You are on page 1of 20

Capitalism: Indirect Economic Governance of a Visible Hand

The Need for a Visible Hand

Capitalism: The Indirect Economic Governance of a Visible Hand

Bruce Scott

The author argues that the United States has two systems of governance: capitalism and democracy. He traces the history of their interaction, a more complex process than is often imagined. But as times change, he argues, one must evolve with the other.

Gabriel Almond pointed out, two systems of governancecapitalism and democracyprevail in the world today.1 Since the collapse of the Soviet Union in 1991, capitalism, in one variation or another, has become the near universal system of governance for economic relationships. The reach of democracy is limited in comparison, yet even in nondemocratic countries it is almost universally held as the ideal, and honored in theory if not in practice. These two systems of governance coexist and overlap, yet each has its own purposes, its own sources of legitimacy, and its own operas the late

Bruce Scott is the Paul Whiton Cherington Professor of Business Administration Emeritus at Harvard Business School. His most recent publication is Capitalism: Its Origins and Evolution as a System of Governance (New York: Springer, 2011).
Challenge, vol. 55, no. 4, July/August 2012, pp. 523. 2012 M.E. Sharpe, Inc. All rights reserved. Permissions: ISSN 0577-5132 (print)/ISSN 1558-1489 (online) DOI: 10.2753/0577-5132550401

Challenge/JulyAugust 2012 5

Scott tional logics. At the same time, each system is characterized by internal competition among its constituent entities, and in addition, the two systems compete with each other for power. Almond has also pointed out that the competitive dynamics of these interacting systems tend to transform both systems through time. Given the importance of capitalism and democracy to modern societies, it is crucial to understand how these systems affect one another. Nevertheless, this area of study seems to have been relatively neglected in the academyindeed, we have not even succeeded in creating a standard definition for either system that is precise enough to allow researchers to identify starting points for the evaluation of such transformations. The article offers an original definition of capitalism that is specific enough to permit the identification of structural changes in how capitalism is governed, as distinct from how it coordinates supply and demand, and also to permit a start in evaluating various societies progress toward their respective goals. Then it shows how this concept of capitalism is borne out by an examination of its historical origins and by the subsequent evolution of distinctive varieties of capitalism. Finally it looks more closely at the ongoing power dynamics between capitalism and democracy, and illustrate what these dynamics have meant for the evolution of capitalism in the United States.

Capitalism: An Indirect, Three-Level System of Governance

Social historian Michael Merrill has noted that many economists view capitalism as little more than a synonym for a market economy.2 With this clear but narrow focus, they can employ rigorous mathematical methods to analyze the markets, based on the axiom that the price mechanism tends to lead to the equilibrium of supply and demand. It is the genius of capitalism that this process, with all its concomitant benefitsthe release and utilization of dormant energies and resources to meet the needs and desires of a constantly changing societydoes not require any external authority to direct the actions of the participants. This power of self-coordination is none other than Adam

6 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand Smiths invisible hand. Many economists go farther and state that markets self-regulate, and that any attempt to influence or constrain markets from the outside is unnecessary, if not harmful. However, to facilitate economic development through time, a capitalist system must be able to evolve, modernizing its institutions in light of changing conditions. For example, markets alone cannot be relied on to prevent the emergence of monopolies, or to moderate potentially disastrous bubbles. Nor can they protect society from the negative side effects of private transactions, such as damage to the environment. Furthermore, as pointed out by Douglass North, societies are best served if the markets can also reflect changing societal priorities, and in these situations the invisible hand is powerless to actit is a system of coordination, not a system of governance.3 Markets exist within a set of institutions that lie beyond the control of the economic actors; the property rights and trading relationships that are essential to capitalism exist within legal frameworks established by governments. Refashioning the institutions of capitalism can only take place under the aegis of the visible hand of a political authority. The genius of the visible hand of political authority over a capitalist system is that it governs indirectly. Capitalism permits economic actors the freedom to pursue their own interests, subject to a set of rules and institutions that establish the boundaries and the incentives for that competition. Generally, the rules and institutions are designed to prohibit certain kinds of behavior; any behavior not explicitly prohibited is permitted, allowing for flexibility and creativity. This indirect form of governance contrasts with direct rule through hierarchy, where only specific kinds of behavior are authorized by higher levels in the governance system through the hierarchy within a governmental bureaucracy or a firm. Organized sports provide an illustration of indirect governance, as seen in Figure 1. The soccer field sets boundary lines, and play is governed by a set of rules that strictly limit the use of hands for advancing the ball while leaving a wide range of choices open to the players. (Within a team, as within a firm, of course, individual players

