Capitalism and the rule of law

The rule of law is said to exist where all people and institutions (including law makers) are subject to and accountable to law that is fairly applied and enforced. That is, individuals, organizations and governments shall submit to, obey and be regulated by law, and not by arbitrary action of the authorities. Capitalism requires a substantive definition of the rule of law and the following institutions are needed: private property rights, the law of contract, an independent judiciary, and a constitution.

The rule of law concept was already known in some ancient and medieval societies, and it was well expressed in Cicero’s dictum that “we are all servants of the laws in order that we may be free”. Yet, only the capitalist economic system depends on a substantive rule of law to ensure that all trading parts have freedom of entry into a level playing market where contracts freely agreed between the parts can be enforced.

The importance of contract enforcement is easy to understand by imagining that someone at an auction had bided successfully for an item but before collecting it met somebody offering him an identical article for a lower price and decided to default on the previously agreed offer. Or, inversely, the seller asked for more money because meanwhile had found a buyer willing to pay more. So, whenever negotiation and settlement do not occur simultaneously, the parts have to rely on the law to enforce their agreement.

Obviously, legal enforcement presupposes freedom of contract and the existence of due process. For instance, if after a proper due process a legitimate Court had determined that the bidder in the example above was forced to raise his hand then it should declare the contract to purchase as null.

The freedom of contract is essential in a market economy regardless of the legal system prevailing in a specific jurisdiction – whether based on common or civil law. Although a civil law jurisdiction of the type prevailing in Continental Europe places more restrictions on the contractual terms that may be agreed between the parts to an exchange it does not follow that a common law legal system is indispensable for capitalism. Likewise in relation to the principles of classical liberalism. Although these have their own merits they are not essential features of capitalism.

However, the rule of law is critical to ensure a level playing field where arbitrary power is banned and the equality of all before the law is guaranteed. Thus excessive regulation or discrimination are not compatible with capitalism. For instance, compulsory purchases, price controls and distortionary taxes or subsidies are all in flagrant violation of the fair treatment principle required under the rule of law. Nevertheless, in some circumstances, described next, it might be difficult to distinguish between fair and unfair treatment.

Take for instance the payment of wages. Under a freedom of contract rule firms should be free to negotiate wages in cash, kind or a mix of both. But if a department store were to pay his employees partly in food and clothing it would be preventing their freedom to buy the quantities they wanted wherever they liked. Even if the firm were to use the payment in kind to increase the workers compensation (rather than reduce it as is sometimes the case) it would still be an unfair exchange as long as workers had no option to be paid in a universal medium of exchange (money).

Often, governments engage in policies of rationing, price controls or subsidization that distort the prices even in markets that are typically competitive. For example, the price of bread, coffee, low skilled labor, medications, etc. may be controlled and yet in such markets there are thousands of buyers and sellers. The alleged reason is the protection of the poor and weak. Although these may be legitimate social objectives such protection should be given directly to those in need without affecting the functioning of free markets.

There are however special circumstances, activities and places where exemptions can be acceptable within a capitalistic system based on the rule of law. For example, during wars or other calamities that disrupt supplies it may be necessary to introduce temporarily rationing or administrative prices.

Note that such restrictions are different from price controls and similar policies applied regularly to state and regulated monopolies because the purpose of such policies is to prevent abuses of position by those granted such monopolies.

Similarly, there are cases where it is fair for sellers to discriminate among customers, as in the sale of alcohol to youngsters or to inebriated adults, but it would illegitimate to restrict access to a bar or restaurant on the basis of race or religion.

It is also important to note that although governments are entitled to special powers under the principles of the rule of law they should not be entitled to special privileges. Consider for example the collection of payments refused or disputed by debtors. While private citizens can only seize the debtor’s assets following a due process and ruling by a judge, some tax authorities (e.g. in Portugal) exercise the right to offset or dispose of the tax payers property without any due process through the judicial process.

To guarantee the rule of law essential for a capitalist systems it is also necessary the existence of an independent judiciary and a constitutional bill of rights that protect the smallest economic agent (the individual) from arbitrary actions of democratic and dictatorial rulers alike.

