Redefining capitalism

Despite its ability to generate prosperity, capitalism is under attack. By shaking up our long-held assumptions about how and why the system works, we can improve it.

September 2014 | byEric Beinhocker and Nick Hanauer

http://www.mckinsey.com/insights/corporate_social_responsibility/redefining_capitalism

This may be a bit ethereal, but I believe it is critical to future innovation in our global economy.

Capitalism is under attack. The financial crisis of 2008, the stagnation of the middle class in many developed countries, and rising income inequality are challenging some of our most deeply held beliefs about how a fair and well-functioning society should be organized…. 

…. This article will argue that while we have been correct to believe that capitalism has been the major source of historical growth and prosperity, we have been mostly incorrect in identifying how and why it worked so well…. the conventional economic theories we have relied upon for the past century have misled us about the workings of capitalism.. 

… neoclassical economics—has painted a narrow and mechanistic view of how capitalism works, focusing on the role of markets and prices in the efficient allocation of society’s resources. The story is familiar: rational, self-interested firms maximize profits; rational, self-interested consumers maximize their “utility”; the decisions of these actors drive supply to equal demand; prices are set; the market clears; and resources are allocated in a socially optimal way…. utility; and that is problematic because it has long been the device economists use to show that markets maximize social welfare. Empirical economists have identified anomalies suggesting that financial markets aren’t always efficient. And the macroeconomic models built on neoclassical ideas performed very poorly during the financial crisis…. 

…. our perspective on how and why markets work from their allocative efficiency to their effectiveness in promoting creativity…. The genius of capitalism is that it both creates incentives for solving human problems and makes those solutions widely available. And it is solutions to human problems that define prosperity, not money…

Prosperity redefined

… This is why prosperity in human societies can’t be properly understood by looking just at monetary measures, such as income or wealth. Prosperity in a society is the accumulation of solutions to human problems…. 

Growth Redefined 

… In our view, the biggest problem with GDP is that it doesn’t necessarily reflect how growth changes the real, lived experience of most people. In the United States, for example, GDP has more than tripled over the last three decades. Although those increases have been concentrated at the top of the income spectrum, people across the board have benefited from improvements in technology (say, safer cars, new medical treatments, and smartphones)…. 

… If the concept of growth is to have significance, it should represent improvements in lived experience. ….it must be a measure of the rate at which new solutions to human problems become available.
… Growth is best thought of as an increase in the quality and availability of solutions to human problems…. 

…. Can the rate at which solutions appear and their availability be measured? While such a measure has not been tried yet, we believe it is possible. Inflation is measured by looking at changes in the prices of goods and services in a “basket” typically consumed by households. Similarly, it’s possible to look at how the actual contents of such a basket are changing across time or how they differ across countries or levels of income. What kind of food, housing, clothing, transport, healthcare, education, leisure, and entertainment do people have access to?... 

Capitalism redefined 

… Capitalism provides incentives for millions of problem-solving experiments to occur every day, provides competition to select the best solutions, and provides incentives and mechanisms for scaling up and making the best solutions available. Meanwhile, it scales down or eliminates less successful ones. The great economist Joseph Schumpeter called this evolutionary process “creative destruction.”… 

… The orthodox economic view holds that capitalism works because it is efficient. But in reality, capitalism’s great strength is its problem-solving creativity and effectiveness. It is this creative effectiveness that by necessity makes it hugely inefficient and, like all evolutionary processes, inherently wasteful…. 

… Every business is based on an idea about how to solve a problem. The process of converting great ideas into products and services that effectively fulfill fast-changing human needs is what defines most businesses. Thus, the crucial contribution business makes to society is transforming ideas into products and services that solve problems…. 

… But some argue that elevating the creation of shareholder value to the status of primary objective is based on a faulty assumption—that capital is the scarcest resource in an economy, when in reality it’s knowledge that’s the scarce, critical ingredient in solving problems.5 It has also led to a myopic focus on quarterly earnings and short-term share-price swings, to say nothing of a decline in long-term investment….. This is not to say that shareholders or other owners are unimportant. But providing them with a return that is competitive compared with the alternatives is a boundary condition for a successful business; it is not the purpose of a business…. 

Government redefined 

… solving people’s problems—has, by necessity, a dark side: the solution to one person’s problem can create problems for someone else. This is the age-old puzzle of political economy: how does an economic system resolve conflicts and distribute benefits?... It can be challenging to distinguish between problem-solving and problem-creating economic activity. And who has the moral right to decide? Democracy is the best mechanism humans have come up with for navigating the trade-offs and weaknesses inherent in capitalism. Democracies allow its inevitable conflicts to be resolved in a way that maximizes fairness and legitimacy and that broadly reflects society’s views.
Seeing prosperity as solutions helps explain why democracy is so highly correlated with prosperity. Democracies actually help create prosperity because they do several things better than other systems of government. They tend to build economies that are more inclusive, enabling more citizens to be both creators of solutions and customers for other people’s solutions. And they offer the best way to resolve conflicts over whether economic activity is generating solutions or problems. Many (though not all) government regulations are created to do just that—to encourage economic activity that solves problems and to discourage economic activity that creates them—thus fostering trust and cooperation in society. 

Business people often complain about regulation—and indeed many regulations are poorly designed or unnecessary—but the reality is that solving capitalism’s problems requires the trust and cooperation that good regulation fosters. It is notable that the most prosperous economies in the world all mix regulation with free markets, while unregulated and anarchic economies are universally poor