Tuesday, 31 January 2012

Notes on Capitalism for those without an Economics background (very long)

As long as I can remember (and much longer still) there have always been those who have repeated that most venerable of arguments: Capitalism will surely destroy itself. And sure enough it has, many times, only to startle its critics by rising phoenix-like, each time fresh-faced and re-invented with some change of regulation or modification to the status quo and a promise of “never again”. A new state of play but the same old game.

To most of us, it would be nice if capitalism would simply define itself. After all, the lines between capitalism and socialism, and socialism and communism all blur if seen from the right perspective (or side of the Atlantic). So what is capitalism, and how can we reform it?

There isn’t a single form of capitalism of course, and in conversation we constantly hear it conflated with ‘markets’, privatisation and the profit motive. This essay will strive to set out some basic, hopefully accessible definitions and descriptions which are universal across the capitalist systems of the west, and to examine in brief what it means to ‘reform capitalism’.

The Capital Idea

A good starting point is capital itself. Capital comes in many forms, and can be divided into potentially limitless categories, but the basic meaning is some productive value capable of producing or constituting wealth. Human capital includes personal skills and aptitudes, while physical capital usually refers to machinery, technology and so on. There’s also capital in intellectual property, social arrangements, roads and sewers and so on.

The total stock of capital a country has is a good indication of its wealth and future prospects, but not all capital is equal. If an earthquake destroyed all our factories tomorrow we might rebuild in time, if we lost all our accumulated knowledge from the past two thousand years, it might take considerably longer. In fact science, engineering and information play a unique and critical role in determining national wealth and potential, as they provide the ceiling above which a country cannot develop, and information is readily transmitted.

Consequently countries which lack vast human and physical capital can rapidly catch up to more advanced countries because they don’t need to go through the same process of scientific discovery and invention, though they still do need to take a long time to develop the skills, knowledge, institutions and infrastructure to rival advanced countries. For this reason, countries like China and India can grow more rapidly than the UK or US because they started from a lower base, but are catching up swiftly. We would not expect this growth to continue indefinitely.

Productive Assets

Growth itself is growth in GDP, and GDP is a measure of the total production in a country in a given year. Production is a function of capital; everything from new farming techniques to better training to more advanced machinery can increase productivity, and increased productivity means a lower unit cost for each ‘thing’ produced. Imagine this in terms of a farm, if you were able to produce more from the land via any of these methods, be it a combine harvester or crop rotation, you could produce more food from the same workforce.

Alternatively you could produce the same food from fewer workers. And that’s precisely what has happened across history, we’ve moved from a majority of humans working to feed themselves, to a percent or two in most countries. This increase in production leaves those workers unemployed, but they remain capable of production, and soon enough will produce some other desired good, be it a luxury like jewelry, or perhaps clothes, horseshoes and so on.

This is also why it’s possible for rich countries to produce more cars, computers or candles despite a smaller portion of the population doing those jobs. We can’t necessarily do the same for comedies though, at least until computers write the jokes. This contains a serious point, of course, some things are pretty much strictly the result of human endeavour. We can, however digitally distribute the fruits of this intellectual labour for an incredibly low distribution cost, and that’s a whole other set of problems.

In Demand

Economics is often said to be the science of satisfying infinite desires with finite resources, and this is lent a new reality in the information age by the capacity of the internet to take performances which only a few dozen people might normally see, and transmit them to millions over Youtube within hours or days. So is there an infinite demand for such performances?

For simplicity’s sake we can divide demand into two types: Expressed demand, and subjective demand, or external and internal if you like. Expressed demand is the stuff of supply and demand curves seen in economics, it relates to both the relative desire for some good or service, and the capacity to pay for it balanced against its price.

Demand is like a Russian doll, though, even when you demand a single object, like a car, you are really expressing a bundle of different preferences. You might want a red car, a car with a certain type of engine, and so on. Inevitably you will have to decide which preferences matter more to you, and compromise on which car you ultimately choose to buy, and this expression is in that sense impure, but weighted. The fact you bought a blue car registers within the market as demand for blue cars, even though in reality you preferred Red.