Challenge/JulyAugust 2012 7


The playing fields of organized sports are like markets where competitors interact.
Figure 1.The Governance of Organized Sports Is Indirect, Based on Rules and Regulations

may be explicitly told what to do, and privately disciplined if they fail to follow through, but the essence of the game is free competition according to a public set of rules.) Another key point is that capitalism is not a one-level or even a two-level but a three-level system of governance. Here, too, sports provide a useful analogy. In the sports world, the first level is the game, in which athletes act and compete against one another, individually and as teams. This competition is usually the focus of audience attention. The second level comprises the rules and regulations according to which the game is carried out, along with the referees who monitor the game to ensure fair play according to those rules and regulations, and the institutions that organize and maintain the games infrastructure, including determining who is eligible to compete. The third, highest level represents the political authority, or governing body, for

8 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand

Organized Sports
Political authorities

Organized Capitalism
Political authorities
Parliament (U.S.) Congress, president, and Supreme Court

Institutions, regulations, and referees

Institutions, regulations, and regulators

Officially sanctioned games

Formal markets

Figure 2. Parallels in Governance Between Sports and Capitalism

Source: Bruce R. Scott, Capitalism (New York: Springer, 2011).

the sportfor example, the International Federation of Association Football (FIFA), which sets the rules and regulations for World Cup football and U.S. soccer. As Figure 2 suggests, the same three levels exist in capitalism. The first level is the realm of the markets, where economic actors compete and where, through their actions, the price mechanism works to achieve equilibrium. Many economists focus almost exclusively on this level, failing to acknowledge that it could not exist, much less thrive, on its own. The second level comprises the rulesthe legal boundaries within which economic actors must operateand the administrative personnel of the regulatory institutions, who interpret and enforce those rules, as well as maintain the common infrastructure. The third, highest level is the political authority, which bears ultimate responsibility for the content of the rules and the existence and form of the institutions that administer them and the powers that they wield. In the United States, the legislative branch, the executive branch, and the Supreme Court are all part of this governing authority (more on the peculiar role of the U.S. Supreme Court below). The administrative role of the political authority in both sports and

Challenge/JulyAugust 2012 9

Scott capitalism is familiar; it entails maintaining the institutions that underpin the status quo (e.g., by the necessary budget appropriations). In both systems, however, the political authority must also play an entrepreneurial role to secure changes in the system. In a democracy, since governance depends on consent of the governed, leaders cannot promulgate new laws without mobilizing political support to secure the needed legislative majorities. The three-level system suggested by modern organized sports not only illuminates modern capitalism; it also has important parallels in the distant past. For organized sports to qualify as such, the games are not played out in the weeds, at uncoordinated times, among random assortments of athletes acting without supervision. Rather, the competition unfolds in carefully marked out areas, at specifically designated times, and under the supervision of a neutral set of referees. This designation of a specific area, set of rules, and team of regulators is comparable to the nascent capitalism of the late Middle Ages, when markets were confined to specific locations and specific market days, and trade was carried out according to a prescribed set of rules under the supervision of chartered guilds of registered tradesmen. Further, as in sports, the nature of the rules and the appointment of officials to monitor their enforcement depended upon a political authorityin the case of early capitalism, the king or local notable. The political authority needed the backing of coercive power, although this did not necessarily mean armed officials. As in organized sports, effective punishment for unauthorized actions could take the form of small penalties for small infractions or exclusion from the activity in the case of larger violations.

