Free Market Capitalism - A Thumbnail Sketch

Several months ago I tuned into an interview of Michael Steel, Chairman of the Republican National Committee, in which he contrasted the Democrats and Republicans as Democrats looking to Government for solutions while the Republicans look to business. This may be true but it points out that there is a general misunderstanding of the roles of Government and business in a Free Market Capitalist System and for that matter a lack of understanding of free markets. The subject is very complex and people have spent their lives studying and writing about it. I am going to be presumptuous and try to relate my layman’s understanding of the Free Market System. My insight, though at best amateur, is based on 30 years experience as a CEO of a Manufacturing Company, almost 70 years of living in various socio- economic circumstances, books, magazines, broadcasts and a series of lectures entitled “Thinking about Capitalism” by Professor Jerry Z. Muller of The Catholic University of America.
We have been trading commodities in markets since recorded time. Most things were grown or produced for family consumption. To meet the family needs large varieties were grown in small quantity. About a millennium ago people found that they could produce things much more economically if they grew or produced fewer things but in larger quantities. To make this strategy effective there needed to be a place to bring ones surplus and trade it for another’s. As time went on more and more items were traded and new markets created. In the 17th century, the Dutch East India Company was formed to trade luxury commodities acquired by various means, some pretty brutal, from faraway lands. The undertaking was very expensive and required capitol from numerous sources. This created a new market where individuals could provide capitol to ventures in exchange for a share in the anticipated profits. The industrial revolution with its division of labor, created a need for ever more manufacturing workers and labor became another item brought to market. Prior to that and well into the 19th century in Russia, most workers were either slaves or serfs under the control of landowners.

A way to think of the Free Market System is to contrast it to one using central planning as was the case in the Soviet Union before its collapse a few decades ago. This collapse has pretty much invalidated Central Planning and even China is moving to free markets. (It is important to point out that free markets do not imply democracy. Neither China nor Singapore is a democracy but both, with Singapore with the freest markets, are practice free market economics. However there are no democracies that do not employ Free Market Systems.) In central planning, the planner, most often the Government, develops a plan (in the case of the Soviets it was a 5 year plan) and based on that plan decides how much of what to produce and when and at what price to sell it. The Free Market System, on the other hand, assumes that understanding what, how much, when and at what price is far too complex an undertaking and a more efficient way to achieve this is to allow the markets to guide these decisions with individuals and enterprises, motivated by self interest, determining what and how much to make and at what price to sell it.
The System counts on the individual self-interest resulting in a collective good for society. The actions of individuals and enterprises are not expected to be, nor indeed are, altruistic. The goal is to maximize the benefit to the individual and in a Capitalist system to the owners of an enterprise. The term capitalist indicates that ownership of the means of production is private instead of in the hands of the Government. One of the many broad societal benefits is the reduction in price. As the demand for a good or service increases and supply dwindles, prices go up and new enterprises come to life to meet this demand. This new competition brings down prices making more and more products and services available to a broader range of society. An example often cited is that of silk stockings, where they were once available to only the wealthiest ladies, with competition created through a Free Market System, they were made available to the “girls working in factories”.
At a point, equilibrium is reached when the prices start approaching the costs (perfect competition). The natural forces want to drive a market toward perfect competition bringing down prices but reducing profits. A way of increasing or maintaining profit, which is also beneficial to society, is to differentiate. The more differentiated a product or service the greater the opportunity for larger gains. This quest for differentiation leads to innovation by providing new, better and cheaper products and services. Another benefit (my favorite) of free markets is the creation of markets for more and more individual characteristics, skills and talents. There is now a market for large men in pro football, tall men in basketball, pretty women in modeling and news casting, antisocial individuals in computer programming (sorry computer fanatics), insecure people in the theater, and attention deficit disordered ons in upper management. As time goes by more and more markets will arise for what are now considered useless attributes or even shortcomings. The system works and the economic success of the United States proves it.
