Capitalism and Society

Volume 4, Issue 3 2009 Article 2

THE FUTURE OF CAPITALISM

Refounding Capitalism
Edmund S. Phelps, Director, Center on Capitalism and Society, Columbia University

Recommended Citation: Phelps, Edmund S. (2009) "Refounding Capitalism," Capitalism and Society: Vol. 4: Iss. 3, Article 2. DOI: 10.2202/1932-0213.1064

Phelps: Refounding Capitalism

The lesson drawn from the crash of 1929 was the need for regulatory reform. In the United States, regulations were enacted to reduce the vulnerability of investors, lenders, banks, companies, and workers to unanticipated swings in financial markets. The lesson drawn from the recent spectacle by some governments at any rate was the need for intervention of a different sort. Recently envisioned legislation in the U.S. would supplement the capitalist system with new programs for health care, climate control and energy conservation. Yet the recent experience the speculative excesses and the ensuing collapse reveal a perverse financial sector and a dysfunctional business sector that are not well treated by enlarged regulation or enlarged public expenditure. In the felicitous term of President Sarkozy, the need is to refound capitalist systems in ways that will make them well-functioning again. This need is acute in the United States, where the perversion and deterioration of capitalist mechanisms appear to have left the economy with less dynamism as well as less business activity. It is profound in Europe, where capitalist mechanisms have long been hamstrung by Italian corporatism, French statism, German socialism, Scandinavian welfarism and the rest. Over the past decade I have maintained that countries would still benefit from the innovative activity of original thinkers, visionary entrepreneurs, canny investors, pioneering managers and devoted employees that starting in the 19th century and in some countries ending in the 20th drew an ever widening share of people in an ever-growing number of nations into engaging jobs, exciting explorations and remarkable commercial advances. I will try to explain, leaving for the last section the issues of instability and their resolution. What is capitalism? Any concept of a capitalist economy must include private wealth owning. Yet that private wealth must extend to ownership of all or most of the economys business capital not merely cars, homes and debts of the state and state enterprises, as under market socialism. It is also necessary that private owners of businesses be accorded control over where to invest not just along the narrow lines assented to by managers, guilds or unions, as in corporatism, or as dictated by the state or oligarchs. To this day there survives an image of capitalism as a game in which each generations players make their moves in hopes of riches and then leave the field to take stock of the wealth they won or lost. But these wealth-centered features are insufficient to capture the character of capitalism in the modern age, particularly the importance of the experience of participating in it. Modern economies of which several well-functioning capitalist economies are thus far the sole historical specimens started to sprout up only in the 19th century. With the development of company law, corporate finance, investment banking and patent law, the way was opened for a process of

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innovation: the conception of novel commercial ideas, the selection by financiers of some of these ideas for development, the realization by entrepreneurs of the envisioned products or methods, and the adoption or rejection by managers or consumers of some of the new products reaching the market. The propensity of such a system to innovate depends very much on a multiplicity of idea-men, entrepreneurs, financiers, marketers and end-users consumers and managers. It helps to have diversity in their business backgrounds, education, strategic vision, and talents. It is not surprising, therefore, that significant indigenous innovation, since it began early in the 19th century, has been driven mainly by the private sector; private ownership has been typical, whether or not required in every case. Laissez-faire a free market of low taxes, tariffs and regulation is not required; so much freedom would badly undermine capitalisms functioning. In the recent episode, we have seen again that capitalist systems require well-chosen regulations. Note that a new commercial idea in a country may be an application of an invention or discovery made by scientists outside the economy or an innovation made by a business in another economy. That was Josef Schumpeters early view of how commercial ideas came to a country.1 Or the new idea might come from within the nations economy: an original idea inspired by the observations and imagination of producers, employees, managers or consumers people on the spot. This was the view of Friedrich Hayek2 and of most experts today.3 If innovation were mere Schumpeterian application or imitation, a socialist system could approximate the results of a capitalist system.4 What is the distinctive merit of capitalism? For many, capitalisms main merits are the wealth accumulation it fosters and the individual freedom it helps to protect. Referring to capitalism in his Inaugural Address, President Obama said that [i]ts power to generate wealth and expand freedom is unmatched.5 For me, that does not capture the value of a well-functioning capitalism. In fact, it largely misses the value.
1

