How compatible are democracy and capitalism?

How compatible are democracy and capitalism?

Economic stress and demographic change are weakening a symbiotic relationship

Of late, the world’s older democracies have begun to look more vulnerable than venerable. America seems destined for a constitutional showdown between the executive and the legislature. Brexit has mired Britain in a constitutional morass of its own. Such troubles could be mistaken for a comeuppance. In recent years, political economists have argued that rising inequality in the Anglo-American world must eventually threaten the foundations of democracy; a book on the theme by Thomas Piketty, a French economist, has sold well over a million copies. That argument channels a time-worn view, held by thinkers from Karl Marx to Friedrich Hayek, that democracy and capitalism may prove incompatible.

As powerfully as such arguments are made, the past century or so tells a different story. The club of rich democracies is not easy to join, but those who get in tend to stay there. Since the dawn of industrialisation, no advanced capitalist democracy has fallen out of the ranks of high-income countries or regressed permanently into authoritarianism. This is not a coincidence, say Torben Iversen of Harvard University and David Soskice of the London School of Economics, in their recent book, “Democracy and Prosperity”. Rather, they write, in advanced economies democracy and capitalism tend to reinforce each other. It is a reassuring message, but one that will face severe tests in years to come.

Economists and political theorists have imagined all sorts of ways capitalist democracies might fail. The oldest is the worry that grasping masses will vote to expropriate the wealth (hard-earned or not) of entrepreneurs and landowners—and without secure property rights there can be no capitalism. Hayek thought that the governments of the early 20th century, in responding to the concerns of the masses, had over-centralised economic decision-making, a road that led eventually to totalitarianism. Other thinkers followed Marx in reckoning that it was the greed of the capitalists that would do the greatest harm. Joseph Schumpeter feared that as firms grew more powerful, they might push a country towards corporatism and clientelism, winning monopoly rights that would generate profits they could share with politicians. Mr Piketty and others say that inequality naturally rises in capitalist countries, and that political power becomes concentrated alongside economic power in an unstable way. Other economists, like Dani Rodrik, have argued that full participation in the global economy forces a country to give up a degree of either national sovereignty or democracy. Lowering barriers to trade means harmonising trade and regulatory policies with other countries, for instance, which reduces each government’s ability to accommodate domestic preferences.

But if capitalism and democracy are such uneasy bedfellows, what explains their long co-existence in the rich world? Mr Iversen and Mr Soskice see capitalism and democracy as potentially mutually supporting, with three stabilising pillars. One is a strong government, which constrains the power of large firms and labour unions, and ensures competitive markets. Weaker countries find it harder to resist the short-term expediency of securing power by protecting monopolies. The second is a sizeable middle class, forming a political bloc that shares in the prosperity created by a capitalist economy. A bargain is struck in which the state provides mass higher education on generous terms, while encouraging the development of frontier industries that demand skilled workers. Middle-class households thus reckon that economic growth is likely to benefit them and their children. (Rising inequality is not a threat to capitalist democracies, the authors reckon, because middle-class voters care little about the poor and do not support broader redistribution that could raise their tax bills.)

Providing the education, infrastructure and social safety net that support a prosperous middle class requires substantial tax revenue. For the system to hold a third pillar is needed: large firms that are not very mobile. Before recent rapid globalisation that was no problem. Yet even now firms are more rooted than commonly thought. Though multinationals are adept at shifting production and profits around the world, in a knowledge economy leading firms cannot break their connections to networks of skilled individuals like those in London, New York or Silicon Valley. Their complex business plans and frontier technologies require the know-how developed and dispersed through these local networks. That increases the power of the state relative to firms, and allows it to tax and spend.

Middlemarch

Quibble with the details, but the overarching story—immobile companies giving governments a degree of sovereignty, which they self-interestedly use to boost the middle classes—seems a plausible account of the stability of advanced capitalist democracies. It leaves plenty to be concerned about, however. It hinges on the middle classes feeling confident about the economy. A sharp slowdown in growth in real median incomes, as in America and Britain in recent years, might not send voters rushing to the barricades, but could strengthen the appeal of movements that threaten to disturb the status quo. Governments, too, are becoming less responsive to middle-class priorities. America’s is too dysfunctional, and Britain’s too distracted by Brexit, to focus on improving education, infrastructure and the competitiveness of markets.

Demographic change might also take a toll: older and whiter generations may not much care whether a would-be middle class that does not look like them has opportunities to advance or not. Then, too, the authors may have underestimated the corrosive effect of inequality. Threatening to leave is not the only way the rich can wield power. They control mass media, fund think-tanks and spend on or become political candidates. Proud democracies may well survive this period of turmoil. But it would be a mistake to assume survival is foreordained.

Thomas Piketty’s thoughts on Capitalism and Democracy

Thomas Piketty, a professor at the Paris School, has become the most-talked-about economist with the release of the English edition of his book, Capital in the Twenty-First Century. The importance of this book can be seen from the fact that it is being compared with Karl Marx’s Das Capital. Here are his thoughts on the future of capitalism and democracy:

Has capitalism failed the world?

Capitalism and market forces are very good at producing new wealth. The problem is simply that they know no limit, nor morality. They can sometimes lead to a distribution threatens that is so extremely concentrated that it threatens working of democratic institutions. We needed adequate fiscal policies to ensure that all groups in society benefit from globalisation and economic openness. We want capitalism to be the slave of democracy rather than the opposite.

How capitalism leads to inequality?

