Classical liberal political economy

The classical economists

The basic premise for the market economy was outlined by Bernard Mandeville in 1714. Mandeville’s poem, The Fable of the Bees, first laid out the rationale for the competitive market. Mandeville proposed that private vices are public benefits, and that ‘every species of virtue is at bottom some form of gross selfishness, more or less modified’. Private vices such as luxury and pride and the pursuit of individual self-interest, he claimed, were beneficial in producing public benefits such as employment,

trade and general affluence. 2 Adam Smith applied Mandeville’s logic to the internal workings of the market economy in his Wealth of Nations in 1776. Smith’s work was based on the rationalist and individualist beliefs of the eighteenth-century Enlightenment. In his Wealth of Nations, Smith defined markets as the uncoordinated voluntary transactions between buyers, which resulted in mutually beneficial outcomes. The central argu- ment of the book was that wealth is created through a process of market competition. In the economic sphere, he claimed, the pursuit of individual self-interest and wealth in commerce resulted in collective prosperity for society, which could not be as effective as if planned by an external agent. Market transactions, Smith famously argued, were not overseen by

a bureaucratic authority, but rather, as D. D. Raphael points out, led by an ‘invisible hand’. This hand is guided by the Stoic idea of a ‘natural harmony’ which comes into being automatically, through the interplay

between individual interests and the system of exchange. 3 At the heart of Smith’s understanding of the market economy is the vital, if limited, role played by government. The functions of the state in a market economy, according to Smith, go beyond the traditional protective duties of the night-watchman state. Smith assigned the state three important duties: the administration of justice, the provision of defence, and the mainte- nance of certain public goods aimed specifically at improving welfare. These duties, Smith maintained, facilitate the operation of market exchanges and provide a moral code which is consistent with the free- market virtues of ‘natural liberty’ and ‘natural equality’. 4

It was in The Wealth of Nations, as Desmond King points out, that ‘the market acquired modern intellectual significance’. 5 Indeed, the significance of Smith’s work is that it challenged the governmentalisation of the national politico-economic system and presented the market economy as It was in The Wealth of Nations, as Desmond King points out, that ‘the market acquired modern intellectual significance’. 5 Indeed, the significance of Smith’s work is that it challenged the governmentalisation of the national politico-economic system and presented the market economy as

a credible alternative system in the organisation of economic and political life. He was the first to attempt to develop an understanding of the internal workings of markets, which still constitutes the basis for much economic theorising on markets today. As Charles E. Lindblom noted, ‘We may no longer live in a Smithian world of atomistic competition, but the market remains one of the few institutions capable of organising the co-operation of millions of people. We owe his Wealth of Nations, written over 200 years ago, much of our understanding of what markets can and cannot do.’ 6

Smith’s ideas were significantly refined and elaborated by subsequent economists. David Ricardo’s classical micro-economic model of the market economy, formalised in modern economic theory as the ‘perfect competition’ model, emphasised the role and activities of individual markets in the production and consumption of individual goods and services. In his On the Principles of Political Economy and Taxation, published in 1817, Ricardo claimed that equilibrium is maintained through the price system, which balances the supply and demand for goods. Ricardo’s theory of comparative advantage provided a rationale for ending the government’s regulation of markets by arguing that the advantages of specialisa- tion and trade outweighed the constraints of social considerations. Markets, he maintained, regulate themselves through a process of ‘market clearing’, whereby the price mechanism adjusts itself naturally to accom- modate changes in consumer demand. Like Smith before him, Ricardo claimed that the freely operating market system, through processes of spe- cialisation in production and market clearing, generates economic growth and welfare. 7

