save capitalism from capitalists

67Fourth Quarter 2003

IIn the early 1990s the great, century-long

competition between economic systems en-

dedwithawhimper.Communismimploded;

the guys with the Adam Smith neckties won. ¶ Or so it seemed at the time. But a decade

of dislocation – everything from the meltdown of the

Asian economies to the exposure of rot in America’s

corporate boardrooms – has illustrated all too clearly

that it takes more than faith to make free markets work.

For, like communism, capitalism contains the seeds

of its own destruction. Hence the timeliness of Saving

Capitalism From the Capitalists: Unleashing the Power of

Financial Markets to Create Wealth and Spread Oppor-

tunity*, the striking new book by Raghuram Rajan and Luigi Zingales. ¶ Rajan, inci-

dentally, will have an unusual opportunity to test the merits of his recommendations:

he has just been appointed the chief economist and director of research

for the International Monetary Fund. — Peter Passell

b y r a g h u r a m r a j a na n d l u i g i z i n g a l e s

Saving CapitalismFrom

The Capitalists

*©2003 by Raghumam Rajan and Luigi Zingales. Published by arrangement with Crown Business, a division of Random House Inc.

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68 The Milken Institute Review

Our view, which draws in many ways froma long tradition at the University of Chicago,has elements in common with all these posi-tions. We do think that capitalism – more precisely described today as the free enter-prise system – in its ideal form is the best sys-tem to allocate resources and rewards. But theforms of capitalism experienced in mostcountries are very far from the ideal. They arecorrupted versions of it, in which vestedinterests prevent competition from playing itsnatural, healthy role. Many of the accusationsagainst capitalism – that it oppresses workers,that it creates private monopolies, that it isonly an instrument for the rich to get richer –relate to the corrupted, uncompetitive sys-tems that exist rather than a true free enter-prise system.

We do not believe that capitalism is fun-damentally flawed; markets can be given thepolitical support to remain free. Much of thisbook is about why that support is necessary:markets cannot flourish without the very vis-ible hand of the government, which is neededto create and maintain the infrastructure thatenables participants to trade freely and withconfidence.

But who has an interest in pushing thegovernment to support the market? Eventhough everyone collectively benefits fromthe better goods, services and equality ofaccess that competitive markets make possi-ble, no one in particular makes huge profitsfrom keeping the system competitive and theplaying field level. Thus, everyone has anincentive to take a free ride and let someoneelse defend the system.

A competitive market is a form of publicgood (a good, like air, that is useful but hardto charge for), and somewhat paradoxically,collective action is needed for its mainte-nance. Given its dependence on politicalgoodwill, democratic capitalism’s greatestproblem is not that it will destroy itself eco-nomically, as Marx would have it, but that itmay lose its political support. Capitalism’sbiggest political enemies are not the firebrandtrade unionists spewing vitriol against thesystem, but the executives in pin-striped suitsextolling the virtues of competitive marketswith every breath while attempting to extin-guish them with every action.

Adam Smith recognized the inexorabletendency toward suppressing competition

For nearly two centuries, scholars and

politicians have debated the future of capitalism. Its critics, most promi-

nent among them Karl Marx, have seen capitalism as intrinsically unsta-

ble, full of contradictions that will lead eventually to its collapse. Its sup-

porters see it as the best way to allocate resources and rewards. Some even

hint that democratic capitalistic society is not just a phase in the evolution

of economic systems but its ultimate end. In the middle are all those

searching for a “third way,” a kinder and gentler form of capitalism or a

more market-driven form of socialism.


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when he wrote, “People of the same trade seldom meet together, even for merrimentand diversion, but the conversation ends in aconspiracy against the public, or in some contrivance to raise prices.” Unfortunately, alltoo often and in all too many countries, theconspiracy enlists the help of the state inenforcing limitations on competition.

Marx also understood that capitalistswould enlist the state in securing their posi-

tion when he and Friedrich Engels wrote inThe Communist Manifesto that the govern-ment is essentially “a committee for manag-ing the common affairs of the whole bour-geoisie.” But he thought that the problem wasspecific to bourgeois democracies and woulddisappear in a socialist state. Unfortunately,all the socialist revolution did was to changethe identity of the elite and strengthen itshand by eliminating not just economic com-petition but all semblance of political compe-tition.

Free enterprise capitalism is not the finalstage of a deterministic process of evolution.It is better viewed as a delicate plant, whichneeds nurturing against constant attack bythe weeds of vested interests. It is useful toconsider where the weeds might spring from,for that will help us build the appropriatedefenses.

The market is threatened by two diversegroups: the incumbents, who want to retaintheir position and thus have a strong incen-tive to suppress any potential source of com-

petition, and those who lost out, who wouldbe happy if the rules of the game that causedtheir troubles were changed. The long-termfeasibility of free markets rests on reducingthe incentives of each of these groups to proceed against the market, and limiting theirchances of success if they do proceed.

