Review: Free Market Economics, by Steven Kates - The Objective Standard

Free Market Economics: An Introduction for the General Reader, by Steven Kates. Northampton, MA: Edward Elgar Publishing, 2011. 352 pp. $50 (paperback).

kates-economicsNot since 1924 has there been a comprehensive yet readable book on economics aimed at the ordinary but intelligent citizen that defends and incorporates the field’s foundational principle, Say’s Law (named after Jean-Baptiste Say, 1767–1832) and its main corollaries: the primacy of production, the entrepreneur as prime mover, and prices as the commercial language that coordinates economies and their subsectors. Now we have such a book: Free Market Economics: An Introduction for the General Reader by Australian business economist Steven Kates. His prior books examined the prevalence of Say’s Law among top economists during the pro-capitalist 19th century and its abandonment by most economists in the anti-capitalist 20th century.

The handful of texts on economic principles since the 1920s that recognize the superiority of a free economy have been too technical, narrowly devoted to refuting economic fallacies, or tainted by dubious philosophy. This book avoids such flaws. Kates accomplishes what was last achieved by Oxford professor Henry Clay (1883–1945) in Economics: An Introduction for the General Reader (1924). Better still, Kates’s book offers a modern, more sophisticated, more pro-capitalist treatment than did Clay’s book, and it provides the ideas people need to grasp and refute the disastrous dogmas and policies of Keynesianism.

At the core of this book is Say’s Law, the principle that supply constitutes demand, that one cannot demand (or purchase) anything in any market without first producing an economic value for offer (or, in a monetary economy, without first earning spendable income by producing value). This principle recognizes that markets are made by the producers and that the most economically important producer of all is the entrepreneur, who specializes in soliciting and coordinating the other main factors of production: land (including raw materials), labor, capital, and financing. Say’s Law condenses the truth that material prosperity is attained not by consuming (using up) wealth, but by saving, investing, and producing wealth. Unlike most textbooks today, Kates’s says economics should explain wealth creation, or “net added value,” not how we ration “scarce resources.”

Keynesianism, Kates explains, explicitly rejects Say’s Law and asserts that a free market is prone to “failures” and crises, to excessive production, deficient consumption, and depressions; it further insists that government deficit spending, money printing, and near-zero interest rates can fix said market failures. Keynesian policies assume, contra Say’s Law, that there can be an aggregate, economy-wide excess of abundance, or deficiency of aggregate demand. Say’s Law holds that aggregate supply and aggregate demand are the same thing viewed from different perspectives and thus cannot be unequal; recessions entail reduced production and typically (but not always) are caused by government policies that are antithetical to production and profits.

In contrast to Keynesianism, Say’s Law, properly understood, tells economists (and citizens) to reject the contradictory claim that a contracting economy reflects an overexpanding economy, that somehow poverty is caused by prosperity, and it recommends the rejection or removal of any policies that impede or depress the incentive or capacity of entrepreneurs to create wealth or employ other factors of production. According to Kates, Say’s Law “is the essence of market-based economics”; and “without the clarity that [it] brings, economic theory has lost its moorings and the irreplaceable value of leaving things to the market in directing economic activity cannot be understood” (p. 6). Yet, the classical, Say-based theory of the business cycle and public policy “has the ability to penetrate the darkness left by Keynesian theory in understanding the causes of recessions and the steps that are needed to bring recovery about” (p. 7).

