BOOK REVIEW

The Concept of Capitalism
by
Bruce R. Scott

FUTURECASTS online magazine
www.futurecasts.com
Vol. 11, No. 11, 11/1/09

Homepage

Describing the elephant:

 

&

  So, what is "capitalism," anyway? For two centuries, whole library shelves have been filled with efforts to answer that question. However, there is little confidence in the answers. There is always evidently so much left unexplained. Theorists resemble at best the blind men describing the elephant by the part they find themselves examining.
 &

The focus is too narrow that inevitably leaves out much of the rest of the elephant.

 

Economic analysts must step back and open their eyes to view substantially more of the elephant.

 

Both political and economic systems must be robust enough to function with imperfect men and women achieving imperfect results at all levels. There are strong natural incentives that create constant threats to the proper functioning of both spheres and require constant effort at containment. At any moment, they must be a part of any valid economic analysis.

  In "The Concept of Capitalism," Bruce R. Scott of the Harvard Business School demonstrates conclusively one major shortcoming of most efforts. The focus is too narrow. It inevitably leaves out much of the rest of the elephant. This short - 75 page - monograph is the author's summary of a much larger work, "Capitalism, Its Origins and Evolution as a System of Governance," that will be published shortly.
 &
  Adam Smith started us with an elegant description of the functioning and capabilities of markets and the ways unwise government policies undermined those capabilities. See, Smith, "The Wealth of Nations," Part I, "Market Mechanisms," and Part II, "Economic Policy." That government plays vital roles in facilitating markets was clearly recognized by Smith, as was the need to consider the entire complex of pertinent government policies when analyzing any economic system. Much of the theoretical work that followed elaborated on Smith's work and continued his attack on government constraints on economic markets, especially with respect to international trade. See, Ricardo, "Principles of Political Economy," and Wolf, "Why Globalization  Works," Part I, "Globalization of Market Systems." and Part II, "Criticism of Market System Globalization."

  Laissez faire is an obvious myth. Government has always played major roles in capitalist systems - since well before there was a word for "capitalism." Much of what the government does is clearly beneficial - even essential -  and much of it is clearly unwise. The Constitution - an 18th century document - has been interpreted as an economic document, with its provisions for due process, property rights, the uniform and non preferential regulation of interstate commerce, an independent judiciary, patent and copyright protection, the postal system, bankruptcy, and standardized weights and measures. Such basic rights as petition and press freedom also have commercial implications. The essential and beneficial aspects of government economic policies as well as those policies that are unwise have long been a major theme in FUTURECASTS articles. See, Future Economic Myths, at segment on "The  'Laissez Faire' Straw Man," and Government Futurecast at Part I, "Economic virtues of the U.S. political system," and Part II, "Government management."

  Scott asserts convincingly that economic analysts must step back and open their eyes to view substantially more of the elephant. Government and private institutions and political policy facilitate market mechanisms and do much that is absolutely essential. While the author discusses the economic institutions and political spheres separately for analytical purposes, the monograph right from the beginning emphasizes the deep relationships.
 &
  Also right from the beginning, Scott avoids presenting idealized versions of markets, institutions or pertinent political activities. Both political and economic systems must be robust enough to function with imperfect men and women achieving imperfect results at all levels. There are strong natural incentives that create constant threats to the proper functioning of both spheres and require constant effort at containment. At any moment, all of these factors must be a part of any valid economic analysis.
 &

Indirect governance through regulated competition:

  The capitalist system is characterized by "indirect governance through regulated competition" both in economic and political markets.
 &

It is an economically, politically and legally empowered civil society working through the political markets and the courts that maintain limits on political excess.

 

"Only a political authority can correct these market frameworks, and this in itself should warn us that externalities will never be eliminated. Thus a market economy should be presumed to contain distortions that range from small to large, and even 'extra-large.'"

  The political and economic systems are interdependent, with each influencing the other. Competitive economic markets provide economic discipline and accountability through the trading process, and competitive political markets provide political discipline and accountability through the election process.
 &
  Strenuous efforts are always directed at tilting the political and economic markets in favor of narrow interests. However, in the U.S., both markets have robust procedures that have enabled them to perform often surprisingly well despite constant efforts to bias their outcomes, and to recover from periods of political or economic excess. Scott notes that the political markets are unbounded by natural constraints. However, the checks and balances wisely included in the Constitution do impose considerable obstacles to political excess. (Various ideologues often fret about the constraints of those checks and balances.)
 &
  Government authorities in the courts, administrative agencies and especially in the legislatures possess the power to shape economic markets as they wish. However, they don't have the economic resources or knowledge possessed by participants in the economic markets. They are always playing catch-up with developments in economic markets. Nor do they always make wise laws and regulations, but they will in most cases determine the ultimate shape of economic and political markets. It is an economically, politically and legally empowered civil society working through the political markets and the courts that maintain limits on political excess.

