Issue #31, Winter 2014

Capitalism Redefined

What prosperity is, where growth comes from, why markets work—and how we resolve the tension between a prosperous world and a moral one.

For everyone but the top 1 percent of earners, the American economy is broken. Since the 1980s, there has been a widening disconnect between the lives lived by ordinary Americans and the statistics that say our prosperity is growing. Despite the setback of the Great Recession, the U.S. economy more than doubled in size during the last three decades while middle-class incomes and buying power have stagnated. Great fortunes were made while many baby boomers lost their retirement savings. Corporate profits reached record highs while social mobility reached record lows, lagging behind other developed countries. For too many families, the American Dream is becoming more a historical memory than an achievable reality.

These facts don’t just highlight the issues of inequality and the growing power of a plutocracy. They should also force us to ask a deeper set of questions about how our economy works—and, crucially, about how we assess and measure the very idea of economic progress.

How can it be that great wealth is created on Wall Street with products like credit-default swaps that destroyed the wealth of ordinary Americans—and yet we count this activity as growth? Likewise, fortunes are made manufacturing food products that make Americans fatter, sicker, and shorter-lived. And yet we count this as growth too—including the massive extra costs of health care. Global warming creates more frequent hurricanes, which destroy cities and lives. Yet the economic activity to repair the damage ends up getting counted as growth as well.

Our economic policy discussions are nearly always focused on making us wealthier and on generating the economic growth to accomplish that. Great debates rage about whether to raise or lower interest rates, or increase or decrease regulation, and our political system has been paralyzed by a bitter ideological struggle over the budget. But there is too little debate about what it is all for. Hardly anyone ever asks: What kind of growth do we want? What does “wealth” mean? And what will it do for our lives?

The Price of Everything, the Value of Nothing

The most basic measure we have of economic growth is gross domestic product. GDP was developed from the work in the 1930s of the American economist Simon Kuznets and it became the standard way to measure economic output following the 1944 Bretton Woods conference. But from the beginning, Kuznets and other economists highlighted that GDP was not a measure of prosperity. In 1959, noted American economist Moses Abramovitz cautioned that “we must be highly skeptical of the view that long-term changes in the rate of growth of welfare can be gauged even roughly from changes in the rate of growth of output.”

In 2009, a commission of leading economists convened by President Nicolas Sarkozy of France and chaired by Nobel laureate Joseph Stiglitz reported on the inadequacies of GDP. They noted well-known issues such as the fact that GDP does not capture changes in the quality of the products (think of mobile phones over the past 20 years) or the value of unpaid labor (caring for an elderly parent in the home). The commission also cited evidence that GDP growth does not always correlate with increases in measures of well-being such as health or self-reported happiness, and concluded that growing GDP can have deleterious effects on the environment. Some countries have experimented with other metrics to augment GDP, such as Bhutan’s “gross national happiness index.”

Our issue isn’t with GDP per se. As the English say, “It does what it says on the tin”—it measures economic activity or output. Rather, our issue is with the nature of that activity itself. Our question is whether the activities of our economy that are counted in GDP are truly enhancing the prosperity of our society.

Since the field’s beginnings, economists have been concerned with why one thing has more value than another, and what conditions lead to greater prosperity—or social welfare, as economists call it. Adam Smith’s famous diamond-water paradox showed that quite often the market price of a thing does not always reflect intuitive notions of its intrinsic value—diamonds, with little intrinsic value, are typically far more expensive than water, which is essential for life. This is of course where markets come into play—in most places, water is more abundant than diamonds, and so the law of supply and demand determines that water is cheaper.

After lots of debate about the nature of economic value in the nineteenth and early twentieth centuries, economists considered the issue largely settled by the mid-twentieth century. The great French economist Gerard Debreu argued in his 1959 Theory of Value that if markets are competitive and people are rational and have good information, then markets will automatically sort everything out, ensuring that prices reflect supply and demand and allocate everything in such a way that everyone’s welfare is maximized, and that no one can be made better off without making someone else worse off. In essence, the market price of something reflects a collective judgment of the value of that thing. The idea of intrinsic value was always problematic because it was inherently relative and hard to observe or measure. But market prices are cold hard facts. If market prices provide a collective societal judgment of value and allocate goods to their most efficient and welfare-maximizing uses, then we no longer have to worry about squishy ideas like intrinsic value; we just need to look at the price of something to know its value.

Debreu was apolitical about his theory—in fact, he saw it as an exercise in abstract mathematics and repeatedly warned about over-interpreting its applicability to real-world economies. However, his work, as well as related work in that era by figures such as Kenneth Arrow and Paul Samuelson, laid the foundations for economists such as Milton Friedman and Robert Lucas, who provided a devastating critique of Keynesianism in the 1960s and ’70s, and recent Nobel laureate Eugene Fama, who pioneered the theory of efficient markets in finance in the 1970s and ’80s. According to the neoclassical theory that emerged from this era, if markets are efficient and thus “welfare-maximizing,” then it follows that we should minimize any distortions that move society away from this optimal state, whether it is companies engaging in monopolistic behavior, unions interfering with labor markets, or governments creating distortions through taxes and regulation.

These ideas became the intellectual touchstone of a resurgent conservative movement in the 1980s and led to a wave of financial market deregulation that continued through the 1990s up until the crash of 2008. Under this logic, if financial markets are the most competitive and efficient markets in the world, then they should be minimally regulated. And innovations like complex derivatives must be valuable, not just to the bankers earning big fees from creating them, but to those buying them and to society as a whole. Any interference will reduce the efficiency of the market and reduce the welfare of society. Likewise the enormous pay packets of the hedge-fund managers trading those derivatives must reflect the value they are adding to society—they are making the market more efficient. In efficient markets, if someone is willing to pay for something, it must be valuable. Price and value are effectively the same thing.

Even before the crash, some economists were beginning to question these ideas. Robert Shiller of Yale University, who ironically shared this year’s Nobel with Fama, showed in the early 1980s that stock market prices did not always reflect fundamental value, and sometimes big gaps could open up between the two. Likewise, behavioral economists like Daniel Kahneman began showing that real people didn’t behave in the hyper-rational way that Debreu’s theory assumed. Other researchers in the 1980s and ’90s, even Debreu’s famous co-author Arrow, began to question the whole notion of the economy naturally moving to a resting point or “equilibrium” where everyone’s welfare is optimized.

