Theory of Capitalism

Capitalism is a system of largely private ownership that is open to new ideas, new firms and new owners—in short, to new capital. Capitalism’s rationale to proponents and critics alike has long been recognized to be its dynamism, that is, its innovations and, more subtly, its selectiveness in the innovations it tries out. At the same time, capitalism is also known for its tendency to generate instability, often associated with the existence of financial crises, job insecurity and failures to include the disadvantaged.  

There are basic questions about capitalism that have hardly begun to be studied.  What economic and social institutions engender innovation in the more capitalist of today’s advanced economies, and what institutions function badly in this regard?  How large are the benefits of this system both in productivity and more broadly in the rewards to its participants? How much worse (if at all) is this system with respect to stability and inclusion - compared with corporatist systems found in continental western Europe and east Asia?  What changes or additions to those institutions and policies could be hoped to improve its dynamism, stability or inclusiveness?  Are capitalists systems more or less prone to financial crises than corporate ones? The mandate of Columbia’s Center on Capitalism and Society is to advance our scholarly understanding of capitalism’s workings, its social benefits and costs, and its place in a democracy.

The Debate Over Capitalism

The claims for capitalism differ from the classical case for a competitive market economy.  Adam Smith’s thesis two centuries ago was that the presence of many buyers and many sellers competing with one another in the marketplace would weed out wasteful resource allocations “as if by an invisible hand.” (So, in equilibrium conditions, one person’s earnings could not be further increased except at the expense of another’s.)  This valuable ability of unimpeded markets could not be matched by a central government bureau, as Ludwig von Mises warned the socialists in the 1920s.  But Smith’s insights left it unclear how or whether economic change might be generated. Would competition among firms suffice to generate change, with or without private ownership?

A few central European economies twice became laboratories in recent decades for testing competition without private ownership.  From the late 1960s to the late 1980s they allowed each state-owned firm to set their own prices, outputs, wages and workforce in competition with the others.  Whether or not efficiency improved, it was clear that economic dynamism did not ensue. It was said in defense of these state firms that their managers’ plans for them were often blocked by the state and that the managers knew they could get their losses covered by the state so they didn’t need to take chances.  In the 1990s, the state firms were put on their own. This time, with their backs to the wall, they began innovating like mad, hoping that with luck it would be their ticket to survival. But these state firms were not able to innovate successfully.1  Competition, it appears, is not sufficient for economic dynamism.

More recently, it has come to be argued that the corporatist economies of east Asia, which had achieved wonders when there was a yawning gap with the West, ran into trouble in the 1990s because state intervention in the corporate sector through permissions, subsidies and guarantees led ultimately to mass overinvestment and insolvency.2  On this thesis, private ownership is not sufficient for dynamism either:  capitalism, in which capital is free to go in new directions without a green light from the state, becomes necessary at some point in economic development if dynamism is to continue.

How does capitalism do it? The mechanism of capitalism’s economic advances became the leading object of economic research early in the twentieth century and remained so for decades.  With the upheavals of the late 19th century still in their thoughts, the German School, led by Arthur Spiethoff and Gustav Cassel, linked innovations to technological developments and the opening up of overseas markets and materials.3  A new discovery creates new outlets for investment. The investments made “express the zeal of employers to profit by meeting the increased demand of the community for fixed capital.” This made macroeconomic sense of big waves of innovation: they are exogenous and markets react constructively to them.5  But it failed to identify the institutions crucial to fostering early and decisive responsiveness to the newly arrived opportunity. And it did not provide an economics of innovations in normal times, when capitalism has to generate endogenous innovations, if there are to be any at all.

A decade later, Joseph Schumpeter arrived with a new perspective. Innovations are normally the creation of business people, he said, and do not spring reliably or quickly from recent inventions by scientists and engineers. Furthermore, innovations “are as a rule new firms.”6  Thus the agent of change was the entrepreneur who, hitting upon the prospective profitability of some unnoticed commercial application, sought to start up an enterprise to implement the innovative idea. Banks—the venture capitalists of that era—selected which investment projects of these entrepreneurs to finance. The start-ups that met success inspired other entrepreneurs and together caused the “creative destruction” of various established enterprises. However, this mechanism of Schumpeter, for which he became renowned, is not consonant in an important respect with subsequent understanding of the essential nature of innovative ideas, and it doesn’t apply to a large sector of capitalist economies in the present age.

