Capitalism and Freedom is Nobel Prize-winning economist Milton Friedman’s classic 1962 treatise on economic freedom. Friedman argues that a society cannot maintain liberal democracy and representative institutions without a robust commitment to free-market capitalism. For capitalism to function best, it must be as free of government interference as possible.
Today, it is hard to overstate the extent to which Friedman’s once-controversial ideas have triumphed. Over the past 40 years, governments across the Western Hemisphere have reoriented their economic strategies toward more market-based solutions, including reducing marginal tax rates, all but eliminating tariffs, privatizing public monopolies, and even introducing choice and competition in public education. While reasonable people can disagree about the effects of Friedman’s ideas in the real world, no one can deny their influence.
In this summary, we’ll explore:
Economic freedom is an essential component of total freedom—the ability of an individual to pursue her own happiness and fulfillment without any external impediments, provided that she does not infringe on the freedom of others. Any form of coercion is an assault on freedom.
Economic freedom is vital to political freedom. A society simply cannot have political freedom without the ability of individual buyers and sellers in a marketplace to engage in voluntary transactions that satisfy their needs. There has never been a successful example of a society that joined state control of the economy (in the form of socialism or communism) with political liberty.
Political power is dangerous, because it can be easily concentrated and centralized in the hands of the few. Economic power, however, works differently. In a well-functioning capitalist society, millions of individual buyers and sellers make decisions about which goods and services they require to satisfy their needs. As long as there are no monopolies, buyers are free to choose their sellers, sellers to choose their buyers, and workers to choose their employers. Free markets are inherently decentralized in nature, thus maximizing individual freedom and choice.
Despite the threat of government power, even those most committed to free-market principles must accept the idea that there are some societal functions that the market is unable to perform, such as national defense, domestic security, and the enforcement of property rights. These functions are crucial to the preservation of economic liberty, and can only be performed by the
public sector. Beyond these basic duties, governments also have a responsibility to:
One of the government’s most important responsibilities is to curb the power of monopolies.
A monopoly occurs when a market for a particular good or service has only one seller. Because they make it impossible for buyers to find an alternative seller, markets dominated by monopolies cannot be considered free.
Because monopolies pose a threat to economic freedom, it is a legitimate exercise of government power to limit them or break them up.
There are three forms of monopoly:
All three forms involve the elimination of competition, and are therefore harmful to economic freedom. But, all things being equal, unregulated private monopolies are usually the least harmful. Regulated private monopolies and public monopolies use the coercive power of the state to enforce anti-competitive practices. Competition is literally illegal in such cases.
Monopolies and near-monopolies benefit from poorly designed features of the US tax code. For example, corporate, capital gains, and dividend taxes all disincentivize shareholders from putting corporate profits toward new investments. Because investors face a tax penalty when they sell stock or collect a dividend, it is often a better option to simply plow money back into an existing large company by purchasing more shares, thus increasing the stock price for shareholders. The effect is to protect large incumbent businesses by giving them the lion’s share of available capital, even when they have little productive use for it.
Governments also have a responsibility to provide those services that have strong neighborhood effects. Neighborhood effects arise when some individual economic activity confers benefits upon individuals whom it is extremely difficult to charge for their receipt of such benefits.
A good example is local parks. People who regularly walk through such parks, have views of them from their homes, or just happen to pass by them can reasonably be said to receive a benefit from them. But because the benefits of these local parks are so widely dispersed and difficult to assign a true “value” to, it would be infeasible and inefficient for a private owner of such a park to charge fees to everyone who derives enjoyment from them. Therefore, the public sector can more efficiently provide goods like local parks that confer widespread positive neighborhood effects.
Free-market principles also allow for some other, limited functions of government. One of these is the issuance of currency and the regulation of the money supply.
Commodity standards based on metals like gold or silver systems have proven unworkable due to their limited supply. Most economies therefore evolved to have governments issue paper money to facilitate transactions. As long as the government guarantees that official paper currency can be used as legal tender, it has value.
Central banks are government-chartered financial institutions that have the power to increase or decrease the supply and circulation of money in an economy, primarily through their control of interest rates. The American central bank is the United States Federal Reserve System (usually referred to as “the Fed”).
The Fed’s activities are meant to ensure that the banking system has the liquidity it needs to conduct business, as well as provide price stability throughout the economy. Nevertheless, control of interest rates vests a great deal of power in government and represents the most consequential intervention by the public sector into the market.
In light of this power, it is particularly important to look at the Fed’s failure to rescue the banking system in the critical early years of the Great Depression. As depositors began to worry about broader economic conditions in November 1930, they began to pull their money out of banks en masse. Banks struggled to meet these demands, beginning a series of disastrous bank runs. This was the moment when the Fed should have acted decisively to cut interest rates and pump liquidity into the system.
But instead, the Fed simply did nothing. The unwillingness to act led to the worst two-year period of economic contraction in US history.
Governments also play a significant role in revaluing or devaluing their currencies relative to those of other countries. Both a strong dollar (one that has a high exchange rate relative to other currencies) and a weak dollar (one that has a low exchange rate relative to other currencies) have different advantages for different players in the economy.
A strong currency benefits importers of raw materials from abroad and consumers of foreign goods, because it enables them to purchase pounds sterling or yen or euros with fewer dollars, in turn enabling them to purchase more goods and services denominated in those currencies. A weak currency, on the other hand, benefits exporters, because it enables them to sell American goods and services cheaper in foreign markets, giving them a competitive advantage.
Systems that peg the value of a currency to a commodity (like gold) or to another currency tend to be harmful to economic freedom, because they require the government to impose heavy-handed controls over capital flows in and out of the country and restrict the freedom of individuals to conduct ordinary business transactions (because they have to maintain adequate stocks of gold or foreign currency to keep the ratios stable).
In a free society, competent individuals should face no restrictions on their ability to conduct transactions and make contracts.
Instead of this elaborate and carefully managed system of international currency pegging, countries should be free to let their currencies simply “float”—i.e., let the free market determine the value of currencies relative to one another.
The inflows and outflows of currency would always balance out under such a system—the seller of dollars would need to find a buyer willing to pay her in the equivalent value of foreign currency. Losses of domestic currency would by definition be offset by gains in foreign currency reserves.
Monetary policy has a significant impact on economic freedom. But so does fiscal policy—how (and how much) the government chooses to tax and spend. Following the Great Depression, there was a groundswell of public support for aggressive fiscal policy on the part of the federal government. The public wanted the government to offset the collapse in private spending with large, deficit-financed spending from the federal government (that is, increases in spending without offsetting tax increases).
The intellectual underpinning of this policy was the Keynesian school of economics. Named for the British economist John Maynard Keynes, Keynesianism argued that government spending could make up for the shortfall in consumer spending during an economic downturn.
The fiscal multiplier effect is a lynchpin of Keynesian economics. According to this principle, when the government spends money, it creates new spending power in the economy above and beyond the original government expenditure, because it stimulates several rounds of private spending that otherwise would not have occurred. When Individual A receives money from the government, she spends it at a business owned by Individual B, which then becomes her income, which she will in turn spend to contribute to someone else’s income, and so on.
If the government uses its fiscal power to publicly subsidize some service that you once paid for with your own private spending (like access to a beach), then in theory, it has freed you up to spend that money on something else.
But since you had been freely spending your money to get access to the beach, it is reasonable to assume that you placed a higher value on that use of your money than you did on alternative uses. Since you are now getting that access for “free,” you are unlikely to increase your spending on other goods or services above and beyond what you were already spending, because you don’t value those other goods and services as highly.
To finance new expenditures, the government is likely borrowing the money from investors and issuing bonds to them. This does not increase the total stock of money in the private sector—it merely moves it from one party (the purchaser of government bonds) to another (the ultimate recipient of government spending). Under most economic conditions, those investors would have spent the money they used to purchase bonds on some other set of goods and services in the private sector. The borrowing in and of itself, then, only diverts and offsets spending that would have occurred anyway.
We’ve already seen that there are services that the government provides that are intended to confer broad benefits to society. Yet many of these government efforts end up harming economic liberty by unfairly inhibiting freedom of contract or establishing public monopolies that deprive individuals of market choices they would otherwise have. Although its efforts are often well-intended, the ways in which the government provides many of its services restrict the freedom of individual buyers and sellers to enter into contracts of voluntary exchange.
One sector where the government plays a nearly monopolistic role is in the financing and administration of education. Education has strong neighborhood effects, as it benefits society to have a population that is literate, civic minded, and adequately prepared to take on the responsibilities of citizenship. But while the financing of education through public money can be justified on the basis of neighborhood effects, its administration cannot be.
Parents are legally mandated to send their children to the school for which they are zoned, even if the quality of education at that school is known to be poor or if they dislike the content being taught. If they had a choice in where to educate their children (as they do in nearly all other markets), parents might choose to send their children to other schools, where the content and quality of education is more in line with their preferences.
