On September 15, 2008, John McCain, the republican candidate for president, took the stage in Jacksonville and said, “Our economy, I think is still – the fundamentals of our economy are strong…”1 Over the next month, the stock market tumbled freely – the S&P shed 40% of its value after registering its highest ever close only a year ago2. The Obama campaign quickly labeled McCain as being out of touch, and needless to say, the label stuck. What are the “fundamentals of our economy”, really? And what can we expect given its characteristics? Knowing the answers to these questions can help us clearly assess whether the prognosis offered by a particular candidate is actually reasonable.
The most fundamental characteristic of our economy is that it is overwhelmingly market-oriented, i.e. a capitalist economy in which private individuals and businesses make most of the decisions, and governments (both federal and state) buy the goods and services they require from the private marketplace3. How do we expect this system to work? According to Adam Smith, in “the system of Perfect Liberty”, individuals seeking to advance their self-interests invest their efforts (and money) and compete to meet society’s demands. Competition ensures that products are sold at prices that society is willing to pay, and in quantities society requires. When investments return profits, businesses re-invest those profits and expand, hoping to capture a larger share of the demand. This expansion usually involves employment of more people, perhaps at higher wages. Our standard of living increases. Increasing incomes further stimulate demand, and the cycle continues.
Such a description implies a steady upward climb towards prosperity in capitalism. However, in reality the behavior of the market system is more wave-like. In fact, even in Adam Smith’s time, the upward climb never lasted more than a few years. For instance, the state of the British economy has been described as “bad in 1801, good in 1802, bad in 1808, good in 1810, bad in 1815, and so on for over a hundred years”4. Likewise, following the great depression (1929-33), the US economy was in a recession in 1937, 1945, 1949, 1953, 1958, 1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, 2001, and 2007-20095. What does this reveal about our economic model? It reveals that in addition to its propensity for expansion, capitalism also has the inherent tendency to frequently contract the economy and increase social misery. In fact, except for the 1990s, every decade in the last 100 years was marked by at least two recessions.
As I mentioned before, understanding the characteristics of our model of capitalism is important because it allows us to calibrate our expectations of politicians and the government. For instance, can government really spur economic growth through its policies when it does not have the authority to make most of the decisions pertaining to the economy? How much blame do our elected representatives bear in a recession if recessions are an inherent property of capitalism? More importantly, does government have the tools to lift us out of a recession or ease social misery during a recession? If so, should it employ those tools?
To be sure, I am not contending that all these questions can be answered just by considering the two characteristics of capitalism mentioned above. Our model of capitalism has other important properties that are extremely relevant to our current debate, and we will consider them in the upcoming posts. Likewise, I haven’t even mentioned the government, the tools it wields, and how it influences our capitalist economy. There remains much to be covered…
4. Heilbroner, R. L. (1999). The Wordly Philosophers: The lives, Times and Ideas of the Great Economic Thinkers.