Source: An essay in Toward Liberty: Essays in Honor of Ludwig von Mises on the Occasion of his 90th Birthday, September 29, 1971, vol. 2, ed. F.A. Hayek, Henry Hazlitt, Leonrad R. Read, Gustavo Velasco, and F.A. Harper (Menlo Park: Institute for Humane Studies, 1971).
At the present time the outlook for capitalism is far from hopeful. This is not owing to any inherent defects of capitalism considered as a system, but to the fact that great evils and injustices are attributed to it and that its merits are so little understood. As a result it is being maligned, thwarted, sabotaged, and slowly regulated to death.
But before we discuss the probable future of capitalism, we ought to be clear concerning exactly what it is. Capitalism is free enterprisè. The two terms are synonymous in what they denote, though much different in what they connote. Capitalism was originally coined as a smear word in 1854 by Karl Marx and his followers. It was intended to imply a system run by the capitalists and for the capitalists, to exploit the workers. Yet even this smear word unintentionally emphasizes one great merit of the system, which is that it tends to promote the accumulation and increased use of capital, and so tends constantly and acceleratively to increase the production of wealth.
Capitalism may be thought of as a combination of two institutions—private property and the free market. Private property means that everyone is free to keep the fruits of his labor, or to put them to any use he sees fit, as long as he does not infringe the similar rights of others.
It should be obvious that without the right of private property men would lose most of the incentive to produce anything of permanent value. If a farmer knew in advance that after he had plowed and planted and tended a field, anyone else would have as much legal right as he to harvest the crop, or to appropriate it even after he had harvested it, he certainly would not bother to plant the crop in the first place. If any man knew in advance that after he had built and furnished a house, anyone else would have as good a legal right as he to occupy it, he would not build the house in the first place. Private ownership is absolutely essential to give any incentive for sustained work and sustained production of durable wealth.
Again, the free market, the right to sell or exchange one's property for the best bargain one can make, is also essential to the maximum production of wealth. It is through the mechanism of the free market—through the search by the individual as producer for the maximum monetary profit, combined with his search as consumer for the most advantageous exchange for what he wants for his own use—that production is not only maximized but optimized—that it goes into the creation of tens of thousands of different goods and services in the amounts and proportions in which they are wanted by the great body of consumers.
Let us look closely at the way in which this productive balance is brought about. When production is in equilibrium there tends to be approximately the same profit margin, relative costs and risks considered, in the production of each of the thousands of different commodities and services. Now let us say that there is suddenly an increased demand for commodity X. The competitive bids of consumers against each other will raise the price of that commodity. This will raise the profit margin in making it above the prevailing profit margin in making other things. The firms that are already producing commodity X will tend to increase their production of it. They will hire more workers away from other producers and increase their investment in inventories or equipment. Other firms will also try to start producing X because it is more profitable than producing Y or Z. In this way the price of X, or the profit in making it, will tend to fall again to the prevailing level in other lines. Meanwhile the comparative production of X will have increased.
The opposite result will tend to happen if the demand for commodity Y declines. Comparatively less of it will be produced, until the profit margin in making it is once again at least as high, relative risks considered, as in making other commodities.
As a consequence of this market mechanism, in short, the thousands of different commodities and services tend to be produced at minimum cost and in the relative proportions in which they are socially wanted. This is the way in which a capitalist system solves the problem of economic calculation, which a dominantly socialist system is utterly incapable of solving. (The first economist to demonstrate this conclusively was Ludwig von Mises.)
We should notice in passing that the success of this capitalistic process does not require that producers or sellers earn a so-called “fair” profit. It is not the absolute height of the profit that determines the direction of output; it is the comparative profit that serves as the spur and the guide. A uniform “fair” profit would leave production without a yardstick, map, or compass. It is a mistake to call the capitalist system “the profit system.” It is a profit-seeking system, of course; and a perfectly proper name for it would be a profit-and-loss system. It is just as essentail to its proper functioning and health that under it inefficient operations or the creation of unwanted goods should be penalized by losses as that efficient operations or the creation of wanted goods should be rewarded by profits.
We may also note parenthetically here that normally profit is not something “added to the price”; it is not a cost that falls on the consumer. The bulk of profits go to those producers who are making better goods than their competitors, or producing them at less than average cost.
Many economists contend that there is no net profit at all in a stationary economy; the profits of producer A are offset by the losses of producer B.
