What’s the case for capitalism?

People often assert that socialism doesn’t work, or at least that capitalism is superior. Yet they seldom provide evidence for that claim. How do we know it’s true? If you know some economics, you can probably list some theoretical reasons why it could be true. Or perhaps you’ve read first-hand accounts of life under communism, and consider the question settled. But what empirical or historical evidence would you point to if someone asked you to make the case for capitalism relative to other systems of economic management?

I recently happened upon two attempts to answer this question, one from the excellent new intro econ textbook The Economy, and the other from some of the essays in the fantastic Cambridge History of Capitalism Volume 2.

The treatment in the textbook looks at East vs. West Germany:

The division of Germany at the end of the Second World War into two separate economic systems—centrally planned in the east, capitalist in the west—provided a natural experiment… The East German Communist Party forecast in 1958 that material wellbeing would exceed the level of West Germany by 1961. The failure of this prediction was one of the reasons the Berlin Wall separating East from West Germany was built in 1961. By the time the Berlin Wall fell in 1989, and East Germany abandoned central planning, its GDP per capita was less than half of that of capitalist West Germany…

Unlike some capitalist economies that had even lower per capita incomes in 1950, East Germany’s planned economy did not catch up to the world leaders, which included West Germany. By 1989, the Japanese economy (which had also suffered war damage) had, with its own particular combination of private property, markets, and firms, along with a strong government coordinating role, caught up to West Germany, and Spain had closed part of the gap.

We cannot conclude from the German natural experiment that capitalism always promotes rapid economic growth while central planning is a recipe for relative stagnation. Instead what we can infer is more limited: during the second half of the twentieth century, the divergence of economic institutions mattered for the livelihoods of the German people.

That’s a good start, and one of the nice things about The Economy is that it includes a lot of economic history relative to other introductory texts. But what about the overall record of capitalism? And what about in terms of human welfare, rather than just economic growth?

In an essay titled “Capitalism and human welfare” in the Cambridge History of Capitalism Volume II, Leandro Prados de la Escosura tackles this question, using a measure of human welfare combining economic growth (adjusted for inequality), life expectancy, and educational attainment. After providing and considering the data, he writes:

How do the capitalist and socialist systems compare? It has been frequently argued that it is at low levels of economic development when socialist societies have an advantage over capitalist ones in lifting human well-being and, in particular, its non-income dimensions. A glance at the former Soviet Union shows that substantial gains in human development were obtained between the 1920s and the 1960s, which resulted in an impressive catching-up to the OECD. Since the mid-1960s, however, this progress gave way to stagnation… A preliminary evaluation suggests that, but for Russia during the central decades of the twentieth century and Cuba, socialism has not delivered higher human development for developing countries than capitalism… The results presented in this chapter suggest that, despite its initial success as provider of ‘basic needs’, socialist experiences failed to sustain the momentum and, but for Cuba, stagnated and fell behind before the demise of communism. Furthermore, its suppression of agency and freedom prevented real achievements in human development.

Another essay in the same volume provides some detail, context, and theory to support the conclusion above. The essay is titled “Modern capitalism: enthusiasts, opponents, and reformers” by Jeffry Frieden and Ronald Rogowski. They write:

The centrally planned economies achieved rapid growth in the twenty years after World War II, as they drew underutilized resources into production. But Soviet-style planning had many limitations. As was true of the import-substituting economies, the Soviet bloc found that it increasingly needed imports — not only of food, but of technology and precision parts — that it lacked the hard currency to buy. Collectivized agriculture proved massively inefficient, forcing the formerly grain-exporting USSR to expend scarce foreign currency, year after year, on imported cereals. Recurrent campaigns to increase manufactured exports, particularly from the bloc’s most advanced economies (e.g., East Germany), brought little success. Only the bloc’s raw materials and a few artisanal products found ready purchasers in the West. The absence of incentives gave workers and managers little need to monitor quality, or to innovate either in the production process or with new products. Over time, the industrial plant fell farther and farther behind the technological and quality criteria prevailing in the West, and by the 1980s growth had slowed dramatically. With Western Europe within easy reach of people in the Soviet bloc’s central and eastern European nations, it was easy for citizens to see the relative failure of the system.

Together, it seems reasonable to conclude that the conventional wisdom is roughly accurate. But each source provides reasons for humility. The success of capitalism over socialism may be apparent, broadly and in aggregate. But the historical record contains various partial exceptions. We ought to be cautious about overly sweeping generalizations.