The Origins and Evolution of Capitalism

By reviewing the history of capitalism, we can gain a clearer understanding of the importance of governance, which is so closely intertwined with the development of democracy. A clear and robust definition is essential to this process. Some authors have conflated trade with capitalism, allowing them

10 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand to date the origins of capitalism to a period before Christ, because we are told that in that time frame there were money changers in the temples. We are also told that capitalism was present in what we now call Mexico before the arrival of the Spanish adventurers.4 However, in my view, the eminent economic historian Fernand Braudel had it right when he reasoned that capitalism cannot be said to have existed as a system (of governance or otherwise) until it encompassed most commercial activity within a given state or region, which in almost all circumstances meant until it had displaced feudalism. Pre-Columbian Mexico was predominantly feudal; powerful local notables lived from the dues they collected from peasants tied to their land. The Spanish generally maintained these systems, substituting European overlords for their indigenous predecessors. I would date the advent of capitalism in Mexico to the nineteenth century. In my view, the first appearances of capitalism were probably in a handful of cities in Italy, before 1300 (and perhaps in northern Europe in the Hanseatic League, and in Antwerp). Let us look at Venice, arguably the clearest early example of successful capitalism. Venice was exceptionally placed to develop an alternative system to feudalism. It had so little land in its core group of seven small islands that self-sufficiency in food would have severely restricted its population and thus its capacities for self-defense from marauding Germanic tribes or naval forces from Genoa, its archrival. To prosper as needed to hire mercenaries for territorial defense, Venice had to learn to manufacture and trade with other societies. There was no room on those tiny islands for a large landowning class whose livelihood depended upon agriculture. Fortuitously, its political power was vested in its islanders, and thus in its merchant class. From this dominant social structure Venice built a mercantilist trading system that eventually expanded into a city-based empire that included much of the Dalmatian Coast, a number of the major Greek islands and, for a time, even Istanbul. Venice was early to develop many of the financial institutions familiar to us today, such as double-entry bookkeeping, commercial banking, banking supervision, and the use of sovereign debt as the

Challenge/JulyAugust 2012 11

Scott base for an elastic money supply. At the same time, it developed a trading system that used armed convoys to protect a state-owned fleet of merchant ships, which rented space commercially to the highest bidders. The taxes on its trading system financed its defenses. This federation, which predates the year 1000, was thus able to choose its own leaders, including its bishops, and formulate its own laws and institutions well before the year 1300 and thus to be a capitalist society before that date as well. England is another important case because the Channel allowed it to develop a stable sense of nationhood and government relatively early. There is considerable room for judgment on when one should credit this country with a capitalist regime, since it had less of a feudal system than most of continental Europe and developed its property rights and other economic institutions gradually. I would date English capitalism to shortly after the Glorious Revolution of 1689, when the political settlement sharply limited the powers of the monarchs. From then on, Parliament had to authorize government expenditures. This change opened the way to the creation of the Bank of England, where the government of England would borrow on the basis of Acts of Parliament and not the personal signatures of the king. Since the credit standing of Parliament was far higher than that of the crown, interest costs on state debts fell by about two-thirds, allowing England to finance much larger military forces. This, in turn, facilitated the rise of England to a world power. The path to a capitalist Europe was not smooth or automatic. Capitalism did not spread gradually from one country to its neighbors, but rather emerged in individual places as the result of discrete political decisions, often by revolutions or conquests that overthrew incumbent regimes. The French Revolution in 1789 is an example of the deliberateand bloodyabolition of feudalism. Italy, Prussia, and Spain adopted capitalism still later; between the advent of Venetian capitalism and that of Spain, there was a lag of at least 500 years.5 Over the course of the centuries, an overall pattern of capitalist emergence is evident. Competition from rival powers put intense pressure on feudal rulers to open up markets in land and labor to en-