And each of us has many competing demands, and limited money. We are constantly weighing up one thing against another in our minds, and in Economics the act of weighing a purchase against the next best thing is referred to as the opportunity cost. If you buy two Mars bars for 50p each, you forgo the opportunity to buy a bottle of lucozade for £1 (your prices may vary).

Finally, when we come to our purchase we interface directly with the price. If the price of Mars bars goes up but the price of Lucozade stays the same, this may change our decision. In this way an increase in price will lower our expressed demand for that specific thing.

A Market for Everything

And so we come to markets. Markets are a strange thing, at once natural and inevitable, and yet simultaneously contrived by social convention. It is possible for a society to operate without ownership laws and rules, though it is not common, and virtually nonexistent in the modern world. Certainly the rules by which markets operate differ enormously from country to country, and even the mechanisms by which they operate can differ.

Even so, markets are fundamentally ‘emergent’ systems, they have no independent existence, there is no ‘market’, rather the market is just a way of understanding the self-organising properties of economic systems. This is worth exploring for a moment.

For any good there is of course a supply and a demand. If the supply of a good exceeds the demand at a given price, suppliers will tend to discount the goods in order to sell the excess. Similarly, if the demand exceeds supply buyers will compete for the scarce supply of goods, and in the process those who value the goods the most will opt to pay more in order to secure them. In this way, we can say that the market for a good exhibits a negative feedback-- that is to say, it opposes the direction of change from a given homeostatic point, which we call the equilibrium.

The equilibrium is nothing more or less than the price at which supply and demand are equal. This works because goods of a certain type will be more or less fungible, operating as close substitutes for each other. A barrel of oil, or a bag of sugar of a certain type from one source, is just as good as one from another source. This fact puts buyers and sellers in competition with one another, because if my price is too high, you can just as easily go to someone else.

This is a ‘competitive’ market framework, a theoretical system in which there are millions of buyers and sellers, and no individual is able to set the price. Rather the price ‘emerges’ from the interactions of all buyers, and all sellers. And this is the market.

An Embarrassment of Efficiency

In reality markets are far more complex. Free markets are never truly free, for without fierce regulation corporations and cartels swiftly concentrate power, the costs of ‘entry’ to the market rise, and information costs are ruthlessly exploited. Information costs are the cost of learning what you need to know to navigate the system, get the best price for a good, etc.

Similarly markets operate on the basis of the doctrine of ‘privity of contract’ (mostly), meaning that prices are set on the basis of transactions between buyer and seller only. This leaves so-called externalities unaccounted for in the price level. For example, a young person’s education does not only benefit them, it also benefits wider society, and the pollution generated by industry may be cheaper for them, but costly to the local community (or indeed the planet). These costs and benefits apply to society as a whole, and are not part of the transaction, which produces inefficient results.

Likewise markets can sometimes produce positive feedbacks, and this can be seen in speculative activity, where the direction of market movements is driven by the direction of market movements. This produces S-wave bubbles which are mediated primarily by State action via monetary and fiscal policy.

Even when markets work perfectly, the production is not always ‘good’. There is such a thing as both good, bad and indifferent GDP in various degrees. An easy example is that of US healthcare, which costs perhaps twice as much as a proportion of GDP as many other western nations, and delivers worse outcomes. Certainly a lot of production is going on, but is it beneficial?

It is as a rule always beneficial, on the other hand, to maintain the highest productivity possible. So-called “bad GDP” is not a cause for reducing GDP, simply for re-aligning it, so that everyone is able to be productive towards a socially beneficial goal, rather than a less beneficial goal. After all, production means taking less percentage GDP to achieve the same goal, as well as higher overall GDP. It also does not mean being environmentally unfriendly, as productivity gains can mean achieving more for fewer inputs.

In this respect, green technology offers enormous potential productivity gains by reducing both the externalities of pollution, and the costs derived from increasingly scarce hydrocarbon fuels.

Markets are themselves neither good nor evil, they are simply natural mechanisms by which our activities regulate themselves in large communities. It’s not unlike evolution in this sense, and the comparison has often been made, though just as with evolution, it is not survival of the fittest-- a term Darwin never used--, merely survival of the best adapted and best placed. Cooperation is just as valuable to survival as individual merit.