The essence of capitalism’s innovations was uncovered by European theorists in the interwar period. Friedrich Hayek saw it as a core feature that, under capitalism, entrepreneurs are self-selected, aided by their particular experience and driven by their distinctive visions. For this reason capitalism will generally draw on richer experience and wider knowledge than any one central planner could draw on.7  John Maynard Keynes added that entrepreneurs (and others) may also have opposing notions about the macro forces and mechanisms in the economy, which complicates predicting their investment activity.8  Lastly, Michael Polanyi argued that entrepreneurs, like discoverers generally, take creative leaps and invariably these leaps involve some “tacit” or “personal” knowledge, which is outside of objectively recognized knowledge and which goes beyond what can be communicated in explicit terms.9  For this reason; a state investment bank would not be well-suited to select among entrepreneurs’ projects: being accountable to the central government for its mistakes, it would avoid all the very innovative proposals because of the ambiguity of the evidence for them and thus the uncertainty of their profitability. This modern view of capitalism, however, poses a difficulty for Schumpeter’s model as well.  In supposing that lenders and investors selecting among entrepreneurs’ projects were capable of discerning the talent of every entrepreneur and the worth of very project, Schumpeter was attributing information and knowledge to financiers that is incongruent with the modern view of entrepreneurs’ ideas.  In reality, financiers must also act on intuition, taking an initial and limited chance on an applicant in spite of the ambiguity of the evidence. Since an innovative project is in part inherently difficult to articulate, the success of bankers and venture capitalists in selecting among them hinges not so much on their knowledge of the project as on their ability to enter into a sequential and provisional relationship with the entrepreneur that leaves the latter leeway to experiment and prove himself.10 

The other shortcoming of Schumpeter’s mechanism is that, in centering on the entry of start-up firms, it does not encompass the innovations that come from the sector of established firms. The innovation is there: the heavy research and development expenditure in the sector of established firms is circumstantial evidence that many large firms are oriented toward innovation.11  Besides, we have the direct evidence of radical innovations made by established firms—from Bang & Olufson’s designs to Sony’s Walkman to the Swatch to Bert Claeys’ rethinking of cinemas. But the entrepreneurship differs: in contrast to Schumpeter’s theory, the big corporations do not usually have a principal lender or core investor and even the entrepreneur can barely be identified, if at all. In this sophisticated sector, other institutional mechanisms are evidently at work but their functioning is not well understood and their effectiveness is not yet estimated with much confidence.The thesis of Amar Bhidé is that small firms have a role in innovation since they can better tolerate ambiguity while large firms have a role since they can better manage and finance projects with high capital costs.12  The specialization between the start-up and the established firms, and also the possible interplay between the small-firm sector and the large-firm sector, are obviously areas ripe for further research.

Thus the system of innovation is the great “black box” in research on capitalism and it will be the most central of the Center’s interests. Yet innovation is not the only aspect of capitalism on which there is not yet much fundamental understanding. The influence of capitalism on fluctuations is not addressed in standard monetary macroeconomics or in the “real business cycle” literature.  It is obvious that jobs are far more precarious in the relatively capitalist economies than in the corporatist ones, where governments try to avoid any rocking of the boat and to backstop with assorted job protection laws.  

Capitalism’s proponents respond that the right both to hire and to fire freely helps to embolden firms to take the risks of job creation and thereby raises the average level of wages and perhaps employment too. However, capitalism appears to exhibit long swings in economic activity, as measured by employment and unemployment rates, of far wider amplitude than those detectable in the more corporatist economies. Here too a reply is conceivable. It may be that when contractionary forces strike, the prompt restructuring that firms in the relatively capitalist economy are generally permitted to do actually dampens the size of the slump that follow, while the rigid posture maintained by firms in the relatively corporatist economies, with their strictures against layoffs, entails a much deeper and longer slump. Another of the fluctuation issues is the justice of regarding long booms as no better than long slumps. A more radical position raises questions about the justification for blocking or moderating long slumps, provided they are purely or mainly structural rather than the result of monetary malfunctioning.13  The subject of long swings is only now beginning to enjoy a revival of attention in the economic literature, and there is much to be done in this area.

