Capitalism vs. Socialism: The Background

Ideology and The First World

A lot of people argue about communism, capitalism, and socialism. These are questions of ideology. In political discussions people easily throw around the labels “socialist” or “greedy capitalist”. In the 2008 U.S. presidential election some Republicans accused Barak Obama of being a “socialist”. On the other side, some Democrats accused the Republicans of being “greedy capitalists” and “free market fundamentalists”. These accusations continued into the 2012 presidential campaign. What do these terms mean? Just exactly what is “socialism”? And just exactly what is “capitalism”? What’s the difference between them? Which one is “best”? In a sense, these are the key questions that I hope this course will help you answer. Right now, at the beginning of the course, it’s too soon to offer an answer to these questions. Instead, I will suggest that the questions are themselves too simplistic.These are important issues. Indeed, in the course of the 20th century nations went to war over these issues. During a particularly nasty 60-year period of the 20th century, well over a hundred million people were slaughtered or died prematurely because of what were essentially disputes of economic ideology. Much of the same thinking has persisted into the 21st century. For most of this time, the ideological disputes have had their roots in the nations we now call the First World, the “Developed” or “Industrialized” Nations of the world.

Why Do We Have Economic Systems?

I have a problem. You have a problem. In fact, we all share a common problem. The problem is that we humans, being the imaginative beings we are, always want something more. No matter how well off we are, we always want something more. We always imagine that if only we had some more of something, or some of something else, we would be even better off than we are now. It could be more things like more money, more clothes, a bigger/better home, more or newer electronic gadgets, or a bigger or faster car. I have no doubt that you can think of few things that would make your life better right now! It’s not just things we want, though. We might want more time to do activities, more fame, more friends, more privacy, or more power. We always want more. Economists have a phrase for this aspect of humans: unlimited or insatiable wants. Unlimited wants by themselves aren’t necessarily a problem. After all, they provide the motivation for us to work and produce. By working, producing, and making things, we create more and better stuff and better conditions, and that helps us satisfy our wants. What makes our unlimited longings into a really big problem is another fact that economists observe: our resources are limited. Thus, an essential feature of the human condition is that we work and produce in order to satisfy our unlimited wants, but the resources we use to produce satisfaction are themselves limited. Economists have a name for this problem: the Economic Problem. The existence of the economic problem means that people, you and I, have to make some choices. We have to choose. Some wants won’t be satisfied. Some will. And, of course, since humans are social animals, that means our society has to make choices. Actually not only does our society face this Economic Problem and the need to make choices, all societies face the Economic Problem.The processes, interactions, and consequences of how people make these choices is what economists study. In other words, most economists define economics as “the study of human choice in the face of scarcity”.

The Economic Problem and Economic Systems

In very broad terms, we (both as individuals and as a society), have to make four types of decisions over and over and over all the time. These four decisions are what economists call the “four fundamental questions”. They are:

1. What goods should we produce with our limited resources?
2. How much of those goods should we produce (quantity)?
3. How do we produce them? What technology or method? Who does the work?
4. Who gets to consume the goods we produce and get the benefits?

Each society or country creates rules, laws, and institutional arrangements to help decide these questions. Economists refer to these institutional and legal arrangements as an economic system. There are many economic systems. Strictly speaking, every country and society develops their own economic system as part of their culture and development. But there are, of course, some general patterns to economic systems. The better known economic systems you may have heard of are “capitalism”, “communism”, and “socialism”. Other people classify economic systems into “command systems” vs. “market systems”. These are very simplistic labels, as we’ll learn later in this course. There are actually many different varieties of capitalism and of socialism, for instance.

Criticisms of this Idea of “Economic Problem”

There are critics of modern economics that object to this foundation, this assumption of scarcity. They observe that not everything is scarce – some things can be produced in nearly unlimited quantities at nearly free costs, such as making electronic copies of files. Other critics object to the implication that people are or must be greedy. Both of these objections result from misunderstanding the issue of scarcity. When economists observe that people have unlimited wants, we are not saying that people are greedy. We are simply observing that people always think their condition could be improved. It doesn’t necessarily mean that they want more stuff, although that does describe a lot of people. Even a selfless saint is likely to feel that they would be better off if they had more time or money to help others. We can always imagine ways to become better off.

