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What Is Capitalism?
"Free-market capitalism is a network of free and voluntary exchanges in which producers work, produce, and exchange their products for the products of others through prices voluntarily arrived at." —Murray N. Rothbard, “Capitalism versus Statism” (1972)
"Capitalism is a social system based on the recognition of individual rights, including property rights, in which all property is privately owned." —Ayn Rand, Capitalism: The Unknown Ideal (1962)
So how has the United States gotten so far from true capitalism? How have so many pernicious myths about capitalism come to be so prevalent?
The answer is that too many Americans are ignorant of how capitalism really works—though with some of the most ardent anticapitalists, the ignorance is willful. To counter such ignorance, it is useful to return to the first great treatise on capitalism, Adam Smith’s The Wealth of Nations, published in 1776, the same year the American colonies declared their independence from Britain. Smith described the basic workings of capitalism succinctly:
In civilized society [man] stands at all times in need of the co- operation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons. . . . Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, brewer, or the baker, that we expect our dinner, but from their regard to their own interest. . . . Nobody but a beggar chuses to depend chiefly upon the benevolence of his fellow citizens.
Here Smith clearly explained some of the most important elements of capitalism—the division of labor, social cooperation, and free exchange. The division of labor is a natural, and beneficial, consequence of the fact that each human being is unique in a thousand different ways—in motivation, intelligence, interests, physical attributes and abilities, preferences, goals, skill levels, age, formal and informal education, worldly experiences, family history and culture, psychology, and much more. So, for example, people who happen to live in a fertile part of the world are more inclined to specialize in farming than, say, people who live in the arid Middle East. But because of this specialization, we rely daily on thousands of people whom we don’t even know for the basic necessities of life. This breeds social cooperation. The farmer in the American Midwest can sell food to Middle Easterners and use some of the money he earns from that to purchase, for instance, petroleum products that are generated in the Middle East. Imagine how poor we would all be if we were to live under what is called economic autarky—where we all had to grow our own food, build our own houses, make our own clothing, manufacture and fuel our own cars, and so on.
Free exchange allows us to avoid the economic desperation of autarky. It also provides powerful incentives to continue educating ourselves and improving our skills so we can provide our fellow man with better and better (and less expensive) goods and services in return for money. This notion of serving one’s fellow man is central to any capitalist economy. In fact, the economist and syndicated columnist Walter Williams refers to dollars (and other currencies) as “certificates of performance,” for one can only earn money by providing one’s fellow man with a good or service that he values more than the money he pays for it.
Nevertheless, as Smith observed, capitalism does not operate on the principle of altruism or “benevolence”; a basic fact of human nature is that we all have an instinct for self-preservation and personal advancement. Capitalism succeeds precisely because free exchange is mutually advantageous; each party serves his own self-interest, or what Smith called “self-love.” Cattle ranchers in Montana, for instance, rise at 4 a.m. and work until well after dark at a number of physically demanding jobs not out of love for their fellow man but because they want to earn a living for themselves and their families. Yet the marvelous advantage of capitalism is that it captures this motivation and channels it in a way that encourages human cooperation and betterment.
In a capitalist economy the primary means (the only means, for most people) of improving one’s standard of living is, in Adam Smith’s formulation, giving others that which they want. Indeed, most exceptionally wealthy people amassed their fortunes precisely because they provided valued products to millions of people all around the world. This is what Bill Gates did with Microsoft and what Henry Ford, Andrew Carnegie, and many other well-known industrialists did before him. The clothing industry, the grocery industry, mechanized agriculture, and many other industries have created multimillionaires or billionaires because these individuals have vastly improved the standard of living of the masses. A common myth spread by anticapitalists is that the wealthiest capitalists profit at the expense of the rest of the society, particularly the working classes. But it is amazing to consider the innovations and improvements that entrepreneurs have brought to everyone. As the Austrian economist Ludwig von Mises wrote, “Every advance first comes into being as the luxury of a few rich people, only to become, after a time, the indispensable necessity taken for granted by everyone. Luxury consumption provides industry with the stimulus to discover and introduce new things.” Indeed, the most successful capitalists have brought to the masses products and services that were once considered luxuries available only to the rich. The result is that the average American working person today lives better in many ways than kings did several hundred years ago, with his automobiles, central heating and air conditioning, swimming pools and hot tubs, inexpensive food, and all the other “necessities” of modern life that those kings would have considered miracles. All of this is the product of capitalism. The economist Joseph Schumpeter summed up how capitalism benefits the masses:
The capitalist engine is first and last an engine of mass production which unavoidably also means production for the masses. . . . It is the cheap cloth, the cheap cotton and rayon fabric, boots, motorcars and so on that are the typical achievements of capitalist production, and not as a rule improvements that would mean much to the rich man. Queen Elizabeth owned silk stockings. The capitalist achievement does not typically consist in providing more silk stockings for queens but in bringing them within reach of factory girls.
