Capitalism—Posner

I agree wholeheartedly with Becker that capitalism is a superior economic system to any other that has been tried, the others being mainly socialism and communism. The best evidence for this is that out of the 194 countries in the world, I can think of only two that are not capitalist—Cuba, which however is moving slowly in the capitalist direction, and North Korea, the greatest economic failure on the planet. 

But this statistic indicates that capitalism is a necessary condition of economic success rather than a sufficient condition. Many of the world’s countries, though capitalist, are basket cases—not as badly off as North Korea, but plenty badly off. Per capita incomes in rich capitalist countries such as the United States, Canada, Germany, Britain, and Japan greatly exceed per capita incomes in poor capitalist countries, which are the majority of countries. 

So the big question is, given capitalism, what else does a country need in order to prosper? We know that it doesn’t need abundant natural resources or a large population. But it needs a legal and political system that protects property rights, allows a large degree of economic freedom, minimizes corruption, controls harmful externalities (like pollution) and subsidizes beneficial ones (like education), distinguishes between equality of opportunity (which it promotes) and equality of incomes (which it promotes only to the extent of combating poverty), welcomes and assimilates skilled and wealthy immigrants, and (related to protecting economic freedom) avoids public ownership or control of economic enterprises. To create and maintain such a legal and political system a country also requires a culture of respect for business success, of competition and risk-taking, and of consumerism—since, as Keynes argued, consumption drives production. 

Such a combination is difficult to achieve; no nation has achieved it. The variance across nations in culture and in institutional structure is very great, and determines the relative economic success of the different nations. 

Since there is so much variance across capitalist countries—so much that can go wrong with a capitalist system because of the complex institutional structure and social culture that capitalism requires if it is to be maximally successful in contributing to social welfare—we need to avoid complacency. Complacency was a major factor in the surprising economic collapse that began in September 2008, a collapse the consequences of which are still very much with us. 

When I started teaching in the late 1960s, the economist Harold Demsetz was talking about the “Nirvana Fallacy.” He defined that as the belief of many economists that any market failure, such as monopolization or pollution or underproduction of public goods, could be rectified at little cost by government intervention. If that were true, it would indeed enable “Nirvana” (in the sense of heaven—which isn’t actually what the word means; it’s nearer to “oblivion”) to be attained. But as Demsetz pointed out, it isn’t true. There are government failures as well as market failures, and they have to be taken into account in deciding whether and what the government should be asked to do about market failures. 

Over time, however, a reverse Nirvana Fallacy took hold of many economists, most famously Alan Greenspan. This was the idea that capitalism was a self-regulating system; market failures were, with few exceptions, either self-correcting, or less harmful than regulation aimed at eliminating them. Such thinking influenced the regulatory laxity that contributed (decisively in my view) to the financial collapse of September 2008 and the ensuing worldwide depression, and to the disbelief until then of many economists that there would ever again be a major depression. Greenspan and other like-minded economists and political leaders were wrong to think capitalism self-regulating; they neglected the need for an institutional structure, and a culture, that differentiate successful from unsuccessful capitalist economies. 

The institutional structure of the United States is under stress. We might be in dangerous economic straits if the dollar were not the principal international reserve currency and the eurozone in deep fiscal trouble. We have a huge public debt, dangerously neglected infrastructure, a greatly overextended system of criminal punishment, a seeming inability to come to grips with grave environmental problems such as global warming, a very costly but inadequate educational system, unsound immigration policies, an embarrassing obesity epidemic, an excessively costly health care system, a possible rise in structural unemployment, fiscal crises in state and local governments, a screwed-up tax system, a dysfunctional patent system, and growing economic inequality that may soon create serious social tensions. Our capitalist system needs a lot of work to achieve proper capitalist goals.

Comments

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[Jimbino]

While I admit that education of kids represents a positive externality, the breeding itself represents a negative externality, causing or contributing to miseries such as pollution, traffic, war, loss of species, lack of water, spread of disease, global warming, etc.

The more we encourage and subsidize education, the more we encourage the breeding. While it makes sense to educate a kid once he's here, it makes no sense to breed more of them, particularly when we can get them already potty-trained and ready to work from other countries.

[Terry Bennett]

It used to be, in bygone centuries, that when a person was thinking about putting money in a bank, he would consider competing banks and inquire about their solvency and the degree of risk they took in investing their / his assets. Then the FDIC was created to relieve us of that responsibility.

It used to be when a person wanted to borrow money for a house, the bank would take a close look at the value of the collateral and the borrower's ability to repay. Then the government decided to encourage home ownership, and told banks to stop acting so responsibly.

