Adam Smith started a conversation in 1776 about the economic and moral benefits of the “invisible hand” in the marketplace – making society better off, in spite of there being no coordinated plan.  Karl Marx argued that the unstoppable workings of history would inevitably lead to a socialist utopia.  In 1976, the sociologist Daniel Bell wrote of the “Cultural Contradictions of Capitalism”, whereby the underlying Protestant Work Ethic is corroded because of the hedonistic consumerism in a capitalist society.  Marx was wrong.  Bell was wrong about the end of capitalism, even if his critique of an aimless society still stings.  Where do we stand today on Smith’s breakthrough claims regarding the moral and economic superiority of the “free market”?

Support for the most simplified view of markets being truly perfect reached its peak following the Reagan/Thatcher years when the totalitarian communist alternative collapsed and the Atlantic version of a mixed economy demonstrated significant ongoing advantages compared with the Nordic version with greater state involvement.  Events of the last two decades – rise of China/emerging markets and fall of US/UK from the Great Recession – have undercut the plausibility of an extreme market solution being the best,  only or final answer.

It is obvious in hindsight that the business cycle has not been tamed, that financial markets are inherently unstable and subject to “animal spirits”, that markets are not perfect and that greed will continue to drive many market participants.  In spite of the positive societal benefits of financial innovations such as options, mutual funds, checkable deposits, portfolios and securitized assets, the broad financial sector seems to be an ongoing source of the greatest failures in capitalism.  The formal definition of “perfect market theory” has not reduced volatility, but it has led to a finance sector where every possible trick is used to generate “wealth”: Ponzi schemes, the carrying trade in foreign investing, borrowing short and lending long, off-balance sheet vehicles, hedge funds and extreme leverage to name a few.

A visible part of the general business sector appears to be equally enamored of finding every possible way to create financial wealth beyond “the old fashioned way, we earn it”.  Mergers and acquisitions continue because they can reduce competition, leverage overvalued stock prices and employ low-cost borrowing, even though on average they do not provide a net return to stockholders.  Corporations manage reported earnings, producing smooth growth for quarters until the next recession provides an opportunity to report losses due to extraordinary items and business conditions.  Executive pay increases as a share of revenues, as stockholders find themselves unable to solve “the agency problem”.  Corporations promote legal and public relations executives to the highest levels because the opportunities to create incremental wealth through influencing public policy are greater than investing in new products or markets.

On the other hand, it remains clear that capitalism remains a tremendous value creating mechanism for society, with productivity growth, innovation and personal incomes rising at strong rates without any long-term end in sight.  The system’s incentives do focus resources on innovation and dynamic value creation.  In spite of John Kenneth Galbraith’s old claims in “The Affluent Society”, there appears to be no limit to the demand for personal consumption at any income levels in society.  The recent work “Richistan” notes that individuals with $5M of annual income feel they would be secure if they only earned 50% more!

In a fundamental way, we’ve come back to the basic framework and issues of economics raised in the post-war period.  What is the right role for government in a mixed economy? 

We have learned some things in the last 50 years and the consensus view is more to the right than it was in 1950 or 1970.  The dynamic long-run wealth creating role of capitalism is better appreciated, including its role as a poverty and inequality reducing strategy.  Most agree that monetary policy matters, expectations about government behavior matter and “fine tuning” is only a theory.  Market competitors are the best anti-monopoly force, so regulation should be light and focus on anti-competitive actions rather than narrowly defined market shares.  Ongoing growth of real incomes in the bottom third of society can offset rising dollar inequality.  John Rawls’ philosophical justification for some income redistribution resonates for many moderates and liberals, but Robert Nozik’s emphasis on “fair rules” alone provides conservatives with a deeply felt alternative view.  Government actors are as subject to self-interest as consumers and capitalists, especially with regard to being “captured” by those they aim to regulate.  Countervailing forces such as labor unions are blunt instruments, which may not even benefit the groups they aim to support.

Many economists would like to see the public policy debates return to the post-war topics, with the two political parties sliding from left to right within the informed framework of current economic knowledge.  Capitalism provides great value as Adam Smith demonstrated.  There are inherent risks due to relying on self-interest (as Smith also noted).  There is a role for government in counterbalancing the business cycle, maintaining fair markets, managing the self-interest of government actors and ensuring public support for capitalism in spite of the unequal distribution of benefits.  The political parties exist to find a “happy medium” on these issues.

The current political climate does not readily support this possibility.  The Republican Party has become increasingly consistent, philosophical, libertarian and monetarist in its views.  Its leaders increasingly define a single economic viewpoint: minimal government, no taxes, minimal economic regulations, rules based monetarism, minimal anti-competitive policy or enforcement, zero income redistribution, etc.  While each of these views has philosophical and substantive research support, the combination of doctrinaire views leaves no room for a sliding scale in public policy, for the only preferred solution is “zero”. 

The Democratic Party has not lost its preference for “redistributing the pie” versus “growing the pie”.  It has not helped its union supporters to evolve into a German or Japanese style alternative way.  It has championed continued protection of its public sector employee supporters from accountability or competition.  It has reached the goal of universal social welfare coverage for health care.  In spite of some tactical moves to the center on economic issues (welfare reform, the means of health care reform, international trade), the Democratic Party continues to emphasize those policy areas that increase the role of the state versus the individual, rather than identifying ways to better leverage the value creating potential of markets.

It seems that it will take more than President Obama’s slogans of “hope and change” to get our political parties and politicians to focus on the potential for increased economic growth and pragmatically justified economic roles for the government.  Perhaps, we need another “political economist” to develop a breakthrough theory of the political sector as insightful and valuable as Smith’s view of the market.