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The Limits of Democracy: The Real and the Imagined

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The Limits of Democracy: the Real and the Imagined (p. 77)

Mainstream Austrian theory asserts the existence of no limits to the power of markets and important
limits to the operation of the public sector and the effectiveness of democracy, relying upon public
choice insights for much of the analysis. Even Austrians who generally champion the utility of the
institutions of democratic governance (i.e., who are not anarchists and who are democrats) readily
agree that significant and inevitable causes of government failure provide a valid rationale for
extending the private sector and minimizing government provision and policies suspending or
modifying the operation of the market.

Our thesis in this chapter is that if the nature and functions of modern democratic mixed economies
are properly understood, it must be acknowledged that the government sometimes succeeds in
fulfilling those functions. In this sense, the asserted “limits of government” do not in fact exist. We
shall, for reasons which should be obvious, refer to these limits as (which we are denying) as “inner
limits.” We hasten to add that, as we shall see, this denial of the existence of any “inner” limits to
the state does not, by itself destroy the possibility of economically justified extension of the market
into these areas. But acceptance of our thesis will, nonetheless, alert us to the searching and
challenging questions which must be asked before such privatization can in fact be justified on
purely economic grounds.

As Kirzner writes: “Our thesis in this chapter, building on insights developed in modern Austrian
economics, is that of the nature and functions of the market are properly understood, it must be
acknowledged that the market never fails to to fulfill these functions.” (2000: 77) These 'inner'
limits – market failures – are denied, but 'outer' limits created by the 'institutional pre-requisites'
required to allow markets to emerge are conceded. We can of course say the same about democracy.

This chapter will consider possible institutional and social-cultural prerequisites for the
effectiveness and efficiency of public sector policies and programs. We shall refer to such limits as
the “outer” limits of the state. We wish to emphasize the truth of the Austrian insight that, for its
very existence, the state must rely on the presence of market institutions, without which the idea of
public sector provision must be a mere (dangerous) dream, commonly known as socialism. These
genuine limits to the state, because they do not refer to government failure, cannot provide any
rationale for further extension of markets.

But they certainly do point our thinking concerning the public sector towards the market ethics or
principles which may, practically speaking, be the necessary basis for those institutions upon which
the state itself must rest (requiring, as it must, market prices and functions, for its economic base).
Our quarrel with economists concerning this latter point relates to a certain tendency within modern
economics to understand the establishment of public property—that bedrock institution required for
the very idea of state provision—as somehow historically and conceptually independent of specific
institutional choice. Such simplistic theories of public provision, explaining these programs in terms
of blind, ignorant, fixed forces, as if acting in the prehistory of the modern mixed economy, in effect
deny the existence, or at least the relevance, of “outer” limits to the state.

The Real and the Imagined

Mainstream Austrian theory asserts the existence of important limits to the efficient operation of the
public sector, especially with regard to the allocation of goods and distribution of income. Even
among those economists who generally champion the ethical properties of government, most

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concede that public sector inefficiencies may result from incentive problems including free riders,
moral hazard, bureaucracy, and in general the lack of the discipline and guidance provided by the
profit and loss system. Post-Austrian economists recognize these arguments and do not question
the assertion that a simple policy change through provision by the state, or nationalization or
subsidy of a private firm in a system already ripe with self-interest and rent-seeking will tend to
lead to bad outcomes.

Coordination, Public and Private

(p. 79) In Austrian economics the models and conclusions concerning the function of the market
refer routinely to the achievement of a coordination between individuals' plans, and consequently an
efficient spontaneous ordering of society, which public sector intervention is said to disrupt rather
than improve upon. (It is with reference to this criterion of efficient societal resource coordination
that Austrian theorists find the government wanting). “In particular, this function has been
interpreted as that of promoting mutual discovery by market participants of the availability of and
needs for exchangeable goods and services (Kirzner, 2000: 79)”.

“It should be noticed that while this view of the functions of the market rejects—on methodological
individualist grounds—holistic treatment of society as faced by the Robbinsian challenge of
efficiency in resource allocation, it certainly does recognize a supra-individual function for the
market” (Kirzner, 2000: 79). This reveals a double-standard that Austrians must recognize and
address: the spontaneous order of the market is understood to have a supra-individual function and
character, but Austrians fail to recognize the supra-individual function and character of other
spontaneous orders of society, including culture and democracy.

