What Is Laissez-Faire Economic Theory?

Definition and Examples of Laissez-Faire Economics

Laissez-faire economics is a theory that says the government should not intervene in the economy except to protect individuals' inalienable rights.

In other words, let the market do its own thing. If left alone, the laws of supply and demand will efficiently direct the production of goods and services. Supply includes natural resources, capital, and labor. Demand includes purchases by consumers, businesses, and the government.

Former U.S. President Herbert Hoover was a famous proponent of laissez-faire policies. He believed an economy based on capitalism would self-correct. His commitment to a balanced budget in the face of the 1929 stock market crash turned the recession into the Great Depression.

Even when Congress pressured Hoover to take action, he focused on stabilizing businesses. He believed that their prosperity would trickle down to the average person. He lowered the tax rate to fight the Depression, but only by one point. Despite his desire for a balanced budget, Hoover's laissez-faire approach to the Depression added $6 billion to the debt. 

How Laissez-Faire Economics Work

In a laissez-faire economy, the only role of the government is to prevent any coercion against individuals. Theft, fraud, and monopolies prevent rational market forces from operating.

Laissez-faire policies need three components to work: capitalism, the free market economy, and rational market theory. 

Capitalism

Capitalism is an economic system in which private entities own the factors of production. In the 1987 movie "Wall Street," Michael Douglas as Gordon Gekko summed up the philosophy of laissez-faire capitalism when he famously said, "Greed, for lack of a better word, is good."

Gekko argued that greed is a clean drive that "captures the essence of the evolutionary spirit. Greed, in all of its forms: greed for life, for money, for love, knowledge, has marked the upward surge of mankind." 

Government intervention had made the United States a "malfunctioning corporation" in the mind of Gordon Gekko, but he felt that greed could still save it if the government allowed it to operate freely.

As former U.S. President Ronald Reagan said, "Government is not the solution to our problem. Government is the problem." In laissez-faire, the government allows capitalism to run its own course with as little interference as possible.

Free Market Economy

Capitalism requires a market economy to set prices and distribute goods and services. Businesses sell their wares at the highest price that consumers will pay. At the same time, shoppers look for the lowest prices for the goods and services they want. Workers bid their services at the highest possible wages that their skills will allow, and employers strive to get the best employees for the least compensation.

A market economy requires private ownership of goods and services. The owners are free to produce, buy, and sell in a competitive market. The force of competitive pressure keeps prices low. It also ensures that society provides goods and services efficiently.

As soon as demand increases for a particular item, prices rise thanks to the law of demand. Competitors see they can enhance their profit by producing it, adding to supply. That lowers prices to a level where only the best competitors remain.

The government protects the markets. It makes sure no one is manipulating the markets and that all have equal access to information.

Rational Market Theory

Laissez-faire economics assumes that free-market forces alone correctly price every investment. 

Rational market theory assumes that all investors base their decisions on logic rather than emotion. Consumers research all available information about every stock, bond, or commodity. All buyers and sellers have access to the same knowledge. If someone tried to speculate and drive the price above its value, the smart investors would sell it. Even a well-run mutual fund could not outperform an index fund if the rational market theory is true.

Investors incorporate all knowledge of present and expected future conditions in their trades. The best motive for a company's CEO is to pay with future stock options. In fact, research has found an inverse relationship between a CEO's pay and corporate performance.

Rational market theory ignores human reliance on emotion when buying even a single stock. In contrast to this theory, investors often follow the herd instead of the information. In this case, greed leads them to overlook dangerous warning signs—the 2007 financial crisis was a prime example.

Notable Opinions on Laissez-Faire Economics

Russian-American writer Ayn Rand argued that pure laissez-faire capitalism has never actually existed. She said the government should only intervene to protect individual rights. She agreed with the Founding Fathers that each person has a right to life, liberty, property, and the pursuit of happiness; they do not have an inalienable right to a job, universal health care, or equity in education.

Austrian economist Ludwig von Mises argued that laissez-faire economics leads to the most productive outcome. A government could not make the myriad economic decisions required in a complex society. It should not intervene in the economy, except for the military draft. Von Mises also believed that socialism must fail.

Laissez-Faire Policy in the United States

The United States has never had a free market, as described by Rand and Mises. As a result, attempts at laissez-faire policies have not worked.

However, the U.S. Constitution has provisions that protect the free market:

• Article I, Section 8 protects innovation as a property by establishing a copyright clause.
• Article I, Sections 9 and 10 protect free enterprise and freedom of choice.
• Both prohibit states from taxing each other's goods and services.
• Amendment IV protects private property and protects people from unreasonable searches.
• Amendment V protects the ownership of private property.
• Amendment XIV prohibits the state from taking away property without due process of law.
• Amendments IX and X limit the government's power to interfere with any rights not expressly outlined in the Constitution.

Laws created since the Constitution grant favor to many particular segments and industries. These include subsidies, tax cuts, and government contracts. Laws protecting individual rights have been slow to catch up. Many still contest laws that prohibit discrimination based on gender or race. In some cases, corporations have more rights than individuals.