How Capitalism Will Save Us

by Steve Forbes

  Obama told Leonhardt, “Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be half of our economy.” He strongly implied that the government would be playing a greater role in its direction, with less influence from the private sector: “And that means that more talent, more resources will be going to other sectors of the economy.”2

  Condemning the “massive risk-taking that had become so common,” the president said, “What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade.”3

  Obama’s words raised eyebrows among many, especially supporters of democratic capitalism. Not only was the president implying that the government would be stepping up its role in directing economic activity, but he did not seem to appreciate the processes—including normal business cycles and risk taking—that make possible economic progress.

  What role should the government play in a democratic capitalist economy? The fight over this fundamental question helped give birth to this nation. Righteous anger over Britain’s trampling of what North American colonists perceived as the traditional rights of Englishmen—especially “no taxation without representation”—sparked the American Revolution. In contrast to many of today’s politicians, the Founding Fathers and framers of the Constitution saw the greatest threat to liberty as coming from an overly powerful government.

  For the first hundred years of America’s history, government for the most part had little role in the economic lives of Americans. The one exception during that time was the Civil War. This began to change in the late 1800s. Industrialization was transforming a previously agrarian society, bringing with it growing fear of big corporations, or “trusts.” The Progressive movement sought to impose order on the threatening, seemingly chaotic forces of change. Progressives’ efforts resulted in passage of the Sherman Antitrust Act and the creation of government agencies like the Interstate Commerce Commission and, later, the Food and Drug Administration and the Federal Trade Commission. In 1913, the Federal Reserve System was established. In the words of Florida State University economist and author Randall Holcombe,

  the federal government had been transformed into an organization not to protect rights, but, ostensibly, to further the nation’s economic well-being…. A government initially committed to protecting the liberty of its citizens now seemed to be just as firmly committed to looking out for their economic welfare.4

  Until the 1930s, most economists believed that the economy would remain stable and self-correcting if the government largely stayed out of the way. But this view began to change amid the turmoil of the Great Depression. In 1936, economist John Maynard Keynes published The General Theory of Employment, Interest and Money. He advanced the idea, which must have been comforting to many at the time, that the nation’s economic woes could be cured by an activist government. Keynes believed that the way to economic vitality was through heavy government spending during slumps. This spending, he asserted, had a “multiplier effect,” creating more output than the dollars originally spent, increasing “aggregate demand” for products and services that would stimulate the economy and lead to “full employment.”5 No matter if the government had to pay for it by printing more money. Keynes famously called gold “a barbarous relic.”6

  Far from a believer in the efficacy of markets, Keynes believed that a group of wise economists could dispassionately direct the economy, independent of normal political pressures. Columbia University economist Edmund Phelps has written that Keynes, while not a socialist, was a “corporatist” and “an exponent of top-down growth.”

  Keynes rejected atomistic competition as an efficient market form. The policy he advocated called for the government to assist the ongoing movement toward cartels, holding companies, trade associations, pools and others forms of monopoly power; then the government was to regulate the affected industries.7

  Keynesian beliefs became the economic mantra of FDR, and a major influence on the policies of presidents Kennedy, Johnson, Nixon, and Obama. The Keynesian mantle has long conveyed an air of seriousness and legitimacy in policy circles. President Nixon famously proclaimed, “We are all Keynesians now.”8 But when this mystique is put aside and Keynesian policies are viewed from the perspective of history, Keynes the high priest ends up looking more like the Wizard of Oz. Pull back the curtain and he’s less than he’s cracked up to be.

  Over decades, Keynesian ideas have rarely worked and have done serious damage. A growing number of economists and historians—including Amity Shlaes, senior fellow at the Council on Foreign Relations and Forbes columnist, economic historian Burton Folsom, and University of Chicago professor John Cochrane—believe that Franklin Roosevelt’s Keynesian interventionism, along with his spending, did not end but rather prolonged the Great Depression of the 1930s.9

  Decades later, Richard Nixon, the Keynesian convert who was ostensibly a conservative Republican, created an economic nightmare through Keynesian mismanagement. He severed the dollar’s tie to gold so that he could print more money to boost the economy, along with the equally wrong-headed wage and price controls. All this did, however, was trigger a brief spike in demand, an artificial boom in 1972 that was instantly followed by more inflation and then a severe recession one year later. Price controls on energy suppressed oil and gas exploration and production, strangling supply. Everyday Americans suffered the consequences of these distorting policies. Drivers found themselves idling in gas lines that stretched for blocks. The economy stalled. We ended up with the “stagflation” of the 1970s—economic stagnation and rising prices.

  Keynes’s most famous critic, Friedrich von Hayek, explained why Keynesian economic policies, with their emphasis on government solutions, were destined to fail. They were not that different from centralized planning. They distorted an economy and undermined growth because they subverted the natural processes of resource allocation and wealth creation that normally take place in a free market.

  Hayek explained that prices in an open market function as “a mechanism for communicating information” or “a system of telecommunications” that tells both producers and consumers, buyers and sellers, how they should conduct their activities.