The functions of these orders must effect both the workings of the market and the character and
effectiveness of public sector and charitable institutions and organizations. These spontaneous
orders should also be studied for their ability, like markets, to promote knowledge discovery.
Perhaps they too have a supra-individual function, one which can supplement society where
markets fall short.

Kirzner continues: “Successful achievement by the market of this 'social' function requires that it
spur those discoveries that will promote those sets of individual decisions which will best enable
individuals severally to fulfill their respective objectives, in light of their own endowments and in
conjunction with the opportunities implicit in the endowments and objectives of others.” (p. 79)
Successful achievement of any other order would similarly require such an ability—that it spur
discovery. The learning – knowledge discovery – possible in other social orders, such as through
use of open sharing of information, conversation and deliberative discussion of a rational and
friendly sort, could fill this requirement. Because markets depend upon initial endowments1 and
magnify their impact, such an alternative order and use of it to supplement the provision and
distribution of markets might be an important part of a good society.

1 As Kirzner concedes in this discussion:

“What is important to emphasize is that this coordination function, promoting the exploitation by individuals of the
potential for mutually gainful exchanges amongst them, can be denied only against the background of given
individual rights to endowments. If individual A possesses money and is hungry, while individual B possesses a
surplus of food but lacks money, then we can appraise social mechanisms in regard to their effectiveness in
promoting the coordinating mutual discovery by A and B of the gains to be achieved by exchange.” (Kirzner, 2000:
79-80)

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It would be “idle to speculate” about coordination without taking the “initial given position” of the
participants into account (Kirzner 2000: 80). Because it is impossible to know all individual
endowments and context existing for all individual exchanges, we cannot predict the outcome or
sum the total welfare before and after these exchanges. However, we can recognize that the initial
position matters. We can see that if individual A possesses no money and is hungry, while individual
B possesses both money and food, then the “coordination” suggested by Kirzner in the example will
be absent. This is why the market must be supplemented by something if we are to achieve an
outcome that does not leave some behind, particularly because the market requires that individuals
(who do not inherit wealth) are able to work and able to find an employer willing and able to pay
them for what work they can do. There will always be some who are unlucky on one of these
counts.

II (p. 80) Human Nature and Social Norms

Government failure theorists focus attention on situations where (as, for example, when individuals
are able to divert resources toward projects from which they may personally benefit) individual self-
interested decision-making produces a globally suboptimal outcome. All public sector programs
will not fall into this category.

(p. 81) What we wish to argue in this section is that these situations (in which self-interested
individual decisions generate what are held to be socially suboptimal outcomes) do not constitute
examples of what could properly be called “democratic failure,” if that is to be understood as
situations producing inevitable negative outcomes. This is due to the important function of culture
and civil society upon the workings of the public sector, and of course the outcome will also rely
upon the institutional structure, including the transparency and responsiveness of the public sector,
how it has evolved, and whether the policies have emerged or merely been designed and imposed.

It is not only rational plans, but also the reliance upon rationality and self-interest that must be
conquered—even in an economy with spontaneous order guiding the economy—in order to
overcome the current dichotomy of economic-social systems. The recognition of a broader nature
for individuals and a new emphasis on social interaction and emergent social systems offers
alternative possibilities for analysis of the economy and new policy solutions. For example,
Andriani (2004) argues that “prosociality” leads to greater transparency of information and
cooperation among the parties to financial contracts. In “segmented regional markets,” Andriani
(2004: pp) points out, are affected by “different socio-cultural framework and dynamisms,” and thus
there is a “crucial connection between the social values of a community and its economic-financial
outcomes.” The outcome occurs in part through the effect upon social norms and resulting
disparities. Austrians would not disagree with this, but Austrian theory does not take into account
the full ramifications of this phenomenon.

The “protestant work ethic” is an example of the effect of social norms upon behavior, but do we
really want to focus our culture upon work in this modern age of abundance? Arguably we have
gone to an extreme in our economic focus, putting production and consumption ahead of family,
community, compassion, leisure, friendship, love, and other values. This reliance upon the values
and norms of personal responsibility and self-sufficiency, has, in turn, magnified our focus upon
material wealth and increased the driving force of self-interest, by regarding these values as all-
important indicators of person's whole worth. Social norms can affect economic outcomes in many
ways, as will be discussed further in later chapters.

