It is clear today that the recent crisis has exposed the deep fissures in our capitalist system. The two of us firmly believe that capitalism is the best mechanism for generating wealth and -- in a broad sense -- making people better off. But the last few years have demonstrated why preservation of markets can never be an end in itself. We must seriously rethink the relationship between markets and government.
The framework we propose is simple, but (in our humble opinions) its simplicity belies its important implications in the “markets vs. government” debate. A regulator asks: Will the situation, if left unregulated, pose a threat to the social, political, and/or economic system (defined as civil society generally)? If yes, the action should be regulated. If no, the market should be permitted to work on its own. Note what this does: First, it creates an important role for markets to function. Second, it recognizes that free markets are too costly for society if the very existence of markets threatens civil society or if individuals and firms are incapable of participating in that system.
We explicate this framework in the paper and derive various policy proposals, all of which I will get to later. But in our paper, we more or less take it as given that regulation is defensible in the context we describe (to create and/or preserve a well-functioning social, political, and economic system). Why is this the case? That's the question I'll address in a couple of posts here. (Before going any further, I should note that James Partridge provided excellent research assistance on this point.)
Our position draws on Kantian theory. The Critique of Pure Reason set forth Kant's basic transcendental argument. Relevant for our purposes, Kant argued that experience is dependent upon the existence of “concepts” and “percepts”, the cognitive processing of those sensory inputs together with the mind’s concepts, and the presentation of this concept-laced sensory data to a unified consciousness. He coined the term “synthesis” to refer to these functions. Among the mind’s innate concepts, argued Kant, was the intuition of space and time, which, he argued, is introduced into our experience during cognitive synthesis, and does not obtain in any mind-independent reality. These concepts, and others, and their synthesis in the mind with perceptual data from the external world, are what, Kant believed, form the “necessary conditions for the possibility of experience”.
Kant thus introduced the notion of "conditions of possibility". Consider the example of a book that falls and causes a loud "thud". A condition of possibility is not merely a cause (book causes thud), but rather those facts that, "like it or not", are logically necessary for the result to obtain: existence of air in the room to transmit sound waves constituting the thud, the absence of intense noise that would otherwise drown out the thud, etc. Note the distinction: although air is a necessary condition for the possibility of a loud thud, it does not cause the sound. The two are analytically distinct.
Wilfried Ver Eecke has probably done the most work to connect Kantian theory to economics. Ver Eecke notes that, in economic theory, goods are typically justifiable if they fulfill consumer preferences, and unjustifiable if they do not. This leads to the voluntary exchange theory of economics, under which free transactions between willing buyers and willing sellers are presumptively legitimate and welfare-enhancing, and under which government intervention (which must on some level involve coercion) is presumptively illegitimate. The exception is the so-called public good -- when we all chip in to install a streetlight on a dark alley -- but in this case, too, the consumer preference is being honored.
Ver Eecke's crucial insight was in demonstrating that there is another category of "goods" that are -- or rather, that must be -- legitimate: those that are logically necessary for some other, desired good. A buyer might want widgets from the seller. But (just a falling book requires air and gravity), there are conditions of possibility at play here as well. The environment in which the buyer and seller are operating must have some defense of property rights. And there must be some notion of contract law to formalize the agreement. These must exist whether the buyer wants them or not. The fact that buyer bought widgets implies private property, just as the notion of a cube implies three dimensions.
Let us consider a more complex example. If I want to borrow money to buy a house, I will take out a mortgage. But to have a properly functioning mortgage market, there are several logically necessary components: a willing lender with capital, some way to connect borrower and lender, contracts that counterparties are reasonably sure will be enforced over long periods of time, courts to enforce those contracts, and so on. We can no more have a functioning mortgage market without these necessities than we can have a two-dimensional cube.
Because we know that a market economy involves the private ownership of capital, we know, analytically, that a possible world with a free market necessarily will also exhibit private ownership of capital; such a scenario by definition requires it. That is, we can deduce a priori, from our concepts of market and private property alone, that a market economy is logically impossible without some degree of private ownership of capital.
