How Capitalism Will Save Us Read online

  Most of the transactions that take place every day in free markets are actually based on the opposite of greed: millions of people exchange goods and services in mutually beneficial transactions based on verbal promises or written agreements, cooperating with one another in “webs of trust.”

  We rely on this trust each day: The knowledge that the overwhelming majority of customers will pay. Or that we will get a paycheck from our employer every two weeks. Or that the dry cleaners will return our clothing cleaner than it was before. Without this kind of reliability and predictability, our economy couldn’t function.

  A prime example of capitalism’s “web of trust”: the auction site eBay, where customers buy and sell to one another anonymously, based on little more than a thumbnail product profile, a seller rating, and a credit card number.

  EBay’s sellers and buyers are not always honest. But most often they are. Without this expectation of reliability there could be no commerce. People would not be able to buy, sell, and create wealth—not only on eBay, but in any market.8

  Trust, not greed, was the reason that so many people were duped by Bernard Madoff. Few could anticipate his over-the-top villainy because such a willful violation of the rules is relatively rare. Madoff’s annual returns to clients also appeared reasonable.

  The idea that capitalism is based on greed is belied when taking a closer look at the great fortunes of the people on the Forbes 400 list of wealthiest Americans. Number 33 on the 2008 list, Jeff Bezos, founded the hugely successful Internet bookstore Amazon.com, which has since become an online megastore selling virtually anything. He built his $8.7 billion fortune not because of greed, but because he correctly saw the potential of emerging Internet technology to do a better job selling books than bricks-and-mortar retailers.

  And what about Oprah Winfrey (number 155 in 2008, with a net worth of $2.7 billion)? Her story is well-known: born in Mississippi, she rose to become a TV talk show host, actress, producer, publisher, and owner of a media empire. Her productions and publications promote positive values of self-improvement. She has also built her fortune by bringing wealth to others, launching the media careers of personalities like Dr. Phil and Rachael Ray. As if all of this were not enough, she has donated millions to charity, including starting a school for girls in South Africa.

  Henry Hillman (number 134 in 2008, with a net worth of $3 billion) was not self-made. He inherited his family’s steel fortune. But he, too, has been anything but greedy. He has invested in real estate, medical technology, and other high-tech companies. Hillman has been one of Pittsburgh’s most active philanthropists—a heavy supporter of medical and computer research. He has given some $20 million to cancer research and recently gave $10 million for a new computer science research building at Carnegie Mellon University.

  Number 68 on Forbes’ 2007 list was James Sorenson. The inventor, who passed away a year later at age 86, made a $4.5 billion fortune from medical devices, including a patented plastic catheter and a disposable surgical mask. Sorenson had more money than he could ever spend and nothing to prove. Yet he started another new venture, Sorenson Forensics, in 2006, shortly before his death. The company’s genome-based technologies have helped solve cold-case murder mysteries. Asked why he risked his capital so late in life to start yet another new business, the habitual entrepreneur replied, “It soothes the soul to help people.”

  John Drummond isn’t on the Forbes 400 list. His business, Unicycle.com, started out as a hobby. Drummond discovered that the unicycling he’d loved as a child could help him take off weight.

  Yes, Drummond had a self-interested reason for building his business—he had been laid off by IBM and needed a job. But he also wanted the sense of personal fulfillment that comes from bringing something good to others. Drummond felt that people would enjoy unicycling and appreciate its unique, if quirky, value as a fitness workout. He succeeded because he was an innovator: he made a hard-to-find product more easily available over the Internet.

  Today Drummond’s business has franchises in eight countries, and he recently started another business, Banjo.com.

  The claim that capitalism is based on greed is often used by politicians to sell solutions to economic problems that are supposed to be more moral—from taxes on windfall profits to government health insurance. These government-imposed remedies are supposed to deliver greater morality and fairness. But as we will show repeatedly in this book, they generally do neither. That’s because political solutions are not developed to serve the Real World needs of people who make up a market but the narrower concerns of those who happen to be in power. They’re frequently less fair, and less moral, than grassroots market solutions.

