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How Does Laissez-Faire Economics Really Work?

Protesters, Glass-Steagall Act
Protesters ask the government to reinstate the Glass-Steagall Act. The 1933 act, which separated the activities of commercial and investment banks, was partially repealed in 1999, and some people think this may have contributed to the Great Recession. Charles Hutchins/FLckr/CC By 2.0

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According to legend, the 17th-century French King Louis XIV once called a meeting of wealthy businessmen and industrialists and asked what the monarchy could do to support the economy. Their response — "Leave us alone." Over the ensuing centuries, the economic policy that became known as "laissez-faire" (French for "leave it alone") has been embraced by free-market capitalists and demonized by progressive reformers.

But rather than praise or bash the policy, let's explore the economic rationale behind laissez-faire and see how it really works in action.

Adam Smith and the Invisible Hand

Known as both the "father of economics" and the "father of capitalism," no figure did more to extol the benefits of laissez-faire economic policy than the Scottish economist and Enlightenment philosopher Adam Smith. In his landmark treatise "The Wealth of Nations," published in 1776, Smith criticized the prevailing economic policy of mercantilism, in which governments hoarded gold and punished each other with retaliatory tariffs.

Adam Smith
Economist Adam Smith was known as the "Father of Capitalism."
Wikipedia

Instead, Smith argued for the creation of free markets and free trade. Under such a system, privately owned businesses would be free to compete for customers. This healthy competition would naturally keep prices down and quality high. Not only would the free market reward those who worked hard and with the greatest efficiency, but it would benefit society as a whole because the customers would receive better products and services.

In Smith's view, the free-market system works because it's guided by the "invisible hand" of self-interest. In the "selfish" pursuit of more profit, the business owner provides something of greater value to the market. Or as Smith put it:

"By directing that industry in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."

Does That Mean 'Greed Is Good'?

Smith and his invisible hand have been used to argue that unfettered free markets — without safeguards like government regulations or minimum wages — are the only way to ensure economic prosperity. But Smith himself did not believe that greed was inherently good, or that people left entirely to their own selfish motivations would result in paradise on Earth.

In his writings, Smith expressed a much more nuanced understanding of the power and limits of the free market. As a moral philosopher, he didn't believe that humans should be motivated purely by self-interest. He wrote frequently about the importance of sympathy and charity. He also saw a clear and important role for government in supporting free-market competition.

By creating and enforcing laws about contracts and copyrights, for example, the government builds trust and fairness into the system. Smith also believed the government should fund infrastructure projects, the large-scale building of roads, bridges and ports that support industries of all sizes.

The U.S.'s Laissez-Faire Heritage

Smith's free-market ideas were embraced in the fledgling United States, which had waged a revolution not only for political freedom, but economic freedom. Founding Fathers like James Madison and Alexander Hamilton believed that the most efficient and productive economy would protect the liberties of private citizens against interference from despotic kings or meddling bureaucrats.

But like Smith, America's founders were not blind to the limits of laissez-faire. They understood that humans, when left free to pursue their self-interest, may start to infringe on the liberties of others. In that case, the government has a duty to step in and take more of an active role.

Over its nearly 250-year history, the United States has lived through periods of unfettered free-market capitalism and also of boldly interventionist government regulation. The debate over the ideal role of government in the economy remains a fiercely dividing political issue.

America's love affair with laissez-faire reached its peak in the 1870s as the United States economy was going through rapid industrialization. New railroads, factories and mining operations enabled the efficient conversion of natural resources into commercial goods. The first corporations were born and earned massive profits for industrialist entrepreneurs.

But it wasn't long before those same wealthy industrialists banded together to form anticompetitive monopolies to fix prices, and exploited their workers (including children) through unsafe and unsanitary working conditions. In response, there was a shift away from pure laissez-faire economic policy and toward "trust-busting" and labor regulations.

A similar policy reversal happened in the 1920s and 1930s. During the boom economy of the "roaring twenties," Republican presidents Warren Harding and Calvin Coolidge held firm to a laissez-faire, do-nothing economic policy that allowed businesses to maximize profit. After the 1929 stock market crash, fellow Republican Herbert Hoover tried to temper his predecessor's laissez-faire stance, but it was too late. Franklin D. Roosevelt New Deal policies represented a 180-degree shift toward active intervention, big-government social programs and economic stimulus measures.

Laissez-Faire Today

There's still ardent political support for laissez-faire economic policies worldwide, and also firm opposition. After runaway inflation of the 1970s, political conservatives in the U.S. embraced a strong anti-regulation, free-market platform. As President Ronald Reagan famously said, "Government is not the solution to our problem, government is the problem."

In America, that same sentiment has been echoed by the conservative Tea Party movement and in the business friendly policies of the modern Republican party. While in Europe, the "neoliberal" political movement has tried to reform Europe's free markets by limiting government regulation and public ownership.

In a more recent example of laissez-faire run amok, the U.S. financial services industry was allowed to operate largely unregulated in the early 2000s under the belief that the stock market will self-correct if there was a speculative bubble. Left to their own devices, banks and mortgage lenders created a credit crisis that sunk the housing industry and triggered the Great Recession. In response, Democratic President Barack Obama pushed for greater regulation of Wall Street, including the creation of the Consumer Financial Protection Bureau.

The Heritage Foundation runs an "Economic Freedom" index, where it rates countries based on 12 freedoms including trade freedom, investment freedom, business freedom, labor freedom, and monetary freedom. By their ranking, Hong Kong was the "freest" country in 2019 (the country with the most laissez-faire economic policy), followed by Singapore. The U.S. ranked 12th.

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