In Praise of Neo-liberalism

The period 1875 to 1945 (or more precisely, to 1947) saw the inner logic of classical liberalism slowly unravel. Ironically, it was around the middle of the 19th century, just when free trade was triumphant, that classical liberalism took a turn in the wrong direction at the hand of John Stuart Mill; his proposal to fundamentally change the institution of private property was the first step on the primrose path. Mill was trying to respond to the growing attraction of socialism, which had started to take hold of the minds of intellectuals unsatisfied with mere equality before the law. He also tried to take account of nationalism, a rhetoric increasingly used by politicians to harness the free economy to state-creation and expansion. Come 1900, nations around the world began to mimic Bismarck’s Social Insurance. At the same time, Teddy Roosevelt surfed on the wave of Progressivism in the United States. After the upheaval of WWI, the reaction against classical liberalism deepened. The Soviets and fascism became respectable in some quarters of Europe. In America, Franklin Delano Roosevelt barefacedly called his political program “liberal,” when it was fundamentally contrary to what had been taught by liberals from Adam Smith to Frederic Bastiat. After a short let-up in the last years of the 20th century, the tide is again turning against economic liberty. Markets and corporations are under constant scrutiny; legal means to avoid taxation are considered less than respectable; the size of government has expanded to the point where no more surplus can be extracted from taxpayers, present or future; public action has become discretionary rather than rule-based. The Welfare State is dogma.

It is no mere coincidence that the retreat from freedom coincides with economics coming under increasing suspicion. Ideas matter. A century of social change and scientific criticism has put economic liberalism on the defensive, so that private property and laissez-faire are made to carry the burden of proof. The economic conception of human nature is considered unrealistic, the straining for growth seen as prodigal, any and all inequality denounced as unjust. This has led either to ideological rejection of the economic point of view among egalitarians or to growing agnosticism among professional economists; in both cases economics has been reduced to a kit of technical tools when it originally was central to the liberal world-view. Part of the blame for this demotion, however, must be laid at the door of economists themselves. Perhaps it is the classical formulation of the free society that was at fault. Perhaps it is theory-less modeling and mechanical testing of the present-day that is responsible.

The thesis of this essay is that a reformulation of the tenets of the great classical economists will help undo the damage caused to liberalism by a century of negative criticism. I am averse to labels and do not much mind whether I am seen as a libertarian or an Austrian economist or a follower of the Chicago school, as long as what I hold makes sense from the point of view of truth and liberty. But I have now come to think “neo-liberalism” a useful label, for its defiant assertion that economic theory and policy must be put back at the center of the philosophy of liberty.

The 1947 turning point

Why do I say that the century of slow liberal decay ended in 1947? That was the year when Friedrich Hayek founded the Mont Pèlerin Society. William Coleman, in his perceptive paper on neo-liberalism (2013) on which I want to build my present reflections,1 pointed out two developments from the early years of that Society: that Hayek, with the help of fellow-minded historians, economists and philosophers, wanted liberalism to face new problems not apparent in the great classical days, and that the increasingly pro-market stance of the members of the Society led to the resignation of liberal relativists such as Röpke. Indeed, Röpke’s idea that the economic market left to its own devices tends to self-destruct had important followers at the time, such as Karl Polanyi and Joseph Schumpeter, and it is enjoying renewed popularity today when so many critics have suddenly discovered that the orgy of greed and dishonesty at the heart of capitalism is to blame for the late crisis.

The connection between ethical values and the free market does pose a problem, as we shall see. This problem is not solved by denying it, as Ayn Rand did when she extolled selfishness and proposed a kind of Superman worship. Neither is the opposite view satisfactory, that capitalism will run into excess unless it is embedded in the social mores of an ethical or even a religious society. In this essay, I will hold that the values needed for the capitalist system to subsist and move forward are created by the system itself. In this I will follow Adam Smith’s lead, who rightly pointed out that while beneficence is an ornament to society, justice must be regarded as “the main pillar that upholds the whole edifice,” meaning by “justice” respect for property and contract.

