In his superb essay, “The Law,” Frederic Bastiat called this kind of interaction “legal plunder.” It is legal in that legislation permits or requires it, but it is plunder nonetheless because it involves taking without consent.
Ayn Rand, the great Russian-born American novelist, celebrated in this regard the American idea of “making money.” When one makes profit in a free and open market, in a very real sense one does make money—one creates new wealth for himself and others. But when one profits by the political means, one creates no new wealth, but simply gets wealth that rightly belongs to someone else. In free markets, where property is private and protected, exchange is free, and contracts are enforced, relationships among people are symbiotic: each person benefits the others she deals with. By contrast, where governments require interactions or forbid them, relationships among people can become parasitic, with some benefitting at the expense of others. In such cases it is not clear that profit indicates new wealth created for others.
Figure 2.1 Profit on a Free Market versus Profit by Political Means
Market-based Profit
“Legal Plunder”
Economic Means
Political Means
“Make Money”
Get Money
Create Value
Transfer Value
Symbiotic
Parasitic
Here are some examples we will take up at more length in later chapters:
Subsidies to logging companies in the National Forests: The logging companies do not have to pay for the roads they use for access to the timber in the Tongass National Forest and other national forests; you and I and other taxpayers pay for those roads. Because we cover a substantial portion of the cost of their operations, the profits of logging companies are correspondingly higher. These extra profits (or profits where otherwise there would be losses) do not represent new value created; they are a consequence of our being forced to pay for logging roads. That profit is legal plunder.
Hairdresser licensing: Licensing law prevents you and me from paying someone to cut our hair if that person does not have a license. The arbitrary and costly requirements of licensing (many of which are unrelated to professional competence or customer safety) make it difficult for people to get licenses. Licensing law further prevents us from hiring even a licensed hairdresser to do our hair in any place but a licensed salon or barbershop. The consequence of these restrictions is less competition and, accordingly, higher profits for established hairdressers and salons. But again, these higher profits do not result from new value created for consumers; they result from political restrictions on choice. That profit is legal plunder, plunder taken from both consumers and the capable would-be hairdressers excluded from the business.
Milk marketing orders: Because these state laws hold the price of milk higher than it would otherwise be, some dairy farmers make more profit than they otherwise would. Indeed, that is the goal of the policy. But is this additional profit an indication of additional value created for consumers? No. Here political means are used; dairies are forbidden to compete with one another on price, as they would have to in free competition. The resulting addition to the profits of dairy companies comes not from benefitting consumers, but from the laws requiring dairies to charge more than competition would allow them to charge.
We could fill many books with such examples, but these three illustrate the point: We should endorse and celebrate profits that are earned in free markets, because they come from creating value for other people. We should condemn profits made through the political means, because they come from transferring rather than creating value, and they provide misleading signals about where human effort and other resources should be applied to help humanity flourish. Crony capitalism is a helpful term that has come into use since the many government bailouts of the financial crisis of 2008. We should applaud free-market capitalism but condemn crony capitalism. This book is not pro-business; it’s pro-market.
Guidance for the Future, Not Reward for the Past
Before we close this discussion of profit and loss, I want to acknowledge many good people who are put off by free enterprise because of a concern about the morality of profit making. The concern is that sometimes profits (or losses) earned in a truly free market just aren’t fair; and therefore, actions that lead to profits (or losses) should be restricted.
To return to the previous chapter’s discussion of price gouging, for example, consider the high profits made by merchants who sell bottled water and generators after a hurricane for five or ten times the normal price. Those profits don’t seem fair. The store owners have done nothing brilliant to merit those high profits; they just got lucky. And they got lucky because others got unlucky. Why should the economic system reward them?
Some ask the same thing about the large profits made in recent years by oil companies. If prices go up just because of increasing demand from India and China, and through no foresight or hard work of the oil companies themselves, why should the economic system reward them?
On the loss side, as I write these words following the financial turmoil and Great Recession of 2008, many claim that it is unfair for various firms or industries to be driven to bankruptcy by economic forces beyond their control. Why should the economic system punish them? These firms or industries are said to deserve a bailout at taxpayer expense.
I leave to other writers and other books the (to me compelling) philosophical and ethical reasons for not interfering with free-market profit and loss, and focus on the practical, economic reason. That is, what society requires from profit and loss is not reward for past action, but guidance for future action. Forward-looking profit and loss projections together with backward-looking profit and loss accounting give entrepreneurs indispensable (though not infallible) guidance for what to do today to make the world a better place tomorrow, and we can’t have that guidance for the future without rewarding past results—even results of dumb luck.