History tells us that there are powerful forces going in both directions -the reduction or the amplification of inequality. Which one will prevail depends on the institutions and policies that we will collectively adopt. In the very long run, one powerful force pushing in the direction of rising inequality is the tendency of the rate of return to capital (r) to exceed the rate of output growth (g). That is, when r exceeds g, as it did in the 19th century and seems quite likely to do again in the 21st, initial wealth inequalities tend to amplify and to converge towards extreme levels.

The top few percents of the wealth hierarchy tend to appropriate a very large share of national wealth, at the expense of the middle and lower classes. This is what happened in the past, and this could well happen again in the future. According to Forbes global billionaire rankings, top wealth holders have been rising more than three times faster than the size of the world economy between 1987 and 2013. That clearly is a reason to worry.

Why economic growth rate in future will be lower than the return on capital?

With the decline of population growth in most parts of the world, total GDP growth rates are likely to fall. Also, as emerging economies catch up with developed economies, productivity growth rates are likely to resemble what we have always observed at the world technological frontier since the Industrial revolution, i.e. between 1% and 2% per year. With zero or negative population growth, this suggests that total GDP growth rates will fall much below 4-5%, which has been the typical value for the average rate of return to capital in the very long run.

The main point here is that we should have more democratic transparency about how different income and wealth groups are doing so that we can adjust our policies and tax rates to whatever we observe. As long as top groups grow at approximately the same speed as the rest of society, there is no problem with inequality per se. But if the top rises three times faster than the size of the economy, you need to worry about it.

A very brief summary of

“Capital in the Twenty-First Century”

It is the economics book that took the world by storm. Capital in the Twenty-First Century, written by the French economist Thomas Piketty, was published in French in 2013 and in English in March 2014. The English version quickly became an unlikely bestseller, and it prompted a broad and energetic debate on the book’s subject: the outlook for global inequality. Some reckon it heralds or may itself cause a pronounced shift in the focus of economic policy, toward distributional questions. The Economist hailed Professor Piketty as “the modern Marx” (Karl, that is). But what is his book all about?

Capital draws on more than a decade of research by Piketty and a handful of other economists, detailing historical changes in the concentration of income and wealth. This pile of data allows Piketty to sketch out the evolution of inequality since the beginning of the industrial revolution. In the 18th and 19th centuries western European society was highly unequal. Private wealth dwarfed national income and was concentrated in the hands of the rich families who sat atop a relatively rigid class structure. This system persisted even as industrialisation slowly contributed to rising wages for workers. Only the chaos of the first and second world wars and the Depression disrupted this pattern. High taxes, inflation, bankruptcies and the growth of sprawling welfare states caused wealth to shrink dramatically, and ushered in a period in which both income and wealth were distributed in relatively egalitarian fashion. But the shocks of the early 20th century have faded and wealth is now reasserting itself. On many measures, Piketty reckons, the importance of wealth in modern economies is approaching levels last seen before the First World War.

From this history, Piketty derives a grand theory of capital and inequality. As a general rule wealth grows faster than economic output, he explains, a concept he captures in the expression r > g (where r is the rate of return to wealth and g is the economic growth rate). Other things being equal, faster economic growth will diminish the importance of wealth in a society, whereas slower growth will increase it (and demographic change that slows global growth will make capital more dominant). But there are no natural forces pushing against the steady concentration of wealth. Only a burst of rapid growth (from technological progress or rising population) or government intervention can be counted on to keep economies from returning to the “patrimonial capitalism” that worried Karl Marx. Piketty closes the book by recommending that governments step in now, by adopting a global tax on wealth, to prevent soaring inequality contributing to economic or political instability down the road.

The book has unsurprisingly attracted plenty of criticism. Some wonder whether Piketty is right to think that the future will look like the past. Theory argues that it should become ever harder to earn a good return on wealth the more there is of it. And today’s super-rich (think of Bill Gates, or Mark Zuckerberg) mostly come by their wealth through work, rather than via inheritance. Others argue that Piketty’s policy recommendations are more ideologically than economically driven and could do more harm than good. But many of the sceptics nonetheless have kind words for the book’s contributions, in terms of data and analysis. Whether or not Professor Piketty succeeds in changing policy, he will have influenced the way thousands of readers and plenty of economists think about these issues.

Excerpts

“When the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the twenty-first, capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.”

“Over a long period of time, the main force in favour of greater equality has been the diffusion of knowledge and skills.”

“For millions of people, “wealth” amounts to little more than a few weeks’ wages in a checking account or low-interest savings account, a car, and a few pieces of furniture. The inescapable reality is this: wealth is so concentrated that a large segment of society is virtually unaware of its existence, so that some people imagine that it belongs to surreal or mysterious entities. That is why it is so essential to study capital and its distribution in a methodical, systematic way.”

“Democracy will never be supplanted by a republic of experts—and that is a very good thing.”

“As long as the incomes of the various classes of contemporary society remain beyond the reach of scientific inquiry, there can be no hope of producing a useful economic and social history.”

“At the heart of every major political upheaval lies a fiscal revolution.”

“Refusing to deal with numbers rarely serves the interests of the least well-off.”

“The history of the distribution of wealth has always been deeply political, and it cannot be reduced to purely economic mechanisms.”

“Among the members of these upper income groups are US academic economists, many of whom believe that the economy of the United States is working fairly well and, in particular, that it rewards talent and merit accurately and precisely. This is a very comprehensible human reaction.”