Capitalism is an economic system characterized by private property and freely functioning markets without central planning. Prices in capitalist economic systems are determined by the free and open exchanges of buyers and sellers guided by self-interest but constrained by both an ethical consensus and the rule of law. While capitalism is widely viewed as the most effective system for generating wealth and higher material standards of living, capitalist economies also go through periods of instability, some of which have raised concerns about the overall appeal of the system.
In addition to concerns rooted in these periodic cycles, other concerns have been raised regarding broader social issues such as the distribution of income. Most economists believe that the benefits of capitalist systems have far outweighed the costs but this article will present both sides of the argument. To understand capitalism in its present form also requires that we consider the historical developments, both intellectual and material, that gave rise to the modern capitalist system.
Capitalist economic systems are relatively new developments in the broad span of human history and gradually evolved over time in response to previous economic systems. Yet the fundamental driving force of market capitalism, self-interested exchange between buyers and sellers, is as old as humanity itself. M. M. Postan and H. J. Habakkuk described evidence that mammoth hunters of the Russian steppes and the Cro-Magnon hunters of central France both obtained Mediterranean shells through long-distance trading. The late Robert Heilbroner wrote of how the Tablets of Tell-el-Amarna described lively trade in 1400 B.C. between the Levantine kings and Egyptian pharaohs. Large-scale enterprise, buttressed by financial systems, was a part of Ming China (13681644). In addition, Avner Greif has described how the Maghribi traders, a group of Jewish traders from parts of northern Africa and from Muslim Sicily and Spain, were engaged in long-distance trading throughout the Mediterranean by the 11th century. These traders seem to have enforced contracts, a critical requirement for any successful long-distance trading to emerge, through private coalitions composed of merchants and the agents who worked for them.
While there was little formal enforcement of business agreements at the time, these private coalitions enforced contracts themselves through the sharing of information; in effect, they relied on reputation mechanisms and punished those who violated business agreements. Since the emergence of long-distance trading was an important development on the long, slow path toward capitalism, these institutional developments that made distant trading possible are of central importance.
While important stepping stones on the path toward modern capitalism, none of these examples of early exchange were conducted within the economic system we call capitalism. The term itself was first used in the late 19th century and did not become common parlance until the early 20th century. However, most economists would view capitalism as an economic system that emerged out of the demise of mercantilism in the late 18th century. The mercantilist system had emerged alongside the nation-states of Europe and is generally dated to the early 16th century.
These powerful nation-states grew out of the demise of the highly structured medieval feudal society in which economic activity was centered around a manor, which was a district controlled by an elite member of feudal society called a lord. The manorial system was one in which lords owned property that was worked by landless serfs. This system was one of stagnation and lack of exchange, which contrasts nearly completely with the modern capitalist systems that are identified by constant change and the cen-trality of the free exchange process. Eventually, medieval feudal society broke down in part because of the Black Death that killed at least one-third of Europe's population beginning in 1348.
The Black Death also intensified social tensions within European feudal society. The sharp declines in urban population (and thus demand) forced down the price of food while wages simultaneously rose because of the shrinking supply of workers. In response, wage controls that sought to prevent wages from rising too far were imposed but these only served to magnify the already rising social tensions. Worker revolts occurred throughout Europe and ultimately altered the economic conditions of feudalism. In the end, these changes gradually brought about freedom for the serfs. If there is any silver lining to the disastrous 14th century in Europe it is that it paved the way for the eventual emergence of capitalism. Yet there was one more step on the path to market capitalism, the economic system known as mercantilism.
Mercantilism, while not generally viewed as a coherent school of economic thought, can best be described as a system of extensive economic regulations whose purpose was to enhance the power of the nation-state by acquiring as much gold and silver as possible. This was to be done by selling more to foreigners than was purchased from them; that is, the goal was to export as much as possible while importing as little as possible. To accomplish this, the mercantilists established extensive regulations on both international trade and domestic industry. In 1684 Philipp von Hornick enumerated a set of mercantilist policies including those that would promote a large population to drive down wages and thus benefit the merchant class that was most directly engaged in exporting activity.
