60 FREE MARKET ECONOMICS
Localized markets such as this
one in Kerala, India, exhibit all the
hallmarks of Smith’s free market and
demonstrate the natural way in which
supply and price adjust to demand.high proportion of unproductive
workers. He claimed that capital is
more productive in agriculture than
in manufacturing, which is higher
than in trade or transport.
Ultimately, the economy will grow
until it reaches a wealthy, stationary
state. In this, Smith underestimated
the role of technology and
innovation—the Schumpeterian
growth described earlier (p.58).
Classical legacy
Smith’s system was comprehensive.
It considered small (microeconomic)
details and the large (macroeconomic)
picture. It looked at situations in
both the short and long run, and its
analysis was both static (the state
of trade) and dynamic (the economy
in motion). It looked in detail at the
class known as workers,
distinguishing entrepreneurs such
as farmers and factory owners from
suppliers of labor. In essence it
established the parameters for
“classical” economics, which
focuses on the factors of production
—capital, labor, and land—and
their returns. Later, free market
theory took a different,
“neoclassical” form with general
equilibrium theory, which sought
to show how a whole economy’s
prices could reach a state of stable
equilibrium. Using mathematics,
economists such as Léon Walras
(p.120) and Vilfredo Pareto (p.133)
reframed Smith’s claim that theThere is no art which
one government sooner
learns of another than
that of draining money
from the pockets
of the people.
Adam Smithinvisible hand would be socially
beneficial. Kenneth Arrow and
Gérard Debreu (pp.208–11) showed
how free markets do this, but they
also showed that the conditions
needed were stringent and did not
bear much relation to reality.
This was not the end of the
story. After World War II the idea
of laissez-faire was in hibernation.
However, from the 1970s, Keynesian
policies, which advocated state
intervention in economies, seemed
to break down, and laissez-faire
enjoyed a strong resurgence. The
seeds of this flowering can be
found in works on the market
economy by Milton Friedman
(p.199) and the Austrian School,
notably Friedrich Hayek (p.177),
who were skeptical about the good
that interfering governments can
do and argued that social progress
would be attained through
unfettered markets. Keynesians,
too, recognized the power of
markets—but for them markets
needed to be nudged to work best.
The free market approach
enjoyed an important boost from
theories in the 1960s and 70s based
on the role of rationality and rational
expectations (pp.244–47). Public
choice theory, for example, depicts
government as a group of self-
seeking individuals who maximize
their own interests and extract
money without regard to the social
good (“rent-seeking”). New classical
macroeconomics uses Smith’s
assumption that markets always
sort themselves out and adds the
point that people can see the future
implications of any government
actions and understand the