Capitalism without democracy?

Is capitalism indifferent to the form of government? Not in its pure form of market capitalism.

Just like competition and free markets are indispensable for economic success, democracy and freedom are essential for a good system of government and the rule of law. For this reason, capitalism and democracy are often said to go hand in hand.

Yet, there are some on the right and left who still believe the opposite. Some take such view on the basis of a mistaken interpretation of democracy and capitalism, while others simply dislike the outcomes of both systems.

Democracy is “Government of the people, by the people, for the people”. This form of government is achieved through majority rule by people's representatives, subject to the constitutional separation of powers and the rights of the minorities, who are elected periodically on the basis of one person one vote.

The alternatives to democracy can be gathered into two groups – totalitarian and authoritarian. Totalitarian regimes are typically governed by a despot or a small group of leaders, invoking an ideology or religion as the general basis for all aspects of life, where any form of opposition is brutally repressed. Authoritarian regimes are a softer version with less dogmatism in terms of ideology or creed, and granting some level of economic and religious freedom as long as their personal enrichment and hold on power is not challenged.

Former examples of totalitarian regimes include Nazi Germany and Stalin’s USSR, while living examples can be found now in countries like North Korea and Saudi Arabia. Today, the classification as totalitarian or authoritarian in countries like Iran, Russia or China is controversial.

For instance, the classification within a given category is not indifferent to the regime evolution, and in this sense one may say that China is moving towards an authoritarian regime while Russia is moving towards a totalitarian system, although, objectively, now there is still more freedom in Russia than in China. Likewise, the distinction between democratic and authoritarian regimes is also controversial in countries like Singapore.

In fact, nowadays, authoritarian and totalitarian regimes do not follow an open anti-capitalist ideology and may even portray as strong capitalist supporters, as long as their rule is not challenged.

The two standard yardsticks to judge the evolution of a political regime are the direct state involvement in the economy and the exercise of civic freedoms under the rule of law. These do not necessarily preclude regimes with strong leaders or with one-party long-term dominance.

However, these inevitably end up creating a self-perpetuating elite that will oppose any competition. To overcome such danger the pursuit of liberalism constitutes an important antidote to preserve both capitalism and democracy.

Indeed representative democracy and capitalism share similar problems in terms of governance. As sometimes I remind my students, there is a remarkable similitude between shareholders and electors. For instance, elections are the equivalent of the shareholders annual meeting, asset managers are similar to political parties, the board of directors resembles the parliament, and the executive officers the government while the senior managers are like the top civil servants.

Therefore, they share similar challenges. For instance, in terms of representation, the need to avoid a divorce between the electors and the elected is analogous to the separation between shareholders and management. Likewise, the rise of self-perpetuating insider elites in political parties is similar to that found in the selection of company board members.

Not surprisingly, the false alternatives to representative democracy, namely direct and “guided” democracy, have an equivalent in the attempts to extend voting rights to non-shareholders and on collusion to adopt rules restricting voting rights.

In conclusion, capitalism and democracy are two distinct but mutually-reinforcing systems. When in pursuit of their true form – market capitalism and representative democracy – they are inseparable. Temporary moves away from any one of them is only possible for short periods or under perverse forms of capitalism.

Russian fears after 20 years

Since the fall of communism, Russia has become again a case study on the loss of freedom in non-capitalist systems, this time the result of a system of oligarchic state capitalism developed in the country.

I am not an expert on Russia, a country I visited only twice and briefly. I visited Moscow in 1991 and S. Petersburg in 2013. The last time, during the visit to the over-crowded Hermitage Museum I seated for a while wondering what had struck me more and it was not the museum.

Mostly, I wondered why after more than 20 years this beautiful imperial city still looked dilapidated and decrepit, and people in the streets and tourist shops still looked fearful, nationalistic and resentful of westerns. It also struck me how limited was the offer of products beyond the babushkas, amber and other semi-precious stones and communist memorabilia.

Having lived my youth under Salazar’s authoritarian regime, a model admired by President Putin, I can understand the Russians’ fear, longing and delusions about past imperial might and equality in poverty. It also lets me sense the body language of those living in fear of the authorities or in servility before those in authority to whom they owe their business.

