What Went Wrong with Capitalism

1. Government's role in the economy has steadily expanded since the 1930s

Since 1930, spending by government—including state and local—has quadrupled on average to 48 percent of GDP in the LCEs, but within a broad range, rising from 4 percent to 36 percent in the United States and from 19 percent to 58 percent in France.

The growth of government has been a consistent trend across developed economies since the Great Depression. This expansion encompasses various aspects:

• Welfare state: Social spending, healthcare, and pension systems
• Regulatory state: Increasing rules and oversight across industries
• National security state: Expansion of defense and intelligence agencies

The pace and scale of this growth have varied among countries, but the direction has been uniform. Even in the United States, often perceived as more market-oriented, government spending as a percentage of GDP has increased significantly. This trend challenges the notion that there has been any meaningful reduction in government's economic role in recent decades.

2. The era of "small government" is a myth perpetuated by misunderstanding

There was no golden age of capitalism, when government got its role just right.

Misinterpretation of history has led to a widespread belief in a recent era of small government, particularly associated with leaders like Ronald Reagan and Margaret Thatcher. However, this narrative is largely inaccurate:

• Reagan's presidency saw continued growth in government spending and debt
• Deregulation efforts often resulted in more complex, not fewer, regulations
• The welfare state continued to expand, albeit at a slower pace

The perception of small government was fueled by:

• Rhetoric emphasizing free markets and individual responsibility
• Privatization of some state-owned enterprises
• Globalization and technological changes that appeared to reduce state power

In reality, government's economic influence continued to grow, albeit in less visible ways, such as through monetary policy and financial market interventions.

3. Easy money policies have distorted capitalism and fueled debt addiction

When government becomes the dominant buyer and seller in the market—as it has in recent decades—it distorts the price signals that normally guide capital.

Central bank interventions have fundamentally altered the functioning of capitalist economies. The era of easy money, characterized by low interest rates and quantitative easing, has had far-reaching consequences:

• Encouraged excessive risk-taking and speculative behavior
• Inflated asset bubbles in stocks, bonds, and real estate
• Enabled unsustainable levels of corporate and government debt

This environment has created a "bailout culture" where market participants expect government intervention during crises, leading to:

• Moral hazard in financial decision-making
• Misallocation of capital to less productive sectors
• Suppression of the natural business cycle's cleansing effects

The result is a capitalism that no longer efficiently allocates resources based on market signals, but instead responds to artificial stimuli provided by government and central bank policies.

4. Zombies and oligopolies thrive in the current economic environment

Though a zombie may be hard to kill, surely it is easy to outrun. Before 2000, that was still true. Healthy firms were able to borrow at significantly lower cost, and faced less pressure to sell off assets. Then, over the last two decades, increasingly friendly government "forbearance" narrowed what should be the natural advantages of healthy firms.

Distorted market dynamics have led to the proliferation of two problematic business types:

1. Zombie companies:

   • Firms that can't cover debt payments with profits
   • Survive on cheap loans and government support
   • Drain resources from more productive sectors

2. Oligopolies:

   • Dominant firms in concentrated industries
   • Benefit from economies of scale and regulatory barriers
   • Often prioritize financial engineering over innovation

These entities persist due to:

• Low interest rates making debt servicing easier
• Expectations of government bailouts reducing risk
• Regulatory complexity favoring large incumbents

Their prevalence slows economic dynamism by reducing competition, hindering new entrants, and misallocating capital away from more innovative and productive enterprises.

5. Constant bailouts and interventions undermine creative destruction

As more of the money printed by the Fed flowed into the financial markets, naturally "income growth thus shifted from labor to the owners of property," including stocks, bonds, and exotic derivatives, writes historian Jonathan Levy.

Schumpeter's "creative destruction" process, essential for capitalist renewal, has been significantly impaired. Government interventions, particularly in financial markets, have disrupted this natural cycle:

• Bailouts of failing firms prevent necessary market corrections
• Monetary policy props up asset prices, benefiting asset owners
• Regulatory barriers protect incumbents from new competitors

Consequences of this disruption include:

• Reduced economic dynamism and innovation
• Misallocation of resources to less productive sectors
• Widening wealth inequality as asset owners benefit disproportionately

By repeatedly intervening to prevent market corrections, policymakers have created an environment where inefficient firms persist, dragging down overall economic productivity and growth potential.