But the private ownership of capital can be threatened by theft, fraud, and breach of contract. This is the insight of the social contract theorists, who suggest that private ownership of capital is impossible in the state of nature. If this is true, then a capitalist economy requires, as a condition of possibility, the existence of the state, for a centralized coercive body, offering the stabilizing influence of legislation, enforcement, and adjudication, is the most efficient means by which private ownership of capital can be imposed upon a population.
But what other conditions must obtain if a free market economy is to be possible? There must also be private investment in capital, which requires some modicum of stability and certainty in the outcomes, or else entrepreneurs will be disinclined to invest. Stability in the social and political context means, at bare minimum, the absence of mass civil unrest, and, even better, a freedom from the arbitrary and unpredictable threat of violence and usurpation at the hands of a corrupt dictator or junta. Stability in a society also arguably requires at least a base level of human health and wellbeing, and environmental conservation, to ensure that human and natural ecosystems are not significantly disrupted, undermining investor certainty with the wild volatility of disease, poverty, and environmental degradation. Adam Smith has written about the necessity of national defense and a strong infrastructure.
Though there may conceivably be other kinds of possible worlds in which the basic requirements for a private market—including stability and private ownership—are observed to obtain, it just so happens that the duty of imposing these necessary conditions frequently falls upon the state, and these conditions are often maintained with the use of force. Thus, we arrive at the following biconditional:
For all possible worlds, there is a free market economy if [(there exists a state that enables the basic conditions adequate for free enterprise) OR (the base requirements for free enterprise obtain by some other means)].But if we are granting the State a monopoly on the powers of coercion, we must also ensure that citizens are sufficiently capable of an environment conducive to private enterprise, or they must at least be monitored so as to be prevented from diverting the instruments of state power toward the pursuit of personal objectives, at the expense of ensuring the basic requirements for commerce and production. Therefore, we arrive at the realization that a civically engaged citizenry -- we argue, in the context of a constitutional democracy -- is capable of restraining and modifying State authority to conform to the principles and purposes of its existence, is a necessary condition for the existence of a functional free market economy.
(An opponent of this argument might reply that the state, accompanied by a vibrant, democratically active and free civil society, is merely one out of many conceivable scenarios in which a free market would be permitted to occur. Thus, such a state of affairs is not a necessary condition for the incidence of capitalism. If this is true, then it falls upon the opponent to describe those alternatives he or she thinks could suffice for producing a genuine private market economy, that is, a system with private profit and ownership of capital, voluntary exchange, etc.)
The skeptical reader might think that we have simply constructed an elaborate mechanism to justify the existence of an intrusive state. It is true that our theory is more intrusive than, for example, a Nozickian ultra-minimalist state. But note what our theory does: it imposes limits on government action. Suppose, for example, that the government wanted to confiscate houses of everyone who angered the president. It is clear that such a course of action cannot, in any reasonable way, be defined as a condition necessary for the functioning of a market democratic system. Such an intervention is thus presumptively illegitimate. To take a more realistic example, our theory also rejects confiscatory taxes on bankers, as such taxes are borne out of animus or some other passion. (We treat differently compensation regulations that are keyed toward addressing systemic risk.)
If our derivation is correct, then we have created an expansive role for government to be active -- but a role that has sharply defined limits. The government would create (and preserve) social, political, and economic systems that permitted market transactions to take place. We can collectively call these systems "civil society", broadly defined. After such a civil society was in place, government would have no role, unless there was a risk to that system.
And so we arrive at the policy guidance set forth at the outset:
A regulator asks: Will the situation, if left unregulated, pose a threat to civil society? If yes, the action should be regulated. If no, the market should be permitted to work on its own.
We have this framework in mind in our article -- which I will write about soon.
(1) I may edit this over time to sharpen the argument and streamline it a bit
(2) A couple of Ver Eecke's key articles are below:
Ver Eecke, W. (1998). The Concept of a 'Merit Good': The Ethical Dimension in Economic Theory and the History of Economic Thought or the Transformation of Economics into Socio-Economics. Journal of Socio-Economics, 27(1), 133-53.
Ver Eecke, W. (2003). Adam Smith and Musgrave's Concept of Merit Good. Journal of Socio-Economics, 31, 701-720.