Again, the purpose of a constitution is to define the citizens’ rights and to limit the power of government to coerce and encroach upon individual rights, property and freedom; regardless of whether they are based on the philosophy that one is free to do whatever is not explicitly forbidden or it is only allowed what is explicitly permitted, notwithstanding the obvious advantages of the first philosophy.

In conclusion, societies that do not adhere to the fundamental principles of the rule of law cannot guarantee the basis for fair competition and usually end up with perverted forms of capitalism.

Free Markets and Competition

Generally speaking, a free market is a contestable market with free entry. That is, a market where buyers and sellers are free to agree their exchanges without any undue interference on demand and supply.

To understand the importance of free entry let us imagine a remote small island community with a single store. Its population is not enough to sustain two stores and as expected the existing store is a natural monopoly. If one of the inhabitants decides to challenge the incumbent monopolist and opens a new store both will run their stores at a loss until one of them eventually is ruined and gives up.

While the two stores remain competing the islanders benefit from greater supply at a lower price, but once the monopoly is re-established they face reduced supply and higher prices so that the surviving store can recover the losses incurred while competing with the other store. Meanwhile, during the competitive period the two store owners engaged in both fair and unfair tactics to gain or keep market share through better customer service, credit terms, product quality, etc. Some of these sales tactics are considered beneficial while others disrupt the traditional rules of civility and trust in the community. Therefore, the islanders’ ruler received many requests to stop them or to let them fight to the end. Which are his options?

He can uphold the laisser-faire principle of no interference to ensure an absolute right to free entry. Alternatively, he may introduce a licensing system to grant the monopoly on a temporary or permanent basis. Both options could be improved to retain the benefits of competition and minimize its costs. For instance, he could ban unfair sales tactics or he could auction periodically the store license. These two options should be carefully assessed to determine which would be the most efficient in a Pareto sense. That is, which would allow competition to generate greater benefits.

This example is not a simple curiosity in remote societies. Indeed, we find many similar situations in developed countries. For instance, licensing is very common in public transport, pharmacies, funerary services, roads and other infrastructures, healthcare, telecommunications, etc. And, such licensing while often done under the guise of consumer protection is in fact used to regulate or limit competition.

In fact, free markets are only a foundation of capitalism as long as they contribute to enhance fair competition, that is to create competitive markets where prices are established in accordance with supply and demand.

The simplest form of a competitive market is a market without entry barriers and where there are many suppliers and buyers so that all parties are price-takers. But, this is not always required. For instance, Stanley Jevons (1871) one of the founders of the marginal utility theory of value, considered that a market could be made of only two counterparties.

Although one may idealize market structures that create a system of perfect competition, capitalism does not need such a stringent form of competition. Some imperfections or regulations are tolerable or even desirable to achieve what Churchill (1909) called the need for competition upward but not downward (e.g. competition that could drive labor into slavery or tax rates to zero).

Such departures from an idealized world of perfect competition may be more or less extensive depending on the nature of the market, e.g. largest in labor markets than in capital or in goods and services markets. Even among the latest one must distinguish between markets with prohibitive carrying costs (e.g. fish markets) and speculative markets where carrying costs are negligible. The second factor to bear in mind is whether the so-called market failures and divergences between private and social optimization are significant and susceptible of correction without secondary damages.

In modern capitalism the most relevant issue is whether monopolistic and oligopolistic markets still can be considered competitive. For instance, does the fact that the Coca-cola and Pepsico share of the soft drinks market has risen from about 50% in the 1960s to the current level of around 70% means that such market is no longer considered as competitive? Of course not, because there is no entry barriers in such market and in fact there are many small producers competing with these two giant firms. However, if their dominance had been achieved or preserved through licensing or any other form of government favoritism then we should not consider such market as competitive.

Currently, there is a market – the market for corporate control - whose freedom is essential to preserve because of the growing separation between ownership and control. In most big firms the degree of capital dispersion is sufficiently large to facilitate collusion between managers and a small group of shareholders who introduce many obstacles (e.g. poison pills) to prevent others from challenging their power within the firm and to seclude them from hostile takeovers. Moreover, invoking the risk of short-termism and the speculative nature of such markets these groups of insiders often succeed in persuading politicians to enact legislation to obstruct the development of markets for corporate control which are indispensable to protect minority shareholders.