  "Imperfections, such as externalities, are the rule and not the exception; indeed they are to be expected of a system where imperfect political markets inevitably lead to imperfect legislative solutions that then impose imperfect institutional frameworks to underpin the economic markets. Only a political authority can correct these market frameworks, and this in itself should warn us that externalities will never be eliminated. Thus a market economy should be presumed to contain distortions that range from small to large, and even 'extra-large.' Furthermore these distortions can range far beyond asymmetries of information to include asymmetries of power and their routine abuse."

  Thus, the maintenance of competitive capitalist markets that meet the broad economic needs of the people and the nation depends on the political markets functioning properly to assure that both political and economic markets work for the people instead of just for the politically influential and economically powerful.
 &

Capitalism is as much a political phenomenon as an economic  one. It involves - and requires - not just Smith's "invisible hand" in economic markets, but the "visible hands" of political actors in political markets.

  Capitalism must be viewed as part of a system where economic markets are embedded in institutions designed and governed by political authority. Capitalism is as much a political phenomenon as an economic one. It involves - and requires - not just Smith's "invisible hand" in economic markets, but the "visible hands" of political actors in political markets. In democracies, political markets include elections, legislatures, and the activities of civil society and economic interests. "Visible hand" impacts of human agency also flow from government and private institutions that have economic authority.
 &
  That the nature of "democracy" is as poorly defined as that of capitalism is a major complication. Democracy, too, has a defining feature - democratic elections. However, democracy must be complemented by a broad panoply of supporting institutions. Elections alone do not constitute "democracy." One man, one vote, one time is not democracy. The defining feature of capitalism is indeed its free economic markets, but a free market alone may be nothing more than a Middle East bazaar or the town square on market day in a feudal or slave society.
 &

The huge concentrations of industrial power were ironically used by socialists and communists as a reason for establishing "a centrally planned, coercive state that would monopolize power even more" than either feudalism or the 19th century industrial giants.

  "Smith's conception of atomistic capitalism, where firms had little or no economic power," was already an inadequate framework for analyzing capitalist systems as they had developed by the last part of the 19th century. By that time, capitalist markets were dominated by vast industrial giants. Democracies were few in number at that time and governments had not launched any efforts to "embed markets in regulatory frameworks" to protect labor or other interests.
 &
  Scott points out that "capitalism" was being defined at that time by its adversaries, including most notoriously Karl Marx. (See the six articles on Marx, "Das Kapital," beginning with Part I: "Value Determined by an Abstract Labor Standard.") One of Marx' many great analytical weaknesses was his failure to recognize the possibilities for reform (a recognition that would have undermined his revolutionary aspirations). Capitalist proponents were more preoccupied with fending off utopians like Robert Owen. For this purpose they invoked the "laissez faire" propaganda myth that markets functioned best when governments intervened least.
 &
  Capitalism was just a very imperfect alternative to feudalism at that time. Huge concentrations of industrial power replaced concentrated feudal power. This imperfection was ironically used by socialists and communists as a reason for establishing "a centrally planned, coercive state that would monopolize power even more" than either feudalism or the 19th century industrial giants. The ongoing contest between a democratic capitalism and an oligarchic capitalism was just beginning.
 &

The narrow scope of modern economics:

 

 

&

  Capitalism was actually viewed in a broader context at that time. The field was called "political economy" and it recognized the role of politics in economic markets. Since then, theoretical and analytical economists have persistently narrowed their focus first to just economic relationships and then "to economic relationships that can be mathematically modeled, as though economics were a science devoted to the discovery and exposition of a system of natural laws."
 &

The massive role of government in facilitating and governing markets has been obvious throughout the two century history of capitalism.

