Why we misunderstand capitalism

Wealth isn’t money. It’s having solutions to human problems.

I think everyone would profit from reading this recent article by Nick Hanauer and Eric Beinhocker, entitled Capitalism Redefined. Hanauer is a venture capitalist, Beinhocker an economist, and they offer a very unconventional view on what capitalism is, how it works, and why it is valuable. Forget the supposed efficiency of markets, or the allegedly “optimal” character of economic equilibrium, ideas you often hear about in discussions of modern economic theory. Hanauer and Beinhocker argue that this is mostly nonsense; capitalism isn’t efficient at all, nor are economies in any equilibrium. In fact, capitalism is hugely wasteful, but it is also an extremely effective evolutionary, problem-solving system. Understand this correctly, they suggest, and we could make capitalism work better, and not only for 1% of us.

Perhaps the most important point they make is that this evolutionary perspective makes it clear why rising economic inequality — all over the news today — is a terrible thing for our societies, and especially for capitalism itself. That’s not something you’re like to hear in the Wall Street Journal.

Capitalism Redefined is worth reading in its entirety. Below, I just want to highlight the part of their argument that looks at capitalism as an evolutionary system. Why evolution? Because human prosperity and wealth ultimately depend on our ability to find solutions to a vast array of human problems. Money is only useful through the solutions it can buy; the solutions themselves are primary. Wealth is having solutions. And evolution is the best recipe we know of for finding solutions to complex problems:

If prosperity is created by solving human problems, then the key question for society is what kind of economic system will solve the most problems for the most people the fastest? We have centuries of evidence now that capitalist economies do better at delivering high standards of living to their citizens than do economies run by communist, authoritarian, or other nonmarket systems. The explanation for this in standard economics is that capitalism uses price signals to provide incentives to produce and allocate goods in a way that will maximize people’s welfare. But if real-world markets are not the simple mechanistic systems imagined by thinkers of past centuries, but rather are complex, adaptive, and more like ecosystems, then the benefits of capitalism may be both different and greater than we imagined.
Every business is based on an idea about how to solve a problem, from the most mundane (“How do you make a potato chip crunchier?”) to the most profound (“How do we make a new life-saving cancer drug?”). The process of converting great ideas into products and services that effectively fulfill fast-changing human needs is what defines most businesses. But effectively finding good solutions requires a system that provides incentives and allows for creativity and trial and error. A capitalist economy is best understood as an evolutionary system, constantly creating and trying out new solutions to problems in a similar way to how evolution works in nature. Some solutions are “fitter” than others. The fittest survive and propagate. The unfit die. The great economist Joseph Schumpeter called this evolutionary process “creative destruction.” And he highlighted the importance of risk-taking entrepreneurs to make it work.
Thus, the entrepreneur’s principal contribution to the prosperity of a society is an idea that solves a problem. These ideas are then turned into the products and services that we consume, and the sum of those solutions ultimately represents the prosperity of that society.
Making all but the simplest products and meeting customer demand usually require more than one person, so entrepreneurs with new solutions hire workers. Those jobs in turn provide the means for people to purchase products and services from other entrepreneurs, which then creates the demand that generates more hiring and jobs. This positive feedback loop is the central dynamic found in capitalist economies. The more power this feedback loop has, the more growth and prosperity the economy creates.
Capitalism’s great power in creating prosperity comes from the evolutionary way in which it encourages individuals to explore the almost infinite space of potential solutions to human problems, and then scale up and propagate ideas that work, and scale down or discard those that don’t. Understanding prosperity as solutions, and capitalism as an evolutionary problem-solving system, clarifies why it is the most effective social technology ever devised for creating rising standards of living.

This perspective has a lot in common with the views of economists working in the area of Evolutionary Economics (which is very much not part of the mainstream). Hanauer and Beinhocker take this idea as a starting point, and then go much further.

They go on, first, to examine in more detail how modern economics has largely misconstrued capitalism, mainly because of its fascination with the concept of “efficiency.” Most economists believe, in some approximation at least, that markets are efficient in the sense that they pool information and act to bring all resources to their best use. Famous theorems in economics even claim to prove this (although they have to make lots of completely unrealistic assumptions to do so). But look around you, at companies going out of business, old factories left abandoned, city industrial centers in decay, etc., and it’s not easy to see a lot of efficiency. In financial markets, there’s huge speculative activity in all assets that is, in a very real sense, wasted. Again, there’s little here that is efficient in any ordinary sense of the term. But, Hanauer and Beinhocker argue, this activity is very effective in finding solutions, or in helping the capitalist system find its way to solutions:

The orthodox economic view holds that capitalism works because it is efficient. But viewing the economy as an evolving complex system shows that capitalism works because it is effective. In fact, capitalism’s great strength is its creativity, and interestingly, it is this creativity that by necessity makes it a hugely inefficient and wasteful evolutionary process. Near one of our houses is a site where each year, someone would open a restaurant only to see it fail a few months later. Each time, builders would come in, strip out the old furniture and decor, and put in something new. Then finally an entrepreneur discovered the right formula and the restaurant became a big hit, which it is to this day. Finding the solution to the problem of what the local residents wanted to eat wasn’t easy and took several tries. Capitalism is highly effective at finding and implementing solutions but it inevitably involves trial and error that is rarely efficient.
A critical element of understanding capitalism as an evolutionary, problem-solving system is the idea that it is not how hard we try to solve a problem that is critical, but rather, as the University of Michigan theorist Scott Page has shown, it is the diversity of ideas and approaches that matters most in problem-solving effectiveness. This “difference principle” helps makes clear why open and fair markets, diversity, and inclusive institutions are signal features of successful economies.

