Fundmastery Blog

Kurt Brouwer March 13th, 2008

Paul Krugman, a professor of economics at Princeton, is probably best-known as a columnist for the New York Times on both political and economic topics. He wrote this piece when he was at the Massachusetts Institute of Technology and it was published by one of Japan’s leading economic newspapers. In this excerpt, he ruminates on the failure of socialist economics [emphasis added]:

CAPITALISM’S MYSTERIOUS TRIUMPH (Nihon Keizai Shimbun, 1997, Paul Krugman)

…[N]either technological change nor globalization can explain the fact that socialist economies did not merely lag the West: they actually went into decline, and then collapse. Why couldn’t they at least hold on to what they had?I don’t think anyone really knows the answer, but let me make a conjecture: the basic problem was not technical, but moral. Communism failed as an economic system because people stopped believing in it, not the other way around.

A market system, of course, works whether people believe in it or not. You may dislike capitalism, even feel that as a system it will eventually fail, yet do your job well because your family needs the money you earn. Capitalism can run, even flourish, in a society of selfish cynics. But a non-market economy cannot. The personal incentives for workers to do their jobs well, for managers to make good decisions, are simply too weak. In the later years of the Soviet Union, workers knew that they would be paid regardless of how hard they tried; managers knew that promotions would depend more on political connections than on performance; and nobody was offered rewards large enough to justify taking unpopular positions or any sort of serious risk. (There can’t have been more than a few dozen people in the Soviet Union – all of them politicians – who had the kind of lavish life style enjoyed by tens of thousands of successful entrepreneurs and executives in the United States). So why did the system ever work? Because people believed in it. I don’t mean that people went singing to their jobs, praising the motherland. I do mean that they did not take as much advantage of the system as they might have (and did, in the system’s later years). And I also mean that because people in authority believed in the system, they were willing to impose brutal punishments on those who did try to take advantage. (Stalin used to shoot unsuccessful generals).

We see this kind of thing all the time, in microcosm. The market does not require people to believe in it; but the centrally planned economies that live inside a market economy, known as corporations, do. Everybody knows that financial incentives alone are not enough to make a company succeed; it must also build morale, a sense of mission, which makes people work at least somewhat for the good of the company rather than think only of what is good for them. Luckily, under capitalism an individual company can fail without taking the whole society down with it – or it can be reformed without a bloody revolution.

This aspect of capitalism that Professor Krugman identified is absolutely critical. Companies must be allowed to fail if they no longer can operate profitably producing a product or service that customers want and can afford. Joseph Schumpeter, the Austrian economist, called this the ‘creative destruction of capitalism.’

In this current environment, it is valuable for the Federal Reserve to restore liquidity and order to the financial system, but it is also imperative that companies be allowed to fail. This is a rough discipline that ‘wonderfully concentrates’ the minds of the owners of all companies.

Why did people stop believing in socialism? Part of the answer is simply the passage of time: you can’t expect revolutionary fervor to last for 70 years. But perhaps also the unexpected resurgence of capitalism played a role. By the 1980s Russia’s elite was all too aware that the country, instead of overtaking the capitalist nations, was slipping behind – that Russia was failing to take advantage of new technology, that if anyone was challenging the West it was the rising nations of Asia. Communism lost any claim to the mandate of history well before it actually fell apart, and perhaps that is why it fell apart.

In the end, then, capitalism triumphed because it is a system that is robust to cynicism, that assumes that each man is out for himself. For much of the past century and a half men have dreamed of something better, of an economy that drew on man’s better nature. But dreams, it turns out, can’t keep a system going over the long term; selfishness can.

In the last sentence, I think the good professor chose the wrong word. Capitalism does not succeed due to selfishness, but due to its understanding that men and women concentrate on their own self interest. He should have said, self interest, not selfishness.

When we try to get the best deal on a car (or a computer or a home), we are acting in our self interest. However, the car dealer is acting in his or her own self interest. If we do not like what that dealer is offering, we are free to go elsewhere. If a buyer tries to strike too good a deal, the dealer is free to say no. We are free to choose with whom we do business.

In a similar way, when we consider taking a job, we seek our own best self interest as does our prospective employer. These opposing forces help both parties get closer to what they want. In our history, there have been times when one party (employers or employees / buyers or sellers) had the upper hand. In those cases, they system did not work well. However, this system, though often messy and chaotic, is far more likely to achieve both the self interest of the buyer and the seller than any other economic system that has been created.

Fortunately, in the years since this piece was written, the world has moved towards a more capitalistic and more free market system. These words of Professor Krugman were true back in 1997 and they are true today. It is unfortunate that some countries still fall prey to the blandishments of those selling socialism. Yet, even in those countries, people still seek their own self interest. Eventually, the socialist system will fail and be succeeded by a more successful one –capitalism and the free market.

Update: For those who are not familiar with Joseph Schumpeter and his view of creative destruction, here is an excerpt from his book, Capitalism, Socialism and Democracy (New York: Harper, 1975), on this topic [emphasis added]:

“…This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. . . .

Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull…

…But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance)–competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives…”

As an example of Schumpeter’s theory consider the personal computer industry over the past 25 years. It was begun by entrepreneurs and hobbyists tinkering in their basements or garages. Eventually, larger companies got in the business, but many of them failed in their effort to make and market personal computers profitably. Yet, despite all the disarray and corporate destruction, we have access to personal computers today that are much better and cheaper than ever.

Via: BrothersJuddBlog

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