What Went Wrong With Capitalism?

Book Review

This book, What Went Wrong with Capitalism, by Ruchir Sharma, was recently recommended to me by a colleague in the financial industry. While browsing the shelf in the library I came across a couple more books critiquing the current capitalist economy and financial system and decided to read those as well. One was Good Capitalism Bad Capitalism, a collaboration by three economists. The other was The Battle for the Soul of Capitalism by the legendary founder of Vanguard index mutual funds, John Bogle. Both of the latter were written about 20 years ago in the first decade of the 21^st century while Sharma’s book was more recently published within the last year. I found all three to offer important criticisms of what I have called casino capitalism, but found each incomplete in analysis and thus prescriptions.

First, Sharma’s book does a commendable job of recounting recent history and exactly what has gone wrong with modern capitalist systems, citing the rise of easy money since 1971 that facilitated the enormous expansion of government with rising public deficits. Exponential debt is certainly the most obvious and disconcerting outcome from the mismanagement of capitalist economies. Sharma also explains how expanding public sectors have created inefficiencies that crowd out private sector growth needed to pay for that public sector spending. He draws parallels to the rise of zombie companies and banking systems in Japan and China, where market clearing pricing and reallocation of resources is prevented by state intervention. The same has happened in the West, in the US and Europe, as central banks have used bailouts, financial repression, and easy credit to shore up faltering markets and banks. In conclusion, Sharma’s main culprit is overprotective government and the bailout culture it has created. His prescription is to get government out of the way so that private market capitalism can flourish.

Unfortunately, this prescription is not likely to find much support in the current cultural and political climate. The problem is that Sharma neglects to hone in on the major causes and drivers of capitalism’s missteps and miscues. While he has well-documented those excesses and miscues, he has failed to really explain how and why capitalism has gone wrong over the past 50+ years. Why has the corporate sector lost its sense of proportion and responsibility? Why have politicians paid only lip service to civic responsibility and public service while serving their narrow self-interest in becoming as wealthy as their elite peers? Why has popular culture sunk into a narcissistic pool? How has this happened?

Sharma hints at the main factor, which is easy money or cheap credit, but never fully explains how or why or what to do about it. Credit has become cheap across the world because it currently has no anchor in real value. In 1971 the US broke the Bretton-Woods monetary system by recognizing its gold peg was no longer viable. This transformed the international monetary system into a fiat currency-based system under the control of central banks in collusion with governments. It virtually financialized the real economy over the ensuing decades, whereby finance is now the tail that wags the dog of the economy and the governments that seek to manage it. Sharma never mentions the policy instruments central bank monetary policies developed under fiat regimes, such as Zero Interest Rate Policy and Quantitative Easing.

The root problem here is that hard credit – how much you can borrow from a lender based on credit-worthiness and an investment pro-forma – is a hard constraint on human behavior, both economic and ethical. When we remove that constraint, all hell breaks loose. Any parent that has indulged a child with unlimited funds has learned this first-hand. It is said that power corrupts and absolute power corrupts absolutely. We can apply this axiom to money as well, where money corrupts, and free money corrupts absolutely. When there is no credit constraint, merit makes no difference. What matters is who gets to the trough first and who one knows, because there are no merit-based criteria by which the free money is distributed. When the government issues free credit through the banking system, the financial sector gets first access, then those most politically connected, and finally, if there is any left, it trickles down to the most deserving.

This arbitrariness encourages people to play the system, rather than earn their way through merit. It creates a sense of entitlement, unsupported by effort and substance. Soon, one gets rewarded for showing up at the right place at the right time, without contributing anything to the process. This attitude quickly permeates through the population from top to bottom, reshaping the culture from meritocracy and productivity to favoritism and entitlement. CEOs, politicians, financiers, educators, union leaders, etc. all get overpaid to fail, and collude to keep the game going. Eventually, a free society collapses of its own dead weight. This is how it happens. Now we need to think about why it happens if we have any hope of reversing the process before it implodes.

The human condition is about how to survive in a world that can be a dangerous place. To survive we have banded together for protection and safety. We built cities with walls and moats, raised armies to defend them, developed agriculture and animal husbandry to stave off hunger and famine, developed science to tame nature. Then we created systems of government to help manage all this. The implicit promise we make to ourselves is that we will collectively maintain our safety through collective action, or politics. The world, however, is still a dangerous place and not easily tamed into submission.

The natural world is unsympathetic to our survival needs. The universe throws change and uncertainty into our lives and nature rewards those individuals and species that can best adapt to change over time. Those who cannot adapt, often fail to survive. The upshot here is that this process of survival and adaptation rewards those who succeed in a virtuous cycle. This occurs in the natural world where successful species, like cockroaches survive and prosper, while others, such as dinosaurs and dodos, go extinct. This sorting process works within human societies and economies as well. This is important to note: markets reward success with more success and failure with potential extinction. Schumpeter called this creative destruction and it leads to the successful adaptation of civilization. It can also conflict with our promise to protect and ensure the safety of all within the community and ecosystem. We demand this protection because loss aversion dominates our survival instinct. But moral values sometimes conflict with economic realities. What happens politically is that collective government ends up overpromising and underdelivering.

