Good Capitalism, Bad Capitalism

William J. Baumol

Robert E. Litan

Carl Schramm

Many people assumed that when the Berlin Wall fell in 1989, “capitalism” had won the ideological cold war and that “communism” had lost. But, while “capitalism” – defined as an economic system built on private ownership of property – clearly has prevailed, there are many differences among the nearly 200 countries that now practice it in some form.

We find it useful to divide the capitalist economies into four broad categories. While many economies straddle several of these, most economies fall primarily into one of them. The following typology helps explain why some economies grow more rapidly than others.

Oligarchic capitalism exists where power and money are highly concentrated among a few. It is the worst form of capitalism, not only because of the extreme inequality in income and wealth that such economies tolerate, but also because the elites do not promote growth as the central goal of economic policy. Instead, oligarchs fix the rules to maximize their own income and wealth. Such arrangements prevail in large parts of Latin America, the Arab Middle East, and Africa.

State-guided capitalism describes economies where growth is a central economic objective (as it is in the other two forms of capitalism), but attempts to achieve it by favoring specific firms or industries. Governments allocate credit (through direct bank ownership or by guiding credit decisions by privately owned banks), provide direct subsidies and/or tax incentives, grant trade protection, or use other regulatory devices in an attempt to “pick winners.”

Southeast Asian economies have demonstrated great success with state guidance, and, until the late 1990’s, there were calls in the United States to emulate their practices. But the Achilles heel of state guidance is that once such economies near the “production-possibility frontier,” policy makers run out of industries and technologies to copy. When government officials rather than markets then try to choose the next winners, they run a great risk of choosing the wrong industries, or channeling too much investment – and thus excess capacity – into existing sectors. Such a tendency contributed significantly to the Asian financial crisis of 1997-98.

Big Firm or managerial capitalism characterizes economies where large firms – often so-called “national champions” – dominate production and employment. Smaller enterprises exist, but are typically retail or service establishments with one or only a few employees. Firms get to be large by exploiting economies of scale, refining and mass-producing the radical innovations developed by entrepreneurs (discussed next). Western European economies and Japan are leading exemplars of managerial capitalism, which, like state guidance, also has delivered strong economic performance.

But managerial capitalism, too, has its Achilles heel. Bureaucratic enterprises are typically allergic to taking big risks – that is, developing and commercializing the radical innovations that push out the production-possibility frontier and generate large sustained jumps in productivity and thus in economic growth.

Large firms are relatively risk-averse not only because they are bureaucracies, with layers of management required to sign off on any innovation, but also because they are reluctant to back innovations that threaten to render obsolete the products or services that currently account for their profits. In our view, the limits of managerial capitalism explain why, after approaching US levels of per capita income in the late 1980’s, both Western Europe and Japan failed to match America’s information-technology-driven productivity resurgence that began in the 1990s.

This leads to the fourth type: entrepreneurial capitalism . Economies in which dynamism comes from new firms historically have commercialized the radical innovations that keep pushing out the production-possibility frontier. Examples from the last two centuries include such transformative products and innovations as railroads, automobiles, and airplanes; telegraph, telephones, radio, and television; air conditioning; and, as just noted, the various technologies responsible for the IT revolution, including both mainframe and personal computers, routers and other hardware devices, and much of the software that operates them.

To be sure, no economy can realize its full potential only by having entrepreneurial firms. The optimal mix of firms contains a healthy dose of large enterprises, which have the financial and human resources to refine and mass-produce radical innovations, along with newer firms.

It required Boeing and other large aircraft manufacturers, for example, to commercialize what the Wright Brothers pioneered, or Ford and General Motors to mass-produce the automobile, and so on. But without entrepreneurs, few of the really bold innovations that have shaped our modern economy and our lives would be in place.

The challenge, then, for all economies seeking to maximize their growth potential is to find the right mix of managerial and entrepreneurial capitalism. Economies where entrepreneurs now flourish must not become complacent. State-guided economies can continue their rapid growth path, but ultimately they will need to make a transition to a suitable blend of the other two forms of “good capitalism” if they want to continue rapid growth.

India and China, each in its own way, is already moving in this direction. The hardest challenge will be for economies mired in oligarchic capitalism to accomplish a similar transition. It may take nothing less than revolution – ideally peaceful, of course – to replace the elites who now dominate these economies and societies, and for whom growth is not the central objective.