(81) In situations characterized by mainstream Austrian theory as cases of government failure (or

3
planning or public sector failure), the pattern of institutional responsiveness and transparency, as
well as culture and corresponding reputation of public sector workers, is such as to create
unsustainably high costs of policy improvement. In light of such costs the resulting public sector
outcomes—no matter how “suboptimal” they may appear to be from the perspective of omniscience
—do tend to promote discovery of relevant information, encouraging the possibility of evolutionary
improvement in the public sector, producing more accumulated information about what does and
does not lead to the ends desired. We must, after all, remember that the concept of “evolutionary
improvement” can only come into practical force under the conditions provided by (a) initial policy
situation and bureau's endowments, and (b) the 'transaction costs' of changing policies created by
(lack of) institutional responsiveness, transparency, and level of public debate.

(82)To say that the collective process can work successfully in the context of common ownership is
is certainly not to pronounce the public sector socially optimal – and, to make things more complex,
we must question the meaning of economic efficiency versus social optimality, and we must
determine how to attain it in a world of dispersed information and scarcity.

Kirzner (p. 82) concedes that “government policy may seek to reflect citizens' preferences as these
are understood in moral or political terms, rather than in the narrow, austerely 'scientific' terms
within which economic science is confined.” This is almost an admission that the citizens'
preferences can be known. At the very least it is the recognition that factors other than cost might be
taken into account, and if governments attempt to take these into account, officials might seek to
know what values the citizens have, rather than basing their choices upon their own self-interest.
The more complete and representative the public debate and discussion, and the more transparent
and responsive the government and its policies and programs, the more likely that the citizens'
values, preferences, and priorities will be known by officials, and will enter into their decisions,
respectively.

(p. 82) Kirzner argues that “The market process has no 'inner limits',” in which it fails to alert and
incentivize market participants to form “firms or organizations of a size best able to participate.”
There are no natural limits of markets to “encourage necessary cooperation.” However, he does
concede that: “It is true that the market will not inspire cooperation where the transactions costs of
doing so are prohibitive” even when “such cooperation may appear highly desirable from a
perspective which sees these transactions costs as in principle avoidable—say, through government
compulsion.”

This is an interesting concession, with two aspects worth noting. First, there is a concession that
“cooperation” that the market has not induced “may appear highly desirable” to citizens who
believe (rightly or wrongly) that the government can reduce the costs; second, with regard to
transactions costs, public provision may indeed help to avoid these costs through use of government
compulsion—consider health insurance or national healthcare, like the NHS in Britain. By forcing
the healthy to purchase insurance, or pay into the program through taxation, the costs due to adverse
selection can be reduced. Of course, it is possible that the costs due to other factors may be
increased by nationalization.

We have argued that individuals are not driven solely by self-interest; similarly, we should
recognize that society may collectively choose to use the government and public sector provision
for reasons other than pure economic efficiency. When choosing whether to protect and support the
last firms of a dying industry (consider subsidies for an inefficient steel plant), there may be reasons
that are not economic, such as a national security reason: in case a war interferes with global trade
and one could be left with the choice of buying from the enemy or going without steel. Finally, we

4
should recognize that rational citizens may support intervention to improve market functioning, and
that a representative government can thus act upon this collective or social choice.

Austrians and public choice economists argue that voters have little power or ability to learn from
their mistakes compared with consumers with “dollar votes” who have price signals and can
purchase each item separately and learn from mistakes, not buying from a bad company twice.
Politicians stand for many policies (in a representative democracy) and voters can only vote once
every few years, getting fooled each time, with limited options, etc. This all may be true, but what
about society as a whole, given a broad and transparent public debate, learning from its mistakes
regarding individual policies? Instead of relying upon the voter to learn and choose better
representatives, we can ask society to discuss policies and learn from the results as a social whole,
with open conversation and treating each policy individually – taking what we learn and enforcing
our decisions upon both elected officials and civil servants.

(83) Institutional Prerequisites, Knowledge Kirzner and Hayek

These “limits” on the government are imposed by its institutional prerequisites. Kirzner asserts,
referencing an earlier work (Kirzner, 1992, chapter 10), that we cannot rely upon market forces to
spontaneously produce the institutions necessary for a market economy, nor can we “rely upon any
spontaneous social forces to foster those institutions” (p. 83). This almost sounds as if he is arguing
that market institutions are, and must necessarily be, a result of rational planning. Ioannides (2000)
argues that Hayek but not Mises was successful in arguing against a mixed economy because Mises
accepted that institutions can be rationally planned. “In the case of Mises, it is again the absence of
an evolutionary approach and especially his insistence on the possibility of a rational understanding
of the function and scope of institutions that undermines his critical stance towards state
intervention” (Ioannides, 2000 : 46-47)

