Capitalism

I

INTRODUCTION

Capitalism, economic system in which private individuals and business firms carry on the production and exchange of goods and services through a complex network of prices and markets. Although rooted in antiquity, capitalism is primarily European in its origins; it evolved through a number of stages, reaching its zenith in the 19th century. From Europe, and especially from England, capitalism spread throughout the world, largely unchallenged as the dominant economic and social system until World War I (1914-1918) ushered in modern communism (or Marxism) as a vigorous and hostile competing system.

The term capitalism was first introduced in the mid-19th century by Karl Marx, the founder of communism. Free enterprise and market system are terms also frequently employed to describe modern non-Communist economies. Sometimes the term mixed economy is used to designate the kind of economic system most often found in Western nations.

The individual who comes closest to being the originator of contemporary capitalism is the Scottish philosopher Adam Smith, who first set forth the essential economic principles that undergird this system. In his classic An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith sought to show how it was possible to pursue private gain in ways that would further not just the interests of the individual but those of society as a whole. Society's interests are met by maximum production of the things that people want. In a now famous phrase, Smith said that the combination of self-interest, private property, and competition among sellers in markets will lead producers “as by an invisible hand” to an end that they did not intend, namely, the well-being of society.

II

CHARACTERISTICS OF CAPITALISM

Throughout its history, but especially during its ascendency in the 19th century, capitalism has had certain key characteristics. First, basic production facilities—land and capital—are privately owned. Capital in this sense means the buildings, machines, and other equipment used to produce goods and services that are ultimately consumed. Second, economic activity is organized and coordinated through the interaction of buyers and sellers (or producers) in markets. Third, owners of land and capital as well as the workers they employ are free to pursue their own self-interests in seeking maximum gain from the use of their resources and labor in production. Consumers are free to spend their incomes in ways that they believe will yield the greatest satisfaction. This principle, called consumer sovereignty, reflects the idea that under capitalism producers will be forced by competition to use their resources in ways that will best satisfy the wants of consumers. Self-interest and the pursuit of gain lead them to do this. Fourth, under this system a minimum of government supervision is required; if competition is present, economic activity will be self-regulating. Government will be necessary only to protect society from foreign attack, uphold the rights of private property, and guarantee contracts. This 19th-century view of government's role in the capitalist system was significantly modified by ideas and events of the 20th century.

III

ORIGINS

Merchants and trade are as old as civilization itself, but capitalism as a coherent economic system had its origins in Europe in the 13th century, toward the close of the feudal era. Human beings, Adam Smith said, have always had a propensity to “truck, barter, and exchange one thing for another.” This inclination toward trade and exchange was rekindled and stimulated by the series of Crusades that absorbed the energies of much of Europe from the 11th through the 13th centuries. The voyages of discovery in the 15th and 16th centuries gave further impetus to business and trade, especially following the vast flood of precious metals that poured into Europe after the discovery and conquest of the New World. The economic order that emerged from these events was essentially commercial or mercantile; that is, its central focus remained on the exchange of goods rather than on their production. Emphasis on production did not come until the rise of industrialism in the 19th century.

Before that time, however, an important figure in the capitalistic system began to emerge: the entrepreneur, or risk taker. A key element in capitalism is the undertaking of activity in the expectation that it will yield gain in the future. Because the future is unknown, both the risk of loss and the possibility of gain always exist. The assumption of risk involves the specialized role of the entrepreneur.

The thrust toward capitalism from the 13th century onward was furthered by the forces of the Renaissance and the Reformation. These momentous developments changed society enormously and paved the way for the emergence of the modern nation-state, which eventually provided the essential peace, law, and order crucial for the growth of capitalism. This growth is achieved through the accumulation of an economic surplus by the private entrepreneur and the plowing of this surplus back into the system for further expansion. Without some minimum of peace, stability, and continuity this process cannot continue.

IV

MERCANTILISM

From the 15th to the 18th century, when the modern nation-state was being born, capitalism not only took on a commercial flavor but also developed in another special direction known as mercantilism. This peculiar form of capitalism attained its highest level in England.

The mercantilist system rested on private property and the use of markets for the basic organization of economic activity. Unlike the capitalism of Adam Smith, the fundamental focus of mercantilism was on the self-interest of the sovereign (that is, the state), and not the self-interest of the individual owners of economic resources. In the mercantilist era, the basic purpose of economic policy was to strengthen the national state and to further its aims. To this end the government exercised much control over production, exchange, and consumption.

The most distinctive feature of mercantilism was the state's preoccupation with accumulating national wealth in the form of gold and silver. Because most nations did not have a natural abundance of such precious metals, the best way to acquire them was through trade. This meant striving for a favorable trade balance—that is, a surplus of exports over imports. Foreign states would then have to pay for imports in gold or silver. Mercantilist states also favored maintaining low wages, believing that this would discourage imports, contribute to the export surplus, and thus swell the influx of gold.

More sophisticated proponents of the mercantilist doctrine understood that the real wealth of a nation was not its hoard of precious metals, but its ability to produce. They correctly saw that the influx of gold and silver from a favorable trade balance would serve as a stimulus to economic activity generally, thus enabling the state to levy more taxes and gain more revenue. Only a few states that practiced mercantilism, however, understood this principle.