Schumpeter, Theorie der wirtschaftlichen Entwicklung, Leipzig: Duncker & Humblot, 1912. His main thesis was that developing a new idea into a new product at an economical price required the skills of a savvy entrepreneur. 2 The earliest example is F. A. Hayek, Collectivist Economic Planning, London: Routledge, 1935. See also Hayek, Competition as a Discovery Procedure [1968], in Hayek, New Studies in Philosophy, politics, Economics, and the History of Ideas, Chicago: Univ. of Chicago Press, 1978. 3 It is the view of Alfred Chandler, Peter Drucker, Richard Nelson, Sidney Winter, Giovanni Dosi, Roman Frydman and Andrzej Rapaczynski, Virginia Postrel, Amar Bhide and my view too. 4 In the U.S. the greater part of medical progress comes from practice, not from science. See Richard Nelson, How Medical Know-How Progresses, Working Paper No. 23, Center on Capitalism and Society, 2008, which is available at www.capitalism.columbia.edu 5 Barack Obama, Inaugural Address, January 20, 2009.
DOI: 10.2202/1932-0213.1064 2

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Regarding wealth, it may be that the challenge of making money, perhaps getting rich, in ones young or middle years is absorbing and fun: as Friedrich Nietzsche and Frank Knight suggested, trying to make a fortune is like participating in a sport. Yet social observers are right to question whether people find significant satisfaction from increased relative wealth beyond a certain point.6 After you have won the game, what point is there in winning by a bigger point spread? Many entrepreneurs speak of the wealth received as a by-product of what they sought to do or achieve rather than as the goal. In any case, an increase in some peoples relative wealth means a decrease in some others relative wealth. There is no reason for the government of a society to promote that sort of sport. The value of nationwide advances in wealth may be on more solid ground. It is better to have more wealth in a city or nation where most others have more wealth too: possibilities of a richer and more rewarding life result. The fault in this view is that the relatively capitalist countries are not distinguished by high levels of wealth. The somewhat more socialist economies and more corporatist economies of Western Europe reach wealth levels exceeding the levels in the capitalist economies. The reasons are familiar. One of the major drivers of wealth, the propensity to save, is higher in Luxembourg, Switzerland, Belgium, France and Germany than in the U.S., the U.K. and Canada despite the high security offered by the continental welfare system. The other driver of private wealth, namely, the level of productivity, is also equal if not greater in the former group of countries than in the latter group. A proposed explanation is that while the capitalist exemplars may be at or close to the technical frontier, thanks to their lead in cutting-edge innovation, they waste much of their output potential in false steps, in the costly processes of marketing, and in over-investment caused by the winner-take-all competition of costly R&D projects.7 Furthermore, the top-down techno-nationalist projects that some relatively corporatist nations have substituted for discoveries bubbling up naturally from the business sector may do well on that score thanks to the resources saved by avoiding wasteful competition for new products involving parallel development work and marketing efforts. One has to conclude that generation of wealth is not special to capitalism. Corporatist economies are quite good at that.
I am thinking of attitude surveys and commentaries by Bruno Frey, Richard Layard and Andrew Oswald, to name just those that immediately come to mind. 7 Historically, some corporatist economies have sought to substitute a top-down scientism for the discoveries bubbling up naturally from the business sector. Of course, the techno-nationalist projects undertaken in corporatist economies may produce some productivity gains. Yet the selection among these projects and the development decisions along the way are not immune to mis-steps. And techno-nationalism is prone to flaws of its own, such as a tendency to the grandiose and to over-engineering. So it is doubtful that industrial research policy can be credited for the good productivity levels exhibited in some corporatist economies.
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As for freedom, some have argued that a capitalist economy far more than a socialist or a corporatist one helps to buttress peoples political freedoms and some of their personal freedoms against the tyrannies of the state, communities and the culture. Owners of a firm in a capitalist economy would feel it in their pocket book if employees were hired or fired on the basis of their beliefs rather than the firms profits.8 Yet the evidence is mixed: some of the relatively socialist and corporatist economies of western Europe appear to be pretty tolerant of deviance from the mainstream. A merit of a well-functioning capitalism (again: I do not mean free-market policy: low tax rates, etc.) is the economic freedoms it offers entrepreneurs, managers, employees and consumers freedoms that socialist, corporatist and statist systems do not provide. It is worth noting that some personal freedoms are also economic. If you have a deep need, say, to be a dancer or to restore mid1930s films, capitalism is likely to be the system for you. I came away with the impression that Milton Friedman valued these economic freedoms (and other freedoms) for their own sake, though other readers may interpret him differently. Friedmans work, however, does clearly value the freedom to choose as a means to income.9 He suggests that incomes will be higher when participants are free to move over a wide range of regions, occupations and industries and when individuals and enterprises are free to collect micro data on which to make decisions. But, as noted earlier, the thesis that well-functioning capitalist economies are better at producing income and wealth than more corporatist systems (and socialist ones) is in doubt: the best corporatist economies tend to exhibit comparable productivity. In a different vein, Amartya Sen has been emphasizing the value of economic systems that provide participants with an expansion of their capabilities.10 The work of Hayek from his Road to Serfdom onward is suggestive of another kind of value in some economic freedoms.11 In any real life economy (not theoretical models in which everything in the present and the future is known), actors may sense or conjecture opportunities or dangers about which there is little or no public knowledge while the individual has significant private knowledge about possible benefits or costs as well as imagination and personal experience.
8

