Rage Could End Up Hurting Us

The story of American capitalism is, among other things, a love-hate relationship. We go through cycles of congratulation, revulsion and revision. Just when the latest episode of revulsion and revision began is unclear. Was it when Lehman Brothers failed? Or when General Motors pleaded for federal subsidies? Or now, when AIG's bonuses stir outrage? No matter. Capitalism is under siege, its future unclear.

Joseph Schumpeter, one of the 20th century's eminent economists, believed that capitalism sowed the seeds of its own destruction. Its chief virtue was long term—the ability to raise wealth and living standards. But short-term politics would fixate on its flaws—instability, unemployment, inequality. Capitalist prosperity also created an oppositional class of "intellectuals" who would nurture popular discontents and disparage values (self-enrichment, risk-taking) necessary for economic success.

Almost everything about Schumpeter's diagnosis rings true with the glaring exception of his conclusion. American capitalism has flourished despite being subjected to repeated restrictions by disgruntled legislators. Consider the transformation. In 1889, there was no antitrust law (1890), no corporate income tax (1909), no Securities and Exchange Commission (1934) and no Environmental Protection Agency (1970).

Great reform waves often proceed from scandals and hard times. The first discredit business; the second raise a clamor for action. Present parallels with the past can be eerie. "No one in 1928 thought that the head of the New York Stock Exchange would end up in Sing Sing [prison] in 1938," says historian Richard Tedlow of the Harvard Business School. That was Richard Whitney, convicted of defrauding his clients. Flash forward: Bernie Madoff, once head of NASDAQ and also a member of the financial establishment, goes to the slammer, a confessed swindler.

But Schumpeter's question remains. Will capitalism lose its vitality? Successful capitalism presupposes three conditions: first, the legitimacy of the profit motive, meaning the ability to do well; second, widespread markets that mediate success and failure; and finally, a legal and political system that, aside from establishing property and contractual rights, also creates public acceptance. Note that the last condition modifies the first two, because government can—through taxes, laws and regulations—weaken the profit motive and interfere with markets.

The central reason why Schumpeter's prophecy remains unfulfilled is that U.S. capitalism is enormously adaptable. It adjusts to evolving public values while maintaining adequate private incentives. Meanwhile, the ambitious, striving character of American society supports an entrepreneurial culture and work ethic—capitalism's building blocks. As for the costs of new regulations, many don't depress profitability because they're passed along to consumers.

It's also wrong to pit government as always oppressing business. Just the opposite often holds. Government boosts business. Some New Deal reforms helped by "making risk more manageable," says Stanford historian David Kennedy. Deposit insurance ended old-fashioned bank panics. Mortgage guarantees aided a post–World War II housing boom.

Still, the outcome of the present populist backlash may not be benign. The parade of big companies to Washington for rescues, as well as the high-profile examples of unvarnished greed, has spawned understandable anger that could veer into a vindictive retribution. Congressmen love extravagant and televised displays of self-righteous indignation. The AIG hearing last week often seemed a political gang beating.

If companies need to be rescued from "the market," then why shouldn't Washington permanently run the market? That is a dangerous mindset. It justifies punitive taxes, widespread corporate mandates, selective subsidies and more meddling in companies' everyday operations. Older and politically powerful industries may benefit at the expense of the new. Innovation and investment may be funneled into fashionable, though economically dubious, projects (think ethanol).

Greater government is an inevitable reaction to today's economic breakdown. But there is a thin line between "saving capitalism" from itself and vindicating Schumpeter's long-ago prediction.

© 2009