This year is the fiftieth anniversary of the publication of Milton Friedman’s Capitalism and Freedom (1962) and the seventieth anniversary of Joseph Schumpeter’s Capitalism, Socialism and Democracy (1942). They are without doubt the two most influential studies of capitalism since Karl Marx predicted its demise and the triumph of socialism and communism. What were Friedman and Schumpeter’s main messages about capitalism and how have they held up against time? This is the first part of a two-part essay to commemorate two intellectual giants of the last century.
The word capitalism was of course invented by Marx to describe the industrial market economy that replaced the pre-industrial feudal agricultural economy, a process that first appeared in Western Europe. For Marx, feudalism had inherent contradictions that led to its eventual demise to make way for capitalism. Similarly, capitalism also contained inherent contradictions that he predicted would lead to its subsequent demise to make way for socialism and communism.
Flaws of Marxism
Marx’s millennium message of capitalist exploitation was appealing to the poor who saw it as a scientific interpretation of their social and economic condition and also as an opportunity to bring about change through violent political revolution.
Unfortunately the poor were misled. In a sense, Marx’s believers might have misinterpreted the master’s message either profoundly or deliberately. Marx had a deep appreciation for the enormous productive powers of capitalist accumulation. Indeed he expected capitalism to only fail in those nations where industrialization through capitalist accumulation was most advanced, notably rich England, rather than poor Russia. Marx believed that capitalism created wealthy societies, but this would not save them from failing because of the inherent contradictions within the capitalist system.
Marx’s prediction of the fall of capitalism not only failed to materialize, but the subsequent history of communism has been a constant source of profound disappointment and deep embarrassment to its intellectual advocates. Capitalism has not only survived, it has also thrived in the 150 years since Marx.
For Schumpeter, writing in 1942, capitalism was successful in producing ever-increasing amounts of goods and services. Despite recurrent recessions and regardless of the Great Depression (1929-39), the capitalist mode of production had resulted in a high-sustained rate of economic growth unprecedented in history. Furthermore, the fruits of this growth were not limited to any elite class. The incredible productivity of the capitalist engine had enabled the great mass of society to obtain higher standards of living than were known even to kings in the pre-capitalist era. The industrial worker was the major beneficiary of capitalism.
Schumpeter attributed the success of capitalism to the market reward structure of the bourgeois capitalist system. In a system of unfettered capitalism, the successful entrepreneur has the opportunity to make enormous sums of money. Schumpeter regarded the carrot of spectacular prizes combined with the stick of threats of destitution as particularly effective in calling forth both the productive ability and energy of the business class, as well as providing an automatic regulating mechanism for entry into, success within, and exit out of that class. For Schumpeter, the profit motive was a powerful incentive in organizing society’s resources effectively.
Capitalism Explained Again
Schumpeter saw the world of capitalism as being dominated by large firms that exercised considerable control over the market and made attempts to fix prices, deter entry, engage in predatory acquisition of competitors, and pursue other forms of noncompetitive behavior. But the dominance of monopolistic firms in the market would not suffocate competition because the capitalist process was dynamic. For Schumpeter, the process of Creative Destruction propelled an economic system to attain dynamic efficiency through entrepreneurial innovations that harnessed new technologies and open new markets. He stated:
“The fundamental principle that sets and keeps the capitalist engine in motion comes from the new customers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. [These developments] incessantly revolutionize the economic structure “from within”, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.” (p. 83)
In shunning the static efficiency of the textbook competitive economic model as the central feature of capitalism, Schumpeter transferred the defense of capitalism from the ground of the superiority of markets over central planning to that of the superiority of capitalism over socialism as an engine of creativity, innovation and technological progress. However, his argument also made economic disruption resulting from the process of Creative Destruction inseparable from capitalism, which meant the system was inherently vulnerable to social and political unrest.