V

BEGINNINGS OF MODERN CAPITALISM

Two developments paved the way for the emergence of modern capitalism; both took place in the latter half of the 18th century. The first was the appearance of the physiocrats in France after 1750; and the second was the devastating impact that the ideas of Adam Smith had on the principles and practice of mercantilism.

A

The Physiocrats

Physiocracy is the term applied to a school of economic thought that suggested the existence of a natural order in economics, one that does not require direction from the state for people to be prosperous. The leader of the physiocrats, the economist François Quesnay, set forth the basic principles in his Tableau économique (1758), in which he traced the flow of money and goods through the economy. Simply put, this flow was seen to be both circular and self-sustaining. More important, however, was that it rested on the division of society into three main classes: (1) The productive class was made up of those engaged in agriculture, fishing, and mining, representing one-half of the population. (2) The proprietary class consisted of landed proprietors and those supported by them, which amounted to one-quarter of the population. (3) The artisan, or sterile, class, made up the rest of the population.

Quesnay's Tableau is significant because it expressed the belief that only the agricultural classes are capable of producing a surplus or net product, out of which the state either could find the capital to support an expansion of the flow of goods and money or could levy taxes to meet its needs. Other activities, such as manufacturing, were regarded as essentially sterile, because they did not produce new wealth but simply transformed or circulated the output of the productive class. It was this aspect of physiocratic thought that was turned against mercantilism. If industry did not create wealth, then it was futile for the state to try to enhance society's wealth by a detailed regulation and direction of economic activity.

B

The Doctrine of Adam Smith

The ideas of Adam Smith represented more than just the first systematic treatise on economics; they were a frontal attack on the doctrines of mercantilism. Like the physiocrats, Smith tried to show the existence of a “natural” economic order, one that would function most efficiently if the state played a highly limited role. Unlike the physiocrats, however, Smith did not believe that industry was unproductive or that only the agricultural sector was capable of producing a surplus above the subsistence needs of society. Rather, Smith saw in the division of labor and the extension of markets almost limitless possibilities for society to expand its wealth through manufacture and trade.

Thus, both the physiocrats and Smith contributed to the belief that the economic powers of governments should be limited and that there existed a natural order of liberty applicable to the economy. It was Smith, however, far more than the physiocrats, who opened the way for industrialization and the emergence of modern capitalism in the 19th century.

VI

THE RISE OF INDUSTRIALIZATION

The ideas of Smith and the physiocrats provided the ideological and intellectual background for the Industrial Revolution—the material side of the sweeping transformations in society and the world that characterized the 19th century. No precise date can be given for this “revolution”; it is generally conceded to have begun in the late 18th century.

The fundamental characteristic of the industrialization process was the introduction of mechanical power (originally steam) to replace human and animal power in the production of goods and services. As the mechanization of production gained momentum in England and gradually spread to other parts of the world, several fundamental changes occurred. Production became more specialized and concentrated in larger units, called factories. The artisans and small shops of the 18th century did not disappear, but they were relegated to the periphery of economic activity in the leading nations, especially in England, the United States, and Germany. The modern working class began to emerge; workers no longer owned their tools, they had little property, and generally they had to exchange their labor for a money wage. The application of mechanical power to production brought with it a great increase in worker efficiency, which made goods abundant and cheap. Consequently, the real standard of living rose throughout much of the world during the 19th century.

The development of industrial capitalism had serious human costs. The early days of the Industrial Revolution were marred by appalling conditions for large numbers of workers, especially in England. Abusive child labor, long working hours, and dangerous and unhealthy workplaces were common. These conditions led Karl Marx, who spent most of his adult life in England, to produce his massive indictment of the capitalistic system, Das Kapital (3 volumes, 1867-94). Marx's work, which is the intellectual foundation for the kind of Communist economic systems used in the former Union of Soviet Socialist Republics (USSR), struck at the fundamental principle of capitalism—private ownership of the means of production. Marx believed that land and capital should be owned collectively (that is, by society) and that the products of the system should be distributed according to need.

Capitalism was also beset by cycles of 'boom and bust,' periods of expansion and prosperity followed by economic collapse and waves of unemployment. The classical economists who refined the ideas of Adam Smith had no ready explanation for the ups and downs of economic life, being content to view such cycles as the inevitable price that society had to pay for the material progress experienced under capitalism. Marxian criticisms, along with frequent depressions in the major capitalist nations, helped establish vigorous trade-union movements that fought to raise wages, shorten working hours, and improve working conditions.

In the late 19th century, especially in the United States, the modern corporation, with its limited liability and immense financial power, began to emerge as the dominant form of business organization. The tendency toward corporate control of manufacturing led to many attempts to create combines, monopolies, or trusts that could control an entire industry. Eventually, the public outcry against such practices was great enough in the United States to lead Congress to pass antitrust legislation. This legislation attempted to make the pursuit of monopoly by business illegal, using the power of the state to force at least a bare minimum of competition in industry and commerce. The antitrust laws never succeeded in restoring to industry the competition of many small businesses that Adam Smith had envisaged, but it did impede the worst tendencies toward creating monopolies and restraining trade.

