Saturday, February 4, 2012

In Defense of Free Markets – Private Enterprise – Capitalism

Recently we have heard capitalism attacked. Perhaps not so surprisingly, from Newt Gingrich in his trying to turn Mitt Romney’s business experience at Bain Capital into a negative, something many people did not expect to happen until President Obama would attack Romney in the 2012 fall General Election. So, this raises the questions, “How good is capitalism? Are free markets beneficial? Should private enterprise be prized?”

The Invisible Hand. Economics is the study of the allocation of scarce resources. Adam Smith in “The Wealth of Nations” [published as a five-book series in 1776] espoused what came to be known as the “invisible hand” theory, when he explained how rational self-interest in a free-market economy leads to economic well-being. According to Adam Smith, in a free market each participant will try to maximize his or her self-interest. He believed that there was a natural force, or "invisible hand", that would guide market participants to trade in mutually beneficial exchanges of goods and services where everyone would be better off than when simply producing for himself/herself.

Someone earning money by his own labor benefits himself. Unknowingly, he also benefits society, because to earn income on his labor in a competitive market, he must produce something others value. In Adam Smith’s words, “By directing that industry in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

Smith claimed that an individual would invest a resource—for example, land or labor—so as to earn the highest possible return on it. Consequently, all uses of the resource must yield an equal rate of return (adjusted for the relative riskiness of each enterprise). Otherwise reallocation would result through competition for scarce resources.

Theory of Pure Competition. This idea of reallocation of resources morphed into the theory of pure or “perfect” competition. The standard model of price competition that is presented in almost all principles of microeconomics texts, tells us that in an un-concentrated market with many small suppliers, the consumer will pay lower prices than she would if the same market less competitive. And, best of all, resources would be allocated where each unit of resource would return the highest rate of return in the system possible. In other words, this would be the most efficient economic system. If “excess profits” were earned from a resource (whether it be one’s labor, land or capital) in a particular market segment or other economic pursuit, resources from another market segment would rush in to capture those excess profits, and as a result, the system would reach a new equilibrium where returns would be equalized. When a new disruption would occur, a similar readjustment would occur. Conversely, if a resource was not earning what it could earn in another pursuit, that resource would be redeployed into a higher paying pursuit. Prices (or rates of return) were the signals the participants in the market paid attention to. Price competition is the essential element in this theory. Due to the interaction of supply and demand, prices were at market clearing levels, meaning there were no surpluses or shortages in the long run as market participants responded, generating stability in the marketplace.

Creative Destruction. While the theory of pure or perfect competition viewed the world in rather static equilibrium, momentarily disrupted from time to time, followed by reallocation of resources to a new equilibrium, Schumpeter introduced the argument that capitalism exists in the state of ferment he dubbed "creative destruction," with spurts of innovation destroying established enterprises and yielding new ones. He believed creative destruction is the process in which technological advance is the main source of economic growth and improvements in the quality of life, as the new innovative processes or new products dynamically leapfrogged competition. He envisioned the process of creative destruction being the form of competition in capitalism that is capable of dramatic improvements in the quantity and quality of our lives. And, many economists also believe that smaller, often start-up, firms are the most likely source of new leapfrog innovation. See “Schumpeter’s Creative Destruction: A Review of the Evidence”, by Arthur M. Diamond, Jr. at

As another writer eloquently put it:

“Capitalism, Socialism, and Democracy [Joseph Alois Schumpeter’s 1942 book]. . . is also a sparkling defense of capitalism on the grounds that capitalism sparks entrepreneurship. Indeed, Schumpeter was among the first to lay out a clear concept of entrepreneurship. He distinguished inventions from the entrepreneur’s innovations. Schumpeter pointed out that entrepreneurs innovate not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. These innovations, he argued, take just as much skill and daring as does the process of invention.

Innovation by the entrepreneur, argued Schumpeter, leads to gales of “creative destruction” as innovations cause old inventories, ideas, technologies, skills, and equipment to become obsolete. The question is not “how capitalism administers existing structures, ... [but] how it creates and destroys them.” This creative destruction, he believed, causes continuous progress and improves the standards of living for everyone.

