, check out our Inflation Tutorial.)

Governments Can Save Us
Government solutions to problems are suspect at best. Most solutions get "pork-barreled," meaning they have all sorts of special interest riders inserted that increase the cost and damage of government intervention. Many government interventions end up carrying a political agenda as the main priority. The "New Deal" reforms of the 1930s were expensive in their own time, but one of the surviving political creations, Social Security, has been an increasing tax burden, ever since. In many cases, government solutions to economic woes can turn into debt-heavy schemes to redistribute wealth (i.e., your tax dollars) into areas that will buy political support.

From a true free market perspective, it often appears as though the real motivation behind political decisions is to keep the decision-makers in politics. Fiscal responsibility is quickly shed if there are votes at stake. This oft-ignored reality doesn't turn people off government intervention; all the thousands spent on Pentagon toilet seats or million-dollar bridges to nowhere may do the job, someday. (For more, see Economic Meltdowns: Let Them Burn Or Stamp Them Out?)

Free Market Means No Regulation
Free market is a bit of an unfortunate misnomer, because people tend to equate "free" with "unregulated." Unfortunately, "self-regulated market" doesn't roll off the tongue, so we're stuck with this misconception. The fact is, there are many indications of what an unregulated market would look like. Every time you consult a consumer review of a product, a car for example, you're seeing non-government regulation at work. Car manufacturers watch what people are saying about their cars and they change the next year's models, to eliminate the things that irked reviewers.

Consumer interest groups and self-set industry standards are two powers that free market economists argue could replace most government regulation, saving taxpayer money and bureaucracy, in the meantime. These two groups do, in a sense, control regulation, while the lobbying of consumer groups and industry that influences legislation, could be argued to be a more expensive and less efficient way to get the job done.

Taxes Don't Affect Output
Taxes are sometimes portrayed as a zero-sum game. The government takes a certain amount out of private hands and then spends it on other things, so the sum total of economic activity is unchanged; we pay taxes, we get roads and schools. However, free market thinkers argue that taxes have a negative economic effect, by reducing the incentives to produce more and, thus, lower the national output.

Whether profits or personal income, the fact is that the more you make, the less you keep as a percentage of your total income. The elimination of bracket creep lessens this for individuals, when increases in income are purely an inflationary phenomenon, but the government simply takes a larger and larger portion, as you work harder to earn more and more. (For more, see Should The U.S. Switch To A Flat Tax?)

Although not everyone reacts the same way to this stimulus, the effect in aggregate may be a decrease in production. Even the government understands that taxes drag on the economy. It admits as much when it uses temporary (one to five-year) tax cuts or redemptions to stimulate the economy. The government is, however, addicted to tax revenue. Every time government revenues have expanded, government itself has expanded to use it all up and write I.O.U.s for more.

Instead of using temporary tax relief measures to goose the economy into production, an effective free market alternative would be to reduce government spending and lessen the tax burden. After all, virtually all of the most productive and prosperous periods in peace time, have followed significant tax rollbacks. (For more insight, see Do Tax Cuts Stimulate The Economy?)

The Bottom Line
Academic opinion, despite vehement protests, seems to follow the rules of supply and demand. The economics of Adam Smith, Fredrik Hayek and Milton Friedman are simple and straightforward and suggest an ideal world of low taxes, self-regulation and solid money. The desires of the world governments running printing presses, runs contrary to this brand of economics. Thus, we have a demand for competing theories that, contrary to experience, call for deficits, government stimulus, inflation targets and massive public spending.

While it's nice to expose fallacies, it's difficult to get excited about the possibility of change. It doesn't matter if we have one-handed economists or not, because governments are often the victims of a different handicap: hearing only what they want. (To learn more, check out Free Markets: What's The Cost?)

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