  Today, microeconomics and the prevailing conception of capitalism focuses predominantly on largely self regulating markets assisted by such basic government services as property rights and rule of law and security for persons and property. (Smith specifically recognized defense, rule of law and infrastructure as important government roles.) This may have been adequate in Smith's time, Scott points out, but is certainly inadequate today.
 &
  This narrow focus has been coming under increasing criticism. Scott notes that one critic, Michael Merrill, in a 1995 article directed at getting economics back to political economy, suggested a broadened definition of capitalism. Merrill asserted that capitalism is not just economic markets, but "a market economy ruled by, or in the interests of, capitalists." As Scott points out, Merrill's view is untenable. It "assumes that the interests of capitalists not only do prevail but should prevail." (emphasis in original)

  Adam Smith discusses "The Wealth of Nations," not the wealth of businessmen. Even Marx acknowledged that free markets imposed ruthless competitive pressures on capitalists that they were largely helpless to oppose.
 &
  For Smith, the free market system is justified by benefits to consumers, benefits to government, and benefits to society as a whole. Nor was atomistic competition the whole story. There were at that time giant trading companies and other monopolies chartered by the Crown that dominated entire economic spheres. 

  Merrill's view is also hopelessly simplistic. The massive role of government in facilitating and governing markets has been obvious throughout the two century history of capitalism. Human agents from the political sphere, Scott points out, must play substantial roles "if the market frameworks are to reflect public interest through proper recognition of true social costs and benefits."
 &

Competition cannot be the only regulatory agency.

  Other critics, most prominently Milton Friedman, have also provided alternatives to the narrow focus of the mathematical economists, but their focus, too, has been too narrow. Scott criticizes Friedman for concentrating on the abuse of political power and ignoring the potential for abuse of economic power. (See, three articles beginning with Friedman & Schwartz, "A Monetary History of the U.S.(1867-1960)," Part I, "Greenbacks and Gold (1867-1921)") Competition may be a powerful disciplinary force in the economic markets, but its impact on market participants may vary greatly with size, geographical position, economic status and other factors. The interests of those with "meager resources, little education or human capital, and/or no financial capital with which to take advantage of market opportunities," will not be adequately protected by unfettered markets. Competition cannot be the only regulatory agency.

  
  Even Keynesian economists are increasingly criticizing the unrealistically narrow focus of mathematical economics. See, Akerlof & Shiller, "Animal Spirits," criticizing mathematical economics for intentional ignorance of obviously outcome determinative psychological and social factors. Such factors as "confidence" and "trust" and "corruption" are ignored simply because they cannot be measured or estimated and expressed as an equation. Mathematical economics thus fails to even adequately cover the trading markets. The same criticism is raised by Baumol, Litan and Schramm, in "Good Capitalism, Bad Capitalism," This criticism, too, has been a persistent FUTURECASTS theme since its inception. See, "Capital as Purchasing Power."
 &
  See, also, Tavakoli, "Dear Mr. Buffett," explaining why the Credit Crunch cannot be explained or its problems adequately remedied without taking into account the regulatory failures and Congressional mismanagement involved. Cooper, "The Origin of Financial Crises," explains the massive role of  central banks, especially the Federal Reserve, and the mismanagement of monetary policy in generating financial crises, particularly including the Credit Crunch.

  The need for a broader focus than mathematical economists can provide is obvious. Economic influence can undermine political functions just as political influence can undermine economic functions, Scott points out. "Economic power can be a force for the subversion of equality among persons, and thus a force for the subversion of freedom and democracy."
 &

Neo-classical theory has proven inadequate as a basis for development policy. "It is concerned with the operation of markets, not with how the markets develop."

  The five decades of failure of development economics since WW-II has been the subject of economic historian Douglas North. Scott supports his view that neo-classical theory has proven inadequate as a basis for development policy. "It is concerned with the operation of markets, not with how the markets develop," Scott points out.
 &
  The institutions in which markets are embedded must be a part of economic analysis and the definition of capitalist systems. It is institutions that create the incentives that promote economic growth or stagnation or decline. However, even North fails to actually analyze those institutions as existing, evolving, thriving or declining entities in their own right. To what degree is economic development guided by human agency, natural forces, or both?
 &

Factor markets:

 

&

  Human agency - human political choices - play a major role in the development of the pertinent institutions, Scott emphasizes. The focus on the "trading paradigm" misses the aspect of capitalism which bears most directly on the "productive paradigm" involving the marshalling of resources for profitable development.
 &

Capitalism is certainly more than a system for trading. It is the production paradigm that "is most susceptible to gross abuses of power," and is most subject to the influence of human agency within the capitalist system. If political actors do not develop and maintain property rights, contract rights, rule of law systems and the whole panoply of supporting and regulatory institutions, modern capitalism cannot exist.