  Without the mechanism of pricing, producers can’t signal to the market how rare or available their product is, and consumers aren’t given the knowledge they need to adjust their activities accordingly. With each side not knowing the needs of the other, the mutual benefit of a freemarket transaction is not achieved, and you end up with distortions and imbalances—to cite some Real World examples, people waiting on those 1970s gas lines, or waiting even longer in a staterun healthcare system for a doctor’s visit.

  Building on the work of his mentor, the eminent Austrian economist and philosopher Ludwig von Mises, Hayek argued that Keynes’s analysis of boom-and-bust cycles neglected the degree to which government with its powerful central bank can adversely influence economic activity. Decades before Fannie and Freddie, he explained that a central bank, by lowering interest rates and printing money, produces economic bubbles. Overly abundant, loose money creates a heady, artificial environment where marginal business ventures that would not otherwise have existed spring up and even prosper. That is, until they inevitably collapse. Sound familiar?

  In his book The Road to Serfdom, Hayek warned that government management of the economy is ultimately driven by the whims of politicians and not the needs of people.10 He thought Keynes was fundamentally misguided in his belief that a knowledgeable few could successfully shepherd the economy; Hayek believed it opened up society to the political overreaching that threatens individual liberty.

  Keynes himself acknowledged that his economic nostrums “can be much easier adapted to the conditions of a totalitarian state.”11 Hayek and Keynes debated each other in journals during the 1930s. Their famous exchange foreshadowed today’s debate ov
er the direction of the economy. Just as Keynes overlooked the role of government in producing the Great Depression of the 1930s, his current adherents, as we’ve previously noted, underemphasize the role of the Federal Reserve, Fannie Mae and Freddie Mac, and the SEC in producing the financial crisis and recession.

  But what activist Keynesians miss altogether is that real growth comes not from theoretical assessments of a market that originate in an ivory tower, but from unmanaged activities where people are figuring out how to meet one another’s needs and desires in the Real World. Government can command resources; it can redistribute them. But it cannot, long-term, expand an economy. That’s because the kind of jobs and businesses that drive wealth creation and growth can emerge only from the trial-and-error process of innovation that takes place in the private sector.

  How does capitalism’s dynamism and innovation generate growth? By giving millions of people the latitude to come up with and try totally new ideas—from the iPod to selling groceries over the Internet. Government cannot do this, because it simply does not have the bandwidth—the expertise, imagination, and resources—of the millions of people who make up a free market. Its decisions are based on political influences. Government programs that don’t perform can continue for decades—welfare, begun in the mid-1930s, wasn’t reformed until 1996. But a company that fails promptly goes out of business.

  As we explain later in this chapter, the core capability of government is mainly providing (1) services that maintain order through promoting the rule of law, (2) a sound defense, (3) protection of, as the Constitution puts it, “domestic tranquility,” and (4) assuring basic education for its citizens. That is one reason why policy makers so often assail “unfettered” capitalism and attempt to score political points by promising to end routine business cycles. Capitalism, with its dynamic, ever-changing markets, can be chaotic. But it’s this very disorder—the process of experimentations, success and failure, carried out among millions of people—that produces the new technologies and ways of doing business that lead to genuine growth in an economy.

  Take the Home Depot. Founded about thirty years ago, the hardware chain pioneered a new approach to selling home-improvement products, offering a vast array of low-cost products out of enormous warehouses. The chain provided the convenience of one-stop shopping, allowing customers to save time and money. Its huge success created jobs for employees and business for its vendors. But that is not the only way it ends up creating wealth. The Home Depot’s founders invested their personal wealth in unrelated sectors of the economy. Cofounder Bernard Marcus, moreover, donated a portion of his personal wealth to nanotechnology research at Georgia Tech that may eventually yield more growth-creating technologies.

  Stanford Graduate School of Business economist Paul Romer has pointed out that wealth and growth are generated not only by the big breakthrough advances that everyone hears about, but also by minor improvements in the way people do things.

  Take one small example. In most coffee shops, you can now use the same size lid for small, medium, and large cups of coffee. That was not true as recently as 1995. That small change in the geometry of the cups means that a coffee shop can serve customers at lower cost. Store owners need to manage the inventory for only one type of lid. Employees can replenish supplies more quickly throughout the day. Customers can get their coffee just a bit faster. Although big discoveries such as the transistor, antibiotics, and the electric motor attract most of the attention, it takes millions of little discoveries like the new design for the cup and lid to double a nation’s average income.12

  This freemarket “dynamism” is why Hayek wrote that no government could contain the “know how” that existed throughout a freemarket society. Government spending, with its increased taxation, drains businesses and people of the capital needed for this kind of innovation. Thus, it eventually ends up slowing an economy.

  This is the very reason why massive federal government spending during the Great Depression failed to restore sustained growth. Yet when the federal government shrank its presence in the economy during the 1980s and ’90s, the nation enjoyed its greatest expansion to date. The United States got closest to the Keynesian goal of “full employment” through cutting taxes and regulations.

