An understanding of economic theory is an important component of financial literacy and education. The financial decisions you make during your lifetime will be a function of your economic environment. In turn, this environment will be caused by political decisions made to implement policies based on certain economic beliefs.
If you live in a democracy, it is critical that you have at least a familiarity with economic theories. Politicians habitually misrepresent or are incompetent about the effects of their decisions on the financial well-being of their societies. Knowledge of economic theory will allow you to make the best decision for yourself when you go to the ballot box.
In its most basic sense, the study of economics seeks to answer the following questions:
- How is wealth created?
- How should wealth be distributed?
There are two basic views that attempt to answer these questions: capitalism and socialism. We shall now turn to our review capitalism and socialism, and what their adherents believe in answering the questions of how wealth is created and how it should be distributed.
HOW IS WEALTH CREATED?
Capitalists believe that wealth is created by the owners of capital. “Capital” is anything that generates property for its owner. To be more precise, capital is property that generates more property (most commonly cash) for its owner.
Capital could be subdivided into “tangible capital”, such as a car factory owned by General Motors or “intellectual capital”, such as the website code written by Mark Zuckerberg of Facebook. Tangible capital can be seen and touched. In contrast, intellectual capital is generated from the intellect and creativity of its owner.
There are plenty of examples to support the notion that wealth is created by the owners of capital. This is particularly true in the case of intellectual capital. For example:
- Mark Zuckerberg created a successful business based on the code he wrote for his Facebook website and became a billionaire at the age of 23
- Through his vision, creativity and leadership skills, Steve Jobs revolutionized five industries: (1) personal computers with the Apple II and Macintosh; (2) smartphones with the IPhone; (3) digital animation with Pixar; (4) computer tablets with the IPad; and (5) music with the IPod. The company he co-founded and managed until his death briefly became the world’s most valuable company in 2011, creating wealth for himself and his fellow shareholders.
It is no coincidence that many of the world’s most successful businesses were created in the United States. Its relatively free markets and low taxes create an economic environment that rewards success. Thus, the traditional American view is that free markets and private property work especially well for entrepreneurs, motivating many of its citizens to become entrepreneurs themselves and create businesses. Businesses create jobs for workers and tax revenue for governments to enable it to finance society’s needs.
In contrast, socialists generally believe that owners of capital do not derive their wealth from any inherent talent or ingenuity, but through exploitation: the exploitation of labour, the exploitation of political connections and the exploitation of customers through the misrepresentation of products and services. To be succinct, socialists believe that owners of capital achieve their success through ruthlessness and guile, rather than through creativity or innovation.
This view is well supported by business practices employed by the U.S. financial sector prior to the 2008 Financial Crisis:
- Predatory lending practices in the housing sector enticed people to take on mortgage commitments they didn’t understand and couldn’t afford to pay. The most flagrant practitioner of such practices was Countrywide Financial, whose CEO Angelo Mozilo received approximately $470 million in compensation during the United States housing bubble of 2001 to 2006.
- The investment bank Goldman Sachs created collateralized debt obligations (essentially a financial product built from subprime mortgages – these mortgages eventually went bad) which it sold to investors and then bet short against them. That is, Goldman sold financial products to investors knowing they would go bad, and by making financial bets, reaped a windfall when that occurred. Goldman eventually agreed to pay a settlement of $550 million ($300 million to the U.S. government and $250 million to investors) after the Securities Exchange Commission filed a lawsuit against it. The company did not admit or deny wrongdoing.
- The American insurance company AIG had made a series of bad business decisions which led to its insolvency during the height of the 2008 Financial Crisis. It received $170 billion in taxpayer bailout funds from the U.S. government. After it received these funds, it was publicly disclosed in March 2009 that it would pay approximately $218 million in bonuses to employees of its Financial Services Division, the same division which was responsible for AIG’s near bankruptcy.
Upon further investigation, it appeared that Connecticut Senator Chris Dodd had arranged to included a provision in the bank bailout legislation that allowed AIG to make bonus payments under previously negotiated contracts with its employees. Interestingly, Dodd had received approximately $233,000 from AIG employees for his recent political campaigns.
HOW SHOULD WEALTH BE DISTRIBUTED?
Capitalists believe that the best manner to allocate wealth is through free markets and private ownership.
Capitalists believe that individuals should be smart and knowledgeable enough to make their own economic decisions with respect to purchasing and selling goods and services.
In contrast, socialists believe that government should actively intervene in the markets to ensure optimal outcomes for everyone. They criticize the implicit assumption of free market theorists that all individuals have the ability to readily obtain information and analyze it in a rational and non-subjective manner to make optimal decisions for themselves. This view does not consider the possibility that individuals may make irrational choices due to ignorance or fear. Therefore, government has a role in the marketplace to ensure that people are protected from making bad decisions based on their own ignorance.
Today, socialists often support their viewpoint with the events that led to the 2008 Financial Crisis. At the root of the crisis were home buyers who committed themselves to mortgages they couldn’t afford to pay due to their financial ignorance. These bad mortgages were subsequently securitized and purchased by individual and institutional investors that did not understand the risks of purchasing these securities, which all became worthless. This of course led to the 2008 Financial Crisis.
Socialists assert, with good reason, that this crisis could have been avoided had the housing and financial markets been adequately regulated.
Capitalists believe that individuals should be able to own property derived from their efforts and should be free to sell or bequeath it to whomever they choose.
In contrast, socialists believe that property should be owned or redistributed by the government, either through expropriation or taxation respectively. The socialist view coincides with its view that the owners of capital don’t create wealth. Rather, they assert that wealth is accumulated either through exploitation, as previously discussed. Consequently, socialists support higher taxes in order to transfer this “unearned” wealth to finance the needs of society’s less fortunate.
As you can see, capitalism can create great wealth for society, but it also has the potential to destroy society’s wealth while making a few people very rich.
We refer to the first type of capitalism as “creative capitalism”. Creative Capitalists actually create something that benefits society as a whole. Of course, they wish to become wealthy, but a happy byproduct of their pursuit of wealth is that they create great products and services, as well as jobs. These “byproducts” add value to the society in which they operate. Here is a list of some Creative Capitalists:
- Thomas Edison, founder of General Electric
- Henry Ford, founder of Ford Motor Company
- Steve Jobs, co-founder of Apple
- Bill Gates, co-founder of Microsoft
- Mark Zuckerberg, founder of Facebook
Now, imagine what daily life would be like without electric light bulbs (Edison), cars (Ford), personal computers (Jobs and Gates) and social networking (Zuckerberg). Creative Capitalists have made great contributions to society, improving living standards for everyone.
On the other side, there are the Crony Capitalists. This type of capitalist is the quintessential caricature of what socialists see as “capitalism”. Today, most of them can be found on Wall Street. Through their connections with government and through deceiving the public at large, they accumulate great wealth for themselves at the expense of the rest of society.
We feel that on a net basis, capitalism greatly benefits society, but we also recognize that capitalists can “game they system” by leveraging political connections in their favour at the expense of everyone else. Therefore, these are the solutions that we propose:
- Ban political donations made by corporations
- Place a maximum cap (e.g., $1,000) on political donations made by individuals
- Implement a five year ban on politicians who’ve left office from acting as directors, lobbyists or consultants for corporations
The root of the problems capitalism faces today is crony capitalism. These simple policy changes would go a long way in creating wealth for everyone based on innovation and talent rather than through government connections.
The preceding was a very basic introduction to the subject of Capitalism versus Socialism. We encourage the reader to conduct further research should this subject be of interest.
© Copyright Fong and Partners Inc., 2011.