Why free-market capitalism doesn’t work, according to Ha-Joon Chang
How liberal or restrictive governments should be on economic and trade policy has been debated extensively. Theoretically, free-market ideology most efficiently allocates resources. With an invisible hand guiding the market forces of supply and demand, while also stating that firms ought to have unlimited freedom, they know how to produce goods and services most efficiently, which then positively transmits to the rest of society. This theory states that government intervention is inefficient and increases the cost of doing business for everyone, since governments, supposedly, rarely have the necessary information or incentives to make good business decisions, and so cannot know exactly which goods to produce and how much, while free markets can. Free-market capitalism, both in free international trade as well as domestic free markets, has dominated the world recently, being increasingly advocated by international organisations such as the IMF and the World Bank. Ha-Joon Chang, however, in his book ‘23 Things They Don’t Tell You About Capitalism’ is here to counter this ideology. He explains the outcomes of such free-market policies over the last three decades have often worsened economic prospects significantly: slower growth, especially in the developing world; rising inequality; heightened instability; and not least the financial catastrophe of 2008.
Should companies always be aiming to maximise profits?
This question challenges the concept of shareholder capitalism. Shareholder capitalism maintains that the sole objective of a company is to maximise shareholder returns, which can be achieved through dividends, share buybacks or share price appreciation. Directors of companies are often incentivised to maximise shareholder returns, through share price-linked compensation packages. This concept, which became increasingly trendy from the 1980s, relies on the idea that profits should have a positive social contribution and create wealth. The problem with this strategy, however, is that it is much easier for a firm to cut production costs than to increase revenues in the goal of profit maximisation. Now, whilst shareholder capitalism does not lead a priori to these problems, the structure of compensation schemes, which may be done without a long-term outlook, does. The result can often incur negative externalities, including a detrimental squeezing of stakeholders such as cutting the wages of workers and suppliers and firing middle-level managers, as well as environmental disregards such as excessive pollution. The result is often a deficiency in investment, essential to any firm’s long-term welfare, and potentially backward technology threatening the firm’s very existence. While shareholders, who have the most ease in entry into and exit out of a company, are often only interested in short-term profits – which means they rarely question this ‘squeezing’ that is so clearly detrimental. Although one could make the claim that job cuts may improve worker productivity (output per unit input), the by-product of higher job insecurity can have social and economic drawbacks too, including structural unemployment. Additionally, companies buying back their own shares (another way of maximising shareholder returns) and giving out higher dividends reduce the amount of retained profit, an important source of corporate investment. The result, therefore, is not necessarily the expected ‘profits translate into social contribution’ idea and wealth creation, benefitting the whole of society, but an overemphasis on shareholders and a neglect of stakeholders, leading to losses of jobs and the destruction of companies chasing the greatest returns for shareholders.
Do free-market policies make poor countries rich?
Contrary to popular belief, free-market policies rarely make developing countries rich. The author points to examples like America, now a neo-liberal preacher, which went completely against today’s orthodox neo-liberal policies during its development in the 18th and 19th centuries. In fact, in the 1880s, it had an industrial tariff rate of 40-55%, discriminated heavily against foreign investors (they could not become directors of companies, nor were they allowed to vote), had no competition law allowing monopolies to emerge unchecked, and had weak protection of intellectual property rights – all features that seem incompatible with our current model of free-market capitalism. Based on this, one could hardly imagine good development prospects for this country. However, there are several reasons why such policy recipes have worked for America and many countries (while they adopted them). One is the idea of ‘infant industries’, where developing industries need to be heavily shielded from the full force of global competition, through government subsidies and protectionist policies, so that they have a chance to stand on their own feet before being made to compete against stronger and better countries. Another is that government policies can encourage innovation and new industries. For example, Britain’s Industrial Revolution was only possible after its move into the woollen manufacturing industry (accompanied through a combination of tariffs, subsidies, and other supports) allowing it to import the food and raw materials required to initiate the Revolution. There is also evidence for such combinations of policies working. Singapore, for example, produces over 20% of its output through state-owned enterprises (the international average is 10%). Additionally, many currently rich countries, such as Japan, Finland, and Korea, restricted foreign investment during important periods of growth, even regarding such involvement as ‘dangerous’ in the case of Finland from the 1930s to the 1980s. If we look at the picture more generally, during the period with the greatest number of free-market reforms in developing countries, growth and income growth rates slowed significantly – in Latin America, growth was 3.1% in the 1960s and 70s, but from 1980 to 2009 only 1.1%, and income growth per capita in the developing world fell from 3% in the 1960s and 70s to 1.7% in the 1980-2000 period. The conclusion is that free-market capitalism may not be the miracle it pretends to be, especially true within the context of free trade. However, there is scope for debate within this topic. For example, there are many stories to the contrary of countries opening up and suddenly making the most out of supply chains, and it can also be argued that free-market policies are often not carried out properly; for example, developing countries are often bridled with corruption.
Are we really smart enough to leave things to the market?
Free-market theory adopts a traditional laissez-faire approach, trusting the rationality of individual agents, but incorrectly ignores the concept of ‘bounded rationality’ arising from various factors, including intrinsic human inconsistency and the sheer complexity of the world. Now, a separate debate is whether the potential government failures resulting from government intervention outweighs the presence of market failure, but the point we are considering is, given that the rationality assumption does not hold, whether we should think differently about the role of the government and the market than what free-market economics tell us to. Herbert Simon, winner of the Nobel Prize for Economics in 1978, noted that our limited capability to process not a shortage but a surplus of information was a key problem that resulted in humans making decisions using heuristics – convenient shortcuts or patterns to base decisions on – which often led to choosing options that did not maximise their satisfaction, or were unnecessarily risky, contrary to traditional expected utility theory. Turning to the lead-up to 2008, amongst a multitude of other problems, a huge number of complex financial instruments (CDSs, CDOs, even CDOs created by using other CDOs as collateral!) were created such that even financial experts did not fully understand them. Additionally, as the ‘distance’ increased between assets derived from assets which were derived from other assets, for example, it is increasingly difficult to price these ‘derived’ assets accurately, meaning that an increasingly fragile tower was being built by investors, most of whom did not understand the components of which, on a base that was already unstable (sub-prime mortgages). The author suggests, in the midst of such overwhelming choice and confusion, banning such financial instruments until we fully understand them. This might seem rather extreme, but Chang compares it to how we treat any other new product that appears on the market, such as drugs and electrical products – these do not go out until they have been extensively tested and shown to be 100% safe. Of course, the whole debate stems around the balance between promoting innovation and new products with protecting consumers, and what is best, but perhaps, sometimes the quantity of regulation matters less than its quality.