The Fourth of July is all about political and economic freedom and inalienable individual human rights, and in honor of those themes we'd like to discuss the important distinction between "free markets" and "free enterprise."
Although it may not be a distinction drawn by economists, we like to make a distinction between the terms "free markets" and "free enterprise."
By enterprise, we mean the practice of providing value to others by offering goods and services that they need or want.
Enterprises (or businesses) offer their goods and services in the marketplace, and thus the expression "free markets" is often used as a synonym for free enterprise.
But there is a subset of the word "markets" which refer to the institutions by which capital is matched up with business enterprises -- the exchanges where shares of those businesses are bought and sold, the banks through which those businesses raise capital through loans and other offerings, and all the other mechanisms which surround the process of pairing investment capital with corporate activity. In America, this entire landscape of capital-matching mechanisms is often referred to as "Wall Street."
While we are strong supporters of free markets in the sense that the phrase is used to describe the freedom of businesses to offer their goods and services in the marketplace, we acknowledge that the second sense -- dealing with capital markets -- requires a series of rules and regulations in order to ensure smooth and orderly operation and the ability of all parties to evaluate and compare different capital investment opportunities, much the same way a game of basketball requires rules to enable the game to take place.
These rules involve accounting standards by which companies are evaluated by others, and standards governing all the ways in which transactions are ordered and executed. Government has a proper role in ensuring these boundaries are in place and that they make sense, just as government has a role in ensuring the roads are properly marked with stop signs, center lines, and appropriate speed limits.
We would argue that much of the problem of the past ten years, including the market crashes of 2000-2002 and 2007-2009 as well as the housing bubble and the misallocation of capital that we have highlighted in previous discussions, was a market problem. In large degree, the most recent market panic was related to problems with the accounting regulations (such as FAS 157, which we discussed at length in various posts) and with changes to longstanding short-selling rules. It was also a government problem, with interference in bank lending through the CRA and other legislation, as well as manipulation of interest rates in order to stimulate borrowing and lending.
The reason this distinction is important is that proponents of "free enterprise" and "free markets" (in the sense that the term "free markets" is used as a synonym for "free enterprise") can be caricatured as being against any government role in providing reasonable rules for "markets" in the second sense (the "Wall Street" sense).
While the events of 2008 have caused many to correctly conclude that the rules governing markets were broken (although few of them realize that important rules such as mark-to-market and the uptick rule were altered in 2007, right before the biggest problems began), this should not cause them to lose faith in free enterprise.
By free enterprise, we mean the ability of anyone to start a business without the permission of the government and to compete against other businesses without interference from the government, as long as they do so without practicing actual violence or fraudulent deception. Of course, free enterprise also requires the Rule of Law and the enforcement of contracts, which is a legitimate and necessary role of the government. However, in many other countries an individual cannot start a new business without permission from the government, and the ability to compete against existing businesses is prohibited by a system of cronyism and legal prohibitions on competition.
We don't believe that faith in free enterprise is going away in this country, and that is very important. We would encourage our readers to be advocates for free enterprise within their own circles of influence, and not to let problems with markets derail their own faith in this important component of human freedom.
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For later posts on this same topic, see also:
- "What Rube Goldberg could teach us about economics" 12/08/2009.
- "Free markets, free enterprise, Friedrich Hayek . . ." 07/13/2010.
- "The political winds are swirling" 09/15/2010.
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