As a socio-economic system, capitalism is a relative newcomer to the world stage, having emerged only within the last 500 years. During its relatively brief life, however, it has grown to occupy a dominant position in the global social economy and has become the de facto model for business, finance and government economic policy.
Major economic thinkers such as Adam Smith, Robert Malthus, David Ricardo, Karl Marx, John Maynard Keynes and Joseph Schumpeter pondered capitalism and sought to explain its complexities and contradictions. Thanks in large part to their ideas, the capitalist system has been reformed and refined over recent centuries, adapting itself into a global powerhouse and subsuming all its weaker siblings into its web of markets. Since the end of World War II, its economic performance is off the charts compared to historical counterparts, producing widespread prosperity at a level previously unknown. Competing economic systems, including communism, have been weighed in the balance and found wanting.
So what is capitalism? On the one hand, it might simply be viewed as a sound economic system whereby each of us reaps the benefit of our own labor. Under a capitalist system, someone who is willing to work hard and do a job well will likely prosper more than someone who is lazy or who takes shortcuts. But of course, there’s much more to it than that. Capitalism is an economic manifestation of people’s natural desire for financial well-being. Unlike in other systems, however, this is made possible by competition, which encourages the pursuit of self-interest—often at the cost of someone else’s interests and well-being.
It Was Not Always So
It may be hard to imagine a time when capitalism was not the economic engine of wealth and prosperity. A quick review of history will help explain how the system came to be what it is today. And by studying its past, capitalism’s future may also become clearer and more predictable. Up to now, its attractiveness as a socio-economic system has only increased. Even China, the final holdout from the communist system (excluding the reclusive totalitarian regimes of North Korea and Cuba) has effectively succumbed to capitalism’s temptations and embraced a free-market economy. As with the former Soviet Union’s effective collapse and capitulation to capitalism’s dominance two decades ago, China has accepted the inevitable and joined the world-dominating system.
But what was the world like before capitalism? How did society function economically, and what rules governed life in terms of money, trade and wealth?
Although economic life was strikingly different in almost every respect, an observer with the benefit of hindsight can see the seeds of capitalism beginning to germinate around 1500. Exploration, overseas trade and nationalism were all conducive to the emergence of a new system. Primarily a western European invention, its markers emerged around the end of the Middle Ages. As crude as medieval society was, it did provide the foundations for capitalism to build on: towns, a farm-to-market system, usable roads, a market structure that allowed for buyers and sellers, and a means to account for business transactions—namely, double-entry bookkeeping.
Land, the principal form of capital during this period, was controlled by royalty, the aristocracy or the Catholic Church, which for example is said to have owned at least a quarter of English land until Henry VIII confiscated its monasteries in the early 16th century. Wealth, not surprisingly, was often defined in terms of land use, primarily agriculture. However, as 20th-century economist Robert L. Heilbroner points out in The Worldly Philosophers, “although land was salable under certain conditions (with many strings attached) it was not generally for sale.”
But if land was in some respects salable, labor was not. Serfs, apprentices and journeymen had only limited rights, and work was highly structured and controlled. Peasant laborers were unable to acquire land and therefore unable to make independent decisions that would produce wealth. Heilbroner notes further that precapitalistic society did not embrace the concept of making a living. Work was not a means to an end but an end in itself. For the working masses, economic and social life were one and the same. And wealth continued to be concentrated in the hands of the powerful and influential few.
Mercantilism and Hegemony
From the 1500s to the 1700s, inevitable economic changes began to take shape. The wealth of a nation came to be measured by two things: trade and gold. As each nation tried to strengthen its economic position in the growing world, it developed nationalistic economic policies that eventually coalesced into a system known as mercantilism. Mercantilists measured national wealth primarily in terms of money and precious metals (from which money was coined). Unless a country could obtain precious metals from the New World, the only road to national wealth was to maintain a favorable balance of trade; that is, selling more merchandise than they bought. It was a simple calculation. Because of this, nations kept wages low and encouraged population growth to ensure their continued ability to produce sufficient exports at low prices. The resulting benefits and prosperity, however, did not flow down to the average citizen, who remained poor and overworked. Machiavelli had described (and idealized) just such a condition in The Prince (1513), proposing that in a well-organized government, the state should be rich and the citizens poor.