In fact the synergies that come with cooperation are also a reason that pooling resources can greatly increase productivity. To take a simple example, imagine a school employs three janitors. One each working eight of the twenty four hours in a day. As they don’t work at the same times, they could share a common set of equipment, they could co-ordinate on what to do, and they could share any special knowledge gained. Or they could all bring their own equipment and learn their own lessons, and do the same job twice for lack of information.

For this reason monopolies and concentrations of economic power can actually be very good for society. It varies depending on the context, but there is no single rule that can be applied to everything. Quite often you want the greatest competition possible and the greatest plurality of firms with the lowest entry costs to the market.

Structures, Institutions and the State

Speaking of synergies and concentrations of power, I mentioned earlier that social, infrastructural and institutional capital are significant factors in the wealth of nations didn’t I? Of course they are, and some of the reasons are more obvious than others.

A good transport network is necessary to get people and goods from A to B, an education system is needed to maintain a steady supply of well educated workers, a consistent legal framework ensures a predictable future, law and order reduces the threat of crime and provides remedies, and a lack of corruption means no bribes, no power plays by your rivals to drive you out of business by political means, and so on.

There are also more subtle aspects, such as cultural norms, work-ethic, even the philosophical disposition of the citizens towards believing they can control their destines, seems to have a connection to the outcomes. The behaviour of corporations, educational institutions and the state can all vary without any difference in the law, as well. A friendly, mutually beneficial relationship between industry and education is indeed mutually beneficial, and by no means automatic or universal. It requires work, and this is precisely what leads major political parties to seek to increase apprenticeships and corporate good citizenship.

Cultural and social connections can lower information costs, making it more likely that people with the right skills will be available for and able to find the right jobs to suit them, or that companies with bad track records are punished by consumers. Job searching and careers advice, as well as consumer advice and advocacy all fall under this province.

The State, apart from providing many of the aforementioned institutions and investing in roads and schools, can also intervene to help to build industries, subsidise important but costly projects, and steer the national economy through troubled waters. Sometimes this means intervening in the same problems that were mentioned when discussing markets.

Path dependency is another factor here. Although one of the functions of the market is pluralism, and to ensure risks and entrepreneurialism, sometimes the start-up costs are simply too high. Where a market already exists you will find expertise, experience, infrastructure and ties with educational institutions which do not exist elsewhere, and creating all of these overnight is simply impossible. As no single player within a market can produce the environment necessary for the activity to be profitable, it is unlikely to happen without state aid. Once it has happened though, new investments and innovations will reduce the costs until it becomes a larger, more diverse and vibrant industry-- assuming it takes off at all.

These are the risks and the benefits of State cultivation of industry. It can carve out a path for the great currents of industry to flow down, or it can dig a hole for itself. In some areas, such as health, the nature of the problem makes government involvement mandatory, as the profit motive will exclude the most expensive and difficult cases, and tends to under-prioritise preventative care.


Path dependency and hysteresis have particular significance in the area of inequality. Even ignoring all the associated problems with lower educational attainment, social development, exposure to crime, violence, stress and anxiety, if you are poor capitalism undiluted is always harsh to you.

The wealthy have assets to pledge as security for any loans they want to take out, if they feel the need to do so at all. The poor are a greater risk, they have less wealth, less income and fewer prospects, all of which means they will attract higher rates of interest, less help and higher information costs. In fact the poor tend to have less knowledge of how to navigate the systems and institutions of society, less ability to pick through the tariffs and deals on offer in the market and greater exposure to financial stresses and strains.

And of course, those in minimum wage jobs are easily replaced by the millions of others in their position and have little bargaining power for determining wages, whereas there are only ever a handful of people with both experience and the skills required to run a massive corporation, and spending a few million on a single person is a good investment if they run a multi-billion pound company better than the next guy (though it is famously difficult to rate the actual contribution of a CEO vs the contributions of those lower down the chain than them, market movements, and sheer luck).

These disparities stretch into every aspect of life. Economics shapes the geography of affluence as well, with wealthier parents being able to pay more for those houses closer to the best schools, closer to their jobs-- thus allowing them to spend less time at work, and more with their children-- and inevitably, closer to each other. The poor, on the other hand, will inexorably go on to live in the postcodes that suit their tax code.

