How Capitalism Will Save Us Page 2

  The capitalist process, so we have seen, eventually decreases the importance of the function by which the capitalist class lives…. Capitalism creates a critical frame of mind which, after having destroyed the moral authority of so many other institutions, in the end turns against its own; the bourgeois finds to his amazement that the rationalist attitude does not stop at the credentials of kings and popes but goes on to attack private property and the whole scheme of bourgeois values.6

  People also question capitalism because free markets are messy and unpredictable. Jobs are lost (and also created) in ways people don’t expect. Companies like Google and WalMart become large and successful without the permission or anticipation of bureaucrats and experts. People become wealthy who offend the sensibilities of the more cultivated establishment.

  The cultural roots of today’s anger go back thousands of years. In ancient times, people struggling to survive amid disease, famine, and other harsh conditions resented the relative wealth of “money changers.” Christ believed rich people had less chance of going to heaven. These beliefs were not limited to Westerners. In feudal Japan, merchants were regarded as parasites because they dared to make a profit by charging more for the goods they sold than what they had paid for them.

  Economist and scholar Thomas Sowell has written extensively about the universal mistrust of people he calls “middleman minorities” in retail trade or in money lending whose work “takes place somewhere between producers and consumers.”

  Retailing and money-lending have long been regarded by the economically unsophisticated as not “really” adding anything to the economic well-being of a community…Both medieval Europe and the Islamic countries regarded the charging of interest as a sin and, in other societies in Asia and Africa, it was considered morally suspect, even without a religious prohibition against it.7

  Ostracized middleman minorities have included the Jews, Asian immigrants in the United States, the Ibo in Nigeria, and the Parsis in India, among many others. But Sowell says that the prejudices against them were not really based in ethnic hatred.

  An often-cited article by a British economist who was a prisoner of war in Germany during World War II pointed out how middleman economic activities arose spontaneously among the POWs—and how the individuals who engaged in those activities were resented by the other POWs, even though these individuals were not from some middleman minority, but ranged from a Catholic priest to a Sikh.8

  While less hostile, America’s attitude toward its merchant class has long been ambivalent, dating back to the political rivalry of Founding Fathers Alexander Hamilton and Thomas Jefferson. A plantation owner and believer in the agrarian model, Jefferson distrusted cities and commerce. He envisioned a more socially stratified, agrarian society. Hamilton, by contrast, believed in an America based on vibrant commerce, where people, regardless of their birth, would have a chance to move ahead economically.

  Their opposing visions partitioned the nation’s soul: America became a country based on capitalist principles and free markets, where some of its most successful entrepreneurs are nonetheless considered “robber barons.” And corporations are seen as mechanistic oppressors of the human spirit.

  But there’s more to today’s rage than cultural ambivalence. The truth is that a surprising number of people simply don’t understand how our economy works. Despite America’s preeminence as the world’s foremost innovator and wealth creator—whose economy is the envy of other nations—many of us are remarkably uninformed about the system that produced our prosperity.

  Little wonder economics is referred to as the “dismal science.” “Dismal” describes how it is taught in most classrooms—a jumble of bloodless equations and technical terms like frictional unemployment, GDP, and income elasticity of demand. It’s difficult to imagine that these subjects have any relation to the lives of real people.

  According to a 2007 study by the National Council on Economic Education, just seventeen states require students to take an economics course.

  Many Americans have had no formal instruction in the economic principles that govern everything from the price of milk to the interest rate on your home mortgage to where you are most likely to find employment. Research has shown that in “test after test,” more than 60 percent of the nation’s high school seniors were unable to define the word profit. Only half of all college seniors could define inflation, productivity, and fiscal policy.9

  Several years ago the Washington Post, the Henry J. Kaiser Foundation, and the Harvard University Survey Project compared the views of more than 1,500 average Americans with those of 250 economists on various economic matters. George Mason economics professor Bryan Caplan reported that average citizens surveyed were far more prone than economists to emotional, negative perceptions and “anti-market bias.”10

  In other words, the less people know about how the economy works, the more likely they are to take the darkest possible view of free markets.

  This book will answer classic questions about democratic capitalism, addressing the central contentions that are a part of capitalism’s bad Rap—that cause people to distrust or dislike free markets. Using examples from recent events, we illuminate what we call Real World Economics, the principles of how markets work, highlighting Real World Lessons that people all too often miss about democratic capitalism—that help explain where we are today.

  We’ve written this book as an informal conversation, the kind of discussion of hot-button topics that you might have at the dinner table or in the classroom. The first chapter asks the question, is capitalism moral?

  Fundamental to the Rap on capitalism is the insidious notion that freemarket transactions are based on “greed,” where one party “exploits” the other. The reality is quite the opposite: capitalism is based on trust.