John Stuart Mill’s Principles of Political Economy approached the market economy and the distribution of wealth from a utilitarian standpoint. In his work, Mill attempted to detach himself from the statist utilitarianism associated with Jeremy Bentham. Like Smith and Ricardo, Mill pioneered the market economy as the best means of producing wealth and of safe- guarding individual liberty. Participation in the free market system, Mill argued, gives individuals a degree of ‘self-rule’ with which they can meet their values, ideals and desires. The free and voluntary relationships of the market economy, he wrote, enables individuals to pursue a life course of their own, choosing free from arbitrary interventions by the state. However, unlike the other classical economists and neo-liberal theorists, Mill did not view production and distribution as an inseparable part of a single economic system. While he saw the production of wealth as having John Stuart Mill’s Principles of Political Economy approached the market economy and the distribution of wealth from a utilitarian standpoint. In his work, Mill attempted to detach himself from the statist utilitarianism associated with Jeremy Bentham. Like Smith and Ricardo, Mill pioneered the market economy as the best means of producing wealth and of safe- guarding individual liberty. Participation in the free market system, Mill argued, gives individuals a degree of ‘self-rule’ with which they can meet their values, ideals and desires. The free and voluntary relationships of the market economy, he wrote, enables individuals to pursue a life course of their own, choosing free from arbitrary interventions by the state. However, unlike the other classical economists and neo-liberal theorists, Mill did not view production and distribution as an inseparable part of a single economic system. While he saw the production of wealth as having

the ‘character of physical truths’, he viewed its distribution as ‘a matter of human institutions solely’. Mill contended that, although the state should not interfere in the production of capital and labour, it was within the moral capacity of the government to intervene in the distribution of wealth where substantial inequalities of income existed. Mill envisioned a ‘social state’ in which ‘humane’ laws and customs governing distribution

in a market society were determined by democratic means. 8 Consequently, neo-liberal economists such as Hayek argued that Mill’s ideas presupposed

a ‘false distinction’ between production and distribution, and that led him to advocate a particular conception of social justice, one notably associated with equality of opportunity. 9

The neo-classical economists

The concept of the market went through a major transition in the late nineteenth and early twentieth centuries. The classical economists’ conception of the market, embodied in their ‘sociology of the economy’ per- spective, was superseded by the ‘marginalist revolution’ led by the neo-classical economists. Three neo-classical schools of thought domi- nated economic theorising on markets – the Marshallian school in Britain, the Megerian school in Austria and the emerging Walrasian school on the continent. These schools led the marginalist revolution that had begun to dominate mainstream economic thought by the late nineteenth century. Marginalist techniques effectively bypassed the problem of value and offered superior quantitative methods to either the classical or the his- toricist system of thought in Germany. 10

In Britain, the foremost architects of the Marshalllian mainstream approach to economics were Alfred Marshall and Lionel Robbins. Marshall approached the market from a scientific standpoint, claiming that eco-

nomics was ‘a branch of biology broadly interpreted’. 11 He was influenced by the ideas of Herbert Spencer in his evolutionary interpretation of market relations. Marshall’s speciality was in micro-economics – the study of individual markets and industries. In his Principles of Economics, he emphasised how the price and output of a good are determined by supply and demand. These two forces, he famously argued, are like scissor blades that intersect at equilibrium. Marshall went on to explain how markets adjusted to changes in supply and demand over time. He argued that, like developments in the natural world, changes in economy are determined by an evolutionary process in which technology, market institutions nomics was ‘a branch of biology broadly interpreted’. 11 He was influenced by the ideas of Herbert Spencer in his evolutionary interpretation of market relations. Marshall’s speciality was in micro-economics – the study of individual markets and industries. In his Principles of Economics, he emphasised how the price and output of a good are determined by supply and demand. These two forces, he famously argued, are like scissor blades that intersect at equilibrium. Marshall went on to explain how markets adjusted to changes in supply and demand over time. He argued that, like developments in the natural world, changes in economy are determined by an evolutionary process in which technology, market institutions

and individual preferences evolve alongside individual behaviour. 12 The Marshallian approach in British economic thought was greatly influenced by the Austrian School, founded by Carl Menger. Indeed, Robbins, who later emerged as a leading liberal economist at the London School of Economics, attended the Vienna seminars in the 1920s. Menger presented