For instance, a souvenir shop I visited still exhibited a wall plaque stating that it had been opened by special permission of a minister. I also had lunch in a restaurant housed in a former Czar palace and headquarters of the Soviet Trade Unions. It housed many other “companies” which did not have any identification and nobody knew what they did or who owned the place. The meal itself was not much different from what one gets in a workers canteen and the service was very poor. However it have the “luxury” of classical live music played by a young violinist. The whole setting was quite surreal.

Only a lack of truly free enterprise can explain the absence of progress in Russia. In fact, the Russian economy continues totally dependent on the exports of arms and energy, with the later accounting for almost 70% of its exports and, together with other commodities, account for about 50% of the Federal Government tax revenue. Overall, Russian exports are less than 15% of the Euro-Area exports.

Searching for explanations for Russia’s poor performance, Chrystia Freeland’s Plutocrats (2013) compares the rent-seeking strategies of the Russian oligarchs with that of the Chinese Communist Party bosses and concluded that “China’s market reforms have been slower and its avenues for rent-seeking have been more varied and more opaque than a quick privatization drive led from the top”. In my view, this does not explain much about the disparate performances of Russia and China.

The key difference resides in the openness and participation of the two countries in international trade. While China began by creating special free trade regions for foreign investors and sought an early entry into the WTO organization, Russia only fulfilled the WTO membership requirements in 2012.

Equally important was the contempt for small business inherited from the communist regime which, coupled with a lack of property protection, rampant corruption and business fear, discouraged free enterprise and entrepreneurship.

The Russian experience confirms the importance of freedom for capitalism and economic development. Otherwise the incumbents fear the loss of power and people the loss of security and sooner or later turn to authoritarian nationalism invoking the risk of social unrest or imaginary external threats.

These fears can only be overcome through genuine democracy and a move towards market capitalism, by opening up to foreign competition and achieving significant progress in complying with the six principles of market capitalism.

Capitalism and individual freedom rights

Regardless of whether we think about individual liberty as the absence of obstacles, barriers or constraints (negative liberty) or we consider collective liberty as the possibility to take control of one’s life and fundamental purposes (positive liberty), there is no doubt that freedom must be defined in relation to the availability of options. However, since options may be incompatible one must frequently balance them. For instance, we have a tradeoff between privacy and safety or between individual and collective wage negotiations.

Equally, when analyzing the relationship between capitalism and freedom, one needs to consider the freedoms essential for capitalism as well as the way it contributes to the many freedoms. Indeed, capitalism is an economic system that requires two fundamental freedoms – private property and freedom of exchange – and these two types of freedom enhance further other forms of freedom, namely the freedom of association required by joint ownership and free consumer choice and the freedom of information necessary for free trading.

Overall, by promoting individual wealth, capitalism contributes to the creation of more options and individual choice thus overcoming one of the major obstacles to liberty. But, through its principles, it also promotes many other fundamental freedoms not directly related to material goods.

For instance, freedom of thought, belief, opinion and expression is promoted by the capitalist’s drive to advertise its products and services. This commercial interest can only be achieved with freedom to choose the channels to reach clients and a free media.

Freedom to contract and exchange is indispensable for competitive markets and it can only be achieved by freedom of movement, absence of coercion and access to information. Freedom of information, like the freedom of expression is crucial for commercial as well investment decisions. Since asymmetric information is a major source of market inefficiency, capitalism thrives better under free markets.

Likewise, free peaceful assembly is a requirement of capitalism so that employers, employees and consumers can discuss their relative interests both in private and in public places, such as conferences, fairs and exhibitions. This freedom extends also to the right to establish unions and peaceful union picketing to persuade other parties to a wage bargaining.

Freedom of association is crucial under capitalism not only for representation purposes, but also to pool private property into forms of joint ownership, namely joint stock companies. Moreover, by separating personal from corporate responsibility through limited liability, capitalism manages a substantial reduction in risk which is essential to foster entrepreneurship.

Most importantly, capitalism generally promotes peace because all forms of social unrest and war destroy assets, production and profits. The profit motive requires all the above mentioned liberties and, not surprisingly, all totalitarian regimes (whether pro or anti-capitalism) are usually searching for new excuses and ways to control capitalism.

To resist such attacks on freedom, it is important to understand when the fundamental freedoms that capitalism requires and promotes can be subject to some restrictions. For instance, freedom of expression does not mean that corporations are free to lie and manipulate consumers and investors. Likewise, freedom of assembly does not mean that such assemblies may be used to collude on illegal and anti-competition practices. Just like the right of association does not mean that it can be used to establish cartels or the right to information allows them to procure insider information from privileged parties.