But an evolutionary approach may also suggest the potential for a more effective and efficient
intervention – or correction – of markets, and the possibility of an evolving, more effective, public
sector. One can imagine a decentralized, and therefore more responsive and transparent public
sector, evolving over time with the cultures of each local area (as Andriani described and as Elinor
Ostrom explores in depth), becoming more and more representative of the people and more and
more efficient. Boettke and Coyne (2005: 154) describe how Vincent Ostrom also models such a
possibility, advocating a 'polycentric' decentralized system of governance2:

Given this dichotomy of the types [planned and spontaneous] of order, one can see
that polycentric systems of governance clearly display both types of order. Within

2 Quoting Ostrom, Tiebout, and Warren (1961), Boettke and Coyne (2005: 153) describe the 'polycentric' model:

“'Polycentric connotes many centers of decisionmaking that are formally independent of each other' (Ostrom,
Tiebout, and Warren 1961, pp. 31–32, in McGinnis, 1999a). ... Competition among the different decision centers can
stimulate individuals within the system to tend toward ‘efficiency’ in production and exchange. 'With the
development of quasi-market conditions in production, much of the flexibility and responsiveness of market
organization can be realized in the public service economy' (Ostrom, Tiebout, and Warren, 1961, p. 45, in McGinnis,
1999a).”

Boettke and Coyne remain unconvinced, arguing that “scholars must be cognizant of the possibilities for pathology
that exist even within a polycentric system of public goods delivery,” because “Without full property rights and a
free market pricing system, the problems of economic calculation will present perversities in the production and
exchange of goods and services” (Boettke and Coyne, 2005: 153). However, we are not arguing here for the
elimination of markets and prices. As explored in more depth later, our argument is that supplementing a healthy
private market with a decentralized and transparent spontaneous order within the public sector will improve price
signals, rather than distort them.

5
 the overall system, there are complex rules and institutional mechanisms that
facilitate social interaction and conflict resolution. The stock of local and tacit
knowledge of “how to get things done” within the polycentric system can be seen as
a spontaneous order that is continually changing. What can be called the cultural
aspects of the social order, how to interact with others, solve problems, and so on can
be characterized as a spontaneous order. Individuals purposefully interact with
others, but the set of norms that evolve are an unintended result of those purposeful
interactions. ... The emphasis on these mechanisms for dealing with unintended
consequences pervades the Ostroms’ work on polycentric systems of governance.

Kirzner (p. 83) argues that not only can we not rely upon spontaneous market forces to evolve the
institutions that markets rely upon, “it can be shown that … we cannot rely upon any spontaneous
social forces to foster institutions.” However, Kirzner (1992), which Kirzner cites here, does not
successfully make this case, and social forces can indeed help to foster institutions.

(84) Hayek, Coordination, and the Evolution of Democracy

Not only is there cooperation and coordination within markets, there is cooperation and
coordination in public-private partnerships. Societies, not just markets, are complex systems with
many and varied voices, initiatives, ideas, projects, and people. Rather than choosing between the
stark choices of public or private, state-run or for-profit or charitable, perhaps a more enlightened
approach involves bringing all these together, allowing a spontaneous collaboration brought
together under a loose confederation with some leader or leaders forging a path and then paving the
way, under the guidance of a set of values that all share.

One example of such a project is the American Prarie Reserve, which aims to become “a grassland
reserve of three million acres – a wildlife spectacle that rivals the Serengeti,” according to its
website, and would be the size of Connecticut. Pete Geddes, Managing Director of the American
Prairie Reserve, was interviewed on EconTalk by host Russ Roberts about the project. In the
podcast they discussed the use of incentives to encourage private farmers to make their land more
friendly to wildlife, the use of private land purchase to give them the freedom they require to
reshape the land, private businesses to raise money3, and their collaboration with state and federal
authorities, especially Montana Fish, Wildlife & Parks. They also work with charities and non-
profits, and businesses interesting in contributing profits toward the project.4 Many of these
organizations in turn partner with many other private and public organizations. These partnerships
form a massive global network of like-minded people and groups, or at least groups and people that
have one goal in common—just as we see in supply chains within markets.