a universalist view on the nature and scope of economic activity. His ideas at the turn of the century represented a completely new approach to economics, compared to the ones taught in German-speaking universities at the time; they were non-historical and abstract, like the British approach. Like Marshall, Menger perceived the economy as a biological organism. He put forward a theory of the ‘organic’ and ‘spontaneous’ evolution of money from a barter economy. The self-interested individual interactions in the barter economy, Menger argued, led to the spontaneous emergence of mon- etary units. He claimed that both sides gain from market exchanges when money is introduced, by the reduction of the number of transactions to a minimum. Menger also developed a theory which refuted the classical economists’ labour theory of value. In his ‘subjective theory of value’ Menger claimed that goods acquire value not because of the amount of labour used in their production, but because of their utility in satisfying people’s wants. Menger’s approach to the market represented a deviation from both classical economics and Marxism, and led to important new insights about the nature of markets and of the capitalist economic system, which were crucial to the intellectual development of Mises and to Hayek’s neo-liberal theory of the market order. 13

The Walrasian approach to the economy developed on the continent in the late nineteenth century saw markets interacting in a system of general equilibrium. The pioneer of the approach, Léon Walras, reached similar conclusions to Menger, but by a different method. Walras’s contri- bution to neo-classical economic theory was his explanation of the functioning of the market system as a whole in terms of the atomistic and individual components of the system. The market system, he claimed, consisted of individual markets tightly embedded in a single, whole economy. Walras’s ‘general equilibrium theory’ stressed the ‘natural’ equi- libriating tendencies of the system. In his theory, Walras argued that markets undergo a constant interactive adjustment process in which supply and demand determine price. He attempted to show how the market could move towards equilibrium as a result of individual interactions and price flexibility, even if the process was periodically interrupted by entrepreneurial activity. 14 The Walrasian approach to the economy developed on the continent in the late nineteenth century saw markets interacting in a system of general equilibrium. The pioneer of the approach, Léon Walras, reached similar conclusions to Menger, but by a different method. Walras’s contri- bution to neo-classical economic theory was his explanation of the functioning of the market system as a whole in terms of the atomistic and individual components of the system. The market system, he claimed, consisted of individual markets tightly embedded in a single, whole economy. Walras’s ‘general equilibrium theory’ stressed the ‘natural’ equi- libriating tendencies of the system. In his theory, Walras argued that markets undergo a constant interactive adjustment process in which supply and demand determine price. He attempted to show how the market could move towards equilibrium as a result of individual interactions and price flexibility, even if the process was periodically interrupted by entrepreneurial activity. 14

Th e Au s t r i a n pa r a d i g m

The classical and neo-classical economists identified the nature of the market economy, described its evolution and attempted to discover the inner laws that explained its operation. One school of thought, however, stands at the forefront of neo-liberal theorising on markets – the Austrian School. The core arguments of its two leading advocates, Mises and Hayek, are used to elucidate the neo-liberal case for the economic superi- ority of the free market at every level of society, from the individual to the global economy which simply represents the aggregate of individual units. The work of Hayek, in particular, can be seen as part of a wider intellectual project to guide society back to the civilised order of nineteenth- century liberalism and to move beyond what he termed the ‘excesses’ of classical liberalism, providing a more favourable environment for the operation of markets. Hayek’s theorising on markets follows four main themes: spontaneous order, epistemic considerations, economic efficiency, and the limited state.