An emerging twenty-first century view of the economy is that it is a dynamic, constantly evolving, highly complex system—more like an ecosystem than a machine. In such a system, markets may be highly innovative and effective, but they can sometimes be far from efficient. And likewise, people may be clever, but they can sometimes be far from rational. So if markets are not always efficient and people are not always rational, then the twentieth century mantra that price equals value may not be right either. If this is the case, then what do terms like value, wealth, growth, and prosperity mean?

Prosperity Isn’t Money, It’s Solutions

In every society, some people are better off than others. Discerning the differences is simple. When someone has more money than most other people, we call him wealthy. But an important distinction must be drawn between this kind of relative wealth and the societal wealth that we term “prosperity.” What it takes to make a society prosperous is far more complex than what it takes to make one individual better off than another.

Most of us intuitively believe that the more money people have in a society, the more prosperous that society must be. America’s average household disposable income in 2010 was $38,001 versus $28,194 for Canada; therefore America is more prosperous than Canada.

But the idea that prosperity is simply “having money” can be easily disproved with a simple thought experiment. (This thought experiment and other elements of this section are adapted from Eric Beinhocker’s The Origin of Wealth, Harvard Business School Press, 2006.) Imagine you had the $38,001 income of a typical American but lived in a village among the Yanomami people, an isolated hunter-gatherer tribe deep in the Brazilian rainforest. You’d easily be the richest Yanomamian (they don’t use money but anthropologists estimate their standard of living at the equivalent of about $90 per year). But you’d still feel a lot poorer than the average American. Even after you’d fixed up your mud hut, bought the best clay pots in the village, and eaten the finest Yanomami cuisine, all of your riches still wouldn’t get you antibiotics, air conditioning, or a comfy bed. And yet, even the poorest American typically has access to these crucial elements of well-being.

And therein lies the difference between a poor society and a prosperous one. It isn’t the amount of money that a society has in circulation, whether dollars, euros, beads, or wampum. Rather, it is the availability of the things that create well-being—like antibiotics, air conditioning, safe food, the ability to travel, and even frivolous things like video games. It is the availability of these “solutions” to human problems—things that make life better on a relative basis—that makes us prosperous.

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

These solutions run from the prosaic, like a crunchier potato chip, to the profound, like cures for deadly diseases. Ultimately, the measure of a society’s wealth is the range of human problems that it has found a way to solve and how available it has made those solutions to its citizens. Every item in the huge retail stores that Americans shop in can be thought of as a solution to a different kind of problem—how to eat, clothe ourselves, make our homes more comfortable, get around, entertain ourselves, and so on. The more and better solutions available to us, the more prosperity we have.

The long arc of human progress can be thought of as an accumulation of such solutions, embodied in the products and services of the economy. The Yanomami economy, typical of our hunter-gatherer ancestors 15,000 years ago, has a variety of products and services measured in the hundreds or thousands at most. The variety of modern America’s economy can be measured in the tens or even hundreds of billions. Measured in dollars, Americans are more than 500 times richer than the Yanomami. Measured in access to products and services that provide solutions to human problems, we are hundreds of millions of times more prosperous.

Growth as the Rate of Solution Creation

If the true measure of the prosperity of a society is the availability of solutions to human problems, then growth cannot simply be measured by changes in GDP. Rather, growth must be a measure of the rate at which new solutions to human problems become available. Additionally, since problems differ in importance, a new view of growth also must take this into account; finding a universal flu vaccine is more important than creating a crunchier potato chip. But in general, economic growth is the actual experience of having one’s life improved. Going from fearing death from a sinus infection one day to having access to life-saving antibiotics the next is growth. Going from sweltering in the heat one day to living with air conditioning the next is growth. Going from walking long distances to driving is growth. Going from needing to go to a library to look up basic information to having all the information in the world instantly available to you on your phone is growth. (Obviously, some solutions, like air conditioning, may create other problems, like global warming. How to make the trade-offs between solutions and problems is one of the central challenges of any society—an issue we will return to later in this essay.)

This all implies that we must find new ways to measure progress. In the same way that no good doctor would measure the health of a person by just one factor—her temperature, say—the economy shouldn’t be measured with just GDP. No single metric such as GDP can capture the way in which economic activity is actually improving the lives of most citizens and the overall health of the economy.

It is not immediately obvious how the rate at which a society solves people’s problems might be directly measured. However, there might be ways to do it indirectly. For example, we measure inflation by tracking the price of a basket of goods. What about measuring access to a “basket of solutions” to human problems? How many people have access to good nutrition, health care, education, housing, transportation, a clean environment, information, communications, and other things that make a tangible impact on the quality of life? We could also ask how the basket itself is changing over time as innovation yields new solutions—for example, solving the problem of getting information has dramatically improved with the development of the Web and smartphones. Growth and prosperity could then be measured as a combination of access to existing solutions and the addition of new solutions through innovations.

The UN’s Millennium Development Goals, which include a number of measures such as gender equality, child mortality, and environmental sustainability, are an example of an attempt to gauge economic health and societal prosperity in a more multidimensional way. Such an approach could be expanded to include the idea of access to a basket of solutions. Likewise, the Organization for Economic Cooperation and Development (OECD) and the World Bank have been working on multidimensional approaches to determining the health of developed economies and already collect much of the data that would be needed to assess access to and innovation in a basket of solutions. Such measures will inevitably not be as neat and simple as GDP, but finding ways to measure both the rate at which we solve new problems and the degree to which we make those solutions broadly accessible is a more complete way to measure the health of our economy.

Capitalism: An Evolutionary, Problem-Solving System

If prosperity is created by solving human problems, then the key question for society is what kind of economic system will solve the most problems for the most people the fastest? We have centuries of evidence now that capitalist economies do better at delivering high standards of living to their citizens than do economies run by communist, authoritarian, or other nonmarket systems. The explanation for this in standard economics is that capitalism uses price signals to provide incentives to produce and allocate goods in a way that will maximize people’s welfare. But if real-world markets are not the simple mechanistic systems imagined by thinkers of past centuries, but rather are complex, adaptive, and more like ecosystems, then the benefits of capitalism may be both different and greater than we imagined.

