1 April 2015

We need to rethink the ideas behind capitalism


The twentieth century saw capitalism triumph. Admittedly, and for a while at least, capitalism was something of a dark horse. After a rather shaky start, one in which socialism spread to all four corners of the earth, capitalism won the race. By contrast, the twenty-first century has so far been one of trauma. Like it or not, capitalism is on trial.

To build a better future, we need to think afresh. Most of us can agree upon what we would like our system to deliver. We want an economy that is capable of delivering greater prosperity, an economy that is able to avoid – or at least effectively deal with – the spectre of boom and bust, and an economy in which rewards are fair. Of course, the problem is that whilst we can perhaps agree upon these three common goals – prosperity, stability and fairness – we disagree in terms of how they can best be delivered.

Here, looking to history can help us to sort out our differences. However, doing so means removing the ideological blinkers that defined the politics of the last century. It also requires facing up to some uncomfortable truths. So, before I continue, you might want to fasten your seatbelt.

1. Prosperity

First, I have to begin with an admission: markets are far from enough to deliver economic success. From ancient Babylonia through to the modern day, one thing that is abundantly clear is that markets have always existed in one form or another. Prosperity, by contrast, is much more recent. Markets are, of course, an essential ingredient of prosperity. However, whilst necessary, they are not sufficient. Two other factors are equally as important: the state and society.

Science and technology are central to rising prosperity, but, as cases such as the internet and GPS technology demonstrate, progress is just as much a result of state funding and risk taking as it is of private sector endeavour. Since the Enlightenment, innovation has been a collective endeavour – and long may it continue. However, this comes with two warnings. Firstly, and as Mariana Mazzucato argues in The Entrepreneurial State, whilst the state has historically provided funds, it has received very little direct reward. The result has not only been unfair to the tax-payer, but has also meant too few resources to help fund the next series of scientific advances. Secondly, the state needs to be careful not to limit the freedom of scientists. Since the Enlightenment, much has been achieved by letting scientists explore avenues which would not have looked profitable in advance. Here, the current system of state funding leaves much to be desired.

In explaining prosperity, not only do economists all too often marginalise the contribution of the state, they also neglect society. As I have argued elsewhere, the rise of the West followed in the footsteps of tremendous changes in society, including in the position of women. Society can, it seems, have a significant effect on economic growth. In turn, economic growth can affect society. If the growing pains that come with rising prosperity are left to fester, permanent damage can be done. We need to work hard to make sure that those that receive the highest rewards from economic growth are not able to lock-out others. Whether it is the super-rich that are able to pass on advantages to their children, reducing downward-mobility, or the areas that lose out from structural change (such as industrial communities in the 1980s), economic growth can put in place vicious circles that lead to a broken society and a waste of talent. We always need to work hard to repair the damage done if we want to sustain progress.

2. Stability

Rising prosperity can help to keep us on the ever-upward march. However, we also want this march to be a stable one – whilst rollercoasters are fun in the fairground they are not so when it comes to the economy. Here, again, I want to begin with a reality check: we will never completely eliminate the trauma of boom and bust. Capitalist or not, an economy cannot avoid lunging from good times to bad.

Economists have tended to explain boom and bust in terms of unwieldy government policies – anti free-market policies. So long as the state keeps out of the way, markets are supposed to naturally equilibrate. Any serious ups and downs that do then occur are, according to Real Business Cycle theorists, nothing to worry about. They are a result of the economy’s optimal response to technological “shocks”. If people end up unemployed, it is because they choose to be so. In other words, so long as we implement free-market policies, the adverse effects of boom and bust will be more or less eliminated.

As an economic historian, I beg to differ. We cannot blindly assume that so long as we pursue the free-market route, all will be well. The reason is simple: we can never predict the future. Unfortunately, and as Keynes pointed out in Chapter 12 of his General Theory, this is something that investors have to attempt to do every day. When deciding whether or not to invest in a particular sector or company, an investor has to think ahead to the future returns. However, and speaking plainly, we have very little basis on which to do this. The result is that investors face extreme uncertainty and, when in such circumstances, it can be very difficult to be cool, calculating and rational. Instead, emotions can creep in – we can be struck by fear and panic, and by over-optimism. Furthermore, lacking any real concrete basis on which to estimate the future ourselves, we tend to look around at what other people are doing. The result is waves of optimism and pessimism that destabilise investment and, with it, our economy.

Until we have invented time machines, our economies will continue to veer from boom to bust – just as they always have. If policymakers are at least aware of this fact – if they are able to remove their rose-tinted spectacles – they can be at the ready.

3. Fairness

Fairness is not only desirable in and of itself. The truth is that unless capitalism can deliver an equitable outcome, it will not survive into the longer-term. Here, we are typically presented with a stark choice: the centre-left view that free-markets cannot deliver on fairness and that redistribution is therefore required and, in opposition, defences of capitalism on moral grounds with the implication that redistribution is nothing but theft. However, each of these positions misses an important point.

Contrary to popular understanding, markets do not exist independently of the state. Like the parks in the centre of our cities, and as pointed out by Alex Marshall in The Surprising Design of Market Economies, whilst markets might look “natural”, they are anything but. The markets of which we truly speak when we use the term “free market” are the ones created by governments – by the legal system. They do not have an independent life of their own. Through the legal system, the state ensures that contracts are upheld and that private property is respected. It determines what can and cannot be sold, such as human organs, child labour, qualifications or votes and helps to erect the very infrastructure that connects buyers and sellers.

The star actors on the stage that is the market are businesses. We often think of these businesses as the creations of entrepreneurs – quite separate to the state. However, modern day businesses would not exist were it not for a raft of legislation over the past 150 years. The very fact that companies are not “natural” means that they exhibit tremendous variety throughout the world – including in corporate governance.

The realisation that there is no single market outcome is liberating. Should we have concerns that the current outcome is unjust, we have the ability to change the rules of the game – we do not, in other words, need to jump straight into redistribution. Furthermore, if markets are designed in a way that is fair – if they can be relied upon to deliver an equitable outcome – the welfare state can afford to be stricter and, with it, lower cost.

With capitalism on trial, we need to think afresh about how we can deliver prosperity, stability and fairness. When building our new future it is essential that we look to the past. Now more than ever, it’s time to take stock. Along the way, we need to face up to some uncomfortable truths – truths that, if accepted, mean that neither socialism nor a blind faith in “free” markets should define the future.

Dr Victoria Bateman is an economic historian. She is Fellow in Economics at Gonville & Caius College at the University of Cambridge, and Fellow at the Legatum Institute, London.