We can apply this analysis to the events that led to the breakdown of Bretton-Woods in the post-war period and the subsequent degeneration that threatens capitalist democracy. The US was the dominant nation after the catastrophic events of WWII and underwrote the subsequent peace and the new world order of international trade and security. The wealth and prosperity of the US funded the rebuilding of Europe and Asia with the Marshall Plan, essentially enabling the rapid rebuilding of the global economy. But this task to maintain global security and economic growth and stability soon became a rising burden that culminated in the 1960s era of “guns and butter,” whereby the US waged a war in Vietnam while also spending on social welfare for its domestic population with the Great Society programs. With the US$ backing the gold-peg, the trade deficits with Europe and Asia began to deplete the gold reserves of the US, gutting them by 50%.

This was financially unsustainable, so the political and economic decision under the Nixon administration was to refuse future gold redemptions by foreign trading partners. Rather, they could take the US$ they earned selling exports to the US and buy US Treasury certificates. This effectively transformed the global monetary system into a fiat currency system whereby currencies were backed by little more than what they could buy under the full faith and credit of the issuer. In other words, the US government could still deficit spend on both guns and butter and pay for it with promises of US$-denominated collateral, such as Treasury bonds or real private assets such as US companies, land, and resources. As a consequence, US budget and trade deficits exploded, and the US$ depreciated by over 75% since 1970, creating real asset bubbles in housing, collectibles, securities, and necessary resources like education and healthcare. We effectively boxed ourselves into this political debt cycle and free money bonanza, but with all the best intentions. This is why it happens.

Sharma understands that part of the solution is that credit must be priced to account for risk and the time value of money. This is a policy challenge because almost all national governments are drowning in exponential debt – they must borrow more just to pay interest on the existing debt. If borrowing rates increase too much, bankruptcies and financial crises happen. Central banks can only ease the debt burden through financial repression whereby the market rate of interest is held below the inflation rate (which actually is the depreciation rate of the currency). But this perpetuates the reality of free money under the illusion of rising nominal values. More simply, if I borrow at 5% but inflation is near 5%, then my borrowing costs are essentially zero. If the Fed uses policy levers to drive borrowing costs below 5%, my borrowing costs go negative, essentially I get paid to borrow money. This destroys the lending industry because nobody lends money in order to lose it.

Sharma also recognizes that government spending has to be cut drastically because it is being paid for by increasing debt. One can imagine how difficult that becomes given the experience of DOGE these days. The idea that we can raise taxes and cut spending to close the deficit is a chimera. For the economy to grow out of the debt crisis would require draconian spending cuts and drastic tax increases – a combination that would tank the economy and risk a severe recession or depression.

So, left to the market, there are only two ways to reconcile a debt crisis short of a debt jubilee: either there is an asset price correction, which is deflationary and causes recessions or depressions depending on the severity; or the debt is inflated away by printing money. We can expect the monetary and fiscal authorities to try a combination of both, hopefully without crashing the economy. But inflation is the politically appealing solution.

These scenarios only address the What and the How of our situation, but not the Why. If we can’t apply a solution to the Why, we’ll just end up at the same place again.

This is where the other two books offer some insights. In Good Capitalism Bad Capitalism, the authors make the distinction between risk-taking private entrepreneurship and predatory casino capitalism with state intervention. Naturally, they argue for policy reforms that reward the former and tax the latter. This is not a difficult case to make as microeconomic theory is quite clear on how to promote economic growth and prosperity. But that has never really been the problem for capitalism, as its wealth-creating capacity is well-documented in history. The problem is distribution and gets back to that idea that capitalist success rewards capitalist success, concentrating the benefits of profitable enterprise. The conundrum is that using social and tax policy to redistribute those benefits gets us back on the track Sharma identifies as to “what went wrong.”

The third book by John Bogle, The Battle for the Soul of Capitalism, focuses primarily on the financial machinations of public corporations – the driving force of capitalist wealth creation. But here the concept of ownership has been diluted by the management class of these corporations. Shareholders that invest in companies, both public and private, are the true owners of those companies. Yet, hired management of these public companies have secured control through conflicts of interest that too often serve their own narrow interests rather than the interests of shareholders. This is referred to as the agency problem, where shareholders as principal owners are unable to monitor the actions of the agents who manage their ownership stakes. What we see here is an actual violation of property rights as defined by the constitution. Shareholders, as true owners, have seniority rights to residual claims on the profits of the firm, yet they surrender control over those rights to management. Management then finds it easy to abrogate those rights for its own purposes. This is why CEOs now earn 400 times the median wage of their employees – money that should rightly be distributed to their shareholders. Defending these rights and broadening participation in ownership would help alleviate the concentration of capitalist success and the resulting wealth and income inequalities.

Shareholder capitalism has been denigrated by its statist opponents, but freedom and autonomy are a function of ownership and control of our person and our property. As such ownership is the basis of a free society and also the key to sustainable capitalism because it spreads the rewards of successful risk-taking. As the wealth of capitalist success spreads through widespread ownership, i.e., equity participation, the population becomes less dependent on transfers from the government. This would reduce the role of the public sector, which absorbs resources better deployed by the private sector. Naturally, those who profit from government largesse are loath to surrender their public sinecures and will fight tooth-and-nail to retain them – once again we can witness this in the backlash to DOGE.

The challenges of capitalism, and for that matter freedom and democracy, are complex and too often confused. These three critiques have come at the problem from different angles, but as such they are each incomplete. The solution requires us to synthesize the several goals of wealth creation, wealth distribution, and risk management while reinforcing the values of liberty and justice. There are a large set of policy reforms and priorities that would serve us well: reward risk-taking; promote participation in risk-taking enterprise; and provide social safety nets (not entitlements) for those who suffer the misfortunes of change and uncertainty. These guideposts for policy reform would go far to ensure our individual pursuits of life, liberty and happiness. Read the books, but critically.