Kates believes a contemporary, Say-inspired text of economic principles is sorely needed today, especially given the recent return to profligate deficit-spending and near-zero interest rates after the financial crisis of 2008 and related “Great Recession” (2007–2009). Kates suggests that Keynesianism—which had failed miserably as public policy in the 1960s and 1970s (with “stagflation”) and appeared to have been eclipsed by the adoption of supply-side policies in the 1980s and 1990s—has been able to mount a comeback because it remained embedded in most economics textbooks and college courses:

[T]o believe there is any other set of arrangements outside the market that will lead to personal prosperity across a society is to be left in complete ignorance about how living standards and the good life can be created. . . . By the time students have emerged from an introductory course they know next to nothing about the market process itself but have been presented with massive evidence [sic] that an economy left on its own (which no economy ever is) will create major problems at every turn. They will not come away with an understanding that the market economy is one of the most beneficial social inventions ever developed by human societies. They will have no concept that an economy in which entrepreneurial decision making is the basis for economic activity cannot be improved upon by any other set of social arrangements. They will not be instructed that heavy-handed government responses aimed at reversing the down-phase of the [business] cycle is possibly unnecessary, and there will certainly be little inkling that such policies may be positively harmful. . . . And over and above all, it will not be pointed out, let alone stressed, that the market economy is the only set of economic arrangements consistent with personal freedom and individual liberty. The political benefits of a market economy may themselves be the greatest benefits that such arrangements bestow. (p. 287)

The rest of the book rectifies many of the flaws in contemporary introductory economics. Moving beyond polemics, Kates patiently builds a rational, integrated structure of market analysis, moving from simpler to more complex economic concepts, propositions, principles, and laws—not only Say’s Law, but also the law of supply and demand, the law of comparative advantage, and many others.

In the opening chapter, Kates discusses the basic “axioms and underlying principles of a free market economy,” such as: The future cannot be known with certainty, so mistakes will be made, but not systematically. Change is ubiquitous, but best managed by self-interested businesses and households, through “commercially useful knowledge” and market prices. A free enterprise economy is not “run” by any person or body but is directed by the aggregate of profit-seeking, value-adding entrepreneurs. Government’s only valid economic role is to establish and preserve institutions to protect property rights and facilitate private production and exchange. And all production, investment, and pricing decisions should be left to individuals and businesses. For Kates, these and related principles “are the bedrock foundations for understanding why a free market economy” is the only type that can “deal with the world as it actually is” (p. 8), not as it is ideally imagined by market critics (policy makers included) who reject market principles.

Most refreshing is Kates’s contention that economics as a discipline is not value-free, as Austrian economists insist, but value-laden; and that neither economic activity nor economic analysis is possible in a lawless, anarchist setting or in a regulated, statist setting, both of which impede and stifle wealth creation. According to Kates, the idea that economics is value-laden—because, for example, “economists think about the good life and how to get it” (p. 4), and things tend to work out best economically when “everyone does what is best for themselves” (p. 13)—does not make the discipline subjective or unscientific. Values and disvalues alike have causal consequences.

Beyond the crucial chapter on Say’s Law, Kates devotes chapters to the following: the principle of “value added”; the factors of production (including the productive role of finance); the hierarchical structure of production; the law of supply and demand (price theory); marginal analysis as crucial to profit maximizing; the value of savings; measurement of the economy (GDP); “the Keynesian macroeconomic model”; aggregate supply and demand; the classical theory of the business cycle; the many problems (e.g., inflation) caused by central banks; and how Keynesian public policies that presume a chronic deficiency of aggregate demand tend to exacerbate cycles and crises instead of minimizing them.

Kates shows that “value added”—the process by which the factors of production create economic value above and beyond those values that must be used up (consumed) in the process of production—is the essence of wealth creation. In effect, profit (a form of adding value) entails production, whereas loss entails destruction. (The principle of value added is either neglected or misrepresented in many textbooks.) “Economic activity, in all its different forms,” he writes “should be recognized as attempts to create value by using up existing goods and services at one end of the production process to produce other goods and services at the other end of the production process”; and a viable economy requires that “all of that previously existing value must be replaced with products at least as valuable as those that were used up.” And prosperity requires more: A “stationary state” is not viable; only “if there is more value created at the end of the process than existed when it began” can we have “an economy that is growing” (p. 49).

