Redefining Capitalism

Redefining capitalism

In other words, the essential role of capitalism is not allocation—it is creation.

May 22, 2019 at 10:35AM

via Instapaper

Capitalism is under attack. The financial crisis of 2008, the stagnation of the middle class in many developed countries, and rising income inequality are challenging some of our most deeply held beliefs about how a fair and well-functioning society should be organized.

market capitalism has yielded massive increases in human prosperity, particularly in the West in the 19th and 20th centuries. More recently, it has lifted hundreds of millions from poverty in emerging economies.

we have been mostly incorrect in identifying how and why it worked so well.

Only by replacing our old theories with better and more modern ones will we build the deeper understanding necessary to improve our capitalist system.

The story is familiar: rational, self-interested firms maximize profits; rational, self-interested consumers maximize their “utility”; the decisions of these actors drive supply to equal demand; prices are set; the market clears; and resources are allocated in a socially optimal way.

Behavioral economists have accumulated a mountain of evidence showing that real humans don’t behave as a rational homo economicus would.

Empirical economists have identified anomalies suggesting that financial markets aren’t always efficient. And the macroeconomic models built on neoclassical ideas performed very poorly during the financial crisis.

The economy—a complex, dynamic, open, and nonlinear system—has more in common with an ecosystem than with the mechanistic systems the neoclassicists modeled their theory on.

Significantly, this view shifts our perspective on how and why markets work from their allocative efficiency to their effectiveness in promoting creativity. It suggests that markets are evolutionary systems that each day carry out millions of simultaneous experiments on ways to make our lives better. In other words, the essential role of capitalism is not allocation—it is creation.

Life isn’t drastically better for billions of people today than it was in 1800 because we are allocating the resources of the 19th-century economy more efficiently. Rather, it is better because we have life-saving antibiotics, indoor plumbing, motorized transport, access to vast amounts of information, and an enormous number of technical and social innovations that have become available to much (if not yet all) of the world’s population. The genius of capitalism is that it both creates incentives for solving human problems and makes those solutions widely available. And it is solutions to human problems that define prosperity, not money.

This is why prosperity in human societies can’t be properly understood by looking just at monetary measures, such as income or wealth. Prosperity in a society is the accumulation of solutions to human problems.

In our view, the biggest problem with GDP is that it doesn’t necessarily reflect how growth changes the real, lived experience of most people.

people across the board have benefited from improvements in technology (say, safer cars, new medical treatments, and smartphones).

unintended consequences (such as the stress many knowledge workers feel from 24/7 connectivity). Is life actually better or worse for most people? How are the gains of growth shared? GDP cannot answer these questions.

growth cannot simply be measured by changes in GDP. Rather, it must be a measure of the rate at which new solutions to human problems become available.

Going from needing to look up basic information in a library to having all the world’s information instantly available on your phone is growth.

Growth is best thought of as an increase in the quality and availability of solutions to human problems.

Can the rate at which solutions appear and their availability be measured? While such a measure has not been tried yet, we believe it is possible

What kind of food, housing, clothing, transport, healthcare, education, leisure, and entertainment do people have access to?

This is the genius of capitalism: it is an unmatched evolutionary system for finding solutions.

Human creativity develops a variety of ways to solve such problems, but some inevitably work better than others, and we need a process for sorting the wheat from the chaff. We also need a process for making good solutions widely available.

The great economist Joseph Schumpeter called this evolutionary process “creative destruction.”

It is this creative effectiveness that by necessity makes it hugely inefficient and, like all evolutionary processes, inherently wasteful.

Thus, the crucial contribution business makes to society is transforming ideas into products and services that solve problems.

But some argue that elevating the creation of shareholder value to the status of primary objective is based on a faulty assumption—that capital is the scarcest resource in an economy, when in reality it’s knowledge that’s the scarce, critical ingredient in solving problems.

If you asked a CEO in the 1950s, an era of tremendous prosperity growth, what his job was, his first reply would probably have been “to make great products and services for customers.” After that, the CEO might have said something about looking after his company’s employees, making profits to invest in future growth—and then, finally, giving the shareholders a decent, competitive return.

But standard measures of business’s contribution—profits, growth rates, and shareholder value—are poor proxies

Today our culture celebrates money and wealth as the benchmarks of success. This has been reinforced by the prevailing theory. Suppose that instead we celebrated innovative solutions to human problems.