Every business is based on an idea about how to solve a problem, from the most mundane (“How do you make a potato chip crunchier?”) to the most profound (“How do we make a new life-saving cancer drug?”). The process of converting great ideas into products and services that effectively fulfill fast-changing human needs is what defines most businesses. But effectively finding good solutions requires a system that provides incentives and allows for creativity and trial and error. A capitalist economy is best understood as an evolutionary system, constantly creating and trying out new solutions to problems in a similar way to how evolution works in nature. Some solutions are “fitter” than others. The fittest survive and propagate. The unfit die. The great economist Joseph Schumpeter called this evolutionary process “creative destruction.” And he highlighted the importance of risk-taking entrepreneurs to make it work.

Thus, the entrepreneur’s principal contribution to the prosperity of a society is an idea that solves a problem. These ideas are then turned into the products and services that we consume, and the sum of those solutions ultimately represents the prosperity of that society.

Making all but the simplest products and meeting customer demand usually require more than one person, so entrepreneurs with new solutions hire workers. Those jobs in turn provide the means for people to purchase products and services from other entrepreneurs, which then creates the demand that generates more hiring and jobs. This positive feedback loop is the central dynamic found in capitalist economies. The more power this feedback loop has, the more growth and prosperity the economy creates.

Capitalism’s great power in creating prosperity comes from the evolutionary way in which it encourages individuals to explore the almost infinite space of potential solutions to human problems, and then scale up and propagate ideas that work, and scale down or discard those that don’t. Understanding prosperity as solutions, and capitalism as an evolutionary problem-solving system, clarifies why it is the most effective social technology ever devised for creating rising standards of living.

Confusing Efficiency for Effectiveness

The orthodox economic view holds that capitalism works because it is efficient. But viewing the economy as an evolving complex system shows that capitalism works because it is effective. In fact, capitalism’s great strength is its creativity, and interestingly, it is this creativity that by necessity makes it a hugely inefficient and wasteful evolutionary process. Near one of our houses is a site where each year, someone would open a restaurant only to see it fail a few months later. Each time, builders would come in, strip out the old furniture and decor, and put in something new. Then finally an entrepreneur discovered the right formula and the restaurant became a big hit, which it is to this day. Finding the solution to the problem of what the local residents wanted to eat wasn’t easy and took several tries. Capitalism is highly effective at finding and implementing solutions but it inevitably involves trial and error that is rarely efficient.

A critical element of understanding capitalism as an evolutionary, problem-solving system is the idea that it is not how hard we try to solve a problem that is critical, but rather, as the University of Michigan theorist Scott Page has shown, it is the diversity of ideas and approaches that matters most in problem-solving effectiveness. This “difference principle” helps makes clear why open and fair markets, diversity, and inclusive institutions are signal features of successful economies.

This feature of successful capitalism also highlights why investing in the middle class with “middle-out” approaches to policy creates a healthier economy. [See “The Middle-Out Moment,” Issue #29.] Even the best of us have only a few ideas. Bill Gates, our era’s wealthiest entrepreneur, arguably had only one big idea. Giving wealthy people like him tax breaks will not suddenly encourage them to have more ideas. It is far better for our country to enable every citizen to participate in our capitalist economy by ensuring that they have the requisite education and access to capital and training to convert their ideas into products that solve the world’s problems. A “middle-out” approach recognizes that effective policy is aimed at creating both new entrepreneurs with new ideas and more customers for those entrepreneurs. If workers have no money, businesses have no customers. Successful capitalist policies recognize and animate this circle-of-life feedback loop by balancing different elements in the economy to create a virtuous cycle of growth and shared prosperity.

The genius of capitalism is the way in which it rewards people for solving other people’s problems. People who effectively solve large problems for a large number of other people can be massively rewarded. Steve Jobs made a lot of people’s lives better through the products his company created, and he was highly rewarded for it. As Adam Smith observed 230 years ago, a thoughtfully managed and regulated capitalist economy harnesses people’s self-interest to the broad interests of society.

It is this freedom and the incentives for every citizen to solve problems that explains why capitalist countries are rich and why authoritarian and communist countries are generally poor. In such countries the problem-solving creativity of people is either circumscribed, prohibited, or quite often directed at solving problems for the regime. The extraordinary difference between the poverty of communist North Korea and the prosperity of capitalist South Korea is a demonstration of this.

It’s important to acknowledge, however, that not all solutions to human problems are created by entrepreneurs. A researcher at a university finding a new way to make computers work faster can solve an important problem just as readily as a capitalist (though it may take a capitalist to produce and spread the researcher’s idea). Likewise a teacher who finds a better way to teach algebra is also solving an important problem for society. So also is the diligent government worker who finds a way to deliver better services at lower cost to the public.

But the public sector sometimes struggles to create a culture and incentives that allow space for the experimentation, risk-taking, and failure that are essential to effective problem solving. Bureaucracies and political forces can stifle or distort evolutionary exploration. That said, there are numerous problems that only government can solve, ranging from the provision of public goods such as roads and other infrastructure, to dealing with externalities such as reducing pollution, enforcing property rights, providing security, and addressing social injustices. Realistically, the public sector is going to play a big role in many parts of the economy as well as in many aspects of society. So governments need to be problem solvers, too. It is imperative that we bring the evolutionary processes of problem solving inside the walls of government and build public institutions that have incentives to innovate and space to experiment.

The view that prosperity is solutions, and growth is the rate at which we create them, also makes more obvious the crucial importance of investments by governments in technology, innovation, and education. Technology and innovation are the cornerstones of any society’s ability to generate new ideas and solutions. In most cases, it will be businesses and entrepreneurs who bring these solutions to citizens. But it will be the education of the workforce and the scientific, technical, and social innovations available to society that will empower these businesses. Thus, investments in R&D, innovation, and education are not luxuries made possible by growth and prosperity, as many policy-makers seem to believe. Rather, these investments are necessary to create growth and prosperity.