While parents technically do have the option of moving to a different school district or sending their children to private school, the costs of doing so are so prohibitively expensive as to not represent a genuine “choice.”
One solution to this problem is to decouple the public financing of education from the public administration of schools. Instead of paying taxes and having no choice in the matter of where to send their children to school, parents should instead receive a voucher from the government.
This voucher would be redeemable for educational services up to a certain amount for each child, provided that they are spent on approved education providers that meet certain minimum standards. Beyond that minimum requirement, parents would be free to spend their vouchers on whatever educational option they deem to be best for their children.
The bedrock principle of a free-market economy is that individuals ought to be able to enter into voluntary contracts with one another. But equal opportunity employment laws, which are intended to prevent discrimination against members of minority groups, constitute a dangerous violation of freedom of contract. For example, such laws might mandate that a minority candidate be hired regardless of whether or not the employer believes they are a proper fit for the position.
This in and of itself violates the employer’s freedom of contract rights. Once the government violates the principle of freedom of contract, any number of abuses becomes possible. If the government can negate freedom of contract by denying the right of employers to discriminate on the basis of race, sex, or any other individual characteristic, it could also theoretically negate freedom of contract by mandating that private employers engage in such discrimination.
Another way in which governments restrict choice is through professional licensure. For example, professional licensure often functions as a means by which existing practitioners in a field limit competition—at the expense of consumers.
A license is a permit from a legal authority to engage in some specific economic activity. Licenses are backed up by force of law—if you don’t have the license, you cannot practice the trade, and will be punished if you attempt to do so.
Professional licensure serves to protect incumbent practitioners in the field by making it difficult and/or expensive for newcomers to enter the profession. By keeping the number of professionals in a given field low, licensure enables incumbents to charge higher prices for their services.
One of the cornerstones of a society based upon voluntary exchange is the right to keep what you earn. After all, what you earn in the market is a product of the productive capacity of your own labor and capital. The fairest and most efficient way to allocate resources in a system of voluntary exchange is through payment according to product. Your compensation is a direct result of the value you create in the economy through your labor (the work you perform for which you are paid in wages and tips) and your capital (the productive assets you own, like land or machinery).
Forced redistribution schemes are inherently unjust. There is no moral justification for a majority to compel a minority to hand over its property—whether it’s a gang of armed robbers telling you to hand over the cash in your wallet or a majority of voters passing legislation to legally confiscate wealth from the so-called “1 percent.”
Unfortunately, some of the government’s most grave threats to economic liberty come cloaked in the language of equality, fairness, and economic justice. Below, we’ll explore some of the worst public manifestations of this.
To combat the alleged dangers of income inequality, most industrialized countries have established systems of progressive taxation. Under such a system, the marginal rate of taxation increases the more one earns. Thus, your income from $0-$49,000 might be taxed at 12 percent, your income from $50,000-$99,999 might be taxed at 25 percent, and so on.
One problem with progressive taxation is that it increases pre-tax income inequality. If high earners know that their top marginal tax rate is going to be high, lucrative jobs become less attractive than they would otherwise be. The only way to compensate for this is to make these kinds of jobs even more well-paid—thereby increasing pre-tax inequality.
Progressive tax codes are also nearly always more complex than alternatives. They contain all sorts of loopholes and deductions that tax certain kinds of income (like capital gains) at different rates than other kinds of income (like standard wages and tips). This creates a strong incentive for wealthy people to devote inordinate resources to devising complex and wasteful tax-avoidance schemes.
A flat tax is more efficient and equitable than a progressive tax. Under a flat tax, everyone would pay the same rate, regardless of income level or income type. A flat tax plan would also broaden the definition of “income,” taxing more types of income than the present system does, while closing loopholes and special-interest exemptions.
Because the rates would be uniform and all types of income would be equally subject to taxation, there would be far less incentive for individuals and businesses to waste resources on tax avoidance schemes.
Progressive taxation is not the only policy by which the government attempts to redistribute income and alleviate poverty. Through a range of programs, including the provision of public housing, the establishment of federal and state minimum wages, and social insurance (most notably Social Security in the United States), public authorities have attempted—nearly always with the best of intentions—to raise the standard of living of the worst-off members of society.
But these anti-poverty programs injure economic freedom by confiscating property from one segment of the population to give it to another, enable the growth of large and increasingly unaccountable government bureaucracies, and paternalistically presume that the government knows what’s best for the people rather than the people themselves.
Perhaps the most famous redistributive program in the United States is Social Security. Social Security is a government pension system that pays benefits primarily to elderly and disabled citizens. It is financed by payroll taxes collected on people during the course of their working lives. As a compulsory program, no one has the option of not paying into Social Security. Taxpayers are forced to hand over their money to purchase a product that they might very well have elected not to purchase if they had been given free use of their own money.
Alleviating poverty does benefit society broadly. But the problem arises when anti-poverty measures require large and expensive bureaucracies to maintain them. To get around these traditional defects of such programs, governments should adopt a negative income tax.
By providing proportional subsidies for people who fall below a certain income threshold, a negative income tax would redistribute income, but on a far more equitable and transparent basis than traditional tax-and-transfer programs. It would effectively guarantee a certain basic income for everyone. It would also be more efficient than the current patchwork of welfare programs, most of which are targeted to specific groups (like veterans, widows, the elderly, and so on). The narrow and targeted nature of such benefits programs requires an expensive bureaucracy to maintain and administer them.
Capitalism has proven itself to be history’s most effective system for alleviating poverty and raising the standard of living for the vast majority of the human population. Supporters of economic and political freedom must resist every attempt—even by the most well-intentioned idealists—to impose central control over systems of voluntary exchange. Increased government control over our lives would ultimately lead to the creation of a less free and less prosperous society. We must always remember that concentrated power is dangerous, regardless of the intentions of those wielding it.
Capitalism and Freedom is Nobel Prize-winning economist Milton Friedman’s classic 1962 treatise on economic freedom. Friedman argues that a society cannot maintain liberal democracy and representative institutions without a robust commitment to free-market capitalism. For capitalism to function best, it must be as free of government interference as possible.
Although these ideas have become mainstream in western policy and intellectual circles in the nearly 60 years since the publication of Capitalism and Freedom, they were highly controversial—even fringe—at the time. In that era, the Keynesian economic policy consensus dominated the postwar United States, advocating for a robust and activist role for government in the management of the economy and the redistribution of incomes.
Today, however, it is hard to overstate the extent to which Friedman’s once-controversial ideas have triumphed. Over the past 40 years, governments across the Western Hemisphere have reoriented their economic strategies toward more market-based solutions, including reducing marginal tax rates, all but eliminating tariffs, privatizing public monopolies, and even introducing choice and competition in public education. While reasonable people can disagree about the effects of Friedman’s ideas in the real world, no one can deny their influence.
In this summary, we will explore:
Economic freedom is an essential component of total freedom—the ability of an individual to pursue her own happiness and fulfillment without any external impediments, provided that she does not infringe on the freedom of others.
Any form of coercion is an assault on freedom. Thus, if you are forced to surrender part of your income to pay for old-age insurance (as with Social Security), you have been robbed of the ability to fully make decisions about what to do with the money you earn from your labor.
Similarly, if you are prohibited from entering a profession of your choice by licensing requirements, you are being prevented from exercising your freedom to apply your talent and initiative as you wish. In this chapter, we’ll explore:
Economic freedom is vital to political freedom. A society simply cannot have political freedom without the ability of individual buyers and sellers in a marketplace to engage in voluntary transactions that satisfy their needs. There has never been a successful example of a society that joined state control of the economy (in the form of socialism or communism) with political liberty.
Political power is dangerous, because it can be easily concentrated and centralized in the hands of the few. Economic power, however, works differently. In a well-functioning capitalist society, millions of individual buyers and sellers make decisions about which goods and services they require to satisfy their needs. As long as there are no monopolies, buyers are free to choose their sellers, sellers to choose their buyers, and workers to choose their employers.
Thus, a great deal of power over a crucial area of day-to-day life is taken away from the hands of the few, and placed into the hands of the many. Free markets are inherently decentralized in nature, thus maximizing individual freedom and choice. In a capitalist society, economic power acts as a check on the power of political authorities because it is not in the hands of the government.
In a communist society, it would be impossible for someone to exercise their political freedom to, for example, champion capitalism. This is because engaging in any political cause costs money. But in a communist society, there is no voluntary exchange—the government controls all the jobs and restricts how money may be spent. Thus, the advocate of capitalism would be dependent on the goodwill of her communist paymasters in order to be able to spread her message. Given their control of her income, it would be unrealistic to assume that they would allow her to do this.
Even if she somehow gathered the money to do this, she would face further obstacles owing to control by the political authorities of all the economic means of production. She would have to print her pamphlets at a government-run print shop, host her website on government-run servers, and speak to audiences at government-run venues. Her lack of economic freedom would thus inhibit the exercise of her political freedom.
Contrast this with the experience of an advocate for communism in a capitalist society. In such a society, the means of production are in private, not government hands. Thus, a communist activist only needs to convince others of the worthiness of her cause and persuade them to contribute funds so she can promote her message.