Spontaneous order and the limits of human reason

The notion of spontaneous order plays a pivotal role in neo-liberalism’s conceptualisation of the market. Indeed, adjacent to the core con - cept of market are the concepts of spontaneous order and evolution. The Austrian School’s theory of spontaneous order follows the anti- rationalist tradition in social thought. It adopts a position originally for- mulated by David Hume, that pure and unaided human reason is incapable of determining a priori those moral and legal norms which the existence of social order is dependent upon. This position rejects the claims made on behalf of reason by the Enlightenment philosophers to the effect that rules could be constructed which are universally appro- priate for order and continuity. The theory of spontaneous order is concerned with ‘natural processes’ which are not the product of reason or human intention. The classical example in neo-liberal ideology is the free-market economy. What Hayek termed the ‘market order’ is not a product of conscious design, but a spontaneous growth, an evolved order: ‘it is a specific outcome of evolution itself’. 15

Hayek argued that the spontaneous order of the market is the outcome of ‘self-coordination’. It is produced by individuals pursuing their own ends, but having no intention of individually or collectively producing Hayek argued that the spontaneous order of the market is the outcome of ‘self-coordination’. It is produced by individuals pursuing their own ends, but having no intention of individually or collectively producing

such an order. In the free-market economy, the coordination of the aims and purposes of countless actors, who cannot know the aims and purposes of more than a handful of their fellow citizens, is achieved by the price mechanism. A change in the price of a commodity is simply a signal which feeds back information into the system, enabling participants to produce that spontaneous coordination which appears to be the result of an omnis- cient mind. Hayek contrasted the market order with an organisation which is the result of cooperation and coordination by a central authority. Crucially, a spontaneous order, for Hayek, ‘is the result of human action,

but not human design’. 16 Hayek therefore conceived of what he termed the Great Society as an evolved order or ‘cosmos’, rather than a con- sciously designed organisation or ‘taxis’. For Hayek, the orderliness of the Great Society is due to the growth and evolution of institutions, practices and rules ‘which had first been adopted for other reasons, or even purely accidentally, and were preserved because they enabled the group which

had engendered them to prevail over less well-endowed rivals’. 17 It has developed from a process of trial-and-error, which ‘requires the efforts and accumulated hard-earned experience of many generations’. 18 The notion of the spontaneous order of the Great Society is one which sits at the heart of neo-liberalism, appealing to both conservatives and liberals alike.

G. C. Roche contends that spontaneous order ‘appeals to conservatives’ moral concern for a functioning social fabric without imposing a planned order’; and for liberals ‘it enshrines personal liberty as the sine qua non of its operation’. 19

The most important spontaneous order for neo-liberals is the market order. Hayek defined the market order as a ‘catallaxy’ rather than an economy. His concept of catallaxy is the modern counterpart to Smith’s ‘invisible hand’. A catallaxy is a collection of interacting economies, all operating within a framework of abstract rules. Unlike an economy, a catallaxy has no specific unitary hierarchy of ends; it has evolved without any conscious design, from the voluntary transactions of individuals. By referring to the market order in this way, Hayek did not base the market on the old naïve assumptions of perfect competition and general equilibrium associated with the classical economists. Rather, he perceived the market as an evolving discovery mechanism, complete with uncertainty and shocks. Norman Barry points out that Hayek talked of a ‘dynamic equilibrium concept, which, although fictitious, describes the hypotheti- cal movement of the economic process through time, and is consistent with space’. 20 The most important spontaneous order for neo-liberals is the market order. Hayek defined the market order as a ‘catallaxy’ rather than an economy. His concept of catallaxy is the modern counterpart to Smith’s ‘invisible hand’. A catallaxy is a collection of interacting economies, all operating within a framework of abstract rules. Unlike an economy, a catallaxy has no specific unitary hierarchy of ends; it has evolved without any conscious design, from the voluntary transactions of individuals. By referring to the market order in this way, Hayek did not base the market on the old naïve assumptions of perfect competition and general equilibrium associated with the classical economists. Rather, he perceived the market as an evolving discovery mechanism, complete with uncertainty and shocks. Norman Barry points out that Hayek talked of a ‘dynamic equilibrium concept, which, although fictitious, describes the hypotheti- cal movement of the economic process through time, and is consistent with space’. 20