These are the facts that the neo-Marxist propagandists ignore when bashing capitalism as a zero-sum game in which “somebody wins, somebody loses.”
We all observe corporate executives, bankers, and businesspeople in general managing the day-to-day affairs of business, from the smallest dry cleaner to the largest multinational corporation. This has led many to believe that they—the public—have no say in their economy, which is largely in the hands of these “plutocrats.” But this is a myth, for as Mises pointed out:
Neither the entrepreneurs nor the farmers nor the capitalists determine what has to be produced. The consumers do that. If a businessman does not strictly obey the orders of the public as they are conveyed to him by the structure of market prices, he suffers losses, he goes bankrupt. . . . Other men who did better in satisfying the demand of the consumers replace him. . . . The consumers . . . make poor people rich and rich people poor. They determine precisely what should be produced, in what quality, and in what qualities. They are merciless egoistic bosses, full of whims and fancies, changeable and unpredict- able. . . . They do not care a whit for past merit and vested inter- ests. . . . In their capacities as buyers and consumers they are hard hearted and callous, without consideration for other people.
Every business depends on repeat sales, and for this reason the consumer really is the captain of the economic ship, as Mises called it. True, some businesses treat consumers poorly, but such behavior is always harshly penalized (by consumers) with lower profits or bankruptcy. Meanwhile, the opposite kind of behavior is rewarded. This goes not only for businesses that deal directly with consumers but for all of their suppliers and workers as well. The demand for labor on the part of businesses, for example, is said to be a “derived demand” in that it is derived from the consumer demand for the product. Thus, if consumers prefer more Bibles and less booze, fewer workers will be manufacturing booze and more will be publishing Bibles. This is why it is ultimately the consumers who pay everyone’s wages in a capitalist economy. People who acquire skills producing goods and services for which there is stronger consumer demand will, all other things being equal, be paid more than those who work in industries in which consumer demand is weaker.
In this sense consumers are “voting” with their dollars. Consumer sovereignty under capitalism is truly a form of economic democracy. But it is much more efficient than political democracy. In political democracies the majority rules and the minority can be largely ignored. In an “economic democracy” everyone’s dollar vote counts the same. That is why, for example, businesses compete fiercely for niche markets with relatively small pockets of customers.
The Central Importance of Property Rights
As the quotation of Ayn Rand at the beginning of this chapter denotes, private property is the most important distinguishing feature of capitalism. The only alternative is communal or governmental ownership—that is, socialism. And socialism is economic poison wherever it is implemented.6 Private ownership of the means of production is the only way to ensure a workable system of human cooperation and division of labor.
The American founding fathers were students of the British philosopher John Locke, whose famous Second Treatise of Government proclaimed that individuals are willing to join in society with others, and form governments, primarily for the mutual preservation of their “lives, liberties, and estates [that is, property].” This was the major function of government, as Locke saw it, and America’s founders agreed. Protection of private property at the very least will minimize political conflict, for the political allocation of resources (as opposed to the market allocation that occurs under capitalism) is primarily legal plunder—one coalition or group uses the power of the state to take from another group. Modern governments actually spend relatively little on programs and systems that benefit all citizens, such as national defense or the judicial system; mainly they are concerned with infringing on the property rights of one (less politically powerful) group of citizens for the benefit of another (more politically powerful) group.
The benefits of private property to a capitalist economy are crucial. In a system with private property, individuals are free to choose different occupations, consumption patterns, or lifestyles as long as they don’t interfere with the freedom of others to do the same. This establishes the supremacy of consumer sovereignty: people are free to choose their occupations, but subject to the demands of consumers.
Private property under capitalism also creates a wide dispersal of economic power. No matter how wealthy any one person becomes, his power is severely limited by the fact that he is just one of millions of property owners. Even Bill Gates is constantly pressured to reinvest his wealth in a way that will please consumers—if he wants to hold on to it. Ludwig von Mises explained:
Private property creates for the individual a sphere in which he is free of the state. It sets limits to the operation of the authoritarian will. It allows other forces to arise side by side with and in opposition to political power. It thus becomes the basis of all those activities that are free from violent interference on the part of the state. It is the soil in which the seeds of freedom are nurtured and in which the autonomy of the individual and ultimately all intellectual and material progress are rooted.
