Liberals applied their ideas about freedom not only to religion and speech but to economic life. Classical liberalism holds that free markets, secure property and voluntary exchange are part of a free society, and that they also tend to make people better off.

Adam Smith

The Scottish philosopher Adam Smith (1723 to 1790) published The Wealth of Nations in 1776. Its most famous passage explains how markets coordinate strangers: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” In other words, people serving their own interests in a free market end up serving one another's needs, without anyone having to plan it. Smith once described this as being led by an “invisible hand” to promote an end that was no part of one's intention.

Smith also explained the gains from the division of labor. In his example of a pin factory, ten workers each doing one step could make many thousands of pins a day, while each working alone could not have made twenty, perhaps not even one.

Smith was no simple cheerleader for business. He attacked mercantilism, the system of trade restrictions and special privileges that governments gave favored merchants, and he warned that businesspeople tend to conspire against the public: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” His earlier book, The Theory of Moral Sentiments (1759), rooted morality in sympathy for others. And he gave government real duties: defense, the administration of justice, and certain public works and institutions that markets would not provide.

The nineteenth century

In the 1800s, classical liberals campaigned for free trade and limited taxation. In Britain, Richard Cobden and John Bright led the movement that won repeal of the Corn Laws, tariffs on imported grain, in 1846. Free trade, they argued, would lower food prices for the poor and bind nations together in peace.

Hayek and the twentieth century

As governments grew in the twentieth century, a new generation defended the classical view. The Austrian-born economist Friedrich Hayek (1899 to 1992) argued in The Road to Serfdom (1944) that central economic planning tends to lead to the loss of political freedom, because planners must override individuals' choices to carry out the plan, and power concentrated over the economy becomes power over people's whole lives.

In an influential 1945 essay, “The Use of Knowledge in Society,” Hayek argued that the knowledge needed to run an economy is scattered among millions of people: local knowledge of particular times, places and circumstances. No central authority can gather it. Market prices solve this problem by transmitting that dispersed knowledge. When a resource becomes scarce, its price rises, and people everywhere economize on it without needing to know why. Hayek later called the result a spontaneous order: complex coordination that no one designed.

Hayek did not oppose all state action. He accepted that government could provide a basic minimum of food, shelter and clothing for those in need, and could set general rules within which markets work. What he opposed was the attempt to direct the economy toward a single plan.

Criticisms

Critics, including many liberals, argue that unregulated markets produce large inequalities, monopolies, unsafe working conditions and economic crises, and that formal freedom to trade means little to someone with nothing to sell but their labor. Classical liberals reply that these problems are often caused or worsened by government favors and badly designed rules, and that market economies have lifted more people out of poverty than any alternative. This debate leads directly to the next level.

Worked example: the price of a pencil

Think about an ordinary wooden pencil. The wood comes from trees cut by loggers in one country. The graphite is mined in another. The rubber eraser comes from yet another, and the metal band from somewhere else. Paint, glue, machines, trucks and ships are each produced by thousands more people. No single person on earth knows how to make a pencil from scratch, and no one directed all these people to cooperate. Yet pencils appear on store shelves at a low price.

This is the kind of spontaneous order Smith and Hayek described. Each person acts for their own reasons: the logger wants wages, the mine owner wants profit. Prices tell each of them what to produce and how much effort it is worth.

Now suppose a drought cuts the supply of the wood used in pencils. Its price rises. Pencil makers switch to other woods where they can; some customers use fewer pencils or switch to pens. None of them needs to know about the drought. The price change carries the message for them, which is exactly Hayek's point about dispersed knowledge.

A critic would add a few questions. Were the loggers paid enough to live decently? Was the forest cut sustainably, or did the cost fall on people downstream who never agreed to it? Did one company gain a monopoly and raise prices? Classical liberals and their critics disagree about how much the market's coordination can be trusted on its own, and when the state should step in.