The increasing competition between nations would have long-term geopolitical implications, but by the 18th century, wealth was still controlled by the privileged few. One thing was clearly changing, however: capital was no longer restricted to the ownership of land. Merchant trade was assuming a more dominant role, as was the importance of financial capital. In other words, the concept of wealth and power was now shifting away from land to trade. The emergence of banking and the rise of a merchant class between the upper and working classes represented important advances for capitalism. Michel Beaud, retired professor of economics at the University of Paris VIII, observes in A History of Capitalism, 1500–2000: “The way was opened to the idea that the wealth of the kingdom depended on the wealth of the merchants and manufacturers.”
Even with these advancements, society still suffered from the chronic problem of underemployment of capital. There were simply too few avenues available for the emerging capitalists to turn a sufficient profit. For wealth to be distributed more evenly in society, more opportunities for profit would have to be created. The emerging long-distance ocean trade, made feasible by the invention of the chronometer and the accurate calculation of longitude, was one such opportunity.
The Rise of the Merchant
Merchants were lured by potentially astronomical returns from shipping trade with Africa, India and the New World, but they balked at the risks. Confronted with this dilemma, the ever resourceful merchants and financiers invented a truly ingenious device, the “joint-stock company,” predecessor of the modern corporation. The Dutch East India Company (1602) was Europe’s first effective joint-stock company, becoming the largest single employer in the Dutch republic in the 1660s. According to Liah Greenfeld in The Spirit of Capitalism, by 1650 the capital return to Dutch East India Company investors was 500 percent.
This important innovation provided two essential elements that would foster capitalism’s development: the sharing of risk, and limitations on personal liability. Now merchants could pool their money and share the risk of long-distance ocean trade, thereby limiting their personal liability.
Even better, though, would be using someone else’s money to fund these joint ventures. To fill this demand, the commercial and investment banking system began to coalesce at the beginning of the 1600s. According to Greenfeld, the Bank of Amsterdam, founded in 1609, “provided merchants with both a most efficient means to settle large accounts and with security.” Borrowed money, or leverage, would become an indispensable part of capitalism, allowing merchants to assume risks and enter business deals that they could not or chose not to enter into using solely their own capital.
At around the same time, investors also concluded that simply being able to invest and withdraw capital in a joint-stock company wasn’t good enough. Why not trade or negotiate one’s interest on an open exchange? The concept of trading the ownership of capital became a reality with the establishment of the Amsterdam Stock Exchange in 1602. Early stock exchanges provided the initial underpinnings of the modern-day temple of capitalism, the stock market.
We can now see most, though not all, of the components of capitalism coming together in a recognizable form. Merchant commerce, banking, the joint-stock company structure and the stock exchange laid the key foundations, but for capitalism to emerge in its current form, two more things were needed: a revolution in economic thought and a revolution in politics. Both were provided in the latter part of the 18th century. Adam Smith would publish An Inquiry Into the Nature and Causes of the Wealth of Nations, and the American colonies would declare themselves independent of Great Britain, both in 1776. Capitalism now had the political system it needed to flourish, and democracy had the economic vehicle it needed to fulfill its pledge of “life, liberty and the pursuit of happiness.”
Smith fundamentally changed the understanding of how society produced wealth. He viewed wealth as the sum of the goods consumed by all people in society. These observations were revolutionary. Prior to this, the ownership of capital and the benefits of the economy were restricted to the privileged elite. Smith recognized, for the first time, the importance of the consumer (each individual in society) in the formation of wealth. In the deft stroke of a pen, he dealt a deathblow to mercantilism.