The definition of such limits on business freedom is usually controversial and difficult to delimit. In particular, there is a widespread tendency to consider that the role of the state is to protect individual freedom against business practices. This is erroneous, because the state and capitalism should not be adversaries but allies in the promotion of freedom. To avoid this dangerous error it is important that regulators understand the differences between market capitalism and other “distorted” versions of capitalism because only the first guarantees the pursuit of liberty.

To conclude, we should not assume that people are either extremely naïve or evil. All restrictions to freedom must be carefully assessed and, if needed, the error should be on the side of liberty.

The free movement of goods, capital and labour

Capitalism confirmed and extended the benefits from free movement of goods and services, capital and labor. Initially mostly at the national level, but progressively also at the international level.

Throughout the middle ages internal trade was not only risky due to the shortage of transport infrastructure and lack of protection against robbers, but also because of the many tolls required to enter cities, navigate the rivers, use bridges or the right of way over the nobles land. For instance, in 1250 there was 12 tolling stations on the Rhine river between Mainz and Cologne, which are only 170 km apart.

By then slavery had been generally replaced by serfdom. But, about half of the population still continued tied to the lord’s land through bondage and had to provide a certain number of labor services. Serfs were forbidden to live outside the seigniorial territory, had to pay fines to marry serfs of another lord and were subject to a number of fees.

Craftsman and artists enjoyed more freedom but were progressively organized in Guilds which restricted severely their training, trade and mobility. So, the concept of free labor mobility was basically unknown.

Likewise, there was very little capital mobility because the sale of land (the main asset at the time) was severely restricted through seigniorial and inheritance laws. Financial investments were equally very limited and lending was typically provided only to royalty by Jewish merchant- bankers. So, apart from travel and trade-related payments, the transfer of financial capital was too little and mostly to pay for ransoms and tributes.

However, the advent of the commercial revolution in the XIII century and the Renaissance changed dramatically the situation in Europe. By the late XVII century international banking and trade had achieved a significant development in Northern Italy, London and Amsterdam. Yet, its driving forces were still the spices and other exotic merchandise made available through the Spanish and Portuguese sea voyages, which were necessarily limited.

It was up to capitalism, with its focus on manufacturing, to change dramatically the growth of international trade through the export of manufactured goods to the colonies and the import of the raw materials used to produce them. This process contributed to the rise of London as a major international clearing and financial center, where it became possible to borrow and invest internationally.

In turn, the financing of major railways and other ventures in the Colonies in North and South America required massive labor migration.

Of course major human migration had been around since the early days of the homo sapiens. He moved out of Africa some 80 millennia ago, and spread across Eurasia 40 millennia ago. Migration to the Americas took place about 20 to 15 millennia ago and, about one millennium ago, all the Pacific Islands were colonized. Later, significant population movements included the Neolithic revolution and the Indo-European expansion.

Throughout history, most major migrations were caused by the collapse of empires, slavery or religious persecution. For instance, it is estimated that before 1830 2.75 million Europeans left to settle overseas, mostly convicted and fugitives from religious persecution.

The difference under capitalism was that migration accelerated not only substantially, but its motivation also became essentially economic. For instance, between 1835 and 1935, the number of European emigrants rose to 75 million who left voluntarily to America and other continents in search of a better life. With a bit of exaggeration, one may say that with capitalism the labor market transformed from a local market into a global market.

Nevertheless, the dismantling of the barriers preventing the free movement of goods, capital and labor was a slow process. Governments had become addicted to customs tariffs as a source of revenue, wanted to force national savers to lend their money only to them or did not wish to extend their social services to immigrants.

In general, capitalists have a duplicitous approach to the freedom of movement. They support free trade as long as it opens up new markets for their products and supplies, but are against when it means direct competition with their products. Likewise, they welcome financing from foreign investors but do not appreciate it when national banks lend to foreign companies. Similarly, they welcome foreign workers as a way of keeping wages lower but do not like it when foreign companies poach their own employees.