Likewise, while it is true that modern technology has brought the cost of some items to nearly zero, and that there may be some resources, such as the sun’s energy, which are unlimited (or seemingly so), it doesn’t invalidate the “resources are limited” observation. Virtually everything we use to satisfy our wants requires a mixture of resources, and most resources are limited. If nothing, else, our time is strictly limited. We get 24 hours in a day. So even if you were the richest person in the world, you would have to make some choices. Even if you could buy any merchandise you wanted, you still need time to consume it. And time is limited. What we are going to study in microeconomics, is how people make choices, given these limited resources, in order to make their life as best as they can.

Key Ideas and Terms from Economics

We’ve already begun to use some of the basic terminology of economics. The way economists model or describe human activity is to imagine that all economic activity is divided into two types: consumption and production.

Consumption is the main point of existence – it is the satisfaction of our wants, such as eating, sleeping, playing games, being entertained, etc. Consumption usually involves the using-up of some stuff: goods. Goods are usually thought of as material things, like food, video games, TV’s, houses, cars, clothes, cell phones, movies, etc. But technically, “goods” can also include services such as being waited upon, or having your hair cut, or having your car washed. Some goods just appear in nature – like fruit on a tree. Some goods are considered “private” because the benefit of consuming them can be limited to one person (society may allow that person to “own” the good). But some goods are “public goods” because their benefits extend to many people, regardless of whether they own it. Instead of thinking of just individuals consuming goods, economists recognize that humans usually live in small groups such as a family. These small groups which make joint decisions about their consumption are called households. It’s usually good enough to think of a “household” as being the people who all live together. Sometimes, as in the case of bachelor living alone, a household may only include one person. In other cases, such as a large family living together in the same house, a household might include several individuals. The typical structure of households is one way that countries often differ from each other economically. When goods are bought or sold between two people it is called an economic transaction or trade. Sometimes the consumption of a good brings either benefits or harm to a third-party that wasn’t either the buyer or seller. This is called an externality. An example of an undesirable externality might be the pollution released by a factory that fouls the air everybody breathes. How a country handles externalities is another way economic systems vary.

Most goods require some humans to engage in production. By production, we mean the work activities of combining resources to create a desirable good. Of course there is an enormous, even innumerable, number of different resources. Typically economists classify resources into three types: land, labor, and capital. Some economists also classify “entrepreneurial spirit” or “risk-taking” as a fourth resource. Land is actually just any type of naturally occurring resource: land, dirt, minerals, the ocean, the air and atmosphere, animals, etc. Labor is broadly defined to include all human effort directed towards production, regardless of how the laborer gets paid. Finally, capital refers to goods that have been produced in the past with the intent of using them to produce more goods. For example, tools, factories, trains, highways, inventories, and even software and computers are considered capital. In some discussions, capital will also refer to the financial capital such as stocks, bonds, savings accounts, etc. Strictly speaking though financial capital should not be considered true capital. True capital is the tools & equipment. Financial capital allows a business to buy the real true capital.

Let’s Go Back In Time – A Brief, Stylized History

For a moment let’s go back in time. Let’s go back say 300-400 years ago to Europe and North America. This is the era of absolute monarch Kings and the feudal system in Europe. Think castles, manors, kings, nobles, armies fighting, and dirt-poor serfs working to grow the food for everybody. In Europe there were some small (very small, as in 1-10 workers) businesses beginning to manufacture products, primarily in the cities. In North America, there are some small colonies of settlers along the Atlantic coast, but most of the continent is populated by native Americans and First Peoples. Both of these types of societies had what we call a traditional economic system. In a traditional economic system, the economic problem isn’t really “solved” except for maybe the King. The fundamental questions of what to produce? how much? who gets the goods? are all answered the traditional way: do them the way society has always done. If your parents were rich nobles, you got to be a rich noble. If your parents were serfs growing wheat and tending sheep, then you were too. And you did it the same way they did using the same tools and methods.