In general, the risk of collusion between sellers is the same whether the oligopolies exist in regulated or non-regulated industries. As Adam Smith reminded us long ago “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. It also common to find businessmen who were enthusiastic free-market supports when they were challenging the incumbents but transform overnight into the most determined protectionists once they join the incumbents.

In fact, this is the reason why capitalists are not always among the main supporters of capitalism and free markets. Only consumers remain always beneficiaries with the greatest interest in free markets. This is the reason why some argue that, if it was not for Marx, capitalism would be better named as consumerism.

However, consumers are frequently too numerous to organize conspiracies or to simply oppose those of the sellers. That is the reason why, in the end, the existence of free competitive markets depends on the rule of law and governments prohibiting or limiting non-competitive practices.

Capitalism and Keynesianism (Left and Right)

Market capitalism is an economic system based on free competition. In theory, it is a system that guarantees automatic market equilibrium and the optimal allocation of resources over the long term. In the short run disequilibrium is a recurrent feature of the system that is permanently corrected through competition.

To put it simply, excessive supply is reduced through diminishing profits and insufficient supply is raised up by entrepreneurs in the lookout for profit opportunities created by such shortages. Unfortunately, this process of automatic adjustment is not instantaneous and in practice market capitalism is naturally bound by cycles in business activity, popularly known as recessions and booms.

Keynesianism is a set of policies advocated by Keynes to smooth such business cycles. Writing in the aftermath of the crisis of 1929, Keynes proposals were aimed at deep and prolonged recessionary phases when the entrepreneurs drive for action, which he termed “animal spirits”, was so depressed that they were unable to restore growth by profiting from the opportunities created by supply destruction.

For these circumstances he advocated a demand shock through monetary and fiscal easing, or just increased government spending for economies caught in a so-called liquidity trap (when interest rates were close to zero). Using a medical analogy, Keynesianism advocates the prescription of hard drugs to treat a severe depression.

It is obvious why his economic stimulus therapy is necessarily controversial. Similarly to hard drugs, more public spending has many negative side effects (most importantly, it may reduce the share of market capitalism in the economy and its competitiveness). Just as doctors may disagree on the severity of a particular depression and the efficacy of soft treatments like exercise and therapy, economists also disagree on the effectiveness of soft supply-side treatments such as more training, deregulation and labour market flexibility to treat severe recessions.

Regrettably, these controversies are inevitably more tainted by ideology in economics than in medicine. So, those more collectivist-driven will see in any mild reduction in economic activity (say a quarterly decline in GDP or a rise in unemployment) a justification for more government intervention. Likewise, when faced with a severe recession (e.g. four or five consecutive quarters of economic contraction), those terrified by the danger of collectivism will repudiate any intervention and ask for more patience to give time for the automatic forces of competition to wake up.

On the collectivist side we often find leftist politicians. And, not surprisingly, Keynesianism is often confused with a left-wing ideology. This is compounded by the fact that some of the most famous Keynesians (e.g. Joan Robison in the past and Paul Krugman today) are influential leftist ideologues.

This is obviously a mistaken perception, because we have many collectivist advocates on the right. Most notably, among them we have the advocates of state and managerial capitalism including many right-wing Corporatists and Christian-democrats.

Indeed, Keynesianism is not about left or right but about wisdom and common sense. That is, economists and politicians should be able to assess in a dispassionate way when to give up on the automatic resumption of growth through the self-correcting mechanisms of competition and to be able to carefully design stimulus packages that do not hypothecate the future of market capitalism.

Common sense must be based on simple benchmarks. For instance, demand-management policies should only be adopted when unemployment exceeds a given range (say, 8% for collectivists and 12% for libertarians). Currently, using such criterion, we need Keynesianism in Southern Europe but not in the rest of the Eurozone. This is obviously a difficult but not impossible task in the context of a monetary union.

