Editor’s note: This is the second of a five-part series examining the Capitalism Problem and what everyone needs to know about its shortcomings and opportunities. To read the series from the beginning, click here.
The Capitalism Problem — a dual issue economic disparity and unethical decisions by corporations — is increasingly a problem that we need to address now.
History Showed Early Signs the Capitalism Problem Would Arise
Milton Friedman, an American economist and Nobel prize winner, described capitalism as a system that “allows buyers and sellers to trade with limited government interference which also allows private ownership of income and wealth” (Auerbach, 2013, p. 383). In his definition, government should be minimized. Milton Friedman also argued that maximizing shareholder value was the sole mission of business leaders (Hart & Zingales, 2017). The sentiment of limited government interference and maximizing shareholder value became the guiding principle of government and business for over three decades, setting the stage for today’s challenges with capitalism.
Taking a step back to Adam Smith, known as the father of capitalism, some simplify the model that he developed as the importance of the invisible hand in keeping a political economy working well (Bassiry & Jones, 1993). The invisible hand refers to how self-interested behavior in an unfettered marketplace tends to allocate resources efficiently (Matthews, 2014). However, the idea of the invisible hand may miss Adam Smith’s intention. Further exploration of the invisible hand concept can lead to an interpretation that emphasizes harmony, community, self-esteem, and concern for others (Painter-Morland & Slegers, 2018).
The reality is that Adam Smith tried to develop a system that was more moral and ethical than the mercantilist times of that period, and a new economic system was a path to address the ethical concerns of the mercantilist system (Bassiry & Jones, 1993). Adam Smith also tried to address what he saw as some of the potential weaknesses of capitalism, which included hurting the spirit and work ethic of the workers, the rising ranks of the idle rich, and a government that catered to the privileged (Bassiry & Jones, 1993).
An often-missed element is that Adam Smith envisioned a moral system through an economic structure.
Adam Smith’s concerns seemed largely sidestepped by Milton Friedman, instead focusing only on increasing shareholder value and limiting government involvement. Over time, executive compensation and maximizing shareholder value became linked. In the 1970s, stock-based executive pay was limited, but starting in the 1980s, the stock-based executive compensation limits disappeared (Lazonick, 2015). Lazonick points out how the focus on maximizing shareholder value and being rewarded for stock price increases led to a downsize and distribute model, manipulating stock price through employee layoffs and stock buybacks. The result created a compensation disparity that also propelled greater distrust of corporate actions.
Limited government translated into minimally coercive actions. Taken in its truest form, Sternberg (2015) argues that capitalism does not include profits, capital, purpose, or competition in its definition. The government’s primary role is to protect people and property and enforce contracts (Sternberg, 2015). In the 1930s, the U.S. government may have more closely represented this depiction (Sternberg, 2015), but The Great Depression introduced greater government involvement that has varied in its enforcement and regulation policies since that time. Milton Friedman’s philosophy on capitalism may have sought to return to a pre-1930s era with the added focus on the role of a business leader, which is maximizing shareholder value.
Milton Friedman was a professor at the University of Chicago when his principles of capitalism were espoused. In 2017, the University of Chicago began to unravel Milton Friedman’s philosophy by introducing the need for maximizing for shareholder welfare since shareholders are concerned not just about money but also for the quality of society, according to Hart & Zingales’ essay in Journal of Law, Finance, and Accounting.
Hart and Zingales (2017) argue that maximizing shareholder welfare takes into account the shareholder’s social values, and shareholders should be able to propose, promote, and vote on policies that support certain societal values. Hart and Zingales do not directly address government intervention; however, they do reference that if the government has policies to address the social issues, then the shareholders do not need to vote or pursue similar policies.
The historical context of capitalism is important in understanding the initial concerns from the father of capitalism and how the philosophy of another economist influenced capitalism to its current state.
Capitalism is not a fixed model, having experienced changes in current thought along with financial, economic, social, and technological changes.
Viewing capitalism as a moral and ethical system, while having an economic system to address these concerns, seems relevant today.
Importance of Addressing the Capitalism Problem
Although a discussion of policies can be passionate, addressing the problems of capitalism cannot be ignored. Concerns with the growing disparities and ethical decline will appear in elections and with citizens who desire a better model of capitalism. Capitalism’s problems need to be addressed to limit the political power of the wealthy few and renew the moral foundations of our economic system.
A widening economic disparity matters because economic inequality limits economic freedom and increases the political power of the elite to gain approval of economic policies they want, according to authors Krieger and Meierrieks in 2016’s European Journal of Political Economy. The quality of institutions in a democracy begins to fail, especially for the middle-class, Krieger and Meierrieks state. Widening gaps trigger policies to be one-sided and institutions to weaken, leaving capitalism with lessening accountability. Moreover, with the economic elite having a greater influence on policies favorable to them, the middle-class will unlikely gain policies to improve their economic standing, according to Krieger and Meierrieks (2016).
Another element is diverting capital from its most productive use. When the wealthy can exert greater influence on tax policy, regulations, and spending priorities, funds can be diverted to unproductive uses, says Gottschang (2016) in Perspectives on Political Science.
Without adequate resources directed toward low-income families, education of their children can suffer, making it difficult for them to raise their income levels as they become adults, Gottschang said.
Addressing the problems of capitalism relates to a strong society and institutions. Having a strong middle-class maintains a balance in the government and the corresponding policies.
Shareholder primacy and short-term incentives place companies on a path that can drive decisions that negatively impact employees and widen income gaps between executives and employees, according to Segal (2017). When this happens, companies begin to lose their moral underpinnings, he argues.
In a recent trust survey, only 20 percent believe that the capitalist system works for them with nearly 50 percent believing the system is failing them. Losing our foundational trust and moral underpinnings can create negative ripples throughout business and society if left unaddressed.
Capitalism is a system that underlies our economic, political, and moral principles, and ongoing scrutiny is necessary to maintain the ethical values that deliver a strong social and business order.
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Auerbach, R. D. (2013). “The benefits of capitalism and freedom will survive the financial crisis and this seminar”. Forum for Social Economics, 42(4), 379–385. doi:10.1080/07360932.2012.701377
Bassiry, G. R., & Jones, M. (1993). Adam Smith and the ethics of contemporary capitalism. Journal of Business Ethics, 12(8), 621–627. doi:10.1007/bf01845899
Gottschang, T. R. (2016). What if Picketty is right? Real economic costs of rising income inequality. Perspectives on Political Science, 46(1), 11–15. doi:10.1080/10457097.2016.1203229
Hart, O., & Zingales, L. (2017). Companies should maximize shareholder welfare not market value. Journal of Law, Finance, and Accounting,2, 247–274. doi:10.2139/ssrn.3004794
Krieger, & Meierrieks. (2016). Political capitalism: The interaction between income inequality, economic freedom and democracy. European Journal of Political Economy, 45, 115–132.
Matthews, C. (2014, August 13). The ‘invisible hand’ has an iron grip on America. Retrieved from http://fortune.com/2014/08/13/invisible-hand-american-economy/
Painter-Morland, M., & Slegers, R. (2018). Strengthening “Giving Voice to Values” in business schools by reconsidering the “invisible hand” metaphor. Journal of Business Ethics, 147(4), 807–819.
Segal, L. (2017). Benefit corporations: A step towards reversing capitalism’s crisis of legitimacy? Virginia Journal of Social Policy & the Law, 24(2), 97–123.
Sternberg, E. (2015). Defining capitalism. Economic Affairs, 35(3), 380–396.