The Limits of Laissez-Faire

But the mere fact that communism and authoritarianism fail does not mean that unfettered capitalism succeeds. Traditional economic theory puts perfect markets on a pedestal, and any deviation makes someone worse off, reducing the welfare of society. But such perfect markets can’t and don’t exist in the real world. Furthermore, this view fails to recognize that the great genius of capitalism—solving people’s problems—has by necessity a dark side: The solution to one person’s problem can in turn create a problem for someone else—or even for the same person.

This is the age-old problem of political economy. How does an economic system resolve conflicts and distribute benefits? A fancy derivative product may help a corporate treasurer solve her problem of managing her company’s risk, and it might make a banker rich, but it might also create a problem of greater systemic risk for the financial system as a whole. Likewise, eating a bacon cheeseburger may solve someone’s problem of satisfying unconscious desires programmed by millennia of evolution, but might also create new problems of clogged arteries and a society burdened with that person’s future health costs.

Overwhelming evidence from the fields of social psychology and behavioral economics shows us that people are not very good at managing these trade-offs, resolving conflicts, or recognizing interdependencies on their own. We overoptimistically believe that house prices will keep rising and that we can refinance when our low teaser rate expires. The corporate treasurer can’t really see how her decision to buy a derivative might boomerang back on her own company and contribute to the collapse of the financial system.

Understanding prosperity and growth in this new way allows us to make important distinctions between different kinds of economic activity. We can now see the difference between “empty” or even “harmful” economic activity and “useful” economic activity. It becomes obvious that an engineer earning $100,000 per year who creates a technology to ensure that those in serious auto accidents walk away unharmed is creating prosperity. It is much harder to make the same case for a hedge-fund manager making $500 million per year doing high-frequency trading to seize on information advantages over ordinary investors. And if that high-frequency trading also makes the global economy more fragile, then that implies something even more damning about this activity.

It can be a challenge, however, to distinguish between “problem-solving” and “problem-creating” economic activity. And who has the moral right to decide? In the traditional framework, it was simple—people vote with their pocketbooks, and if an activity is valued by the market, it must be good. But when an activity solves a problem for some but creates a problem for others—or even the same person later on, or for future generations—who should decide what is good economic activity versus bad, and how?

The usual answer has been that government regulators get to decide. But like markets, regulators create problems as well as solve them. So we also need mechanisms to regulate the regulators. Democracy is the best mechanism humans have come up with for navigating the trade-offs and weaknesses inherent in problem-solving capitalism. Democracies allow the inevitable conflicts of capitalism to be resolved in a way that maximizes fairness and legitimacy, and broadly reflects the views of society.

Although regulation in economies is necessary, the costs to society in terms of restricting the freedom to innovate, invent, and compete can sometimes be high, as conservatives correctly point out. But it also needs to be recognized that sometimes new economic activity actually creates more problems than it solves and needs to be limited. At other times, new economic activity merely threatens the old order and should be encouraged. Finding the balance between these competing demands is difficult. Democratic governments are the only institution with the legitimacy and accountability to make such trade-offs, and that is why the corrosion of our democratic institutions by growing crony capitalism is so threatening to our long-term prosperity. It also means that those who truly care about capitalism should be more concerned about the quality and effectiveness of regulation rather than simply its quantity. [See “A Truer Form of Capitalism,” Issue #29.]

But responsibility for finding the right balance rests not just with governments, but with citizens, too. Viewing prosperity as solutions to problems helps enable citizens to use common moral sense to more clearly discern which kinds of economic activity actually make their community better off versus activity that merely enriches some of its members. Just as the neoliberal orthodoxy of the late twentieth century led to important shifts in popular culture and beliefs, we believe that new views of economics and a new definition of prosperity have the potential to change our culture, too.

Today our culture celebrates money and wealth as the benchmarks of success. Imagine if instead we celebrated innovative solutions to human problems. There are places where such an imperative prevails—for example, the MIT Media Lab, where highly talented people from around the world work tirelessly to solve the most challenging problems they can find, such as using robotics to help disabled people, or using information technology to increase civic engagement, or designing more sustainable cities. They might not necessarily make big money doing it, but they have defined their status in terms of solving big, hairy problems to help people and society. In contrast, 200 miles south of MIT on Wall Street, an equally talented group of people measures status based on the size of their paychecks. Many of these people may do great things for society too—including help the MIT geeks commercialize their inventions—but the culture and values are noticeably different.

Traditional economic orthodoxy makes the people at MIT seem irrational and the Wall Street people seem rational. Our definition of wealth and prosperity reverses this. Solving problems that benefit people is the goal, not making money. Making money might be a necessary condition for solving many problems—businesses need profits to endure and grow. But saying profits are the goal confuses means and ends. Treating profits as the goal is like saying that the purpose of life is to eat—our bodies need food, but it is a means to other ends, not the goal itself.

There are enormous moral implications that grow out of redefining prosperity. We have neither the space, nor frankly, the ability to deal with all those questions here. But we do believe that the obvious moral implications of judging economic activity by the social value of the problem it solves, rather than the money it earns for particular individuals, may lead to cultural and behavioral shifts exceeding the influence of any regulation.

Prosperity and Inequality

Capitalism may be humankind’s greatest problem-solving system, but this view says little about how the benefits of such problem solving might be distributed. In any complex society, initial advantages and disadvantages abound—where you are born, who your parents are, what education you had, what opportunities and barriers you face, and so on. One of the great attractions of capitalism is that it doesn’t care who your parents are—if you solve a big problem for a lot of people, you can be highly rewarded. Capitalist societies have real Horatio Alger stories. But at the same time, the dynamics and path dependency of capitalism can reinforce starting advantages and disadvantages. Work by Nobel laureate James Heckman and the INET Human Capital and Economic Opportunity initiative at the University of Chicago’s Becker Friedman Institute shows how factors such as early childhood nutrition and education can have compounding economic consequences that last through adult life.