  Transactions in free markets are about achieving the greatest possible advantage—but that advantage must be mutual. To cite the classic example from eighteenth-century economist and philosopher Adam Smith, the baker or the butcher sells you food in exchange for your money. True, as Smith points out, this relationship is based on self-interest. They provide your dinner because they seek your money. However, for a transaction to occur, each side must benefit. The deal they strike may not necessarily be the one originally envisioned by both parties—but it is nonetheless the one of greatest mutual benefit based on the realities of supply and demand. As the late freemarket economist Murray N. Rothbard once wrote,

  Both parties undertake the exchange because each expects to gain from it. Also, each will repeat the exchange next time (or refuse to) because his expectation has proved correct (or incorrect) in the recent past. Trade, or exchange, is engaged in precisely because both parties benefit; if they did not expect to gain, they would not agree to the exchange.11

  Smith’s description of what takes place in a market, Rothbard wrote, supplanted antiquated notions held by mercantilists of sixteenth-to eighteenth-century Europe, who argued that “in any trade, one party can benefit only at the expense of the other, that in every transaction there is a winner and a loser, an ‘exploiter’ and an ‘exploited.’ ” After all, a trade does not take place if it is a zero-sum game where only one person gains.

  A freemarket economy is a latticework of these mutually beneficial exchanges. Together they form what Adam Smith referred to as “the invisible hand,” directing resources to where they are most needed.

  How does this take place? That’s the miracle of the free market—it just does. Free markets are spontaneous. No central planner or bureaucrat is needed to determine the needs of others—or how they must be met.

  The classic illustration of how the invisible hand mobilizes people and resources is found in the children’s story I, Pencil, written by Leonard Read and cited by the late Milton Friedman and other freemarket economists. The pencil narrates the story of how it came to be. It started out as a tree—“a cedar of straight grain that grows in Northern California and Oregon.” The pencil goes on t
o describe the countless people and processes involved in its production—from cutting and transporting logs to supplying electrical power to mining graphite and extracting the rapeseed oil from the Dutch East Indies that goes into making erasers.

  Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. … Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: Each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.

  There is a fact still more astounding: the absence of a master mind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we find the Invisible Hand at work.12

  This is how wealth is produced in society: countless individuals seek to meet their own needs by meeting the needs of others. Forming networks of cooperation, they create businesses that produce innovations—not only the pencil, but inventions from laptops to washing machines. In the process of providing for themselves, people generate the capital and innovations that yield economic growth, improving living standards and enabling society to advance.

  Those who buy into capitalism’s bad Rap, who believe free markets are based on “exploitation” and “greed,” fail to appreciate how the invisible hand works. People in a free market are mobilized not by greed but by self-interest. As we will discuss in chapter 1, there’s a big difference between the two.

  Greed means taking what does not belong to you or simply taking too much of something. Texas mom Catherine “K.K.” Patton was motivated by anything but greed when she set out to find a way to minimize the unpleasantness of daily insulin injections for diabetes patients. She perceived a need and a potential market. Patton was mobilized by more than the prospect of financial gain: she herself was a diabetes patient who hated the sticks and bruising of daily needles. Her “self-interest”—both financial and personal—propelled her to invent the i-port injection port, a device worn by patients that reduces the pain of injections. Users inject insulin into a little disk implanted in their skin that delivers medication into their bodies. Recently approved by the FDA, the invention is beginning to catch on with a growing number of diabetes patients.

  Steve Chen, Chad Hurley, and Jawed Karim, three young employees of PayPal, were also motivated to fill a need based on self-interest. They wanted to share their home videos over the Internet. In 2005 the three founded YouTube, which virtually overnight became one of the Internet’s biggest success stories, sold to Google after only one year for $1.65 billion. YouTube, of course, has gone far beyond meeting the simple need for which it was invented. It took the Internet revolution one step further, bringing the Web closer to television in its ability to deliver video content. Countless Web sites, including those of major news organizations, now use YouTube to deliver not only taped but live webcasts.

  That’s how growth occurs in a freemarket economy. No one “orders” it to take place. It happens spontaneously, almost by accident. But it always happens. That’s what people who buy into capitalism’s bad rap don’t get. When there is a need, entrepreneurs will step in to fill it, appearing seemingly out of nowhere.

  Take, for example, what happened in the mid-1980s, after budget cuts forced the U.S. Coast Guard to scale back some services. The guard could no longer provide nonemergency marine assistance to recreational boaters. Almost immediately, small entrepreneurs took up the slack. In Southold, New York, Joseph J. Frohnhoefer founded Sea Tow, an AAA for boats. His small business grew from a single vessel into a thriving franchise network with 121 locations in the United States, Asia, Europe, the Bahamas, and Puerto Rico.