Schumpeter argued with the prevailing view that “perfect” competition was the way to maximize economic well-being. Under perfect competition all firms in an industry produce the same good, sell it for the same price, and have access to the same technology. Schumpeter saw this kind of competition as relatively unimportant. He wrote: “[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization ... competition which ... strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives.” The Concise Encyclopedia of Economics.

The conclusion that might be reached is that the more open the economy is to creative destruction, the faster will be the rate of technological advance, and the greater will be the improvements in longevity, health and quality of life. The United States during the twentieth century was a notable exemplar of openness to creative destruction and we have reaped the benefits from a vastly expanding economy, substantial technological advances, and improvements in longevity, health and quality of life as a result.

An Extension of the Market Reallocation of Resources. Market forces are driven by prices and prices are affected by market forces. The price and use of farm lands serve as good examples. When farmers can earn profits from the production of their crops, that affects the price of their land. As the price of corn goes up, the sales price and lease costs of land capable of producing corn goes up. When prices collapse, land prices and rents fall. Farmers also respond to the relative prices of corn, soybeans and other competing crops to determine how much of each crop they will produce.

Prices also affect whether a resource is used at all. When prices go up, land which might have been marginal for earning a profit when prices are low begin to be placed into production. This explains the increase in the number of tilled acres of corn in recent years as corn prices have surged. A resource which has zero or a negative value will not be used. This explains the vast acreage of farm land in the Upper Peninsula that was formerly farmed but now is reverting to brush and forest lands. Some of these lands are now being considered for production, due not only to the rising prices of the crops, but also due to innovations in crop varieties which are increasing the productivity per acre and reducing the number of growing days needed to produce the crop.

Similarly, a vacant, obsolete property in a downtown area may have a negative value due to the extensive costs of demolition and/or renovation that would be needed to put it back into use. This explains the need for “brownfield” tax credits or allocations of funds to make the property economical for reuse.

Another extension of this theory relates to wages. The higher the cost of any resource, the less of it that gets used. If a resource is artificially priced higher than its value, less of it gets used. To the extent that it is artificially priced higher than someone can use it and still make a profit, it does not get used at all. This explains why conservative economists (and politicians who follow such economists) do not like minimum wage laws, “living wage” laws, prevailing wage laws or even unions. By constraining the drop in wages due to changes in the economy, labor becomes surplus, i.e., people become unemployed. Thus the irony of people who are trying to be compassionate and want people to have a living wage actually help cause the poor to have no wage at all. We would be better off to allow wages to drop and retain people in jobs.

Similarly, people who try to artificially prop up wages by protecting union wages to “preserve the middle class” cause the loss of the very jobs they are trying to protect. Conservatives also object to trying “to protect the middle class” as they view America as without classes, as anyone can move from one income level to another based on his or her merits. We believe in (1) the need for incentives to develop a set of talents and skills (through education, training and experience) that are of value in the marketplace and (2) the need to develop a work ethic that is of value either as an entrepreneur or as an employee for another. We are better off as a society to promote the continued development of our individual and group productivity to continuously improve our competitiveness in the marketplace, both as individuals and as a country in the global marketplace.

But, the objection is that we have developed life styles that require high incomes. First, I would argue that we have lost the distinction between something that would be nice to have versus what we actually need to have. But the “invisible hand” also helps us out, at least in the long run. As wages in an area decline, the demand for goods (food, entertainment, housing, etc.) also declines. As demand declines, the prices of those goods must also decline to retain “market clearing prices”. Witness the cost of housing in Michigan and throughout the country. As prices adjust, the cost of living adjusts downward so that we don’t experience as much of a loss of the non-essentials as might otherwise be expected. But, this is a long run phenomenon, and the transition may be painful and the pain not evenly distributed among all among society.

Reflections on the 2012 Republican Primary Campaigns. Mitt Romney has been attacked for his role as a venture capitalist with Bain Capital, a private equity company. An eloquent defense of venture capitalists is contained in “Stop vilifying venture capitalists”, A paragraph in that article points out a vulnerability that detractors seize upon.