The mercantilists erroneously viewed international exchange as a zero-sum game; that is, they believed there were winners and losers in international trade and they naturally sought to be on the winning side. Thanks to David Ricardo's seminal work first published in 1817, Principles of Political Economy, economists now almost universally believe that international exchange is a positive-sum game; that is, trade benefits both trading partners. Despite its flaws, mercantilism characterized the economic policies pursued by the major European powers from between the 16th and 18th centuries. Indeed, the original 13 American colonies were established by England as a central component of its mercantilist policy.
Eventually, both the internal contradictions of mercantilism and the growing intellectual tide that was part of the Age of Enlightenment (roughly from the Glorious Revolution of 1688 to the end of the French Revolution in 1789) cleared the way for the move toward modern capitalism. The establishment of capitalism, while slowly building over the long term, awaited a powerful and penetrating intellectual argument. This argument would have to convincingly make the case that lack of central direction would not, in fact, result in chaos. It would have to be built on foundations that were seemingly contradictory—that an economy composed of individuals who behaved in ways that were solely consistent with their own personal interests would not degenerate into a chaotic war of all-against-all. This was a high intellectual hurdle to jump and required not just a penetrating argument but an intellectual environment that was a least open to radical ideas. It is thus one of those fortunate coincidences of history that the Scottish philosopher Adam Smith was born into the revolutionary period of Enlightenment that largely defined the western world, at least intellectually, in the 18th century. The Enlightenment thinkers sought to apply reason and systematic, logical thinking to all areas of human activity.
Born in Kirkcaldy, Scotland, in 1723, Adam Smith became the father of modern economics with his monumental treatise An Inquiry into the Nature and Causes of the Wealth of Nations, which was published in 1776. If one must place a date on the beginning of capitalism, the publication of Smith's magnum opus is not a bad one to choose. In it, Smith argued that markets could harness the innate self-interest that motivates each human being and exploit it for the common good. In perhaps the most well-known line from the Wealth of Nations, Smith wrote,
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantage.
Adam Smith, whose ideas have been central to capitalist arguments, is depicted in this 1790 engraving.
Self-interest, commonly thought to be a private vice, could be turned into a public virtue. This notion had earlier been mentioned by Bernard Mandeville in The Fable of the Bees but it was with Smith that it was made part of an overall theory of economic development. Both parties, Smith explained, benefited from the process of voluntary exchange that is a defining feature of capitalism. Yet it is less clear what the impact of self-interested behavior is for society at large. Will this pursuit of self-interest lead to a degeneration of society into a war of all-against-all, as the philosopher Hobbes had most notably argued? How, in other words, is capitalism prevented from simply destroying itself?
The echoes of Smith's eloquent description of the benefits of competitive markets are found in modern mathematical economics (the first fundamental welfare theorem is a mathematical version) and underlie the support afforded free markets by the vast majority of economists. While most economists focus on Smith's Wealth of Nations, its predecessor, The Theory of Moral Sentiments, is equally important and informs us as to the ethical foundations of capitalism that are often overlooked. Smith's work in fact simultaneously examined both ethics and positive laws in conjunction with market exchange. Smith argued that in the absence of a strong civic ethics we would be forced to rely on increasingly extensive laws which would increase the size and role of the government. This, according to Smith, was the very thing that would stifle economic freedom and prevent the process of growth that he had laid out in the Wealth of Nations. Ethical underpinnings were thus central to the success of the capitalist system. Without those underpinnings, the heavy hand of government regulation would be required and would eventually extinguish the very spirit of capitalism.
One of the most counterintuitive ideas that Smith, Hume, and other scholars put forth was how a society that was not regulated from above could still be orderly. The essence of the argument was that the marketplace itself was a form of what the Nobel Prize-winning economist Friedrich Hayek called “spontaneous order.” The fundamental problem is that complex social order simply cannot be constructed by a central authority because the information requirement is beyond any person's abilities to manage. The price system, however, aggregates this information and coordinates behavior so efficiently that it seems as if it must be guided or structured in some way. This coordination, while appearing to be the product of some grand design, is actually nothing more than the product of millions of individuals who followed only their own interests. None had any intention of creating overall social or economic order, so the coordination we observe was a beneficial unintended consequence of the pursuit of self-interest. In Adam Smith's words, “man is led to promote an end which was no part of his intention.” This is what is known as Adam Smith's concept of the Invisible Hand.