  The government does indeed have a critical role in democratic capitalism, not as a growth creator but as a facilitator—performing critical functions such as maintaining public order and enforcing commercial contracts. However, when it strays beyond this role, it usually destroys wealth.

  The stock market, the foremost barometer of the future health of the nation’s economy, seems to grasp this. (After all, what are markets but people?) A little-known but immensely revealing factoid is that the stock market tends to slump when Congress simply convenes. New York portfolio manager Eric Singer has tracked what he calls “the congressional effect.” Between 1965 and 2008, he found that the S&P on average showed more than a 16 percent gain when Congress was out of session—in contrast to just 0.31 percent when it was at work. Singer founded the Congressional Effect Fund, a mutual fund that takes advantage of these gains for investors. Singer invests client money in stocks when Congress is on vacation, such as in the month of August or at the end of October. But he gets out of the market or reduces his positions when Congress is in session. Singer says that the congressional effect is remarkably consistent—but several years have been exceptions. One of them was 1997, when the market realized annualized average price gains of almost 60 percent when Congress was in session. What happened? Congress cut taxes, including on capital gains.

  Q SHOULDN’T GOVERNMENT SPENDING BE SEEN AS AN INVESTMENT THAT AIDS THE ECONOMY?

  A THE WORD INVESTMENT IS OFTEN USED BY POLITICIANS TO JUSTIFY GOVERNMENT SPENDING. HOWEVER, SUCH SPENDING, WHATEVER THE MERITS, RARELY PRODUCES THE RETURNS FOR THE ECONOMY THAT THE PRIVATE SECTOR WOULD.

  When policy makers anticipate having to raise taxes, they often claim the increase is needed for government’s “investment” in the economy. During his 2008 campaign, then-candidate Obama promised to “invest” in job and antipoverty programs. His administration has since lived up to that promise by raising government spending to a level unprecedented in the nation’s peacetime history. Politicians know that the American public takes a dim view of spending, even if it likes particular programs. So they often substitute the word investment for spending—one has a good connotation, the other negative.

  A case can be made that some government spending qualifies as an investment. In the early days of the republic—even with all the politics involved—government spending on the postal system was seen as a wise investment to speed communications and unite the country. The building of the Erie Canal was an investment that helped make New York City the commercial center of the nation by uniting it with the Great Lakes.

  Infrastructure spending that spurs economic growth can also have the characteristics of a private-sector investment. Not only do such projects aid the economy, but people who buy transportation bonds to fund construction of highway projects get a real financial return.

  However, government outlays for actual infrastructure projects make up a small portion of the federal budget. More to the point, a private-sector investment, when successful, produces a gain for investors. Investors in equities, for example, get dividends or make a profit on the sale of stock. Unfortunately, what is often billed as a government “investment” rarely produces a gain for the economy. Most often it’s a no-growth proposition. It produces less economic activity—in other words, a loss. That’s because to underwrite its investment, government has to tax the private sector. It absorbs—some would say “destroys”—capital that would have been used for genuine growth-producing investments. Jobs and businesses that would have been created never come into existence. And some—often many—existing jobs are also destroyed because of the slowing economy.

  Even infrastructure projects funded by government borrowing end up destroying capital, because higher taxation
can be needed to provide the funds to repay bondholders. True, bondholders get a return—at the expense of capital that is destroyed elsewhere. As we’ve seen from the ongoing scandal over congressional earmarks, most infrastructure projects are hardly as strategic as the Erie Canal. And many are anything but worthy “investments”—such as a $150 million airport that a powerful congressman recently built to help his commute.

  Few governments in the last twenty years have “invested” in their economies more than Japan. During the 1990s, the country implemented some ten infrastructure projects. Ronald Utt of the Heritage Foundation recalls,

  Japanese fiscal policy during the 1990s was flamboyantly unrestrained, and during that decade no other advanced industrialized country had expanded government spending by nearly as much. Starting in 1991, government spending (outlays) in Japan accounted for just 31.6 percent of the nation’s GDP—one of the lowest among members of the Organisation for Economic Cooperation and Development (OECD). That year also marked the high watermark of Japanese prosperity.13

  So what did the Japanese government—and taxpayers—get for their “investment”? According to Utt, after years of relative prosperity, they got a bum deal—a long, downward economic slide that was a net loss.

  After peaking at 86 percent of U.S. income in 1991 and 1992, Japanese income continually fell behind the U.S., and by 2000, Japan’s per capita gross national income had fallen to 73.7 percent of that of the U.S. despite the increased spending stimulus in Japan during the 1990s and into the 2000s. This decline in relative performance reflects the fact that the Japanese economy grew at an annual rate of only 0.6 percent between 1992 and 2007. In 1991, only the United States, Austria, and Switzerland had higher per capita incomes than Japan. By 2006 (the most recent OECD numbers), Japan’s per capita income was surpassed by Austria, Australia, Belgium, Canada, Denmark, Finland, Ireland, Holland, Switzerland, Sweden, and the U.S.14