Profit and loss do reward or punish past actions, true, but that is not their essential effect in society or the crucial job they do for us. Their essential effect is to guide future action by entrepreneurs. As we have seen, the high prices of bottled water and generators right after a hurricane—and the high profits they promise—tell anyone watching to bring bottled water and generators to the stricken area. The high prices of gasoline as I write these words—and the high profits they bring—tell oil companies to expand exploration and production and tell other entrepreneurs to develop substitute energy sources. The losses suffered by thousands of investors in mortgage-backed securities who credulously relied on the securities’ AAA credit ratings tell everyone watching to weigh risk more carefully before investing, lest they lose their capital. (Of course that lesson is weakened to the extent that investors are bailed out with taxpayers’ money. See Part III.)
The main job of free-market profits and losses is not to do moral justice for past action but to give practical guidance for future action. Their crucial role is future-oriented. Reward or punishment for past actions is the incidental means, not the essential end. Looking backward at profits or losses realized from past projects, entrepreneurs see how well they created value for others. Based on that information, their own judgment, and current and expected prices, they make profit-or-loss estimates for various other projects they might undertake in the future. When they choose the ones they expect to be most profitable, in the expectation that they will enjoy the profit or suffer the loss, society benefits.
Summary and Implications for Policy
We need free markets because advances in human well-being depend on innovation, the discovery of new and better ways of satisfying human wants and needs, and innovation requires free-market profit and loss to guide it. Profit rewards the creation of value and loss punishes the destruction of value insofar as prices are market prices that “tell the truth.”
The implications of this insight for public policy are straightforward: We should free our mar
kets, all of them. Policies that leave entrepreneurs free to innovate and get accurate profit-and-loss feedback from the consuming public will foster rapid discovery of new and better ways to satisfy the public’s wants. Policies that restrict entrepreneurs’ freedom, limit the profits of those who serve the public well, or shield from losses those who serve the public poorly, will slow down rates of increase in overall well-being.
Society has no better gauge of the contribution an enterprise makes to the world than its profit or loss in an unhampered market. The profitability of an enterprise is a kind of summary judgment that comprises the individual judgments of literally everyone concerned. Potential customers contribute by their decisions to buy or not to buy at various prices, thereby registering the current value of that product to actual people. Potential investors in the enterprise contribute by their decisions to invest or not, at different stock prices or lending rates of interest, thereby registering their judgments of the enterprise’s ability to create wealth in the near and distant future. Potential suppliers to the enterprise contribute by their decisions to sell or not to sell the various inputs the enterprise needs at various prices, thereby registering the judgments of other users of those inputs as to the value of those inputs in other uses.
Accordingly, the ever-changing profitability of an enterprise is the continually-updating outcome of a vast social calculation of its usefulness, based on the knowledge, insights, and judgments of thousands or millions of people to whom the product and enterprise matter. The knowledge content, so to speak, of this process is immense.
Government interventions in the economy substitute the judgments of political bodies, based on the limited view of a relatively few people, for the judgments of the whole market. Rarely, if ever, will such a substitution be justified.
As for subsidies or bailouts: no! Policy should not shield an enterprise from the salutary feedback that is loss. Those in charge of the enterprise need that signal to motivate improvement in their products, production processes, or both. If they can’t return to profitability, that means the resources they are using would be better used elsewhere, in the judgment of actual consumers. The enterprise ought to close down and release those resources to uses that serve others better.
At the same time, public policy should not penalize (tax) profits made in free and open competition. With those profits consumers signal producers to do more of what they are doing and provide producers the means with which to do it.
In judging which enterprises should be tried out, which should expand and which should close down, we can’t do better than leave it to entrepreneurial innovation and profit-and-loss selection in a free market.
Though this chapter has emphasized the informational role of profit and loss in telling businesspeople what to do and how, profit and loss play a motivational role also. In a free market, where interactions are voluntary on both sides, people can profit only when they create benefits for others. Hence in free markets everyone has a strong incentive to perform well in the service of others. In government interventions in the economy, by contrast, where legal force is used to compel or forbid some interaction even against another’s will, incentives to serve others are weak or absent. And incentives matter. This brings us to the third main reason why we should free our markets, the subject of our next chapter.
Chapter Three
Free Market Incentives Foster Service to Others
Human beings are a remarkable blend of knowledge and ignorance, foresight and blindness, good and bad. We have seen that market prices help us overcome our individual ignorance by serving as surrogates for the knowledge of countless others, and that profit and loss feedback in a free market help us discover the value-creating uses of our time, ingenuity, and other scarce resources.
Free markets also help us overcome the inclination to be selfishly inconsiderate of the desires of others. Free markets push us to cultivate a respectful attention to those desires. The incentives inherent in the key institutions on which free markets are based—private ownership and freedom of exchange—restrain and even penalize our baser instincts and require people to consider the well-being of others. Because property rights must be respected in free markets, stealing and cheating are out, whether perpetrated by an individual or a mob … or a legislature. Accordingly, if Tom desires some part of Jane’s property, the only way he can acquire it is with Jane’s consent. Such consent usually must be acquired by offering Jane something she desires. And that means Tom must try to satisfy Jane’s wants. In the words of my teacher at George Mason University, Walter Williams, “In a free market, you get more for yourself by serving your fellow man. You don’t have to care about him! Just serve him.”
