Freedom and Failure; D. R. Lee

Even those who consider themselves supporters of the market economy call for government action to buffer society against the harsh fail ures of unfettered capitalism. It is certainly the case that when viewed in isolation the consequences of economic failure appear cruel, harsh, and unfair. Because of events over which they have little or no control, many hard-working, law-abiding citizens expe rience serious economic hardships in a system of free market capitalism. Noone can argue with credibility that all, or even a significant minority, of these victims of economic failure are getting what they deserve in any particular instance of adversity. But economic outcomes that in isolation seem unjustified may be the necessary consequence of a system that is gen erating an overall, long-run pattern of outcomes that is entirely justified. As Henry Hazlitt has warned repeatedly, the major source of error in economic understanding comes from the ten dency "to concentrate on ... short-run effects Dr. Lee is a professor of economics at the University of Georgia, where he holds the Ramsey Chair of Private En terprise.

on special groups and to ignore ... the long run effects on the community as a whole.,,1 Hazlitt's warning cannot be overemphasized when considering economic failure and the fair ness of free market capitalism. Each market failure is an inseparable part of a wider web of interactions and outcomes that provides every one the maximum opportunity for success in the world of scarcity. Scarcity is an unfortunate fact of life, and it is easy to see scarcity itself as unfair. But unless one is prepared to argue that making the best of an unfortunate situation is also unfair, there can be nothing unfair about free market capitalism. And because instances of failure are necessary companions to the gen eral success of the free market process, it would require a sharp twist of logic to characterize as unfair the failures that arise from free market activity. Economic failure is inevitable if we are to have economic progress. One explanation for this link between failure and progress was pro vided by Joseph Schumpeter when he described capitalism as a "process of creative destruc tion. ,,2 The discovery of improved products, and better ways of producing existing products, necessarily means that many established prod ucts and technologies are valued less. Those who have committed their resources to these now obsolete products and technologies will suffer a decline in wealth as their investments turn sour and their skills become less employ able. They will experience economic failure.

But this destruction of wealth, or economic fail ure, is only part of a larger picture of wealth creation and economic success. The loss of wealth experienced by some is (1) a transfer of resources to those who will put them to more valuable use, and (2) a compelling incentive to redirect efforts into more productive employ ment. The process of "creative destruction" is our best hope for economic success. Entrepreneurial Freedom and Failure There is another vital link between economic failure and progress. Economic progress that expands opportunities for all is clearly a force for fairness. Such broad-based economic prog ress depends on what is best described as the entrepreneurial spirit. Without those with vi sions of what might be, and the dedication and courage to pursue those visions, few of the technologies and products that provide the foundation for our current wealth would be available. It is only because individual entrepre neurs have had the freedom to attempt what the more "sensible" among us would never have attempted that economic development has been possible.

3 This does not mean that most entrepreneurial ventures contribute to our economic well-being. Quite the opposite is true. A relatively small percentage of the projects promoted by entre preneurs add more to our wealth than they con sume in time, talent, and resources. Most entre preneurial ventures turn out to be exactly what most of us would have predicted in advance impractical fantasies. But, it is impossible to know in advance which entrepreneurial gam bles will be an economic step forward. There is only one way to discover these economic suc cesses, and that is by giving entrepreneurs the freedom to snub their noses at the conventional wisdom and venture forth in pursuit of their "impossible" dreams. This freedom to attempt success in the face of daunting odds requires an accompanying free dom to fail. And the freedom to fail has to be sufficiently painful that it cannot be ignored.

The entrepreneur whose project is rejected by the consumer will remain convinced that it is the consumer who is mistaken. Unless such en trepreneurial confidence is sternly subordinated to consumer preferences, the losses from the 393 many entrepreneurial mistakes would persist and overwhelm the gains from the relatively few entrepreneurial successes. Without the dis cipline of failure forcing accountability to con sumer preferences, entrepreneurial ventures would be economically destructive and entre preneurial freedom could not be tolerated. The economic system that cannot condone failure cannot risk freedom. Communication, Honesty, and Concern There is only one economic system that turns failure into a force for the type of accountability that makes freedom possible. That system is free market capitalism. It is a system that allows freedom because it is a system that motivates people, both when they succeed and when they fail, to deal with each other with honesty and fairness.