While Smith deservedly gets much of the credit for the intellectual sea change that pushed the Western world toward market capitalism, he was certainly not alone in this. Nor was Smith the first to extol the benefits of self-interested market exchange. Intellectually, other schools of thought had long been laying the groundwork for Smith. Arguments defining the benefits of open exchange go as far back as Ancient Greek antiquity. Aristotle most prominently discussed the benefits of private property in the 4th century b.c.
Aristotle also saw the importance of private property rights, which are fundamental to capitalist economies. While the nuggets of economic thought that we find in Ancient Greece were practically lost in the Dark Ages, a group of Catholic Church scholars known collectively as the Scholastics would revive elements of Aristotelian thought from approximately the 9th to the 13th century. While the Scholastics are most remembered for their erroneous views on just price and usury (prohibitions on interest), they also adopted the favorable views of private property rights from Aristotle and reintroduced them to Western thought.
The French Physiocrats, led by Francois Quesnay, the court physician to Louis XV, forcefully argued in favor of laissez-faire free-market principles and were important in developing the case for free-market capitalism. The Physiocrats focused not on the accumulation of gold and silver as the mercantilists had done, but argued that the true wealth of an economy lies in its net product; that is, the surplus produced by the agricultural sector. Their focus on agriculture as the only “productive” class (note they did not view manufacturing as unimportant but did not believe it produced a net product) led them to the free-market principles later expanded on by Smith and others.
The various mercantile regulations in France negatively impacted agriculture in that country according to the Physiocrats. Internal taxes on the movement of grains between regions, for example, were part of the vast mercantilist regulatory structure that hampered the agricultural sector. There were also internal restrictions on the mobility of labor so that farmers in some regions faced labor shortages that could not be corrected by wage movements, so those farmers were forced to reduce production activities. The Physiocrats thus arrived at their free-market views largely through their emphasis on the importance of agriculture, and they subsequently called for lifting restrictions on internal trade and other regulatory burdens that had been hoisted upon the French economy by the mercantilists.
David Hume, a friend and contemporary of Adam Smith, was also a towering figure of the Enlightenment period who helped to usher in the age of capitalism. Indeed, it was Hume who first launched a devastating intellectual attack on the flawed mercantilist trade policy. In what became known as Hume's price-specie flow mechanism, he explained that the inflow of gold and silver (specie) that was central to the mercantilist policies would only generate higher prices throughout the mercantilist economy. As the prices of exported goods were pushed higher, Hume explained that this would make foreign consumers of those exported goods purchase fewer of them. Maintaining a trade surplus indefinitely was therefore not a realistic national economic objective.
Later economists would expand on and modify the principles of market exchange that were laid out in the late 18th century, but the fundamental intellectual shift had been made. England's Industrial Revolution was under way and the transition to modern capitalism was at hand both there and across the ocean in the burgeoning new American states.
The American economy got its start with a small British outpost in Jamestown, Virginia, in 1607 but was far from a freely functioning capitalist economy at the time. The British colonized America for the purpose of enhancing British economic power in support of its mercantilist interests. Wide-ranging mercantilist restrictions governed the colonial economy, but even the colonists were generally wealthy compared both to other citizens of the world at that time and even compared to some who live in poverty today.
With the emergence of the new nation after successfully breaking away from British rule, modern capitalist institutions began to emerge, setting the stage for the dramatic economic advances of the 19th and 20th centuries. Alexander Hamilton, the first secretary of treasury under President George Washington, was central in the construction of the early American financial and economic system. These pillars of American capitalism helped to create the conditions needed for the dramatic success that was to come. Hamilton worked feverishly to create an American version of the Bank of England, although he was accused by political opponents of harboring British sympathies partly as a result of this.
Hamilton managed to get his wish and the First Bank of the United States was chartered by Congress in 1791. Hamilton also stubbornly insisted on a powerful manufacturing-oriented economy to the dismay of his political opponents (Thomas Jefferson most prominent among them) who favored a rural agrarian economy. Ultimately, the early American financial system that Hamilton helped build proved resilient despite a variety of problems throughout the 19th century. By the end of that century, the American economy was the most powerful in the world.
