Why the Market Economy, Political Freedom and Democracy Belong Together—Even if Not without Tension

A liberal economic order is based on free markets, entrepreneurial initiative, and personal responsibility, all resting on the foundation of private property. The prerequisites for this, in turn, are legal certainty and, above all, economic freedom. As far as the purely economic aspects of a market economy are concerned, legal certainty can also be achieved by non-governmental means through contractual regulations—as it was, for instance, in late medieval and early modern commercial capitalism. Thus, legal instruments of risk distribution and networks of banks were formed, which even back in the Middle Ages made it possible to have an international credit and payment system with its own sanction mechanisms, but which also involved great risks, especially when banks financed the wars of rulers and became dependent on their success or failure.

Economic Freedom as the Royal Road to Mass Prosperity

When there was not yet a state (in the modern sense of the word) that was able to impose these instruments from above with the coercive power of society, the most economically successful regions were precisely those in which the state did not—like Spain under Philip II—strangle every economic initiative and innovation from above by dirigisme. Those—like England and Holland—in which society, i.e. motivated entrepreneurs, took the organization of the economy into their own hands. England and Holland were able to become great trading powers precisely because the state gave them the freedom to develop structures for trade and commerce that were tailored to the needs of the market and not to those of politics.

However, the economically successful commercial capitalism of the early modern period was by no means completely “state-free.” The most successful actors, especially in the Habsburg Empire, were those who succeeded in acquiring state control—for example, for the mining of copper, silver, or salt—on an exclusive basis, thereby becoming monopolists. Such state-created monopolies were sharply criticized as unfair by moral theologians of the time, who were intensively engaged in economic issues and thus became pioneers in the formation of an understanding of a market-based capitalist society.

What is certain, however, is that the immense success of industrial capitalism in the 19th century was due to a great entrepreneurial freedom that led to innovation and capital accumulation, and thus laid the foundations for modern mass prosperity. Even though the influence of politics led to powerful processes of concentration and cartel formation—directly intended by politicians— towards the end of the 19th century in both Europe and the U.S., free and innovative entrepreneurship remained the real engine for development.  This was made possible by state-secured property rights.

China’s State Capitalism: An Alternative Model for Success?

The example of Chinese state capitalism is often cited in juxtaposition to what is stated above. This seems to be the view that a free economy—i.e. a market economy—and capitalist entrepreneurship being mutually dependent on each other is a culpable lie. The large state-owned enterprises (SOEs) seem to be the dominant ones and offer an alternative model: State capitalism along with a controlled society.

However, as Arthur R. Kroeber writes in his book, China’s Economy. What Everyone Needs to Know (2016), the SOE sector is not responsible for the economic upswing, and especially not the major advancements in productivity of recent decades. Kroeber shows that because private Chinese companies are much more exposed to competitive pressure than state-owned companies, they have been far more profitable. It is actually the very sectors of the Chinese economy that are not organized in a state-capitalist manner which are the main beneficiaries of the Chinese economic miracle. Based on this it is clear: China’s state capitalism is not an alternative model, but rather proof of the superiority of market-based capitalism, which is based on economic freedom and legal certainty.

China also compels us to ask ourselves to what extent a free economy also requires political freedom. A political system that wants above all to retain control over society, and therefore also over the economy, seems not only to run counter to healthy economic development, but also to undermine its psychological preconditions in the long term. As Daron Acemoglu and James Robinson argue in their book, Why Nations Fail: The Origins of Power, Prosperity and Poverty (2012), China’s political system is a prime example of an “extractive” system which, insofar as it is state-centered, privileges a state-based (or party-based) elite due to its lack of liberal institutions, does not have an integrative effect. Therefore it has to fail politically and economically in the long term.

Economic Freedom and Political Freedom Belong Together

Political and social freedom, and the market economy based on economic freedom, thus seem to be inseparably connected. Are there theoretical reasons for this? One reason, and perhaps the most important, is that the free market economy cannot be controlled or even organized in a top-down process, i.e. from the top down. Such constructivism—as criticized, for instance, by Friedrich Hayek—contradicts the logic of entrepreneurial action on which the success of any market economy, and thus any free economy, is based.

Secondly, value creation and lasting innovation require the accumulation of large amounts of capital, which are subject to private powers of disposition and decision-making. Such accumulated capital naturally forms a counterbalance to the power of the state, and thus is also outside of its control. It should not be taken as a counterbalance in the sense of being a political influence, but rather as a limitation of politics, that is, as a limitation of the state’s power of control over society and the freedom of its citizens, as well as a limit to the possibilities of policy-making in general.