Private property also provides powerful incentives for wise stewardship of property. Property owners who do not take good care of their property bear the full cost of their actions when their property—that is, their wealth—depreciates in value. The opposite is also true: those who take care of and improve their property reap the rewards when their property value goes up. This is why private homes are so much better maintained than government housing projects, for example, or why private lakes and streams are carefully maintained while government-owned ones are often overfished and overused, or why private forests that are harvested are often replanted with trees that mature in twenty-five years while public forests are not.
With well-enforced property rights people have the ability to sell goods and services to others as a means of improving their own standard of living. Consequently, secure property rights (minimal or nonexistent levels of governmental confiscation through taxation, for example) create incentives to develop greater skills and abilities to produce goods and services for others and to profit from that. And because they create the ability to profit from one’s own productive endeavors, property rights are the keystone of modern capitalism and of civilization itself. (That’s why Marx and Engels wrote in big capital letters in The Communist Manifesto that a prerequisite for socialism was abolition of private property.)
Another reason private property is essential to a well-functioning capitalist economy is that any such economy is extraordinarily vast and complex. No individual or central planning authority could possibly have command of all the information necessary to keeping a complex economy working smoothly and efficiently.
One of the more famous demonstrations of the complexities of an economic system came in an essay about what goes into making a seemingly simple product: a pencil. In “I, Pencil,” Leonard Read, the founder of the Foundation of Economic Education in Irvington, New York, discussed the many materials necessary to produce a pencil: wood, metal, zinc, rubber, paint, and dozens of other things.8 But that is just the beginning, for there is an entire industry to produce each of those materials—a lumber industry to get the wood, a mining industry to get the zinc, and so on. Moreover, engineering and tool-making businesses are required to supply all of those indus- tries. Finally, neither the pencils themselves nor the various elements needed to manufacture pencils could be transported without the oil and shipping industries.
All told, making the most simple of objects, a pencil, involves thousands of people who possess very detailed knowledge and information about their day-to-day jobs, whether they are in the lumber industry, the rubber industry, or elsewhere. And these people come from all over the world. No central planner or “pencil czar”—even with access to the most powerful computer imaginable—could possibly possess and utilize all the detailed and constantly changing information that goes into making pencils. And yet we still have our pencils. How? Because of private property and the free-market capitalism it enables. Under a free-market system, all of these thousands of people, very few of whom actually know each other, have an economic incentive to cooperate with each other under a division of labor and produce pencils. There’s no magic or invisible hand involved. It is the common sense of everyday life under capitalism. As long as there is a consumer demand for pencils—and thus the potential for profit—people will cooperate with others to figure out a way to produce and market pencils. Consumers get the pencils they want, and the people who produce them improve the standard of living for themselves and their families. Property rights and the capitalist system make all of this possible.
The more complex an economy becomes, the more essential it is to rely on free-market capitalism. Indeed, Leonard Read’s pencil example emphasizes just how misguided government planning of the economy is: no group of experts could possibly possess the knowledge required to produce a simple pencil, let alone “plan” an entire economy. The delusion that a single person or group of government planners could possibly possess such information and manage an entire economy is what Nobel laureate economist Friedrich Hayek called the “pretense of knowledge” or the “fatal conceit.”9Central planning inevitably leads to economic chaos.
Private property and capitalism also provide strong incentives to preserve resources for the future, whereas political resource al- location under democracy tends toward immediate gratification. Whenever the present value of using a resource in the future is larger than the value of current use, that resource will be preserved. For example, tree farmers often replant their land with trees that will not mature for thirty to fifty years, long after the farmers are retired or dead. They do this because, as long as property is transferable, such plantings will enhance the value of their land. When one of these farmers sells his land, he can get a higher price for it and capture the value of his investment; the buyer, meanwhile, benefits from being able to harvest the trees in the future.
It is in this way that free-market capitalism has a conservation ethic. After all, elementary economics teaches that a business can maximize profits by minimizing costs, and the way for any business to minimize costs is to use as few resources as possible in producing its goods or services—to conserve, in other words. Corporations spend large amounts of money on research and development trying to figure out ways to increase their profits by using fewer resources. Coca-Cola, for example, uses considerably less aluminum in its cans than it did several decades ago. Coca-Cola did this not because it became more environmentally sensitive but because it wanted to increase its profits.