American Dream: The Two Faces of Capitalism
THIS HUB IS ANOTHER LOOK AT CAPITALISM, one of many I have published. There are many facets to capitalism which provides a plethora of ways to describe its several good and bad points. Writing, especially to convince, is a bit like composing music or painting; an idea hits you (a motif in music, a sketch in art) and you write it down, then expand on it to see if it goes anywhere.
That is what we have here, you see, and what I hope is a novel way of explaining the good and the bad about capitalism. Why is it important for people to understand this? Because what you believe to be true about capitalism will determine who you send to Congress and the Executive office as well as ultimately the course the Supreme Court will take. And, if the wrong economic philosophy becomes dominant, then the American economy can slip back into the boom-bust instability seen prior to WW II and of which we had a taste the beginning of 2008. If the right one is chosen, on the other hand, the relative economic stability seen between WW II and 2001 can be experienced.
The discussions surrounding capitalism revolve around two different axis; 1) laissez-faire vs government involvement and 2) capitalism vs socialism. Each position has adherents to varying degrees which means there is a continuum of possible beliefs about capitalism. It is this "continuum" aspect that causes many of problems with understanding capitalism, or socialism for that matter.
It is understandable that people want simple, black and white explanations of complex issues. But when talking about economics, such explanations are very hard to come by. So, when a thought hits, another Hub gets published.
Circular Flow of Capitalism
I'm listening to a lecture series on capitalism and the subject at the moment was conservative economists Joseph Schumpeter (1883 - 1950) and his defense of capitalism during the Great Depression of 1929. Something was said that brought this to mind -
- It is human nature for some people to innovate when there is money to be made from it
- It is human nature for some people to cheat your neighbor when there is money to be made from it.
- Capitalism allows the same person to be both, which, therein, lies the seed of destruction of capitalism.
Schumpeter's three points illustrate the good, bad, and ugly of capitalism. What makes his observations so pertinent is the fact that capitalism has no brakes. It's this lack of natural brakes which can bring on the demise of capitalism; without brakes there will almost certainly be a crash. And in American capitalism, the economy has crashed in a major way more than 19 times between 1792 - 1938; and that is counting some closely spaced recessions and depressions as one downturn.
A Brief Look at Life Before Capitalism
PRIOR TO THE MID-1800s, CAPITALISM DIDN'T EXIST; IN FACT, it couldn't exist because the essential elements for it to take hold were absent. Throughout Europe, and most everywhere else, the process was as follows:
- The serfs worked the land of their Lords to provide food to the landowners and, if the noble was benevolent, to themselves.
- Towns primarily contained government personnel, their support, and artisans who produced the luxury items the nobles desired. They did not, however, have merchants to sell their wares to the general public because, except for the great cities, there was no public; virtually all of them were toiling away as serfs.
- Even if the serfs had any money, getting to the market was problematic in those days. Instead, the market, such as it was, had to come to them to sell or barter for the very basic necessities of life.
- Because there was only an artisan class, production was small and very expensive which means their products were out of reach for all but the very wealthy.
- There was, at that time, no way to produce mass quantities of things at low prices.
And that was the way it stayed until technology advanced enough to overcome that last hurdle. Once surmounted, the rest began to crumble.
The Basics of Capitalism
BEFORE GOING MUCH FURTHER INTO TALKING about the "Two Faces of Capitalism", one must first know what capitalism is. When you distill all of the rhetoric, definitions, and explanations, the bottom line is that capitalism is nothing more than two or more parties freely and fairly negotiating for the exchange of one or more things or services for another set of things or services. For this to happen, however, the ability for people to own private property must be protected by the government; without it, there can be no "free" exchange, can there. If you don't own it, how can you exchange it for something else? This, of course, implies someone else doesn't own what is being traded, generally meaning the State, or in the very old days prior to Adam Smith, a Lord or similar nobility. To me, that is the fundamental definition of capitalism and it isn't one you will find in textbooks or Wikipedia.
From the concept of private property and the freedom to exchange it for something else, you derive all of the other properties of what we generally think about capitalism; the ones you do find in textbooks. (By the way, it wasn't called capitalism in Adam Smith's day, you can thank Karl Marx for the term, instead it was called mercantilism.) For example, when you Google Capitalism one of the first things you find in its description is "allocation of resources". I haven't included this as being fundamental because "allocation of resources" follows from the free exchange of products and services. For the same reason I don't start with "profit" either; just free trade.
Most importantly, one of the requirements for capitalism to work, in the long run, is that the negotiations between parties be "fair", meaning neither has, on average, an advantage over the other. Absent that, capitalism devolves into some version of economic, and most likely political, dictatorship The reason for this is that once an advantage is established, barring outside intervention, the advantage will, in many circumstances, build upon itself (called positive feedback) until it becomes absolute where one party simply dominates the other. At this point, capitalism no longer exists. And, peeling the onion back a little bit more, one of the principal reasons this is so is that the person or group with the advantage can raise the barriers to entry such that it becomes more and more difficult for new players to enter the market.