Society may subsist among different men, as among different merchants, from a sense of its utility, without any mutual love or affection; and though no man in it should owe any obligation, or be bound in gratitude to any other, it may still be upheld by a mercenary exchange of good offices according to an agreed valuation. (Smith, The Theory of Moral Sentiments, Book II, Section II, para. 16.. Library of Economics and Liberty.)

John Stuart Mill at the Watershed

Now let us see what happened to classical liberalism in the century before the founding of the Mont Pèlerin Society. In my view, it all started with Mill. Though one of the foremost philosophers of liberty, Mill was instrumental in the erosion of the philosophy he so much cared for in two ways: in the reforms he wanted to carry out regarding private property and in his romantic conception of individual freedom. In his Principles of Economics2 he had much to contribute to economic analysis, but he went clearly astray when trying to subvert the principles of private property. If we remember that in On Liberty3 he added an exaggerated defense of eccentricity, spontaneity and self-expression worthy of Rousseau; the way was open to a concept of society where individuals could expect to be given equal opportunities of happiness without responsibility.

Mill believed he made a most important contribution to political economy with his distinction between the laws of production and the laws of distribution. For him, the laws of production were akin to the laws of nature, in that they necessarily governed the actions of men in society: these were such as the Malthusian law of population, the declining productivity of land, the role of capital in productive activity, or comparative cost in the flows of international trade. But in the field of distribution, society could make its own laws:

It is not so with the Distribution of Wealth. That is a matter of human institution solely. The things once there, mankind, individually or collectively, can do with them as they like. They can place them at the disposal of whomsoever they please, and on whatever terms. (Mill, Principles of Political Economy, Book II, Ch. 1, para. 2.)

He did not mean that the consequences of new distributional arrangements should not be examined before changes were made, but that there was no natural limit to new experiments in distribution. He did examine the proposals of different schools of socialists and found them wanting for this or that reason. However, in the organization of property he thought society had a freer hand. The changes he proposed were based on Locke’s justification of property by labor: one should have a right only to what one had produced with one’s work. Whatever the practice in the society of his time, no one had the right to accrue wealth by inheritance or by the occupation of the productive powers of Nature.4

This is not the place to go into the consequences Mill drew from the exclusive justification of property by labor for the system of private property, nor the reforms he proposed for inheritance, land ownership and corporate organization. My point is another one. Mill thought that the proper institutions for a just society could be imposed from the outside by all-wise politicians led by all-seeing intellectuals. From a proper Smithian starting point, the institutions better suited for social progress and economic development are endogenous to the market—and this includes the political market, as we shall see James M. Buchanan maintained.

The logic of classical liberalism

Coleman aptly compares classical liberalism to a “molecule” of values that were seen to hang together as chemical elements in a stable compound: freedom, wealth and reason.

Adam Smith was the clearest exponent of the idea that the “Natural System of Liberty” promoted wealth. Wealth in its turn would make for rational social conduct, as David Hume and Montesquieu maintained.5 Montesquieu was indeed one of the first to point out the civilizing effects of commerce. Human intercourse in a commercial society tended to bring about independence and rational self-control.6 Freedom, wealth, and reason were seen as unbreakably linked, and the reverse was also held true.

Coleman adds that this triad of values was seen to be consistent with other values treasured by people outside the liberal fraternity. The individualism of classical liberals made them natural allies of the humanitarian anti-slavery movement; their defense of private property helped them with order-loving conservatives. Their belief in equality before the law chimed in with the egalitarianism of the left, and the connection they saw between the distributive shares assigned to individuals with their respective contribution to social production satisfied thinkers preoccupied with justice.7

Liberalism besieged

To start with, the alliance between liberalism and humanitarianism, order and equality started to break up. The free market exploited workers, liberals lit revolutionary flames, and wealth seemed to concentrate in the hands of the rich.

The gradual extension of the franchise led to the first doubts being entertained on the congruence of the liberty element within liberalism. With the growth of democracy, the interpretation of freedom started to change. Mill himself feared that minorities would be oppressed in majoritarian democracies and felt he had to devise constitutional barriers in his essay Considerations on Representative Government .8A further crack appeared when democracy was put at the service of nationalism: should individuals be free or should nations?