These patrons, because they live in a capitalist society, are free to use their money as they please. Thus, the activist’s economic freedom facilitates the exercise of her political freedom.
The experience of blacklisted writers during the 1950s provides a neat real-world illustration of this dynamic. Hollywood screenwriters who were suspected of communist sympathies had been blacklisted by the studios, under pressure from hardline anticommunist politicians. This prevented these screenwriters from exercising their economic freedoms to use their literary talent to earn a livelihood.
But the free market provided the corrective for this gross infringement of economic liberty. Studios simply could not continue the practice of refusing to purchase high-quality scripts because of their writers’ political beliefs—as the studios argued, they had a financial responsibility to make as much money as possible for their shareholders, which, in turn, meant purchasing the best possible scripts to turn into high-quality, high-grossing films.
Thus, because they lived in a free-market society, even communists could enjoy the privilege of exercising their economic and political freedom.
Governments are always coercive. Even in democratic societies, governments operate on the principle of majority rule. Those in the minority must, by definition, yield to the will of those in the majority.
Because of their collective nature and their need to serve the masses, governments cannot satisfy individual needs—instead, they must demand conformity. After all, you cannot have national legislation tailored to suit your individual needs (if anything, national legislation is more likely to work against your individual interests, a topic we’ll explore in greater detail later in the summary).
This is in contrast to how markets operate. By their very nature, free markets serve the individual customer on a voluntary basis. As a buyer, you are free to choose another seller who offers you a fairer price or a better good.
Of course, this is not to say that there is no role for government in a capitalist society. Even those committed to free-market principles accept the idea that there are some societal functions that the market is unable to perform, such as national defense, domestic security, and the enforcement of property rights. In this chapter, we’ll look beyond these basic functions to examine two of government’s most important responsibilities—curbing monopolies and regulating the neighborhood effects of economic activity.
A monopoly occurs when a market for a particular good or service has only one seller. Often, these are technical monopolies, where the production of a particular good or service is dependent on access to an expensive or complex technology that only one firm possesses.
Because they make it impossible for buyers to find an alternative seller, markets dominated by monopolies cannot be considered free. Nevertheless, there are some markets that naturally lend themselves to the formation of monopolies, usually those that involve large startup costs or complex proprietary technology. In the economic history of the United States, railroads and telephones started out as monopolies.
Because monopolies pose a threat to economic freedom, it is a legitimate exercise of government power to limit them or break them up. Thus, a capitalist ought to be in favor of economic regulations like the Sherman Antitrust Act. It is important, however, that governments wield this power on an equitable basis—if large businesses are to be broken up by the Justice Department through antitrust laws, monopolistic unions that control the supply of labor in a given market must also be subject to the same laws.
There are three forms of monopoly:
All three forms involve the elimination of competition, and are therefore harmful to economic freedom. But, all things being equal, regulated private monopolies and public monopolies are usually the most harmful. Regulated private monopolies and public monopolies use the coercive power of the state to enforce anti-competitive practices. Competition is literally illegal in such cases.
For example, the Interstate Commerce Commission (originally created to curb the monopolistic power of private railroads) effectively became a regulated monopoly power that protected those private firms and isolated them from competition. Similarly, public monopolies like the US Postal Service can take advantage of the fact that they are publicly subsidized in order to undercut potential private competition.
A private monopoly, by contrast, does not derive its power from a legal mandate. Therefore, particularly as new technologies emerge, the possibility exists that new players will emerge in the market that can challenge the power of the monopoly. We’ll return to monopolies in greater detail in Chapter 8.
Governments also have a responsibility to promote positive neighborhood effects and prevent negative neighborhood effects.
Negative neighborhood effects (also known as externalities) arise when one individual’s economic activity imposes a cost on another individual for which the former is unable to compensate the latter.
The classic example is of a private company polluting a community water source. The individuals whose water is poisoned have no practical way to avoid participating in this forced “transaction” or of receiving compensation for the costs they’ve incurred outside of government action (either through legislation or lawsuit). Therefore, government regulation of negative externalities (in this case anti-pollution laws) is appropriate and consistent with the preservation of economic freedom.
Positive neighborhood effects, meanwhile, arise when some individual economic activity confers benefits upon individuals whom it is extremely difficult to charge for their receipt of such benefits. A good example is local parks. People who regularly walk through such parks, have views of them from their homes, or just happen to pass by them can reasonably be said to receive a benefit from them.
But because the benefits of these local parks are so widely dispersed and difficult to assign a true “value” to, it would be infeasible and inefficient for a private owner of such a park to charge fees to everyone who derives enjoyment from them. Therefore, the public sector can more efficiently provide goods like local parks that confer widespread positive neighborhood effects.
The same cannot be said, however, of national parks like Yellowstone or Yosemite. These parks have few entrance points, are in remote locations, attract visitors from all over the country, and host visitors for long periods of time. It is much easier, therefore, to determine precisely who is benefitting from them.
In a capitalist society, therefore, there is no reason for goods like national parks—which provide discrete benefits to a relative handful of people—to be publicly subsidized by taxpayers, the great majority of whom will never use them. Instead, private operators should run such parks and charge fees only to those who choose to use them.
Examine the link between economic and political freedom.
Do you think there are freedoms that are more important than the freedom to spend your own money as you wish? Why or why not?
Do you think political freedom stems from economic freedom, or the opposite? Why or why not?
Beyond what we covered in the summary, do you think there are services provided by the government that could be better provided by the private sector? If so, name them and explain your answer.
In the last chapter, we talked about the role of government in curbing monopolies and regulating neighborhood effects. As we saw, the public sector has a role to play in these aspects of economic activity, because the free market would be unable to do them (or do them efficiently).
But free-market principles also allow for some other, limited functions of government. One of these is the issuance of currency and the regulation of the money supply. In this chapter, we’ll analyze how governments manage the domestic money supply through central banks. We’ll also explore how governments balance their currencies against those of other nations—and the implications of these activities for economic freedom.
We’ve already seen how large concentrations of government power tend to threaten individual liberty because of the collective, coercive nature of government itself. Because money is so central to the billions of daily individual transactions that power a market economy, therefore, capitalists tend to favor a reduced role for the public sector in monetary policy.
This aversion to central control of the money supply is why a commodity standard—a system in which money is directly tied to the amount of some physical commodity (usually gold or silver) held in reserve—has historically been attractive to capitalists; it limits the amount of human involvement in monetary policy. After all, if the amount of money in circulation is in direct proportion to the amount of gold or silver held in reserve, then the ability of government bureaucrats to meddle with the money supply is greatly reduced.
But, in reality, such systems have proved unworkable. Digging metal commodities out of the ground requires great effort and expense, and there is a finite amount of it. Thus, if we could only use gold coins to conduct daily transactions, there would never be enough currency on hand to meet demand.
Therefore, most economies evolved to have private individuals and financial institutions issue paper money that could serve as a substitute for gold and would be redeemable in gold if presented to the issuer. From there, it naturally followed that governments would issue their own paper money and begin to regulate the currency so as to prevent fraud.
Over time, people simply came to accept paper money as valuable in and of itself, independent of its convertibility to gold. As long as the government guarantees that official paper currency can be used as legal tender, it has value. Therefore, some amount of government involvement in the issuance of money is inevitable.
Because governments must play some role in the regulation of the money supply in a modern economy, central banks like the Bank of England in the UK or the Federal Reserve System in the US have emerged to take on this core function. Central banks are publicly chartered financial institutions that have the power to increase or decrease the supply and circulation of money in an economy, primarily through their control of interest rates.
When the United States Federal Reserve System (usually referred to as “the Fed”) believes that the money supply is too low (as in cases of deflation, or falling prices), it purchases US Treasury securities from large private banks. These purchases give the banks new reserves of cash that they can use to issue loans to other banks, infusing new liquidity into the system and enabling interest rates to drop throughout the economy.
By contrast, when the Fed believes that the money supply is too high (as in cases of inflation, or rising prices), it sells US Treasury securities to major banks, taking money out of circulation and enabling interest rates to rise throughout the economy.
These activities are meant to ensure that the banking system has the liquidity it needs to conduct business, as well as provide price stability throughout the economy. Nevertheless, control of interest rates vests a great deal of power in government and represents the most consequential intervention by the public sector into the market. This power can be extremely dangerous if placed in the wrong hands.
The onset of the Great Depression provides an excellent demonstration of the potential for the government to misuse its power over the economy. In this case, the Fed utterly failed to prevent the United States from falling into the Great Depression during the critical period from 1930-31.
Although most Americans believe that the famous Wall Street Crash of 1929 (known as “Black Monday”) caused the Depression, this is a misreading of history. The crash, while dramatic, was not nearly a large enough shock to the system to produce the catastrophic collapse in aggregate demand and cascading bank failures that marked those early years of the Depression.
It is particularly important to look at the Fed’s failure to rescue the banking system in those critical early years.