Ultimately, the question remains one of knowing whether restrictions to the free movement should be acceptable as temporary or permanent to avoid major disruptions in the three markets. History has shown that the abolition of barriers has been faster in relation to goods and services, somewhat rapid in relation to long term capital but very slow in relation to labor movement.

In general, and especially in large countries, capitalism can live with movement restrictions, as long as they are not excessive. However, to reach its full potential restrictions must be progressively abolished. Indeed, as our analysis of business cycles has shown, programs of accelerated liberalization usually have been associated with an acceleration of economic growth.

To conclude, capitalism not only accelerates the freedom of movement but it is equally needed to keep the momentum for international free movement of goods, capital and labor.

Political contributions and democracy

Representative democracy has become a very expensive activity. For instance, in 2008 the USA presidential candidates raised more than $1.8 billion in campaign funds, an 80% increase in relation to the 2004 campaign . The Democratic presidential nominee alone, Barack Obama, raised a total of $745.7 million in private funds for his election campaign.

It was the first time in the history of presidential public financing that a major party nominee declined to accept public funds for the general election. Is this a good or bad development and what it says about market capitalism?

The controversy between public and private financing has a long history, especially in what regards the special advantage that private financing may give to incumbents and special interest groups (e.g. trade unions and business associations) over the election process .

In abstract, the freedom of association principle should go with the principle of free financing. However, since public office gives those elected an ample scope for decisions that favor private interests, such power has a monetary value that may supersede the public service motivation. Therefore, the rule of free financing cannot be easily upheld under representative systems.

For this reason, under systems of state capitalism, capping campaign spending and restricting its financing to public funds may prove a better solution to secure a level playing field in democracy.

However, in countries close to market capitalism, why shouldn’t the candidates be able to tender some of their policies to special interest groups? For instance, party A could tender the easing of regulations in the financial sector, more private outsourcing of public services, more arms spending, etc. against political campaign contributions.

There is one fundamental reason why that cannot be made. It would be impossible to create a competitive market for political funding because of the asymmetric nature of the benefits received by the special interest groups and the public in general. Imagine for instance that one thousand banks can earn each 100 million dollars from deregulation while 200 million voters can save one thousand dollars from tighter deposit protection. That is, banks could earn up to 100 billion while depositors could save up to twice that amount. However, this difference may not be enough for voters to outbid the banks because their gain is only a potential saving while that of the bankers is a certain gain.

So, it is unquestionable that market capitalism requires the regulation of political contributions. And, in fact, all democratic countries regulate them, namely by limiting contributions by foreigners, by contractors of public services, trade associations, unions, regulated corporations, etc. These are usually complemented by rules on public disclosure.

Nevertheless, these limits and rules are easily evaded through soft dollars and by setting up special vehicles to make contributions (e.g. foundations, think tanks, etc.) or through the media and other unrelated intermediaries.

So, a level playing field in political campaigning must be promoted more vigorously, namely by capping the size of donations to small amounts, limiting the amount of advertising, etc. However, such limitations must be based in the principles of constitutional liberalism. Otherwise, the strong positive synergies that exist between market capitalism, constitutional liberalism and representative democracy are lost.

The rise of finance and capitalism

Fostered by a growing incorporation into joint stock companies, the progressive adoption of limited liability, the development of capital markets and the use of fiat money, credit rose to become one of the main drivers of economic growth under capitalism.

Yet, from the beginning, this growth in credit and banking raised many concerns, because it would subordinate the production to money making, giving a special advantage to those with access to money and increasing the scope for speculation at the expense of entrepreneurship.

Before addressing these concerns, I shall give first an overview of today’s relative importance of financial and non-financial assets in global wealth.

According to estimates given in Wolf (2010), four economies (USA, Euro-Zone, UK and Japan) held 80% of the $140 trillion in world wealth held in financial assets in 2005. This amounted to 316 percent of world output, up from just 109 percent in 1980.

The breakdown of the global stock of financial assets was: equities ($44 trillion), private debt ($35), public debt ($23) and bank deposits ($38). A substantial share of these assets are held by households and nonprofit organizations.

For instance, in the USA they had 73.5% of all private sector financial assets, mostly in deposits ($6.1 trillion), debt securities ($3.1) and equity ($14.6 trillion in total, mostly directly $5.7 and indirectly through pension funds $4.9). If to this huge sum we add financial derivatives then the ratio between financial and tangible assets (mostly real estate) easily reaches more than 3 to 1.