For this reason, despite his admiration for capitalism, Schumpeter believed that capitalism would not survive and would be replaced by socialism, an outcome he did not welcome but believed was unavoidable. For him capitalism was not only an economic system, but also a cultural and political system. He did not think that capitalism would fail on strictly economic grounds, but culturally and politically it was vulnerable. He argued that capitalism’s “very success undermines the social institutions which protect it, and inevitably creates conditions in which it will not be able to live.” (p. 61)
Entrepreneurs are Unloved
Culturally, Schumpeter thought the core values of capitalism centered on the relentless pursuit of rational choices and profit calculations were too hardhearted. They lacked the “mythical, magical, romantic, and heroic” appeal of the pre-capitalistic societies. The successful entrepreneur may be respected and even admired, but he was unloved. This might be good for the entrepreneur as it cultivated in him a no nonsense personality. But this inability to win the hearts of the people was a crucial weakness in the capitalist system. Being unloved was the fate of the successful entrepreneur and it made him vulnerable to political attack in harsh economic times.
Periodic temporary economic slowdowns due to business cycles were also inherent to the capitalist process, according to Schumpeter. For individual workers the consequences of unemployment associated with these economic slowdowns could be disastrous and would be a continual source of social unrest. The most inviting victim upon which to focus this unrest was naturally the bourgeois entrepreneur. Unloved to begin with, he becomes an easy target of attack for politicians and disgruntled intellectuals seeking to curry favor with the masses. Capitalism under this scenario will not crash to its death, but gradually fade away to be replaced by socialism.
Schumpeter also thought big business would succumb to bureaucratization. Entrepreneurial innovativeness would be replaced with routinized decision-making by bureaus and committees staffed with salaried officials. Even family business empires would decline because successful entrepreneurs would lose interest in raising large families. Schumpeter’s observations were far ranging and perceptive in many ways. Still, he could not have foreseen everything and might have been prematurely pessimistic about the prospects of economic dynamism under capitalism.
Over time big business organizations did become more hierarchical and cumbersome, but the most creative organizations today are new, flat and networked and are just as innovative as those of the past. New entrepreneurs have founded many of them. A combination of outsourcing and active management of supply chains has further enhanced productivity by blurring the boundary between organizations and markets to take advantage of the different strengths of alternative arrangements. Innovations in incentive contracts have enhanced performance by transforming salaried officers into risk-taking entrepreneurs by proxy, sometimes with disastrous consequences as in the Baring and Enron scandals. The capitalist engine is characterized by an unrelenting search for productivity gains and profits.
Common Good is a False Idea
Schumpeter’s most penetrating and creative observations of why capitalism would be replaced by socialism were in regard to the nature of political democracy. Although the democratic method of government emerged together with the rise of capitalism, he thought it could also be compatible with socialism. Political democracy would not prevent the gradual replacement of capitalism by socialism.
To him the assumption that there was “a will of the people” was a serious flaw in the classical doctrine of democracy. He recognized from the outset that it was impossible to assume there was a “common good” recognized by all because people disagreed on what is “best” for society – even intelligent, informed people with no special interest to advocate. He therefore disagreed with the classical doctrine of democracy that states, “The democratic method is that institutional arrangement for arriving at political decisions which realizes the common good by making the people itself decide issues through election of individuals who are to assemble in order to carry out its will.” (p. 250)
Schumpeter, like the English liberal John Stuart Mill, did not believe the role of the elected representative was to represent the narrow interests of the constituency that voted him into office, but to exercise the authority of his office in the best interests of the nation as a whole. In his view, when it came to important matters of public interest beyond the private interests of individual citizens, the goal of the democratic political process and its elected representatives was not to accept and follow but to shape and guide the “will of the people”. The will of the people did not flow from the bottom up; rather it flowed from the top down.
According to Schumpeter, “the will of the people is the product and not the motive power of the political process.” (p. 263) For him the democratic system of government is an “institutional arrangement for arriving at political decisions in which individuals acquire the power to decide by means of a competitive struggle for the people’s vote.” (p. 269)
Five Conditions for a Working Democracy
Schumpeter’s discussion of democracy has had a huge impact on the development of modern political science, particularly in the two propositions that politicians are entrepreneurs in getting votes, and that the true function of democracy is to choose leaders, not policies. He recognized that politicians might be motivated primarily by self-interest, but believed they could still achieve socially desirable ends, just as the self-interested profit maximization in the economic sphere would, in a competitive market system, result in a socially efficient allocation of resources.
He did recognize there were dangers in democratic political arrangements. In particular there would be a natural tendency in a democracy to appeal to voters’ short-term interests to the neglect of longer-run concerns. If this tendency was not controlled, the democratic system would not produce satisfactory results. Schumpeter lists several conditions that a democratic system would have to meet in order to successfully resist this potential danger.