With the rise of American capitalism came dramatic improvements in the quality of life. Economic historians use not only data on employment, production, and prices to measure economic performance but often use less conventional economic variables such as height, weight, and average lifespan to gauge living standards. According to the Centers for Disease Control, American life expectancy at birth was 47 years in 1900 but had risen to nearly 78 years in 2005. gross domestic product (GDP) per capita was $4,921 in 1900 (measured in 2000 dollars), yet had risen some 6.7 times to $38,291 by 2007. With the material wealth produced by American capitalism comes an improved living standard as measured either by life expectancy, weight, height, or income.
Even more mundane measures of material progress are telling. The U.S. Census Bureau reports that over 70 percent of poor American households (those households below the official poverty level) now have air conditioning; by contrast, only 12 percent of all U.S. households had air conditioners as late as 1960. While some segments of the American population have benefited more than others, there is no denying that all have experienced dramatic improvements in material living conditions over the last century.
Most of the world seems to have accepted that capitalism, despite its flaws, is effective at generating economic prosperity, so countries from Eastern Europe to China have adopted capitalist elements in recent years. In some cases, the market institutions of capitalism have developed spontaneously. In particular, John McMillan described how a tiny clandestine meeting of households in the village of Xiaogang in China's Anhui Province initiated dramatic changes in the economic structure of that country. Embedded in that story is a stark tale of the differences between that singular institution of capitalist economies, private property, and the communal property that had been brought to China by the communists in 1949.
The institution of private property, like all economic institutions, creates incentives to which people respond in predictable ways. Unlike common property rights under which individuals share output equally, private property rights link work effort to reward and thus incentivize people to work hard and produce as efficiently as possible. Private property rights reforms created linkages between effort and reward that were missing under the old common property rights systems of Chinese communism. China has now, as a result of these and other economic reforms, become a major economic powerhouse. The internal changes in the Chinese economy have resulted in a more than tenfold increase in GDP since 1978. According to the CIA World Factbook, over 5,000 domestic Chinese enterprises have created direct investments in 172 different countries and regions.
While it holds long-term benefits, transitioning to capitalism is not an easy task. While capitalism is an effective system for generating aggregate wealth, the specifics of the economic institutions that make up an effective system are much more complex. Simply transferring economic institutions that work well in established Western economies to those in the developing world or to transition economies is not sufficient. As such, there are transition economies that have struggled and that continue to struggle. Over time, however, those economies that manage to successfully implement market-based reforms have the potential of reinvigorating their economies and contributing to broad-based increases in the living standards of their citizens.
While economists generally see the benefits of free and open exchange in capitalist economic systems, this is not to say that capitalism is a panacea. Historically, the most prominent critic of capitalism was the German economist and philosopher Karl Marx. Marx's critique, like the man himself, was complex and multifaceted but the essence of his objection to capitalism was that it allowed capitalists to exploit labor. The upper-class capitalists (the bourgeoisie) would eventually find themselves in conflict with the free labor force (the proletariat) because of the separation between capital and labor. The conflict is generated by the ever-present push, because of competition among firms in capitalist systems, to replace labor with capital. As the proletariat were increasingly exploited and eventually replaced by capital, they would rise up in revolt and replace the bourgeoisie as the dominant social class. This, in Marx's view, would create a new socialist order. There are, however, a number of contradictions in Marxist theory that have led most economists to reject it as a valid critique of capitalism.
Despite these problems with the Marxist arguments, there are a variety of other critiques of capitalism. For example, capitalist systems are routinely criticized on grounds of inequality. Capitalist economies are structured around a system of rewards and punishments. Those who find better and more efficient ways to produce are rewarded. Henry Ford, for example, became one of America's most successful businessmen by figuring out a better way to manufacture his automobiles through the assembly line. Those who manage to find novel and unique ways of “building a better mousetrap” have incentives to do so because of the potential profits that are realized only with success. Thus, some people in capitalist economies can rapidly acquire enormous amounts of personal wealth. Others are less fortunate and, through either a lack of skill or simply bad luck, end up on the lower end of the income distribution.