For one thing, the chapter mentioned above on capitalism and human welfare provides an important reminder that the victory of “capitalism” is really a victory for the mixed economy. The author documents “a positive non-linear association between the expansion of social protection and the improvement in human development… Small changes in social transfers are associated with large increases in human development. Then, as we move to the right, we observe that increases in social transfers are associated with smaller, but still positive, increases in human development. As social transfers reach 25 percent of GDP the curve tends to flatten, suggesting a reversal for levels above 30 percent.”

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But does social spending actually cause improvements in human welfare? Or is it merely correlation? The answer comes from yet another essay in the volume, “Private welfare and the welfare state” by Peter H. Lindert. Yes, he says, at least historically:

The modern rise of public social spending probably brought considerable gains in efficiency, GDP, and the larger concepts of human welfare quantified in Chapter 15 in this volume by Leandro Prados de la Escosura. These investments in humans were blocked for millennia by weak and rapacious governments, and by a concentration of political power that rejected universal public schooling, family assistance, and public health insurance…

Yet since about the 1960s, the expansion of public social programs has probably stopped reaping efficiency gains, due to what journalists would call ‘mission creep.’ Several countries, most notably Japan, the United States, Italy, and Greece, have drifted away from their original mission of investing in the young, while at the same time maintaining intergenerational transfers in favor of the elderly. This drift did not bring any obvious net loss of GDP in the late twentieth century, but further population aging in the twenty-first will force reforms that hold support for the elderly within sustainable steady-state limits.

To summarize, then: We can be reasonably confident that capitalism is broadly superior to socialism and state planning, with the caveat that by capitalism we mean a mix of free but regulated markets and a significant welfare state. The historical evidence strongly suggests that social transfers improve human welfare. And some of those transfers — specifically transfers to the young — also improve economic efficiency and spur economic growth.

The linear regression economy

This is a point I meant to blog about, but a new piece from Tech Review led me to more or less sum it up in tweets:

A related point: models are not the constraint for most data science projects. My thinking in all of this is informed by Kalyan Veeramachaneni of MIT, who’s written about some of these issues here.

Amazon, Sears, and market power

Derek Thompson has a nice piece at The Atlantic about the uncanny similarities between Amazon and Sears (a point Benedict Evans has also made):

It’s remarkable how Sears’s rise anticipates Amazon’s. The growth of both companies was the result of a focus on operations efficiency, low prices, and a keen eye on the future of American demographics.

Might this comparison say anything about recent concerns over Amazon’s market power?

Well, you might think the story of Sears illustrates the problems of market power — a big company extends its tentacles, competing with much smaller ones, and controls an extremely large part of the market for lots of different stuff.

But here’s Robert Gordon on what Sears replaced:

In the America of 1870, local merchants had local monopolies, and their customers had little ability to compare prices. Thus there was constant tension between the rural customers and the merchants, for there were few guidelines for judging whether a price was fair… In this environment, we can understand why mail-order catalogs were such a salvation for rural customers.

The Sears story, then, is about the creation of a big, powerful company that, yes, probably gained all sorts of market power via its scale. But it replaced lots of little geographic monopolies — small firms that each had substantial market power and used it to extract rents from customers. The change wasn’t about moving from a competitive environment to a less competitive one. It was about changing from one form of imperfect competition to another one.

Could something similar be true of Amazon? Who knows — all this is speculative at best. But the Sears comparison clearly helps understand Amazon in other ways, so perhaps it’s at least worth thinking about.

Can you trust your feelings?

A few paragraphs from Robert Wright’s new book Why Buddhism is True.

  1. Our feelings weren’t designed to depict reality accurately even in our “natural” environment. Feelings were designed to get the genes of our hunter-gatherer ancestors into the next generation. If that meant deluding our ancestors — making them so fearful that they “see” a snake that isn’t actually there, say — so be it. This class of illusions, “natural” illusions, helps explain a lot of distortions in our apprehension of the world, especially the social world: warped ideas about ourselves, about our friends, our kin, our enemies, our casual acquaintances, even strangers. (Which about covers it, right?)
  2. The fact that we’re not living in a “natural” environment makes our feelings even less reliable guides to reality. Feelings that are designed to create illusions, such as seeing a snake that isn’t there, may at least have the virtue of increasing the organism’s prospects of surviving and reproducing. But the modern environment can take various kinds of feelings that served our ancestors in this Darwinian sense and render them counterproductive in the same sense — they may actually lower a person’s life expectancy. Violent rage and the yearnings of a sweet tooth are good examples. These feelings were once “true” at least in the pragmatic sense of guiding the organism toward behaviors that were in some sense good for it. But now they’re likely to mislead.
  3. Underlying it all is the happiness delusion. As the Buddha emphasized, our ongoing attempts to feel better tend to involve an overestimation of how long “better” is going to last. What’s more, when “better” ends, it can be followed by “worse” — an unsettled feeling, a thirst for more. Long before psychologists were describing the hedonic treadmill, the Buddha saw it.