12 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand terprising citizens and to decentralize power in exchange for a share of the societys new wealth, which could be used to fund military forces. For the rulers, this was a matter of survivalpolitical and, in many cases, physical. In 1500, Europe had an estimated 300500 independent political entities, many of these in what would become Germany and Italy. In 1820, only 40 such entities remained. The military-political competition in Europe was similar to the consolidation of a new industry, where bankruptcy and hostile takeovers reduced the number of firms to a handful. The threat of hostile takeover motivated smaller political units to look for allies or protectors, and the delegation of economic power (and, hence, inevitably, political power) to the private sector was a crucial strategy for keeping ones regime in existence. In the latter part of this period, more and more European nations adopted limited monarchy, in which monarchs were constrained by a constitution or set of laws. Limited monarchy was a precondition for the rule of law, which was in turn fundamental to the establishment of capitalism. Capitalism arose when the monarch allowed the decentralization of certain economic powers in return for loyalty and the payment of taxes, for example in England in 1689; decentralized economic power, in turn, seems to have been a precondition to the establishment of large-scale democracy. Globally, Europe was first to witness the spread of capitalism because it was composed of relatively small states that were in near continuous warfare in the relevant time period. Despite the consolidation of states, none of the European powers was able to establish a durable empire in western Europe like those of the Ming and Qing dynasties in China, the Mughals in India, or the Ottomans in the Middle East and southeastern Europe. Englands foreign policy was to ally itself with powers that were resisting a bid for dominance by a neighbor, acting in effect like an antitrust agency. By mobilizing the coalitions that ultimately defeated Napoleon, England ensured the existence of half a dozen major competitors in Europe, instead of a few mini-states dominated by a single hegemon, France. In Central and South America, as noted above with regard to

Challenge/JulyAugust 2012 13

Scott Mexico, the European settlers created systems that were even more repressive than feudalism. The promise of natural wealth (agricultural and mineral) brought early development in many areas, but these natural resources were produced mainly for export, using forced labor. Authoritarian rule was needed to repress labor. Capitalism did not emerge in Latin America until the nineteenth century, and then with underdevelopment of its human and physical resources. We all know about the twentieth centurys vast experiments with communism; China was the last major holdout against the decentralization of economic power, starting only in 1978. The United States was the first non-European capitalist country; it also became capitalist in advance of many European countries, a circumstance that has been little appreciated on either side of the Atlantic.

The U.S. Experience

I give special attention to the case of the United States not so much in the belief that it is a sound model for others to follow but because it is a model of such importance in terms of wealth and population and power, and in terms of the alleged universality of the Washington Consensus principles. The U.S. capitalist model was influenced almost from its outset by its unusual geographic endowments, including one that is so large it is often overlooked. The expanse of land east of the Mississippi River that was conquered and settled by Europeans in what would eventually become the United States contained millions upon millions of acres of fertile land suitable for rain-fed agriculture. There was little need for collective action in the management of the land (in contrast to, for example, Indonesia, Egypt, or the Netherlands, where land and water management are inescapably major common enterprises). Into this vast expanse, European immigrants arrived to start farms and small businesses, typically with at most one employee or one family. They had relatively low incomes and harsh winters compared to the more southerly territories; indeed, sales promotions were required to

14 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand attract immigrants from an overcrowded Europe and enlarge Americas domestic markets. Pro-immigration measures included dividing the land into small plots to permit maximum diversity of ownership, and the abolition of feudal land rights such as primogeniture and entail, so that land could be treated as a commodity on a market instead of as a semifrozen feudal inheritance. In addition, there was attention to such public goods as good laws and law enforcement, to roads and canals, and to public education. The United States got its start under exceedingly rare conditions: There were almost no large concentrations of internal economic power other than slaveholders, largely in the South. In 1787, there were hardly any firms worthy of special mention; even in 1830, ten employees was a big firm. With horse-drawn vehicles as the main means of transport, trading areas were small, except along the navigable waterways. Thus atomistic capitalism was a natural model to develop, with small farms, small firms, and small villages. The biggest concentrations of economic power were in trading enterprises and slave plantations, and the latter would not count as part of a capitalist system. Slave-based plantations were icons of a production system even more repressive than European feudalism of the time, but they occupied only small portions of the land or population. For its first 200 years, ca. 16301830, the group of colonies and then the independent United States enjoyed a remarkable symbiosis between its atomistic form of capitalism and its government, which was nominally powerful but in reality undersized, decentralized, and weak by design. There was little need for great public works. When, in 1787, James Madison suggested to George Washington that it might be advantageous for the Constitution to give the federal government the power to charter corporations, others countered that such a power was already implicit in the document, and could be explicitly added by Congress at a time of its choosing. Washington was also warned that writing in this chartering power could prevent the entire document from being ratified owing to fears of an excessive concentration of power in central government. In the end, it was left out. Over the next 180 years, 18302010, this picture of atomistic capi-

