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The Institutions of Capitalism And Their Decay

China is not capitalist. Neither are India, Brazil, Greece. It would be a stretch to call all of the OECD member countries capitalist. I doubt whether Japan or Spain really belong in the category. Even countries I call capitalist are all borderline cases.

Though many pre-capitalist countries are progressing in their transitions to capitalism, it is clear capitalism is in regression or decay in several core capitalist countries.

Understanding capitalism as an institutional system could be a step in the direction of identifying what went wrong and how to cure the crisis in advanced societies.

The definition of capitalism’s impersonality:

All the elements of a new “institutional” definition of capitalism rest on a single hard-to-grasp hard-to-tolerate concept, possibly the most outrageous concept ever produced by social science. Capitalism is characterized mainly by the “impersonality” of its institutions.

Max Weber: “Today, the homo politicus, as well as the homo oeconomicus, performs his duty best when he acts without regard to the person in question, without hate and without love, without personal predilection, but sheerly in accordance with the impersonal duty imposed by his calling, and not as a result of any personal relationship.”

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Oxford Thesaurus describes “impersonal judgment” as “neutral, unbiased, nonpartisan, unprejudiced, objective, detached, disinterested, dispassionate, without favoritism”. In capitalist countries the institutions are structured toward that ideal. They have evolved, or been designed, to achieve that principle as their means to ends.

The idea is that policy which is impersonal is oriented to rules rather than persons and is therefore more predictable, more calculable.

It is the procedures of an organization that become impersonal. The procedures by which decisions are made and implemented follow formal predetermined rules. They are not swayed by the motives or emotions of persons making decisions or by the interests of particular persons or groups of persons affected by decisions.

A state impersonal procedural norm = procedurally impersonal government.

State processes are governed by *general* rules for formal equality of treatment, deliberately and without discretion or special treatment.

Institutions of an impersonal state are suffused, in Max Weber’s description, with “the horror of privilege and the principled rejection of doing business from case-to-case”.

The idea is similar to the “generality principle” of Public Choice economics which supports rules-based “nondiscriminatory” policies applied without privilege to any group.

Impersonality is the most comprehensively difficult goal that public policy can be required to pursue. Can you even imagine a government that treats everybody equally? Think of the simplification. Think of the revolutions it would require in, for example, taxation, welfare, or industrial policy. Capitalist societies head in that direction; impersonality is the defining characteristic of their institutions, and it is hard to sustain.

The inadequacy of purely economic definitions:

The commonplace dictionary definition says capitalism is “an economic system in which the production and distribution of goods depend on invested private capital and profit-making [and] the dominance of private owners of capital and production for profit”.

In one sense clearly this is true. But there is too much variety there. It could include countries where rule of law is absent. There is private capital and profit making in China, but not systemic protection of private property rights. Understanding capitalism means knowing the factors sustaining long run economic growth, which are institutional.

A lot of people think capitalism means the growth of the market dynamic. But the market grew phenomenally many centuries ago in early-modern Asia and Europe. It would be more accurate to say that capitalism = market freedom. But market freedom only exists -- is only sustainable (and legitimate) -- if it is regulated by very special institutions.

I’ve tried for ten years to think of an alternative name for capitalism. Because in my definition “capitalism” is an entire *social* system -- a market society -- the best name for it would be “socialism”. Unfortunately that name is already taken by people who imagine a *state* system. In the end, therefore, capitalism is the best name. When someone tells you they support or oppose capitalism you more or less know what they are saying.

What are capitalism’s institutional domains?

1. Law: a universal accessible calculable legal system enshrining rights of opportunity and fair dealing, especially enforcement of property and contract rights on behalf of plaintiffs.

2. Administration: the organization of a service state with impartial processing procedures for consistent objective decision-making and minimal case-by-case discretional powers.

3. Representation: impersonal formal procedures for competitive free selection of policies and leaders. Parliament or equivalent is the final source of authority in all state domains.

The caveat is “ideal types”. Capitalist countries vary in their approximation to ideal type. Ideal type is a rational forward projection, derived empirically from existing reality.

What is a pre-capitalist state?

