National defense has traditionally been regarded, even by believers in a severely limited state, as a fundamental function of government. To understand why, one must first understand the economic concept of a public good and the difficulties of financing a public good without coercion.
A public good is an economic good which, by its nature, cannot be provided separately to each individual but must be provided, or not provided, to all members of a pre-existing group. A simple example is the control of a river whose flooding injures the land of many farmers in the valley below. There is no way that an entrepreneur who proposes to build a dam can protect only those farmers who agree to pay part of the cost of the dam. An individual farmer may refuse to pay, reasoning that if the others all pay he will be protected anyway and if they do not his contribution will not be enough to build the dam. The small probability that his contribution will make the difference between the dam being built and not being built, multiplied by the value to him of the dam, is not enough to justify the expenditure.
This is the traditional problem of the public good. It is a problem because if there are enough farmers like this, each acting rationally on a correct calculation of his own self-interest, the dam will not be built even if the combined value to all the farmers is more than the cost of building the dam.
In our society the usual solution is to use government force, taxation, to make those benefited (and others) pay for the dam. One problem with this solution is that the dam may be produced even when its total value is less than its cost. The government has no market mechanism for measuring the total value of the dam to the farmers. And since government decisions are made on political grounds, the government may choose to ignore cost and value entirely. In practice, public dams are often built even when the return on the capital spent building them, including a generous estimate of nonmonetary benefits, is far below the market rate of return on other investments.
There are several market solutions to the problem of providing a public good. For instance, the entrepreneur might estimate how much the dam is worth to each farmer, draw up a contract obligating each farmer to pay that amount if and only if every other farmer agrees to pay his share, and circulate it. Each farmer knows that if he refuses to sign the dam will not be built, since the contract has to be unanimous. It is therefore in his interest to sign.
In order for this to work, the entrepreneur must estimate correctly the value of the dam to each farmer. If he sets the price for one farmer too high, the dam will not be built. His job is made more difficult by those farmers who realize that it is in their interest to pretend that they think the dam of little value in order to have only a small part of the cost assigned to them.
A farmer interested in raising rice, for instance, might find occasional floods a useful supplement to his irrigation and have no interest in paying for flood control. The entrepreneur would have to remove such a farmer’s name from the contract in order to have any chance at all of getting it signed. That is fair enough; there is no reason for the farmer to pay for something that is worthless to him. But as soon as word spreads, other farmers realize that an interest in growing rice can save them a lot of money. The Rice Growers’ Gazette acquires new subscribers, all of whom are careful to leave their copies in prominent places around the house when the dam entrepreneur comes to call. Talk at the general store shifts from mowing hay to the relative virtues of different strains of rice. The entrepreneur is faced with the problem of figuring out which farmers are really interested in growing rice and which are only interested in being interested in growing rice, with the objective of growing wheat and getting flood control without paying for it. If he guesses wrong and puts a real rice farmer on his unanimous contract, it does not get signed. If he plays safe and takes everyone who pretends to be interested in rice off the contract, he may not be able to raise enough money.
The larger the public for a given public good, the harder it is to arrange such a unanimous contract successfully. The larger the difference between the value of the good and its price, on the other hand, the easier the entrepreneur’s job. He can leave a generous margin for error by only listing the farmers of whom he is sure and charging each of them less than the dam is probably worth to him, yet still raise enough money.
Another way to provide a public good without coercion is by temporarily converting it into a private good. The entrepreneur could do this by purchasing most of the land in the valley before telling anyone that he is thinking of building a dam. He then builds the dam and resells the land at a higher price, since the dam raises the land’s value. The increase in the value of the land measures the total benefit from the dam. If it is much larger than the cost of the dam, the entrepreneur makes a profit. There may be a few farmers who refuse to sell, but as long as the entrepreneur owns most of the land he receives most of the benefit.
Here again, the entrepreneur’s job is harder the more people are involved. It becomes difficult to buy all the land before the owners realize what is happening and raise their price. Here also, the job is easier the bigger the difference between cost and benefit. If the benefit is more than twice the cost of building the dam, the entrepreneur makes a profit even if he can only buy half the land.
In both cases the transactions themselves have a cost and thus increase the effective cost of building the dam. Gathering the information needed to draw up a successful unanimous contract may be expensive. Buying up all the land in the valley involves substantial brokerage fees. Farmers who were not planning to sell must be paid more than the market price to compensate for their inconvenience. A clever entrepreneur, buying not the land but merely an option to buy at a predetermined price, can reduce such costs but not eliminate them.
How does this apply to national defense? Is it a public good? Can it be financed without coercion?
Some contemporary anarchists argue that national defense can be provided or not provided for each individual or at least each small group. One form of this argument is the assertion that national defense is unnecessary in an anarchist society, since there is no nation to defend. Unfortunately, there will still be nations to defend against, unless we postpone the abolition of our government until anarchy is universal. Defense against nations, in the present state of military technology, is a public good. It is all very well to fantasize about fighting the invader village by village, commune by commune, or corporation by corporation, according to the dreamer’s particular brand of anarchy. A serious invader would inform each unit that if it resisted or failed to pay tribute it would be destroyed by a nuclear weapon. After the invader proved that he meant business, the citizens of the surviving communities would be eager to create the institutions, voluntary or otherwise, necessary to give the invader what he wanted.