Then, in the second half of the 19th century, doubt was thrown on the connection between wealth and freedom. That was the time of the spectacular development of positive science. The hopes and prosperity of humanity were seen to hinge on natural science and its applications. Rather than rely on the free market, should societies not harness technology directly by entrusting common affairs to technicians? Very early on the St. Simonians proposed world government by engineers. This idea took wing. Coleman tellingly mentions Thorstein Veblen‘s The Engineers and the Price System (1921) and the Soviet attempt to establish rule by engineers as the culmination of the process. The pseudo-scientific hubris of some neo-Darwinists also led them to question equality before the law, when they pretended to dictate an ethic where liberty and individualism had little role.

Finally, socialists took over the connection between science and reason. The market, apart from bringing dire consequences for equality and stability, was too chaotic to be trusted. Planning was more rational. Society was best administered by scientifically minded planners. In the years between the two World Wars, planning was generally accepted as a necessary substitute for the disorder of the market. Ironically, the more elaborate proposals for economic planning were based on the general equilibrium theory of Leon Walras, himself a man of deep socialist convictions. I myself heard Oskar Lange say shortly before his death in 1965 at a meeting in the Old Theater of the London School of Economics, that the optimality of the plan for a national economy could be tested by solving a Walrasian system of equations with the new-fangled instrument of the computer—much to the amusement of a skeptical Lionel Robbins who was in the chair.

The onslaught on the market economy in the first half of the 20th century proved difficult to resist. The troops are well known. Arthur Pigou, in his The Economics of Welfare9 demanded the correction of inevitable external effects of the free market. Walras’ disciple, Enrico Barone, wrote “The Ministry of Production in a Collectivist State” (1935). E. H. Chamberlin (1926) and Joan Robinson (1933) characterized the economic market as monopolistically or imperfectly competitive. The main battering ram, of course, was John M. Keynes’sGeneral Theory (1936). The Great Depression had thoroughly undermined the confidence in the free market system. Keynes, by vesting in governments the role of saviors of bourgeois civilization when it was facing utter breakdown, seemed to plant the last nail into the coffin of classical liberalism.

Hayek, Friedman, Coase, and Buchanan

In their different ways these four economists, who, with the exception of Ronald Coase, have now left us, helped reestablish the philosophy of freedom on a more solid basis than in classical times. They did not all see eye to eye on everything, but their suggestions are the basis of the reconstruction work carried out in the second part of the 20th century.

The work of this group of “neo-liberal” economists is what, rightly in my view, William Coleman sees as genuine scientific and policy progress. The first contribution I want to note was that of Hayek in the field of knowledge and economics. It came early in the story we are telling. The year was 1934 and the book a collection of essays under the title Collectivist Economic Planning . In 1920, Ludwig von Mises had written a seminal article on the impossibility of centralized economic calculation. Hayek took it up and re-published it with an introduction and a conclusion of his pen. The book also included Barone on the” Ministry of Production,” as a foil for the position taken up by the critics of planning. Hayek took up the central idea of this book in his 1945 essay “The Use of Knowledge in Society.”10 Hayek’s initial object was to rebut Oskar Lange’s proposal for a Central Pricing Board to set prices in a planned socialist society. The market was much more efficient than a central board in setting prices because the dynamic of their movements reflected the knowledge of millions of different people, who could only know a minimal fraction of reality individually. What Mises and Hayek had explained theoretically in the 1930s was proven right in fact when the protecting screen of the Berlin Wall was dismantled in 1989.

Hayek always thought that redressing economic history and the history of economic thought was a necessary condition of the re-founding of liberalism. In 1954 he edited Capitalism and the Historians , where he put together a collection of essays purporting to change the accepted picture of the cruelty of the Industrial Revolution. This should have helped to repair the broken relationship between liberals and humanitarians, on the basis of the same logic that should explain why the harsh realities of urbanization in developing countries should not tell against capitalist development.11

Milton Friedman’s contribution to “neo-liberalism” was just as important in its own way. People forget that he wrote The Theory of the Consumption Function in 1957, where, in parallel with Albert Ando and Franco Modigliani, he dismantled Keynes’s loose “fundamental law” of human psychology that people save proportionally less the greater their income. Keynes’ conclusion was based on deficient statistical work; individuals made their consumption decisions on the basis of their perceived long term prospects. There is no need to extol the work of Milton Friedman and Anna Schwartz on the mistakes of the Federal Reserve during the Great Depression. That has spelled the end of Keynes’ pretence of having written a general theory of the macro-economy: so much then for the essential impossibility of the market system to self-equilibrate. Also, Friedman and his wife Rose wrote books and made films to rescue the necessary relationship between freedom and wealth.