First, a democracy must attract a sufficient number of high quality and skilled politicians.
Second, the effective range of political decisions cannot be extended too far. Many governmental decisions should be left to experts and technicians rather than determined by the short-term concerns of the electorate.
Third, related to the above is the requirement for a well-trained, respected bureaucracy that can insulate itself from the short-term political whims of the public. The civil service has to be de-politicized.
Fourth, there must exist a sufficient amount of “democratic self-control”. People must have faith that the democratic system can work and the government it produces will function reasonably well. The public should have patience with the government it elects and should not be poised to pounce on every mistake that the government makes. This requires voluntary restraints on the part of the electorate and opposition political parties in their attacks on the elected government.
Fifth, for a democratic system to function there must be within society a large tolerance for difference of opinion. A necessary condition for the existence of such tolerance is general agreement on the basic principles governing society, including the principles on the organization of the economy.
Schumpeter believed that the capitalist economic system provided a fertile bed for the flowering of democracy. Political democracy is the mirror image of a capitalist economic system. Both systems are based on the same principles of freedom of individual choice. In particular, the capitalist economic system seeks to limit the sphere of political decision-making.
This goal is embedded in the concept of laissez faire that restricts the state’s role to protecting private property rights and individual freedom, national defense, maintaining law and order, and enforcing contracts. These limitations on the public functions of the state make it easier to practice democratic self-control and make the threat to the individual of a misconceived policy appear less immediately threatening. Under the laissez faire concept, the capitalist economic engine continues to produce ever-higher standards of living to work the magic for peaceful coexistence with a democratic political arrangement.
Schumpeter, however, did not believe political democracy could protect capitalism. The competitive struggle for the people’s vote requires the creation of a political class to protect its own interests. But he saw the bourgeoisie as being disinclined toward political activities and therefore forfeiting political leadership to other class interests. Schumpeter simply assumed that bureaucratized big business would gradually be taken over by the state. The bourgeois class would wither away as its economic role was no longer required. The capitalist economic engine would grind to a halt. Innovation would cease and technological progress would stagnate. Socialism and democracy would coexist, but the economy would make no progress. His analysis did not go beyond this.
Blind Spot in Schumpeter’s Theory
Schumpeter’s view of the passivity of the bourgeoisie in politics is of course an idealization of that class. This is surprising, for long before Schumpeter Adam Smith had recognized the propensity of merchants to scheme. Historically the bourgeoisie is not adverse to lobbying the government for special privileges for themselves or for regulatory barriers to thwart market competition against their own businesses.
When the bourgeoisie pursues rent-seeking activities, economic competition in free markets is replaced with political competition to restrict market access to competitors. Activities that stimulate innovation and productivity are replaced by those that suffocate economic creativity. And when government gets increasingly involved in regulating business the march to public ownership under socialism quietly begins.
It is surprising that Schumpeter failed to see this development. He had foreseen the possibility that big business would become increasingly bureaucratized and staffed with salaried managers. Would it not be logical to see these managers lobbying for protection and privileges?
Schumpeter also did not pursue the possible consequences of electoral competition on the economy. If politics is primarily a game of competing for the right to make income transfers between social classes, then an enormous amount of time and resources is spent on redistributive activities. Things get even worse when the transfer goes to the politicians themselves or their narrow constituencies.
Schumpeter thought that a socialist economy could function with a political democracy. But he did not envisage that such a system could lead not only to economic stagnation but also retrogression. Under socialism a larger share of the economy is in the hands of the government than under capitalism. This only makes rent-seeking activity and redistributive electoral competition even more rewarding and vicious as more resources are in the control of government.
Schumpeter had a blind spot about these dangers under democratic socialism. Without a capitalist engine to generate growth, zero-sum politics could cause an economy to go backwards.
Capitalism, Socialism and Democracy could not possibly have foreseen everything. But as a piece of analysis it was full of foresight and forced us to think of the interconnectedness of political and economic systems. Schumpeter’s concepts of creative destruction and electoral competition continue to illuminate the political economy questions of today.
Milton Friedman, Capitalism and Freedom, University of Chicago Press, 1962.
Joseph Schumpeter, Capitalism, Socialism and Democracy, Harper and Brothers, 1942.