Challenge/JulyAugust 2012 15

Scott talism would change radically. U.S. entrepreneurs would spawn firms that would grow to become some of the largest centers of private power the world had ever seen. And, as time passed, these economic giants would bid for and acquire political power. Large private firms were able to challenge and even overwhelm local and state governments, reducing their payment of taxes and their obedience to local regulations. In doing so, the firms were in fact subverting democracy. The Industrial Revolution brought a new, capital-intensive form of capitalism. The rationale for powerful industrial firms lay in their increasing economies of scale and speed, due largely to new technologies. Size itself became vital to maximum economic gains for individual firms, and to maximum growth for the country. Indeed, the largest U.S. firms grew by about a thousandfold between 1800, when 100 employees was about tops, to 1900, when there were at least ten firms with 100,000 employees. Their growth was even larger when measured in turnover, assets, or cash flow. Size was also a key to political powerand to corruption of the political system for private benefit. From the 1840s onward, individual states competed to offer the most lenient terms for corporate charters, in what became a race to the regulatory bottom. Theodore Roosevelt and William Howard Taft, his successor, each proposed what amounted to legislation to create a system of federal chartering, but without success. Their efforts were scuttled by the Senate, whose members were elected by state legislatures, many of which were dominated by the interests of big business. Meanwhile, after the Civil War, the Supreme Court became a powerful arbiter of U.S. capitalist development. It routinely overturned federal and state statutes that it deemed inconsistent with laissez-faire capitalism, as though this variant of capitalism had been mandated by the founding document. Since laissez-faire rewarded the strong actors, it led to increased inequality and corruption. In reality, the federal structure embodied in the Constitution, coupled with a public mistrust of centralized power inherited from the early tensions with the mother country, was a recipe for vesting more and more power

16 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand in the private sector, and thus for shifting the balance of political as well as economic power toward business leaders. U.S. capitalism was developing its distinctive characteristic of managing firms in the interests of shareholders or very senior managers rather than of other potential claimants on its resourcesstakeholders such as consumers, employees, or communities. In his dissent in the famous Lochner case in 1905, Justice Oliver Wendell Holmes pointed to the profound political significance of this intervention, writing that a constitution is not intended to embody a particular economic theory, whether of paternalism and the organic relation of the citizen to the state or of laissez-faire. Justice Holmes saw capitalism as a system of governance in which political decisions to change priorities and institutions were properly the domain of the legislature. However, his views were expressed in dissent, and would still be today, which makes the United States distinct from other developed countries. It was not until 1937 that the Court changed course, ostensibly through the efforts of President Franklin Roosevelt, who framed the issue as the excessive workload of nine mostly old men on the Supreme Court. In the end, Roosevelts proposal to pack the Court was rejected; instead, the issue was finessed through a change in the membership of the Court, and a change in the voting pattern of one of its members, hence a change in its decisions from supporting laissezfaire to one supporting social democratic capitalism. However, there was no definitive settlement of the underlying regulatory issue of the concentration of power, which, indeed, has recurred since 1980. From 1937 until 1980, one can say that the United States had a social democratic form of capitalism much like that extant in western Europe at the time. Furthermore, the United States had a distribution of incomes much like the European patterns. With its return to laissezfaire since 1980, the United States has returned to the pattern of the 1920s; virtually all the increase in national income since 1980 has flowed to the top 10 percent of the working population, and roughly 40 percent to the top 1 percent, the most extreme such pattern among the traditional industrial countries. This shift has not been due to further growth in relative size of U.S.

Challenge/JulyAugust 2012 17

Scott corporations so much as to the deregulation of our democracy, which has reduced the governing powers of Congress. Deregulation of the political system has been followed by the deregulation of capitalism as well.6 Selecting legislators in open primaries has had the effect of polarizing both parties as well as making candidates more dependent upon financial contributions from special interests. Legislators now need to finance two elections in each cycle instead of one. And once elected, they are now entitled to introduce bills on their own, in a process open to both the press and lobbyists, creating incentives for legislative entrepreneurship. Coordination has become steadily more dependent on that tried and true indicator of market forces, money. This brings us back to the nature of the relationship between capitalism and democracy. How do the internal dynamics of each system affect the workings of the other system?