I’m enjoying the book so far. Here’s The New Yorker on it, and The New York Times — one, two —  and here’s a piece Wright wrote about meditation for The Atlantic almost five years ago.

The arc of the social universe is long, however it bends

Technology can be used for good or ill, but over the course of human history it’s clearly been a source of major progress. (If you’re not convinced, Robert Gordon’s book is one of my favorites to make the case.) But even if technology ultimately contributes to progress, it can cause a lot of harm along the way. I’ve just happened across a couple of reminders of that lately, and so wanted to put them (along with some others) together.

John Lanchester writing about the transition to agriculture in The New Yorker:

So why did our ancestors switch from this complex web of food supplies to the concentrated production of single crops? We don’t know, although  Scott speculates that climatic stress may have been involved. Two things, however, are clear. The first is that, for thousands of years, the agricultural revolution was, for most of the people living through it, a disaster. The fossil record shows that life for agriculturalists was harder than it had been for hunter-gatherers…Jared Diamond called the Neolithic Revolution ‘the worst mistake in human history.’ The startling thing about this claim is that, among historians of the era, it isn’t very controversial.

And here is Leandro Prados de la Escosura, writing in the Cambridge History of Captialism Volume II. The chapter is on capitalism and human welfare:

Trends in human development do not match closely those observed in real GDP per head. More specifically, phases of economic globalization have a dramatic impact on per capita income growth but not on the progress of human development. A counterintuitive lack of association is observed between human development and per capita income prior to World War I. Although the initial large-scale progress in health can be traced back to the late nineteenth century, with the diffusion of the germ theory of disease, and primary education experienced a significant advance in the era of liberal capitalism, the progress in human development dimensions fell short on the economic advancement resulting from globalization and industrialization. The negative impact of urbanization on life expectancy and the lack of public policies on education and health may account for human development’s slower progress in the late nineteenth century. More significantly, while real GDP per head stagnated or declined during the globalization backlash of the interwar years, human development progressed steadily. Health and education practices became increasingly globalized during the economic backlash of the period 1914 to 1950. Could a delayed impact of economic globalization on human development be, perhaps, hypothesized? Since 1950, advancement in human development has been hand in hand with growth in the world economy, although at a lower pace during the Golden Age (1950-1973) and, again, since 2000.

The bit on urbanization echoes Robert Gordon’s account, in The Rise and Fall of American Growth, that America’s shift toward cities in the 19th century “brought with it a host of public health problems.” From our vantage today, urbanization looks like a good and necessary thing. But for many if not most people, things got worse before they got better.

The last thing I’ll add here is James Bessen’s book Learning by Doing, which looks at the wages of weavers during and after the Industrial Revolution. His thesis:

Workers can benefit by acquiring the knowledge and skills necessary to implement rapidly evolving technologies; unfortunately, this can take years, even decades.

These examples are worth bearing in mind when we think about human progress in relation to things like globalization and technology today. Arguably, many ‘elites’ are waking up to the fact that they ignored the possibility that the benefits from economic changes that seemed likely to be net positive (trade with China, the adoption of IT) would cause dislocations measured not in months but in decades. But the historical record suggests that these painful lags are the rule rather than the exception. The discovery of agriculture was net positive, as were urbanization, the industrial revolution, and global trade. But every one of them came with massive suffering, experienced over long periods of time. The answer isn’t to be complacent and wait it out. It’s to undertake the necessary actions to lessen this suffering. To make the investments in public health that improved urban life; to erase the lag between the financial benefits of globalization and the benefits to overall well-being.

Nowhere is this more important today than with technology. Overall, technology has been a force for good. I think it can continue to be. But if we are not vigilant — if we do not pay attention to the harms that it causes, and do not prioritize investments to deal with them — then it will cause a lot of suffering along the way.

What is financial innovation?