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”
Capitalism is, in essence, a democratic philosophy of wealth. The individual lies at the heart of capitalism. Smith believed that the individual’s self-interest, in an environment of similarly motivated individuals, would result in competition. It was this market competition that would provide the goods that society wanted, in the quantities it desired, and at prices that it preferred to pay. He observed in The Wealth of Nations, “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” Smith found in the mechanism of the market a self-regulating system for society’s orderly provisioning. He summed up the consumer’s preeminent position within capitalism by stating, “Consumption is the sole end and purpose of all production.” However, his knowledge and experience were limited to 18th-century England, so he did not (and could not) foresee the changes and difficulties that would come from the industrial revolution of the 19th century.
The Industrial Revolution
It was during the 19th century that economics earned the moniker “the dismal science,” thanks in part to Thomas Robert Malthus. The “Malthusian peril” predicted that population would eventually outstrip all possible means of existence. Malthus observed that “famine seems to be the last, the most dreadful resource of nature.” His contemporary, David Ricardo (who was an optimist compared to Malthus), described capitalism in terms reminiscent of an escalator, in that some got a ride to the top while others were shoved to the bottom. Those who got past the furious struggle for a place on the stairs found that life at the top was not easy either.
“Had population and food increased in the same ratio, it is probable that man might never have emerged from the savage state.”
In defense of Malthus and Ricardo, both formed their views in England during the first half of the 19th century, where the situation was, in a word, gloomy. The Industrial Revolution was in full swing, and the average laborer endured horrendous conditions, with 16-hour workdays and child labor as the norm.
The Industrial Revolution resulted in the rapidly increased urbanization of society. As often happens, the people displaced from the land provided a ready source of cheap labor for industry; and industry, in turn, provided the means for increased farm production through mechanization.
A second result was mass emigration to the United States, where a more vibrant form of capitalism would emerge. Unlike Europe, America had no feudal society to abolish, and the Civil War in the 1860s destroyed the economic base of the landed aristocracy of the south, encouraging industrialization and setting the stage for economic expansion.
But the Industrial Revolution in England would also produce an influential antagonist of capitalism: Karl Marx. The father of communism became the sworn enemy of capitalism, seeing it as the vehicle for the exploitation of workers (the “proletariat”) by the “bourgeoisie.” Marx believed that capitalism contained the seeds of its own destruction and would inevitably collapse, giving rise to the classless proletariat state. Reality proved otherwise, with the Kremlin hierarchy assuming the power and rank of the bourgeois ruling class. Marx also made a fundamental error in assuming capitalism to be static, and he was unable or unwilling to perceive the potential for its mutations. But the system would soon demonstrate its ability to transform itself when threatened.
Capitalism Learns to Travel
Capitalism had inadvertently created a problem for itself in its inequitable distribution of wealth. And so during the 19th century, it adapted yet again to ensure its continued growth. The problem was that the poor wanted to consume, but lacked the money. The wealthy had the money, but did not have the physical capacity to consume their proportionate share of economic production. Therefore the wealthy had to save or invest their excess wealth. But it made no sense to invest domestically to produce shoes if there were already more shoes than they could use.
The solution? Invest overseas. Imperialism is far more of a capitalistic than a nationalistic phenomenon; through it capitalism demonstrated its ability to displace competing noncapitalistic economic systems. The imperial age of overseas expansion was, in reality, the internationalization of capitalism. It would lead to the multinational corporation, with its transplantation of production facilities overseas in the inexhaustible search for cheap labor and raw materials.
The imperialism of the 19th and 20th centuries would result in numerous wars, dramatically altering the geopolitical landscape and power structures of the day. Not surprisingly, the most capitalistic of nations, the United States of America, would emerge in a dominant position and become the economic engine for the world, establishing rules by which all other nations would play. However, this would not occur without some significant pain and suffering, in the form of the Great Depression of the 1930s, followed by World War II. During that dark period, when both the economy and liberty itself seemed to hang in the balance, no one could have imagined the economic prosperity to come, as capitalism drove the world economy into the 21st century.
And that’s where we’ll pick up in Part 2.