Despite its ability to generate prosperity, capitalism is under attack. By shaking up our long-held assumptions about how and why the system works, we can improve it.
September 2014 | by David Delaney, Chief Financial Officer
Capitalism is under attack. The financial crisis of 2008, the stagnation of the middle class in many developed countries, and rising income inequality are challenging some of our most deeply held beliefs about how a fair and well-functioning society should be organized. Many business leaders are of two minds about the situation. They note that market capitalism has yielded massive increases in human prosperity, particularly in the West in the 19th and 20th centuries. More recently, it has lifted hundreds of millions from poverty in emerging economies. Yet despite these historic accomplishments, it’s also easy to worry that something is wrong with how the system is performing today.
This article will argue that while we have been correct to believe that capitalism has been the major source of historical growth and prosperity, we have been mostly incorrect in identifying how and why it worked so well. By analogy, our ancestors did know that the stars and planets moved in the sky and had various theories to explain their observations. But it wasn’t until the Copernican model replaced the Earth with the sun at the center of the solar system and Newton articulated his laws of gravitation that people understood how and why they move.
The Role of Business
Every business is based on an idea about how to solve a problem. The process of converting great ideas into products and services that effectively fulfill fast-changing human needs is what defines most businesses. Thus, the crucial contribution business makes to society is transforming ideas into products and services that solve problems.
This sounds simple and obvious, and many executives would say, “Of course that is what we do.” But again, that is not what standard theory says businesses should do. In the 1970s and 1980s, academic work based on neoclassical theory argued that maximizing shareholder value should be the sole objective of business. If corporations just did this, said these professors, they would maximize overall economic efficiency and social welfare. This focus did correct some deficiencies in the previous system, most notably by empowering shareholders to push back against CEOs who maximized the size of their empires rather than economic returns.
But some argue that elevating the creation of shareholder value to the status of primary objective is based on a faulty assumption—that capital is the scarcest resource in an economy, when in reality it’s knowledge that’s the scarce, critical ingredient in solving problems. It has also led to a myopic focus on quarterly earnings and short-term share-price swings, to say nothing of a decline in long-term investment. This is in startling contrast to the attitudes of even the recent past. If you asked a CEO in the 1950s, an era of tremendous prosperity growth, what his job was, his first reply would probably have been “to make great products and services for customers.” After that, the CEO might have said something about looking after his company’s employees, making profits to invest in future growth—and then, finally, giving the shareholders a decent, competitive return.
Once we understand that the solutions capitalism produces are what creates real prosperity in people’s lives, and that the rate at which we create solutions is true economic growth, then it becomes obvious that entrepreneurs and business leaders bear a major part of both the credit and the responsibility for creating societal prosperity. But standard measures of business’s contribution—profits, growth rates, and shareholder value—are poor proxies. Businesses contribute to society by creating and making available products and services that improve people’s lives in tangible ways, while simultaneously providing employment that enables people to afford the products and services of other businesses. It sounds basic, and it is, but our economic theories and metrics don’t frame things this way.