A bank run is when depositors (such as individuals, businesses, and even other banks) demand to withdraw their funds from a bank all at the same time, usually in response to fears that the financial system as a whole is on the verge of collapse.
Unfortunately, these fears can become self-fulfilling prophecies. Banks do not hold cash in reserves equal to their deposits. When you deposit $100 in the bank, the bank might keep $5 on hand as reserves. The remaining $95 is loaned out at interest to borrowers—this is how banks make a profit. The system is known as the fractional-reserve system.
Because of this, banks face enormous pressure to satisfy depositors’ demands during a bank run. Under pressure, they will begin calling in loans that they’ve made to other banks, adding further strain to the system. If left unchecked, the contagion can spread throughout the financial system and lead to total collapse.
This is where a central bank plays a critical role as a lender of last resort, through its ability to reduce interest rates, pump liquidity into the system, and ensure that banks are able to meet demands for withdrawals. If a central bank acts quickly, correctly, and decisively, it can inspire confidence in the banking system and stop demands for withdrawals from getting out of hand.
Unfortunately, the Fed failed catastrophically in this role in the run-up to the Depression. November 1930 saw the beginning of a series of disastrous bank runs in the US. This was the moment when the Fed should have acted decisively to cut interest rates, buy Treasury bonds, and pump liquidity into the system.
But instead, the Fed simply did nothing, apparently not believing that the situation merited any intervention. In fact, the Fed’s account books from the time show that it actually tightened the money supply, making credit scarcer at the worst possible time.
The unwillingness to act led to the worst two-year period of economic contraction in US history. While some downturn was likely inevitable, the Fed could have averted the worst of its effects through aggressive monetary policy. Its failures turned a mild slump in the business cycle into a full-blown economic disaster of historic proportions that saw the US money supply contract by one-third.
This history of the Fed’s failure to perform during its most critical test—indeed, the very type of
situation it was created to address—demonstrates the danger of concentrating too much economic power in the hands of a few central bankers.
Although we’ve established that some level of government involvement in the management and implementation of monetary policy is unavoidable, it is not without risks. The Fed is a highly centralized system that leaves day-to-day management of crucial economic policy in the hands of powerful bureaucrats, without meaningful oversight from elected officials.
These officials have broad discretion to manage the supply of money as the situation may dictate, without reference to any particular overriding rule or general principle. While this may provide the Fed with a high degree of flexibility, it also leaves the door open for bad decisions with wide-ranging consequences, based solely on the misguided judgment of the handful of bureaucrats making key decisions.
Moreover, the Fed is charged with a dual mandate of achieving both price stability and full employment. These mandates are in competition with one another, as employment and inflation tend to have an inverse relationship. While the Fed’s actions do have some effect on both, the effect is indirect and often difficult to predict. Fed officials cannot reliably use the mandate to achieve either price stability or full employment as a guide to their day-to-day actions.
The Fed should instead operate strictly according to rules about governing the money supply and set reasonable targets for its growth. Although it is impossible to say with certainty, a good rate of growth would be between 3 and 5 percent per month. This would make the Fed’s actions stable and predictable, while limiting the institution solely to the performance of those functions over which it has more or less direct control—namely, control of the money supply.
Governments also play a significant role in revaluing or devaluing their currencies relative to those of other countries. Both a strong dollar (one that has a high exchange rate relative to other currencies) and a weak dollar (one that has a low exchange rate relative to other currencies) have different advantages for different players in the economy.
A strong currency benefits importers of raw materials from abroad and consumers of foreign goods, because it enables them to purchase pounds sterling or yen or euros with fewer dollars, in turn enabling them to purchase more goods and services denominated in those currencies. A weak currency, on the other hand, benefits exporters, because it enables them to sell American goods and services cheaper in foreign markets, giving them a competitive advantage.
Because of these advantages and disadvantages of currency valuations, countries used to frequently try to manipulate the value of their currencies relative to others in order to benefit some sector of their domestic market. Unsurprisingly, political lobbying and influence peddling (not free-market principles) were central to this process, with special interests pressuring governments and central bank officials to adopt monetary policies that would benefit them.
This was the state of affairs until the introduction of the Bretton Woods System in 1944. The Bretton Woods system pegged the value of the US dollar to gold at $35 per ounce of gold. In turn, the other parties to the Bretton Woods agreement had to peg their currencies to the US dollar in fixed ratios, with only minor diversions permitted.
The purpose of this arrangement was to create a stable monetary system that would more easily facilitate international transactions by maintaining parity and predictable exchange rates between currencies. It was also designed to prevent countries from engaging in competitive cycles of devaluing their currencies. It was the international monetary system in place in 1962, when Capitalism and Freedom was published.
Unfortunately, to make this whole system work, the US had to constantly maintain adequate reserves of gold and dollars in order to be able to convert dollars to gold (and vice versa) at the specified price, whenever the need arose. This meant that the United States had to impose heavy-handed controls over capital flows in and out of the country and restrict the freedom of individuals to conduct ordinary business transactions.
For example, the aforementioned convertibility of the US dollar to gold only applied to foreign central banks’ holdings of US dollars. To maintain adequate gold stocks, the US government forbade US citizens from exchanging their dollars for gold, holding stocks of gold (except for artistic or limited industrial purposes), or writing private contracts that specified payment in gold.
To prevent dollars from flowing out of the country, the government mandated that foreign countries spend their American foreign aid dollars in the United States; prevented families from joining members of the military serving abroad (knowing that they would spend their dollars outside the US); and strictly limited the quantities of foreign goods that Americans could bring into the country without paying a duty.
All of these measures represented a direct affront to the most core principles of economic freedom. In a free society, competent individuals should face no restrictions on their ability to conduct transactions and make contracts.
Instead of this elaborate and carefully managed system of international currency pegging, countries should be free to let their currencies simply “float”—i.e., let the free market determine the value of currencies relative to one another.
Skeptics of free-floating exchange rates once worried that such a system would lead to wild fluctuations in the relative value of currencies. But this fear was not grounded in reality. After all, the United States and other countries with market economies had free price systems for the buying and selling of ordinary domestic goods and services—it was not as if the government mandated prices for televisions or automobiles.
This did not lead to unpredictable price swings in these markets, because prices of goods and services are fundamentally a reflection of broader underlying economic conditions and policies. As long as this macroeconomic structure remained the same, price changes would be slow and modest. There was no reason to believe that the market for currency would behave differently.
The inflows and outflows of currency would always balance out under such a system—the seller of dollars would need to find a buyer willing to pay her in the equivalent value of foreign currency. Losses of domestic currency would by definition be offset by gains in foreign currency reserves.
This system would enable the United States to abandon all capital controls (including the guarantee to purchase gold and foreign currencies at guaranteed rates), end restrictions on transactions between private firms and individuals, and expand the zone of free trade. Absent major structural changes, this free-floating currency system would produce stable and predictable currency valuations—without cumbersome and intrusive government meddling.
(Shortform note: Since the original publication of Capitalism and Freedom in 1962, Friedman’s vision for the international monetary system has more or less come true. Most major industrialized economies, including the United States, Japan, and the EU, have adopted free-floating currencies and have abandoned any attempts to peg them to either a commodity like gold or another currency.)
In the last chapter, we analyzed monetary policy—a government’s control of its money supply and its currency’s value—and its impact on economic freedom. In this chapter, we’ll turn our attention to fiscal policy—how (and how much) the government chooses to tax and spend.
In particular, we’ll focus on the once-dominant Keynesian school of economics—and why its simplistic assumptions failed to deliver the real-world benefits it promised.
Following the Great Depression, there was a groundswell of public support for aggressive fiscal policy on the part of the federal government. The public wanted the government to offset the collapse in private spending with large, deficit-financed spending from the federal government (that, is, increases in spending without offsetting tax increases).
The intellectual underpinning of this policy was the Keynesian school of economics. Named for the British economist John Maynard Keynes, Keynesianism argued that gross domestic product (GDP) was primarily made up of four components:
According to this theory, when a severe recession or depression caused a decline in one or all of the other three components (especially consumer spending), government spending could make up for the shortfall by infusing cash into the economy.
Countercyclical fiscal policy is at the heart of Keynesian economics. It states that during a recession, the government should stimulate the economy by raising spending and cutting taxes to “prime the pump” and infuse cash into the system. This gives consumers and businesses the necessary funds to make purchases.
When the economy begins to recover, however, the government should pare back its expansionary fiscal policies. This cycle of spending during the slump and austerity during the recovery is meant to ensure that aggregate demand in the economy remains stable.
Unfortunately, it has historically been difficult for policymakers to turn the fiscal pump on and off at the right time. New spending programs are hastily voted on, but often only go into effect after the crisis has passed and they’re not needed anymore. Because these programs inevitably create beneficiaries, politicians tend to be highly reluctant to end them, for fear of antagonizing voters. The result over time is a cycle of higher spending, higher taxes, higher borrowing, and higher inflation, all to pay for an out-of-control welfare state.