To conclude we need Keynesianism as a temporary solution for special circumstances. But we are left without knowing if Keynesianism also can be used in a pre-emptive way to face anticipated external shocks (e.g. a breakup of the Euro Zone). This controversial issue is left for a future post.

Political Parties and Representative Democracy

What do the Norwegian bomber, the London rioters and the Madrid sit-in have in common? All questioned the capacity of the elected representatives to listen to their demands. All used the new media to organize themselves to commit and promote their acts. Politicians and the media have always been blamed for steering the extremism and madness of individuals and mobs. Such events are also invariable followed by repeated calls for regulation of the parties and the media. Let us consider then the case for more party regulation.

It is a well established fact that representative democracy needs to be complemented by constitutional liberalism and an independent judicial system to protect individuals and minorities from unwarranted interference of governments and oppression by the majorities. That is generally considered enough and therefore political parties were usually left to themselves. So, has something changed? Yes and no!

The mainstream parties lost most of their ideological imprint, leaving the confrontation of ideologies for non-parliamentary small parties. There has been also a growing trend towards rotation within a two-party system. Therefore political parties became murky grand coalitions of interests, relying on large secretive organizations fed by an ever increasing number of partisan jobs in government and the regulated industries. Their communication with the electorate is delegated to expensive marketing and public relations groups with enormous resources and privileged access to the mass media, which perpetuates them in a duopolistic position at the expense of the small parties.

The smaller parties (parliamentary and non-parliamentary) occasionally achieve ephemeral visibility but only by taking radical positions on single-issue policies. This is a self-defeating route. It bars them from participating in government or having their views considered by legislators and the public in general. They face a situation similar to that of the small suppliers of large corporations. Likewise they would benefit from a stronger regulation of big political parties to get closer to a leveling playing field in the electoral system.

It is true that technological progress towards internet-based media may give them a new opportunity to challenge the big players. But as the emergence of cheap email brought with it the need for anti-spam programs so will the public ask for protection against a spam of miniscule parties.

Therefore, any increase in regulation needs to address both big and small parties, but it needs to differentiate. For instance, while the public disclosure of membership should be required from both types of parties, rules on the selection of their electoral candidates should apply only to the big parties. Likewise, the same applies to many aspects of the regulation of their financing and access to broadcasting services.

One important area of the regulation of big political parties is the imposition of limits on their campaign spending. This is so because long media-based campaigning periods become absurdly long, and consequently expensive. This gives the incumbent leading parties an unfair competitive advantage. Moreover, it compromises effective public governance and generates “democracy fatigue”.

Yet, although the new realities require a better regulation of political parties, representation in democratic societies is still better protected by restricting it to clearly defined broad political associations like the political parties. Resorting to other types of associations, pursuing specific interests or confessional values, would easily degenerate into broken societies falling either in anarchy or totalitarianism. That is, we need to improve competition between parties rather than search for new players.

Capitalism, What Capitalism?

In most countries wealth is created under various economic systems. An economic system is defined by a set of rules defining the relationship between interacting economic agents. For instance, in a feudal system the relationship between the landlords and their subjects was based on serfdom. Similarly the relation between the state and its citizens is exerted through coercion.

By contrast in voluntary and capitalist sectors the relationships between economic agents are defined freely through contractual arrangements. The first is based on bundling resources, risks and benefits while capitalism is based on unbundling them. In a capitalist system capitalists own the resources and profits but take the risks, while guaranteeing a contractual wage paid to workers. Both systems require the right to private property and its protection but only capitalism requires that most transactions between different agents be carried out through free and competitive markets.

The study of wealth predates the emergence of capitalistic systems but the modern economic science has its foundations in Adam Smith’s book on the Wealth of Nations. His book does not use the words capitalism or capitalist (curiously, the word capitalism had been used since 1633 but it was only popularized in the mid 19th century by the Marxist opponents of capitalism). Instead, the book is centered in showing why competition through competitive markets is the most efficient way of allocating resources and producing wealth. Since the capitalist system is the only system dependent on market competition it follows that, apart from a short experiment with communism, the history of modern economics and capitalism are inextricably intertwined.