This statement will seem startling to most laymen, but mainly because “profit” in the popular sense is a much wider term than “pure” profit as defined by economists. Profit in the popular sense includes nearly the whole return going to the entrepreneur or the capitalist, or both, whereas much of this return, according to economists, should really be counted as a form of interest on the entrepreneur's invested capital, or “rent” on his self-owned factory, or “wages” for the entrepreneur's own work of management, and therefore under a proper accounting system should be imputed to interest, rent, and wages respectively, counting only the remainder as pure profit.
In an economy that is expanding, there is presumably a net total of pure profits for the producers. But even if these are counted (as they should not be), as a net cost to the consumers, they are at most a temporary cost; for the greater part of the profit is reinvested in additional and more efficient plant that reduces costs of production (and hence prices) and increases output.
So capitalism is a system of both incentives and deterrents. This system does not maximize incentives to all production; it maximizes incentives to the more efficient production of the goods that are most urgently wanted.
Capitalism accomplishes this result in still another way. It is continually putting capital into the hands of those who have shown that they know how to make the most productive use of it. Those who exercise the best judgment in directing production into the most profitable channels, and in choosing the most efficient methods and the ablest managers, make the highest profits. This means that they obtain still more capital to reinvest wherever they think it will reap the highest returns. Those who use their capital to make unprofitable investments or who choose poor managers will lose their capital and will have less or finally none to reinvest.
Many people talk as if “production” and “distribution” were two separate processes, as they would be under socialism, and as if goods were first produced and then distributed. Nothing like this happens in a market system. Goods come on the market as the property of those who have produced them. Under a free competitive market system, as the American economist John Bates Clark was the first to point out explicitly, each factor of production tends to get the specific marginal product that it contributes to production—which means that for the most part each man tends to get what he himself produces. To quote Clark:
“Free competition tends to give to labor what labor creates, to capitalists what capital creates, and to entrepreneurs what the coordinating function creates ... [It tends] to give to each producer the amount of wealth that he specifically brings into existence.”
Let us take a very simple—indeed an oversimplified—illustration. Suppose Peter and Paul are two chairmakers, working as individuals. They turn out chairs of equal quality, but Peter, working hard and well, turns out a chair every day for a working week of six days; and Paul, working more leisurely or less efficiently, turns out only three chairs a week. Each sells his chairs for $40 apiece. Then Peter has a gross income of $240 a week, and Paul of only $120. It would be absurd for Paul to complain that he is a victim of unfair “distribution” of income. There is no “distribution”; each gets the value of what he produces.
And this happens whether we are talking of chairmakers, shoemakers, tailors, builders, or lawyers. Each gets the value that his individual customers or clients put on his product or services, multiplied by the quantity he turns out. If there are a dozen chairmakers in a town, and each decides to increase his output by taking on helpers, it will pay them to take on a helper for any amount up to what his services add to their own revenue from sales; and the competition of the employer-chairmakers for helpers will tend to bring the helpers' wages up to this amount. Each will tend to get the value that he adds to production.
We cannot indict such a system as being “unjust.” Under it, rewards are proportionate to quantity and quality of output (quality as judged by the market). The system is one which maximizes incentives to effort and production.
The free market system is also one which permits and encourages freedom of competition. Competition is often denounced by socialist writers as being duplicative and wasteful. Its effect is exactly the opposite. As we have seen, one effect of competition is to take production constantly out of the hands of the less competent managers and put it more and more into the hands of the more efficient managers. Competition constantly promotes more and more efficient methods of production: it tends constantly to reduce production costs. Competition rewards most those who reduce their production costs most; it penalizes most those who are tardiest in getting costs down. As the lowest-cost producers expand their output they cause a reduction of prices and so force the highest-cost producers to sell their product at lower prices, and ultimately either to reduce their costs or to transfer their activities to other lines.
But capitalistic or free-market competition is seldom merely competition in lowering the cost of producing a homogeneous product. It is almost always competition in improving a specific product. And in the last century it has been competition in introducing and perfecting entirely new products or means of production—the railroad, the dynamo, the electric light, the motor car, the airplane, the telegraph, the telephone, the phonograph, the tape-recorder, the camera, motion pictures, radio, television, refrigerators, air conditioning, the computer, and an endless variety of plastics, synthetics, and other new materials. The effect has been enormously to increase the amenities of life and the material welfare of the masses.
Capitalistic competition, in brief, is the great spur to improvement and innovation, the chief stimulant to research, the principal incentive to cost reduction, to the development of new and better products, and to improved efficiency of every kind. It has conferred incalculable blessings on mankind.
