There was not a lot of economic news out today, so I think I am going to step back and be a bit more philosophica. I want to talk a bit about capitalism itself.
I know that some of you see me as some sort of unreconstructed wild-eyed lefty. To that charge I plead: not guilty. I have a deep respect for capitalism and the free market.
As a student of economic history I know that for about 1500 years, there was little or no real economic progress in the world after the fall of the Roman Empire. A time traveler from say 800 AD would find the world more or less familiar if he suddenly found himself in 1800. Oh, some of the news would be different — all that talk of a new world and all — but agriculture was still the dominant form of economic activity, and was entirely dependent on human and animal power, just as was in the time of the Caesars. If you traveled, you did so on foot, horse or horse-drawn cart on land, and under sail if at sea.
The fundamental forces that shape capitalism — greed and fear — are elemental, and have been around since the dawn of time. Capitalism did not cause them or create them, it channeled them.
The History of Capitalism
Capitalism as we currently understand it dates from 1776. Not with the Declaration of Independence, but with the publication of Adam Smith’s “The Wealth of Nations.” If you have never read it, pick it up sometime — it is well worth the time you will spend reading it. What capitalism is able to do is to channel those basic forces into a powerful productive force.
Most other systems simply try to fight those forces — they try to fight against human nature and try to change humans — and ultimately fail miserably. For example, prior to the advent of capitalism, the Church was an enormous economic and social factor. It simply put “avarice” of greed as one of the seven deadly sins, and said you would go to hell if you were greedy. Later, the Left tried to create the “new Soviet man” who would be so filled with common purpose and the love of his fellow man that he would give according to his ability and take only according to his needs.
Of course, ability and needs are very flexible concepts, something that any parent should recognize when the kids say they “need” a car or a cell phone or a new toy. In the end, the “new Soviet man” ended up in a system where “they pretended to pay us, and we pretended to work.” The end result was that communism was not able to raise overall living standards much more than feudalism was.
The world has changed beyond recognition since 1776. Heck, a time-traveler from 50 years ago let alone 200 years would find the world a completely different place than he was used to, much more than the time traveler of 1500 years would in the earlier era. When JFK took office, computers were massive machines only used by the government and perhaps a few of the world’s largest firms, we still had rotary telephones; people used egg-timers when they made long distance calls; only the super affluent could afford to fly (aka “the jet set”).
In addition, price signals are a way for the economy to relay information about where shortages of some sorts of goods exist, and where gluts of other goods exist, and thus the economy can allocate resources much more efficiently than any group of smart people sitting in a room trying to decide where to increase and where to decrease production ever could.
To use Milton Friedman’s famous example, think just for a minute about the complexity involved in producing even a simple number 2 pencil. The wood comes from one part of the world, the minerals to produce the graphite have to come from another, the “rubber” in the eraser has to be manufactured out of a range of substances, most notably oil.
How do you know if you are going to need to increase the production of that certain type of wood, and if it became too scarce, when to switch to a different type of wood? What if people all of a sudden decide to start using pens more and pencils less? How would any group sitting in a room ever be able to keep tabs on it all? With capitalism, if something gets scarce, it goes up in price, meaning that producing more of it would be profitable, and “magically” production of it starts to rise.
Unlike other systems, this happens without the need for any coercion by the state. Just the self-interest of people gets the “right thing” done. Thus, capitalism is more congruent with personal and political freedom than other economic systems.
Is Greed Good?
Almost all of that progress can be traced to capitalism and its ability to channel greed. So am I channeling my inner Gordon Gecko here and saying “greed is good”? Well, let me answer that with another question: is fire a good thing? It, too, is a fundamental force of nature.
Without fire, civilization would not be possible. We would be severely limited in what parts of the world we could live in, we would have no metals to work with, no light at night, etc. On the other hand, if you are living in Southern California and a wildfire is being pushed by the Santa Ana winds is heading for you, you might not think that fire is such a great thing. Left uncontrolled, fire can be enormously destructive; when we control it, it is an enormous force for good. The trick is not to let it get out of control, but also not to constrain it so much that the flame goes out.
