Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity by William J. Baumol, Robert E. Litan, Carl J. Schramm, Carl Schramm

From the Publisher

Imagine this: a mere century ago, the purchasing power of an average American was one-tenth of what it is today. But what will it take to sustain that growth through the next century? And what can be said about economic growth to aspiring nations seeking higher standards of living for their citizens?
In this important book, William J. Baumol, Robert E. Litan, and Carl J. Schramm contend that the answers to these questions lie within capitalist economies, though many observers make the mistake of believing that “capitalism” is of a single kind. Writing in an accessible style, the authors dispel that myth, documenting four different varieties of capitalism, some “Good” and some “Bad” for growth. The authors identify the conditions that characterize Good Capitalism—the right blend of entrepreneurial and established firms, which can vary among countries—as well as the features of Bad Capitalism. They examine how countries catching up to the United States can move faster toward the economic frontier, while laying out the need for the United States itself to stick to and reinforce the recipe for growth that has enabled it to be the leading economic force in the world. This pathbreaking book is a must read for anyone who cares about global growth and how to ensure America’s economic future.

Foreign Affairs

The collapse of communism as an economic system has encouraged close scrutiny of the diverse versions of capitalism, particularly given the significant differences in performance among capitalist countries. In pursuit of their interest in economic growth, the authors distinguish four types of capitalism: entrepreneurial, big-firm, state-directed, and oligarchic. All function within market economies but with very different motivating forces and with significant differences in long-term economic growth. The authors favor a judicious combination of entrepreneurial and big-firm capitalism, such as is found in the United States. Entrepreneurship ensures growth-enhancing innovation, while large firms consolidate and distribute the innovations. They argue, furthermore, that government policy can promote entrepreneurial capitalism, and hence economic growth, by implementing suitable legal, tax, and institutional arrangements that reward entrepreneurship; making market entry (and exit) easy; discouraging unproductive rent seeking; and ensuring vigorous competition (including from imports), so that entrepreneurs cannot rest comfortably on their past successes. The book also offers a thorough nontechnical review of what we know, and what we do not know, about the sources of economic growth in modern market economies.<

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GOOD CAPITALISM, BAD CAPITALISM, AND THE ECONOMICS OF GROWTH AND PROSPERITY

Yale University Press

Chapter One

The most astonishing thing about the extraordinary outpouring of growth and innovation that the United States and other economies have achieved over the past two centuries is that it does not astonish us. Throughout most of human history, life expectancy was about half what it now is, or even less. We could not record voices or speech, so no one knows how Shakespeare sounded or how "to be or not to be" was pronounced. The streets of the greatest cities were dark every night. No one traveled on land faster than a horse could gallop. The battle of New Orleans took place after the peace treaty had been signed in Europe because General Andrew Jackson had no way of knowing this. In Europe, famines were expected about once a decade and the streets would be littered with corpses, and in American homes, every winter the ink in inkwells froze.

Today we can create paintings on our laptop computers, put the artwork on a Web page, and quickly receive comments about it from all over the globe. There are two toy-like vehicles driving over the terrain of Mars, analyzing its surfacematerials and sending back crystal clear motion pictures in color. But after the initial awe and enthusiasm, this ongoing interplanetary research merits only brief notices on the inside pages of our newspapers. For the average citizen, the most plausible explanation of how these things work is that they are acts of magic, yet we have come to take such technological innovations for granted.

Economic growth has been equally astounding. It is estimated that the purchasing power of an average American a century ago was one-tenth what it is today. A moment's thought will make you realize what a significant change has occurred in an individual's economic circumstances over the past few generations. Suppose you were accustomed to receiving the income of an average American today, and suddenly nine-tenths of it were confiscated. We cannot imagine what our mode of living would then be like. Similar calculations can be made for other countries that have grown remarkably fast in recent years: India, China, much of Southeast Asia during the past two decades and, of course, both Western Europe and Japan since the end of World War II.

The fact is that never before in human history has there been anything like the economic progress that citizens of these countries have been privileged to witness and enjoy. The current most critical long-term economic issue for the world is how this performance can be sustained in the wealthiest countries and how it can be transplanted to societies where much of the population lives in abject poverty. To find an answer to these questions, it is necessary to investigate what is different about the economies that have already achieved this spectacular success.

In the past couple of decades, after a long spell of inattention, there has been a resurgence of interest in this topic among economists claiming to have some of the answers. (We will express our skepticism about some of their work in a later chapter.) Of course, we certainly do not pretend to have the "silver bullet" answer to what causes differences in economic growth rates among countries and over time, but we do believe we can contribute to the inquiry by focusing on the overall structure of economies (capitalist economies in particular) that could explain some portion, perhaps a good portion, of the variation. In particular, we will pay special attention to the set of rules and institutions that provide the incentives for entrepreneurs to work unceasingly for the creation, utilization, and dissemination of new products and productive techniques. Indeed, we will argue that these incentives prevent the entrepreneurs in key sectors of different economies from resting on their laurels, forcing them to start planning their next innovative campaign even before the current one has reached its conclusion.