  If greed is the one-sided taking of what does not belong to you, then what does one call pork-laden stimulus packages and other legislation that channel taxpayer money into things like “low bush blueberry research” and a water taxi service in, yes, Pleasure Beach, Connecticut—politicians’ personal projects that produce few if any economic benefits. Whatever you may call them, such “solutions” divert capital that could have been put into productive innovations that would have created more wealth for more people. Is that moral?

  REAL WORLD LESSON

  The self-interest driving democratic capitalism is profoundly different from greed, which ignores the needs of others and is the opposite of what succeeds in a free market.

  Q IF CAPITALISM ISN’T GREEDY, THEN WHY DO SOME COMPANIES CHARGE EXORBITANT PRICES FOR CRITICAL PRODUCTS LIKE GASOLINE AND LIFESAVING DRUGS? AREN’T THEY GOUGING TO REAP EXCESSIVE PROFITS?

  A PROFIT IS A CRITICAL INDICATOR OF CONSUMER DEMAND AND THE ONLY WAY TO ENSURE THAT THERE WILL BE A SUFFICIENT SUPPLY OF ANYTHING. BY THE WAY, PROFIT IS AMONG THE SMALLEST COMPONENTS OF DRUG AND OIL PRICES.

  When gasoline prices soared between 2004 and 2008, people were enraged by the profits being made by oil companies. A Gallup poll found that more Americans believed the high price of gasoline was due to oil company greed rather than to other factors, including the Middle East conflict. Politicians from California senator Barbara Boxer to then New York senator Hillary Clinton called for measures to “get tough” on “Big Oil.” Vermont senator Bernie Sanders sputtered in an editorial: “Exxon-Mobil has made more profits in the last two years than any company in the history of the world.”9

  Similar indignation has been directed at the pharmaceutical industry. Critics accuse drug companies of “gouging,” among other transgressions, calling for various government regulations to rein in “Big Pharma.” “Other countries don’t allow prescription drug companies to gouge their customers,” complained former Congressman Tom Allen (D-Maine).10

  The critics aren’t entirely wrong. Bernie Sanders is correct when he says that oil company profits were the highest in history. And it’s true, as Tom Allen suggests, that newly developed brand-name drugs can cost more in America than in other countries. The cholesterol-lowering medicine Lipitor, for instance, costs about sixty cents a pill in Paris and around four dollars in Philadelphia. 11

  Yet these emotional accusations reflect a misunderstanding of the myriad and complex factors affecting pricing and profit. People who decry oil company profits, for example, don’t understand that a major factor driving up oil prices was the weak value of the dollar on currency markets, a result of the Federal Reserve Bank printing too many greenbacks. Also driving up prices was the high demand for oil, driven by rapid growth in India, China, and eastern and central Europe.

  Both factors, of course, have little to do with profit. In nonrecessionary times, the typical net profit margin of oil companies—what they make off each dollar of revenue—is only around 8 percent. That’s far less than the profit margins of banks (over 19 percent), software companies (17 percent), and even food producers (more than 9 percent). And it’s just a little higher than the profit margin of Starbucks, which is around 7 percent.

  Pharmaceutical profit margins are ordinarily around 18 percent or 19 percent, only nominally highe
r than those in the software industry. Yet they’re especially reasonable considering that only about one in a hundred drugs ends up on the market. Each drug that makes it must generate enough revenue to cover the development costs of the ninety-nine drugs that didn’t—as well as the cost of future drugs. And bringing a single drug to market costs a major pharmaceutical company anywhere from $800 million to $1.5 billion.

  If a drug company does not come up with new, successful drugs, profits stagnate—and stock plummets. Pfizer, for example, has had a dearth of blockbuster drugs in recent years. The result: the stock had plunged over 70 percent in value between 1999 and 2008.