The way to limit the chances of success ofvested interests is not to expand the power ofthe state but to narrow its ability to take in-

efficient economic actions favoring the few atthe expense of the majority. In the same wayas inefficient economic entities are forced toimprove by competition, inefficient govern-ments can be forced to improve, not so muchby competition in the political arena, wherethe committed few can organize and thwartthe will of the majority even in a democracy,but by forcing their subjects to compete in theeconomic arena.

A powerful device to achieve this is toopen borders to the flow of goods and espe-cially to the flow of capital. The country’s capitalists will then feel the impact of badgovernment policies, and they will become aforce for good, market-liberating reform. Theshift over the past 30 years from centrallymanaged, relationship-based economies withheavily controlled financial sectors to freemarket economies with vibrant financialmarkets can be attributed to both increasingtrade and increasing financial flows.

But open borders themselves spawn polit-ical opposition. Technological change and in-

All the socialist revolution did was to change

the identity of the elite and strengthen its hand

by eliminating not just economic competition but

all semblance of political competition.

creasing international competition will createentirely new categories of the distressed. Canthe political opposition be contained?

Before we describe the looming challenges,it is useful to see an example of how econom-ic institutions can adapt to defuse the incen-tives of interest groups to coalesce againstmarket forces. Consider the evolution of theU.S. bankruptcy code in the 19th century. Theeconomic role of bankruptcy law is not just toprovide a mechanism for creditors to collecttheir money, but also to offer a form of insur-ance to debtors, relieving them from some oftheir burden when it becomes overly oppres-sive. When a borrower owes so much that hehas small hope of repayment, he will have lit-tle incentive to exert effort to earn money;any extra dollar earned will simply go tocreditors.

A modern bankruptcy code provides amechanism by which debtors can get relief. Inproviding this flexibility, bankruptcy legisla-tion somewhat paradoxically enhances the se-curity of property in two ways. First, it allowscreditors to charge up front for the possibilitythat they will have to offer relief, thus protect-ing their property. At the same time, it headsoff any need for debtors to organize political-ly, preventing them from arbitrarily wipingout their debts. This further enhances the se-curity of property and the sanctity of contract.

Through much of the 19th century, feder-al bankruptcy laws were enacted in responseto harsh business conditions, only to berepealed soon after. But periodically violatingcreditor rights was no panacea. What guaran-tee was there that organized debtors wouldstop at repudiating their current obligations?Could a debtors’ revolt not spread to ques-tioning other forms of property? To leaverelief to concerted political action was tanta-mount to playing with fire.

A better solution eventually emerged. As

financial markets and institutions developed,as information and communications technol-ogy, like the telegraph, knit the country to-gether (so that, for example, debtors couldnot escape the stigma of bankruptcy by goingWest), as markets for assets improved in liq-uidity, creditors became better able to moni-tor their loans and obtain repayment. Somepermanent leniency was possible. This is whythere was a broad trend in the legislation thatwas contemplated over the 19th century. Thebankruptcy laws that were enacted, albeit forshort periods, became progressively friendlierto debtors, encompassing more of them andgiving them more relief.

The point is that there are solutions thathelp keep the sphere of markets and thesphere of politics separate while recognizingthe imperatives of both. In considering someof the coming challenges, it is important tothink of creative ways of managing the im-plicit tussle between free markets and politicsso that one does not destroy the other.

the political environment andthe coming challengesRecent corporate scandals and suggestions ofextensive conflicts of interest among theguardians of trust in the market – the accoun-tants, investment bankers and analysts – areforcing people to ask the age-old question ofwhether there are in fact two tracks in themarket economy, one for the very rich andone for everyone else. The $735 millionearned by Gary Winnick, the CEO of GlobalCrossing, while his company was headingtoward bankruptcy, the $112 million earnedby Jeff Skilling, president and CEO of Enron,in the three years before his company col-lapsed after being accused of phony account-ing practices, the $240 million earned byTyco’s Dennis Kozlowski before he was firedand accused of tax fraud, undermine the faith



people have in the fairness of the market.It is not that people are concerned about

disparities in wealth; very few Americansquestion the enormous amounts earned bysuperstar athletes like Michael Jordan andTiger Woods. They can observe Michael Jor-dan’s superior talent firsthand, and they arewilling to accept that he deserves what hemakes. In the boom years, this was also truefor corporate America. But corporate disas-ters like Enron or Global Crossing have un-

dermined the belief that corporate leadersdeserve what they make or that financial analysts really understand the stocks theytout, creating room for envy and resentment.It is in these situations of public mistrust ofmarket forces that foes of free markets find iteasier to coordinate and act.

The public resentment in the current eco-nomic downturn feeds into a long-standingdistrust of markets embodied in the anti-globalization movement. While some of this m

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movement is age-old protectionism in a new-age guise, there are also many groups involvedthat genuinely perceive global markets asunfair. Not all these groups understand whatthey are protesting. Some long for the thingsthe modern economy appears to crowd out(such as time, friendships, family and conver-sation) and the things it appears to destroy(such as open spaces and a clean environ-ment). It is change that they fear, and global-ization is unfortunately the most visible and

rapid form of change in recent times.More discerning protesters see that the in-

adequate infrastructure countries have forcoping with globalization’s adverse conse-quences, rather than globalization itself, is theproblem. But it is easier to make commoncause against globalization than to focus onthe more mundane task of fixing the infra-structure. Already, politicians are respondingin the natural way to the downturn by erect-ing tariff barriers and offering domestic



subsidies, a way that is not only shortsightedbut also completely oblivious to the lessons ofhistory.