Many who object to capitalism point to the wide divergence in economic standing among citizens of capitalist economies and propose policies to try to level out that income distribution. While one might see the benefits of such policies in terms of fairness, there is a risk of destroying or at least reducing the very incentives that make capitalism such a dynamic and powerful system for wealth creation if these policies go too far. Moreover, it is easy to overlook the extent to which the dynamic nature of capitalist economies distorts simple measures of inequality.
There are opportunities to move up the income distribution over time in a capitalist system that may not be available under alternative economic systems. The U.S. Treasury Department has reported that from 1996 to 2005, as in the previous 10-year period, a majority of American taxpayers moved from one income group to another. This study found that about half of taxpayers who began in the bottom quintile of the income distribution moved to a higher income group within ten years. For those in the top income group in 1996, only one-quarter of them remained in that group in 2005, so movement across the income distribution is not always upward. Nonetheless, static portraits of skewed income distributions in capitalist economies are misleading because they fail to capture this income mobility, which is a unique feature of capitalism.
A variety of other problems are associated with economic growth. For instance, China's rapid growth, which resulted from its transition toward market capitalism, has led to some serious concerns about environmental damage. While it may take some time to solve these problems, there are promising market-based solutions to issues of environmental pollution including carbon taxes and cap-and-trade systems.
Even those who are ardent supporters of capitalist economic systems admit that it is a system characterized by the creative destruction described by Joseph Schumpeter. The very dynamism that can generate enormous wealth for individuals can and does destroy old, inefficient methods of production and can thus displace workers in those industries. Yet it is this fundamental dynamism that has made capitalism the most successful economic system for generating material wealth and rising living standards.
Despite the economic growth that finally occurred with the introduction of capitalism, market economies do experience periodic expansions and recessions. Effective government fiscal (tax and spending) and monetary policy may be able to counter these fluctuations, as argued by the economist John Maynard Keynes and by most macroeconomists today. In his classic book The General Theory of Employment, Interest and Money, Keynes argued that the government had an important role to play in stabilizing these fluctuations. It could, he argued, “prime the pump” through deficit-spending during economic downturns. By injecting money into the economy through the use of fiscal policy, Keynes believed the government had the ability and obligation to counter the business cycle itself. Keynes was writing in the midst of the greatest challenge to market capitalism ever experienced, the Great Depression.
The “Roaring Twenties” came to an abrupt end in October 1929 when the U.S. stock market crashed. While not the first sign of impending trouble in the economy (the index of industrial production, for example, had turned down in the summer of 1929), the financial market crash was unprecedented and led to widespread consumer pessimism across the country. Whatever its causes, the Great Depression ushered in a serious challenge to capitalism as inflation-adjusted gross national product (GNP) fell by 29 percent between 1929 and 1933 and about one-quarter of the American workforce was unemployed by 1932-33. Waves of bank failures rocked the financial system, wiping out the savings of millions in an era before federal deposit insurance.
Perhaps most important, intellectual challenges to capitalism and its apparent instability threatened to bring down the system altogether. In many ways that are still apparent today, the Great Depression did fundamentally change capitalism. Government did, as Keynes urged, adopt a more interventionist approach to the economy. Both fiscal and monetary policy have been used to counter business cycle fluctuations, although some economists actually blame government intervention for exacerbating the cycles in the economy. Most prominent among those critics was Milton Friedman, whose work with Anna Schwarz on American monetary history blamed monetary policy itself for the downturns. Considerable disagreement remains among economists on the appropriate degree of involvement of the government in the economy.
True capitalism, in the strictest sense, does not exist; instead, the United States today might be more accurately described as a system of welfare capitalism. That is, we have redistributive income taxes in which the wealthy pay a higher fraction of their income than the poor, along with a wide range of government aid programs. The government itself has become a very large part of economic activity, employing more people than any other sector of the economy (government employment accounts for approximately 16 percent of total nonfarm employment in the United States).
Nonetheless, the basic tenets of free-market capitalism remain in the United States and are emerging in a growing number of countries around the world.
Free-trade agreements, robust private enterprise, and sound capitalist institutions all hold promise for the future. Yet there is no reason to think that the very long process of the development of capitalism will stop here. There will undoubtedly be continued challenges and incremental modifications to the system in the years to come.
Communism, Globalization, Free Markets, Free Trade
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