Does Capitalism Work?

[Editor's note: This article was originally published as “Have Smith's Theories Been Proven to Work In Spite Of the Presence of Government Meddling in Economics?.” After further reflection, I determined that the original article was attempting to critique Smith's theories during time which, as demonstrated in the previous article, his theories were not even being tried. Therefore, this article has been rewritten to more accurately reflect what was intended.
- 6 April, 2016]

In the previous article on Adam Smith's economic theory, we determined that his vision of capitalism has never been fully tried. According to some of his followers, we do not currently live in a capitalist economy because the government meddles in economic matters in ways that are incompatible with Smith's theories. In truth, there has not been a time since the publication of his pivotal work, "Wealth of Nations," when his theories have ever been fully implemented. The curious thing is that, when they boast about the prosperity and technological advancements of the last century, modern advocates of capitalism say that these achievements prove that Smith was correct. They declare that capitalism is the only economic system that has actually been proven to work.

For the previous article, we took “capitalism” to mean what Adam Smith advocated. For this article, I will look at what is acknowledged to be capitalism and has been called capitalism for around two centuries, even though it is not what he advocated. Ultimately, it is this form of capitalism to which its modern advocates give credit for the material and technological advancements of the last century. Modern pundits claim that it is when government has gotten out of the way of the natural forces of the market. It is during these brief and imperfect respites from government interference that capitalism has been allowed to flourish and bring prosperity to all. We will ignore for the moment the claim that this can somehow be attributed to Adam Smith. If these pundits are correct, then any example where it can be shown that government was not interfering should be a demonstration of competent of business leaders, at least when we are discussing the leaders of the largest industrial and financial institutions in the country and the world. These are the leaders who ushered in the technological advancements and who financed them. They represent the "cream of the crop," as it were, of the economic elite. Those who, we are told, best understood the nature of the science of economics. Today's advocates of capitalism, who call for the government to stop interfering the the laws of economic science, tell us that capitalism will lift the poor out of their poverty and will be beneficial to society as a whole. 

The claim that material and technological advancement is due to capitalism, that it is when government stops, or at least decreases, meddling in the operation of the free market needs to be challenged rather than blithely accepted. A major claim of capitalists is that, when people are allowed to freely practice capitalism, the ultimate result will be beneficial for all. Because everyone will avoid anything to their own disadvantage, the result of these decisions will ultimately result in an overall balance of good results throughout economic society. This does not mean an equal result for everyone. Not everyone will get rich, but capitalists claim that capitalism results in lifting the poor out of poverty. It is not in the interest of the poor to remain in poverty. It is not in the interest of the middle class that they become poor. Therefore, everyone acting in their own self interest cannot result in anything other than the material enrichment of nearly everyone.

According to capitalists, it is when the government meddles in economic matters, forcing parties to act against what they consider to be their best interest and economic laws, that the economic engine of capitalism fails to work properly. It is government meddling that causes, or perpetuates poverty. If government meddling increases, then poverty and economic disruption will also increase. If government gets out of the way in economic matters, the result will be an overall improvement for everyone. Therefore, we will look at a couple of significant things of economic history to determine how well this claim stands to what actually happened.

The Economic Crisis of 2008

According to capitalists, this was a direct result of government regulations requiring mortgage providers to give loans to people who didn't qualify for them according to market standards. We cannot deny the existence of government meddling in this case, but is that meddling what caused the economic meltdown? Does this government meddling explain why the default of a relatively small percentage of mortgage loans in the U.S. caused a world-wide economic crisis, the effects of which are still prevalent six years later?

The first thing we must look at is the idea that these loans created a financial risk for the lenders. The fact that our economy operates on a fractional reserve system means that there was not. Not one dollar of the reserves of these mortgage providers was ever at risk. Even with the decrease in the market price of the property, the fact is that these mortgage providers acquired a claim to real property on the basis of money they created out of thin air. Unless the market price dropped below what it would cost them to sell it, there was never any actual risk of loss, only less profit than was anticipated. Therefore, absent any other factors, the fact that mortgage providers can create money from nothing means that there is no true risk of loss for granting a mortgage to even the worst potential client. Now, they won't agree with this assessment. When they create the money, it gets entered as an asset to be recovered, and if they can't recover it, then that asset is recorded as a loss. To them, the fact that they created this asset by fiat through the mere act of making a loan is irrelevant. I disagree. If they lose money they never had to begin with, in what sense is there any real loss? What caused the economic meltdown? The main culprits were the financial mechanisms used by the mortgage lenders between themselves: credit default swaps and mortgage derivatives.

When a mortgage provider grants you a loan, they frequently take out an insurance policy to cover the risk that you won't pay them back. There is nothing particularly scandalous or even interesting about this. They are a party to the mortgage and, if you are not considered the best of potential clients, they certainly have an interest in protecting themselves against you not paying the loan. The acceptability of this, however, is based on the fact that they are a party to the loan. A credit default swap is a mechanism where they are allowed to sell their side of your mortgage to another company, but still carry an insurance policy against it. In other words, they are no longer a party to the loan, but if you fail to repay it, they will still get paid from the insurance. Of course, the company that bought your mortgage is likely to cover your policy to protect their investment, but they can also sell your mortgage to another party and continue to have an insurance policy covering it. Through this mechanism, if your policy gets sold off four times, three companies who are not involved with your loan will get paid if you default. This is pure profit for them with no actual risk, especially if you are considered likely to default, so it became extremely popular. It means that the financial system must be able to cover not only your loan, but multiple times your loan. Credit default swaps were not regulated by the government.