The caveat emptor principle serves capitalism well, far better than after-the-fact remedies such as litigation and prosecution (or the current remedy: none). There will always be people looking for shortcuts and susceptible to ethical compromise. The failures we have been seeing of late are not failures of capitalism; rather they are the result of ill-advised adulterations of capitalism.

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[sal magundi]

"the others being mainly socialism and communism"

more accurate for either term to say "bolshevism". social-democratic states have done just as well/poorly as relatively-free-market states, and the free-access, production-for-need schema that characterizes communism has never been implemented on any large scale, though millions of people practice something like it on the individual level every day.

[Michael F. Martin]

"Such thinking influenced the regulatory laxity that contributed (decisively in my view) to the financial collapse of September 2008 and the ensuing worldwide depression, and to the disbelief until then of many economists that there would ever again be a major depression. Greenspan and other like-minded economists and political leaders were wrong to think capitalism self-regulating; they neglected the need for an institutional structure, and a culture, that differentiate successful from unsuccessful capitalist economies."

We cannot manage what we cannot measure. There has been no theory of culture that is susceptible to measurement, and hence no way to organize people around building the kind of capitalist economy that might have avoided some of the messes we're in. Singapore only avoided it because there didn't need to be consensus.

Isn't the best thing about law and economics is the insight it gives (not gave, right?) into all sorts of messy problems that otherwise appeared intractable. For example, what's a fair way to decide product liability disputes? We can argue on and on forever about fairness in the abstract. But if we agree that fairness can be approximated by social welfare maximization (or as a provocateur might call it "wealth maximization") then the analysis deepens, and becomes more tractable. (Who is the cheapest cost avoider? Is a penalty default cost-benefit justified? Where do the transactions costs prevent renegotiation of risk allocation?) Good economic theory helped make messy questions of fairness tractable. While measurements remain difficult to make, falsification is at least in principle possible.

The most depressing part of this depression has not been the consequences of our decisions. It has been the despair at finding a way out.

We are going to find a way out. I don't have a crystal ball, but I don't need one to see that people are continuously building new things or using old things in new ways.

Would you have guessed that it was possible to determine a person's pulse and respiration simply by analyzing normal video images?

http://people.csail.mit.edu/mrub/vidmag/

Maybe we will take advantage of the streams of economic data and computer processing power that is available now to measure and manage capitalist culture better from now on. There are (at least rough) proxies for good culture that can be measured, the same as there are (at least rough) proxies for fairness:

http://brokensymmetry.typepad.com/broken_symmetry/2012/06/inventory-turnover-ratios-as-a-metric-for-innovation.html

[Thomas Fix]

True, .. Posner is saying capital markets cannot efficiently operate and emerging markets' gdp is constrained, when individuals' behavior (i.e. the microeconomics) doesn't "aggregate" to efficient macroeconomic function. For example, China's growth will plateau because the society is rife with mistrust and corruption. Greece doesn't have a problem with productivity.

It's problem is corruption -- its citizens will not pay their taxes. The total sum of taxes owed is nearly the sum of its debt. African countries cannot thrive because of similar primitive behavior. Can they escape? Not really. Macroeconomics depends not so much on unfettering capital markets from regulation, but on ensuring our demographics don't regress us into poor behaviors that lead to microeconomics that don't aggregate.

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[Jon M. Hardy]

Judge Posner writes: "Over time, however, a reverse Nirvana Fallacy took hold of many economists, most famously Alan Greenspan...Greenspan and other like-minded economists and political leaders were wrong to think capitalism self-regulating; they neglected the need for an institutional structure, and a culture, that differentiate successful from unsuccessful capitalist economies..." Simply amazing! Judge Posner pretends that America in 2008 was some laissez-faire financial Wild West dystopia, yet refers to one of the main financial regulators in the United States, Alan Greenspan! Sorry Judge, but the collapse was a government failure, not a market failure, as economist Gary Becker ably stated in the Wall Street Journal on September 2, 2011: "The Federal Reserve kept interest rates artificially low in the years leading up to the crisis. Fannie Mae and Freddie Mac, two quasi-government institutions, used strong backing from influential members of Congress to encourage irresponsible mortgages that required little down payment, as well as low interest rates for households with poor credit and low and erratic incomes. Regulators who could have reined in banks instead became cheerleaders for the banks..."

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let bygones be bygones **

[Marcos Mendes]

this is absurd. Terrible way of thinking.

[Marcos Mendes]

when i said it was a terrible way of thinking i referred to the sentence: "(...)and (related to protecting economic freedom) avoids public ownership or control of economic enterprises", in which the authors defend that the state can not have enterprises under its command, in order to reach the economic development of the country. I do not think it is necessary..

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Very insightful. A nice different perspective.

[firm but fair]

grave environmental problems such as global warming

I don't know how I take this guy seriously after this.