The last of the great questions about capitalism is whether it is best only for the elite of more able and advantaged participants, who can find rich rewards from its stimulation and challenges, or whether ways can be found to integrate the less able and less advantaged into capitalism’s sphere.  This is the question of economic inclusion.  Quite possibly, there is little cost from a failure of highly corporatized or highly socialized economies to include the less advantaged; in those economies a low rate of inclusion is often deemed acceptable and, in some of them, only a minority of the population are in the labor force.  Far more may be at stake in the inclusion of the less advantaged where the business sector is predominantly capitalist.  If these capitalist business sectors offer relatively good job satisfaction and personal growth on the whole or offer relatively high wages in comparison with the pay in underground and domestic activities, then an appreciable deficiency in inclusion arising from a wide gap between low-end wage rates and the median wage, with the consequent demoralization and decline of employability, may be deemed unacceptable and may impose high social costs on virtually everyone.14 

Even more difficult than the task of measuring these social effects of capitalism is the problem of finding solutions to them, if solutions exist. And that problem is now more difficult since the West has grown aware of how fortunate it was to have had the capitalist engine driving its development over the past two centuries and how valuable this engine can be again.  So the West is faced with a conundrum: How does society respond to the social defects and deficiencies of capitalism without choking off capitalism’s potential dynamism? Among the issues are whether retraining can address job losses, whether long booms are to be treated, and whether employment subsidies are cost-effective as a remedy for a deficiency in inclusion.

1Roman Frydman, Gray, Cheryl, Hessel, Marek and Andrzej Rapaczynski, "When Does Privatization Work? The Impact of Private Ownership on Corporate Performance in Transition Economies," The Quarterly Journal of Economics 1999; and Roman Frydman, Hessel, Marek and Andrzej Rapaczynski, “Why Ownership Matters? Entrepreneurship and the Restructuring of Enterprises in Central Europe,” in Fox, M. and M. Heller (eds.), Corporate Governance Lessons from Transition Economies, Princeton University Press, 2006.

2This is the hypothesis in Edmund Phelps, “Lessons from the Corporatist Crisis in Some Asian Nations,” Journal of Policy Modeling, March 1999, given at the Roundtable of the East Asian Crisis, American Economic Association meetings, New York, January 4, 1999.  The other hypothesis is the volatility of financial flows.

3Arthur Spiethoff, Jahrbuch für Gesetzgebung, Verwaltung und Volkswitchaft, 1903. Alvin Hansen marvelously surveys this era of economic thought in his Business Cycles and National Income, W. W. Norton, New York, 1951.

4Gustav Cassel, Theory of the Social Economy, trans. 1918 edn., Harcourt, Brace and World, NY, 1924, p. 622.

5Edmund Phelps and Gylfi Zoega build on Cassel in ‘Structural booms,’ Economic Policy, 32, April 2001.

6Joseph A. Schumpeter, Theory of Economic Development (1911), Harvard University Press, Cambridge, Mass., 1932, quoted p. 66, and “Die Wellenbewegung des Wirtschaftslebens,” Archiv für Sozialwissenschaft, 1914, 1-32.

7A standard citation is Hayek’s “The Use of Knowledge in Society,” American Economic Review, 35, 519-530, 1945.

8John Maynard Keynes, The General Theory of Employment, Interest and Money, Macmillan, London, 1936.

9Michael Polanyi, Personal Knowledge, Chicago, University of Chicago Press, 1962.

10Richard Nelson and others saw the importance of sequential decisions in the 1960s.

11Schumpeter himself recognized this in his Capitalism, Socialism and Democracy, Harper, New York, 1942.

12Amar Bhidé, The Origin and Evolution of New Business, Oxford, Oxford University Press, 1999.

13These questions are briefly discussed in Edmund Phelps and Gylfi Zoega, ‘Structural booms,’ Economic Policy, 32, April 2001, especially pp. 110-114.

14A useful reference is Edmund S. Phelps, Rewarding Work: How to Restore Participation and Self-Support to Free Enterprise, Harvard University Press, Cambridge, Mass., 1997.