Gradually, the Renaissance, Enlightenment, and exploration of the “New World” led to a growth of science and technology and new resources. This led to a rivalry between European countries. Nations competed to see who could be wealthiest. Unfortunately, for the 99+% of people living in these systems, “wealthier” generally was interpreted to mean more wealth for the King and upper classes with a small but growing “merchant” class.

Note: I know this brief history is very Euro- and dead-white-males centric, but unfortunately the dominant players in Economics of the past 250 years have been mostly dead white males. (well, they were alive at the time, but they’re dead now). No reason it has to stay that way in the future, though.

As the industrial revolution took hold and as trading with the New World expanded, the feudal system gradually gave way to a new economic system called “mercantilism”. Under mercantilism, the wealth of the nation was understood to be how much “treasure” or “money” or gold the nation could accumulate and how much territory it could command. Wars were fought, industries expanded, more goods produced, and trade flourished. But the thinking that “wealth” consisted of treasure led governments to pursue a policy of importing only natural resources and discouraging the import of manufactured goods. Colonies and possessions were to be exploited for the benefit of the central government.

At least until the late 1700’s. In 1776 to be specific, things realy began to change. The English colonies in America, of course, declared independence – largely because of the mercantilist policies of the English king. Thirteen years later in France, the people would revolt and decapitate their King. But in 1776 in another English possession, Scotland, a man publishes a book that sets economics onto a new path. His name was Adam Smith and the book was “An Enquiry Into the Nature and Causes of the Wealth of Nations”, commonly referred to as just The Wealth of Nations.

Smith accomplished three things with his book. First, he established the idea that the real wealth of a nation consisted of the living standards and productivity of the nation’s people. Smith established what we now call GDP as the best measure of how well off a country truly is. Second, he powerfully described how markets work and incentives work. Finally, he eloquently overturned the rationale for mercantilism and argued for a freer system.

Note: Smith and Karl Marx nearly a century later are probably two of the most powerful authors of the past few hundred years. To this day, millions, perhaps hundreds of millions, of people claim to be followers of some doctrine they believe Smith or Marx said. Unfortunately very few of these modern followers have ever actually read either Smith or Marx. Smith, were he alive today, would most definitely NOT be a free market capitalist and opponent of government regulation as we typically see in today’s politics. Likewise, near his death, when millions of people claimed to be promoting “Marxism”, Marx was quoted as saying “I am not a Marxist”.

Long After Smith: Capitalism Emerges

Long after Smith died, the industrial revolution and even better technology led to dramatic increases in national incomes and overall national wealth. The system we call Capitalism began to emerge in the 19th century in what we now call “the West”. In particular this means England, France, Germany, Holland, the U.S., and Japan. In 19th century these nations evolved economic systems that were a mix of the old mercantilism mixed with free trade (as promoted by Smith and others) mixed with a new type of heavily industrialized, private property, market-oriented system mixed with large banks. This new system came to be called Capitalism. During this period, those nations that were most Capitalistic and had the free-est markets came to grow the fastest. Capitalism itself then came to be dominated by a new institution: large, privately owned and privately managed corporations and banks who say their primary mission (often only mission) is to maximize profits. Along with the rise of corporations and Capitalism came an expansion of banking and the widespread use of paper money.

While “the West” was growing rapidly and getting richer, the rest of the world wasn’t. Much of it came under the imperialist domination of these few nations. The U.S. and Spain dominated South America. Britain dominated what is now Canada, Australia, New Zealand, Egypt, South Africa, and India. The Europeans split up the domination of China and Africa. Elsewhere, major nations that weren’t colonized by “the West”, such as Russia and the Ottoman Empire (now Turkey) were mired in older traditional, feudal systems.

In the late 19th century and early 20th century, the Capitalist system gained strong advocates and theorists among economists. Indeed most of what we consider the mainstream economists of that period became strong advocates. Eventually, in the 20th century free-market Capitalism would find its greatest and most powerful advocates in two groups of economists called The Austrian School and The Chicago School, led by Friedrich Hayek and Milton Friedman.

