The rule of law is said to exist where all people and institutions (including law makers) are subject to and accountable to law that is fairly applied and enforced. That is, individuals, organizations and governments shall submit to, obey and be regulated by law, and not by arbitrary action of the authorities. Capitalism requires a substantive definition of the rule of law and the following institutions are needed: private property rights, the law of contract, an independent judiciary, and a constitution.
The rule of law concept was already known in some ancient and medieval societies, and it was well expressed in Cicero’s dictum that “we are all servants of the laws in order that we may be free”. Yet, only the capitalist economic system depends on a substantive rule of law to ensure that all trading parts have freedom of entry into a level playing market where contracts freely agreed between the parts can be enforced.
The importance of contract enforcement is easy to understand by imagining that someone at an auction had bided successfully for an item but before collecting it met somebody offering him an identical article for a lower price and decided to default on the previously agreed offer. Or, inversely, the seller asked for more money because meanwhile had found a buyer willing to pay more. So, whenever negotiation and settlement do not occur simultaneously, the parts have to rely on the law to enforce their agreement.
Obviously, legal enforcement presupposes freedom of contract and the existence of due process. For instance, if after a proper due process a legitimate Court had determined that the bidder in the example above was forced to raise his hand then it should declare the contract to purchase as null.
The freedom of contract is essential in a market economy regardless of the legal system prevailing in a specific jurisdiction – whether based on common or civil law. Although a civil law jurisdiction of the type prevailing in Continental Europe places more restrictions on the contractual terms that may be agreed between the parts to an exchange it does not follow that a common law legal system is indispensable for capitalism. Likewise in relation to the principles of classical liberalism. Although these have their own merits they are not essential features of capitalism.
However, the rule of law is critical to ensure a level playing field where arbitrary power is banned and the equality of all before the law is guaranteed. Thus excessive regulation or discrimination are not compatible with capitalism. For instance, compulsory purchases, price controls and distortionary taxes or subsidies are all in flagrant violation of the fair treatment principle required under the rule of law. Nevertheless, in some circumstances, described next, it might be difficult to distinguish between fair and unfair treatment.
Take for instance the payment of wages. Under a freedom of contract rule firms should be free to negotiate wages in cash, kind or a mix of both. But if a department store were to pay his employees partly in food and clothing it would be preventing their freedom to buy the quantities they wanted wherever they liked. Even if the firm were to use the payment in kind to increase the workers compensation (rather than reduce it as is sometimes the case) it would still be an unfair exchange as long as workers had no option to be paid in a universal medium of exchange (money).
Often, governments engage in policies of rationing, price controls or subsidization that distort the prices even in markets that are typically competitive. For example, the price of bread, coffee, low skilled labor, medications, etc. may be controlled and yet in such markets there are thousands of buyers and sellers. The alleged reason is the protection of the poor and weak. Although these may be legitimate social objectives such protection should be given directly to those in need without affecting the functioning of free markets.
There are however special circumstances, activities and places where exemptions can be acceptable within a capitalistic system based on the rule of law. For example, during wars or other calamities that disrupt supplies it may be necessary to introduce temporarily rationing or administrative prices.
Note that such restrictions are different from price controls and similar policies applied regularly to state and regulated monopolies because the purpose of such policies is to prevent abuses of position by those granted such monopolies.
Similarly, there are cases where it is fair for sellers to discriminate among customers, as in the sale of alcohol to youngsters or to inebriated adults, but it would illegitimate to restrict access to a bar or restaurant on the basis of race or religion.
It is also important to note that although governments are entitled to special powers under the principles of the rule of law they should not be entitled to special privileges. Consider for example the collection of payments refused or disputed by debtors. While private citizens can only seize the debtor’s assets following a due process and ruling by a judge, some tax authorities (e.g. in Portugal) exercise the right to offset or dispose of the tax payers property without any due process through the judicial process.
To guarantee the rule of law essential for a capitalist systems it is also necessary the existence of an independent judiciary and a constitutional bill of rights that protect the smallest economic agent (the individual) from arbitrary actions of democratic and dictatorial rulers alike.
Again, the purpose of a constitution is to define the citizens’ rights and to limit the power of government to coerce and encroach upon individual rights, property and freedom; regardless of whether they are based on the philosophy that one is free to do whatever is not explicitly forbidden or it is only allowed what is explicitly permitted, notwithstanding the obvious advantages of the first philosophy.
In conclusion, societies that do not adhere to the fundamental principles of the rule of law cannot guarantee the basis for fair competition and usually end up with perverted forms of capitalism.