The free market system, finally, is a great system of social cooperation. This cooperation exists between producer and consumer, buyer and seller. Both gain from the transactions in which they engage. That is why they make them. The consumer gets the bread he needs; the baker gets the monetary profit which is both his stimulus to bake the bread and the necessary means to enable him to keep baking it. As Adam Smith put it long ago, the essence of every commercial transaction is: “Give me that which I want, and you shall have this which you want.”
And in spite of the enormous labor-union and socialist propaganda to the contrary, the relation of employer and employee is basically a cooperative relation. Each needs the other. Their relationship is essentially one of partnership. The more successful the employer, the more workers he can hire and the more he can offer them. The more efficient the workers, the more successful the employer, and the better paid the workers.
It should be pointed out here (though the idea will strike many as strange) that even economic competition is a form of economic cooperation. At least, it is an integral and necessary part of an efficient system of economic cooperation. If we look at competition in isolation, this statement may seem paradoxical, but it becomes evident when we step back and look at it in its wider setting. General Motors and Ford are not cooperating directly with each other; but each is trying to cooperate with the consumer, with the potential car buyer. Each company is trying to offer the consumer a better car than its competitor, or as good a car at a lower price. Each company is stimulating the other—one might even say compelling the other—to reduce its production costs and to improve its car. Each company, in other words, is putting pressure on the other to cooperate more effectively with the buying public. Each makes the other more efficient. And so, indirectly—triangularly, so to speak—General Motors and Ford cooperate.
Every great firm is itself a huge cooperative enterprise. A big newspaper, for example, is a cooperative organization in which every reporter, every editor, every advertising solicitor, every printer, every delivery truck driver, every newsdealer, cooperates to play his assigned part. A great industrial company, such as General Motors or General Electric—or in fact any of a thousand successful smaller companies—is a miracle of continuous cooperation.
And on a “macroeconomic” scale, the whole free world is bound together in a system of international cooperation through mutual trade, in which each nation supplies the needs of others cheaper and better than the others could supply their own needs acting in isolation. And this cooperation takes place, both on the smallest and on the widest scale, because each of us finds that forwarding the purposes of others is (though indirectly) the most effective means for achieving our own.
Thus the free enterprise system is a huge system of social cooperation which maximizes incentives to production, miraculously guides production so that thousands of goods and services are produced in the proportions in which they are socially most wanted, maximizes output, and does it by its tendency to reward people on the principle of “To each what he creates.” Our main object should be to try to perfect this great system, not to uproot or transform it.
Yet ever since the rise of socialist ideas in the nineteenth century, this great system has been under attack. It is now threatened from a score of directions. The future of free enterprise depends upon its ability to ward off these attacks, to save itself from these alleged reforms.
Let us look at the main present threats to free enterprise, beginning with the most direct and most serious.
In the first half of the present century, the most direct and serious threat to free enterprise was outright socialism—that is, socialism in the “orthodox” form of government ownership and management of the means of production. This is what we have today in rather complete form in the communist world and in a modified and partial form in most of the non-communist world. But government ownership of the means of production has lost prestige. It has proved disillusioning everywhere. It has been tried. Most of the governments of Europe own and operate their country's railroads and telegraph and telephone services. The result has been chronic poor service and chronic deficits. Even the overregulated private railroads in the United States do better, particularly with freight; and the private telephone service in the United States, though also overregulated, is still the best in the world. The service of the government post office is a joke everywhere. The socialist parties of Europe still want to keep nationalized the industries they have already nationalized, if only to save face; but few of them are actively pushing for more nationalization.
Perhaps the biggest threat to free enterprise today is the demand for more equality of personal incomes. Very few socialist or other reformers today demand absolute equality of incomes (as Bernard Shaw did or pretended to) because they sense that this would be completely destructive to all incentives to work and own. If we can imagine a society in which every adult would be guaranteed an income of, say, $4,000 a year, regardless of what kind of work he did, or whether he worked or not, and in which nobody would be allowed to earn or keep more than $4,000 a year, then we can see that if everybody acted in what seemed his immediate self-interest, thinking of himself in isolation, nobody would work and everybody would starve.
The reason for this ought to be clear. Everybody who had been getting less than the $4,000 guarantee (and who would now get just that whether he worked or not) would not need to work productively at all. And no one who had been earning more than the $4,000 guarantee and limit would find it worth while to continue to earn the excess, because it would be seized from him in any case. More, it would soon occur to him that it wasn't worth while earning even the $4,000, for it would be given to him in any case, and his income would be that whether he worked or not. So if everybody acted under an income equalization program merely in the way that seemed most rational in his own immediate self-interest considered in isolation, almost nobody would do any sustained or disagreeable work, and the nation would soon be destitute.