A New Alternative: Socialism

The 19th century wasn’t all roses and rising incomes though. The industrialization and urbanization of the western economies led to grinding poverty of many workers in the cities. The economies, while growing over the long-term, were prone to terrible instability. Periods of depression, recession, or financial panics occurred frequently. Some depressions, such as in 1871, lasted for years. Capitalism had its critics. Some of the critics were literary and motivated by compassion, telling the story of the poor in books and novels. Charles Dickens, the author of “A Christmas Carol” and “Oliver Twist”, was one of these critics. Other critics attempted to create or advocate the formation of small communities that would share all property and work for a common welfare. These critics took the name of “Socialists”.

Eventually an extremely powerful economist by the name of Karl Marx became the most famous of the critics of capitalism. Together with his friend and backer Friedrich Engels, Marx published two powerful documents: The Communist Manifesto and Das Kapital between 1848 and 1868. Many political movements grew up around Socialism. The followers of Marx named themselves Communists.

The several varieties of Socialism became extremely politically popular. However, Socialists never really gained control of any major government politically until the 20th century. Nonetheless, the political popularity of Socialist ideas forced governments to adopt many partly socialist policies such as welfare, public education, legalization of unions, and worker protection laws.

The Stage is Set and New Systems Emerge

The growing popularity of socialism and the rising wealth of capitalism set the stage for monumental confrontations in the 20th century that would change the economic system of virtually every country on the planet. Quite unfortunately, many of these changes were introduced violently through war or revolution. Four events in set the confrontation in motion. First, the First World War began in 1914 among the European powers and soon involved most of the world, destroying much of the economies that had been built up in the previous 50 years. (except for the U.S. which thrived during the war since the war was fought elsewhere) Second, this same war led to revolution in Russia and the establishment of the first avowedly communist system, the USSR. After the Russian revolution, a Communist system was no longer a theoretical option – there was an actual example of it.

Next the failure to successfully rebuild the world economy following the war combined with another of Capitalism’s frequent financial crises in 1929 to create the Great Depression of the 1930’s. Poverty and unemployment soared. The capitalist countries struggled and failed to restore prosperity in the 1930’s while the USSR boomed and industrialized. Capitalist countries were filled with fears of Socialist revolution and Capitalist theories were seemingly unable to provide any guidance on how to end the Depression. Then, a great British economist, John Maynard Keynes, emerged to explain the crisis and describe a way out. What he outlines is a kind of modified Capitalist system with a large over-sight role for government. His ideas are quickly dubbed Keynesianism.

At the same time, the post-World War I crises gave rise in Italy, Japan, and Germany to yet another type of economic system. It is called Fascism in Italy and National Socialism in Germany but lacks a name in Japan. The new system is variant of capitalism, in that it depends on private ownership and corporations, but the economic activity is strongly directed by the central government and monopolies encouraged. Fascism is, in effect, a strong alliance between big government and big business with a heavy dose of militaristic nationalism added.

By 1940, the world has a choice of at least six clearly different types of economic systems: Capitalism, Democratic Socialism, Communism, Keynesian Mixed Capitalism, Fascism/National Socialism, and traditional systems.

Capitalism vs. Socialism, The Great Confrontation

Over Simplifying Things: Capitalism vs. Socialism As Ideologies

As we’ve seen, the growing popularity of socialism, the rising wealth of capitalism, and the frequent crises of capitalism set the stage for monumental confrontations in the 20th century. These confrontations changed the economic system of virtually every country on the planet at some point. For some countries, they have changed multiple times. We have also seen there have actually been several different types of systems. Yet to many, especially non-economists, any discussion or classification of economics systems is limited to a simple choice: Capitalism vs. Socialism. In political discussions and in high school social studies courses, society’s need to have a system that answers the fundamental questions is usually characterized as a simple choice between Capitalism on one side vs. Socialism on the other. A few decades ago during the Cold War, the choice was more often characterized as either Capitalism or Communism.

Of course, this simple division of economic systems into Capitalist vs. Socialist/Communism is far too simplistic. It also tends to bring heavily political overtones to the discussion. Therefore, many principles of economics principles and economists prefer to classify economic systems into a simple Market system vs. Command/Planned system.