  Yet some people believe that pharmaceutical makers and oil companies shouldn’t be allowed to make a profit—or that their profits should be limited through taxation or price controls. They don’t understand how profit functions and the role it plays in a Real World economy.

  Profit does more than make some people rich by generating dividends and capital gains. It is also the way our economic system mobilizes people to provide for others. This goes beyond merely serving as an incentive: profit is a critical barometer of demand, telling producers where they should invest—or where they should cut back. It keeps supply flowing smoothly.

  For example, if demand soars for, say, coffee, producers will raise their prices. And why not? Java is in greater demand and thus more valuable. So what happens? The lure of higher profits encourages producers to grow and process more. New coffee suppliers may also be enticed to enter the market. The result: supply increases.

  Then something else happens: profits create competition. Higher profits bring more players into the market. To compete, producers have to slash prices. The result: profits eventually fall.

  An example: Xerox, inventor of the modern photocopying machine. The enormous profits the company made with its first copiers soon attracted countless competitors, including Canon, Ricoh, and Mita (now Kyocera), to name a few. At one time only large offices could afford these machines. Today they’re so cheap that even students can afford desktop models. And not only do they copy, they scan and print, too.

  Scores of other examples are provided by the electronics industry. A few years ago flat-screen TVs cost ten thousand dollars or more. Now you can get many for under five thousand dollars.

  What happens when companies aren’t allowed to generate profits? No barometer exists to adjust supply to meet demand. Politicians like to think that punishing profits serves the public interest. But the Real World economic truth is that it does the opposite. You end up with shortages of essential products—and sometimes surpluses of things no one wants.

  Many people today are too young to remember what happened after President Richard Nixon imposed controls on the price of oil in the 1970s. Immediate shortages of gasoline resulted, which led to gas lines. People had to fill up on given days, depending on whether they had odd-or even-numbered license plates.

  Taxing profits to punish “greedy” companies doesn’t work, either. That’s because profit is a key source of the investment capital companies use to expand operations, innovate, and create jobs.

  In the case of oil companies, taxes on profits destroy capital that would otherwise go toward exploration and new oil production. In 1980 President Jimmy Carter enacted the Windfall Profit Tax to punish supposedly avaricious oil companies. What happened? Domestic production plunged. With oil companies producing less, the levy generated far less for Uncle Sam than proponents had predicted. The Windfall Profit Tax was widely considered a disappointment and was eventually repealed.

  Decades later, when gasoline prices skyrocketed from 2004 to mid-2008, there were no gas lines. Why? Because there were none of the kind of profit-punishing price controls imposed by President Nixon in the 1970s—something antiprofit protesters have failed to notice.

  As for drugs, a major reason newly developed medications are more expensive in the United States is not because of “gouging.” It’s because drug makers charge more in this country to recover the costs of selling to Canada and European nations whose staterun heath-care systems keep drug prices artificially low.

  So what do Canadians and Europeans get for their “fairer” drug prices? As we will explore in chapter 7, they get fewer new medicines and treatment with older, frequently less effective drugs.

  Critics say profit is merely a bribe to get businesspeople to provide products and services. Actually, profit is essential to achieving innovation and a higher standard of living.

  The late renowned management guru Peter Drucker repeatedly emphasized this key, oft-ignored point: without profits, there is no capital to build the advances of the future. If you don’t have profit, you don’t get change.

  Profit is not only moral. It’s essential to a healthy economy. What’s immoral is not allowing people to make it.

  REAL WORLD LESSON

  Profit isn’t a greedy surcharge but a vital barometer of demand and supply, and a source of capital critical to a smoothly functioning economy.

  Q HOW CAN CAPITALISM BE HUMANE WHEN LOW-INCOME PEOPLE SUFFER THE MOST FROM MARKET FLUCTUATIONS LIKE THE SUBPRIME-MORTGAGE CRISIS?

  A THE SUBPRIME-MORTGAGE CRISIS IS A CLASSIC CASE OF THE “MORAL HAZARD” THAT RESULTS WHEN GOVERNMENT INSULATES PEOPLE FROM THE CONSEQUENCES OF RISKY BEHAVIOR.