“Venture capitalists won't always get it right though. Sometimes they'll encourage companies to take on too much debt, or they'll back ill-conceived business plans. When the venture capitalists and entrepreneurs make bad decisions, it hurts just as when the government makes a bad decision. But when venture capitalists and entrepreneurs make bad decisions, the people who are hurt are people who knowingly chose to invest, work for or do business with them.”

Another potential vulnerability is the the existence of dividend recaps (i.e., the way private equity firms can make money even if the equity of the company they invest in is wiped out). See “Let's be honest about private equity”. That is, in a leveraged purchase of a company, the private equity firm sometimes pays “dividends” to itself from the cash from the loans. If later the company does not succeed, it appears as if the private equity firm hollowed out the company to benefit itself to the detriment of the company which later may be forced into bankruptcy. This looks even worse if the company received favorable tax treatment from state or local governments through tax abatements or credits.

CNN's Fareed Zakaria puts these attacks into an interesting perspective:

“Instead, a second line of attack has been gaining traction against Romney – that of Romney as job-killer or Romney as the private equity guy, who buys companies, hollows them out and outsources jobs.

Now it is striking that this attack is coming in a Republican presidential primary. After all, what Romney did while at Bain Capital was classic capitalist “creative destruction.” He took over businesses and tried to make them more productive and efficient. To do so, he often had to shed jobs.

Republicans should be celebrating Romney’s prior work as an example of how the market functions – driving out inefficiency, generating productivity and creating a lean, mean capitalist machine.

The fact that Romney’s past has turned into a line of attack tells you that something has changed in America. Even in the Republican Party, there is a huge concern about what globalization and technological change are doing to the average, middle-class American. There is a sense that the system is not working for the median American worker.

If you look at job creation over the last 20-25 years in America, you’ll notice that we haven't been able to create any jobs in what is called the “tradable sector” of the economy - those jobs that are subject to global competition. The only jobs we’ve really created have been in industries like health care, government, and construction, which are basically local industries shielded from global competition. You can't outsource the building of a New York skyscraper to a Chinese worker.

America hasn’t been able to create jobs in any sector that’s subject to global and technological pressures. As a result, there is a huge sense of disillusionment, disappointment and pessimism among Americans.” “Zakaria: Romney’s real problem”.

Query? Why haven’t we been able to continue to compete in the “tradable” or manufacturing sectors? The reason most often given is that the labor cost of producing a product in the U.S. exceeds the labor cost in the emerging economies of China, India, Korea and others. With the labor cost being a product of the wage and benefit rates times the productivity, we can compete in terms of labor costs by either increasing productivity or decreasing wage and benefit rates. To the extent that wage laws and union contracts have made wages and benefits “sticky downward”, we have lost competitiveness when our productivity gains have not occurred quickly enough. Recent news articles, however, indicate that America is regaining our manufacturing competiveness, as labor costs are rising in China. See, for example,China’s manufacturing industry becoming less competitiveand “Can China compete with American manufacturing?”

Theory of the Firm. A business has many stakeholders. The reason for the existence of a business is to return a profit, that is, a return on the investment of resources employed by the firm, whether it be the owners’ labor, land or capital. Therefore the owners or investors are stakeholders. Other stakeholders are the firm’s customers, who must be satisfied or the firm will cease to exist. The employees also have a stake in the success of the business. Many argue that businesses also have another stakeholder – the community at large. That is, the needs of the surrounding community needs to also be considered in the decision-making of the business leaders. This is certainly the case where considerable “externalities” such as pollution occurs. But, many believe that a company also “owes” the community more, such as in decisions whether to close a plant – whether it be to entirely go out of business, relocate or to “outsource” part of its production.

Conservative economists will argue that to the extent that the needs of stakeholders other than the owners are taken into account, distortions in the market result. That is, to the extent that employee wages and benefits are more costly than justified by the market or its competitors, the business gets less competitive and may be forced out of business. Or, if a firm were coerced by government edict to remain open when it is losing money, a misallocation of resources would occur. Or, if prices were restrained lower than the market allowed, less of the product or service would be produced than if market clearing prices were to occur.

