E. Two crucial economic factors for a free market
If a nation establishes a clear and simple path to private ownership of property, and if it establishes the rule of law, two other economic policies are crucial for a free-market system to function effectively: (1) a stable currency, and (2) low tax rates. This is because a stable currency ensures that the prices in the market give accurate signals about value and supply and demand, and low tax rates guarantee that people are genuinely free to decide how to use their money themselves rather than a government agency that has taken their money deciding this for them.
The government must establish a stable currency
The free-market economy we have described, based on private property and voluntary exchange, can be viewed as a massive auction of buyers and sellers responding to a vast array of prices. Everyone gets what they want when they exchange money for a good or service. This means that prices are the signaling system. But how are prices going to be measured? In what kind of money or currency?
It is a remarkable fact that market prices, if they can be measured and fairly compared, produce actions by both selfish and unselfish individuals that benefit everyone. While an entrepreneur might intend to promote only his enlightened (or even unenlightened!) self-interest and personal gain, the secondary effect of a voluntary exchange is a significant benefit to the buyer. The agreement of a seller and a buyer on a price is voluntary, and therefore both must think it is mutually beneficial. But it is the currency used that provides a mutually understood means of exchange, and allows both seller and buyer to evaluate whether the deal is a good one for them. In order for the system to work correctly, the currency used in a transaction must have a known and stable value.
More efficient than barter, a system of currency—whether it be furs, stones, shells, beads, copper, or fiat paper—reduces the cost of all our exchanges because it provides a common denominator into which all goods and services can be converted. Paper currency that is truly backed by gold (or sometimes silver) has often worked well, because individuals are confident they can exchange their currency for an equivalent value in gold if they wish.
When money consists of printed paper that is not backed by gold (or a similar valuable metal), it is called fiat currency. (The term fiat is a Latin verb form that means “let it be done,” and it communicates the idea that paper money has value because the government declares that it has value.) Fiat currency is vulnerable, however, because it has value only as long as people trust the government enough to think that it has value. It is easier to debase a fiat currency that the government merely says is valuable than a currency backed by gold.
Money has power only because it can be used to purchase something, so its value is measured in terms of what it can buy. Money allows us to engage in exchanges, even ones of long duration. It gives us a way to store purchasing power for future use. It also acts as a unit of account that keeps track of all costs and revenues by telling us what we need to know now and for future time periods. Without money, exchange would be difficult. It definitely qualifies as one of the best social inventions ever.
But the productive contribution of money to the exchange is di?rectly related to the stability of its value. The pieces of paper that government authorize as money have value because everyone thinks they have value. If you destroy that belief, you destroy the value of money.
Underlying every piece of paper money are the industry, ingenuity, resources, and economic capacity of a nation’s citizens. In this regard, money is tied to an economy as much as language is tied to communication. Without definitions, words could mean anything. So it is with money. If money does not have a stable and predictable value, the price-signaling system breaks down.
The loss of the purchasing power of money through inflation, for example, makes it more costly for lenders and borrowers to conduct exchanges, as uncertainty continually alters the meaning of the agreed exchange. Saving and investing also have additional risks under inflation, and time-dimension transactions (such as paying for a house or an automobile over time) are fraught with additional dangers because the real value of the agreed-upon price constantly changes. When the value of money is unstable, everything economic—supply, demand, profits/losses, specialization, trade, production, social cooperation—is less clear and less efficient, and this causes uncertainty and confusion in decision making.
Milton Friedman explains how this happens:
Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.
When a government increases the money supply faster than the productivity of the economy, too much money chasing too few goods produces inflation. (Actually, what “inflates” first is the supply of money.) Inflation is an ongoing rise in the general level of prices— and thus it is a fall in the overall purchasing power of a unit of currency. Inflation causes the signaling system of a market system to inaccurately reflect buyer and seller intentions. “It is like a country where nobody speaks the truth.” Likewise, it is a disease that nearly destroys nations: for example, Russia and Germany after World War I, and China, Chile, and Argentina after World War II.
Inflation gives the illusion that we have more money than we really do—we never quite catch up with how fast prices are climbing. When people know that their future buying power is being reduced, lenders raise interest rates, reduce loan periods, and eliminate fixed mortgages. In short, credit becomes less available. Everyone loses, except government.
Hundreds of years of economic history indicate that prices and the stock of money have moved together. Since governments control the money supply, their policies are the main causes of inflation. They inflate the money supply because it is easier to pay off massive government debt with cheaper money created by printing it. If the policy makers’ alternatives are (1) to default on the government’s debt, (2) to devalue their currency, (3) to declare national bankruptcy (all of which are very painful), or (4) to inflate the nation’s currency, is it any wonder they often choose inflation?
The famous British economist John Maynard Keynes said: “There is no surer means of overturning the existing basis of society than to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
Likewise, Friedman writes, “Inflation distorts price signals, undermines a market economy, and is a form of taxation that can be imposed without legislation.”
-  Milton and Rose Friedman, Free to Choose: A Personal Statement (New York: Harcourt Brace Jovanovich,1980), 254.
-  Walter B. Wriston, Risk and Other Four Letter Words (New York: Harper and Row, 1986), 106.
-  Milton and Rose Friedman, Free to Choose, 253.
-  John Maynard Keynes, Economic Consequences of the Peace (New York: Harcourt, Brace, and Howe,1920), 235.
-  Friedman and Friedman, Free to Choose, 225.