The market as an epistemic device

Adjacent to the core concept of the market is also the concept of limited knowledge. What makes the spontaneous market order superior over a planned economic order, for Hayek, is its ‘use of knowledge in society’; the way knowledge is acquired and transmitted through social interaction. In Hayek’s account, markets have a coordinating role to play, imposing order on these social interactions, allowing individuals to use their knowledge in pursuit of their own objectives. Hayek interprets the intractability of central direction in the catallaxy in terms of information and knowledge. Such an ordering of human cooperation, Hayek claimed, exceeds the limits of knowledge and perception. Knowledge of individual preferences and of production factors in mass society is tacit and dispersed, and therefore no single agent could ever know what members’ preferences are and how they rank them. Thus Hayek defined the economic problem con- fronting society as that of the ‘utilisation of knowledge which is not given

to anyone in totality’. 21 More specifically, the problem for Hayek is

how to extend the span of utilisation of resources beyond the span of the control of any one mind, and how to dispense with the need of conscious control and provide inducements which will make individuals do desirable things without anyone having to tell them what to do. 22

For Hayek, this is a problem of ‘rational economic organisation’ – both a problem of coordinating the actions of innumerable agents without the pos- sibility of any adequate centralised knowledge of their needs and, resources, and, more importantly, a problem of generating new knowledge in society.

Hayek argued that only the market order based on private property over the means of production can solve this problem. The market acts as what John Gray terms an ‘epistemic machine’ – ‘an institutional device for the transmission of fragmented knowledge in a form which makes it generally

accessible and usable’. 23 Hilary Wainwright states that the market in Hayek’s view is an ‘engine of self-education’. 24 It performs a central role in generating information, through the unregulated price mechanism, as to how economic agents ignorant of each other may best attain their equally unknown purposes. Individual fields of vision may be limited, but Hayek maintained that in the market these fields overlap so that through many intermediaries the relevant information can be communicated to all participants. The competitive market may not be a perfect system, but it is one which is superior to a planned economy through its coordination of individual activities, enabling dispersed information to be exploited. 25 accessible and usable’. 23 Hilary Wainwright states that the market in Hayek’s view is an ‘engine of self-education’. 24 It performs a central role in generating information, through the unregulated price mechanism, as to how economic agents ignorant of each other may best attain their equally unknown purposes. Individual fields of vision may be limited, but Hayek maintained that in the market these fields overlap so that through many intermediaries the relevant information can be communicated to all participants. The competitive market may not be a perfect system, but it is one which is superior to a planned economy through its coordination of individual activities, enabling dispersed information to be exploited. 25

Market efficiency

It is this coordination that makes market society the most advantageous economic system for Hayek. The economic agents in Hayek’s market order are autonomous individuals. His ideal is a market society composed of self-employed entrepreneurs and commercial agents. The competition between these individual agents in the market is akin to a ‘game’ in which luck and misfortune are distributed more or less evenly, thereby giving everyone a fair chance of earning a particular income. Indeed, Hayek contended that the market order is beneficial because it ‘increases’ and even makes ‘as great as possible the prospects and chance of everyone selected

at random’. 26 He argued that a planned economy is undesirable because it denies chance any role. Income distribution in the market order is related to luck. The level of distribution, Hayek argued, should not be a matter of political will, but an impersonal self-ordering process which goes beyond any single agent’s responsibility. Thus he did not see market outcomes in terms of the old Protestant work ethics: a reward for virtue. For Hayek, there is no such thing as a ‘just reward’. Income in a market society is not relative to merit. The rewards an individual receives are related to the market’s valuation – ‘the value as perceived by consumers of the goods and services produced’ and ‘these values which services will have to their fellows will often have

no relation to their individual merits and needs’. 27 Production and distribution, Hayek asserted, are interdependent – the market can maximise its productive capacity only if the distribution of income is not interfered with. The spontaneous economic order of the market maximises average individual income by increasing everybody’s chances as much as possible. Economic success is attributed to the driving forces of market competition and the harnessing of individual initiative. Like Darwinian natural selec- tion, competition in the market order acts to eliminate negative ineffi- ciency by selecting out winners by their profit achievement and eliminating inefficient loss-makers. This makes market society, for neo-

liberals, the most productive and efficient economic order.