A less extreme equalization would, of course, have less extreme results. But any program to take from those who earn and give to those who don't earn must reduce working incentives to a certain degree. I don't know whether it is possible, or whether it will ever be possible, to determine exactly what levels of income guarantee, or exactly what percentages of income taxation, will reduce incentives and production by exactly what percentages. But it is probably a good prima facie rule of common sense that any income-tax rate above 50 per cent, overall or marginal, must reduce incentives and production and be counter-productive even of government revenue in the long run. The empirical studies of Colin Clark and others suggest that any income-tax rate even over 25 to 35 per cent must in the long run cut very seriously into the growth of national income.
Any program that supplies income to people who don't work must reduce incentives to a certain extent; and all taxes, considered by themselves, must discourage production, depending both on their level and their nature. (Grossly excessive as our progressive personal income tax rates are at present, our excessive corporation tax is probably doing even more to retard our potential growth.)
If excessive government spending is in itself a threat to the free enterprise system, such spending not paid for by taxation, but financed by deficits and inflation, is still more of a threat. A mild inflation in its early stages may seem to be a stimulus to production, but inflation is always a false stimulus; it leads to malinvestment, malconsumption, gambling, waste, cynicism, and corruption, and is as debilitating to a nation as the drug-habit is to an individual.
What is even worse than inflation is price controls which attempt to mask or suppress the consequences of inflation. Price controls, wage controls, rent controls, and interest-rate controls always misdirect, reduce, unbalance and disrupt production. They are nearly always more harmful than the inflation they try to conceal.
A very serious threat to free enterprise today is the excessive coercive “bargaining power” given to the labor unions by present labor laws and bureaucrats. Contrary to the century-old myth, labor unions cannot increase real wages for the whole body of the workers. At best they can increase the money wage-rates of their own members at the cost of reducing employment or reducing the real wages of non-union workers. Whatever gains the unions make by strikes or strike-threats are at best short-run gains even for themselves; for if they gain excessive wage-rates and diminish or even wipe out profit margins and profit expectations, they discourage and reduce new investment. In the long run there is then less production, less employment, and less real income for everybody. If free enterprise is to be preserved, present labor laws simply must be modified.
Still another threat to the free enterprise system, which has increased in recent years, is outright hostility to business. We might divide this hostility for convenience into two types: (1) hostility to public utilities, such as railroad, telegraph and telephone companies, power companies and the like; and (2) hostility to any large and successful business whatever.
The first kind of hostility has been with us for a longer time; it leads to overregulation, to chronic charges of dishonesty and gouging, and to the fixation by governmental regulatory bodies of rates so low that they do not allow sufficient funds for research and development, for improvement and expansion of services, and for reinvestment.
The second kind of hostility has recently grown more frequent and intense. It leads to opposition to mergers of all kinds, to prosecution under the anti-trust laws on so many grounds that no company knows when and for what practice it will be sued. It leads particularly to an immense growth of laws ostensibly designed to “protect the consumer.” These laws now attempt to dictate in detail how goods should be labeled and packaged, how automobiles should be made, what interest rates should be charged and how the charges should be stated, etc. Since 1962 new pharmaceuticals have had to surmount so many hurdles before they can be put on the market that there has been a dramatic fall in the number and importance of new life-saving drugs discovered and introduced. When the drug companies are not attacked for their products they are attacked for charging exorbitant prices. And so it goes.
The saddest part of all this is that big business has lost the courage to defend itself even from direct attack. The late Joseph A. Schumpeter commented upon this acidly a generation ago, in his pessimistic book, Capitalism, Socialism, and Democracy published in 1942. He maintained the thesis that “in the capitalistic system there is a tendency toward self-destruction.” And as one evidence of this he cited the “cowardice” of big businessmen when facing direct attack:
They talk and plead—or hire people to do it for them; they snatch at every chance of compromise; they are ever ready to give in; they never put up a fight under the flag of their own ideals and interests—in this country there was no real resistance anywhere against the imposition of crushing financial burdens during the last decade or against labor legislation incompatible with the effective management of industry (p. 161).
So here is the outlook. Capitalism, the system of private property and free markets, is not only a system of freedom and of natural justice—which tends in spite of exceptions to distribute rewards in accordance with production—but it is a great cooperative and creative system that has produced for our generation an affluence that our ancestors did not dare to dream of. Yet it is so little understood, it is attacked by so many and intelligently defended by so few, that the outlook for its survival is dark.
It may still be saved, but only if its merits come to be understood by the masses before it is too late. The world is now in a race between true economic education and catastrophe.
Last modified April 10, 2014