Behind the “-Isms”

Societies around the world have always matched people with capital. No matter when or where, there have been only four institutions through which people carried out this matchmaking: Parents (bankers furnished by nature), savings and financial markets, governments, and criminal organizations. The choice of these means lies at the core of our “-isms,” including the two that figure most prominently in American public opinion right now: capitalism and socialism. The better ability of capitalist democracies to efficiently match capital to people according to their talent comes about because there are more institutions to restore accountability faster, with the deeper financial sector and the risk of default playing the critical roles.

Capitalism refers to a system in which most of the matching—and mismatching—of people to capital happens through parents and financial markets, with limited roles for government as a financial intermediary.

Communism is the name we often give to societies in which capital markets are outlawed and parents’ disposable incomes are determined by government, resulting in the presumption that government is doing all the matching. I say “presumption” because even in communist Russia black markets played extensive roles, demonstrating that the centralized decision-making was a delusion. Moreover, people under these regimes risked their lives, voted with their feet, and escaped—in boats from Cuba, and over land from Eastern Europe and today’s Venezuela—showing that centralization, even when enforced with draconian laws, has its limits. Mao’s drastic re-education programs and the somewhat less drastic ones attempting to indoctrinate Eastern Europe failed too.

Societies labeled “socialist” are those experimenting with institutions that sometimes lead to more government matchmaking (through taxing and borrowing) and sometimes to less. The term “democratic socialism” refers to this pendulum, reflecting the swing toward greater centralization as the mismatches compound and the political process seeks to correct them. The pendulum eventually swings back—but this takes a long time. “Capitalist democracy” is subject to swings too, but they are of shorter duration since the deeper financial markets correct the mismatches faster, as explained below.

Parents, intermediaries in financial markets, politicians, and bureaucrats—all those engaged in matchmaking between people, resources, and capital markets—make mistakes. This is true even when they have the best intentions for their countrymen, let alone when they pursue private interests, establish dynasties, or try to keep particular parties in power. Parents make mistakes too, as the recent college admissions scandal shows, indulging their not-so-talented kids and using the political process to secure for them admittance to brand name schools, bribing intermediaries, or practicing nepotism.

Intermediaries in financial markets are making their share of mistakes too. The 2008 financial crisis was a perfect storm of the private sector’s unaccountable mismatching compounded by a range of political mistakes. The latter started, perhaps, with the best intentions, such as exempting up to $500,000 in capital gains in real estate (but not from stocks and bonds) from taxation, thus directing resources to the real estate sector. The existence of Fannie Mae and Freddie Mac; a range of misguided banking regulations; and a government-granted oligopoly of rating agencies all also started with good intentions but ended up contributing to disaster.

Democracy, many presume, corrects such mismatching and mitigates the compounding of mistakes, preventing society from digging itself deeper into holes. Every mismatch is a loss, never mind how statisticians specialized in aggregates count the spending. After all, it does not matter if a private company categorizes $100 million in spending as R&D, or government categorizes similar spending as “investment”—if the spending does not lead to the creation of assets bringing future incomes or tax receipts, it was a redistribution only, transferring incomes from some pockets to others. Democratic socialism presumes that voting, combined with a maze of institutions—the political process and centralization of decisions—is the most effective way to correct such mistaken mismatching in society.

Capitalist democracy is also associated with this pendulum—the difference being that it presumes that capital markets do a better and faster job at correcting such mistakes, with all parties in the matching process being held accountable.

Those believing in the superiority of capitalist democracy do not deny the role of governments in certain sectors and certain situations. (Adam Smith, superficially viewed as the high priest of markets, though he was far more than that, was in favor of both the Navigation Act, which protected industry linked to the military, and severe regulation of banks.) The difference between a believer in capitalist democracy and a believer in democratic socialism is that parents and players in the private sector (including an independent legal system) correct their mismatching and restore accountability faster than do politicians and government bureaucracies.

The reason for the greater speed is that governments can pursue mistaken policies longer since they have monopoly powers on imposing taxes and regulations and on coordinating monetary policies with central banks. Players in the private sector go bankrupt if they compound their mistakes. Their cost of accessing capital markets increases, and eventually they have no access at all. Put simply, players in private markets can be held accountable faster than governments because the Damoclean sword of bankruptcy hovering above their heads falls faster.  The wide range of evidence from around the world leaves no doubt about this speedier adjustment.

Why then has democratic socialism become more popular the last few years in the U.S. and Western Europe? The answer is that so many grave policy mistakes accumulated that the private sector could not correct them. The government’s own policies impeded private solutions.  As a result, people voted for politicians advocating additional government policies promising to solve the problems, not realizing that the new policies brought about even more complex mazes of mismatches. The failures of the many Latin American, Middle Eastern, and Asian economies pursuing “social democracy” of one superficial variety or another are the more extreme cases in point—not having financial sectors to disperse power and help correct mistakes. Though Western European countries have deeper financial sectors than the newer “social democracies” around the world, they are still shallow compared to that of the U.S.—as a glance at their angel investments and venture capital data instantly show.

The historical evidence leaves no doubt: while some misguided “isms” spread for a while, the resulting mismatches will compound, leading to defaults and competitive disadvantage when compared to societies using a better method of matching. In what has, for the moment, been a mild expression of this process, events in the United States the last few years reflect this reality.

The use of these “isms”—having been turned into strident caricatures—distracts us from the basic question: what political and private institutions are better at mitigating mismatches, and, when mismatches occur, correcting them faster by holding people more accountable?

The origin of such distraction was perfectly captured in an exchange in Moss Hart’s and George Kaufman’s classic play, You Can’t Take It with You:

Grandpa: Penny, why don’t you write a play about Ism-Mania?

Penny: Ism-Mania?

Grandpa: Yeah, sure, you know, Communism, Fascism, Voodoo-ism, everybody’s got an -ism these days.

Penny: Oh. I thought it was some kind of itch or something.

Grandpa: Well, it’s just as catching. When things go a little bad nowadays, you go out, get yourself an -ism and you’re in business.

I would add to this last sentence that, yes, while you’re in business with an “-ism,” whether you get better or worse depends on which way the “pendulum” is swinging. While people are familiar with the saying “necessity is the mother of invention,” they conveniently forget the second part of this saying—which the historical evidence supports strongly too—namely that “necessity is also the stepmother of deception.”

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