See for example Henry C. Wallich, The Cost of Freedom, New York, Harper, 1960. Somewhere Professor Wallich is quoted as writing that power is the great enemy of freedom. 9 Milton Friedman, Capitalism and Freedom, Chicago: University of Chicago, 1962, and Milton & Rose Friedman, Free to Choose, New York, Harcourt, 1980. 10 Amartya Sen, Inequality Reexamined, New York, Norton, 1992, and Commodities and Capabilities, New York: Oxford University Press, 1999. The critique of both communism and capitalism by John Dewey was that neither system was good at allowing workers to develop their talents. The classic work is Experience and Education (New York: Simon and Schuster, 1938). 11 Hayek, The Road to Serfdom, London: Routledge, 1944. See also the commentary in Amartya Sen, An Insight into the Purpose of Prosperity, Financial Times, September 20, 2004.
DOI: 10.2202/1932-0213.1064 4

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Individuals freedom to act (or not act) on their unique knowledge, intuition and judgment may be indispensable to their sense of self-worth and self-reliance. In this view, it would be inadequate to gauge the value of freedom by its contribution to income, consumption, investment and even to the pragmatists expansion of talents and capabilities. The freedom to act on this basis to take charge of ones own heading and make ones own mistakes is a primary good in itself, one of huge importance. Is there evidence of greater economic freedoms in capitalist economies than in the more socialist or corporatist economies?12 My research using survey data supports the widespread impression that, in the relatively capitalist economies, people in ordinary jobs have freedoms that they value more so than workers in the relatively socialist or corporatist economies. In the former economies more than in the latter, workers say they want jobs offering chances to take initiative and responsibility (which reveals that they know that such jobs are available), while acknowledging also the value of teamwork thus the need both to give and take orders.13 Relatedly, earning ones way in the impersonal world of business supporting oneself is, for most people, necessary for what John Rawls called self-respect.14 I would make a further point in the same context and in a somewhat similar vein that Hayek left unsaid. As a long line of Western humanists and philosophers from Bergson, James and Nietzsche back to Cervantes and Cellini have propounded, in a world in which we know little about the effects of what is untried, ones freedom to experiment, to explore, to act on impulse, and to test ideas offer another category of benefits: self-actualization and self-discovery. In my recent papers I have been arguing that most people, if not all, find such satisfactions from taking part in the innovation process of a capitalist economy: from examining untried ways of producing something, conceiving and developing an innovative product or method, and pioneering the adoption of a new product or method.15