  It’s a question often raised by freemarket critics: how can capitalism be a moral system when low-income people are so often harmed by the fluctuations of “unfettered” markets?

  For many, the subprime-mortgage debacle provided the most painful example in years of this moral pitfall of capitalism. According to the popular narrative, “predatory” lenders trapped low-income borrowers with lenient subprime loans. Ridiculous introductory terms seduced thousands of unsuspecting homeowners into signing on the dotted line—only to be slammed later with higher interest rates.

  The result: hundreds of thousands of subprime borrowers went into default. Bad subprime loans were blamed for a 53 percent rise in delinquencies and foreclosure proceedings on 1.5 million homes in 2007, a situation that only got worse in 2008.

  Media reports about the crisis highlighted heartbreaking personal stories of poor people facing the loss of their homes. During her presidential primary campaign, Hillary Clinton called for curbs on “abuses” by “unscrupulous brokers.” Her Democratic rival John Edwards compared the mortgage market to “the wild, wild West.”

  Of course, poor people were hardly the only ones hurt. The crisis ripped through the economy. Several major lenders, such as New Century Financial and American Home Mortgage, were forced into bankruptcy. Even the largest mortgage company, Countrywide Financial Corporation, was laid low. It was ultimately sold to Bank of America at the fire-sale price of about five dollars per share—a stark contrast to its forty-three-dollar-a share price in 2006, before the bubble burst.

  The financial crisis has been a global disaster, but the collapse and economic devastation were not the fault of “unfettered markets.” It was a classic case of what economists refer to as “moral hazard,” the damage that occurs when government artificially protects people from the consequences of their high-risk behavior.

  Cato Institute senior fellow Gerald P. O’Driscoll explains:

  Government programs and policies often serve to insulate individuals from the full consequences of their actions. For instance, subsidized federal flood insurance leads individuals to build more homes in flood plains than would otherwise be the case. The public naturally feels sympathy for homeowners who are the victims of flooding, and supports more assistance for those caught up in these dreadful situations. The “help” often exacerbates the problem, however, by removing incentives for homeowners to build on higher and drier land.12

  In the case of the subprime crisis, overly low interest rates and an overabundant money supply, combined with well-intentioned though misguided policy, encouraged lenders to engage in risky behavior. They made ill-advised loans that they wouldn’t have made under normal circumstances to t
oo many unqualified borrowers, ultimately causing a collapse.

  It all began several years back after the dot-com bust of 2000 and 2001. Seeking to boost the economy, the Federal Reserve Bank made two critical mistakes. First, it kept interest rates too low for too long. Second, it started printing more money, triggering an inflation in home values.

  Suddenly the market was on steroids. Prices kept rising with no end in sight. These upwardly spiraling prices—rather than “greed”—were one reason that lenders lowered their standards. People figured, So what if you weren’t really qualified to receive a loan? There was a way out: you could sell your house for more money or refinance later.

  Inflating the bubble still further were the government-created mortgage giants, Fannie Mae and its cousin, Freddie Mac. We go into additional detail about these two giants in later chapters. President Franklin Roosevelt set up Fannie Mae during the Great Depression to indirectly boost a flagging housing market. Freddie Mac, a Fannie Mae clone, was launched in 1970. Fannie and Freddie were eventually spun off by the government, selling shares and becoming enormous publicly held corporations. Their mission is to indirectly help the housing market by buying mortgages from banks, bundling them into packages to be sold to investors. The idea was to generate money for banks that would increase mortgage lending and help more Americans achieve the dream of owning their homes.

  Fannie’s and Freddie’s money comes from selling their own bonds, as well as stock, to investors. However, the two companies owe their enormous size—as well as their immense political and market power—to their ties to government. They had emergency lines of credit with the U.S. Treasury Department. Investors thereby believed that the companies were implicitly backed by the government. As we mentioned in the introduction to this book, they are larger than any private-sector competitors.