The steel tariffs in the United States werefollowed by a farm bill that substantially in-creased the level of subsidies available to theagricultural sector. This will inevitably enragedeveloping countries, which would willinglyforgo all the foreign aid developed countriesoffer if only the developed world wouldreduce the extent to which it pampers domes-tic agricultural sectors. Developing countrieswill respond by being more reluctant to lowertheir tariff barriers, for unfortunately, historysuggests that protectionism is contagious.

We are in a dangerous period of hangover,the morning after the ecstasy of a boom.Many feel betrayed by the bust and are de-manding action against the markets. Evenwhen the economy picks up, as sooner or laterit inevitably will, new challenges are comingthat will cause severe dislocation in society.These could be exploited by the few to con-strain the market, so it is important to under-stand what they are.

technological changeFor centuries, technology has created newproducts and new ways of making them thatrender workers and their skills redundant.While the dislocation stemming from techno-logical change is not new, its pace hasincreased tremendously. Moreover, it is nowaffecting the professions that have not muchchanged their way of doing business over thecenturies. Because it will affect those whohave not yet learned to fear for their jobs, itspolitical impact will be all the more severe.

Drafting, for example, used to be a signifi-cant component of an architect’s job. Com-puter-aided design software has made thisskill all but irrelevant. Older architects nowfind themselves at a serious disadvantage rel-

ative to younger colleagues who have beentaught to use the software as an integral partof design. Even if older architects do not draftanymore, their ability to supervise and coachtheir younger colleagues is much diminished.In the race for career advancement, an entiregeneration has been handicapped.

Other jobs are vanishing because cus-tomers now have access to information andtransactions technology to which only inter-mediaries had access earlier. Stockbrokersused their privileged access to research re-ports in order to entice customers into main-taining trading accounts with them – in theprocess, generating large brokerage fees. Now,Internet brokers offer all the research cus-tomers need and charge minuscule tradingcommissions.

Travel agents are also finding businessincreasingly difficult as customers not onlyhave access to the same information theycommand, but can sometimes get better ratesdirectly from airlines and hotels. This doesnot mean that all stockbrokers and travelagents will vanish overnight. However, manywill not survive, and the ones who do willwork very differently from the way they worktoday.

Technology is also having a differential im-pact within professions. Take our own: teach-ing in universities. Using new communicationtechniques, one gifted professor can teach stu-dents in many locations around the country.While technology will increase the demandfor such superstar teachers, it will reduce thedemand for the merely good, and the demandfor the mediocre may vanish completely.

Not only is technology making certain hu-man skills obsolete quickly, it is creating en-tirely new sources of distress. As research intogenetics progresses, scientists will more easilyidentify those who are likely to die of particu-lar diseases at a young age. This knowledge

has important benefits. It alerts individuals towarning signs and lets physicians diagnoseand intervene more quickly. But those whoare identified as highly prone to debilitatingdiseases will find it hard to keep jobs thatinvolve substantial training by their employ-ers, or to get insurance, or even to maintainnormal social relationships.

Imagine that you receive bad news fromthe medical lab: you have a genetic predispo-sition to a debilitating, irreversible disease.Though you may feel fine now, you anticipatea bleak economic future. You have everythingto gain, and nothing to lose, by seeking re-dress through political action. You will be un-likely to settle for handouts if there is a possi-bility of suppressing the disease-identifyingtechnology. (Simply leaving it up to the indi-vidual to disclose if she chooses is tanta-mount to giving her no choice. Those whotest well will disclose their results, with theimplication that anyone who does not dis-close is predisposed to disease.)

If you achieve a ban on the technology, yourestore the status quo ante – and your fearsabout getting health insurance and good jobswill evaporate. That society will be worse offtoday, and that pharmaceutical firms will notget the data to help future generations, willnot particularly concern you – after all, formost sufferers, the gain will far exceed anysense of altruism they might have lost.

The fear that political constraints may beplaced on the use of valuable new technolo-gies is not unfounded. Twenty-one states inthe United States already restrict the use of

genetic records for employment purposes,even though genetics technology and thedebate about its use are still in their infancy.

competition from emergingeconomiesChina and India, accounting together formore than 2.5 billion people, are finally onthe move. Never before in history have somany people become wealthier at such a pace.While the peoples of these and other develop-ing countries will add to the global economicpie in many ways, they will also compete forjobs that they can do more cheaply and moreefficiently.

