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.