A mortgage derivative is an especially curious thing. Credit default swaps don't make sense on the grounds that companies no longer involved in a mortgage shouldn't be allowed to carry an insurance policy against it to cover the loss of a potential return that no longer exists. A mortgage derivative is a mystical process where you are simultaneously regarded as both a low risk and a high risk borrower. Let's say that a calculation is made that you are 20% very likely to pay off your loan, 30% to pay it off but with some late payments, and 50% likely to default. The holder of your mortgage can divide your loan up accordingly and sell shares in it. Even though all of the shares come from the same mortgage, and even though your default on the loan would mean simultaneously defaulting on all of it, the risk of those shares are not treated equally. The risk given to the individual shares of your mortgage are divided according to the above percentages. Even though it is believed there is a 50% chance you will default, 20% of those shares were sold as though you were very unlikely to do so. These "low risk" shares were sold to retirement portfolios, other investment bundles, and to other banks. This one mortgage became part of the success or failure of a vast multitude of investment portfolios. Multiply that by all of those sub-prime mortgages that were out there, and you can see why the failure of this small percentage of mortgage loans caused world-wide economic chaos. There was little to no government regulation of mortgage derivatives.

Child Labor & Low Wages

The late 19th and early 20th Centuries were the heyday of industrialization. This was the time when business empires were built and great amounts of wealth were generated. In the large urban areas where the factories of industry were built, the wages were extremely low. So low, in fact, that husbands and fathers found themselves unable to earn enough in wages to provide for their families' needs. The result was that wives and mothers were forced into the workplace. I'm not against the availability of jobs for those women who need and want them, but this is not the situation I am discussing. This is a situation where women who wanted to stay home to raise and take care of their families were not able to do so because their husbands who were already working full time jobs in the factories were not paid enough to support a family. However, this is not the end of the situation. Eventually, even the incomes of both parents did not provide enough of an income to provide for the needs of a family. So the children were also sent off to work as well. After a day at school, if they were even able to continue school, they would march off to the coal mines, textile mills, and other hard jobs just so their families had a place to live and food to eat.

In addition to pay being very low, work conditions were frequently unsafe. I'm not comparing those conditions to today's standards. There are plenty of pictures of young children standing on moving machinery, or whose faces are covered with coal dust. It was known that those who worked in textile mills frequently suffered from lung conditions caused by the high levels of dust that floated through the air. The fact is that such conditions were not voluntarily addressed by the owners of these businesses. While the owners lived in mansions and went to fine parties, their employees lived in slums and suffered health problems caused by their work environment. States had to implement regulations to ensure that sufficient ventilation shafts were installed in the mines. They refused to move on wages, hours, and child labor. The federal government attempted to address the issue of child labor, but were successfully fought off multiple times by the owners of the industries who employed them. When employees tried to organize to force their employers to pay them better wages, those employers organized gangs of thugs to attack them rather than listen to their just complaints. In other words, employers refused to bargain wages or to pay even a living wage when there was nothing requiring them to do so. I agree that many unions have become organizations of corruption, but we should not forget that it was unregulated business practices that made them necessary. It was unregulated business practices that led to the federal child labor laws, safety regulations, the forty hour work week, the establishment of a national minimum wage, and many of the other instances of government "meddling" in the free market that capitalists criticize.

It is not necessary that capitalism will result in such practices as I have described. However, it cannot be denied that the captains of capitalism have engaged in these practices and were able to do so freely because there was little or no regulation to even try to prevent them. It was unregulated capitalism that led to the plight of the poor in the heavily industrialized urban areas. It was unregulated capitalism that led to the foundation of unions. It was unregulated capitalism that led to increased state and federal regulation of business practices. It was unregulated capitalism that led to the acceptance of Keynesian economics. It was unregulated capitalism that made the common citizen in the most highly developed nations of the world so desperate that they considered the false promises of socialism preferable to their situation under capitalism.

If capitalists want to claim that these terrible conditions were not a result of capitalism, then they cannot claim credit for the advancements of the time. These advancements were made by companies that treated their employees very badly. Later on, advancements were made by companies who were forced by regulations to treat them better. I do not claim that capitalism cannot claim responsibility for any advancements that have occurred, but the claim that it is responsible for all of the advancement cannot be maintained along side the claim that it is not also responsible for many of the economic problems and the wretched conditions of the poor that have occurred during its history.

The capitalism under which Western economies grew and the industrial giants were formed and were extremely profitable was not the capitalism advocated by Adam Smith. Therefore, we can dismiss the claims of those capitalists who want to credit Smith and his theories with the economic advancements that have taken place. On the positive side, for Mr. Smith, is that he cannot be blamed for the economic problems that took place at the same time.

Today's capitalists claim that every advancement and technological development that has occurred over the last 100 years and more is because of capitalism.  They simultaneously claim that just about every economic problem that has occurred during that same time is not because of capitalism but because of some level of government interference in the market, and some go as far as to say that the presence of government interference means that capitalism was not actually in practice. This is a self-contradiction. If capitalism was not in practice, it cannot take credit for the advancements. If it was in practice, then it failed to raise up the poor as today's capitalists claim it does.