A valuable feature of the book is Kates’s expansion of the standard list of factors of production from three to five. Historically, the factors presented in economic texts have been only “land, labor, and capital.” The typical approach is to show that without each of these inputs combined with a division and specialization of labor, there could be no advanced economic activity or rising prosperity. Other than Jean-Baptiste Say and Joseph Schumpeter (1883–1950), most authors of economics texts omit the crucial role of entrepreneurship. Kates includes it as “the most important one of all,” for absent the “free, private, individual decision maker” a modern market economy cannot possibly work. The entrepreneur, Kates explains, “rents, purchases, and hires” the other factors and decides precisely how to divide laborers into their productive specialties, while also integrating their activities according to a unified and profitable business plan.

The fifth and final factor of production is finance, the supply of investment funds drawn from savings. Financial resources help firms to launch new ventures before sufficient sales are booked, to pay for various factors of production, and to expand existing operations. Kates is to be credited with this crucial supplement, for banks and capital markets are rarely presented in economics texts as adding genuine value. Marxists and Keynesians, cashing in on centuries-long prejudice against moneylending and interest income (“usury”), have long derided financiers as parasites, gamblers, or wreckers deserving of regulation and taxation (or bailouts). Lacking in Kates’s account of finance is a sufficiently rich explanation and analysis of the markets and prices of stocks and bonds, which, of late, have become more volatile and thus of greater interest.

In excellent discussions of the structure of production, the law of supply and demand, and profit maximization, Kates not only explicates the rational and efficient workings of free markets, but he is admirably candid in conceding that things do not always work out for the best in free markets. Mistakes, he notes, are made sometimes (usually in firms or sectors) but not systematically, and markets are self-correcting, as capital tends to flow to where money is to be made. Further, he notes, self-interest leads people to avoid losses (risk aversion); and when people do lose money, they thereby gain a better understanding of what is commercially right and wrong. Besides, observes Kates, market mistakes, although unavoidable (because we are not omniscient), cannot be prevented or fixed by government intervention; more often, such intervention worsens relatively minor mistakes made by businesses and then spreads or deepens them into systematic, economy-wide problems. For example, if, in a free market, a homebuilding firm erects too many houses, suffers excess inventories, and loses money, the harm is delimited to the firm, its investors, and a relatively small radius of people and businesses these problems might affect. But, if government boosts home ownership artificially for those who can’t afford a home, it can result in widespread mortgage defaults, house-price declines, and bank failures.

Kates ingeniously conveys the seeming irony that the more advanced an economy, the more precarious it is, not because of some inherent instability or “internal contradiction” (as Marxists claim), but because any sophisticated, fine-tuned, and delicate system is more prone than is a less complex system to being disrupted by primitive management and destructive policies adopted in ignorance of the system’s prerequisites. This is equivalent to acknowledging that more can go wrong at a nuclear power plant than a town incinerator, not because nuclear power cannot be both safe and productive (indeed, it can be more so than most alternatives), but because more sophisticated designs are more vulnerable to ignorance and negligence—especially when bureaucrats are involved. This is the case with an advanced market economy, with its innumerable subsectors and sophisticated inter-market relations; its instantaneous, market-clearing price changes; its hierarchical and temporal chain of output from early-stage extractive industries to manufacturing, wholesaling, retailing, and finance—in short, its complex “structure of production.” If an advanced market system is to function optimally, to advance still further, and to avoid systemic crack-ups, it must work amid the rule of law and by the intelligence of businessmen.

What of recessions and their prevention or cure? Keynesians blame the “Great Recession” of 2007–2009 (indeed, all recessions) on excessive prior production and an unsustainable distribution of income (due partly to tax cuts), such that the rich got richer, saved relatively more than lower-income people would have, and thus deprived the economy of the purchasing power needed to buy up excessive output. The supposed cure for recession entails massive government “stimulus” schemes (to foster make-work), deficit spending (to supplement deficient private spending) and consequent accumulation of national debt, near-zero interest rates (to deter saving), and central-bank money printing (to further boost aggregate demand relative to aggregate supply). Kates and his Say-based economic analysis justifiably rejects the Keynesian interpretation and its alleged policy remedy, and shows why these can only make matters much worse.