The challenge from emerging economies isnot unrelated to the challenge from technolo-gy, for technological advances will lead tocompetition in sectors that hitherto wereimmune. Consider that a typical secretary inNew York is about as well educated and pro-ductive as a typical secretary in Mumbai,India. They use the same word processing andpresentation software, the same fax machines,the same e-mail programs to communicateover the Internet. The secretary in New York,however, makes about 13 times the salary ofher Indian counterpart.

The reason for this difference is that secre-tarial work has, thus far, been protected fromforeign competition. Immigration controlsand perhaps an affinity for being in Mumbaikeep the Indian secretary far from New York.Thus, her willingness to work at a lower wagehas little effect on the wages of secretaries inNew York.


We are in a dangerous period of hangover, the

morning after the ecstasy of a boom. Many feel

betrayed by the bust and are demanding action

against the markets.

This is not to say that secretarial wages aredetermined arbitrarily. Like all prices, they aredetermined by supply and demand. One fac-tor determining the supply of secretaries istheir alternative employment possibilities.Suppose a secretary’s alternative is to be asteelworker. There is a world market for steel(provided protectionism does not close itdown), so no country can afford to pay itssteelworkers much more than what they con-tribute at the margin to output. U.S. steel-workers are paid much more than Indiansteelworkers because U.S. steelworkers aresubstantially more productive. Therefore,because U.S. steelworkers are more produc-tive, the U.S. secretary is paid more, eventhough she herself is not more productive.Thus, in the United States, the secretary earnsa hefty salary because she controls a scarcefactor: specialized labor.

But what is scarce here is secretarial laborin the United States, not secretarial labor inthe world. And technology is increasinglymaking it possible for all kinds of labor to besupplied at a distance. As the cost of commu-nication falls, a Chicagoan complaining abouthis utility bill is just as likely to find a middle-aged woman in Manila on the other end ofthe line as an American.

Not every job will be at risk. But, overtime, competition will move to more skilledactivities as foreigners learn the local stan-dards. While large firms may still employpartners in big accounting firms to advisethem on arcane tax-minimization strategies,the small-business owner may well deal overthe Internet with an Indian or a Chineseaccountant who has familiarized herself withU.S. laws. A Russian physician may performan operation over the Internet at a fraction ofthe cost that a Western European physicianwould charge.

In short, while workers in “traded” indus-

tries like steel have faced up to foreign com-petition for decades and have adapted to it,for many in “non-traded” service sectors, thiswill be something they have never experi-enced before. They currently enjoy compen-sation in excess of what they would earn in aworldwide competitive market. An increase incompetition will jeopardize this excess com-pensation. Hence, like the steelworkers, thesenew victims of competition will mobilize totry to block it. But unlike the case of trade inphysical goods, border controls will be inef-fective.

the fear of developed economiesEven while developed countries fear competi-tion from cheap, skilled, educated labor fromdeveloping countries, the latter fear that theirindustries could be wiped out by multina-tionals with global brands. In the same wayworkers in the developed world see cheaplabor in the developing world as an unfairthreat (no matter how much this fear is dis-guised as concern for the working conditionsand benefits of developing-country workers),owners and managers in the developingworld see the better infrastructure in thedeveloped world as unfair.

In truth, each side has a source of compar-ative advantage, which will help it compete.And in a world of open borders, each side canbenefit from the other’s strengths – the devel-oped world getting access to cheap labor andthe developing world getting access to infra-structure. But all this implies dislocation anddistress in the short run. And the developingworld is even less prepared than the devel-oped world to handle it.

In some developing countries, the precon-ditions for respect for property or for creatingmarket infrastructure have not yet beenestablished. Property is highly concentratedin the form of large feudal landholdings or


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monopolies, especially in extractive indus-tries. Not only can these countries not copewith volatile, competitive markets, but theirdominant political groups have little interestin creating the infrastructure that wouldallow them to cope.

One reason many firms in developingcountries are inefficient, despite their accessto cheap labor, is that they have been protect-ed against domestic and foreign competition

and have consequently become slow and lazy.Equally important, however, these firms arenot managed by the best talents available.

To obtain the management they need in anincreasingly competitive world, firms mustlook farther and wider, and dispense morequickly with managers who are not up to themark. But such a change requires an outsider-dominated governance system; it is easier tofire top managers when they do not control alarge fraction of a firm’s voting rights andwhen they are actively monitored by outsiderson the board. Unfortunately, these are not theconditions prevailing in most of the world.Many companies are controlled by insiders,who acquired that right at birth rather than inthe marketplace.

In a rapidly changing world with immensedislocation, such entrenched management islikely to have strong incentives to co-opt thedistressed into demanding protection. A clas-sic example of such an organization is what isloosely termed the Bombay Club in India, anamorphous organization led by the scions

of the old, venerable business families thatstrongly oppose opening up the economy.

Another serious concern in developingcountries is the near-complete absence of aformal safety net for those hurt by competi-tion. In developing countries, transfers andsubsidies represent just one-fourth the pro-portion of the budgets in developed coun-tries. Until the Asian crisis in 1997, evenSouth Korea had little in the way of unem-

ployment compensation and had to institutesuch a scheme rapidly when faced with work-er demonstrations.