Either of these simple dichotomies is a drastic oversimplification. Every country’s economic system has features that are unique to it. Further, there is not now and has never been any country that had a “pure” economic system. What most people describe as an “economic system” is in fact an ideology – a statement of their theoretical desire. So with this disclaimer in mind, let’s venture into a simple characterization of what is involved in these ideologies.

A Market System

A market system is one where individuals are free to trade goods and resources with each other. Typically all property, goods, and resources (or most) are privately owned. Further, individuals are free to make their own decisions about whether and what to trade based on their own objectives. Typically these objectives are to maximize utility, profit, and their own individual welfare. Substantial theory and experience exists to support the idea that competitive markets are powerful institutions capable of achieving enormous efficiency and growth under certain circumstances.

Among extreme market ideologues, government is seen as an undesirable. Government power and actions in the economy are to be minimized. Market advocates are more concerned with efficiency and growth than with fairness of the distribution of wealth. Such a viewpoint is expressed in phrases such as: “a rising tide lifts all boats” and “make the pie bigger instead of fighting over how it’s sliced”.

What goods are produced and in what quantities is a decentralized decision made by various different producers, typically businesses. These producers get their signals from consumers via prices. The distribution of goods is according to wealth and income.

In modern industrialized societies, markets are a pervasive feature of the economic system. In the U.S., for example, markets help determine the allocation of many resources and markets coordinate the decisions of millions of individuals. Even in the U.S., though, markets are not the only way to allocate resources, coordinate decisions, and answer the four fundamental economic questions. At least 40% (and some would argue over 50%) of U.S. economic resources are allocated according to government or political processes, not market processes. Also, the markets that do exist, vary greatly in how free they are and how competitive they are.

Command/Centrally Planned Systems

A command economy or centrally planned system involves having the government or some government agency consciously make most of the economic decisions. An extreme example is from the former USSR where a central agency called Gosplan made annual and 5-year plans. These plans decided what products each factory made, in what quantities. The plans also determined what wages workers would get and what all prices of goods would be. Transactions not in the plan were illegal and prohibited.

Capitalism

The defining feature of capitalism is private ownership and management of productive capital: factories, equipment, investment monies, hospitals, etc. Along with this ownership comes the ability of the private owners to reap profits. Often Capitalism is combined with a market system so that the power to decide what goods to produce and in what quantities is also made by the owners of the businesses. In many people’s minds, Capitalism is often associated with competition in markets, but there is no reason why Capitalism must be competitive. Indeed, the history of most capitalist economies indicates a tendency towards monopoly in many industries. In other cases, such as Fascist Italy or National Socialism in Germany, capitalist ownership and management of businesses was combined with central planning by the government.

Socialism/Communism

Under Socialism/Communism, the ownership of at least the critical key productive resources such as major factories is owned by society, a government agency, or perhaps the workers themselves. Typically, the owning group is the government. At other times, such as the early years of the USSR, the ownership and management of factories was controlled by the councils of workers themselves called “Soviets”. In socialism, the intent is often to redistribute the rewards or wealth or income of the nation to achieve greater fairness of both opportunity and results. At other times, the dominant concern is to achieve greater stability even at the cost of slower economic growth.

Keynesianism

Under a Keynesian system, an economy is essentially a mixed or free market capitalist system. However, the government takes an active role in the economy to try to stabilize the ups and downs of capitalism. The typical tools by which Capitalism is stabilized in a Keynesian system involve: a) changing the government budget (taxes and/or spending), b) establishing regulations for safety or information, and c) changing interest rates or the availability of credit from banks. This does require a degree of “economic planning” by the government, but far short of the kind of detailed planning involved in a command economy. It’s more of setting the right conditions for Capitalism to thrive.

Combinations of Systems

In reality, all economies today have a Mixed Economic System with strong Keynesian features. A mixed system has features of all of these above systems. However, some countries and systems tend towards one or another of these ideologies. In truth, history is messy. Countries, societies, and economies are messy, mixed things. Economies evolve. So while politicians and intellectuals may hold particular ideologies and have a theoretical model of how they want the economic system to be and to operate, it rarely works that way.  Adam Smith wouldn’t recognize nor likely approve much of what people claim are “capitalist free markets”. Neither would Karl Marx have approved what the Soviet Union did. Real economic systems just happen.