Such a large degree of financialization, puts financiers at par with other leading groups associated with system change, like the merchants during the commercial revolution and industrialists in the industrial revolution.

So, many see this development as a symptom of financial capitalism rents dominating the economic motives and feeding a time-bomb of debt and speculation which will end in disaster. Before discussing its consequences one needs to assess first its true dimension.

In this regards, the obvious question, is: why do we need so many financial assets when they are often defined just as a pro rata share on a claim? If such claims were only on property titles on existing non-financial assets the ratio would be simply 1:1. However, claims may be also on future assets (financial or non-financial) and their income as well as on contracts (bets) on future events. This distinction is important because while the first is still linked to expectations about future economic growth contracts are mostly related to expectations about expectations and so can easily turn into a form of gambling.

Although speculation has a positive role in providing liquidity and risk sharing, when it goes beyond the needs of markets for goods and services one cannot distinguish between speculators and gamblers in a casino.

But, the fact that some investments are similar to casino games does not mean that financial assets do not have an utility per se. Financial assets are important for the safekeeping and accounting of non-financial assets, to facilitate the transfer, holding and hoarding of such assets (across space, through time and between asset holders) and for risk-sharing and part-ownership. This said, they may also have utility for entertainment, like a roulette in a casino.

However, since most financial assets are not collateralized by non-financial assets this turns them into promises, with a small cost of production, an easiness of transferability and volatile prices. Therefore, there are reasonable concerns that their growth may be subject to wide fluctuations and a cause of periodic crises. Such crises may arise in banking, in currency markets or in securities markets. Sometimes, these crises may even occur simultaneously, spread globally and may lead or lag the business cycle.

Some people are also critical of the growing collusion between financial and political elites. This is nothing new. Already during the emergence of banking in the XV century the bankers played a leading role in the financing of permanently indebted kingdoms. Even in periods of expansion, kings like D. Manuel in Portugal, Henry the VIII in England or Charles V the Holy Roman Emperor were permanently indebted to finance their wars and growing royal courts.

Such loans were frequently interest free and obtained against business concessions for tax farming and other monopolies. Default on such loans was frequent, but their impact in the economy was mitigated by the smaller size of governments and the fact that bankers mostly used their own capital. Then, like now, the obvious solution was to diversify by lending to other merchants and non-sovereign borrowers. Given the growing size of government and managerial capitalism now diversification can only be achieved by strengthening the market capitalism sector.

Another concern is whether the current system creates major global imbalances which favor some countries or are a threat to global stability. Indeed, in the past 25 years there was a major shift in the flows of international capital which now go from emerging and less developed economies to a handful of developed countries, whereas in the past they moved in the opposite direction. The table below shows the recent trend among four of the six major countries ( the other two are China and Saudi Arabia), which account for about 80% of global saving and borrowing.


The table shows that as a percentage of domestic GDP the current imbalances are around 3%, a value that can be sustained over a long period of time. However, it also shows that the UK and USA have had persistently negative savings which were largely financed by Germany and Japan (plus China and Saudi Arabia).

Moreover, it also shows that, with the exception of the USA, non-financial firms have become net savers which is a worrisome signal in terms of finding profitable investment opportunities domestically or reluctance to return capital to shareholders.

So why is investment being directed mainly to the UK and USA? This is a very complex issue. On one hand these two countries benefit from having the most sophisticated capital markets and from being perceived as the most politically stable countries. On the other hand the lack of investment by domestic firms suggests that they may be lagging in technological development and compromise their future competitiveness.

A negative view on this rising role of finance has traditionally been expressed through the so-called immorality of making money out of money, the waste of human talent and resources in non-productive activities (a claim also made in the feudal system against priests and soldiers) and the creation of firms that are too big to fail. This has led some to question the role of the firm, suggesting that instead of value creation to shareholders they should instead aim at maximizing customer satisfaction. For instance, Peter Drucker (1973) claimed that the “only valid purpose of a firm is to create a customer”.

As explained before, these claims are erroneous because the profit motive is one of the fundamental requirements for competition and customer satisfaction.

Indeed, the rise of finance is the inevitable consequence of economic growth and widespread private and institutional capital accumulation. It is therefore a positive feature of capitalism, despite the fact that from time to time some financial markets may get carried away causing some volatility in employment and economic activity.

