It turns out that these ‘truisms’ of the market aren’t actually true at all.
Thirty years ago, in the face of a serious economic challenge from Japan and Europe, the United States embraced a form of free-market capitalism that was less regulated, less equal, and more prone to booms and busts. Bolstering that embrace was a set of useful myths about motivation, fairness and economic growth that helped restore American competitiveness.
Over time, however, the most radical versions of these ideas polarised US politics, threatened its prosperity and undermined the system’s moral legitimacy. (A recent survey found that only 42 per cent of millennials support capitalism.) Here are five of the most persistent ones.
Greed, a natural human instinct, makes markets work.
Adam Smith, the father of economics, first pointed out in his most famous work, The Wealth of Nations, that in vigorously pursuing our own selfish interests in a market system, we are led “as if by an invisible hand” to promote the prosperity of others. Years later, Smith’s theme that capitalism runs on selfishness would find its most famous articulation in a speech by a fictional corporate raider, Gordon Gekko, in the movie Wall Street: “Greed … is good, greed is right, greed works.” (Defenders of free markets have been desperate to disown the “greedy” label ever since.)
Smith, however, was never the prophet of greed that free-market cheerleaders made him out to be. In other passages from The Wealth of Nations, and in his earlier work, The Theory of Moral Sentiments, Smith makes clear that for capitalism to succeed, selfishness must be tempered by an equally powerful inclination towards cooperation, empathy and trust – traits that are hard-wired into our nature and reinforced by our moral instincts.
These insights have now been confirmed by brain researchers, behavioural economists, evolutionary biologists and social psychologists. An economy organised around the cynical presumption that everyone is greedy is likely to be no more successful than one organised around the utopian assumption that everyone will act out of altruism.
Corporations must be run to maximise value for shareholders.
This is an almost universal belief among corporate executives and directors – that it is their principal mission and legal obligation to deliver the highest possible return to their shareholders. The economist Milton Friedman first declared in the 1970s that the “one social responsibility of business [is] to increase its profits”, but the corporate raiders of the 1980s were the ones who forced that view on executives and directors, threatening to take their companies or fire them if they didn’t go along.
Since then, “maximising shareholder value” has been routinely used to justify lay-offs and plant closings, rationalise an orgy of stock buy-backs and defend elaborate corporate schemes to avoid paying taxes. It is now taught widely by business schools, ruthlessly demanded by Wall Street’s analysts and “activist” investors, and lavishly reinforced by executive pay packages tied to profits and share prices.
In fact, corporations are free to balance the interests of shareholders with those of customers, workers or the public, as they did routinely before the 1980s, when companies were loath to boost profits if it meant laying off workers or cutting their benefits. Legally, corporations can be formed for any purpose. Executives and directors owe their fiduciary duty to the corporation, which is not owned by shareholders, as widely believed, but owns itself (in the same way that no one “owns” you or me). The only time a corporation is obligated to maximise its share price is when it puts itself up for sale.
Workers’ pay is an objective measure of economic contribution.
The theory of “marginal productivity” holds that a worker’s wage or salary reflects the “amount of output the worker can produce”, according to Harvard’s Greg Mankiw, author of a best-selling economics textbook. This idea is useful in constructing economic models, but Mankiw and others also relied on it to justify widening income inequality and to oppose proposals to redistribute income based on subjective notions of what is “fair”. It is why we are supposed to accept that private-equity king Steve Schwartzman, at $US800 million, should earn 20,000 times what the average American worker earns, as he did last year.
In reality, however, the pay set by markets is also subjective, reflecting the laws and social norms under which markets operate. The incomes earned by workers who planted tobacco – and those who owned tobacco plantations – changed considerably after slavery was abolished, and again after laws protecting share-croppers were enacted, and again when minimum-wage laws were passed, and again when farm workers won the right to unionise. Changes to trade law, patent law and anti-trust law also alter the distribution of income. While it is probably better to rely on markets rather than the government to set pay levels, that doesn’t mean that the way the markets set pay is a purely objective assessment of economic contribution or that redistribution is theft.
Equality of opportunity is all people need to climb the economic ladder.
No moral intuition is more hard-wired into Americans’ concept of economic justice than equality of opportunity. The reason Americans tolerate higher levels of income inequality is because of their faith that everyone has a fair chance of achieving the American dream or becoming the next Bill Gates. “In America, we stand for equality,” writes Arthur Brooks of the American Enterprise Institute, a leading defender of the morality of capitalism. “But for the large majority of us, this means equality of opportunity, not equality of outcome.” In a 2015 New York Times poll on income inequality, 35 per cent of Americans said they believed everyone has “a fair chance to get ahead”.
But while the US has made great strides in removing legal barriers to equal opportunity, at least half the difference in income between any two people is determined by their parents, either through inherited traits like intelligence, good looks, ambition and reliability (nature), or through the quality and circumstances of their upbringing and education (nurture). As our society has become more meritocratic, we’ve simply replaced an aristocracy based on title, class, race and gender with a new and equally persistent aristocracy based on genes, education and parenting. Unless we are prepared to engage in extensive genetic reengineering, or require that all children be brought up in state-run boarding schools, we must acknowledge that we can never achieve full equality of opportunity.
Making the economy fairer will make it smaller and less prosperous.
Economists have long believed that there is an unavoidable trade-off between equality and growth – having more of one means having less of the other. Arthur Okun’s book about it, Equality and Efficiency: The Big Trade-off, remains a classic. The implosion of communism and the decisions of socialist countries like Sweden to reduce taxes and welfare are widely seen as acknowledgments of the failure of overly egalitarian systems to produce adequate economic growth.
But evidence suggests that there is also a point at which high levels of inequality begin to deliver less economic growth, not more – and that the US has passed that point, according to research by the International Monetary Fund. That’s partly because more-unequal economies tend to have oversize and overcompensated financial sectors that are more prone to booms and busts. Other researchers have found that worker productivity suffers when economic gains are not widely shared.
A further reason may be that rising income inequality erodes the trust people have in one another and their willingness to cooperate. As the political economist Francis Fukuyama has written, this “social capital” lubricates the increasingly complex machinery of market economies and the increasingly contentious machinery of democracy. Countries with more social capital tend to be healthier, happier and richer.
*Steven Pearlstein, is a Washington Post economics columnist and the Robinson professor of public affairs at George Mason University. He is the author of Can American Capitalism Survive? (St Martin’s Press, September 2018).