The Operational Logics of Capitalism and Democracy

One may say that the purpose of capitalism is to facilitate rising productivity and incomes through the decentralization of decision making, in a context in which market forces can reallocate resources in light of changing opportunities. This is carried out by means of a frequently rough-and-tumble process that has aptly been called creative destruction.7 Since individuals have different abilities and motivation to work, capitalism is bound to promote inequality. And one may say that the purpose of democracy is to secure the consent of the governed through the institution of government of the people, by the people, for the people, as Lincoln explained at Gettysburg. Democracy considers all persons morally equivalent, and thus, the purposes of these two systems are partially supportive of one another and partly competitive or even antagonistic.8 Much the same is true of their logics of operation. There is bound to be at least periodic tension between these two systems, and the outcomes of such tensions will affect the evolution of one or both. What are their respective logics of operation? Capitalism is usually

18 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand regarded as an impersonal system that relies on the invisible hand of the pricing mechanism to coordinate supply and demand. But this merely defines a system of coordination, not a system of governance. As my own definition of capitalism presented earlier in this paper tries to make clear, the market is only one of three levels in the system of capitalism. In contrast, democracy is an acknowledged system of governance, which means that the visible hands of political and administrative actors have the power and the legitimacy to design, operate, and modify institutions to promote societal welfare, guided by citizens preferences as expressed through votes in elections and in legislatures. Arguably, the most distinguishing institution of both capitalism and democracy is the reliance on competitive markets for decision making. Yet the two systems rely upon quite different conceptions of markets. Political markets are frequently less transparent and more easily subject to manipulation than are their economic counterparts. Economic actors can use their economic power to influence political markets as well. Consequently, the distinction between presumably transparent economic markets and the often less transparent political markets is becoming increasingly nuanced as capitalist actors amass economic and thus political power. The political markets of democracy also work differently than capitalist markets in that interest groups normally offer voters a bundle of proposals that cannot be readily unbundled. In addition, the range of outcomes of competition among political actors includes winnertake-all victories, even if only by razor-thin majorities, as well as quasi equilibrium solutions, where political actors work out negotiated compromises, in contrast to the impersonal processes in capitalist markets. There are other crucial differences as well. For instance, the geographic scope of capitalism is much greater than that of any democratic government; its factor markets can be, and its product markets frequently are, worldwide, while the markets of democracy, for the election of candidates and the passage of legislation, are usually limited to particular political jurisdictions. Another difference is that

Challenge/JulyAugust 2012 19

Scott democracy has the capacity for self-correction through the redesign of institutions; the markets of capitalism do not have this capacity, though they are often perceived as if they did. For capitalism to yield results that benefit society as a whole, its institutions must be designed and administered with human intentionality. This can only be effected by the political system, that is, by a government. The recent attempts to correct the financial system illustrate this point: reforms had to be enacted by Congress before they could take effect; the coordination provided by the invisible hand could not meet this challenge. It cannot be said too often or too emphatically: coordination is not equivalent to governance, because, as Douglass North has pointed out, market operations are not the same as market development through the purposeful reform of institutions.9 Given the asymmetries of scope, power, and operational principles of these two systems, their continuing potential to transform one another is bound to be fraught with possibilities for tensions and corruption, as well as synergy and well-being. Lobbyists and cronies form bridges of corruption between democracy and capitalism. Lobbyists acting on behalf of particular capitalist interests attempt to persuade legislators to change market frameworks for the benefit of their preferred class of participants. To the extent that they succeed, not only is democracy likely to be corrupted, but the legitimate system of economic coordination through markets is likely to become corrupted as well, with the markets politicized for the benefit of special interests. As noted above, deregulation of the institutions of democracy makes the system more vulnerable to lobbying. Economic deregulation has been a force for mobilizing increased energy in more open and fluid markets, in a process that can be expected to yield increased productivity and wealth. At the same time it can be expected to yield increased inequality of incomes and economic power, as the strong outperform the weak. Furthermore, unless there is some form of intervention to limit the pass-through of such advantages from one generation to the next, capitalism may be said to corrupt democracy over time through rising income inequality. It does not have to be this

