Since Adam Smith wrote The Wealth of Nations, scholars and others have debated the merits of capitalism and limited government. This essay seeks to shine some light on recent calls for abandoning the capitalist model (or, more accurately, usually some highly distorted caricature of the capitalist model) in favor of some alternative.
As recently as the 1980s, there were calls for the convergence of all economic systems to heavily managed gigantic welfare states; in the 1990s, calls for a “third way,” based on some other system of values; and the almost hysterical recent calls from hedge fund managers, prime ministers, pundits, and even economists who should know better to “do something” about “global capitalism.” Commentaries with titles such as The Crisis in Global Capitalism, Global Capitalism RIP, Collapse of Capitalism, Who Lost Capitalism? and The Free Market’s Crisis of Faith deserve a response, for their prescriptions of capital controls and even larger government almost certainly will cause great harm to those the authors claim to want to protect.
POSTWAR GROWTH OF GOVERNMENT
The post–World War II era has seen the expansion of the absolute and relative size of governments in most market economies and democracies. In the United States, for example, in the mid-1950s federal government spending was only $70 billion; today it is more than five times as large in constant dollars and a larger share of GDP. Also during the 1950s, one out of every seven dollars of government spending went to transfer payments; the other six were spent on purchasing goods and services, from defense procurement to the interstate highway system. Today the majority of federal spending (net of interest on the debt) is on transfer payments to people. Thus, it is not only the size but the role of government that has changed.
Of course, in Western Europe, government had become even larger—and done so earlier—than in the United States. By the 1970s, taxes and spending accounted for over half of GDP, massive transfers were undertaken, and substantial regulation, nationalization of key industries, and restrictive labor market rules were implemented or followed. Sweden, often the darling of Western intellectuals because of its economic performance in the early postwar period, had at one time almost 9 percent of its GDP devoted to industrial subsidies! At the same time, we had a communist, authoritarian, centralized, bureaucratic, command-and-control model, most often associated with the Soviet Union and other economies in Eastern Europe but also with important less-developed economies such as China.
The other alleged “intermediate” model was the market socialism of then Yugoslavia. A popular prediction of politicians, economists, and pundits was that the world’s economic systems would somehow converge somewhere in the region between the Swedish and Yugoslav economies. The capitalist economies would grow larger welfare states, the communist countries would round off some of their rough edges, and we would all happily converge in the “middle.” This of course was ridiculous and not just in hindsight.
Meanwhile, the United States did experience an explosive growth of government in the 1960s and 1970s, accompanied by high and rising inflation, more regulation, and huge growth and centralization of the government. Still, the total size of government in the U.S. economy relative to Western Europe was modest, about two-thirds as large. The same could be said of Japan, the other major industrial economy.
THE CASE OF JAPAN
The rapid growth of Japan led to the next nonsensical attack on the limited-government capitalist model. The Japanese economy grew rapidly in the postwar period up to the 1990s, and the Japanese did many things that any economist would applaud. They had high rates of saving and investment, worked hard and long hours. The relative success of the Japanese economy led in the 1980s to calls for the United States to emulate it. The calls were for a larger role for government, worker/business/government councils, government direction of private pension funds into “needed infrastructure,” managed trade, and an industrial policy of the government picking winners and losers for subsidies and protection.
The fear of the Japanese in the late 1980s was incredibly palpable. They were growing rapidly, we were growing slowly; there was large Japanese investment in the United States; many predicted they would overtake or outcompete us. Some panicked pundits and political figures, joined by some powerful business interests and some economists and would-be economists, clamored for the government “to do something.”
Fortunately, we did not waste billions of dollars trying to emulate some other economic system. In hindsight, it is clear that Japan’s success had little or nothing to do with the government’s micromanagement of the Japanese economy. As we have seen in the 1990s, that micromanagement has caused severe problems in Japan and made it immensely difficult to unwind foolish economic policies. Does anyone still believe most Americans would benefit much from emulating the Japanese model?
MORE VERSUS LESS GOVERNMENT INTERVENTION
The practical lesson on the damage done by excessive government is learned from comparing economic performance in the United States and Western Europe during the past three decades. Although worker compensation has been growing more slowly for the past twenty years than in the previous two decades, the American economy has been flexible and dynamic enough to provide employment to virtually all those who seek it. Compare that performance with the sorry state of Western Europe, where the unemployment rate is now 11 percent, more than double that of the United States.
There were 30 million more working-age people in Western Europe in 1994 than in 1970. The labor force, however, grew by only 19 million, and unemployment and government employment swelled. And there were 1 million fewer private-sector employees in Western Europe at the beginning of 1994 than at the beginning of 1970! What a stark indictment of an inflexible, protectionist, highly regulated, and overtaxed economic system. By comparison, there were about 40 million more working-age people in the United States, the labor force grew even more, and, despite a small increase in unemployment and government employment, the overwhelming bulk of the workers found productive private-sector employment. The problems of Western Europe offer us a window on our future if we allow a marked expansion in government’s role.
On the relative merits of capitalism and socialism, we hear today calls from economies in transition to return to central planning. History has already performed that experiment. Compare the former East and West Germany. Both were shattered by World War II. Both had similar problems and opportunities. One was dosed with communism—the heavy hand of state planning, controls and government intervention, regulation and state ownership of virtually everything. The other was dosed with capitalism. The West grew into an economic superpower—struggling now under the burden of economic integration with the East—while the East stagnated. When the two Germanys were reunited, the standard of living in the West was five times that in the East, which had a spoiled environment, a decrepit capital stock, and a demoralized labor force. Indeed the saying among East German workers was, “They pretend to pay us and we pretend to work.” That is about as close as we get to a natural experiment in economics. And the answer is unambiguous. There is no longer any doubt about whether there are two alternative paths to economic prosperity. Socialism and central planning do not work. Only some form of capitalism and free markets, despite their problems, works over the long haul.