Other ways of maximizing profits, however, actually work against the general good. Some of these are driving wages down, eliminating competition through unethical means such as predatory pricing, conspiring to fix prices, and creating monopolies. Often actions that benefit the individual or enterprise like those leading to pollution, are also detrimental to society. A single small firm may not do any damage but the effect of large numbers of polluters can be devastating. I liken this to a family using antibacterial soaps. It is very good for the family in that it will decrease the number of ailments. However the overuse of antibacterial soaps broadly by a society leads to an evolution of new and increasingly more difficult to defeat bacteria which is bad for society and ultimately the family in question.
Following is an excerpt from Professor Muller’s notes regarding Adam Smith’s thoughts. Adam Smith is highly regarded by today’s business community though the fact that he was a Moral Philosopher and in his later years worked as a public servant, embarrasses many conservatives.
“Adam Smith (1723-1790) began his career as a Professor of Moral Philosophy, and he took his moral concerns into his study of what he called “commercial society” and the new science of political economy. The goal of the market economy, as Smith conceived of it, was to make possible ongoing rise in the standard of living of the vast majority of the population. In The Wealth of Nations (1776), he laid out a model that explained how a competitive market channeled self-interest in socially beneficial directions. It did so by making commodities available at cheaper prices, affordable by ever-broader portions of the population. This is the famous “invisible hand” – a metaphor for institutional arrangements that channel self-interest toward socially desirable outcomes.”
Today there is a lot of chatter about “too much Government”, “too little Government”, etc. At an intellectual level, the question should be whether the markets can indeed regulate themselves and what if any is the role and the size of Government in a Free Market Capitalist Society. Unfortunately, politics does not operate on an intellectual level. Following is another excerpt from Professor Muller’s notes regarding Adam Smith’s thoughts.
“Smith thought that commercial society had the potential of making people not only better off materially, but also of improving their character. It had a propensity to promote certain positive character traits, such as industriousness and probity (honesty). It held out the possibility of a society in which most people would be more self-controlled, prudent, and free. That was no small achievement. Under the right institutional conditions, a capitalist society could make people better, as well as better off. But where the rule of law was lacking – or where there was inequality before the law, as in the case of slavery or of colonial companies- commerce could lead to immoral outcomes.”
There are a number of broad categories of markets; a market for goods and services, a market for labor and one for capital. In each of these you have buyers and sellers. The providers of goods and services, besides buying other goods also buy labor. Because the higher their cost, the lower the profits, the buyers want to keep the cost of materials and labor as low as possible. The providers of labor, on the other hand, also for self serving reasons want to get the best price for their labor. The capital markets are more complex in that almost everyone in the industrialized world today is both providing and consuming capital. When a worker puts their savings in a bank they are in fact providing capitol and when they borrow, they consume capitol. Enterprises borrow money and exchange equity for capitol and uses profits to invest in means for increasing profits. An individual taking out a loan against their credit card or a mortgage is consuming capital as is an enterprise that borrows money from a bank or sells shares to an investor.
In general when people think of individuals selling labor they think of the factory worker. However the CEO, unless they are the owner of an enterprise, sells his labor as do the athletes or actors earning millions. Maybe it is better to think of labor as falling into two broad categories; workers and professionals. In fact the law treats the two groups differently. I don’t know if it is because workers are considered inferior or union activity, but laws are passed to protect them that do not apply to professionals. I also suspect that the general public does not think of professionals as selling labor and tend to lump them in with business people.
