Monday, August 25, 2014

Why Does Capitalism Work?

This post is about the important topic of why capitalism works. The most common answers to why capitalism works usually has to do with concepts like economies of scale, the advantages of specialization and how specialization strengthens economies, and the idea of capitalist economies being more "efficient". These reasons for why capitalism works is complete nonsense. First off, economies of scale doesn't show in the data: as firms get larger, they become more fragile. Secondly, specialized economies are not a sign of strength but a sign of weakness as small shifts in international supply/demand in the aggregate or in a few goods can cause the economies to blow up. Thirdly, economic efficiency means nothing without talking about geopolitical risk.

Let's start off by talking about the idea of economies of scale. As firms get larger, they usually gain a greater and greater control of the market share. This may seem like a good thing, but it's really not. Why is firms gaining a larger and larger singular share of the market not a good thing? The reason becomes clear when we look at the upside vs the downside. As firms get larger, their upside becomes limited because the markets often become saturated while the downside remains the same (they can go to zero). In other words, as firms get larger, their possible upside reaches some kind of a limit while the downside remains the same at zero. So, by definition, the larger firms become, the more fragile the firms actually become. Eventually, when firms become large enough, small shifts in consumer preferences or supply side shifts or any small shock can doom the firms. This is why, in many cases, economies with a few large firms often buy out politicians and bureaucrats while using government agencies in the name of "regulation" to start controlling economies. These kinds of ideas are what usually gets called as "free market" ideas, but this kind of economic system usually ends in a rentier economy where a few people control the entire economy. This also leads to burgeoning economic inequality as the middle class gets completely wiped out while the families of a few oligarchs run the entire society. Over the past 40 years, we've seen this procedure play out in the US starting in the late 70's and early 80's with Jimmy Carter and Ronald Reagan. These ideas are about as crony capitalist as they get.

Not only is the idea of economies of scale hogwash, but specialization in an economy isn't a sign of strength. Why is specialization not a sign of strength? Usually, this specialization argument leads to emerging markets and less developed countries (LDCs) specializing in things like commodity production. The reason is because LDCs don't have the ability to compete directly with developed countries on the production of goods and services that require capital inputs. Not only do LDCs usually specialize in commodity production or low wage labor, but we must remember that commodities and raw materials are primarily used as inputs in other economies. It's also important to note that commodity prices and the demand for raw materials is highly sensitive to shifts in the worldwide demand for raw materials, the current production levels of other countries, the geopolitical climate, and a whole host of other factors. In other words, the specialization theory actually makes economies extremely fragile as any shock can blow up these economies. Specialized economies aren't even close to robust and are often banana republics.

Expecting LDCs to remain specialized is usually used as a theoretical justification for an elite to extract rent from these much poorer countries while leaving the mass populace of these countries repressed. Diverse economies, on the other hand, are much more robust. Small shocks not only don't affect diverse economies on the same scale, but they actually strengthen diverse economies. Due to their diverse nature, economies that are diverse will experience some volatility in the system, but other industries are able to brace and even strengthen by the negative impacts caused by the shock. In diverse economies, shocks lead to volatility that allows the system to adjust rapidly and quickly--although there may be a small short term cost, the small short term costs create long term structural benefits. The people who really get hosed in a diverse economy are the rent-seeking, unproductive elite. Basically, we can think of specialized economies as being short volatility and diverse economies as being long volatility.

We must remember that economic systems codevelop with geopolitical systems. What this means is that the tradeoff between economic efficiency and geopolitical risk is an important one. It may be more "efficient" in the short run for an economy to specialize in certain types of production, but small international shocks can have a major impact for specialized economies. In other words, specialized economies are actually highly leveraged and can be extremely fragile. History hasn't been kind to highly specialized economies and has led to famines and depressions in many countries when exports or worldwide demand suddenly collapses.

So this bring us to the next question: why does capitalism work?
Capitalism works primarily because it allows an economic system the ability to adjust automatically to shocks in a decentralized and robust manner. The shocks happen instantly to any sight of volatility as short term shocks allow the system as a whole to develop longer term structural advantages. In other words, decentralized capitalist economies are robust, and even antifragile, because they adjust automatically to shocks. Centralized or centrally planned economies are often the opposite. They often get locked into single policy options while the primary players (usually a non-productive elite) often have little skin in the game and are usually worried more about covering their own ass than they are about the actual health of the economy overall.

Another strength about capitalist economies is that they're the only economies that actually have the capacity to become diverse, and thus robust. Due to the decentralized nature of capitalism, all sorts of different ideas and industries can co-develop together. As shocks hit the economy, the economy adjusts very rapidly and quickly. If something does go wrong, individual agents in the economy can come together, cooperate, and voluntarily work together in ways that centrally planned economies simply cannot. We must remember that economies are systems with many different moving parts. Having fragility at the localized level is a requirement to having antifragility, and sometimes even being robust, at the systemic level

We must understand that uncertainty plays a critical role in economic systems (and in almost all organic, complex systems). Decentralized economies can adjust to, and benefit from more uncertainty and unpredictability. Centralized systems, on the other hand, do not have the same response to uncertainty. We must also remember that centralized systems are built from the top-down, which implies that one small policy error at the top can blow the entire system to smithereens. Decentralized capitalist economies do not have to worry about the same problems because the decision making isn't centralized.

Another important note about centralized systems is that there is no volatility at the surface due to their centralized, top-down structure. In other words, there's a build-up of risk underneath the system while the system exhibits no visible risks at the surface due to the suppression of volatility. This is the exact same phenomenon we see occur in forests when all of the small forest fires of a forest are put out quickly. Flammable deadwood builds up at the forest floor and the forest fires, although they occur less often, are much larger in size, scope, and damage. This is why we see controlled burns occur in most forests that're managed by human beings now. Economic systems exhibit the exact same phenomenon because, like environmental systems, they've got an organic, bottom-up structure.

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