IMPERFECT MARKETS VERSUS IMPERFECT GOVERNMENT SOLUTIONS
Markets sometimes fail. Imperfect markets, however, must be compared to imperfect government solutions implemented by fallible people. Thus, when we try to correct perceived externalities, we must insist on strong, sound science and flexible market mechanisms, not on scare tactics and command and control. When competition is stifled, naturally or otherwise, we need sensible rules, antitrust laws, or regulation or some combination thereof enforced in a sensible manner. We need serious protection of private property through contract and bankruptcy law and consistent accounting standards and supervision of financial markets in a way that maximizes openness and transparency. These are important foundations of well-functioning, market-based economies. In my view, the risk is that the problems we face in the American economy will lead to too much, not to not enough, intrusion of the government in the marketplace.
Recently there have been near-hysterical calls from prime ministers, pundits, and even economists who should know better to “do something” about “global capitalism.” But big-government solutions would make matters worse.
The current hysteria over hedge funds is an example. The problem wasn’t the financial instruments themselves. Futures, options, and other derivatives generate sizable net benefits when properly used in hedging various risks. Of course, there are also potential costs in their misuse or abuse. When ridiculous amounts of leverage provided by banks and brokerages with little or no knowledge of the positions of the funds to whom they lend were combined with positions that were not market neutral, potential bankruptcy loomed. This is no different conceptually from highly leveraged borrowing short and lending long betting on interest rate stability—the saga of the S&L industry in the United States; nor is it very different from Asian banks or industrial companies borrowing in dollars and lending in baht or rupiah, pocketing the spread, betting on currency pegs to continue indefinitely, unhedged; nor is it very different from Western banks’ Russian investments, hedging with Russian banks. None of this has much to do with capitalism per se. It has a lot to do with foolish financial decisions pressing at the limits, moral hazard, and mispriced risk.
The answer is not to curtail the flow of global capital. The problems of the Asian and Russian economies are not primarily due to “global capitalism,” a phrase now sometimes employed as if some communicable disease were encompassing all of humankind. The fundamental problems that led to the original crisis were severe imbalances in the Asian economies that were growing at an unsustainable pace, heavily leveraged risks with poorly supervised financial institutions, and domestic economic policies that could not support the exchange rates at which they had pegged, given the declining inflation in the United States and their higher inflation rates. Fixed exchange rates mean domestic monetary policy cannot be independent and vice versa. The only way to reconcile the dilemma is a far worse course—controlling the free flow of capital. It is not theoretically, let alone practically, possible to reconcile fixed exchange rates, independent domestic monetary policy, and free flows of investment capital; something must give. This was the core problem facing countries such as Thailand, Indonesia, and South Korea and the primary cause of their financial crises. Unfortunately, some countries are retreating into capital controls; surely their need for foreign capital to supply both funds and the market discipline that properly priced foreign risk capital brings will be decisive to their long-run prospects.
Clearly, we need a serious reexamination of our international financial institutions. The combination of changing world economic conditions, mission creep, and a mixed record of success, including some recent failures, suggests that a serious rethinking of the purposes, procedures, resources, and operations of these institutions is an urgent priority. The IMF should be playing the role of convenor of private lenders, lest lender runs on countries analogous to depositor runs on banks occur unnecessarily. The role of global lender of last resort requires a rapid determination of the difference between illiquidity and insolvency, something not easily done in a political context.
But let us not confuse traditional economic mistakes with fundamental problems of economic systems. For these economies to retreat back toward protectionism, capital controls, and even greater centralization of decision making in government would be a disaster for the mass of humankind. Sensible improvements in the supervision of their financial institutions and better central bank policies are the place to start. For example, higher reserve requirements for short-term deposits and sensible risk-based capital requirements for financial institutions, if necessary, make a lot more sense than capital controls or taxes.
My conclusion is simple. In addition to their strong moral base in personal freedom, capitalism and competitive markets work to deliver substantial economic progress; communism, socialism, even large bureaucratic welfare state “third ways” do not work. They sap individual incentive, initiative, and creativity and ultimately cannot deliver sufficiently rising standards of living to meet the expectations of their citizens for better material lives for themselves and their progeny. Episodic economic downturns or other perceived market failures create great opportunity for misplaced permanent expansion of government’s role in the economy.
The recent financial crises in Asia and Russia have little to do with the shortcomings of capitalism—and a lot to do with foolish financial decisions.
Clearly, we have learned that government has a number of important roles to play in our economy and that we must remain vigilant to make sure that it plays only those necessary roles in the least intrusive manner possible. A consistent rules-based monetary policy, the lowest possible level and rates of taxation, less command and control in favor of more flexible market-oriented incentive regulation, slower growth of government spending (including entitlement reform), and expanded open rules–based trade are surely the lessons of economic history.
The calls for capital controls, greatly expanded taxes and spending, vast new regulation, extensive industrial policy, and dangerous protectionism threaten our economic progress and personal liberty. Such calls by pundits and decriers of capitalism are frequent and occasionally frenetic, both inside and outside the economics profession. Of course, as economies evolve and conditions change (e.g., due to changing demography), the role of government based on sound market principles may reasonably ebb and flow. But capitalism once again needs its defenders, teachers, exemplars, and champions. The alternative models have proven historically, intellectually, and practically bankrupt. We would all be better off if the decriers of capitalism remained permanently discontented.