The sellers of goods and services should also be segmented. There are the owner operated businesses and the businesses that are owned by a diverse group of individuals through stocks in the enterprise. Generally small businesses fall into the owner operated enterprises and are thought of as entrepreneurial while large enterprises not operated by owners, though generally considered entrepreneurial, are in fact bureaucracies run by administrators. The person with a one man plumbing business, a farmer, restaurant owner a partner in a law office a doctor with their own practice all are entrepreneurs while the CEO of a multi-billion public corporation, a doctor working in a hospital, a corporate lawyer, a plumber working for someone, a policeman and a farm hand are all selling their labor. A case in point is the recent California Republican primaries won by Meg Whitman and Carly Fiorina. Both are painted with the same brush but Meg was the founder of e-Bey and thus an entrepreneur while Carly was the CEO of Hewlett Packard, an administrator, and not a particularly good one at that. (She was fired by the Board)
Getting back to Michael Steel, I don’t believe his comparison of government and business is valid. The government, however good or bad, large or small has as it responsibility the well being of the society which has put it into office. Leaders of business on the other hand are there to maximize benefit to themselves or in the case of administrators, to the owners and occasionally to other constituencies and any benefit derived by the society is strictly coincidental. The Markets are constantly attacked from both the left and the right, each vying for legislation to advantage their constituencies, the sellers and buyers of labor. When properly reigned in, the free market has proven to serve the general good effectively, certainly more so than the competing systems. Yes, Democrats look to the Government. Republicans however, don’t look to business but to the modern equivalent of aristocracy. The free market, unfettered, has no morals, respects no communities, and constantly innovates and destroys. It supports self-interest in whatever fashion and by whatever means. It is innovative and this innovation, often led by intellectuals and the “newly moneyed” has historically been considered a threat to the existing institutions. The responsibility for conserving them fell to the aristocrats in the early stages and their equivalent today. Following is another excerpt from Professor Muller’s notes.
Edmund Burke (1729-1797) offered a conservative analysis of the hazards posed by some forms of capitalism to the politics and culture of an already commercialized society. As a member of Parliament, he became the leading critic of the British East India Company. He argued that the company’s agents, in search of gain and unrestrained by the inherited culture of England, were riding roughshod over traditional Indian society. Burke then applied this analysis to the French Revolution in “Reflections on the Revolution in France” (1790), his seminal work of conservative thought. He argued that the revolution was propelled into dangerous radicalism by a combination of radical intellectuals and newly rich entrepreneurs who were oriented toward risk and failed to appreciate the existing institutions and their society.
The conservatives want to preserve the institutions, customs and mores but the free market with its innovation is always assailing these. Innovation is threatening in that its outcome is unpredictable and intellectuals who studied, discussed and encouraged change were suspect from the very earliest times. At the onset of Free Market Capitalism, the task of reigning in this innovation and the intellectuals promoting them was left to the aristocracy. It was up to them to preserve the institutions and mores. Here, where we have no aristocracy, that role is relegated to the old moneyed gentry who, to preserve their advantage preserve the institutions. In Burkes eyes the restraints must come from the “inherited culture” (aristocracy) and not the law (government).
Most swords have two sharp edges. There is a downside to all the innovation facilitated by free markets. As new things arise, old things die. As enterprises and industries are supplanted by competition or technology, in the wake they leave behind people in great distress. The slave labor that created a tremendous agricultural and great wealth to plantation owners in the south left behind a large population without means, a lost culture and tremendous obstacles to integration into society. Competition from abroad (remember that markets, if free, know no borders) devastated the textile and shoe industries leaving hundreds of thousands (it may be millions) unemployed. In the current times more and more well paying manufacturing jobs are being lost and there are new jobs emerging requiring totally different skills often paying lower wages. I was watching proceedings of an American Enterprise Institute, a conservative think tank and I heard Arthur Brooks, the speaker use a term I had not heard before when referring to the bottom of the socio-economic ladder, “free riders”. I believe that this suggests that these people through their choice, are along for the ride without contributing. When thinking back to the days of slavery, I wonder if the slaves or the masters were the free riders.
Republicans, being conservative want to restrain the market by conserving the existing institutions and providing an advantage in the market to the new aristocracy on whom they rely to maintain the “inherited culture”. Democrats look to Government, through its policies and laws to provide this restraint and to make sure that the damage done to the people at the bottom by the displacement caused by innovation is contained. Bothe in their way trying to make sure that the markets work for the general good, one for the good of community, the other for the good of society. I am not critical of self interest when properly guided. The System works. But we need to keep in mind that any societal benefit derived through business is strictly coincidental. In fact I suspect that any CEO of a public company who makes a decision to advance the public good at the expense of profits or future growth would keep a few law firms in business fighting suits by shareholders.