Freedom of exchange means freedom to exchange with anyone (any adult) a person might choose, independent of permission from any government body or other meddler, and also freedom not to exchange if one does not like the terms or can get better terms elsewhere. That means that, in a free market, businesspeople must constantly strive to serve others better than their competitors (or potential competitors!) can do; no legislature, licensing board, union, or professional association protects them from the rigor of market competition.
We should free our markets because we need the incentives that private ownership and freedom of exchange give us to serve one another. The alternative is to give some people the legal authority to compel others, and people with such power lose the incentive to consider the desires of others. Human beings don’t handle well the power to coerce, not even when the power is meant to be used to benefit society. Thus, the third of three principles of spontaneous economic order that account for why human beings need free markets:
Private ownership and freedom of exchange, the foundational institutions of a free market, lead people to serve others in order to benefit themselves, whereas government interventions tempt people to benefit themselves at others’ expense.
In this chapter we illustrate this principle with two natural resource management examples, then contrast directly the incentives people face in free markets and those they face in government intervention.
Subsidized Waste in a Government-Owned Forest
The Tongass National Forest blankets the Pacific coast of southeast Alaska. The nation’s largest national forest, larger than West Virginia, it is also the largest temperate-zone rain forest in the world; while there are larger tropical rain forests, the Tongass is the largest cool-weather rain forest. It is a magnificent land of densely wooded islands, bays and inlets. It is home to grizzly bears, wolverines, Sitka black-tailed deer, bald eagles, and eight hundred year-old Sitka spruce rising 250 feet to the sky. Some 30 percent of all Pacific salmon spawn in its streams.
There has been a major industrial logging operation in the Tongass for about the last four decades. The US Forest Service builds logging roads into the forest and leases to private companies the right to take timber. The logging companies then sell the timber on the open market.
The logging causes environmental damage. Much of the old-growth timber in the virgin rain forest has been cut down. Thousands of miles of heavy logging roads—heavy because the thin, moist soil cannot support the heavy logging equipment—crisscross the forest. For years the loggers clear cut right down to stream beds, allowing erosion to silt up the streams. According to the Anchorage Daily News, one stream, “locally called Fubar Creek, was so filled with sediment that water hadn’t flowed in it for 13 years.” The siltation makes it harder for salmon to spawn. This is a serious economic problem for the region because its main industry is fishing. Sometimes the logging crews would drive excavators right down the stream beds and drag logs through the channel. This practice also damaged habitat where salmon rest as they make their upstream swim because it eliminated the pools of slow-moving water that naturally occur where fallen trees impede the flow.
As painful as this damage to the Tongass is to most of us, it could conceivably be justified if the value of the timber taken out of the Tongass were
sufficiently high. After all, as I point out to my students when we discuss this topic, you are taking notes on paper made from trees, writing on desktops made of particle-board, sitting in a building framed up with wooden two-by-fours. We value wood products.
In the case of the Tongass, however, the economic value of the timber taken out is less than the value of the resources used up in getting it out. In the words of economist John Baden,
[T]he economic costs of securing the timber far exceeded any commercial value the timber had.… Roads funded at taxpayer expense allowed access to timber that was too sparse, too marginal, or too slow-growing to justify the high price of the roads and other development costs. In essence, taxpayers are subsidizing environmentally destructive behavior that no private timber company or private landowner would ever consider.
Lest the reader misunderstand these facts, let me repeat for emphasis: Much of the logging in the Tongass causes environmental damage at a net loss. The market value of the timber that comes out of the forest is less than the cost of building the logging roads into the forest and otherwise managing the logging. Timber companies’ lease payments to the Forest Service are far smaller than the Forest Service’s expenditures on the logging roads. Consequently, the U.S. Treasury loses most of every dollar it spends on the program. No profit-seeking company would carry on such an operation because it would mean ruinous losses.
The quotation from John Baden above is from 1986, but the logging has continued for decades. As of 2004, the latest year for which the US Forest Service’s website provides information, the logging companies paid an average of $42.54 per thousand board feet of timber they extract. But the Forest Service spends on average “between $300 and $400” per thousand board feet. By those estimates, the program loses between 85 and 89 cents out of every dollar. The website attributes the dramatic difference to the “low value of western hemlock lumber,” the cost—“as high as $500,000/mile pending stream crossing needs and a host of other high cost items”—of logging roads “that will support a loaded truck over muskeg or floating bog soils,” and generally “difficult access since the land consists of forested islands.”
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