20 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand way. Canada has quite a different capitalist system from that of the United States, and one that is much less corrupt. As a consequence, it was able to weather the 2008 financial crisis without the bankruptcy of a single bank. Unlike the United States, it did not deregulate its banks or allow a huge increase in their leverage. In short, it was more effectively governed before and during this crisis. If a capitalist system is to be effective in adjusting to changing circumstances, it must be subject to overall political governance. Markets cannot, by themselves, supply the institutional changes that may be imperative as conditions change. However, political oversight carries the risk that political leaders will make very poor economic decisions to gain short-term political advantages. There are no perfect solutions to the problems of governance, only better or worse compromises. The analysis thus far suggests a set of questions for the study of capitalism and democracysome focused on historical issues and some on understanding contemporary societal dynamics. The former category would include: When and how did these two dynamic systems originate, and how has capitalism spread in a geographic sense? The latter category would include: When is it legitimate or illegitimate for power to flow from one system to the other? And: Has the balance of power between these two systems been relatively stable, or has it been drifting to favor one system over the other? The relationship between capitalism and democracy can be expected to evolve as circumstances change, making the study of societal governance a continual challenge to keep up with evolving circumstances.

Lincolns Insight
Abraham Lincolns Gettysburg Address called for government of the people, by the people, for the people. He used this phrasing for good reason. The simplistic notion that government by the people is automatically for the people opens the political process to the exercise of power by well-financed special interests, and hence to government on behalf of those special interests. California is a leading example of what can happen. It has been transformed from one of the best-governed

Challenge/JulyAugust 2012 21

Scott states not just in the United States but in the world, as recently as the 1960s, to one of the worst-governed states in the United States, not far above third world levels, all in the name of governing by the people. Openness and transparency may be essential elements of democracy, but they go only so far. Institutions must be fashioned in a way that encourages government to work for the people. This is a challenge that can never be achieved once and for all. It is a work in progress, which demands public understanding and active support to protect the substance of democracy as well as its appearance. Public education is thus a vital component of governance, for both capitalism and democracy. From the 1830s until 1970, the United States was ranked number one in the world in public education. This position began to erode in the 1960s, and has since been lost. For the first time in its history, the United States faces the prospect that its current graduating students will not earn as much in real terms as their parents and, more ominously, that they will not be as well educated either. To be sure, rising foreign competition, especially from Asia, has affected our standing. But the decline in U.S. competitiveness comes more directly from the declining quality of governance at home, in most if not all of its major institutions, from its firms to its Congress, its state and local governments, and its public education. The fact that No Child Left Behind has tried to set national standards for math, science, and language, with no mention of civics or governance, is emblematic of this neglect. Deregulation, when adopted as a panacea for governance, leaves a society dependent on money as the great arbiter of value. It invites increased corruption in the processes of governance and increased inequality of incomes and opportunities as a result. We have a long way to go in understanding how capitalism and democracy evolve together. The question does not appear to receive the attention it deserves in the research and teaching at some of our great universities, including the one that I know best. As a society, we have taken both capitalism and democracy more or less for granted; if they are to endure in robust form, we must do better.

22 Challenge/JulyAugust 2012

Capitalism: Indirect Economic Governance of a Visible Hand

1. Gabriel Almond, Capitalism and Democracy, PS: Political Science and Politics 24, no. 3 (1991): 46774. 2. Michael Merrill, Putting Capitalism in Its Place: A Review of Recent Literature, William and Mary Quarterly 52, no. 2 (April 1995): 31526. 3. Douglass C. North, Institutions, Journal of Economic Perspectives 5, no. 1 (1991): 97112. 4. Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000). 5. Braudel did not acknowledge these points as clearly as he might have. 6. Fareed Zakaria, The Future of Freedom: Illiberal Democracy at Home and Abroad (New York: W.W. Norton, 2004). 7. Joseph Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Brothers, 1942). 8. Robert Dahl, On Democracy (New Haven: Yale University Press, 1998). 9. North, Institutions, 97.

To order reprints, call 1-800-352-2210; outside the United States, call 717-632-3535.

Challenge/JulyAugust 2012 23

Copyright of Challenge (05775132) is the property of M.E. Sharpe Inc. and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.