  Before Frohnhoefer and other entrepreneurs appeared, government was thought to be “needed” to assure nonemergency boater safety. But Frohnhoefer’s private-sector business filled the need for this service as well as, if not better than, government. Frohnhoefer is called on by the Coast Guard to assist in finding lost boaters and major emergencies; his operation aided in the recovery of victims of the crash of TWA Flight 800. But his business is more than a private version of the Coast Guard. It offers a variety of other services such as boat financing and insurance.

  Of course, there will be criminals and greedy individuals in a freemarket economy. That is where government is critical to a free market—to enforce contracts, protect property rights, and maintain order, as it does in the rest of society.

  However, most of the time, democratic capitalism’s self-interest compels people to act responsibly and predictably, to work together in networks of cooperation based on trust. After all, it is in people’s self-interest to act reliably if they want to succeed in the marketplace.

  These roots in a voluntary, open market are what make democratic capitalism more moral than a statedominated economy—even if the staterun economy is a democracy. Why? Because state-imposed economic solutions reflect the interests of a group of bureaucrats or politicians who are currently in power.

  You may happen to agree with those government solutions. And the designers of those solutions may have good intentions. But when you get down to it, their ideas reflect the wishes and interests of a relative few more than they reflect the broad-based needs of people.

  REAL WORLD LESSON

  Markets are people voting with their money.

  In many ways, a market is an ecosystem. There is no way to know all the forces and factors that propel it forward. Just as no one person can fully fathom all the people and processes that go into making a pencil, no one individual—including the smartest policy wonks and bureaucrats—can have complete knowledge of why a market for any product works as it does.

  We are not the first to point out that if government were charged with creating a pencil, bureaucrats at the Department of Pencils would probably order up too many logs in order to please their lumber-industry constituents. (Or they might order too few because of demands from environmentalists.) The graphite miners would be overpaid as a result of political pressures. People involved in the manufacture of pencils would have to comply with an assortment of government rules and regulations, some sensible but many arbitrary. They’d have to spend hours filling out forms to show compliance. Costs would spiral out of control, as they do on so many government projects. Pencils would be priced to reflect those spiraling costs. No one would be able to afford them. You’d have a surplus. Or maybe pencils would be priced too low by the Department of Pencils. Demand would be excessive and there’d be a shortage.13

  As this book will show, efforts by politicians to manage markets have consistently produced similar consequences. You see this in the government-dominated economies of nations such as Venezuela, North Korea, Cuba, and, years ago, the Soviet Union—as well as in heavily regulated sectors of our own economy, such as health care. Bureaucrats and politicians don’t realize that the market has already allocated resources in the most broadly beneficial way possible, based on existing conditions of supply and demand. Thus, their attempts to make markets work according to how people think they should work generally never succeed.

  Hugo Chávez, the increasingly dictatorial president of Venezuela, a socialist and ardent believer in the Rap, imposed price controls on hundreds of goods to make food and other essentials more affordable for low-income people—an admirable goal and one that has endeared him to some critics of capitalism in the United States. But what he didn’t understand is that the price of a product reflects the costs of the countless transactions and processes required to make it. The prices that he imposed may have pleased his political constituencies and won him votes, but they did not reflect the Real World costs of making those products. As a result, they threw the markets for these products, and his nation’s economy, out of whack.

  The on
ly place where many food staples can be obtained in Venezuela today is on the black market—where they are now many times more expensive than before price controls. That’s typical of the economic solutions devised by people who dislike free markets. They almost never remedy perceived problems or, to use the economists’ lingo, the “market failure” they were supposed to correct. Instead they create even worse market failure.

  A friend who emigrated from Bulgaria to the United States recently described government-controlled health care in his former country: “Health care is free,” he said. “But you can’t get it.”

  As we will see throughout this book, government intervention rarely solves economic problems, because it politicizes them. The solutions it imposes to promote fairness are designed primarily to satisfy the desires of those in power, not the Real World needs of people in a market.

  What could be a better illustration of this than the Detroit bailout and government’s takeover of GM? We discuss in chapter 2 that GM would probably have been able to cut its staggering labor costs and plot out a recovery strategy had the Obama administration allowed the market to work; GM would have taken the usual route and restructured in bankruptcy court. But with the government taking control, GM has been prevented from making the kind of tough Real World decisions needed to bring about a true turnaround.

  Wall Street Journal columnist Holman W. Jenkins Jr. wrote in the spring of 2009 that the true priority of GM’s new government-appointed CEO, Ed Whitacre, was not the needs of the marketplace but “first and foremost, making sense of GM’s relationship with Washington.” Whitacre’s decisions are likely to be driven not by what will succeed with customers but by what will please his political bosses, as well as the people who they need to please, the labor unions.