good capitalism, bad capitalism

8/8/2019 Good Capitalism, Bad Capitalism

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ECONOMICREFORMFeature Service

Center for International Private Enterprise

Good Capitalism, Bad Capitalism:What Is a Market Economy and How Can It Deliver?

Article at a glance

The traditional approach to studying economic growthoverlooks the importance of individuals and individualfirms.

Market economies are not monolithic there are fourdifferent types of capitalism (oligarchic, state-guided,big-firm, and entrepreneurial), each with different

features and implications for growth.

Entrepreneurial capitalism is the most effective driver ofeconomic growth because it provides opportunities fornew firms to innovate and create new markets.

January 30, 2010

Robert E. Litan, Ph.D.The Kauffman Foundation

This article is based on the remarks delivered by Robert Litan atDemocracy that Delivers: An International Conference on Improving

the Quality of Democratic Governance and Economic Growth, held inWashington, DC on October 27, 2009. The remarks were inspired byGood Capitalism, Bad Capitalism, and the Economics of Growth andProsperity by William J. Baumol, Robert E. Litan, and Carl J. Schramm,available from Yale University Press.

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The Story of Economic Growth

What is a market economy and how does itmaximize growth? Nobel Laureate Robert Lucassaid that once someone begins to focus on growth,it is hard to think about anything else. Economicgrowth is the engine that drives improvements instandards of living for people around the world.The purpose of any economic system should bepromoting economic growth and thus advancingthose standards of living.

Economic history shows that there was a longhiatus after the early economists Adam Smithand David Ricardo when there were almost noeconomists focusing on economic growth overthe long-run. True, macro-economic stabilization

came to the fore during the Great Depression andof course, John Maynard Keynes wrote about howto stimulate aggregate demand. But the focus ofKeynes work was not on the long-term growthof the economy. There was no resurgence of thatinterest until Robert Solows work in the 1950s,which eventually led to a Nobel Prize.

Still, Solows work did not vault economicgrowth into the pantheon of the most importantsubjects that economists study. The subject

remained a minor concern until the famousSummers-Heston Penn World Table databases weremade available and economists were able to do thething that they love to do most, which is to use a setof economic data to explain trends and outcomes in other words, run regressions. They were ableto use income data, appropriately adjusted fordifferences in purchasing parity, and compare it toevery kind of socio-economic variable one couldwant. Economists since have made an industry outof running such cross-country regressions to try tofigure out the magic recipe for growth.

These recipes have encouraged the so-calledbake the cake approach to economic growth, which is the notion of taking some ingredients such as capital, labor, knowledge, innovation,or institutions putting them all in a bowl, andmixing up growth. Using different coefficients orcombinations of ingredients, depending on the

time period and on how many other ingredientsare in the mixing bowl, economists came up withmany different formulas. That is basically the wayeconomists thought for a long time about economicgrowth.

It is not, however, the onlyway to think aboutgrowth. After all, economies consist of individualpeople and individual firms. If there is one thingto learn from economic history, it is that aggregategrowth arises from the growth of firms; economiesare nothing more than the aggregation of the firmswithin them. Thus, the really interesting story ineconomics is what accounts for the formation andthe growth of individual firms.

There were seeds of interest in this notion

of growth among economists as long as 30 yearsago. Examples include Richard Nelson, who nowteaches at Columbia University, but who was alsoa professor at Yale University and Sidney Winter, who wrote a pioneering book 30 years ago onthe evolutionary approach to firm formation andgrowth as a basis for understanding economy-widegrowth. More recently, William Baumol and NobelPrize-winning economist Edmund Phelps havefocused on the formation and growth of firms asthe engine for economic advancement.

The Kauffman Foundation has been one ofthe leading funders of this kind of growth-relatedresearch in the world, and much of its traditionof in-depth and critical analysis is now embodiedin the bookGood Capitalism, Bad Capitalism, andthe Economics o Growth and Prosperity, which Ihad the good fortune to co-author with WilliamBaumol and Kauffmans President Carl Schramm.

