(C) Copyright 1998: Graham Strachan
The economic theory underlying the policy known as ‘economic rationalism’ is supposed to be free market theory. As we will see, the resemblance to genuine free market theory is at best superficial.
THE CLASSICAL PERIOD
Classical free market economic theory originated with Adam Smith and David Ricardo in the early days of the Industrial Revolution (late 1700s, early 1800s). It was intended to apply under certain conditions and certain conditions only, namely:
(1) All business was small-to-medium sized and entrepreneurial (not corporate). Mostly the people who ran the business owned the business, and financed it with their own capital, or capital raised in partnership with others (1). There were stock exchanges, but corporations (joint stock companies) were rare and required a special act of parliament, so there were few of them listed (2).
(2) The free market was defined as a market of potentially unlimited numbers of these small/medium sized businesses, competing on a more or less equal footing, in a market which newcomers could freely enter, and in which none could control prices.
(3) The economy was national; capital must not flow freely across national borders or the theory did not hold (Ricardo)(5).
(4) The market had to be supervised by a sovereign government which (a) protected the public interest (b) made sure all businesses played by the rules (c) provided a stable currency, and (d) ran public utilities, which were regarded as not profitable for private enterprise.
THE NEO-CLASSICAL PERIOD
During the 1800s academic economists got hold of the theory and elaborated on it, incorporating its basic assumptions into mathematical models which were intended to predict economic trends. But as the century proceeded the predictions became progressively wider of the mark. Nearly all the basic assumptions on which free market theory was based no longer applied:
(1) From the 1840s on, business could incorporate, which meant the people who owned the business usually no longer ran it, and it had perpetual succession like the nation state.
Shares could be traded on the stock exchange, and the fiction of the ‘corporate personality’ meant that companies could own other companies.
(2) Big business was buying up and consolidating the small/medium sized businesses with borrowed money, combining them into monopolies and cartels which could control production and prices, and which made competition in the marketplace anything but equal. It became increasingly difficult for newcomers to enter the marketplace.
(3) Capital was starting to flow freely across national borders.
In short, the rise of big business destroyed the possibility of the free market as defined by free market theory.
Bankruptcies and unemployment increased, so that governments were obliged to intervene in the public interest and exert controls on big business (3). The American Sherman anti-trust laws (like Australia’s Trade Practices Act) emerged from this.
In particular, governments as a matter of social policy protected small/medium sized businesses with tariffs and subsidies, and allowed them exemptions under anti-monopoly legislation. This enabled them to form buying and selling cooperatives, and to exert power which ‘countervailed’ that of the developing conglomerates. The result became known as the Mixed Economy, and this, a combination of the market and government controls, was the system which built the wealth of the developed world. As Galbraith wrote in 1958, “....the support of countervailing power has become in modern times perhaps the major domestic peacetime function of the federal government (4).
Meanwhile, the monopolist mind was at work. How to control governments and get them out of the way so corporations could proceed without restrictions? Stay tuned.
REFERENCES:
(1) Sima Lieberman, Ed., “Europe and the Industrial Revolution’ (1972) esp. p.425.
(2) Herbert Heaton, ‘Economic History of Europe’ (1948) pp. 360-366.
(3) See Funk and Wagnalls Encyclopaedia under ‘laissez-faire’, and J.K.Galbraith, ‘The Affluent Society’ (1958).
(4) ‘The Affluent Society’ p.150.
(5) Paul Ormerod, ‘The Death of Economics’(1994), p.17: ‘Ricardo was careful to point out that his theory was dependent upon the assumption that funds available to invest in industry....did not flow freely from one country to another.