Man is free if he needs obey no person but solely the laws
~ Immanuel Kant
The rule of law was defined succintly by Friedrich Hayek in The Road to Serfdom as the idea that 'government is in all its actions bound by rules fixed and announced beforehand'. This is the opposite of rule by fiat, which involves the state doing what the hell it wants when it feels like it. Nineteenth century liberals (in the laissez faire sense) believed their achievement was in creating a government of laws, not of men. Their laws were fundamentally reactive, and established a framework inside which people could act.
An example is in order. For instance, contract law defines the rules whereby I may make a contract with my friend Bob. Once me and Bob have chosen of our own volition to make a contract, we have certain obligations to one another. However, we are only being burdened by these obligations because we chose to enter into a contract with one another, something no-one forced us to do. In a similar way, criminal law defines what the state can do to me when, I mean if, I hunt down Al Gore and give him a good slap. The guy's really annoying, but no-one forced me to hunt him down and give him a slap, so once again I knew the risks when I got on the plane.
The point of the rule of law is that it establishes a framework in which I can predict what the consequences of my actions are going to be. In the sphere of individual action, this is a safeguard against arbitrariness and tyranny inflicted by a powerful state. The state only has the legitimacy to enforce laws which the representatives of the people have established in the legislature or to exercise powers which were invested in the executive by the constitution. With the help of a lawyer and with the exception of judicial discretion, I can work out what the state's responses to my actions will be. This is the 'nightwatchman state', wandering around shining its lamp on transgressions and acting accordingly.
In the twentieth century, Britain and America began to practice something called social democracy. The social democratic state is an activist state which redefines the sphere of private liberty to exclude the negative right to property, and uses the surplus it gains thereby to gift positive rights to those deemed underprivileged. It is no longer the referee, but intervenes in the game to help the weaker team. In Britain, this was controversial but there was no constitutional opposition to it happening. The Westminster system vests complete sovereignty in the King-in-Parliament, and Parliament can do what the hell it wants, including over-riding any previous legislation it has passed. Hence, a progressive income tax abides by the rule of law as I know that if I earn £10, the government will take £1. Laws have begun to apply to the sphere that was previously my individual liberty, but I can still predict what is going to happen.
Things become more complicated when there is full-blown socialism, or any direct state management of the economy. When a government nationalizes an industry, it becomes involved in the day-to-day decisions of how to run that industry and how to interact with all the other entities this industry comes into contact with in the economy. This state is now not just responding to transgressions of the law like its more limited counterpart, but is directly involved in running a part of society's life. When a state involves itself in the nitty-gritty of economic life, it can no longer set down general principles in advance by which it will conduct itself. It will have to decide whether to invest in heavy industry or consumer goods, or whether to feed people with meat or fish. Its decisions will benefit one group and penalize another.
Thus socialism is incompatible with the rule of law, replacing it with rule by fiat. Once the state creates bureaucracies which are backed by its power, but make decisions without consulting the people's representatives, the rule of law cannot be said to exist. As the state's ability to plan increases, the individual's ability to plan diminishes accordingly. I cannot predict whether the state will choose to order me to produce shirts or pants, or predict whether the state will order me to go and work in a different factory altogether. By giving myself up to this arbitrary rule I supposedly gain economic security in return, for the state is pledged to shield me from the vagaries of the market.
Furthermore, my trouble multiplies when it is realised that distributional questions are at root normative, and not technical. The decision about who gains and who loses in a planned economy are based on a moral decision, which means the administrators issuing their orders have to make moral judgements. This arbitrary rule has the ability to put me out of a job, or reduce my real income to benefit someone else. The whole philosophy that one exists not for oneself, but for the good of some metaphysical conception of a higher community, allows the state to sacrifice my interests and needs for the benefit of others, or 'the community'.
When these decisions are made by a democratic legislature they are bad enough. For instance, there is nothing in the British system of parliamentary democracy except its tradition of sanity and morality to prevent a plurality of citizens deciding on the liquidation of a minority group, and passing legislation whereby this is enforced. However, our system of representative democracy makes this extremely unlikely to happen, having various checks and balances against such an eventuality. But if this same legislature creates a board or corporation with complete power over the nation's economic resources, and one able to act without further reference to the legislature, there is nothing to stop this small group of men reaching a bizarre consensus and implementing it. This is the nadir of democratic government, too far removed from the people to be considered 'democratic' at all.
No such extremity has ever existed in Britain or America, although students of Communism or fascism will recognise such a situation and its connotations for all of the liberties considered inalienable in the Anglo-American tradition. However, as just one example, the government by consensus which existed in Britain from the end of World War II to the epoch of Thatcherism had some of these characteristics. It was government in consultation with bodies such as businesses and trade unions, all of which were able to exert a significant influence over the government's policy and even to bring governments down. These unelected economic powers were able to subvert the rule of law by creating an 'informal constitution' where rules were made and enforced not by the people's representatives, but by bargaining between interest groups which represented a small fraction of the nation.
Such is the inevitable fate of political systems which take on redistributionist aims, or in any way overstep the mark of merely protecting negative rights and begin to promote positive ones. Every interest group will clamour to claim its representation in determining the course of policy, and the centre of gravity will shift away from laws passed by the people's representatives and to decisions made by fallible groups of civil servants in dark rooms in Whitehall, White House and Kremlin. We have passed the age of the rule of law and entered a gray area in which an activist state is controlled for brief periods by political parties which use it to satisfy the desires of their supporters in the hope of re-election. This creates an unstable and potentially dangerous situation in which the state's power reaches further than ever before, and no right is entirely inviolable.
On social democracy in the Anglo-American world, see - new liberalism, Thatcherism, Poor Law Amendment Act 1834, ratchet theory of government growth and social democracy in post-war America.