Traditional economics looks at inequality through a monetary lens—for example, what share of total income the top 1 percent have. But we can also look at it as a question of access to solutions to human problems. What percentage of the population has access to good housing, transport, health care, entertainment, and so on? How does the quality of that access differ between the rich and the poor? Matt Ridley in his book The Rational Optimist makes the strong argument that viewed from this perspective, things have become both significantly better and significantly more equal—particularly when seen against the long sweep of history. The gap in nutrition between a lord and a serf in the Middle Ages was immense. Meanwhile, Warren Buffet’s nutritional intake is unlikely to be much better than that of the average middle-class American (in fact, it may be worse, as Buffett is a self-confessed lover of cheeseburgers and Coke). Likewise, Donald Trump may own a number of very nice TVs, but more than half the homes in the United States now have three or more TVs. This narrowing of the gap in material prosperity has happened not just in America but in developing countries as well, as more than a billion Chinese and Indian citizens are entering the global middle class and gaining access to important solutions like indoor plumbing, mobile phones, and motorized transportation.

Inequality as an outcome may actually look less severe than it does from traditional money-based measures. But if we consider inequality not just as an outcome but as an input into a capitalist system, things look more problematic—in particular, if it is limiting access to opportunities. As discussed, effective capitalism depends on a population of competitive, diverse problem solvers. If society is not making adequate investments in that population and providing equality of access to opportunities, the circle-of-life feedback loop of growing prosperity is broken. In a recently released international survey of skills of the adult population by the OECD—the first of its kind—the United States ranked 21st out of 23 countries in numeracy, and 14th out of 19 in “problem solving in a technology-rich environment.” Most striking was how polarized the results were for the United States. Unlike any other country in the survey, the United States had more people in both the very top and very bottom rankings for many categories. Likewise, most countries saw higher skill levels in younger versus older survey respondents. In contrast, the younger generation in the United States performed roughly the same as older Americans. Decades of underinvestment in the skills of the middle class threaten to stall America’s capitalist engine of prosperity.

Concentrating money in the hands of fewer and fewer people has further deleterious effects. It allows the richest people to bid up the price of the things in society that define the good life, such as housing, education, and health care. And concentrating money and wealth also slows down the feedback loop between consumers and businesses, limiting the dynamics of innovation, problem solving, growth, and prosperity. Finally, it also undermines the political legitimacy of capitalism itself.

Prosperity, Growth, and the American Dream

Americans are correct to believe that capitalism has been the source of our historical prosperity. But knowing that it works is different than understanding how and why it works. Our ancient ancestors knew that the stars and planets moved in the sky. But it was the revolutionary Copernican perspective that replaced the Earth with the Sun at the center of the solar system and Newton’s laws of gravitation that enabled people to understand how and why they move.

Traditional economic orthodoxy assumes that markets are efficient, people are rational, and economies naturally move to an optimal state. But we now understand that markets can be far from efficient, people are not always rational, and the economy is a complex, dynamic, evolutionary problem-solving system—more like an interdependent ecosystem than an efficient machine. This recent Copernican-like shift in perspective provides a powerful new framework for understanding how and why capitalism works, what wealth truly is, and where growth comes from. This twenty-first-century way to understand economics allows us to understand capitalism as an evolutionary problem-solving system. It allows us to see that the solutions capitalism produces are what create real prosperity in people’s lives, and the rate at which we create solutions is true economic growth. This perspective also allows us to see that good moral choices will be the ones that create true prosperity.

This new perspective also makes obvious why both the laissez-faire policies of the far right and the statism of the far left fail. Policies that provide opportunities for all citizens to fulfill their potential, and investments that enable them to expand their potential, are the surest ways to animate prosperity and growth. Recognizing the ecosystem-like nature of economies highlights the essential feedback loop between businesses and customers. Policy must aim to create customers as well as entrepreneurs, and to create as many of these feedback loops as possible.

We must have the courage to enact policies that are good for capitalism broadly, not policies that benefit a few capitalists narrowly. There can be an immense difference. We must recognize that a thriving middle class isn’t a consequence of growth, but rather, the cause of growth and prosperity.

Measuring the number, quality, and availability of solutions to human problems rather than just GDP alone could have a radically positive effect on our economy and the lives of our citizens. By creating incentives for problem solving and disincentives for problem creation, we would focus the nation’s incredible creativity and energy on the things that truly make our lives better. The market failures, moral failures, collective-action problems, and externalities that plague our economy and our lives today would be moderated as we refocused on the quality of growth, not just the quantity. Resolving the tension that orthodox economic thinking creates between a moral world and a prosperous one could unite us around a new set of economic and social principles. Seeing prosperity as the contribution we make to our community reveals economic malfeasance and rent seeking more clearly for what they are, while reaffirming the age-old lessons of our faiths and moral traditions.

Our great country is knit together by the American Dream, the idea that if we work hard and play by the rules we will have a better life than our parents, and that our children will have a better life than we did. Indeed, the golden age of American capitalism in the 1950s and ’60s was not so much marked by the accumulation of great fortunes, but by the massive dispersal of new solutions to human problems that virtually every American family enjoyed—houses, cars, televisions, dishwashers, and good schools. It was also a period of great investment in research and infrastructure, and a period of opening up of opportunities to minorities and women that greatly increased the diversity and problem-solving power of our society. We believe deeply in the core idea of the American Dream—not just because it is a moral imperative, but also because it is the surest way to build prosperity for every American.

 

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Post a Comment

Apinak:

Disappointing that you would write on new perspectives on capitalism without addressing sustainability and resource limitation. I think in next 20 years, we will realize that sustainability is more important than efficiency in the long-term. Capitalism often is a way to use resources most rapidly. If you assume resources are unlimited that is a good thing. In a resource-based economic view that recognizes current realities, that is a fatal flaw.

Nov 13, 2013, 1:44 AM
Marvin T Brown:

It is not a bad idea to look at capitalism as a dynamic problem-solving system, but we need to say more about how it has formulated and solved its problems. A central problem was the availability of cheap labor, which it solved through slavery during Adam Smith's time, and other forms of forced labor today. It also solved the problem of availability of resources by turning land into property, and it has solved the problem of limited material resources by creating a world of fiance. Capitalists may be problem solvers, but whether they improve the lives of people depends on who defines the problems.

Nov 13, 2013, 10:59 AM
Peter A:

This would have been a far more convincing article if fewer bald faced assertions were made that were not merely opinions but were backed buy evidence.