  The importance of institutional framework becomes clearly evident from a summary of the corporate production paradigm.

  "The production paradigm can be - - - characterized in terms of its primary actors and forces: Private parties are allowed to mobilize resources through various legal vehicles such as corporations to develop and exploit new technologies in search of profits, while corporations are permitted to lock in shareholder capital indefinitely at the discretion of the board of directors, and they are permitted the rights of self-governance through hierarchies; shareholders are shielded from losses through legislative grants of limited liability; managers are permitted to coordinate activities across functions and sectors through hierarchical organizations; employers are permitted to use implicit coercion, such as the loss of a job for employees who fail to carry out assigned roles; and competition for profits governs the allocation of resources and of internal rewards."

  As focus on the production paradigm demonstrates, capitalism is certainly more than a system for trading. It is the production paradigm that "is most susceptible to gross abuses of power," and is most subject to the influence of human agency within the capitalist system. If political actors do not develop and maintain property rights, contract rights, rule of law systems and the whole panoply of supporting and regulatory institutions, modern capitalism cannot exist.

  "Focusing on trade misses the importance of the production paradigm in developing the factor markets and thus in developing capitalism itself. Moreover, it misses the role of human agents, specifically political actors, in the emergence and ongoing evolution of capitalism."

  The essential elements of the capitalist economy thus include not just the product markets but also the factor markets and the supporting institutions and the political activities that develop and govern them. Politics includes political and societal institutions that are generally studied in the field of political science and remain outside the purview of economists. However, the contests for political influence have a direct impact on economic developments, and economic influence directly influences political developments.

  "Economic governance thus inevitably involves political institutions as well as political objectives, and capitalism cannot be reduced to the impersonal science of market forces alone."

The role of the "visible hand:"

 

&

  Scott views capitalism as a particular system of governance. Since it is more than just markets, it must be analyzed as part of the broader field of political economy. It must include the political authority that governs how institutions, incentives and constraints are designed and shaped through political processes and the courts as well as how they are administered.
 &

The modern field of economics in general and mathematical economics in particular are currently focused narrowly just on market transactions. Without the broader scope of political economy, economic policy will continue to fail at development economics, and the field of modern economics will continue to fail to provide an understanding of the business cycle.

  In the political sphere, human agency "determines the rights, responsibilities, and resulting powers of individuals and institutions within the economic system over time." This is the broad province of "political economy." The modern field of economics in general and mathematical economics in particular are currently focused narrowly just on market transactions. Without the broader scope of political economy, economic policy will continue to fail at development economics, and the field of modern economics will continue to fail to provide an understanding of prosperity or decline in developed nations. Major causes involved in the swings of the business cycle will remain beyond the understanding of modern economists.
 &
  The "visible hand" of human agents working through political and institutional processes establish and maintain the institutional structures that "shape the markets in which the invisible hand of the pricing mechanism operates." The emergence and development of capitalism is inexplicable without such "constant human intervention." It has not been a "natural" process. Capitalist systems have been "driven by human purposes from their very origins." Human agents remain involved in purposive adaptations. This implies a human strategy, "even if an imperfect or incoherent one," working through government. There exist varieties of economic governance and varieties of capitalism.
 &

Market participants act in the relatively free economic markets within the bounds of laws and rules that establish acceptable behavior.

  Scott explains capitalism as a three level system of economic markets, private and public institutions, and political authority accountable to political markets. It is an indirect system of governance, since market participants act in the relatively free economic markets within the bounds of laws and rules that establish acceptable behavior.  Informal customs among market participants are of course also very important.
 &
  There are both product markets and factor markets. Many of the defining institutions of capitalism, such as land, labor, and capital, tend to be in the factor markets. Any economic system can have markets to trade products, but the lending of capital, the sale of land, and the contracting of labor require a particular social and legal system that permits and enforces freely negotiated contracts involving the factors of production.
 &
  The author emphasizes that widely spread opportunity is a vital capitalist element. Feudal and slave labor societies lack such opportunity - as do societies where education is not widely available. To gain widespread opportunity, people in Europe have often had to violently overthrow feudal and slaveholder overlords. Slave and feudal systems are "statist" systems of direct governance through hierarchy using command and control systems, whereas capitalism as Scott envisions it is "an indirect system of governance where governance occurs not by political authority itself but rather through the rules and institutions it shapes." (emphasis in original)

  Many Latin American states are today suffering the consequences of their failure to offer education and other civil society benefits to their indigenous underclass. The result has been underclass support for demagogues, demagogic mismanagement of economic systems and the failure yet once again of democratic experiments in these states. See, Chua, "World on Fire."