While we have never had “pure capitalism” in the sense that the government was not in some ways involved in economic activity, favoring some groups and disfavoring others. Even in the late 19th century which was the closest we have ever come to “pure capitalism,” the government was giving away a significant portion of the land area of the country to the railroads.
In “pure capitalism,” government stays out of the economy altogether, with the exception of enforcing contracts and property rights are absolute. Of course, there was also that assault on property rights known as the Civil War. After all, slaves were either the first or second most important source of property or capital in the South prior to the Civil War (along with land).
While overall the economy grew enormously in the last half of the 19th century, the economy was incredibly unstable. The panics of the 1870’s and 1890’s were far deeper and more painful than what we have been through in the last few years.
Left to its own devices, capitalism will always lead to huge concentrations of wealth and income inequality. This was not only true of the “Gilded Age of the robber barons” here in the U.S., but also the Victorian era in the U.K. that Dickens wrote about (also on the suggested reading list would be something along the lines of the actual novel “Oliver Twist” rather than just Andrew Lloyd Weber’s musical about it).
Companies will always try to buy each other out and try to create monopolies, or at least oligopolies. You can make a lot more money if you have a monopoly than you can if you have to face the competition. Rather than fight price wars, businessmen will generally try to seek a truce, at the expense of the consumer. If they do go into a price war, the objective is to defeat the competition and thus emerge as the monopolist. The actual Adam Smith warned about this extensively in his actual Wealth of Nations, but that is a point that has been very much played down by those who today run around in Adam Smith neckties.
Concentration of Wealth
Ultimately though, the concentration of wealth will undermine the capitalist system. It is very good at mass production, but for that to work, the masses have to have enough income to buy the production. It is a pretty rare capitalist who will see this and actually be in a position to do anything about it if he does, unless of course he has already achieved a monopoly position.
Henry Ford was perhaps the greatest exception to the rule when he started paying his workers $5 a day. However, at the time, he was close to being in a monopoly position in the low-end car market, although Chevy was starting to gain ground. If he decided to pay his workers more, he would be at a competitive disadvantage, and besides, he would only be employing a small fraction of the people.
From the mid-1930’s through the 1980’s, unions were able to act as a countervailing force, especially for unionized companies, but the implicit threat of organization at non-union firms also tended to force the gains from productivity to be shared between capital and labor.
Over the past thirty years, unions have become progressively more irrelevant in the U.S., especially in the private sector. The end result (or at least it is a contributing factor) is that in recent decades, the gains from productivity have been mostly accruing to capital, not shared with labor. Thus, his unilateral decision to raise wages would not result in a big impact on the sales of his product. At the same time, there is a limit to how much any one person can consume, regardless of how conspicuous he chooses to be.
The money would simply pile up in the hands of the very top of the pyramid. What to do with all that money? Well, what you could do is invest it directly in new equipment and expand production. Oh, the people don’t have enough money to buy the product? It just sits on the shelves.
The other thing that you could do is lend it out. This would probably happen through a financial intermediary like a bank. To the extent the bank lends it to someone else to buy more plant and equipment, that is fine. But with overall demand weak since the vast mass of people don’t have any money, those sorts of investment opportunities become rare relative to the amount of excess savings in the system.
That imbalance between the desired level of savings and investment opportunities causes interest rates to fall. Some of it will end up being lent to the masses and they end up using it to support their consumption, perhaps thinking that their current low income is only temporary. A lot of the money starts being used to bid up the price of existing assets, including land and the stock market. As those prices start to rise, it becomes profitable to speculate on the prices continuing to rise.
The more leverage the better in that situation (generally more in real estate than in equities, although through derivatives a lot of leverage can also be applied to equities). Keep in mind that for the system as a whole (either a national economy in a relatively closed system or the world economy) savings has to equal investment, and spending has to equal income.
Bubble Formation and Fallout
The consumption lending to the masses helps keep up production and employment for awhile, but eventually the power of compound interest results in still more money being shifted to the top of the pyramid. Ultimately, this forms a bubble that pops, or to go back to my earlier metaphor, “the fire gets out of control.” Demand then starts to crumble, and with it so does employment.