Nov 13, 2013, 2:32 PM
bett martinez:

is there anyone able to put together some emotional sound bites that might stand a chance of communicating to scared and needy people who are buying in to those put out by those whose wealth increases as long as they keep convincing those at the bottom that they should be wary of government, entitlements, handouts, public options, etcetera, that the vision propounded above would actually be in their best interests if acted upon?

Also agree that sustainability, resource limits ought to be addressed; not sure if this is too big in one gulp, though.

Nov 14, 2013, 12:48 AM
Jim H:

PeterA: An argument always requires assertions. "Bald faced" is your assertion that their assertions are bad, but lacking the rest of the argument - logic and evidence - all it tells us is "I don't like it".

Much of what they say is becoming common wisdom within the field of economics. The main innovation is to connect prosperity to the availability of solutions to problems and call capitalism an evolutionary problem-solving system, which I find intuitively appealing.

So, what's your specific problem here?

Nov 17, 2013, 5:00 PM
George N. Wells:

The article fails to consider the effect of sociopaths and their behavior. The sociopaths have convinced us that corporations, and by implication, all business has a singular purpose: to make the capitalist more wealthy. Anything, and everything that stands in the way of pure profit is wrong even if it means delivering harmful products or not producing beneficial ones because they are not sufficiently profitable.

Why is it that humans reward sociopathic behavior? That, to me, is the real question.

Nov 20, 2013, 10:50 AM
Jon Kolsky:

I would tend to agree, there seems to be a lot of hot air being blown without ANY substance

Nov 21, 2013, 6:14 PM
Anarcissie:

Are we still talking about The American Dream and Prosperity? Hey, I'm sure they're just around the corner, along with pie in the sky and a pony for everybody.

People need to start facing the fact that capitalism doesn't work except for a few rich people. Really.

Nov 21, 2013, 9:40 PM
Justin Chapweske:

Wow. Thank You.

Nov 22, 2013, 2:28 AM
David Wall:

Often markets are small (few buyers/sellers), such as credit default swaps, so they don't have the scale required to become efficient.

The concentration of wealth also affects the future because those rich folks often invest only in people they know, limiting all their accumulated wealth to just service the ideas from the few.

Nov 22, 2013, 1:48 PM
Geoff:

Thank you so much for this work. You have captured and explained the conflict and questions I've had with macroeconomics for 25 years.

Dec 10, 2013, 1:24 AM
Bill B:

Kudos for distilling out and presenting the problems that threaten American Capitalism. Contrary to some of the comments here, capitalism has lifted more people out of poverty than any other economic system. But when unrestrained, it can also be destructive to the common good. Your article helps focus on the real goal for which profits are the means not the end.

Dec 11, 2013, 12:00 PM
Paul C:

This is a very interesting article that presents a valuable way of conceptualizing economic thinking. The thing that will prevent it from being widely accepted and used is that solutions don't have an obvious numerical value; some solutions are clearly of more importance than others so you cannot simply count them even if you could identify them.

Still it is an interesting and valuable perspective. In the last thirty years economists seem to have lost sight of the fact that so much of their work is theoretical and hypothetical, based on idealized theoretical assumptions that just are not true in the real economy; but nonetheless they hammer their conclusions onto the real economy. This intellectual hubris has levied a serious catastrophe on the real economy.

From the end of WWII to around 1980 we had a messy economy that just did not conform to the pure free-market hallucinations of the neoconservative economists. The public sector meddled in business, running utilities, hospitals and schools while they strictly regulated transportation and communications. It wasn't according to new-found theories but it worked pretty well giving people jobs, good income and overall prosperity.

Obviously, that all had to change to conform better with the dreamy theoretical postulates of some radical but prominent economists.

Dec 12, 2013, 10:47 AM
Dan Kervick:

"Americans are correct to believe that capitalism has been the source of our historical prosperity."

That is completely untrue, and until we realize how untrue that myth is, we will continue to struggle.

The greatest source of US prosperity has been democracy. Americans spread democratic institutions across the continent as they expanded the American polity and the American way of life. The result was strong, deliberating, consensus-building, well-governed communities with a civilized and effective rule of law, educated citizens and a participatory spirit of self-governance and democratic dignity. Communities came first; capital accumulation and private whim came second.

And the greatest period of US economic progress was during the second world war and the decades immediately following it. That is the period when we had the greatest degree of federal government planning, agenda-setting, public investment and regulation in our history. Enterprising capitalists enhance the public good best when their actions and investment decisions take place in the context of a strong national government that is setting the strategic direction for the country.

The capitalists didn't do the highway program, the GI bill, the publicly-funded land grant university system, the NIH, the labor laws that enabled the construction of the middle class, or the space program. They didn't invent the technologies that now make up our internet and cell phones - almost all of those were developed as a result of government programs. They also didn't give us the powerful renaissance of a democratic ethos that came out of the shared national experience and burden-sharing of the second world war.

The capitalists gave us the gilded age and great depression. The US got moving again when it took a lesson from the socialists and mixed much more government planning into the economy, and when it re-empowered the democracy to put the capitalists under the public thumb as servants of the public interest.

Dec 13, 2013, 5:51 AM
Patrick:

How about we increase taxes on capital gains to the ordinary rate on income?

It seems so obvious, yet everyone turns to these elaborate explanations on inequality.

Dec 13, 2013, 2:40 PM
Laura:

I agree that sustainability is important. I also think that
measuring the effectiveness of problem-solving would be a clearer way to define the impact of capitalism, since the historic term ``efficiency``is not the type of measurement which is needed now.

Using this method would mean learning about the measures our diverse population now uses. Then
the differences in answers from people of various
socioeconomic positions
would need to be
standardized in some way (by ``weighting``the
measures in some way?) Whatever method is used, it should assure that answers can be measured
similarly against a standardized value scale.

I don`t know how to do this; it`s not my area of expertise. However, the
essay on redefining capitalism leads me to think that there are people out there who do know how.

Dec 16, 2013, 5:26 PM
Evil Overlord:

This is an interesting article, and I recognize that part of its intent was to provide a new way of looking at capitalism so that we can better understand how it works. Nonetheless, it's difficult to see how this view leads to any meaningful new tools or insights (yes, I'm sure they said the same about Copernicus).