Many countries have the formal organizational facade of the depersonalized state. Behind the surface decision-making is systematically ad hoc, discretionary, informal, face-to-face, rentist. Influence is by interpersonal connection and the networks of interest groups. There are various labels for this kind of state, such as patrimonialism or clientelism.

1. The *legal* precondition of capitalism:

Continuity of economic relationships is the condition for the sustainability of profit making. Informal economic ethics -- which evolved into law -- did not guarantee continuity. Wherever markets are highly developed there is a concomitant diminishment of ambiguity and arbitrariness in economic regulation. Repeated, extensive, and complex exchange, production, and financing require a calculable legal system as arbiter of last resort.

Laws protect business enterprise from being compelled to undertake an exchange, and guarantee the legitimacy of the methods by which the exchange occurs. Economic transaction in an advanced exchange system requires at least a perception that the legal security of property and contractual claims need not be repeatedly tested.

Capitalism is a transition to validly enforced rules of the game for market competition.

Max Weber’s subtle and careful definition of “market freedom” in competition:
“the complete appropriation of all material means of production by owners and the complete absence of all formal appropriation of opportunities for profit in the market”.

Formal equality in law. By standardizing consensual understanding with third party enforcement the legal machinery becomes the impersonal backstop to resolve conflict of interest, to discourage malfeasance, and protect competition from monopolistic closure.

Formally binding economic rights, codes, procedures operate independently of parties, enterprises, agencies. They cannot be appropriated by an individual, group, or class.

2. The *public administration* precondition of capitalism:

A service state’s actions are delimited by impersonal selection of personnel and policies. Procedure requires formally equal treatment and opportunity for state incumbents and state clients. Conduct is continuous, consistent, i.e. calculable. State purposes are oriented to well-understood procedures for formulating and implementing policy.

Officials are effective because they act with minimum regard to personal relations, feelings, or popularity, but rather with maximum regard to assigned duties, circumscribed powers, and technical competence. The powers of officialdom do not rest on accumulation of political or material assets or the personality of officials. Instead power accumulates with expertise, aptitude, and the knowledge assets for leadership and administration.

Routine authority of state agencies is based on the principle of “equality before the law”. The creed of a service state is the criteria of “general” rather than “case-by-case” decision.

Eliminating incentives for private or group interests in public agencies means reducing the risks related to official discretion. Modern states introduce delegated policy discretion only in proportion to a demonstrable increase in the state capacity for impersonal action.

State responsiveness and flexibility requires minimizing state functions to core public services and power objectives. By limiting direct interventions the state increases its control and adaptive efficiency. It thereby reduces collusion and evasion.

States that do not achieve substantial procedural impersonality are those that have extended too far beyond primary functions of legal regulation, natural monopoly infrastructure, and monetary and fiscal policy.

3. The *representational* political precondition of capitalism:

Free representation with voluntary association and the competitive selection and training of leaders and policies is most developed in the modern parliament or equivalent.

Representatives are recruited to exercise their influence and authority over their voters and retain their autonomy only for as long they prove their electoral worth.

Features of the rules-based political system are calculability of procedures, formal mechanisms for comprise, and committee work with representation by experts. Pervasive competition mechanisms ensure reputations and expertise of political leaders are perpetually tested. This system weeds out the demagogues and dilettantes.

Procedural impersonality with safeguards against monopolistic closure are the prerequisites for free representation in modern parliament. Somewhat like competitive economic enterprises in the market, political parties exercise their domination within the law. Political battlefields, like markets, need formal rules.

Two important functional characteristics of modern representation are (a) systematic supervision of the public bureaucracy by parliament, and (b) elimination of systematic representation in parliament on behalf of economic or other interest groups.

The totality is the *interaction* of the institutional domains:

In capitalism each of these three evolved institutional domains has a role in monitoring and regulating each of the other two spheres.

The majority of the world’s pre-capitalist countries have facades of the institutions of law, administration, and representation, but separately and dysfunctionally. Only capitalism has them together and functionally.