Pigou’s case against free markets was they were inefficient due to an endless number of external effects. Ronald Coase effectively turned the tables on Pigou with two arguments: that people and firms in the market often corrected externalities by mutual agreement, and that solutions imposed by government were more often a worse outcome than the starting situation. In the famous 1959 dinner at the home of Aaron Director, where Milton Friedman and George Stigler were present with another seventeen skeptical economists, Coase presented his case that, given low transaction costs, the parties confronting a situation beset by external effects would find an optimal agreement with no need for government intervention. He also showed that the solution imposed by authorities as self-evident could be shown to have little or no justification. Coase overturned a majority of twenty against his theorem at the beginning of the dinner. What is important for the neo-liberal position is that Coase did not take it for granted that markets functioned perfectly. High transaction costs made it difficult to come to effective agreements. So, as Coleman underlines, the neo-liberal renovation does not posit perfect markets. It rather builds on the often unrecognized fact of the imperfections of government. After Coase, the case for liberty came to rest on the high probability of government failure—something that was more often than not overlooked in economics textbooks and political discussion.

There still was the snag of the possible incompatibility of freedom and democracy. The case of Schumpeter is especially telling on this point. He well understood the essence of capitalism but saw it as necessarily bound for self destruction. In his Theory of Economic Development (1912) he had characterized the free market system as moved by “creative destruction,” where progress is based on new procedures that bring about the obsolescence of existing modes of production. But in his notorious Capitalism, Socialism and Democracy (1943) he came to the shocking conclusion that creative destruction would come to a grinding halt in a democracy because the people would not willingly bear its cost. Only a more or less hidden socialist dictatorship could force the people to accept the sacrifices demanded by economic progress. His conclusion was: “Can capitalism survive? No, I don’t think it can. [… ] Can socialism work? Of course it can.”12 No great prophesy, but still a pointed formulation of the paradox of democracy.

Buchanan’s attempt to solving the conflict between democracy and freedom is a decisive contribution to the neo-liberal reconstruction of the case for freedom. For him, political processes cannot be imposed or be judged from the outside. Buchanan especially directed this prohibition to political philosophers, who should never “play at being gods.” It is for people themselves to vote and decide how to arrange social matters concerning them. The problem is that often in actual democracies ,the result of collective decisions is wanted by none of the people concerned. So Buchanan proposed that collective decisions should be taken in two separate forms. One is the constitutional mode, when the basic rules of the game should be decided unanimously or nearly so. The other is the political mode, in which decisions would be taken by majority vote. People would be careful to agree to a Constitution that guaranteed their basic rights whatever their future situation in society would be compared to their present one. The rules of poker should be decided by customary agreement for the long term, whatever the hand one holds at the moment.

Buchanan would not presume to tell voters what they should prefer. In this, he treats the political game as another market where consumers and producers will not be told what to prefer or do. But as in the economic market, he would hope that institutions emerge that better reflect the wishes of voters in the long term. This he tried to attain by separating decisions about the rules of the game from day to day politics; in this way voters would slowly learn to organize their democracies under a Constitution that would protect them even when they were not in power.

The neo-liberal transformation

Whatever one may think of the results obtained by the efforts of those economists that, following William Coleman, I have decided to call “neo-liberals,” there is little doubt that a reconstruction of liberalism was need by the middle of the 20th century. The audacity lay in holding that liberalism could only be revived by strictly applied free market economics.

Their achievements should not make one think that all is done. If nothing else we still have fully to understand the reasons and causes of the deep financial crisis from which we are barely emerging.