In the first place, Kates argues, “it is governments that are now, and may always have been, the single most important cause of recession,” for “it is their actions, rather than the market itself, that are far more likely to cause instability, recession and unemployment.” He continues: “[B]ehind the ebb and flow of the market are the actions taken by governments and government agencies,” consisting of the power to tax, spend, regulate, and manipulate interest rates. “Each of these [four actions] can and do have major effects on economic outcomes,” and “no business can be expected to forecast with perfect accuracy the effect of some government action on its own business” (pp. 282–83).

Of the four main policy actions, notes Kates, the most consequential regarding the instability of an economy is a central-bank manipulation of money, credit, and interest rates. Instead of smoothing the business cycle, as interventionists claim, such manipulations accentuate it. A business cycle may occur even in a fully free, highly complex economy, Kates acknowledges (as have many classical economists), but not nearly as severe as the cycles observed during the past century of government intervention.

Interest rates, Kates correctly explains, are not “the price of money” but rather the price of credit (p. 299), and credit (or finance) is a crucial factor of production, not to be tampered with. Yet, interest rates are “directly and often deliberately manipulated” by a central bank and, regardless of the motive (including Keynesian), the action “causes a divergence between market interest rates and the natural rate of interest,” the latter of which he defines as the real rate of interest that prevails under a gold standard (which precludes fiat paper money and chronic inflation) and equilibrates real savings and real investment. Central-bank manipulations of interest rates, he explains, disrupt business plans and distort the structure of production, which increases the frequency and materiality of business mistakes, losses, and insolvencies. The result of all this is recession, which cannot be cured by resorting to further artificial schemes. (Unfortunately, Kates neglects to explain the superiority of a gold-based free banking system.)

Although this book is highly recommended, it has a few flaws. Kates is not always clear on whether to classify government activity, particularly public spending, as productive (value adding), or merely less productive than private sector activity, or as wholly unproductive (wasteful or even destructive). This leads to some confusion about whether and to what extent government spending should be included in measures of annual production, as is purportedly done with GDP. Readers would have benefited from a clearer presentation of the proper purpose and functions of government, with legitimate functions (police, courts, national security) being noted as productive or conducive to productivity, and illegitimate ones being noted as nonproductive or destructive. Although Kates on rare occasion asserts that government may provide welfare, a social safety net, and some regulations, to his credit he at least consistently classifies such policies as nonproductive. He is also to be credited with acknowledging that most economic activity in an advanced economy consists of the production and exchange of wealth among businesses, whereas far less involves the more visible final sales made by businesses to households. But he fails to use this insight to criticize the deliberate subtraction of such activity from official measures of annual output (GDP), which makes it appear as though an economy is driven primarily by the expenditures of consumers and governments.

Its few flaws aside, Kates’s book will be enormously valuable to anyone seeking a succinct presentation of valid economic principles, a better grasp of recent market swings, and a clearer window on our material future.

Written for the intelligent layman, Kates’s book is readable, understandable, and thus retainable, not only because it conveys an array of solid truths, but because it is relatively free of the technical jargon, intrusive footnotes, and pretentious nomenclature that can grow like weeds in economic texts and impede learning. He makes judicious use of some graphs and charts, but only to better illustrate and concretize the more abstract principles. In reading Kates, we begin to learn that if today’s economic world seems increasingly chaotic, incomprehensible, and unpredictable, it is due not to any inherent deficiency in the workings of truly free markets, or in the science of economics per se, but to the tragic prevalence of Keynesianism, of its ubiquitous falsehoods and its persistent use as a guide to public policy making. If Kates’s book can gain a wide audience, perhaps even in introductory college courses in economics, in time it can help restore economic stability, predictability, and prosperity, as such ideas did in the pro-capitalist 19th century.

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