Another lynchpin of Keynesian economics is the fiscal multiplier effect. According to this principle, when the government spends money, it creates new spending power in the economy above and beyond the original government expenditure. This is best illustrated by example.
This cycle continues on and on, stimulating more aggregate demand. In this particular cycle, since one-fifth of the money is being saved in each round of spending, we can say that the multiplier is 5—in other words, the initial $100 increase in government spending
leads to $500 in private spending.
Thus, according to Keynesian economics, government fiscal policy delivers great return on initial investment.
Unfortunately, the simple Keynesian analysis leaves much out of the equation. It neglects to consider what the government spends money on. If the government uses its fiscal power to publicly subsidize some service that you once paid for with your own private spending (like access to a beach), then in theory, it has freed you up to spend that money on something else—thereby adding new private spending into the economy.
But since you had been freely spending your money to get access to the beach, it is reasonable to assume that you placed a higher value on that use of your money than you did on alternative uses. Since you are now getting that access for “free,” you are unlikely to increase your spending on other goods or services above and beyond what you were already spending, because you don’t value those other goods and services as highly.
The subsidy, in this case, would cause you to pull back your private consumer spending. Government spending therefore crowds out private spending.
We see this further when we consider where the government is acquiring the funds for its aggressive fiscal policy. Most likely, it is borrowing the money from investors and issuing bonds to those creditors.
This, of course, does not increase the total stock of money in the private sector—it merely moves it from one party (the purchaser of government bonds) to another party (the ultimate recipient of government spending). Under most economic conditions, those investors would have spent the money they used to purchase bonds on some other set of goods and services in the private sector.
The borrowing in and of itself, then, diverts and offsets spending that would have otherwise occurred. If we return to our previous example with the $100 check you receive from the government, the multiplier effect is closer to $0 than it is to $500.
Government bondholders will only be willing to lend money to the government if they receive an adequate rate of return. If the government borrows too much money, this will cause a general rise in borrowing costs throughout the economy. This will have a dampening effect on consumption and investment, as potential borrowers will be wary of taking out a mortgage or an auto loan at high prevailing interest rates.
Keynesian economics thus fails to deliver on its core promises. It is also at odds with economic freedom. Because it places such powerful emphasis on aggressive fiscal policy to recessions, Keynesianism explicitly calls for the political management of the economy.
During recessions, fearful legislators clamor for new outpourings of federal expenditure, unwilling to consider the knock-on effects of their actions. The result has been the growth of both the scale and scope of government since the Great Depression—the state is vastly greater than it was before the 1930s and is engaged in a range of activities in which it has no legitimate business.
Moreover, because the government plays such an outsized role in national GDP, government officials have enormous—and, from the point of view of supporters of economic and political freedom, dangerous—influence over decisions made by individuals and firms in the private sector.
Even in a capitalist society supposedly based upon voluntary exchange between individuals, we have come to accept a large role for the government in the management of economic affairs and the provision of certain goods and services. We’ve seen this already with important government functions like the curbing of monopolies and regulation of the money supply.
But should the government play such a key role in our lives? Is much of what the government does truly defensible in the context of a society that claims to value economic freedom?
One sector where the government plays a nearly monopolistic role is in the financing and administration of children’s education. In this chapter, we’ll explore:
We discussed neighborhood effects in Chapter 2. To recap, neighborhood effects describe
those actions by an individual (let’s call them “Individual A”) that:
Because of the nature of such transactions, they make voluntary exchange impractical. Transactions that yield significant neighborhood effects should be undertaken by governments, not the private sector.
The provision of education to children and adolescents has strong neighborhood effects. Especially in a democratic system, society broadly benefits by having a population that is literate, civic minded, and adequately prepared to take on the responsibilities of citizenship. Basic education instills these qualities in young people and confers significant benefits upon everyone else, but it is impossible to “charge” everyone else for the “value” of the benefit they receive. Therefore, it is appropriate that governments guarantee K-12 education (although we’ll explore later in the chapter why neighborhood effects don’t apply to education beyond this age range).
Because of the clear neighborhood effects, nearly all advanced, industrialized countries make significant investments in public education. In the United States, K-12 public education is financed primarily through property taxes assessed on those owning property within a given school district. This is often supplemented by additional money from the state and federal government, usually based on standard school aid formulas.
But while the financing of education through public money can be justified on the basis of neighborhood effects, its administration cannot be. Having governments actually run the schools and directly provide educational services means that parents are legally mandated to send their children to the school for which they are zoned, even if the quality of education at that school is known to be poor or if they dislike the content being taught.
Children attend school in government-owned buildings and are taught government-approved material by government-paid teachers. Parents, given a choice, may not wish to send their children to school in a large physical building, which is expensive to maintain, and where their money as taxpayers might be spent on all manner of activities that they do not deem appropriate or relevant to their child’s education (including art, music, gym, and extracurricular clubs and sports).
If parents do not wish to have their money put to such uses or to send their children to low-quality neighborhood schools, their only options are to:
This state of affairs is clearly in conflict with economic freedom, eliminating, at least in a practical sense, the right of individuals (parents) to enter into voluntary contracts to pay for the services they wish to receive (education).
The solution to this problem is to decouple the public financing of education from the public administration of schools. Instead of paying taxes and having no choice in the matter of where to send their children to school, parents should instead receive a voucher from the government.
This voucher would be redeemable for educational services up to a certain amount for each child, provided that they are spent on approved education providers that meet certain minimum standards. Beyond that minimum requirement, parents would be free to spend their vouchers on whatever educational option they deem to be best for their children.
This introduction of school choice would greatly enhance equality of opportunity, particularly for children in underserved communities. Under the existing system of the government’s near-monopoly on K-12 education, children in such communities are trapped in failing schools.
The tax base of their neighborhood is usually too poor to raise adequate funds to finance decent schools. Because of their poverty, these children’s families rarely have the necessary funds to send them to private school or to move out of the neighborhood. Thus, the system locks in an incumbency advantage for underperforming public schools that only families of means can hope to escape. It is inherently prejudicial to economically disadvantaged children—and in America, this often means children of color.
With a voucher system, disadvantaged families would be able to spend their money on schools of their choice, enabling them to escape their failing local schools. Because the vouchers would be standardized, these families would have the same purchasing power for educational services as everyone else—reducing their comparative disadvantage in the market and enabling them to compete on more equal footing with families of greater means.
This would also be likely to break down de facto racial segregation in the school system, as children of color would have greater freedom to leave the neighborhood schools for which they are zoned.
A voucher program would also inject some much-needed competition into the market for education providers. Because government-operated schools enjoy a near-monopoly on the provision of educational services, they have little incentive to become more efficient or to raise their standards.
They receive guaranteed revenue that their “customers” are legally required to pay them in the form of taxes, regardless of performance. Teachers, like the school system itself, have few incentives to perform well because they are not paid more for producing better results. Their wage increases are instead tied to their acquisition of certain teaching degrees and to seniority (where the longest-tenured teachers automatically receive higher salaries).
Vouchers would deprive underperforming schools and teachers of their guaranteed revenue stream. With parents having greater freedom in the choice of where to send their children to school, market forces would introduce more efficiency into the system. Government-run schools that produced poor results would soon find themselves deprived of revenue (like any other seller that produced inferior goods); ineffective teachers would find themselves out of a job.
Over time, resources would flow to those schools that produced better results and away from those that didn't, as they would in any market.
As one proceeds in one’s educational career, however, it becomes more difficult to justify direct public expenditure on educational institutions on the basis of neighborhood effects. When young people reach college age, their continued education might confer some general benefits on society, but by and large, the students themselves are the beneficiaries.
This is because of the high degree of specialization that usually characterizes education at this level. The knowledge and skills gained tend to have much more limited application in the economy. It is difficult to argue, for example, that society benefits directly from one’s decision to study Norse mythology or French literature at a university. Such studies might confer non-economic benefits on those who choose to study them, but it is not a cost that ought to be subsidized through taxation.
Public support for technical schools or vocational schools present a similar problem. Learning a skill for a particular trade might very well increase an individual’s earning power in the job market. But we as taxpayers will never see the return on investment from that individual’s education. The costs, in taxes, are borne entirely by society; the gains, in higher wages, are enjoyed entirely by the individual. This arrangement is a violation of economic freedom because it forces taxpayers into an involuntary exchange for which they may receive no benefit.
We’ve seen in earlier chapters how voluntary exchange provides a decentralizing check against the power-centralizing forces of government. Despite this, capitalism is often seen by its critics as an exploitative system that rewards the already-powerful and subjugates the powerless. But precisely the opposite is the case.
By celebrating and promoting voluntary exchange, capitalism is actually a great promoter of human freedom, especially for traditionally marginalized groups. In this chapter, we’ll explore:
(Shortform note: Friedman’s opposition to equal employment opportunity laws reflects what was once mainstream opinion, particularly among economic conservatives at the time of Capitalism and Freedom’s publication in 1962. Many today will find this view offensive, arguing that the repeal of such laws would cause direct harm to people of color and provide further support for systemic racism. We recognize these concerns and, in this summary, merely present for the reader Friedman’s arguments as they appeared in the original text.)