By "entrepreneurs" whom do we mean? The term is commonly used to refer to anyone who starts a business. This definition counts the numbers of self-employed persons and new business starts, regardless of what the business does. Throughout this book, we will use the term in a narrower and, we believe, more significant manner: as any entity, new or existing, that provides a new product or service or that develops and uses new methods to produce or deliver existing goods and services at lower cost. As management guru Peter Drucker has pointed out, "not every new small business is entrepreneurial or represents entrepreneurship" (Drucker, 1965, 21). He (and we) prefer the definition that Drucker attributed to the nineteenth-century French economist Jean-Baptiste Say, noting that the term: "was intended as a manifesto and a declaration of dissent: the entrepreneur upsets and disorganizes." Joseph Schumpeter (the great twentieth-century economist who celebrated the role of the entrepreneur) coined the famous term "creative destruction" to describe the entrepreneurial process. As Drucker paraphrases Schumpeter's analysis: "[the] dynamic disequilibrium brought on by the innovating entrepreneur, rather than equilibrium and optimization, is the 'norm' of a healthy economy and the central reality for economic theory and economic practice" (Drucker, 27). Or, Drucker puts it more bluntly: "Entrepreneurs innovate. Innovation is the specific instrument of entrepreneurship" (Drucker, 30).

By focusing narrowly on what might be called "innovative" entrepreneurs, we admittedly give short shrift to the many more "replicative" entrepreneurs-those producing or selling a good or service already available through other sources-who are found throughout capitalist economies. Eighteenth-century English writer Richard Cantillon had replicative entrepreneurs in mind (although he probably didn't know it at the time) when he referred to "wholesalers in Wool and Corn, Bakers, Butchers, Manufacturers and Merchants of all kinds who buy country product to work them up and resell them gradually as the Inhabitants require them" (Cantillon, 1931, 51). To be sure, replicative entrepreneurship is important in most economies because it represents a route out of poverty, a means by which people with little capital, education, or experience can earn a living. But if economic growth is the object of interest, then it is the innovative entrepreneur who matters; hence our focus on that form of entrepreneurship throughout much of this book. Put differently, entrepreneurship-as we use the term-is not to be confused with "small business" or even many new businesses.

We recognize, of course, that no economy can be fully successful with entrepreneurs alone. Many such firms will be too small to realize economies of scale. And there is a long distance between what may be the germ of a radical, but useful, idea generated by an entrepreneur and a commercially useful product that is sufficiently affordable and reliable to induce many consumers to buy it. For this reason, the most successful economies are those that have a mix of innovative entrepreneurs and larger, more established firms (often two or more generations removed from their entrepreneurial founding) that refine and mass-produce the innovations that entrepreneurs (and, on occasion, the large firms themselves) bring to market. When we speak of "entrepreneurial economies" at various points in the book, we are referring to this blend of the two types of firms.

What Drives Economic Growth?

To some readers perhaps unfamiliar with much economic writing what we have presented so far may seem obvious. After all, growing economies seem to thrive on new things-new cars, new products, new services. But look through any basic economics textbook and you'll find precious little discussion, let alone analysis, of the entrepreneurs who think up and commercialize many of these new things. In more advanced textbooks and articles, one will find extensive, usually highly mathematical discussions of what determines economic growth. But here, too, entrepreneurship, and the accompanying necessary role of larger firms, is rarely mentioned. Nobel Laureate Ronald Coase put it well when he observed: "The entities whose decisions economists are engaged in analyzing have not been made the subject of study and in consequence lack any substance. The consumer is not a human being but a consistent set of preferences. The firm, to an economist, as Slater has said, 'is effectively defined as a cost curve and a demand curve, and the theory is simply the logic of optimal pricing and input combination' (Slater, 1980, ix). Exchange takes place without any specification of its institutional setting. We have consumers without humanity, firms without organization, and even exchange without markets" (Coase, 1988, 3).

Instead, economists generally focus on two main sources of growth: (1) the addition of more inputs (capital and labor), and (2) innovation, technological change, or, in technical economic terms, "total factor productivity" (the increase in productivity of both capital and labor, considered together). For simplicity, one could call these two different strategies growth by "brute force" and "smart growth." Robert Solow of MIT won his Nobel Prize in economics for showing in the late 1950s that in the United States and a few other industrialized countries, innovation or "smart growth" was more important than brute force (more inputs) in generating additions to output over time (Solow, 1956, 1957). A number of scholars have since confirmed this basic insight and extended it to many countries around the world (see Denison, 1962, 1967; and Easterly and Levine, 2001).

But what is innovation, beyond something new? As we (and others) use the term, it is the marriage of new knowledge, embodied in an invention, with the successful introduction of that invention into the marketplace. Even the best inventions are useless unless they have been designed, marketed, and modified in ways that make them commercially viable. This requires someone who realizes the commercial opportunity presented by the innovation (or even a seemingly small element of the breakthrough), which sometimes is not the purpose the inventor had in mind, and then takes all the steps necessary to turn that opportunity into something many consumers will want to buy. These tasks are inherently entrepreneurial, an insight we will return to repeatedly throughout this book.