12

Jeffrey D. Sachs says no in his Response to Easterly on Hayek, Greg Mankiws Blog, Monday, November 27, 2006. He notes that the Heritage Foundation/Wall Street Journal Index of Economic Freedom ranks Finland, Sweden and Denmark as free economies, with Denmark ranked ahead of the United States and this in spite of their high rates of taxation, which counts heavily in the Heritage index. This is undeniably interesting, since those three countries are widely regarded as pretty corporatist as well as somewhat socialist. However, the Heritage indicators of freedom largely differ from the individual freedoms in the workplace, financial markets, and product markets that I am clearly referring to. 13 Phelps, Economic Culture and Economic Performance: What Light is Shed on the Continents Problem, 3rd Annual Conference of the Center on Capitalism and Society, Venice, July 2006. 14 Rawls, A Theory of Justice Cambridge, Mass., Harvard University Press, 1971. 15 See my Prize Lecture, Macroeconomics for a Modern Economy, Stockholm: Nobel Foundation, 2007, and papers of mine going back at least to 2003.
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From the latter perspective, the dynamism of a well-functioning capitalism has a fundamental merit. Ordinary people, if they are to find intellectual growth and an engaging life, have to look outside the home: these things can be found only at work, if anywhere. And for these rewards to be available for large numbers of people, the economy must be modern. And as a practical matter, that requires that it be based predominantly on a well-functioning capitalist system. Thanks to the grassroots, bottom-up processes of innovation, capitalism at its best can deliver far more broadly than Soviet communism, eastern European socialism, and western European corporatism can chances for the mental stimulation, problem-solving, exploration and discovery required for a life of engagement and personal growth.16 Can dynamism justify capitalism? Could it be that the value of a wellfunctioning capitalism in providing participants with opportunities to act on their own knowledge, intuition and judgment, and in providing opportunities to be engaged and to flourish serves to justify that capitalism? It is clear how that might be argued: if a well-functioning capitalist system offers a broad swath of society chances for a life of initiative and discovery, while the other systems deprive people of that experience, then imposing the latter systems on society would be terribly unjust. The answer would appear to be yes. I argue as follows. Dynamic innovation transforms the workplace (in the firms developing an innovation and also in the firms competing against them). The challenges that arise in developing a new idea and in its acceptance in the marketplace provide the workforce with high levels of mental stimulation, problem solving, and thus employee engagement and personal growth. An individual working alone cannot easily create the continual arrival of new challenges; it takes a village, or even a whole society. The notion that people need problem-solving and intellectual development is an old one. Aristotle wrote of the development of talents; in the Renaissance, Cellini jubilated in his achievements and Cervantes admired vitality and challenge. In 1892, Alfred Marshall observed that the job is in the workers thoughts for most of the day. And Gunnar Myrdal wrote in 1932 that the time would soon come when people would be more satisfied by working than by consuming. This view, sometimes called vitalism, became strongly associated with the pragmatist school of philosophy, but perhaps most famously with Abraham Maslows concept of self-actualization. All of these writers were pointing out the importance of a persons emerging sense of mastery and the experience of adventure. The American application of this western ethic Aristotle plus Cervantes is the thesis that self16

My argument can be sampled in my paper for a 2003 Baumol conference and my June 2006 speech at Sciences-Po as well as the Venice paper and Prize Lecture cited above.
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realization and self-discovery can come from the involvement and challenge offered by the business sphere of a modern economy. Americans cannot go tilting at windmills but they can take on the ever-fresh challenges of a business career. For most people there is nowhere else from which such challenges can arise. I should also mention a derived benefit of the capitalist model that flows from the effects of dynamism on productivity. A more innovative economy tends to devote more resources to investments of all kindsto investing in new employees and new customers as well as new office and factory space. And although this may come about through a shift of resources from the consumergoods sector, it also comes from the recruitment of new participants into the labor force. Employees who are thus engagedemployees who do not need to work for pressing financial reasons, but are drawn to work for its intrinsic satisfactions are less likely to quit, reducing the natural unemployment rate. Thus, dynamism tends to bring a pervasive prosperity to an economy in addition to higher levels of productivity caused by product innovationas well as higher levels of selfrealization. Of course, even the healthiest economy may suffer slumps. A plausible objection is that even a well-functioning capitalist system would not be just if it failed to strive for the largest possible inclusion of the productive population in that system. We can accept that such a system is not fully just, thus unjust. I certainly agree. But that does not imply that dynamism is not and cannot be just until a just level of inclusion is sought and achieved. Moreover, it is not capitalism that stands in the way of inclusion; it is the failure to legislate wage subsidies and inadequate desegregation of neighborhoods and schools. Taking instability and crisis into account. When President Sarkozy spoke of a refounding of capitalism I wondered whether he had in mind what might be termed a capitalist reformation analogous to the Protestant Reformation of the 1500s. There is the appearance of a parallel between the Churchs creation in medieval times of lucrative indulgences, which national governments did nothing to stop, and the banking industrys sale in recent years of overvalued packages of mortgages, called CDOs, which governments did nothing to stop. But the banks held such CDOs on their own account, in addition to selling them to nave buyers. The moral shortcoming in the banks, it appears, was that the leaders did not have the moral strength to protest the rise of leverage and the deterioration in the quality of the securitized assets to which they gave their seal of approval. With varying discomfort, the CEOs seem to have felt too weak to try to call a halt to further expansion of credit to get off the merry-go-round, in the famous words of Charles (Chuck) Prince, former CEO of Citigroup. I feel that in combating this aspect of the financial sectors problem, the first line of defense ought to be laws and regulations. Altruism is a valuable