It is a great irony that traditionally marginalized groups are disproportionately drawn to anti-capitalist politics, viewing free markets as instruments of oppression. Yet it has historically been the very introduction of free markets that has removed the shackles of oppression from such groups.
For example, because of their religion, Jews were usually severely restricted in their economic activities during the Middle Ages. But the rise of capitalism and contract arrangements in economic life created a strong incentive for Christians to work with Jews, because the religious status of one’s business partner became subordinate to the potential for profit.
Free markets enable individuals to advance on the basis of their talent and productivity, not skin color, gender, religion, or other irrelevant characteristics. This is not to say, of course, that people in a free-market society don’t practice discrimination—experience plainly shows that they do.
But their decision to do so is irrational and against their economic interests. If a white restaurateur, acting on her racism, refuses to serve black customers, hire black staff, or purchase supplies from black wholesalers, she is harming her own interests by limiting her range of options and restricting potential revenue from black customers who might otherwise be happy to spend their money in her establishment.
In a capitalist society, the entrepreneur benefits from choice and competition. Our restaurateur is limiting her options and, as a result, will face higher labor and overhead costs—while limiting herself to fewer customers. Capitalism thus explicitly punishes segregation and rewards egalitarianism.
Those on the political left tend to favor equal employment opportunity laws, enacted to solve the problem of discrimination in hiring. But such laws, while undoubtedly well-intentioned, clearly violate the economic freedoms of employers and employees.
The bedrock principle of a free-market economy is that individuals ought to be able to enter into voluntary contracts with one another. But equal opportunity employment laws might mandate that a minority candidate be hired regardless of whether or not the employer believes they are a proper fit for the position.
This in and of itself violates the employer’s freedom of contract rights. It could also have harmful consequences for their business. For example, if a department store in a community where there is strong hostility to black people is compelled by equal opportunity laws to hire a black employee, it might trigger a negative reaction from customers. The store could lose business and suffer damages as a result.
Once the government violates the principle of freedom of contract, any number of abuses becomes possible. If the government can negate freedom of contract by denying the right of employers to discriminate on the basis of race, sex, or any other individual characteristic, it could also theoretically negate freedom of contract by mandating that private employers engage in such discrimination.
To combat discriminatory practices by employers, it is far better to change the attitudes of individuals and convince them that prejudice is wrong and self-destructive than it is to use the coercive power of the state.
But the political left is not solely guilty when it comes to impeding freedom of contract in the name of preventing discrimination. For their part, conservatives tend to favor state “right-to-work” or “open shop” laws. These are laws that prohibit employment contracts from requiring all employees to be members of a labor union. But if workers wish to bargain collectively with their employers and the employers agree to such terms in a contract, that is solely the business of the two parties.
So-called free-market capitalists who support anti-union legislation of this kind are favoring the use of government power to inhibit freedom of contract. There is, however, a danger that labor unions may grow so powerful as to constitute a monopoly within the labor market, thereby infringing the economic freedom of employers.
In such a scenario, the government must have the political will to employ anti-trust legislation against unions, just as it has against businesses. We will explore monopolies and their consequences on economic freedom in greater detail in the next chapter.
Explore how capitalism might support or undercut discrimination.
According to Friedman, why is discrimination irrational in a capitalist system?
How do you explain the persistence of discrimination and bias in a capitalist system that is theoretically based solely on profit maximization?
In the last chapter, we saw the hollowness of charges that capitalism is an instrument of oppression and discrimination. In a similar vein, those who favor a movement away from a system of voluntary exchange toward one of central state control over the economy often cite monopolies as a dangerous—and inevitable—aspect of capitalism.
But this is also incorrect. While monopolies are indeed harmful to individual liberty, free-market capitalism in fact offers the best antidote to the dangerous concentration of economic power they represent.
In this chapter, we’ll explore:
In Chapter 2, we looked at the three types of monopolies: private unregulated, private regulated, and public. But within private monopolies, there are two sub-categories: industrial and labor monopolies.
An industrial monopoly is when a private company fully corners the market share for a particular product or service. This enables the company to set prices more or less at will, as it is in no immediate danger of competition. The industrial monopolist exerts unchecked leverage over customers, employees, and suppliers.
Although such monopolies are certainly harmful to the free market and to basic principles of economic freedom (which, as we saw in Chapter 2, is why supporters of voluntary exchange ought to be in favor of antitrust laws), they are actually quite rare in the United States.
Although some industries are indeed heavily concentrated (like smartphones, where a relative handful of producers control nearly 100 percent market share) and others are diffuse (like the restaurant industry, which features hundreds of thousands of independent competitors), few industries that are not government-controlled can be said to be monopolistic in the modern American economy.
A labor monopoly is when a set of workers in an industry gains full control of its labor market. This is usually achieved through labor unions and “closed-shop” contracts, which stipulate that all employees hired by management must be members of the union (a topic we explored in the last chapter). With a labor monopoly, unions can demand higher wages of employers, the costs of which ultimately get passed along to consumers.
As with industrial monopolies, however, labor monopolies are rare. The vast majority of unions simply lack the kind leverage necessary to exert this level of control. But even without a monopoly, there is a special danger that a heavily unionized workforce in a key industry can collude with the owners of capital in that industry (who would traditionally be the adversaries of labor) to drive up prices for consumers.
This is precisely what happened with the United Mine Workers (UMW) and the coal companies during the 1930s. The UMW scheduled strikes or work stoppages in order to halt the production of coal whenever the supply of coal in the market got too high. This had the effect of driving prices of coal up—with the union and the mine owners sharing in the profits of this collusion.
Although labor monopolies are rare, unions still influence the structure of the economy in important ways. Because of their collective bargaining power, unions drive up the price of labor in the industries where they are most prevalent. But by raising the “price” of labor, unions drive down the demand for labor in those industries—just as price increases in any industry cause buyers to either reduce overall demand or seek substitutes.
By reducing employment in one sector, unions then drive people to seek work in other sectors. This makes the labor markets in those sectors more competitive. Because employers in those industries have more workers competing over the same number of jobs, the result is to reduce wages in those non-unionized industries.
Labor unions tend to be most prevalent and powerful in those industries that feature a highly skilled labor force (which would likely receive higher wages even without the union) and weakest in those industries dominated by a low-skill workforce. Thus, the real effect of unions is to enrich highly skilled, highly paid labor at the direct expense of unskilled workers.
As we’ve seen, the private sector is not really the source of most monopolistic behavior in the United States. Instead, monopolies are most prevalent in those industries that are most heavily controlled by the government.
Public monopolies can occur when the government directly produces goods for sale. Because they are taxpayer-supported and don’t need to earn a profit to stay afloat, these government monopolies can easily undercut private competitors. Examples of this form of government monopoly include the post office and the construction and maintenance of roads and highways.
But in a capitalist economy like the United States, there are few examples of the government directly providing services for sale of which it is the sole provider. Instead, a more common form of public monopoly is when the government uses its regulatory authority to entrench private firms and lock out potential competitors within a particular industry.
In the United States, for example, many utilities like water and electricity are provided by “public utilities,” which are effectively private monopolies backed up by government subsidy and regulation. Historically, other examples of these mixed public-private monopolies have included:
Governments have a number of tools at their disposal to reduce private competition within an industry. Tariffs, for example, tax imported goods and services and make it more difficult for foreign firms to compete. This enables domestic firms to gain a competitive advantage that they might otherwise lack, but leads to less choice for consumers.
Private monopolies or near-monopolies also benefit from poorly designed features of the US tax code. For example, corporate, capital gains, and dividend taxes all disincentivize shareholders from putting corporate profits toward new investments. Because investors face a tax penalty when they sell stock or collect a dividend, it is often a better option to simply plow money back into an existing large company by purchasing more shares. This chokes off investment into other ventures that might be more productive and yield a higher rate of return.
The effect is to protect large incumbent businesses by giving them the lion’s share of available capital, even when they have little productive use for it.
We often hear the view expressed by public officials and activists that large private businesses like those we’ve been discussing in this chapter have a greater responsibility to their communities and societies beyond simply making money. This is the idea of “corporate social responsibility.” But corporate social responsibility is at odds with how private firms, especially those with shareholders, should behave in a free-market economy.
The role of the corporation in a free society is to maximize profits for its shareholders—period. The corporation and its officers (including the CEO) are hired by the shareholders to manage the firm’s day-to-day operations and to prioritize profit maximization with every decision they make.
After all, the shareholders are the owners of the corporation—expenditures are made with their money. Thus, when a CEO or board of directors decides to make a corporate gift to a hospital, school, or other philanthropic endeavor, it is doing so with other people’s money. The shareholders did not choose to have their money spent this way. Presumably, if they wished to make such gifts on their own, they would do so.
