Unit 1 Prosperity, inequality, and planetary limits

1.12 Varieties of capitalism: Institutions, government, and politics

Not every capitalist country is the kind of economic success story exemplified in Figure 1.1 by Britain, later Japan, and the other countries that caught up. Figure 1.19 tracks the fortunes of a selection of other countries during the twentieth century. In Africa, the success of Botswana in achieving sustained growth contrasts sharply with Nigeria’s relative failure to do so. Both are rich in natural resources (diamonds in Botswana, oil in Nigeria), but differences in the quality of their institutions—the extent of corruption and misdirection of government funds, for example—may help explain their contrasting trajectories.

The star performer in Figure 1.19 is South Korea. In 1950 its GDP per capita was the same as Nigeria’s, but by 2013 South Korea was six times richer than Nigeria by this measure.

developmental state

A government that takes a leading role in promoting the process of economic development through its public investments, subsidies of particular industries, education, and other public policies.

South Korea’s take-off occurred under institutions and policies sharply different from those prevailing during the take-off in Britain. The most important difference is that the South Korean government (along with a few large corporations) played a leading role in directing the process of development, explicitly promoting some industries, requiring firms to compete in foreign markets and providing high-quality education for its workforce. The term developmental state refers to cases like South Korea, Japan, and China, where the government plays a leading role in economic take-off.¹

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https://www.core-econ.org/microeconomics/01-prosperity-inequality-12-capitalism-varieties.html#figure-1-19

Figure 1.19 Divergence of GDP per capita among latecomers to the capitalist revolution (1928–2018).
Note: Former Soviet Union series excludes Russian Federation post-1992.

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Jutta Bolt and Jan Luiten van Zanden. 2020. Maddison Project Database, version 2020. ‘Maddison style estimates of the evolution of the world economy. A new 2020 update’.

In 1928, GDP per capita in the Soviet Union was a third of that in Argentina, and higher than in Brazil and South Korea. Communist central planning produced steady growth for nearly 50 years, outstripping Brazil by a wide margin and even overtaking Argentina before Communist Party rule ended in 1990.

One reason why central planning was abandoned as an economic system was its failure—as illustrated by the case of East Germany—to deliver the improvements in living standards achieved by some capitalist economies. Yet the transition to a new economic system in the former Soviet Union following the collapse of communism proved very costly. Dismantling the planned economy and creating functioning market economy institutions, including the rule of law, in the successor economies was accompanied by a deeper and more prolonged decline in per capita output than observed in the Second World War, the global financial crisis, or the COVID-19 pandemic.

When is capitalism dynamic?

The lagging performances of some economies in Figure 1.19 demonstrate that the existence of capitalist institutions is not enough, in itself, to create a dynamic economy—that is, an economy that brings sustained growth in living standards. Two sets of conditions affect the dynamism of the capitalist economic system. One set is economic; the other is political, and concerns the government and the way it functions.

Economic conditions

The potential advantages of capitalism will not be realized if:^2 3

• Private property is not secure: There is weak enforcement of the rule of law and of contracts, or expropriation either by criminal elements or by government bodies.
• Markets for firms’ output are not competitive: Firms lack incentives to produce efficiently, expand, and innovate.
• Firms are controlled by people who owe their positions to connections to government or privileged birth: They did not become owners or managers because they were good at delivering high-quality goods and services at a competitive price. The other two failures would make this more likely to occur.

Failures of the three institutions of capitalism can mean that individuals and groups gain more from lobbying and criminal activity to shift the distribution of income in their favour, than from the direct creation of economic value.⁴

Capitalism is the first economic system in history in which membership of the elite often depends on economic performance. A feudal lord who managed his estate poorly was just a shabby lord. But firm owners who fail go bankrupt—and a bankrupt owner is an ex-owner. The discipline imposed by market competition—produce and sell good products profitably, or fail—is automatic. Competition provides a mechanism for weeding out firms and individuals who underperform.

Of course, if the owners and managers of capitalist firms are initially wealthy or well connected politically, they may survive despite their failures. And, as Adam Smith pointed out, capitalism brings with it powerful incentives for firms to reduce the competition they face. But there are no guarantees: staying ahead of the competition means constantly innovating.

Political conditions

Government is also important. Irrespective of the extent of their direct involvement in the economy, governments establish, enforce, and change the laws and regulations that influence how the economy works. Markets, private property, and firms are all regulated by laws and policies.

A well-functioning legal system is essential for markets to work well. Governments adjudicate disputes over ownership and enforce property rights, and they establish the regulations that prevent firms from undermining market competition by colluding with each other or engaging in unfair competitive practices.

In addition to supporting the institutions of capitalism, the government provides essential goods and services such as physical infrastructure, education, and national defence. In this book, we investigate why government policies in such areas as sustaining competition, taxing, and subsidizing to protect the environment, thereby influencing the distribution of income, the creation of wealth, and the level of employment and inflation may also make good economic sense.

Political systems

political system

A political system determines how governments will be selected, and how those governments will make and implement decisions that affect all or most members of a population.

democracy

A political system that ideally gives equal political power to all citizens, and which is defined by individual rights such as freedom of speech, assembly, and the press; and fair elections in which virtually all adults are eligible to vote, and the government leaves office if it loses.

One of the reasons why capitalism comes in various forms is that it coexists with different political systems. A political system, such as democracy or dictatorship, determines how governments are selected, and how those governments make and implement decisions that affect the population.

Capitalism emerged in Britain, the Netherlands, and most of today’s high-income countries long before democracy. In no country were most adults eligible to vote before the end of the nineteenth century (New Zealand was the first). Even in the recent past, capitalism has coexisted with undemocratic rule, as in Chile from 1973 to 1990, Brazil from 1964 to 1985, and Japan until 1945. Contemporary China has a variant of capitalism with a high level of state intervention, but its system of government is not a democracy by our definition. In many countries today, however, capitalism and democracy coexist, each system influencing how the other works.

Like capitalism, democracy comes in many forms. The head of state may be elected directly by the voters, or by an elected body, such as a parliament. Some democracies strictly limit the ways in which individuals can influence elections or public policy through financial contributions; in others, private money has great influence through contributions to electoral campaigns, lobbying, and even bribery.

These differences even among democracies are part of the explanation for governments’ differing roles in the capitalist economy. The Japanese and South Korean governments play a central role in setting the direction of the economy. But the amount of tax collected (both locally and nationally) is low compared with some rich countries in northern Europe, where it is almost half of GDP. In Sweden and Denmark, the tax system is used to reduce income inequality to a far greater extent than in Japan and South Korea.