[Global warming is a problem]

"grave environmental problems such as global warming"
"I don't know how I take this guy seriously after this."

People like you who don't understand or take science and reason seriously are the problem.

[Ravi Shanghavi]

Thank you Judge Posner, It's great to see that someone is awake at the wheel. The patent wars are stifling technology and impeding progress. You've done us all a great service with your recent ruling on the Apple vs Motorola case. I hope other justices take note, and this starts a movement putting technology firms back in their research labs, instead of courtrooms.
Cheers, Ravi Shanghavi, Ottawa, Canada

[Taran Rampersad]

Factoring in the Great Divergence (and its end) lends more weight to the perspective viewed here.

Reference:
http://www.ted.com/talks/niall_ferguson_the_6_killer_apps_of_prosperity.html

[ktizo]

Is amazing how widely different the definitions of socialism and capitalism are around the world.

In the US socialism often has a narrow meaning that seems more strictly left and homogenising than it does in many other places.

Many policies that are implemented in supposedly capitalist countries are far more socialist in nature, but coexist with capitalist policy as the two can support the other, like socialised education, scientific research, healthcare, infrastructure, transport and welfare programs.

In simple terms, this works because there are many useful people, for whom life is nevertheless difficult, and if you can lower the barrier to entry for getting stuff done by subsidising those things that are necessary, but not necessarily profitable, or are only profitable if you make them less useful, then you have more productive people available to actually take part in the capitalist economy.

One thing to remember in all this is that economies themselves are subject to their environment, and one day even capitalism could find itself obsolete for the vast majority of transactions.

[RB]

The last paragraph *really* puts everything in perspective

[Andy]

very nice discussion...
the short note that you wrote on "what else does a country need in order to prosper?" was so precise.. it made me think of our country governance and the areas where they are lacking

[Philip]

although I mostly agree with this post, Posner's use of Cuba and North Korea as his examples undermines his argument. North Korea is hardly the "greatest economic failure on the planet", despite having a brutal and expensive military dictatorship, crippling sanctions, and a terrible lack of quality farm quality, North Korea's GDP per-capita (PPP) is 6 times that of the Congo's, at least according to the CIA world fact book. And, this doesn't consider many of the social services provided by the DPRK such as universal housing, and an educational system that has achieved 99% literacy (campare to the 94% literacy of Hong Kong). Similarly, Cuba has attained high quality educational and health systems, and is rich by comparison to a country such as Haiti.
Also, the entire premise is wrong. North Korea doesn't claim to be a "socialist" or "Marxist/Leninist" state anymore, while China, Vietnam, Laos, Cyprus, and Nepal all have "Marxist" parties in power. It also doesn't match any objective measure of government spending: Norway has over 70% of its GDP as government expenditure (the highest in Europe) yet has the third highest GDP per capita in the world, a fantastic HDI, the 6th best Ease of Doing Business, and a 3.6% unemployment rate. Based on the most recent data I can find, Cuba's government spending as a percentage of gdp is only 64% (still very high, but lower than exceedingly rich "capitalist" Norway).
Some degree of economic freedom is clearly essential to robust growth. Strong evidence can be marshaled to support relatively small governments (although the optimal size and roll of government is still a hard problem). Sadly, this and similar post with its characteristic scare mongering about socialists doesn't do that. What is worse, it hampers the ability to have productive discusion about *how* to optimize American capitalism...which was Judge Posner's topic.

[ObjectiveSee]

"People like you who don't understand or take science and reason seriously are the problem."

People like who don't understand how climate science is funded are the problem. Or maybe you do and are on the scare mongering take. I wonder if any climate scientists have actually done a carbon foot print analysis of their contribution to global warming given all the conferences they attend.

[NEH]

ObjectiveSee, Are you familiar with the phenomena of "Critical Mass/Critical Path" analysis and "Tipping Points" in regards to Physical Process's? I thought so...

[Jonathan Story]

There is much to be said for Terry Bennett's comment on nationalizing risk. Not only does it increase the risk of the "safety net" failing, but also increases the impact when it happens. Even worse, however, it encourages risky behavior since the link between action and negative consequence is broken.

A similar point has been made by Roger Martin (http://ergsec.ca/index.php/articles/29-can-the-nfl-save-capitalism) about companies whose CEOs are rewarded based on stock performance. A CEO can explain away disappointing results on factors outside his control, so with limited downside and a very rewarding upside, CEOs are predisposed to taking actions that undervalue risk. It is this that has been blamed as a reason for the corporate meltdowns of the past (WorldCom, Tyco, Enron, etc.) and the investment meltdowns of the present. Without structural change in executive compensation, the threat of more scandals lies ahead.