Emphasis mine:

Whatever the cause or focus of financial innovation, it involved four basic forms, namely product, market, organization, and regulation. Product innovation was the design of a financial instrument to meet a specific need. Market innovation was the creation of a trading system through which these financial products could be bought and sold. Organizational innovation involved the grouping of separate financial activities together in such a way as to be greater than the sum of their parts. Regulatory innovation was a response to the need to reduce the risks involved and so increase the use made of the product, market, or organization.

That’s from the financial capitalism chapter in the Cambridge History of Capitalism, Volume II. The author is Ranald Michie. That last line is worth keeping in mind during the continued debates over how we regulate the financial system.

Nobel Prize-winning psychologist Dan Kahneman: AI will surpass humans in emotional intelligence

Some economists with whom I work hosted a conference on the economics of AI in Toronto last week, and while I couldn’t attend, some of the videos are online. And Brad Delong has provided a “rough transcript” of psychologist Dan Kahneman’s remarks, which include this bit about emotional intelligence:

[????] said yesterday that humans would always prefer emotional contact with with other humans. That strikes me as probably wrong. It is extremely easy to develop stimuli to which people will respond emotionally. A face that changes expressions, especially if it’s sort of baby-shaped, are cues that will make people feel very emotional. Robots will have these cues. Furthermore, it is already the case that AI reads faces better than people do, and can and undoubtedly will be able to predict emotions and their development far better than people can. I really can imagine that one of the major uses of robots will be taking care of the old. I can imagine that many old people will prefer to be taken care of by robots by friendly robots that have a name and that have a personality that is always pleasant. They will prefer that to being taken care of by their children.

Now I want to end on a story. A well-known novelist—I’m not sure he would he appreciate my giving his name—wrote me some time ago that he was planning a novel. The novel is about a love triangle between two humans and a robot. What he wanted to know is how would the robot be different from the individuals. I propose three main differences:

  1. One is obvious the robot will be much better at statistical reasoning and less enamored with stories and narratives than people.

  2. The robot would have much higher emotional intelligence.

  3. The robot would be wiser.

More from Kahneman at the link. This seems like an underrated possibility to me. Too often commentary on AI assumes that as machines take over analytical tasks, humans will focus on emotional ones. All this reminded me of a piece I wrote for HBR a couple years back that included this bit:

In his own research Gratch has explored how thinking machines might get the best of both worlds, eliciting humans’ trust while avoiding some of the pitfalls of anthropomorphism. In one study he had participants in two groups discuss their health with a digitally animated figure on a television screen (dubbed a “virtual human”). One group was told that people were controlling the avatar; the other group was told that the avatar was fully automated. Those in the latter group were willing to disclose more about their health and even displayed more sadness. “When they’re being talked to by a person, they fear being negatively judged,” Gratch says.

This is something we’d traditionally think of as interpersonal or emotional work, and yet people preferred machines because they didn’t come equipped with certain types of social/emotional reactions. That suggests to me that the bar is even lower than we think. Machines will get better at EQ, but they’ll also be able to respond differently than most people do, in ways that give them an edge. A machine that’s almost as good at listening and perceiving might still be preferable to a human in some cases if the machine also knows, for example, not to be judgmental. A machine that is nearly as good as a human at having a conversation might be preferable in some situations if it’s a more generous conversationalist and asks you more about yourself. AI may one day pass an emotional Turing test. But I expect we’ll start using them in social contexts well before then because of the other advantages they bring.

Larry Summers gives a great answer on competition, concentration, and market power

His podcast with Tyler Cowen is worth a listen for many reasons, but this was particularly in line with my own thinking:

COWEN: Regular economics: one hears increasingly these days that the higher concentration ratios in the American economy are an economically relevant fact. We all know those ratios are up somewhat.

But at the same time, consumers don’t, in an obvious way, seem to feel the burden of monopoly. If you look just at product choice and variety, productivity may be slow, the growth of manufacturing output appears to be quite steady. There’s not obviously a break in that series where all the monopolies restrict output.

We have all these different pieces of data: high-share values, high measured profits, very steady output behavior, a lot of product variety. How do you think about the issue of monopoly in the American economy right now? Is it significant or not?

SUMMERS: Most things I might be right or wrong, but I’m confident.

[laughter]

SUMMERS: This is one where I’m not certain. On the one hand, Tyler, higher concentration ratios, higher profit — with lower investment — manifest in lower interest rates. More monopoly power fits the story. On the other hand, take a thing like Apple Pay. Apple Pay means that Apple, which is already the largest company in America, is even larger.