But for a corporation in which they have invested as shareholders to do this amounts to unelected corporate leaders imposing an arbitrary tax. This situation is compounded further by wrongheaded public policy, which awards corporations with generous tax deductions for such gifts—effectively subsidizing this unsanctioned use of shareholder wealth.
(Shortform note: Friedman expanded on this idea further in his famous 1970 article for the New York Times Magazine, “The Social Responsibility Of Business Is to Increase Its Profits.” Friedman’s ideas were highly influential in the shareholder value maximization model, which became popular with business leaders beginning in the 1980s. This model of business activity held that the most important measure of a company's success was the financial returns to its shareholders.)
Corporations are also pressured to demonstrate social responsibility by keeping prices of certain staple goods low so as to prevent inflation. But this is also ruinous in the long-run to a free economy.
If corporations cannot get the price they want for a particular good, they will simply produce less of it. The inevitable results of such price ceilings are shortages and the emergence of black markets. With such a state of chaos in the market for core commodities, governments would inevitably face enormous political pressure to step in and manage production and distribution directly. From there, it is a slippery slope to a planned economy and the end of voluntary exchange.
Governments trample on economic liberty in a variety of ways. We’ve already seen how public monetary, fiscal, and educational policies hamper the proper functioning of free markets based on voluntary exchange.
In this chapter, we’ll explore another aspect of state interference with capitalism—professional licensure. Specifically, we’ll look at how licensing regimes use public safety as a justification to protect (and enrich) existing practitioners at the expense of consumers.
A license is a permit from a legal authority to engage in some specific economic activity. Licenses are backed up by force of law—if you don’t have the license, you cannot practice the trade and will be punished if you attempt to do so.
An astonishing range of professions in the United States require practitioners to obtain some sort of license in order to practice legally. Depending on the locality, every occupation from medicine to hairdressing to dog grooming mandates the acquisition of a license.
We encounter licensed professionals so frequently that we seldom question the wisdom or justice of such licensing requirements. We generally assume that they exist to protect the public from incompetent or unqualified practitioners. But while this may be the stated purpose of such licensing regimes, this is rarely their effect.
Professional licensure serves to protect incumbent practitioners in the field by making it difficult and/or expensive for newcomers to enter the profession. One must often receive specialized training, complete apprenticeships, pass examinations, and receive the approval of a licensing board (not coincidentally led by incumbent professionals in the field) in order to obtain the license.
All of these entail significant commitments of time, money, and energy. Facing such hurdles, many would-be professionals give up and choose to enter a different line of work. By keeping the number of professionals in a given field low, licensure enables incumbents to charge higher prices for their services.
This is why licensing systems are so harmful to economic freedom. They deprive people of the right to use their talent and initiative in the field of their choosing, while robbing consumers of the range of choices that would otherwise be available to them.
Even the “public safety” rationale is insulting, as it paternalistically assumes that consumers lack the intelligence to make informed decisions about whom to pay for professional services. Far from being agents of public welfare, licensing boards are really the modern-day equivalent of medieval guilds—powerful trade associations that use their political clout to monopolize the sale of a good in a particular area and restricted entry into the trade.
Many of the criteria used to screen candidates for licensed practice have little relevance to public safety or best practices within the field. At the time of Capitalism and Freedom’s publication in 1962, anti-communist hysteria induced many licensing boards to require candidates to swear that they were not, nor had they ever been, members of the Communist Party of the United States.
These boards required even veterinarians and barbers to take such oaths, even though the threat of communist subversion from such quarters was ridiculously low. Whatever one’s opinion of communism (and an evangelist for capitalism like Milton Friedman certainly had a low opinion of it), it had nothing to do with one’s ability to practice medicine on animals or cut hair.
Similarly, during the Great Depression, professional associations of doctors (chiefly the American Medical Association) pressured state governments to make it more difficult for foreign doctors to practice medicine in America. This was simple protectionism—domestic doctors feared that competition from medical professionals fleeing fascism in Germany, Italy, and Spain would give consumers too much choice.
But there was little basis for this other than naked self-interest. The human body is the same in every country. Although training may differ slightly from country to country, a doctor’s nationality in and of itself should not be a barrier to practicing medicine wherever she chooses to.
Although such licensing requirements for medicine are clearly arbitrary, it is true that medical practice presents a more compelling case for stringent professional licensure than other professions. After all, we surely wish to be protected from incompetent and unqualified doctors. But while there is a stronger rationale for medical licensing than there is for something like cosmetology, medical licensure still imposes a cost.
The largest and most powerful association of medical professionals in the United States is the American Medical Association (AMA). For decades, the AMA has exerted a dominant and near-monopolistic control over the practice of medicine in America, specifically through its control of the supply of incoming doctors. The AMA works closely with state legislatures to create high barriers to entry for medical students looking to break into the profession.
One way they do this is through controlling medical schools. All US states require that doctors obtain a license to practice in the state. A universal requirement of such licenses is that the doctor must have graduated from a credentialed medical school. But the only credentialed medical schools in every state are those approved by the AMA.
The typical rationale for such restrictions is that they ensure that physicians are of the highest quality. But it is not clear that medical licensing succeeds even on these grounds.
If you are unable to access a doctor or afford to see one because of the limited supply, you might have your medical needs go untreated. Licensing regimes might guarantee high quality of care for those who can access it; but by severely reducing the quantity of care available to the general population, they harm overall health outcomes. Quantity cannot be separated from quality.
Furthermore, many components of what is legally defined as medical practice are actually capable of being performed by technicians and other non-doctors. Thus doctors end up spending an inordinate amount of time engaging in aspects of medicine that could be more efficiently and cheaply handled by others—further reducing the quality of care for everyone.
It would be better to loosen restrictions on who can become a doctor and let more physicians enter the field. This would increase the supply of doctors and lower costs and barriers to access for patients. There is a variety of quality in every market—we pay more for high-quality organic foods than we do for canned or freeze-dried foods. There’s no reason that the market for medical services should function any differently. After all, we don’t demand that every car be a Rolls-Royce, because then only the wealthy elite would be able to afford automobiles.
One of the cornerstones of a society based upon voluntary exchange is the right to keep what you earn. After all, what you earn in the market is a product of the productive capacity of your own labor and capital.
Yet critics of capitalism assert that one’s right to private property is itself an injustice. They claim that capitalism as a system inherently leads to unequal—and, according to their worldview, unjust—outcomes.
In this chapter, we’ll explore why income and wealth inequality are not injustices, but rather, the natural outcomes of a system based upon economic freedom. We’ll see how inequality is not merely a regrettable by-product of capitalism but vital to the maintenance of a voluntary exchange system. Lastly, we’ll explore how redistributive government policies like progressive income taxes fail to achieve their stated goals of reducing income inequality.
The fairest and most efficient way to allocate resources in a system of voluntary exchange is through payment according to product. Essentially, you get what you put in. Your compensation is a direct result of the value you create in the economy through your labor (the work you perform for which you are paid in wages and tips) and your capital (the productive assets you own, like land or machinery).
Outcomes are unequal because human beings all have different endowments of energy, talent, and capital. Some jobs are more unpleasant, entail more risk, or require longer hours than others—because fewer people will wish to do such jobs, they tend to be more highly compensated. Those who avoid such jobs tend to receive alternative compensation in the form of greater job security or more leisure time. Presumably, these individuals place greater value on such non-monetary rewards.
A system that mandated equal compensation would therefore produce unequal outcomes, because individuals doing unpleasant work would receive the same money as those doing more leisurely work. But because one group values money more than the other, the total compensation would be more unequal than it was before.
In a capitalist society like the United States, where there is great mobility of people and capital and a tremendous variance in the level of individual talent, it is extremely difficult to determine what the source of someone’s wealth is at any given time.
Far too many factors come into play to determine one’s net worth, many of them completely beyond an individual’s control. It is simply impossible to determine how much anyone’s wealth is “earned” or “unearned,” however we choose to define the terms. But even if a system could somehow be devised that only redistributed “unearned” wealth (like from an inheritance) and left “earned” wealth alone, it would still be harmful to economic freedom.
This is because there is no moral difference between earned wealth and inherited wealth. Even if you inherit a vast fortune from your family, it is still ultimately a product of human endeavor—at some point, someone did create that wealth. Moreover, economic freedom demands that individuals have the ability to do as they please with their property, so long as it does not impose a cost on someone else. Thus, choosing to pass property along to one’s heirs is a perfectly legitimate act within a capitalist system.
If we accept that payment according to product is a just and rational way to allocate resources within a system of voluntary exchange, then any forced redistribution schemes are inherently unjust.
There is no moral justification for a majority to compel a minority to hand over its property—whether it’s a gang of armed robbers telling you to hand over the cash in your wallet or a majority of voters passing legislation to legally confiscate wealth from the so-called “1 percent.”
Moreover, inequality of outcomes also creates the basis for voluntary exchange itself. If we all received identical compensation or had all of our needs taken care of by the government, we would have no reason to buy, sell, or trade with others through markets. After all, in any voluntary transaction, the buyer lacks what the seller has and seeks to obtain it through exchange.
