When enthusiasts of the free economy address a social problem by saying, “The market will handle it,” critics accuse them of being simplistic, even glib. But in reality, that sentence points to a process so complex and open-ended that no one can grasp it in detail. What the sentence really means is that one or more people operating individually or in concert in the vast and subtle political-economic-legal context known as liberalism — Adam Smith’s “obvious and simple system of natural liberty” — would have an incentive to solve the problem in question. As a result, these persons would benefit others to benefit themselves.
This raises questions about incentives and, hence, institutions. These two concepts are closely related, like lock and key. Institutions determine incentives: what conduct gets rewarded. They also forge expectations, which bestow a degree of regularity on day-to-day life.
Institution in the broadest sense subsumes countless “formal and informal ‘rules of the game,’” as economists Peter Boettke and Christopher Coyne write. These rules, political and nonpolitical, encourage some actions and discourage others, and they need not be written down. (England has no written constitution.) In fact, the written rules sometimes are not necessarily a society’s governing rules. (The Soviet constitution proclaimed freedom of speech and press.) Thus tacit rules and mores, which may never be articulated, are crucial.
Even though people are essentially the same everywhere, as the public choice school of political economy emphasizes, they act differently in different institutional contexts because the incentives vary. Unlike a market economy, a political system that rewards “pull” with subsidies and restrictions on competition will encourage actions that will not serve society generally. Institutions and incentives matter.
In a market economy unencumbered by politicians — that is, one without privileges or impediments to peaceful action — profit-seeking behavior benefits people other than the actors. As Smith famously said, “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” As a result, people are motivated to serve themselves by serving others. Thus the socialist slogan “People before profits” makes no sense in a free economy. To the extent a society’s rules cause such conduct to be rewarded, it prospers in peace. We can see evidence of this across the globe and throughout history.
What institutions bring that about? Among them are stable and tradable property and the prima facie inviolability of freely accepted contracts. When the rules and expectations implied by these institutions can be relied on, people can confidently engage in long-term planning that best serves others. Who would make such plans under the likely prospect that the fruits of those activities would be confiscated?
Secondary institutions are spawned by the first set. The price system, which is indispensable for generating knowledge as well as incentives, is one. Prices enable people to use particular knowledge of supply and demand — often unarticulated — that is otherwise scattered throughout society. Prices are not perfect guides, but entrepreneurial detection of price discrepancies can lead to profitable correction of errors that prevented consumers from enjoying greater satisfaction.
The economist Ludwig von Mises showed that without secure property rights in capital goods, no prices for those goods could exist. And without prices, the rational economic calculation we all take for granted would be impossible. The result would be “planned chaos.” When socialist economists responded that a bureaucracy could generate asset prices by trial and error, Mises’s student and the future Nobel laureate F.A. Hayek showed that, considering the nature of knowledge and learning, ersatz prices simply were not up to the job.
Focusing on what institutions make possible may lead people to think — mistakenly — that we need wise individuals to construct the rules of the game. But because of the limits of knowledge and the law of unintended consequences, no one could be wise enough. Nevertheless, we can understand — and have understood — the rules that have emerged and succeeded through the generations. Our knowledge of the logic of human action helps us see why those rules emerged unplanned, “spontaneously,” and, as Smith wrote, “as if by an invisible hand.”
Smith realized that institutions that promote human flourishing would emerge if we practiced the virtue of justice:
All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society.
The philosopher Roderick Long elaborated this point by noting, as Aristotle showed, that “justice and benefit are conceptually entangled” and thus it is no mere “happy coincidence” that justice has good consequences.