  Friedman's view, the author points out, is that most market constraints should be by the customs developed over time by market participants. Markets should be impersonal, apolitical, and unbiased, and government should play as minimal a role as possible. However, even Friedman accepts that government's role has to include doing what "the market cannot do for itself, namely to determine, arbitrate and enforce the rules of the game." But Scott asserts that the market system described by Friedman actually describes informal gray or black market trade or the roadside fruit stand, not capitalism. It would be neither as efficient nor transparent as appropriately governed capitalist markets.
 &

  The assertion that market capitalism "separates economic activities from political views" is a practical impossibility, the author points out in a further criticism of Milton Friedman. Political biases are inherent realities in these as in all political actions. The laws "are always created by political actors and therefore, to some extent, always contain a political agenda or tilt within them." Economic analysis must be broad enough to encompass this political fact of life.
 &

  Laws and regulations designed to facilitate markets contrast with those designed to burden markets or constrain them in favor of the politically influential. As an example of a rule that facilitates a market, Scott refers to the credit card law requirement that issuers assume responsibility for most charges on lost or stolen cards. The issuers can spread these costs widely and most effectively act to minimize them. This rule increases cardholder confidence in the use of the cards.
 &
  Thus, in addition to the market price mechanism, capitalism requires an elaborate institutional framework including "the administrative apparatus through which the visible hand of government translates estimated societal costs and benefits into various rights, taxes, and subsidies in order to approximate true social costs for each particular society." Modern capitalism also requires private institutions - firms large and small with their hierarchical control apparatus and their strategies for competition.

  One of the key political questions concerning any particular economic policy is thus whether the government apparatus is facilitating market mechanisms and pursuing broad societal goals or directing benefits to politically influential entities or groups. There is also the ongoing problem of differentiating big firm competitive strategies from abusive strategies. Competition provides an essential disciplinary factor in all three spheres - economic market, political market and private firm - so all efforts to provide protection from competition should be vigorously fought. But, as Scott points out, even competition is hardly all-powerful. The incentives for rent seeking and claims for benefits from the public treasury are omnipresent, and most efforts at "reform" in Washington include thinly disguised efforts at promoting particular interests.
 &
  The great strength of Scott's broadened concept of capitalist economics is that it brings into focus the Good, the Bad, and the Ugly of political sector economic activities. Without focus on the political sphere, the reasons for the failures and successes of economic development are inexplicable. The economic differences between the U.S. and Argentina, for example, are primarily found in the political sphere.
 &
  Learned economists consider such matters a "mystery." Paul Krugman, for another example, in "Peddling Prosperity" (1995),  finds economic growth "magic" and both economic development and the business cycle a "mystery." The reasons for persistent high levels of unemployment in Europe during the 1980s is yet another "mystery." All of these economic mysteries can only be resolved by a critical examination of the mix of government policies and the characteristics of pertinent institutions.
 &
  Thus, Scott's broadened  focus is absolutely essential for understanding the business cycle and economic development. It brings into consideration all the many things that governments do well as well as everything they do to undermine economic stability. Learned economists concentrating only on broad economic aggregates like "savings" and "GDP" and "effective demand" miss the essential causative elements in the economic and political and institutional spheres. Keynesian economists are forced to openly and candidly confess incompetence at the essential task of forecasting the business cycle, largely because of the narrowness of their focus. Yet it is precisely the mitigation of the business cycle that is the primary focus of Keynesian policies. The 40 year record of accurate published economic forecasts compiled by the publisher of FUTURECASTS was made possible precisely because of his broader focus. See the four articles setting forth his forecasting record available through the links on the About the publisher page.
 &
  Of course, political leaders may not be welcoming towards this broader focus that shines a light on their policy misadventures. It will make harder the essential business of throwing blame on scapegoats - such as speculators, OPEC and the oil companies, and the current favorite target, the insurance companies. The response of the economists who serve them will be interesting - and important - since their government positions give them extraordinary status within the economics profession.

Democratic governments thus have an unavoidable responsibility to protect the citizenry from the abuse of economic power. They must also provide a wide range of "public goods."  The study of economics and the analysis of economic markets thus must include both the political and economic spheres and all their interactions.