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resource but we do not want to risk wreaking havoc by appealing to it in a comprehensive way at all levels of life. There must be social responsibility at critical points, but we cannot afford to over-use this resource lest we find ourselves with too little of it left when we need it most. How does the element of instability in capitalist systems affect the argument for continuing with capitalism? Ones first reaction, especially if one has high appreciation for capitalism, might be to say that the big swings to which capitalist systems are inherently prone should not stay societys hand in creating and maintaining a system that is so essential to engaging work and personal growth. The instability experienced does diminish our satisfaction as participants in the economy but it does not diminish our thirst for the good life. On reflection, there are valid points in favor of regulation aimed at reducing vulnerability to severe fluctuation. First of all, the good life is not a binary variable: you have it or you dont. A capitalist system dogged by frequent crisis and fears of crisis may levy a toll not only on peoples comforts and sense of security but also on the generation of innovation itself. So there may be a gain in the degree of dynamism to be obtained by fortifying the financial system against speculative crises. The second point I would make involves another dimension: No human system can be expected to innovate at all times, just as no composer would be expected to be constantly in the heat of creation. It is possible, then, that a financial system that is more robust in the face of speculative movements will exhibit dynamism a greater proportion of the time. So, in principle, creating a financial sector that is less vulnerable to speculative shifts might not be harmful to dynamism. It is worth noting that unemployment is viewed with far more anxiety and far more fear by politicians in the United States than it is in continental Europe no matter that there is unemployment compensation in the U.S. as well as Europe. The reason may be in part that in an economy with as much dynamism as ours, there really is no compensation for unemployment. Employment has become a good in itself. The paradox is that greater the dynamism of an economy, the more anxiety there is over the prospect of unemployment. If so, another paradox is that many Americans call for an end to dynamism in the interest of job security as if their own job would remain as engaging and rewarding as ever. But this enters the realm of speculation. Indeed, most economists discussing the need for financial reform appear to believe that better alignment of incentives and serious regulatory restraints on ruinous competition for profits, though aimed at economic efficiency and perhaps increased returns to shareowners, will cost the economy nothing in innovation and employment. But this sort of theorizing, though well-intentioned and even useful in exposing the perils of excessive gearing of pay to crude measures of performance, is itself dangerous in leaving the impression that, after

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reforming bonuses, asset markets will no longer be susceptible to huge asset price swings that are driven only by speculative excesses (to use Spiethoffs convenient shorthand). Unambiguously good reforms. Are there reforms that address speculative swings while causing little or no damage to economic dynamism and inclusion? There are ways of fortifying the financial sector against the speculative fever of investors and entrepreneurs in the business sector without obstructing the speculative investment waves that are emblematic of a healthy capitalism. One suggestion, which comes from my colleague Richard Robb, calls for a small tax on the shortterm indebtedeness of financial companies such as banks.17 So much of the banks problems arose from excessive short-term borrowing of little or no social utility. Let us tax that in order to force banks to finance their lending with long-term borrowing instead. There are also ways of tempering the speculative swings themselves without suppressing the spirit of capitalism. A suggestion from my long-time collaborator Roman Frydman calls for the introduction of a band around the index of housing prices, a band around the main index of stock market prices, and so forth.18 When the index rises or falls outside the band, the government will increase margin requirements, short-selling requirements, and various other costs so as to dampen but not outlaw speculation on a further move of the asset price index. Are there reforms that would address the decline in the past decade of economic dynamism while causing little or no increase in instability? I have been moving toward a proposal to establish new banks of a new kind. It is not uncommon to see financial entities in a country that are dedicated to residential construction, agriculture, or exports and so forth. This is curious and disturbing because little or no economic dynamism comes from our stock of housing as against, say, our stores of clothing and from producing for export rather than home use. There is no awareness among the general public and its legislatures that most of the economic dynamism inherent in the structure of a countrys economy comes from the innovative inclinations of the ordinary people making their careers in the business sector! To right the balance, I suggest that every countrys government establish a corps of banks that are dedicated to lending to or investing in companies in the business sector, particularly for investment projects of an innovative character. This is not really new. I like to remind audiences that Germany, with its famous Deutsche Bank, had just such a financial