CNN’s Michael Lind has written an insightful piece on this issue:

“In a presidential primary season distinguished so far by the absence of substantive debates, the controversy over whether Mitt Romney and his partners at Bain Capital should be considered job creators or job destroyers raises a profoundly important issue.

Beyond the concerns about the loss of American jobs to off-shoring or automation and the food-fight tactics of Romney's rivals is a legitimate question about what kind of capitalism 21st century Americans should want.

The choice is between "stakeholder capitalism" and "shareholder capitalism." According to the theory of stakeholder capitalism, corporations are and should be quasi-public entities with responsibilities to the nation-state and to the communities in which they are embedded. The corporation should make a profit and provide a fair return to investors. At the same time, workers who contribute their labor to the company have a legitimate interest in it as well as investors who provide capital. Managers serve the company and the country, not merely the investors.

In the theory of "shareholder capitalism," the corporation exists solely for the purpose of the investors, whom the managers serve as agents. In shareholder capitalism, short-term profits are the only goal, and if that means laying off workers instead of retraining them or reassigning them, breaking up the company and selling the assets to enrich private equity partners and shareholders, so be it.
. . .

What are the implications? If America continues to favor shareholder capitalism, there is no guarantee that policies to favor American business will preserve or create jobs or help anyone other than investors. On the other hand, if the United States were to move away from shareholder capitalism toward stakeholder capitalism, the law might limit hostile takeovers of companies or require workers and even local governments to have a say in corporate decisions. In some cases this might preserve jobs and factories at the expense of innovation and efficiency.

As a practitioner of the shareholder capitalism of the last generation, Mitt Romney as president would probably support policies that assume that the short-term interests of investors like Bain are identical to the long-term interests of the economy. By the same token, he would probably resist policies that increased the influence of managers, workers and local communities over companies at the expense of shareholders and financiers.” “What kind of capitalist is Romney?”

Mitt Romney has been attacked as being a “vulture capitalist” as well, because as a private equity firm, Bain Capital sometimes purchased companies that they perceived had greater value as a sum of its parts than as an ongoing business. That is, companies can sometimes be undervalued by the market and if purchased, the company can be dismantled and its parts sold for a greater amount than the price the entire business was valued. Also, in attempts to turn around companies, the purchased companies (or companies they invested in) were restructured to reduce their costs to be more competitive. This may have involved closing down of plants and/or outsourcing some production, causing jobs to be lost in certain communities. Economists who believe in “creative destruction” as important to reallocate resources to where they have higher value believe this is a good thing, but those intimately affected obviously think otherwise.

For example, some commentators, mostly from the left of the political spectrum see venture capitalists as immoral, as they don’t sufficiently consider the humans involved. See “Immorality and venture capitalists”, Froma Harrop, January 22, 2012.

Pushback Versus Attacks on Romney. Pushback is developing against charges that Romney was a "vulture capitalist" or a “predatory capitalist” who looted companies and fired workers when he was running the private equity firm Bain Capital in the 1980s and 1990s. See, “Perry donor defects to Romney”, citing Bain attacks” and Gingrich attack exposes desperation and elitism”.

Crony Capitalism. Another term that might be confused is the term “crony capitalism”. This refers to the granting of favors by government entities to certain companies and not to others. The favors might be tax abatements, tax credits, special contracts, subsidies, mandates, etc. The basic objection is the picking of winners and losers by government. What makes this favoritism objectionable is the disbelief that governments or government “experts” can do a better job of allocating resources in the marketplace than the “invisible hand”. See “Can Monkeys Pick Stocks Better than Experts?”. While this article reports of slightly better investment results than throwing darts, the results were not much better than the DJIA, and they questioned whether they were better at all when you considered the risk-return ratio and the long run results. In other words, do government experts actually have a clearer crystal ball then the most expert private investors and companies looking for opportunities? Critics say, “No!’Another objection to such favors is the opportunities for corruption in the political system, something clearly seen in some areas in Michigan and elsewhere. Thus, conservatives do not defend this kind of “capitalism”.