  As in professional sports, the institutional context shapes but does not control competitive behavior. In the formative years, the rules of a sport draw upon "custom, consensus and un-coerced conformity," evolving over time. However, modern professional games are governed by formal rule-making bodies. Modern capitalist markets are governed according to sometimes narrow majorities in legislatures and courts.
 &
  The fictional atomistic market is a propaganda ploy, Scott points out. (It is the "laissez faire" propaganda ploy.) It is invoked in efforts to change laws that impact the markets. It supports deregulation that opens the gates "to a free-for-all in the markets." It "becomes a form of political reasoning masquerading as economics."

  The "laissez faire" propaganda ploy is today more often used for the opposite purpose, to denigrate and silence opposition to political initiatives instead of considering those initiatives on their merits.

  The vast growth of power and political as well as economic influence of the 19th century industrial giants provides prominent examples of how unfettered market participants can destroy freedom in political as well as economic markets. Economic power can be, and has been, abused just like political power. Markets can be shaped to work for the few rather than for the many. This has in fact been common in oligopolistic nations from Russia and Central Asia to Latin America.
 &
  Democratic governments thus have an unavoidable responsibility to protect the citizenry from the abuse of economic power. They must also provide a wide range of "public goods."  The study of economics and the analysis of economic markets thus must include both the political and economic spheres and all their interactions.
 &

Institutions:

  The power relationships in capitalist systems are emphasized by Scott. He focuses on the scope and interplay of the linkages between economic and political power.
 &

Capitalism cannot be understood without the political inputs of "human agency." There is and always has been a "visible hand" involved in shaping free market capitalism through political processes.

 

Capitalist free markets are embedded in institutions of public administration and government.

 

It is the state that grants the power to enter, compete and exit from markets, and restrains participants from abuse of such power. Market participants are compelled to follow the rules.

  Numerous alphabet soup institutions play governing and administrative roles in the U.S. Economic analysis must cover "the basic institutional foundations, including physical and social infrastructure as well as the individuals and organizations operating them." The author mentions transportation and communications infrastructure as well as educational, public health and legal systems. These institutions define acceptable market behavior. They are agents of the state. (They also include the private agencies that have public responsibilities, like securities and commodities exchanges and regional reserve banks.)
 &
  Above them all are the political institutions that govern political markets. In democracies, they include reasonably fair elections and the influence of a politically, legally and economically empowered civil society. "Laws do not make themselves or enforce themselves. Unless there is demand for enforcement, it will not normally happen." Capitalism cannot be understood without the political inputs of "human agency." There is and always has been a "visible hand" involved in shaping free market capitalism through political processes.

  "[The] invisible hand can only align individual and societal priorities if the institutional foundations of capitalism have shaped those markets so that individual costs and benefits reflect those of society rather than those of an unruly mob or powerful elites. The pricing mechanism cannot come close to achieving an optimal coordinating role absent the effective work of the visible hand of government." (emphasis in original)

  Indeed, various forms of economic, administrative and political coercion are pervasive in free market capitalism. Coercion is employed "to create the freedoms of a capitalist system." It is the rule of law that creates and enforces contract rights. Thus, capitalist free markets are embedded in institutions of public administration and government.
 &
  In developed capitalist systems, freedom is thus almost always "conditional" on the rules and regulations established and enforced by the state. It is the state that grants the power to enter, compete and exit from markets, and restrains participants from abuse of such power. Market participants are compelled to follow the rules.
 &

  The state, in turn, has a powerful interest in the efficient functioning of its markets. Aside from nations suffering from the oil or other natural resources curse, it is from a prosperous market economy that governments draw their revenues and derive their power - political, economic, diplomatic and military. Historically, during times of military threat, free market nations like Great Britain and the Netherlands actively mobilized their economic resources for use in their conflicts. Even mercantilist policies could be justified as a means of mobilizing economic power for state purposes.
 &
  Wise or not, purposes other than consumer welfare were reflected in economic policy. Human political agency was involved "in the design of economic institutions to pursue societal objectives, actively directing the markets towards their desired equilibria."

  Like waves in the ocean, markets always seek their equilibrium levels but can never remain there due to the constant influence of economic and political winds, tides and currents.

  However, equilibrium alone is not enough. Equilibrium may be at a very low point due to distortions or inefficiencies affecting the market. Scott mentions the Great Depression and also the Credit Crunch with the prior expansion of the housing and mortgage debt bubbles. During the Credit Crunch, the markets struggled to maintain and regain equilibrium in supply and demand against major distorting influences. (See, "Moral Hazard and Conflicts of Interest in the Credit Crunch.")