Pending major technological change, defense against nations must be provided on a large enough scale to support retaliatory, and perhaps also defensive, nuclear forces. This makes it difficult to sell national defense on the free market. An ABM fired at a missile a thousand miles from its target cannot distinguish warheads aimed at those who have paid for defense from warheads aimed at those who have not. Even if defense is retaliatory and even if the retaliatory system is secure enough to hold its fire until it knows whether its customers have been hit, the problem remains. The citizens of New York, having paid their share of defense costs, can hardly look with equanimity on the H-bombing of Philadelphia, which has contributed not a penny. Not, at least, if the wind is blowing the wrong way.
So national defense—defense against nations—must defend areas of national size, whether or not they contain nations. It is thus a public good, and one with a very large public.
Can this public good be financed by some variant of one of the noncoercive methods I have discussed? It is not obvious how. The size of the public is so enormous that a unanimous contract is virtually impossible, especially since one secret supporter of a foreign power could prevent the whole deal. Buying up most of the land affected by national defense might be less difficult than negotiating a unanimous contract among 200 million people, but hardly easy, since the land must be purchased before sellers realize what is going on and increase their price. Raising enough money to buy the United States would be a hard project to keep secret. In addition, the transaction costs would be substantial—about $100 billion in realtor commissions for all the fixed property in the United States.
There is one favorable factor to help offset these difficulties. I estimate the cost of a minimal national defense at about $20 billion to $40 billion a year.  The value to those protected is several hundred billion dollars a year. National defense is thus a public good worth about ten times what it costs; this may make it easier, although not easy, to devise some noncoercive way of financing it.
The problem would be simpler if it could be subdivided. Groups much smaller than our present population might be able to create defense organizations and finance them voluntarily. It would be in their interest to do so if such groups could defend themselves. Once such organizations existed, hundreds of them could combine, via unanimous contracts, to defend areas of national or even continental size. One could imagine an alternate history in which, as military technology developed, such voluntary arrangements evolved, just as coercive governments evolved in our history.
But in the present world small groups cannot defend themselves. They therefore have no incentive to develop voluntary arrangements to finance defense.
A solution to the problem of developing institutions that provide defense without the state, paradoxically enough, might be provided by the state itself. Suppose that over the next fifty or a hundred years private institutions gradually take over all governmental functions except defense. The state, without control of local institutions, might find the cost of collecting taxes substantial and be tempted to raise money in the manner of the French monarchy, by selling tax exemptions. It could offer to exempt any community from taxation in exchange for either a capital sum or an annual payment. Such a tax exemption would itself be a public good (defense, via bribery, from one’s own state) for the community. Since the collection costs of taxation are high, the value of a tax exemption is greater than its cost. The members of the community might therefore find it in their interest to set up an organization designed to pay off the state. It could be financed voluntarily by one of the ways of financing public goods that I have described. It would probably pay an annual fee instead of a lump sum in order to make sure the state stayed bought.
Over a period of time, many or most communities develop such institutions. There then exists a group of organizations, voluntarily funded either by the interest on a capital endowment or by contractual agreements to pay on the part of members of the community and charged with the task of defending their communities. These organizations could then contract with each other to take over from the existing state the job of financing and providing national defense.
So one solution to the problem of national defense might be the development for some related purpose of local defense organizations. These must be organizations permanently endowed for the purpose of providing defense; they cannot be simply local firms with an interest in the protection of their territory, since such firms, having agreed to pay part of the cost of national defense, would be driven out of business by new competitors who had not.
This is the problem with Morris and Linda Tannahill‘s idea of financing national defense through an insurance company or companies which would insure customers against injury by foreign states and finance national defense out of the money saved by defending their customers. Such an insurance company, in order to pay the cost of defense, would have to charge rates substantially higher than the real risk, given the existence of its defense system, justified. Since people living in the geographical area defended would be protected whether or not they were insured by that particular company, it would be in their interest either not to be insured or to be insured by a company that did not have to bear the burden of paying for defense and could therefore charge lower rates. The national defense insurance company would lose all its customers and go bankrupt, just as it would if it were simply selling national defense directly to individual customers who would be defended whether or not they paid.
The same difficulty occurs with Ayn Rand’s suggestion of financing national defense by having the government charge for the use of its courts. In order to raise money for defense, such a government must either charge more than competing private court systems or provide a worse product. Such private courts, if permitted, would therefore drive the government out of the court business, depriving it of its source of income.
Miss Rand apparently expects her government to have a monopoly of the court (and protection) business. But if the government does not use coercion to keep out competitors there is no obvious reason why the sorts of institutions described earlier in this section should not arise. If the government does claim special rights that it does not give to private courts and rights enforcement agencies —for instance, the right of policemen to make mistakes and not be responsible for the damage done or the right of government courts to subpoena witnesses—then it becomes a government in my sense of the term (Miss Rand uses a different definition), an agency of legitimized coercion. Either the things the government does but forbids its competitors from doing are coercion, in which case it is coercing private citizens, or they are not coercion, in which case it coerces the private rights enforcement agencies by forbidding them to do the same (noncoercive) things. Either way, Rand’s government must be coercive in order to work, so it is not a solution to the libertarian’s problem of providing national defense without coercion.