What's needed for capitalism to be "free and fair"? Two things, 1) equal access to information and 2) trust. Without both, capitalism necessarily fails. To take a recent example, you buy (invest in) from an investment banker a "tranche" of mortgages (meaning a slice of a package of mortgages which have been sold as a lot) where the components aren't well known, or known at all. but nevertheless has attractive rate of returns (or at least having been promised such) . If neither party has access to information about the fundamental "riskiness" of this package, then the transaction is both free and fair. If, however, the seller knows that the pool of mortgages the tranche was from created from had a high proportion of "toxic" mortgages in its mix and doesn't disclose it, then the transaction is no longer fair. In other words the seller is taking advantage of the buyer's lack of knowledge turning a transaction where caveat emptor applies to that can be properly called fraud; this is exactly what happened leading up to and was one of the major contributors to the Great Recession of 2008,
On the other hand, if you send off money to a mail order house for a purchase, you expect ... you trust that the seller will send you back your merchandise. Without that trust, capitalism must crumble; imagine Ebay working without that trust mechanism being operable. But with adequate information and trust intact, the kind of capitalism the Right think actually exist, could exist.
What an Unstable and Stable Economy Looks Like
The Bad Face of Capitalism
I WANT TO START WITH THE NEGATIVE SIDE OF CAPITALISM (seen as the boom-bust cycles prior to WW II in the Chart above) because it seemed like a good idea to end on a positive note. Why? Since, on the whole, capitalism is the best thing going it only makes sense to emphasize it. But, if it can't overcome the negatives, capitalism disappears and some sort of dictatorship will take its place.
I guess you can say what is behind all of capitalism's negative attributes is the idea of "fragility". What I mean by that is that the structure of capitalism is very weak and depends entirely on human altruism and minimizing greed. Let me explain.
As I mentioned above, in so many words, for capitalism to survive, what Adam Smith called a "Free Market" must exist in almost all circumstances. As soon as the market becomes "less free", either through government or private interference, capitalism quickly fades away. It may seem like capitalism because you still have a market where people are consumers and people are sellers who appear to negotiate on equal footing, but, it isn't. It isn't because the market forces of supply and demand are interrupted and some other outcome results rather than the one a free market would have produced.
Extreme examples of government interference are things like various forms of price fixing, such as rent controls, or forms of protection, e.g., minimum wage and tariffs. In each case, price is not allowed to move to its "natural level" because both the supply and demand curves are perturbed and nature is not allowed to take its course, as it were. Likewise, if labor is not allowed, for whatever reason, to organize in order to challenge management, then management is able to simply set the price they are willing to pay for labor (which has been the case for all of the 21st century so far). It matters not, except in rare, overy-full employment circumstances, do individual laborers have the ability to "negotiate" freely and fairly with the employer. Consequently, the labor supply and demand curves end up being all out of kilter which most often leaving the cost of labor well below its natural level. The same thing would be true if the labor union(s) became too powerful (like the guilds did in the 18th and 19th centuries) and/or corrupt; the playing field becomes tilted in labor's direction.
One of the principal attributes of capitalism which works to upset the free-market as well as being responsible for most of the "bad" about capitalism is ... the profit motive. (In the next section, I will replace "bad" with "good" and develop those ideas as well.) Common sense, observation, and empirical evidence all point to the profit motive driving bad behaviour. It leads to employers using their clout to pay only subsistence wages, a practice which was common until after the depression, as well as powerful unions striking at the drop of a hat. It also leads to oligopolies, monopolies, monopsonies, and other "ies" which diminish the egalitarianism that is the basis of a truly free market. Lastly, in my list, is that the profit motive is also behind all sorts of economic fraud at all levels, from the mom-and-pop stores to AGI and Citibank as well as at all levels of government.
Another fundamental feature of capitalism which drives the "free" out of the free-market as well is the lack of natural negative feedback loops to counteract the impact of bad behaviour. Even worse, capitalism as a built-in positive feedback loop that makes things worse with each iteration when things get badly out of whack Take note that I am not talking about simple supply and demand which, in a true or nearly free-market, does have mechanisms to drive prices back to the "natural" price of an item. Instead, I am referring to a market badly twisted out of shape, such as was the case in 2006 before housing prices topped out. When the economy is in this precarious position, even a small action (like the Fed not bailing out Lehman Bros.) will upset the applecart and, over time, will send the cart on a steep downhill path; a path which ultimately must lead to self-destruction without any more help from anybody. It is this facet of capitalism with the Right denies happening.