Good Capitalism, Bad Capitalism

The premise of the book is that marketeconomies or capitalism are not monolithic although there has been a tendency to think so afterthe Berlin Wall fell. The perception was, at least inthe United States, that capitalism had won andcommunism had lost and that was the end of thestory. There was little discussion about the variousforms that capitalism took. Out of the worlds


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roughly 190 countries, 188 recognize privateproperty, (except Cuba and North Korea) but all188 look very different, even controlling fordifferences of per capita income.

Good Capitalism, Bad Capitalism attemptsto bring order to this chaos. Its four typologiesof capitalism are not meant to suggest that everyeconomy fits perfectly into a particular category.The typologies are mental constructs someeconomies are more one kind than another, somestraddle multiples, and many economies haveelements of all four kinds of capitalism.

Oligarchic capitalism

Oligarchic capitalism, where resources andpower in the economy are concentrated in thehands of a few, is without question bad capitalism.Examples of oligarchic economies include Russia,oil-rich Middle East countries, and many states inAfrica and Latin America. The objective function ofoligarchic capitalism is not to maximize economicgrowth but to maximize the welfare of the powerfulwho capture most resources and often divert theirprofits to offshore bank accounts. The objectivefunction of these leaders does not coincide withadvancing the welfare of their people. Marginal

interest in economic growth may arise only as apolitical strategy to keep constituents happy enoughto not revolt.

There are huge inequalities in income levelsunder oligarchic capitalism. It is no accident tofind huge degrees of informality in the markets inthese countries. Often, those in power and withmoney do struggle to keep property rights or thekinds of accoutrements of market economies we seeelsewhere from the rest of the population. If the

people acquire these powers, they can challenge theeconomic and political dominance of the those incharge.

State-guided capitalism

Although the name provides some potentialconfusion, state-guided capitalism is notcommunism. In communism, the state owns the

means of production. In a state-guided economy,means of production are privately owned, but thestate guides resources to the industries most likely tobe successful, for example, through state ownershipof banks. Chinese banks control substantial portionsof the resources in the economy while in India, 75percent of the banking system is controlled by thestate. That is clearly one way to guide an economy.Other tactics include import protection, exportsubsidies, regulatory incentives, and more.

The basic premise of state-guided capitalismis that the state knows what it is doing and itcan decide how to get there. In very limitedcircumstances, state-guided capitalism can beeffective at producing growth, for example, in therise of Southeast Asia. As the region was far behind

the global economic frontier, it looked to theeconomies at the leading edge the United States,Europe, and Japan as models. The governmentsimported the technology for manufacturing, appliededucated low-cost labor, and started trading. State-guided capitalism systems often lead to rapid earlygrowth, but their likelihood to eventually stall ishigh. In the case of Southeast Asia, some countries(like Singapore) have almost caught up to the front,at least in terms of manufacturing.

The question becomes, once they are closeto the frontier, can state bureaucrats figure outwhere to put the money? That is the Achilles heelof state-guided capitalism. It is also why weargue Southeast Asia suffered as it did in thefinancial crisis. The state put too much capitalinto industries that later had too much capacityand descended into crisis. There is a limit to state-guided capitalism, and Singapore will be its acidtest. Singapore is still actively engaged in guidingthe economy toward biotech, while at the same timeencouraging entrepreneurship. Singapore will be atrue-life experiment in practicing state-guidanceclose to the frontier.

Big-firm capitalism

The third kind of capitalism big-firm ormanagerial capitalism makes up the economies ofWestern Europe and Japan, and of post-World War


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II United States. Harvard economist John KennethGalbraith described it as a new industrial state wherebig steel, big auto, and other large corporations were checked by countervailing powers of biglabor and big government.

There is great benefit to big-firm capitalism:economies of scale, financial and human resourcesfor research and development, and of course, capitalto deploy. Due to their size and their ability todiversify resources, they can establish research anddevelopment centers such as the famous Bell Labsor Xerox PARC. As innovation becomes routinized,big-firm and managerial economies become expertsat incremental innovation Americas great strengthfor much of the 20th century. Today, Japan andGermany today have similar routinized innovation

patterns.

Yet a significant weakness of big-firm capitalismis its discomfort with radical innovation. Almost bydefinition, big firms do not want to invest in newproducts or services that can make their currentprofit centers obsolete. This leads us to the finalform of capitalism.