Consider the characteristics of a system of human interaction that would be ideal from the perspective of economic accountability and fairness. First, this system would have each of us in constant communication with everyone else. If there is to be any hope of being account able to the preferences of others in our use of resources, each of us will need to receive infor mation from others on their preferences. Sec ond, the communication that took place would be honest. Transmitting inaccurate information on the value derived from resources would make it impossible to direct resources into their highest valued uses. Third, each individual would give the preferences of others the same weight he gives his own. No matter how much an individual may desire one economic out come, if others communicate to him that they value another outcome even more he would ac commodate their preferences.

It is possible to achieve a real world approxi mation to this ideal system-free market capi talism. The key to understanding this approxi mation is in recognizing the incentives established by the private property system which forms the foundation of the market. In the private property system, resources are transferred from one individual to another through voluntary exchanges. The market prices that arise from these exchanges are the 394 THE FREEMAN • OCTOBER 1986 means by which all market participants commu nicate their preferences to each other. There ex ist strong incentives for people to communicate honestly through prices. It is in the interest of all market participants to assess carefully the value realized from different resources, and to communicate their desire for more of a particu lar resource only if it is honestly worth more to them than the prevailing market price. The temptation sellers would otherwise have to overstate the values of their products with ex cessive prices is controlled by market competi tion.

Finally, each market participant is motivated to act as ifhe has the same concern for the pref erences of others as he has for his own. When an individual reduces his use of a product in response to a higher price, h~ is in effect say ing, "Others are telling me that this product is worth more to them than it is to me, so I will consume less so that they can consume more." Similarly, economic failures such as bankrupt cies and unemployment can be thought of as people saying, "Others are telling me that my resources would be more valuable in other ac tivities, so I will respond to their preferences." These "failures" reflect the success of free market capitalism in getting people to cooperate with each other freely, fairly, and honestly. Focusing on Failure Unfortunately, few people heed Henry Hazlitt's warning and look beyond the isolated trees of economic failure to see the overall for est of economic success. This oversight is ex plained in part by the fact that it is easier to concentrate on particular outcomes than to comprehend the larger pattern of which these outcomes are only a part. But this is far from a complete explanation. The fact is that there is more for people to gain as members of orga nized interest groups by concentrating on the isolated failures than by considering the overall success of free market capitalism.

When individuals suffer losses from the oper ation of free market capitalism, they are in fact making a necessary contribution to the working of an economic system that serves the long-run interest of all. From the perspective of each in dividual, however, the best possible situation would be to receive protection against personal economic failure while benefiting from the con tributions the failures of others make to eco nomic progress. The fundamental fairness of the free market is that it does not provide any one a free ride on the contributions of others. In the free market everyone has to contribute to the general economic prosperity by accepting the failures as well as the successes that come his way. It is the legitimate function of government to enforce the private property rights upon which the fair and honest cooperation of the free mar ket depends. When property rights are enforced no one can avoid making the cooperative ad justments required by economic failure while benefiting from the cooperative adjustments economic failures force on others.

Unfortunately, government power, though justified as a means of protecting property rights, can be destructive of these rights. This abuse of government power is sure to occur when, as has been the case in recent decades, government ceases to be viewed as a necessary evil and instead is seen as the primary source of social progress. Once it becomes widely be lieved that the discretionary use of government power is an acceptable means of solving partic ular economic problems, economic failure will become a useful justification for the politically organized to receive unfair advantages at the expense of the politically unorganized. The negative consequences of economic fail ure are highly visible because at anyone time they tend to be concentrated on a relatively few. The positive consequences of economic failure are largely invisible because they are indirect and spread over the entire population. When the few who experience economic failure are orga nized they will see it to their advantage to lobby government for relief. By granting this relief, politicians receive the gratitude of the benefit ing few by imposing a diffused cost on the en tire population. This imparts a clear political bias in favor of substituting unfair government force for the fairness of market cooperation.