Capitalism is a procedural solution to the problem of spontaneously coordinating durable public institutions of market society. The invisible hand is the impersonal procedural norm. The norm is a coordination surrogate. This procedural norm shared by all three domains gives predictability or calculability in the absence of any single coordinating institution.

For example, if a new property right or welfare reform is adopted it must prove itself economically efficient, enforceable in law, administratively feasible, as well as politically legitimate. In evaluating the relative merits of that innovation, decision makers in all the institutional spheres are all oriented to identical general (impersonal) rather than particularistic (discretionary) criteria.

The organizationally and functionally segmented domains of law, administration, and representation depend reciprocally on one another. If one sphere loses or gains power disproportionately to the others the system will weaken. Crisis results.

Paradoxically, as Max Weber observed, this objective instability created by separate spheres of authority within the state “introduces an element of calculability favourable to the formal rationalisation of economic activity”.

Now there are signs of *decay* in the capitalist institutions:

In the current crisis it is quite easy to use the framework outlined here to explain the institutional decay of advanced capitalist societies in terms of disproportionality in the interactions between the institutional spheres.

Using conventional language, there were two broad sets of problems in advanced societies -- (a) excessive yet foreseeable vulnerability to large-impact crisis as a result of fiscal indiscipline and over-expanded state welfare functions, resulting finally in sovereign debt crises (b) lags in structural reform and the failure to enforce disciplines of market freedom which should have preserved more robust economies, flexible labour markets and the safety valve of ongoing creative destruction in banking and other sectors.

Put more simply. Governments became captive to the political cycles of welfare states. Politics became overburdened far beyond its safety-net function. Governments intruded in markets to protect economic enterprises, shielding them from market clearing. Regulation became complex and detailed. Supply-side liberalizing reform never got properly done.

Actively spontaneous coordination between law, administration, and representation broke down in ways foreseen by Public Choice constitutional economics. For example, balanced budget constitutional requirements were not introduced or not enforced. Discriminatory political constraints on market freedom prevented the natural Darwinian extinction of failed enterprise and produced a dangerous build-up of risky enterprise in the system.

The impersonal procedural norm was not sufficiently operative. There was too much discretion in state welfare provisions and financial rescues and, as a consequence, insufficient calculability and predictability of outcomes.

Weberian and Schumpeterian analysis warned of danger zones:

- discretionary intervention by market-ignorant state administrators
- government failure to foster the robust economics of market failure
- discretionary monetary and fiscal policy which diminishes predictability
- administrative money creation dictated by the mood of the bureaucracy
- excessive legalism, complexity and detail in economic regulation
- insufficiently simple parametric constitution-level market rules
- letting the legal profession capture the legal process
- insufficient autonomous leadership over the demos by political representatives
- complexity and unpredictability of the tax burden
- discretionary tax and spend systems as tools of social engineering
- inadequate budgetary and functional control of administration by parliament
- welfare policies saddled on the state by interest groups
- welfare policies usurped by the state for reasons of power or ideology
- capture of politics by interest groups hostile to structural reform

All of these have unintended consequences too.

The lists could go on and on, but this post must finish.

The impersonal invisible hand mechanism which the three large institutional spheres had begun last century to learn to use to monitor and regulate each other broke down or regressed. Intellectual complacency may be the principal cause. Capitalist countries stopped teaching the impersonal procedural norm to new generations.

Pre-capitalist countries like China which have yet to reach the point at which law, administration, and representation are interactive have a clear future to look forward to. The capitalist countries should perhaps look back to see where they lost sight of the path, and then forward with fresh insight.

Today’s students of capitalism have university libraries with excellent but dusty neglected how-to capitalism instruction books written in the early and mid-twentieth century.

Too much discretion at the margin and inadequate boundary rules at the centre make capitalism an unhappy place to be.

This blogpost proposed no fixes, and only hints at solutions.

Radically simplify governance.
Automate governance wherever possible.
Replace plethoras of regulations with constitution-level rules.
Take unnecessary welfare burdens off representational politics.
Foster private insurance innovations that devolve risk back to individuals.

Be skeptical of people who say such proposals are politically infeasible or would cause great suffering. They are wrong. Some are already in the statute book and only want enforcing.