17

For more detail on Robbs ideas, refer to my letter to the G-20 written immediately following the 6th Annual Conference of the Center on Capitalism and Society in February 2009, available at http://capitalism.columbia.edu/view/events/conference. 18 More on this idea is available in the same letter to the G-20, mentioned above.
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institution serving its business sector during its brilliant economic development in the 1890s, when the bank backed the new electrical engineering industries. Are there reforms that would address the still insufficient levels of economic inclusion without stifling dynamism? Here I would recall the sort of program that has been adopted to a degree in France, the Netherlands, and most recently Singapore: subsidies to companies for their ongoing employment of lowwage workers. (Mention might be made also of Italys cassa integrazione and Germanys kurzarbeit.) Notwithstanding these breakthroughs, the United States still has no program of general subsidies for low-wage employment. And the outlays of this kind in Europe are still under 2 per cent of the GDP. Yet there is the looming threat that the public, in its understandable desire to keep fluctuations within tighter limits, will push regulations affecting incentives and competition to a point where a tradeoff begins: where further regulatory tightening weakens or narrows some of the sources of dynamism. Europeans, in vilifying all hedge funds, all private equity and all short selling, are making it more difficult to increase dynamism in their economies while failing to get at the real sources of excessive swings. We must hope that the Europeans will come to see that they are aiming their wrath at the wrong targets. References John Dewey, Experience and Education, New York: Simon and Schuster, 1938. Milton Friedman, Capitalism and Freedom, Chicago: University of Chicago, 1962. Milton & Rose Friedman, Free to Choose, New York: Harcourt, 1980. Friedrich von Hayek, Collectivist Economic Planning, London: Routledge, 1935. , The Road to Serfdom, London: Routledge, 1944. , Competition as a Discovery Procedure [1968], in Hayek, New Studies in Philosophy, politics, Economics, and the History of Ideas, Chicago: University of Chicago Press, 1978. Richard Nelson, How Medical Know-How Progresses, Working Paper No. 23, Center on Capitalism and Society, 2008, available at http://capitalism.columbia.edu/working-papers.

DOI: 10.2202/1932-0213.1064

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Barack Obama, Inaugural Address, January 20, 2009. Transcript available at http://www.nytimes.com/2009/01/20/us/politics/20text-obama.html. Edmund S. Phelps, Economic Culture and Economic Performance: What Light is Shed on the Continents Problem, 3rd Annual Conference of the Center on Capitalism and Society, Venice, July 2006. , Nobel Prize Lecture, Macroeconomics for a Modern Economy, Stockholm: Nobel Foundation, 2007. , Letter to the G-20: Recommendations from the 6th Annual Conference of the Center on Capitalism and Society, March 2009, available at http://capitalism.columbia.edu/view/events/conference. John Rawls, A Theory of Justice Cambridge, Mass.: Harvard University Press, 1971. Jeffrey D. Sachs, Response to Easterly on Hayek, Greg Mankiws Blog, November 27, 2006. Joseph Schumpeter, Theorie der wirtschaftlichen Entwicklung, Leipzig: Duncker & Humblot, 1912. Amartya Sen, Inequality Reexamined, New York: Norton, 1992. , Commodities and Capabilities, New York: Oxford University Press, 1999. , An Insight into the Purpose of Prosperity, Financial Times, September 20, 2004. Henry C. Wallich, The Cost of Freedom, New York: Harper, 1960.

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