This bias, however, although generated by the political muscle of organized special interests, ultimately rests on perceptions of fairness. If protecting a particular group against the consequences of economic failure is widely considered to be an unjust use of government power, then politicians· will be very reluctant to provide such protection. Special interest groups lobbying government for· relief from an eco nomic failure cannot rely solely on the organi zational advantage they have over the general public. Success depends crucially on the per ception that justice is served by indemnifying particular groups against failure. There is much to be gained by those that are, or would be, po litically influential from portraying their eco nomic failures as unfair. No one should be sur prised that as government has grown, the focus on economic failures has increased, as has the perception that these failures are unfair. With government standing ready to transfer wealth to those whom the economy has treated "un fairly," the private payoff is increasingly in la menting the "unfairness" of failure rather than celebrating the fairness of the cooperation, wealth, and freedom that this failure makes pos sible.

Conclusion The fact is that government cannot reduce economic failure. It can only protect some against failure by increasing the overall level of failure and imposing it on others. As Hayek warned over 40 years ago: "The more we try to provide full security by interfering with the market system, the greater the insecurity be comes; and, what is worse, the greater becomes the contrast between the security of those to whom it is granted as a privilege and the ever FREEDOM AND FAILURE 395 increasing insecurity of the underprivileged. ,,4 The special favors granted by government are not only unfair, they become the justification for yet more futile government attempts to pro vide security against economic failure. Once government starts down the road of buffering people against the failures of market activity it becomes difficult to turn back. And the ultimate destination if we remain on this road is a politicized economy lacking both fair ness and prosperity because it cannot provide the accountability nor tolerate the freedom which are essential for economic success and honest cooperation. The best hope for preserv ing the market process is by advancing public understanding of how this process works to pro mote a broad-based prosperity. Only through economic understanding can we pierce the rhe torical facade of fairness used by organized spe cial interests to acquire political favors. Once this facade has been stripped away, it will be difficult for political opportunists to undermine the freedom and prosperity of all under the pre tense of concern and justice. 0 1. Henry Hazlitt, Economics in One Lesson, New York, Arlington House Publishers, 1979; p. 17.

2. Joseph A. Schumpeter, Capitalism, Socialism and Democracy, New York, Harper Torch Books, 1962; pp. 81-86. 3. The benefits from freedom are clearly not confined to those who choose to exercise it. As F. A. Hayek has said, "The benefits I derive from freedom are thus largely the result of the uses of free dom by others, and mostly of those uses of freedom that I could never avail myself of. It is therefore not necessarily freedom that I can exercise myself that is most important for me." See F. A. Hayek, The Constitution of Liberty, The University of Chicago Press, 1960; p. 32. 4. F. A. Hayek, The Road to Serfdom, The University of Chicago Press, 1944; p. 130. Subsidizing Inefficiency B ECAUSE FAILURE is repugnant to a welfare-oriented society, we see contin ued efforts made to put a floor under everything. This includes a spreading attempt to bolster up faltering business firms or even whole areas or indus tries by government grants, loans, subsidies, defense contracts, and the like.

Ironically, the greatest danger to our economic system today lies not in a direct attack on profits, but in a well-meaning effort to insure everyone against failure. To put it bluntly, this means SUbsidizinginefficiency; it is the antithesis of the effective operation of the profit motive. We are in danger of losing one of our greatest freedoms: the freedom to fail. Profit and loss are two sides of the same coin; take away one side and you take away the whole coin. Our greatest economic asset is the right to invest private capital in the hope of making a profit, but at the risk of losing our shirt. -GEORGE CLINE SMITH IDEAS ON LIBERTY 396 A REVIEWER'S NOTEBOOK The Start-Up Entrepreneur by John Chamberlain I n his Discovery and the Capitalist Process, which was reviewed in The Freeman last winter, Israel Kirzner speaks of three levels of entrepreneurial endeavor. One is at the level of arbitrage, where paired buying and selling transactions are simultaneous. A second level of entrepreneurship is pure speculation on the future. This depends on alertness but without any simultaneity in the buying and selling of physically identical objects. The third level in Kirzner's triad is that of productive creativity in which the entrepreneur sees possibilities in novel forms of combination.