In part, the low level of social spendingreflects a belief that the role of the govern-ment is only to create market infrastructure,while social networks provide insuranceagainst adversity. This belief has served coun-tries well during periods of rapid economicgrowth. But with the expansion of the marketeconomy, social networks tend to breakdown; Singapore passed legislation in the1990s empowering parents to sue childrenwho did not support them in their old age!

Legislation, however, is unlikely to fullyrepair social bonds that have been sunderedby the market. The developed world has tocare about these vulnerabilities in the devel-oping world. As developed and developingeconomies become more intertwined – notonly through trade in goods but also throughservices – they are becoming more exposed todisturbances in each other. Moreover, as trademoves from manufacturing to services, the

As developed and developing economies become

more intertwined, not just through trade in

goods but through services, they are becoming

more exposed to disturbances in each other.

degree of mutual dependence and specializa-tion is likely to increase; it is arguably harderto change your accountant or the firm thatmaintains your system software than tochange the firm from which you purchasesteel. It is also hard to build inventories of ser-vices to act as buffers.

There is a silver lining to these interdepen-dencies. When, in May 2002, the governmentsof India and Pakistan started threatening eachother with nuclear war, businesses in bothcountries became alarmed at the possibilitythat foreign buyers would get scared off byperceptions of increased risk. As a result, theypressured their governments to tone downthe rhetoric. These benefits notwithstanding,growing global integration is exposing theworld to new risks of disruption that have tobe addressed.

aging populationsNo analysis of the potential future threats tothe political viability of free markets canignore the dramatic effects that the rapidlyaging population in developed countries willhave on the distribution of resources. In 1970,there were 17.2 million children under agefive and 3.7 million adults over 80 in theUnited States. By 1995, the figures were 19.6million and 8.1 million respectively, and by2040, they will be 25 million and 26.2 millionrespectively. The United States, with substan-tial immigration, is not even close to beingthe most rapidly aging country. By 2010,Japan will have fewer than three working-ageadults for each elderly citizen, and by 2050, itwill have only 1.5 taxpaying workers per pen-sioner. At that time, Italy will have fewer tax-paying workers than pensioners.

A smaller and smaller working populationwill have to support a larger and larger groupof the non-working. If no change occurs, fu-ture working generations will pay ever more

to the elderly while expecting ever less fortheir own old age. This will set up a clash ofinterests between the incumbent old and theyounger working generation, between thosewhom democracy renders powerful becauseof their numbers and organizational powerand those whom economics renders powerfulbecause of their control over human capital.Historically, a mismatch between politicalpower and economic power has represented athreat to the security of property rights. Sucha threat is possible again in the future.

Another source of tension arises from theinternational distribution of resources. If theproductive capabilities of the economy fall asthe population ages, goods for consumptionwill have to be imported. Developed econo-mies will have to invest abroad – not in otherdeveloped economies, as has been the trendin the past but in younger, developing coun-tries. Developing countries need to build thecapacity to absorb these investments in sensi-ble ways.

Moreover, if developed countries are tohold significant quantities of financial claimson developing countries, they will demandsafeguards to ensure that they will not be dis-possessed at a later date when they need tocash in those investments. Historically,respect for property rights emerged whenowners were sufficiently represented politi-cally to make expropriation politically diffi-cult and when expropriation hurt the expro-priator in the long run. Clearly, investorsfrom developed countries have had little orno political representation in developingcountries, at least since the days of gunboatdiplomacy.

So whether their rights will be respectedhinges on whether, going forward, developingcountries will find it costly to expropriateowners in developed countries. Populationaging will force developed countries to be



increasingly reliant on respect for property indeveloping countries. It is in our collectiveinterest that market infrastructure expandworldwide.

international governanceWe have argued that the cause of markets isaided within a country if its large industrialand financial firms are competitive, for theywill then not have to rely on shackling the freemarket to survive. Internationally, the causeof free markets is helped if the dominantpolitical power is also an efficient producer,for it then will press others to open up theirborders.

During the 19th century, England promot-ed free markets around the world. A similarrole has been played by the United States inthe post-World War II era. It is periods whenthe political leadership of the world changeshands or when the dominant political powerloses its economic leadership that we are es-pecially likely to face ambivalence about openmarkets.

The United States is still the dominanteconomy in the world as well as the sole su-perpower, but neither attribute is immutable.Certainly, with the steel tariffs and the farmsubsidies, we see the consequences of U.S.economic weakness in some sectors im-pinging on its commitment to open borders.What if weakness spreads? Will the UnitedStates continue to champion free markets?

Of course, the United States is only onecountry. Competition among different politi-cal entities can still further the cause of themarket even if a major player jumps ship. Thedanger here is the growing political integra-tion among countries of the type occurring inEurope. It reduces political competition andmakes coordinated antimarket moves morefeasible.

In its early years, what is now the European

Union was the European Economic Commun-ity (EEC) – a focused attempt to break downnational barriers in Europe to enlarge themarket. When it was largely intent on a pro-market goal, it was a force for the good, andcoaxed many countries to liberalize. In ensur-ing equal access to foreigners, countries alsowere forced to level the playing field for theirown citizens, thus fostering the developmentof competitive arm’s-length markets.