Real Demands, Real Needs

All of which raises a noteworthy point. I said earlier that those who value a thing more can bid more for it, and in this way economic transactions are supposed to be pareto efficient. That is to say, the people who value things the most end up with them, with both sides of a transaction better off, maximising utility. Clearly our more affluent citizens do not value nice neighbourhoods so much more than our more impoverished denizens, or at least, not in proportion to their bidding power.

Of course the answer is obvious, expressed demand is contingent on affordability. The poor cannot afford to express their demands to the same extent. What we can afford is just the tip of what promises to be titanic-sinking desire, but to what extent are our demands natural? Our ancestors probably didn’t yearn for ipads, or diet pepsi for that matter.

Obviously this area as with all others is immensely complicated, but here are three distilled sources:

1) Demand creates its own demand. Once you try something, you’re far more likely to want it, and if you’re used to something, perhaps you grew up with it, or it has emotional significance to you (I find tea immensely reassuring, personally), you are much more likely to want that thing.

2) Placebo or sugar? The mere association of a brand name with something, like the aforementioned pepsi can be enough to significantly change our subjective experience of it, to the point that a person tasting two identical liquids would enjoy the one in the brand-name container more-- if they like that brand.

In much the same vein, marketing, advertising and branding are used to create initial awareness-- you can’t want something you haven’t even heard of.

3) Social appearances. Keeping up with your peers is a known factor behind the desire to acquire. This is true of all income groups, and therefore, critically, is true despite the fact that in absolute terms relatively poor people today consume vastly more goods than wealthy people from centuries past.

More unequal societies may be unhappier for this reason alone-- the distance between the haves and the have-nots is great, social mobility is low, so the sense of your personal standing within society, and your power to change your own life is commensurably weak. Control and identity are critical factors in stress, anxiety and happiness.


Making no judgments-- or as few as I can manage-- about macroeconomic theory, consumerism, environmentalism and even feminism (does pornography shape demands, and social interactions, what are its negative externalities?), I’ve tried to outline the basic concepts which underly capitalism in the west. Some countries have more interventionist industrial policies, some have stronger social safety nets. Some have more concentrated market power, others are more pluralistic. Ultimately all have relied on markets to a greater or lesser extent, and with varying degrees of regulation and intervention. Pretty much none of them exhibit ‘pure’ capitalism, which almost certainly would destroy itself fairly quickly. Income and wealth inequality vary significantly, as do investment levels, and the degree of research and development each contributes.

Capitalism is not innately efficient. As well as externalities and market failures, its tendency towards inequality severely drains human capital and systemically under-invests in people whose potential may never be known simply because of their background. Ultimately, via debt, it can even produce scenarios where the capacity to express demand of large sections of the system breaks down, producing liquidity crises and demand shocks such as the one we’re experiencing at present, and without state intervention can enter into a cataclysmic freefall, much as it did in the great depression.

This point is somewhat moot however, as capitalism is not innately anything. Capitalism as a term is used to denote certain systems which have conditional, non-absolute but strong property rights, do not employ centrally controlled economies, and which aim to maximise net capital, with the proceeds of capital going to the capital owner to a greater or lesser extent, as controlled by the tax system.

Within that scope there are many ways to run a health care system or the media, to tax, to educate, to structure corporations, to regulate markets.

To reform capitalism three things are required: A goal, an understanding, and a plan. The goal might be to avoid disasters, such as the great depression, stagflation or anthropogenic climate change. It might be to achieve equality, or fairness, or egalitarianism. Maybe you really do just want to achieve efficiency, or maybe you want to empower citizens to fulfill their individual potential. Maybe you want to create a better citizen, encourage more voluntary work, more selfless behaviour.

There are lots of ways to change capitalism. Collectivism, socialism, civic republicanism. Employee owned firms and cooperatives. Changing the structure of corporations, or the role of unions. National service initiatives, incentives for non-profit organisations, even honour systems. And of course, apprenticeships, internships, work experience, job centres.

But it all starts with being clear about where we are, and what we want. Markets are brilliant, wonderful, elegant and utterly human creations, distant cousins of natural selection. The profit motive isn’t everything, nor is competition, but both have their place. And capitalism isn’t a monolith, it’s just that some capital is more equal than others.

No comments:

Post a Comment