Once we understand this point, it is then a short step to some rather worrying conclusions regarding the likely consequences for rising inequality on the future effectiveness of capitalism. The new book on inequality by Thomas Piketty is getting wide coverage everywhere. It essentially documents the fact that socioeconomic inequality HAS increased dramatically in the past few decades in almost every western nation. It looks less at how inequality might ultimately affect economic activity in the future. Hanauer and Beinhocker suggest that if we consider how evolution works, it follows that inequality is likely to have a strongly negative impact on future economic growth (i.e. the rate at which we discover new important solutions to human problems).

Evolution, aft all, depends on parallel exploration on the past of many independent elements, and inequality will tend to reduce the number of people with the skills, education and means to contribute meaningfully to the capitalist solution-finding process. Capitalism, like evolution, thrives on exploration by many minds in parallel:

This feature of successful capitalism also highlights why investing in the middle class with “middle-out” approaches to policy creates a healthier economy… Even the best of us have only a few ideas. Bill Gates, our era’s wealthiest entrepreneur, arguably had only one big idea. Giving wealthy people like him tax breaks will not suddenly encourage them to have more ideas. It is far better for our country to enable every citizen to participate in our capitalist economy by ensuring that they have the requisite education and access to capital and training to convert their ideas into products that solve the world’s problems. A “middle-out” approach recognizes that effective policy is aimed at creating both new entrepreneurs with new ideas and more customers for those entrepreneurs. If workers have no money, businesses have no customers. Successful capitalist policies recognize and animate this circle-of-life feedback loop by balancing different elements in the economy to create a virtuous cycle of growth and shared prosperity.
The genius of capitalism is the way in which it rewards people for solving other people’s problems. People who effectively solve large problems for a large number of other people can be massively rewarded. Steve Jobs made a lot of people’s lives better through the products his company created, and he was highly rewarded for it. As Adam Smith observed 230 years ago, a thoughtfully managed and regulated capitalist economy harnesses people’s self-interest to the broad interests of society.
It is this freedom and the incentives for every citizen to solve problems that explains why capitalist countries are rich and why authoritarian and communist countries are generally poor. In such countries the problem-solving creativity of people is either circumscribed, prohibited, or quite often directed at solving problems for the regime. The extraordinary difference between the poverty of communist North Korea and the prosperity of capitalist South Korea is a demonstration of this.
It’s important to acknowledge, however, that not all solutions to human problems are created by entrepreneurs. A researcher at a university finding a new way to make computers work faster can solve an important problem just as readily as a capitalist (though it may take a capitalist to produce and spread the researcher’s idea). Likewise a teacher who finds a better way to teach algebra is also solving an important problem for society. So also is the diligent government worker who finds a way to deliver better services at lower cost to the public.
But the public sector sometimes struggles to create a culture and incentives
that allow space for the experimentation, risk-taking, and failure that are essential to effective problem solving. Bureaucracies and political forces can stifle or distort evolutionary exploration. That said, there are numerous problems that only government can solve, ranging from the provision of public goods such as roads and other infrastructure, to dealing with externalities such as reducing pollution, enforcing property rights, providing security, and addressing social injustices. Realistically, the public sector is going to play a big role in many parts of the economy as well as in many aspects of society. So governments need to be problem solvers, too. It is imperative that we bring the evolutionary processes of problem solving inside the walls of government and build public institutions that have incentives to innovate and space to experiment.
The view that prosperity is solutions, and growth is the rate at which we create them, also makes more obvious the crucial importance of investments by governments in technology, innovation, and education. Technology and innovation are the cornerstones of any society’s ability to generate new ideas and solutions. In most cases, it will be businesses and entrepreneurs who bring these solutions to citizens. But it will be the education of the workforce and the scientific, technical, and social innovations available to society that will empower these businesses. Thus, investments in R&D, innovation, and education are not luxuries made possible by growth and prosperity, as many policy-makers seem to believe. Rather, these investments are necessary to create growth and prosperity.

Personally, I think this is a brilliant take on capitalism. It’s too easy to hear the word “capitalism” and see images of greedy cigar-smoking industrialists or bonus-hungry Wall St. traders. This is the stuff that often gets emphasized, of course, as does the view that the few super-wealthy must be the wealth creators.

The evolutionary perspective is much more balanced, and, I think, positive — it sees capitalism as an engine of creativity that only works well if everyone is involved, and where every single human brain is a hugely valuable resource of creativity. In this sense, the 1% really do need the 99%. We all do.

Follow The Physics of Finance on Twitter: @Mark_Buchanan

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