So, with that pretty picture in mind, let me sum up this section. At the end of the day, it is the profit motive leads to bad behavior which, in turn, interferes with the free-market operations. And, because capitalism has no natural way of righting these wrongs, they just keep compounding until capitalism will cease to exist.
What Capitalism Can Provide
The Good Face of Capitalism
ON THE OTHER HAND, THE PROFIT MOTIVE is also the source for much good as well. While the profit motive may motivate people, and therefore organizations, to do bad things, it also motivates people to improve existing capabilities in addition to inventing new ones. The reason pure socialism fails in the long-run is that human beings, as a rule, will not go above and beyond what is minimally necessary without material incentive. Socialism relies on human altruism and, as Adam Smith clearly shows in a couple of his works, altruism is, for the most part, absent from the business world. Instead, self-love, or what we call self-interest today, is what drives people to do bigger and better things.
As Smith puts it, the baker, the butcher, and the candlestick maker (the latter is my choice, not his) do not make those products simply to have them available for you to purchase out of the goodness of their heart. Instead, it is self-interest, the desire to improves one's lot in life, that drives them to such labors. And, it is the competition between makers of like products to continue to improve in order to get a competitive advantage over another.
A natural consequence of this is rising standards of living for the society as a whole as the profit motive and competition drive people to excel. It does this by being the most efficient AND effective method for buyers to communicate with sellers, writ large as well as economically allocate resources. Through an actually "free" marketplace, as Smith points out, prices of things assume what he calls a "natural" price that balances the willingness of the public to buy a thing or a service and the seller's willingness to make or provide it, rather than something else. This, of course, is the classical Supply and Demand theory.
One of the consequences of this process is the efficient allocation of resources, including labor, materials, and money. And, so long as the population and/or technology keeps growing, so will the economy, in the long run. If the economy grows then, in theory, societies standard of living will increase as well..
This, I believe, cannot be said of any other economic system, be it a barter economy or a socialist one. There are, of course, many other benefits from capitalism but the above discussion constitutes a very good face indeed and is well worth preserving.
Keeping Capitalism Alive
ALMOST ALL ECONOMISTS, FROM ADAM SMITH FORWARD, understood that left to its own devices, capitalism will transition to some sort controlled economy; and history bears this out. So, what must be done to keep capitalism alive? Why, regulating it, of course.
And I think I felt a shudder go through the Conservatives and Minimal-State Liberals! But what choice is there? Regulate it or Lose it, to coin a phrase. This isn't much different than a train going through lightly rolling hills and then rolling hills. Discounting the effects of friction for the moment, once a train gets going, due to momentum it will keep going with no more power being applied to the engine; in theory, you could turn the engine off and it would keep going at the same velocity.
Assume the train enters those lightly rolling hills. So long as the average gain in altitudes equal the average loss in altitudes, the train will keep on going on its own accord. It will lose velocity going uphill but gain it back going downhill; much like the economy does when trouble isn't brewing.
But, what happens if the train enters steeper, uneven terrain? Well, its momentum isn't large enough to overcome climbing long steep hills, and without additional power, the train will come to a stop and start rolling backwards, won't it? Likewise, if it goes down a steep slope, it will gather speed until such time as it jumps the track; unless, of course, you apply the brakes to slow it down. Again, the economy is no different. If it becomes superheated, which generally give rise to some sort of asset bubble, then at some point, the economy will derail like it did in Dec 2007. I hope this all made sense.
So, enter the Fed (which certain aspects of it has been operating off and on since 1785) to save the day .. sometimes. The purpose of the Federal Reserve is to apply more throttle or brakes when it is needed, and only when it is warranted. Unfortunately, the Fed is run by humans, and humans have this habit of being biased in one direction or another; it is a rare individual who can govern appropriately in spite of their bias. Historically, the Fed got off to a rough start and was responsible for a few economic downturns becoming worse, sometimes much worse than they should have been; examples are 1920, 1929, and 2008.
In the first case, Federal Reserve actions was part of the reason their was a recession in the first place. In the Great Depression, it was Fed inaction that exacerbated the problems. In the latter case, it was Alan Greenspan's philosophy which allowed the problems to persist and grow until it was too late to do anything, even though he finally saw the error of his ways. But, throughout the 1950s through 2000, the Fed did its job pretty well, as you can see from Chart 2 above.
Obviously this is not the place to get into the details on how the Fed, through monetary policy, and Congress, through fiscal policy. can regulate the economy (something those on the Right don't think it can do or should happen), so I think I will close this way. Like the train analogy, the capitalist economy is an engine which can often operate successfully on autopilot; no other economic system can make this claim. And, like a train, which is most effective in moving material around the country, capitalism is most effective at moving a large economy forward ... so long as it is treated with some TLC.
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© 2015 Scott Belford