6. Rising inequality is a symptom of distorted capitalism, not its cause

If frustrated young generations want to correct the growing ills of capitalism, the first step is to get the diagnosis right.

Wealth concentration is often blamed for capitalism's current problems, but it's more accurately a symptom of underlying distortions:

• Easy money policies inflate asset values, benefiting the already wealthy
• Regulatory complexity favors large corporations over small businesses
• Bailouts and interventions protect established interests

Key aspects of rising inequality:

1. Income inequality: Growing gap between top earners and the rest
2. Wealth inequality: Concentration of assets among a small percentage
3. Opportunity inequality: Reduced social mobility and access to opportunities

While addressing inequality is important, focusing solely on redistribution without tackling the root causes of distorted capitalism is likely to be ineffective in the long run.

7. Productivity decline stems from government overreach, not technology

The cumulative effects of government intervention thus could explain why the U.S. productivity revival around the year 2000 suddenly faded, never to return.

Persistent productivity slowdown across developed economies is often attributed to technological factors, but government policies play a crucial role:

• Misallocation of capital due to artificially low interest rates
• Survival of inefficient firms (zombies) reducing overall productivity
• Regulatory burdens diverting resources from innovation to compliance

Productivity impacts:

• Slower economic growth and wage stagnation
• Reduced competitiveness in global markets
• Lower living standards than potential

Addressing this decline requires rethinking the role of government in the economy and allowing market forces to more efficiently allocate resources and drive innovation.

8. The U.S. dollar's reserve currency status masks economic vulnerabilities

The decline could already be underway. The dollar share of global central bank reserves has been eroding steadily.

America's "exorbitant privilege" as the issuer of the world's primary reserve currency has allowed it to sustain policies that would be unsustainable for other nations:

• Persistent trade deficits
• High levels of government debt
• Expansionary monetary policies

However, this status is not guaranteed:

• Rising challenges from alternative currencies (Euro, Renminbi)
• Growing international concerns about U.S. fiscal and monetary policies
• Increasing use of non-dollar currencies in international trade

The potential loss of reserve currency status could force significant economic adjustments and limit the U.S. government's ability to finance deficits and implement expansionary policies.

9. Successful capitalist models balance state involvement and market forces

Switzerland is capitalist to its core, its government spending well below the average for rich countries, as a share of GDP. The Scandinavian governments are unusually bloated in comparison.

Effective capitalism requires finding the right balance between government involvement and market freedom. Examples of successful approaches:

1. Switzerland:

   • Limited government spending
   • Strong protection of property rights
   • Emphasis on local decision-making

2. Taiwan:

   • Strategic industrial policy
   • Investment in education and research
   • Openness to global trade

3. Vietnam:

   • Gradual economic liberalization
   • Focus on export-oriented growth
   • Pragmatic approach to reforms

These models demonstrate that:

• There's no one-size-fits-all approach to successful capitalism
• Effective governance matters more than size of government
• Balancing state and market forces can drive sustainable growth

10. Restoring capitalism requires acknowledging excesses and finding balance

A capitalism for the twenty-first century would restrain these wildly experimental buying sprees, particularly in recoveries.

Revitalizing market economies necessitates a fundamental reassessment of current policies and practices:

1. Monetary policy:

   • Normalize interest rates to reflect true cost of capital
   • Reduce reliance on quantitative easing and other unconventional tools

2. Fiscal policy:

   • Address unsustainable debt levels
   • Reform entitlement programs for long-term sustainability

3. Regulatory approach:

   • Simplify and streamline regulations to reduce compliance burden
   • Focus on maintaining competitive markets rather than protecting incumbents

4. Crisis response:

   • Develop more targeted, time-limited interventions
   • Allow for necessary market corrections and creative destruction

Implementing these changes requires political will and public understanding of the long-term costs of current policies. The goal is to restore capitalism's dynamism while maintaining necessary safeguards and social protections.

Last updated: February 28, 2025