Under the social compact theory of government (see, for instance, in no particular order, Locke, Rousseau, and Hobbes) men begin in a state of nature where each man is equally free to do what he will so long as that does not interfere with the freedom of another to pursue his interests.  Each man, also, whether in this state or not, has certain rights inherent in his existence (our Declaration of Independence acknowledges them as an inalienable endowment from our Creator); these include a sole ownership property in his own mind and body; from these, a sole ownership property in his labor; and from that, a sole ownership in the produce of his labor.  This Natural Man, though, in fact leads a quite, umm, Hobbesian existence: his life is short and brutish, the strong and greedy prey on the weak, and the Devil takes the hindmost. As a result, men band together in groups—form social compacts—in order to create more or less formal governments (and so the structure must exist only with the consent of those who will be governed by this new entity), whose sole purpose is to protect the members of a compact from each other and from depredations from outside.

Among the members’ attributes being protected (as part of protecting the members themselves) is that ownership of labor and of labor’s output.  This necessarily includes the right to engage in trade with others according to terms agreeable to those engaged in the trade.  Any interference with that trade is a violation of those men’s inalienable rights: government’s legitimate role here is limited to ensuring that trades occur only on terms those participants, of their own accord, accept.

But this only addresses the rights of men.  It also is man’s nature to be free and unbounded: in the present context, to engage only in transactions that are profitable to himself.  Adam Smith recognized this with his “invisible hand.”  That hand is nothing more than a man’s self-interest—his greed—in pursuing what he sees as beneficial to himself combining with another man’s self-interest—that other’s greed—to result in the production of a better outcome for both than either could have achieved individually.

Thus, one man works his field and produces a quantity of wheat, which he then trades for something of value with a baker.  The baker then bakes a loaf of bread, and he either has food for himself and his family, or he trades that loaf with a third man for something of value.  Meanwhile, the first man takes what he got in trade from the baker and uses it himself, or he trades with a fourth man….  This network of trades, by satisfying the separate greed of four individuals, makes all four men better off than any of them were individually, and it makes the four as a group better off than the sum of the four in a state of nature, where one, being stronger than the others, simply takes it all—and cannot get more bread, for instance, because he has driven the baker out of business, cannot even get more wheat for having forced the farmer into the same fate.

Legitimate governments preserve that system of free trade.  (As an aside, it’s important to note that all money does to this barter system of free trade system is facilitate its efficiency: money is only a store of value that is easier to transport, track, store, and so on than are the hard goods—or the labor—whose value is represented by sums of money.)  Illegitimate governments interfere with free trade, whether by design or by side effect of good intentions.  When governments tax trade, it reduces the amount of trade: taxes collected are funds not available to men to support their commerce, which leads to fewer goods available and so increases their costs to all.  When governments tax goods, it reduces the amount of money available to men to pursue their own ends, including their commerce, with the same results.  When governments say that only certain forms of commerce are allowable, or only certain goods can be exchanged, or specific parameters of exchange must be followed, they directly reduce the degree and flexibility of commerce—increasing the costs of commerce and of the goods exchanged.

What happens when these interferences become too onerous?  Men follow their nature and seek ways to step outside the sanctioned, “legal” system of commerce, and engage in their trade away from the eyes of that government—in a black market.  Indeed, one can see a measure of the legitimacy of a government by how extensive is a black market in that polity.  The greater the black market, the greater the interference by government in the legal market.

Yet, a black market is not wholly free, or efficient, either; it only represents men’s efforts to trade more freely than their (not so legitimate) government will allow.  The black market, with its added costs of concealment so as to avoid sanction, is costlier to its participants than is a truly free market, although its participants view it as better than their own legal market.  The black market, too, for being outside government protection, is much more Hobbesian than a legal, free market.

Those are passive failures of a black market; there is at least one active failure.  We can see this illustrated in the present Greek situation.  As governments attempt to raise revenue by taxing commercial activity, or any stage of it, black market activity, being outside the “legal” system, goes untaxed.  Without considering the legitimacy of closing the Greek budget deficit by raising taxes on its citizens, where is the effectiveness of such a move when the transactions, being outside the tax system, never were taxed and remain untaxed under the new, higher tax régime?

But the takeaway from this long scrivening is this: black markets, with all their shortcomings, are freer trade systems than the market allowed by the government that coughed up the black market.  Men will engage in free trade; it is our nature: the existence of black markets proves this.  From this we see that governments that interfere with our free trade, that interfere with our nature and with our inalienable rights, are moving toward illegitimacy, and one index of this illegitimacy is the extent of the black market in the polity.  The loss created by this illegitimacy, in purely economic terms (eliding the moral costs; that’s another post), can be found in the difference between the costs of a black market compared with a free market summed with the difference between the costs of the government-hindered market and a free market.