Limited government

Hayek’s idea of a market system of cooperation, establishing and maintaining itself without any interference from a central authority, should not

be misinterpreted. It is important to stress that his views are not at the be misinterpreted. It is important to stress that his views are not at the

more extreme end of the laissez-faire continuum. Like the German ordo- liberals, Hayek had no faith in a system of pure laissez-faire. He saw government intervention as a necessary means of maintaining institutions favourable to individualism and market exchange. The fundamental point is to draw up the proper boundaries of the state, where intervention is restricted to non-coercive activities.

Hayek’s conception of a limited state stems from his vision of the Great Society. In the Great Society individuals exist prior to, and separate from, society. It is a society that is free and open, therefore respects the individual within the protected spheres of private enterprise and private owner- ship of the means of production. Hayek was diametrically opposed to the collectivist vision of society, in which government attempts to treat the Great Society as part of its organisation. He argued that such a development ‘necessarily leads to a gradual transformation of the spontaneous order of a free society into a totalitarian system conducted in the service

of some coalition of interests’. 28 Hayek identified the proper functions of the liberal state as non-interventionist; as being restricted to the individualist minimum sanctioned in the Constitution of Liberty, whereby government becomes ‘the guarantor, rather than the invader of individual

liberty’. 29 Hayek, however, recognising the state as an important feature of real markets, allocated it a catalogue of important tasks in maintaining, correcting and supplementing market deficiencies.

The principle that determines the legitimacy of government activity, Hayek argued, is the rule of law. Embracing a Rechtsstaat conception of a liberal legal order, he claimed that how well the market will function is determined by the character of government activity, not by its volume; the rule of law is concerned not with the level of state, but with the methods by which intervention is brought about. This emerges from his distinctive epistemological position concerning the limits of human reason, where law is contrasted with legislation. The former belongs to a spontaneous order, where the ‘abstract’, ‘goal-dependent’ and ‘agent-dependent’ character of law protects negative liberty. The latter is associated with an arti- ficially created social order, in which commands are directed to the achievement of specific ends, such as positive liberty and social justice. 30 In The Constitution of Liberty, Hayek set out his ideal rule of law state, in which political arrangements do not interfere with the spontaneous coordination of the market order, but serve to reinforce uncreated social rules of conduct. In Hayek’s market order, politics acts as a means of coordination, so that individuals may pursue their ends independently from the The principle that determines the legitimacy of government activity, Hayek argued, is the rule of law. Embracing a Rechtsstaat conception of a liberal legal order, he claimed that how well the market will function is determined by the character of government activity, not by its volume; the rule of law is concerned not with the level of state, but with the methods by which intervention is brought about. This emerges from his distinctive epistemological position concerning the limits of human reason, where law is contrasted with legislation. The former belongs to a spontaneous order, where the ‘abstract’, ‘goal-dependent’ and ‘agent-dependent’ character of law protects negative liberty. The latter is associated with an arti- ficially created social order, in which commands are directed to the achievement of specific ends, such as positive liberty and social justice. 30 In The Constitution of Liberty, Hayek set out his ideal rule of law state, in which political arrangements do not interfere with the spontaneous coordination of the market order, but serve to reinforce uncreated social rules of conduct. In Hayek’s market order, politics acts as a means of coordination, so that individuals may pursue their ends independently from the

body politic. The roles of the state are limited to non-coercive activities ‘compatible with a functioning market’. 31 The state, Hayek argued, has a duty to ‘facilitate the acquisition of reliable knowledge about facts of general significance’, provide certain regulations within the rules of just conduct such as health and safety regulations, allow for some measure of government intervention in the provision of public goods through pro- portional taxation, and provide a minimum social safety net for those without marketable skills. Hayek, however, did allow the state one coercive function: enforcing the rules of just conduct so as to prevent coercion by private individuals. He made it explicit that ‘a free society demands that government have a monopoly of coercion’. 32

Classical liberal political economy