It is worth comparing the evolution of democracy in the UK and the US, as well as the cultures and
subcultures within each society, such as those between the wealthy and the 'working class'
subcultures. As one example, consider the following line of dialogue from the film The Big Short.
One of the bankers goes to England when he is ready to sell and make millions – the pubgoers
overhear him making an $80 million sale and ask him: “What are you a drug dealer or a banker?
Because if you're a banker, you can fuck right off!” The film follows several groups of investors
who short the housing market. They are alone among their subculture of wealthy bankers in
recognizing the coming housing crisis, however I would argue that many not from that subculture
could see it coming, but simply had no money or ability to undertake such a short.
3 Especially their Wild Sky beef company, which has the mission “to support wildlife-friendly ranching through the
sale of premium beef.”
4 The actual number of associations listed on their collaborations webpage so far (as of 2015) - and their project is still
in its early stages - is sixteen and is a wonderful cross-section of different kinds of organizations.
http://www.americanprairie.org/aboutapf/collaborations/

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(85) Conclusion

A system must evolve culturally, with technology and institutions changing in time with culture,
otherwise the legal changes will be forced and will tend to fail. This is clear when one looks at the
transitions to socialism and from socialism back to markets. For example, with regard to why China
had more success than Russia in the transition to markets, Gregory (2012) writes: “Gorbachev,
dissatisfied with the status quo, initiated reforms to expand markets and private trade. His reform
failed. Deng Xiaoping was presented with an unsanctioned market by Chinese traders as a fait
accompli. All he had to do was legalize it after its success was obvious.” In China, the people had
already embraced markets, even when they were illegal, the institutional change was not forced
from above. Many people fail to recognize this and assume that policies can be forced through. New
York Times columnist Thomas Friedman (2009) extols: “A one party system can just impose the
politically difficult but critically important policies needed to move a society forward in the 21st
century.” This kind of assertion is usually labelled a 'nirvana fallacy' by Austrians—the assumption
that well-intended policies will be successfully imposed. It is no more true than a perfectly efficient
market or a market that meets the needs and wants of all the people.

We have argued in this chapter against the existence of inherent inefficiency in the public sector
based upon self-interest driven rent-seeking and bureaucracy. This is not to say that such things do
not exist – they certainly do in many countries and many economic systems, including the
nominally “free market” United States – but if one may discuss the benefits of “freed markets” then
similarly it is worth discussing a more ideal democracy as well, and we have argued that the extent
of such inefficiencies relies upon certain factors. These include the culture surrounding the public
sector – what it is expected to provide and what is expected of its workers and contractors – as well
as the laws and institutions producing it, and especially upon its transparency, the public
conversation helping it to evolve and improve, and its ability to function as a cumulative
spontaneous order.

The Post-Austrian argument is that radical policy change based on a design created by a team of
experts is likely to fail; any public sector based system is likely to fail if created rather than evolved.
Yet, if the Austrian concerns are not only kept in mind but are included in the formation of
institutional design, and these insights combined with insights from the likes of Elinor Ostrom,
Geoffrey Hodgson, behavioral economics, and complex adaptive systems and management theories;
if the design is allowed to emerge from public conversation and evolve over time within a
transparent and responsive system and these theorists suggest, then a more efficient and effective
public sector might emerge.

Networking, emergence, and complex systems theory all have the goal of understanding not just the
individual but the group, and for the study of economics, the way that society and culture are as
important as individual rationality. These might emerge naturally from Austrian economics,
especially following certain Hayekian paths. However, it is difficult to do justice to these ideas
while omitting from models any possibility of the analysis of groups like classes, and other aspects
of society and culture that are not only very evident in the real-world but are also very important to
many of us (perhaps even to the Austrian scholars themselves), and which might radically change
the models' conclusions. These omissions perhaps were the cause of the Austrian support for the
dictator Pinochet (by Hayek, see Farrant, McPhail and Berger, 2012; Nell, 2014) and to radical

7
statements such as that government cannot possibly raise social welfare and the homeless must
prefer to live without homes (by Rothbard, 1956, and his followers, see Nell, 2013).

It is possible to have a market-based society divorced from the peculiarities of capitalism, both
institutional and cultural. In place of of laissez-faire style “free” markets there might be markets
based on an alternative set of property rules that favors corporations less, with policies and laws that
“even the playing field” and support individuals and communities. This would still allow the
decentralized knowledge creation that Austrians stress in markets, and furthermore would allow it in
the public sector as well. Such a system would also alter radically the social structure and culture
experienced by citizens. A good start would be to re-examine how important profit is to spontaneous
orders, both recurring and cumulative. Before we examine this, a brief digression on ethics might be
in order.

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