So what determines innovation? In Solow's model, innovation is like manna from heaven, something that policy makers largely cannot control. Although they may modestly influence it by way of government-funded research or incentives for research and development, the pace of innovation is essentially taken as a given. A growing number of economists have been uncomfortable with that assumption, and over the past two decades they have put much effort into a better explanation of innovation's role in economic growth. These researchers, using increasingly sophisticated statistical methods, have posited a range of other variables that influence innovation, some of which governments can control (like openness to goods and investment from abroad, spending on research and development, and training of more scientists and engineers), and others of which governments cannot control (like geographic location). We discuss these efforts in chapter 3.

We do not take the position that these factors are unimportant, because many or most of them are. Instead, we suggest that it is more useful to pare down (economize, if you will) the list of suggestions that societies should implement by thinking of economies as potential "growth machines," which need fuel to operate but which also must have some essential primary parts or components that work in harmony if they are to promote entrepreneurship, innovation (and its dissemination), and growth most effectively. The "fuel" for an economy is the right set of macroeconomic policies: essentially, prudent fiscal and monetary policies to keep inflation low and relatively stable and to prevent economic downturns (or even worse, financial crises) from derailing progress toward growth in the long run. We realize that maintaining macroeconomic stability is far from easy. Indeed, it is the focus of much, if not most, of the attention political leaders give to economic policy. But by definition, economic growth is a long-run phenomenon, and so the much greater challenge is to design and implement policies that foster growth in the long run.

We believe that policy makers are most usefully served by having a relatively simple framework for achieving this objective. Not a ten-point list, such as the so-called Washington Consensus list of reforms, or even longer lists of policy prescriptions, which we discuss in chapter 3. The danger in long lists is that they are too easily ignored by busy policy makers, who generally operate under the intense pressure of competing interest groups and have the energy and political capital to concentrate on only a few major endeavors at a time. The other extreme, the search for a single silver bullet answer to the growth problem, is equally dangerous. Economic systems are complicated, and no single policy prescription, even if followed to the letter, is likely to be sufficient to ensure rapid, sustainable growth over the long run.

We attempt to strike a balance between these extremes in concentrating on four factors or conditions that we believe are most important in contributing to long-run growth for all capitalist economies, but especially for those at the "technological frontier," where future progress requires continued innovation more than it does mere replication. We flesh these out in greater detail in chapter 4 but give a brief preview here so readers can keep them in mind before proceeding further. The factors should be understood as forming the bare blueprint of a well-oiled growth machine-the "big picture" that busy policy makers can keep in mind when considering more detailed initiatives or programs.

We also limit our attention to growth-enhancing conditions for capitalist economies, or those that at least to some degree allow private ownership of property and reward individuals and firms for serving consumer needs. Although we discuss in some detail in chapter 5 different models of capitalism-and elevate one of them, "entrepreneurial capitalism," above all the rest-the various models differ sharply from the central planning that governed much of the world (the Soviet Union, Eastern Europe, and China) from the end of World War II until the fall of the Berlin Wall in 1989. History has shown that central planning cannot deliver high and rapidly improving standards of living and we therefore will not consider it (even though central planning lives on in a few dark corners of the world, notably Cuba and North Korea).

Our four elements of a well-oiled economic growth machine, the successful entrepreneurial economy, are the following:

1. First, and perhaps quite obviously, in the successful entrepreneurial economy, it must be relatively easy to form a business, without expensive and time-consuming bureaucratic red tape. As a corollary, abandoning a failed business (that is, declaring bankruptcy) must also not be too difficult because, otherwise, some would-be entrepreneurs may be deterred from starting in the first place. A reasonably well-functioning financial system must also exist, one that channels the funds of savers to the users of funds, entrepreneurs in particular. And the importance of flexible labor markets cannot be overstated: if entrepreneurs cannot attract new labor, they cannot grow, nor will they want to grow if labor rules are overly restrictive (especially if rules limit the ability of firms to fire nonperforming workers or shed workers they no longer need).

2. Second, institutions must reward socially useful entrepreneurial activity once started; otherwise individuals cannot be expected to take the risks of losing their money and their time in ill-fated ventures. Here, the rule of law-property and contract rights in particular-is especially important.

3. Third, government institutions must discourage activity that aims to divide up the economic pie rather than increase its size. Such socially unproductive (though, in a sense, entrepreneurial) activities include criminal behavior (selling of illegal drugs, for example) as well lawful "rent-seeking" behavior (i.e., political lobbying or the filing of frivolous lawsuits designed to transfer wealth from one pocket to another).

4. Finally, in the successful entrepreneurial economy, government institutions must ensure that the winning entrepreneurs and the larger established companies (which were launched at some earlier time by entrepreneurs) continue to have incentives to innovate and grow, or else economies will sink into stagnation. The ostensible importance of effective antitrust laws here comes to mind, but we place greater emphasis on openness to trade (which works automatically and without the long lead times inherent in legal antitrust enforcement). (Continues...)

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