The connection between economic freedom and the limitation of state power is called limited government in the Anglo-Saxon world. We also speak of constitutionalism and “rule of law” (and less precisely of Rechtsstaatlichkeit in German). This refers to a plan according to which the power of government, in order to be legitimate, is limited by law and justice; indeed every state power is controlled and restricted by corresponding legal and institutional counterbalances.

It seems clear that a free economy cannot exist without limited government. But this raises the question: Is democracy necessary for this?

Do We Need Democracy for Economic and Political Freedom?

Historically, the limited form of government that characterizes classical political liberalism has nothing to do with democracy. And in some cases, free market economies have been able to develop in authoritarian states or dictatorships; however, if they were successful and lasting, these states developed into democracies (such as Chile). The liberals of the 19th century did not advocate democracy: in fact, advocates of democracy were called “radicals” at the time. Democracy, in the liberal view, classically formulated by Alexis de Tocqueville, was often seen as opposed to freedom. For democracy is no stranger to the danger of the tyranny of the majority.

The question is whether democratic decision-making knows limits or whether limits can be set in the interest of freedom. Another question is to what extent political freedom can be maintained at all in the long term without democracy—without becoming the dictatorship of a wealthy and educated elite. Is democracy perhaps even a means to limit the power of the state and thus to secure freedom?

What we understand by “democracy” today does not simply mean “rule of the people” or “rule of the majority.” Today’s Western democracies are complex entities and the result of an equally complex historical evolution. Today’s democracies are representative, parliamentary systems of government of a constitutional nature, integrated into a constitutional state, and even more: they are based on the protection of enforceable individual liberty rights and the protection of minorities. Universal suffrage has only been added at the end of the historical process. Our democracies are therefore first and foremost constitutional states, i.e. legally limited forms of government—as “limited government” is traditionally understood—in which the democratic principle is only partially effective, and are under the control of the rule of law and the division of powers. They are mixed systems—not dissimilar to what was called regimen conmixtum in the Aristotelian tradition and in the Middle Ages.

Democracy Ensures the Rule of Law, But Can Also Become a Threat to Freedom and Prosperity

If we call such a form of government “democracy,” then it seems clear that it is conducive to, indeed necessary for, a free economy, since this form of democracy guarantees those conditions that make economic freedom possible. For under such conditions, it is precisely the democratic principle that in turn ensures the maintenance of the rule of law. It protects the freedom of the majority against powerful elites and prevents the law from becoming the plaything of any social group.

On the other hand, it is undeniable that the democratic majority principle exists in particular tension with the protection of minorities, and in general with the freedom of the individual, smaller social groups and subsystems, and can even threaten them. In particular, due to the often dominant influence of organized special interests, majority or referendum decisions tend to hinder or even considerably restrict the entrepreneurial freedom that is indispensable for the creation of economic value and thus the generation of wealth. This is because such decisions tend toward interventionist policies that are ultimately harmful to everyone. As Brian Kaplan discusses in his book The Myth of the Rational Voter: Why Democracies Choose Bad Politics (2007) American voters generally decide against their interests in economic matters because they do not understand the economic context and are misled or seduced by economically unrealistic promises made by politicians.

Conclusion: Democracy, the Rule of Law, and a Free Society Are Mutually Dependent

There seems to be no clear answer to the question whether democracy is necessary for economic and political freedom. The best thing for a liberal economic order and thus for the generation of widespread prosperity and the preservation of civil liberty is a system that minimizes the disadvantages of the democratic principle, namely through decentralization, federalism, constitutional control, and above all, through clear, constitutional limitation of state powers. Moreover, it is best that such a system strengthens the legitimacy of democratic institutions and processes by clearly linking them to the rule of law and legal certainty, especially in the area of property protection and civil liberties.

A state that is lean but strong in enforcing the law, and that is limited to the strictly necessary tasks of the state, is the basic prerequisite for an innovative free economy to develop its full value-adding potential in the service of the common good. But we are far from this, indeed it seems almost utopian in view of the current zeitgeist. But we can also hope that a new day will dawn, when the spirit of economic freedom, without which there can ultimately be no political freedom, will reawaken.


This text is the slightly expanded version of a statement at the symposium “What Future Does the Liberal Social Order Have? And What Follows Geopolitically from It” by the Flossbach of Storch Research Institute (Cologne) on November 22, 2018, at the Villa Rothschild, Königstein im Taunus.

Translated from German by Thomas and Kira Howes

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