The authors are up front about some of the limitations of their view. However, others go unacknowledged. If Kim Kardashian is the solution to a problem (reducing boredom in television viewers?), can we still say that this 'innovation' is contributing to prosperity? If robots for the disabled are a solution, and an entrepreneur hires workers, is his robot solution more important to prosperity than his 'here's a job that will feed you' solution?

In short, this is an interesting thought experiment, but I'm unconvinced that it's a useful new approach to managing capitalism and will somehow make more of us more prosperous.

Dec 20, 2013, 9:18 AM
Ronald Ein:

This is a very worthwhile paper. But i kept waiting for a discussion of the ways in which powerful organizations--economic and political--use advertising and marketing technologies and social psychology to innoculate the public with false ideas about how society should be. The development of these tools in the 20th century made any concept of a "free" market simply a fairytale. Media, both mass and social, are deep into aggregation by private interests, which will serve to cement social control into everyone's daily life. We are afraid of the NSA spying. How about the internet companies spying and then shaping our online experiences to fit their idea of who we are? How about government controls over what is allowed onlline in any case? People are ceasing to be free actors in society, regardless of the formal nature of their economy or government.

Dec 29, 2013, 6:16 PM
Derryl Hermanutz:

The theory of capitalism is counterfactual to reality. The theory does not, and never did, describe reality. The theory is more like a veil that is pulled over people's minds so they can't see what is actually happening.

Capitalism as it actually exists, finance capitalism, commercial capitalism, and industrial capitalism, is not so much a visible economic system as an invisible political system. Capitalism is rule by ownership. It is feudalism, without the official titles of M'Lord and M'Lady. And bankers are king.

Bankers decide who gets credit and for what purpose, and all decisions are based on the money outcome, so the decisions about what gets done and what doesn't are determined by banker arithmetic, not social or economic solutions.

Corporate industry owns and dominates markets, crushing individual free market competitors under a burden of corporate sponsored regulations that advantage the mass corporate solutions over the individual innovator solutions. And corporate propaganda power via mass media advertising literally manufactures public opinion in favor of corporate solutions.

I agree with Dan Kervik that political democracy is the solution to capitalist rule by ownership. But political democracy is castrated by the bankers' monopoly on the issuance of financial credit, "money". He who issues the money decides what kinds of human activities money will enable.

"Effective" demand, as an investor or as a consumer, is demand that is backed up with money to spend. You can "want" until your face turns blue. You only "get" if you have money to pay for what you want. And in an almost fully financialized economy like we have today, bankers decide who gets money to do what they want to do.

Banker arithmetic favors monopolists whose market power ensures profits to service debts owed to the bankers/financiers. Commercial and industrial market competition is a direct threat to the interests of finance capitalism, so free market competitors are eliminated with extreme prejudice. James Galbraith made this abundantly clear in his 2008 book, The Predator State. NSA industrial espionage, and the development of vast insider networks who crush upstarts by every means including genocide, is business as usual in the Predator State.

The root of real democracy is economic democracy, and that is not possible without monetary democracy, government issuance of its own money, and distributing that money to all citizens as a guaranteed minimum income. Then innovators can compete to sell stuff to the citizens, to earn that money to fund their operations and to keepas profits, and become personally self-sufficient in money and able to enjoy a higher personal standard of living than the minimum income will purchase.

David Ricardo admitted in 1817 that the Luddites were right (his section, On Machinery), that replacing men with machines does worsen the lot of the working class. JS Mill and Karl Marx recognized 166 years ago, in separate 1848 books, that industrial mechanization was eliminating the need for full employment, and that an alternative to "earned income" would be needed to distribute the cornucopia outputs of mechanized production. In the 1920s and 30s CH Douglas advocated his social credit system as an aternative to banker money issuance, c/w a "social dividend" paid to all citizens as their share of our cultural inheritance of the technologies of industrial production. In 1948 Milton Friedman argued that governments should create, not borrow, the money that they deficit spend. In 2012 Adair Turner spoke the policy that dare not speak its name, overt money financing, government issuance of its own spending money.

It's not that the solution to industrial capitalism is mysterious and unknown. The problem is political: rich capitalists have financial, industrial, political, and public opinion-shaping power. Everybody else does not have these kinds of power. Capitalists enjoy owning and ruling, and will not voluntarily surrender their power to serve the common good. And nobody else has any power to take the capitalists' power away from them, and use that power to serve democratic interests.

So under ongoing capitalist rule, work serfs choose which corporate master they will labor for, consumer serfs are brainwashed to desire corporate produced junk, and political serfs vote for which capitalist puppet will implement and enforce ruler friendly government policies. And the whole capitalist system is ruled by the monopoly issuers of money, the bankers who rule by the absolute and impossible dictates of banker arithmetic: We must always get more money out of the system than the amount we put in.

Meanwhile capitalism sells us solutions to problems we don't have, and refuses to address problems we do have, because solving our real problems does not serve the dictates of banker arithmetic.

Jan 14, 2014, 7:13 PM
roger erickson:

Capitalism Redefined? .. Not Really
http://mikenormaneconomics.blogspot.com/2014/01/capitalism-redefined-not-really.html

Jan 14, 2014, 11:00 PM
Ken Presting:


Hanauer and Beinhocker claim to present new ideas, but in fact they are showing at least two significant misunderstandings, and several other serious mistakes. For many generations, economists have studied substitution of commodities and externalized costs, which are very close analogues to their proposals of competing solutions and one persons solution is another persons problem. These ideas are not new at all, and it is misleading for the authors to discuss their own neologisms without reference to the vast literature which precedes them. Interested readers will surely gain by checking Wikipedia for references.

(I am having trouble with the posting system, I will try to continue)

Feb 3, 2014, 8:16 AM
Ken Presting:

(continued)

Rather more serious is their claim that the work of Kenneth Arrow (and others) allowed Milton Friedman to make a devastating critique of Keynesianism. This view is common among Tea Party activists and right-wing think tanks, but it is preposterous. Arrows work was about ordinal utility, a concept so abstract that it has no role in macroeconomic discussions whatsoever. And to claim that Keynes has been devastated is belied by the fact that a Keynesian stimulus is precisely what ended the crash of 2008. Even the G. W. Bush administration embarked on a Keynesian response to the crisis. Again, interested readers can find extensive discussion elsewhere under the topic of stimulus vs austerity but the present authors simply pretend the issue is settled in their favor. That is nonsense.