However, as the aims of the European Un-ion have broadened to a common program of governance, its directives could well havethe potential of becoming more intrusive andilliberal. Consider an extreme but illustrativecase. Suppose after a severe stock marketcrash, the European Union decides that toomany companies brought to market were lit-tle more than a dream and a prayer. It decidesto tighten the rules under which companiescan issue shares on the market, a move in-cumbents might well support because itstarves entrants of capital. Given that theserules would apply immediately in all neigh-boring country capital markets a new Euro-pean firm might think of tapping, that poten-tial entrant might be hard-pressed to raisefinance under the new rules.

By contrast, if a single country tried toimpose those rules, it would see the potentialentrant go to a neighboring country to raisefinance. Thus, the migration of business tofriendlier political entities is a very strong dis-ciplinary force for keeping policies market-friendly. This force is suppressed when neigh-boring political entities coalesce.

saving capitalism from the capitalistsThere is no magic bullet. A call for forcefulaction by the government runs the risk thatthe action will be distorted by incumbents. Acall to neuter the government runs the risk

that the necessary infrastructure will remainunderdeveloped and the market will be ex-posed to political backlash during the inevi-table cycle of business creation and destruc-tion. The only way out consists of initiativesthat can check and balance each other so thatthe government supports, but does notintrude on, the functioning of the market. Inisolation, each proposal may seem benign oreven counterproductive. But together, theybecome a force to foster free markets.

Our proposals rest on four pillars. First, itis important to ensure that the control of pro-ductive assets is not concentrated in a fewhands, and that those who do have controlalso have the ability to use the assets produc-tively. Second, a safety net is essential for thedistressed – one that does not simply helppeople to cope with business cycle downturnsbut makes it possible for them to bounce backfrom the loss of a career. Third, the scope forpolitical maneuvering can be limited by keep-ing borders open. Finally, the public shouldbe made more aware of its stake in the marketand what the costs of seemingly innocuousanticompetitive policies can be.

Reduce Incumbents’ Incentives to Oppose Markets

We cannot wish away the fact that economicpower translates to political power. No matterwhat kinds of campaign finance reforms areenacted, some form of the real-world “goldenrule” – he who has the gold makes the rules –

will always apply. But the nexus between eco-nomic and political power is of special con-cern in two situations.

If a few incumbents have much of the eco-nomic power, they can rely on their ownpolitical clout to achieve business ends andwill feel little need to establish transparentrules that make markets accessible to all. Thisis more likely to be a problem in a countrythat does not have an established marketinfrastructure because the pressure to create

it will then be low. More dangerous still thanthis benign neglect of the market is if the in-cumbents are incompetent at business, forthey may then suppress the competitive mar-ket so as to preserve their own positions.

The two concerns are not unrelated. Thediamond trade in India is dominated by asmall community of Palanpuri Jains fromGujarat. For nearly half a century, thesetraders have worked in secrecy, dealing large-ly with other members of extended families,to buy, cut, polish and resell diamondsaround the world. Working without legalcontracts, they have been so effective thatnine out of 10 diamonds in the world nowpass through India.

The reason this system has worked so farin a country with a creaky legal system is thatit is based on trust. The community ostracizesanyone who violates the implicit understand-ing among traders. The problem, however, isthat outsiders cannot participate in the sys-tem, and insiders have no incentive to create


No matter what kinds of campaign finance reforms

are enacted, some form of the real-world “golden

rule” — he who has the gold makes the rules — will

always apply.


a more arm’s-length, transparent system; it is easier to build trust when profits are largeand trading is confined to a well-known few.

The concentration of trading in a fewhands can be harmful if the system stopsworking, as well. And there are signs of this astrade expands and business has to be donewith more and more outsiders: a courierrecently absconded with $10 million worth ofdiamonds, and two Bombay traders lost theirclients’ money in stock speculation (they wereso ashamed, they committed suicide). Butmembers of the community are not eager toaccept modernization and professionalism,however necessary, because these changes willalso bring competition.

Change is therefore coming slowly, per-haps too slowly. The point: concentration ofeconomic power, even if currently benign,need not remain benign, especially if the privileged few have their own ways of doingbusiness. This suggests two goals of policy: tokeep economic power from becoming overlyconcentrated and to ensure that those whocontrol economic resources are capable ofusing them efficiently.

These goals are often, but not always, com-patible. For example, it is clear that a policy ofsubjecting firms to competition from the out-side helps keep them efficient. There is littlepressure on a protected industry to becomecompetitive, and it will use the windfall prof-its earned while being protected to lobby formore protection instead of taking the stepsnecessary to restructure. The Indian Ambas-sador automobile (a version of the ancientBritish Morris Oxford) was introduced in1957 and was sold virtually unchanged until2002 because it had little domestic (and noforeign) competition during much of its his-tory. Even an allegedly temporary pause inmarket discipline, such as the recent imposi-tion of steel tariffs in the United States, risks

creating incumbents who will fight to makethe barriers permanent.