Yet, the statisticians who have been developing the system of national accounts since the 1930s have never attempted to report the wealth contributed by each economic system – state, voluntary and capitalist. Instead they give us a breakdown of employment and GDP by sectors of activity and type of organization (e.g. households, government, financial and non-financial firms). Thus, when one wants to measure the contribution of the agents working in the capitalistic sector the task becomes almost impossible.

This is so because the so-called for-profit sector includes many types of capitalism. Moreover, the exchanges between for-profit firms and the other two sectors (state and voluntary) have reached a large volume of transactions which are not always executed on a competitive basis. Often such activities create a sector called grey-capitalism.

The various types of capitalism must be defined on the basis of their reliance on free and competitive markets. The purest form of capitalism is called market capitalism and it includes all self-employed and investor-controlled firms which are basically price-takers trading in free and atomistic markets. Other types of capitalism include the regulated industries, oligopolies, and management-controlled firms that operate under various not-fully-competitive systems, namely: managerial capitalism, crony capitalism, socialist state capitalism, corporatist state capitalism or social market capitalism.

Since economic theory has only proved the supremacy of pure competitive systems, any departures from such systems should be accepted only as a second best option justifiable solely by market failures and externalities. However, in the absence of entirely free markets, competition between the various types of capitalism does not ensure that the winner in terms of market share will be market capitalism. Indeed, quite the opposite may happen.

So, paradoxically, a rising share of market capitalism can only be achieved by regulating the growth of the other not-for-profit and capitalistic sectors. The rationale for such regulation is that the maximum collective welfare can be only achieved by a growing sector of market capitalism. That is, true capitalism ≡ market capitalism!

Subsidy Madness: The New Energy Policy of Germany

Free money is everywhere and every time a sure way to waste money in the most ludicrous ways.

Often this is only pathetic without causing serious damage to the economy. For instance when Brussels pays you to keep your pony paddock or when you no longer need even to pretend to grow olives; you simply have to show that you have title to the land and that you are keeping it in good nick, olives or no olives.

French farmers used to be the champions when it came to exploit the madness of government subsidies, but they are now being surpassed by the German producers of the so-called renewable energy (mostly wind and solar power).

Some years ago Germany established by law a ‘feed-in tariff,’ which obligated private utilities to buy renewable electricity from private producers at prices up to seven times higher than the market price and make their ratepayers pay for it (other countries like Portugal followed with similar measures). Some years after the German government imposed a moratorium on building nuclear power plants (one of the cheapest producers of electricity, see the table below) and ordered the existing ones – which produced 25 percent of the country’s electricity – decommissioned by the year 2021. The annual cost of this madness costs German taxpayers more than 17 billion Euros, this is an amount equivalent to more than 10% of the entire European Union annual budget).

To understand why this is economic madness you just need to consider this example. Imagine that a firm has two power plants, one powered by wind and the other by oil. The first has fixed costs of 40 cents per Kwh and zero variable costs. The second has 10 cents in fixed costs and 5 cents in variable costs. In a free market firms would build a second fuel-powered plant and decommission the wind-powered plant. But this not so as long as the government pays them a subsidy or lets them charge a tariff high enough to make the wind-power profitable. Now the firm’s optimal mix in terms of the two technologies will depend on the vagaries of the government policy not on the economics of the most efficient technology.

Unfortunately the madness of this policy is not an exclusive of the rich Germans. The debt-laden Portuguese responded to the recent rise in imported energy prices by switching to a similar energy policy and they have even overtaken Germany. Portugal now gets 53% of its electricity from renewable sources. The bad news is that it costs them 3 or 4 times more than conventional sources (at their current high level). Not a rational move, is it?

Grow or Fail!?

The FT published recently some comments by James Murdoch claiming that News Corporation – the world’s largest media conglomerate – is not big enough. The reason, he argues, is that “When you actually look at the competitive set in an all-media market place, where you have monolithic brands, from Google and Apple etc, to the big [telecoms incumbents] Telefónica, Deutsche Telekom, Verizon – all the characters on a playing field or a terrain that has essentially collapsed – there are much, much bigger beasts than a News Corporation, or a Time Warner”.