Most serious is the dismissive treatment they give to Democracy itself. Just a few short paragraphs of a fourteen page article. There is a tendency in every discipline to see itself as the hammer which will drive all nails, and the authors may be excused for arguing that Capitalism is the only broken thing in our society, and once that is fixed, all will be well. Thus, they allow that crony capitalism has distorted our democratic processes. But this is the Tea Party line all over again. Responsible economists have argued for generations that only political action can correct for market failures such externalized costs, or abuses of the market like insider trading, cut-throat pricing, and securities fraud.

It is no defect of Capitalism that those with the most money have the most influence. That is the essence of capitalism, but it does lead to ever-increasing concentration of wealth. That is a problem, and the solution is Democracy, where all voters have equal influence.

Feb 3, 2014, 8:17 AM
Pat:

No upside limits based upon risk based entrepreneurs is false in that every disclaimer is meant to control, limit risk. No risk based insurance policies prevail in business, as do court processes, and tax credits. Firms and manufacturers even go overseas to avoid risks of product liability suits, and torts based upon deceptive business practices. If job creators, it is for other nations to limit their risks.

Tryin to have it both ways - socialism of distributive risk but not distributive profits - is now a commercial fact, and risk shifting is epidemic, erasing the last redeeming quality of GOP bravado as risk takers to be job creators. Nonsense! The only persons risked are employees and the American public. Twisted capitalism as predatory is the result. All God's children need security to thrive, but Bridgegates to bring that about is beyond the dignity of humans.

Feb 4, 2014, 8:35 PM
Bill:

A system predicated on perpetual growth is destined to fail. And it will leave a trail of environmental destruction along the road to its implosion.

Once a society's basic needs are met, our long term prosperity depends upon shifting from an emphasis on "growth" (which someone has said is the philosophy of a cancer cell) to an emphasis on sustainability. It seems to me that the accumulation of lots of money and stuff by a few megalomaniacs isn't something about which we need worry as long as we have a just society in which everyone can meet their basic needs. And for the society to be truly just it will require that we reflect in our buying practices an ethic that looks at more than just price.

Imagine what society would like if we all collectively understand and appreciate the prosperity we already have.

Mar 3, 2014, 11:29 AM
JSeydl:

Me likey. Just one quibble, though. Philosophers have a strict definition of intrinsic value: it is non-instrumental. Water can't be intrinsically valuable - or at least not in the way you bleieve it is - if its value is to sustain life (instrumental).

Apr 3, 2014, 1:00 PM
Christian:

Great article!! Definitely a great approach to emphasize the ability of capitalism to destil solutions to people.

However, there is one weakness that pops up right away: this is a totally utilitarian view upon satisfaction. Solutions are satisfactions of needs as described BUT whatif we do not only search for solutions to needs but are actually more irrational. As sad as it is but the Maserati car does instill some sort of happiness as satisfaction on some people but it will never be categorized as desire in need for a solution...

How do you address this utilitarian bias?

Apr 11, 2014, 6:32 AM
Anastasia Roupakioti (Absinthia Stacy):

Very insightful article. I think solutions are really more important than money. If we have solutions, then money is irrelevant, really.

Apr 23, 2014, 8:19 PM
Scooter:

I don't know why you insist on trying to ram capitalism down our throats. The reason capitalism fails is because it's primary philosophical tenet IS inequality. It cannot function without inequality. It strives to create inequality. That's what it does. It cannot exist without it. The consequences of it's ambitions for inequality result in plutocracy and authoritarianism. That is the nature of capitalism.

The only way to beat or tamp dowm economic inequality is through a social democracy whose primary philosophical tenet is equality.

Jun 28, 2014, 12:49 PM
Alan:

Well said, particularly to the points of the economy being a complex adaptive system (Bill White) or a dynamic system (Steve Keen) like an ecosystem, and GDP being entirely unsuitable as a measure.

When we say entrepreneurs need to provide solutions, however, there is a conundrum, because the entrenched interests of Capitalism are exactly those who are purveying the many problems. When they take over the machinery of government, as presently, the entrepreneur is as helpless as the average citizen in creating solutions on the scale and structure needed -- the solutions you identify here. It is not simply that government must be a help-mate to the process. Somebody has to plan or the mess of Capitalism will simply produce the next easy dollar.

But that aside, very much appreciate this piece. Good work.

Jun 28, 2014, 1:23 PM
NGM:

As long as externalities continue existing, price distortion will continue leading consumers decisions, both corporate or individual.

How effectiveness can be fairly measured without taking into account externalities? It might not be easy to tackle this question and out of the interest of parties benefited from asymmetries, in fact the wealthiest and more poweful lobbies, due to there is no market for most of these externalities. Consumers do not have information enought, even qualitative, to weight externalities in their decisions so how can the capitalist system deal with externalities? How can goverments avoid lobbies exerting pressure over regulations and policies?

Jul 3, 2014, 6:39 AM
Mark Montgomery:

It's really sad to see so many commenting making this into a polar political issue, when really it isn't. The philosophy is hardly new--it's as old as capitalism itself, and in my lifetime I've known many from all parties that share a very similar view--and practice it. Can be reduced to behavior, what we'll collectively accept and support, and in the neural network economy especially --governance systems. Well done.

Jul 3, 2014, 5:50 PM
Joseph Savon:

"other metrics to augment GDP" How about a "national misery index"?
Pace Dr. Bhutan, but "happiness" is idiosnycratic, nebulous & a slave to fashion. Misery is easier to quantify e.g hospital admissions, child poverty/malnutrition, incarceration rate, unemployment, absenteeism

Jul 6, 2014, 5:24 PM
Frunobulax718:

"The chief cause of problems is solutions"

-- Eric Sevareid

Oct 17, 2014, 12:09 AM
Frunobulax718:

"The chief cause of problems is solutions"

-- Eric Sevareid

Oct 17, 2014, 12:12 AM

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