Although local defense organizations must be endowed, they might evolve in ways other than those I have described. For instance, existing insurance companies would receive a capital windfall at the time an adequate national protection system was first constructed, since outstanding policies that had been sold at high rates under high risk conditions could be paid off under low risk conditions. They could use this windfall, which comes only from policies already written and thus represents only that small part of the benefit of defense which accrues in the near future to those already insured, to endow national defense. Such an endowment would not be sufficient to pay all the costs of national defense, unless it becomes far cheaper than it now is, but it might cover some of them.
There are other ways that part of the cost might be paid. Charities exist for the purpose of financing public goods. They currently collect billions of dollars a year. There is no reason why national defense should not be partly financed by charitable contributions. Historically it has been; in time of war people often donate money, labor, and weapons and purchase war bonds for more than their market value.
There is another common way of financing public goods that is intermediate between normal economic methods and charity. The best example is the institution of tipping. Customers at a restaurant leave a tip even if they have no intention of eating there again and therefore no personal interest in rewarding good service. The rewarding of good service is a public good; if everyone does it, everyone will benefit by the improved service, but if I do it at a restaurant where I rarely eat most of the benefit goes to the other people who use the restaurant. I tip partly because I realize this and view good restaurant service as a desirable goal—in effect, a worthy object of charity. A more important reason is that I feel I ought to tip; an internal feeling of obligation or external social pressure make me act according to a sort of implicit contract, an obligation to reward the waiter if he does a good job, even though I know that there is nothing forcing me to do so and that I will suffer no material loss if I do not. Similarly, if national defense were financed voluntarily, people would give money not as a matter of charity but because they felt that they were receiving something and ought to pay for it. As with tipping, the amount received might have some connection with how good a job they thought was being done. And, like tipping, people might feel obligated to give something even if the job were only barely satisfactory; however bad the service, few of us have the temerity to leave no tip at all.
How much are people willing to pay on such a basis? I do not know, but one way of getting a rough idea is by seeing how much they pay in tips under circumstances where they receive no direct benefit by tipping well. This is usually the case with taxis, since few of us expect to get the same driver twice, but only sometimes with restaurants, since many customers go to the same restaurant regularly. Taxi tips total about $150 million a year; all sorts of tips combined total about $2 billion. Such figures suggest that individual feelings of obligation, reinforced by social pressure, might provide a substantial fraction of the cost of defending against foreign enemies—a service most of us regard as more important than keeping up the quality of restaurant service.
Although national defense is primarily a public good, there are parts of it which can be sold separately to individuals or groups. Foreign states would probably treat a national defense agency as a government with respect to such matters as passports and extradition treaties. It could get some income by selling passports, arranging to extradite criminals from foreign countries at the request of local rights enforcement agencies, and similar enterprises.
In addition, there would be some areas which a national defense agency would have the option of defending or not defending. Hawaii, to take an extreme example, could be excluded from the nuclear umbrella covering the mainland. Communities on the edges of the defended area, although necessarily protected from nuclear attack by any national defense system, could be defended or not defended against conventional attack. A national defense agency could go into these areas and inform those individuals and corporations who had the most to gain by being defended (large landholders, insurance agencies, and the like) that they would have to pay a price for defense.
In all of these ways a national defense agency might raise enough money to finance national defense without taxation. Obviously, a system that depends on local agencies evolved for a different purpose or a ramshackle system financed by charity, passport sales, and threats to Hawaiian insurance companies is economically very imperfect. So is a system financed by coercion and run by government.
These arguments suggest that it may be possible to defend against foreign nations by voluntary means. They do not prove that it will be; I am only balancing one imperfect system against another and trying to guess which will work better. What if the balance goes the other way? What will I do if, when all other functions of our government have been abolished, I conclude that there is no effective way to defend against aggressive foreign governments save by national defense financed by taxes—financed, in other words, by money taken by force from the taxpayers?
In such a situation I would not try to abolish that last vestige of government. I do not like paying taxes, but I would rather pay them to Washington than to Moscow—the rates are lower. I would still regard the government as a criminal organization, but one which was, by a freak of fate, temporarily useful. It would be like a gang of bandits who, while occasionally robbing the villages in their territory, served to keep off other and more rapacious gangs. I do not approve of any government, but I will tolerate one so long as the only other choice is another and worse government. Meanwhile, I would do my best to develop voluntary institutions that might eventually take over the business of defense. That is what I meant when I said, near the beginning of this book, that I thought all government functions were divided into two classes, those we could do away with today and those we hope to be able to do away with tomorrow.
 All numbers as of about 1970, when this chapter was written.
[Chapter 56 contains additional ideas on national defense that I have come up with in the forty some years since this chapter was written.]