Wednesday, December 28, 2011

Capitalism is Capitalism Because It Changes and is Never the Same

There is an interesting lead editorial in the Financial Times this morning: “Capitalism is dead; long live capitalism.” (

The basic conclusion of this piece is that “Capitalism will endure, by changing.”  It has in the past.  Capitalism will change in the present circumstances.  And, it will change in the future.

The argument: “the market economy is not…unchangeable…It is successful not because it stays the same, but because it does not.

Two centuries ago there was no limited liability, no personal bankruptcy, little central banking, no environmental regulation and no unemployment insurance. 

All these changes occurred in response to economic or political pressures.  All brought with them new solutions and new challenges.

At a time of ongoing financial shocks, this need for adaptation has not ended.  On the contrary, it is as important as ever.”

The argument presented in this editorial is aimed at a “straw man”.  That “straw man” apparently believes that capitalism is an ideal system that can function in total independence of changing technology, changing institutional arrangements, and changing flows of information. 

The “straw man” believes in the “general equilibrium” model of the theoretical economist, a model that only includes profit maximizing and utility maximizing economic units…such units, by the way, are all exactly the same.

This pure economic view of the world has very little basis in reality.  In fact, this economic view of the world is at odds with current work in economics that views the study of economics as the study of incentives…incentives that exist everywhere.  This current view of economics is represented by work of Steven D. Levitt and Stephen J. Dubner in the books “Freakonomics” and “SuperFreakonomics”.

Economics, the study of incentives, is a field that indicates that “things” are always changing because the flow of information is always changing and, as a consequence of this, incentives are always changing.  If incentives are always changing then the behavior of individuals and institutions will always be changing.  And, that is exactly what we see in the world. 

The Financial Times editorial goes on: “At the heart of the renewed debate (about capitalism) are three issues: finance, corporate governance, and taxation.  These are the questions raised by the ‘occupy’ movements which, for all their intellectual incoherence, have altered the terms of the political debate.

The financial sector grew too big, partly because risks were misunderstood and partly because it was encouraged by policymakers to expand. …

Again, corporate management has too often rigged executive compensation in its own interests, rather than that of shareholders.

Finally, a plethora of incentives have allowed many of the most successful people to escape taxation.”

In response to the issue that the financial sector grew too big, I can only agree with the conclusion that “it was encouraged by policymakers to expand.”  Fifty years of “Keynesian-type” government policy aimed at stimulating high levels of employment and home ownership for more and more people in society created an environment of almost continuous credit inflation that encouraged increasing levels of risk taking, greater degrees of financial leverage, and more and more financial innovation.  And, given these incentives, General Electric and General Motors, to take two major manufacturing companies, became major financial institutions by the end of the twentieth century.

Why did the financial sector grow to become such a large proportion of the economy?  The incentives were created in such a way that the financial sector had to become a larger proportion of the economy.

Within an economy that produced almost fifty years of steady credit inflation, things were good: the real economy grew (but not at an exceptional rate), people owned their own homes, they owned TV sets…and cars…and second homes…and so forth.  Debt was readily available for all!  Who really cared if executive compensation was excessive if the prices of homes were rising at close to double-digit rates?  The “piggy bank” of the middle class (the homes that were owned by the middle class) kept growing and growing…so who should be concerned about top management salaries?

And, the Financial Times article explicitly states that “a plethora of incentives” existed to allow “many of the most successful people to escape taxation.”  But, the rising incomes created by credit inflation can itself create higher taxation where a progressive tax system exists, and this, alone, may be an incentive to find ways to evade taxation. 

People respond to incentives.  They always have.  They always will.

What we have found is that “The market economy is the most successful mechanism for creating prosperity humanity knows.  Allied to modern science, it has done more than transform the world economy; it has transformed the world.” 

In other words, if the “right” incentives are in place, a market economy can produce incredible prosperity and “good.”

However, if the “wrong” incentives exist, prosperity will not be as great and many, many people can face stagnation and suffer, as a consequence.

We can look back over the past two centuries and argue that people responded to “right” incentives and, as a result, we put in place limited liability, developed the concept of personal bankruptcy, created central banking and environmental regulation and produced unemployment insurance.  The response to these incentives worked to complement the market economy to bring about even greater prosperity.

Over the past fifty years the credit inflation created by many governments in the developed world produced incentives that have turned out to be harmful, even to the people that the credit inflation was supposed to help.  The consequence has been economic stagnation and human suffering.   

Therefore, one can accuse “Capitalism” of many things and make “Capitalism” the villain in the picture.  But, capitalism is going to continue to exist and the market economy will continue to create prosperity.  What we need to be careful of is the incentives that we create within this “capitalistic” economy and the “unintended consequences” that might result from these incentives.  Ideally, what we really want is a system of incentives that creates opportunities for everyone and the openness and mobility for anyone to take advantage of these opportunities and prosper in them.  These incentives will come from the public sector as well as from the private sector.  But, we must be careful of the incentives that are created and how they are implemented.    

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