A Political Antitrust Law. Antitrust law hasbeen used to prevent firms from squeezingsupernormal profits out of customers. But itis also useful to consider the political versionof antitrust law – one that prevents a firmfrom growing big enough to gain the clout indomestic politics to suppress market forces.

There are obvious problems in framingsuch a law precisely, but it has been implicitlyin place in the United States for some time –especially in finance. The attack on theSecond Bank of the United States by AndrewJackson in the 1830s, the breakup of John D.Rockefeller’s Standard Oil in 1911, the cre-ation of the Federal Reserve in 1913 to coun-ter the power of the House of Morgan, theGlass-Steagall Act of 1933 to curb the powerof the large national banks, and the ongoingcase against Microsoft can all be seen as con-sequences of political antitrust law.

Better Corporate Governance. Some of themost important properties in advancedeconomies are not operated by their ownersbut rather by professional managers. We refer,of course, to corporations. On the one hand,the separation between ownership and con-trol facilitates a better matching betweenfirms and managers, leading to more efficientfirms. On the other, it creates conflicts ofinterest between managers and shareholders,potentially leading to inefficiencies.

To facilitate a healthy separation betweenownership and control, more legal protectionshould be guaranteed to investors who en-trust their savings to somebody else. In ad-dition, appropriate mechanisms, such as in-dependent boards, effective auditors and avibrant market for corporate takeovers, areessential to ensure that managers are coaxedinto maximizing the value of the companiesthey run, and are quickly replaced when they


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demonstrate their inability to do so.In other words, corporate governance is

important not only to enhance value for in-vestors, but also to ensure that incumbentfirms welcome (rather than) fear competition.Recent scandals suggest that much needs tobe done on this front even in advanced mar-ket economies.

Inheritance Tax on Transfer of Control.Inheritance is a particular form of transfer ofcontrol of assets that typically tends to beinefficient because the receiver has little qual-ification to manage the assets other than theaccident of birth. Imposing serious impedi-ments on how the rich dispose of their wealthwould reduce their incentive to create thatwealth in the first place. Inefficient and con-centrated control of wealth does, however,impose all kinds of costs on society. That iswhy an inheritance tax, structured so that therich are encouraged to transfer passive own-ership of productive assets (for example,minority stakes in a portfolio of firms), ratherthan active control, to their children wouldmake sense. Inheritance taxes may be espe-cially important in developing countrieswhere there is immense concentration oflandholdings.

Another way to break down the excessiveconcentration of asset ownership is to makeequal inheritance by all children, male andfemale, the default. Such prescriptions are notnew. They can be traced back at least to theBritish philosopher James Harrington, whohad tremendous influence on William Penn(and thence on the Constitution of Philadel-phia), on Thomas Jefferson (and thereby onthe Constitution of Virginia), and on Theo-dore Roosevelt (and thus on federal antitrustlegislation).

A Safety Net for the DistressedCompetition triggers failures. These failures

are essential to the creative destruction pro-cess, but are extremely painful for the people affected. The bigger the cost of adjust-ment and the larger the numbers of the dis-tressed, the stronger the political demand tointervene.

Insure People, Not Firms. While perfectlyunderstandable, this demand for interventionis very dangerous because it can be easilymanipulated. To prevent the victims of cre-ative destruction from being transformedinto human shields for special interests, weneed to provide for them in other ways. Onerule, therefore, to prevent the politicization ofrelief is to insure people directly – notthrough firms.

For example, economists generally agreethat the best way to provide relief to workerswho lose their jobs is to offer them lump-sumpayments, perhaps dependent on the dura-tion of their previous employment. Not onlydoes this not interfere with the competitiveprocess, but also it gives workers the right in-centive to look for new jobs (they get to keepthe payment regardless of how long it takes)while relieving them of the privations ofunemployment. Unfortunately, such simplesolutions are rarely implemented becausethey disassociate worker relief from politics.

Design Insurance Before the Fact. Gov-ernments typically prefer to wait for an eventbefore responding instead of preparing forthe uncertain eventuality; not only can themagnitude of the relief required be bettergauged after the fact, but also resources donot have to be held in reserve. One reason todesign relief in advance is simply that a planprovides people a greater sense of security.Moreover, it eliminates the need for the dis-tressed to organize to obtain relief. Since theircollective actions are not likely to be friendlyto the market, a plan for relief before the facteliminates a significant threat to the markets.

This, in fact, is suggested by our briefaccount of the evolution of U.S. bankruptcylaw. Once a flexible law was put in place, theneed for debtors to organize to press for reliefduring each recession disappeared. Also, theycould obtain relief based on individual cir-cumstances, rather than wait for collectivemisery to tip the political scales. Relief pro-vided after the fact is not insurance but pureredistribution. As such, it is driven solely bythe political power of the parties involved, notby the needs of people.

Insure Against Permanent Change. Socialwelfare programs were designed to fight thelast wars – notably, temporary dislocationcaused by business cycles. Structural change,not cyclical change, is the primary concernnow.