Despite such difficulties, capitalism continued to expand and prosper almost without limit throughout the 19th century. It was successful because it demonstrated an enormous ability to create new wealth and to raise the real standard of living for nearly everyone touched by it. As the century closed, capitalism was the dominant economic and social system.

VII

20TH-CENTURY CAPITALISM

For most of the 20th century capitalism was buffeted by wars, revolution, and depression. World War I brought revolution and a Marxist-based communism to Russia. The war also spawned the Nazi system in Germany, a malevolent mixture of capitalism and state socialism, brought together in a regime whose violence and expansionism eventually pushed the world into another major conflict. In the aftermath of World War II (1939-1945), Communist economic systems took hold in China and Eastern Europe. However, as the Cold War came to an end in the 1980s and the former Soviet-bloc nations turned to free enterprise (though with mixed success at first), China was the only major power to retain a Marxist regime. Many of the developing nations, strongly influenced by Marxist ideas in the early postcolonial period, turned to a modified form of capitalism in their search for answers to economic problems.

In the industrial democracies of Western Europe and North America, the sharpest challenge to capitalism came in the 1930s. The Great Depression was by far the most severe economic upheaval endured by modern capitalism since its beginnings in the 18th century. Contrary to the logic of Marx's prophecy, however, Western nations failed to collapse into revolution. Rather, in meeting the challenge of the Depression, these capitalist systems demonstrated remarkable abilities for survival and adaptability to change. Democratic governments began to intervene in the economy to correct the worst abuses inherent in capitalism.

In the United States, for example, the New Deal administration of President Franklin D. Roosevelt restructured the financial system so as to prevent a repeat of the speculative excesses that had led to financial collapse in 1929. Action was taken to encourage collective bargaining and build a strong labor movement in order to offset the concentration of economic power in large industrial corporations. The foundation for the modern welfare state was laid through the introduction of Social Security and unemployment insurance, measures designed to protect people from the economic hazards endemic to a capitalist system.

The most important intellectual event in the development of contemporary capitalism was the publication by the British economist John Maynard Keynes of General Theory of Employment, Interest and Money (1936). Like Adam Smith's ideas from an earlier era, Keynes's thought profoundly affected the way in which capitalism worked in Western democracies.

Keynes demonstrated that it is possible for a modern government to use its powers to spend money, vary taxes, and control the money supply in ways that can dampen down, if not eliminate, the age-old curse of capitalism—cycles of “boom and bust.” According to Keynes, in a depression, government should increase its spending, even at the cost of unbalanced budgets, to offset the decline in private spending. The process should be reversed if a boom threatens to get out of hand, leading to excessive speculation and inflation. The Keynesian viewpoint became incorporated into U.S. law when Congress passed the Employment Act of 1946. This act, which committed the American government to maintaining high levels of employment and production, is a legal landmark representing the formal abandonment of laissez-faire as national policy.

VIII

OUTLOOK FOR THE FUTURE

For 25 years after World War II the mixture of Keynesian ideas with traditional forms of capitalism proved extraordinarily successful. Western capitalist countries, including the defeated nations of World War II, enjoyed nearly uninterrupted growth, low rates of inflation, and rising living standards. Beginning in the late 1960s, however, inflation erupted nearly everywhere, and unemployment rose. In most capitalist countries the Keynesian formulas apparently no longer worked. Critical shortages and rising costs of energy, especially petroleum, played a major role in this change. New demands imposed on the economic system included ending environmental pollution, extending equal opportunities and rewards to women and minorities, and coping with the social costs of unsafe products and working conditions. At the same time, social-welfare spending by governments continued to grow; in the United States, these expenditures (along with those for defense) accounted for the overwhelming proportion of all federal spending.

The current situation needs to be seen in the perspective of the long history of capitalism, particularly its extraordinary versatility and flexibility. The events of the 20th century and the beginning of the 21st century show that modified “mixed” or “welfare” capitalism has succeeded in building a floor under the economy. It has so far been able to prevent economic downturns from gaining enough momentum to bring about a collapse of the magnitude of the 1930s. This is no small accomplishment, and it has been achieved without the surrender of personal liberty or political democracy.

The inflation of the 1970s came to an end in the early 1980s, mainly because of two developments. First, restrictive monetary and fiscal policies led in 1981-82 to a deep recession, both in the United States and in Western Europe. As unemployment rose, inflation slowed. Second, energy prices dropped as worldwide oil consumption moderated. In the mid-1980s most Western economies recovered from the recession, but then the stock market crashes of 1987 introduced a new period of financial instability. Economic growth slowed, and many nations—in particular the United States, where the national, corporate, and personal debt had reached record levels—dropped into recession, with rising unemployment, in the early 1990s.

The elusive goal for capitalist nations is to secure, simultaneously, high employment and stable prices. This is a formidable task, but given the historical flexibility of capitalism, the goal is both reasonable and attainable.

See also Business Cycle; Socialism; Trade Union; Trade Unions in the United States; See also History of United States Business. For additional information on individual economists, see biographies of those mentioned.