  "But the invisible hand could not judge the adequacy of the design of the market frameworks in which transactions between [market participants] took place and, as is now clear, many and perhaps most of the economic actors and regulators proved equally inept at judging the adequacy of the system. Many were even arguably unwilling to engage in such judgment, believing instead that any outcome of a so-called free market system would be acceptable if not ideal. To ignore the fundamental import of the regulatory role of a political authority in such circumstances is to substitute ideology for analysis and to invite chaos, as the results of their inaction now demonstrates."

Political economy:

  Capitalism thus must be analyzed as a mix of sociology, administration, politics, economics and law.
 &

"The essential institutions of capitalism cannot develop along with the needs of society absent the informed and capable input of human agents, such as those empowered through a government."

  Capitalism must be viewed as including the "political level" where human agency impacts markets.

  "[Capitalism is] a system of governance that requires first, the articulation of political vision to guide [and] design market frameworks that will work toward achievement of societal goals and, second, the mobilization of political power to implement those frameworks so as to shape the markets, to monitor the actions of human agents who ensure that the competitors follow the rules, and, crucially, to modify these institutional frameworks as needed to ensure that the markets yield results that are considered to be broadly in the interests of society. No invisible hand can create the frameworks in the first place, nor monitor them, nor - - - design and implement modifications to correct their unwanted side effects. The essential institutions of capitalism cannot develop along with the needs of society absent the informed and capable input of human agents, such as those empowered through a government."

  The political role may appear static in the short run. As the system operates according to its existing rules and regulations, government is involved only in an administrative capacity. However, government is not just a "given" factor. As time passes, changing conditions in the markets and changing societal objectives require adjustments to the laws and regulations that only political authority can provide. Thus, political markets are just as dynamic and vital as economic markets in understanding capitalism.
 &
  Political markets require the foresight to understand what is needed and the "entrepreneurial" political skills to mobilize the political power to effect the desired changes. This steps beyond the political role envisioned by Adam Smith, which extended to just "peace, easy taxation and a tolerable administration of justice." Changing market conditions and changing societal objectives are not accommodated by Smith's vision. Patent laws and food and drug regulations are dependent on the political and institutional spheres and are essential facilitators of economic markets. 

  Joint stock companies were already legally empowered in Smith's time and were a part of his analysis. The modern limited liability company has since become a dominant market institution.
 &
  Regulation is never the answer to any economic problem. It is always just an approach for handling otherwise intractable problems. Regulation is always operating behind the power curve of changes in market conditions and the market adjustments made in response to the regulations themselves. Regulatory "visible hands" are forever active, and unfortunately tend towards increased regulatory elaboration and complexity that may materially reduce their benefits over time. Whole volumes have been written about such difficulties.

  Scott is not nave about the capabilities of the political decision making process. He recognizes that government policies can undermine the markets, and frequently have. Loose credit and low interest rate policies played a significant role in the housing and mortgage bubbles of the Credit Crunch, and it was an obvious political mistake to leave it to the markets to deal with the results. Economic analysts thus have no choice but to cover the mix of political influences when analyzing market conditions. Political authorities must be held accountable for policies that adversely impact the markets.
 &

Abuse of the commons:

  Mitigating "the tragedy of the commons" is a vital political and institutional role emphasized by the author.
 &

  He uses the term "commons" broadly to encompass not just tangible assets but intangible assets as well, like defense, law, and the institutions of capitalism and democracy themselves. Prevention of the degradation of such assets can only be done through government.

  "Simply put, a legitimate political authority employing coercive force indirectly through politico-economic institutions ensures that such abuse is limited or perhaps non-existent."

  Currently, the degradation of fisheries provides a classic example of the tragedy of the commons in a still largely informal economic market of the type Friedman described. Atmospheric pollution provides another example.

  However, a large part of the environmental abuse of the 19th and early 20th centuries was due to political and judicial decisions to limit riparian rights and nuisance laws. The political market almost invariably has to wrestle with unintended consequences and, as Scott notes, is hardly infallible.

  Market frameworks themselves are an intangible "common" that can be - and have been - and even today are being - subject to abuse. The framework for goods and services markets grew naturally from common practices and the laws, infrastructure and physical security that facilitate the markets. However, factor markets, involving land, labor, technologies and capital, required far more political and institutional input. Serfs and slaves had to be freed from feudal obligations, corporate entities had to be accorded legal status. These developments occurred much earlier in some nations than in others, and sometimes required violent change. In some states, even today, these changes remain partial at best.