Conservatives also object to other interference in the marketplace. For example, the National Highway Traffic Safety Administration’s tough new fuel economy mandates forcing automakers to spend $50 billion to $150 billion on technology to more than double current vehicle performance to get today’s light vehicle fleet average today of about 22 mpg up to 54.5 mpg in 13 years is thought to be an arrogant disregard for the marketplace. Source: “Column: Feds mark taming of Detroit”. To the extent that such government action attempts to allocate resources differently than the market otherwise would, such conservative economists, commentators and politicians believe that the country is worse off, as fewer products or services will be produced, lowering the standard of living that our country’s citizens would otherwise enjoy.

Where Does the Free Market Fail?

a. Business Cycles. Any market is subject to the possibility of booms and busts, and free markets are no exception. Due to human psychology, in the absence of price controls, there will be periods of great optimism (or excessive exuberance or "irrational exuberance" as expressed by then-Federal Reserve Board Chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the Dot-com bubble of the 1990s, warning that the market might be somewhat overvalued).


Whether they be tulip bulbs as in the 'Dutch Tulip Bulb Market Bubble' which occurred in Holland during the early 1600s when speculation drove the value of tulip bulbs to as much as six times the average person's annual salary or the high prices of internet stock companies in the late 1990’s, or the real estate prices in the 2000’s, optimism will exceed reality as people try to “get their share” along with everyone else. When the bust comes, then excessive fear will cause the prices to plummet, often well beyond reasonable values. Eventually, people begin to realize that the market has adjusted too much and will begin to pick up again. This “greed” and “fear” cycle is as old as time and there is little that anyone can do to prevent it. That is, when you are in a greed period, how can you tell it is irrational exuberance or just “a new time in history” as many thought the internet bubble was?

The “prevention” tried by the government sometimes has been price controls which artificially constrained the price signals in the market and caused shortages for those products or services whose prices were held down. (Conversely, excess production has occurred where the prices were held artificially high, as with price supports for farm products.) The “cure” imposed by government has been federal deficit spending to try to “prime the pump” or “cheap money” by the Federal Reserve Bank in downturns, but the reverse has less frequently been used to “choke off” booming economic times, as this
would not be politically popular.

b. Monopolies/Oligopolies/Restraints of Trade.
The conditions for perfect competition and the efficient allocation of resources are violated where an industry becomes too concentrated in one or few competitors, or competitors engage in anti-competitive practices, such as price fixing. The excesses of the big trusts in the early 1900’s brought on the Anti-trust laws and regulations
which continue through today.

c. Natural Monopolies. There are some services for which it does not make sense to duplicate providers. Examples would be electrical, phone or natural gas lines into neighborhoods, as there would be massive duplication of capital costs which would make providing those services much more expensive. Roads, rail lines and airports would be other examples. These economists have long believed that the most appropriate way for these services to be provided would be either by the government or by private firms under government regulation. |

d. Externalities. There are some economic activities in which the total costs of the activity are not entirely borne by the private company, while enjoying all of the benefits. The typical example used is a business which is causing pollution which harms others, but which harm is not compensated for by the firm. The typical response to these problems are regulations, such as air pollution control requirements, to either reduce the externality or to compensate those harmed by the activity.

There are also activities for which a business would find it very difficult to capture all of the benefits of providing a service. For example, if a private company were to construct a road, the only way to capture all of the benefits would be to charge tolls for its use. The costs of collecting those tolls (or charging special assessments for those benefitted and excluding others from using them) may be excessive in comparison to the benefit. In those cases, it makes more sense for the public to in some way share in the cost of the roads in the entire city, state or country and forego the expense of the toll or special assessment collection.

Conclusion. I believe in the free market system. It has provided us in the United States with as unparalleled standard of living while allowing us to enjoy individual freedoms previously unavailable to the masses.

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