The debt is very hard to repay and huge numbers default. One response to this, particularly if those at the top of the pyramid have most of the political power, is to put the fear of God into anyone who defaults. That was the system in 19th Century Britain, with debtors prisons. Obviously, someone in prison was not in a position to earn the money pay back what he owed. The idea was to be an object lesson for anyone else thinking about defaulting.
More recently, here in the U.S. we sort of went with a “debtors prison lite” version with the bankruptcy reform act of 2005, which was very punitive to debtors. That approach has not proved to be very successful historically, and both the U.S. and U.K were subject to very big booms and busts in the 19th century.
Left to their own devices, capitalists will always want to add a bit more fuel to the fire, and have a bit less regulation. This is particularly true when the ones making the decisions are going to be compensated on relatively short-term results. Their concern is to make as much money as they can for the individual company they run (and to thus get as big a bonus as possible), not for the health of the overall economy. They will always want the fire to burn just a little bit hotter and resist any attempts to regulate it.
They are greedy. I don’t mean that in a pejorative sense — they are just following that basic human nature. They will want to make their products as cheaply as possible, which usually means with as little labor as possible, and to sell the products at the highest possible prices. For any company, provided they could generate the same revenues as they do now, the ideal labor force would be simply the CEO. Clearly, that is not going to happen in most companies. But most companies will try to get as much possible revenue from as few employees as possible.
As long as those other people can find other opportunities, that great — it is known as rising productivity. But if this is repeated over and over in company after company across the economy, the net result is a mass of people without work and thus with out income. The company finds that it can no longer maintain the same level of revenues since no one can afford to buy the products. The fire has gotten out of control and is no longer a force for good, but has turned destructive.
How to Fight the Fire
That does not mean that we should do away with capitalism, and all the enormous progress and relatively efficient allocation of resources that it brings. Other systems, such as Communism and the Feudal/Church system, simply declared the fire of greed to be evil and immoral and tried to put it out. The end result was a frozen economy. No, what it means is that we need to control the fire and make sure it does not turn destructive.
That is why we need laws and regulations. Most of economics, particularly micro-economics, is based on the assumption that most markets are close to perfectly competitive. In the real world, that is rarely the case. For example, in many transactions, one side is likely to have more information than the other.
Nowhere is this more clear than in the case of the financial industry. Effectively starting in the late 1990’s, we began to remove the devices that regulated the flame of capitalism. Those controls were put in place in the wake of the Great Depression — things like the Glass-Stiegel Act, which said that banks could not have insured deposits and then use those deposits to gamble recklessly on highly risky investments.
Gambling “recklessly” on highly risky investments has a very useful place in an economy. Investing in a couple of guys with a shop in the garage and some interesting electronic gear is a risky thing to do, but two of those guys were Bill Hewlett and Dave Packard. A generation later it was Steve Jobs.
However, that is the business of investment banks, operating without a government backstop, not commercial banks using insured deposits. The decision that things like credit default swaps would not be regulated at all was another example, and they soon grew to be several times the size of the entire world economy, at least in notational size.
We need to regulate the amount of fuel the fire gets and control it. There are times when regulation can get too heavy, and the flame almost dies out. A case could be made that that is what happened by the 1970’s. There were all sorts of regulations still on the books that might have made sense at one point, but had become just plain silly, such as the requirement that most trucks could not haul freight on their return trips.
Regulators are always in danger of being captured by those that they seek to regulate. When that happens, regulation simply becomes a way of keeping out new competitors, not something that enhances the stability of the system or protects consumers. If we go too far the other way, there is not an immediate danger of the fire going out, but of it getting out of control.
To my mind, we are still shifting through the ashes of a fire that got out of control, particularly in the financial and real estate sectors. We need to put more controls on the fire to make sure we don’t burn ourselves again.
But let me make one thing absolutely clear: I don’t want to put out the flame altogether. I disagree with those who claim that the reason the economy is so lukewarm right now is that we have put too many regulations on it and are trying to boil 100 gallons of water with just a single candle.
The economy is too cool because we are still trying to unwind the massive over-leverage in the private sector. To the economy, paying down debt is the same thing as saving. The available supply of savings, especially worldwide, simply greatly exceeds the availability of good investment opportunities.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