  "While excessive regulation has stifled many economies for long periods, inadequate regulation is also a threat to effective decentralized decision-making throughout the global common. Abuse of the common is an ever-present temptation that comes with economic freedom. Effective use of a commercial common, as well as its effective protection from abuse, depends upon the maintenance of an effective system of economic governance, and, for all practical purposes, today that means governance through a capitalist system headed by a legitimate political authority.

Government enterprises:

 Government ownership of economic entities creates conflicts of interest that as a practical matter become irresistible. (This applies to government sponsored enterprises, too.)
 &

  The regulatory and tax framework will always be biased in favor of the government entities.

  Fannie Mae and Freddy Mac are the most recent and dramatic examples of this bias - and the budget costs that these non-budget activities can accrue. The same thing will most assuredly occur with respect to the "public health insurance option." Private "competition" is routinely destroyed by taxpayer benefits and regulatory advantages for such entities. Private entities are tax payers, the public entity is a tax absorber. Such "competition" becomes a joke as the government entity uses its taxpayer benefits to take over or dominate the entire market. Already, Congress is aggressively loading up private insurers with  mandates, regulations and tax burdens that will doom them in favor of the public "option."

  Scott thus advises caution in establishing government economic entities or in government takeover of private entities. Exceptions for public utilities and during periods of national emergency are recognized.

  "If direct interventions are widespread and/or last indefinitely, they invite corruption and the distortion of market frameworks for the benefit of the few at the expense of society as a whole. In a second, more passive form of abuse, the government may indirectly contribute to others' abuse by allowing those economic actors with greater economic or political power to influence its own agents and thereby shape the institutions and markets of capitalism to their private advantage."

  This in fact occurred with Fannie Mae and Freddy Mac as they used their implied credit subsidies to dominate their markets. They became cash cows funneling millions into the campaign funds of incumbent politicians. Party favorites were routinely given the highest management positions and munificent pay packets. These abuses were notorious and were the frequent subject of articles in the financial press, but the politicians did nothing to disturb their cash cow. Now the taxpayer is on the hook for hundreds of billions of dollars, and the politicians pretend innocence and shocked amazement as to what has occurred.

Competition in the political market:

  Government actions inevitably "tilt" the markets towards politically influential groups. The tilt may be explicit and/or implicit. Indeed, there will always be a combination of impacts, and they will not always be consistent.
 &

  Among the broad categories of people vying for political favor are capital and labor, investors and creditors, producers and consumers. Promotion of growth and development may vie with protection of the status quo. Different levels of risk may be accepted or rejected. Responsibilities are allocated. Government decisions inevitably favor certain interests over others.
 &
  Government "strategies" may be implicit or explicit, broadly or narrowly focused. They typically are developed and applied over time and are the work of numerous people and groups, acting usually in a haphazard sequence of action rather than according to some grand plan. Government strategy can be influenced by outside groups through campaign funding and lobbying.

  Business groups, for example, routinely engage in "managed" litigation. They settle unattractive cases while waiting for attractive cases to take to appellate levels to establish favorable legal rules.

  The market for land is a primary example. This market is shaped by zoning laws and laws governing property rights. Both zoning laws and property rights can be changed by pertinent officials as societal priorities change.
 &
  Different strategies lead to different outcomes.
The author contrasts the different strategies in the EU and the U.S. concerning gasoline and pharmaceuticals.
 &
  Higher taxes in the EU make its gasoline considerably more expensive. Although both the EU and the U.S. favor increased fuel efficiency, Europe's market oriented tax policy has been far more effective than the administered U.S. alternative of imposed regulatory requirements. The U.S. permits patent monopoly pricing for patent drugs while almost all other nations enforce price controls at lower price levels. Thus, the U.S. market subsidizes drug research for the whole world. The world is free-riding on the U.S. market. Since much of this extra cost is borne by employers, U.S. producers are at a competitive disadvantage.
 &
  The quintessential capitalist example is the way governments distribute risks and rewards amongst creditors and investors, corporations and individuals. Corporations, with their rights and risks, are creatures of the law. Foreclosure rights and creditors rights are also creatures of the law.
 &
  Governments thus shape capitalist systems, fulfilling their political "entrepreneurial" role to - at best - achieve societal goals or - at worst - favor the politically influential. Usually, there is a mix of both in market reform efforts.

Please return to our Homepage and e-mail your name and comments.
Copyright 2009 Dan Blatt