So you could say that’s more monopoly and more market power. Or you could say there’s a whole financial industry it’s now getting competed with from outside the financial industry, and so it’s making things more competitive.

Both those views have merit. I think the second may have more merit than the first. Some of the rhetoric one hears recently, which leaves you with the impression that we’re seeing an era of a lot of new Standard Oils, seems to me to be quite overdone, with respect to the facts as I understand them.

On the other hand, are there combinations of healthcare systems in cities where we go from having some real competition to there being one dominant provider and networks to consumers’ benefits.

COWEN: Clearly, there’s problems there.

SUMMERS: There’s almost certainly some problems there. Are there difficult issues when information is central, as it would be with a Facebook or a Google? Yes, there are difficult issues: privacy, reliance on information, networks.

But are those best thought of through the prism of antitrust and monopoly? I’m not at all sure that that is the best way to think about them. After all, in some sense, the products in those two examples are given away to consumers for free. One of the most important issues for economists to figure out over the next couple of years is how to think about these trends.

I think there are some selective grounds for concern. It’s much more likely that antitrust has been insufficiently tough than it is that it’s been too tough over the last decade. But I also think one needs to be careful about the fact that being a successful business will tend to cause you to have more profits. We usually think of that as a good thing, not a bad thing.

A few things I think Summers gets right: 1) lack of certainty; 2) attention to ways in which business may be getting more competitive; 3) separating the tech platforms out from the broader story.

My best attempt to grapple with these trends is here; my reading list on the subject is here.

Blue Bottle, brands, and market power

Nestle has bought a majority stake in Blue Bottle, the fancy coffee chain. Why? As The New York Times reports:

The rapidly expanding niche accounts for 15 to 20 percent of coffee consumed in the United States, according to the Specialty Coffee Association. Perhaps more important than the sector’s rapid growth is that it commands higher prices and generates bigger profit margins.

So much of the talk of marker power, markups, and concentration has focused on technology and in particular the big tech giants. But what if Blue Bottle is the more representative example?

I don’t mean to knock the product when I say that Blue Bottle’s success is to a large degree about branding:

Although Blue Bottle is one of the most important players in the third-wave coffee sector, it has distinguished itself from its rivals in significant ways. It has spurned many of the hallmarks of high-end shops — barista competitions, lengthy travelogues about journeys to find the perfect small coffee farm — while emphasizing the aesthetics and experience of a well-prepared cup.

The strategy is a reflection of the company’s founder, a soft-spoken, classically trained musician who began roasting coffee as a hobby while on the road with traveling orchestras. Mr. Freeman’s approach has less of the rebellious rock ‘n’ roll attitude displayed by competitors like Stumptown, and more of the quiet calm that one might associate with a slowly but well-brewed cup of coffee.

You can argue over whether some of these differentiators are about product or brand, but the news reminded me of a paper I read recently: a 2016 review paper on branding by Bart J. Bronnenberg and Jean-Pierre Dubé. Some relevant bits:

In the latter part of the twentieth century, the degree of concentration in consumers goods industries grew at a much faster pace than other industries in the US (Caves and Porter, 1980). By the end of the twentieth century, most consumer goods industries were dominated by a small number of brands commanding most of the share of sales (Bronnenberg, Dhar, and Dubé, 2007). Most striking, many of the dominant consumer brands in 1923 were still the dominant brands in their respective categories in 1983 more than half a century later1 , although the findings are predominantly in food categories.2

And:

In general, the sales in these CPG product categories are very concentrated, as summarized in Table 2. On average across categories and Scantrack markets, the top brand commands 46% of equivalent unit sales, which is consistent with the analysis of food categories in Bronnenberg, Dhar, and Dubé (2011). The average four-firm concentration ratio is 79%

And:

The key consistent finding is the persistence in market shares and the advantages to early movers (even if not for the first entrant) that “survive” long-term.

And:

The body of literature and the collection of empirical evidence supports the long-standing notion that established brands constitute important barriers to entry

To recap, branding appears linked to rising industry concentration. Branding should increase markups by the definition used in this recent and widely discussed paper if good branding requires higher up front costs relative to marginal ones. And it represents market power to the extent it deters new entrants. You could imagine digital technology amplifying the importance of branding, but also perhaps creating opportunities for new entrants like Blue Bottle as the ways that companies brand themselves change.

Needless to say, this is all speculative, and not, I think, in tension with other common explanations of market power, like lobbying, network effects, etc. But concentration + market power is a big, complicated trend, likely with many partial explanations. Perhaps the rise of branding is one.