Innovation, intellectual property and capitalism

Economic history shows a remarkable similarity between economic and technological long term cycles. By looking at a timeline of inventions one can easily detect many points of contact. Indeed, given the two-way causality between technical progress and economic growth it is inevitable that most of the controversies are about the direction in the virtuous circle between science and economic growth. At a microeconomic level, microeconomic textbooks usually explain how innovation benefits both trading parties.

However, the role of capitalism is not just to ease the sharing of the benefits from technical progress. A further advantage, and possibly more important, is the stimulation of innovation. In fact, it is no coincidence that capitalism and technical advancement go hand-in-hand driven by two of the basic principles of capitalism.

First, the pursuit of profit maximization is a major driver of innovation. For instance, all the fantastic new drugs that pharmaceutical companies produce every year are not the result of their concern for the patients but of their lush for profits. Moreover, if they lag in innovation, their competitors will take over their market share. Thus, the profit motive plays simultaneously the role of carrot and stick in the motivation of innovation.

Second, the protection of intellectual property for only a limited period of time provides innovators with enough protection to recover their investment in research, while preventing the undue state protection for incumbent producers. Obviously, the duration of such protection is subject to discussion and in the end its desirable extension is as much a result of political discussion as of empirical analysis.

While the role of profit maximization is often accepted, the legitimacy of intellectual property is at the origin of much heated debate, namely on whether it represents the granting of a temporary monopoly or the protection of a property right.

Many of the issues may be gauged by considering the following question raised by Paul H. Rubin and Tilman Klumpp (2011): “On the one hand, ideas, novels, or musical compositions are products of the mind, and if a man owns his mind as much he owns his body then it seems that, indeed, he would acquire property over what he conceives in his mind. On the other hand, ideas are vague and often conceived in similar form by many people. Since two persons cannot, independently of each other, have ownership over the same good, how can property be acquired over an idea that one conceives the day after it was conceived by somebody else?”.

Thus, the products of the mind are not easily treated within the traditional marginalist cost-benefit analysis. Moreover, the debate between supporters and opponents of intellectual property is often, but not always, aligned politically.

Take for instance the following libertarian views.

Among anarcho-capitalists we have some arguing for infinite copyright terms similar to those applying to non-intellectual property while others oppose them on the grounds that they divert resources from fundamental to patented research.

While amongst left-wing libertarians some oppose intellectual property because it represents an infringement of freedom of speech and the press.

In turn, some conservative libertarians advocate that a distinction should be made on the basis of who supported the costs of R&D and on the purpose of the invention. For example, Deepak Lal (2006) argues against granting copyrights to fundamental research on the grounds that it is mostly done at public financed institutions while supporting them in the case of pharmaceutical companies developing new drugs but not in the music industry selling a new song.

However, others agree with patent and copyright laws but oppose laws protecting trademarks or anti-counterfeiting laws.

Finally, others champion against patents and copyrights on moral grounds, namely arguing that is immoral to refuse to give new medicines for people in need.

The moral dilemma is especially difficult when dealing with life threatening diseases, as illustrated recently during the 2004-2005 Ebola epidemic or with the new Sovaldi drug for Hepatitis C.

The latter, involved a dispute over the price charged by Gilead, the company selling this drug capable of curing this previously incurable disease (priced at US$ 84,000 an amount not covered under most insurance schemes). The company argued that the price was needed to obtain a “fair profit” in the investment of $US 11 billion she had made to acquire the small company that had developed the drug.

This example illustrates another complexity with the regulation of intellectual property – the transferability of copyrights and patents.

Another problem is the enforceability of intellectual property rights on a global scale since some countries do not recognize or enforce such rights. This has led the USA and the European Union to negotiate bilateral agreements (the so-called TRIPS) to secure the protection of patents and trademarks, but these have been perceived as promoting protectionism rather than free trade.

Overall, if one accepts copyrights, patents and other forms of intellectual property protection as a necessary evil in the form of a temporary monopoly the shorter it will be the better. Because, being a form of censorship, it precludes the greater good that comes from sharing each other’s ideas and discoveries.

Moreover, the Internet has created a new tool to achieve the ancient dream of compiling all human knowledge and culture and to store it for free use by present and future generations. The benefits of this universal access to knowledge may outweigh those of granting temporary protection to intellectual property.