Lastly, inequality enables entrepreneurs to use their extra resources to invest in new ventures that can yield higher rates of return—which creates new opportunities and benefits society as a whole.
Contrary to the views of anti-capitalists, advanced capitalist countries have less inequality than underdeveloped countries or those with legal caste systems.
Moreover, ownership of property represents a far smaller share of national income in capitalist countries than it does in underdeveloped or non-capitalist societies. In advanced capitalist societies, wages earned through labor represent a far greater share of national income. That’s no coincidence. Labor is far more productive in such societies, and thus, provides workers with greater opportunities and earning power.
The record of capitalism has shown it to be highly successful at raising the standard of living for the vast majority of people living under it. Through efficient mass production, modern capitalism gives the majority of people access to those goods and services that were historically only available to the very wealthy.
Capitalism, unlike a socialist or caste system, also creates the possibility of upward mobility. Your position in the wealth hierarchy can change, and is not established by law or custom.
To combat the alleged dangers of income inequality, most industrialized countries have established systems of progressive taxation. Under such a system, the marginal rate of taxation increases the more one earns. Thus, your income from $0-$49,000 might be taxed at 12 percent, your income from $50,000-$99,999 might be taxed at 25 percent, and so on.
Yet they seldom succeed in reducing inequality or even raising more revenue than would be earned through a non-progressive tax system. One problem with progressive taxation is that it increases pre-tax income inequality. If high earners know that their top marginal tax rate is going to be high, lucrative jobs become less attractive than they would otherwise be. The only way to compensate for this is to make these kinds of jobs even more well-paid—thereby increasing inequality.
Progressive tax codes are also nearly always more complex than alternatives. They contain all sorts of loopholes and deductions that tax certain kinds of income (like capital gains) at different rates than other kinds of income (like standard wages and tips).
This adds an element of arbitrariness into the tax code and is often the product of special-interest lobbying. It also creates a strong incentive for wealthy people to devote inordinate resources to devising complex tax-avoidance schemes to help them lower their overall tax liability. This tax avoidance spending is extraordinarily wasteful.
This is why progressive taxation often fails even on purely redistributive grounds—the loopholes and carve-outs give those who can afford to pay tax professionals (who are likely to be wealthy themselves) an opportunity to avoid paying their share owed by law.
A flat tax is more efficient and equitable than a progressive tax. Under a flat tax, everyone would pay the same rate, regardless of income level or income type. A flat tax plan would also broaden the definition of “income,” taxing more types of income than the present system does, while closing loopholes and special-interest exemptions.
Because the tax base would be broader, a flat tax would also enable the overall tax rate to be much lower. By closing loopholes and strictly limiting deductions, a flat tax would likely yield more revenue than a progressive system, while smoothing out inequalities in the tax code. Because the rates would be uniform and all types of income would be equally subject to taxation, there would be far less incentive for individuals and businesses to waste resources on tax avoidance schemes.
Progressive taxation is not the only policy by which the government attempts to redistribute income and alleviate poverty. Through a range of programs, including the provision of public housing, the establishment of federal and state minimum wages, and social insurance (most notably Social Security in the United States), public authorities have attempted—nearly always with the best of intentions—to raise the standard of living of the worst-off members of society.
But these anti-poverty programs:
Moreover, they usually fail to achieve the goals for which they were created. Instead of alleviating poverty, they exacerbate it and give rise to new social problems—which, in a vicious circle, create a rationale for even more ineffective government action.
Public housing programs are designed to alleviate the shortage of housing and ensure that everyone has a roof over their head. In the United States, federal housing programs destroyed existing housing units in urban areas to make room for new, government-subsidized housing projects.
This was counter-productive. The poor design of this program resulted in a net decrease in the supply of available housing units, because local special interest groups demanded that slums be cleared and that new government housing be set up in its place. Unfortunately, this sort of special-interest lobbying is central to how federal programs of this type work, as they inevitably come to serve the few at everyone else’s expense.
With the public-housing program, this created a situation where more people had to crowd into fewer and fewer housing units, decreasing the standard of living for the occupants of these projects and taking a severe toll on the emotional development of children living there.
By concentrating housing projects in certain geographic areas of cities, federal housing policy created pockets of poverty. This, in turn, destroyed the tax base of these communities, leading to lower-quality schools and fewer economic opportunities to escape neighborhood poverty.
If the government wishes to alleviate housing insecurity, it would be better (and more in accordance with economic freedom) to give families direct cash grants to buy or rent homes in the neighborhoods of their choice.
Minimum wage laws backfire in a similar way. The case for a minimum wage is that it provides a basic livable income for people who would otherwise not be able to survive on smaller wages.
But just because a state passes a minimum wage law, it does not mean that employers will hire people at that rate. If labor becomes too expensive, employers will simply demand less of it. By reducing employment opportunities at the lower end of the wage scale, minimum wage laws harm the very people they are designed to help. Surely a job that pays less than some arbitrarily defined minimum wage is better than no job at all.
Perhaps the most famous redistributive program in the United States is Social Security. Social Security is a government pension system that pays benefits primarily to elderly and disabled citizens. It is financed by payroll taxes collected on people during the course of their working lives. As a compulsory program, no one has the option of not paying into Social Security.
Essentially, the government mandates that everyone purchase a retirement plan and forcibly takes money from people to compel them to purchase the government plan—not a private alternative. This is the most coercive way that such a system could be designed. Taxpayers are forced to hand over their money to purchase a product that they might very well have elected not to purchase if they had been given free use of their own money.
Even if they were still compelled to purchase a retirement annuity of some sort, many people might have elected a private alternative. But because they are taxed to pay for Social Security, they are deprived of such a choice (and would essentially be paying double if they still chose to purchase a private plan with their after-tax money).
Moreover, the way Social Security is financed represents an unjust redistribution of income from the young to the old. A person retiring today is far more likely to receive more in benefits than they contributed in taxes than a young person just beginning to pay into the system.
This is doubly unfair, as older people are more likely to have accumulated wealth through a lifetime of savings and capital accumulation, whereas young people are less likely to have wealth of their own. Social Security taxes the comparatively poor young to benefit the comparatively well-off old.
In the end, Social Security is premised on a paternalistic assumption that government bureaucrats can plan your future better than you can and that you shouldn’t be trusted to handle your own money.
But one should not take these criticisms of anti-poverty programs to mean that being pro-capitalist necessarily makes one indifferent to poverty. Indeed, alleviating poverty benefits everyone throughout society.
The problem arises when anti-poverty measures are coercive, are targeted only to certain groups of people, or distort the proper functioning of the market. To get around these traditional defects of such programs, governments should adopt a negative income tax.
A negative income tax provides a direct cash subsidy to people earning below a certain income threshold. To illustrate how this would work, we’d need to know:
Let’s assume that the income threshold is $50,000—that is, those earning below this amount pay no taxes. Let’s further assume that the income tax rate is 20 percent (we’ll assume a flat rate for simplicity’s sake, though the negative tax rate could be graduated). Lastly, let’s assume that the subsidy rate is also 20 percent.
A negative income tax would redistribute income, but on a far more equitable and transparent basis than traditional tax-and-transfer programs. It would effectively guarantee a certain basic income for everyone. It would also be more efficient than the current patchwork of welfare programs, most of which are targeted to specific groups (like veterans, widows, the elderly, and so on). The narrow and targeted nature of such benefits programs requires an expensive bureaucracy to maintain and administer them.
The negative income tax would deliver cash benefits directly to people without forcing them to jump through endless government red tape and would give them the freedom to spend their money as they saw fit.
A true capitalist system must always put equality of opportunity before equality of outcomes. Proponents of redistribution and government intervention in the economy do not have the evidence of history on their side.
During the early days of socialism in the 19th and early 20th centuries, it may well have been possible to imagine a collectivist utopia as a superior form of social organization to industrial capitalism—simply because such collectivist societies existed only on paper.
But this can no longer be the case. The experience of poverty, inefficiency, and, inevitably, severe political repression in socialist and communist countries cannot be ignored. This is as true of North Korea and Cuba today as it was of the Soviet Union at the time Milton Friedman was writing.
Capitalism has proven itself to be history’s most effective system for alleviating poverty and raising the standard of living for the vast majority of the human population. Lovers of economic and political freedom must resist every attempt—even by the most well-intentioned idealists—to impose central control over systems of voluntary exchange.
Increased government control over our lives would ultimately lead to the creation of a less free and less prosperous society. We must always remember that concentrated power is dangerous, regardless of the intentions of those wielding it.
Explore the main takeaways from Capitalism and Freedom.
How did the book challenge your existing ideas about the balance between free markets and government? Did it change any of your ideas? Explain why or why not.
Which of Friedman’s claims do you most strongly disagree with? Explain your answer in a few sentences.
Do you think that what you earn in a capitalist system is solely the product of your own productive capacity? What factors beyond your control might affect this?