Peoples’ most valuable assets are typicallytheir productive skills. To develop flexiblehuman capital a worker needs sound healthinto old age, a basic general education thatgives him the ongoing ability to learn ratherthan filling him with facts with a very shorthalf-life, and an education system that cantake him in whenever he needs retraining.

In the United States, life expectancy hasincreased by 29 years since 1900. Yet mostpeople stop formal education early in life,much as they did a hundred years ago.Education is still geared toward that first job,even though technological change, competi-tion, and greater job mobility mean that formost people, the first job (or even the firstcareer) will not be the last. Would it not makemore sense to cut back a little early on andhave more opportunity for education later?

Finally, it should be possible for those withneither the desire nor the ability to make car-eer changes to retire. A viable pension schemewould allow this. Unfortunately, the genera-tions coming of age today, when the risks ofstructural change are so great, have little rea-

son to feel secure about their pensions. Withpay-as-you-go financing, the aging of popula-tions means that the social security systemscurrently in place in almost every developedcountry will prove inadequate.

There are few formal systems of insurancein place in developing countries; these coun-tries rely on social networks like extendedfamilies and villages to serve as buffers to economic volatility. The silver lining is thatthe level of government expenditure on socialsecurity in many of these countries is still low.So they have the ability to create formal secu-rity systems without repeating the mistakesmade by developed countries.

Reduce Incumbents’ Ability to AffectGovernance

Thus far, we have proposed ways of reducingthe incentives of incumbents and the dis-tressed to go against markets. We now turn tomeasures that would reduce their ability toaffect governance.

Open Goods and Capital Markets. The mosteffective way to reduce the power of incum-bents is to keep domestic markets open tointernational competition. It is especiallyimportant to keep financial markets open.Countries have little incentive to close theirborders to trade and capital flows unilaterallywhen the rest of the world is open. This isbecause goods and capital will leak throughanyway unless the country goes the totalitari-an route of a North Korea. But a mass move-ment against open borders, even if only in afew large countries, can make it attractive forpoliticians to close borders.

This is the danger posed by the growingantiglobalization protests. Economists haveresponded to these protests by emphasizingthe productivity gains generated by interna-tional trade. However, they have generallybeen lukewarm in their support for the free



movement of capital. While we certainly donot dismiss the importance of the efficiencygains generated by trade, we emphasize a dif-ferent argument in favor of openness – itscapacity to undermine the power of domesticincumbents. A commitment to opennessforces incumbents to abandon politics and tofocus on the tougher task of defending theirpositions in the marketplace by becomingmore efficient.

While openness is clearly beneficial fordeveloped economies with sound infrastruc-ture, sudden liberalization can be problemat-ic for underdeveloped economies. Subjectingill-prepared economies to the gale-forcewinds of international competition can beharmful because it may wipe out the veryconstituencies – the professional classes,small- and medium-size entrepreneurs, com-mercial farmers – that can push for a marketeconomy.

According to some, the right policy for thelarge developing economy is to limit competi-tion until the institutions necessary for an ef-ficient market economy are in place. But thereis a great risk in such gradualism: slowingdown the liberalization process may bring itto a standstill. If incumbents know that open-ing up to competition hinges on improve-ments in infrastructure and skills, they canblock movement on either front.

In fact, while gradualists argue that finan-cial-sector reforms should precede the opencapital flows, in practice they seem to followit. So the dilemma for a reformist governmentin a developing country is how to create acommitment to increase competition whileallowing time for market institutions to bebuilt.

Provide Incentives Through Trading Zones.Richer countries, which have come togetherin free trade zones, have a very powerfulinstrument to encourage (rather than to

force) reforms: offer membership in theirtrading zones, conditional on progress onmarket infrastructure development. By usingthe carrot of the opportunity to trade with alarge group of countries (like the EuropeanUnion or Nafta), they make reform politicallyappealing for the developing or transitioneconomy. It is impressive how much Turkey istrying to change (with respect to humanrights as well as economic structure) in orderto qualify for membership in the EuropeanUnion.

There are, of course, countries that do notfit naturally into a trade zone. But the broadprinciple of providing incentives for reformstill applies. Developed countries could do agreat deal for the cause of markets, both intheir countries and around the world, bystopping subsidies to their own farmers andby lowering trade barriers in key goods liketextiles. Farmers and small entrepreneurs indeveloping countries, who have a betterchance of growing rich if protectionism indeveloped countries is reduced, can be a greatforce for opening markets in their own coun-tries – just as their counterparts were in thedeveloped world.

public awarenessThroughout, we have argued that organizedinterests drive government policies. One rea-son politicians can ignore the public interestwith impunity is that they believe the publicis unaware of what its interests really are andcannot be bothered to find out. Our goal is tomake more people think like economists do.If they see the benefits of free markets, yetunderstand their political fragility, it will beharder for narrow interest groups to prevail.It will become easier for public-spiritedpoliticians – there are some – to advancesound reforms. And the world will become afairer and better place. M