However, this requires a difficult judgement whose answer depends on whether free access would erase the profit motive and the rate of capital accumulation. So far, the so-called creative industries have continued to develop through a mix of conventional secrecy, intellectual property protection and new business finance models based on the winner takes all dream and crowd-funding. Whether these new business models will be more capitalist-friendly or not is still too early to know.

Capitalism and international free trade

Free trade is a foundation of capitalism not only at the national level but also at the international level. However, while locally it is easy to understand why free competition protects the capitalist system from capitalists who acquired a dominant position, when dealing with foreigners nationalist sentiments often win. For instance, it is common to find many arguments in favor of domestic producers using the infant industry argument, the notion of national champions or even a mercantilist ideology.

Yet, it is at the international level that societies may achieve better levels of specialization based on relative comparative advantage. This can be confirmed by looking at the link between exports and economic growth in the follow up to major reductions in international trade barriers.

The reduction of tariffs and non-tariff barriers started in 1947 with the signing in Geneva of the General Agreement on Trade and Tariffs (GATT). It continued through subsequent rounds of negotiations and played an important role in the extraordinary growth of international trade. For instance, between 1948-1968 the total volume of merchandise exports from non-communist countries grew 290 percent. Moreover, it outpaced the growth of world output. For example, from 1953 to 1963, trade in manufactured products increased by 83 percent, while manufacturing output rose by only 54 percent.

International trade liberalization was certainly a major driver of economic growth during the so-called Golden Age (1950-1973). Yet, although there are two virtuous circles associated with export-led growth (Marques-Mendes, 1988), one should not confuse the rising share of international trade in GDP as the direct cause of economic growth, because a faster rise in trade is not always associated with accelerating economic growth.

This can be easily confirmed by looking at two countries with high degrees of openness but significant differences in growth performance. For instance, Singapore and Hong Kong, classified ex aequo by ICC as the two most open economies in the world, were reported by the World Bank to have grown between 1966-2013, at market prices and 2005 $US, at an average annual rate of 7.8% and 5.8%, respectively. Meanwhile, during the same period their exports as a percentage of GDP rose 67 and 154 percentage points to reach 191% and 230%, respectively. That is, Hong Kong’s GDP grew less than Singapore’s despite a much faster growth in exports.

Likewise, the next two most open economies, Luxembourg and Belgium, grew in the same period at 3.7% and 2.5%, respectively, but their exports as a percentage of GDP grew 124 and 39 percentage points to reach 203% and 83%, respectively. Overall, in terms of economic growth over the past 47 year period Singapore outperformed Hong Kong by 162% and Luxembourg outpaced Belgium by 75%.

There are many factors explaining such disparate performances, including geography and sector specialization (both Singapore and Luxembourg are regional low tax financial centers) as well as demand factors (see Marques Mendes, 2011 and 2014, on why not all exports are the same), but the type of capitalism pursued is also a driving factor.

To understand the relation between exports and GDP it is useful to breakdown the latter in relation to the three identities used in GDP estimation – expenditure, income and production. For instance, the condition required for exports to exceed GDP under the expenditure approach is that the foreign trade balance (in ratio form) exceeds the ratio between domestic absorption (consumption and investment) and imports. This is more easily achieved in smaller countries and/or in countries where exports have a larger import content.

Likewise, using the income identity, we can see that the excess of exports over GDP requires that exports exceed wages by a factor equal to the wages/profits ratio. Thus, assuming a normal capital share of 40%, exports must exceed wages by 66% which is more easily achieved in low wage countries.

Finally, taking a production approach and splitting it into tradable and non-tradable we need exports to exceed non-tradable by a factor bigger than the tradable/non-tradable ratio. Since many non-tradable are produced in the non-capitalist sectors, it is easier for countries with a smaller state sector to achieve a high export/GDP ratio.

To understand the great advantage of capitalism in terms of capital accumulation and the deepening of the division of labor, one must bear in mind that the later can be achieved through rotation or specialization. These two distinct ways have substantial differences in terms of productivity impact as can be illustrated through a domestic example.

For example, my wife is much better than me at both cooking and doing the dishes, but her greatest advantage is in cooking. So, following the rule of relative comparative advantage she does the cooking and I do the dishes and we both gain by spending less time in the kitchen and having better meals. However, we could share the chores of preparing meals by alternating so that one day I would prepare dinner and she would do it the following day. This seems a more egalitarian division of labor but it would be much less efficient. For one, half of the week we would eat lousy food because it was me cooking. But I would also spend more time in the kitchen.