Entrepreneurial capitalism

The final type of capitalism is entrepreneurialcapitalism where economies are dominated bynew firms. The advantage of new firms is theirindependence. Founders do not often have a vestedinterest in the status quo and thus are more likelyto commercialize the disruptive innovation that isresponsible for the lions share of long-run economicgrowth.

Consider the modern inventions that have beencommercialized and radically changed our lives:

the steam engine, electricity, the automobile, theairplane, air conditioning, computers and software,the Internet. These innovations and the resultingindustries were created by entrepreneurs, notby established firms, as entrepreneurs are free totry something new. Do we then conclude that aneconomy can rely only on entrepreneurs? Unlessa country has a small economy that is connectedto other, larger economies with big firms like

Israel or Taiwan we argue that the ideal is a mixbetween managerial firms and new firms. Sucha combination creates a constant, creative, andproductive tension. Many small firms innovate, while big firms commercialize, refine, and massproduce goods and services based on new ideas.

Capitalism in the Aftermath of the

Financial Crisis

The financial crisis that began in 2008 providesseveral key lessons concerning the role of incentivesin the four types of capitalism. When incentives arewrong, entrepreneurs can be worse than unproductive;they can be destructive. The ongoing recession is aresult of such destructive entrepreneurship in thefinancial arena, exacerbated by enormous amounts

of leverage in financial firms. The crisis started inthe sub-prime mortgage sector and spread to therest of the economy. While entrepreneurship isneeded to sustain growth, we must also be carefulto properly align incentives in the system to protectagainst destructive entrepreneurship that can wipeout an entire economy.

The point that entrepreneurs drive an economyis still relevant, and may be more so than everbefore. The current crisis has taught us about thelimitations of big firms. With bailouts for big firms,the government was propping up old businesseslike General Motors or Chrysler, and in the processdiverting scarce capital that could have been usedfor financing new businesses. This strategy is not arecipe for long-term growth. It may be the answerto prevent the economy from running over a cliff,but over the long-run, a vibrant, growing economymust maximize opportunity for new firms at themargin. China, for one, has started its enormous

transition by withdrawing from the state-runsector and putting its marginal resources in theentrepreneurial sector. India has done much of thesame. The importance of the entrepreneurial sectoris clear: if we look at economic history, there isserious cause for hope.

The Kauffman Foundations recent research hasfound that half of todays Fortune500 companies were formed during a bear market or recession.


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That is an amazing statistic. Half of the Inc. 500companies (a list of the fastest growing companies)were formed during recessions or slowdowns. Tougheconomic times do not need to defer renewal andregeneration in an economy hit by a downturn.

More to the point, all net new jobs created from1980 to 2005 in the United States were created infirms less than five years old. Without the continualinflux of entrepreneurial firms, employment inthe United States would have shrunk. To put thatanother way, something like 30 percent of todaysU.S. gross domestic product is produced by firmsthat did not exist before 1980. That is a trulyremarkable number. If America is going to restorethe economic leadership it once had, it will have torely on a rebirth and another wave of entrepreneurial

activity. Entrepreneurial job creation has notreceived enough attention in Washington yet, butit is a subject that will be crucial to the welfare ofthe United States and to the rest of the world in theyears ahead.

_____________________________________________

Robert Litan is the Vice President or Researchand Policy at the Kauman Foundation and aSenior Fellow in Economic Studies at the Brookings

Institution. During his career, Dr. Litan hasauthored or co-authored 22 books, edited another15, and authored or co-authored over 200 articlesin journals, magazines, and newspapers. Since theonset o the inancial crisis, he has authored or co-authored a number o essays on inancial reorms or the Brookings website (www.brookings.edu). Dr.Litan has served in several capacities in the ederal government: as Associate Director o the Oice oManagement and Budget, Deputy Assistant AttorneyGeneral, Antitrust Division, Department o Justice;

and Sta Economist, Council o Economic Advisers.He received his bachelors degree in Economics (summacum laude) rom the Wharton School o Finance at theUniversity o Pennsylvania, his juris doctorate rom

Yale University Law School, and both his masters andPh.D. in Economics rom Yale University.

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