So, he means that because the whole media sector (from production to distribution) is going through a technological revolution we are in for a “winner-takes-all competition”. I do not think so!

Interestingly enough the founders of News Corp, Google and Apple still control their companies and are not considered as part of the managerial capitalism sector, which thrives on rent-seeking behavior secured through oligopoly and regulatory protection. So, he is probably just voicing the usual kids whine about “that boys’ toy is bigger than mine” so dear to CEOs of managerial controlled firms.

There is however a case to consider whether the new technologies are promoting a mitigated from of winner-takes-all, the so called long-tail business model. In this model (with a long history in music and book publishing) the top sellers take about 80/90% of the total revenue while the remaining millions of producers have to fight for the residual 10/20% of revenues.

Whether this will be exacerbated or attenuated will depend not only on technology but also on the profit maximization choices of the leading companies. Should those “running the pipes” and the viewing devices – the telecoms and IT companies (e.g. Verizon and Apple) – be allowed to build oligopolistic positions based on competition for subscribers by offering “”all-you-can-eat” contents and devices for free, and then some producers and content aggregators (e.g. News Corp) would become almost entirely dependent on an oligopolistic advertising aggregator (e.g. Google). Under this scenario, it is not unreasonable to expect that content aggregators would also need to build oligopolistic positions.

Thus the fundamental question is whether atomized content producers and end-consumers would be well served by a supply chain (from aggregators to device manufacturers) that would be mostly oligopolistic. I do not think that they would benefit from such an end-game. Here is where economists and regulators should focus their attention. Our first impression is that some size limits should be considered before we get into “too big to fail” situations, regardless of whether they are managerial or entrepreneurial run firms.

These limits should be designed in a way similar to those that we advocate for the managerial sector in general. Not based on some old fashioned ideas like the percentages of ownership and national content.

Only a leading sector of market capitalism can protect the entire capitalist system as one of the main pillars of happiness for humankind.

The dangerous rise of managerial capitalism

In yesterday’s post we argued for limits on the rise of corporate wealth in the managerial capitalist sector. Concentration of wealth comes together with concentration of assets which necessarily reduces the scope for competitive market transactions.

Since then we collected the following data which gives us an overview of the size of the sector in a selected number of countries, as measured by the percentage of assets controlled by the largest one percent of all companies.

The data used excludes insurance, securities and banking firms because the assets held by these are mostly cash or securities issued by non-financial corporate. It probably over-estimates the size of the managerial sector because it is based only on listed public companies and the listing in individual countries may differ. This is partly offset by the fact that the number of management-controlled firms is usually more than just the top 1%.

Nevertheless the figures are sufficiently expressive to show that the virus of managerial capitalism is more widespread than we had thought. Even in countries closer to a system of market capitalism, such as Hong Kong and Singapore the top 1% of firms controls more than 22% of total assets.

Also interesting is the fact that among the countries where the problem is more serious we have three different regimes of capitalism. The most problematic situation occurs in the Mediterranean countries (Greece, Slovenia, Italy, Spain and Portugal) with a regime of state capitalism inherited from dictatorial regimes. Surprisingly this group is followed by the UK, a country traditionally identified with the so-called Anglo-Saxon liberalism. Next, comes China a country with a non-democratic regime of socialist state capitalism.

When we take together the shares of total assets (32%) and the share of regulated industries in the USA (25%, in defense, energy, utilities and telecoms) it turns out that here the threat of managerial capitalism is not as serious as we had anticipated. This seems to contradict other factors pointing in such direction, namely the obscene rise in CEO pay which now is over 300 times that of the average worker. So we may take this result with some reserve before we investigate further the impact that the size of the market has in these indicators.

Finally, another surprising case is Germany. We often identify the German style of capitalism as very socially-responsive, but it turns out that it is closer to market capitalism than we could imagine.

In conclusion, we may say that the danger posed by managerial capitalism is a global phenomenon. Moreover, its strong presence in regulated industries demands that we understand better the triangle between government – financiers – and managerial-controlled corporate. Only then can we understand how they constrain the move towards dominant market capitalism.