Obviously, capitalism relies on the division of labor through specialization and has a much greater scope in pursuing it through joint ownership, which facilitates accumulation and the unbundling of the production process.

Nevertheless, imagine that a washing machine is invented that reduced by 2/3 the time and skills needed to do the washing. Who would benefit? We could benefit both by, for example, me using half of the time saved to set the table a task previously done by my wife. But, what if I were a selfish person and insisted in doing only the dishes in exchange for the meal. Now my wife would have to consider to either forego the benefit of technical progress or to divorce me and find a more obliging husband.

Fortunately, in non-domestic activities we would not have such a dilemma because there would be many other suppliers competing to do the washing and those doing the cooking could play them to share on the gains from technical progress. That is why capitalist principles are better suited for non-family activities because one can contract and re-contract frequently.

So, to understand which are the most important drivers for international specialization and trade, one must examine the role played by each foundation of capitalism.

Starting with private property it is evident that the more this is protected the greater will be the level of private investment which accounts for the largest relative share of tradable goods and services. The profit motive is needed to increase the return on capital in a context of high wages. Free markets are indispensable to have a country specialization driven by dynamic comparative advantages needed to foster the benefits of export growth. Meanwhile, joint ownership and limited liability are needed to foster risk sharing and mitigation in international business. Yet, to prevent that these advantages are seized by protectionist interest groups, it is indispensable that the rule of law prevails.

The fundamental principle of the rule of law is that all be treated equal, regardless of sector of nationality. For instance, preference for national suppliers, price controls and distortionary taxes or subsidies are all in flagrant violation of the fair treatment principle required for a level playing field whether at the national or international level.

Cycles and fads in economic growth

The history of business cycles in capitalist economies shows many leading drivers depending on the duration and amplitude used. These range from those based on inventory theories (3-5 years), on fixed-investment (7-11 years), on infrastructure (15-25) or on technology (45-60 years). These cycles interact with credit and financial market cycles. They are often associated with specific events or policies. And, ever since Keynes, a discussion continues among economists and policy makers on whether cycles can be managed through monetary and fiscal policy.

Not surprisingly, the ascending sides of such cycles are often qualified as economic miracles or simply as fads if they take place in just a few regions or sectors. Likewise, one should note that fluctuations in economic activity (a better name than cycles, if one disagrees about their regularity) are not specific to capitalism. Indeed, we may find them in other economic systems, where often they are the result of natural or man-made disasters. For instance, droughts in Africa or Mao’s famine in China. And, it is important to remind, in long term stagnating economies business fluctuations are not always noticeable.

However, the notion that cycles of excess supply or shortages were inherent to capitalism, as claimed by Karl Marx, is not proved at the macroeconomic level. They happen at the level of individual businesses or industries who fail to react on time to the law of diminishing returns, but they rarely occur simultaneously to cause a macroeconomic cycle.

Others invoke temporary spurs in economic activity to support the idea that more centralized (often undemocratic) systems of state capitalism are more successful than a system of market capitalism. In fact, although such systems may have an initial advantage in terms of rapid capital accumulation this quickly transforms into a drag due to the rise of rent-seeking and the loss of competitiveness.

These fads (or economic miracles) are present in the history of almost any country (e.g. in Italy from 1963-74), but will subside whenever they fail to create enduring conditions such as – a high level of education, good governance, business culture and business elites supporting the six principles of market capitalism.

Business elites and culture are ephemeral whenever policies are dependent on a good ruler and not on a wise system, or when they rely excessively on foreigners or a few tycoons that sooner or later will be gone.

Leaders are important to mobilize people and resources, but if they stretch too much their power of persuasion soon their followers will be called down to earth by the correcting forces of the market. And the earlier these are allowed to work the smaller will be the cost of adjustment. This is a key reason why market capitalism is superior to managerial or state-controlled forms of capitalism.

Unfortunately, politicians on the left and the right often use such short-lived episodes to justify and perpetuate their anti-capitalist ideology.

It is therefore, crucial to assess all episodes of a sudden economic success in relation to their sustainability and reliance on an enduring system or a fad and passing leadership.